Fwd & Future

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Lecture 19: Forwards & Futures



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 ricewarehouses in 1673.

� Dojima futures exchange had precise definitionsof 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 pricediscovery for rice, allows merchants tohedge.



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, noliquidity.

� What will warehouse think if rice farmer tries toget 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:

$1

1(Y/$) rate exchangespot

(Y/$) rate exchange forward

r

r Y

v

!



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

vv

vv!

)100(

)(Settlement



Futures Contracts� Futures contracts differ from forward

contracts in that contractors deal with an

exchange rather than each other, and thusdo not need to assess each others¶ credit.

� Futures contracts are standardized retailproducts, rather than custom products.

� Futures contracts rely on margin calls toguarantee performance.





Buying or elling Futures� When one ³buys´ a futures contract, one agrees

with the exchange to a daily settlement procedure

that is only loosely analogous to buying thecommodity. One must post initial margin with thefutures commission merchant.

� Usually, one has no intention of taking delivery of

the commodity� ame as when one ³sells´ a futures contract, nointention of selling the commodity. Again, postmargin.



Daily ettlement� Every day, the exchange defines a price called the

³settle´ 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) withthe amount: change in settle price v contractamount

� If contract is cash settled, on the last day themargin account is credited with (cash settle price-last settle price)vcontract amount.

�I

f contract is physical delivery, on last day buyer must receive commodit



Example: Farmer inIowa

� Farmer in March is planting crop expected to yield50,000 bushels of corn. By this business, farmer is

³long´ 50,000 bushels. Farmer ³sells´ ten Chicacoeptember corn contracts for $2.335*$50000=$116,750. Posts margin.

� Corn products manufacturer plans to buy corn atharvest time, ³buys´ the ten contracts, postsmargin.

� Come eptember, both buyer and seller close outposition.

� Changes in margin account mean that price waseffectivel 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 contractmeans 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.



Fair Value in Futures Contract� r = interest rate

� s = storage cost

� r +s=cost of carry

( ee http://www.indexarb.com)

)1( sr P P spot future !



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( sr P P spot future



Holbrook Working on Futures

� ³Futures´ term is misleading, ³cash´ or ³spottransactions sometimes involve deliveries that are

further in the future� Only a few percent of farmers use futures

� Grain elevators often serve as risk-managingintermediaries for farmers

� But open interest tends to follow inventories incommercial storage, not crop growing in thefields.

� 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

� ¾ of U wheat crop is hard.

� Hard wheat is used for bread, soft wheat for

pie crusts, breakfast foods and biscuits



Working¶s Example of Wheat in

torage, Typical Year � July 2

pot 229 ¼

ept future 232 ¼pot premium ±3

Basis 3

� eptember 4

pot 232 ½

ept future 233 ½pot premium ±1

Basis 1

Gain of 2 (reflects gain inpremium)



Continuing Working¶s Example� ept 4

pot No. 2 232 ½

Dec. Future 238 ¼pot Premium ±5 3/4

� December 1

252

2520

Gain of 5 3/4



Just Before MayH

arvest� May 1

pot No. 2 247 ¼

July future 229 ¼pot premium +18

� July 1

pot No. 2 218 1/2

July future 225pot premium ±6 ½

Loss of 24 1/2



I

owa Electronic Markets





From Agricultural Futures to

Financial Futures� Financial futures markets began in U in

1970s.

� ame concepts of fair value, hedging, gain

and loss due to change in basis.

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