Commodity exchange is a centralized market for buyers and sellers of contracts related to a wide range of items. These items include agricultural goods, stocks, bonds, and foreign currencies. In the United States, the largest commodity exchanges include the Chicago-based CME Group and Atlanta-based IntercontinentalExchange (ICE). ICE acquired the New York Board of Trade in 2007. The CME Group was created in 2007 by the merger of the Chicago Board of Trade and the Chicago Mercantile Exchange. In 2008, CME Group acquired the New York Mercantile Exchange. A federal agency called the Commodity Futures Trading Commission regulates the exchanges.
Prices at a commodity exchange are set through a competitive auction process. By bringing together many buyers and sellers, the exchanges ensure that the auctions set fair prices. The prices are then sent around the world on electronic networks and later published in newspapers. Individuals can buy or sell contracts on a commodity exchange by placing orders with brokers.
Commodity exchanges handle three basic kinds of contracts: (1) cash market contracts, (2) forward and futures contracts, and (3) options contracts.
Cash market contracts.
The first major U.S. commodity exchanges opened in the mid-1800’s in such cities as Chicago and New York City. They handled the buying and selling of corn, wheat, and other farm commodities (goods). At first, these goods were traded on the exchanges only in cash markets, also called spot markets. In these markets, farmers and other traders made contracts for immediate delivery of, and payment for, a certain quantity of an agricultural product.
Relying only on cash market contracts became impractical, however, as trade grew and as many farmers attempted to deliver crops at the same time—soon after the fall harvest. At such times, the deliveries overwhelmed transportation and storage facilities, and prices of goods fell sharply due to the great supply. In the following spring, supplies could dwindle to inadequate levels, causing prices to soar.
Forward and futures contracts.
To organize agricultural buying and selling more efficiently, traders began using forward contracts. A forward contract guarantees the price of merchandise to be delivered on a future date. For example, in September a farmer can sell, and a cereal company can buy, a forward contract that promises to exchange 5,000 bushels of wheat in Chicago in the following March for $4 per bushel. Forward contracts allow farmers to space their deliveries to the markets throughout the year without worrying about the price they will receive. Also, the cereal company knows exactly what it will pay for the wheat on the future date. Reducing risk by locking in a price for a future date is called hedging.
By the 1860’s, forward trading had expanded so much that forward contracts for many commodities became standardized. The standardized agreements specified commonly used delivery dates and locations and typical quantities and qualities of goods. Today, these standardized contracts are known as futures contracts.
Both hedgers and speculators can buy and sell futures and other contracts on commodity exchanges. Speculators trade contracts in the hope of making a profit. For example, a speculator who buys a wheat futures contract for $4.00 per bushel and later sells it for $4.50 per bushel earns a profit of 50 cents per bushel. The participation of speculators in futures markets helps the markets work by raising the number of buyers and sellers.
Traders of futures contracts deposit money known as margin to back up their pledge to fulfill their obligations under a contract. Margin deposits guarantee the fulfillment of the contract, even if the contract’s market value changes or if one of the parties is unable, or refuses, to complete the deal. Each commodity exchange has a clearinghouse that holds margin in the form of a performance bond in a separate account for each trader. In addition, the clearinghouse monitors each contract’s market value, which can vary from day to day. As the value changes, the clearinghouse, in a daily process called marking to market, adds money to a trader’s account or asks the trader to deposit more money. The additional money deposited by the trader is called variation margin. By marking to market, the exchange’s clearinghouse guarantees that all contracts will be fulfilled.
Financial futures.
In the 1970’s and 1980’s, the exchanges developed futures contracts for foreign currencies, stock indexes, and bonds. These kinds of futures contracts are called financial futures.
Traders can use currency futures to hedge risk associated with changes in currency prices. Currency values can change from day to day. These changes make future currency prices hard to predict and thus increase the risk for businesses in international trade. A typical currency futures contract allows a trader to lock in the price of buying, for example, British pounds with U.S. dollars at a later date.
Traders can use stock index futures to limit risk associated with changes in stock market prices. Stock indexes are statistics that measure the level of stock prices. The value of stock index futures varies in direct proportion to changes in these indexes.
Bond prices are determined largely by interest rates. Traders therefore use bond futures to help reduce risk associated with changes in interest rates.
Businesses all over the world try to reduce risk that is connected with changes in currency values, stock prices, and interest rates. Thus, the amount of trading in financial futures contracts has grown far beyond the level of traditional agricultural contract trading. The exchanges have also introduced futures contracts for petroleum, gold, and other key commodities whose prices can be hard to predict.
Options contracts.
The exchanges began organized trading in options in the 1970’s. In 1973, the Chicago Board Options Exchange opened as a market for trading call options on major stocks. Buyers of these options acquire the right, but not the obligation, to buy a fixed number of shares of stock at a certain price at any time over a fixed period. For example, in August, an investor could buy a call option that expires in December and allows the purchase of 100 shares of a company’s stock at $75 per share. If the price of the stock rises above $75 during the period, the call option becomes valuable. Its owner may then choose to exercise the option, forcing the option’s seller to complete the deal. If the price remains below $75 throughout the period, the option buyer will not exercise his or her right.
In 1977, traders began trading put options. Buyers of put options acquire the right to sell shares of stock at a certain price at any time over a fixed period. Soon, the commodity exchanges began offering options for foreign currencies, stock indexes, bonds, and farm goods.
Like futures contracts, options contracts provide a way to minimize losses due to price changes. Assume, for example, that an investor owns bonds and plans to sell them in six months. By buying a put option, the investor guarantees a minimum selling price. The investor also leaves open the possibility that if the bonds’ price rises, he or she can ignore the put option and sell the bonds at a higher price.
