Lecture 20: Stock Index, Oil and
Other Futures Markets
Stock Price Index Futures
• Cash settlement rather than physical
delivery
• Settlement is 250*(Indext-Futurest-1)
F  P  P(r  y )
• Fair value:
F  fair value futures price
P  Stock price index
r  financing cost (interest rate)
y  dividend yield
Lower Trading Costs on Futures
vs. Spot Market for Stock
• Theory of optimal bid-asked spread.
• Even though futures markets are not dealer
markets, there is in effect a bid-asked
spread, and it is narrower than for
individual stocks.
• Less likely to be superior information to
“pick off” dealers in stock index futures
market than in market for individual stocks.
Futures on Individual Stocks
• US ban on futures on individual stocks was fully
lifted in December 2001.
• Trading in futures on individual stocks began at
LIFFE (London International Financial Futures
and Options Exchange) on NQLX LLC January
29, 2001
• US trading began 2002 at OneChicago LLC
(owned jointly by CME, CBOT and CBOE)
• Volume of trade has been very disappointing,
delisting is occurring
Why a Market for Futures on
Individual Stocks?
• In London, traders avoid the UK Stamp Duty
• In US, traders circumvent margin requirements on
stocks. Final demise of margin requirements.
• Principal argument that accounts for US approving
them is that foreign countries are now approving
them, and US does not want to be left out.
Oil Futures
• Crude light sweet oil (New York Mercantile
Exchange) contract size: 1000 barrels, open
interest 431,000 contracts
• Brent crude, North Sea (International
Petroleum Exchange, London) contract size:
1000 barrels, open interest 232,000
contracts
Nature of Oil Storage
• Most stored oil is “moving through the
pipeline” of oil tankers, refiners, distributors
and retailers.
• Estimated oil inventories can be found on
web site www.api.com
Government Oil Reserves
• Strategic Petroleum Reserve (created 1975) in
caverns in Louisiana and Texas – 572 million
barrels, only 60 days supply. Not used to stabilize
prices.
• In 2000, President Clinton established a 2 million
barrel heating oil reserve in New York and New
Haven to help stabilize US heating oil prices. US
consumption of heating oil about 100 million
barrels a year.
• Govt will sell from reserve when price triggers are
hit. Effectiveness?
Nationalizations of Oil
• Mexico 1938
• Iran 1951
• Cause: resentment of foreign control, but
justification was needed.
• “Nationalization” a 19th century word, OED says
1874, socialist connotations.
• “Eminent Domain” is older word, does not seem
to justify such expropriation of oil producing
lands.
OPEC
• Organization of Petroleum Exporting
Countries established 1960 by Iran, Iraq,
Kuwait, Saudi Arabia and Venezuela
• Qatar (1961), Indonesia and Libya (1962),
Abu Dhabi (1967), United Arab Emirates
(1974), Algeria (1969), Nigeria (1971),
Ecuador (1973), and Gabon (1975)
Optimal Extraction of a Natural
Resource
• Problem facing a monopoly oil producer
facing a downward sloping demand curve:
P(Qt , t )  price if Qt is put on market
Max t 0 P(Qt , t )Qt /(1  r )t

subject to
Q  t 0 Qt

Solution of Extraction Problem
with Constant Demand Growth
Suppose P(Qt , t )Qt  c(1  a)t ln( Qt ).
Euler equation is :
1  a t 1
1  a t 1 1
c(
) Qt  c(
) Qt 1
1 r
1 r
1 a t
Qt  Q0 (
) (problem : neg price)
1 r
Subsitute into resource constraint ,
solve,
r a
Q0 
Q
1 r
Fair Value for Oil Futures
• In this example, price rises at less than
interest rate.
• Oil futures is below conventional fair value.
• Optimal strategy for non-OPEC oil
producers?
• Other considerations: extraction costs,
Gold Futures
• Gold miners face same optimal extraction
problem as oil producers
• If there are extraction costs, what is
theoretical quantity of gold held above
ground?
Real Oil Price (West Texas Interm ediate) and Unem ploym ent Rate,
Monthly Jan 1948-Jan 2004
100
90
80
70
60
Real Oil Price
50
Unemployment Rat e
40
30
20
10
0
1940
1950
1960
1970
1980
1990
2000
2010
First Oil Crisis, 1973-4
• Arab countries’ retaliation for US support of
Israel in Yom-Kippur war 1973.
• Triggered sharp recession around world
• 1973-4 is second sharpest stock market
crash in US history. S&P Composite lost
53% of its real value between Dec. 1972
and Dec. 1974. (Only worse two-year
experience was June 1930 to June 1932.)
Second Oil Crisis, 1979-80
• 1979: Iranian revolution, expulsion of the Shah of
Iran, Ayatollah, capture of US Embassy hostages
in Teheran Nov. 1979.
• Iran-Iraq war erupts 1980, disrupts oil supplies.
• US CPI inflation reaches 18%/year in March,
1980.
• The “great recession”of 1981-82 is the worst
recession since Depression of the 1930s.
Collapse of OPEC Cartel, 1986
• After suffering bombing by Iraq, Iran
demands that Iraq be given the same oil
export quota as everyone else.
• Other arguments about the disproportionate
share of some OPEC states.
Persian Gulf War, 1990-1991
• August 2, 1990, Surprise invasion of Kuwait by
Iraq
• UN Security Council deadline for Iraq to
withdraw by January 15 1991.
• January 16, 1991 Air bombardment of Iraq and its
Kuwaiti positions begins.
• February 24, 1991 Allied ground invasion begins.
• War is over February 26, 1991.
• Brief interruption of oil supplies mark recession:
NBER dates July 1990-March 1991.
Oil Price Collapse 1997
• Nov. 1997 OPEC Meeting, the “disaster in
Jakarta” involved bitter disputes among
OPEC nations about market share
• Fuming about widespread cheating in
limiting exports to quotas
• Asian financial crisis dropped demand for
oil
Oil Price Spike 1999
• OPEC resolve to stop cheating left supplies
shorter than they expected
• Erroneous data led them to underestimate
how fast inventories were dropping.
• Backwardation in oil futures market (futures
price below spot price) began in January
1999.
• OPEC Increased quotas
Oil the Day Hussein Announces
Embargo, April 8, 2002
Natural Gas April 8, 2002
Second Gulf War Oil Spike
• In anticipation of war, oil rises to nearly $36
per barrel February, 2003
• US invaded Iraq, March 19, 2003
• Symbolic end of war: after capture of
Baghdad, crowd topples Hussein stature
April 8, 2003
• Oil falls to $28 per barrel by April, 2003
Federal Funds Futures Market
• Created by CBOT 1988
• Settlement price is 100 minus annualized
federal funds rate, averaged over contract
month.
• Show timing of expected actions of Federal
Open Market Committee.
• One-month-ahead forecast errors typically
in the ten to twenty basis point range.