ECON 252: Financial Markets (2008)

Lecture 22

 - Stock Index, Oil and Other Futures Markets


Futures markets have expanded far beyond their initial application to farmer’s planting and harvest cycles. These markets now allow investors and traders to set prices for a broad spectrum of assets and for a whole term structure stretching into the distant future. Some of these markets are often priced according to simple fair-value formulae, others are not. Futures markets can be in backwardation, where the future price is lower than the present, spot price. They can also be in contango, where the price rises with maturity and is higher in the future than it is today. The S&P/Case-Shiller Home Price Index is a recent invention that has transferred the mechanics of futures markets to the prices of single-family homes in ten real estate markets, in an effort to create a national market for residential real estate.

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Financial Markets (2008)

ECON 252 (2008) - Lecture 22 - Stock Index, Oil and Other Futures Markets

Chapter 1. Introduction: On the Extinction of Ticker Tapes [00:00:00]

Professor Robert Shiller: First thing, I wanted just to — I forgot to show — I don’t know how exciting this is, but this is a ticker tape. They weren’t brown. This tape is about a half-century old. It came from the attic of the New York Stock Exchange. When I was at a conference there a year ago, I mentioned to the vice president there that I had told my class about ticker tape machines and they had never heard of them — didn’t know what they were; well, at least some of them hadn’t. So, he sent me this. This was never used, but normally it would go into a machine and it would print out stock prices at trades.

I was giving a talk yesterday at the New York Stock Exchange and I met him again and I said, thank you for this; my class was happy to see it. He said, well I could have given you a whole ticker tape machine. He said, well the attic at the New York Stock Exchange was filled with them, but they finally threw them out, so it’s too late. I think it is — this is evidence that information technology really has dominated stock prices. We didn’t really have active stock markets before the electronic age, which is an interesting thing to think about because the ticker tape machine was invented by Edison in 1867. In 1867, there were hardly any — there were stock markets, but they were very small. It was really the electronic communications that made it what it is. It’s exciting to think about the future and where electronic communication is going to take markets going forward.

Chapter 2. How Futures Markets Included Financial Securities [00:01:49]

I wanted to continue today about our futures markets. Let me just step back and think, what is a futures market? Today, I’m going to talk about how it has expanded to cover lots of other things, notably financial instruments. Let’s just think, what is a futures market? If you read Holbrook Working, who’s on your reading list, and his half-century old paper, back in those days that he was writing, he says that the name “futures” is a bit misleading because that suggests that it’s talking about the future rather than today. If you listen to the news about any commodity price, it’s always talking about futures price. They don’t talk about the price today. The futures price is the interesting — the point that Working made is not so much that it’s in the future is that it’s well-defined and standardized. For agricultural futures, it’s true that the contract doesn’t mature for a month or so, but as Working points out, any contract for delivery of something has some term. They don’t just deliver it instantly and Working says, there are times when the so-called spot price is actually further in the future than the futures price.

If you look at the way things are traded — I’m going to be talking a lot about oil, but let me just talk generally about oil. What is the price of oil and how does anybody know what it is? If you go to people who buy and sell oil, they will tell you, well we don’t just sell oil; we don’t just have it ready to go. Almost all of the oil is sold in long-term contracts, so an oil company will sell a contract to deliver regularly to some refinery, oil. They’ll have these tankers appear and we sign a five-year contract — or whatever — and it has all kinds of terms. If you read the contract it would be fifty pages long and it would specify all kinds of “what we’ll do if we don’t deliver” or “what happens if we can’t deliver the grade we promised.” Lots of uncertainties are defined, so who knows what the price of oil is when it’s being part of a long-term contract. That’s why you need a futures market and the futures market is the market that’s free of — it has a standardized contract.

We know exactly what the price means and attention focuses on the futures market because the trade there is — everybody understands it; everyone knows exactly what’s being traded. The minute-to-minute changes reflect something; they reflect something real, namely change in the market not any change in what’s being delivered. Anyway, it used to be that the only futures markets were for commodities — for things — typically it was thought that futures markets are good to have for things that are not standardized — that are difficult to define. So, we want rice futures and we want wheat futures because there are so many different kinds of rice in different areas and different — so, we want to have a standardized price.

There were no financial futures until the 1970s and people felt back then that we don’t need futures contracts because there’s a standardization of shares. Every share in a given company is exactly identical. When you say, I’d like to buy a hundred shares of a company, you’re not going to ask the broker, well which shares did I get? And can I look at them? Your broker would say in disbelief, look you’ve got shares; they’re all absolutely identical. You might think there’s no need for a futures market because the prices are already standardized in the cash market. Moreover, the prices that you see traded on the stock exchange floor — you know exactly when the trade took place; they’re not future-traded.

Why did we get futures markets? Let me come back to that. Let me just first — why did we get stock futures markets? Let me come back to that and talk about — let’s be clear what they are. Stock index futures markets came in around 1980 and one of the very first was the Standard & Poor 500 Stock Index Futures Market traded at the Chicago Mercantile Exchange. It was a radical innovation when it came in because people thought, what’s the point? I can see farmers delivering their corn or their oats or whatever, but stocks — what’s the point? Well, it turned out to be absolutely right because — the CME was absolutely right to create this market because — within a few years, there was more trade on the futures market than there was on the stock market itself.

Let’s be clear what they created — and this is the terms of the contract as it is today. The S&P 500 is an index of stock prices produced by Standard & Poor’s Corporation and it’s — they take the prices of 500 stocks and they form a weighted average. It’s an arithmetic average where the weights correspond to the amounts outstanding of the various stocks, so it’s a value-weighted index. It’s just a number published by the American Stock Exchange — no, by Standard & Poor’s. All it is at — just as with agricultural futures — I don’t know how clear I was about this yesterday. If you — maybe I didn’t say this. Let me say that it applies to both agricultural futures and financial futures.

If you want to trade in the futures market, you have to put up margin and there’s a margin requirement for each contract. The margin is there to eliminate counterparty risk with other contracts. When you sign a contract with another person you have to worry whether that person will come through, but with the exchange that counterparty risk is eliminated. The way the exchange eliminates it is it takes the other side itself — of every contract who — it stands between you and the counterparty and it protects itself by demanding margin. You have to, up front, put up margin for any futures contract and the margin is settled daily. Every day, they look at your margin account and they adjust it. So, if — let me go back to wheat futures because that’s the simpler — I don’t think I really explained this well. If you buy — when we say “buy wheat futures,” what does that mean? That means — the word buy or sell has a different meaning in futures markets. When you buy wheat futures or, for that matter, S&P 500 in futures, it means that you put up margin. You did not pay the price for the contract; you only paid margin, which might be 5% or less than the price.

If you’re buying wheat futures, what are you doing? You’re putting up margin and standing ready to see your margin account credited or debited depending on the change in the futures price from day to day. If the price of wheat in the futures market goes up and you bought futures, they will increase your margin account by the amount that it went up. If the price of wheat goes down, they will decrease your margin account balance by that amount. How do they get the money? Well, that’s because for every buyer there’s a seller in the futures market, so somebody else sold futures. Both of you put up margin; if you are buying, you put up margin; if you are selling, you put up margin. So, the result is that they have a place to get the money. If the price goes up and you bought, your margin account will go up. The exchange will get the money by taking it from the margin account of the guy who sold and they’ve always fixed it so that the number of buyers always equals the number of sellers. You see how the exchange can’t lose and you can’t lose; this is a guaranteed thing.

The only problem is that what if a margin account runs dry? Both buyer and seller have put up margin and then the price — let’s say the price drops a lot; the futures price drops a lot. Then, that means that the buyer’s margin account is wiped out. What will happen then is that the futures commission merchant will go to the person who bought the futures and say, do you want to post more margin or do you want me to close you out? That person has a decision to make and if he or she puts up more margin, then that replenishes the margin account and the person can keep trading. That’s how the exchanges eliminate counterparty risk, by daily resettlement of the contracts.

It’s an invention — actually goes back to Japan; although, it was slightly different in form. It’s an invention that eliminates any risk of the counterparty not performing so that risk doesn’t affect price. So it’s the same — are you clear on that now — how the margin account works? You might not enjoy this. Depends on how much of a gambling instinct for how much fun this is. If you buy or sell futures, you can expect a phone call from your broker sooner or later; well, not necessarily, unless you have incredibly good luck.

Hillary Clinton, when she invested in the futures market, she had incredibly good luck. You know this story? When her husband, Bill Clinton, was Governor, she got a call from — a friend recommended to her a very good broker who knew how to trade in commodity futures. So, she put up something like $1,000 of her own money and then the broker kept calling her and asking her what she wanted to do. She just never lost anything; she turned it into a $100,000 within a year and then she stopped. We don’t know why — I’m not anti-Hillary Clinton; this is just a futures market story. I like her a lot, but what do you think happened there? Her margin account just kept going up, and up, and up. I mean, it went up amazingly. You could conclude that she is a brilliant trader and she ought to be President of the United States, but then the next question is, why did she stop? Why did she run it for a hundred-fold increase and stop? Does anyone have any idea? Is this common knowledge — this story? Well, the story ends there; nobody knows what happened.

Futures traders are willing to exercise a guess of what happened. Does anyone have any guess what you think happened? Well, I shouldn’t say things so political. I do like Hillary Clinton, but what likely happened is some futures commission merchant was thinking of bribing the Governor. Maybe he didn’t — never actually did it — but let’s do a little favor for his wife and then maybe I can ask him for something later. So, the futures merchant just didn’t listen carefully to what she said. He just — well, he sort of cooked the books and gave her money by making it look like a trade. When she found out — what finally likely happened is someone said, do you think you’re making so much money in the futures market? Remember who your husband is and this guy — do you trust him? This is a likely guess. She finally wondered, what is going on here? And she stopped because she didn’t know what was happening either. Somehow money was coming in and — that’s the very — now, maybe she was just very savvy in her investing ability, but usually your futures accounts go both up and down and you get margin calls.

Anyway, the last day of the contract there’s a settlement and — in agricultural futures, the last day there’s delivery if you’re still in the contract. If you are a seller on the last day, you must deliver the specified number of barrels or bushels of whatever it is. Or, if you are a buyer, you must take delivery of them. With stock futures it’s different because nobody expects you to deliver shares of stock. What happens on the last day is there’s a final settlement and that is in dollars in this case — 250 times the S&P 500 Index on the last day minus the futures price of the preceding day; that’s the settlement. Of course, you have been gaining the changes in the futures prices every preceding day. If you — this is what you receive as a buyer if you bought the contract and this is what you pay if you sold the contract.

Everyday between the time you originally bought, you’ve been getting — if you were a buyer — the change in the futures price and at the end you get this. If you sum all those up — all the settlements you got since you bought the contract until the expiration of the contract — you would be getting the index at time T minus the futures when you bought. That defines it. Everyday you get the change in the futures price; those all add up into your margin account and on the last day you get this.

What is it, really, you’re doing? You could say — and they wouldn’t like to put this way at the futures exchanges; they don’t like gambling analogies, but I make gambling analogies freely in this course. It’s like placing a bet on the stock market. If you think the stock market is going to go up, you buy the futures, and if you think it’s going to go down, you sell the futures. If you buy one contract, how much money do you get? You get, in total, over the total interval, between the purchase date and the expiration of the contract, you get the stock index minus the initial futures price you paid, times $250; that’s the gamble. If you sell, it’s just exactly the opposite.

Chapter 3. Fair Value and the Influences of Contango and Backwardation [00:18:06]

Now, there’s something called fair value and you’ll see this talked about a lot in futures. This is what the futures price should be; we talked about it in terms of wheat. Remember, the fair value of a wheat futures was equal to the price of wheat today times one plus the interest rate, plus the storage costs; that was the formula we had last time. That was the fair value because we concluded that somebody who’s storing grain has to make their expenses, they have to make the interest cost and they have to make the storage costs, so the futures price should be equal to fair value. It’s the same here with stock index futures. The fair value F of a futures contract is equal to the stock price plus the stock price times the interest rate, plus the storage cost. The storage cost for stocks is negative because it doesn’t cost you anything to store a stock. Well, you don’t even have to store certificates anymore; your name will be held electronically. It’s negative because you get dividends.

So, y is the dividend yield that you get on the stock. So r minus y is the adjustment you have to make. You see this — to get from stock price to fair value — you see this is the same formula that we had for wheat, except that you understand that storage costs for stocks are negative because they pay a dividend. So, all I’ve done is I’ve — the way I wrote it before was P x (1 + r + s) in the preceding lecture; now it’s P x (1 + r – y) because s = -y. That’s the fair value of a stock index futures. Now, we said last time that sometimes prices deviate from fair value — or maybe they don’t depending on how you define fair value. But, if you define fair value as 1 + r + s, where s is just the cost of a warehouse, then sometimes that formula doesn’t work because we talked about last time, at the end of the growing season nobody is storing wheat anymore. So, the wheat market falls into backwardation and the futures price gets low.

Other than that — normally wheat is being stored, so normally wheat prices are essentially equal to fair value, but stocks are always being stored. There’s no — it would be unusual to see backwardation in this market; it would be abnormal because we’re always storing stocks. That’s what we do with them is we hold them. Dividend yield — you can have backwardation, however, if the dividend yield is greater than the interest rate because then the adjustment would make the futures price below the cash price. Otherwise, you can’t have backwardation in this market, so price should always equal fair value. Right now, we’re in an unusual circumstance where the interest rate and the dividend yield are about the same. Right now, the Fed has cut short-term interest rates — federal funds rate — to 2.25%; that’s very close to the dividend yield on the S&P 500. So, at this point of time, the futures price is very close to the spot price, so fair value calculations are relatively unimportant.

Are there any questions? Do you understand this? I have a clipping from — I took it from yesterday’s Wall Street Journal and this is to prove that The Wall Street Journal is still publishing financial data even though they’ve cut way back. This used to be a longer entry, but this is what they have as of yesterday. This says the Standard & Poor 500 — this is under futures prices — Chicago Mercantile Exchange — and they’re reminding you that the settlement is 250 times the index and they show two contracts, one expiring in June and one expiring in December. These are the prices; this is the opening price at the beginning of the day; this is the highest price for the day that the contracts traded; this is the lowest price traded for the day; and this is the settled price, which is essentially the last price of the day. This is the change in the settled from the preceding day and this is the open interest; it’s 550,000 contracts. Do you understand what all this means?

Now, interesting, it looks like there’s backwardation because the December futures at open is lower than the June futures, but I think this must be — it’s not much lower. I think it may have something to do with timing of the trades. If you look at the settled price over here they are almost exactly identical between June and December. It’s not backwardation; it’s contango — the futures is above — it’s going up as the horizon goes out. That’s where we are today and they talk an awful lot about futures — stock index futures. If you watch CNBC, they’re always talking about it and the reason is is that it’s such a big and liquid market. In fact, the futures market — the S&P futures market — as I said, it’s gotten bigger than the stock market itself, at least at certain times. It’s also just a more trustworthy number and it moves faster, so it’s gotten a great deal of attention.

Why does the future market move so fast and why is it such a popular instrument? I think the main reason is that it is a market that — it’s like a wholesale market for antiques rather than the local antique dealer. If you went to an antique dealer in New Haven to try to buy some furniture for your apartment who knows what price you would get; it would be very erratic and you’d be dealing one-on-one with the dealer. Well, that’s what happens in the futures — in the stock market as well. Remember, I was telling you that a dealer has to have a bid-asked spread. An antique dealer — they’ll buy the chest of drawers at a lower price then they’ll sell it and the difference between bid and asked is their bid-asked spread and that’s their profit. Dealers have to keep a wide bid-asked spread because they have a lot of expenses and they have the risk of being ripped off by more knowledgeable people who really know antiques and will buy their best stuff and leave behind the junk. Because they’re constantly exposed to this risk antique dealers keep wide bid-asked spreads. It’s the same with the stock market.

The people — the specialists or the dealers who trade on the stock market with customers have the same concerns, so they keep relatively wide bid-asked spreads. In the futures market, there is — it’s cleaner. There’s a huge volume of trade; it’s very competitive; and there’s less fear about being ripped off by someone who has special knowledge because who knows what this index is going to do anyway. So, dealers have narrow bid-asked spreads in the futures market and, as a result, the futures market is where the action is. The people who doubted that back in 1980 — who doubted that financial futures would ever take off — were really wrong. Even though stocks are perfectly standardized — every share is the same as every other share — we do need a futures market, so the futures market is very important.

Anyway, I wanted to talk about oil. Are there any questions about oil — about stock futures? I went through it kind of quickly, but the important thing to know is just to understand fair value. It’s actually a very simple market to understand. Once you know this formula you pretty much know the price for any future date. Remember the r again, as in the preceding lecture, is not the annual interest rate unless we’re talking about a contract that matures in one year. It’s the interest between now and the expiration date and the same thing with dividends. This is the dividend yield where we’re not talking about annual dividend yield, but the dividends as a fraction of the price between now and maturity of the contract. That’s the only formula that we really need.

Let’s think of the stock index futures market; it’s where you really look to see where the stock market is moving. It’s faster than the stock price index itself that the S&P publishes. The S&P 500 is a little bit behind the thing that it’s trading on. Why is that? Well, that’s because some of the stocks in the S&P 500 Index don’t trade really minute-by-minute with the same speed that you’d think, so the S&P 500 is always catching up on itself — the actual index. This market has all the smartest traders trading it and they kind of know when the S&P 500 is lagging and they immediately correct it in the futures price. The futures price is the place to look for what the stock market is really doing.

Chapter 4. Volatility in the Oil Futures Market [00:28:57]

I’ll move to oil futures, which is a matter of great interest right now because of the turmoil in the oil market. Oil futures actually go back — they’re not so old either compared to wheat or corn; they developed in the early 1980s. This is the NYMEX oil futures market and there are many futures markets for oil, but the NYMEX is the most important one. They are trading — this is different — it’s a physical delivery oil futures market, no different from the agricultural futures. They define a particular grade of oil and they call it light, sweet crude oil. Sweet oil is better than sour oil. I wouldn’t try tasting it, but the refiners like it better generally. So, it’s a grade of oil; it’s also called West Texas Intermediate. You have to — if you buy a contract and you hold it to maturity, you are going to have to take delivery of 1,000 barrels of light, sweet crude oil in Cushing, Oklahoma. They pick Cushing, Oklahoma as kind of central to the country. You could call your broker and buy a contract today and then you could get the May contract. Then, in May you’d have to take a trip down to Cushing and get your 1,000 barrels or you could sell in the futures market and that would mean that you would have — you would be promising to deliver 1,000 barrels.

As I said last time, almost nobody who trades these contracts actually takes delivery or makes delivery because almost everyone closes out their contract before that. It’s the same idea as all the other oil contracts. You have contracts maturing in each month, there’s one — we’re already — we’ve already passed the expiration of the April contract, so it’s May, June, July, August, etc., and this is the price. These are — well actually, they make a distinction between last and settled. The settled price is the important price because that determines the changes in your margin account. The settled price as of yesterday reached $113.44 per barrel, which is a record high. You can see that as delivery dates go out the settled price goes down, so the oil market is currently in backwardation. Now, remember what we said about futures is that normally they’re in contango. Remember, the futures price fair value tends to equal the price today, times one, plus the interest rate, plus storage costs. Storage costs for oil are substantial; this is a thick, bulky commodity. You’ve got to have one of those storage tanks; you see them out there in New Haven Harbor. They cost money; it’s expensive to store, so storage costs are not negligible for oil; plus, interest rates are positive.

We would think that oil should have contango normally. Its price should be going up, but very frequently oil is not in contango; right now it is not. You can see that oil prices are lower by October, according to the futures market. I wanted to reflect a little bit on what oil — what is going on in the oil market. The thing you have to understand in terms of what — you understand the contract; it’s exactly the same as a wheat contract. It’s just a contract to deliver 1,000 barrels or receive it and if you do that you don’t have to come up with oil today. You probably never come up oil; you just have to come up with margin today and your margin account will reflect the change in oil prices. This is the number you see in the newspaper. This is when they talk about the price of oil in the newspaper; this is it.

There’s also something called Platts, which is a company that — I guess it’s a McGraw-Hill Company — that does cash prices of oil. It’s not quoted as much because I don’t think it’s as reliable as this. The problem with — you might say, this is a month in the future. Isn’t that — that’s not today’s price, but that’s what people are quoting as today’s price because it’s the most accurate price. Now, why is it going into backwardation? I wanted to think about storage of oil because we were saying that everything should be generally in contango. Aren’t they storing oil? As I said, if you drive out to New Haven Harbor you see all these storage tanks. Don’t they have oil in them? I wanted to think a little bit about where the oil is. Most of the oil is still in the ground in the Persian Gulf, in Mexico, in Russia, and all sorts of places, but we don’t count that as storage of oil because it has to be extracted and it’s not just there for sale — there’s a lag.

So, we have to consider oil that’s above ground and ready to go. It is stored and it’s stored here in New Haven. In fact, the Government of the United Stated has created what they call a “strategic petroleum reserve.” It has taken oil and it’s storing it in caverns, in caves, and this is in case of a national emergency where we suddenly really need oil. That isn’t going to affect this market because it’s being held by the Government for some war or some terrible event. It’s not on the market, so that doesn’t affect the — even though the market is in backwardation the Government is not going to sell off this oil, so it’s not affecting the market.

The other thing that’s happened is there’s a heating oil reserve; this was created by President Clinton in the year 2000. That is actually in two places; it’s in New York and New Haven. So, we are the storage place for heating oil. This is not a strategic petroleum reserve, but it’s the reserve that the Government can use to stabilize the heating oil market. They were concerned about spikes in heating oil affecting people who are in difficult economic circumstances. That reserve could ultimately affect the market if the government chooses to sell it off, but they only have two million barrels, so it’s not big.

I think the first thing to recognize about the oil market is that there isn’t much storage compared to the flow through. Basically, what we have in oil is we have those wells all over the world pumping oil. They put it into tankers; the tankers take it across the ocean to various countries where it goes into temporary storage at harbors, but it doesn’t stay there long. It keeps flowing through, then it’s put on oil trucks and it’s driven to refineries and then it ends up in gas stations. So, there’s not a lot of oil in storage. That’s why the oil market is very often in backwardation, because the price of oil reflects the temporary scarcities of oil. If there’s any shortage of oil, if something happens, then the oil price can jump up and everybody knows it’s going to come back down; so, you can have backwardation.

Basically, you don’t have people selling off their stores when there’s a backwardation like we talked about last time. It’s not like at the end of the harvest people know — when the wheat harvest is coming in, people know that wheat prices should go down and they sell off their stores; it’s not like that here. The stores that we have of oil are — have a convenience yield, so it’s something that doesn’t — backwardation doesn’t quickly correct itself. I think that what this means here — this backwardation in the oil market — is that people think that oils have spiked up, there’s a temporary shortage, and that prices are going to come down somewhat, although not a whole lot here.

This is a futures term structure; I have it plotted for a number of years. I should have made this a little bigger; it’s a little hard to read. This is today. What this is for — all of these are from today’s news on this top line and what it shows is, for every maturity out to six years, what the futures price is. Right now, we’re at $114 a barrel, but the market is predicting a decline. Not a huge decline, but back to something like $108 a barrel in six years. You can see that the futures market has often been predicting either increases or declines. You can look at different times in history; particularly of interest here I have Hurricane Katrina and I can’t — this is Hurricane Katrina. Right after the hurricane, in August of 2005, the hurricane destroyed some of our refining capability and some of our storage tanks because New Orleans is an oil center where tankers come and they go up the Mississippi River. We destroyed — the hurricane destroyed part of our infrastructure, so everybody in the market knew that that means that oil prices are temporarily high; so, you can see the backwardation in the market.

We see even more backwardation today; that’s an indication that there’s something going on in the short run in our market, if you believe the market. What do I have? I have here — this goes way back — this one is 1990. You notice it stops after eighteen months; that’s because in 1990 the futures market wasn’t as developed as it is now; it only went out eighteen months. You can see there was strong backwardation. This was when Saddam Hussein invaded Kuwait and it caused a tremendous disruption of oil supply and everybody knew that was temporary, so the futures prices were lower. That was about the most backward-dated futures market we’ve seen in oil. Today it’s pretty backward-dated, but not so dramatically percentage-wise, as it was after Katrina.

Chapter 5. Why Is the Price of Oil so High? On International Development, Nationalization, and World Politics [00:41:31]

This is a plot of oil prices in the United States. This is West Texas Intermediate. Well actually, I’m not sure it’s all the way back — is West Texas — no, it’s not all the way because Texas Oil wasn’t discovered until around 1900, I think; I’m not sure about that date exactly. This is Pennsylvania Oil back here; I’ve got it going way back. The interesting thing about this — this is of interest at the moment — that oil prices now are higher than they’ve ever been and this is in real terms — real, inflation-corrected terms. Very interesting what this means for our lives; just ten years ago oil was at a record low. We were at a little over $10 a barrel.

So, what is going on here? We’ve seen the oil price jump up something close to ten-fold in ten years; it’s a huge surprise. There are other surprises. One thing I wanted to do was to go through just a few — go through a few stories about oil prices here. This was a period when oil was generally very stable. In the post World War II period, there was a Texas Railroad Commission that was stabilizing oil prices. At that time, the U.S. was not a big importer of oil; we had our own oil supply and we tended to — we had sort of a monopoly that tried to stabilize the price and they were pretty successful for this long time period. The huge shock came — and this is called the first oil shock — and that was in 1973-74. Oil went up; it more than doubled — almost three times increase in oil prices all of a sudden. That was associated with a particular — it’s called the first oil crisis — and it coincides with the Yom Kippur War between Israel and her Arab neighbors. It caused a — Israel quickly triumphed in that war, but it left a lot of bad feelings among the surrounding Arab countries who were sympathetic with the Palestinian cause, so they cut back on their oil production.

We have an organization called OPEC — that’s the Organization of Petroleum Exporting Countries — and it was established in 1960 with a small number of Arab countries, but it has gradually grown and has more and more countries that are members. It was OPEC that constrained the supply of oil for the first oil crisis. This is the second oil crisis here and that was in 1979-80. This again had its origin — at least the common story and there must be some truth to the story. It had its origin in another crisis in the Middle East and that was the war between Iraq and Iran. There was an Iranian revolution in 1979, where the Shah of Iran was thrown out and the Ayatollah Khomeini came in and Iraq used this as an opportunity to try to grab some oil from Iran. This war completely disrupted oil supplies and we had this huge spike in oil prices then. A lot of these spikes seem to have political causes; this spike in the oil price is caused by the 1991 invasion of the — well, the United States was the primary invader of Iraq. This was after September 11th and this disrupted oil supplies again.

All these times were periods of backwardation in the oil market because people saw them as crises that were limiting the supply of oil for now, but would eventually correct themselves. What’s happening now? This is just an amazing spike of oil right now. There isn’t — we have this war in Iraq, but it’s not a sudden, intense thing that — it’s not disrupting oil supplies. So, why are we seeing this huge spike in oil? That is an interesting question. Part of it has to do with the fact that we have a rapidly growing world economy and developing countries are moving forward faster than was anticipated. So, there’s a lot of demand for oil from India, China, and other rapidly developing countries. They say that China builds a new city the size of Houston, Texas every month, so they’re consuming an awful lot of energy to do this. The other side of it is that discoveries of oil have been disappointing. I was just down in Mexico and the President Calderon is talking about privatizing the Mexican oil — or at least part of it — oil industry because they have been disappointing in their exploration. They’re not finding oil, so the reserves that Mexico has been actually declining rapidly.

This brings up another thing about the ownership of oil. I just wanted to mention nationalization. It used to be that most of the oil in the world was owned by private companies or individuals, but nationalization began in 1938 in Mexico, where a left-leaning government decided that all the Mexican oil that was owned by foreigners really belonged to the Mexican people. So, the Mexican government just said, it’s ours. That was an outrageous thing to say then, but it was greeted by shock by international law. They just took the oil in their country, saying that it wasn’t fair the way it was sold. It was followed up in 1951 by Iran and other countries followed as well. Now we’re seeing a reverse. Mexico nationalized its oil in 1938, but now that the supply is dwindling, President Calderon wants to reverse the process; this is controversial now.

In yesterday’s newspaper — I don’t know if you read The Wall Street Journal — it had a story saying that Russian — for the first quarter of 2008, Russian production of oil declined for the first time in ten years. There’s worry now that Russia is running out of oil. I think it’s these — this impact of — news like this is having a psychological effect on the market and it’s causing a huge, well, you might consider this a bubble in oil prices, but I’m not so sure that it’s a bubble. It’s certainly unprecedented. It seems like we’re entering a period of great market volatility. We’ve seen an unprecedented bubble in home prices and now the economy is reeling from the effects of this bubble.

Look what’s happening, as well, in oil prices. Once again, there’s no war right now; there’s nothing really dramatic. We do have — you could call it a war, but it’s not something that has shut down the Persian Gulf and closed off oil supplies. So, it seems like it’s something more systemic. It’s something more to do with the economic situation than before or it’s something speculative. We have — so we have backwardation, but it’s not a whole lot of backwardation. They’re still predicting oil prices to come down to something like there — well over $100 in eight years — so it’s not a — it’s not something that’s related to a particular crisis that is going to end quickly.

I wanted to go — this just is a clipping I got from — this was the day that Saddam Hussein announced an oil embargo. This was his reaction to the United States’ pressure on him and so oil prices spiked up. It seemed dramatic when I made this clipping, but now oil is $100 a barrel; that’s only six years ago, but at that time people thought — the market thought that oil prices were coming back down by ‘03. They were really wrong; people didn’t get it. All this time, people thought that oil — a large part of the time it was in backwardation. They thought there was some special event occurring — this is Saddam Hussein — but it turns out that there was something driving it up. This is again — this is natural gas on that same date. This is still in contango because the prices are going up through time, so that kind of explains if Saddam Hussein was selectively hitting on the oil market and not the natural gas market; that explains those two markets.

Chapter 6. The Development of a Home Price Futures Market [00:52:30]

I wanted to talk briefly about other futures. There’s a gold futures market and the gold futures market — this is an old clipping I had of a very steady contango market. That’s because gold is very different than oil. Gold is in storage. There’s nothing to do with gold except hold it. You don’t burn it. That’s the difference; oil you burn it and it’s gone, so we don’t have much around and we’re always vulnerable to some supply interruption. But with gold, there’s no supply interruption; we don’t burn gold; it just sits there and we’re holding this stuff. We don’t know what to do with that. It can’t really be in contango for very long because someone who’s holding gold is going to say, hey if it’s going down in the futures market I’m not going to sit on this stuff; I’m going to sell it. It stays in — did I say contango? If it’s in backwardation people would sell it. It stays very nicely in contango and it’s going up at the rate of interest. The storage — there’s a storage cost as well, but I don’t know how big that is for gold. I guess you’d have to pay for a police force to defend your gold — something like that. So, it must have some storage costs, but it’s a very simple market because it stays in contango all the time.

Copper futures — now copper is different from gold because it’s not — this is a 2004 clipping again. Copper is an industrial commodity that gets used up, so it suffers from supply disruptions and it can — like oil — it can fall into backwardation. Here, I should write these — did I ever write these down? Contango, just to make sure, is when futures prices are going up as the maturity — with maturity; higher prices for more future dates. Backwardation is when it’s going down. This is an example of a backwardated market. The prices as we go out to further and further — this is 2004 — when we go out to December of that year, it’s down from $139 to $136. When we go out to December of the following year, it’s down to $118. Gold, by the way, has gone up a lot too. There’s been a lot of commodity price increases that surprised us.

This is the federal funds futures — another clipping. There’s a futures market for the federal funds rate and it’s cash-settled because you can’t deliver federal funds. The settlement — the price shown is $100 minus the federal funds rate. So back then — this is 2004 — the federal funds rate was about 5%. So, this looks like 5.25%, so $100 minus $94.74 is 5.25%; that’s what the federal funds rate was expected to be in March of 2004. Here you see that the federal funds rate was expected to continue to decline at that time. This market can go either way because you don’t store federal funds, so there’s no fair value calculation like there are with the other markets. It reflects the expectations of future interest rates. Right now, I don’t — I should have gotten today’s, but I think the federal funds futures market is predicting right now, with the federal funds rate at 2.25%, the federal funds market — this would be $97.75, or $100 minus 2.25%; or it would be close to that and it would be going down with time. People are expecting the Fed to cut interest rates — I’m sorry, these numbers would be going up, but I don’t have the clipping for today.

I just finally wanted to talk about home price futures, which is a market that I’ve gotten involved with creating at the Chicago Mercantile Exchange. I got involved with them because I have a price index. My colleague and I, Karl Case, who’s a professor at Wellesley College — he and I, in the late 1980s, created a home price index. This was our research; we put it out as a working paper here at Yale twenty years ago. From the beginning, we thought that the real importance of having a home price index is for trading. We live in a world where people don’t trade — there’s no international market for real estate. It’s quite remarkable that there is not because real estate is a huge asset class. The value of single-family homes in this country is about 30% bigger than the value of the stock market in the U.S.; yet, we see so much talk about the stock market.

When we started in 1988 we realized not only was there no market for single family homes, except the very local market, there was also no price index for single family homes. It’s just sometimes amazing how undeveloped things are. Here we are in the twentieth century, everything is computerized and all that, but you just want to know what home prices have been doing in the United States in the late 1980s and you couldn’t find out. There were some indexes, but they were rather poor, we thought, and not very reliable. We did our econometric work and devised a method of repeat sales method of home price indexes. I wrote a book in 1993 called Macro Markets about — it talked a lot about index number construction. I said in the book that we need to devise a home price index that is as close as possible to something like the S&P 500, which is a stock price index.

The problem with home prices is we have a much bigger non-trading problem. The S&P 500 is not very out-of-date because stocks usually don’t go untraded for more than a few minutes or maybe a few hours at times. With homes, the typical home doesn’t trade every ten years, so we have a huge non-trading problem. What we did is we created an index that was as close as possible to a stock price index so that it could be traded on a financial market. Then I had a student here, Allan Weiss, who said, why don’t we get going and get — my student was graduating; he was an SOM student — MBA student. He was graduating and he thought we should produce these indexes for sale for use in financial markets, so he wanted to do it. He set up our company, Case Shiller Weiss, Incorporated, and he ran it.

Now, Case and I were just on the advisory — well, we were on the board of directors, but we were just advising the operations. I was so proud of him; my student created the Case-Shiller Home Price Indexes and we started publishing them. Then in early 1990s, we traveled to all the futures markets, proposing to them that they create home price futures based on our indexes. It was disappointing; we couldn’t get anyone to do it. I thought we had such a strong case. Shouldn’t there be a futures market? We went to the — I mentioned the coffee, sugar, cocoa — we tried them all. So, we’d go to these guys and they’re trading coffee, sugar, and cocoa. I said, look coffee is nice, everyone wants their cup in the morning, but we’re talking about twenty trillion dollars of unhedged risk. Most households in the United States — that’s what they own. The typical household — they don’t own much stock; they own real estate and they can’t hedge it.

I think we had the most progress with the Chicago Board of Trade; they actually did some research with us. The funny thing that happened was that CBOT did research in 1994 on whether they should set up a futures market for single-family homes. The basic conclusion — they made a lot of phone calls — that’s how they did research — asking people, are you worried about your home price falling and would you like to be able to hedge the risk in the futures market the way farmers do in the agricultural market? Basically, the answer was no and people said, I don’t worry about my home price falling. So, they didn’t want to start a market because they thought — but I was going around saying, don’t you know? There’s no law of economics saying that home prices don’t fall. They did — they have fallen; they fell a lot in the Depression and they could do it again. So, why don’t people want to have a market that would — they don’t just go steadily up. But people said, well the Depression — that was so long ago; we can’t remember that. So, we couldn’t seem to get anyone focused on it.

I think there’s something about this that we learned about the origins of our current economic situation. We went around to a lot of people trying to get them interested in hedging real estate prices. Remember, the purpose of futures markets is not gambling; it’s hedging; it’s protecting yourself. I should write that term on the board as well. Hedging — I hope I made this clear. If you are running — let’s go back to wheat. If you have a warehouse full of wheat, you are a wheat warehouser and you are like a stable business. So, what do you do? You don’t know what the price of wheat is going to do; it goes up and down internationally. So, what do you do? You sell it in the futures market and that means you’ve hedged your risk of wheat prices. If wheat prices go down, true the value of the stuff in storage that you own is going to go down, but offsetting that is your futures contract price, which will go up, and that hedging will protect you. You have reduced risk of your business and this is done a lot.

Holbrook Working, in the reading, talks about that. So, farmers also can hedge; they’ve got wheat growing in the fields and they’re worried about the price they can sell it at, so let’s lock it in today; let’s sell in the futures market. If the price of wheat declines, your short position in the futures market will appreciate and offset your loss, so you want to hedge your risk. We went around asking people, don’t you want to hedge your risk in the real estate market? Unfortunately, people are rather confused about that and they’re not used to hedging that.

Anyway, with the recent boom in home prices, we were able — we finally approached the Chicago Mercantile Exchange in 2006 and said, we want to work with you to create — try to create — a futures market for single family homes. They said, okay let’s try it. So, this was what we did in May of 2006; we created a futures market — not the very first, there was an attempt in London in 1991 that failed, but we were essentially the first futures market for single-family homes in the United States.

This market has been in backwardation almost from the first day. When we opened the market in May of 2006, our market maker, who was brought in by the Chicago Mercantile Exchange, thought like everyone else who reads the newspapers — well, home prices just always go up. So, the market maker put out a bid-asked that implied contango in the market — that home prices would go up. The market maker quickly learned that there was no market — contango market. After losing a huge amount of money, he pushed his bid-asked spreads into the backwardation range and left it there ever since. This shows the backwardation in the futures market recently, but it’s been this way for a couple years now.

So, what’s going on in the housing market? I think that what has been happening is that newspapers, and real estate agents, and lots of commentators — people you see on the news — have been telling us that home prices always go up; they’ve never fallen and don’t worry. A lot of casual people have believed that, but the kind of people who trade in futures markets didn’t believe it, even going back to early 2006.

People who are ready to put their money on the line have been predicting a decline in home prices now for two years. You can see what dramatic declines are being predicted in our futures market. I have it for various cities — Boston, Chicago, Denver. We have separate markets for each of the ten — of these ten cities — Las Vegas, Los Angeles, Miami, New York, San Diego and San Francisco. The worst market of them all is Miami and this market is predicting almost a 35% home price decline by November of 2012. The second worst — what is the second worst? I can’t quite read it; they kind of merged here. There’s a bunch of cities where the prediction is for a 20-25% drop; the best city of all is Chicago, but even there they’re predicting a 7% drop. So, we’ve seen a lot of backwardation in that market. I think this is reflecting the unusual economic circumstance we’re in.

Chapter 7. The S&P Case-Shiller Home Price Index and Conclusion [01:08:01]

Finally, this is my last slide; this shows the S&P Case-Shiller Home Price Index. That line is the actually home price index and it has these jumps in it every month; that’s because it’s a monthly index. We only publish it every month, but you can see that it’s been smooth. It was increasing until around the time we started the futures market and then it’s been declining at an accelerating rate. We are now down in real terms about 15% nationwide on home prices, which peaked in early 2006. This is the futures price that we’ve had and that’s for the closest futures contract — the nearest to expiration.

We’re hoping to get a lot of publicity for this because we thought this was a very interesting number. This is futures market price for homes and it moves around day by day. All those little wiggles reflect new information that came in on a particular day. Unfortunately, we have not been able to get much attention for this number, but there’s been a lot of attention to the S&P Case-Shiller Home Price Indexes now. In fact, we’re getting newspaper stories all the time written about our indexes, but they don’t write about our market, so we’ve had trouble getting a futures market started. It’s going, but it’s going only at a low level. I think that in the future this will take off eventually and I think that we’ll have futures markets for many more things.

Eventually, we’ll have a futures market for New Haven as well. Right now, New Haven is too small to warrant its own futures market. So, I was thinking, well someone in New Haven could just buy two — if you wanted to hedge your house, you’d sell two New York contracts and one Boston contract. I’m sort of interpolating between New York and Boston, but eventually we have to do better than that and I’m hopeful that there will be a day in my lifetime when we’ll see all cities of the world traded on futures market. In my new book, Subprime Solution, I also claim, and I think I have some basis to say this, that it will help reduce bubbles and help reduce this kind of instability. Next period, we’re going to talk about options and then we have only one more lecture; the last lecture on the democratization of finance.

[end of transcript]

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