WEBVTT 00:01.960 --> 00:05.440 Professor Robert Shiller: I wanted first to 00:05.440 --> 00:09.490 just think back a little bit about the lecture we got from 00:09.488 --> 00:11.688 Steve Schwarzman on Friday. 00:11.690 --> 00:15.070 Before he came, I talked with him in my office 00:15.070 --> 00:19.580 and I had the audacity to ask him if he thought there was any 00:19.578 --> 00:23.258 chance that his fortune was just due to luck. 00:23.260 --> 00:29.380 I said, why we have this efficient markets theory in 00:29.375 --> 00:35.605 finance that says that nobody can beat the market. 00:35.610 --> 00:37.570 So, what do you think he said? 00:37.570 --> 00:43.620 Well, obviously he believes in himself, but I'm inclined to 00:43.616 --> 00:45.906 believe in him also. 00:45.910 --> 00:52.110 Efficient markets theory never sounded right; 00:52.110 --> 00:56.220 one thing about efficient markets theory that has always 00:56.217 --> 01:00.767 bothered me is this idea that the so-called "smart money" sets 01:00.772 --> 01:02.642 prices in the market. 01:02.640 --> 01:07.470 The thing that bothers me about it is, who is the "smart money," 01:07.469 --> 01:09.659 anyway? It's as if it's all or nothing 01:09.659 --> 01:11.549 thing; there's the smart money and 01:11.551 --> 01:14.521 then it's the dumb money and the smart money rules. 01:14.519 --> 01:18.099 Aren't there all different gradations of intelligence and 01:18.100 --> 01:21.160 insight? It's not like--why should there 01:21.158 --> 01:23.808 be just one level of smart money? 01:23.810 --> 01:29.080 So, I think he probably exemplifies a higher level of 01:29.077 --> 01:31.607 smart money than smart. 01:31.610 --> 01:36.560 I think a lot of mistakes people make in judging financial 01:36.557 --> 01:40.457 markets is being easily impressed by someone's 01:40.463 --> 01:46.023 stockbroker or someone's analyst who seems very smart and is very 01:46.018 --> 01:48.808 smart, but may not be enough to 01:48.813 --> 01:50.423 outsmart the markets. 01:50.420 --> 01:55.390 That's the lesson of efficiency, especially when 01:55.385 --> 01:59.535 you're young. I think you may not realize how 01:59.542 --> 02:04.112 many smart people there are in the world, so when you're 02:04.106 --> 02:09.076 dealing in a--trying to win in financial markets--you have to 02:09.084 --> 02:13.984 take account of who is really out there and how much insight 02:13.980 --> 02:19.540 and effort and research are they putting into their trading. 02:19.539 --> 02:22.829 Do you really think you can beat that? 02:22.830 --> 02:26.190 That's the lesson of efficient markets. 02:26.189 --> 02:30.829 I don't think the lesson is that you can't--it's impossible 02:30.830 --> 02:34.990 for anyone no matter how smart to beat the market. 02:34.990 --> 02:37.810 Now of course, Albert Einstein never made any 02:37.807 --> 02:39.597 money in the stock market. 02:39.599 --> 02:42.189 In fact, TIAA-CREF, the pension fund, 02:42.193 --> 02:45.873 had an ad campaign in which they pointed that Albert 02:45.867 --> 02:50.187 Einstein left all of his pension investing to TIAA-CREF. 02:50.190 --> 02:54.800 He was a professor and they're a pension fund for professors. 02:54.800 --> 02:59.430 Einstein didn't think he could beat the market and Mr. 02:59.426 --> 03:04.226 Schwarzman very candidly pointed out that he didn't have 03:04.228 --> 03:06.758 the greatest math scores. 03:06.760 --> 03:08.130 Isn't that how he put it? 03:08.129 --> 03:14.349 He said he was no math genius and you think finance requires a 03:14.354 --> 03:20.384 lot of math, but I think that it's something about practical 03:20.375 --> 03:24.485 intelligence. Psychologists have talked about 03:24.492 --> 03:27.802 different kinds of intelligence--this is all 03:27.796 --> 03:30.636 supposed to be coming up here now. 03:30.639 --> 03:33.869 At least we're seeing something now. 03:33.870 --> 03:36.450 This is why I don't like Powerpoint, actually; 03:36.449 --> 03:54.469 this kind of thing happens it always seems to happen. 03:54.470 --> 04:01.100 So, that's it. I'm not going to use this for a 04:01.096 --> 04:07.916 few minutes.--But, remember Carl Icahn, 04:07.920 --> 04:14.330 when he talked to us, said something about he always 04:14.326 --> 04:18.236 just had some--he was always just good at making money. 04:18.240 --> 04:23.000 I think that there are separate talents. 04:23.000 --> 04:25.310 I mean, some people love markets and they like to think 04:25.306 --> 04:27.096 about them and figure out how they work. 04:27.100 --> 04:31.700 If they have the right kind of intelligence and the right kind 04:31.703 --> 04:35.783 of spirit to do the work, they ought to be able to beat 04:35.778 --> 04:39.018 the market. I've talked to Icahn a number 04:39.018 --> 04:43.308 of times and I have the idea that he's a very down-to-earth, 04:43.307 --> 04:46.937 solid, inquisitive sort; he wants to know what's going 04:46.939 --> 04:48.789 on. When I've talked to him, 04:48.794 --> 04:51.844 sometimes he'll ask the same question of me; 04:51.839 --> 04:53.729 he's trying to get information from me. 04:53.730 --> 04:57.410 He asks the same question from me three different ways because 04:57.408 --> 05:00.908 apparently my answer isn't satisfactory and he must think I 05:00.905 --> 05:03.855 might know something because he keeps asking. 05:03.860 --> 05:08.580 But, I think that's the kind of persistence--certain personality 05:08.583 --> 05:13.083 traits--persistence at trying to figure out what really makes 05:13.081 --> 05:16.531 things work is important in these markets. 05:16.529 --> 05:20.539 I think it's just relish or inclination to keep thinking 05:20.537 --> 05:24.687 about them, so maybe that's why I went into economics as a 05:24.689 --> 05:27.309 professor. I don't know that I really was 05:27.306 --> 05:29.856 someone who wants to watch the markets all day; 05:29.860 --> 05:33.220 so, you have to judge your own interests. 05:33.220 --> 05:40.910 Anyway, it was very nice that we got--that Steve Schwarzman 05:40.906 --> 05:46.336 came and told us about his life's work. 05:46.339 --> 05:54.109 Anyway, I want to talk today about futures. 05:54.110 --> 05:57.930 One more thing I wanted to say about Schwarzman. 05:57.930 --> 06:00.020 At one point, he said very confidently, 06:00.016 --> 06:03.366 I thought--and I don't know if you heard this right--that this 06:03.365 --> 06:06.435 current financial crisis ought to be over in a year. 06:06.439 --> 06:10.409 He said something--and maybe it was a little vague--about 06:10.409 --> 06:14.309 investing in distressed securities now as an opportunity 06:14.308 --> 06:18.698 because I think he pointed out that AAA mortgage securities are 06:18.703 --> 06:23.173 selling for eighty some cents on the dollar and it can't be that 06:23.169 --> 06:25.789 bad. This is the same theme that we 06:25.794 --> 06:29.174 got from David Swensen and I've heard it from others--that 06:29.165 --> 06:30.935 that's the opportunity now. 06:30.939 --> 06:34.219 When I hear Steve Schwarzman proclaiming that he thinks 06:34.217 --> 06:37.007 this--I thought he said something like that, 06:37.009 --> 06:40.659 that this business crisis will be over before long. 06:40.660 --> 06:43.440 It made me wonder, do I know more than he does 06:43.438 --> 06:47.268 about that sort of thing because I don't think it's going to be 06:47.265 --> 06:49.405 over soon? Then it gets back to, 06:49.408 --> 06:52.938 I think, you have to put all these people in perspective; 06:52.940 --> 06:55.290 there are so many different kinds of expertise. 06:55.290 --> 06:59.800 When you listen to someone you always have to ask, 06:59.804 --> 07:04.784 well what does he or she know that is specific to their 07:04.780 --> 07:08.280 expertise? I don't think Schwarzman is a 07:08.280 --> 07:11.480 macroeconomist, so I don't want to say he's 07:11.481 --> 07:13.921 wrong, but he might be wrong. 07:13.920 --> 07:20.390 The good thing is to listen to everyone and not accept that 07:20.386 --> 07:23.616 anyone has the whole truth. 07:23.620 --> 07:27.560 Anyway, I want to get on to futures markets. 07:27.560 --> 07:33.910 That is a very important topic in finance and the important 07:33.905 --> 07:39.525 thing to understand is, when I put an "s" on the end 07:39.533 --> 07:45.323 "futures," that refers to a marketplace with a particular 07:45.319 --> 07:50.669 characteristic, as traded on a number of 07:50.670 --> 07:54.780 exchanges. Notably, in the U.S. 07:54.779 --> 08:01.929 the biggest exchange for futures is the Chicago 08:01.934 --> 08:09.094 Mercantile Exchange, which just merged with The 08:09.089 --> 08:19.199 Chicago Board of Trade and they are now called the CME Group. 08:19.199 --> 08:22.489 Futures, since it has its origin in agriculture, 08:22.490 --> 08:25.990 is a Chicago thing rather than a New York thing. 08:25.990 --> 08:31.030 Chicago is the "second city," or it was the second biggest 08:31.034 --> 08:36.174 city, hog-butcher to the world, farmers' marketplace in the 08:36.167 --> 08:38.847 Midwest; so, futures in the United 08:38.847 --> 08:40.267 States started there. 08:40.270 --> 08:45.680 08:45.679 --> 08:49.769 Actually, futures didn't start in Chicago; 08:49.769 --> 09:06.899 it started in Japan on an island in Osaka called Dojima in 09:06.903 --> 09:14.123 the 1600s. I'm sorry, did I--yeah it was 09:14.116 --> 09:21.326 the 1600s--1673 is the date for the first futures market. 09:21.330 --> 09:28.340 I was just in Osaka again a few months ago and I again asked, 09:28.341 --> 09:35.471 can I please see Dojima because it's such a historic place. 09:35.470 --> 09:37.790 Again they said, there's nothing to see there, 09:37.791 --> 09:40.011 it's all--anything from long ago is gone. 09:40.009 --> 09:43.169 That was where these markets started. 09:43.169 --> 09:48.429 Let's go back--and I'm not sure how well-developed it was in 09:48.432 --> 09:54.142 1673, but let's say early 1700s in Dojima--what was happening? 09:54.139 --> 09:56.429 Well, it was the rice center for Japan. 09:56.429 --> 10:02.379 The people--rice merchants would bring their rice to Dojima 10:02.375 --> 10:04.625 and sell them there. 10:04.629 --> 10:11.029 Naturally, as you would expect, there were big warehouses for 10:11.034 --> 10:17.714 rice, which would store it; it would be a natural thing to 10:17.709 --> 10:21.049 see at the center of trade. 10:21.049 --> 10:26.309 It was a big and thriving trade center. 10:26.309 --> 10:29.439 People, when they buy--so incidentally, 10:29.439 --> 10:32.979 let's talk about the fundamental problem. 10:32.980 --> 10:38.810 Agricultural commodities like rice are harvested typically 10:38.808 --> 10:43.088 once a year. Actually, I think rice has more 10:43.090 --> 10:47.320 than one harvest, but let's just simplify it; 10:47.320 --> 10:49.300 let's say it's harvested once per year. 10:49.299 --> 10:52.649 People depend on it for their lives, actually, 10:52.648 --> 10:56.218 because they need the food for the whole year. 10:56.220 --> 10:58.550 That means there's a storage business; 10:58.550 --> 11:02.530 rice has to be stored; you have to keep it away from 11:02.529 --> 11:06.369 moisture and rot and away from rats and vermin. 11:06.370 --> 11:12.320 That's a business and it's a very important business for any 11:12.321 --> 11:15.101 country. If it weren't rice, 11:15.103 --> 11:19.493 it would be some other grain, which is stored. 11:19.490 --> 11:23.940 When people buy and sell grain they know it's--they're thinking 11:23.938 --> 11:28.168 out at least a year because that's how long the cycle is for 11:28.172 --> 11:30.112 one harvest--one cycle. 11:30.110 --> 11:34.600 So, lots of contracts are signed to buy and sell rice, 11:34.600 --> 11:37.650 but typically at some future date. 11:37.649 --> 11:45.069 We talk about "spot contracts," which means buying and selling 11:45.065 --> 11:47.735 something right now. 11:47.740 --> 11:51.840 If you show up at the warehouse and say, I've got my wagons, 11:51.841 --> 11:53.581 I want to load rice in. 11:53.580 --> 11:56.680 How much do I have to pay to get rice? 11:56.679 --> 12:00.579 That price would be called the "spot price"--on the spot, 12:00.583 --> 12:04.263 right now. But often, you would show up at 12:04.261 --> 12:09.121 the warehouse and you would say, I have some trucks, 12:09.120 --> 12:14.780 wagons coming next week or next month and I want to arrange now 12:14.777 --> 12:19.627 to buy the rice. If you say--if you agree on a 12:19.627 --> 12:26.477 price today for delivery in one month, that's called a "forward 12:26.484 --> 12:29.364 contract," not futures. 12:29.360 --> 12:32.210 There's an important distinction between forward and 12:32.210 --> 12:34.590 futures. A forward contract--let me 12:34.590 --> 12:38.160 explain what a forward contract--it's very simple. 12:38.159 --> 12:43.779 It's a contract between two parties to exchange something at 12:43.783 --> 12:49.413 a future date for a price in the future that's predetermined 12:49.406 --> 12:51.406 today. For example, 12:51.408 --> 12:56.388 a forward contract will be between a rice merchant and the 12:56.387 --> 13:01.627 warehouse that in two months I will come and take delivery of 13:01.628 --> 13:06.688 so many bushels of rice and then I will pay such and such a 13:06.694 --> 13:09.574 price; that's a forward contract. 13:09.570 --> 13:12.950 Before 1673, there were lots of forward 13:12.945 --> 13:17.205 contracts and lots of people trading in these, 13:17.210 --> 13:22.420 so someone in Dojima thought, why don't we set up a big 13:22.415 --> 13:28.195 market for these because people have trouble knowing what the 13:28.199 --> 13:31.669 price is for a forward contract. 13:31.669 --> 13:34.689 People would travel around from one warehouse to another and 13:34.688 --> 13:37.398 they'd get a different price from one or the other; 13:37.399 --> 13:40.009 they'd kind of wonder what the price is today, 13:40.007 --> 13:43.487 so someone said well why don't we kind of create a market for 13:43.485 --> 13:44.755 forward contracts. 13:44.759 --> 13:47.599 But, we don't call them forward contracts; 13:47.600 --> 13:49.950 I don't know what they called them in Japan, 13:49.951 --> 13:52.031 but I just want you to get the idea. 13:52.029 --> 13:54.219 The idea is, let's create a marketplace, 13:54.223 --> 13:57.543 a central marketplace so that all these different--you don't 13:57.542 --> 14:00.922 have to go around to a hundred different warehouses to try to 14:00.917 --> 14:03.687 find the best price; you find out what the real 14:03.694 --> 14:07.364 price is. What they did was they created 14:07.363 --> 14:13.373 an exchange in Dojima and the exchange had a lot of modern 14:13.374 --> 14:17.584 features; it had a trading floor. 14:17.580 --> 14:22.960 There was a designated area where people who wanted to trade 14:22.957 --> 14:28.697 in rice futures would congregate and all trades were supposed to 14:28.699 --> 14:31.689 be done there, so it became a central 14:31.685 --> 14:34.625 marketplace. So many people came to the 14:34.628 --> 14:39.578 exchange floor that it got very noisy and traders can be very 14:39.584 --> 14:43.224 noisy people--shouting and getting upset; 14:43.220 --> 14:46.320 trading rapidly back and forth. 14:46.320 --> 14:49.210 So, they developed, in Dojima, a set of hand 14:49.214 --> 14:53.394 signals so that it was so noisy and loud that you couldn't talk 14:53.388 --> 14:57.018 sometimes and it was hard to--especially to communicate 14:57.023 --> 15:00.863 something to someone on the other side of the room. 15:00.860 --> 15:04.950 So, they invented hand signals so the traders would be--I don't 15:04.950 --> 15:07.930 know exactly what they were, but typically when the--if you 15:07.932 --> 15:09.842 had something like this--you hold your hand with your palm 15:09.836 --> 15:11.716 out, that means I want to sell and 15:11.716 --> 15:14.666 if it's four fingers up, that means four contracts. 15:14.669 --> 15:18.379 If you put it this way, it would be buying; 15:18.380 --> 15:20.180 I want to buy four contracts. 15:20.179 --> 15:25.599 Those hand signals developed in Osaka and they became a mainstay 15:25.597 --> 15:28.347 of futures markets after that. 15:28.350 --> 15:36.400 Another thing they did in Japan to create the central market was 15:36.398 --> 15:39.718 to standardize the rice. 15:39.720 --> 15:47.120 15:47.120 --> 15:50.860 Now, this is very important; if you go shopping around to 15:50.863 --> 15:54.193 different warehouses to try to buy rice, you'll get some 15:54.189 --> 15:57.309 warehouse who says, well I'm charging a higher 15:57.314 --> 16:01.184 price but my rice is better then that other guy's rice. 16:01.179 --> 16:04.349 His has some worms in it sometimes; 16:04.350 --> 16:09.090 don't trust that other guy, or whatever it is. 16:09.090 --> 16:13.130 Rice isn't all the same; there are different varieties 16:13.128 --> 16:15.868 and some of them taste better than others. 16:15.870 --> 16:19.040 So, how would you ever know what the price of rice is; 16:19.040 --> 16:20.210 it's just a mess. 16:20.210 --> 16:26.400 What they did in Osaka is they made a standard form of rice for 16:26.396 --> 16:29.286 delivery in their contract. 16:29.289 --> 16:34.039 That's important because it--there are many kinds of 16:34.036 --> 16:39.806 rice, but they picked one that's maybe the most common and then 16:39.807 --> 16:42.167 they said, that's what all of our 16:42.174 --> 16:44.674 contracts are about; so, you would be taking 16:44.667 --> 16:46.527 delivery of a standard rice. 16:46.529 --> 16:50.089 Moreover, at the exchange, they had experts on rice who 16:50.085 --> 16:52.845 could tell whether it was that contract. 16:52.850 --> 16:57.720 It's not the best rice; it's the most common rice. 16:57.720 --> 17:01.320 I visited the coffee, sugar and cocoa exchange in New 17:01.322 --> 17:05.482 York once and jokingly I said, can I have a cup of coffee? 17:05.480 --> 17:09.730 This is the coffee, sugar and cocoa exchange; 17:09.730 --> 17:12.100 surely I can get a cup of coffee here. 17:12.099 --> 17:14.589 Then the guy said, who was showing me around, 17:14.589 --> 17:17.929 he said, well we could give you a cup of coffee but it's not 17:17.928 --> 17:19.228 what we trade here. 17:19.230 --> 17:22.640 He says, you wouldn't like the coffee we trade here; 17:22.640 --> 17:25.830 it's not Starbucks; it's the most standard. 17:25.829 --> 17:29.569 So, they set up a standard for coffee at the coffee--maybe he 17:29.567 --> 17:30.997 was being too candid. 17:31.000 --> 17:32.860 I don't know if they would say that officially. 17:32.859 --> 17:35.709 They set up a standard for coffee at the coffee, 17:35.710 --> 17:39.470 sugar, cocoa exchange and then no one would ever deliver better 17:39.471 --> 17:41.171 coffee than that, right? 17:41.170 --> 17:43.400 Well, I have to explain that. 17:43.400 --> 17:45.250 Everyone--well, they wouldn't even be allowed 17:45.249 --> 17:47.959 to; the whole idea is the contract 17:47.960 --> 17:51.120 has standards. What actually happens--if you 17:51.115 --> 17:55.185 have a contract to deliver rice or coffee or anything like that 17:55.188 --> 17:58.928 and there's some expert there who's going to judge whether 17:58.933 --> 18:02.813 what you delivered was up to quality standards and you are a 18:02.810 --> 18:07.110 smart businessperson, you will deliver exactly the 18:07.113 --> 18:10.723 minimum quality to fulfill the contract. 18:10.720 --> 18:14.590 It'll never be below the minimum quality because no one 18:14.591 --> 18:18.431 can deliver it; the testers will not allow that. 18:18.430 --> 18:21.990 And it can't be above the minimum standard because you'd 18:21.993 --> 18:24.313 never do that; you'd be stupid to do that. 18:24.309 --> 18:27.689 So, you always--it always becomes the standard variety. 18:27.690 --> 18:33.960 What they did at the futures market is they then not only had 18:33.958 --> 18:39.388 standardized the rice, but they standardized delivery 18:39.392 --> 18:42.842 dates and delivery locations. 18:42.840 --> 18:46.470 18:46.470 --> 18:50.860 What would you trade in these futures markets? 18:50.859 --> 18:55.149 You would be trading--you'd either be buying or selling rice 18:55.149 --> 18:59.149 for future delivery on a standardized delivery date at a 18:59.148 --> 19:03.658 standardized location--probably one of the warehouses that they 19:03.656 --> 19:08.106 designate. That might not be the rice you 19:08.114 --> 19:14.374 want or the date you want and yet, somehow the market gets 19:14.374 --> 19:17.344 going and gets very big. 19:17.339 --> 19:21.299 This is the reason: what a futures market does 19:21.296 --> 19:26.126 that's different from a warehouse market is it sets up a 19:26.131 --> 19:29.561 standard price and a liquid market. 19:29.559 --> 19:35.469 So, people end up using the futures market to lock in the 19:35.467 --> 19:42.107 price or to hedge price risk and they know that the price in the 19:42.113 --> 19:46.653 futures market is the meaningful price. 19:46.650 --> 19:50.720 You hear all kinds of prices of rice; 19:50.720 --> 19:54.430 there will be rumors here and there that someone will say, 19:54.434 --> 19:58.344 I saw rice sell for such and such--so many Yen or whatever it 19:58.343 --> 20:00.273 is. Don't believe any of that 20:00.271 --> 20:02.611 nonsense. Who knows what was sold or what 20:02.614 --> 20:05.334 terms there were or what exigencies there were. 20:05.329 --> 20:09.449 Only look at the futures market because the futures market is 20:09.446 --> 20:11.226 absolutely standardized. 20:11.230 --> 20:13.900 You know the terms of delivery, the location, 20:13.903 --> 20:15.243 and everything else. 20:15.240 --> 20:20.200 What ended up happening is that everyone wanted to trade in the 20:20.200 --> 20:24.920 futures market and it became a huge market and then everyone 20:24.920 --> 20:28.040 started watching the futures price. 20:28.040 --> 20:36.140 That's what we now have; that's what is in a futures-- I 20:36.142 --> 20:39.702 wanted to tell you one other curious thing about the--well, 20:39.701 --> 20:42.341 two other things about the Osaka market. 20:42.339 --> 20:46.839 They had trading hours, just as do today. 20:46.839 --> 20:49.559 In other words, only certain hours of the day 20:49.563 --> 20:52.413 the floor was open and then it was shut off. 20:52.410 --> 20:56.580 People would get very excited and trade very actively; 20:56.579 --> 21:00.309 you have to somehow let people know that the trading time is 21:00.308 --> 21:03.908 over and all trades have to stop at the end of the day. 21:03.910 --> 21:06.820 So, they had a burning fuse, which they would light in the 21:06.815 --> 21:10.025 middle of the trading floor just a few minutes before the end of 21:10.026 --> 21:13.136 the day and you could see this flame and that meant you better 21:13.135 --> 21:16.545 finish your trades right now because when the flame goes out, 21:16.550 --> 21:20.960 it's over. We don't have fuses anymore; 21:20.960 --> 21:24.750 we have clocks and a bell that announces the beginning and end 21:24.752 --> 21:27.482 at an exchange. There's one other thing they 21:27.480 --> 21:31.240 had, which I think is kind of curious that hasn't been copied. 21:31.240 --> 21:34.910 They had people called watermen, who after the fuse 21:34.914 --> 21:39.254 went out they carried buckets of water onto the exchange. 21:39.250 --> 21:43.850 If anybody was still trading, they splashed them with water. 21:43.849 --> 21:46.279 That was to douse the--the fuse is out; 21:46.280 --> 21:47.910 everything is doused for today. 21:47.910 --> 21:51.770 We don't do that in modern futures exchanges. 21:51.769 --> 21:53.809 Of course, it's all electronic now; 21:53.809 --> 21:56.179 there's no--well, it's getting increasingly 21:56.177 --> 21:59.607 electronic. The CME and the CBOT still have 21:59.607 --> 22:04.997 trading floors like Dojima's and they're still using these hand 22:05.002 --> 22:10.012 signals, but it's getting lonely there 22:10.010 --> 22:18.530 because everything is moving away to the electronic markets. 22:18.529 --> 22:22.569 You'll still see on CNBC, Bob Pisani will be standing at 22:22.569 --> 22:27.199 the T-bond trading pit and he'll give his little--they focus the 22:27.196 --> 22:31.596 camera right on where all the people are at and they're still 22:31.603 --> 22:36.233 out there jostling each other and shouting at each other. 22:36.230 --> 22:39.760 So, it's still going on, but it's increasingly becoming 22:39.757 --> 22:41.257 an electronic market. 22:41.259 --> 22:47.919 I guess the most important thing to realize about futures 22:47.919 --> 22:54.219 markets is that they're different from forward markets 22:54.221 --> 22:58.741 in that it--with a futures market, 22:58.740 --> 23:02.500 when you buy and sell a contract you are buying and 23:02.498 --> 23:07.458 selling with the exchange or the clearing house of the exchange. 23:07.460 --> 23:10.860 You do not know the counter party; 23:10.859 --> 23:12.989 you do not know who's on the other side. 23:12.990 --> 23:20.150 With a forward market, you know very well who's on the 23:20.153 --> 23:23.633 other side; you're going to a warehouse and 23:23.629 --> 23:26.679 there's this warehouse who's going to take your grain. 23:26.680 --> 23:30.610 In the warehouse, you better trust the other side 23:30.611 --> 23:34.381 because suppose the other side doesn't work. 23:34.380 --> 23:37.730 Suppose you have your--you've loaded up all your rice and you 23:37.734 --> 23:40.144 come to the warehouse and then the guy says, 23:40.139 --> 23:42.319 I don't want to honor the contract. 23:42.319 --> 23:44.209 I signed it, but I'm just not going to take 23:44.214 --> 23:46.484 it; I'm going to lower the price on 23:46.480 --> 23:48.740 you. Then you have to sue this guy 23:48.741 --> 23:50.141 and it's a big mess. 23:50.140 --> 23:53.970 The problem with forward contracts is that they're not 23:53.966 --> 23:56.196 standardized; you're not dealing with a 23:56.200 --> 23:57.120 reputable exchange. 23:57.119 --> 24:00.089 With an exchange, there is of course a counter 24:00.091 --> 24:02.251 party. If you're selling rice and 24:02.252 --> 24:05.832 someone else is buying it, there's an intermediary between 24:05.832 --> 24:07.782 you and that's the exchange. 24:07.779 --> 24:10.189 Since the exchange will honor any contract, 24:10.186 --> 24:12.876 you don't have to worry about the other side. 24:12.880 --> 24:19.590 That's another reason why futures prices are so much more 24:19.593 --> 24:26.313 meaningful than spot or forward prices because there's no 24:26.307 --> 24:34.217 counter-party risk unless you worry about the exchange itself. 24:34.220 --> 24:36.630 Since the futures exchanges in the U.S. 24:36.630 --> 24:39.230 have been here since the nineteenth century and they've 24:39.226 --> 24:42.026 never lost a contract, people assume as a first 24:42.028 --> 24:44.978 approximation, that there's no counter-party 24:44.980 --> 24:49.050 risk. I still haven't maybe fully 24:49.045 --> 24:51.515 explained futures. 24:51.519 --> 24:55.469 Let me--before we go on, I want to talk a little bit 24:55.467 --> 24:59.567 about forwards because now we have a slide up here. 24:59.569 --> 25:03.959 We do have forward contracts and they still play an important 25:03.964 --> 25:07.144 function. The reason is that futures 25:07.138 --> 25:12.328 markets, by their very nature, are standardized markets. 25:12.329 --> 25:16.559 Or you might say they're retail markets. 25:16.559 --> 25:18.249 They have a huge number of people trading in them, 25:18.253 --> 25:19.363 but it's all a standard thing. 25:19.359 --> 25:24.719 Forward markets are between persons and so they can be--the 25:24.721 --> 25:28.051 contract can be anything you want. 25:28.049 --> 25:33.929 So, forward contracts are very important but they tend to be 25:33.929 --> 25:39.509 less--I tend to observe them less because they don't have 25:39.510 --> 25:42.500 this newsworthy character. 25:42.500 --> 25:45.660 Everyone's talking about futures prices because everyone 25:45.663 --> 25:47.563 knows that is a very well-defined, 25:47.561 --> 25:49.461 central market, liquid price. 25:49.460 --> 25:54.050 The forward contracts are not liquid; 25:54.050 --> 25:55.460 you can't get out of it. 25:55.460 --> 26:00.120 So if you, as a rice merchant, sold your rice--as a rice 26:00.117 --> 26:04.937 farmer--you sold your rice forward to a warehouse and then 26:04.944 --> 26:09.944 you change your mind--you want to get out--you can't because 26:09.940 --> 26:13.290 unless the other guy says, I'll let you out, 26:13.291 --> 26:14.651 because you've just got a contract. 26:14.650 --> 26:18.760 The futures has this active trading in and out, 26:18.755 --> 26:21.785 so the prices seem to mean more. 26:21.789 --> 26:24.169 Let's talk about forward markets. 26:24.170 --> 26:26.130 There are forward markets for a lot of things. 26:26.130 --> 26:29.800 One very important forward market is the foreign exchange 26:29.804 --> 26:32.774 forward market. This happens a lot because 26:32.768 --> 26:36.888 there are tons of businesses that have--they sell things in 26:36.892 --> 26:41.302 countries around the world and they get foreign currencies. 26:41.299 --> 26:45.269 If you sell some--you're a manufacturer and you sell 26:45.273 --> 26:49.093 something in Japan, then they're paying you in yen 26:49.091 --> 26:52.911 and they might be paying you in three months. 26:52.910 --> 26:56.530 So, you worry about the exchange rate between dollars 26:56.528 --> 26:59.588 and yen, so you want to get it in dollars. 26:59.589 --> 27:03.779 You might want to find a counter party who will exchange 27:03.780 --> 27:08.580 your yen for dollars in three months or whatever the term is; 27:08.579 --> 27:11.919 that's called a forward contract for exchange of 27:11.916 --> 27:14.616 currencies. Very simple. 27:14.619 --> 27:19.419 I'm getting--I'm selling cars in Japan--that sounds--that does 27:19.418 --> 27:22.148 happen--U.S. cars sold in Japan. 27:22.150 --> 27:25.600 So, I'm going to get--I know I'm going to get this yen in 27:25.596 --> 27:28.486 three months. I just signed a contract with 27:28.490 --> 27:32.430 somebody to exchange dollars--we fixed the exchange rate; 27:32.430 --> 27:34.270 that's called the forward exchange rate. 27:34.269 --> 27:37.849 It's not necessarily the same as today's exchange rate; 27:37.849 --> 27:40.409 in fact, it would generally be systematically different. 27:40.410 --> 27:44.520 So, we have this, what's called forward interest 27:44.517 --> 27:47.657 parity relation. The forward--this is an 27:47.656 --> 27:51.536 arbitrage relationship that holds very well in the forward 27:51.538 --> 27:53.648 market for foreign exchange. 27:53.650 --> 27:58.880 The forward exchange rate--that's yen per dollar, 27:58.884 --> 28:03.254 in the case, if we're talking about Japan 28:03.246 --> 28:09.346 and U.S.--equals the spot exchange rate that's in yen per 28:09.354 --> 28:15.904 dollar times one plus the yen interest rate--that's for three 28:15.897 --> 28:22.217 months if it's a three-month horizon--times one plus dollar 28:22.222 --> 28:27.942 interest rate. And that relation holds very 28:27.936 --> 28:30.676 well. If it didn't hold, 28:30.677 --> 28:37.257 I could make money quickly without risk and that shouldn't 28:37.255 --> 28:40.085 happen. Think of it this way, 28:40.087 --> 28:44.957 the interest rate in Japan is different from the interest rate 28:44.961 --> 28:48.371 in the U.S. Government bonds issued in 28:48.369 --> 28:50.659 Japan are perfectly safe. 28:50.660 --> 28:54.160 Well, I mean you could say of course the Japanese government 28:54.155 --> 28:56.875 could default, but it's not going to happen. 28:56.880 --> 29:00.850 To a first approximation, it's not going to--we'll call 29:00.846 --> 29:02.606 it a zero probability. 29:02.610 --> 29:04.540 Same thing with the U.S. 29:04.539 --> 29:08.029 How can two different countries have different interest rates? 29:08.029 --> 29:10.219 You would think, well wouldn't an investor 29:10.224 --> 29:13.494 always invest in the country with the higher interest rate? 29:13.490 --> 29:14.950 Why not if it's riskless? 29:14.950 --> 29:17.710 Well, there is risk and that's exchange rate risk. 29:17.710 --> 29:21.510 You can get rid of the risk by taking a forward contract. 29:21.509 --> 29:23.819 You could say, if you're living in Japan, 29:23.822 --> 29:26.772 I note that interest rates are higher in the U.S. 29:26.769 --> 29:30.929 than Japan, so I'm not going to go--I'm not going to invest in 29:30.931 --> 29:33.071 yen bonds; I'm going to invest in U.S. 29:33.068 --> 29:35.678 bonds. Then, I'm going to cover myself 29:35.683 --> 29:40.013 by making a forward contract to get the money back in yen. 29:40.009 --> 29:44.379 Well, that's a very clear thing to do, but the problem is you 29:44.378 --> 29:48.598 can't make any money doing it because this holds because of 29:48.600 --> 29:51.380 arbitrage. There are so many people who've 29:51.377 --> 29:54.607 noticed that--that interest rates are higher in the U.S. 29:54.610 --> 29:57.140 than Japan; they're both riskless interest 29:57.139 --> 29:59.509 rates. It can't be right that there's 29:59.505 --> 30:03.275 this profit opportunity that's riskless, so the forward 30:03.276 --> 30:06.416 exchange rate satisfies this relationship. 30:06.420 --> 30:10.570 The forward rate equals the spot rate times the relative 30:10.567 --> 30:13.637 interest rates. This is over the horizon 30:13.644 --> 30:17.314 between now--this is not the annual interest rate, 30:17.309 --> 30:20.449 unless it's an annual forward contract. 30:20.450 --> 30:24.110 If it's a three-month forward contract this would be the 30:24.111 --> 30:28.041 interest earned in three months in yen and this would be the 30:28.038 --> 30:31.298 interest earned in dollars over three months. 30:31.299 --> 30:34.999 That's one kind of forward rate agreement and this market works 30:35.003 --> 30:36.523 very well. It satisfies this 30:36.517 --> 30:38.767 relation--we've explained--we know this market; 30:38.769 --> 30:42.219 it just satisfies the forward interest parity condition. 30:42.220 --> 30:57.330 Another forward market is the market for different interest 30:57.326 --> 31:05.686 rates. We can have a forward loan. 31:05.690 --> 31:09.110 We can say, I want to make a loan at a future date of a 31:09.114 --> 31:12.944 certain maturity; let's tie in the interest rate 31:12.937 --> 31:16.337 now, so R is the contract rate. 31:16.339 --> 31:20.589 Suppose you want to either borrow or lend money in the 31:20.588 --> 31:22.788 future; we talked about forward rates 31:22.786 --> 31:25.736 implicit in the term structure earlier and you could try to 31:25.740 --> 31:28.590 achieve those forward rates as we talked about earlier by 31:28.592 --> 31:30.682 buying and selling government bonds, 31:30.680 --> 31:33.000 but this is another way to do it, which may be simpler. 31:33.000 --> 31:36.690 It doesn't involve shorting bonds; 31:36.690 --> 31:38.090 you can just make a contract. 31:38.089 --> 31:42.749 There's a contract rate in the forward contract and the 31:42.746 --> 31:47.396 contract says--the contract specifies the contract rate 31:47.402 --> 31:52.492 R and the number of days in the contract period; 31:52.490 --> 31:56.510 that's how many days hence this contract will be delivered--will 31:56.507 --> 31:59.237 be executed. You can make any forward rate 31:59.235 --> 32:02.205 contract you want, but this is the most standard 32:02.210 --> 32:04.490 contract; yet, it's between counter 32:04.492 --> 32:07.052 parties, so you can do whatever you want. 32:07.049 --> 32:10.119 But, if you talk with a broker and you got a standard contract 32:10.121 --> 32:11.431 you'd probably get this. 32:11.430 --> 32:14.070 Now, the purpose of this contract is to lock in an 32:14.068 --> 32:16.228 interest rate. It's a risk management 32:16.226 --> 32:19.696 contract, so you don't actually want to borrow and lend from 32:19.704 --> 32:23.064 this other person--you'll arrange that separately--but you 32:23.063 --> 32:26.603 want to protect yourself so that you know today what interest 32:26.600 --> 32:28.840 rate you can get in the future. 32:28.839 --> 32:37.019 What they do is they define some measure of actual interest 32:37.020 --> 32:45.760 rate and it could be something like LIBOR, the London Interbank 32:45.764 --> 32:49.684 Offer Rate; it's just an interest rate 32:49.680 --> 32:52.380 that's defined by an agency in London. 32:52.380 --> 32:54.160 They have a website and you can read it. 32:54.160 --> 32:57.120 It's a well-known, well-defined interest rate. 32:57.119 --> 33:00.829 So, you could say, three-month LIBOR is the 33:00.831 --> 33:04.811 interest rate, 90 days in the future--D 33:04.807 --> 33:08.817 would be 90 and so, what the contract specifies--it 33:08.824 --> 33:11.644 also specifies a contract amount, A, 33:11.640 --> 33:16.820 and B is actually usually 360, but sometimes 33:16.816 --> 33:20.406 they'll say 365. You can write whatever you want 33:20.410 --> 33:23.200 in these contracts, but this is standard--typically 33:23.200 --> 33:26.190 360 days. So, all it specified--what the 33:26.185 --> 33:29.655 contract says--there are two counterparties; 33:29.660 --> 33:33.540 there's the long and the short; somebody is receiving interest 33:33.539 --> 33:35.319 and someone is paying interest. 33:35.319 --> 33:39.949 The settlement is this amount, from one side to the other. 33:39.950 --> 33:44.600 This formula actually--it doesn't appear in Fabozzi in 33:44.604 --> 33:49.084 exactly this notation, but this is in the chapter on 33:49.083 --> 33:51.773 futures markets. This equation, 33:51.767 --> 33:55.467 although it's written a little differently, it's the same 33:55.474 --> 33:59.254 equation that appears in Fabozzi in the chapter on futures 33:59.249 --> 34:01.239 markets. What you do, 34:01.235 --> 34:06.955 the standard forward contract says, one counter party pays the 34:06.955 --> 34:12.295 other this amount and that is equal to the actual interest 34:12.301 --> 34:18.281 rate minus the contract rate, times the number of days, 34:18.281 --> 34:24.871 times the contract amount, divided by B, times 100. 34:24.869 --> 34:29.719 This 100 is here because L and R are 34:29.724 --> 34:35.074 assumed to be measured in hundreds, like percent--3% is 34:35.074 --> 34:38.744 really .03 x L x D. 34:38.739 --> 34:44.329 This equation might be easier if you divide both numerator and 34:44.329 --> 34:49.919 denominator by 100 then you can see that all that 100 is doing 34:49.918 --> 34:56.238 is correcting the interest rates from percent to--from 3% to .03. 34:56.239 --> 35:01.129 All it's doing--all this contract is is an amount--a 35:01.131 --> 35:06.701 promise--to pay the difference between the contract and the 35:06.695 --> 35:10.335 actual interest rate on that date. 35:10.340 --> 35:14.310 That effectively allows you, if you want to borrow at that 35:14.314 --> 35:18.574 rate, to lock in the interest rate today because I will get an 35:18.567 --> 35:22.327 amount of money from this contract that will offset any 35:22.332 --> 35:25.542 changes in interest rates in the future. 35:25.539 --> 35:29.509 That's another example of a contract. 35:29.510 --> 35:35.930 I wanted to emphasize here futures, not--where am I? 35:35.930 --> 35:38.110 Let's talk about futures prices. 35:38.110 --> 35:42.590 I took this from an old newspaper--it's from an old 35:42.593 --> 35:45.903 lecture. This is what used to be in 35:45.900 --> 35:51.190 The Wall Street Journal and this is an example of a 35:51.185 --> 35:53.035 futures contract. 35:53.039 --> 35:56.519 I'm going to stick here with agricultural futures and next 35:56.521 --> 35:59.821 lecture we're going to talk about financial futures. 35:59.820 --> 36:04.360 But, I'd like to talk about agricultural futures because 36:04.364 --> 36:08.174 it's just really expanding on the Japan, Osaka, 36:08.165 --> 36:11.995 Dojima story. It's so earthy--agriculture, 36:11.998 --> 36:17.288 down-to-earth--I like to start with that because it seems very 36:17.288 --> 36:19.368 simple to understand. 36:19.369 --> 36:24.279 I wanted to explain one contract and I thought I would 36:24.276 --> 36:31.156 emphasize corn. This is as it was laid out in 36:31.161 --> 36:33.691 2001; that was seven years ago. 36:33.690 --> 36:37.080 I was giving these lectures seven years ago and I clipped it 36:37.084 --> 36:39.534 out; that was before--I must have 36:39.527 --> 36:43.797 covered it earlier in the semester because I have March 15 36:43.797 --> 36:46.417 up there and we're now April 14. 36:46.420 --> 36:50.140 But, we'll just use this just as an--I'll show you in a second 36:50.136 --> 36:51.656 what you can get today. 36:51.659 --> 36:55.559 Newspapers, just seven years ago, covered lots more financial 36:55.562 --> 36:59.662 data than they do today because we're moving to the Internet. 36:59.659 --> 37:02.079 Of course, they had the Internet in 2001, 37:02.084 --> 37:05.844 but we weren't so into it then, so they still published this in 37:05.842 --> 37:08.632 The Wall Street Journal as of 2001. 37:08.630 --> 37:11.290 So, let me just use this as an example. 37:11.290 --> 37:15.720 What is this? This is corn; 37:15.720 --> 37:19.610 that's maize. It was--what this means is that 37:19.612 --> 37:24.892 one contract is a contract to deliver 5,000 bushels and the 37:24.894 --> 37:28.814 price here is shown in cents per bushel. 37:28.810 --> 37:34.240 These are the contracts; there is a--now this is--today 37:34.239 --> 37:38.159 is March 15,2001; there's a May contract, 37:38.162 --> 37:42.302 a July contract, and this is--this shows the 37:42.297 --> 37:46.527 price over today, which is March 15,2001. 37:46.530 --> 37:50.770 The guys in the pit at the--this stands for Chicago 37:50.768 --> 37:53.738 Board of Trade. I put an O in it, 37:53.739 --> 37:56.349 but often they just say CBT. 37:56.349 --> 38:03.649 There's a corn pit with traders and there might be 50 guys 38:03.647 --> 38:06.717 there--guys and girls. 38:06.719 --> 38:11.959 It's a rough--my colleague Ronit Walny worked in the 38:11.963 --> 38:18.443 futures pits in Chicago and she told me that it was so rough; 38:18.440 --> 38:22.570 she got pregnant and there was--she was still coming into 38:22.570 --> 38:26.850 work and she got knocked over one day by one of the traders 38:26.847 --> 38:30.037 and her boss said, no way you have to take a 38:30.038 --> 38:32.108 vacation until the baby is born. 38:32.110 --> 38:34.430 This is no place for a pregnant woman. 38:34.430 --> 38:37.930 It's true; they get rough and tumble there. 38:37.929 --> 38:42.909 When I had a tour of the CBOT--this was like ten years 38:42.911 --> 38:46.391 ago--I was asking--I was observing; 38:46.389 --> 38:50.939 the guys in the pit were so raucous and at one point one 38:50.942 --> 38:55.832 trader got another trader in a head lock and he was dragging 38:55.825 --> 38:59.545 him around and I think it was all in fun, 38:59.550 --> 39:01.220 at that time anyway. 39:01.219 --> 39:04.189 So, the guy said, well we had a good record this 39:04.187 --> 39:06.707 year; we've had only two broken arms 39:06.711 --> 39:09.071 this year and that's a good year. 39:09.070 --> 39:13.300 In Chicago, they're not as--they're farmers--I shouldn't 39:13.299 --> 39:15.299 put them down; they're different; 39:15.300 --> 39:16.760 they have a different spirit. 39:16.760 --> 39:18.590 They're not--they're down-to-earth, 39:18.587 --> 39:20.527 real people; let's put it that way. 39:20.530 --> 39:24.920 It's fun to watch, but unfortunately it's probably 39:24.915 --> 39:28.215 too late. Unless you go to the Treasury 39:28.223 --> 39:32.233 bond pit, it's all fading away onto the Internet. 39:32.230 --> 39:37.470 What this means is these were the prices that corn took per 39:37.474 --> 39:40.644 bushel over that day of March 15. 39:40.639 --> 39:45.979 So, the price was going up and down as they were trading all 39:45.977 --> 39:48.087 day. This was the opening price when 39:48.089 --> 39:49.809 the market opened in the morning; 39:49.809 --> 39:52.899 this was the highest price for May futures; 39:52.900 --> 39:55.180 this was the lowest price. 39:55.179 --> 39:59.149 And this is called the settle, which is essentially the last 39:59.150 --> 40:02.650 price, but not necessarily because the exchange has a 40:02.650 --> 40:06.350 settlement committee and they decide on what is the last 40:06.352 --> 40:08.612 price. The reason it's not the same 40:08.607 --> 40:11.657 thing as the last actual trade is that they're worried about 40:11.657 --> 40:14.707 somebody trying to manipulate the market and doing something 40:14.707 --> 40:16.307 funny with the last trade. 40:16.310 --> 40:19.560 It's like the last trade. 40:19.559 --> 40:24.109 So, this is the change from the previous day of the price. 40:24.110 --> 40:28.150 This is the price for May delivery at a specified 40:28.150 --> 40:30.760 warehouse of corn to Chicago. 40:30.760 --> 40:37.130 Open interest is the number of contracts. 40:37.130 --> 40:40.560 There were 186,000 May contracts; 40:40.559 --> 40:43.079 that's only two months away--March, April, 40:43.081 --> 40:45.211 May. Almost all of the open interest 40:45.208 --> 40:46.738 is in the short contracts. 40:46.739 --> 40:52.089 Now, if you drive through the country and turn on the radio, 40:52.086 --> 40:56.886 you will hear at regular intervals--the announcer will 40:56.889 --> 40:59.789 tell you what corn is doing. 40:59.789 --> 41:06.269 They say, corn at the latest trading is up to $2.18 a bushel. 41:06.270 --> 41:09.320 What price is that guy quoting? 41:09.320 --> 41:12.770 It's always going to be the futures price. 41:12.769 --> 41:15.139 You might say, well that's two months in the 41:15.141 --> 41:17.241 future--March, April, May--why are they 41:17.236 --> 41:18.446 talking about May? 41:18.449 --> 41:22.209 Because this is March, why doesn't the announcer tells 41:22.207 --> 41:25.607 us that at some warehouse the price today was? 41:25.610 --> 41:27.970 The reason is that, as I was saying, 41:27.965 --> 41:32.205 those prices are not meaningful because they jump around because 41:32.205 --> 41:35.095 of crazy reasons, so this is the price. 41:35.100 --> 41:41.840 41:41.840 --> 41:48.620 The other thing that I want to emphasize is that these markets 41:48.623 --> 41:54.743 are used to manage risks of holding or raising grain. 41:54.739 --> 41:58.369 Most of the time, people who are trading in this 41:58.367 --> 42:01.297 market do not complete the contract. 42:01.300 --> 42:04.660 In other words, if I--let's say I'm a farmer 42:04.660 --> 42:09.040 raising corn and I'm worried that the price of corn might 42:09.036 --> 42:12.706 fall while I'm raising it and I lose money. 42:12.710 --> 42:17.940 If the world market for corn drops, then I might not be able 42:17.939 --> 42:23.699 to cover my expenses this year and so I could be at great risk. 42:23.699 --> 42:28.249 So, I can sell in the futures market, but I probably won't 42:28.253 --> 42:30.813 deliver to the futures market. 42:30.810 --> 42:34.130 Why not? Because the delivery point is 42:34.127 --> 42:38.537 in Chicago and I'm a farmer in Iowa and I don't know how to 42:38.543 --> 42:41.363 deliver it all the way to Chicago. 42:41.360 --> 42:46.170 I'd have to rent trucks and drive to Chicago with my corn; 42:46.170 --> 42:47.240 I'm not going to do that. 42:47.239 --> 42:50.499 I'm always just delivering to the local grain elevator. 42:50.500 --> 42:52.680 In fact, I don't have to--I don't need any trucks; 42:52.679 --> 42:56.889 the guy will pick it up from my farm, so that's what I want to 42:56.885 --> 42:59.725 do. What I do typically is I sell 42:59.734 --> 43:02.844 in the futures market, I as a farmer, 43:02.844 --> 43:06.994 and then one day before the contract expires, 43:06.989 --> 43:10.379 instead of delivering, I will buy it back and cancel 43:10.382 --> 43:13.832 out my contract. So, all I've done is a purely 43:13.827 --> 43:16.227 financial trade in the future. 43:16.230 --> 43:17.250 Do you see the difference? 43:17.250 --> 43:20.950 I don't actually want to deliver because it's too much 43:20.951 --> 43:24.371 trouble to deliver, so you get farmers trading all 43:24.374 --> 43:28.434 over the country and all over the world in this market as a 43:28.425 --> 43:30.655 way of hedging their corn. 43:30.659 --> 43:34.029 Very few of them will ever deliver. 43:34.030 --> 43:39.420 The only reason why delivery is kept open as an option is that 43:39.422 --> 43:43.402 is what determines the price in the market. 43:43.400 --> 43:47.840 Ultimately, the only people who deliver are professional 43:47.842 --> 43:52.772 arbitragers, who on the last day or right when the contract is 43:52.769 --> 43:55.399 expiring, they look at the futures price 43:55.396 --> 43:57.286 and they say, maybe I can deliver it, 43:57.288 --> 44:00.278 maybe I can buy it for less than that and deliver and I'll 44:00.284 --> 44:03.344 really do it. Those are the only people; 44:03.340 --> 44:06.630 so, if they can buy for less than that and deliver, 44:06.627 --> 44:09.907 they'll do it. They compete with each other 44:09.908 --> 44:14.608 and that brings the futures price and the spot price in line 44:14.605 --> 44:16.765 at the end. Alternatively, 44:16.767 --> 44:20.877 if the spot price is above the futures price at the end, 44:20.884 --> 44:25.304 then these arbitragers will say, hey I'll take delivery. 44:25.300 --> 44:29.030 I'll go there and take delivery on a contract and then I'll sell 44:29.034 --> 44:30.224 it and make money. 44:30.219 --> 44:35.219 It's because of the arbitragers that the cash price and the spot 44:35.217 --> 44:40.787 price line up at the end; it's not through any law 44:40.791 --> 44:44.471 requirement. You see what people are doing? 44:44.469 --> 44:47.529 They're using the futures market as a purely financial 44:47.530 --> 44:50.700 market. Most people rely on the 44:50.704 --> 44:57.284 arbitragers to enforce the futures price converging on the 44:57.284 --> 45:00.174 spot price at the end. 45:00.170 --> 45:03.310 Most people are not even raising the right kind of corn 45:03.305 --> 45:05.425 maybe; I don't know how--a lot of them 45:05.427 --> 45:06.387 certainly aren't. 45:06.389 --> 45:07.649 There are all different kinds of corn. 45:07.650 --> 45:12.350 If you are raising one kind of corn and are hedging your risks 45:12.349 --> 45:17.049 with a different kind of corn, that's called cross-hedging. 45:17.050 --> 45:26.770 That means across products; I'm going from one product to 45:26.766 --> 45:29.176 another. So, I could be raising some of 45:29.180 --> 45:32.590 this beautiful Indian corn that--remember it turns all 45:32.591 --> 45:36.321 these different colors and people hang it on their doors at 45:36.324 --> 45:40.254 Halloween--that's not suitable for delivery at the CBOT. 45:40.250 --> 45:43.950 If I'm raising that, there's no market--it's no 45:43.951 --> 45:47.011 future--it's no big market for that, 45:47.010 --> 45:49.310 but it probably correlates with regular corn, 45:49.305 --> 45:50.605 so I could cross-hedge. 45:50.610 --> 45:53.780 If I'm raising Indian corn and I'm worried about the price, 45:53.784 --> 45:56.694 I can sell in the futures market in Chicago and buy it 45:56.685 --> 45:57.885 back the next day. 45:57.889 --> 46:01.209 I said I was going to show you what's in The Wall Street 46:01.208 --> 46:03.338 Journal. I got this this morning from 46:03.344 --> 46:06.654 The Wall Street Journal; that's all they have for 46:06.650 --> 46:10.510 futures markets in the newspaper, unless I missed it, 46:10.507 --> 46:12.137 I couldn't find it. 46:12.139 --> 46:15.229 Commodities and currencies--they don't have any 46:15.229 --> 46:19.129 agricultural futures mentioned at all in The Wall Street 46:19.125 --> 46:22.445 Journal. As I'm going to talk about next 46:22.448 --> 46:26.358 period, most futures have migrated to financial futures 46:26.364 --> 46:28.424 anyway. It's the same idea, 46:28.424 --> 46:30.324 but it's not agricultural. 46:30.320 --> 46:32.240 I don't see anything agricultural up here. 46:32.240 --> 46:35.900 There are commodities; there's crude oil, 46:35.903 --> 46:39.883 natural gas, gold--everything else is purely 46:39.878 --> 46:42.238 financial. Well actually, 46:42.237 --> 46:45.377 you've got the DJIIG Commodity Index; 46:45.380 --> 46:49.080 that's an index of a number of prices, probably including 46:49.079 --> 46:53.819 agricultural. So, that's traded; 46:53.820 --> 46:55.120 lots more is traded. 46:55.119 --> 47:00.789 I went down to CBOT.com this morning and I got wheat futures 47:00.794 --> 47:04.414 prices. This is on their website and 47:04.411 --> 47:10.111 you don't need any special permission to get on CBOT.com. 47:10.110 --> 47:12.400 They're actually changing the name of the website though; 47:12.400 --> 47:17.830 I think it will be CMEgroup.com because of their merger with the 47:17.826 --> 47:20.406 Chicago Mercantile Exchange. 47:20.409 --> 47:22.869 This is the same thing that we just saw. 47:22.869 --> 47:28.099 This is the price of a bushel of wheat; 47:28.099 --> 47:42.979 this is as of last Friday--$.932 a bushel. 47:42.980 --> 47:48.530 It ranged from $.885; it closed at its high--it 47:48.529 --> 47:52.749 opened at its high and it settled down, 47:52.754 --> 47:55.204 so wheat went down. 47:55.199 --> 48:01.249 This is for delivery in May of 2008 and these contracts go out 48:01.248 --> 48:03.588 to 2010. This doesn't shown open 48:03.585 --> 48:06.095 interest, but you understand what this is? 48:06.099 --> 48:12.899 Now, the real--the price that we talk about when we talk about 48:12.897 --> 48:18.577 commodities is the futures price, overwhelmingly. 48:18.579 --> 48:28.369 This is the Chicago Board of Trade price for corn since 1929. 48:28.369 --> 48:33.229 We could take it even further back, but futures exchanges have 48:33.228 --> 48:37.368 been going since--the CBOT goes back to the 1860s. 48:37.369 --> 48:43.549 Anyway, this is a long time horizon plot of the price of 48:43.550 --> 48:49.960 corn and I adjusted it for CPI inflation, so this shows in 48:49.955 --> 48:52.535 dollars per bushel. 48:52.539 --> 48:55.149 Of course, contracts are for 5,000 bushels, 48:55.145 --> 48:58.305 so you'd have to multiply these numbers by 5,000. 48:58.309 --> 49:04.519 This just shows what has been happening to the real price of 49:04.516 --> 49:08.496 corn since 1929. There's a lot of talk recently; 49:08.500 --> 49:11.540 you must have heard it--about this spike up. 49:11.539 --> 49:14.489 In fact, it's quite a hefty spike up; 49:14.489 --> 49:17.679 it's doubled--more than doubled in real terms in just the last 49:17.676 --> 49:19.986 couple years. Do you know why this is? 49:19.989 --> 49:22.829 Why is corn getting expensive right now? 49:22.830 --> 49:26.230 What's that? That's the theory; 49:26.230 --> 49:33.540 I think it's right--that it's because oil prices are getting 49:33.535 --> 49:40.585 high and because we can make alternative fuels out of food 49:40.594 --> 49:43.694 stuffs--cane or corn. 49:43.690 --> 49:48.630 In response to the high oil prices, well also subsidies for 49:48.634 --> 49:52.734 ethanol production, corn is being demanded to run 49:52.726 --> 49:56.976 automobiles. All these rich people who want 49:56.983 --> 50:02.963 their SUVs--they want to have a good drive--are now paying more 50:02.963 --> 50:08.943 for the corn and bidding it up and this is a huge international 50:08.942 --> 50:12.582 crisis. It's spreading over all of the 50:12.582 --> 50:17.462 grains and it's a worrisome situation because people in some 50:17.464 --> 50:22.354 of the poorest parts of the world cannot tolerate a doubling 50:22.345 --> 50:26.725 of the price of grain; they'll starve. 50:26.730 --> 50:31.890 This is a huge moral issue that we're facing right now. 50:31.889 --> 50:35.819 In order to keep our cars going, we're driving some people 50:35.817 --> 50:38.397 to starvation. On the other hand, 50:38.395 --> 50:43.395 I don't mean to minimize that, I thought it was interesting to 50:43.395 --> 50:47.735 look at the whole run of corn prices back to 1929; 50:47.739 --> 50:50.779 they have come down a great deal. 50:50.780 --> 50:55.660 It's quite curious, if you correct for inflation; 50:55.659 --> 50:59.089 it was like $15 a bushel in 1950. 50:59.090 --> 51:01.710 On top of that, our incomes have risen and so I 51:01.707 --> 51:04.887 think this says something about why futures--agricultural 51:04.894 --> 51:07.914 futures--are not as prominent as they used to be. 51:07.909 --> 51:12.049 It used to be that food was really a lot more expensive and 51:12.048 --> 51:14.258 a bigger share of our income. 51:14.260 --> 51:17.580 We live in a very plenteous time; 51:17.579 --> 51:19.729 this is very unusual by historical standards. 51:19.730 --> 51:22.820 Right now, you just eat whatever you want; 51:22.820 --> 51:24.740 you don't even look at the price; 51:24.740 --> 51:25.950 it's all so cheap. 51:25.950 --> 51:28.990 Maybe you do; maybe you don't eat caviar 51:28.994 --> 51:32.324 because of price, but we're just in a time of 51:32.319 --> 51:35.719 plenty with the real price of food so low. 51:35.719 --> 51:38.769 It's not normal times, historically, 51:38.767 --> 51:43.467 so our agricultural futures are somewhat downplayed. 51:43.469 --> 51:49.799 I wanted to give an example of wheat futures because this 51:49.797 --> 51:55.667 is--we have a reading on the reading list by Holbrook 51:55.673 --> 51:59.333 Working. Holbrook Working was the great 51:59.327 --> 52:04.147 theorist of futures markets and it's actually--the reading comes 52:04.153 --> 52:08.293 from the 1950s and he is explaining futures market. 52:08.289 --> 52:12.109 I like this article because it sets it forth very well and 52:12.110 --> 52:16.000 nothing has changed since the 1950s except that the markets 52:15.998 --> 52:17.538 are electronic now. 52:17.539 --> 52:22.329 I wanted to focus in on one futures market and this is the 52:22.332 --> 52:23.932 market for wheat. 52:23.929 --> 52:29.279 These are the standards for delivery at the Chicago Board of 52:29.284 --> 52:31.524 Trade. I got this off their website 52:31.519 --> 52:33.329 and this current; this is today. 52:33.329 --> 52:37.849 If you--one contract is 5,000 bushels. 52:37.849 --> 52:43.129 They will accept a number of different kinds of wheat that 52:43.129 --> 52:48.689 meet their--there must be some standards for quality--no bugs 52:48.686 --> 52:54.056 in it and whatever else--but they'll accept number two soft 52:54.059 --> 52:59.339 red winter or number two hard red winter or--I just copied 52:59.338 --> 53:04.838 this from the--it says, no dark northern spring. 53:04.840 --> 53:07.350 It must be number something, what happened? 53:07.349 --> 53:10.829 I must have lost the--number two, northern spring. 53:10.830 --> 53:12.440 All those are at par. 53:12.440 --> 53:17.440 However, you can also deliver number one soft red winter. 53:17.440 --> 53:20.980 That's different because this is number two soft red 53:20.977 --> 53:24.787 winter--or number one hard red winter or number one dark 53:24.792 --> 53:28.332 northern spring and number one northern spring; 53:28.329 --> 53:31.409 you get $.03 a bushel over the contract price. 53:31.409 --> 53:37.549 What they're trying to do is recognize that there are so many 53:37.548 --> 53:43.278 different kinds of wheat and so I thought we would remind 53:43.278 --> 53:46.448 ourselves of what they are. 53:46.449 --> 53:52.409 One hard--soft wheat is used for making biscuits and 53:52.406 --> 53:58.576 breakfast cereals and cakes; hard wheat is used for making 53:58.584 --> 54:00.464 bread. If you do baking, 54:00.461 --> 54:03.941 you should not just always use all-purpose flour, 54:03.937 --> 54:06.977 you should get the different varieties. 54:06.980 --> 54:10.780 That's what is being mentioned here--these different varieties. 54:10.780 --> 54:17.090 I wanted to--let me see, I wanted to talk about the 54:17.086 --> 54:20.236 Holbrook Working paper. 54:20.239 --> 54:30.419 Holbrook Working talks about winter--is anyone here who is a 54:30.417 --> 54:35.037 farmer? Did anyone grow up on a farm? 54:35.039 --> 54:37.899 Can anyone tell the story of winter wheat? 54:37.900 --> 54:41.750 Nobody? We're not very down-to-earth 54:41.747 --> 54:43.317 people here, are we? 54:43.320 --> 54:48.230 There are two plantings; there's winter wheat and spring 54:48.231 --> 54:50.481 wheat. Winter wheat--you plant it in 54:50.482 --> 54:53.482 the winter and you harvest it in the spring. 54:53.480 --> 54:56.760 It stays in the ground all winter and it comes up first 54:56.762 --> 54:58.892 thing in the--it's coming up now. 54:58.889 --> 55:02.629 You harvest winter wheat in May, so we're almost close to 55:02.634 --> 55:04.854 the harvest. Did you know that? 55:04.849 --> 55:10.009 There are amber waves of grain blowing in the wind out there in 55:10.012 --> 55:14.682 the wheat belt right now and it will soon be harvested in 55:14.675 --> 55:17.085 another month and a half. 55:17.090 --> 55:20.570 Spring wheat--you plant it in the spring and you harvest it in 55:20.572 --> 55:22.652 the fall. But they're allowing now 55:22.650 --> 55:24.100 delivery of either one. 55:24.099 --> 55:28.039 When Holbrook Working wrote the paper, there was a separate 55:28.044 --> 55:32.264 contract for hard winter wheat and so I think that there's some 55:32.261 --> 55:36.071 consolidation of these markets as agricultural futures is 55:36.069 --> 55:38.109 becoming less important. 55:38.110 --> 55:42.310 That's why we just have--this is the only CBOT wheat market 55:42.311 --> 55:43.761 that's listed now. 55:43.760 --> 55:48.280 You understand what the contract is? 55:48.280 --> 55:51.650 The contract is to deliver one of these varieties and there's a 55:51.649 --> 55:54.039 separate contract for each of these dates. 55:54.040 --> 56:00.950 What is the pricing? 56:00.949 --> 56:03.659 This is the thing--what is the futures price? 56:03.659 --> 56:09.539 Now there's--this is what I'm going to try to conclude on. 56:09.539 --> 56:13.969 It depends on whether wheat is in storage or not. 56:13.969 --> 56:18.019 Normally, wheat is in storage because we only harvest a 56:18.019 --> 56:22.449 particular variety once a year and we have to consume it all 56:22.445 --> 56:25.325 year. So, after the harvest the 56:25.330 --> 56:30.460 warehouses get full and then they're brimming with wheat. 56:30.460 --> 56:34.980 Then, as the year goes down, the warehouses deplete their 56:34.983 --> 56:39.833 contents of wheat and it hits zero right when the new harvest 56:39.829 --> 56:43.009 comes in. Then, it all gets put back into 56:43.009 --> 56:45.509 the warehouse. This is a physical necessity. 56:45.510 --> 56:52.130 When there is wheat in storage, normally, most of the time, 56:52.126 --> 56:55.316 this relation should hold. 56:55.320 --> 57:00.590 The price of the futures contract should equal the spot 57:00.590 --> 57:04.300 price times one plus the interest rate, 57:04.299 --> 57:07.129 between now and delivery. 57:07.130 --> 57:11.370 That means that if, say interest rates are 5% a 57:11.373 --> 57:16.723 year and the delivery is in six months, then this should be 57:16.723 --> 57:19.033 .025--half of a year. 57:19.030 --> 57:22.070 I want to--it's not annual interest rate; 57:22.070 --> 57:24.320 it's the interest rate until delivery. 57:24.320 --> 57:28.160 If it's a third of a year, you divide by whatever 57:28.155 --> 57:32.625 the--it's the interest from today until delivery date. 57:32.630 --> 57:37.520 S is the cost of storage from today until the delivery 57:37.519 --> 57:42.969 date. This should hold normally all 57:42.967 --> 57:47.337 the time and why is that? 57:47.340 --> 57:51.580 Because if I'm running a warehouse storing grain, 57:51.579 --> 57:56.789 I can either sell at the spot price or I I can always unload 57:56.790 --> 58:02.180 my warehouse and sell it today or I can wait and deliver it in 58:02.178 --> 58:05.798 the future at the futures contract. 58:05.800 --> 58:10.970 Today, as a warehouse, I'm losing money because of the 58:10.973 --> 58:14.843 cost of storage. I have to pay insurance and I 58:14.841 --> 58:18.771 have to do other things that maintain the quality of my 58:18.772 --> 58:21.032 storage and that's S. 58:21.030 --> 58:24.130 On top of that, I'm losing on interest because 58:24.134 --> 58:28.004 if I'm storing the grain, I'm not getting interest on the 58:27.997 --> 58:30.547 money that I paid for that grain; 58:30.550 --> 58:32.800 that's another loss to me. 58:32.800 --> 58:36.480 So, this is the break even for storing grain. 58:36.480 --> 58:40.670 If the futures price is enough above the spot price that it 58:40.674 --> 58:43.934 pays for my interest cost and my storage cost, 58:43.928 --> 58:46.458 I'm making money storing grain. 58:46.460 --> 58:52.000 If the futures price is below this, I'm not going to store 58:52.002 --> 58:54.062 grain; I'll unload my warehouse. 58:54.059 --> 58:56.159 Why should I store grain for another minute? 58:56.159 --> 59:00.549 If I'm a professional warehouse offer and I see that I can make 59:00.546 --> 59:04.646 more money by selling my grain today, then I will do it. 59:04.650 --> 59:09.700 Conversely, if the futures price is above the spot price, 59:09.695 --> 59:13.745 then I'm going to want to store more grain. 59:13.750 --> 59:17.220 I'm going to go out and buy up other grain and that's going to 59:17.223 --> 59:19.163 tend to force the spot price up. 59:19.159 --> 59:23.589 So, this relationship tends to hold almost all the time or you 59:23.594 --> 59:28.324 might say it holds all the time, if you interpret it correctly. 59:28.320 --> 59:32.880 Normally, the futures price is above the cash price because 59:32.880 --> 59:37.680 interest rates are positive and storage costs are positive and 59:37.675 --> 59:39.715 it has to be that way. 59:39.719 --> 59:44.949 The normal course of grain prices over the harvest year is 59:44.945 --> 59:47.965 to rise as the year progresses. 59:47.970 --> 59:52.800 It has to be that way; the grain is cheapest right 59:52.800 --> 59:58.090 after the harvest when there's lots of grain around and then 59:58.089 --> 1:00:03.559 the grain price goes up steadily throughout the year until the 1:00:03.557 --> 1:00:07.857 new harvest comes in and then it collapses. 1:00:07.860 --> 1:00:15.890 The price of grain over the year is a sawtooth pattern. 1:00:15.889 --> 1:00:27.689 If there's nothing interfering with it, the price of grain will 1:00:27.691 --> 1:00:37.591 tend to look like this and these are the harvests. 1:00:37.590 --> 1:00:42.240 The reason the price of grain is going up between harvests is 1:00:42.235 --> 1:00:45.095 to compensate the warehouse owners. 1:00:45.099 --> 1:00:47.849 They're not going to do this business if they're not getting 1:00:47.849 --> 1:00:50.179 compensated, so this is almost like an iron law. 1:00:50.179 --> 1:00:53.879 This is going to hold, but it doesn't necessarily hold 1:00:53.881 --> 1:00:57.861 in a given year because there are other things that affect 1:00:57.861 --> 1:01:01.131 price. This is what I was saying--that 1:01:01.130 --> 1:01:03.700 arbitrage enforces fair value. 1:01:03.699 --> 1:01:08.219 There is a problem if there is no grain in storage. 1:01:08.219 --> 1:01:10.939 For example, right at the harvest end when 1:01:10.943 --> 1:01:14.463 the harvest is coming in, the relation between futures 1:01:14.463 --> 1:01:17.323 and spot price can become very erratic. 1:01:17.320 --> 1:01:21.240 The futures price can be way below the fair value; 1:01:21.239 --> 1:01:23.749 the right hand side--spot times one plus R plus 1:01:23.754 --> 1:01:25.324 S--is called fair value. 1:01:25.320 --> 1:01:30.930 Futures can be below fair value and there's no way for arbitrage 1:01:30.929 --> 1:01:35.919 to make up the difference because there's nothing--if the 1:01:35.915 --> 1:01:40.905 futures were very low, you would want to take money 1:01:40.907 --> 1:01:46.257 out of--take grain out of storage and sell it on the spot 1:01:46.263 --> 1:01:48.323 market. If there is no grain in 1:01:48.315 --> 1:01:49.645 storage, you can't do that. 1:01:49.650 --> 1:01:54.660 It sometimes happens when the grain is not in storage that the 1:01:54.660 --> 1:01:58.110 price of the future is below fair value. 1:01:58.110 --> 1:02:00.310 There's another interpretation of it. 1:02:00.309 --> 1:02:02.969 People would say, well but there is still some 1:02:02.969 --> 1:02:05.629 grain in storage--it's not gone everywhere. 1:02:05.630 --> 1:02:10.290 So, how can it sometimes be that the futures price is below 1:02:10.294 --> 1:02:14.044 fair value? Well, you might say--and this 1:02:14.042 --> 1:02:19.632 is that--you could either say that sometimes the relationship 1:02:19.634 --> 1:02:25.324 between price and fair value is violated or you could say, 1:02:25.320 --> 1:02:29.280 no it's never violated, but sometimes the storage cost 1:02:29.275 --> 1:02:33.025 is negative. So, we have something called a 1:02:33.034 --> 1:02:37.114 convenience yield, which is a negative storage 1:02:37.106 --> 1:02:40.616 cost. Suppose you are a corn merchant 1:02:40.624 --> 1:02:44.954 and you're noting that right now the market is in 1:02:44.951 --> 1:02:50.721 backwardation--the futures price is less than the spot price. 1:02:50.719 --> 1:02:55.459 So, you're thinking, I want to get grain somehow and 1:02:55.457 --> 1:03:00.007 sell it on the spot market and I'll make money. 1:03:00.010 --> 1:03:04.000 You go around trying to find someone to sell you grain and 1:03:04.004 --> 1:03:08.214 you find that someone has it and won't sell it to you and you 1:03:08.208 --> 1:03:09.748 say, well why not? 1:03:09.750 --> 1:03:13.440 The guy will say, because I need this grain. 1:03:13.440 --> 1:03:16.570 Who has grain when the market is in backwardation? 1:03:16.570 --> 1:03:19.060 It's somebody who really needs it. 1:03:19.059 --> 1:03:22.119 For example, in the case of wheat, 1:03:22.120 --> 1:03:27.690 you might find that you go to the factory that makes Wheaties 1:03:27.685 --> 1:03:31.885 and you say, I'd like to buy your 1:03:31.887 --> 1:03:38.677 wheat--noting that the spot price is really high. 1:03:38.680 --> 1:03:40.830 You won't tell him that; you say, I just want to buy 1:03:40.829 --> 1:03:44.159 your wheat. Whatever you've got, 1:03:44.164 --> 1:03:51.474 I'll buy it at the--you shouldn't put it that way. 1:03:51.469 --> 1:03:55.939 I guess I'm saying that it's not going to work if you do--why 1:03:55.937 --> 1:03:59.657 doesn't the Wheaties manufacturer sell its grain on 1:03:59.660 --> 1:04:03.600 the spot market? The reason is that they need 1:04:03.599 --> 1:04:08.849 wheat to make Wheaties and so for them they want to have some 1:04:08.847 --> 1:04:10.777 on hand. They might think, 1:04:10.776 --> 1:04:14.016 well if we didn't have any storage of wheat we would be at 1:04:14.015 --> 1:04:17.365 the mercy of delivery and who knows when--the harvest is out 1:04:17.368 --> 1:04:19.378 now, we might not be able to get any 1:04:19.378 --> 1:04:22.278 wheat and we may have to shut our whole factory down and tell 1:04:22.279 --> 1:04:23.729 everyone to take a day off. 1:04:23.730 --> 1:04:28.150 That costs us a lot of money, so we really need to have wheat 1:04:28.146 --> 1:04:30.866 in storage at the Wheaties factory. 1:04:30.869 --> 1:04:35.049 When the market is in backwardation, 1:04:35.054 --> 1:04:41.874 the only grain that's stored is the grain that's there for 1:04:41.870 --> 1:04:44.740 convenience purpose. 1:04:44.739 --> 1:04:49.059 I'm just going to go through the example that Holbrook 1:04:49.059 --> 1:04:52.889 Working gives in his reading, which you have. 1:04:52.889 --> 1:04:57.319 Back then, there was a number two hard winter wheat Kansas 1:04:57.321 --> 1:05:00.121 City future--maybe there still is; 1:05:00.120 --> 1:05:02.000 I don't know, but not at CBOT. 1:05:02.000 --> 1:05:10.020 We're going to do this 1956 or 1957 story--I have it here. 1:05:10.019 --> 1:05:13.459 Hard wheat is used for bread, soft wheat for--remember, 1:05:13.461 --> 1:05:14.801 this a cooking tip. 1:05:14.800 --> 1:05:20.520 You can buy bread flour at the grocery store and you can buy 1:05:20.524 --> 1:05:23.924 cake flour and they're different. 1:05:23.920 --> 1:05:28.830 Holbrook Working is just talking about what happens in a 1:05:28.834 --> 1:05:32.144 typical year for hard winter wheat. 1:05:32.139 --> 1:05:38.529 So, we're starting out now with July 2, typical year, 1:05:38.528 --> 1:05:44.468 spot wheat was $2.29 a bushel; that's the price on July 2. 1:05:44.469 --> 1:05:49.239 The September future is $2.32 a bushel, so the difference 1:05:49.238 --> 1:05:53.578 between the future and the spot is called the basis, 1:05:53.580 --> 1:05:55.880 which is $.03 a bushel. 1:05:55.880 --> 1:05:59.870 Another term is spot premium, but that would be minus $.03, 1:05:59.870 --> 1:06:02.760 but that's--let's just talk about basis. 1:06:02.760 --> 1:06:06.670 The basis is the futures price minus the spot price. 1:06:06.670 --> 1:06:11.600 This is just a typical story. 1:06:11.599 --> 1:06:13.959 So, the futures price is selling for higher, 1:06:13.959 --> 1:06:16.149 as it should be, because between July and 1:06:16.154 --> 1:06:18.134 September, this is winter wheat. 1:06:18.130 --> 1:06:21.990 The harvest is recently in; the harvest came in in May and 1:06:21.987 --> 1:06:26.327 so this is when there's a lot in storage and we really should see 1:06:26.333 --> 1:06:30.343 the futures price above the spot price and indeed we do. 1:06:30.340 --> 1:06:36.340 This spot premium is the profit that is offered to the 1:06:36.338 --> 1:06:39.088 warehouser. The warehouser looks at 1:06:39.087 --> 1:06:41.747 this--or the basis--the warehouser--people in the 1:06:41.753 --> 1:06:44.863 warehouse business are always watching this every day and 1:06:44.863 --> 1:06:47.753 they're looking always at a basis of $.03 and they're 1:06:47.751 --> 1:06:49.921 thinking, are we going to make money on 1:06:49.916 --> 1:06:51.276 that, because they have costs. 1:06:51.280 --> 1:06:54.940 But, this is how much more they can sell it in the future than 1:06:54.940 --> 1:06:58.120 they can sell it today, so they're comparing the basis 1:06:58.119 --> 1:07:00.689 with their costs; they do that all the time in 1:07:00.688 --> 1:07:01.808 the warehouse business. 1:07:01.809 --> 1:07:04.579 Now, September 4--now it's still--remember, 1:07:04.579 --> 1:07:07.279 the harvest was May; we're not anywhere near the 1:07:07.275 --> 1:07:10.275 harvest. Now, we still have a basis, 1:07:10.277 --> 1:07:13.917 but now the basis has gotten smaller; 1:07:13.920 --> 1:07:15.310 this is what happens. 1:07:15.309 --> 1:07:18.869 So, the warehouse operator is starting to feel uncomfortable. 1:07:18.869 --> 1:07:22.269 I was doing really well in July--I had a basis of 3. 1:07:22.269 --> 1:07:26.079 Now the basis is down to 1, so it's getting kind of iffy 1:07:26.083 --> 1:07:28.513 for me--whether I can make money. 1:07:28.510 --> 1:07:29.820 Maybe I should sell. 1:07:29.820 --> 1:07:33.790 So, they're always watching these markets and thinking about 1:07:33.789 --> 1:07:34.259 that. 1:07:34.260 --> 1:07:38.590 1:07:38.590 --> 1:07:42.250 I'm sorry, I take that back; I forgot, this is both the 1:07:42.247 --> 1:07:43.427 September future. 1:07:43.429 --> 1:07:47.869 So, the basis should get smaller because we're getting 1:07:47.871 --> 1:07:52.901 closer to the expiration date because now it's only one-month 1:07:52.900 --> 1:07:56.240 interest. Well actually, it's even less; 1:07:56.240 --> 1:07:59.530 we're almost expiring; I wasn't thinking when I first 1:07:59.525 --> 1:08:02.885 saw that. The basis should shrink to zero 1:08:02.885 --> 1:08:08.225 as the time--as you approach the expiration of the contract. 1:08:08.230 --> 1:08:13.000 Someone in a warehouse who's worried about the fluctuation in 1:08:13.002 --> 1:08:17.702 the grain will sell it in the futures market and then expect 1:08:17.695 --> 1:08:22.385 to get the basis because it doesn't matter what the price of 1:08:22.387 --> 1:08:25.777 grain does; the spot and the futures price 1:08:25.776 --> 1:08:29.136 should converge. The basis should go to zero and 1:08:29.143 --> 1:08:33.433 the $.03 a bushel is the profit that they make on the futures 1:08:33.427 --> 1:08:36.437 trade. It's riskless for them at the 1:08:36.439 --> 1:08:41.009 warehouse because they're hedging the price risk and then 1:08:41.013 --> 1:08:44.693 it becomes a nice clean and easy business. 1:08:44.689 --> 1:08:48.709 So, I'm looking in July 2 to see what are my costs at the 1:08:48.708 --> 1:08:51.738 warehouse. I'm looking at this basis and I 1:08:51.736 --> 1:08:55.226 think if I can keep my costs under $.03 a bushel, 1:08:55.229 --> 1:08:59.109 including interest, then I will make money because 1:08:59.114 --> 1:09:03.794 this basis is converging to zero at the end for sure--or the 1:09:03.791 --> 1:09:08.471 stock premium will go from minus 3 to 0--so this is a normal 1:09:08.468 --> 1:09:11.178 month. Some months storing grain had 1:09:11.183 --> 1:09:14.713 this basis of $.03 a bushel and is doing business as usual, 1:09:14.711 --> 1:09:17.571 storing for less than that and making money. 1:09:17.569 --> 1:09:19.949 If not less than that, then get out of it. 1:09:19.949 --> 1:09:26.369 Then, continuing through the year--now they roll into 1:09:26.366 --> 1:09:32.656 December futures because I'm still storing grain; 1:09:32.660 --> 1:09:34.220 I do this all year. 1:09:34.220 --> 1:09:38.020 I'm trading in the nearest month contract because that's 1:09:38.024 --> 1:09:42.524 where the open interest is and that's where all the trading is. 1:09:42.520 --> 1:09:46.700 So, as soon the September contract expires, 1:09:46.698 --> 1:09:50.178 I don't actually want to deliver. 1:09:50.180 --> 1:09:53.840 I'll sell out and I'll make the profit, which is the change in 1:09:53.840 --> 1:09:56.320 basis. Now, when it comes to--now, 1:09:56.324 --> 1:09:59.524 September 4, I've made that profit of $.02 a 1:09:59.517 --> 1:10:02.287 bushel. The difference between the $.03 1:10:02.293 --> 1:10:06.233 a bushel basis and the $.01 and now I start a new contract. 1:10:06.229 --> 1:10:09.879 Now, because September is expiring, I move in. 1:10:09.880 --> 1:10:13.900 I roll over into the December contract and I'm just going to 1:10:13.897 --> 1:10:15.597 do this every contract. 1:10:15.600 --> 1:10:19.030 Every three months I'm going to roll over into the next 1:10:19.031 --> 1:10:22.381 contract. In this case--I didn't put the 1:10:22.381 --> 1:10:26.111 basis; the basis was $.0575 a bushel. 1:10:26.109 --> 1:10:28.889 So now, it's looking even better here in September. 1:10:28.890 --> 1:10:31.880 I mean, it jumps around; the basis jumps around with 1:10:31.883 --> 1:10:34.363 market conditions, but it's looking good now 1:10:34.358 --> 1:10:36.428 because I have a basis of $.0575. 1:10:36.430 --> 1:10:42.700 So, I'll sell my grain again on a futures contract and then I 1:10:42.700 --> 1:10:49.180 will close it out December when the--this is December 1 now. 1:10:49.180 --> 1:10:53.990 Now the price of wheat has gone up a lot from $2.38 to $2.52, 1:10:53.990 --> 1:10:58.000 but you know it's not going to be profit for me. 1:10:58.000 --> 1:11:01.570 I'm not--I hedged it, but I'll make the--for me, 1:11:01.569 --> 1:11:05.139 the profit is the change in the spot premium. 1:11:05.140 --> 1:11:08.300 So, I made $.0575 a bushel minus my costs. 1:11:08.300 --> 1:11:11.690 I'll just stop; I know I'm running out of time. 1:11:11.690 --> 1:11:13.370 What happens at harvest? 1:11:13.370 --> 1:11:15.110 I'm doing this all year. 1:11:15.109 --> 1:11:19.299 Finally on May--this is--the new harvest is coming in and 1:11:19.295 --> 1:11:24.265 look what happens; now this market is suddenly in 1:11:24.270 --> 1:11:28.050 backwardation. Now, look what's happening; 1:11:28.050 --> 1:11:30.480 the spot premium is $.18 a bushel; 1:11:30.480 --> 1:11:32.590 the basis is minus 18. 1:11:32.590 --> 1:11:36.520 If I hold on--if I rolled into July futures and hold on, 1:11:36.521 --> 1:11:40.811 I'm going to lose really big time, so I'm out--I'm out of the 1:11:40.810 --> 1:11:43.370 business. We sell off everything in the 1:11:43.369 --> 1:11:44.829 warehouse and we're done. 1:11:44.829 --> 1:11:49.539 This is the process by which warehousing is optimized and we 1:11:49.537 --> 1:11:52.567 get grain smoothly through the year, 1:11:52.569 --> 1:11:56.729 but it's the basic principle that we'll see in the next 1:11:56.733 --> 1:12:00.663 lecture--extends as well to other kinds of financial 1:12:00.664 --> 1:12:02.704 futures. Next period, 1:12:02.699 --> 1:12:07.139 we're going to talk about other kinds of futures, 1:12:07.135 --> 1:12:09.995 including financial futures.