The CME Group Risk Management Handbook: Products and Applications: 410 (Wiley Finance) - Hardcover

CME Group; Labuszewski, John W.; Nyhoff, John E.; Co, Richard; Peterson, Paul E.

Hardcover

ISBN 10: 0470137711 ISBN 13: 9780470137710

Publisher: Wiley, 2010

Synopsis

Invaluable insights on trading today's futures market

The CME Risk Management Handbook provides an accessible overview of the futures market in today's electronic world of trading. Page by page, it outlines the various CME products currently available and explains how those products can be used to manage risk. Financial professionals around the world will find this book to be a comprehensive reference to the most widely used risk management, trading, and hedging strategies. Editors John Labuszewski and John Nyhoff–two of the most highly-regarded names in futures and options research and risk management–put this discipline in perspective and offer readers invaluable insights into successfully operating within this environment.

Chicago Mercantile Exchange Inc. is an international marketplace that brings together buyers and sellers on its trading floors and GLOBEX around-the-clock electronic trading platform. CME offers futures contracts and options on futures, primarily in four product areas: interest rates, stock indexes, foreign exchange, and commodities. John W. Labuszewski, MBA, is a Director of Clearing Development at CME. John Nyhoff, MBA, is a Director of Financial Research and Development at CME.

About this title

About the Author

JOHN W. LABUSZEWSKI is Managing Director of Research and Product Development at CME Group. Labuszewski came to CME from Nikko Securities International, where he was general manager of the asset management division. He had previously worked for Fenchurch Capital Management, Refco, and the Chicago Board of Trade. Labuszewski is coauthor of four previous industry-related texts. He earned an MBA from the University of Illinois.

JOHN E. NYHOFF is Director of Financial Research and Product Development at CME Group. He has lectured extensively in the interest rate derivative product area, and has taught financial futures and options and related courses at DePaul University and several other Chicago-area colleges. Nyhoff is coauthor of two industry-related texts: Trading Options on Futures and Trading Financial Futures (both from Wiley). He holds a master's in financial economics from the University of Rochester, a master's in economics from Northern Illinois University, and a bachelor's degree in economics from DePaul University.

RICHARD CO is Director of Financial Research and Product Development at CME Group. He joined CME in 1999. Dr. Co received a PhD in economics from the University of Chicago in 2000 and is a Chartered Financial Analyst.

PAUL E. PETERSON is Director of Commodity Research and Product Development at CME Group. He joined CME in 1989. Before that, Peterson served as vice president, research, for Brock Associates from 1988 -1989; manager, education and marketing services, for the Chicago Board of Trade from 1986-1988; and manager, market analysis, for the American Farm Bureau Federation from 1983-1986. Peterson holds a PhD in agricultural economics from the University of Illinois and has authored a number of articles in professional journals and business/trade publications.

CME Group is an international marketplace that brings together buyers and sellers on its trading floors and CME Globex around-the-clock electronic trading platform. CME Group operates leading derivatives exchanges including CME, Chicago Board of Trade, and NYMEX, offering futures contracts and options on futures, in diverse product areas including interest rates, stock indexes, foreign exchange, agricultural, energy, and metals.

From the Back Cover

Praise for The CME Group Risk Management Handbook

"Wow! The CME Group Risk Management Handbook is a 'ten strike' and long overdue. A must-read and reference for the risk management industry!"
―Jack Sandner, retired chairman of CME Group, member of the Executive Committee

"This is a powerful book for its integration of futures and options markets with an understanding of the whole economy. It is an eye-opener to see how central these markets are to our economic lives."
―Robert J. Shiller, Okun Professor of Economics, Yale University; Chief Economist, MacroMarkets LLC

"Risk management is essential to successful investing, and The CME Group Risk Management Handbook provides the essentials for understanding risk management. In the wake of the financial turmoil of the last few years, managing risk should be part of any investment program. Among the key elements of risk management are stock index, bond, currency, and commodity futures as well as a growing number of futures, options, swaps, and other financial instruments built on indices tracking housing prices, weather conditions, and the economy. The CME Group Risk Management Handbook offers a comprehensive guide for using all of these to better manage financial risks."
―David M. Blitzer, PhD, Managing Director and Chairman of the Index Committee, S&P Indices

"Dare we ignore the advice of a financial institution, the largest of its kind in the world, that navigated the recent financial crisis without the aid of a single TARP dollar or access to the Fed's cheap loans? For CME Group, risk management has meant risk minimization as it enters its 151st year of life and its 85th year of central counterparty clearing without a single trading debt unpaid. It has been, and continues to be, a leader by example."
―Philip McBride Johnson, former CFTC chairman

"For the first time, a comprehensive handbook outlining the futures market in today's world is available. The CME Group Risk Management Handbook covers futures basics for the novice trader, while the veterans will benefit from an in-depth look at options and hedging. This handbook is a necessity for any professional, investor, or other market participant seeking to manage risk in the perpetually changing futures market."
―H. Jack Bouroudjian, CEO, Index Futures Group

From the Inside Flap

Where futures were once regarded as arcane trading vehicles largely utilized by speculators in search of outsized profits, they are now widely regarded and accepted by institutional and retail traders alike as a legitimate and, more so, essential component of many investment and risk management programs. Futures now cover products as diverse as interest rate, equity, foreign exchange, and commodity markets and have been extended to include somewhat more esoteric items including real estate values, economic indicators, and even weather conditions. These instruments have focused attention and interest on Chicago as the epicenter of futures market developments and innovation, and the CME Group stands out as a leader in this regard.

The CME Group Risk Management Handbook provides an overview of the futures market in today's electronic trading world and outlines the various CME Group products, explaining how they can be used to manage risk for both professionals and individuals.

Principle authors John Labuszewski, John Nyhoff, Richard Co, and Paul Peterson are some of the most highly regarded names in futures and options research and risk management. They offer you a primer and reference to the most significant of CME Group products and the applications for which they may be deployed. The book begins with a basic explanation of futures markets, defining futures contracts, methodologies of order entry and execution, and the role of the clearing house. The authors then explain the intricacies of each of the various futures products, including currency futures, stock index futures, Eurodollar futures, and U.S. Treasury futures. In addition, they describe the major commodity markets and some alternative investment market fundamentals.

This reliable resource also offers a review of technical analysis, covering Elliott Wave Theory, pattern recognition, empirical analysis, and other essential information. It concludes with a look at options markets, outlining a range of options trading strategies, including hedging with options.

The development of futures markets has rapidly accelerated in the past few decades. The CME Group Risk Management Handbook will provide professionals around the world with an up-to-date, comprehensive reference to today's most popular and widely used risk management products and trading and hedging strategies.

Excerpt. © Reprinted by permission. All rights reserved.

The CME Group Risk Management Handbook

Products and ApplicationsBy John W. Labuszewski John E. Nyhoff Richard Co Paul E. Peterson Leo Melamed

John Wiley & Sons

Copyright © 2010 John Wiley & Sons, Ltd
All right reserved.
ISBN: 978-0-470-13771-0

Chapter One

Futures Market Fundamentals

John W. Labuszewski

The precise origins of the futures markets are obscure but arguably might be traced back to ancient Greece or medieval Europe or perhaps Japan. Modern futures markets as we know them today emerged from the North American grain trade as it evolved during the nineteenth century, driven in large part by the development of grain transportation patterns in the central and eastern United States. In more recent times since the early to mid-1970s, a variety of financial futures have been introduced in addition to the more traditional agricultural or physical commodity futures markets. These instruments now cover products as diverse as interest rate, equity, and foreign exchange markets but have been extended to include somewhat more esoteric items including real estate values, economic indicators, and even weather conditions.

Whereas futures were once regarded as arcane trading vehicles largely used by speculators in search of outsized profits, they are now widely regarded and accepted by institutional and retail traders alike as a legitimate and even essential component of many investment and risk-management programs. The popularity of these instruments has in fact grown to achieve immense scale. The notional value of futures transacted frequently exceeds the values traded in the underlying markets to which these futures are tied. In the process, these instruments have focused attention and interest on Chicago as the epicenter of futures market developments and innovation.

CME Group stands out as the leader in this regard, representing the amalgam of futures exchanges including Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), New York Mercantile Exchange (NYMEX), and Commodity Exchange (COMEX).

It is beyond the scope of this chapter to discuss the many direct and less subtle uses of these versatile risk management and investment tools. Rather, it is our intent to introduce and discuss the fundamental terminology and concepts associated with the futures markets in general and the specific instruments traded on CME Group as the leading derivatives trading organization whose products are distributed worldwide and attract active participation from all parts of the globe.

WHAT IS A FUTURES CONTRACT?

Perhaps the first and most fundamental question to consider is simply, "What is a futures contract?" A simple answer is that a futures contract represents a standardized commitment to make or take delivery of a specific quantity and quality commodity or security during a specified future delivery month. For example, one may transact CME Group futures contracts based on $1 million face value of Eurodollars; or $100,000 face value of 10-year Treasury notes; or based on a value equal to $50 times the venerable Standard & Poor's 500 (S&P 500) stock price index; or, 12.5 million Japanese yen; or 40,000 pounds of live cattle; or 1,000 barrels of crude oil. Actually, the question becomes a bit more complicated to the extent that not all futures contracts actually call for the physical delivery of the underlying product or security. As discussed later, many futures contracts are settled in cash and never actually entail a physical delivery.

Because futures contracts trading on a particular exchange are standardized or generic, they are fungible and readily offset. A fungible item is one that is precisely alike another. Futures are fungible in the sense that one (for example) March 2008 CME Eurodollar futures contract is exactly like every other March 2008 CME Eurodollar futures contract and can be used to offset a previous transaction. That is, a market participant may buy, or "go long," a March 2008 CME Eurodollar futures contract and subsequently sell a March 2008 CME Eurodollar contract at the prevailing market price before entering the delivery or cash settlement process. As a result, the original commitment to buy is canceled. Or a market participant may sell, or "go short," futures and subsequently buy at the prevailing market price before entering the settlement or delivery process. This series of transactions means that the original commitment to sell is canceled.

Although we often speak of the futures markets in the generic, it is noteworthy that futures exchanges also typically offer options on futures contracts. Options generally come in the form of call options and put options. A call option conveys the right to buy, or go long (for example), one Eurodollar futures contract at a specific strike or exercise price on or before a specific expiration date. A put option conveys the right to sell, or go short (for example), one Japanese yen futures contract at a specific strike or exercise price on or before a specific expiration date. One may either buy or sell (or write) puts or calls and, as such, there are four fundamental transactions one may engage in with respect to options. The buyer of an option pays a negotiated premium or price to the seller or writer of an option in consideration for rights received by the buyer and obligations assumed by the seller.

Futures and options on futures contracts (or, simply put, futures markets) are generally considered exchange-traded derivatives. That is, they are developed by organized exchanges authorized by the appropriate government agencies to offer futures trading to an institutional and retail public audience. Exchanges exist fundamentally to allocate access to the trading process. Not too many years ago, futures were largely traded via "open out-cry" in physical trading pits that were crowded by many local traders and floor brokers. Accordingly, exchanges sold memberships in an auction-like process to allocate access to the physically confined space in a trading pit. Today, however, roughly 85% of volume in CME Group products is conducted completely electronically through the CME Globex electronic trading platform. Many other futures exchanges around the world operate on a completely electronic basis. As such, distribution and access to the trading process is much enhanced relative to conditions just a few short years ago. Thus, futures market activity in the form of volume or number of contracts traded and open interest or the number of contracts entered into but not yet closed through an offsetting or opposite transaction has been growing very rapidly in the early part of the twenty-first century.

Once a futures trade is executed or matched, records of such transaction are reported to the exchange clearinghouse. The classic explanation is that, once executed and cleared, regardless of the actual counterparty to the specific transaction, the clearinghouse steps in to act as buyer to every seller and seller to every buyer. This is the fundamental nature of a multilateral clearing mechanism that allows transactions to be offset and stricken from the books regardless of who the actual counterparty may be in the opening and closing transactions. Subsequently, a clearinghouse takes on a bookkeeping and surety role by maintaining records of each executed and outstanding futures trade in coordination with the network of brokerage houses and other proprietary trading organizations that act as clearing members of the clearinghouse. These clearing members act on behalf of their ultimate customers by taking financial responsibility for each and every transaction. Market participants holding open futures positions are required to post performance bonds or, in slang, "margins." These margins are generally determined to cover the maximum one day's price movement from close to close with perhaps a 95 to 99% statistical level of confidence.

Futures exchanges are generally closely regulated by the appropriate government agency. In the United States, the Commodity Futures Trading Commission (CFTC) acts as the primary regulator of the futures industry, and the Securities and Exchange Commission (SEC) acts as the primary regulator of the securities industry. This dichotomy is rather unique because a single regulator serves both purposes in most other jurisdictions around the world. In addition, the National Futures Association (NFA) serves as an industry self-regulatory organization to supplement the activities of the CFTC as well as the self-regulatory functions of the exchanges themselves. Note that the CFTC monitors and scrutinizes the rules and operating procedures of U.S. exchanges.

Historical Development of Futures

Although the origins of futures trading may arguably be traced to ancient Greek or Phoenician times, we recount the development of these markets with a Chicago-centric viewpoint beginning in the early 1800s. Chicago is located at the base of the Great Lakes, close to the farmlands and cattle country of the U.S. Midwest, making it a natural center for transportation, distribution, and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price. This led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change and enable them to hedge.

Forward contracts were quite commonplace at the time. However, forward contracts were quite frequently defaulted on by either the buyer or the seller. For example, consider the execution of a forward contract that calls for the delivery of corn at a fixed price at a fixed date in the future. But if the price of corn dramatically increases by the time the delivery date rolls around, there is a possibility that the seller might default on such delivery, selling his or her corn into the open market at the current higher market price. Or if the price of corn declines dramatically, there is the possibility that the buyer may refuse delivery, opting to purchase his or her corn requirements in the open market at a reduced price. Exacerbating the problem was the fact that these early forward contracts were negotiated bilaterally between two counterparties and were often quite illiquid. An exchange was needed that would bring together potential buyers and sellers of a commodity instead of shifting the burden of finding counterparties to the individual market participants.

The epicenter for much of the early trade in grain forward contracts (nearly futures contracts) was in the city of Buffalo, New York. Buffalo was strategically located as an important bulk grain transshipment hub upon the completion of the Erie Canal in 1825 that linked the Great Lakes to the Hudson River and on to New York City and European export centers. In fact, forward trading in grain sprung up at several cities on the Great Lakes system, including Chicago, Duluth, Toledo, and Milwaukee. Forward trading of various types of grain and other agricultural produce grew up at many other important hubs along other U.S. waterways along the Mississippi and its tributaries, such as Minneapolis, Kansas City, Memphis, and New Orleans; along the Atlantic in New York and Baltimore; and eventually by the early twentieth century on the West Coast in Seattle, Portland, San Francisco, and Los Angeles.

But Chicago emerged as a particularly strategic transshipment point by 1848 with the completion of the Illinois and Michigan Canal along with the completion of the Chicago and Galena Union Railroad. These transportation routes effectively linked the Great Lakes with the Mississippi River system. Eventually, railroad transport proved more economical and became preferred over waterway transport, enhancing Chicago's importance to the extent that a large number of railway systems used Chicago as a key hub in connecting the fertile Midwest farm fields to the bulk of the consuming population on the East Coast and beyond to European export markets.

Thus, the Chicago Board of Trade (CBOT) was formed in 1848 and emerged over time as the preeminent grain exchange. Trading was originally in forward contracts; the first contract on corn was written on March 13, 1851. Standardized futures contracts were introduced on the CBOT in 1865.

In a parallel development, the Chicago Produce Exchange (CPE) was established in 1874, specializing in the cash trade of butter and eggs. The year 1882 witnessed the first use of "time contracts," essentially a futures contract, on the CPE. Several reorganizations saw the introduction of the Produce Exchange Butter & Egg Board (1895) and then the Chicago Butter and Egg Board as a splinter group in 1898. Eventually, in 1919, the Chicago Butter and Egg Board became formally known as Chicago Mercantile Exchange (CME), adopting renewed resolve to promote the use of time or futures contracts and with the foresight that other commodities could be added to the product line in coming years.

The Great Depression of the 1930s, followed by strict price controls of agricultural products during World War II, put a damper on commodity trading. In particular, the postwar support price of $0.25 effectively did away with butter as a viable futures contract. Trading in other agricultural commodities, including potatoes and onions, was introduced but eventually discontinued, sometimes amid turbulent circumstances. Throughout this period, CME's fortunes were flagging. But the 1960s saw renewed vigor at the exchange, led by a group of so-called young Turks including Leo Melamed, along with a commitment to develop new product lines. As a result, CME launched products in pork bellies (1961), live cattle (1965), and live hogs (1966), breathing new life into the institution.

Deflated grain prices in the postwar period led to some degree of stagnation at the CBOT as well. By the early 1970s, the CBOT was looking far from its origins for new sources of growth. It financed the development of organized stock option trading by creating the Chicago Board Options Exchange (CBOE). As such, "financial" in additional to agricultural or physical commodities started to become fair game for the nation's futures exchanges.

Financial futures trace their origins from the early 1970s and established a revolutionary new direction for the industry. Leo Melamed created the International Monetary Market (IMM) in 1971 for the purpose of developing financial futures. The concept took form in 1972 with the introduction of foreign currency futures including the British pound, Canadian dollar, German mark, Japanese yen, Mexican peso, and Swiss franc. This roughly coincided with the breakdown of the postwar Bretton Woods system, which generally had provided for fixed international exchange rates, in favor of floating market-driven exchange rates. These products quickly emerged as the first successful financial futures products, opening up new vistas for the futures industry. (The IMM was merged with CME by 1976.)

Subsequent years saw the development of financial futures contracts focused on trading in interest rates. These contracts included the GNMA CDR contract introduced on the CBOT in 1975 as the very first interest rate futures contract. This initiative was quickly followed in the late 1970s and throughout the 1980s by products including CME Treasury bills, CBOT Treasury bonds, 10-year, 5-year, and 2-year Treasury notes, and the 90-day Eurodollar contract introduced on CME in 1981. These interest rate contracts had an enormous impact on the financial landscape in general and served to invigorate the development of other derivatives on an over-the-counter (OTC) basis including the interest rate swap (IRS) market. Stock index futures followed soon thereafter with the development of the Value Line Composite Average (VLCA) futures contract on the Kansas City Board of Trade, followed quickly by CME's Standard & Poor's 500 (S&P 500) contract as well as the Nasdaq 100 and Russell 2000 contracts and the Dow Jones Industrial Average (DJIA) offered on CBOT.

(Continues...)

Excerpted from The CME Group Risk Management Handbookby John W. Labuszewski John E. Nyhoff Richard Co Paul E. Peterson Leo Melamed Copyright © 2010 by John Wiley & Sons, Ltd. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Edition details

• Publisher: Wiley
• Publication date: 2010
• ISBN 10: 0470137711
• ISBN 13: 9780470137710
• Binding: Hardcover
• Language: English
• Edition number: 1
• Number of pages: 624