Amazingly, as if the current $1,500,000,000,000,000 global derivatives “market” is not adequately irresponsible, fanciful, and insulting in itself, we are actually standing on the cusp of removing yet more blocks from the bottom of this economic Jenga tower, thanks to an another brilliant idea by the ever-creative fiatists. This one is not a bundle of toxic subprime mortgage-pieces magically granted AAA status; not a handful of Greek paper; not a bucket of Duetsche Banks’ gold ETN’s. No, those are soooo 2007! Now way--get with the program, man, it’s time for the latest, greatest, sure-fire investment that’s gonna make us all of gazillion dollars: its time for Box office futures!
I kid you not. Very soon—soon as in weeks--the CFTC will likely grant a major investment bank the authority to host a futures exchange market for trading contracts based on domestic box office revenue. The firm is Cantor Fitzgerald, an established Wall Street player in debt/equity brokerage, investment banking, securities dealings, and especially market data. You can bet they have a carbon trading arm: CantoCO2e. And now they want a Hollywood scheme.
The prototype for the deal has been around now for over decade, though it has been a roller coaster decade. Max Keiser (yeah, that Max Keiser who you hear on Alex Jones and see in Fall of the Republic!) and some partners invented a virtual, web-based box office futures trading platform in the late 1990's with the goal of predicting box office performance. The timing on it was perfect, considering the .com bubble at the time, but it was only a virtual system--no real money, only "Hollywood dollars." They called it the Hollywood Stock Exchange (HSX). At its peak, Keiser was on television predicting movie performances, and producers were getting quite upset about these hot-shots telling them (and the audience) what a particular movie was going to gross before it was even released. But the platform proved an excellent predictor of revenue, perhaps due to its huge, enthusiatic base. At its peak in 1999, the HSX had investors and companies lining up with millions to get a piece of it, and an IPO was the goal. The .com crash quickly quelled that goal, and the company lost nearly all of its paper value. Enter Cantor Fitzgerald. In 2001, Cantor bought the company and has been operating it since.
Cantor's virtual Hollywood Stock Exchange (HSX) has been up for almost a decade now. Since its inception, HSX has had millions of traders, and has just under 1 million today. That's a lot of experienced virtual traders who might be willing to start risking real money. As it stands now, the HSX is still a vitual money trading scheme where people can join up and get a free 2 million "Hollywood dollars" with which to trade. You can apparently win prizes, but again, no real money changes hands. Cantor holds patents on the exchange and exchange processes, which they probably acquired from Keiser’s company when they bought the exchange. Personally, I had never heard of this exchange, but I don't, exactly follow movies. I follow commodities. I know about the ICE Futures for Tropical Winds, but I wasn't watching the movie futures. So this is my crash course, because the virtual HSX is about to go real Cantor Exchange.
Cantor Fitzgerald is expecting the CFTC the okay their creation by April 20. It will be called the "Domestic Box Office Receipt Movie Futures" contract, or DBOR (DBOR--will this be pronounced as de-bore? As in, to make us not "bored" anymore? Is that a Fruedian slip or what?!). It will be traded on the Cantor Exchange (CX). Click here for the contract rules book (pdf) that Cantor submitted to CFTC. Below are some choice parts:
"Chapter II-1-(a) Pursuant to each DBOR Contract entered into through the Exchange, the seller agrees to sell to the purchaser, and the purchaser agrees to purchase from the seller, a specified portion of an identified film title’s DBOR, as measured by the sum of the daily box office receipts in the U.S. and Canada, in accordance with these Rules, during the first four weeks after the film title’s initial release (such contract a “DBOR Contract”).
"Chapter II-2-The unit size of each DBOR Contract will be the aggregate DBOR during the Final Settlement Period for the relevant underlying film title, divided by the contract divisor of 1,000,000. Therefore, each DBOR Contract will represent 1/1,000,000th of the aggregate DBOR during the Final Settlement Period; a $1,000,000 change in revenues will cause a $1.00 change in the value of a Contract. The method of determining the Final Settlement Price is further described in Rule IV-9(a)."
"Chapter II-6-(c) Entities that are engaged in hedging activities through the use of short positions in DBOR Contracts, and Market Makers, may be granted hedge exemptions that exceed the short side speculative position limits by application to the Exchange; provided, however, that no short side hedge exemptions will be granted that would permit sale of more than 30% of the underlying position on which such hedge exemption is based and provided further that under no circumstances shall any hedge exemption be granted that would permit a Participant to hold a position exceeding 300,000 DBOR Contracts. Commercial entities eligible for short side hedge exemptions include (but are not necessarily limited to) film studios, film funds or other investors in films. Participants that are engaged in hedging activities through the use of long positions in DBOR Contracts, and Market Makers, may be granted hedge exemptions that exceed the long side speculative position limits by application to the Exchange. Any application for hedge exemptions made under this Rule shall include by any information or supporting material prescribed or reasonably requested by the Exchange, and shall include such facts as may be necessary to demonstrate the applicant's need to use DBOR Contracts for hedging purposes."
"Chapter IV-2-(a) The Exchange’s DBOR Contract market (excluding the Pre-Opening Auction) is a continuous (seven days a week, 24 hours each day), first-in first-out, two-way, limit order book, as described in Rule IV-3 below. Orders will be accepted in price/time priority effective 9:30 A.M. on the First Trading Day. Continuous trading of a DBOR Contract in this manner commences immediately following the close of its Pre-Opening Auction at 9:30 A.M. on the First Trading Day and terminates at the End of Trading on the Last Trading Day.
"Chapter IV-6- (b) On each Trading Day, the amount by which the price of a DBOR Contract may increase or decrease is limited to an amount equal to 10% of its prior day’s Settlement Price rounded to the next highest 0.5, which in no event will be less than 2.5, provided that the Exchange shall have the authority, under extraordinary market circumstances, to set daily price limits at different levels if, in the reasonable judgment of the Exchange, such action is warranted for the protection of the market and Participants."
"Chapter IV-12-(a) Subsequent to the commencement of the Pre-Opening Auction with respect to any DBOR Contract, any person in possession of Material Non-Public Information regarding the relevant film title will be prohibited from trading in DBOR Contracts with respect to such title.
(b) Notwithstanding anything to the contrary in these DBOR Contract Rules, the prohibitions on trading described in Rule IV-12(a) will not supersede any applicable prohibitions on fraud and manipulation, whether such prohibitions are prescribed by law, regulation or the Rules of the Exchange or the Rules of the Clearinghouse. The Exchange and the Clearinghouse each retain the right to take any appropriate disciplinary actions against Participants as permitted by the Rules of the Exchange or the Rules of the Clearinghouse, as applicable."
It reads like a regular future contract rule book--except for the fact that it is talking about movie revenues! Yes, I'm sure there will be no such need for "appropriate disciplinary actions against Participants" references in IV-12-(b), because I can't possibly see anybody finding a way to add fraud to this! Oh man, I can't even believe I'm writing about a futures contract on Hollywood box office reciepts--excuse me, I mean DBOR’s--but I am.
As you can see from the contract, much of it is very similar to another other futures contracts. The biggest difference is that you're betting on "movie commodities" that will disappear from trading after a certain period of time. It is very much like the sports betting: the game will be over soon, in other words. The contracts are limited by time. This is a huge difference from something like copper, where trading is building on previous years of data and looking out years to the future.
These DBOR contracts will be announced 6 months in advance of the expected opening day of the film (aka First Trading Day) to start the price discovery process. If there are delays, I guess that's just going to happen. The DBOR futures contracts themselves are one-one-millionth of the buyer's predicted revenue for the film. This article explains it nicely:
"This exchange will enable the trading of contracts based on a movie's first four weeks of domestic box office sales. Each contract will be priced at one-millionth of the ticket sales estimate. So a contract trades for $100 if it predicts a $100 million box office gross. A prediction of $150 million in ticket sales would trade for $150, etc. If the movie grosses more, the contract increases proportionally, if it comes in short of expectations, the contract drops in value. The speculation will begin six months before a movie opens and will continue through the first four weeks at the box office."
It is that last part that is just flashing "DANGER!!" to me (beside the fact that this is MOVIES!)--six months of "speculation"? That's a very unique thing--there's nothing else in the futures world that just comes into existence, is speculated on for six months, reaches an actual price, and then disappears in four weeks. The speculation part is danger...especially when you combine it with these quotes:
"Richard Jaycobs, president of the Cantor Exchange, says he expects most of the investors will be people already familiar with the vagaries of the film industry, including producers and distributors who want to hedge against their investment in a particular film. However, anyone may invest and he says the "public response to this product has been very positive."" (article)
“I’ve worked in the futures industry for a long time,” said Richard Jaycobs, the president of Cantor Exchange, who has worked with derivative markets and the cotton exchange. “And none of the products has the overall appeal that this does. This just has a tremendous potential audience.” (different article)
The last thing we need the public getting into is nationwide, 24-hr movie "DBOR" gambling. And, as it is a futures contract, yes, margins are fine! In fact, if it is like any of the other futures contracts, margin trading will be the base, because the whole investor/speculator attraction of a futures contract is the leverage you can get on swings using margins. DBOR Margins must be secured through a clearinghouse, and cash, Treasuries, or "other non-cash assets that may be approved by the Clearninghouse from time to time" are eligible collateral for against the margin. That last "asset class" is interesting--we can only guess what will end up as "collateral" in these margin accounts if "non-cash assets that may be approved by the Clearinghouse from time to time" is the standard. But hey, anyone who plays this game gets exactly what they deserve!
You can check it all out here, at Cantor's flashy new "Cantor Exchange" (CX) DBOR site: http://www.cantorexchange.com/. In fact, you can even start practice trading DBOR contracts right now! Yes, to introduce everyone to the joys of blowing your entire paycheck on a Box Office bet, the CX is currently running the "It Pays to Practice!" Promotion. Sign up free and get $10,000 fake dollars to start trading now! Whatever you're left with, Cantor will give you $10 real dollars for every $1000 fake ones you have left after March 31, and you'll be ready to go when the real market opens April 20, where you will promptly lose your rent, phone bill, and electricity bill money! Cantor says: "Now, with Cantor Exchange, you can do what you love to do - trade on box office revenues - for real money!" (Oh, yes, this is just so great...I can't see any problems with this at all...oh my gosh, we are so screwed!)
So come April 20, we will likely have Cantor's CX streaming us live, 24-hr DBOR contract prices. With a CFTC like the one we have, I'd be stunned if they didn't approve it. After all, it will boost our economy, right? Cantor will likely be the first--but they won't likely be the last. In Sept 2009, another company called Media Derivatives, applied to the CFTC to launch a box office revenues trading platform of their own, called the MDEX. Why have one death-nail when you can have two?
By the way, Cantor was fined half a million bucks in 1997 by the CFTC, and agreed to an entry that it "aided and abetted fraud and registration violations" in a case where "although Cantor became aware that VFS falsely represented the ownership of a securities trading account VFS had opened in its own name, Cantor allowed the account to be traded in VFS' name. The account was actually owned by a commodity pool, the order finds. The order also finds that Cantor failed to determine the ownership of the VFS account, and failed to obtain the trading authority needed to allow VFS to enter trades in this account. In addition, the order finds that Cantor assisted VFS in obtaining $950,000 to which VFS was not entitled by making wire transfer payments to First Republic Securities, a wholly owned subsidiary of VFS, out of customer funds held in the account at Cantor." That's from the CFTC report--but I'm sure they've spiffied-up their trading practices since then. They've been holding this potato for almost a decade now, and they are ready to go. They want this derivative machine a-movin.'
I don't know what, but Cantor is definitely up to something. Maybe they are tired of masquerading trading as an "investment practice" and they are just outright advertizing it as gambling (which, of course, it is). Earlier this year, Cantor acquired the sports betting parts of three Las Vegas casinos-- Palazzo, the Venetian, and the new M Resort. That's right--sports betting. It is detailed in this Wall Street Journal article, from which is a quote by a Cantor executive in charge of the operation. He said: "We wanted to turn gamblers into traders." Indeed. They call it Cantor Gaming.
Cantor Gaming has transformed the floors of these betting rooms into models of Wall Street trading floors. They opened bets on everything from win, to spread, to whether or not the quarterback would complete the next pass, or if the field-goal would be good or not. And no, I’m not exaggerating: Cantor allows mid-game bets and even bets on particular plays. The article mentions the exposure that Cantor Gaming is accepting, which is certainly something worth noting!
"In the back room, Cantor employees plugged in data so a computer could spit out a new set of odds for the next play.
Cantor makes money by charging a small commission on bets. It tries not to take on any risk itself. That means that a bet that Miami is about to score has to be matched with the opposite wager. But frequently, there isn't the same amount of money on the other side of the bet, leaving Cantor exposed.
"Employees scan a risk-management chart—imported from trading platforms—which shows bets that Cantor still hasn't been able to match. When the charts show too much imbalance, Cantor gaming operator Andrew Patterson adjusts the odds to try to persuade gamblers to bet for the other team. "I manage risk," Mr. Patterson said. "If the pricing gets heavy on one side, I can adjust."
"While most Las Vegas sports books discourage professional betters because they expose the house to more risk, Cantor is trying to increase its gambling business to the point where it can use its software to create an efficient market. To do that, it must convince more casinos to sign up with Cantor's service."
Yeah, that's just great. I'm sure you've got it totally under control. Your sports and your movies. And, and in case your wondering, Cantor Fitzgerald itself is NOT publicly traded. It’s a private partnership. And one last thing about Cantor Fitzgerald, their Cantor Exchange, and the Domestic Box Office Revenues future contract: Cantor Fitzgerald, the mastermind behind this all, has been a primary dealer in the Federal Reserve System since 2006. (What do you mean you're not surprised?!)
So, now we just have to sit back and watch the CFTC okay this, and here we go. Witness a bubble, right before our eyes! There has been a lot of media attention about this over the last week that I detected during my searches. I found articles in the WSJ, NYT, CBC, CNBC, Reuters, Vanity Fair, LA Times, Business Wire, and many more. People are going to be hearing about this soon. Those million traders on the HSX surely already know about it. We'll see how much this magic trick drains from the American economy in the name of "financial innovation."
Isn’t this getting old?
Showing posts with label deriviatives. Show all posts
Showing posts with label deriviatives. Show all posts
Tuesday, March 30, 2010
Wednesday, December 30, 2009
Penny Arbitrage, the US Dollar, and the Commodities Market
Question: When is a penny worth more than a penny?
Answer: When there’s the chance for penny arbitrage.
Arbitrage is any investor’s dream come true! It is an opportunity to make money through a trade with zero risk of a loss. Literally: in an arbitrage situation, you cannot lose. If you can, then its not true arbitrage. While this may sound too good to be true, arbitrage is quite possible, and there is an entire niche of specialized investors who are constantly hunting down the latest chance to taken advantage of it. Arbitrage is an idiosyncrasy of the free market: as much as it might burn some people who don’t take advantage of it—including “people” of the international finance realm like those are the BIS, IMF, etc—arbitrage reveals locality in pricing over global uniformity. Therefore, of course, globalists hate arbitrage, because that locality threatens the centralized world they seek to unilaterally control. Here’s the IMF’s explanation of arbitrage, from Demystifing Hedge Funds, an external document on the IMF's website:
"The technique of arbitrage tries to profit from the fact that sometimes an asset trades at a different price in different markets at the same time. Because an asset should have the same price in all markets at the same time, a way to capture a low-risk profit is to sell the higher-priced asset in one market (sell it short) and buy the lower-priced asset (buy it long) in the other market. When the prices converge, an arbitrage profit can be captured by selling the formerly low-priced asset and buying back the formerly high-priced asset. A typical example of potential arbitrage opportunities is company bonds that are convertible into equity shares of the company.”
Please note, by “asset,” the authors are talking about financial assets—market-traded securities, stocks, debt, derivatives, etc—and not off-exchange commodities. Commodities often have different prices in different geographic areas: bananas are cheaper in Guatemala than in Russia, right? The availability of a commodity is often geographically limited or specific, thus the above-mentioned “assets” are those electronically exchanged paper assets which are equally accessible in all corners of the planet. Indeed, commodities can be lsited on exchanges, and when they are, they also be subject to price uniformity, and possibily arbitrage when locality breaks that uniformity. Just recently, a major arbitrage oppurtunity occured for Chinese copper traders who spotted a price difference between the London Metals Exchange (LME) price and the Shanghai price on futures contracts for copper: within hours, these savvy traders rallied the price up and pocketed a risk-free return. And of course, they never even touched the metal. It is pure arbitrage.
Arbitrage is not Chiquita buying bananas in Guatemala for $0.02/lbs, bringing them to the US, and selling them for $0.69/lbs. Chiquita is not conducting arbitrage because, while if everything goes well, they’ll make a nice profit, it is also possible that they could lose money. True arbitrage is totally protected from loss. Chiquita is trading: they are moving the cheap-to-produce, widely available, local commodity of bananas from a place like Guatemala to a higher-priced market where the bananas are otherwise unavailable, like Minnesota. Chiquita takes a risk and could lose: after all, the banana ship could get raided by gorilla pirates (not guerillas, but actual gorillas!), who eat all the bananas, kill the crew, and sink the ship. Its not likely, but its possible, and now Chiquita is out a load of bananas, a crew, and a ship. Therefore, there is risk to Chiquita’s venture, and so it is not arbitrage. Remember: arbitrage carries zero risk—it must be impossible to lose. Also, true arbitrage happens nearly instantly: the trade is executed and the profit is collected. So, then, what is an example of arbitrage, and how to pennies relate to this?
Think about pennies while this example of arbitrage unfolds. Probably the simplest, easiest, and most common form of arbitrage happens when a trader realizes that the convertible bonds (bonds of a company that can be converted to stock in that same company) have a premium (or discount) to the current price of the equity (stock). This is called convertible arbitrage. Demystifing Hedge Funds explains it as:
“Convertible arbitrage. A strategy in which managers purchase a portfolio of securities that are convertible into other kinds of securities. For example, corporate bonds are often convertible into equity shares of the issuing companies. Normally, the prices of the bonds and shares trade in a close relationship. Sometimes bond and stock market conditions cause the prices to get out of line. Hedge funds buy and sell the bonds and stocks simultaneously, pushing the prices back into line and profiting from market mispricing."
Let’s say you are a trader. You are looking through convertible bonds, and notice that Company Z’s stock is trading at $10 a share. You also notice, however, that for some reason, Company Z’s convertible bonds are trading at 99% of face value, and are convertible to 11 shares. You do the math: you can buy $100 face value of Company Z’s bonds for $99, and it convert to 11 shares at $10 a share. In other words, you can buy spend $99 and get $110, instantly. You don’t know anything about Company Z, nor do you particularly care, because you will execute the buy and sell of the bonds and converted stocks instantly and simultaneously. Others, of course, will quickly notice this, and soon those with the bonds which you seek to purchase will demand a higher price (or convert the bonds to stocks themselves), and/or those with the stock you wish to buy will sell and buys bonds, thus driving down the price of the stock. Either way, the arbitrage will quickly evaporate, as the bond price will go lower or the stock price will go higher to equalize, or the stock will go higher and the bonds lower. Either way, those others in the market with Company Z bonds/stocks will have the market power to demand a higher price which will correct the arbitrage situations.
So, in convertible arbitrage the trader exercises the right to convert one to the other, or use one to purchase the other at a zero risk of loss. It must be instantaneously, electronically accomplished so that the arbitrager never “holds” the bonds/stocks, which will soon be subject to correction. The other huge example (though much less common) version is regulatory arbitrage. In regulatory arbitrage, traders can take advantage of some legal constraint that varies in different markets. Regulatory arbitrage plays one government’s policies against another, or with Basel II, one securitization framework against the other. There are financial geniuses in the regulatory arbitrage market, who have, as mere individuals, actually greatly hampered the Bank for International Settlements’ push for “standardisation” by revealing that the BIS’ Basel II framework itself is wrought with contradictions and arbitrage opportunities—and they are using it against the banks with great success. And banks themselves use regulatory arbitrage. Regulatory arbitrage along these lines, according to many analysts and the disgruntled finance ministers of the top twenty economies (aka the G20), had a significant role in sparking the current meltdown, particularly and specifically with the Basel II minimum capital requirement’s various ridiculous “capital calculation” schemes. (But I’m getting sidetracked: there will be a complete post on the role of regulatory arbitrage in Basel II soon.) So, that’s basic financial asset arbitrage. It’s a simple concept, even though the execution can be a little complex, and arbitrage helps keep prices of financial assets in line throughout the global paper investment market.
Thus is one example of paper asset arbitrage. Now for commodities arbitrage—penny arbitrage. I acknowledge outright that my penny arbitrage example is in no way a true arbitrage, because you cannot instantly make profits nor can you execute it while sitting behind a trader screen. To be totally technical, penny “arbitrage” is more like a hedge, as one “asset” (the penny) exposes the holder to two different markets simultaneously—the copper market (as a copper penny) and the currency market (as a unit of the US dollar). But unlike hedging, it actually carries zero risk--you'll always have whatever you started with. Therefore, I’m going to call it penny arbitrage, and maybe you’ll see why and agree.
Penny arbitrage demonstrates what fiat money does: it disintegrates value. Reach into your pocket, and pull out all of the change. Of course, we already know that any pre-1965 quarters or dimes that you might have in that mix are 90% silver, and therefore, currently, those silver coins are worth more than ten times the face value (in fact, with silver at about $17/oz today, they’re worth over twelve times face value). But, in all honesty, it is not very likely that you’ll have a pre-1965 quarter or dime. Most of the silver coins have been pulled from circulation by investors and collectors who know what they are worth, and so you’ll have to pay the about $12.29 for 4 silver quarters (in other words, $12.29 for $1 face value). That said, however, it is very likely that you’ll have some pennies. And it is also very likely that you’ll have some copper pennies.
So, do it now, check your pennies: any one with a date of 1981 or older is a 95% copper coin. During 1982, the penny’s composition was changed from 95% copper, 5% zinc to 95% zinc, and only 5% copper (coating), due to the increasing price of copper, which had peaked to over $1/lb in 1980, and was holding steady above $0.70/lb. (Do you see where this is going yet?) Some 1982 pennies are 95% copper, and some are 95% zinc, but you cannot easily tell unless you weigh them: the copper pennies weigh about 3.1 gm, and the zinc pennies weigh about 2.5 gm. Of course, the price of copper wasn’t simply increasing on its own in a vacuum as industrial commodity: the price of copper was increasing relative to the value of the dollar (or, in this case, the penny), which, because of its inflationary fiat nature, is constantly deteriorating. Congress changed the composition of pennies in 1982 because the cost of making the physical coins was increasing, while the purchasing power value of each $0.01 was decreasing.
Now for the arbitrage: those easy-to-find copper pennies have a declared face value of $0.01. Therefore, for monetary exchange, a penny (whether copper or not) is worth only $0.01. But, as copper, your little penny exposes you to the commodities market, and as metal, the little thing is worth more that double the face value—its actually worth a whopping $0.02 (or 0.0217498, to be more precise, today, Dec 30 2009, with copper at $3.35/lb). That is penny arbitrage.
As stated above, the mass of a copper penny is 3.1 grams, but as it is 95% copper, the actual copper content is 95% x 3.1 = 2.945 grams. There are 28.35 grams to an ounce (metric converter), and 16 ounces to a pound, therefore 453.6 gm/lb. So, to calculate the price per gram of copper, simply convert the price/lb to price/gm by following this equation:
Price/lb ÷ 453.6 = Price/gm
At $3.35/lb, copper is currently $0.0073853 a gram. At 95% copper, each copper penny contains 2.945 gm copper. Therefore, multiply the price by the content weight, and you’ll see that each copper penny contains $0.0217498 worth of copper, or more than twice the face value.
An easier way to do this is to calculate the number of copper pennies needed to make a pound of copper. Copper pennies are 95% copper and lose very little of their composition through circulation.
Number of 95% copper pennies needed to make 1 lb copper:
453.6 (gm in 1lb of copper) ÷ 2.945 (gm of copper in 1 penny) = 154.023 pennies.
So, you need 155 pennies (or $1.55) to have one pound worth of copper. Of course, as they are 5% zinc, these 155 pennies will actually weigh slightly more than one pound if placed on a scale (they'll weigh 3.1 gm x 155 = 480.5 gm / 453.6 gm (per pound) = 1.059 lbs).
Now, consider that the current price per lb of copper is $3.35 (Dec 30 2009). Do you get it now?
Answer: When there’s the chance for penny arbitrage.
Arbitrage is any investor’s dream come true! It is an opportunity to make money through a trade with zero risk of a loss. Literally: in an arbitrage situation, you cannot lose. If you can, then its not true arbitrage. While this may sound too good to be true, arbitrage is quite possible, and there is an entire niche of specialized investors who are constantly hunting down the latest chance to taken advantage of it. Arbitrage is an idiosyncrasy of the free market: as much as it might burn some people who don’t take advantage of it—including “people” of the international finance realm like those are the BIS, IMF, etc—arbitrage reveals locality in pricing over global uniformity. Therefore, of course, globalists hate arbitrage, because that locality threatens the centralized world they seek to unilaterally control. Here’s the IMF’s explanation of arbitrage, from Demystifing Hedge Funds, an external document on the IMF's website:
"The technique of arbitrage tries to profit from the fact that sometimes an asset trades at a different price in different markets at the same time. Because an asset should have the same price in all markets at the same time, a way to capture a low-risk profit is to sell the higher-priced asset in one market (sell it short) and buy the lower-priced asset (buy it long) in the other market. When the prices converge, an arbitrage profit can be captured by selling the formerly low-priced asset and buying back the formerly high-priced asset. A typical example of potential arbitrage opportunities is company bonds that are convertible into equity shares of the company.”
Please note, by “asset,” the authors are talking about financial assets—market-traded securities, stocks, debt, derivatives, etc—and not off-exchange commodities. Commodities often have different prices in different geographic areas: bananas are cheaper in Guatemala than in Russia, right? The availability of a commodity is often geographically limited or specific, thus the above-mentioned “assets” are those electronically exchanged paper assets which are equally accessible in all corners of the planet. Indeed, commodities can be lsited on exchanges, and when they are, they also be subject to price uniformity, and possibily arbitrage when locality breaks that uniformity. Just recently, a major arbitrage oppurtunity occured for Chinese copper traders who spotted a price difference between the London Metals Exchange (LME) price and the Shanghai price on futures contracts for copper: within hours, these savvy traders rallied the price up and pocketed a risk-free return. And of course, they never even touched the metal. It is pure arbitrage.
Arbitrage is not Chiquita buying bananas in Guatemala for $0.02/lbs, bringing them to the US, and selling them for $0.69/lbs. Chiquita is not conducting arbitrage because, while if everything goes well, they’ll make a nice profit, it is also possible that they could lose money. True arbitrage is totally protected from loss. Chiquita is trading: they are moving the cheap-to-produce, widely available, local commodity of bananas from a place like Guatemala to a higher-priced market where the bananas are otherwise unavailable, like Minnesota. Chiquita takes a risk and could lose: after all, the banana ship could get raided by gorilla pirates (not guerillas, but actual gorillas!), who eat all the bananas, kill the crew, and sink the ship. Its not likely, but its possible, and now Chiquita is out a load of bananas, a crew, and a ship. Therefore, there is risk to Chiquita’s venture, and so it is not arbitrage. Remember: arbitrage carries zero risk—it must be impossible to lose. Also, true arbitrage happens nearly instantly: the trade is executed and the profit is collected. So, then, what is an example of arbitrage, and how to pennies relate to this?
Think about pennies while this example of arbitrage unfolds. Probably the simplest, easiest, and most common form of arbitrage happens when a trader realizes that the convertible bonds (bonds of a company that can be converted to stock in that same company) have a premium (or discount) to the current price of the equity (stock). This is called convertible arbitrage. Demystifing Hedge Funds explains it as:
“Convertible arbitrage. A strategy in which managers purchase a portfolio of securities that are convertible into other kinds of securities. For example, corporate bonds are often convertible into equity shares of the issuing companies. Normally, the prices of the bonds and shares trade in a close relationship. Sometimes bond and stock market conditions cause the prices to get out of line. Hedge funds buy and sell the bonds and stocks simultaneously, pushing the prices back into line and profiting from market mispricing."
Let’s say you are a trader. You are looking through convertible bonds, and notice that Company Z’s stock is trading at $10 a share. You also notice, however, that for some reason, Company Z’s convertible bonds are trading at 99% of face value, and are convertible to 11 shares. You do the math: you can buy $100 face value of Company Z’s bonds for $99, and it convert to 11 shares at $10 a share. In other words, you can buy spend $99 and get $110, instantly. You don’t know anything about Company Z, nor do you particularly care, because you will execute the buy and sell of the bonds and converted stocks instantly and simultaneously. Others, of course, will quickly notice this, and soon those with the bonds which you seek to purchase will demand a higher price (or convert the bonds to stocks themselves), and/or those with the stock you wish to buy will sell and buys bonds, thus driving down the price of the stock. Either way, the arbitrage will quickly evaporate, as the bond price will go lower or the stock price will go higher to equalize, or the stock will go higher and the bonds lower. Either way, those others in the market with Company Z bonds/stocks will have the market power to demand a higher price which will correct the arbitrage situations.
So, in convertible arbitrage the trader exercises the right to convert one to the other, or use one to purchase the other at a zero risk of loss. It must be instantaneously, electronically accomplished so that the arbitrager never “holds” the bonds/stocks, which will soon be subject to correction. The other huge example (though much less common) version is regulatory arbitrage. In regulatory arbitrage, traders can take advantage of some legal constraint that varies in different markets. Regulatory arbitrage plays one government’s policies against another, or with Basel II, one securitization framework against the other. There are financial geniuses in the regulatory arbitrage market, who have, as mere individuals, actually greatly hampered the Bank for International Settlements’ push for “standardisation” by revealing that the BIS’ Basel II framework itself is wrought with contradictions and arbitrage opportunities—and they are using it against the banks with great success. And banks themselves use regulatory arbitrage. Regulatory arbitrage along these lines, according to many analysts and the disgruntled finance ministers of the top twenty economies (aka the G20), had a significant role in sparking the current meltdown, particularly and specifically with the Basel II minimum capital requirement’s various ridiculous “capital calculation” schemes. (But I’m getting sidetracked: there will be a complete post on the role of regulatory arbitrage in Basel II soon.) So, that’s basic financial asset arbitrage. It’s a simple concept, even though the execution can be a little complex, and arbitrage helps keep prices of financial assets in line throughout the global paper investment market.
Thus is one example of paper asset arbitrage. Now for commodities arbitrage—penny arbitrage. I acknowledge outright that my penny arbitrage example is in no way a true arbitrage, because you cannot instantly make profits nor can you execute it while sitting behind a trader screen. To be totally technical, penny “arbitrage” is more like a hedge, as one “asset” (the penny) exposes the holder to two different markets simultaneously—the copper market (as a copper penny) and the currency market (as a unit of the US dollar). But unlike hedging, it actually carries zero risk--you'll always have whatever you started with. Therefore, I’m going to call it penny arbitrage, and maybe you’ll see why and agree.
Penny arbitrage demonstrates what fiat money does: it disintegrates value. Reach into your pocket, and pull out all of the change. Of course, we already know that any pre-1965 quarters or dimes that you might have in that mix are 90% silver, and therefore, currently, those silver coins are worth more than ten times the face value (in fact, with silver at about $17/oz today, they’re worth over twelve times face value). But, in all honesty, it is not very likely that you’ll have a pre-1965 quarter or dime. Most of the silver coins have been pulled from circulation by investors and collectors who know what they are worth, and so you’ll have to pay the about $12.29 for 4 silver quarters (in other words, $12.29 for $1 face value). That said, however, it is very likely that you’ll have some pennies. And it is also very likely that you’ll have some copper pennies.
So, do it now, check your pennies: any one with a date of 1981 or older is a 95% copper coin. During 1982, the penny’s composition was changed from 95% copper, 5% zinc to 95% zinc, and only 5% copper (coating), due to the increasing price of copper, which had peaked to over $1/lb in 1980, and was holding steady above $0.70/lb. (Do you see where this is going yet?) Some 1982 pennies are 95% copper, and some are 95% zinc, but you cannot easily tell unless you weigh them: the copper pennies weigh about 3.1 gm, and the zinc pennies weigh about 2.5 gm. Of course, the price of copper wasn’t simply increasing on its own in a vacuum as industrial commodity: the price of copper was increasing relative to the value of the dollar (or, in this case, the penny), which, because of its inflationary fiat nature, is constantly deteriorating. Congress changed the composition of pennies in 1982 because the cost of making the physical coins was increasing, while the purchasing power value of each $0.01 was decreasing.
Now for the arbitrage: those easy-to-find copper pennies have a declared face value of $0.01. Therefore, for monetary exchange, a penny (whether copper or not) is worth only $0.01. But, as copper, your little penny exposes you to the commodities market, and as metal, the little thing is worth more that double the face value—its actually worth a whopping $0.02 (or 0.0217498, to be more precise, today, Dec 30 2009, with copper at $3.35/lb). That is penny arbitrage.
As stated above, the mass of a copper penny is 3.1 grams, but as it is 95% copper, the actual copper content is 95% x 3.1 = 2.945 grams. There are 28.35 grams to an ounce (metric converter), and 16 ounces to a pound, therefore 453.6 gm/lb. So, to calculate the price per gram of copper, simply convert the price/lb to price/gm by following this equation:
Price/lb ÷ 453.6 = Price/gm
At $3.35/lb, copper is currently $0.0073853 a gram. At 95% copper, each copper penny contains 2.945 gm copper. Therefore, multiply the price by the content weight, and you’ll see that each copper penny contains $0.0217498 worth of copper, or more than twice the face value.
An easier way to do this is to calculate the number of copper pennies needed to make a pound of copper. Copper pennies are 95% copper and lose very little of their composition through circulation.
Number of 95% copper pennies needed to make 1 lb copper:
453.6 (gm in 1lb of copper) ÷ 2.945 (gm of copper in 1 penny) = 154.023 pennies.
So, you need 155 pennies (or $1.55) to have one pound worth of copper. Of course, as they are 5% zinc, these 155 pennies will actually weigh slightly more than one pound if placed on a scale (they'll weigh 3.1 gm x 155 = 480.5 gm / 453.6 gm (per pound) = 1.059 lbs).
Now, consider that the current price per lb of copper is $3.35 (Dec 30 2009). Do you get it now?
As the table above demonstrates, the price of copper overwhelms the one-cent face value of the penny when the metal hit $1.55/lb. A copper penny will be worth a dime ($0.10) when copper hits $15.41/lb.
For historical comparison, the Treasury could no longer afford to maintain the 90% silver content of halves, quarters, and dimes by 1962. The value of the paper dollar had decreased (read: "had been debased by the Federal Reserve System") to the level that silver was nearing a 1:1 ratio. The year 1964 was the last for 90% silver coins (40% silver halves through 1968, and then all circulating coins were silver-free). Since 1965, when silver traded at roughly $1.10 - 1.29/oz, the price of silver has increased by approximately $16.90, or 1536% (based on recent $18/oz silver; silver is today at about $17, and reached over $20 in early 2008).
Likewise, since gold was removed from the $35/oz peg in 1971, the metal has moved $1065, or 3043% (based on recent approximate $1,100/oz gold).
Therefore, as a monetary unit, a copper penny (and its zinc version) is pegged at $0.01, which sets both the floor value and the investment price for it as an “arbitrage” opportunity. However, as a piece of metal, the old copper penny’s value is over 2 cents. Over the long term, the copper price will likely rise in step with general prices, especially as the industrial demand for copper increases and more nations become industrialized, but an even greater factor in the “price” of copper will be the long-term loss of value of the US dollar unit.
I’ll be the first to declare that copper prices are very volatile: after a 60-year low of $0.60/lb in the 1990’s, copper has spent much of the last 15 years under $1.50/lb, which made the price nearly the same as the $1.55/lb copper-penny price. In 2006, the price of copper and nickel surged, making the coins more valuable as metal than as US currency, and forcing high replacement costs on the US Mint. Until 2006, it was not illegal to melt coins, but facing these high replacement costs, the Treasury prompted the US government to illegalize the melting of pennies and nickels (which are 75% copper, 25% nickel), and impose restrictions on the export of the coins to $100 face value. The copper price moved down in 2007 before again surging during the summer 2008 commodities bubble that pushed oil to $148/barrel. The melt/export ban remains in place for nickels and pennies. (A similar ban was placed on the melting of silver coins as part of the Coinage Act in 1967, and this ban was eventually lifted once the Mint could meet the US coin demand with the “clad” silver-free coins.)
At the 2006 and 2008 $4/lb level, $1.00 in copper pennies was actually worth $2.60 in copper. For the record: I am absolutely NOT suggesting to anyone to melt pennies or nickels—as detailed above, it is a federal crime punishable by a $10,000 fine and five years in prison, or both. I am simply using the difference in the “currency value” of copper pennies versus the “commodities value” of the copper in them to demonstrate what fiat money does to the value of our currency and the spending power of our savings.
So think about what the Federal Reserve’s fiat printing machine is doing to your savings next time you have a little copper penny in your hand. It is not rocket science, and it is not some crazy derivative: a dollar in paper, or as an electronic entry at your bank, is worth $1.00, period. Yet, a dollar in little copper pennies is currently worth $2.17. This is why we call the central bankers by their proper name: central banksters.
Perhaps anyone with electronic “cash” sitting in an account, or paper bills stuffed under a mattress, collecting zero or near zero percent interest should, maybe, think about turning all that savings into pennies, sorting through them, and filling up Arrowhead water jugs with the coppers! Hey--it can be a new home decorating item: a few thousand pounds of copper pennies in whatever will hold them! After all, it really doesn’t take up that much space: according to a very unscientific Google search, a 5-gallon Arrowhead jug filled with copper pennies would weigh about 245 lbs, and contain 35,000 pennies, or about $350 face value in pennies, with a copper content of 95%. Put it in the closet, and when copper is at $10/lb in 15 years, it will be worth $2275, or $1,925 more than the face value. Worst case scenario, the police-state raids your house, takes your pennies, and gives you Federal Reserve notes!
Left as electronic money in a savings account at 5% compounding interest (which you’d be lucky to find these days), that $350 will have grown to just $570 in 10 years (calculator). Left as cash in an envelope, it will remain at $350, and simply further lose purchasing power as the dollar devalues. Considering this, pennies are looking better by the minute! Plus, there’s the added benefit of denying a banking institution from taking your $350 and leveraging it out at 10:1, "buying" up the economy, further contributing to inflation, strengthening the Federal Reserve System, and continuing the devaluation of the dollar and atrophy of spending power! Why not pennies?
In 1924, in the Weimar Republic, paper money was worth more as fuel for the fire than currency; in 2009, in Mugabe’s Zimbabwe, a $1,000,000,000,000 (that's one TRILLION) in bank notes was used as wall paper. And today, a little old US penny is worth more as metal than as currency. We’re lucky..,but for how long?
For historical comparison, the Treasury could no longer afford to maintain the 90% silver content of halves, quarters, and dimes by 1962. The value of the paper dollar had decreased (read: "had been debased by the Federal Reserve System") to the level that silver was nearing a 1:1 ratio. The year 1964 was the last for 90% silver coins (40% silver halves through 1968, and then all circulating coins were silver-free). Since 1965, when silver traded at roughly $1.10 - 1.29/oz, the price of silver has increased by approximately $16.90, or 1536% (based on recent $18/oz silver; silver is today at about $17, and reached over $20 in early 2008).
Likewise, since gold was removed from the $35/oz peg in 1971, the metal has moved $1065, or 3043% (based on recent approximate $1,100/oz gold).
Therefore, as a monetary unit, a copper penny (and its zinc version) is pegged at $0.01, which sets both the floor value and the investment price for it as an “arbitrage” opportunity. However, as a piece of metal, the old copper penny’s value is over 2 cents. Over the long term, the copper price will likely rise in step with general prices, especially as the industrial demand for copper increases and more nations become industrialized, but an even greater factor in the “price” of copper will be the long-term loss of value of the US dollar unit.
I’ll be the first to declare that copper prices are very volatile: after a 60-year low of $0.60/lb in the 1990’s, copper has spent much of the last 15 years under $1.50/lb, which made the price nearly the same as the $1.55/lb copper-penny price. In 2006, the price of copper and nickel surged, making the coins more valuable as metal than as US currency, and forcing high replacement costs on the US Mint. Until 2006, it was not illegal to melt coins, but facing these high replacement costs, the Treasury prompted the US government to illegalize the melting of pennies and nickels (which are 75% copper, 25% nickel), and impose restrictions on the export of the coins to $100 face value. The copper price moved down in 2007 before again surging during the summer 2008 commodities bubble that pushed oil to $148/barrel. The melt/export ban remains in place for nickels and pennies. (A similar ban was placed on the melting of silver coins as part of the Coinage Act in 1967, and this ban was eventually lifted once the Mint could meet the US coin demand with the “clad” silver-free coins.)
At the 2006 and 2008 $4/lb level, $1.00 in copper pennies was actually worth $2.60 in copper. For the record: I am absolutely NOT suggesting to anyone to melt pennies or nickels—as detailed above, it is a federal crime punishable by a $10,000 fine and five years in prison, or both. I am simply using the difference in the “currency value” of copper pennies versus the “commodities value” of the copper in them to demonstrate what fiat money does to the value of our currency and the spending power of our savings.
So think about what the Federal Reserve’s fiat printing machine is doing to your savings next time you have a little copper penny in your hand. It is not rocket science, and it is not some crazy derivative: a dollar in paper, or as an electronic entry at your bank, is worth $1.00, period. Yet, a dollar in little copper pennies is currently worth $2.17. This is why we call the central bankers by their proper name: central banksters.
Perhaps anyone with electronic “cash” sitting in an account, or paper bills stuffed under a mattress, collecting zero or near zero percent interest should, maybe, think about turning all that savings into pennies, sorting through them, and filling up Arrowhead water jugs with the coppers! Hey--it can be a new home decorating item: a few thousand pounds of copper pennies in whatever will hold them! After all, it really doesn’t take up that much space: according to a very unscientific Google search, a 5-gallon Arrowhead jug filled with copper pennies would weigh about 245 lbs, and contain 35,000 pennies, or about $350 face value in pennies, with a copper content of 95%. Put it in the closet, and when copper is at $10/lb in 15 years, it will be worth $2275, or $1,925 more than the face value. Worst case scenario, the police-state raids your house, takes your pennies, and gives you Federal Reserve notes!
Left as electronic money in a savings account at 5% compounding interest (which you’d be lucky to find these days), that $350 will have grown to just $570 in 10 years (calculator). Left as cash in an envelope, it will remain at $350, and simply further lose purchasing power as the dollar devalues. Considering this, pennies are looking better by the minute! Plus, there’s the added benefit of denying a banking institution from taking your $350 and leveraging it out at 10:1, "buying" up the economy, further contributing to inflation, strengthening the Federal Reserve System, and continuing the devaluation of the dollar and atrophy of spending power! Why not pennies?
In 1924, in the Weimar Republic, paper money was worth more as fuel for the fire than currency; in 2009, in Mugabe’s Zimbabwe, a $1,000,000,000,000 (that's one TRILLION) in bank notes was used as wall paper. And today, a little old US penny is worth more as metal than as currency. We’re lucky..,but for how long?
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