lecture 19: forwards & futures. first futures market: osaka begun at dojima, osaka, japan, in...
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Lecture 19: Forwards & Futures
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First Futures Market: Osaka
• Begun at Dojima, Osaka, Japan, in 1670s. World’s 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:
$1
1(Y/$) rate exchangespot
(Y/$) rate exchange forward
r
rY
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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
DLB
ADRL
)100(
)(Settlement
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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 buyer’s 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 $2.335*$50000 =$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 don’t have to ship to Chicago.
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Fair Value in Futures Contract
• r = interest rate
• s = storage cost
• r+s=cost of carry
(See http://www.indexarb.com)
)1( srPP spotfuture
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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:
)1( srPP spotfuture
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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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Working’s Example of Wheat in Storage, Typical Year
• July 2Spot 229 ¼
Sept future 232 ¼
Spot premium –3
Basis 3
• September 4Spot 232 ½
Sept future 233 ½
Spot premium –1
Basis 1
Gain of 2 (reflects gain in premium)
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Continuing Working’s Example
• Sept 4Spot No. 2 232 ½
Dec. Future 238 ¼
Spot Premium –5 3/4
• December 1252
252
0
Gain of 5 3/4
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Just Before May Harvest
• May 1Spot No. 2 247 ¼
July future 229 ¼
Spot premium +18
• July 1Spot 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.