Chicago Merc to buy old rival CBOT

Deal for nearby board of trade reflects growth of derivatives

October 18, 2006|By Walter Hamilton | Walter Hamilton,Los Angeles Times

The United States' two largest futures exchanges announced plans yesterday to merge in an $8 billion deal that reflects the growing role of trading in complex financial instruments tied to interest rates, foreign currencies and even the weather.

In the deal, the parent of the Chicago Mercantile Exchange will buy the holding company that runs its longtime rival, the Chicago Board of Trade. The acquisition is part of a wave of consolidation in financial markets, as securities exchanges seek to cut costs, expand product offerings and fortify themselves against global competition.

"This merger takes us to the next level in the evolution of our high-growth business," said Terrence A. Duffy, the Chicago Merc's chairman.

In the deal, Chicago Mercantile Exchange Holdings Inc. would acquire CBOT Holdings Inc. for $8 billion in stock, up to $3 billion of which could be paid in cash. The resulting entity, CME Group Inc., would have a market capitalization of more than $25 billion.

The deal would give the Chicago Mercantile Exchange a stronger hand as it competes against rivals Eurex and the InterContinentalExchange.

Chicago Merc shareholders would own 69 percent of the new company, with board of trade shareholders controlling 31 percent. The deal, which is subject to shareholder and regulatory approval, also calls for the Chicago Merc to close its trading floor and consolidate operations at the board of trade. It is expected to close by mid-2007.

The companies have nearly 2,200 employees. Officials declined to say whether any would be laid off but said the combination would lead to $125 million in cost cuts.

Both of the institutions involved in the deal specialize in derivatives, which are known by that name because their values are derived from underlying instruments, such as interest rates.

Derivatives have soared in popularity among big investors such as hedge funds because of their potential to pay bigger returns than stocks, and without a long wait. Corporations also use derivatives to limit their risk from unforeseen changes in business conditions.

"The derivatives market is growing much faster than the equities [stock] market, and it's more profitable," said David Easthope, an analyst at Celent, a financial research firm in Boston. "This creates the biggest derivatives powerhouse that there is."

The two Chicago exchanges have their roots in the 1800s as agricultural marketplaces where farmers and merchants met to swap futures contracts for livestock and grains, agreeing to buy or sell commodities at predetermined prices in the future.

The exchanges still trade futures on such commodities, but each began branching out in the 1970s into derivatives tied to foreign currencies and prices on U.S. Treasury bonds.

U.S. and foreign companies use derivatives to cut their risks from adverse shifts in foreign exchange rates or other market conditions. Derivatives are most commonly based on interest rates, because even minor rate swings can upset a corporate bottom line, experts said.

"Interest-rate futures are where the CME and the CBOT have always shined and will now shine brighter," said Michael Pagano, an associate finance professor at the Villanova University School of Business in Pennsylvania.

But there are growing markets in other kinds of derivatives, including instruments tied to the weather, which can affect business performance in many ways.

For example, weather-related derivatives allow energy companies to hedge against losses that they might suffer from storms in an offshore drilling area, or help retailers protect themselves against a downturn in sales caused by snowstorms in the Northeast.

Derivatives have soared in part because of speculative trading by hedge funds, which are aggressive investment pools that seek fast profits in global markets.

The complexity and rapid growth of derivatives have raised concerns about the potential destabilizing impact on security markets in the event of an external financial shock.

Their popularity has led to enormous gains in the share prices of the two companies.

CBOT Holdings Inc., the Board of Trade's parent, went public a year ago at $54. It gained $17.48 yesterday to close at $151.99.

Chicago Mercantile Exchange Holdings Inc. has fared even better. Since it went public in December 2002 at $35, it has surged more than 14-fold. It gained $13.25 yesterday to finish at $516.50.

Walter Hamilton writes for the Los Angeles Times. James P. Miller of the Chicago Tribune contributed to this article.

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