ECON 252: Financial Markets (2008)

Lecture 21

 - Forwards and Futures


Futures markets were started in Osaka, Japan in the 1600s to create an authoritative and meaningful market price for agricultural products, using standardized contracts. Since then, futures markets have been copied around the world to allow the hedging various future risks, financial and other. In the United States, the Chicago Mercantile Exchange and the Chicago Board of Trade have been the most popular futures trading markets. Although futures markets are changing and becoming more electronic, they are still important risk management tools for farmers and present financial opportunities for all manner of hedgers and arbitrageurs.

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Financial Markets (2008)

ECON 252 (2008) - Lecture 21 - Forwards and Futures

Chapter 1. Introduction: Thoughts on Guest Speakers [00:00:00]

Professor Robert Shiller: I wanted first to just think back a little bit about the lecture we got from Steve Schwarzman on Friday. Before he came, I talked with him in my office and I had the audacity to ask him if he thought there was any chance that his fortune was just due to luck. I said, why we have this efficient markets theory in finance that says that nobody can beat the market. So, what do you think he said? Well, obviously he believes in himself, but I’m inclined to believe in him also. Efficient markets theory never sounded right; one thing about efficient markets theory that has always bothered me is this idea that the so-called “smart money” sets prices in the market. The thing that bothers me about it is, who is the “smart money,” anyway? It’s as if it’s all or nothing thing; there’s the smart money and then it’s the dumb money and the smart money rules. Aren’t there all different gradations of intelligence and insight? It’s not like — why should there be just one level of smart money? So, I think he probably exemplifies a higher level of smart money than smart.

I think a lot of mistakes people make in judging financial markets is being easily impressed by someone’s stockbroker or someone’s analyst who seems very smart and is very smart, but may not be enough to outsmart the markets. That’s the lesson of efficiency, especially when you’re young. I think you may not realize how many smart people there are in the world, so when you’re dealing in a — trying to win in financial markets — you have to take account of who is really out there and how much insight and effort and research are they putting into their trading. Do you really think you can beat that? That’s the lesson of efficient markets. I don’t think the lesson is that you can’t — it’s impossible for anyone no matter how smart to beat the market. Now of course, Albert Einstein never made any money in the stock market. In fact, TIAA-CREF, the pension fund, had an ad campaign in which they pointed that Albert Einstein left all of his pension investing to TIAA-CREF. He was a professor and they’re a pension fund for professors.

Einstein didn’t think he could beat the market and Mr. Schwarzman very candidly pointed out that he didn’t have the greatest math scores. Isn’t that how he put it? He said he was no math genius and you think finance requires a lot of math, but I think that it’s something about practical intelligence. Psychologists have talked about different kinds of intelligence — this is all supposed to be coming up here now. At least we’re seeing something now. This is why I don’t like Powerpoint, actually; this kind of thing happens it always seems to happen. So, that’s it. I’m not going to use this for a few minutes. — But, remember Carl Icahn, when he talked to us, said something about he always just had some — he was always just good at making money. I think that there are separate talents. I mean, some people love markets and they like to think about them and figure out how they work. If they have the right kind of intelligence and the right kind of spirit to do the work, they ought to be able to beat the market.

I’ve talked to Icahn a number of times and I have the idea that he’s a very down-to-earth, solid, inquisitive sort; he wants to know what’s going on. When I’ve talked to him, sometimes he’ll ask the same question of me; he’s trying to get information from me. He asks the same question from me three different ways because apparently my answer isn’t satisfactory and he must think I might know something because he keeps asking. But, I think that’s the kind of persistence — certain personality traits — persistence at trying to figure out what really makes things work is important in these markets. I think it’s just relish or inclination to keep thinking about them, so maybe that’s why I went into economics as a professor. I don’t know that I really was someone who wants to watch the markets all day; so, you have to judge your own interests. Anyway, it was very nice that we got — that Steve Schwarzman came and told us about his life’s work.

Anyway, I want to talk today about futures. One more thing I wanted to say about Schwarzman. At one point, he said very confidently, I thought — and I don’t know if you heard this right — that this current financial crisis ought to be over in a year. He said something — and maybe it was a little vague — about investing in distressed securities now as an opportunity because I think he pointed out that AAA mortgage securities are selling for eighty some cents on the dollar and it can’t be that bad. This is the same theme that we got from David Swensen and I’ve heard it from others — that that’s the opportunity now.

When I hear Steve Schwarzman proclaiming that he thinks this — I thought he said something like that, that this business crisis will be over before long. It made me wonder, do I know more than he does about that sort of thing because I don’t think it’s going to be over soon? Then it gets back to, I think, you have to put all these people in perspective; there are so many different kinds of expertise. When you listen to someone you always have to ask, well what does he or she know that is specific to their expertise? I don’t think Schwarzman is a macroeconomist, so I don’t want to say he’s wrong, but he might be wrong. The good thing is to listen to everyone and not accept that anyone has the whole truth.

Chapter 2. From Osaka’s Rice Warehouses: The Development of the Forward and Futures Market [00:07:23]

Anyway, I want to get on to futures markets. That is a very important topic in finance and the important thing to understand is, when I put an “s” on the end “futures,” that refers to a marketplace with a particular characteristic, as traded on a number of exchanges. Notably, in the U.S. the biggest exchange for futures is the Chicago Mercantile Exchange, which just merged with The Chicago Board of Trade and they are now called the CME Group. Futures, since it has its origin in agriculture, is a Chicago thing rather than a New York thing. Chicago is the “second city,” or it was the second biggest city, hog-butcher to the world, farmers’ marketplace in the Midwest; so, futures in the United States started there.

Actually, futures didn’t start in Chicago; it started in Japan on an island in Osaka called Dojima in the 1600s. I’m sorry, did I — yeah it was the 1600s — 1673 is the date for the first futures market. I was just in Osaka again a few months ago and I again asked, can I please see Dojima because it’s such a historic place. Again they said, there’s nothing to see there, it’s all — anything from long ago is gone. That was where these markets started.

Let’s go back — and I’m not sure how well-developed it was in 1673, but let’s say early 1700s in Dojima — what was happening? Well, it was the rice center for Japan. The people — rice merchants would bring their rice to Dojima and sell them there. Naturally, as you would expect, there were big warehouses for rice, which would store it; it would be a natural thing to see at the center of trade. It was a big and thriving trade center. People, when they buy — so incidentally, let’s talk about the fundamental problem. Agricultural commodities like rice are harvested typically once a year. Actually, I think rice has more than one harvest, but let’s just simplify it; let’s say it’s harvested once per year. People depend on it for their lives, actually, because they need the food for the whole year. That means there’s a storage business; rice has to be stored; you have to keep it away from moisture and rot and away from rats and vermin. That’s a business and it’s a very important business for any country. If it weren’t rice, it would be some other grain, which is stored.

When people buy and sell grain they know it’s — they’re thinking out at least a year because that’s how long the cycle is for one harvest — one cycle. So, lots of contracts are signed to buy and sell rice, but typically at some future date. We talk about “spot contracts,” which means buying and selling something right now. If you show up at the warehouse and say, I’ve got my wagons, I want to load rice in. How much do I have to pay to get rice? That price would be called the “spot price” — on the spot, right now. But often, you would show up at the warehouse and you would say, I have some trucks, wagons coming next week or next month and I want to arrange now to buy the rice. If you say — if you agree on a price today for delivery in one month, that’s called a “forward contract,” not futures.

There’s an important distinction between forward and futures. A forward contract — let me explain what a forward contract — it’s very simple. It’s a contract between two parties to exchange something at a future date for a price in the future that’s predetermined today. For example, a forward contract will be between a rice merchant and the warehouse that in two months I will come and take delivery of so many bushels of rice and then I will pay such and such a price; that’s a forward contract. Before 1673, there were lots of forward contracts and lots of people trading in these, so someone in Dojima thought, why don’t we set up a big market for these because people have trouble knowing what the price is for a forward contract.

People would travel around from one warehouse to another and they’d get a different price from one or the other; they’d kind of wonder what the price is today, so someone said well why don’t we kind of create a market for forward contracts. But, we don’t call them forward contracts; I don’t know what they called them in Japan, but I just want you to get the idea. The idea is, let’s create a marketplace, a central marketplace so that all these different — you don’t have to go around to a hundred different warehouses to try to find the best price; you find out what the real price is. What they did was they created an exchange in Dojima and the exchange had a lot of modern features; it had a trading floor. There was a designated area where people who wanted to trade in rice futures would congregate and all trades were supposed to be done there, so it became a central marketplace.

So many people came to the exchange floor that it got very noisy and traders can be very noisy people — shouting and getting upset; trading rapidly back and forth. So, they developed, in Dojima, a set of hand signals so that it was so noisy and loud that you couldn’t talk sometimes and it was hard to — especially to communicate something to someone on the other side of the room. So, they invented hand signals so the traders would be — I don’t know exactly what they were, but typically when the — if you had something like this — you hold your hand with your palm out, that means I want to sell and if it’s four fingers up, that means four contracts. If you put it this way, it would be buying; I want to buy four contracts. Those hand signals developed in Osaka and they became a mainstay of futures markets after that.

Another thing they did in Japan to create the central market was to standardize the rice. Now, this is very important; if you go shopping around to different warehouses to try to buy rice, you’ll get some warehouse who says, well I’m charging a higher price but my rice is better then that other guy’s rice. His has some worms in it sometimes; don’t trust that other guy, or whatever it is. Rice isn’t all the same; there are different varieties and some of them taste better than others. So, how would you ever know what the price of rice is; it’s just a mess. What they did in Osaka is they made a standard form of rice for delivery in their contract. That’s important because it — there are many kinds of rice, but they picked one that’s maybe the most common and then they said, that’s what all of our contracts are about; so, you would be taking delivery of a standard rice. Moreover, at the exchange, they had experts on rice who could tell whether it was that contract. It’s not the best rice; it’s the most common rice.

I visited the coffee, sugar and cocoa exchange in New York once and jokingly I said, can I have a cup of coffee? This is the coffee, sugar and cocoa exchange; surely I can get a cup of coffee here. Then the guy said, who was showing me around, he said, well we could give you a cup of coffee but it’s not what we trade here. He says, you wouldn’t like the coffee we trade here; it’s not Starbucks; it’s the most standard. So, they set up a standard for coffee at the coffee — maybe he was being too candid. I don’t know if they would say that officially.

They set up a standard for coffee at the coffee, sugar, cocoa exchange and then no one would ever deliver better coffee than that, right? Well, I have to explain that. Everyone — well, they wouldn’t even be allowed to; the whole idea is the contract has standards. What actually happens — if you have a contract to deliver rice or coffee or anything like that and there’s some expert there who’s going to judge whether what you delivered was up to quality standards and you are a smart businessperson, you will deliver exactly the minimum quality to fulfill the contract. It’ll never be below the minimum quality because no one can deliver it; the testers will not allow that. And it can’t be above the minimum standard because you’d never do that; you’d be stupid to do that. So, you always — it always becomes the standard variety.

What they did at the futures market is they then not only had standardized the rice, but they standardized delivery dates and delivery locations. What would you trade in these futures markets? You would be trading — you’d either be buying or selling rice for future delivery on a standardized delivery date at a standardized location — probably one of the warehouses that they designate. That might not be the rice you want or the date you want and yet, somehow the market gets going and gets very big. This is the reason: what a futures market does that’s different from a warehouse market is it sets up a standard price and a liquid market. So, people end up using the futures market to lock in the price or to hedge price risk and they know that the price in the futures market is the meaningful price.

You hear all kinds of prices of rice; there will be rumors here and there that someone will say, I saw rice sell for such and such — so many Yen or whatever it is. Don’t believe any of that nonsense. Who knows what was sold or what terms there were or what exigencies there were. Only look at the futures market because the futures market is absolutely standardized. You know the terms of delivery, the location, and everything else. What ended up happening is that everyone wanted to trade in the futures market and it became a huge market and then everyone started watching the futures price. That’s what we now have; that’s what is in a futures —

I wanted to tell you one other curious thing about the — well, two other things about the Osaka market. They had trading hours, just as do today. In other words, only certain hours of the day the floor was open and then it was shut off. People would get very excited and trade very actively; you have to somehow let people know that the trading time is over and all trades have to stop at the end of the day. So, they had a burning fuse, which they would light in the middle of the trading floor just a few minutes before the end of the day and you could see this flame and that meant you better finish your trades right now because when the flame goes out, it’s over. We don’t have fuses anymore; we have clocks and a bell that announces the beginning and end at an exchange.

There’s one other thing they had, which I think is kind of curious that hasn’t been copied. They had people called watermen, who after the fuse went out they carried buckets of water onto the exchange. If anybody was still trading, they splashed them with water. That was to douse the — the fuse is out; everything is doused for today. We don’t do that in modern futures exchanges. Of course, it’s all electronic now; there’s no — well, it’s getting increasingly electronic. The CME and the CBOT still have trading floors like Dojima’s and they’re still using these hand signals, but it’s getting lonely there because everything is moving away to the electronic markets. You’ll still see on CNBC, Bob Pisani will be standing at the T-bond trading pit and he’ll give his little — they focus the camera right on where all the people are at and they’re still out there jostling each other and shouting at each other. So, it’s still going on, but it’s increasingly becoming an electronic market.

I guess the most important thing to realize about futures markets is that they’re different from forward markets in that it — with a futures market, when you buy and sell a contract you are buying and selling with the exchange or the clearing house of the exchange. You do not know the counter party; you do not know who’s on the other side. With a forward market, you know very well who’s on the other side; you’re going to a warehouse and there’s this warehouse who’s going to take your grain. In the warehouse, you better trust the other side because suppose the other side doesn’t work. Suppose you have your — you’ve loaded up all your rice and you come to the warehouse and then the guy says, I don’t want to honor the contract. I signed it, but I’m just not going to take it; I’m going to lower the price on you. Then you have to sue this guy and it’s a big mess.

The problem with forward contracts is that they’re not standardized; you’re not dealing with a reputable exchange. With an exchange, there is of course a counter party. If you’re selling rice and someone else is buying it, there’s an intermediary between you and that’s the exchange. Since the exchange will honor any contract, you don’t have to worry about the other side. That’s another reason why futures prices are so much more meaningful than spot or forward prices because there’s no counter-party risk unless you worry about the exchange itself. Since the futures exchanges in the U.S. have been here since the nineteenth century and they’ve never lost a contract, people assume as a first approximation, that there’s no counter-party risk.

Chapter 3. Forward Contracts for Currency Exchange and Interest Rates [00:24:47]

I still haven’t maybe fully explained futures. Let me — before we go on, I want to talk a little bit about forwards because now we have a slide up here. We do have forward contracts and they still play an important function. The reason is that futures markets, by their very nature, are standardized markets. Or you might say they’re retail markets. They have a huge number of people trading in them, but it’s all a standard thing. Forward markets are between persons and so they can be — the contract can be anything you want. So, forward contracts are very important but they tend to be less — I tend to observe them less because they don’t have this newsworthy character.

Everyone’s talking about futures prices because everyone knows that is a very well-defined, central market, liquid price. The forward contracts are not liquid; you can’t get out of it. So if you, as a rice merchant, sold your rice — as a rice farmer — you sold your rice forward to a warehouse and then you change your mind — you want to get out — you can’t because unless the other guy says, I’ll let you out, because you’ve just got a contract. The futures has this active trading in and out, so the prices seem to mean more.

Let’s talk about forward markets. There are forward markets for a lot of things. One very important forward market is the foreign exchange forward market. This happens a lot because there are tons of businesses that have — they sell things in countries around the world and they get foreign currencies. If you sell some — you’re a manufacturer and you sell something in Japan, then they’re paying you in yen and they might be paying you in three months. So, you worry about the exchange rate between dollars and yen, so you want to get it in dollars. You might want to find a counter party who will exchange your yen for dollars in three months or whatever the term is; that’s called a forward contract for exchange of currencies. Very simple.

I’m getting — I’m selling cars in Japan — that sounds — that does happen — U.S. cars sold in Japan. So, I’m going to get — I know I’m going to get this yen in three months. I just signed a contract with somebody to exchange dollars — we fixed the exchange rate; that’s called the forward exchange rate. It’s not necessarily the same as today’s exchange rate; in fact, it would generally be systematically different. So, we have this, what’s called forward interest parity relation. The forward — this is an arbitrage relationship that holds very well in the forward market for foreign exchange. The forward exchange rate — that’s yen per dollar, in the case, if we’re talking about Japan and U.S. — equals the spot exchange rate that’s in yen per dollar times one plus the yen interest rate — that’s for three months if it’s a three-month horizon — times one plus dollar interest rate. And that relation holds very well. If it didn’t hold, I could make money quickly without risk and that shouldn’t happen.

Think of it this way, the interest rate in Japan is different from the interest rate in the U.S. Government bonds issued in Japan are perfectly safe. Well, I mean you could say of course the Japanese government could default, but it’s not going to happen. To a first approximation, it’s not going to — we’ll call it a zero probability. Same thing with the U.S. How can two different countries have different interest rates? You would think, well wouldn’t an investor always invest in the country with the higher interest rate? Why not if it’s riskless? Well, there is risk and that’s exchange rate risk. You can get rid of the risk by taking a forward contract.

You could say, if you’re living in Japan, I note that interest rates are higher in the U.S. than Japan, so I’m not going to go — I’m not going to invest in yen bonds; I’m going to invest in U.S. bonds. Then, I’m going to cover myself by making a forward contract to get the money back in yen. Well, that’s a very clear thing to do, but the problem is you can’t make any money doing it because this holds because of arbitrage. There are so many people who’ve noticed that — that interest rates are higher in the U.S. than Japan; they’re both riskless interest rates. It can’t be right that there’s this profit opportunity that’s riskless, so the forward exchange rate satisfies this relationship.

The forward rate equals the spot rate times the relative interest rates. This is over the horizon between now — this is not the annual interest rate, unless it’s an annual forward contract. If it’s a three-month forward contract this would be the interest earned in three months in yen and this would be the interest earned in dollars over three months. That’s one kind of forward rate agreement and this market works very well. It satisfies this relation — we’ve explained — we know this market; it just satisfies the forward interest parity condition.

Another forward market is the market for different interest rates. We can have a forward loan. We can say, I want to make a loan at a future date of a certain maturity; let’s tie in the interest rate now, so R is the contract rate. Suppose you want to either borrow or lend money in the future; we talked about forward rates implicit in the term structure earlier and you could try to achieve those forward rates as we talked about earlier by buying and selling government bonds, but this is another way to do it, which may be simpler. It doesn’t involve shorting bonds; you can just make a contract.

There’s a contract rate in the forward contract and the contract says — the contract specifies the contract rate R and the number of days in the contract period; that’s how many days hence this contract will be delivered — will be executed. You can make any forward rate contract you want, but this is the most standard contract; yet, it’s between counter parties, so you can do whatever you want. But, if you talk with a broker and you got a standard contract you’d probably get this.

Now, the purpose of this contract is to lock in an interest rate. It’s a risk management contract, so you don’t actually want to borrow and lend from this other person — you’ll arrange that separately — but you want to protect yourself so that you know today what interest rate you can get in the future. What they do is they define some measure of actual interest rate and it could be something like LIBOR, the London Interbank Offer Rate; it’s just an interest rate that’s defined by an agency in London. They have a website and you can read it. It’s a well-known, well-defined interest rate. So, you could say, three-month LIBOR is the interest rate, 90 days in the future — D would be 90 and so, what the contract specifies — it also specifies a contract amount, A, and B is actually usually 360, but sometimes they’ll say 365. You can write whatever you want in these contracts, but this is standard — typically 360 days.

So, all it specified — what the contract says — there are two counterparties; there’s the long and the short; somebody is receiving interest and someone is paying interest. The settlement is this amount, from one side to the other. This formula actually — it doesn’t appear in Fabozzi in exactly this notation, but this is in the chapter on futures markets. This equation, although it’s written a little differently, it’s the same equation that appears in Fabozzi in the chapter on futures markets. What you do, the standard forward contract says, one counter party pays the other this amount and that is equal to the actual interest rate minus the contract rate, times the number of days, times the contract amount, divided by B, times 100. This 100 is here because L and R are assumed to be measured in hundreds, like percent — 3% is really .03 x L x D. This equation might be easier if you divide both numerator and denominator by 100 then you can see that all that 100 is doing is correcting the interest rates from percent to — from 3% to .03.

All it’s doing — all this contract is is an amount — a promise — to pay the difference between the contract and the actual interest rate on that date. That effectively allows you, if you want to borrow at that rate, to lock in the interest rate today because I will get an amount of money from this contract that will offset any changes in interest rates in the future. That’s another example of a contract.

Chapter 4. The Completely Financial Futures Market [00:35:30]

I wanted to emphasize here futures, not — where am I? Let’s talk about futures prices. I took this from an old newspaper — it’s from an old lecture. This is what used to be in The Wall Street Journal and this is an example of a futures contract. I’m going to stick here with agricultural futures and next lecture we’re going to talk about financial futures. But, I’d like to talk about agricultural futures because it’s just really expanding on the Japan, Osaka, Dojima story. It’s so earthy — agriculture, down-to-earth — I like to start with that because it seems very simple to understand. I wanted to explain one contract and I thought I would emphasize corn. This is as it was laid out in 2001; that was seven years ago. I was giving these lectures seven years ago and I clipped it out; that was before — I must have covered it earlier in the semester because I have March 15 up there and we’re now April 14. But, we’ll just use this just as an — I’ll show you in a second what you can get today.

Newspapers, just seven years ago, covered lots more financial data than they do today because we’re moving to the Internet. Of course, they had the Internet in 2001, but we weren’t so into it then, so they still published this in The Wall Street Journal as of 2001. So, let me just use this as an example. What is this? This is corn; that’s maize. It was — what this means is that one contract is a contract to deliver 5,000 bushels and the price here is shown in cents per bushel. These are the contracts; there is a — now this is — today is March 15, 2001; there’s a May contract, a July contract, and this is — this shows the price over today, which is March 15, 2001.

The guys in the pit at the — this stands for Chicago Board of Trade. I put an O in it, but often they just say CBT. There’s a corn pit with traders and there might be 50 guys there — guys and girls. It’s a rough — my colleague Ronit Walny worked in the futures pits in Chicago and she told me that it was so rough; she got pregnant and there was — she was still coming into work and she got knocked over one day by one of the traders and her boss said, no way you have to take a vacation until the baby is born. This is no place for a pregnant woman. It’s true; they get rough and tumble there.

When I had a tour of the CBOT — this was like ten years ago — I was asking — I was observing; the guys in the pit were so raucous and at one point one trader got another trader in a head lock and he was dragging him around and I think it was all in fun, at that time anyway. So, the guy said, well we had a good record this year; we’ve had only two broken arms this year and that’s a good year. In Chicago, they’re not as — they’re farmers — I shouldn’t put them down; they’re different; they have a different spirit. They’re not — they’re down-to-earth, real people; let’s put it that way. It’s fun to watch, but unfortunately it’s probably too late. Unless you go to the Treasury bond pit, it’s all fading away onto the Internet.

What this means is these were the prices that corn took per bushel over that day of March 15. So, the price was going up and down as they were trading all day. This was the opening price when the market opened in the morning; this was the highest price for May futures; this was the lowest price. And this is called the settle, which is essentially the last price, but not necessarily because the exchange has a settlement committee and they decide on what is the last price. The reason it’s not the same thing as the last actual trade is that they’re worried about somebody trying to manipulate the market and doing something funny with the last trade. It’s like the last trade. So, this is the change from the previous day of the price. This is the price for May delivery at a specified warehouse of corn to Chicago. Open interest is the number of contracts. There were 186,000 May contracts; that’s only two months away — March, April, May. Almost all of the open interest is in the short contracts.

Now, if you drive through the country and turn on the radio, you will hear at regular intervals — the announcer will tell you what corn is doing. They say, corn at the latest trading is up to $2.18 a bushel. What price is that guy quoting? It’s always going to be the futures price. You might say, well that’s two months in the future — March, April, May — why are they talking about May? Because this is March, why doesn’t the announcer tells us that at some warehouse the price today was? The reason is that, as I was saying, those prices are not meaningful because they jump around because of crazy reasons, so this is the price.

The other thing that I want to emphasize is that these markets are used to manage risks of holding or raising grain. Most of the time, people who are trading in this market do not complete the contract. In other words, if I — let’s say I’m a farmer raising corn and I’m worried that the price of corn might fall while I’m raising it and I lose money. If the world market for corn drops, then I might not be able to cover my expenses this year and so I could be at great risk. So, I can sell in the futures market, but I probably won’t deliver to the futures market. Why not? Because the delivery point is in Chicago and I’m a farmer in Iowa and I don’t know how to deliver it all the way to Chicago. I’d have to rent trucks and drive to Chicago with my corn; I’m not going to do that. I’m always just delivering to the local grain elevator. In fact, I don’t have to — I don’t need any trucks; the guy will pick it up from my farm, so that’s what I want to do. What I do typically is I sell in the futures market, I as a farmer, and then one day before the contract expires, instead of delivering, I will buy it back and cancel out my contract.

So, all I’ve done is a purely financial trade in the future. Do you see the difference? I don’t actually want to deliver because it’s too much trouble to deliver, so you get farmers trading all over the country and all over the world in this market as a way of hedging their corn. Very few of them will ever deliver. The only reason why delivery is kept open as an option is that is what determines the price in the market. Ultimately, the only people who deliver are professional arbitragers, who on the last day or right when the contract is expiring, they look at the futures price and they say, maybe I can deliver it, maybe I can buy it for less than that and deliver and I’ll really do it. Those are the only people; so, if they can buy for less than that and deliver, they’ll do it. They compete with each other and that brings the futures price and the spot price in line at the end. Alternatively, if the spot price is above the futures price at the end, then these arbitragers will say, hey I’ll take delivery. I’ll go there and take delivery on a contract and then I’ll sell it and make money. It’s because of the arbitragers that the cash price and the spot price line up at the end; it’s not through any law requirement.

You see what people are doing? They’re using the futures market as a purely financial market. Most people rely on the arbitragers to enforce the futures price converging on the spot price at the end. Most people are not even raising the right kind of corn maybe; I don’t know how — a lot of them certainly aren’t. There are all different kinds of corn. If you are raising one kind of corn and are hedging your risks with a different kind of corn, that’s called cross-hedging. That means across products; I’m going from one product to another. So, I could be raising some of this beautiful Indian corn that — remember it turns all these different colors and people hang it on their doors at Halloween — that’s not suitable for delivery at the CBOT. If I’m raising that, there’s no market — it’s no future — it’s no big market for that, but it probably correlates with regular corn, so I could cross-hedge. If I’m raising Indian corn and I’m worried about the price, I can sell in the futures market in Chicago and buy it back the next day.

I said I was going to show you what’s in The Wall Street Journal. I got this this morning from The Wall Street Journal; that’s all they have for futures markets in the newspaper, unless I missed it, I couldn’t find it. Commodities and currencies — they don’t have any agricultural futures mentioned at all in The Wall Street Journal. As I’m going to talk about next period, most futures have migrated to financial futures anyway. It’s the same idea, but it’s not agricultural. I don’t see anything agricultural up here. There are commodities; there’s crude oil, natural gas, gold — everything else is purely financial. Well actually, you’ve got the DJIIG Commodity Index; that’s an index of a number of prices, probably including agricultural. So, that’s traded; lots more is traded.

I went down to this morning and I got wheat futures prices. This is on their website and you don’t need any special permission to get on They’re actually changing the name of the website though; I think it will be because of their merger with the Chicago Mercantile Exchange. This is the same thing that we just saw. This is the price of a bushel of wheat; this is as of last Friday — $.932 a bushel. It ranged from $.885; it closed at its high — it opened at its high and it settled down, so wheat went down. This is for delivery in May of 2008 and these contracts go out to 2010. This doesn’t shown open interest, but you understand what this is?

Now, the real — the price that we talk about when we talk about commodities is the futures price, overwhelmingly. This is the Chicago Board of Trade price for corn since 1929. We could take it even further back, but futures exchanges have been going since — the CBOT goes back to the 1860s. Anyway, this is a long time horizon plot of the price of corn and I adjusted it for CPI inflation, so this shows in dollars per bushel. Of course, contracts are for 5,000 bushels, so you’d have to multiply these numbers by 5,000. This just shows what has been happening to the real price of corn since 1929. There’s a lot of talk recently; you must have heard it — about this spike up. In fact, it’s quite a hefty spike up; it’s doubled — more than doubled in real terms in just the last couple years. Do you know why this is? Why is corn getting expensive right now? What’s that? That’s the theory; I think it’s right — that it’s because oil prices are getting high and because we can make alternative fuels out of food stuffs — cane or corn.

In response to the high oil prices, well also subsidies for ethanol production, corn is being demanded to run automobiles. All these rich people who want their SUVs — they want to have a good drive — are now paying more for the corn and bidding it up and this is a huge international crisis. It’s spreading over all of the grains and it’s a worrisome situation because people in some of the poorest parts of the world cannot tolerate a doubling of the price of grain; they’ll starve. This is a huge moral issue that we’re facing right now. In order to keep our cars going, we’re driving some people to starvation. On the other hand, I don’t mean to minimize that, I thought it was interesting to look at the whole run of corn prices back to 1929; they have come down a great deal. It’s quite curious, if you correct for inflation; it was like $15 a bushel in 1950. On top of that, our incomes have risen and so I think this says something about why futures — agricultural futures — are not as prominent as they used to be.

It used to be that food was really a lot more expensive and a bigger share of our income. We live in a very plenteous time; this is very unusual by historical standards. Right now, you just eat whatever you want; you don’t even look at the price; it’s all so cheap. Maybe you do; maybe you don’t eat caviar because of price, but we’re just in a time of plenty with the real price of food so low. It’s not normal times, historically, so our agricultural futures are somewhat downplayed.

Chapter 5. A Case Study of Futures: The Price of Wheat and the Question of Storage [00:51:44]

I wanted to give an example of wheat futures because this is — we have a reading on the reading list by Holbrook Working. Holbrook Working was the great theorist of futures markets and it’s actually — the reading comes from the 1950s and he is explaining futures market. I like this article because it sets it forth very well and nothing has changed since the 1950s except that the markets are electronic now. I wanted to focus in on one futures market and this is the market for wheat. These are the standards for delivery at the Chicago Board of Trade. I got this off their website and this current; this is today.

If you — one contract is 5,000 bushels. They will accept a number of different kinds of wheat that meet their — there must be some standards for quality — no bugs in it and whatever else — but they’ll accept number two soft red winter or number two hard red winter or — I just copied this from the — it says, no dark northern spring. It must be number something, what happened? I must have lost the — number two, northern spring. All those are at par. However, you can also deliver number one soft red winter. That’s different because this is number two soft red winter — or number one hard red winter or number one dark northern spring and number one northern spring; you get $.03 a bushel over the contract price.

What they’re trying to do is recognize that there are so many different kinds of wheat and so I thought we would remind ourselves of what they are. One hard — soft wheat is used for making biscuits and breakfast cereals and cakes; hard wheat is used for making bread. If you do baking, you should not just always use all-purpose flour, you should get the different varieties. That’s what is being mentioned here — these different varieties. I wanted to — let me see, I wanted to talk about the Holbrook Working paper. Holbrook Working talks about winter — is anyone here who is a farmer? Did anyone grow up on a farm? Can anyone tell the story of winter wheat? Nobody? We’re not very down-to-earth people here, are we?

There are two plantings; there’s winter wheat and spring wheat. Winter wheat — you plant it in the winter and you harvest it in the spring. It stays in the ground all winter and it comes up first thing in the — it’s coming up now. You harvest winter wheat in May, so we’re almost close to the harvest. Did you know that? There are amber waves of grain blowing in the wind out there in the wheat belt right now and it will soon be harvested in another month and a half. Spring wheat — you plant it in the spring and you harvest it in the fall. But they’re allowing now delivery of either one. When Holbrook Working wrote the paper, there was a separate contract for hard winter wheat and so I think that there’s some consolidation of these markets as agricultural futures is becoming less important. That’s why we just have — this is the only CBOT wheat market that’s listed now.

You understand what the contract is? The contract is to deliver one of these varieties and there’s a separate contract for each of these dates. What is the pricing? This is the thing — what is the futures price? Now there’s — this is what I’m going to try to conclude on. It depends on whether wheat is in storage or not. Normally, wheat is in storage because we only harvest a particular variety once a year and we have to consume it all year. So, after the harvest the warehouses get full and then they’re brimming with wheat. Then, as the year goes down, the warehouses deplete their contents of wheat and it hits zero right when the new harvest comes in. Then, it all gets put back into the warehouse. This is a physical necessity.

When there is wheat in storage, normally, most of the time, this relation should hold. The price of the futures contract should equal the spot price times one plus the interest rate, between now and delivery. That means that if, say interest rates are 5% a year and the delivery is in six months, then this should be .025 — half of a year. I want to — it’s not annual interest rate; it’s the interest rate until delivery. If it’s a third of a year, you divide by whatever the — it’s the interest from today until delivery date. S is the cost of storage from today until the delivery date. This should hold normally all the time and why is that? Because if I’m running a warehouse storing grain, I can either sell at the spot price or I I can always unload my warehouse and sell it today or I can wait and deliver it in the future at the futures contract. Today, as a warehouse, I’m losing money because of the cost of storage. I have to pay insurance and I have to do other things that maintain the quality of my storage and that’s S.

On top of that, I’m losing on interest because if I’m storing the grain, I’m not getting interest on the money that I paid for that grain; that’s another loss to me. So, this is the break even for storing grain. If the futures price is enough above the spot price that it pays for my interest cost and my storage cost, I’m making money storing grain. If the futures price is below this, I’m not going to store grain; I’ll unload my warehouse. Why should I store grain for another minute? If I’m a professional warehouse offer and I see that I can make more money by selling my grain today, then I will do it. Conversely, if the futures price is above the spot price, then I’m going to want to store more grain. I’m going to go out and buy up other grain and that’s going to tend to force the spot price up. So, this relationship tends to hold almost all the time or you might say it holds all the time, if you interpret it correctly.

Normally, the futures price is above the cash price because interest rates are positive and storage costs are positive and it has to be that way. The normal course of grain prices over the harvest year is to rise as the year progresses. It has to be that way; the grain is cheapest right after the harvest when there’s lots of grain around and then the grain price goes up steadily throughout the year until the new harvest comes in and then it collapses. The price of grain over the year is a sawtooth pattern. If there’s nothing interfering with it, the price of grain will tend to look like this and these are the harvests. The reason the price of grain is going up between harvests is to compensate the warehouse owners. They’re not going to do this business if they’re not getting compensated.

Chapter 6. Backwardation and Spot Premiums [01:00:47]

So this is almost like an iron law, this is going to hold, but it doesn’t necessarily hold in a given year because there are other things that affect price. This is what I was saying — that arbitrage enforces fair value. There is a problem if there is no grain in storage. For example, right at the harvest end when the harvest is coming in, the relation between futures and spot price can become very erratic. The futures price can be way below the fair value; the right hand side — spot times one plus R plus S — is called fair value. Futures can be below fair value and there’s no way for arbitrage to make up the difference because there’s nothing — if the futures were very low, you would want to take money out of — take grain out of storage and sell it on the spot market. If there is no grain in storage, you can’t do that. It sometimes happens when the grain is not in storage that the price of the future is below fair value. There’s another interpretation of it. People would say, well but there is still some grain in storage — it’s not gone everywhere.

So, how can it sometimes be that the futures price is below fair value? Well, you might say — and this is that — you could either say that sometimes the relationship between price and fair value is violated or you could say, no it’s never violated, but sometimes the storage cost is negative. So, we have something called a convenience yield, which is a negative storage cost. Suppose you are a corn merchant and you’re noting that right now the market is in backwardation — the futures price is less than the spot price. So, you’re thinking, I want to get grain somehow and sell it on the spot market and I’ll make money. You go around trying to find someone to sell you grain and you find that someone has it and won’t sell it to you and you say, well why not? The guy will say, because I need this grain.

Who has grain when the market is in backwardation? It’s somebody who really needs it. For example, in the case of wheat, you might find that you go to the factory that makes Wheaties and you say, I’d like to buy your wheat — noting that the spot price is really high. You won’t tell him that; you say, I just want to buy your wheat. Whatever you’ve got, I’ll buy it at the — you shouldn’t put it that way. I guess I’m saying that it’s not going to work if you do — why doesn’t the Wheaties manufacturer sell its grain on the spot market? The reason is that they need wheat to make Wheaties and so for them they want to have some on hand. They might think, well if we didn’t have any storage of wheat we would be at the mercy of delivery and who knows when — the harvest is out now, we might not be able to get any wheat and we may have to shut our whole factory down and tell everyone to take a day off. That costs us a lot of money, so we really need to have wheat in storage at the Wheaties factory.

When the market is in backwardation, the only grain that’s stored is the grain that’s there for convenience purpose. I’m just going to go through the example that Holbrook Working gives in his reading, which you have. Back then, there was a number two hard winter wheat Kansas City future — maybe there still is; I don’t know, but not at CBOT. We’re going to do this 1956 or 1957 story — I have it here. Hard wheat is used for bread, soft wheat for — remember, this a cooking tip. You can buy bread flour at the grocery store and you can buy cake flour and they’re different. Holbrook Working is just talking about what happens in a typical year for hard winter wheat.

So, we’re starting out now with July 2, typical year, spot wheat was $2.29 a bushel; that’s the price on July 2. The September future is $2.32 a bushel, so the difference between the future and the spot is called the basis, which is $.03 a bushel. Another term is spot premium, but that would be minus $.03, but that’s — let’s just talk about basis. The basis is the futures price minus the spot price. This is just a typical story. So, the futures price is selling for higher, as it should be, because between July and September, this is winter wheat. The harvest is recently in; the harvest came in in May and so this is when there’s a lot in storage and we really should see the futures price above the spot price and indeed we do.

This spot premium is the profit that is offered to the warehouser. The warehouser looks at this — or the basis — the warehouser — people in the warehouse business are always watching this every day and they’re looking always at a basis of $.03 and they’re thinking, are we going to make money on that, because they have costs. But, this is how much more they can sell it in the future than they can sell it today, so they’re comparing the basis with their costs; they do that all the time in the warehouse business. Now, September 4 — now it’s still — remember, the harvest was May; we’re not anywhere near the harvest. Now, we still have a basis, but now the basis has gotten smaller; this is what happens. So, the warehouse operator is starting to feel uncomfortable. I was doing really well in July — I had a basis of 3. Now the basis is down to 1, so it’s getting kind of iffy for me — whether I can make money. Maybe I should sell. So, they’re always watching these markets and thinking about that.

I’m sorry, I take that back; I forgot, this is both the September future. So, the basis should get smaller because we’re getting closer to the expiration date because now it’s only one-month interest. Well actually, it’s even less; we’re almost expiring; I wasn’t thinking when I first saw that. The basis should shrink to zero as the time — as you approach the expiration of the contract. Someone in a warehouse who’s worried about the fluctuation in the grain will sell it in the futures market and then expect to get the basis because it doesn’t matter what the price of grain does; the spot and the futures price should converge. The basis should go to zero and the $.03 a bushel is the profit that they make on the futures trade. It’s riskless for them at the warehouse because they’re hedging the price risk and then it becomes a nice clean and easy business.

So, I’m looking in July 2 to see what are my costs at the warehouse. I’m looking at this basis and I think if I can keep my costs under $.03 a bushel, including interest, then I will make money because this basis is converging to zero at the end for sure — or the stock premium will go from minus 3 to 0 — so this is a normal month. Some months storing grain had this basis of $.03 a bushel and is doing business as usual, storing for less than that and making money. If not less than that, then get out of it. Then, continuing through the year — now they roll into December futures because I’m still storing grain; I do this all year. I’m trading in the nearest month contract because that’s where the open interest is and that’s where all the trading is. So, as soon the September contract expires, I don’t actually want to deliver. I’ll sell out and I’ll make the profit, which is the change in basis.

Now, when it comes to — now, September 4, I’ve made that profit of $.02 a bushel. The difference between the $.03 a bushel basis and the $.01 and now I start a new contract. Now, because September is expiring, I move in. I roll over into the December contract and I’m just going to do this every contract. Every three months I’m going to roll over into the next contract. In this case — I didn’t put the basis; the basis was $.0575 a bushel. So now, it’s looking even better here in September. I mean, it jumps around; the basis jumps around with market conditions, but it’s looking good now because I have a basis of $.0575. So, I’ll sell my grain again on a futures contract and then I will close it out December when the — this is December 1 now. Now the price of wheat has gone up a lot from $2.38 to $2.52, but you know it’s not going to be profit for me. I’m not — I hedged it, but I’ll make the — for me, the profit is the change in the spot premium. So, I made $.0575 a bushel minus my costs.

I’ll just stop; I know I’m running out of time. What happens at harvest? I’m doing this all year. Finally on May — this is — the new harvest is coming in and look what happens; now this market is suddenly in backwardation. Now, look what’s happening; the spot premium is $.18 a bushel; the basis is minus 18. If I hold on — if I rolled into July futures and hold on, I’m going to lose really big time, so I’m out — I’m out of the business. We sell off everything in the warehouse and we’re done. This is the process by which warehousing is optimized and we get grain smoothly through the year, but it’s the basic principle that we’ll see in the next lecture — extends as well to other kinds of financial futures.

Next period, we’re going to talk about other kinds of futures, including financial futures.

[end of transcript]

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