fwd & future
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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 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
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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 pricediscovery for rice, allows merchants tohedge.
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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, noliquidity.
� What will warehouse think if rice farmer tries toget 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
r Y
v
!
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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
vv
vv!
)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 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.
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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.
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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
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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.
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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 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.
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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 !
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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( sr P P spot future
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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
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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 U 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
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)
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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
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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
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I
owa Electronic Markets
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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.