Lecture 20: Stock Index, Oil and Other Futures Markets

Stock Price Index Futures

• Cash settlement rather than physical delivery

• Settlement is 250*(Indext-Futurest-1)

• Fair value:

yield dividend

rate)(interest cost financing

index priceStock

price futures fair value

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r

P

F

yrPPF

Lower Trading Costs on Futures vs. Spot Market for Stock

• Theory of optimal bid-asked spread.• Even though futures markets are not dealer

markets, there is in effect a bid-asked spread, and it is narrower than for individual stocks.

• Less likely to be superior information to “pick off” dealers in stock index futures market than in market for individual stocks.

Futures on Individual Stocks

• US ban on futures on individual stocks was fully lifted in December 2001.

• Trading in futures on individual stocks began at LIFFE (London International Financial Futures and Options Exchange) on NQLX LLC January 29, 2001

• US trading began 2002 at OneChicago LLC (owned jointly by CME, CBOT and CBOE)

• Volume of trade has been very disappointing, delisting is occurring

Why a Market for Futures on Individual Stocks?

• In London, traders avoid the UK Stamp Duty• In US, traders circumvent margin requirements on

stocks. Final demise of margin requirements.• Principal argument that accounts for US

approving them is that foreign countries are now approving them, and US does not want to be left out.

Oil Futures

• Crude light sweet oil (New York Mercantile Exchange) contract size: 1000 barrels, open interest 431,000 contracts

• Brent crude, North Sea (International Petroleum Exchange, London) contract size: 1000 barrels, open interest 232,000 contracts

Nature of Oil Storage

• Most stored oil is “moving through the pipeline” of oil tankers, refiners, distributors and retailers.

• Estimated oil inventories can be found on web site www.api.com

Government Oil Reserves

• Strategic Petroleum Reserve (created 1975) in caverns in Louisiana and Texas – 572 million barrels, only 60 days supply. Not used to stabilize prices.

• In 2000, President Clinton established a 2 million barrel heating oil reserve in New York and New Haven to help stabilize US heating oil prices. US consumption of heating oil about 100 million barrels a year.

• Govt will sell from reserve when price triggers are hit. Effectiveness?

Nationalizations of Oil

• Mexico 1938• Iran 1951• Cause: resentment of foreign control, but

justification was needed.• “Nationalization” a 19th century word, OED says

1874, socialist connotations.• “Eminent Domain” is older word, does not seem

to justify such expropriation of oil producing lands.

OPEC

• Organization of Petroleum Exporting Countries established 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela

• Qatar (1961), Indonesia and Libya (1962), Abu Dhabi (1967), United Arab Emirates (1974), Algeria (1969), Nigeria (1971), Ecuador (1973), and Gabon (1975)

Optimal Extraction of a Natural Resource

• Problem facing a monopoly oil producer facing a downward sloping demand curve:

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Solution of Extraction Problem with Constant Demand Growth

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Fair Value for Oil Futures

• In this example, price rises at less than interest rate.

• Oil futures is below conventional fair value.

• Optimal strategy for non-OPEC oil producers?

• Other considerations: extraction costs,

Gold Futures

• Gold miners face same optimal extraction problem as oil producers

• If there are extraction costs, what is theoretical quantity of gold held above ground?

Real Oil Price (West Texas Intermediate) and Unemployment Rate, Monthly Jan 1948-Jan 2004

0

10

20

30

40

50

60

70

80

90

100

1940 1950 1960 1970 1980 1990 2000 2010

Real Oil Price

Unemployment Rate

First Oil Crisis, 1973-4

• Arab countries’ retaliation for US support of Israel in Yom-Kippur war 1973.

• Triggered sharp recession around world• 1973-4 is second sharpest stock market

crash in US history. S&P Composite lost 53% of its real value between Dec. 1972 and Dec. 1974. (Only worse two-year experience was June 1930 to June 1932.)

Second Oil Crisis, 1979-80

• 1979: Iranian revolution, expulsion of the Shah of Iran, Ayatollah, capture of US Embassy hostages in Teheran Nov. 1979.

• Iran-Iraq war erupts 1980, disrupts oil supplies.• US CPI inflation reaches 18%/year in March,

1980.• The “great recession”of 1981-82 is the worst

recession since Depression of the 1930s.

Collapse of OPEC Cartel, 1986

• After suffering bombing by Iraq, Iran demands that Iraq be given the same oil export quota as everyone else.

• Other arguments about the disproportionate share of some OPEC states.

Persian Gulf War, 1990-1991

• August 2, 1990, Surprise invasion of Kuwait by Iraq• UN Security Council deadline for Iraq to withdraw

by January 15 1991.• January 16, 1991 Air bombardment of Iraq and its

Kuwaiti positions begins.• February 24, 1991 Allied ground invasion begins.• War is over February 26, 1991.• Brief interruption of oil supplies mark recession:

NBER dates July 1990-March 1991.

Oil Price Collapse 1997

• Nov. 1997 OPEC Meeting, the “disaster in Jakarta” involved bitter disputes among OPEC nations about market share

• Fuming about widespread cheating in limiting exports to quotas

• Asian financial crisis dropped demand for oil

Oil Price Spike 1999

• OPEC resolve to stop cheating left supplies shorter than they expected

• Erroneous data led them to underestimate how fast inventories were dropping.

• Backwardation in oil futures market (futures price below spot price) began in January 1999.

• OPEC Increased quotas

Oil the Day Hussein Announces Embargo, April 8, 2002

Natural Gas April 8, 2002

Second Gulf War Oil Spike

• In anticipation of war, oil rises to nearly $36 per barrel February, 2003

• US invaded Iraq, March 19, 2003• Symbolic end of war: after capture of

Baghdad, crowd topples Hussein stature April 8, 2003

• Oil falls to $28 per barrel by April, 2003

Federal Funds Futures Market

• Created by CBOT 1988• Settlement price is 100 minus annualized

federal funds rate, averaged over contract month.

• Show timing of expected actions of Federal Open Market Committee.

• One-month-ahead forecast errors typically in the ten to twenty basis point range.