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Lecture 19:
Forwards & Futures
First Futures
Market: Osaka
Begun at Dojima,
Osaka, Japan, in 1670s. World00 only futures market until 1860s.
Dojima was center
for rice trade, with 91 rice warehouses in 1673.
Dojima futures exchange
had precise definitions of quality, delivery date and place, experts
who evaluated rice quality, and clearinghouses for contracts.
Trading floor, daily
resettlement, burning fuse, and watermen
Function of
Osaka Futures Market
Japan had sophisticated
financial contracts before the futures market, partly under influence
of Dutch.
Rice bills and silver
bills were kinds of forward contracts.
Osaka market provided
liquidity and price discovery for rice, allows merchants to hedge.
Issues for Rice
Warehouser
Warehousing itself
is a stable business, little risk
Great risk in fluctuation
in rice price
Warehouser may seek
to sell the rice forward and lock in initial price. But, a forward contract
is illiquid, difficult
Forward Contract
Forward is just
a contract to deliver at a future date (exercise date or maturity date)
at a specified exercise price.
Example: Rice farmer
sells rice to warehouser.
Example: Foreign
Exchange (FX) forward. Contract to sell 拢 for 楼.
Both sides are locked
into the contract, no liquidity.
What will warehouse
think if rice farmer tries to get out of the contract?
Problem with
Forwards: Default
Farmer and warehouser
must check each others00creditworthiness
Forward contracts
are inherently credit instruments.
Only people with
good credit can use them.
FX Forwards
and Forward Interest Parity
FX Forward is like
a pair of zero coupon bonds.
Therefore, forward
rate reflects interest rates in the two currencies
Forward Interest
Parity:
Forward Rate
Agreements
Promises interest
rate on future loan.
L=actual
interest rate on contract date
R=contract
rate
D=days in
contract period
A=contract
amount
B=360 or
365 days
Futures Contracts
Futures contracts
differ from forward contracts in that contractors deal with an exchange
rather than each other, and thus do not need to assess each others00
credit.
Futures contracts
are standardized retail products, rather than custom products.
Futures contracts
rely on margin calls to guarantee performance.
Buying or Selling
Futures
When one 00uys00
a futures contract, one agrees with the exchange to a daily settlement
procedure that is only loosely analogous to buying the commodity. One
must post initial margin with the futures commission merchant.
Usually, one has
no intention of taking delivery of the commodity
Same as when one
00ells00a futures contract, no intention of selling the commodity.
Again, post margin.
Daily Settlement
Every day, the exchange
defines a price called the 00ettle00price, which is essentially
the last trade on that day.
Every day until
expiration a buyer00 margin account is credited (or debited if negative)
with the amount: change in settle price 00/font> contract amount
If contract is cash
settled, on the last day the margin account is credited with (cash settle
price-last settle price)00ontract
amount.
If contract is physical
delivery, on last day buyer must receive commodity
Example: Farmer
in Iowa
Farmer in March
is planting crop expected to yield 50,000 bushels of corn. By this business,
farmer is 00ong0050,000 bushels. Farmer 00ells00ten Chicaco
September corn contracts for $2.335*$50000 =$116,750. Posts margin.
Corn products manufacturer
plans to buy corn at harvest time, 00uys00the ten contracts, posts
margin.
Come September,
both buyer and seller close out position.
Changes in margin
account mean that price was effectively locked in at $2.335/bushel for
both.
Basis Risk
Basis risk = risk
that Iowa corn prices will not match Chicago settle prices
Option of physical
delivery in the corn contract means that arbitrageurs will keep basis
risk down.
Arbitrageurs may
load corn in Iowa and ship to Chicago if Iowa price is below Chicago
price. Arbitrageurs activity means farmers don00 have to ship to Chicago.
Fair Value in
Futures Contract
r = interest
rate
s
= storage cost
r+s=cost
of carry
(See
http://www.indexarb.com)
Arbitrage Enforcing
Fair Value
If commodity is
in storage, there is a profit opportunity that will tend to drive to
zero any difference from fair value.
If commodity is
not in storage, then it is possible that:
Holbrook Working
on Futures
00utures00term
is misleading, 00ash00or 00pot transactions sometimes involve
deliveries that are further in the future
Only a few percent
of farmers use futures
Grain elevators
often serve as risk-managing intermediaries for farmers
But open interest
tends to follow inventories in commercial storage, not crop growing
in the fields.
Essence of futures
market is standardization, price discovery, and liquidity
Example of Hard
Winter Wheat (Holbrook Working)
No. 2 Hard Winter
Wheat Kansas City Wheat Futures
Plant winter wheat
in Fall, harvest in May
戮 of US wheat crop
is hard.
Hard wheat is used
for bread, soft wheat for pie crusts, breakfast foods and biscuits
Working00
Example of Wheat in Storage, Typical Year
July 2
Spot 229 录
Sept future 232 录
Spot premium 00
Basis 3
September 4
Spot 232 陆
Sept future 233 陆
Spot premium 00
Basis 1
Gain of 2 (reflects gain
in premium)
Continuing Working00
Example
Sept 4
Spot No. 2 232 陆
Dec. Future 238 录
Spot Premium 00 3/4
December 1
252
252
0
Gain of 5 3/4
Just Before
May Harvest
May 1
Spot No. 2 247 录
July future 229 录
Spot premium +18
July 1
Spot No. 2 218 1/2
July future 225
Spot premium 00 陆
Loss of 24 1/2
Iowa Electronic
Markets
From Agricultural
Futures to Financial Futures
Financial futures
markets began in US in 1970s.
Same concepts of
fair value, hedging, gain and loss due to change in basis.
Iowa Electronic Markets
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