Why commodity markets were started

The first recorded instance of futures trading occurred with rice in 17th Century Japan. There is some evidence that there may also have been rice futures traded in China as long as 6,000 years ago.

Futures’ trading is a natural outgrowth of the problems of maintaining a year-round supply of seasonal products like agricultural crops. In Japan, merchants stored rice in warehouses for future use. In order to raise cash, warehouse holders sold receipts against the stored rice. These were known as "rice tickets." Eventually, such rice tickets became accepted as a kind of general commercial currency. Rules came into being to standardize the trading in rice tickets. These rules were similar to the current rules of American futures trading.

In the United States, futures trading started in the grain markets in the middle of the 19th Century. The Chicago Board of Trade was established in 1848. In the 1870s and 1880s the New York Coffee, Cotton and Produce Exchanges were born. Today there are ten commodity exchanges in the United States. The largest are the Chicago Board of Trade, The Chicago Mercantile Exchange, the New York Mercantile Exchange, the New York Commodity Exchange and the New York Coffee, Sugar and Cocoa Exchange.

Worldwide there are major futures trading exchanges in over twenty countries including Canada, England, France, Singapore, Japan, Australia and New Zealand. The products traded range from agricultural staples like Corn and Wheat to Red Beans and Rubber traded in Japan.

The biggest increase in futures trading activity occurred in the 1970s when futures on financial instruments started trading in Chicago. Foreign currencies such as the Swiss Franc and the Japanese Yen were first. Also popular were interest rate instruments such as United States Treasury Bonds and T-Bills. In the 1980s futures began trading on stock market indexes such as the S&P 500.

The various exchanges are constantly looking for new products on which to trade futures. Very few of the new markets they try survive and grow into viable trading vehicles. Some examples of less than successful markets attempted in recent years are Tiger Shrimp and Cheddar Cheese.

Futures’ trading is regulated by an agency of the Department of Agriculture called the Commodity Futures Trading Commission. It regulates the futures exchanges, brokerage firms, money managers and commodity advisors.

what exactly is a stock, anyway? When you buy stock in a company, you are literally purchasing an ownership stake in that company. Even if you own just one share of a company's stock you have a legitimate claim (albeit a very small one) on every asset and every dollar that company earns. Of course, companies sell stock to raise money, not because they want 100,000 new executive VPs.

Stocks can generally be divided up and classified according to market capitalization (size), style and sector. The market capitalization of a company is how much investors think the entire company is worth, based on the current share price times the total number of shares outstanding. In other words, if a company is trading 50 million shares of stock at $10 per share, that company is considered to be worth $500 million (50,000,000 x $10 = $500 million).

    Foreign exchange market
In recent years, the increasing division of work at international level has lead to even greater interdependence between various national economies. In particular, countries which have no raw materials and whose economy is highly specialised, depend heavily on their economic relations with other nations. 

A marked increase in economic integration leads to an increase in the number of international commercial and financial transactions. In the beginning, foreign exchange transactions were predominantly used to pay for imports and exports. Today they are used more for portfolio restructuring, direct investments and arbitrage.

The last report of the Bank for International Settlements (BIS), published in March 2005, confirms this trend. According to this study, the daily volume of foreign exchange transactions was estimated in April 2004 to be approximately 1,880 billions US dollars. Significantly, since the previous report, which dates back to 2001, the net turnover for foreign exchange transactions has gone up by some 57%.

All of these commercial and financial activities necessitate a large number of transactions which lead to payments to/from abroad and consequently an exchange of one currency for another. This is the foundation of foreign exchange commerce. The foreign exchange market is the place where the supply and demand for foreign currencies resulting from commercial and financial transactions is negotiated.   

    Organisation and financial operators   

The commercial banks play the main role in the trading of foreign currencies and money market products. They participate in almost all operations, buying or selling currencies and borrowing or lending short-term funds. From the point of view of a commercial bank, foreign exchange and money market operations take place in various ways:
a) with non banking operators (customers)
b) with other commercial banks (interbank market)
c) with other commercial banks and non banking establishments via broker intermediaries
d) with central banks.

Fundamentals of price hedging instruments

The role of foreign exchange and money market commerce is not only to allow foreign exchange transactions or to lend or borrow short-term funds. It also provides hedging instruments against price and interest rate fluctuations.
In this section, we will show one way to guard against price fluctuations: forward transactions. We are consciously leaving "options" to one side, since they are not in any case offered for trading by the MINI-FINANCIAL-MARKET.

Forward transaction
Definition: Purchasing or selling agreement for a commodity which stipulates that the delivery and the payment will take place at a later date, according to conditions agreed today. The quantity of the commodity, the date and the place of execution as well as the price, are fixed at the time the deal is entered into.

In contrast to spot operations, delivery and payment are deferred to a later date. With forward transactions, a distinction is made between forward contracts and futures. With a forward contract, the two parties freely negotiate a forward transaction and fix the duration and amount themselves. These contracts are adapted to individual requirements and are dealt over-the-counter (OTC). They have the advantage of meeting individual requirements exactly. On the other hand, the future is a standardised contract which is often quoted on exchange. The various components of the contract such as currency, amount, base price, duration, due date (e.g. only end of March, June, September and December) are laid down. The main interest in futures resides in the greater liquidity of the market. This is why they are generally better value than forward contracts.

In the beginning, only agricultural products and other commodities (e.g. precious metals and raw materials) were forward traded (commodity futures). Later, financial futures were introduced. Today, exchange rates, interest rate hedging instruments, various shares and share indexes may be forward traded.

Futures have three important functions:

a) Transfer of the price variation risk
The seller of a commodity already knows today what price he will receive for his commodity on the fixed due date. He therefore passes the risk of a price fall which may arise in the meantime to the buyer. On the other hand, he cannot profit from any increase in price of his commodity.

b) Fixing a forward price
Given that the seller knows the price that he will obtain later, he can base the calculation of his costs and production on certain fixed data. He will make optimal use of existing means and will subsequently be able to produce in an efficient manner.

c) Reflection of the market:
The futures market can provide the financial operator with important information. The prices which form on this market reflect the expectations of the operators. If one of them thinks that the current price is lower than the spot price which can be realised in the future, he will forward purchase the commodity at an advantageous price and sell it later at a higher price. In addition, the forward price should increase. However, forward prices do not indicate later market prices reliably. At the time the forward prices are fixed, all of the events which will subsequently take place are as yet unknown.

The charts below illustrate the chances of profits and the risks of losses for:
- an open position
- concluding a forward transaction

The horizontal axis shows the price of the commodity, the vertical axis shows the profit or loss

Spot foreign exchange commerce

Cash transactions are the original form of foreign exchange commerce. They are also called spot transactions. A spot transaction consists of buying or selling a certain amount in a foreign currency at a set price. Delivery and payment take place two business days after the contract is entered into (on the spot).
Spot foreign exchange transactions are made with contracting parties throughout the world. Given the different time zones, a certain time lapse is needed to execute payment orders and to make the necessary accounting entries. This is why custom dictates that delivery and payment are carried out at the latest two days after a spot transaction is entered into.

Example
The Dupont company, based in Switzerland, needs $US 10 million to pay an invoice. Mr. Dupont telephones his bank to find out the $US/CHF parity. The bank gives him a bid rate ¹⁾ and an ask rate ²⁾. The client must decide immediately whether to accept the offer, because the forex trader fixes the rate in accordance with the current market situation. If the forex trader quotes the rate $US/CHF 1.6430/1.6440, for example, this means that he is prepared to buy a dollar for 1.6430 Swiss francs and sell a dollar for 1.6440.

By accepting the offer of 1.6440, the client is indicating to the forex trader that he will buy 10 million dollars and pay 16.44 million Swiss francs to the bank. The bank will credit him with 10 million dollars with value two business days after the contract is concluded. On the same value date, it will debit the client’s account in Swiss francs.
No commission is paid for spot transactions. It is the margin between the bid rate and the ask rate which covers the bank’s costs. This margin depends, among other things, on the transaction amount ³⁾.

1) bid rate: price at which the bank buys the quoted currency (base currency).
2) ask rate: price at which the bank sells the quoted currency (base currency, also known as offered rate).
3) a currency transaction of 1 or 100 million costs the same amount.

Fixing a rate

A distinction is made in foreign exchange commerce between direct quotations and indirect quotations. In the case of direct quotations, an amount in a foreign currency is expressed in units of the national currency. So, for example, the USD/CHF rate indicates the price in francs for 1 dollar.

As regards indirect quotations, the price of one unit of the national currency or that of the contract is expressed in units of the central currency. It is predominantly the British pound and the Irish pound, the Euro, the Australian dollar and the New Zealand dollar which are quoted indirectly. The £/USD rate is the rate for one pound expressed in dollars.

The forex trader must always be informed of the most recent exchange rate fluctuations. Indeed, if he does not offer rates reflecting the market, the forex traders from other banks will try to conclude deals to their own advantage. If he offers too low a rate, the other forex traders will buy the currencies in question from him and he will then have to buy them back for more to cover his short position. However, if he quotes too high a rate, his competitors will sell him the corresponding currencies and he will then only be able to dispose of them at a lower rate.

The forex trader follows the most recent rate movements by speaking directly with colleagues from other banks, getting information from brokers or consulting electronic information systems such as Reuters or Telerate. The banks can hire a page in these systems and in this way transmit their most recent indication rates (which are used for reference by the MINI-FINANCIAL-MARKET).

In order to have a general idea of price trends, the forex trader needs to know the current rates of several banks. For this purpose, the electronic information systems include special pages (multi-contributor pages) collecting the last rates that the banks have quoted for each of the currencies. A rate remains on these pages until another bank indicates a new rate. Thanks to these information networks, the forex traders are informed at all times about the exchange rate movements on the international interbank market and they can adapt their bid and ask rates to market conditions.

In order to quote a rate to the client, the forex trader therefore refers to the indication rates of the interbank market and those used by brokers. He adds a margin to this based on the transaction amount. In this way, the bank’s costs are covered. The forex trader is also subject to pressure as regards the margin. If it is too high, the client will conclude the deal with another bank. Given the margins applied under normal conditions, he obtains the following rate approximately .

Interbank rate : amount : margin : client rate :

1.6540 / 50 CHF 500,000 + / - 20 points (1) 1.6520 / 1.6570

CHF 10 million + / - 5 points 1.6535 / 1.6555

When it comes to fixing rates for interbank transactions, a bid and ask rate is quoted for a given currency without knowing whether the counterpart wishes to buy or sell. It is therefore very important to quote the bid rate and the ask rate exactly as the following example shows:

A forex trader from bank A quotes a rate of $US/CHF 1.6540/50. The forex trader from bank B accepts this price and sells forex trader A 10 million US dollars at the rate 1.6540 against Swiss francs. At this time, forex trader A thinks that bank B is either expecting the rates to drop or that he has quoted a bid rate which is too high.

If the bank A forex trader believes that the rates will continue to rise, he will continue to quote 40/50 hoping to obtain an even greater quantity of dollars at an advantageous price. If he knows bank B well and knows through experience that it evaluates the market trend wisely, he will bring his rates down to $US/CHF 1.6535/45 for example. However, if he is not confident and he does not wish to conclude a deal at that time, he widens the price and quotes an unattractive spread, for example 1.6525/1.6555. 

Again, if the forex trader believes that he is anticipating the market trend and he is convinced that the rate will fall, he quotes a rate of $US/CHF 1.6525/1.6540 for example. He hopes to sell the dollars that he bought beforehand at that rate and without making any losses. Generally, the smaller the spread, the greater the probability of being able to offer more advantageous bid and ask rates than the competitors, and of increasing the turnover. At the same time, the possibility of recording profits reduces and the risk increases.

1) 1 point = CHF 0.0001

Cross transaction

It is usual with foreign exchange commerce to express exchange rates against the US dollar. If the rates of all the currencies are known against the dollar, it is possible to calculate the direct parity of any two currencies, which results in a cross (cross rate). For example, the forex trader will apply a cross for a client who wishes to buy 2 billion Yen against Swiss Francs.

 Fixing a rate

Fixed at the time when the contract was concluded, the forward rate is the rate at which the foreign exchange transaction will be executed at a later date. Given that neither the bank nor the client know the subsequent spot rate, the forward rate is determined using current data. The forward rate is based on the interest rate differential between the two currencies (interest rates parity).

a) Forward purchase
In the case of a forward purchase, the bank undertakes to forward purchase a given amount of a foreign currency. For example (cf. chart above), it buys one million dollars on 11th April 2000 payable 13th April 2001. It thus holds a subsequent long position in dollars. In exchange, it is obliged to forward deliver (13.4.01) Swiss francs to the client. The bank can cover its short position in Swiss francs and long position in dollars by taking out today (11.4.00) a loan in US dollars for one year, which it will repay through its bull position in dollars resulting from the forward transaction. It will exchange the amount of the loan against Swiss francs at the spot rate, for example at the rate $US/CHF 1.6540, and it will invest this for one year. After twelve months, the bank will give its client the investment in Swiss francs including the accrued interest. In addition to the current exchange rate, the interest in US dollars (loan) and the interest in Swiss francs (investment) play a role in determining the forward rates. The flow of capital is as follows :

 Fixing a rate

Fixed at the time when the contract was concluded, the forward rate is the rate at which the foreign exchange transaction will be executed at a later date. Given that neither the bank nor the client know the subsequent spot rate, the forward rate is determined using current data. The forward rate is based on the interest rate differential between the two currencies (interest rates parity).

a) Forward purchase
In the case of a forward purchase, the bank undertakes to forward purchase a given amount of a foreign currency. For example (cf. chart above), it buys one million dollars on 11th April 2000 payable 13th April 2001. It thus holds a subsequent long position in dollars. In exchange, it is obliged to forward deliver (13.4.01) Swiss francs to the client. The bank can cover its short position in Swiss francs and long position in dollars by taking out today (11.4.00) a loan in US dollars for one year, which it will repay through its bull position in dollars resulting from the forward transaction. It will exchange the amount of the loan against Swiss francs at the spot rate, for example at the rate $US/CHF 1.6540, and it will invest this for one year. After twelve months, the bank will give its client the investment in Swiss francs including the accrued interest. In addition to the current exchange rate, the interest in US dollars (loan) and the interest in Swiss francs (investment) play a role in determining the forward rates. The flow of capital is as follows :

Exchange rate predictions

As far as currencies are concerned, the exchange rates, like any other price, are determined through supply and demand. The supply or the demand for currencies depends on many factors which can be grouped together as follows :

#1-the monetary system, which lays down the political framework in relation to exchange rate matters ;

#2-economic data such as the trade balance, inflation and the national product. Fundamental analysis is based on observation and appraisal of this economic data which, as has been proved in the past, has influenced exchange rates. By taking these correlation’s into consideration an optimal analysis can be made to give an indication of the long-term trends of the exchange rates ;

#3-technical factors. Historic rate fluctuations and volumes are examined and analysed. Some models, which are expected to repeat themselves over time, can be used as forecast criteria for short-term rate trends (technical analysis) ;

#4-expectations. The activities of financial operators are not only based on known economic data, but also on their expectations of future trends ;

#5-political events/psychological factors, such as upcoming elections, political tension, etc.

Fundamental analysis of the market

Fundamental analysis is based on a study of the economy. It is based on the assumption that the supply and demand for currencies is a result of economic processes that can be observed in practice and which can be predicted. Fundamental analysis studies the relationship between the evolution of exchange rates and economic indicators, a relationship which it verifies and uses to make predictions.

Up to this point, none of the theories put forward meets all of the exchange rate prediction requirements. This is why there are many parallel evaluation factors, valid for one part of the area studied, but also likely to be mutually exclusive.

Analysis of the balance of payments
This analysis is based on the balance of payments ¹⁾ of a given country. The internal situation determines the volume of imports and the economic situation abroad determines that of exports. To this is added capital movements which depend on the difference between interest rates. Overseas trade and capital movements together determine the supply and demand for currencies on the market and therefore their price (exchange rate).

1) The balance of payments is made up of the value of all economic transactions (trade balance, services, capital yield) undertaken in one year between a given country and overseas.