The CME Group Risk Management Handbook

FOREWORD
by
Leo Melamed

However we view it, the twentieth century must be assessed as remarkable.  Although it recorded a new low in the history of violence—with two world wars and the Holocaust—it was also a century that bespoke of unprecedented advances in human endeavor:   At its outset, Joseph J. Thompson’s detection of the electron proved that atoms were at the foundation of matter just as the Greeks believed; Emmeline Pankhurst lit the torch on behalf of women’s right to vote; Wilbur and Orville Wright transformed human transportation at Kitty Hawk; Sigmund Freud unlocked the mysteries of our subconscious; and Albert Einstein, the foremost scientist of the century, recorded his earth-shaking three papers.  The combination of these breakthroughs fulfilled their promise and directed the destiny of humankind.  Metaphorically speaking, the twentieth century propelled civilization from the horse and buggy to the moon and beyond.  

To put it another way, the technology of the last century moved mankind from the vast to the infinitesimal.  In physics, Einstein’s theory of General Relativity dealt with the universe—the big.  As the century progressed we journeyed to quantum physics—the little. Similarly, we moved from macro to the micro in biology—from individual cells to gene engineering.  And just as technology brought us to subatomic particles in physical science, just as technology brought us to molecules in biological science, so in financial markets when computer technology was applied to established investment strategies, the evolution from the big to the little was strikingly similar.  With computer science, the most complicated risk-management structure could be broken down into its separate components.  Financial engineers disaggregated, repackaged, and redistributed risks and their corresponding rewards, exchanging one set of risks and rewards for another that responded better to an investors’ preferences.  We moved from macro to micro applications.  In other words: the over-the-counter (OTC) derivatives market with its attendant risks was born.  Indeed, derivatives were the financial equivalents to particle physics and molecular biology.  Charles Sanford, the former chairman of Bankers Trust, dubbed it, “particle finance.”

Derivatives in OTC venues and those on regulated futures exchanges are now used by the largest and most sophisticated financial institutions in the world—domestic and international banks, public and private pension funds, investment companies, mutual funds, hedge funds, energy providers, asset and liability managers, mortgage companies, swap dealers, and insurance companies.  Financial entities that face foreign exchange, energy, agricultural, or environmental exposure use our markets to hedge or manage their price risk. Financial intermediaries that have exposure in equities use our markets to hedge or to benchmark their investment performance. Financial institutions that have interest rate exposure from lending and borrowing activities, or their dealing in OTC interest rate instruments, swaps and structured derivatives products, or their proprietary trading activities use our markets to hedge or arbitrage their exposure in money market swaps or to convert their interest rate exposure from a fixed rate to a floating rate or vice versa.  

Few would argue that the modern era of futures markets was born with the launch of financial futures at the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME).  This first-mover advantage provided the momentum which ultimately brought the CME Group today’s pinnacle of futures markets. The metamorphosis ensued directly after August 15, 1971, the date when President Nixon dropped the U.S. dollar convertibility to gold.  By closing the gold window, Nixon’s action led to an irreversible breakdown of the system of fixed exchange rates, initiated the modern era of globalization, and provided the rationale for the CME and other futures exchanges to prove that the traditional idea about use of futures markets in physical commodities was applicable to instruments of finance and beyond.

Our birthright in futures markets was to mediate risk during a narrow window for a few big agricultural products.  Upon adulthood we extended this heritage into finance.  With the advent of the digital age we launched CME Globex, becoming electronic and international.  Now we provide risk management capabilities on a nearly round-the-clock basis on a vast array of products that cover the gamut from finance to energy, from securities to the environment, from banking to agriculture.  We provide alternative investments coverage, maintain strategic alliances with other exchanges, serve as a global benchmark for valuing and pricing risk, provide most transparent markets, offer an array of mini products for individual investors, and maintain educational facilities along with a complement of banking services.  Most importantly, we manage an efficient, financially sophisticated central-party clearinghouse that guarantees, clears and settles every trade within a no-debt structure.    

Although OTC derivatives experienced problems during the 2007-2008 financial break-down, the financial safeguards in regulated futures markets proved solid and demonstrated our market’s undeniable value in the management of complex business risks.

Our introduction of Globex near the end of the twentieth century transported the trading “pit” to every corner of the globe.  Whereas, as little as six years ago American futures exchanges were still limited to floor-based execution, now the trading screen enables customers around the globe to execute trades without the need for physical representation on the floor of an exchange.  The impact on growth is evidenced in the quantum leap in our annual transaction volume since the launch of CME Globex.  Not so long ago if a financial official, say, in China, made a statement that affected the value of the dollar, it could take hours if not days before that knowledge was translated into market action.  Today, nobody of consequence can say anything anywhere without the potential of it being instantly reduced into a buy or sell on a screen.  You can execute a complex spread or do an entire panoply of connected transactions that includes markets across multiasset classes as fast as your fingers press the keys.  The digital age reduced the Globex execution speed from 2, 500 milliseconds a decade ago to less than 10 milliseconds today.

Indeed, advanced technology has dramatically altered the nature and definition of the “trader,” morphing the computer into an instrument that uses artificial intelligence and algorithms that direct the execution of the trade itself.  These apply advanced proprietary mathematical models to execute countless sophisticated trading strategies to capture even minute profits based on price correlations, price distortions, and value associations between markets.  Housed within proprietary trading enterprises throughout the globe—sometimes referred to as “high-frequency” trading operations—they are an extension of the digital revolution and supply enormous liquidity and breadth to market structures both in equities and futures and options markets.

The preceding brief historical sketch of financial markets provides a clear understanding that OTC derivatives and exchange-traded futures are a product of the dramatic changes in the science and technology of the twentieth century.  The same can be said for the “modern” Chicago Mercantile Exchange—now CME Group.  Clearly, during the last century the “House that Pork Bellies Built” in the 1960s evolved into today’s “House that Innovation Built.”  Far less known, however, is the fact that during the same time span it was also the “House that Education Built.”  Among its achievements was the CME’s commitment to advance market education.  Beginning in the early 1970s, and continuing throughout its ensuing four-decade march to the top of the futures world, the CME was and remains a leading force in advancing academic education, courses, textbooks, studies, learning centers, workshops, and symposia in the field of futures and options.

It was the first exchange to promote a center for futures education in partnership with the Commodity Exchange, Inc. at Columbia University in the early 1970s, to establish in 1978 a prize in financial writing at the University of Chicago, and to endow chairs for the study of futures at both the University of Chicago and Northwestern University in the 1990s.  In 2003, it founded the CME Center of Innovation.  Among its accomplishments is the establishment of the Fred Arditti Innovation Award to individuals who have made significant conceptual or practical contributions to commerce or markets.  The Innovation Center also teamed up with the Mathematical Sciences Research Institute (MSRI) to create a prize for the innovation of mathematical, statistical or computational methods in the study and behavior of markets.  In 2007, the original Chicago Mercantile Exchange Trust (created in 1969) was converted into the CME Charitable Trust with a primary goal of promoting, teaching and learning about financial markets, futures, and derivatives.  Indeed, it would be impossible to attempt to enumerate the number of books, textbooks, magazines, journals and periodicals about financial markets that have been published as a result of these initiatives.

As the expansion of futures markets continues into the twenty-first century, so will the need for education.  The present publication, The CME Group Risk Management Handbook,” by principal authors John W. Labuszewski, John E. Nyhoff, Richard Co, and Paul E. Peterson, is a continuation of the CME’s grand educational tradition. Labuszewski, Nyhoff, Co, and Peterson are extremely well qualified for this undertaking, having spent their professional lives in our industry at this exchange and with brokers and asset managers that utilize exchange products.  The handbook, with contributions by Dale Michaels, Jim Moran, Brett Vietmeier, Fredrick Stum, and Charles Piszczor, contains information, data, details, facts, and background of a vital nature concerning the use and application of the most notable products traded at the CME and beyond.  The material includes consummate intelligence with respect to both the underlying fundamentals that affect the instruments described as well as technical analysis and interpretations of price movements.  This handbook, a long sought-after work, will in my opinion become an indispensable reference textbook for futures and option markets.

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