Lecture 19 Forwards amp; Futures.ppt

Lecture 19: Forwards Futures First Futures Market: Osaka Begun at Dojima, Osaka, Japan, in 1670s. World’s only futures market until 1860s. Dojima was center for rice trade, with 91 rice warehouses in 1673. Dojima futures exchange had precise definitions of quality, delivery date and place, experts who evaluated rice quality, and clearinghouses for contracts. Trading floor, daily resettlement, burning fuse, and watermen Function of Osaka Futures Market Japan had sophisticated financial contracts before the futures market, partly under influence of Dutch. Rice bills and silver bills were kinds of forward contracts. Osaka market provided liquidity and price discovery for rice, allows merchants to hedge. Issues for Rice Warehouser Warehousing itself is a stable business, little risk Great risk in fluctuation in rice price Warehouser may seek to sell the rice forward and lock in initial price. But, a forward contract is illiquid, difficult Forward Contract Forward is just a contract to deliver at a future date (exercise date or maturity date) at a specified exercise price. Example: Rice farmer sells rice to warehouser. Example: Foreign Exchange (FX) forward. Contract to sell ￡ for ￥. Both sides are locked into the contract, no liquidity. What will warehouse think if rice farmer tries to get out of the contract? Problem with Forwards: Default Farmer and warehouser must check each others’ creditworthiness Forward contracts are inherently credit instruments. Only people with good credit can use them. FX Forwards and Forward Interest Parity FX Forward is like a pair of zero coupon bonds. Therefore, forward rate reflects interest rates in the two currencies Forward Interest Parity: Forward Rate Agreements Promises interest rate on future loan. L=actual interest rate on contract date R=contract rate D=days in contract period A=contract amount B=360 or 365 days Futures Contracts Futures contracts differ from forward contracts in that contractors deal with an exchange rather