PROFESSOR ROBERT SHILLER:
OK, good morning. Well, today I want to talk about
what, to me, is a very interesting topic, and that
is futures markets. Not very interesting
to most people. Most people have no idea
what they are. But I think that, well, futures
markets, what we're really talking about is -- There are different ways
of viewing it. Futures markets for things like
agricultural commodities, or interest rates, or financial
securities, are markets about the future. They're markets that, in some
sense, predict the future. And future matters, right? We live a life. We have a long horizon. I said before, I think that your
planning horizon must be at least a century, because
you'll probably live that long anyway, with modern medicine. And you care about other
people, too. So, the beauty of futures
markets is that we have prices for the future. We talked already about
forward markets. We talked about forward
interest rates. And that is related to what
we're talking about. Forwards and futures are
similar concepts. Futures is the more
precise concept. Or the more developed concept. And I'll explain the difference
between forwards and futures. But just in a nutshell, futures
markets are organized markets, like the stock
market, that trade standardized contracts,
representing things that will happen at future dates. And because they're standardized, they're worldwide. Everybody looks at them
and uses them. Whereas forward markets are more
specialized markets that, typically, are not as easy
to interpret or as clear. So, futures markets are, in some
sense, more fundamental and important. I have a particular
interest -- I've been interested in futures
markets myself for many years. And wondering, why
they're not even bigger and more important. So, in 1993, I wrote a book
called Macro Markets, about let's make our markets
bigger and more important, and more pervasive. And I've been trying
to do that. Notably, in 2006, I was working
with the Chicago Mercantile Exchange, which
is the biggest futures market in the world. And we created home
price futures. And they've been trading
now for five years. But I'm not really going to talk
about them, because they have so far disappointed. They're not important,
at least not yet. But I'm going to
talk about some important futures markets. First, I want to put just a
couple of definitions up. Futures, that's what we're going
to talk about most in this lecture, and it has a
special meaning in finance. And I was contrasting
that to forwards. But both of these together
are derivatives. And that means that the price in
these markets derives from a price in some other market. There's a primary or underlying
market, which has its own price. And then there's a derivative
market that has a futures price or a forward price. I guess I'm speaking in kind of
abstract terms. Well, let me just start -- I want to give you an example,
and we'll see better what I'm talking about. But let me just first comment
just on this word, derivatives. To people in finance,
derivatives are an exciting development of financial
markets. We start out with a simple
market and we develop derivative markets, that add
more detail and information than was in the underlying
or primary market. That's exciting. I find it exciting. However -- I don't know how often you hear
this word, derivative -- it's become a four-letter
word. It's become an ugly word. Why is that? I think it's, because people
blame the current financial crisis on derivatives, whether
rightly or wrongly. And it's because, I think,
there's a public anger about derivatives that is largely
due to misunderstanding. I mentioned before that I think
that finance tends to attract sociopaths. I mentioned that, I defined
that for you. People who want to manipulate,
and fool, and deceive people. But I don't think the financial
community is particularly populated
by sociopaths. You might think so, reading
some accounts. But I think, it's not true. And I think, it's not true,
because the financial community knows about
this problem and ejects such people. They get caught. And you can't make a career in
finance if you're a sociopath. So, if you think you have this
problem, that you have sociopathic tendencies, I would
advise you not to go into finance, because you will
get caught and ejected. So, save yourself the trouble. Don't go into finance. Pick some field where you
can't hurt anybody. And that would be a smart
thing to do, if you have such a problem. So, I think we need to regulate
derivatives markets, and that's what I'm
talking about. And we need self-regulation of
the markets themselves, but we need government regulation
as well. But there's nothing evil
about derivatives. And in fact, derivatives are
fundamental to the way I think a modern economy works. So, I had you read
an article -- I put it on an earlier section
of the reading list -- by Charles Conant, who wrote
a book in 1904 called Wall Street and the Country. And you should have
read that by how. He starts out by saying, it's
just amazing, how public opinion thinks that speculation
is evil. And they don't understand that
speculation is just business. I mean, business decisions
involve guesses about the future. And so, when you have
well-developed markets, these guesses become market prices. And so, the prices go into
the calculations that everyone makes. And the calculations are
just done better. Somehow, there's just a failure
for most people to understand it. And I'm hoping in this lecture
to try to give some more understanding of
these markets. I think they're fascinating. Most people apparently don't,
because you don't hear them brought up very much. I want to just say a little
bit more about hostility toward derivative markets
and futures markets, and speculation in general. In 1991, that was 20 years
ago, I wrote a joint paper with a -- I don't remember whether
I mentioned this, probably not -- with a Russian, a young man from
Russia that I met when I was visiting the Soviet Union,
just before the end of the Soviet Union. And we were talking about how
antagonistic Russians are toward capitalism. And he said, this is
a big problem. Russia just can't embrace
capitalism. These people hate it. They hate the profit makers
and the financiers. And I said to him, well, you
know, it's the same in the U.S. How do you know it's
any worse in Russia? And so, we decided to do
a questionnaire survey. And I was going to read one of
the questions, comparing people in Moscow and people in
New York, to see, which one understands capitalism better. So, one of the questions that
we had was the following -- We wrote these questions and
translated them into Russian. And we tried to make them
exactly the same questions between Russian and English. So, here's the question we asked
in both cities: ''Grain traders in capitalist countries
sometimes hold grain without selling it, putting
it in temporary storage in anticipation of higher
prices later. Do you think this speculation
will cause more frequent shortages of flour, bread and
other grain products? Or will it cause such shortages
to become rarer?'' What do you think,
people said? Does the process of speculating
in grain cause problems or solve problems? Well, we found that, in the
USA, 66% said it will make shortages more common. But in the Soviet Union, in
Moscow, only 45% thought it would make shortages
more common. Both of them were wrong. A lot of them were wrong, but
the Russians were better, closer to the truth than
the Americans. Living in the financial capital
of the USA, most people think that speculating in
grain creates problems. But wait a minute, what is
speculation in grain? That means holding it off,
expecting higher prices later, right? Isn't that what you have
to do if you are managing a grain market? Now, think of it this way
-- and I'm coming now to agricultural futures. In the simplest world,
there's one harvest of wheat every year. And that harvest comes in a
certain time of the year, every year. Once a year. And it has to be held in storage
over the year, right? Because people don't
eat it all at once. You eat it over the
whole year. So, somebody is storing grain. This is a fundamental problem. That's a business. So, you have to know that
somewhere there's some warehouse holding the grain that
you will be consuming in six months time. And that warehouse
is run by some professionals who do that. If they think prices are higher
later, they'll keep it longer in the warehouse. And what does that do? That evens out the price. It doesn't make it worse. If they think there's going to
be a shortage of grain, they hold it back now and the
price of grain goes up. And so, everyone starts
consuming a little less because of the higher price, and
it smoothes things out and it works better. And this is elementary
economics, but it's not understood, I think,
by most people. And the futures markets are
just sophisticated markets that help that process. So, I'm going to start with
agricultural futures in talking about this. And I want to start also with
a very homely -- it's not homely -- it's a very elementary
example, because it's the first futures market. So, where do you think futures
markets started? You would think, it started in
New York, or Chicago, or London, or Paris. It actually started in Japan
in a place called Dojima, which is in the city of Osaka. And they started in the 1600s. So, let's go back. If we can go back to the year
1673, in Osaka in Japan. Japan was heavily dependent
on rice. And the rice farmers would farm
all over Japan, but there was a rice market in Dojima,
which was the national rice market. And I have data here. According to a study, there
were 91 rice warehouses in Dojima in 1673. That's a long time
ago, isn't it? So, it was a big storage place
for rice, and they were storing it all year. And people would come, people
who were merchants for rice, and they would come to Dojima
and they would sign contracts to get rice. I live in some town
20 miles from here, I'm a rice merchant. I need a regular supply of
rice from your warehouse. Can you supply it to me? And the guy would give you a
terms, and that would be a forward contract. And this is what was happening
before the futures market. Forward contracts precede
futures contracts. So, do you see what it is? You're a rice merchant. You make a deal. You sign a contract that I
will pay you so much in currency at every month, and
you'll give me so much rice. And you'll deliver it here,
and I'll take it, and I'll sell it in my town. Problems developed in the
forward market that led to the development of a
futures market. And the problem is, one of the
problems is that there's counterparty risk. You are a rice merchant. You make a deal with
a warehouse. That's one person dealing
with one person, right? What if one of the guys
reneges on the deal? So, for example, what if the
price of rice falls? Then you, the merchant, will
say, I'm not going to go back and buy according to this
contract, because it's cheaper now. I'll buy it somewhere else. So, I just don't show up, and
then the warehouse is saying, what happened to our contract? And you're nowhere
to be found. Or if it goes the other way, if
rice goes up, the warehouse might renege. They'd say, we signed this
contract but there's something wrong with it, and we're
not going to honor it. So, it messes up. It is also possible that one of
the two counterparties is just a sociopath or something,
or is an alcoholic, or something is wrong. So, the market doesn't
work well. So, what they invented in
Japan was the first true futures market. And the market worked like
this: There was a trading floor in Dojima. And rice traders would come
there, and there were certain hours of the day, when you
would trade contracts for future delivery. But they were standardized
contracts, mediated by the exchange, so that there
would be no problem with the contract. And then every day, there would
be a trading time, and you could buy and sell contracts
for future delivery. Moreover, they enforced
trading hours. And this is something
that's kind of an interesting invention. They didn't have -- I guess they didn't
have clocks. I don't know what they had. But they had a certain time,
when trading would stop, and they wanted to stop all the
trading at the same time. They didn't want people
dribbling out. They wanted it to be
a good market. So, they would light a fuse, and
it would be a bright light in the middle of the
trading floor. And you'd see the fuse burning
down, and when it burned out, all trading stopped. So, they had trading hours. Moreover, they had a problem
that some of the traders wouldn't stop trading. So, this is something that they
did in Dojima, they had men called watermen, who came
out with buckets of water. And they would throw the buckets
of water on anyone who was still trading. So that worked. It stopped trading. They also had hand signals. This was big. This is big time. You were trading rice
for all of Japan. And you may think the 16- or
1700s are long ago, but a lot of rice was traded and it got
really noisy and difficult. They found that it was so many
people trading on the floor, that you couldn't hear
anyone talk. And there'd be shouting and
it was noisy, and so, they devised a system of
hand signals. And the Dojima hand signals
were, I don't know exactly, but something like this. If your hand was out,
you put your hand out, that means sell. You put your hand this
way, it meant buy. And if you put three fingers
up, it means selling three contracts. That kind of thing. I don't know the whole system,
but that's where it started. That whole concept was copied
all over the world in subsequent centuries. So, what is it that happened? And the other thing is, what
were the contracts that you bought and sold? The problem with the forward
market is that the contracts are all different. One guy made a contract with one
guy, and he said, I want my delivery here. And I don't like this
kind of rice. I want this kind. And you better make sure that
there's not a single insect in it, or I'm going to reject
the whole thing. But that's all different. So, you don't know what -- these contracts, you don't
even know what the price of rice is. If someone said, I paid
so much to get rice in the future -- but you have to say, well,
under what circumstances? And what kind of rice? And where? And what are the terms
for possible failure? You know, there's so many terms
in the contract, so you don't even know what the
price of rice is. But at the futures market, they standardized the contract. So, it may not be exactly
what you want, but it's standardized. So, you deliver rice -- I don't know all the details
of Dojima, but I'm talking about futures markets,
as they evolve. In a modern futures market,
agricultural futures market, you deliver your -- the contract is to deliver some
commodity like rice at a specified future date, at a
specified future warehouse, which would be run
by the exchange. And there's inspectors
at the warehouse who are expert on grain. And they verify, because
they know rice. They know it really well. And they know that some
rice has bugs in it. They know how to find out. They have a standard. Of course, there can always be
some bugs in it, but they have a standard and they have
a way of measuring, and they get it right. And so, all those contracts
are exactly the same. And so, they become the price. It turns out, funny thing, the
futures market almost becomes the real market, because they're
all standardized. The futures price -- You know where it's delivered. You know what's delivered,
exactly. The futures market becomes
the market, in a sense. The fact that it's in the future
is, in effect, a help, because since it's a comfortable
time in the future, it's well defined. Whereas the spot market -- the spot market is the market
for rice, or whatever it is, today as it's traded. The spot market is
inscrutable. It's hard to understand. So, let's think about a farmer
today, who grows rice, or wheat, or soybeans,
or something. If you drive through farming
countries, listen to the radio, regularly they'll
give prices. Soybeans, wheat, rice,
et cetera. Why do they give that? Because farmers care. They're raising this stuff. It's their whole livelihood,
whether they make a profit or not, depends on it. What prices do they quote? They quote the futures
prices, even though they're in the future. But they quote them, because
they mean something and they're standardized. So, that's why the
futures market becomes the central market. I want to just say something
about futures -- Japan started the futures
markets in the 1600s, and they were the world leader in rice
futures until 1939. And then, at World War II, the
Japanese government shut the futures market down. And to this day since,
there is no rice futures market in Japan. Believe it or not. The inventors, they're talking
now of starting it up again. Where do they trade
rice futures? Well, the USA is the main
market, even though you don't think of the U.S. as
a market for rice. But the point is, that markets
have to be centralized. And that people want the
centralized market, and if it happens to be in Chicago,
so be it. So, it becomes a huge
international rice market. And so, I looked up -- this is called Rough Rice
Futures, and this is the futures curve as
of last Friday [addition: March 18, 2011]. So, what we have is different
delivery months. This is May of this year. And then, there's other delivery
months, and then there's next year. It goes out about a year,
different delivery dates. And this is cents
per 100 weight. 100 weight is 100
pounds of rice. And since this is USA, we mean
100 U.S. pounds of rice. But anyone in the world can
figure this out and trade in this market. And it's in dollars, because
it's what we're trading in the USA. So, someone in Japan, who wants
to trade in the futures market, has to come to the USA,
change their yen into dollars, and do this. Now, you see that the futures
price is going up. This was all quoted
last Friday [addition: March 18, 2011]. This is the market, essentially,
right now. But you see, it's a futures
market, because it's giving prices of rice at dates
in the future. These prices way out here,
next year, are not so reliable, because there's
not much trade. The trade tends to dominate
at the front months. So, here's where most
of the trade is. They're trading May, and
maybe this is July. I forgot exactly. Is that clear, what
this means? It's going up. And it's going up pretty
fast, isn't it? From about less than
$0.13 to $0.15. What this means is that, in
effect, the market is expecting huge increases
in the price of rice. So, that's interesting. Anyone who's doing business in
rice looks at this and says, look, there's price increases
anticipated. Now, I just want to talk about
the world at this point in history, and try to interpret
this curve. You must have heard that there
is a food shortage in the world developing. And it's a source of crisis. It's developing in
the Middle East. One reason why that's been given
for the revolutions that have happened in the
Middle East are, that people are hungry. There's dissatisfaction when
the price of food goes up. A lot of people are living much
more at the margin than you'd imagine. So, this increase in rice
prices matters a lot. So, it's very interesting that
it's showing this steep increase in the price of rice. But the first thing you want to
think of as a financier is how much is this going up? I didn't actually do
the calculation. It goes up from 14 -- under 13.75 to 15.5. That's quite an increase
in six months, right? So, it sounds like there's a
profit opportunity here. Buy rice today and sell it
on the futures market. This is a good time
to sell it. I'll sell it in 2012. And that's my futures profit. I can lock in this price today,
because that's what the futures market does. The contract is a contract to
deliver rice as of that future date, and this would
be in Chicago, OK? And so, I could make a profit. This is a very professional
market with real expertise. You talk to the rice traders
or the wheat traders, they know what they're doing. Believe me, they know
what they're doing. We're looking at this
for the first time. People who trade this
all their lives -- And if you ask, why is it? Look how much it's going up,
this is a big profit opportunity. They'll tell you,
why it isn't. Why it isn't such an opportunity
as you think. There must be some reason, why
I can't make huge money by trading in rice, because
otherwise other people would do it. This is such a liquid
market, open to everybody in the world. So, somebody's going to take
advantage of this. You understand, this is futures
prices quoted as of a single date, for various
horizons in the future. Don't get confused by it. This is not a plot
through time. This is now. This is what's quoted now. And so, when you have an upward
slope in futures curve like that, we call
that contango. And that is what we usually see,
maybe not upward sloping so much as this. The opposite is called
backwardation, if futures prices are declining
through time. That happens, and I'll show
you that in a minute. But it's not happening
in rice. So, not happening now in rice. It must be that there's
something that prevents you from just making a killing by
buying rice and selling it on the futures market. Do you understand,
this is riskless? If I sign a contract to sell
rice in Chicago on the futures market, that is riskless
[addition: only if I own the underlying commodity]. And so, why don't
I just do that? I think that there
must be some -- in some level, there must be
some storage cost problem. In order to actually do this,
you'd have to buy the rice and store it for six months. And I'm thinking, that
must explain it. It must be that at this point in
time, storage costs are, in some sense, too high for this
to be a real profit opportunity. So, this is what happens
now in the real world. There are people
who store rice. There has to be, right? I think, rice comes in more
than one harvest, because there's different kinds, but
there's no more than a few harvests in the year. And some of them are
bigger than others. And so, it's got to be stored. And this really, really matters,
because if it's not stored, some people are going
to starve to death. So, it really matters. And you have professional
warehouse operators, who -- they sure do know what
this curve says. And they're thinking, right now,
I'm sure lots of people looked at this curve yesterday,
and they thought, look at that contango, wow. I'm going to see if I can get
some other warehouse. Can I get another one? There's an empty building on
the south side of Chicago, maybe I can fill it
up with rice. And so, I have to look up, and I
have to get inspections, and sanity checks -- sanitation checks. And think about insurance. And they're thinking
about that. But, you know, they find out
that it's not going to work, and they're trying. This generates, when you have
a lot of contango on the market, it generates
enthusiastic efforts by smart people to try to store
more rice. And you see, what
that's doing. It's helping prevent a famine. And this goes back to -- I know, I'm putting it
in dramatic terms -- but this goes back to Adam
Smith, who in his Wealth of Nations in 1776, has a famous
passage, which I can't quote exactly, but it was something to
the effect that, you know, there's a lot of people who
express benevolent impulses. They give to charity. They go to church regularly, and
they talk about ''love thy neighbor.'' But they're not
doing a single thing to prevent the next famine. They're not thinking about it. The people who are really
effective are these quiet guys dealing in the markets. And they see a contango, and
they see something coming. And so, they get in the
business of storing. And it's purely out of self
interest. So, the famous quote that is quoted a million times
from Adam Smith is, these people operating in their own
self interest seem to be more important in promoting human
welfare than all the benevolent people combined. I'm quoting him roughly. Well, there has to be an element
of truth to that. You know, people who do these
storages of grains do not get much respect. And at dinner conversations,
nobody cares what they do. They're really good at
what they do, and they know this market. And, you know, they're
not saints, either. They're speculators. They're trying to
make a profit. Now, one thing I wanted to say
about futures also, which I didn't really clearly -- in forward markets, which are
markets between a pair of counterparties, there's always
counterparty risk. I'll write that. That means, you've
got a contract. You had a lawyer. A lawyer wrote up the terms.
You can take this guy to bankruptcy court or something,
but that's all a nuisance and it costs money. You never know. Futures markets get rid of
counterparty risk, or essentially get rid of it. And how do they do that? The system is a standardized
retail market that anyone can play in, but you have
to post margin -- and that's the idea,
margin, when you either buy or sell futures. OK, so this is what happened. This is what a futures
contract looks like. You can do this. I don't know what would happen,
if you called up a broker at your age, but
essentially you can do this. I know, Jeremy Siegel, my
friend, said, he would actually lend money to
students and let them play the markets. His own money. I have never done that, so
don't ask me to do that. But you can basically call
up a broker and say, I'm interested in rice futures. It sounds like fun to me. I'd like to play that game. So, the broker would
say, fine, I'll open a margin account. How much money are you
going to put in? All right. The first question is, money. He doesn't know who you
are, but money talks. So, you say, all right -- you have to come up with
some money to do this. Let's say, I'll put in
$5,000 into a futures account at your brokerage. And he would then say, OK. Now, you have $5,000. And the margin requirement for
rice futures, I don't remember what it is, say it's something
like 3% or 5%. You can buy or sell up to the
limits imposed by your margin. Your margin has to be whatever
percent of the contract that you sign. You're only putting up $5,000,
I'll let you buy and sell $100,000 worth of rice. So, this would happen. You say, OK, I want to buy -- what do I want? What do I want to do? I'm going to store rice, and
then I want to sell it. So, I want to sell futures. It doesn't matter, whether
you buy or sell. Either way, you've got
to put up money. Let say, I'm going to do this
rice storage business. I can do it. It's open to anybody
in the world. I can find a warehouse. I can buy some rice. I can store it. And I can sell it
at that price. So, I want to sell futures. I can sell $100,000, even
though I've only got $5,000 put up. But then, you know
what happens. Every day, they look
at the change -- the futures price is the price
on that contract today, but it's not a price that
you pay today. You would pay it at the end,
effectively, when the contract comes due. Or in the case of selling,
you'd be receiving it. So, if I sell futures for, say,
May of 2012, then I am promising to deliver rice to
the warehouse in Chicago on that date in 2012, and
take the price. OK, but now, the futures price
today is the price that the market has today. Tomorrow, the futures price
will be different. And so, what they have in the
futures markets is daily settlement. And that means that if
I sold futures -- I'm storing rice and
selling futures -- if the price goes down -- I'm sorry, if the
price goes up -- it works against me,
because I've locked in the lower price. So, the broker debits my margin
account by the daily -- every day they change
my margin account. So, if I've sold futures and the
price goes up, they take it out of my margin account. If the price goes down, they put
it into my margin account. And I can quickly deplete
my $5,000. The post price keeps going up. Then I say, gee, I wish I hadn't
signed that contract, because I could have waited
a few days and gotten a better price. Meanwhile, the broker calls you
on the phone and says, I'm sorry, your margin account
is almost depleted. Do you want to put
up more margin? And this is where you get the
reality of futures trading. Because there's no counterparty
risk. That means, that if you don't
put up more margin, the broker closes you out and says,
here's your money. Do you understand how
this works now? So, there's no counterparty
risk, because it doesn't matter, whether you're a drunk
or a sociopath, the broker has you trading. And it doesn't matter
at all what you do. Once you put up the money, and
if you just don't answer the phone -- if you, say you don't
answer the phone, the broker will close you out, when
the margin is depleted. So, the broker takes no risk. The counterparty is not
even given to you. You don't even know, who's
on the other side of that contract, because the other
side is making -- you're both making a contract
with the exchange. And so, you don't care about
counterparty risk, and there's no risk to this contract. That means, these prices are
pure prices, and they don't have any counterparty risk. I wanted to show you another
futures contract. This is Soft Red Winter Wheat,
which is a major crop in the U.S. Winter wheat, you
plant it in the fall. Believe it or not, some people
are surprised to hear this. You plant it in the fall, and
then it stays in the ground over all the winter, and
it comes up really early in the spring. And then, it's harvested
in early summer. And the Soft Red Winter Wheat is
very good for biscuits, and cold cereal, and cakes, but
not so good for bread. So, it's a particular kind
of wheat that is grown. So, this is the futures
curve, as of Friday [addition: March 18, 2011], for this. And this is in cents
per bushel. So, this is the front month
future, and it's -- it looks like it's 723 cents,
$7.23 a bushel. And now, we see this sharp
contango again, and the prices are going up really rapidly
through time. Again, this is all prices
quoted last Friday. This is futures contracts and
different maturities. And then, you see sometime
around summer of 2012, it loses contango, and it becomes,
actually, declining. And then, this market goes
out to 2013, and stops. That's as far out as
they trade futures. So, why is it declining
in 2012? Well, there's probably a
million factors in it. You need to talk to
a futures expert. But I think, one thing that
comes to my mind, is the harvest. And so, they
harvest grain sometime around that time. You know, you shouldn't be
storing grain at the harvest. This contango is a compensation for the cost of storage. So, you shouldn't be storing
grain in the harvest time. You should be clearing out your
warehouses, and sweeping them out, and cleaning them up,
and waiting for the new harvest to come in. So, you don't expect contango
to continue. There's a seasonal -- it's not so clear here. It's not dropping very much. I don't know, there's
many factors that determine these prices. But I wanted to just give
a little bit of simple mathematics about
futures pricing. The basic formula is that -- you have to think of futures
markets as storage markets. And the basic equation is, that
the price of any futures contract, p sub f, is the
futures price on one of those dates, is equal to 1 plus r,
plus s, times the spot price. Where the spot price,
p sub s -- I'll write it out, p spot,
is the price today. Now, this is kind of
theoretical, because I just told you, nobody ever knows
what the price today is anyway, because the only way
you ever know prices is through futures markets. But let's just think a little
bit abstractly. Say, there's a cash market
for wheat, that it's bought and sold with. And we know what the price
is on that market. So, this is the interest
rate between now -- it's not the annual
interest rate. It's the total interest as a
percent between now and the maturity of the contract. So, if it's one year and
the interest rate is 5%, then r is 0.05. But if it's one and a half
years, it's going to be more like 0.075, because the total
interest between now and one and a half years in the
future is 7.5%. And s is the storage cost. So, this is called fair value,
and what it means is, normally you think futures prices should
behave like that. So, the normal situation in
futures markets is contango, which means that prices are
normally going up through time, because the longer in the
future we're looking at, the longer time that we're
losing interest and storage. See what this really is, this
fair value equation, is just the equation that defines, when
it is that there's just no profit to storing grain. There's only a normal
profit, right? If people who do it -- This equation can't
hold exactly. Or if it held exactly, then no
one would store grain, but it has to be approximately
valuable. So, do you see? How else do I say this? It shows that normally the
futures price is above the spot price. And as time goes on -- I don't mean time in this sense,
I mean calendar time -- the futures price will converge
on the spot price, because the interest rate, the
horizon for the interest rate and the storage costs -- this is in percent, and
this is in percent -- goes down. So, let me just clarify that. Let's talk about a perfect
world, where there's no harvest uncertainty, nothing
happens except the crop is normally produced. And it's wheat. And let's say -- I'm going to do a plot. And this is time. This is calendar time,
not maturity time like on this plot. And this is the price of -- I'm going to plot the
price of wheat. Now, what does wheat
do over the year? It has a seasonal pattern. I'm going to do an abstract
form of seasonal. This is what the price
of wheat does. And this is a year. This is year 1, this is year
2, this is year 3, year 4. This is the price of wheat
in each of these years. It falls every harvest
time, right? It has to be rising until
harvest, because somebody has to be storing grain. And the price has to go
up, because they're facing storage costs. And then, every spring, every
harvest time, it collapses. And it does it again
every year. No uncertainty. What do futures prices do? Well, let's consider a futures
market that's -- a futures contract that has a
maturity right here at the peak, just before the harvest.
But if there were no uncertainty, the futures price
would just be constant throughout that whole time. It would always equal the
expected spot price on that future date. And again, it would repeat
the next year. Futures contracts have no
expected price change in this perfect world. Do you see what I'm saying? This equation always holds,
because, as this contract matures, the time to the
expiration date goes down. And so, this r goes down,
and s goes down. And eventually, it hits 0
on the expiration date. And the futures price equals
the spot price on the expiration date. But in reality, we don't see
such a nice and perfect match. I want to talk about another
futures market, which is maybe the most important futures
market of all. I've been talking just about
agricultural futures. Agricultural futures are the
origins of futures markets. And I like to talk about them,
because I like to imagine -- well, our ancestors all lived
on farms, once in the past. And it just seems like such
a family story that we all should know about farming. It's our history. But now let's move forward
into other classes -- we can have futures markets
for oil as well. So, this is last Friday's
[addition: March 18, 2011] futures curve for Light
Sweet Crude Oil. This used to be at the New York
Mercantile Exchange, but the Chicago Mercantile Exchange
has been buying everybody up. And now, it's the CME. They call it the CME group,
actually, Chicago Mercantile Exchange Group. And this is the price of oil. Look, what's happening here. Isn't this something,
this curve? The price of oil as of last
Friday, on the nearest month future, was selling
at $101 a barrel. It's gone up a lot. This is part of the crisis
now around the world. People need food and
they need oil. Incidentally, the two markets
are related, because we can turn fuel -- we can create fuel from food
by using grains to produce ethanol, and that substitutes
for oil. So, it's not independent. These two markets are
not independent. Now, oil is so important. It's the energy that drives
the world economy. And any events, like the recent
earthquake in Japan and the nuclear disaster in Japan,
it affects this market. Everyone's thinking, what
does it mean for oil? Maybe, we won't have so many
nuclear plants anymore, so that's going to mean, oil's
going to go up. The other thing that's happening
is, at this point in history, there's a crisis in
the Middle East, and it's cutting off the flow of oil. So, people are trying to
predict it, and those predictions come into
this market. So, here's what we see. We see right now, the market is
predicting increases of oil until December, and then, a
collapse of oil prices, bottoming out in January
of 2015. This market goes all the
way out to almost 2020. That's a long time. That's because it's such
an important commodity. So, this futures curve
matters for -- The total value of oil in the
ground in the world is probably over $100 trillion. It's bigger than the GDP of
just about any country. It's huge and important. And people who are thinking of
extracting their oil, they're looking at -- everyone's
looking at this curve. So, why does it peak
in December 2011, and then collapse? I'm guessing that has something
to do with the crisis in the Middle East, that
the people who trade in these markets are thinking, that
the crisis will be over by then and prices will
start coming down. So, we're seeing contango here,
and backwardation here. I'm using a simple definition of
contango and backwardation. There's more subtle
definitions, but we'll keep it simple. We're seeing an increase,
expected in oil prices, and then it decreases. And then, it has it
going up again. Is this right? Well, if it isn't right,
there's a profit opportunity for you. If you know better, you can get
in and you can do it with, I think, all you need is
something like $5,000. I'm not trying to entice you
to trade this, but I'm just trying to give the idea
of what these markets really mean. That the oil, it means
survival for people. I mean, oil and food are what
keeps people going and alive. And there's not enough. There's not enough
for everybody. And so, this market is all about
extracting oil at a good rate, thinking about when
to sell it, so that it, ultimately, I think, serves
the purpose of humanity. Now, incidentally, what's
happening here? When you see the curve falling,
how can that be? I just wrote this equation here,
saying that the futures price has to equal 1 plus r,
plus s, times the spot price. So, the futures price
has to be greater than the spot price. I just wrote that, right? But you can see that this
futures price, this is essentially the spot price. This is the front month future,
and it's about to expire, so it's converging. And this is what we call
the price of oil. When you hear oil prices quoted
on TV or on magazines, they're quoting the front
month futures. Let me be clear about that. Oil is mostly sold on
long-term contracts. So, just like our rice merchant,
buyers of oil are typically -- who buys crude oil? It's some refinery. They've got a big operation
and they refine oil. And they care about, what
kind of oil do I get? And when is it going
to be delivered? And what are you going to
do for me, if it's not delivered on time? They have complicated
delivery contracts. Almost all oil is sold
through that. So, what is the price of oil? You can't figure it out. There's just too many contracts and they're all different. There is a spot market for oil,
but that's just overflow. You know what happens? There'll be some mistake. Someone delivered too much oil
to the New Haven harbor, or someone reneged on a contract,
now I've got this extra oil. It goes on to the spot market,
but that market is tiny and is not reliable. You don't know what kind of oil
it was, you know, it's all different -- what the issues are. So, when you hear oil prices,
you're hearing futures prices. So what's happening? How can it be that the futures
price in 2015 is lower than the price today? Well, there is something
funny going on. I'll tell you one thing that
it does mean to me, is that nobody is planning to store oil
between now and 2015, at least not as a storage
business. Because I'm going
to lose money. I'm going to be selling at less,
unless I have negative storage costs. I'm not going to store oil
between now and then. I'll store it for now. So, that means that people are
kind of trying to store a lot of it now, because the contango
is there, but it's going to end in December, and
then they're going to empty their storage tanks. That must be what storers
are thinking. So, this thing doesn't
always hold. This only holds when there's
commodity in storage. Or you could say, well, it still
holds even when you have backwardation, because, in some
sense, storage costs can get negative. And so let me just talk about,
there's a term that they use called convenience yield. When the futures curve is in
backwardation, somebody is still going to be storing oil. So, suppose I have a factory,
and my factory depends on oil, because I use it to burn, to
produce whatever we make. Am I going to let my warehouse,
my storage tank of oil go dry? No, I'm going to need some,
just because we might need more than we think. We might have a buffer stock. So, that means, I actually have
negative storage costs. I always want oil. I don't want ever to let
my tanks go dry. So, the only people who are
storing oil, when you have a backwardated futures market,
are the people who want convenience yield. Now, I'm omitting some
subtleties here. I'm sorry, but I'm trying to
make the basic point, that this equation holds
when the commodity underlying is in storage. But it doesn't always hold. So, now I wanted to talk about
oil a little bit more, because it's so important. I have here the price of oil. I like history. I like to give you
long history. I wanted to give you the price
of oil back to 1871. And this is, well, U.S. oil
price in U.S. dollars. But I've corrected for
inflation, so it's real oil prices from 1871 until just a
short while ago, last week [addition: data ends
on March 18, 2011]. And now, in recent
years this is the front month oil contract. The oil futures market started
in the 1970s, so this is all the front month futures
contract. Before that, this is someone's
guess as to what the price of oil was, because there weren't
such well-developed markets. We didn't have oil futures
until the 1970s. So, I wanted to think about what
was happening at these various dates. These early swings in the 1870s
were due to discoveries of oil, and discoveries
of uses for oil. Pennsylvania oil was discovered
somewhere around this time in the
United States. Texas oil was discovered
somewhere around this time in the United States. Our economy wasn't so dependent
on petroleum. Actually, if you look up ''oil''
on ProQuest, back in 1870 they didn't even
call it oil. They called it petroleum,
because what was oil? What did they think
oil was in 1870? Whale oil, OK. It was a different world. So, we see a lot of jumping
around of oil prices. But we see a big surge
going into the 1890s. And there was a big scandal
about Standard Oil. Remember that? And the government eventually
busted up Standard Oil as a monopoly. So, they were starting to
get concerned about oil. But then, if you go forward in
time, you see this interesting pattern here. What was going on here? The price of oil became very
stable, until, bang, there was this huge upswing in oil. Well, what was happening in
this interval of time? In the '40s to 60's, the U.S.
was a big producer of oil. It kind of got started here, oil
production, with Drake's invention of the oil rig. And the U.S. was the biggest
producer of oil. And during this period, when you
see oil prices were very stable, the oil prices were
actually stabilized by the -- it was produced mostly
in Texas -- Texas Railroad Commission. It says railroad, but it was a
government agency in the state of Texas, which worked to
stabilize oil prices. But during this period of time,
the U.S. was depleting its oil, and other oil
discoveries were coming in. And so, this whole period --
this is before there were any futures markets, because
there was no reason for a futures market. Oil prices were very stable. And then, you see, here, a
sudden jump up in oil prices. And this point right here is
called the first oil crisis. So, the first oil crisis, it
kind of stands out on a diagram, right? Looking at the whole history,
if you exclude those early fluctuations in oil that you see
in the 1870s, which were not really so important, because
people were really so dependent on oil. So, the first oil crisis
was 1973 to '74. And this prompted the creation
of the futures market. Because what happened was -- it was actually coincided with
the Yom Kippur War in Israel. And it was created by a blockade
against oil in oil-producing countries. The U.S. was no longer,
by this time, the major producer of oil. We had something called OPEC,
which is the Organization of Petroleum Exporting Countries. It actually goes back
to 1961 with Qatar. 1962, Libya, Indonesia. And then, we added the Abu Dhabi
in '67, the United Arab Emirates, '74, Algeria in 1969,
Nigeria in 1971, Ecuador in 1973, Gabon in 1975. So what happened was, although
the U.S. broke the Standard Oil monopoly around the turn of
the century, a new monopoly developed, and it was outside
the U.S. And so, there was no trustbusters to break
this monopoly. And so, what happened was, the
oil exporting countries who belonged to OPEC, who wanted
to use oil prices as a strategy to deal with Israel,
they restricted their supply of oil. And it caused the first
oil crisis right here. I was going to mention another
historical fact that, I think, precedes this, but it's
part of the story. And that is nationalizations
of oil. It used to be that big oil
companies went around the world and found oil deposits. And then, they would buy the
land, and they wouldn't tell anybody what they were doing. They'd buy the land that
had the oil under it. So, the oil companies
were very rich. But there was discontent in the
less developed countries, who sold them the land and
thought, why did we get gypped like that? And so, they started
a process. It started with Mexico
in 1938. So, oil used to be owned
by the oil companies. Mexico said, no,
not any longer. It's our national heritage. We never should have
sold it to you. We're just taking it back. This was considered outrageous
at the time. No country should violate
property rights like that. But it was kind of
a leftist -- the word nationalization
was a new word. It was kind of like the people
expressing their heritage. It started to take. Then, Iran in 1951. And then, other countries
followed. So, oil got taken away from
international companies and put under government control of
less developed countries. And then, there was a monopoly
called OPEC, and that produced this crisis right here. There was a second oil
crisis in 1979-80. And this one, again, was
associated with trouble in the Middle East. So, in '79-80, we
had the Iranian revolution, which again disrupted
oil supply. So, 1979-80 is the second
oil crisis. And that is due to the fall of
the Shah of Iran, and the arrival of the Ayatollah
Khomeini, and the Iran-Iraq War. And so, you can see the huge
increase in oil prices. These were real panic situations
at the time, because people were not
used to these -- people were used to the stable
oil prices, and it was just something taken for granted. But this put the world in a
state of shock, because oil prices really jumped up almost
sixfold, about sixfold, in a matter of -- how many years is that? -- six, seven years. So, this left a lot of interest
and enthusiasm for oil futures, and it became a
major market of the kind we know about today. You know, what happened here? This mark. This is another -- This is the second Iraq War,
when Saddam Hussein was overthrown. And the U.S. and
other countries were involved in that. But what it did is, it cut off
the supply of oil briefly, because the Persian Gulf was
shut down because of a war. You can bet that the futures
market was heavily backwardated right
then, for oil. Because everyone knew that the
oil prices were not -- we weren't running out of oil,
we couldn't get at it because of the war. And so, this was another
oil-induced spike. Every one of these spikes
produced a major worldwide recession, because the world
wasn't ready for these spikes enough. So, we see this huge spike
in oil in '73, and a worldwide recession. Again, another worldwide
recession. This one was called The Great
Recession, people forgot that they called it that,
and they use that term again more recently. And then there was another
worldwide recession -- every one of these did it. And so, you can see the
fundamental importance of oil, and of oil futures, because
oil futures is managing the risk. If you bought an oil futures
contract, you weren't impacted by this. If you bought a contract just
before this, then the oil crisis doesn't mean
anything to me. It's not my problem, because
I've already locked in my price. And it's really safe, because
the way the futures markets work, they've got this daily
settlement process. So, you don't have to
worry about your counterparty reneging. It's very civilized. It's a tough world out there,
where they're fighting wars, but in Chicago, where the
futures markets are -- or it was in New York
back then -- it's a very civilized market. And so, look here, we have
the latest spike. It's even bigger. So, oil got to -- I can't even reach up there -- oil got up to over $140
a barrel in 2008. That's just a short time ago. Now, what did that? That is kind of a puzzle. It has something to do with the
world financial crisis. But it's not as well understood
as a reaction to any military situation. So, it seems like there's
some speculative element that took place. See ultimately, oil is stored in
the ground, and it's owned by people, and they have to
decide how to develop it and how fast to produce
it and sell it. And there were some quick
changes of thinking around then, that surprised
everyone, I think. And oil is, again, up above
$100 a barrel right now. Just we saw in the
futures curve. So, actually the futures curve
that we saw would look kind of unimpressive on this
diagram, right? It would be just going up a
little more and a little down, not big swings that
are predicted. I just want to finally conclude
with financial futures, which I didn't
emphasize in this lecture. But we also have futures
markets in financial commodities, and I'm just
going to tell you about one of them. It's called the S&P 500 futures
market, index futures. And now, in effect, you have to
deliver not oil, or rice, or wheat, but you have to
deliver the S&P 500 index. How do you do that,
by the way? How do I deliver 500 stocks? Well, there's a procedure, and
it's called cash settlement. It's different. Instead of showing up at
warehouse with your trucks full of wheat, you only show
up with the money, because they don't expect you to
do that with stocks. What is the storage
cost for stocks? Well, you know, it's
actually negative. It doesn't cost me
anything to buy. If I buy a share in a company
and store it, it doesn't cost -- it's a negative cost, because
they pay a dividend. So, the fair value, and this is
what you'll see quoted all the time on CNBC, or any
of these business -- Bloomberg -- these business networks is -- So, the futures price is equal
to 1 plus r minus y, times the spot price. Same formula. This is the interest rate. And this is the dividend
yield. So now, whether the futures
price is above or below the spot price, is less clear here,
because it depends on whether the interest rate
is higher than the dividend rate or lower. At this point in history, for
short time horizons, the interest rate is less than
the dividend rate. We have about a 2% dividend
yield on stocks, and we have essentially a 0%
interest rate. So, for short horizons, we'd
expect to see the futures price less than the spot price
in stock index futures. But at longer horizons, I think
that would be reversed. But this market is very clear. The fair value relationship is
highly predictive of futures prices in the S&P 500 index
futures, because there's always storage of stocks. We never deplete the warehouses
of stocks, so they're always there. And so, that means that the
futures curve is less interesting for stocks
than it is for oil. All it does is reflect
fair value. And so, it's not like oil, where
the storage situation is very complicated, and it's
constantly changing. So in a sense, the S&P 500 index
futures is not so much about the future. The futures curve is not so much
about the future of the stock market. So, don't make the mistake of
looking at the futures curve for the S&P 500, and thinking
I'm going to forecast the market using this curve. You can't. Basically, the S&P 500 is very
hard to forecast. And the futures curve doesn't do you
anything, because all it reflects is fair value. So, some futures markets, like
gold futures is like this also, there's always gold in
storage, it never gets depleted to zero. It's always being stored, so the
gold futures curve is not so interesting, either. Next, after the midterm exam,
which you have coming up on Wednesday, we will come
to options pricing. And that's another fascinating
market that we'll talk about.
I'm too lazy to watch the video but it's called a doji candle because of the dojima rice exchange where the first futures were traded.
The chad trader in that exchange basically invented candlestick charts and TA. He used things like head and shoulders patterns back when literally nobody knew they existed to become one of the richest people.
You can read his book, it's called something ridiculous like the "three golden monkeys strategy" or something, but it's basically primordial TA, and it worked very well for him despite nobody else knowing it existed. So much for the self fulfilling prophecy argument.
I'll short AND buy puts on brown rice. The stuff is a bitch to cook.
Good find brotha
Great video, especially found the part about Soviet citizens is Moscow having a higher (and more accurate) view of capitalism vs. Americans to be interesting.
Watching it all the way through and 53:00 he talks about people having negative storage costs for crude oil. Reminded me of the beginning of the pandemic when people were getting paid to buy oil and it was like-$25 a barrel.
Is this college in South America? I’ve never heard of Ya-lay.