Lecture 19: Forwards & Futures
First Futures Market: Osaka
• Begun at Dojima, Osaka, Japan, in 1670s. World’s
only futures market until 1860s.
• Dojima was center for rice trade, with 91 rice
warehouses in 1673.
• Dojima futures exchange had precise definitions
of quality, delivery date and place, experts who
evaluated rice quality, and clearinghouses for
contracts.
• Trading floor, daily resettlement, burning fuse,
and watermen
Function of Osaka Futures
Market
• Japan had sophisticated financial contracts
before the futures market, partly under
influence of Dutch.
• Rice bills and silver bills were kinds of
forward contracts.
• Osaka market provided liquidity and price
discovery for rice, allows merchants to
hedge.
Issues for Rice Warehouser
• Warehousing itself is a stable business, little
risk
• Great risk in fluctuation in rice price
• Warehouser may seek to sell the rice
forward and lock in initial price. But, a
forward contract is illiquid, difficult
Forward Contract
• Forward is just a contract to deliver at a future
date (exercise date or maturity date) at a specified
exercise price.
• Example: Rice farmer sells rice to warehouser.
• Example: Foreign Exchange (FX) forward.
Contract to sell £ for ¥.
• Both sides are locked into the contract, no
liquidity.
• What will warehouse think if rice farmer tries to
get out of the contract?
Problem with Forwards: Default
• Farmer and warehouser must check each
others’ creditworthiness
• Forward contracts are inherently credit
instruments.
• Only people with good credit can use them.
FX Forwards and Forward
Interest Parity
• FX Forward is like a pair of zero coupon
bonds.
• Therefore, forward rate reflects interest
rates in the two currencies
• Forward Interest Parity:
forward exchange rate (Y/$) 
spot exchange rate (Y/$) 
1  rY
1  r$
Forward Rate Agreements
•
•
•
•
•
•
Promises interest rate on future loan.
L=actual interest rate on contract date
R=contract rate
D=days in contract period
A=contract amount
B=360 or 365 days
( L  R)  D  A
Settlement 
( B 100)  L  D
Futures Contracts
• Futures contracts differ from forward
contracts in that contractors deal with an
exchange rather than each other, and thus do
not need to assess each others’ credit.
• Futures contracts are standardized retail
products, rather than custom products.
• Futures contracts rely on margin calls to
guarantee performance.
Buying or Selling Futures
• When one “buys” a futures contract, one agrees
with the exchange to a daily settlement procedure
that is only loosely analogous to buying the
commodity. One must post initial margin with the
futures commission merchant.
• Usually, one has no intention of taking delivery of
the commodity
• Same as when one “sells” a futures contract, no
intention of selling the commodity. Again, post
margin.
Daily Settlement
• Every day, the exchange defines a price called the
“settle” price, which is essentially the last trade on
that day.
• Every day until expiration a buyer’s margin
account is credited (or debited if negative) with
the amount: change in settle price  contract
amount
• If contract is cash settled, on the last day the
margin account is credited with (cash settle pricelast settle price)contract amount.
• If contract is physical delivery, on last day buyer
must receive commodity
Example: Farmer in Iowa
• Farmer in March is planting crop expected to yield
50,000 bushels of corn. By this business, farmer is
“long” 50,000 bushels. Farmer “sells” ten Chicaco
September corn contracts for $2.335*$50000
=$116,750. Posts margin.
• Corn products manufacturer plans to buy corn at
harvest time, “buys” the ten contracts, posts
margin.
• Come September, both buyer and seller close out
position.
• Changes in margin account mean that price was
effectively locked in at $2.335/bushel for both.
Basis Risk
• Basis risk = risk that Iowa corn prices will not
match Chicago settle prices
• Option of physical delivery in the corn contract
means that arbitrageurs will keep basis risk down.
• Arbitrageurs may load corn in Iowa and ship to
Chicago if Iowa price is below Chicago price.
Arbitrageurs activity means farmers don’t have to
ship to Chicago.
Fair Value in Futures Contract
• r = interest rate
• s = storage cost
• r+s=cost of carry
Pfuture  Pspot (1  r  s )
(See http://www.indexarb.com)
Arbitrage Enforcing Fair Value
• If commodity is in storage, there is a profit
opportunity that will tend to drive to zero
any difference from fair value.
• If commodity is not in storage, then it is
possible that:
Pfuture  Pspot (1  r  s )
Holbrook Working on Futures
• “Futures” term is misleading, “cash” or “spot
transactions sometimes involve deliveries that are
further in the future
• Only a few percent of farmers use futures
• Grain elevators often serve as risk-managing
intermediaries for farmers
• But open interest tends to follow inventories in
commercial storage, not crop growing in the
fields.
• Essence of futures market is standardization, price
discovery, and liquidity
Example of Hard Winter Wheat
(Holbrook Working)
• No. 2 Hard Winter Wheat Kansas City
Wheat Futures
• Plant winter wheat in Fall, harvest in May
• ¾ of US wheat crop is hard.
• Hard wheat is used for bread, soft wheat for
pie crusts, breakfast foods and biscuits
Working’s Example of Wheat in
Storage, Typical Year
• July 2
Spot 229 ¼
Sept future 232 ¼
Spot premium –3
Basis 3
• September 4
Spot 232 ½
Sept future 233 ½
Spot premium –1
Basis 1
Gain of 2 (reflects gain in
premium)
Continuing Working’s Example
• Sept 4
Spot No. 2 232 ½
Dec. Future 238 ¼
Spot Premium –5 3/4
• December 1
252
252
0
Gain of 5 3/4
Just Before May Harvest
• May 1
Spot No. 2 247 ¼
July future 229 ¼
Spot premium +18
• July 1
Spot No. 2 218 1/2
July future 225
Spot premium –6 ½
Loss of 24 1/2
Iowa Electronic Markets
From Agricultural Futures to
Financial Futures
• Financial futures markets began in US in
1970s.
• Same concepts of fair value, hedging, gain
and loss due to change in basis.