Lecture 19: Forwards & Futures

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Lecture 19 Forwards Futures
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First Futures Market Osaka

• Begun at Dojima, Osaka, Japan, in 1670s. Worlds
  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

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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.

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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

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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 for .
• Both sides are locked into the contract, no
  liquidity.
• What will warehouse think if rice farmer tries to
  get out of the contract?

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Problem with Forwards Default

• Farmer and warehouser must check each others
  creditworthiness
• Forward contracts are inherently credit
  instruments.
• Only people with good credit can use them.

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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

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Forward Rate Agreements

• Promises interest rate on future loan.
• Lactual interest rate on contract date
• Rcontract rate
• Ddays in contract period
• Acontract amount
• B360 or 365 days

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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 others credit.
• Futures contracts are standardized retail
  products, rather than custom products.
• Futures contracts rely on margin calls to
  guarantee performance.

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Buying or Selling Futures

• When one buys 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 sells a futures contract, no
  intention of selling the commodity. Again, post
  margin.

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Daily Settlement

• Every day, the exchange defines a price called
  the settle price, which is essentially the last
  trade on that day.
• Every day until expiration a buyers margin
  account is credited (or debited if negative) with
  the amount change in settle price ? contract
  amount
• If contract is cash settled, on the last day the
  margin account is credited with (cash settle
  price-last settle price)?contract amount.
• If contract is physical delivery, on last day
  buyer must receive commodity

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Example Farmer in Iowa

• Farmer in March is planting crop expected to
  yield 50,000 bushels of corn. By this business,
  farmer is long 50,000 bushels. Farmer sells
  ten Chicaco September corn contracts for
  2.33550000 116,750. Posts margin.
• Corn products manufacturer plans to buy corn at
  harvest time, buys the 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.

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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 dont have to
  ship to Chicago.

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Fair Value in Futures Contract

• r interest rate
• s storage cost
• rscost of carry
• (See http//www.indexarb.com)

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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

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Holbrook Working on Futures

• Futures term is misleading, cash or spot
  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

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Example of Hard Winter Wheat (Holbrook Working)

• No. 2 Hard Winter Wheat Kansas City Wheat Futures
• Plant winter wheat in Fall, harvest in May
• ¾ of US wheat crop is hard.
• Hard wheat is used for bread, soft wheat for pie
  crusts, breakfast foods and biscuits

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Workings Example of Wheat in Storage, Typical
Year

• July 2
• Spot 229 ¼
• Sept future 232 ¼
• Spot premium 3
• Basis 3

• September 4
• Spot 232 ½
• Sept future 233 ½
• Spot premium 1
• Basis 1
• Gain of 2 (reflects gain in premium)

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Continuing Workings Example

• Sept 4
• Spot No. 2 232 ½
• Dec. Future 238 ¼
• Spot Premium 5 3/4

• December 1
• 252
• 252
• 0
• Gain of 5 3/4

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Just Before May Harvest

• May 1
• Spot No. 2 247 ¼
• July future 229 ¼
• Spot premium 18

• July 1
• Spot No. 2 218 1/2
• July future 225
• Spot premium 6 ½
• Loss of 24 1/2

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Iowa Electronic Markets
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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.