Entry‐deterring contract specification on futures markets

Abstract

n a recent article, Lien (1989(b)) shows that within a mean-variance framework the I optimal futures contract for a commodity with various grades is a conventional cash settlement contract that dictates the futures price as a linear combination of various cash prices (at maturity) such that the weights are independent of both the variance-covariance matrix of cash prices and the risk aversion coefficients of hedgers. The criteria for optimality are based upon the assumption that the exchange attempts to maximize either the hedgers' expected utility levels or the total futures transaction volume in the absence of competitive pressure.The two objective functions seem reasonable. In particular, transaction volume maximization is well accepted in the literature because brokers' revenues, market liquidity, and the seat price for floor traders all respond positively to increasing transaction volume (see Silber (1981) and Grossman (1986)). The assumed absence of competitive pressure may, however, be an unrealistic assumption. Based upon empirical evidence, Fischel (1986) argues that the current Commodity Futures Trading Commission (CFTC) regulations appear to favor new contracts that are very similar to existing contracts instead of those that are more innovative.Moreover, it is argued that the existence of contracts for various grades of the underlying commodity improves cross-hedging effectiveness and, in turn, helps gain CFTC approval. Examples of competing futures contracts are: the Treasury note futures contract traded at the New York Cotton Exchange (NYCE) and those traded at the Chicago Board of Trade (CBOT). Despite differences between the two contracts (they differ in deliverable notes and in the conversion formula used to evaluate the cheapest deliverable notes) trading statistics suggest that these contracts compete directly (Angrist (1988)).Since there is always a possibility of competing futures contracts, an innovative exchange tries to prevent entry of rival exchanges and thus maintain a monopoly. This article investigates the impact of entry deterrence objectives upon the choice of contract settlement specifications of a new futures contract.The approach adopted here is a normative analysis. That is, this article asks the question how the exchange "ought to" behave in certain circumstances upon imposing *This research was, in part, supported by The Center for the Study of Futures Markets at Columbia University. I wish to acknowledge Lee Benham, Paul Messinger, Mark Powers, James Quirk, and two anonymous referees for helpful comments. Anne Sholtz provided editorial assistance. Of course, I am solely responsible for any remaining errors.

A theoretical comparison of composite index futures contracts

“…For a general cash settlement contract, the choice of settlement index is discussed in Jones (1982), Lien (1989b), and Cita and Lien (1992). mathematical property that the geometric average underperforms the arithmetic average (referred to as the Holder inequality).…”

“…However, this property by itself does not imply that the futures contract based on the former is less desirable than the futures contract based on the latter. For example, if a futures contract is evaluated by its hedging effectiveness [Ederington (1979); Lien (1990b)], then only the second moments of the futures and spot prices are relevant. Underperformance has no bearing in this case.…”

“…Underperformance has no bearing in this case. Nonetheless, within a representative hedger framework, Lien (1989bLien ( , 1990a demonstrates that a futures contract based on some sort of arithmetic average index (with weights reflecting the hedger's cash positions) dominates all possible index specifications in terms of both hedger's utility and trading volume. However, this conclusion is dubious when information asymmetry prevails in the markets.…”