1 00:00:00,090 --> 00:00:02,430 The following content is provided under a Creative 2 00:00:02,430 --> 00:00:03,820 Commons license. 3 00:00:03,820 --> 00:00:06,030 Your support will help MIT OpenCourseWare 4 00:00:06,030 --> 00:00:10,120 continue to offer high quality educational resources for free. 5 00:00:10,120 --> 00:00:12,690 To make a donation or to view additional materials 6 00:00:12,690 --> 00:00:15,150 from hundreds of MIT courses, visit 7 00:00:15,150 --> 00:00:17,000 MITOpenCourseWare@ocs.MIT.edu. 8 00:00:21,150 --> 00:00:24,270 ANDREW LO: So far, the stock market is down. 9 00:00:24,270 --> 00:00:26,770 But on the other hand, if you look at the three-month T-bill 10 00:00:26,770 --> 00:00:32,049 rate, it's up about 60, 70 basis points. 11 00:00:32,049 --> 00:00:33,480 So that's not bad. 12 00:00:33,480 --> 00:00:38,790 Looks like there is some sense that liquidity is going 13 00:00:38,790 --> 00:00:42,552 to be good for the market. 14 00:00:42,552 --> 00:00:44,710 And I guess we'll wait and see. 15 00:00:44,710 --> 00:00:46,797 But clearly, the Fed is making a-- 16 00:00:49,720 --> 00:00:54,960 the Fed is making every effort to maintain liquid markets. 17 00:00:54,960 --> 00:00:57,480 We should keep in mind-- those of you who are starting 18 00:00:57,480 --> 00:00:59,340 to panic and thinking, gee, really, 19 00:00:59,340 --> 00:01:01,530 all hell is about to break loose-- 20 00:01:01,530 --> 00:01:07,140 keep in mind that interest rates are still pretty low overall. 21 00:01:07,140 --> 00:01:09,180 Obviously, the Fed cutting rates is 22 00:01:09,180 --> 00:01:11,910 going to mean that the overnight borrowing rate between banks 23 00:01:11,910 --> 00:01:13,360 and the Fed is low. 24 00:01:13,360 --> 00:01:15,420 But if you look at commercial paper-- 25 00:01:15,420 --> 00:01:19,560 if you look at a variety of other indicators of borrowing 26 00:01:19,560 --> 00:01:23,820 rates, they're relatively low, to the extent that markets 27 00:01:23,820 --> 00:01:25,560 are, quote, "frozen." 28 00:01:25,560 --> 00:01:30,810 It really means that the banks and other agencies 29 00:01:30,810 --> 00:01:32,550 are waiting to figure out what's going 30 00:01:32,550 --> 00:01:36,270 to happen with regard to the rescue package and other market 31 00:01:36,270 --> 00:01:39,330 events before they start to lend again. 32 00:01:39,330 --> 00:01:42,030 And there's nothing structurally wrong 33 00:01:42,030 --> 00:01:45,930 with their particular business models, 34 00:01:45,930 --> 00:01:49,380 nor is it the case that we somehow run out of money 35 00:01:49,380 --> 00:01:51,749 or we've all lost these assets. 36 00:01:51,749 --> 00:01:53,790 Investors right now are waiting on the sidelines. 37 00:01:53,790 --> 00:01:55,530 And you can tell from market dynamics 38 00:01:55,530 --> 00:01:58,500 that there's enormous amount of fear that 39 00:01:58,500 --> 00:01:59,940 is really affecting markets. 40 00:01:59,940 --> 00:02:05,250 And this is exactly the kind of reaction 41 00:02:05,250 --> 00:02:08,310 that the Fed was trying to forestall two weeks ago when 42 00:02:08,310 --> 00:02:10,530 the money markets broke the buck. 43 00:02:10,530 --> 00:02:13,710 And hopefully, they will still be able to do so. 44 00:02:13,710 --> 00:02:15,690 But you can tell that it's building. 45 00:02:15,690 --> 00:02:18,150 And market fear, as measured by things 46 00:02:18,150 --> 00:02:20,970 like the stock market and bond markets, 47 00:02:20,970 --> 00:02:23,100 that's still a concern. 48 00:02:23,100 --> 00:02:24,430 So we'll wait and see. 49 00:02:24,430 --> 00:02:27,060 But so far, it seems like the developments 50 00:02:27,060 --> 00:02:31,020 are as we pretty much expected. 51 00:02:31,020 --> 00:02:34,560 There really isn't any huge surprises going on. 52 00:02:34,560 --> 00:02:35,530 Any questions? 53 00:02:35,530 --> 00:02:36,033 Yep? 54 00:02:36,033 --> 00:02:39,490 AUDIENCE: I wanted to share my experience. 55 00:02:39,490 --> 00:02:43,120 It's like about six years ago in Argentina, 56 00:02:43,120 --> 00:02:45,690 we had this crises that it was similar to this, 57 00:02:45,690 --> 00:02:49,990 in the sense that the whole country disappeared. 58 00:02:49,990 --> 00:02:52,600 We had five presidents in a week. 59 00:02:52,600 --> 00:02:53,400 We defaulted. 60 00:02:53,400 --> 00:02:55,150 The government defaulted. 61 00:02:55,150 --> 00:02:56,940 Half of the public companies defaulted. 62 00:02:56,940 --> 00:02:58,760 We devalued our currency. 63 00:02:58,760 --> 00:03:02,170 It was really chaotic. 64 00:03:02,170 --> 00:03:04,950 And still, I don't know how we survived. 65 00:03:04,950 --> 00:03:09,090 And two years afterwards, I went into working to this investment 66 00:03:09,090 --> 00:03:09,960 fund. 67 00:03:09,960 --> 00:03:12,740 And we just started buying companies 68 00:03:12,740 --> 00:03:14,840 that were really in sale. 69 00:03:14,840 --> 00:03:18,710 And when he says that this creates opportunity, 70 00:03:18,710 --> 00:03:21,880 it sort of feels a little naive or something like that, 71 00:03:21,880 --> 00:03:23,945 but it really creates opportunities. 72 00:03:23,945 --> 00:03:30,290 So those who survive can have really good choices afterwards. 73 00:03:30,290 --> 00:03:31,560 So I don't know. 74 00:03:31,560 --> 00:03:34,942 What I'm doing now is trying to take a deep breath 75 00:03:34,942 --> 00:03:37,829 and flow through the crisis. 76 00:03:37,829 --> 00:03:39,870 ANDREW LO: Yeah, I think that's very good advice. 77 00:03:39,870 --> 00:03:42,510 And in fact, in terms of opportunities-- 78 00:03:42,510 --> 00:03:44,600 I think that right now, because everybody 79 00:03:44,600 --> 00:03:49,082 is transfixed on the problems with the economy, 80 00:03:49,082 --> 00:03:50,790 people aren't thinking about opportunity, 81 00:03:50,790 --> 00:03:51,748 because they're scared. 82 00:03:51,748 --> 00:03:54,210 And I wish I could fast forward and give you 83 00:03:54,210 --> 00:03:56,737 my last lecture for this course now, 84 00:03:56,737 --> 00:03:58,320 because it's actually pretty relevant. 85 00:03:58,320 --> 00:04:00,810 The last lecture of the course is where I actually 86 00:04:00,810 --> 00:04:04,334 bring in some evidence about psychological biases 87 00:04:04,334 --> 00:04:05,250 that affect all of us. 88 00:04:05,250 --> 00:04:07,208 And in particular, there's some recent evidence 89 00:04:07,208 --> 00:04:09,510 in the neurosciences that explain 90 00:04:09,510 --> 00:04:13,210 why it is that when we are stricken with fear, 91 00:04:13,210 --> 00:04:14,610 it almost paralyzes us. 92 00:04:14,610 --> 00:04:18,329 Actually, physiologically it can paralyze us 93 00:04:18,329 --> 00:04:20,519 in terms of decision-making ability. 94 00:04:20,519 --> 00:04:22,350 So I don't want to talk about it now, 95 00:04:22,350 --> 00:04:24,310 because that's going to be the last lecture. 96 00:04:24,310 --> 00:04:26,730 And I feel we have to cover the material. 97 00:04:26,730 --> 00:04:29,490 But it's true that when you're in the midst of it, 98 00:04:29,490 --> 00:04:33,060 it's very difficult to think rationally. 99 00:04:33,060 --> 00:04:35,020 But I'll give you one example of, I think, 100 00:04:35,020 --> 00:04:38,640 a wonderful idea that nobody has mentioned but is 101 00:04:38,640 --> 00:04:43,440 perfect for an MIT audience or an MIT entrepreneur. 102 00:04:43,440 --> 00:04:47,560 One of the problems that we face right now is the unknown. 103 00:04:47,560 --> 00:04:50,880 We don't know what CDOs and CDSes and all 104 00:04:50,880 --> 00:04:53,950 these complex securities are worth. 105 00:04:53,950 --> 00:04:57,190 Wouldn't it be wonderful to have a website that did nothing 106 00:04:57,190 --> 00:05:01,960 more than post the prices of transactions 107 00:05:01,960 --> 00:05:05,470 in these securities over a period of time, 108 00:05:05,470 --> 00:05:07,840 really as a means of providing information 109 00:05:07,840 --> 00:05:11,500 to the marketplace about what kinds of deals are being done 110 00:05:11,500 --> 00:05:13,360 and at what prices? 111 00:05:13,360 --> 00:05:15,160 We don't have an organized exchange. 112 00:05:15,160 --> 00:05:17,110 So that's another idea is to create 113 00:05:17,110 --> 00:05:20,510 a kind of an eBay for CDOs. 114 00:05:20,510 --> 00:05:21,340 It may not work. 115 00:05:21,340 --> 00:05:22,210 It may be naive. 116 00:05:22,210 --> 00:05:24,340 It may be something that somebody has already 117 00:05:24,340 --> 00:05:25,060 thought of. 118 00:05:25,060 --> 00:05:27,040 But these are the kind of innovations 119 00:05:27,040 --> 00:05:28,720 that the market is crying for. 120 00:05:28,720 --> 00:05:30,550 And I promise you, if you are the first one 121 00:05:30,550 --> 00:05:33,280 to the market with one of these innovations, 122 00:05:33,280 --> 00:05:35,860 my guess is that that's going to be a billion dollar idea, 123 00:05:35,860 --> 00:05:38,410 because everybody right now is looking 124 00:05:38,410 --> 00:05:41,980 for some means of getting transparency and liquidity 125 00:05:41,980 --> 00:05:43,820 into these marketplaces. 126 00:05:43,820 --> 00:05:46,600 And so if you could be the first, or second or third 127 00:05:46,600 --> 00:05:49,240 even, to come up with that mechanism for being 128 00:05:49,240 --> 00:05:52,150 able to provide pricing information just 129 00:05:52,150 --> 00:05:55,490 a little bit better than nothing at all, 130 00:05:55,490 --> 00:05:57,042 you can actually do incredibly well. 131 00:05:57,042 --> 00:05:58,750 That's an example-- very simple example-- 132 00:05:58,750 --> 00:06:02,260 of how technology can actually transform that market, 133 00:06:02,260 --> 00:06:03,640 because most of that market right 134 00:06:03,640 --> 00:06:05,950 now is still paper and pencil. 135 00:06:05,950 --> 00:06:09,460 It's just really relatively backward, 136 00:06:09,460 --> 00:06:12,240 from a technological perspective. 137 00:06:12,240 --> 00:06:12,740 OK. 138 00:06:12,740 --> 00:06:13,824 Yeah? 139 00:06:13,824 --> 00:06:16,184 AUDIENCE: [INAUDIBLE] transparency, why do you 140 00:06:16,184 --> 00:06:19,834 think the banks push to get rid of mark-to-market accounting? 141 00:06:19,834 --> 00:06:21,750 ANDREW LO: Well, I'm glad you brought that up. 142 00:06:21,750 --> 00:06:23,708 We're going to talk about that in this lecture. 143 00:06:23,708 --> 00:06:25,040 That's a very important point. 144 00:06:25,040 --> 00:06:27,074 First of all, I want to define mark to market. 145 00:06:27,074 --> 00:06:28,490 And we're going to talk about that 146 00:06:28,490 --> 00:06:30,949 and the difference between forward and futures contract. 147 00:06:30,949 --> 00:06:32,490 But let me give you the short answer. 148 00:06:32,490 --> 00:06:35,390 And then I'm going to spend the rest of this lecture hopefully 149 00:06:35,390 --> 00:06:37,370 justifying it. 150 00:06:37,370 --> 00:06:39,830 The idea that some banks have proposed 151 00:06:39,830 --> 00:06:45,200 to suspend mark-to-market accounting 152 00:06:45,200 --> 00:06:49,040 is probably the worst idea I've ever 153 00:06:49,040 --> 00:06:51,515 heard of in this entire crisis. 154 00:06:54,020 --> 00:06:59,390 Now let me not mince words and explain what-- 155 00:06:59,390 --> 00:07:02,660 the idea of not marking to market 156 00:07:02,660 --> 00:07:08,150 is a little bit like telling a crowded theater, where 157 00:07:08,150 --> 00:07:13,840 you smell smoke and you see flames on the stage-- 158 00:07:13,840 --> 00:07:16,090 instead of letting people get out of that theater, 159 00:07:16,090 --> 00:07:18,802 it's like telling everybody in the theater, all right, 160 00:07:18,802 --> 00:07:21,010 we're not really sure exactly what the smoke is from, 161 00:07:21,010 --> 00:07:23,530 but we want everybody to sit down, relax, 162 00:07:23,530 --> 00:07:26,590 take a deep breath, and let us think about it for another half 163 00:07:26,590 --> 00:07:29,590 an hour, and then we'll decide. 164 00:07:29,590 --> 00:07:31,983 That's what suspending mark-to-market will do. 165 00:07:31,983 --> 00:07:34,730 AUDIENCE: So do you think when the SEC has come out 166 00:07:34,730 --> 00:07:36,813 and said that companies now can use their judgment 167 00:07:36,813 --> 00:07:40,516 to [INAUDIBLE] sale prices, do you 168 00:07:40,516 --> 00:07:42,520 think that's going to happen [INAUDIBLE]? 169 00:07:42,520 --> 00:07:44,520 ANDREW LO: Well, it's a little too soon to tell, 170 00:07:44,520 --> 00:07:46,480 because we don't know exactly what the treasury will do. 171 00:07:46,480 --> 00:07:48,240 The SEC can say whatever they want. 172 00:07:48,240 --> 00:07:49,980 The bottom line is, is there a market 173 00:07:49,980 --> 00:07:53,580 for these securities at prices that these companies come up 174 00:07:53,580 --> 00:07:54,480 with? 175 00:07:54,480 --> 00:07:58,890 I may think that my ideas are the most valuable in the world. 176 00:07:58,890 --> 00:08:00,510 That doesn't make it so. 177 00:08:00,510 --> 00:08:01,902 And in the same way, corporations 178 00:08:01,902 --> 00:08:04,110 that feel that their securities are the most valuable 179 00:08:04,110 --> 00:08:06,390 in the world, that doesn't make it so. 180 00:08:06,390 --> 00:08:10,830 What makes it so is what we said on the very first day of class. 181 00:08:10,830 --> 00:08:11,610 And that is, what? 182 00:08:11,610 --> 00:08:14,190 What determines the value of security? 183 00:08:14,190 --> 00:08:14,820 Exactly. 184 00:08:14,820 --> 00:08:16,660 You all-- the market. 185 00:08:16,660 --> 00:08:20,550 And so if nobody wants to buy or sell at any price, 186 00:08:20,550 --> 00:08:22,640 then that's not really a price. 187 00:08:22,640 --> 00:08:26,370 A price is a number at which two mutually consenting adults 188 00:08:26,370 --> 00:08:27,924 agree to transact. 189 00:08:27,924 --> 00:08:30,090 And if you can't find two mutually consenting adults 190 00:08:30,090 --> 00:08:31,631 to agree to transact, you can come up 191 00:08:31,631 --> 00:08:33,690 with all sorts of really interesting numbers, 192 00:08:33,690 --> 00:08:35,549 but those aren't prices. 193 00:08:35,549 --> 00:08:38,400 So we're going to talk about that exactly in this lecture, 194 00:08:38,400 --> 00:08:41,460 because what I want to do is to describe to you how 195 00:08:41,460 --> 00:08:44,400 forward contracts and futures contracts work. 196 00:08:44,400 --> 00:08:46,961 You've heard of both terms, I think. 197 00:08:46,961 --> 00:08:48,960 We've talked explicitly about forward contracts, 198 00:08:48,960 --> 00:08:50,640 but we haven't talked about futures. 199 00:08:50,640 --> 00:08:52,400 The innovation of futures contracts 200 00:08:52,400 --> 00:08:55,450 is exactly this mark-to-market issue. 201 00:08:55,450 --> 00:08:57,810 So let's get to the topic for today 202 00:08:57,810 --> 00:09:00,990 and talk about forward and futures. 203 00:09:00,990 --> 00:09:03,240 So in this lecture, what I'm going to cover 204 00:09:03,240 --> 00:09:05,540 is the definition of forward and futures contracts. 205 00:09:05,540 --> 00:09:07,290 And then I want to show how to value them. 206 00:09:07,290 --> 00:09:08,760 The valuations of these contracts 207 00:09:08,760 --> 00:09:12,210 will also use net present value formulas, 208 00:09:12,210 --> 00:09:14,490 but it'll be used in a somewhat different way. 209 00:09:14,490 --> 00:09:16,937 So that's why we want to spend extra time going over 210 00:09:16,937 --> 00:09:18,020 these kinds of securities. 211 00:09:18,020 --> 00:09:21,510 They're different from what we've looked at so far. 212 00:09:21,510 --> 00:09:23,250 There's some motivation from why you 213 00:09:23,250 --> 00:09:25,800 might want to consider these contracts that I've got up here 214 00:09:25,800 --> 00:09:26,760 in the slide. 215 00:09:26,760 --> 00:09:28,860 But really, the motivation is pretty simple. 216 00:09:28,860 --> 00:09:31,080 And actually, the motivation is brought home 217 00:09:31,080 --> 00:09:33,870 by current events because of the uncertainty 218 00:09:33,870 --> 00:09:36,120 in markets right now. 219 00:09:36,120 --> 00:09:38,690 The first example-- your company, based in the US, 220 00:09:38,690 --> 00:09:40,320 supplies machine tools to customers 221 00:09:40,320 --> 00:09:41,940 in Germany and Brazil. 222 00:09:41,940 --> 00:09:44,250 Prices are quoted in each country's currency, 223 00:09:44,250 --> 00:09:47,850 so fluctuations in the euro, dollar, and the Real dollar 224 00:09:47,850 --> 00:09:50,640 exchange rates have a big impact on the firm's revenue. 225 00:09:50,640 --> 00:09:54,700 How can the firm reduce or hedge these risks? 226 00:09:54,700 --> 00:09:59,580 This is an example where you're making machine tools. 227 00:09:59,580 --> 00:10:03,209 You have no idea what exchange rate markets are going to do. 228 00:10:03,209 --> 00:10:04,500 And that's not really your job. 229 00:10:04,500 --> 00:10:06,360 You don't really care about that. 230 00:10:06,360 --> 00:10:07,830 But the fact is that it does have 231 00:10:07,830 --> 00:10:09,930 an impact on your company's performance, 232 00:10:09,930 --> 00:10:12,240 because a large part of your revenues 233 00:10:12,240 --> 00:10:15,540 are going to be coming in in these foreign currencies. 234 00:10:15,540 --> 00:10:18,780 So what you'd like to do is to figure out 235 00:10:18,780 --> 00:10:21,720 a way to eliminate that kind of uncertainty, 236 00:10:21,720 --> 00:10:23,765 or at least reduce it. 237 00:10:23,765 --> 00:10:25,140 And there are many other examples 238 00:10:25,140 --> 00:10:29,640 here where an individual has a particular objective in mind, 239 00:10:29,640 --> 00:10:33,990 and market fluctuations are so extreme that they end up 240 00:10:33,990 --> 00:10:36,720 being a distraction and, in some cases, a decrement 241 00:10:36,720 --> 00:10:38,970 to the business opportunity. 242 00:10:38,970 --> 00:10:40,860 The idea behind a forward contract 243 00:10:40,860 --> 00:10:43,350 is to try to reduce or, in some cases, 244 00:10:43,350 --> 00:10:45,690 eliminate that kind of fluctuation 245 00:10:45,690 --> 00:10:49,530 by finding a counterparty that's willing to deal 246 00:10:49,530 --> 00:10:51,480 with you to eliminate that uncertainty, 247 00:10:51,480 --> 00:10:57,750 because that counterparty faces the opposite uncertainty. 248 00:10:57,750 --> 00:11:03,180 So this is an example of just how big the uncertainty is 249 00:11:03,180 --> 00:11:04,560 that we're talking about. 250 00:11:04,560 --> 00:11:09,030 If you take a look at exchange rates from 1995 to 2003, 251 00:11:09,030 --> 00:11:12,780 you can take a look at the dynamics of these currency 252 00:11:12,780 --> 00:11:13,410 movements. 253 00:11:13,410 --> 00:11:16,690 They are extreme in some cases. 254 00:11:16,690 --> 00:11:20,570 So if you're a company manufacturing machine parts, 255 00:11:20,570 --> 00:11:23,670 you have no idea how to deal with this. 256 00:11:23,670 --> 00:11:26,730 You're not a currency forecasting firm. 257 00:11:26,730 --> 00:11:29,250 And so what you'd like to be able to do 258 00:11:29,250 --> 00:11:31,650 is just get rid of it, or at least reduce it 259 00:11:31,650 --> 00:11:36,330 to the point where you actually don't have to think about it. 260 00:11:36,330 --> 00:11:42,180 And to give you a sense of how significant this problem is, 261 00:11:42,180 --> 00:11:47,429 this is the sales for Caterpillar from 1980 to 1989. 262 00:11:47,429 --> 00:11:49,470 And most of you have heard of Caterpillar, right? 263 00:11:49,470 --> 00:11:54,460 They manufacture tractors and other kind of heavy machinery. 264 00:11:54,460 --> 00:11:56,730 This is their sales figures. 265 00:11:56,730 --> 00:11:58,440 But you can take a look at what happens 266 00:11:58,440 --> 00:12:01,110 when you take their sales figure and you denominate it 267 00:12:01,110 --> 00:12:02,730 in US dollars. 268 00:12:02,730 --> 00:12:06,090 That's a pretty big difference between US denominated 269 00:12:06,090 --> 00:12:10,180 and foreign currency denominated levels. 270 00:12:10,180 --> 00:12:14,640 So what we want to do is to address that concern 271 00:12:14,640 --> 00:12:18,690 by using financial markets in a particular way. 272 00:12:18,690 --> 00:12:22,270 Now there is an issue regarding futures and forwards as to 273 00:12:22,270 --> 00:12:24,270 whether or not the people who are in the markets 274 00:12:24,270 --> 00:12:26,827 are hedging or speculating. 275 00:12:26,827 --> 00:12:29,160 And so we're going to talk a bit about that a little bit 276 00:12:29,160 --> 00:12:31,410 later on. 277 00:12:31,410 --> 00:12:34,380 But before we do that, we need to develop some terminology 278 00:12:34,380 --> 00:12:36,000 for what these contracts are. 279 00:12:36,000 --> 00:12:37,890 But I want to raise that as an issue upfront, 280 00:12:37,890 --> 00:12:39,760 because it's very controversial. 281 00:12:39,760 --> 00:12:41,520 There are some people that argue that it's 282 00:12:41,520 --> 00:12:45,480 all these evil speculators that are causing market dislocation 283 00:12:45,480 --> 00:12:47,520 and we ought to just get rid of them. 284 00:12:47,520 --> 00:12:51,510 And I'm going to argue that you really 285 00:12:51,510 --> 00:12:54,120 can't, because speculators provide 286 00:12:54,120 --> 00:12:56,550 an enormously valuable service. 287 00:12:56,550 --> 00:12:58,860 They are the opposite side of the same coin. 288 00:12:58,860 --> 00:13:03,350 So it's like trying to do applause with only one hand. 289 00:13:03,350 --> 00:13:06,930 The sound of one hand clapping is not particularly loud. 290 00:13:06,930 --> 00:13:11,200 So there are a number of ways of hedging. 291 00:13:11,200 --> 00:13:15,540 Obviously, using futures, forwards, options, and swaps 292 00:13:15,540 --> 00:13:18,210 are what we're going to be focusing on in these next three 293 00:13:18,210 --> 00:13:19,530 lectures. 294 00:13:19,530 --> 00:13:23,340 But you can also think about insurance, diversification, 295 00:13:23,340 --> 00:13:25,470 you can match assets and liabilities 296 00:13:25,470 --> 00:13:28,380 in terms of their duration, or you 297 00:13:28,380 --> 00:13:31,470 can match sales and expenses across countries 298 00:13:31,470 --> 00:13:34,030 to try to reduce your currency risk. 299 00:13:34,030 --> 00:13:37,080 And frankly, that's one of the reasons why companies often set 300 00:13:37,080 --> 00:13:40,590 up production facilities in countries where they 301 00:13:40,590 --> 00:13:43,410 do a lot of business, because this is a natural hedge, 302 00:13:43,410 --> 00:13:46,230 in the sense that they're generating expenses, as well as 303 00:13:46,230 --> 00:13:48,100 revenues in the same currency. 304 00:13:48,100 --> 00:13:50,250 And so that cancels itself out. 305 00:13:50,250 --> 00:13:51,850 But you can't always easily do that. 306 00:13:51,850 --> 00:13:53,590 And you certainly can't do that quickly. 307 00:13:53,590 --> 00:13:58,020 And if you're a foreign company trying to do business today, 308 00:13:58,020 --> 00:14:00,901 life is very, very interesting, shall we say. 309 00:14:00,901 --> 00:14:02,400 So you want to be able to hedge now. 310 00:14:02,400 --> 00:14:04,650 You don't want to wait a year or two 311 00:14:04,650 --> 00:14:09,984 when you are building that plant to be able to do that. 312 00:14:09,984 --> 00:14:11,400 Now what we're going to talk about 313 00:14:11,400 --> 00:14:16,050 is whether or not it's possible to hedge with derivatives. 314 00:14:16,050 --> 00:14:18,870 But there are various different views 315 00:14:18,870 --> 00:14:24,210 on the impact of derivatives for non-financial firms. 316 00:14:24,210 --> 00:14:27,300 One extreme is that derivatives are extremely efficient tools 317 00:14:27,300 --> 00:14:29,430 for risk management. 318 00:14:29,430 --> 00:14:33,570 And the other, espoused by none other than Warren Buffett, 319 00:14:33,570 --> 00:14:36,390 is that derivatives are financial weapons 320 00:14:36,390 --> 00:14:38,250 of mass destruction. 321 00:14:38,250 --> 00:14:43,500 And the truth is actually both. 322 00:14:43,500 --> 00:14:47,670 Both of these statements, I think, are correct. 323 00:14:47,670 --> 00:14:53,070 So from uranium-238, you can get a nuclear power plant 324 00:14:53,070 --> 00:14:56,620 that can provide power for huge areas of the country 325 00:14:56,620 --> 00:14:58,320 and that do today. 326 00:14:58,320 --> 00:15:02,760 Or from uranium-238, you can build a dirty thermonuclear 327 00:15:02,760 --> 00:15:05,610 bomb that can be very bad. 328 00:15:05,610 --> 00:15:08,880 So the point is that technology, in and of itself, 329 00:15:08,880 --> 00:15:12,030 has no particular good or bad properties. 330 00:15:12,030 --> 00:15:13,410 It's how you use it. 331 00:15:13,410 --> 00:15:16,260 And so derivatives are definitely more complicated 332 00:15:16,260 --> 00:15:17,940 and more sophisticated. 333 00:15:17,940 --> 00:15:20,890 This is not the kind of thing you want to try at home, 334 00:15:20,890 --> 00:15:23,070 unless you are a professional in how you 335 00:15:23,070 --> 00:15:24,854 use these kind of instruments. 336 00:15:24,854 --> 00:15:27,270 And so that's one of the reasons why we want to spend time 337 00:15:27,270 --> 00:15:30,870 on these particular securities. 338 00:15:30,870 --> 00:15:31,434 OK. 339 00:15:31,434 --> 00:15:32,850 There are a couple of other views, 340 00:15:32,850 --> 00:15:36,780 too, regarding whether or not hedging should be done at all. 341 00:15:36,780 --> 00:15:41,100 One view, which we'll talk about in more detail 342 00:15:41,100 --> 00:15:42,690 towards the latter part of the course 343 00:15:42,690 --> 00:15:45,210 when we get into corporate financing decisions, 344 00:15:45,210 --> 00:15:49,950 is that hedging for a company should be irrelevant. 345 00:15:49,950 --> 00:15:53,880 If you're running a company, even if your company's assets 346 00:15:53,880 --> 00:15:57,780 are in foreign denominated currencies and changes 347 00:15:57,780 --> 00:16:01,280 in those currencies cause huge swings in your company value, 348 00:16:01,280 --> 00:16:03,900 there is an argument to be said that you shouldn't bother 349 00:16:03,900 --> 00:16:08,460 hedging, because as long as shareholders of your company 350 00:16:08,460 --> 00:16:13,780 have free access to the market, they can hedge. 351 00:16:13,780 --> 00:16:17,170 So anything you can do, they can do. 352 00:16:17,170 --> 00:16:18,680 At least, that's the argument. 353 00:16:18,680 --> 00:16:20,680 Now the counterargument is that that's not true, 354 00:16:20,680 --> 00:16:22,180 because most people who buy shares, 355 00:16:22,180 --> 00:16:24,070 they don't know enough about what the company is doing 356 00:16:24,070 --> 00:16:25,444 to be able to hedge, nor are they 357 00:16:25,444 --> 00:16:29,150 set up to trade in some of these kinds of hedging vehicles. 358 00:16:29,150 --> 00:16:31,150 But the frictionless model would say 359 00:16:31,150 --> 00:16:32,950 that you shouldn't bother hedging, 360 00:16:32,950 --> 00:16:34,570 because what investors want you to do 361 00:16:34,570 --> 00:16:36,550 is to focus on your business. 362 00:16:36,550 --> 00:16:38,730 And hedging is just something that, if they 363 00:16:38,730 --> 00:16:41,680 are concerned about, they can do on their own. 364 00:16:41,680 --> 00:16:44,860 The alternative view is that hedging creates a lot of value, 365 00:16:44,860 --> 00:16:49,030 because it reduces uncertainty for a company's cash flows. 366 00:16:49,030 --> 00:16:52,450 It focuses the company on its core competencies, 367 00:16:52,450 --> 00:16:55,240 as opposed to other factors in the marketplace that 368 00:16:55,240 --> 00:16:57,490 are causing volatility. 369 00:16:57,490 --> 00:16:59,470 It also reduces the chances of getting 370 00:16:59,470 --> 00:17:01,090 into financial distress. 371 00:17:01,090 --> 00:17:03,640 And if we believe that financial distress creates 372 00:17:03,640 --> 00:17:07,750 these huge costs that can't be easily recoverable, even 373 00:17:07,750 --> 00:17:12,380 through the bankruptcy process, then you ought to hedge. 374 00:17:12,380 --> 00:17:15,670 Now there are lots of examples of all of these perspectives 375 00:17:15,670 --> 00:17:16,569 in the industry. 376 00:17:16,569 --> 00:17:17,920 I'll give you three of them. 377 00:17:17,920 --> 00:17:21,160 Homestake Mining is a mining company that 378 00:17:21,160 --> 00:17:23,950 mines precious and base metals. 379 00:17:23,950 --> 00:17:25,690 They have an explicit corporate policy 380 00:17:25,690 --> 00:17:28,930 that says, we do not hedge, because shareholders 381 00:17:28,930 --> 00:17:32,110 will achieve maximum benefit from such a policy of not 382 00:17:32,110 --> 00:17:34,370 hedging. 383 00:17:34,370 --> 00:17:35,660 OK. 384 00:17:35,660 --> 00:17:36,456 Sorry, yeah. 385 00:17:36,456 --> 00:17:38,580 AUDIENCE: Is there a difference in hedging strategy 386 00:17:38,580 --> 00:17:42,923 when it's an input production versus production output? 387 00:17:42,923 --> 00:17:46,220 For example, an oil company hedging gasoline exposure 388 00:17:46,220 --> 00:17:49,075 versus [INAUDIBLE] company hedging gas [INAUDIBLE]? 389 00:17:49,075 --> 00:17:51,200 ANDREW LO: Well, there is a difference in the sense 390 00:17:51,200 --> 00:17:54,950 that typically when you're producing an output, 391 00:17:54,950 --> 00:17:56,570 there's no point in hedging that, 392 00:17:56,570 --> 00:17:58,945 because that's actually the output that you're producing. 393 00:17:58,945 --> 00:18:00,050 You're a gold company. 394 00:18:00,050 --> 00:18:01,100 You're producing gold. 395 00:18:01,100 --> 00:18:03,320 The only question about hedging is whether or not 396 00:18:03,320 --> 00:18:05,780 you feel that there's some temporary mispricing that you 397 00:18:05,780 --> 00:18:08,000 want to be able to take advantage of, given where 398 00:18:08,000 --> 00:18:10,000 markets are today versus where you think they'll 399 00:18:10,000 --> 00:18:11,330 be three months from now. 400 00:18:11,330 --> 00:18:13,469 But effectively, the output is what you're 401 00:18:13,469 --> 00:18:14,510 supposed to be producing. 402 00:18:14,510 --> 00:18:17,060 So their argument is that we're producing gold, 403 00:18:17,060 --> 00:18:19,910 why would you want us to hedge the price of gold? 404 00:18:19,910 --> 00:18:22,790 We're a gold company, so you're supposed 405 00:18:22,790 --> 00:18:26,817 to be getting the risk of gold with a gold company. 406 00:18:26,817 --> 00:18:29,150 So it's typically the inputs that they're talking about. 407 00:18:29,150 --> 00:18:32,270 But on occasion, they may be talking about outputs as well. 408 00:18:32,270 --> 00:18:35,270 And the argument here is that you shouldn't be hedging that. 409 00:18:35,270 --> 00:18:37,610 Now the American Barrick has another view. 410 00:18:37,610 --> 00:18:39,650 Their view is that hedges-- 411 00:18:39,650 --> 00:18:41,990 they want to provide financial stability. 412 00:18:41,990 --> 00:18:46,070 And so by hedging their output exposure, 413 00:18:46,070 --> 00:18:49,130 they're actually providing that stability, because right now, 414 00:18:49,130 --> 00:18:52,670 for example, gold prices are extremely volatile, 415 00:18:52,670 --> 00:18:54,734 because there's a flight to quality, 416 00:18:54,734 --> 00:18:56,150 and then people change their mind, 417 00:18:56,150 --> 00:18:58,460 or another group decides to sell. 418 00:18:58,460 --> 00:19:00,350 And so the prices are moving back and forth 419 00:19:00,350 --> 00:19:01,640 and back and forth. 420 00:19:01,640 --> 00:19:07,310 That output uncertainty creates volatility in earnings. 421 00:19:07,310 --> 00:19:09,980 And we all know that shareholders 422 00:19:09,980 --> 00:19:12,360 like stability in earnings. 423 00:19:12,360 --> 00:19:13,520 So that's another view. 424 00:19:13,520 --> 00:19:15,260 Now the first company, Homestake Mining, 425 00:19:15,260 --> 00:19:17,280 would say, look, if you don't like the heat, 426 00:19:17,280 --> 00:19:18,860 get out of the kitchen. 427 00:19:18,860 --> 00:19:19,952 We're a gold company. 428 00:19:19,952 --> 00:19:21,660 If you don't want the volatility of gold, 429 00:19:21,660 --> 00:19:23,450 then don't buy a gold company. 430 00:19:23,450 --> 00:19:25,310 Put your money in T-bills. 431 00:19:25,310 --> 00:19:27,750 And so that's another view. 432 00:19:27,750 --> 00:19:30,890 And then, of course, we've got Battle Mountain Gold, 433 00:19:30,890 --> 00:19:35,670 which is a company that hedges up to 25%. 434 00:19:35,670 --> 00:19:37,820 So their argument is that a recent study 435 00:19:37,820 --> 00:19:40,439 indicates that there may be a premium for hedging. 436 00:19:40,439 --> 00:19:42,230 But they're not quite sure, so they're just 437 00:19:42,230 --> 00:19:43,063 going to go partway. 438 00:19:46,180 --> 00:19:51,410 It's not clear what the answer is, because largely, the issues 439 00:19:51,410 --> 00:19:54,380 depend upon how the public will react 440 00:19:54,380 --> 00:19:56,060 to this kind of uncertainty. 441 00:19:56,060 --> 00:19:58,160 There are some people that are quite 442 00:19:58,160 --> 00:20:00,920 rational about their exposures, and they want 443 00:20:00,920 --> 00:20:02,357 to have the volatility of gold. 444 00:20:02,357 --> 00:20:04,190 But they don't put all their assets in gold, 445 00:20:04,190 --> 00:20:05,810 because they understand that there's 446 00:20:05,810 --> 00:20:08,101 a limit to how much volatility they're willing to bear. 447 00:20:08,101 --> 00:20:12,620 So maybe 5% of their portfolio is in precious metals, 10% base 448 00:20:12,620 --> 00:20:15,020 metals, so on and so forth. 449 00:20:15,020 --> 00:20:16,730 They do the asset allocation. 450 00:20:16,730 --> 00:20:18,500 But there are other perspectives that 451 00:20:18,500 --> 00:20:21,020 say, you've got to worry about volatility of earnings, 452 00:20:21,020 --> 00:20:23,120 you want to have a stable share price. 453 00:20:23,120 --> 00:20:26,600 And then they engage in that activity as well. 454 00:20:29,760 --> 00:20:31,850 There's some empirical evidence that I thought 455 00:20:31,850 --> 00:20:33,830 you might be interested in. 456 00:20:33,830 --> 00:20:38,592 A couple of academics, Guay and Kothari-- 457 00:20:38,592 --> 00:20:41,050 SP Kothari is a faculty member here in our accounting group 458 00:20:41,050 --> 00:20:42,920 who's on leave-- 459 00:20:42,920 --> 00:20:45,860 published a paper just about five years ago 460 00:20:45,860 --> 00:20:50,060 where they took a random sample of 413 large companies 461 00:20:50,060 --> 00:20:54,110 with average cash flows of about $700 million. 462 00:20:54,110 --> 00:21:01,470 And 57% of those firms used derivatives in 1997. 463 00:21:01,470 --> 00:21:03,120 Now that's 11 years ago. 464 00:21:03,120 --> 00:21:05,510 So this is dated information. 465 00:21:05,510 --> 00:21:08,060 If you went and re-did the survey today, 466 00:21:08,060 --> 00:21:10,820 my guess is that that number, 57%, 467 00:21:10,820 --> 00:21:13,190 will have gone up by quite a bit. 468 00:21:13,190 --> 00:21:16,400 But I don't know for a fact that it has. 469 00:21:16,400 --> 00:21:18,942 But the idea behind the survey was just 470 00:21:18,942 --> 00:21:20,900 to get a sense of how many companies really are 471 00:21:20,900 --> 00:21:22,760 making use of hedging programs. 472 00:21:22,760 --> 00:21:27,410 And it's become much, much more significant than before. 473 00:21:27,410 --> 00:21:30,920 Part of the reason that it's not 100%, I suspect, 474 00:21:30,920 --> 00:21:35,030 is that it's not that easy to implement some of these hedges, 475 00:21:35,030 --> 00:21:38,420 because the concepts are rather subtle. 476 00:21:38,420 --> 00:21:41,960 You'll see, when we go over it in this lecture, how 477 00:21:41,960 --> 00:21:44,160 straightforward you think it is to hedge. 478 00:21:44,160 --> 00:21:47,000 Some of the ideas are a little subtle. 479 00:21:47,000 --> 00:21:51,230 And so it's not a simple asset class purchase decision, 480 00:21:51,230 --> 00:21:55,490 like I'm going to buy bonds, I'm going to sell stocks. 481 00:21:55,490 --> 00:21:58,145 It requires a certain level of expertise and comfort. 482 00:22:00,690 --> 00:22:03,360 So let's talk about that now. 483 00:22:03,360 --> 00:22:04,841 Let's talk about derivatives. 484 00:22:04,841 --> 00:22:06,840 There are going to be three kinds of derivatives 485 00:22:06,840 --> 00:22:09,054 we're going to focus on. 486 00:22:09,054 --> 00:22:10,470 Forwards and futures-- that's what 487 00:22:10,470 --> 00:22:13,490 we're going to talk about in this lecture and the next. 488 00:22:13,490 --> 00:22:16,490 Then in lecture 10, we're going to talk about options. 489 00:22:16,490 --> 00:22:20,130 And then there's a third class, which we probably won't get to 490 00:22:20,130 --> 00:22:23,310 in this course, but you will get to in 402, as well as 491 00:22:23,310 --> 00:22:24,540 in investments. 492 00:22:24,540 --> 00:22:26,770 And that is swaps. 493 00:22:26,770 --> 00:22:29,680 The idea behind a forward and futures contract 494 00:22:29,680 --> 00:22:35,080 is that it's a contract to exchange something 495 00:22:35,080 --> 00:22:37,390 in the future. 496 00:22:37,390 --> 00:22:44,110 So today, we agree on engaging in a specific transaction 497 00:22:44,110 --> 00:22:47,100 sometime in the future. 498 00:22:47,100 --> 00:22:50,670 And the difference between a forward contract and a futures 499 00:22:50,670 --> 00:22:54,349 contract really has to do just with the issue that 500 00:22:54,349 --> 00:22:55,890 was raised the beginning of the class 501 00:22:55,890 --> 00:22:58,267 by [INAUDIBLE], which is mark-to-market. 502 00:22:58,267 --> 00:23:00,100 But let's not worry about that for a moment. 503 00:23:00,100 --> 00:23:02,700 Let's just focus on the contract itself. 504 00:23:02,700 --> 00:23:06,730 So a forward or futures contract is, as the name suggests, 505 00:23:06,730 --> 00:23:10,620 an agreement that we enter into today-- you and I-- 506 00:23:10,620 --> 00:23:16,920 to engage in a transaction, say, six months from now. 507 00:23:16,920 --> 00:23:22,490 So all we do today is agree to do that transaction. 508 00:23:22,490 --> 00:23:24,450 And in agreeing to do that transaction, 509 00:23:24,450 --> 00:23:26,280 we have to specify a couple of things. 510 00:23:26,280 --> 00:23:30,140 One is we have to specify what we're going to transact 511 00:23:30,140 --> 00:23:31,854 and at what price. 512 00:23:31,854 --> 00:23:33,520 And the second thing we have to agree on 513 00:23:33,520 --> 00:23:36,800 is when we're going to do the transaction. 514 00:23:36,800 --> 00:23:41,110 Once we sign the document, we are both 515 00:23:41,110 --> 00:23:43,850 obligated to follow through. 516 00:23:43,850 --> 00:23:47,830 So this is not an option in the sense 517 00:23:47,830 --> 00:23:51,850 that we can choose not to do it or to do it. 518 00:23:51,850 --> 00:23:54,310 Once we sign the forward contract today, 519 00:23:54,310 --> 00:24:00,220 it is a legal, binding contract so that we are agreeing today 520 00:24:00,220 --> 00:24:02,630 to engage in that transaction six months from now. 521 00:24:02,630 --> 00:24:04,930 Now if it ends up that we default-- 522 00:24:04,930 --> 00:24:08,800 we don't have enough money, we declare bankruptcy-- 523 00:24:08,800 --> 00:24:11,740 then that contract, like all other contracts, 524 00:24:11,740 --> 00:24:16,180 will have to go to court and be dealt with by the legal system. 525 00:24:16,180 --> 00:24:18,790 But assuming that we are not in default, 526 00:24:18,790 --> 00:24:22,300 we will have to perform-- we are obligated to perform-- 527 00:24:22,300 --> 00:24:24,340 on that contract, like any other. 528 00:24:24,340 --> 00:24:25,660 It's a binding agreement. 529 00:24:25,660 --> 00:24:27,410 With an option, on the other hand-- 530 00:24:27,410 --> 00:24:29,784 we're going to get to this in more detail in lecture 10-- 531 00:24:29,784 --> 00:24:32,080 with an option, we do not have to follow through 532 00:24:32,080 --> 00:24:33,710 with the transaction. 533 00:24:33,710 --> 00:24:36,820 In other words, the buyer of the contract 534 00:24:36,820 --> 00:24:41,060 has the right but not the obligation 535 00:24:41,060 --> 00:24:43,520 to exercise that option. 536 00:24:43,520 --> 00:24:45,860 That's why it's called an option. 537 00:24:45,860 --> 00:24:47,690 So that's a key distinction. 538 00:24:47,690 --> 00:24:50,510 So let me be very explicit now and now focus 539 00:24:50,510 --> 00:24:51,500 on a forward contract. 540 00:24:51,500 --> 00:24:53,570 A forward contract is a commitment 541 00:24:53,570 --> 00:24:56,330 to purchase, at a future date, a given 542 00:24:56,330 --> 00:24:57,740 amount of a commodity or an asset 543 00:24:57,740 --> 00:25:00,270 at a price agreed upon today. 544 00:25:00,270 --> 00:25:03,230 So first thing we do, draw a timeline. 545 00:25:03,230 --> 00:25:04,950 Today is date zero. 546 00:25:04,950 --> 00:25:06,740 That's when we enter into the agreement. 547 00:25:06,740 --> 00:25:11,120 And to be clear, because a forward contract always 548 00:25:11,120 --> 00:25:12,380 has two parties-- 549 00:25:12,380 --> 00:25:13,970 a buyer and a seller-- 550 00:25:13,970 --> 00:25:16,100 let's just use, as the convention, 551 00:25:16,100 --> 00:25:19,790 that the buyer of the forward contract 552 00:25:19,790 --> 00:25:27,860 is the party that has agreed to buy whatever in a future date. 553 00:25:27,860 --> 00:25:34,550 So the price that we agree to is fixed, as of today. 554 00:25:34,550 --> 00:25:37,670 And that's known as the forward price. 555 00:25:37,670 --> 00:25:41,240 If the particular commodity that we're talking about 556 00:25:41,240 --> 00:25:46,580 happens to be alone, then it will be a forward borrowing 557 00:25:46,580 --> 00:25:49,310 rate that we agree to today. 558 00:25:49,310 --> 00:25:51,461 So it's either a rate or a price. 559 00:25:51,461 --> 00:25:53,210 And it's typically called the forward rate 560 00:25:53,210 --> 00:25:55,160 or the forward price. 561 00:25:55,160 --> 00:25:57,170 And the buyer of the commodity is 562 00:25:57,170 --> 00:26:00,560 said to be long the forward contract. 563 00:26:00,560 --> 00:26:02,900 And the other counterparty-- the counterparty that 564 00:26:02,900 --> 00:26:05,510 is selling the asset-- is said to be 565 00:26:05,510 --> 00:26:09,380 short the forward contract. 566 00:26:09,380 --> 00:26:11,662 Now these terms are, in some sense, arbitrary. 567 00:26:11,662 --> 00:26:14,120 But there is a logic to them that I'll explain in a minute. 568 00:26:14,120 --> 00:26:15,734 Yeah, question? 569 00:26:15,734 --> 00:26:23,480 AUDIENCE: [INAUDIBLE] forward contract? 570 00:26:23,480 --> 00:26:25,160 ANDREW LO: A revolving loan. 571 00:26:25,160 --> 00:26:27,410 Well, I would call a revolving loan 572 00:26:27,410 --> 00:26:31,280 a sequence of forward contracts, because it revolves 573 00:26:31,280 --> 00:26:32,749 and constantly updates. 574 00:26:32,749 --> 00:26:33,290 That's right. 575 00:26:33,290 --> 00:26:34,780 Yeah. 576 00:26:34,780 --> 00:26:36,860 So for the moment, let's just focus on one, 577 00:26:36,860 --> 00:26:39,890 and then we'll talk about how we can extend that. 578 00:26:39,890 --> 00:26:44,270 So this is a very, very standard set-up. 579 00:26:44,270 --> 00:26:47,690 And in terms of long versus short, 580 00:26:47,690 --> 00:26:50,960 there's a reason why we use that terminology. 581 00:26:50,960 --> 00:26:54,170 Obviously, the ambiguity is the fact 582 00:26:54,170 --> 00:26:58,280 that a forward contract actually has no value on the day 583 00:26:58,280 --> 00:26:59,480 that it's struck. 584 00:26:59,480 --> 00:27:02,630 So to say that one side is long and the other side of short 585 00:27:02,630 --> 00:27:05,360 is, in a way, a little bit unnatural, because in fact, 586 00:27:05,360 --> 00:27:08,540 the value of the contract that's struck is zero. 587 00:27:08,540 --> 00:27:10,560 So you're either long zero or short zero. 588 00:27:10,560 --> 00:27:11,630 Well, who cares? 589 00:27:11,630 --> 00:27:15,080 But there's a reason why we call the buyer long 590 00:27:15,080 --> 00:27:19,100 and the reason we call the seller of the asset short. 591 00:27:19,100 --> 00:27:23,290 It's because tomorrow, if the value of the asset 592 00:27:23,290 --> 00:27:30,120 goes up beyond where the current price is, then the person who 593 00:27:30,120 --> 00:27:33,090 has agreed to buy the asset at this price 594 00:27:33,090 --> 00:27:34,920 is going to make money. 595 00:27:34,920 --> 00:27:36,690 So when the price goes up-- 596 00:27:36,690 --> 00:27:39,720 when the spot price, the price today and then 597 00:27:39,720 --> 00:27:42,570 the price tomorrow spot price-- when that goes up, 598 00:27:42,570 --> 00:27:46,200 the person who was holding it long will profit. 599 00:27:46,200 --> 00:27:49,170 And the person who is short will lose. 600 00:27:49,170 --> 00:27:50,460 And so that makes sense. 601 00:27:50,460 --> 00:27:52,440 When prices go up, long positions 602 00:27:52,440 --> 00:27:55,020 tend to be profitable, and short positions 603 00:27:55,020 --> 00:27:56,340 tend to be unprofitable. 604 00:27:56,340 --> 00:27:58,325 That's why we use the normalization. 605 00:27:58,325 --> 00:27:59,700 Now right then and there, I think 606 00:27:59,700 --> 00:28:01,283 I've described something that may have 607 00:28:01,283 --> 00:28:02,580 slipped by you a little bit. 608 00:28:02,580 --> 00:28:07,110 So I want to just beat this down and make sure that we all 609 00:28:07,110 --> 00:28:09,430 understand it completely. 610 00:28:09,430 --> 00:28:12,190 The price that I'm talking about going up or down 611 00:28:12,190 --> 00:28:13,600 is not the forward price. 612 00:28:13,600 --> 00:28:14,920 It's the futures price. 613 00:28:14,920 --> 00:28:19,440 Excuse me, it's the future spot price. 614 00:28:19,440 --> 00:28:24,070 Today's spot price for oil is, let's say, $100 a barrel. 615 00:28:24,070 --> 00:28:26,800 Suppose that we enter into an agreement six months from now 616 00:28:26,800 --> 00:28:31,690 to purchase oil at $110 a barrel. 617 00:28:31,690 --> 00:28:34,930 So the forward price of that contract is 110. 618 00:28:34,930 --> 00:28:38,560 Today's spot price is 100. 619 00:28:38,560 --> 00:28:42,400 When we have agreed to that contract, you and I, 620 00:28:42,400 --> 00:28:46,330 the value of that agreement is worth zero. 621 00:28:46,330 --> 00:28:47,800 It's got to be worth zero. 622 00:28:47,800 --> 00:28:51,010 The reason is that if it's not at all worth zero, 623 00:28:51,010 --> 00:28:52,930 then you and I aren't going to be 624 00:28:52,930 --> 00:28:54,760 willing to enter into that contract today, 625 00:28:54,760 --> 00:28:57,280 because that means either I'm losing and you're winning, 626 00:28:57,280 --> 00:28:58,750 or you're losing and I'm winning. 627 00:28:58,750 --> 00:29:00,520 So we won't strike that deal. 628 00:29:00,520 --> 00:29:02,420 Let me give you an example. 629 00:29:02,420 --> 00:29:08,140 Suppose that I propose to buy oil from you 630 00:29:08,140 --> 00:29:12,730 six months from now at $40 a barrel. 631 00:29:12,730 --> 00:29:15,340 Now that's a legitimate contract, right? 632 00:29:15,340 --> 00:29:17,200 In other words, I can propose that. 633 00:29:17,200 --> 00:29:19,300 And if you and I, we agree to that, 634 00:29:19,300 --> 00:29:22,930 that transaction will be carried out. 635 00:29:22,930 --> 00:29:26,730 How many people would agree to that today? 636 00:29:26,730 --> 00:29:27,490 Nobody. 637 00:29:27,490 --> 00:29:28,910 You would? 638 00:29:28,910 --> 00:29:29,610 All right. 639 00:29:29,610 --> 00:29:30,920 Seriously? 640 00:29:30,920 --> 00:29:32,106 No. 641 00:29:32,106 --> 00:29:33,600 AUDIENCE: You're buying? 642 00:29:33,600 --> 00:29:36,020 ANDREW LO: I'm buying at $40 a barrel. 643 00:29:36,020 --> 00:29:36,690 No. 644 00:29:36,690 --> 00:29:39,900 Because given that oil is at 100 and given that there's 645 00:29:39,900 --> 00:29:45,030 nothing in the news or in any kind of projection that 646 00:29:45,030 --> 00:29:48,690 suggests that we're going to find tremendously large, 647 00:29:48,690 --> 00:29:51,604 untapped oil reserves or that somehow oil 648 00:29:51,604 --> 00:29:53,520 is going to become less relevant in six months 649 00:29:53,520 --> 00:29:57,240 time, being able to buy oil at $40 a barrel 650 00:29:57,240 --> 00:29:59,970 six months from now is an incredibly good deal. 651 00:29:59,970 --> 00:30:01,800 If I can find a deal like that, it's 652 00:30:01,800 --> 00:30:07,030 got to have a lot of net present value to me today. 653 00:30:07,030 --> 00:30:08,610 If I can find a piece of paper that 654 00:30:08,610 --> 00:30:11,070 allows me to buy oil six months from now at $40 a barrel, 655 00:30:11,070 --> 00:30:15,460 that piece of paper, we all agree, has positive NPV. 656 00:30:15,460 --> 00:30:18,470 So in order for you to agree to sell me that piece of paper, 657 00:30:18,470 --> 00:30:21,760 you're basically giving me money. 658 00:30:21,760 --> 00:30:23,020 You're not going to do that. 659 00:30:23,020 --> 00:30:26,359 So we're not going to get that deal done today. 660 00:30:26,359 --> 00:30:28,900 On the other hand, suppose that we have a piece of paper that 661 00:30:28,900 --> 00:30:33,730 says, I will buy oil at $250 a barrel six months from now. 662 00:30:33,730 --> 00:30:36,460 I suspect all of you would be delighted to sell me 663 00:30:36,460 --> 00:30:38,464 that forward contract. 664 00:30:38,464 --> 00:30:40,630 I'm not going to do that, because that's ridiculous. 665 00:30:40,630 --> 00:30:42,127 That price just makes no sense. 666 00:30:42,127 --> 00:30:44,210 And that means you're going to get a lot of value. 667 00:30:44,210 --> 00:30:46,990 So if both you and I agree that we want 668 00:30:46,990 --> 00:30:49,840 to do a deal regarding oil-- 669 00:30:49,840 --> 00:30:52,690 you're an oil producer, I'm an oil user, 670 00:30:52,690 --> 00:30:57,730 I want to lock in some price for oil six months from now-- 671 00:30:57,730 --> 00:31:00,520 we're going to haggle until such time 672 00:31:00,520 --> 00:31:04,360 as we reach a price for that transaction six months from now 673 00:31:04,360 --> 00:31:07,930 that seems fair to both you and me. 674 00:31:07,930 --> 00:31:08,990 When we do that-- 675 00:31:08,990 --> 00:31:12,880 when we reach that price-- $110, let's say-- 676 00:31:12,880 --> 00:31:17,200 that's a price where the present value of that contract 677 00:31:17,200 --> 00:31:19,060 is worth nothing. 678 00:31:19,060 --> 00:31:22,900 So both you and I have found a price, such 679 00:31:22,900 --> 00:31:25,930 that we're happy to take it or leave it. 680 00:31:25,930 --> 00:31:30,040 If we made it 115, then I might not be so willing to do it. 681 00:31:30,040 --> 00:31:31,480 You might be happy about that. 682 00:31:31,480 --> 00:31:34,630 If we made it 105, I'm happy to do that, 683 00:31:34,630 --> 00:31:36,760 but you think that you're not getting a good deal. 684 00:31:36,760 --> 00:31:39,490 So the way that a forward price is established 685 00:31:39,490 --> 00:31:40,510 is like any other price. 686 00:31:40,510 --> 00:31:42,550 We put it up for auction. 687 00:31:42,550 --> 00:31:46,690 We set a system where supply and demand determines that price. 688 00:31:46,690 --> 00:31:51,638 And when that price is struck, the contract is worth nothing. 689 00:31:51,638 --> 00:31:52,610 Question? 690 00:31:52,610 --> 00:31:54,068 AUDIENCE: Could you argue that it's 691 00:31:54,068 --> 00:31:56,498 based on the price of a futures contract 692 00:31:56,498 --> 00:31:59,900 and not of the market [INAUDIBLE]? 693 00:31:59,900 --> 00:32:03,302 Let's say they're in the range [INAUDIBLE] $130 694 00:32:03,302 --> 00:32:06,056 and we enter into [INAUDIBLE], wouldn't that 695 00:32:06,056 --> 00:32:07,710 create a little bit of a problem there? 696 00:32:07,710 --> 00:32:08,430 ANDREW LO: Yeah, it would. 697 00:32:08,430 --> 00:32:10,050 Let's not talk about that yet, because we haven't talked 698 00:32:10,050 --> 00:32:11,670 about futures prices yet. 699 00:32:11,670 --> 00:32:13,950 So we're only talking about forward prices right now. 700 00:32:13,950 --> 00:32:15,600 We're going to come back to future prices, 701 00:32:15,600 --> 00:32:17,224 and arbitrage is going to come into it. 702 00:32:17,224 --> 00:32:18,656 But I want to do it step by step. 703 00:32:18,656 --> 00:32:20,280 So let's hold off on that for a minute. 704 00:32:20,280 --> 00:32:20,780 Yeah? 705 00:32:20,780 --> 00:32:23,612 AUDIENCE: So when there's like a natural gas company that sells 706 00:32:23,612 --> 00:32:25,040 [INAUDIBLE] for next year, that's 707 00:32:25,040 --> 00:32:26,359 forward contract [INAUDIBLE]? 708 00:32:26,359 --> 00:32:27,150 ANDREW LO: Exactly. 709 00:32:27,150 --> 00:32:28,260 That's right. 710 00:32:28,260 --> 00:32:30,990 And companies are delighted to do that, because this way, 711 00:32:30,990 --> 00:32:33,270 they know what their costs are going to be, 712 00:32:33,270 --> 00:32:35,910 as opposed to who knows, it depends 713 00:32:35,910 --> 00:32:37,760 on what happens with this rescue package, 714 00:32:37,760 --> 00:32:39,510 or it depends on whether or not we get hit 715 00:32:39,510 --> 00:32:41,340 with a terrorist attack or not. 716 00:32:41,340 --> 00:32:43,230 That creates so much uncertainty, 717 00:32:43,230 --> 00:32:44,980 companies don't want to deal with that. 718 00:32:44,980 --> 00:32:47,400 So if I use oil in my production facilities 719 00:32:47,400 --> 00:32:51,330 and I can lock in at 110 for a six month period, 720 00:32:51,330 --> 00:32:52,230 that's OK with me. 721 00:32:52,230 --> 00:32:53,880 I'm willing to do that. 722 00:32:53,880 --> 00:32:55,405 Yeah? 723 00:32:55,405 --> 00:32:57,780 AUDIENCE: Considering that the trend of the global market 724 00:32:57,780 --> 00:33:02,790 is upwards in the long term, I suspect that it makes sense, 725 00:33:02,790 --> 00:33:06,050 especially to try to short in the short term, 726 00:33:06,050 --> 00:33:07,850 that would be there-- 727 00:33:07,850 --> 00:33:10,600 exceptions when I want to try and do it in the long term 728 00:33:10,600 --> 00:33:11,507 as well? 729 00:33:11,507 --> 00:33:13,840 ANDREW LO: Well, that's a very tough question to answer, 730 00:33:13,840 --> 00:33:16,298 because it depends upon what your forecast is for long term 731 00:33:16,298 --> 00:33:17,100 prices. 732 00:33:17,100 --> 00:33:19,140 And the longer the term is for your forecast, 733 00:33:19,140 --> 00:33:21,215 the more inaccurate your estimate goes. 734 00:33:21,215 --> 00:33:22,590 So the question is whether or not 735 00:33:22,590 --> 00:33:23,700 you really want to take that risk 736 00:33:23,700 --> 00:33:24,825 and make those projections. 737 00:33:24,825 --> 00:33:27,090 In fact, this is one of the reasons why companies 738 00:33:27,090 --> 00:33:29,640 don't want to do that and they'd rather lock in the price. 739 00:33:29,640 --> 00:33:32,940 Companies feel like they're not in the business of forecasting 740 00:33:32,940 --> 00:33:34,956 prices in the long term. 741 00:33:34,956 --> 00:33:36,330 They're producing oil, or they're 742 00:33:36,330 --> 00:33:39,280 using oil as an input to their production process. 743 00:33:39,280 --> 00:33:41,790 So they basically just want to eliminate that uncertainty 744 00:33:41,790 --> 00:33:43,260 if they can get a reasonable price. 745 00:33:43,260 --> 00:33:45,810 And by reasonable-- I just gave you an example-- 746 00:33:45,810 --> 00:33:48,930 a $10 premium over a six month period 747 00:33:48,930 --> 00:33:52,170 where we have uncertainty about both supply and demand 748 00:33:52,170 --> 00:33:55,594 may be reasonable to certain corporations. 749 00:33:55,594 --> 00:33:57,085 Yeah? 750 00:33:57,085 --> 00:34:00,067 AUDIENCE: Is there a limit on how much can 751 00:34:00,067 --> 00:34:03,049 be done in a forward contract? 752 00:34:03,049 --> 00:34:06,266 And the example I sort of have in mind is over the past few 753 00:34:06,266 --> 00:34:08,516 years, we keep reading how Southwest has hedged on its 754 00:34:08,516 --> 00:34:10,842 fuel, but the other airlines haven't. 755 00:34:10,842 --> 00:34:13,818 So was there some sort of financial or legal perspective 756 00:34:13,818 --> 00:34:16,300 [INAUDIBLE]? 757 00:34:16,300 --> 00:34:17,800 ANDREW LO: Certainly not anything 758 00:34:17,800 --> 00:34:20,925 from a legal perspective. 759 00:34:20,925 --> 00:34:22,300 For a financial perspective, that 760 00:34:22,300 --> 00:34:23,830 depends upon the particular company 761 00:34:23,830 --> 00:34:26,860 and the shareholders and the balance sheet and so on. 762 00:34:26,860 --> 00:34:28,659 But no, there's no limit, as long 763 00:34:28,659 --> 00:34:30,987 as you can find a mutually consenting adult that's 764 00:34:30,987 --> 00:34:32,320 willing to do the deal with you. 765 00:34:32,320 --> 00:34:33,030 That's it. 766 00:34:33,030 --> 00:34:33,530 All right. 767 00:34:33,530 --> 00:34:34,021 Yeah? 768 00:34:34,021 --> 00:34:35,395 AUDIENCE: Does it have to be more 769 00:34:35,395 --> 00:34:36,814 expensive than the current price? 770 00:34:36,814 --> 00:34:39,230 ANDREW LO: Well, no, it doesn't have to be more expensive. 771 00:34:39,230 --> 00:34:41,050 So the question is, does the forward price always 772 00:34:41,050 --> 00:34:42,675 have to be more than the current price? 773 00:34:42,675 --> 00:34:44,420 No, it doesn't. 774 00:34:44,420 --> 00:34:46,880 It depends upon what the expectation is for what's 775 00:34:46,880 --> 00:34:48,380 going to happen in the future. 776 00:34:48,380 --> 00:34:52,550 It turns out with oil, typically it goes the other way-- 777 00:34:52,550 --> 00:34:56,010 that these oil prices generally are rising over time. 778 00:34:56,010 --> 00:34:57,870 However, there are situations. 779 00:34:57,870 --> 00:35:01,340 For example, it may be that within the next few weeks, 780 00:35:01,340 --> 00:35:03,470 if there is more of an expectation 781 00:35:03,470 --> 00:35:06,380 that business will slow down worldwide, 782 00:35:06,380 --> 00:35:09,740 then we would expect oil prices to decline over time, 783 00:35:09,740 --> 00:35:12,350 because the demand is going to decline. 784 00:35:12,350 --> 00:35:14,960 If that's the case, then oil producing companies 785 00:35:14,960 --> 00:35:17,390 may be delighted to do a deal at par. 786 00:35:17,390 --> 00:35:19,850 So if the current price of oil is $100 a barrel, 787 00:35:19,850 --> 00:35:22,384 they may be delighted to say, OK, six months from now, 788 00:35:22,384 --> 00:35:24,050 I think the economy is going to go down, 789 00:35:24,050 --> 00:35:26,660 I'm willing to sell you oil at $100 a barrel six months 790 00:35:26,660 --> 00:35:28,640 from now, let's lock it in. 791 00:35:28,640 --> 00:35:30,090 That's possible. 792 00:35:30,090 --> 00:35:33,120 So what does that tell you about the price 793 00:35:33,120 --> 00:35:36,090 of oil today versus the price of oil six months, 794 00:35:36,090 --> 00:35:37,950 in terms of the forward prices? 795 00:35:37,950 --> 00:35:41,880 That tells you that the market is providing information 796 00:35:41,880 --> 00:35:42,630 about the future. 797 00:35:42,630 --> 00:35:46,080 So future price forecasts are implicit 798 00:35:46,080 --> 00:35:47,130 in these forward prices. 799 00:35:47,130 --> 00:35:50,880 In just the same way that when we look at the yield curve 800 00:35:50,880 --> 00:35:55,710 and we see the implicit forward rates for future borrowing, 801 00:35:55,710 --> 00:35:58,920 when you look at forward prices of commodities 802 00:35:58,920 --> 00:36:00,990 and other instruments, that's giving you 803 00:36:00,990 --> 00:36:04,020 information about what the market is telling you 804 00:36:04,020 --> 00:36:07,090 that it thinks will happen six months from now. 805 00:36:07,090 --> 00:36:10,710 So if you see forward prices for oil at $90, 806 00:36:10,710 --> 00:36:13,470 whereas today it's at 100, that's telling you 807 00:36:13,470 --> 00:36:16,110 either people are expecting to find lots of oil 808 00:36:16,110 --> 00:36:18,570 in the next six months, or it's telling you 809 00:36:18,570 --> 00:36:20,880 that there's a forecast that demand 810 00:36:20,880 --> 00:36:25,650 will decline precipitously over the next six months. 811 00:36:25,650 --> 00:36:26,590 OK. 812 00:36:26,590 --> 00:36:30,550 So the features of forward contracts are the following. 813 00:36:30,550 --> 00:36:31,990 They're customized. 814 00:36:31,990 --> 00:36:35,470 So we have to enter into this contract counterparty 815 00:36:35,470 --> 00:36:36,190 by counterparty. 816 00:36:36,190 --> 00:36:39,100 In other words, this is not a share of IBM 817 00:36:39,100 --> 00:36:41,235 that anybody can buy and sell and is the same 818 00:36:41,235 --> 00:36:43,360 whether you trade it in the New York Stock Exchange 819 00:36:43,360 --> 00:36:45,660 or in London or anywhere else. 820 00:36:45,660 --> 00:36:48,430 A forward contract is a customized agreement 821 00:36:48,430 --> 00:36:50,950 between two parties. 822 00:36:50,950 --> 00:36:54,910 The second feature is that it's typically nonstandard, 823 00:36:54,910 --> 00:36:59,240 so we can do as much of it or as little of it as we want. 824 00:36:59,240 --> 00:37:03,260 And also, it doesn't trade on exchanges. 825 00:37:03,260 --> 00:37:06,560 These are known as over-the-counter securities. 826 00:37:06,560 --> 00:37:08,600 It doesn't trade on an organized exchange. 827 00:37:08,600 --> 00:37:13,010 Two people trade with each other over a counter. 828 00:37:13,010 --> 00:37:14,280 That's the customization part. 829 00:37:14,280 --> 00:37:14,883 Yeah? 830 00:37:14,883 --> 00:37:16,591 AUDIENCE: You said that there's sometimes 831 00:37:16,591 --> 00:37:20,306 a circular effect on prices on certain commodities. 832 00:37:20,306 --> 00:37:22,771 For example, if I think that copper 833 00:37:22,771 --> 00:37:25,564 is going to be more expensive six months from now, 834 00:37:25,564 --> 00:37:27,824 then I'm going to buy more copper today, which 835 00:37:27,824 --> 00:37:30,112 is going to drive up the price, then 836 00:37:30,112 --> 00:37:32,179 it's going to make it lower in the future? 837 00:37:32,179 --> 00:37:33,720 ANDREW LO: If you drive up the price, 838 00:37:33,720 --> 00:37:36,774 why would you make it lower in the future? 839 00:37:36,774 --> 00:37:38,238 AUDIENCE: Because my demand for it 840 00:37:38,238 --> 00:37:43,120 would be substituted now instead of six months from now. 841 00:37:43,120 --> 00:37:47,440 ANDREW LO: Well, it's not clear that it would make the price 842 00:37:47,440 --> 00:37:49,240 lower, because if you're doing it, 843 00:37:49,240 --> 00:37:50,740 that may indicate that there's going 844 00:37:50,740 --> 00:37:52,840 to be a shortage, because you're trying 845 00:37:52,840 --> 00:37:54,500 to get ahead of that curve. 846 00:37:54,500 --> 00:37:57,200 And therefore, the price may stay that way. 847 00:37:57,200 --> 00:37:59,860 So I'm not sure I understand your question. 848 00:37:59,860 --> 00:38:01,870 Are you worried about price manipulation, 849 00:38:01,870 --> 00:38:03,880 or are you worried about the fact 850 00:38:03,880 --> 00:38:05,770 that the futures prices or forward prices 851 00:38:05,770 --> 00:38:09,280 don't reflect current supply and demand conditions? 852 00:38:09,280 --> 00:38:11,610 AUDIENCE: I'm just trying to think that if I expect 853 00:38:11,610 --> 00:38:16,040 a certain price to go up in the future, 854 00:38:16,040 --> 00:38:20,040 rather than hedging against-- 855 00:38:20,040 --> 00:38:22,040 the inflammation that's in that price 856 00:38:22,040 --> 00:38:24,574 is based on the inflammation of the price 857 00:38:24,574 --> 00:38:27,552 right now, so I'm going to substitute my demand for-- 858 00:38:27,552 --> 00:38:29,010 ANDREW LO: OK, I see what you mean. 859 00:38:29,010 --> 00:38:30,850 So let me rephrase the question. 860 00:38:30,850 --> 00:38:34,300 Your question is, if you think the prices are going to go up 861 00:38:34,300 --> 00:38:36,430 for a particular input-- say, copper-- 862 00:38:36,430 --> 00:38:39,190 then rather than buy it six months 863 00:38:39,190 --> 00:38:41,020 from now at the potentially higher price, 864 00:38:41,020 --> 00:38:45,450 you might decide to do it sooner by buying it now. 865 00:38:45,450 --> 00:38:46,440 Right. 866 00:38:46,440 --> 00:38:50,500 That's a perfectly sensible thing to do with one exception. 867 00:38:50,500 --> 00:38:55,240 And that is that when you buy it now, you have to store it. 868 00:38:55,240 --> 00:39:00,970 And copper, oil, other kinds of factor inputs 869 00:39:00,970 --> 00:39:02,470 are typically not the kind of things 870 00:39:02,470 --> 00:39:05,380 that are costless to store. 871 00:39:05,380 --> 00:39:09,880 So you can either do that, buy it now, store it, and then use 872 00:39:09,880 --> 00:39:13,240 it later, or you could do a financial transaction 873 00:39:13,240 --> 00:39:15,310 that will have the same effect. 874 00:39:15,310 --> 00:39:20,110 And so that idea is going to be exactly how we 875 00:39:20,110 --> 00:39:21,514 price these things. 876 00:39:21,514 --> 00:39:22,930 So I'm going to come back to that. 877 00:39:22,930 --> 00:39:24,471 Hold onto that thought, because we're 878 00:39:24,471 --> 00:39:26,800 going to use that approach to figure out how 879 00:39:26,800 --> 00:39:28,100 to price a forward contract. 880 00:39:28,100 --> 00:39:30,641 So far, I haven't told you how the forward price comes about. 881 00:39:30,641 --> 00:39:32,800 All I've said is, the market determines it. 882 00:39:32,800 --> 00:39:34,750 Like before, we're going to want to work out 883 00:39:34,750 --> 00:39:38,200 the logic for what the market is doing when it figures out 884 00:39:38,200 --> 00:39:39,100 what that price is. 885 00:39:39,100 --> 00:39:41,710 And it will actually be exactly the calculation 886 00:39:41,710 --> 00:39:43,780 that you just proposed. 887 00:39:43,780 --> 00:39:47,230 So in other words, either we transact in the forward market, 888 00:39:47,230 --> 00:39:49,900 or we do it directly in the spot market. 889 00:39:49,900 --> 00:39:51,500 Those are our two choices. 890 00:39:51,500 --> 00:39:53,230 And in the end, it's going to have 891 00:39:53,230 --> 00:39:55,540 to be the case that those two choices, which 892 00:39:55,540 --> 00:39:57,910 lead to the same cash flows, they 893 00:39:57,910 --> 00:39:59,180 have to have the same price. 894 00:39:59,180 --> 00:40:00,982 And that's how we're going to get the forward price. 895 00:40:00,982 --> 00:40:01,364 Yeah? 896 00:40:01,364 --> 00:40:02,560 AUDIENCE: Do you have to have cash on hand now 897 00:40:02,560 --> 00:40:04,167 to enter into a forward contract? 898 00:40:04,167 --> 00:40:04,750 ANDREW LO: No. 899 00:40:04,750 --> 00:40:06,458 AUDIENCE: So that could be another reason 900 00:40:06,458 --> 00:40:08,150 why, if you're an airline, for example, 901 00:40:08,150 --> 00:40:09,820 you wouldn't want to buy millions 902 00:40:09,820 --> 00:40:12,760 and millions of dollars worth of gas if you can't afford it now? 903 00:40:12,760 --> 00:40:13,760 ANDREW LO: That's right. 904 00:40:13,760 --> 00:40:16,120 But if you can't afford it now, you're 905 00:40:16,120 --> 00:40:19,810 really talking more about a short term kind of a borrowing 906 00:40:19,810 --> 00:40:22,270 situation, because presumably, you're 907 00:40:22,270 --> 00:40:24,020 going to have to pay for it at some point, 908 00:40:24,020 --> 00:40:25,390 particularly when you use it. 909 00:40:25,390 --> 00:40:27,610 But you're right that if you don't have the cash now, 910 00:40:27,610 --> 00:40:30,340 then one way you can do it is enter into a forward contract 911 00:40:30,340 --> 00:40:31,510 when you know you'll have the cash later. 912 00:40:31,510 --> 00:40:31,946 AUDIENCE: Right. 913 00:40:31,946 --> 00:40:33,445 Because American Airlines, I'm sure, 914 00:40:33,445 --> 00:40:36,520 couldn't afford to buy five years' worth of fuel today, 915 00:40:36,520 --> 00:40:39,442 because they just don't have enough assets to do that. 916 00:40:39,442 --> 00:40:40,150 ANDREW LO: Right. 917 00:40:40,150 --> 00:40:42,630 So you can't buy that-- not only that, 918 00:40:42,630 --> 00:40:43,900 where are you going to put it? 919 00:40:43,900 --> 00:40:48,020 Five years' worth of oil is a lot of oil. 920 00:40:48,020 --> 00:40:50,990 And it's very, very expensive. 921 00:40:50,990 --> 00:40:52,930 So your consideration is absolutely right. 922 00:40:52,930 --> 00:40:56,980 The borrowing cost, or the opportunity cost of capital, 923 00:40:56,980 --> 00:40:58,790 is also part of the equation. 924 00:40:58,790 --> 00:41:00,730 So if we think about all the ingredients 925 00:41:00,730 --> 00:41:03,340 that have to go into determining the forward price, 926 00:41:03,340 --> 00:41:05,750 one is the cost of storage. 927 00:41:05,750 --> 00:41:08,300 The other is the borrowing cost implicit in that-- the cash-- 928 00:41:08,300 --> 00:41:11,740 because a forward contract requires no money down. 929 00:41:11,740 --> 00:41:14,080 So this is one of these true financial deals 930 00:41:14,080 --> 00:41:15,460 with no money down. 931 00:41:15,460 --> 00:41:19,040 The problem is that it's not always a short profit. 932 00:41:19,040 --> 00:41:19,870 Yeah? 933 00:41:19,870 --> 00:41:22,165 AUDIENCE: You may also not have the product to sell. 934 00:41:22,165 --> 00:41:25,890 For example, in the case of soybean or food, 935 00:41:25,890 --> 00:41:27,690 you may enter into a six month forward 936 00:41:27,690 --> 00:41:30,750 and I still did not harvest a product. 937 00:41:30,750 --> 00:41:31,750 ANDREW LO: That's right. 938 00:41:31,750 --> 00:41:33,160 So you may want to wait for the uncertainty 939 00:41:33,160 --> 00:41:35,590 to resolve and get a better sense of what your needs are. 940 00:41:35,590 --> 00:41:36,220 Yup? 941 00:41:36,220 --> 00:41:38,053 AUDIENCE: So if between the buyer and seller 942 00:41:38,053 --> 00:41:40,750 they have a different or asymmetric information, 943 00:41:40,750 --> 00:41:43,500 is it possible that the overall forward contract 944 00:41:43,500 --> 00:41:45,650 has positive NVP? 945 00:41:45,650 --> 00:41:47,650 ANDREW LO: Well, let me put it to you this way-- 946 00:41:47,650 --> 00:41:53,020 the forward contract may have an expected value 947 00:41:53,020 --> 00:41:56,770 for one party or the other based upon what they know. 948 00:41:56,770 --> 00:41:59,380 But in principle, the NPV-- 949 00:41:59,380 --> 00:42:02,140 that's an objective NPV-- has to be zero, 950 00:42:02,140 --> 00:42:05,020 because if it's not zero, then one party can 951 00:42:05,020 --> 00:42:08,860 take that contract and basically sell it to a third party 952 00:42:08,860 --> 00:42:11,080 and make money off of it. 953 00:42:11,080 --> 00:42:11,800 See what I mean? 954 00:42:11,800 --> 00:42:13,570 In other words, your question is, 955 00:42:13,570 --> 00:42:16,270 if two parties have different information, 956 00:42:16,270 --> 00:42:18,830 is it possible that the contract has different value? 957 00:42:18,830 --> 00:42:21,380 Well, certainly they have different value to each party. 958 00:42:21,380 --> 00:42:25,690 In other words, if I'm willing to buy oil forward contracts 959 00:42:25,690 --> 00:42:29,320 from you, I must think either that oil prices 960 00:42:29,320 --> 00:42:30,490 are going to go way up-- 961 00:42:30,490 --> 00:42:32,652 that's my view-- or I just need the oil, 962 00:42:32,652 --> 00:42:34,360 and I want to get rid of the uncertainty. 963 00:42:34,360 --> 00:42:37,000 But both of those are possible. 964 00:42:37,000 --> 00:42:40,370 If you're selling me this oil forward contract, 965 00:42:40,370 --> 00:42:42,370 the two possible reasons you might want to do it 966 00:42:42,370 --> 00:42:44,200 is because you've got a lot of oil 967 00:42:44,200 --> 00:42:46,720 and you want to lock in a price for selling 968 00:42:46,720 --> 00:42:48,550 that oil six months from now-- 969 00:42:48,550 --> 00:42:51,070 that's one possibility-- or you have 970 00:42:51,070 --> 00:42:54,070 some asymmetric information-- some private information-- 971 00:42:54,070 --> 00:42:57,160 that oil prices are going to go down. 972 00:42:57,160 --> 00:43:01,060 So both of those interpretations are legitimate. 973 00:43:01,060 --> 00:43:04,390 But the statement that I made that the price of that contract 974 00:43:04,390 --> 00:43:07,840 has to be zero, that's a statement not about your views 975 00:43:07,840 --> 00:43:09,310 or my views or her views. 976 00:43:09,310 --> 00:43:12,970 It's a statement about the market price of that contract 977 00:43:12,970 --> 00:43:16,247 if we were to auction it off to people in the marketplace. 978 00:43:16,247 --> 00:43:17,830 If we were to auction it off to people 979 00:43:17,830 --> 00:43:22,290 in the marketplace in general, it would have to sell for zero, 980 00:43:22,290 --> 00:43:26,119 because if it were positive, then I would be benefiting 981 00:43:26,119 --> 00:43:27,660 and the person who's selling it to me 982 00:43:27,660 --> 00:43:31,050 would be losing out and vice versa. 983 00:43:31,050 --> 00:43:33,200 So we can have our own speculative motives 984 00:43:33,200 --> 00:43:34,940 for doing the deal. 985 00:43:34,940 --> 00:43:37,610 But when the price is set, the way that it's set 986 00:43:37,610 --> 00:43:44,055 is not just based upon simple expectations of you and me. 987 00:43:44,055 --> 00:43:46,430 But it's the market that's determining the forward price. 988 00:43:46,430 --> 00:43:46,873 Yeah? 989 00:43:46,873 --> 00:43:48,289 AUDIENCE: Then what's the function 990 00:43:48,289 --> 00:43:52,137 of the over-the-counter market for the forward contract? 991 00:43:52,137 --> 00:43:53,720 ANDREW LO: The over-the-counter market 992 00:43:53,720 --> 00:43:55,480 is that you and I are the ones that 993 00:43:55,480 --> 00:43:57,194 are entering into the deal. 994 00:43:57,194 --> 00:43:58,610 And so we're signing the contract. 995 00:43:58,610 --> 00:44:00,260 So it's between us. 996 00:44:00,260 --> 00:44:03,470 But my point is that if the forward price that we are using 997 00:44:03,470 --> 00:44:07,010 to strike that deal is so one-sided, 998 00:44:07,010 --> 00:44:10,010 then it's going to be very clear from the market 999 00:44:10,010 --> 00:44:13,700 that that's a stupid contract for one of us to enter into. 1000 00:44:13,700 --> 00:44:17,790 So it's a private transaction between you and me. 1001 00:44:17,790 --> 00:44:20,220 And for that matter, if it's a private transaction, 1002 00:44:20,220 --> 00:44:22,170 you're right that it could be the case 1003 00:44:22,170 --> 00:44:24,810 that we can make up any price. 1004 00:44:24,810 --> 00:44:28,560 Let's say $200 a barrel. 1005 00:44:28,560 --> 00:44:34,740 Would you ever see a contract that's at $200 a barrel? 1006 00:44:34,740 --> 00:44:40,350 No, because that would mean that either you or me 1007 00:44:40,350 --> 00:44:42,130 is being really stupid. 1008 00:44:42,130 --> 00:44:44,605 Now we're perfectly allowed to be stupid. 1009 00:44:44,605 --> 00:44:47,970 The Constitution guarantees that right. 1010 00:44:47,970 --> 00:44:51,810 But it's unlikely, because we know, both you and I, 1011 00:44:51,810 --> 00:44:53,100 how oil is doing. 1012 00:44:53,100 --> 00:44:57,450 And therefore, the price will be set to make that contract worth 1013 00:44:57,450 --> 00:44:58,680 nothing. 1014 00:44:58,680 --> 00:45:02,340 If it were not worth nothing, then one of us 1015 00:45:02,340 --> 00:45:04,260 is making a very bad deal. 1016 00:45:04,260 --> 00:45:07,080 And money is going to be exchanged from one party 1017 00:45:07,080 --> 00:45:08,561 to the other. 1018 00:45:08,561 --> 00:45:09,060 Yeah? 1019 00:45:09,060 --> 00:45:11,410 AUDIENCE: Does this always have to happen 1020 00:45:11,410 --> 00:45:14,594 between a buyer and a seller, or could that be in communities? 1021 00:45:14,594 --> 00:45:15,760 ANDREW LO: Could it be what? 1022 00:45:15,760 --> 00:45:17,301 AUDIENCE: Could it be in communities? 1023 00:45:17,301 --> 00:45:19,480 ANDREW LO: I'm going to get to that in two minutes. 1024 00:45:19,480 --> 00:45:21,520 Right now, it's only between buyer and seller. 1025 00:45:21,520 --> 00:45:22,900 That's a forward contract. 1026 00:45:22,900 --> 00:45:25,990 With the futures contract, that's a different story. 1027 00:45:25,990 --> 00:45:27,200 Another question? 1028 00:45:27,200 --> 00:45:29,320 AUDIENCE: I'm just wondering, does this actually 1029 00:45:29,320 --> 00:45:31,141 assume physical delivery of the asset? 1030 00:45:31,141 --> 00:45:32,140 ANDREW LO: Yes, it does. 1031 00:45:32,140 --> 00:45:34,410 Yes, it does, although if it doesn't have to. 1032 00:45:34,410 --> 00:45:36,914 If the contract that you strike as a forward contract 1033 00:45:36,914 --> 00:45:38,830 is one where you don't want physical delivery, 1034 00:45:38,830 --> 00:45:41,110 you can make it a pure bet-- a side bet. 1035 00:45:41,110 --> 00:45:44,290 But in fact, typical forward contracts that are entered into 1036 00:45:44,290 --> 00:45:47,200 are for physical delivery of the actual commodity 1037 00:45:47,200 --> 00:45:49,120 being agreed upon, because that's 1038 00:45:49,120 --> 00:45:50,320 why people enter into them. 1039 00:45:50,320 --> 00:45:54,100 They need the oil or the gas or the copper. 1040 00:45:54,100 --> 00:45:54,692 Yeah? 1041 00:45:54,692 --> 00:45:56,050 AUDIENCE: What does [INAUDIBLE]? 1042 00:45:56,050 --> 00:45:57,430 ANDREW LO: So let me get to that. 1043 00:45:57,430 --> 00:45:59,230 I want to make sure we get all the other questions answered, 1044 00:45:59,230 --> 00:46:00,400 though, before I go down. 1045 00:46:00,400 --> 00:46:02,110 The last point that I want to make 1046 00:46:02,110 --> 00:46:04,960 is that with a forward contract, because it's 1047 00:46:04,960 --> 00:46:08,460 a contract between two parties, there 1048 00:46:08,460 --> 00:46:10,930 is significant counterparty risk, 1049 00:46:10,930 --> 00:46:14,490 meaning there is a risk that you don't pay up 1050 00:46:14,490 --> 00:46:17,434 on your end of the deal or that I don't pay up 1051 00:46:17,434 --> 00:46:18,350 on my end of the deal. 1052 00:46:18,350 --> 00:46:24,270 There is a significant risk that one of the parties reneges. 1053 00:46:24,270 --> 00:46:28,590 So this is not a riskless kind of a contract. 1054 00:46:28,590 --> 00:46:32,100 It has significant default risk. 1055 00:46:32,100 --> 00:46:35,580 How significant depends upon the counterparty. 1056 00:46:35,580 --> 00:46:37,380 If you're dealing with-- 1057 00:46:37,380 --> 00:46:40,420 I hate to say this-- but a AAA counterparty, 1058 00:46:40,420 --> 00:46:42,850 then the risks should be small. 1059 00:46:42,850 --> 00:46:46,286 But we all know what AAA means these days. 1060 00:46:46,286 --> 00:46:47,910 It used to be the case that when you're 1061 00:46:47,910 --> 00:46:50,250 dealing with a AAA counterparty, you had 1062 00:46:50,250 --> 00:46:52,714 very little counterparty risk. 1063 00:46:52,714 --> 00:46:54,630 But if you're dealing with a counterparty that 1064 00:46:54,630 --> 00:46:56,877 doesn't have the same kind of financial wherewithal, 1065 00:46:56,877 --> 00:46:58,710 then you're going to have to bear that risk. 1066 00:46:58,710 --> 00:47:01,770 And it's up to you to decide, is it worth it to you 1067 00:47:01,770 --> 00:47:03,060 to take that risk? 1068 00:47:03,060 --> 00:47:04,120 Yeah? 1069 00:47:04,120 --> 00:47:08,525 AUDIENCE: So in event of the very [INAUDIBLE] market 1070 00:47:08,525 --> 00:47:13,962 fluctuation [INAUDIBLE], somebody will lose in the end 1071 00:47:13,962 --> 00:47:15,270 upon the settlement. 1072 00:47:15,270 --> 00:47:21,027 So is it common for people that participate in this to hedge 1073 00:47:21,027 --> 00:47:23,332 their positions as well? 1074 00:47:23,332 --> 00:47:24,377 [INAUDIBLE] 1075 00:47:24,377 --> 00:47:25,960 ANDREW LO: To hedge counterparty risk? 1076 00:47:25,960 --> 00:47:26,580 AUDIENCE: Yes. 1077 00:47:26,580 --> 00:47:27,580 ANDREW LO: It is common. 1078 00:47:27,580 --> 00:47:29,380 And you know how they do it? 1079 00:47:29,380 --> 00:47:30,850 They don't use a forward contract. 1080 00:47:30,850 --> 00:47:33,080 They use a futures contract. 1081 00:47:33,080 --> 00:47:35,221 So we're going to get there in just a few minutes. 1082 00:47:35,221 --> 00:47:36,970 Maybe I should go faster, given that there 1083 00:47:36,970 --> 00:47:40,130 are all these questions that are anticipating the futures 1084 00:47:40,130 --> 00:47:40,630 contract. 1085 00:47:40,630 --> 00:47:42,046 Or maybe it's just that all of you 1086 00:47:42,046 --> 00:47:43,780 are scared to death of counterparty risk, 1087 00:47:43,780 --> 00:47:46,447 given what's going on, that you just want to get rid of it. 1088 00:47:46,447 --> 00:47:49,030 So let me go quickly through an example of a forward contract. 1089 00:47:49,030 --> 00:47:51,655 Then I'll get to your point, and I"ll show you how you go about 1090 00:47:51,655 --> 00:47:56,172 hedging that risk by essentially doing a transaction every day. 1091 00:47:56,172 --> 00:47:57,880 But I want to make sure we all understand 1092 00:47:57,880 --> 00:47:59,870 the concept of a forward first. 1093 00:47:59,870 --> 00:48:01,300 So here's an example. 1094 00:48:01,300 --> 00:48:05,170 The current price of soybeans is $160 a metric ton. 1095 00:48:05,170 --> 00:48:07,750 That's the current spot price-- 1096 00:48:07,750 --> 00:48:10,590 the price today. 1097 00:48:10,590 --> 00:48:13,150 And there's a tofu manufacturer that 1098 00:48:13,150 --> 00:48:17,335 needs 1,000 tons, not now but three months from now. 1099 00:48:17,335 --> 00:48:18,960 And they want to make sure they can get 1100 00:48:18,960 --> 00:48:21,940 that 100,000 tons at that time. 1101 00:48:21,940 --> 00:48:26,320 So they might enter into a three-month contract 1102 00:48:26,320 --> 00:48:31,570 to buy 1,000 tons at 165 tons. 1103 00:48:31,570 --> 00:48:34,570 So they're going to offer the seller of the soybeans-- 1104 00:48:34,570 --> 00:48:35,580 the soybean farmer-- 1105 00:48:35,580 --> 00:48:38,265 they'll offer them a little bit of a premium-- 1106 00:48:38,265 --> 00:48:43,030 a $5 premium-- in order to lock in that price. 1107 00:48:43,030 --> 00:48:44,980 Now it doesn't have to always be a premium. 1108 00:48:44,980 --> 00:48:47,979 In certain cases, there could be a discount. 1109 00:48:47,979 --> 00:48:50,020 And there are different names for those that I'll 1110 00:48:50,020 --> 00:48:51,890 talk about in a few minutes. 1111 00:48:51,890 --> 00:48:54,180 But for now, it's at 165. 1112 00:48:54,180 --> 00:48:57,070 And it's what the market seems to agree 1113 00:48:57,070 --> 00:49:00,320 is an appropriate price three months from now. 1114 00:49:00,320 --> 00:49:03,370 So you've all identified, I think, 1115 00:49:03,370 --> 00:49:05,080 the issues with a forward contract. 1116 00:49:05,080 --> 00:49:06,020 There are two issues. 1117 00:49:06,020 --> 00:49:09,070 One is illiquidity, and the second is counterparty risk. 1118 00:49:09,070 --> 00:49:11,590 Illiquidity means, suppose that I no longer 1119 00:49:11,590 --> 00:49:12,820 want to be in the contract-- 1120 00:49:12,820 --> 00:49:15,690 I want out. 1121 00:49:15,690 --> 00:49:17,910 Well, it's not easy for me to get out. 1122 00:49:17,910 --> 00:49:20,820 I can't sell my contract unless I 1123 00:49:20,820 --> 00:49:26,550 find somebody else who wants to buy soybeans at 165 tons three 1124 00:49:26,550 --> 00:49:27,442 months from now. 1125 00:49:27,442 --> 00:49:28,650 I can't get out of it easily. 1126 00:49:28,650 --> 00:49:31,110 I can go back to the farmer and say, 1127 00:49:31,110 --> 00:49:33,120 would you mind canceling the contract? 1128 00:49:33,120 --> 00:49:36,020 And they'll probably say, well, it depends, where 1129 00:49:36,020 --> 00:49:37,890 is the price of soybeans today? 1130 00:49:37,890 --> 00:49:40,380 If the price of soybeans is at $180, 1131 00:49:40,380 --> 00:49:42,270 I'm happy to cancel the contract. 1132 00:49:42,270 --> 00:49:44,820 If the price of soybeans is at $50, sorry, 1133 00:49:44,820 --> 00:49:47,250 you're stuck with the agreement. 1134 00:49:47,250 --> 00:49:49,080 So the illiquidity is an issue. 1135 00:49:49,080 --> 00:49:51,780 But then of course, counterparty risk 1136 00:49:51,780 --> 00:49:53,610 is another issue that we have to deal with. 1137 00:49:53,610 --> 00:49:54,360 Yeah, [INAUDIBLE]? 1138 00:49:54,360 --> 00:50:00,120 AUDIENCE: [INAUDIBLE] trying to hedge the quantity. 1139 00:50:00,120 --> 00:50:01,720 It's not the actual price. 1140 00:50:01,720 --> 00:50:03,960 Do companies do that where they want to guarantee 1141 00:50:03,960 --> 00:50:05,784 that there will be a supply? 1142 00:50:05,784 --> 00:50:06,450 ANDREW LO: Yeah. 1143 00:50:06,450 --> 00:50:07,560 Well, it's both. 1144 00:50:07,560 --> 00:50:09,510 They want to guarantee that they have enough 1145 00:50:09,510 --> 00:50:11,676 to be able to produce whatever they need to produce. 1146 00:50:11,676 --> 00:50:14,300 So they need a certain amount of input. 1147 00:50:14,300 --> 00:50:17,450 But they won't want to guarantee it at any price. 1148 00:50:17,450 --> 00:50:20,490 They want to be able to figure out a reasonable price. 1149 00:50:20,490 --> 00:50:23,510 So in this example of the tofu manufacturer, 1150 00:50:23,510 --> 00:50:25,400 they need 1,000 tons in three months. 1151 00:50:25,400 --> 00:50:27,260 That's definite. 1152 00:50:27,260 --> 00:50:29,754 That's the quantity that they need. 1153 00:50:29,754 --> 00:50:31,170 The question is, what's the price? 1154 00:50:31,170 --> 00:50:34,950 If the current spot price is at $160, 1155 00:50:34,950 --> 00:50:37,020 then they need to make a decision. 1156 00:50:37,020 --> 00:50:39,690 In three months time, do they think 1157 00:50:39,690 --> 00:50:44,400 that the price will be greater or less than 165? 1158 00:50:44,400 --> 00:50:48,750 If they think that it may be much more than 165, 1159 00:50:48,750 --> 00:50:50,220 then they'll enter into it. 1160 00:50:50,220 --> 00:50:51,720 But if they think that there's going 1161 00:50:51,720 --> 00:50:54,480 to be a huge crop of soybeans, because we've 1162 00:50:54,480 --> 00:50:57,450 had a lot of rainfall and a lot of sunshine 1163 00:50:57,450 --> 00:50:59,400 and there's no problem and we're going 1164 00:50:59,400 --> 00:51:02,952 to have a glut of soybeans, then they may not do this at all. 1165 00:51:02,952 --> 00:51:04,410 They may just say, huh, we're going 1166 00:51:04,410 --> 00:51:06,550 to wait three months to see what happens. 1167 00:51:06,550 --> 00:51:09,180 Of course, if it turns out that between now and three months 1168 00:51:09,180 --> 00:51:11,590 from now there is some kind of bacteria 1169 00:51:11,590 --> 00:51:17,100 that kills half the soybean crop, now it's $190 a ton, 1170 00:51:17,100 --> 00:51:19,040 then they're in trouble. 1171 00:51:19,040 --> 00:51:22,220 So as a tofu manufacturer, you got 1172 00:51:22,220 --> 00:51:24,950 to ask yourself the question, how well 1173 00:51:24,950 --> 00:51:27,980 do you know the soybean market, how much 1174 00:51:27,980 --> 00:51:31,730 are you willing to bet your firm's franchise on soybeans 1175 00:51:31,730 --> 00:51:33,740 being available at the price that you want 1176 00:51:33,740 --> 00:51:36,570 to pay three months from now? 1177 00:51:36,570 --> 00:51:37,880 OK. 1178 00:51:37,880 --> 00:51:41,160 So it's both price and quantity. 1179 00:51:41,160 --> 00:51:41,660 All right. 1180 00:51:41,660 --> 00:51:44,450 Now we're going to get back to [INAUDIBLE] point 1181 00:51:44,450 --> 00:51:48,290 about being worried about counterparty risk. 1182 00:51:48,290 --> 00:51:50,510 And let's just talk about counterparty risk 1183 00:51:50,510 --> 00:51:53,420 in very, very plain detail. 1184 00:51:53,420 --> 00:51:56,330 Suppose that we enter into that soybean contract. 1185 00:51:56,330 --> 00:51:58,910 So today, we agree to buy soybeans 1186 00:51:58,910 --> 00:52:03,280 three months from now, as a tofu manufacturer, for $165 a ton. 1187 00:52:06,090 --> 00:52:09,490 All right, now let's fast forward one month. 1188 00:52:09,490 --> 00:52:11,500 We've got two months to go in our agreement-- 1189 00:52:11,500 --> 00:52:13,270 in our forward agreement-- 1190 00:52:13,270 --> 00:52:18,790 and all of a sudden, something happens in the soybean market, 1191 00:52:18,790 --> 00:52:24,610 and the spot price for soybeans has now dropped to $100 a ton. 1192 00:52:24,610 --> 00:52:28,750 Huge glut that has hit the market, because the weather 1193 00:52:28,750 --> 00:52:36,790 was unexpectedly nicer, lots of rainfall, just tremendous crop 1194 00:52:36,790 --> 00:52:37,820 output. 1195 00:52:37,820 --> 00:52:42,660 So we got $100 a ton for soybeans. 1196 00:52:42,660 --> 00:52:50,020 Now to the tofu manufacturer who's looking to do this deal, 1197 00:52:50,020 --> 00:52:55,270 is he in better shape or worse shape in that circumstance? 1198 00:52:55,270 --> 00:52:55,770 Why? 1199 00:52:55,770 --> 00:52:59,160 Why is he in worse shape? 1200 00:52:59,160 --> 00:53:03,270 He's agreed to buy it at $165, price is at 100. 1201 00:53:03,270 --> 00:53:04,800 But what's the big deal? 1202 00:53:04,800 --> 00:53:08,670 He was willing to do that a month ago. 1203 00:53:08,670 --> 00:53:09,170 What's that? 1204 00:53:09,170 --> 00:53:10,420 Same shape. 1205 00:53:10,420 --> 00:53:12,240 Same shape. 1206 00:53:12,240 --> 00:53:13,910 We agree? 1207 00:53:13,910 --> 00:53:15,327 Worse-- why is it worse? 1208 00:53:15,327 --> 00:53:17,035 AUDIENCE: Because his competitors already 1209 00:53:17,035 --> 00:53:19,170 have access to [INAUDIBLE]. 1210 00:53:19,170 --> 00:53:20,230 ANDREW LO: Right. 1211 00:53:20,230 --> 00:53:23,310 So what do you think the competitors are going to do? 1212 00:53:23,310 --> 00:53:24,030 Exactly. 1213 00:53:24,030 --> 00:53:28,430 The competitors are going to drop the price of tofu. 1214 00:53:28,430 --> 00:53:30,350 Soybeans have come down in price. 1215 00:53:30,350 --> 00:53:33,260 The competitors are going to cut the price of tofu. 1216 00:53:33,260 --> 00:53:35,570 And here you've got a manufacturer. 1217 00:53:35,570 --> 00:53:37,610 If you argue that he's in the same shape, 1218 00:53:37,610 --> 00:53:40,910 that means that he's going to keep the same price of tofu 1219 00:53:40,910 --> 00:53:44,417 and he's going to pay $165 for what's worth $100. 1220 00:53:44,417 --> 00:53:46,250 Basically, he's going to go out of business, 1221 00:53:46,250 --> 00:53:49,520 because his competitors are going to eat his lunch. 1222 00:53:49,520 --> 00:53:52,010 They're going to charge 40% less, 1223 00:53:52,010 --> 00:53:53,960 and he'll have zero market share. 1224 00:53:53,960 --> 00:53:57,480 And he may be able to withstand that for a period of time, 1225 00:53:57,480 --> 00:53:59,430 but not for a sustained period of time. 1226 00:53:59,430 --> 00:54:03,260 So this particular manufacturer of tofu is thinking, 1227 00:54:03,260 --> 00:54:08,420 well, I could buy soybeans at $100 on the market now 1228 00:54:08,420 --> 00:54:12,540 and I got two months before I have to make good on this, 1229 00:54:12,540 --> 00:54:16,020 what if I just walk away from this forward agreement? 1230 00:54:16,020 --> 00:54:19,870 Now legally, he's not supposed to do that. 1231 00:54:19,870 --> 00:54:25,900 So what that means is that if he does do that, he can be sued. 1232 00:54:25,900 --> 00:54:29,470 And from the tofu manufacturer's point of view, 1233 00:54:29,470 --> 00:54:32,800 he might be thinking, well, they can sue me 1234 00:54:32,800 --> 00:54:36,160 and we can figure it out, or I can follow through the contract 1235 00:54:36,160 --> 00:54:39,130 and I'll go out of business, so if I'm faced with those two 1236 00:54:39,130 --> 00:54:41,290 choices and that's my only choice, 1237 00:54:41,290 --> 00:54:44,340 I'm going to renege on that contract 1238 00:54:44,340 --> 00:54:46,820 and let them sue me and see what they get, 1239 00:54:46,820 --> 00:54:49,470 maybe we'll settle out of court, maybe we 1240 00:54:49,470 --> 00:54:51,240 won't, who knows what will happen, 1241 00:54:51,240 --> 00:54:52,680 I'm willing to take that risk. 1242 00:54:52,680 --> 00:54:53,970 That's a calculation. 1243 00:54:53,970 --> 00:54:58,630 It's a business decision that has consequences. 1244 00:54:58,630 --> 00:55:00,820 But it's got consequences for both parties. 1245 00:55:00,820 --> 00:55:04,720 Now imagine you're the soybean farmer dealing with this tofu 1246 00:55:04,720 --> 00:55:06,160 manufacturer. 1247 00:55:06,160 --> 00:55:09,750 And you're rubbing your hands, because you locked in at $165 1248 00:55:09,750 --> 00:55:11,290 a ton. 1249 00:55:11,290 --> 00:55:13,990 But two months from now when you go 1250 00:55:13,990 --> 00:55:17,860 to deliver these soybeans, you find out the warehouse 1251 00:55:17,860 --> 00:55:19,210 is not accepting it. 1252 00:55:19,210 --> 00:55:22,030 And you can't get this tofu manufacturer on the phone. 1253 00:55:22,030 --> 00:55:23,710 He's not returning your calls. 1254 00:55:23,710 --> 00:55:24,690 What do you do? 1255 00:55:24,690 --> 00:55:25,190 Yeah? 1256 00:55:25,190 --> 00:55:26,810 AUDIENCE: This is currently happening with oil. 1257 00:55:26,810 --> 00:55:29,193 A lot of people locked in at $5.00 a gallon and now 1258 00:55:29,193 --> 00:55:30,296 it's above $4.00. 1259 00:55:30,296 --> 00:55:33,047 So the oil companies are scared that everyone's 1260 00:55:33,047 --> 00:55:33,880 going to stiff them. 1261 00:55:33,880 --> 00:55:34,796 ANDREW LO: Absolutely. 1262 00:55:34,796 --> 00:55:37,150 There's counterparty risk that comes 1263 00:55:37,150 --> 00:55:40,733 about when you've got dramatic changes in economic conditions. 1264 00:55:40,733 --> 00:55:41,719 Yeah? 1265 00:55:41,719 --> 00:55:44,677 AUDIENCE: But as far as I know, the system only 1266 00:55:44,677 --> 00:55:47,873 gave you the [INAUDIBLE] deposit [INAUDIBLE] amount of the risk 1267 00:55:47,873 --> 00:55:48,892 that you want to buy. 1268 00:55:48,892 --> 00:55:49,600 ANDREW LO: Right. 1269 00:55:49,600 --> 00:55:51,880 So now you're talking about collateral. 1270 00:55:51,880 --> 00:55:54,700 In order to be able to enter into a forward agreement, 1271 00:55:54,700 --> 00:55:57,440 you might, before you even start talking, say, 1272 00:55:57,440 --> 00:56:00,700 you know what, I'm not going to do business with you unless you 1273 00:56:00,700 --> 00:56:02,420 put up some money-- 1274 00:56:02,420 --> 00:56:06,880 so money as a kind of collateral for making good on it. 1275 00:56:06,880 --> 00:56:09,070 And if you don't make good on it, 1276 00:56:09,070 --> 00:56:11,270 I get to keep the collateral. 1277 00:56:11,270 --> 00:56:13,386 Now the question is, how big is the collateral, 1278 00:56:13,386 --> 00:56:14,260 and what is it worth? 1279 00:56:14,260 --> 00:56:17,010 AUDIENCE: So you say, what reason do you want to buy? 1280 00:56:17,010 --> 00:56:20,510 If you just want to buy a $30 risk [INAUDIBLE], 1281 00:56:20,510 --> 00:56:22,986 so you put $30 [INAUDIBLE] want to buy. 1282 00:56:22,986 --> 00:56:25,446 But you, from the beginning, can say, how much 1283 00:56:25,446 --> 00:56:26,775 [INAUDIBLE] do you want to buy? 1284 00:56:26,775 --> 00:56:28,900 ANDREW LO: Well, but the thing is that they may not 1285 00:56:28,900 --> 00:56:29,733 be willing to do it. 1286 00:56:29,733 --> 00:56:31,300 So let's do the example of soybeans. 1287 00:56:31,300 --> 00:56:36,090 Soybeans at $165 a ton multiplied by 1,000 tons 1288 00:56:36,090 --> 00:56:38,910 is $165,000. 1289 00:56:38,910 --> 00:56:40,122 Right? 1290 00:56:40,122 --> 00:56:44,280 AUDIENCE: I can put [INAUDIBLE] 1291 00:56:44,280 --> 00:56:46,170 ANDREW LO: Right. 1292 00:56:46,170 --> 00:56:50,280 So in order to do the deal, maybe you would agree to put 1293 00:56:50,280 --> 00:56:53,790 $5.00 a ton of deposit as collateral. 1294 00:56:53,790 --> 00:56:55,410 OK? 1295 00:56:55,410 --> 00:56:56,940 That sounds good, right? 1296 00:56:56,940 --> 00:56:59,860 And as a counterparty, I might be happy with that. 1297 00:56:59,860 --> 00:57:04,370 OK, now say the price of soybeans drops to $100 a ton. 1298 00:57:04,370 --> 00:57:08,680 And you've put $5.00 down as earnest money as collateral. 1299 00:57:08,680 --> 00:57:13,570 And so from your perspective, as long as the price goes down 1300 00:57:13,570 --> 00:57:16,090 by more than $5.00, you're going to walk away. 1301 00:57:16,090 --> 00:57:18,070 AUDIENCE: [INAUDIBLE] but I lose the $5.00. 1302 00:57:18,070 --> 00:57:18,350 ANDREW LO: Right. 1303 00:57:18,350 --> 00:57:19,302 You lose the $5.00. 1304 00:57:19,302 --> 00:57:20,260 I'm the soybean farmer. 1305 00:57:20,260 --> 00:57:21,640 Great, I got $5.00 a ton. 1306 00:57:21,640 --> 00:57:22,640 What's that going to do? 1307 00:57:22,640 --> 00:57:24,700 That pays for my postage. 1308 00:57:24,700 --> 00:57:26,380 That doesn't do anything for me. 1309 00:57:26,380 --> 00:57:31,030 So given that I'm worried about your counterparty risk, 1310 00:57:31,030 --> 00:57:34,960 I'm going to say, you know what, I don't want $5.00 a ton, 1311 00:57:34,960 --> 00:57:37,630 I want you to pay me $160 a ton now, 1312 00:57:37,630 --> 00:57:40,000 I want you to deposit that in the bank and put it 1313 00:57:40,000 --> 00:57:41,530 in collateral. 1314 00:57:41,530 --> 00:57:43,750 Would you be willing to do that? 1315 00:57:43,750 --> 00:57:47,509 AUDIENCE: Depends on the rate and the-- 1316 00:57:47,509 --> 00:57:48,300 ANDREW LO: Exactly. 1317 00:57:48,300 --> 00:57:51,510 It depends upon what you think the risks are that the price is 1318 00:57:51,510 --> 00:57:53,800 going to go down quite a bit. 1319 00:57:53,800 --> 00:57:57,780 But in general, you're not going to want to tie up $160 a ton 1320 00:57:57,780 --> 00:58:01,110 for three months if you don't have to, because that costs you 1321 00:58:01,110 --> 00:58:01,620 something. 1322 00:58:01,620 --> 00:58:04,690 The opportunity cost is the interest rate. 1323 00:58:04,690 --> 00:58:05,219 Yeah? 1324 00:58:05,219 --> 00:58:07,260 AUDIENCE: Why don't I just make a contract saying 1325 00:58:07,260 --> 00:58:10,600 I would buy at a 10% markup instead 1326 00:58:10,600 --> 00:58:12,480 of setting a specific price? 1327 00:58:12,480 --> 00:58:14,830 Does it no longer [INAUDIBLE]? 1328 00:58:14,830 --> 00:58:15,874 ANDREW LO: Well, no. 1329 00:58:15,874 --> 00:58:17,040 You could certainly do that. 1330 00:58:17,040 --> 00:58:19,110 But it's not clear that that really makes any difference. 1331 00:58:19,110 --> 00:58:20,280 10% markup over what? 1332 00:58:20,280 --> 00:58:21,570 You have to define something. 1333 00:58:21,570 --> 00:58:22,903 AUDIENCE: The price at the time. 1334 00:58:22,903 --> 00:58:25,500 ANDREW LO: Over the prevailing market price. 1335 00:58:25,500 --> 00:58:28,320 You could do that. 1336 00:58:28,320 --> 00:58:30,310 [INTERPOSING VOICES] 1337 00:58:30,310 --> 00:58:30,810 Right. 1338 00:58:30,810 --> 00:58:32,050 What's the benefit of that? 1339 00:58:32,050 --> 00:58:34,720 That doesn't lock in anything. 1340 00:58:34,720 --> 00:58:38,120 It may lock in the supply, but it doesn't lock in the price. 1341 00:58:38,120 --> 00:58:39,800 You still have price uncertainty. 1342 00:58:39,800 --> 00:58:42,880 So if you do that, unless you're worried about a shortage, 1343 00:58:42,880 --> 00:58:46,540 you can always get something for 10% above the price, 1344 00:58:46,540 --> 00:58:49,990 at least I think you can. 1345 00:58:49,990 --> 00:58:51,460 Markets are pretty crazy. 1346 00:58:51,460 --> 00:58:54,670 But if I were to tell you that no matter what commodity we're 1347 00:58:54,670 --> 00:58:58,060 talking about, I'm willing to pay 10% more than the market 1348 00:58:58,060 --> 00:59:00,290 price, my guess is that everybody here would 1349 00:59:00,290 --> 00:59:01,540 be pretty happy to sell to me. 1350 00:59:01,540 --> 00:59:03,090 Right? 1351 00:59:03,090 --> 00:59:03,646 Yeah? 1352 00:59:03,646 --> 00:59:06,322 AUDIENCE: But these [INAUDIBLE] evaluated by anybody. 1353 00:59:06,322 --> 00:59:10,275 So are these just contracts between producer and supplier? 1354 00:59:10,275 --> 00:59:10,900 ANDREW LO: Yes. 1355 00:59:10,900 --> 00:59:11,580 AUDIENCE: So they're like longstanding agreements 1356 00:59:11,580 --> 00:59:12,360 and I'm just-- 1357 00:59:12,360 --> 00:59:12,640 ANDREW LO: Right. 1358 00:59:12,640 --> 00:59:13,181 That's right. 1359 00:59:13,181 --> 00:59:15,640 These are not governed by any agency 1360 00:59:15,640 --> 00:59:18,280 or any kind of standardization. 1361 00:59:18,280 --> 00:59:21,640 And you now see the problem with these contracts. 1362 00:59:21,640 --> 00:59:25,900 These contracts work if the two parties know each other, 1363 00:59:25,900 --> 00:59:28,750 they've done business for years, there's a lot of trust, 1364 00:59:28,750 --> 00:59:30,750 you don't have to worry about counterparty risk, 1365 00:59:30,750 --> 00:59:32,500 you've got the right amount of collateral, 1366 00:59:32,500 --> 00:59:36,210 you've got the right rating, on and on. 1367 00:59:36,210 --> 00:59:37,950 It's complicated. 1368 00:59:37,950 --> 00:59:40,351 Isn't there a way to make this simpler? 1369 00:59:40,351 --> 00:59:41,850 And the answer is that there's a way 1370 00:59:41,850 --> 00:59:45,500 to deal with all of your objections-- all of them. 1371 00:59:45,500 --> 00:59:48,390 Let's create a new contract called a futures. 1372 00:59:48,390 --> 00:59:52,290 A futures contract is exactly like a forward 1373 00:59:52,290 --> 00:59:55,360 with a few exceptions. 1374 00:59:55,360 --> 00:59:58,510 Exception number one, we're going to standardize a futures 1375 00:59:58,510 --> 01:00:00,040 contract. 1376 01:00:00,040 --> 01:00:03,490 One contract applies to a fixed amount 1377 01:00:03,490 --> 01:00:06,940 of the commodity of a fixed quality that 1378 01:00:06,940 --> 01:00:11,110 is known in advance and is decided objectively. 1379 01:00:11,110 --> 01:00:16,990 It expires, or it settles, on a fixed date. 1380 01:00:16,990 --> 01:00:21,010 And there is a futures price. 1381 01:00:21,010 --> 01:00:25,470 And the price is determined on an exchange. 1382 01:00:25,470 --> 01:00:29,520 OK, so that's one set of changes. 1383 01:00:29,520 --> 01:00:33,570 But the other set of changes is really important, 1384 01:00:33,570 --> 01:00:40,860 which is that we are going to mark to market every day. 1385 01:00:40,860 --> 01:00:44,980 Now what does mark to market mean? 1386 01:00:44,980 --> 01:00:47,290 If you've got a futures contract-- 1387 01:00:47,290 --> 01:00:49,540 or rather, if you've got a forward contract that 1388 01:00:49,540 --> 01:00:54,520 expires in three months, initially it's worth nothing. 1389 01:00:54,520 --> 01:01:00,110 But over time, as the spot price fluctuates, 1390 01:01:00,110 --> 01:01:03,780 that forward contract has value. 1391 01:01:03,780 --> 01:01:07,200 But no money changes hands. 1392 01:01:07,200 --> 01:01:11,400 And so because no money changes hands, and apart 1393 01:01:11,400 --> 01:01:15,180 from collateral, you can have a really big mismatch 1394 01:01:15,180 --> 01:01:19,480 in the value of the contract to one party or another. 1395 01:01:19,480 --> 01:01:22,020 So let's go back to the soybean example. 1396 01:01:22,020 --> 01:01:24,420 I start out by agreeing to buy soybeans 1397 01:01:24,420 --> 01:01:30,120 from you at $165 a metric ton three months from now. 1398 01:01:30,120 --> 01:01:33,340 And the spot price today is 160. 1399 01:01:33,340 --> 01:01:34,170 All right. 1400 01:01:34,170 --> 01:01:43,600 A month from now, let's say, the spot price is down to 150. 1401 01:01:43,600 --> 01:01:46,180 What do you think that contract is going 1402 01:01:46,180 --> 01:01:48,229 to be worth at that point? 1403 01:01:52,100 --> 01:01:53,172 Yeah? 1404 01:01:53,172 --> 01:01:55,241 AUDIENCE: [INAUDIBLE] 1405 01:01:55,241 --> 01:01:56,240 ANDREW LO: That's right. 1406 01:01:56,240 --> 01:01:56,600 $15. 1407 01:01:56,600 --> 01:01:57,530 How did you get $15? 1408 01:01:57,530 --> 01:02:01,341 AUDIENCE: It's the difference between the future price 1409 01:02:01,341 --> 01:02:03,320 and the spot today. 1410 01:02:03,320 --> 01:02:04,340 ANDREW LO: That's right. 1411 01:02:04,340 --> 01:02:08,140 I've agreed to buy it for $165. 1412 01:02:08,140 --> 01:02:15,530 The spot price two months from maturity is $150. 1413 01:02:15,530 --> 01:02:17,840 That's $15 difference. 1414 01:02:17,840 --> 01:02:21,410 And so this piece of paper obligates me to buy it 1415 01:02:21,410 --> 01:02:24,030 for $15 more than today. 1416 01:02:24,030 --> 01:02:26,900 So from my perspective-- the buyer-- 1417 01:02:26,900 --> 01:02:31,890 the contract is worth not zero, but it's worth negative 1418 01:02:31,890 --> 01:02:34,560 $15 divided by the rate of interest, 1419 01:02:34,560 --> 01:02:36,390 because I don't have to pay the $15 today. 1420 01:02:36,390 --> 01:02:39,450 I have to pay the $15 at maturity, at settlement. 1421 01:02:39,450 --> 01:02:43,530 For you, the farmer who sold me that contract, that contract-- 1422 01:02:43,530 --> 01:02:48,720 to you, it's worth $15 per 1,000 metric tons divided 1423 01:02:48,720 --> 01:02:51,390 by the appropriate discount factor-- the interest rate-- 1424 01:02:51,390 --> 01:02:52,710 for that three months. 1425 01:02:52,710 --> 01:02:56,910 Now to say that it's worth that really means it's worth that. 1426 01:02:56,910 --> 01:02:58,800 For example, if you decide that you 1427 01:02:58,800 --> 01:03:01,380 want to get out of the soybean farming business 1428 01:03:01,380 --> 01:03:02,880 and you want to take that contract 1429 01:03:02,880 --> 01:03:05,880 and sell it to one of your fellow farmers, 1430 01:03:05,880 --> 01:03:10,530 they'll pay you $15 divided by the appropriate interest 1431 01:03:10,530 --> 01:03:13,147 rate per 1,000 metric tons. 1432 01:03:13,147 --> 01:03:14,730 You will be able to sell that contract 1433 01:03:14,730 --> 01:03:15,771 for that amount of money. 1434 01:03:18,600 --> 01:03:22,530 So after date zero, as the spot price fluctuates, 1435 01:03:22,530 --> 01:03:27,800 this forward agreement ends up taking on economic value, 1436 01:03:27,800 --> 01:03:31,520 because the prices fluctuate. 1437 01:03:31,520 --> 01:03:34,100 If we allow that price fluctuation-- 1438 01:03:34,100 --> 01:03:36,350 if we allow the value of that contract 1439 01:03:36,350 --> 01:03:38,880 to get really, really big-- 1440 01:03:38,880 --> 01:03:43,010 in my crazy example, if the spot price goes down to 100-- 1441 01:03:43,010 --> 01:03:45,170 well, then that piece of paper is worth a lot 1442 01:03:45,170 --> 01:03:46,550 to you, the farmer. 1443 01:03:46,550 --> 01:03:51,230 And it's worth a lot to me to be able to get rid of that loss. 1444 01:03:51,230 --> 01:03:52,550 That's a big loss. 1445 01:03:52,550 --> 01:03:57,110 The bigger the loss, the more likely it is that one of us 1446 01:03:57,110 --> 01:03:58,440 is not going to perform. 1447 01:03:58,440 --> 01:03:59,120 Why? 1448 01:03:59,120 --> 01:04:03,020 Because the collateral-- if we have a collateral of $5.00 per 1449 01:04:03,020 --> 01:04:08,120 1,000 metric tons, that $5.00 is going to become meaningless 1450 01:04:08,120 --> 01:04:13,490 pretty soon, because I'm looking at a loss of $50. 1451 01:04:13,490 --> 01:04:17,780 If it goes down from $165 to $100, 1452 01:04:17,780 --> 01:04:20,060 I'm looking at a really big loss-- 1453 01:04:20,060 --> 01:04:22,370 $65 per metric ton. 1454 01:04:22,370 --> 01:04:24,770 $5.00 means nothing to me. 1455 01:04:24,770 --> 01:04:28,220 So the bigger the fluctuations away 1456 01:04:28,220 --> 01:04:33,630 from the initial forward price, the bigger 1457 01:04:33,630 --> 01:04:36,190 the potential for counterparty risk. 1458 01:04:36,190 --> 01:04:40,630 So if that's the case, let's you and I agree on something. 1459 01:04:40,630 --> 01:04:44,510 Why don't we agree that every single day, we 1460 01:04:44,510 --> 01:04:50,350 will strike a new contract with a new forward price, 1461 01:04:50,350 --> 01:04:53,390 and then we'll just pay each other the difference 1462 01:04:53,390 --> 01:04:55,450 day by day? 1463 01:04:55,450 --> 01:04:57,340 So in other words, in your example, 1464 01:04:57,340 --> 01:05:00,760 let's say it's $165 today. 1465 01:05:00,760 --> 01:05:01,750 We agree on that. 1466 01:05:01,750 --> 01:05:05,410 The spot price is at $160. 1467 01:05:05,410 --> 01:05:11,180 Let's say tomorrow the spot price goes down to $155. 1468 01:05:11,180 --> 01:05:15,380 OK, you know what, let's you and I agree I'm going to just pay 1469 01:05:15,380 --> 01:05:21,280 you $5.00 divided by the interest over the next three 1470 01:05:21,280 --> 01:05:26,546 months minus a day, and then let's cancel the contract. 1471 01:05:26,546 --> 01:05:28,980 And let's start a new one. 1472 01:05:28,980 --> 01:05:32,870 And let's say that now, today, we're 1473 01:05:32,870 --> 01:05:37,010 going to agree to not $165, but $160. 1474 01:05:37,010 --> 01:05:38,480 The spot price is at $155. 1475 01:05:38,480 --> 01:05:40,704 Let's agree to $160. 1476 01:05:40,704 --> 01:05:43,690 OK? 1477 01:05:43,690 --> 01:05:46,180 And now another day passes by. 1478 01:05:46,180 --> 01:05:48,970 And let's see the price goes down yet again, now down 1479 01:05:48,970 --> 01:05:52,984 to $155. 1480 01:05:52,984 --> 01:05:54,880 AUDIENCE: [INAUDIBLE] $5.00. 1481 01:05:54,880 --> 01:05:56,170 ANDREW LO: Yes. 1482 01:05:56,170 --> 01:05:57,130 Right. 1483 01:05:57,130 --> 01:06:01,000 Or I give you $5.00, you give me $5.00. 1484 01:06:01,000 --> 01:06:03,430 Every single day, we exchange money. 1485 01:06:03,430 --> 01:06:06,370 And every single day, we get rid of the old contract 1486 01:06:06,370 --> 01:06:11,620 and we do a whole new one with a new forward price that reflects 1487 01:06:11,620 --> 01:06:13,840 current market conditions. 1488 01:06:13,840 --> 01:06:14,587 If we do that-- 1489 01:06:14,587 --> 01:06:16,920 well, first of all, it's going to be a pain in the neck, 1490 01:06:16,920 --> 01:06:19,045 because we have to do a lot of contracts every day. 1491 01:06:19,045 --> 01:06:20,720 But suppose we did that. 1492 01:06:20,720 --> 01:06:24,520 If we did that every day, then what we would be doing 1493 01:06:24,520 --> 01:06:29,860 is essentially always figuring out what today's market 1494 01:06:29,860 --> 01:06:34,840 price is for soybean delivery on that settlement date. 1495 01:06:38,370 --> 01:06:41,740 That's what it means to mark to market. 1496 01:06:41,740 --> 01:06:45,460 At every single day, the price of the contract 1497 01:06:45,460 --> 01:06:49,350 reflects today's market valuation, 1498 01:06:49,350 --> 01:06:52,140 not when we did the contract at the beginning 1499 01:06:52,140 --> 01:06:53,670 of that three-month period. 1500 01:06:53,670 --> 01:06:56,610 Every single day as we get closer and closer 1501 01:06:56,610 --> 01:07:01,410 to settlement, we are revising the forward price 1502 01:07:01,410 --> 01:07:03,360 to reflect all the information that's 1503 01:07:03,360 --> 01:07:05,760 accumulated up to that point. 1504 01:07:05,760 --> 01:07:09,600 And I'm either paying you, or you're paying me. 1505 01:07:09,600 --> 01:07:12,420 We're changing money every day so 1506 01:07:12,420 --> 01:07:20,010 that the value of the agreement is never that far out of sync 1507 01:07:20,010 --> 01:07:23,390 from the market's value. 1508 01:07:23,390 --> 01:07:26,360 That way, we can protect this kind of counterparty risk, 1509 01:07:26,360 --> 01:07:29,920 because then the only risk I'm going to have with you 1510 01:07:29,920 --> 01:07:33,100 is the risk that comes from a one-day fluctuation, not 1511 01:07:33,100 --> 01:07:34,600 three months. 1512 01:07:34,600 --> 01:07:37,040 Prices can move a lot in three months. 1513 01:07:37,040 --> 01:07:41,585 But by that time, we will have changed money back and forth. 1514 01:07:41,585 --> 01:07:42,460 And so you know what? 1515 01:07:42,460 --> 01:07:45,379 When you add up all the money that's changed hands 1516 01:07:45,379 --> 01:07:47,170 over the course of the entire three months, 1517 01:07:47,170 --> 01:07:50,590 if we struck a new forward contract every day 1518 01:07:50,590 --> 01:07:53,050 and then we added up all the money that went back and forth 1519 01:07:53,050 --> 01:07:54,591 and did the interest rate just right, 1520 01:07:54,591 --> 01:07:55,889 you know what we would get? 1521 01:07:55,889 --> 01:07:57,430 We would basically get the same thing 1522 01:07:57,430 --> 01:08:01,240 as if we had gotten a forward contract on day one 1523 01:08:01,240 --> 01:08:03,420 and held it to maturity. 1524 01:08:03,420 --> 01:08:06,440 But the difference is that during that three-month period, 1525 01:08:06,440 --> 01:08:08,420 you and I, we've never had to worry 1526 01:08:08,420 --> 01:08:13,970 about either party reneging, because the amount of cash that 1527 01:08:13,970 --> 01:08:17,779 is owed to one party or another has gotten so big 1528 01:08:17,779 --> 01:08:20,500 that it makes it worthwhile to walk away. 1529 01:08:20,500 --> 01:08:25,470 So a forward contract is a situation 1530 01:08:25,470 --> 01:08:27,990 where you don't mark to market every day. 1531 01:08:27,990 --> 01:08:31,740 You allow the value of that contract to go up and down 1532 01:08:31,740 --> 01:08:34,529 and up and down to wherever the spot 1533 01:08:34,529 --> 01:08:38,069 price determines that it does, in relation 1534 01:08:38,069 --> 01:08:39,750 to that forward price. 1535 01:08:39,750 --> 01:08:41,850 With the futures contract, you can 1536 01:08:41,850 --> 01:08:46,740 think of a futures as a sequence of forward contracts 1537 01:08:46,740 --> 01:08:51,180 where you cancel the forward contract every period 1538 01:08:51,180 --> 01:08:56,381 but pay the difference that was won or lost relative to the day 1539 01:08:56,381 --> 01:08:56,880 before. 1540 01:08:59,689 --> 01:09:03,819 So there's one more piece that I have to tell you about. 1541 01:09:03,819 --> 01:09:06,189 And that is that-- somebody asked about an intermediary 1542 01:09:06,189 --> 01:09:07,490 with forward contracts. 1543 01:09:07,490 --> 01:09:10,910 Forward contracts have no intermediary. 1544 01:09:10,910 --> 01:09:13,500 But futures contracts do. 1545 01:09:13,500 --> 01:09:17,189 Some clever person figured out that all of these other changes 1546 01:09:17,189 --> 01:09:19,859 that we want to implement to create a futures contract 1547 01:09:19,859 --> 01:09:25,010 is great, except that there is still this lingering 1548 01:09:25,010 --> 01:09:29,630 concern that somehow you don't show up tomorrow 1549 01:09:29,630 --> 01:09:35,890 when I want to basically do a deal and update my contract. 1550 01:09:35,890 --> 01:09:38,229 So they came up with a brilliant idea 1551 01:09:38,229 --> 01:09:42,700 of establishing an intermediary called the Futures Clearing 1552 01:09:42,700 --> 01:09:44,229 Corporation. 1553 01:09:44,229 --> 01:09:47,350 The Futures Clearing Corporation is an organization 1554 01:09:47,350 --> 01:09:50,250 that sits between you and me. 1555 01:09:50,250 --> 01:09:56,110 And what it does is simply serve as the counterparty. 1556 01:09:56,110 --> 01:09:59,010 So I'm not dealing with you or you or you. 1557 01:09:59,010 --> 01:10:00,930 I'm dealing with one organization that stands 1558 01:10:00,930 --> 01:10:02,700 in the middle of everybody. 1559 01:10:02,700 --> 01:10:04,650 I'm dealing with that organization, 1560 01:10:04,650 --> 01:10:06,960 and you're dealing with that organization. 1561 01:10:06,960 --> 01:10:10,380 And as long as that organization makes sure 1562 01:10:10,380 --> 01:10:14,970 that there are two sides to every transaction-- 1563 01:10:14,970 --> 01:10:17,790 more or less, two sides to every transaction-- 1564 01:10:17,790 --> 01:10:21,480 then that will reduce the risk even more. 1565 01:10:21,480 --> 01:10:24,630 So not only are the contracts standardized, 1566 01:10:24,630 --> 01:10:28,230 not only are they mark-to-market every day, 1567 01:10:28,230 --> 01:10:32,910 and not only do we re-establish this price every day, 1568 01:10:32,910 --> 01:10:36,510 but we then now have the safety of a clearing corporation 1569 01:10:36,510 --> 01:10:39,150 that we know will always be there to transact with us. 1570 01:10:39,150 --> 01:10:41,790 So the market is highly, highly liquid. 1571 01:10:44,660 --> 01:10:45,160 OK. 1572 01:10:45,160 --> 01:10:45,990 Now-- question? 1573 01:10:45,990 --> 01:10:46,490 Yeah? 1574 01:10:46,490 --> 01:10:48,448 AUDIENCE: Are there any industries or companies 1575 01:10:48,448 --> 01:10:52,420 that use forwards rather than futures? 1576 01:10:52,420 --> 01:10:54,170 ANDREW LO: There are some. 1577 01:10:54,170 --> 01:10:56,870 In fact, oil companies, airline companies, 1578 01:10:56,870 --> 01:11:00,562 and other major producers or suppliers, 1579 01:11:00,562 --> 01:11:02,270 they prefer forwards, simply because they 1580 01:11:02,270 --> 01:11:04,436 don't want to deal with these mark-to-market issues. 1581 01:11:04,436 --> 01:11:06,860 And they've dealt with their suppliers 1582 01:11:06,860 --> 01:11:09,007 long enough that they trust them. 1583 01:11:09,007 --> 01:11:11,090 And so they've got standardized forward agreements 1584 01:11:11,090 --> 01:11:14,520 that are customized to exactly what they want. 1585 01:11:14,520 --> 01:11:17,240 For example, a futures contract has very specific settlement 1586 01:11:17,240 --> 01:11:17,920 dates. 1587 01:11:17,920 --> 01:11:19,670 If those settlement dates don't correspond 1588 01:11:19,670 --> 01:11:22,220 with when you need the particular input, 1589 01:11:22,220 --> 01:11:25,180 then you don't want to use that. 1590 01:11:25,180 --> 01:11:28,320 But by and large, the futures contracts 1591 01:11:28,320 --> 01:11:31,740 eliminates a lot of these issues with forward contracts so that 1592 01:11:31,740 --> 01:11:35,850 for liquidity, for transparency, for safety-- 1593 01:11:35,850 --> 01:11:36,929 all of those reasons-- 1594 01:11:36,929 --> 01:11:38,970 they are actually preferred to forward contracts. 1595 01:11:38,970 --> 01:11:41,580 But forward contracts are still very popular. 1596 01:11:41,580 --> 01:11:43,650 For example, there are some markets 1597 01:11:43,650 --> 01:11:45,450 where forward contracts are actually 1598 01:11:45,450 --> 01:11:47,040 even more popular than futures. 1599 01:11:47,040 --> 01:11:49,410 One example-- currencies. 1600 01:11:49,410 --> 01:11:51,600 For a variety of reasons, currencies-- 1601 01:11:51,600 --> 01:11:57,480 where you trade with banks for different foreign currencies 1602 01:11:57,480 --> 01:12:00,600 in the future, the futures exchanges 1603 01:12:00,600 --> 01:12:05,250 have much lower volume, in terms of dollars traded or yen traded 1604 01:12:05,250 --> 01:12:08,160 or cable traded, than the banks dealing 1605 01:12:08,160 --> 01:12:10,110 with these forward contracts. 1606 01:12:10,110 --> 01:12:11,104 Yeah, [INAUDIBLE]? 1607 01:12:11,104 --> 01:12:12,479 AUDIENCE: Looks like in this case 1608 01:12:12,479 --> 01:12:15,497 the interest rate risk is also a [INAUDIBLE] of the future. 1609 01:12:15,497 --> 01:12:16,080 Is that right? 1610 01:12:16,080 --> 01:12:16,990 ANDREW LO: The interest rate is what? 1611 01:12:16,990 --> 01:12:19,100 AUDIENCE: Interest rate risk is also a risk. 1612 01:12:19,100 --> 01:12:20,220 ANDREW LO: Yes, interest rate risk 1613 01:12:20,220 --> 01:12:22,094 is definitely a part of it, because remember, 1614 01:12:22,094 --> 01:12:24,900 we have to divide implicitly by the interest, 1615 01:12:24,900 --> 01:12:27,960 because we're getting paid not now, but in three months or two 1616 01:12:27,960 --> 01:12:29,690 months or 29 days and so on. 1617 01:12:29,690 --> 01:12:30,940 So we're going to get to that. 1618 01:12:30,940 --> 01:12:34,160 In fact, let me do some examples, 1619 01:12:34,160 --> 01:12:36,660 and then we're going to talk about how interest rates figure 1620 01:12:36,660 --> 01:12:38,580 into this explicitly. 1621 01:12:38,580 --> 01:12:42,200 So here's an example of a futures contract. 1622 01:12:42,200 --> 01:12:46,050 NYMEX-- the New York Mercantile Exchange, it's called NYMEX-- 1623 01:12:46,050 --> 01:12:48,990 trades crude oil futures. 1624 01:12:48,990 --> 01:12:52,310 Now there are lots of different kinds of oil. 1625 01:12:52,310 --> 01:12:55,350 And there are futures contracts that are designated 1626 01:12:55,350 --> 01:12:56,740 for a particular kind. 1627 01:12:56,740 --> 01:13:00,480 So crude oil light is one. 1628 01:13:00,480 --> 01:13:03,360 Another one is Brent crude oil-- 1629 01:13:03,360 --> 01:13:05,190 oil from the Brent Seas. 1630 01:13:05,190 --> 01:13:08,700 And each different kind of oil has a different contract. 1631 01:13:08,700 --> 01:13:12,990 Remember, we have to standardize the underlying commodity. 1632 01:13:12,990 --> 01:13:19,650 So NYMEX crude oil futures with delivery in December 2007 1633 01:13:19,650 --> 01:13:27,090 at a price of $76.06 a barrel on July 27, 2007 where there's 1634 01:13:27,090 --> 01:13:31,620 51,475 contracts traded. 1635 01:13:31,620 --> 01:13:34,410 So this is a simple example of an actual contract that 1636 01:13:34,410 --> 01:13:38,490 was traded in the good old days when oil was only $75 a barrel 1637 01:13:38,490 --> 01:13:40,690 a year ago. 1638 01:13:40,690 --> 01:13:43,270 Each contract is for 1,000 barrels. 1639 01:13:43,270 --> 01:13:46,210 So that's part of the standardization. 1640 01:13:46,210 --> 01:13:49,060 The tick size-- tick size meaning, 1641 01:13:49,060 --> 01:13:53,260 what is the denomination that prices will change when they 1642 01:13:53,260 --> 01:13:54,910 change up and down-- 1643 01:13:54,910 --> 01:13:58,180 it's a penny a barrel. 1644 01:13:58,180 --> 01:14:00,130 So in other words, with 1,000 barrels, 1645 01:14:00,130 --> 01:14:02,350 if it moves a penny a barrel, that 1646 01:14:02,350 --> 01:14:05,290 means the contract, which is for 1,000 barrels, 1647 01:14:05,290 --> 01:14:08,530 moves in $10 increments. 1648 01:14:08,530 --> 01:14:10,990 So when you buy one of these contracts, 1649 01:14:10,990 --> 01:14:15,520 you are buying 1,000 barrels of oil 1650 01:14:15,520 --> 01:14:18,610 to be delivered to you in December. 1651 01:14:18,610 --> 01:14:22,120 That's what one of these contracts means. 1652 01:14:22,120 --> 01:14:26,020 Now you actually have to put up some collateral 1653 01:14:26,020 --> 01:14:28,130 for these as well. 1654 01:14:28,130 --> 01:14:29,700 But think about it. 1655 01:14:29,700 --> 01:14:37,580 If it's $75 a barrel and it's 1,000 barrels per contract, 1656 01:14:37,580 --> 01:14:42,920 then how much oil are you controlling with one contract 1657 01:14:42,920 --> 01:14:44,642 in dollar terms? 1658 01:14:44,642 --> 01:14:46,510 Yeah, it's $75,000. 1659 01:14:46,510 --> 01:14:49,990 That's a lot of money for one contract. 1660 01:14:49,990 --> 01:14:53,050 Look at how much collateral you have to post. 1661 01:14:53,050 --> 01:14:54,490 The amount of collateral that you 1662 01:14:54,490 --> 01:14:58,090 have to give your broker to buy one of these contracts 1663 01:14:58,090 --> 01:15:00,430 is $4,050. 1664 01:15:00,430 --> 01:15:05,290 Now by the way, that collateral has increased by about 50% 1665 01:15:05,290 --> 01:15:06,616 as of this morning. 1666 01:15:06,616 --> 01:15:07,990 The New York Mercantile Exchange, 1667 01:15:07,990 --> 01:15:11,080 Chicago Board of Trade, and other futures companies 1668 01:15:11,080 --> 01:15:13,540 have increased margins across the board 1669 01:15:13,540 --> 01:15:17,230 for most of the futures contracts because of concerns 1670 01:15:17,230 --> 01:15:21,190 about liquidity and viability. 1671 01:15:21,190 --> 01:15:24,340 Maintenance margin says that once you establish an account 1672 01:15:24,340 --> 01:15:26,860 and put the $4,000, they know the money is 1673 01:15:26,860 --> 01:15:30,550 going to go down or up as the price of oil goes down or up. 1674 01:15:30,550 --> 01:15:34,380 But at all points in time, you have to keep at least $3,000 1675 01:15:34,380 --> 01:15:34,880 in there. 1676 01:15:34,880 --> 01:15:38,230 So in other words, the $4,000, you could lose some of that 1677 01:15:38,230 --> 01:15:41,620 and it could go down to $3,500 or $3,250. 1678 01:15:41,620 --> 01:15:45,580 But if it goes below $3,000, you're 1679 01:15:45,580 --> 01:15:47,830 going to get a phone call from your broker that 1680 01:15:47,830 --> 01:15:50,710 says, you need to deposit more money, 1681 01:15:50,710 --> 01:15:52,990 you need to bring it up to $3,000, that's 1682 01:15:52,990 --> 01:15:56,110 what you need to do to maintain the account. 1683 01:15:56,110 --> 01:15:59,782 And you know what happens if you don't return that phone call? 1684 01:15:59,782 --> 01:16:01,600 They get rid of the contract. 1685 01:16:01,600 --> 01:16:03,970 You're out of the market. 1686 01:16:03,970 --> 01:16:06,550 If you don't wire that money into the account by end 1687 01:16:06,550 --> 01:16:09,400 of business on the day you get the margin call, 1688 01:16:09,400 --> 01:16:13,943 they have the right, and they will close out your contract. 1689 01:16:13,943 --> 01:16:17,022 AUDIENCE: [INAUDIBLE] 1690 01:16:17,022 --> 01:16:19,230 ANDREW LO: Well, it depends on what your position is. 1691 01:16:19,230 --> 01:16:21,540 No, you have whatever money you have left. 1692 01:16:21,540 --> 01:16:23,620 But you no longer have the position in oil. 1693 01:16:23,620 --> 01:16:26,100 So if that $3,000 goes down to $2,500, 1694 01:16:26,100 --> 01:16:28,500 that's still your $2,500, but you no longer 1695 01:16:28,500 --> 01:16:33,800 have a position in oil anymore at the end of business. 1696 01:16:33,800 --> 01:16:36,060 That's one of the beauties of a futures contract, 1697 01:16:36,060 --> 01:16:38,704 from the perspective of the counterparty. 1698 01:16:38,704 --> 01:16:40,120 It's that they don't have to worry 1699 01:16:40,120 --> 01:16:41,470 that you're going to run away. 1700 01:16:41,470 --> 01:16:45,822 The most they can lose is one day's worth of fluctuation 1701 01:16:45,822 --> 01:16:47,030 in the value of the contract. 1702 01:16:47,030 --> 01:16:52,180 That's why for a $75,000 agreement, 1703 01:16:52,180 --> 01:16:55,540 you only have to put down $4,000 earnest money. 1704 01:16:55,540 --> 01:16:57,130 In the case of that soybean farmer, 1705 01:16:57,130 --> 01:17:00,340 think about how much money you really would be comfortable 1706 01:17:00,340 --> 01:17:02,770 requiring the counterparty to put down 1707 01:17:02,770 --> 01:17:05,816 if you're going to exchange no money for three months. 1708 01:17:05,816 --> 01:17:07,690 Three months, you never see the other person. 1709 01:17:07,690 --> 01:17:09,010 You don't know whether they're still alive. 1710 01:17:09,010 --> 01:17:11,410 You don't know what's going on with their business. 1711 01:17:11,410 --> 01:17:14,200 You're going to actually have them put up a lot more money. 1712 01:17:14,200 --> 01:17:16,180 With the futures contract, you only 1713 01:17:16,180 --> 01:17:18,280 have to put up enough money to make sure 1714 01:17:18,280 --> 01:17:24,235 that on a daily basis, you're not getting taken advantage of. 1715 01:17:24,235 --> 01:17:24,734 Yeah? 1716 01:17:24,734 --> 01:17:26,435 AUDIENCE: How's that initial margin set? 1717 01:17:26,435 --> 01:17:28,810 ANDREW LO: The initial margin is set exactly the same way 1718 01:17:28,810 --> 01:17:31,720 that the margin was going to be set with collateral 1719 01:17:31,720 --> 01:17:33,440 for that soybean contract. 1720 01:17:33,440 --> 01:17:35,410 It's the amount of money that they 1721 01:17:35,410 --> 01:17:40,300 think is enough to cover any daily fluctuations 1722 01:17:40,300 --> 01:17:43,370 in the underlying futures contract. 1723 01:17:43,370 --> 01:17:46,840 So if the underlying price moves by a lot, 1724 01:17:46,840 --> 01:17:48,940 what do you think that will do to the margin-- 1725 01:17:48,940 --> 01:17:51,572 make it go up or down? 1726 01:17:51,572 --> 01:17:52,500 Up. 1727 01:17:52,500 --> 01:17:54,480 So now do you know why all of the exchanges 1728 01:17:54,480 --> 01:17:57,240 decided to increase their margin? 1729 01:17:57,240 --> 01:18:00,030 Fluctuations have started going up. 1730 01:18:00,030 --> 01:18:04,050 And also, people's credit, in general, have gone down. 1731 01:18:04,050 --> 01:18:04,722 Yeah? 1732 01:18:04,722 --> 01:18:06,388 AUDIENCE: Just going back to your answer 1733 01:18:06,388 --> 01:18:11,118 to [INAUDIBLE] physical goods, if you and I can enter 1734 01:18:11,118 --> 01:18:15,054 into a futures contract [INAUDIBLE] traded, 1735 01:18:15,054 --> 01:18:17,162 isn't physical delivery not really expected, 1736 01:18:17,162 --> 01:18:19,622 especially with the margin cost? 1737 01:18:19,622 --> 01:18:21,580 Just by [INAUDIBLE]. 1738 01:18:21,580 --> 01:18:23,330 ANDREW LO: Yes, so with futures contracts, 1739 01:18:23,330 --> 01:18:26,030 the majority of the people that use futures are not 1740 01:18:26,030 --> 01:18:27,620 looking for physical delivery. 1741 01:18:27,620 --> 01:18:31,550 But with most of the commodity futures contracts, 1742 01:18:31,550 --> 01:18:33,290 you actually have to specify. 1743 01:18:33,290 --> 01:18:38,810 So there have been stories of speculators 1744 01:18:38,810 --> 01:18:44,060 that forgot to check the box that says Cash Settled Only 1745 01:18:44,060 --> 01:18:47,390 that have gotten tons and tons of corn 1746 01:18:47,390 --> 01:18:49,350 dumped on their front lawn. 1747 01:18:49,350 --> 01:18:51,050 That has happened. 1748 01:18:51,050 --> 01:18:53,510 It's been a while, but it's happened. 1749 01:18:53,510 --> 01:18:55,730 Most futures contracts are cash settled. 1750 01:18:55,730 --> 01:18:57,865 Cash settled means no physical delivery. 1751 01:18:57,865 --> 01:18:59,240 But there are certain people that 1752 01:18:59,240 --> 01:19:00,860 actually want the physicals. 1753 01:19:00,860 --> 01:19:03,620 And so they will transact in the future markets 1754 01:19:03,620 --> 01:19:05,900 to get physical delivery. 1755 01:19:05,900 --> 01:19:07,410 OK, that's it for today. 1756 01:19:07,410 --> 01:19:09,860 We will see you not Monday, because that's Columbus Day. 1757 01:19:09,860 --> 01:19:12,800 But I'll see you a week from Monday.