Lecture 19: Forwards & Futures

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

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 for .
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
others creditworthiness
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 exchange rate (Y/$)
1 rY
spot exchange rate (Y/$)
1 r$

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
( L R) D A
Settlement
( B 100) L D

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.

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.

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

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.

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.

Fair Value in Futures Contract

r = interest rate
s = storage cost
r+s=cost of carry
Pfuture Pspot (1 r s )

(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:
Pfuture Pspot (1 r s )

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

Example of Hard Winter Wheat

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

Workings Example of Wheat in

Storage, Typical Year
July 2
Spot 229
Sept future 232
Spot premium 3
Basis 3

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

Continuing Workings Example

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

December 1
252
252
0
Gain of 5 3/4

Just Before May Harvest

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

July 1
Spot No. 2 218 1/2
July future 225
Spot premium 6
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.