Forwards - Financial Markets - Lecture Slides, Slides of Marketing

Download Forwards - Financial Markets - Lecture Slides and more Slides Marketing in PDF only on Docsity! Forwards & Futures docsity.com 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 docsity.com 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? docsity.com 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. docsity.com 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: $1 1(Y/$) rate exchangespot (Y/$) rate exchange forward r rY + + × = docsity.com 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. docsity.com 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 price- last settle price)×contract amount. • If contract is physical delivery, on last day buyer must receive commodity docsity.com 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. docsity.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: )1( srPP spotfuture ++< docsity.com 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 docsity.com 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 docsity.com 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 docsity.com 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. docsity.com