1. Lecture 19: Forwards & Futures

2. 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

3. 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.

4. 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

5. 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?

6. 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.

7. 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:

8. 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

9. 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.

11. 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.

12. 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

13. 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.

14. 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.

15. Fair Value in Futures Contract
r = interest rate
s = storage cost
r+s=cost of carry
(See

16. 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:

17. 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

18. 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

19. Working’s Example of Wheat in Storage, Typical Year
July 2
Spot 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)

20. Continuing Working’s Example
Sept 4
Spot No ½
Dec. Future 238 ¼
Spot Premium –5 3/4
December 1
252
Gain of 5 3/4

21. Just Before May Harvest
Spot No ¼
July future 229 ¼
Spot premium +18
July 1
Spot No /2
July future 225
Spot premium –6 ½
Loss of 24 1/2

22. Iowa Electronic Markets

23. Iowa Electronic Markets

24. 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.