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MIT courses, visit MITOpenCourseWare@ocs.MIT.edu. ANDREW LO: So far, the
stock market is down. But on the other hand, if you
look at the three-month T-bill rate, it's up about
60, 70 basis points. So that's not bad. Looks like there is some
sense that liquidity is going to be good for the market. And I guess we'll wait and see. But clearly, the
Fed is making a-- the Fed is making every effort
to maintain liquid markets. We should keep in mind--
those of you who are starting to panic and
thinking, gee, really, all hell is about
to break loose-- keep in mind that interest rates
are still pretty low overall. Obviously, the Fed
cutting rates is going to mean that the overnight
borrowing rate between banks and the Fed is low. But if you look at
commercial paper-- if you look at a variety of
other indicators of borrowing rates, they're relatively low,
to the extent that markets are, quote, "frozen." It really means that the
banks and other agencies are waiting to figure
out what's going to happen with regard to the
rescue package and other market events before they
start to lend again. And there's nothing
structurally wrong with their particular
business models, nor is it the case that we
somehow run out of money or we've all lost these assets. Investors right now are
waiting on the sidelines. And you can tell
from market dynamics that there's enormous
amount of fear that is really affecting markets. And this is exactly
the kind of reaction that the Fed was trying to
forestall two weeks ago when the money markets
broke the buck. And hopefully, they will
still be able to do so. But you can tell
that it's building. And market fear, as
measured by things like the stock market
and bond markets, that's still a concern. So we'll wait and see. But so far, it seems
like the developments are as we pretty much expected. There really isn't any
huge surprises going on. Any questions? Yep? AUDIENCE: I wanted to
share my experience. It's like about six
years ago in Argentina, we had this crises that
it was similar to this, in the sense that the
whole country disappeared. We had five
presidents in a week. We defaulted. The government defaulted. Half of the public
companies defaulted. We devalued our currency. It was really chaotic. And still, I don't
know how we survived. And two years afterwards, I went
into working to this investment fund. And we just started
buying companies that were really in sale. And when he says that
this creates opportunity, it sort of feels a little
naive or something like that, but it really creates
opportunities. So those who survive can have
really good choices afterwards. So I don't know. What I'm doing now is
trying to take a deep breath and flow through the crisis. ANDREW LO: Yeah, I think
that's very good advice. And in fact, in terms
of opportunities-- I think that right
now, because everybody is transfixed on the
problems with the economy, people aren't thinking
about opportunity, because they're scared. And I wish I could fast
forward and give you my last lecture for
this course now, because it's actually
pretty relevant. The last lecture of the
course is where I actually bring in some evidence
about psychological biases that affect all of us. And in particular, there's
some recent evidence in the neurosciences
that explain why it is that when we
are stricken with fear, it almost paralyzes us. Actually, physiologically
it can paralyze us in terms of
decision-making ability. So I don't want to
talk about it now, because that's going
to be the last lecture. And I feel we have to
cover the material. But it's true that when
you're in the midst of it, it's very difficult
to think rationally. But I'll give you one
example of, I think, a wonderful idea that
nobody has mentioned but is perfect for an MIT audience
or an MIT entrepreneur. One of the problems that we
face right now is the unknown. We don't know what
CDOs and CDSes and all these complex
securities are worth. Wouldn't it be wonderful to
have a website that did nothing more than post the
prices of transactions in these securities
over a period of time, really as a means of
providing information to the marketplace about what
kinds of deals are being done and at what prices? We don't have an
organized exchange. So that's another
idea is to create a kind of an eBay for CDOs. It may not work. It may be naive. It may be something that
somebody has already thought of. But these are the
kind of innovations that the market is crying for. And I promise you, if
you are the first one to the market with one
of these innovations, my guess is that that's going
to be a billion dollar idea, because everybody
right now is looking for some means of getting
transparency and liquidity into these marketplaces. And so if you could be the
first, or second or third even, to come up with
that mechanism for being able to provide pricing
information just a little bit better
than nothing at all, you can actually
do incredibly well. That's an example--
very simple example-- of how technology can actually
transform that market, because most of
that market right now is still paper and pencil. It's just really
relatively backward, from a technological
perspective. OK. Yeah? AUDIENCE: [INAUDIBLE]
transparency, why do you think the banks push to get rid
of mark-to-market accounting? ANDREW LO: Well, I'm
glad you brought that up. We're going to talk about
that in this lecture. That's a very important point. First of all, I want to
define mark to market. And we're going
to talk about that and the difference between
forward and futures contract. But let me give you
the short answer. And then I'm going to spend the
rest of this lecture hopefully justifying it. The idea that some
banks have proposed to suspend
mark-to-market accounting is probably the
worst idea I've ever heard of in this entire crisis. Now let me not mince
words and explain what-- the idea of not
marking to market is a little bit like telling
a crowded theater, where you smell smoke and you
see flames on the stage-- instead of letting people
get out of that theater, it's like telling everybody
in the theater, all right, we're not really sure exactly
what the smoke is from, but we want everybody
to sit down, relax, take a deep breath, and let us
think about it for another half an hour, and then we'll decide. That's what suspending
mark-to-market will do. AUDIENCE: So do you think
when the SEC has come out and said that companies
now can use their judgment to [INAUDIBLE]
sale prices, do you think that's going to
happen [INAUDIBLE]? ANDREW LO: Well, it's a
little too soon to tell, because we don't know exactly
what the treasury will do. The SEC can say
whatever they want. The bottom line is,
is there a market for these securities at prices
that these companies come up with? I may think that my ideas are
the most valuable in the world. That doesn't make it so. And in the same
way, corporations that feel that their securities
are the most valuable in the world, that
doesn't make it so. What makes it so is what we said
on the very first day of class. And that is, what? What determines the
value of security? Exactly. You all-- the market. And so if nobody wants to
buy or sell at any price, then that's not really a price. A price is a number at which
two mutually consenting adults agree to transact. And if you can't find two
mutually consenting adults to agree to transact,
you can come up with all sorts of really
interesting numbers, but those aren't prices. So we're going to talk about
that exactly in this lecture, because what I want to do
is to describe to you how forward contracts and
futures contracts work. You've heard of
both terms, I think. We've talked explicitly
about forward contracts, but we haven't
talked about futures. The innovation of
futures contracts is exactly this
mark-to-market issue. So let's get to
the topic for today and talk about
forward and futures. So in this lecture,
what I'm going to cover is the definition of forward
and futures contracts. And then I want to
show how to value them. The valuations of
these contracts will also use net
present value formulas, but it'll be used in a
somewhat different way. So that's why we want to
spend extra time going over these kinds of securities. They're different from what
we've looked at so far. There's some
motivation from why you might want to consider these
contracts that I've got up here in the slide. But really, the motivation
is pretty simple. And actually, the
motivation is brought home by current events because
of the uncertainty in markets right now. The first example-- your
company, based in the US, supplies machine
tools to customers in Germany and Brazil. Prices are quoted in
each country's currency, so fluctuations in the euro,
dollar, and the Real dollar exchange rates have a big
impact on the firm's revenue. How can the firm reduce
or hedge these risks? This is an example where
you're making machine tools. You have no idea what exchange
rate markets are going to do. And that's not really your job. You don't really
care about that. But the fact is
that it does have an impact on your
company's performance, because a large part
of your revenues are going to be coming in
in these foreign currencies. So what you'd like to
do is to figure out a way to eliminate that
kind of uncertainty, or at least reduce it. And there are many
other examples here where an individual has a
particular objective in mind, and market fluctuations are
so extreme that they end up being a distraction and,
in some cases, a decrement to the business opportunity. The idea behind a
forward contract is to try to reduce
or, in some cases, eliminate that
kind of fluctuation by finding a counterparty
that's willing to deal with you to eliminate
that uncertainty, because that counterparty
faces the opposite uncertainty. So this is an example of just
how big the uncertainty is that we're talking about. If you take a look at exchange
rates from 1995 to 2003, you can take a look at the
dynamics of these currency movements. They are extreme in some cases. So if you're a company
manufacturing machine parts, you have no idea how
to deal with this. You're not a currency
forecasting firm. And so what you'd
like to be able to do is just get rid of it,
or at least reduce it to the point where you actually
don't have to think about it. And to give you a sense of how
significant this problem is, this is the sales for
Caterpillar from 1980 to 1989. And most of you have heard
of Caterpillar, right? They manufacture tractors and
other kind of heavy machinery. This is their sales figures. But you can take a
look at what happens when you take their sales
figure and you denominate it in US dollars. That's a pretty big difference
between US denominated and foreign currency
denominated levels. So what we want to do is
to address that concern by using financial markets
in a particular way. Now there is an issue regarding
futures and forwards as to whether or not the people
who are in the markets are hedging or speculating. And so we're going to talk a
bit about that a little bit later on. But before we do that, we need
to develop some terminology for what these contracts are. But I want to raise that
as an issue upfront, because it's very controversial. There are some people
that argue that it's all these evil speculators that
are causing market dislocation and we ought to just
get rid of them. And I'm going to
argue that you really can't, because
speculators provide an enormously valuable service. They are the opposite
side of the same coin. So it's like trying to do
applause with only one hand. The sound of one hand clapping
is not particularly loud. So there are a number
of ways of hedging. Obviously, using futures,
forwards, options, and swaps are what we're going to be
focusing on in these next three lectures. But you can also think about
insurance, diversification, you can match assets
and liabilities in terms of their
duration, or you can match sales and
expenses across countries to try to reduce
your currency risk. And frankly, that's one of the
reasons why companies often set up production facilities
in countries where they do a lot of business, because
this is a natural hedge, in the sense that they're
generating expenses, as well as revenues in the same currency. And so that cancels itself out. But you can't always
easily do that. And you certainly
can't do that quickly. And if you're a foreign company
trying to do business today, life is very, very
interesting, shall we say. So you want to be
able to hedge now. You don't want to
wait a year or two when you are building that
plant to be able to do that. Now what we're
going to talk about is whether or not it's possible
to hedge with derivatives. But there are various
different views on the impact of derivatives
for non-financial firms. One extreme is that derivatives
are extremely efficient tools for risk management. And the other, espoused by
none other than Warren Buffett, is that derivatives
are financial weapons of mass destruction. And the truth is actually both. Both of these statements,
I think, are correct. So from uranium-238, you can
get a nuclear power plant that can provide power for
huge areas of the country and that do today. Or from uranium-238, you can
build a dirty thermonuclear bomb that can be very bad. So the point is that
technology, in and of itself, has no particular good
or bad properties. It's how you use it. And so derivatives are
definitely more complicated and more sophisticated. This is not the kind of thing
you want to try at home, unless you are a
professional in how you use these kind of instruments. And so that's one of the reasons
why we want to spend time on these particular securities. OK. There are a couple
of other views, too, regarding whether or not
hedging should be done at all. One view, which we'll
talk about in more detail towards the latter
part of the course when we get into corporate
financing decisions, is that hedging for a
company should be irrelevant. If you're running a company,
even if your company's assets are in foreign denominated
currencies and changes in those currencies cause huge
swings in your company value, there is an argument to be
said that you shouldn't bother hedging, because as long as
shareholders of your company have free access to the
market, they can hedge. So anything you can
do, they can do. At least, that's the argument. Now the counterargument
is that that's not true, because most people
who buy shares, they don't know enough about
what the company is doing to be able to
hedge, nor are they set up to trade in some of
these kinds of hedging vehicles. But the frictionless
model would say that you shouldn't
bother hedging, because what investors
want you to do is to focus on your business. And hedging is just
something that, if they are concerned about,
they can do on their own. The alternative view is that
hedging creates a lot of value, because it reduces uncertainty
for a company's cash flows. It focuses the company
on its core competencies, as opposed to other factors
in the marketplace that are causing volatility. It also reduces the
chances of getting into financial distress. And if we believe that
financial distress creates these huge costs that can't
be easily recoverable, even through the bankruptcy process,
then you ought to hedge. Now there are lots of examples
of all of these perspectives in the industry. I'll give you three of them. Homestake Mining is
a mining company that mines precious and base metals. They have an explicit
corporate policy that says, we do not
hedge, because shareholders will achieve maximum benefit
from such a policy of not hedging. OK. Sorry, yeah. AUDIENCE: Is there a
difference in hedging strategy when it's an input production
versus production output? For example, an oil company
hedging gasoline exposure versus [INAUDIBLE] company
hedging gas [INAUDIBLE]? ANDREW LO: Well, there is
a difference in the sense that typically when you're
producing an output, there's no point
in hedging that, because that's actually the
output that you're producing. You're a gold company. You're producing gold. The only question about
hedging is whether or not you feel that there's some
temporary mispricing that you want to be able to take
advantage of, given where markets are today versus
where you think they'll be three months from now. But effectively, the
output is what you're supposed to be producing. So their argument is that
we're producing gold, why would you want us to
hedge the price of gold? We're a gold company,
so you're supposed to be getting the risk of
gold with a gold company. So it's typically the inputs
that they're talking about. But on occasion, they may be
talking about outputs as well. And the argument here is that
you shouldn't be hedging that. Now the American Barrick
has another view. Their view is that hedges-- they want to provide
financial stability. And so by hedging
their output exposure, they're actually providing that
stability, because right now, for example, gold prices
are extremely volatile, because there's a
flight to quality, and then people
change their mind, or another group
decides to sell. And so the prices are
moving back and forth and back and forth. That output uncertainty
creates volatility in earnings. And we all know
that shareholders like stability in earnings. So that's another view. Now the first company,
Homestake Mining, would say, look, if you
don't like the heat, get out of the kitchen. We're a gold company. If you don't want the
volatility of gold, then don't buy a gold company. Put your money in T-bills. And so that's another view. And then, of course, we've
got Battle Mountain Gold, which is a company
that hedges up to 25%. So their argument is
that a recent study indicates that there may
be a premium for hedging. But they're not quite
sure, so they're just going to go partway. It's not clear what the answer
is, because largely, the issues depend upon how the
public will react to this kind of uncertainty. There are some
people that are quite rational about their
exposures, and they want to have the volatility of gold. But they don't put all
their assets in gold, because they
understand that there's a limit to how much volatility
they're willing to bear. So maybe 5% of their portfolio
is in precious metals, 10% base metals, so on and so forth. They do the asset allocation. But there are other
perspectives that say, you've got to worry
about volatility of earnings, you want to have a
stable share price. And then they engage in
that activity as well. There's some empirical
evidence that I thought you might be interested in. A couple of academics,
Guay and Kothari-- SP Kothari is a faculty member
here in our accounting group who's on leave-- published a paper just
about five years ago where they took a random
sample of 413 large companies with average cash flows
of about $700 million. And 57% of those firms
used derivatives in 1997. Now that's 11 years ago. So this is dated information. If you went and re-did
the survey today, my guess is that
that number, 57%, will have gone up
by quite a bit. But I don't know for
a fact that it has. But the idea behind
the survey was just to get a sense of how
many companies really are making use of hedging programs. And it's become much, much
more significant than before. Part of the reason that
it's not 100%, I suspect, is that it's not that easy to
implement some of these hedges, because the concepts
are rather subtle. You'll see, when we go over
it in this lecture, how straightforward you
think it is to hedge. Some of the ideas
are a little subtle. And so it's not a simple
asset class purchase decision, like I'm going to buy bonds,
I'm going to sell stocks. It requires a certain level
of expertise and comfort. So let's talk about that now. Let's talk about derivatives. There are going to be
three kinds of derivatives we're going to focus on. Forwards and
futures-- that's what we're going to talk about in
this lecture and the next. Then in lecture 10, we're
going to talk about options. And then there's a third class,
which we probably won't get to in this course, but you will
get to in 402, as well as in investments. And that is swaps. The idea behind a forward
and futures contract is that it's a contract
to exchange something in the future. So today, we agree on engaging
in a specific transaction sometime in the future. And the difference between a
forward contract and a futures contract really has to do
just with the issue that was raised the
beginning of the class by [INAUDIBLE], which
is mark-to-market. But let's not worry
about that for a moment. Let's just focus on
the contract itself. So a forward or futures contract
is, as the name suggests, an agreement that we enter
into today-- you and I-- to engage in a transaction,
say, six months from now. So all we do today is agree
to do that transaction. And in agreeing to
do that transaction, we have to specify
a couple of things. One is we have to specify
what we're going to transact and at what price. And the second thing
we have to agree on is when we're going
to do the transaction. Once we sign the
document, we are both obligated to follow through. So this is not an
option in the sense that we can choose not
to do it or to do it. Once we sign the
forward contract today, it is a legal, binding contract
so that we are agreeing today to engage in that transaction
six months from now. Now if it ends up
that we default-- we don't have enough money,
we declare bankruptcy-- then that contract, like
all other contracts, will have to go to court and be
dealt with by the legal system. But assuming that we
are not in default, we will have to perform-- we
are obligated to perform-- on that contract,
like any other. It's a binding agreement. With an option, on
the other hand-- we're going to get to this in
more detail in lecture 10-- with an option, we do not
have to follow through with the transaction. In other words, the
buyer of the contract has the right but
not the obligation to exercise that option. That's why it's
called an option. So that's a key distinction. So let me be very
explicit now and now focus on a forward contract. A forward contract
is a commitment to purchase, at a
future date, a given amount of a
commodity or an asset at a price agreed upon today. So first thing we
do, draw a timeline. Today is date zero. That's when we enter
into the agreement. And to be clear, because
a forward contract always has two parties-- a buyer and a seller-- let's just use,
as the convention, that the buyer of
the forward contract is the party that has agreed to
buy whatever in a future date. So the price that we agree
to is fixed, as of today. And that's known as
the forward price. If the particular commodity
that we're talking about happens to be alone, then it
will be a forward borrowing rate that we agree to today. So it's either a
rate or a price. And it's typically
called the forward rate or the forward price. And the buyer of
the commodity is said to be long the
forward contract. And the other counterparty--
the counterparty that is selling the
asset-- is said to be short the forward contract. Now these terms are, in
some sense, arbitrary. But there is a logic to them
that I'll explain in a minute. Yeah, question? AUDIENCE: [INAUDIBLE]
forward contract? ANDREW LO: A revolving loan. Well, I would call
a revolving loan a sequence of forward
contracts, because it revolves and constantly updates. That's right. Yeah. So for the moment,
let's just focus on one, and then we'll talk about
how we can extend that. So this is a very,
very standard set-up. And in terms of
long versus short, there's a reason why we
use that terminology. Obviously, the
ambiguity is the fact that a forward contract
actually has no value on the day that it's struck. So to say that one side is long
and the other side of short is, in a way, a little bit
unnatural, because in fact, the value of the contract
that's struck is zero. So you're either long
zero or short zero. Well, who cares? But there's a reason why
we call the buyer long and the reason we call the
seller of the asset short. It's because tomorrow,
if the value of the asset goes up beyond where the current
price is, then the person who has agreed to buy the
asset at this price is going to make money. So when the price goes up-- when the spot price,
the price today and then the price tomorrow spot
price-- when that goes up, the person who was holding
it long will profit. And the person who
is short will lose. And so that makes sense. When prices go
up, long positions tend to be profitable,
and short positions tend to be unprofitable. That's why we use
the normalization. Now right then
and there, I think I've described
something that may have slipped by you a little bit. So I want to just beat this
down and make sure that we all understand it completely. The price that I'm talking
about going up or down is not the forward price. It's the futures price. Excuse me, it's the
future spot price. Today's spot price for oil
is, let's say, $100 a barrel. Suppose that we enter into an
agreement six months from now to purchase oil
at $110 a barrel. So the forward price of
that contract is 110. Today's spot price is 100. When we have agreed to
that contract, you and I, the value of that
agreement is worth zero. It's got to be worth zero. The reason is that if it's
not at all worth zero, then you and I
aren't going to be willing to enter into
that contract today, because that means either I'm
losing and you're winning, or you're losing
and I'm winning. So we won't strike that deal. Let me give you an example. Suppose that I propose
to buy oil from you six months from now
at $40 a barrel. Now that's a legitimate
contract, right? In other words, I
can propose that. And if you and I,
we agree to that, that transaction
will be carried out. How many people would
agree to that today? Nobody. You would? All right. Seriously? No. AUDIENCE: You're buying? ANDREW LO: I'm buying
at $40 a barrel. No. Because given that oil is at
100 and given that there's nothing in the news or in
any kind of projection that suggests that we're going
to find tremendously large, untapped oil reserves
or that somehow oil is going to become less
relevant in six months time, being able to
buy oil at $40 a barrel six months from now is
an incredibly good deal. If I can find a
deal like that, it's got to have a lot of net
present value to me today. If I can find a
piece of paper that allows me to buy oil six months
from now at $40 a barrel, that piece of paper, we all
agree, has positive NPV. So in order for you to agree
to sell me that piece of paper, you're basically
giving me money. You're not going to do that. So we're not going to
get that deal done today. On the other hand, suppose that
we have a piece of paper that says, I will buy oil at $250
a barrel six months from now. I suspect all of you would
be delighted to sell me that forward contract. I'm not going to do that,
because that's ridiculous. That price just makes no sense. And that means you're going
to get a lot of value. So if both you and
I agree that we want to do a deal regarding oil-- you're an oil producer,
I'm an oil user, I want to lock in some price
for oil six months from now-- we're going to haggle
until such time as we reach a price for that
transaction six months from now that seems fair to
both you and me. When we do that-- when we reach that
price-- $110, let's say-- that's a price where the
present value of that contract is worth nothing. So both you and I have
found a price, such that we're happy to
take it or leave it. If we made it 115, then I might
not be so willing to do it. You might be happy about that. If we made it 105,
I'm happy to do that, but you think that you're
not getting a good deal. So the way that a forward
price is established is like any other price. We put it up for auction. We set a system where supply and
demand determines that price. And when that price is struck,
the contract is worth nothing. Question? AUDIENCE: Could
you argue that it's based on the price
of a futures contract and not of the
market [INAUDIBLE]? Let's say they're in the
range [INAUDIBLE] $130 and we enter into
[INAUDIBLE], wouldn't that create a little bit
of a problem there? ANDREW LO: Yeah, it would. Let's not talk about that
yet, because we haven't talked about futures prices yet. So we're only talking about
forward prices right now. We're going to come
back to future prices, and arbitrage is
going to come into it. But I want to do
it step by step. So let's hold off on
that for a minute. Yeah? AUDIENCE: So when there's like
a natural gas company that sells [INAUDIBLE] for
next year, that's forward contract [INAUDIBLE]? ANDREW LO: Exactly. That's right. And companies are delighted
to do that, because this way, they know what their
costs are going to be, as opposed to who
knows, it depends on what happens with
this rescue package, or it depends on whether
or not we get hit with a terrorist attack or not. That creates so
much uncertainty, companies don't want
to deal with that. So if I use oil in my
production facilities and I can lock in at 110
for a six month period, that's OK with me. I'm willing to do that. Yeah? AUDIENCE: Considering that
the trend of the global market is upwards in the long term,
I suspect that it makes sense, especially to try to
short in the short term, that would be there-- exceptions when I want to try
and do it in the long term as well? ANDREW LO: Well, that's a
very tough question to answer, because it depends upon what
your forecast is for long term prices. And the longer the term
is for your forecast, the more inaccurate
your estimate goes. So the question
is whether or not you really want
to take that risk and make those projections. In fact, this is one of
the reasons why companies don't want to do that and
they'd rather lock in the price. Companies feel like they're not
in the business of forecasting prices in the long term. They're producing
oil, or they're using oil as an input to
their production process. So they basically just want
to eliminate that uncertainty if they can get a
reasonable price. And by reasonable-- I
just gave you an example-- a $10 premium over
a six month period where we have uncertainty
about both supply and demand may be reasonable to
certain corporations. Yeah? AUDIENCE: Is there a
limit on how much can be done in a forward contract? And the example I sort of have
in mind is over the past few years, we keep reading how
Southwest has hedged on its fuel, but the other
airlines haven't. So was there some sort of
financial or legal perspective [INAUDIBLE]? ANDREW LO: Certainly
not anything from a legal perspective. For a financial
perspective, that depends upon the
particular company and the shareholders and
the balance sheet and so on. But no, there's
no limit, as long as you can find a mutually
consenting adult that's willing to do the deal with you. That's it. All right. Yeah? AUDIENCE: Does it
have to be more expensive than
the current price? ANDREW LO: Well, no, it doesn't
have to be more expensive. So the question is, does
the forward price always have to be more than
the current price? No, it doesn't. It depends upon what the
expectation is for what's going to happen in the future. It turns out with oil, typically
it goes the other way-- that these oil prices
generally are rising over time. However, there are situations. For example, it may be that
within the next few weeks, if there is more
of an expectation that business will
slow down worldwide, then we would expect oil
prices to decline over time, because the demand
is going to decline. If that's the case, then
oil producing companies may be delighted to
do a deal at par. So if the current price
of oil is $100 a barrel, they may be delighted to
say, OK, six months from now, I think the economy
is going to go down, I'm willing to sell you oil
at $100 a barrel six months from now, let's lock it in. That's possible. So what does that tell
you about the price of oil today versus the
price of oil six months, in terms of the forward prices? That tells you that the market
is providing information about the future. So future price
forecasts are implicit in these forward prices. In just the same way that when
we look at the yield curve and we see the implicit forward
rates for future borrowing, when you look at forward
prices of commodities and other instruments,
that's giving you information about what
the market is telling you that it thinks will happen
six months from now. So if you see forward
prices for oil at $90, whereas today it's at
100, that's telling you either people are expecting
to find lots of oil in the next six months,
or it's telling you that there's a
forecast that demand will decline precipitously
over the next six months. OK. So the features of forward
contracts are the following. They're customized. So we have to enter into
this contract counterparty by counterparty. In other words, this
is not a share of IBM that anybody can buy
and sell and is the same whether you trade it in
the New York Stock Exchange or in London or anywhere else. A forward contract is
a customized agreement between two parties. The second feature is that
it's typically nonstandard, so we can do as much of it or
as little of it as we want. And also, it doesn't
trade on exchanges. These are known as
over-the-counter securities. It doesn't trade on
an organized exchange. Two people trade with
each other over a counter. That's the customization part. Yeah? AUDIENCE: You said
that there's sometimes a circular effect on prices
on certain commodities. For example, if I
think that copper is going to be more expensive
six months from now, then I'm going to buy
more copper today, which is going to drive
up the price, then it's going to make it
lower in the future? ANDREW LO: If you
drive up the price, why would you make it
lower in the future? AUDIENCE: Because
my demand for it would be substituted now
instead of six months from now. ANDREW LO: Well, it's not clear
that it would make the price lower, because if
you're doing it, that may indicate
that there's going to be a shortage,
because you're trying to get ahead of that curve. And therefore, the
price may stay that way. So I'm not sure I
understand your question. Are you worried about
price manipulation, or are you worried
about the fact that the futures prices
or forward prices don't reflect current supply
and demand conditions? AUDIENCE: I'm just trying
to think that if I expect a certain price to
go up in the future, rather than hedging against-- the inflammation
that's in that price is based on the
inflammation of the price right now, so I'm going to
substitute my demand for-- ANDREW LO: OK, I
see what you mean. So let me rephrase the question. Your question is, if you think
the prices are going to go up for a particular
input-- say, copper-- then rather than
buy it six months from now at the
potentially higher price, you might decide to do it
sooner by buying it now. Right. That's a perfectly sensible
thing to do with one exception. And that is that when you buy
it now, you have to store it. And copper, oil, other
kinds of factor inputs are typically not
the kind of things that are costless to store. So you can either do that, buy
it now, store it, and then use it later, or you could do
a financial transaction that will have the same effect. And so that idea is going
to be exactly how we price these things. So I'm going to
come back to that. Hold onto that
thought, because we're going to use that
approach to figure out how to price a forward contract. So far, I haven't told you how
the forward price comes about. All I've said is, the
market determines it. Like before, we're going
to want to work out the logic for what the market
is doing when it figures out what that price is. And it will actually be
exactly the calculation that you just proposed. So in other words, either we
transact in the forward market, or we do it directly
in the spot market. Those are our two choices. And in the end,
it's going to have to be the case that
those two choices, which lead to the same
cash flows, they have to have the same price. And that's how we're going
to get the forward price. Yeah? AUDIENCE: Do you have
to have cash on hand now to enter into a
forward contract? ANDREW LO: No. AUDIENCE: So that
could be another reason why, if you're an
airline, for example, you wouldn't want
to buy millions and millions of dollars worth of
gas if you can't afford it now? ANDREW LO: That's right. But if you can't
afford it now, you're really talking more about a
short term kind of a borrowing situation, because
presumably, you're going to have to pay
for it at some point, particularly when you use it. But you're right that if
you don't have the cash now, then one way you can do it is
enter into a forward contract when you know you'll
have the cash later. AUDIENCE: Right. Because American
Airlines, I'm sure, couldn't afford to buy five
years' worth of fuel today, because they just don't have
enough assets to do that. ANDREW LO: Right. So you can't buy
that-- not only that, where are you going to put it? Five years' worth of
oil is a lot of oil. And it's very, very expensive. So your consideration
is absolutely right. The borrowing cost, or the
opportunity cost of capital, is also part of the equation. So if we think about
all the ingredients that have to go into
determining the forward price, one is the cost of storage. The other is the borrowing cost
implicit in that-- the cash-- because a forward contract
requires no money down. So this is one of these
true financial deals with no money down. The problem is that it's
not always a short profit. Yeah? AUDIENCE: You may also not
have the product to sell. For example, in the
case of soybean or food, you may enter into
a six month forward and I still did not
harvest a product. ANDREW LO: That's right. So you may want to wait
for the uncertainty to resolve and get a better
sense of what your needs are. Yup? AUDIENCE: So if between
the buyer and seller they have a different or
asymmetric information, is it possible that the
overall forward contract has positive NVP? ANDREW LO: Well, let me
put it to you this way-- the forward contract may
have an expected value for one party or the other
based upon what they know. But in principle, the NPV-- that's an objective
NPV-- has to be zero, because if it's not
zero, then one party can take that contract and basically
sell it to a third party and make money off of it. See what I mean? In other words,
your question is, if two parties have
different information, is it possible that the
contract has different value? Well, certainly they have
different value to each party. In other words, if I'm willing
to buy oil forward contracts from you, I must think
either that oil prices are going to go way up-- that's my view-- or
I just need the oil, and I want to get rid
of the uncertainty. But both of those are possible. If you're selling me this
oil forward contract, the two possible reasons
you might want to do it is because you've
got a lot of oil and you want to lock
in a price for selling that oil six months from now-- that's one possibility--
or you have some asymmetric information--
some private information-- that oil prices are
going to go down. So both of those
interpretations are legitimate. But the statement that I made
that the price of that contract has to be zero, that's a
statement not about your views or my views or her views. It's a statement about the
market price of that contract if we were to auction it off
to people in the marketplace. If we were to auction
it off to people in the marketplace in general,
it would have to sell for zero, because if it were positive,
then I would be benefiting and the person who's
selling it to me would be losing
out and vice versa. So we can have our own
speculative motives for doing the deal. But when the price is
set, the way that it's set is not just based upon simple
expectations of you and me. But it's the market that's
determining the forward price. Yeah? AUDIENCE: Then
what's the function of the over-the-counter market
for the forward contract? ANDREW LO: The
over-the-counter market is that you and I
are the ones that are entering into the deal. And so we're signing
the contract. So it's between us. But my point is that if the
forward price that we are using to strike that deal
is so one-sided, then it's going to be
very clear from the market that that's a stupid contract
for one of us to enter into. So it's a private transaction
between you and me. And for that matter, if
it's a private transaction, you're right that
it could be the case that we can make up any price. Let's say $200 a barrel. Would you ever see a contract
that's at $200 a barrel? No, because that would
mean that either you or me is being really stupid. Now we're perfectly
allowed to be stupid. The Constitution
guarantees that right. But it's unlikely, because
we know, both you and I, how oil is doing. And therefore, the price will be
set to make that contract worth nothing. If it were not worth
nothing, then one of us is making a very bad deal. And money is going to be
exchanged from one party to the other. Yeah? AUDIENCE: Does this
always have to happen between a buyer and a seller,
or could that be in communities? ANDREW LO: Could it be what? AUDIENCE: Could it
be in communities? ANDREW LO: I'm going to
get to that in two minutes. Right now, it's only
between buyer and seller. That's a forward contract. With the futures contract,
that's a different story. Another question? AUDIENCE: I'm just
wondering, does this actually assume physical
delivery of the asset? ANDREW LO: Yes, it does. Yes, it does, although
if it doesn't have to. If the contract that you
strike as a forward contract is one where you don't
want physical delivery, you can make it a
pure bet-- a side bet. But in fact, typical forward
contracts that are entered into are for physical delivery
of the actual commodity being agreed upon,
because that's why people enter into them. They need the oil or
the gas or the copper. Yeah? AUDIENCE: What does [INAUDIBLE]? ANDREW LO: So let
me get to that. I want to make sure we get all
the other questions answered, though, before I go down. The last point
that I want to make is that with a forward
contract, because it's a contract between
two parties, there is significant
counterparty risk, meaning there is a risk
that you don't pay up on your end of the deal
or that I don't pay up on my end of the deal. There is a significant risk
that one of the parties reneges. So this is not a riskless
kind of a contract. It has significant default risk. How significant depends
upon the counterparty. If you're dealing with-- I hate to say this--
but a AAA counterparty, then the risks should be small. But we all know what
AAA means these days. It used to be the
case that when you're dealing with a AAA
counterparty, you had very little counterparty risk. But if you're dealing
with a counterparty that doesn't have the same kind
of financial wherewithal, then you're going to
have to bear that risk. And it's up to you to
decide, is it worth it to you to take that risk? Yeah? AUDIENCE: So in event of
the very [INAUDIBLE] market fluctuation [INAUDIBLE],
somebody will lose in the end upon the settlement. So is it common for people that
participate in this to hedge their positions as well? [INAUDIBLE] ANDREW LO: To hedge
counterparty risk? AUDIENCE: Yes. ANDREW LO: It is common. And you know how they do it? They don't use a
forward contract. They use a futures contract. So we're going to get there
in just a few minutes. Maybe I should go
faster, given that there are all these questions that
are anticipating the futures contract. Or maybe it's just
that all of you are scared to death
of counterparty risk, given what's going on, that
you just want to get rid of it. So let me go quickly through an
example of a forward contract. Then I'll get to your point, and
I"ll show you how you go about hedging that risk by essentially
doing a transaction every day. But I want to make
sure we all understand the concept of a forward first. So here's an example. The current price of soybeans
is $160 a metric ton. That's the current spot price-- the price today. And there's a tofu
manufacturer that needs 1,000 tons, not now
but three months from now. And they want to make
sure they can get that 100,000 tons at that time. So they might enter into
a three-month contract to buy 1,000 tons at 165 tons. So they're going to offer
the seller of the soybeans-- the soybean farmer-- they'll offer them a
little bit of a premium-- a $5 premium-- in order
to lock in that price. Now it doesn't have to
always be a premium. In certain cases, there
could be a discount. And there are different
names for those that I'll talk about in a few minutes. But for now, it's at 165. And it's what the
market seems to agree is an appropriate price
three months from now. So you've all
identified, I think, the issues with a
forward contract. There are two issues. One is illiquidity, and the
second is counterparty risk. Illiquidity means,
suppose that I no longer want to be in the contract-- I want out. Well, it's not easy
for me to get out. I can't sell my
contract unless I find somebody else who wants to
buy soybeans at 165 tons three months from now. I can't get out of it easily. I can go back to
the farmer and say, would you mind
canceling the contract? And they'll probably say,
well, it depends, where is the price of soybeans today? If the price of
soybeans is at $180, I'm happy to cancel
the contract. If the price of soybeans
is at $50, sorry, you're stuck with the agreement. So the illiquidity is an issue. But then of course,
counterparty risk is another issue that
we have to deal with. Yeah, [INAUDIBLE]? AUDIENCE: [INAUDIBLE] trying
to hedge the quantity. It's not the actual price. Do companies do that where
they want to guarantee that there will be a supply? ANDREW LO: Yeah. Well, it's both. They want to guarantee
that they have enough to be able to produce
whatever they need to produce. So they need a certain
amount of input. But they won't want to
guarantee it at any price. They want to be able to
figure out a reasonable price. So in this example of
the tofu manufacturer, they need 1,000 tons
in three months. That's definite. That's the quantity
that they need. The question is,
what's the price? If the current spot
price is at $160, then they need to
make a decision. In three months
time, do they think that the price will be
greater or less than 165? If they think that it may
be much more than 165, then they'll enter into it. But if they think
that there's going to be a huge crop of
soybeans, because we've had a lot of rainfall
and a lot of sunshine and there's no problem
and we're going to have a glut of soybeans, then
they may not do this at all. They may just say,
huh, we're going to wait three months
to see what happens. Of course, if it turns out that
between now and three months from now there is
some kind of bacteria that kills half the soybean
crop, now it's $190 a ton, then they're in trouble. So as a tofu
manufacturer, you got to ask yourself the
question, how well do you know the soybean
market, how much are you willing to bet your
firm's franchise on soybeans being available at the
price that you want to pay three months from now? OK. So it's both price and quantity. All right. Now we're going to get
back to [INAUDIBLE] point about being worried
about counterparty risk. And let's just talk
about counterparty risk in very, very plain detail. Suppose that we enter into
that soybean contract. So today, we agree
to buy soybeans three months from now, as a tofu
manufacturer, for $165 a ton. All right, now let's
fast forward one month. We've got two months to
go in our agreement-- in our forward agreement-- and all of a sudden, something
happens in the soybean market, and the spot price for soybeans
has now dropped to $100 a ton. Huge glut that has hit the
market, because the weather was unexpectedly nicer, lots of
rainfall, just tremendous crop output. So we got $100 a
ton for soybeans. Now to the tofu manufacturer
who's looking to do this deal, is he in better shape or worse
shape in that circumstance? Why? Why is he in worse shape? He's agreed to buy it at
$165, price is at 100. But what's the big deal? He was willing to
do that a month ago. What's that? Same shape. Same shape. We agree? Worse-- why is it worse? AUDIENCE: Because his
competitors already have access to [INAUDIBLE]. ANDREW LO: Right. So what do you think the
competitors are going to do? Exactly. The competitors are going
to drop the price of tofu. Soybeans have come
down in price. The competitors are going
to cut the price of tofu. And here you've
got a manufacturer. If you argue that he's
in the same shape, that means that he's going to
keep the same price of tofu and he's going to pay $165
for what's worth $100. Basically, he's going
to go out of business, because his competitors
are going to eat his lunch. They're going to
charge 40% less, and he'll have
zero market share. And he may be able to withstand
that for a period of time, but not for a sustained
period of time. So this particular manufacturer
of tofu is thinking, well, I could buy soybeans
at $100 on the market now and I got two months before
I have to make good on this, what if I just walk away
from this forward agreement? Now legally, he's not
supposed to do that. So what that means is that if
he does do that, he can be sued. And from the tofu
manufacturer's point of view, he might be thinking,
well, they can sue me and we can figure it out, or I
can follow through the contract and I'll go out of business,
so if I'm faced with those two choices and that's
my only choice, I'm going to renege
on that contract and let them sue me
and see what they get, maybe we'll settle
out of court, maybe we won't, who knows
what will happen, I'm willing to take that risk. That's a calculation. It's a business decision
that has consequences. But it's got consequences
for both parties. Now imagine you're the soybean
farmer dealing with this tofu manufacturer. And you're rubbing your hands,
because you locked in at $165 a ton. But two months from
now when you go to deliver these soybeans,
you find out the warehouse is not accepting it. And you can't get this tofu
manufacturer on the phone. He's not returning your calls. What do you do? Yeah? AUDIENCE: This is currently
happening with oil. A lot of people locked in
at $5.00 a gallon and now it's above $4.00. So the oil companies are
scared that everyone's going to stiff them. ANDREW LO: Absolutely. There's counterparty
risk that comes about when you've got dramatic
changes in economic conditions. Yeah? AUDIENCE: But as far as
I know, the system only gave you the [INAUDIBLE] deposit
[INAUDIBLE] amount of the risk that you want to buy. ANDREW LO: Right. So now you're talking
about collateral. In order to be able to enter
into a forward agreement, you might, before you
even start talking, say, you know what, I'm not going to
do business with you unless you put up some money-- so money as a kind of collateral
for making good on it. And if you don't
make good on it, I get to keep the collateral. Now the question is, how
big is the collateral, and what is it worth? AUDIENCE: So you say, what
reason do you want to buy? If you just want to buy
a $30 risk [INAUDIBLE], so you put $30
[INAUDIBLE] want to buy. But you, from the
beginning, can say, how much [INAUDIBLE] do you want to buy? ANDREW LO: Well, but the
thing is that they may not be willing to do it. So let's do the
example of soybeans. Soybeans at $165 a ton
multiplied by 1,000 tons is $165,000. Right? AUDIENCE: I can put [INAUDIBLE] ANDREW LO: Right. So in order to do the deal,
maybe you would agree to put $5.00 a ton of
deposit as collateral. OK? That sounds good, right? And as a counterparty, I
might be happy with that. OK, now say the price of
soybeans drops to $100 a ton. And you've put $5.00 down as
earnest money as collateral. And so from your perspective,
as long as the price goes down by more than $5.00,
you're going to walk away. AUDIENCE: [INAUDIBLE]
but I lose the $5.00. ANDREW LO: Right. You lose the $5.00. I'm the soybean farmer. Great, I got $5.00 a ton. What's that going to do? That pays for my postage. That doesn't do anything for me. So given that I'm worried
about your counterparty risk, I'm going to say, you know
what, I don't want $5.00 a ton, I want you to pay
me $160 a ton now, I want you to deposit that
in the bank and put it in collateral. Would you be willing to do that? AUDIENCE: Depends on
the rate and the-- ANDREW LO: Exactly. It depends upon what you think
the risks are that the price is going to go down quite a bit. But in general, you're not going
to want to tie up $160 a ton for three months if you don't
have to, because that costs you something. The opportunity cost
is the interest rate. Yeah? AUDIENCE: Why don't I just
make a contract saying I would buy at a
10% markup instead of setting a specific price? Does it no longer [INAUDIBLE]? ANDREW LO: Well, no. You could certainly do that. But it's not clear that that
really makes any difference. 10% markup over what? You have to define something. AUDIENCE: The price at the time. ANDREW LO: Over the
prevailing market price. You could do that. [INTERPOSING VOICES] Right. What's the benefit of that? That doesn't lock in anything. It may lock in the supply, but
it doesn't lock in the price. You still have
price uncertainty. So if you do that, unless
you're worried about a shortage, you can always get something
for 10% above the price, at least I think you can. Markets are pretty crazy. But if I were to tell you that
no matter what commodity we're talking about, I'm willing to
pay 10% more than the market price, my guess is that
everybody here would be pretty happy to sell to me. Right? Yeah? AUDIENCE: But these [INAUDIBLE]
evaluated by anybody. So are these just contracts
between producer and supplier? ANDREW LO: Yes. AUDIENCE: So they're like
longstanding agreements and I'm just-- ANDREW LO: Right. That's right. These are not
governed by any agency or any kind of standardization. And you now see the problem
with these contracts. These contracts work if the
two parties know each other, they've done business for
years, there's a lot of trust, you don't have to worry
about counterparty risk, you've got the right
amount of collateral, you've got the right
rating, on and on. It's complicated. Isn't there a way to
make this simpler? And the answer is
that there's a way to deal with all of your
objections-- all of them. Let's create a new
contract called a futures. A futures contract is
exactly like a forward with a few exceptions. Exception number one, we're
going to standardize a futures contract. One contract applies
to a fixed amount of the commodity of
a fixed quality that is known in advance and
is decided objectively. It expires, or it
settles, on a fixed date. And there is a futures price. And the price is
determined on an exchange. OK, so that's one
set of changes. But the other set of
changes is really important, which is that we are going
to mark to market every day. Now what does mark
to market mean? If you've got a
futures contract-- or rather, if you've got
a forward contract that expires in three months,
initially it's worth nothing. But over time, as the
spot price fluctuates, that forward contract has value. But no money changes hands. And so because no money
changes hands, and apart from collateral, you can
have a really big mismatch in the value of the contract
to one party or another. So let's go back to
the soybean example. I start out by agreeing
to buy soybeans from you at $165 a metric
ton three months from now. And the spot price today is 160. All right. A month from now, let's say,
the spot price is down to 150. What do you think
that contract is going to be worth at that point? Yeah? AUDIENCE: [INAUDIBLE] ANDREW LO: That's right. $15. How did you get $15? AUDIENCE: It's the difference
between the future price and the spot today. ANDREW LO: That's right. I've agreed to buy it for $165. The spot price two months
from maturity is $150. That's $15 difference. And so this piece of paper
obligates me to buy it for $15 more than today. So from my perspective--
the buyer-- the contract is worth not
zero, but it's worth negative $15 divided by the
rate of interest, because I don't have
to pay the $15 today. I have to pay the $15 at
maturity, at settlement. For you, the farmer who sold me
that contract, that contract-- to you, it's worth $15 per
1,000 metric tons divided by the appropriate discount
factor-- the interest rate-- for that three months. Now to say that it's worth that
really means it's worth that. For example, if
you decide that you want to get out of the
soybean farming business and you want to
take that contract and sell it to one of
your fellow farmers, they'll pay you $15 divided
by the appropriate interest rate per 1,000 metric tons. You will be able to
sell that contract for that amount of money. So after date zero, as
the spot price fluctuates, this forward agreement ends
up taking on economic value, because the prices fluctuate. If we allow that
price fluctuation-- if we allow the value
of that contract to get really, really big-- in my crazy example, if the
spot price goes down to 100-- well, then that piece
of paper is worth a lot to you, the farmer. And it's worth a lot to me to
be able to get rid of that loss. That's a big loss. The bigger the loss, the more
likely it is that one of us is not going to perform. Why? Because the collateral-- if we
have a collateral of $5.00 per 1,000 metric tons, that $5.00
is going to become meaningless pretty soon, because I'm
looking at a loss of $50. If it goes down
from $165 to $100, I'm looking at a
really big loss-- $65 per metric ton. $5.00 means nothing to me. So the bigger the
fluctuations away from the initial forward
price, the bigger the potential for
counterparty risk. So if that's the case, let's
you and I agree on something. Why don't we agree that
every single day, we will strike a new contract
with a new forward price, and then we'll just pay
each other the difference day by day? So in other words,
in your example, let's say it's $165 today. We agree on that. The spot price is at $160. Let's say tomorrow the spot
price goes down to $155. OK, you know what, let's you and
I agree I'm going to just pay you $5.00 divided by the
interest over the next three months minus a day, and then
let's cancel the contract. And let's start a new one. And let's say that
now, today, we're going to agree to
not $165, but $160. The spot price is at $155. Let's agree to $160. OK? And now another day passes by. And let's see the price goes
down yet again, now down to $155. AUDIENCE: [INAUDIBLE] $5.00. ANDREW LO: Yes. Right. Or I give you $5.00,
you give me $5.00. Every single day,
we exchange money. And every single day, we
get rid of the old contract and we do a whole new one with a
new forward price that reflects current market conditions. If we do that-- well, first of all, it's going
to be a pain in the neck, because we have to do a
lot of contracts every day. But suppose we did that. If we did that every day,
then what we would be doing is essentially always figuring
out what today's market price is for soybean delivery
on that settlement date. That's what it means
to mark to market. At every single day, the
price of the contract reflects today's
market valuation, not when we did the
contract at the beginning of that three-month period. Every single day as we
get closer and closer to settlement, we are
revising the forward price to reflect all the
information that's accumulated up to that point. And I'm either paying
you, or you're paying me. We're changing
money every day so that the value of the agreement
is never that far out of sync from the market's value. That way, we can protect this
kind of counterparty risk, because then the only risk
I'm going to have with you is the risk that comes from
a one-day fluctuation, not three months. Prices can move a
lot in three months. But by that time, we will have
changed money back and forth. And so you know what? When you add up all the
money that's changed hands over the course of the
entire three months, if we struck a new
forward contract every day and then we added up all the
money that went back and forth and did the interest
rate just right, you know what we would get? We would basically
get the same thing as if we had gotten a
forward contract on day one and held it to maturity. But the difference is that
during that three-month period, you and I, we've
never had to worry about either party reneging,
because the amount of cash that is owed to one party or
another has gotten so big that it makes it
worthwhile to walk away. So a forward contract
is a situation where you don't mark
to market every day. You allow the value of that
contract to go up and down and up and down to
wherever the spot price determines that
it does, in relation to that forward price. With the futures
contract, you can think of a futures as a
sequence of forward contracts where you cancel the forward
contract every period but pay the difference that was
won or lost relative to the day before. So there's one more piece
that I have to tell you about. And that is that-- somebody
asked about an intermediary with forward contracts. Forward contracts
have no intermediary. But futures contracts do. Some clever person figured out
that all of these other changes that we want to implement
to create a futures contract is great, except that there
is still this lingering concern that somehow you
don't show up tomorrow when I want to basically do a
deal and update my contract. So they came up with
a brilliant idea of establishing an intermediary
called the Futures Clearing Corporation. The Futures Clearing
Corporation is an organization that sits between you and me. And what it does is simply
serve as the counterparty. So I'm not dealing
with you or you or you. I'm dealing with one
organization that stands in the middle of everybody. I'm dealing with
that organization, and you're dealing
with that organization. And as long as that
organization makes sure that there are two sides
to every transaction-- more or less, two sides
to every transaction-- then that will reduce
the risk even more. So not only are the
contracts standardized, not only are they
mark-to-market every day, and not only do we re-establish
this price every day, but we then now have the safety
of a clearing corporation that we know will always be
there to transact with us. So the market is
highly, highly liquid. OK. Now-- question? Yeah? AUDIENCE: Are there any
industries or companies that use forwards
rather than futures? ANDREW LO: There are some. In fact, oil companies,
airline companies, and other major
producers or suppliers, they prefer forwards,
simply because they don't want to deal with
these mark-to-market issues. And they've dealt
with their suppliers long enough that
they trust them. And so they've got
standardized forward agreements that are customized to
exactly what they want. For example, a futures contract
has very specific settlement dates. If those settlement
dates don't correspond with when you need
the particular input, then you don't want to use that. But by and large,
the futures contracts eliminates a lot of these issues
with forward contracts so that for liquidity, for
transparency, for safety-- all of those reasons-- they are actually preferred
to forward contracts. But forward contracts
are still very popular. For example, there
are some markets where forward
contracts are actually even more popular than futures. One example-- currencies. For a variety of
reasons, currencies-- where you trade with banks for
different foreign currencies in the future, the
futures exchanges have much lower volume, in terms
of dollars traded or yen traded or cable traded, than
the banks dealing with these forward contracts. Yeah, [INAUDIBLE]? AUDIENCE: Looks
like in this case the interest rate risk is also
a [INAUDIBLE] of the future. Is that right? ANDREW LO: The
interest rate is what? AUDIENCE: Interest rate
risk is also a risk. ANDREW LO: Yes,
interest rate risk is definitely a part of
it, because remember, we have to divide
implicitly by the interest, because we're getting paid not
now, but in three months or two months or 29 days and so on. So we're going to get to that. In fact, let me
do some examples, and then we're going to talk
about how interest rates figure into this explicitly. So here's an example
of a futures contract. NYMEX-- the New York Mercantile
Exchange, it's called NYMEX-- trades crude oil futures. Now there are lots of
different kinds of oil. And there are futures
contracts that are designated for a particular kind. So crude oil light is one. Another one is Brent crude oil-- oil from the Brent Seas. And each different kind of
oil has a different contract. Remember, we have to standardize
the underlying commodity. So NYMEX crude oil futures
with delivery in December 2007 at a price of $76.06 a barrel
on July 27, 2007 where there's 51,475 contracts traded. So this is a simple example
of an actual contract that was traded in the good old days
when oil was only $75 a barrel a year ago. Each contract is
for 1,000 barrels. So that's part of
the standardization. The tick size--
tick size meaning, what is the denomination that
prices will change when they change up and down-- it's a penny a barrel. So in other words,
with 1,000 barrels, if it moves a penny
a barrel, that means the contract, which
is for 1,000 barrels, moves in $10 increments. So when you buy one
of these contracts, you are buying
1,000 barrels of oil to be delivered to
you in December. That's what one of
these contracts means. Now you actually have to
put up some collateral for these as well. But think about it. If it's $75 a barrel and it's
1,000 barrels per contract, then how much oil are you
controlling with one contract in dollar terms? Yeah, it's $75,000. That's a lot of money
for one contract. Look at how much collateral
you have to post. The amount of
collateral that you have to give your broker to
buy one of these contracts is $4,050. Now by the way, that collateral
has increased by about 50% as of this morning. The New York
Mercantile Exchange, Chicago Board of Trade,
and other futures companies have increased margins
across the board for most of the futures
contracts because of concerns about liquidity and viability. Maintenance margin says that
once you establish an account and put the $4,000,
they know the money is going to go down or up as the
price of oil goes down or up. But at all points in time, you
have to keep at least $3,000 in there. So in other words, the $4,000,
you could lose some of that and it could go down
to $3,500 or $3,250. But if it goes
below $3,000, you're going to get a phone call
from your broker that says, you need to
deposit more money, you need to bring it
up to $3,000, that's what you need to do to
maintain the account. And you know what happens if you
don't return that phone call? They get rid of the contract. You're out of the market. If you don't wire that money
into the account by end of business on the day
you get the margin call, they have the right, and they
will close out your contract. AUDIENCE: [INAUDIBLE] ANDREW LO: Well, it depends
on what your position is. No, you have whatever
money you have left. But you no longer have
the position in oil. So if that $3,000
goes down to $2,500, that's still your
$2,500, but you no longer have a position in oil anymore
at the end of business. That's one of the beauties
of a futures contract, from the perspective
of the counterparty. It's that they
don't have to worry that you're going to run away. The most they can lose is one
day's worth of fluctuation in the value of the contract. That's why for a
$75,000 agreement, you only have to put down
$4,000 earnest money. In the case of that
soybean farmer, think about how much money you
really would be comfortable requiring the
counterparty to put down if you're going to exchange
no money for three months. Three months, you never
see the other person. You don't know whether
they're still alive. You don't know what's going
on with their business. You're going to actually have
them put up a lot more money. With the futures
contract, you only have to put up enough
money to make sure that on a daily basis, you're
not getting taken advantage of. Yeah? AUDIENCE: How's that
initial margin set? ANDREW LO: The initial margin
is set exactly the same way that the margin was going
to be set with collateral for that soybean contract. It's the amount
of money that they think is enough to cover
any daily fluctuations in the underlying
futures contract. So if the underlying
price moves by a lot, what do you think that
will do to the margin-- make it go up or down? Up. So now do you know why
all of the exchanges decided to increase
their margin? Fluctuations have
started going up. And also, people's credit,
in general, have gone down. Yeah? AUDIENCE: Just going
back to your answer to [INAUDIBLE] physical
goods, if you and I can enter into a futures contract
[INAUDIBLE] traded, isn't physical delivery
not really expected, especially with the margin cost? Just by [INAUDIBLE]. ANDREW LO: Yes, so
with futures contracts, the majority of the people
that use futures are not looking for physical delivery. But with most of the
commodity futures contracts, you actually have to specify. So there have been
stories of speculators that forgot to check the box
that says Cash Settled Only that have gotten
tons and tons of corn dumped on their front lawn. That has happened. It's been a while,
but it's happened. Most futures contracts
are cash settled. Cash settled means
no physical delivery. But there are
certain people that actually want the physicals. And so they will transact
in the future markets to get physical delivery. OK, that's it for today. We will see you not Monday,
because that's Columbus Day. But I'll see you a
week from Monday.
