Happy Wonderer

Don't forget that there are two sides to every transaction. In this case it is true that McDonald's doesn't care if they 'win' or 'lose' on a transction, all they care about it that there is a consistant cost over time. This is essential because they have tiny margins, so they need an excellent cost model in order to make money while competing in a tough market.

However consider the other side. Just because McDs would like price insurance doesn't mean that there has to be anybody willing to sell it to them. There has to be somebody willing to accept McDonald's price in exchange for taking a possibly unbounded risk. If cattle suddenly become $50,000 a head and I owe McDonald's 300 of them in December, I stand to lose a lot more than I could have possibly gained were cattle to become free. (Warning: gross oversimplification.)

The price we agree on for the future is based on my perception of the highest possible price of cattle in the future; you can bet that a seller will know the latest meterological forecast for a drought in Argentina. That is the type of risk that one can be comfortable predicting. If, instead, there was a sudden outbreak of a disease with an unknown probability of wiping out %70 of the cattle in production, the futures market would collapse. You would stand to make some money if the fears were unfounded, but you would lose everything if they came to pass. And as Ruy points out, most people lose in futures market, precisely because they do not have as good an understanding of the risks as they think they do (because the risks may be unquantifiable.)


Insurance companies have really dealt with this by excluding acts of terror from their coverage. This is the same reason that they exclude "acts of God", war, and suchlike. There exists a reinsurance market that the companies sell off some of their risk to, but it too requires a perception that we can predict the future (within bounds.) The risk of a major fire in New York can be compared to the risk of a major fire in New Delhi, and thus a market can be made. But although Washington DC and New York are obvious targets, nobody can really say how much more at risk from a terror attack they are than Los Angeles -- which in fact was the target of a major (thwarted) attack before 9/11. It all depends upon what the terrorist decides; and unpredictablity is their stock in trade.

Reinsurance and terrorism is a very important question, and it may have been an impetus for this hairbrained scheme. IMO, in the end the government ends up being the reinsurer of last resort (we can't let the banking system collapse) which may or may not be a good thing.

hw

shome42

I'm no expert on the futures market, but in the case of 70% of cattle all of a sudden dying, are you sure the market would collapse? Wouldn't all of the traders, particularly the short term traders, keep the market liquid enough to still operate? Sure, the price would go down dramatically, but wouldn't there still be short term speculators buying and selling the contracts?

Happy Wonderer

I'm no expert either, so salt is suggested...

Assuming that the surviving cattle were still edible and cattle were not now thought to be dangerous to humans, the survivors would be more valuable, not less. People would need breeding stock.

My assumption is that the market has problems before the cattle all die: if we don't know anything about the probability of the catastrophy then there can't be a futures market. Assume some cattle in every major producing region drop dead and we don't know why, but it seems contagious and possibly transmitted by something where quarentine doesn't work; say by mosquito.

Now, how do we price a future buy? If I think there is an epidemic coming, who do I buy a future from -- somewhere down the whole chain of command I'm going to be buying a cow from some farmer in December. If that farmer's cow happened to survive then great - I own a super-valuable cow. If the cow died, then on paper I'm owed a cow, but Farmer Brown isn't going to be able to supply one.

If there is no epidemic, then I have wasted my money buying a highly priced cow when the price is going to go down.

The only way I can win in this situation is if Farmer Brown happens to have a surviving cow, and he happens to be honest enough to sell me a cow for $10,000 (say twice normal) when he could get $500,000 for it -- or better still keep it and put it into breeding stock. What is Farmer Brown really going to tell me about the status of ol' bessie?

How do I price a future sell? If there is no epidemic I make money, but who wants to be the other half of this transaction? After all, if there is an epidemic, I'm screwed and declare bankruptcy. In that case the buyer loses money as well.

The only way this market could work is if we thought we had some edge, some reason to believe that the epidemic was or was not coming. I just don't see how anyone could be so foolish as to believe that they could predict what {the set of all terrorists} have in mind. If I had some knowledge, I'd either be a terrorist or obliged to tell my government what was going down; woe be to the guy who kept mum about Bin Laden's latest plot so he could make some money in the futures market.

In the bath I thought of yet one more reason this plan is silly. The point of at least one set of the terrorists is to bring down the US economic system, and that is what this market is really about hedging. How many corporations give a rat's behind about Arafat? So, how much would you pay me for a promise that I'll give you a whole bunch of money if the economic system collapses?

hw

In a case like a mass outbreak of BSE, even the surviving %30 would be worthless. Look at Canadian cattle now, and that was just one animal. This also shows how far terrorism futures are from being a market: US cattle futures are way up (after an initial drop.) Bad news in Canada means good news for American cattle. However, bad news in New York and Washington on 9/11 wasn't good news for anybody except some demented sickos, and long-term it wasn't very good news for them either...