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This chapter discusses advances in formal economic theory by examining how different positions among economists arise from their different assumptions and models. The discussion focuses on ways in which real world economies differ from the ‘competitive equilibrium’ model that has become the benchmark model. The current benchmark competitive equilibrium framework includes new classical, representative agent, and real business cycle models which assume that all markets (including the labor market) have clear, perfect information, complete markets (including perfect capital and insurance markets), perfect wage and price flexibility, perfect competition, perfect rationality, and no externalities. If these models accurately portrayed reality, the economy would be efficient and there would be no need for government intervention. The assumptions of these models, however, are unrealistic and it is difficult to reconcile the required macro-formulations with what is known about microeconomic behavior (without resorting to ad hoc assumptions about the nature of the stochastic shocks to preferences and technology). The inadequacies of these models are even greater for developing countries where information imperfections are more pervasive and more markets are missing or incomplete (e.g., insurance markets). Accordingly, economic research since the 1990s has focused on identifying the most important limitations of the standard competitive model, particularly those limitations that help to explain the nature of economic volatility.

This is the first of two chapters dealing with futures contracts, and it concentrates on the defining characteristics of a futures contract, on ways in which it can be settled, on types of commodities and financial instruments in which futures trading is likely to be successful, and on measures of the importance of futures markets; the discussion is with respect to the USA. The exchanges on which futures contracts are traded are also explored: the history of organized markets, the role of the clearinghouses, the form of quotations, and the main market participants – hedgers, speculators, arbitrageurs and floor traders. The following chapter examines some of the theory and empirical evidence on the pricing of futures contracts, paralleling the discussion of stock and options prices in earlier chapters; it should be noted that some of the finer points in Ch. 9 may not be fully clear without the analysis of futures prices presented in Chapter 10. The first section of Ch. 9 looks at forward contracts, and the rest of the chapter is devoted to futures contracts (which are a highly standardized forwards contract) per se – with sections on the origin of futures trading, basic elements of futures contracts and the organization of futures markets. An appendix discusses the Euromarkets and the swap market.

There are other income factors, besides the aggregate national income and labour income factors discussed in Ch. 4, that contribute as much uncertainty to the incomes of individuals and organizations as do many risks currently traded in financial markets. If those who retail insurance policies against risks of changes in values of claims on incomes or service flows are to be able to tailor their insurance to the various exposures that their different clients have to these risks, they will want to layoff in hedging markets the risks of changes in these income factors that influence them because they are providing the insurance policies. This chapter considers some of the most salient of these other markets: real estate, unincorporated business, and privately held corporations, consumer and producer price index futures, agriculture, and art and collectibles. It also presents some ideas on systematic approaches to finding other markets, including modelling the tendency for co‐movement of incomes and inferring the underlying factors, i.e. looking for the major risk factors to incomes for which new markets would be most useful.

The previous chapter outlined the nature of futures contracts and some of the institutional aspects of the markets in which they are traded; this chapter analyzes the forces that determine the prices of different futures contracts, their relationship to the current market price (known as the spot price), and derives a satisfactory theory of futures prices. Different determinants are explored of the prices of both commodity futures (contracts based on a tangible commodity) and financial futures (those based on another financial instrument or index). After looking at the role of futures in ‘programme trading’ and the realities of so‐called portfolio insurance through the use of futures and options – a concept that was put to the test by the ‘Black Monday’ crash of 1987 – the chapter concludes by discussing futures as an investment. The five sections of the chapter (which is a discussion with respect to the USA) are as follows: Profits and losses on various transactions; Relations among spot and futures prices; Hedgers, speculators, and market equilibrium; The role of expectations; and Futures and portfolio management.

Most people are interested in hedging risk of claims on long‐term income flows, rather than on the risk of the next month's or next year's income, and this means that any market that allows hedgers to protect themselves from information that is adverse to their income over the indefinite future must be a market in the present value (capital value) of this income stream, not a conventional futures or options market in the income itself. This chapter considers two ways in which such new markets, where the information about income flows is so intangible, could be created. One way is to create a sort of derivative market, based on an index of observed prices in other (relatively illiquid) markets for claims on the same income stream (settlement based on cash‐market asset price). Liquid markets in residential real estate might be set up this way (this example is pursued in the chapter), and such a method of insuring against adverse information is analogous to that used to provide fire insurance, where the income stream is the flow of rents (or imputed rents) on the property, and the maximum insurance is the present value of this stream inferred from the sale prices of comparable properties. The other way is to create a market for perpetual, or at least long‐horizon, claims on an income flow itself, making no use of prices of claims on the flow in any other market; the income flow can be a theoretical construct of statisticians, not the dividend on any tradable asset, and liquid markets in national incomes might be set up in this way (settlement based on measures of income rather then price, achieved either through perpetual claims or perpetual futures markets).

The Big Bang described in the last chapter appeared to have answered the doubts over the future of the London Stock Exchange, but from the late 1980s onwards into the 1990s, it both waned in importance within the British financial system and faced increasing competition from rival foreign stock exchanges. This chapter discusses the reasons for this, starting in the first section with relations with government, since one uncertainty was the level of freedom from government control that the Stock Exchange was to enjoy. With the disappearance of the Stock Exchange's quasi‐official status in the 1990s, there still remained doubts over the role that it had to play in the area of securities market supervision, and the next section of the chapter discusses this situation, the effect of the changing nature of its membership, the disaster over settlement services (the replacement of the successful TALISMAN (Transfer Accounting and Lodgement for Investors, Stock Management for Jobbers) by TAURUS (Transfer and Automated Registration of Uncertificated Stock) and the subsequent failure of TAURUS), and the eventual successful replacement of the SEAQ (Stock Exchange Automated Quotations) trading system by the SEQUENCE trading system from 1993 onwards. The third section of the chapter looks at the provision of the market, and the fact that with the proposed introduction of specialists or sole traders in 1992, the Stock Exchange had once again been brought to the attention of the Office of Fair Trading; competition was also forcing a re‐examination of the way the Stock Exchange's market was organized, and this resulted in the introduction in 1997 of order‐driven trading in the form of SETS (Stock Exchange Trading Service); this section also looks at the abandonment of the traded options market to LIFFE (London International Financials Futures Exchange) and of any pretensions to the futures market, the decline of the USM (Unlisted Securities Market) and its replacement by AIM (Alternative Investment Market), negotiations with various foreign stock markets, and the changing investment environment. The last part of the chapter looks specifically at the changing membership of the Stock Exchange.

Innovation can be encouraged by grants of a patent monopoly, subsidies to innovative activities, and prizes to innovators. This chapter examines a fourth mechanism—a firm engaged in R&D has private information about whether it succeeded or failed to innovate. It can profit from this private information by buying or selling an asset whose price will depend on whether the innovation is introduced or not. In particular, we look at an innovation which reduces the cost of abating pollution, reduces the prices of pollution permits, and allows the firm engaged in R&D to profit by buying and selling futures for such permits. We determine the government policy which can generate an equilibrium with sufficient profits to induce a firm to invest in R&D, and to induce the firm which made the innovation to charge a zero price for use of its innovation.

For the purpose of hedging risks to standards of living, the logical place to look first would be to markets for claims on total income; but such markets do not exist, and they have apparently never even been proposed. By making it possible to hedge the capital value of a stream of aggregate income, markets in perpetual claims or perpetual futures, long‐term swap markets, or retail analogues of these would facilitate management of the kind of longer‐run income risk that really matters to individuals and organizations; nations or other groupings of people could also use such markets to insure themselves against the prospect of a declining standard of living or the prospect of relative poverty. By hedging such risks, these macro markets would allow the natural tendency for convergence of incomes to reduce inequality of incomes, and might make significant progress toward equalizing wealth across nations, regions, categories of people, and individuals. There could be markets for hedging the risk of fluctuations in aggregate income, national income, or aggregate labour income for each country (or even region) of the world, and these could be divided up in different ways—although since most people's income is labour income, creating markets for claims on total income means for the most part creating markets for claims on labour income. The different sections of the chapter consider possible hedging arrangements in perpetual claims or perpetual futures markets for national incomes (market structures and associated institutions), whether income markets should be in actual or full‐employment income, and various measurement issues associated with incomes (including uncertainty).

In proposing macro markets, this book describes a substantial array of new markets, and attempts to indicate ways around some of the major barriers to the establishment and success of these markets. These important barriers to the establishment of macro markets—perpetual claims, perpetual futures, options, swaps, and analogous markets—are the subject of most of the book. This introduction aims to give an idea of where the book is heading, what kinds of markets might be established, and a broad sense of whether such markets are in the realm of possibility. The different sections of the chapter are: The ideal: A world market for major income risks; Hedging income risk in today's markets; Markets as inventions; and Markets as accidents of history.

This chapter outlines the role of futures markets in managing commodity price risk and examines the use of futures markets by industrial and developing countries. It describes the factors that negatively affect greater access of developing country producers to futures markets and proposes strategies to enhance their access. It suggests that international and national intermediaries may improve developing countries' access to futures markets by building the know-how about hedging and creating a relationship of trust and confidence between international traders and emerging national intermediaries.

Most financial markets are highly competitive – there are hundreds or thousands of active traders and at any time and place prices vary only within a narrow range – the bid‐ask price spread. Regulation is usually associated with monopoly; it might seem, therefore, that regulation of financial markets is unnecessary. After an introductory section on the ethics of finance and the economic function of financial markets, the second section of this chapter explains why that conclusion is unwarranted. The third section discusses the various levels of US federal regulation (the exchanges, the regulatory commissions and the courts); the fourth looks at federal regulation of trading in corporate shares and bonds by the Securities and Exchange Commission; the fifth shows how futures markets are federally regulated in the US; and the sixth is a case study of an important regulatory failure – the silver manipulation of 1979–80 in the USA. The final section looks at regulation in the UK.

One reaction to proposals for new markets is that the general public will not want to deal in them, because of some psychological inability to appreciate the benefits that the risk management may offer—such a reaction is often given by people in the futures and options industry, who have seen many innovative contracts fail. The general public, it is asserted, will not trade directly in such futures, and if the reason they will not is that they do not appreciate the benefits of risk management, then it may be difficult for retailers of risk‐management services to repackage the contracts in a form that will interest them. However, the general public, including both individuals and firms, does use some risk‐management services, notably insurance policies—the insurance industry has not failed to market risk‐management policies to the general public, rather, their success has been highly variable. This chapter investigates whether the macro markets proposed by the book resemble the life insurance policies (for which there is a ready market), or whether they more resemble the disability or flood insurance markets or farmers’ hedging markets. This is done by analysing the psychological literature on demand for insurance. The issue of promoting proper public use of macro markets (by public education and proper product design) is also discussed.

This chapter discusses the ‘futures’ market or commodities market (bursat al-'uqud), which constitutes the building blocks of the global financial system. Commodities markets are at odds with Islamic law, hence the conclusion that Islamic banks are difficult to integrate into the global system of production and trade. The chapter examines the Egyptian futures market and the global markets for oil.

When creating indices intended for use in cash settlement of futures contracts (or perpetual claims or options, or swaps, or other over‐the‐counter forward contracts or retail insurance contracts), it is critical that that each index represents value associated with a standard claim on future income (or services). The contract settlement must reflect the price of claims on income streams, so that the market can be used to hedge the risk associated with the claims, but the problem is that the available observations on prices or incomes may apply to dissimilar claims, and that standardization in the indices used to settle contracts is essential to liquidity in these markets. This chapter first reviews some existing index number methods, and then extends these methods to deal with the problems described. Chain index and hedonic index number methods are reviewed, and ordinary repeated‐measures indices (like the repeat sales indices) are shown to be in a sense a special case of these, and to have strong parallels to some existing indices used to settle contracts. The last part of the chapter introduces the hedonic repeated‐measures index to allow for control of changing price of quality variables, while retaining the repeated‐measures design.

This epilogue reflects on the evolution of the commodities market since those first grain trades at Haine's Feed Store in Chicago. A number of commodities contracts have come and gone. Just as food traditions evolve, so do food commodities. As some contracts are eased out, it seems certain that futures contracts traded in the United States are likely to reflect global food needs and availabilities—not just those of American eaters. Americans continue to rely on the agricultural futures market to aid in “price discovery” and steadiness—trading keeps food prices generally consistent and at reasonable levels. Farmers, food processors and manufacturers, importers and exporters, retailers, restaurateurs, and consumers are all reliant, to some degree, on the futures market for ultimately getting food on the table. One fact is clear: the commodities markets and food prices are linked more closely than ever before.

In the early 2000s, financial investors began pouring billions of dollars into the commodity futures markets seeking the unique investment benefits of this distinct asset class. This “financialization” process has called into question the fundamental risk and return properties of commodity futures as evidence has emerged favoring the idea that the massive increase in investor flows caused a rise in futures prices, volatility, and intra- and intermarket return correlations. However, a contrarian line of research contends that the effects of the new “speculative” capital on the futures markets are unsubstantiated and the increased participation of financial investors poses little consequence to the economics of the marketplace. This latter line of literature maintains that the investment benefits of commodity futures have not been diminished and that fundamental factors and business cycle variations can explain the observed changes in commodity price behavior.

Sharp movements in crude oil prices and their impact on other commodities have renewed interest in the assessment of dynamic interactions between commodity futures markets. This chapter examines this topic by investigating the intensity and direction of volatility transmission across three major classes of commodities, including agricultural products (corn, coffee, and soybeans), energy (crude oil and gas), and metals (copper, gold, and silver). Overall, the evidence suggests that important volatility episodes and fluctuations exist across major commodity markets; the total cross-market spillovers are limited until the onset of financial crisis of 2007–2008. As the crisis intensified, so too did the commodity volatility spillovers, with substantial stress carrying over from the energy and metal markets to others. These findings are important in understanding the level and transmission mechanism of risk across commodity futures markets and are relevant to regulators in formulating policies to tackle excessive volatility, particularly during turbulent periods.

This chapter explains how commodities trading works. It first considers how the commodities market evolved into what we know today before discussing how the modern commodities market works and how the trading of food-based commodities influences what we eat and what we pay for food. Many traders like to point out that the concept of grain “futures” dates all the way back to the days of the Hebrew Bible, when Joseph analyzed the pharaoh's dream of cattle and crops, discerned that a drought would come, and diligently went about storing immense amounts of grain. Others insist that the birth of the markets took place in Osaka, Japan, in 1730. The first futures market in the United States is the Chicago Board of Trade, established in 1848. The history of America's commodity exchanges runs a parallel course with the history of industrialization and technology. This chapter discusses a number of key market basics, such as what a futures contract is, the key players in the futures markets, what drives commodity prices, and the difference between food and “food commodities”.