WEBVTT 00:00:00.090 --> 00:00:02.430 The following content is provided under a Creative 00:00:02.430 --> 00:00:03.820 Commons license. 00:00:03.820 --> 00:00:06.030 Your support will help MIT OpenCourseWare 00:00:06.030 --> 00:00:10.120 continue to offer high quality educational resources for free. 00:00:10.120 --> 00:00:12.690 To make a donation or to view additional materials 00:00:12.690 --> 00:00:15.150 from hundreds of MIT courses, visit 00:00:15.150 --> 00:00:17.000 MITOpenCourseWare@ocs.MIT.edu. 00:00:21.150 --> 00:00:24.270 ANDREW LO: So far, the stock market is down. 00:00:24.270 --> 00:00:26.770 But on the other hand, if you look at the three-month T-bill 00:00:26.770 --> 00:00:32.049 rate, it's up about 60, 70 basis points. 00:00:32.049 --> 00:00:33.480 So that's not bad. 00:00:33.480 --> 00:00:38.790 Looks like there is some sense that liquidity is going 00:00:38.790 --> 00:00:42.552 to be good for the market. 00:00:42.552 --> 00:00:44.710 And I guess we'll wait and see. 00:00:44.710 --> 00:00:46.797 But clearly, the Fed is making a-- 00:00:49.720 --> 00:00:54.960 the Fed is making every effort to maintain liquid markets. 00:00:54.960 --> 00:00:57.480 We should keep in mind-- those of you who are starting 00:00:57.480 --> 00:00:59.340 to panic and thinking, gee, really, 00:00:59.340 --> 00:01:01.530 all hell is about to break loose-- 00:01:01.530 --> 00:01:07.140 keep in mind that interest rates are still pretty low overall. 00:01:07.140 --> 00:01:09.180 Obviously, the Fed cutting rates is 00:01:09.180 --> 00:01:11.910 going to mean that the overnight borrowing rate between banks 00:01:11.910 --> 00:01:13.360 and the Fed is low. 00:01:13.360 --> 00:01:15.420 But if you look at commercial paper-- 00:01:15.420 --> 00:01:19.560 if you look at a variety of other indicators of borrowing 00:01:19.560 --> 00:01:23.820 rates, they're relatively low, to the extent that markets 00:01:23.820 --> 00:01:25.560 are, quote, "frozen." 00:01:25.560 --> 00:01:30.810 It really means that the banks and other agencies 00:01:30.810 --> 00:01:32.550 are waiting to figure out what's going 00:01:32.550 --> 00:01:36.270 to happen with regard to the rescue package and other market 00:01:36.270 --> 00:01:39.330 events before they start to lend again. 00:01:39.330 --> 00:01:42.030 And there's nothing structurally wrong 00:01:42.030 --> 00:01:45.930 with their particular business models, 00:01:45.930 --> 00:01:49.380 nor is it the case that we somehow run out of money 00:01:49.380 --> 00:01:51.749 or we've all lost these assets. 00:01:51.749 --> 00:01:53.790 Investors right now are waiting on the sidelines. 00:01:53.790 --> 00:01:55.530 And you can tell from market dynamics 00:01:55.530 --> 00:01:58.500 that there's enormous amount of fear that 00:01:58.500 --> 00:01:59.940 is really affecting markets. 00:01:59.940 --> 00:02:05.250 And this is exactly the kind of reaction 00:02:05.250 --> 00:02:08.310 that the Fed was trying to forestall two weeks ago when 00:02:08.310 --> 00:02:10.530 the money markets broke the buck. 00:02:10.530 --> 00:02:13.710 And hopefully, they will still be able to do so. 00:02:13.710 --> 00:02:15.690 But you can tell that it's building. 00:02:15.690 --> 00:02:18.150 And market fear, as measured by things 00:02:18.150 --> 00:02:20.970 like the stock market and bond markets, 00:02:20.970 --> 00:02:23.100 that's still a concern. 00:02:23.100 --> 00:02:24.430 So we'll wait and see. 00:02:24.430 --> 00:02:27.060 But so far, it seems like the developments 00:02:27.060 --> 00:02:31.020 are as we pretty much expected. 00:02:31.020 --> 00:02:34.560 There really isn't any huge surprises going on. 00:02:34.560 --> 00:02:35.530 Any questions? 00:02:35.530 --> 00:02:36.033 Yep? 00:02:36.033 --> 00:02:39.490 AUDIENCE: I wanted to share my experience. 00:02:39.490 --> 00:02:43.120 It's like about six years ago in Argentina, 00:02:43.120 --> 00:02:45.690 we had this crises that it was similar to this, 00:02:45.690 --> 00:02:49.990 in the sense that the whole country disappeared. 00:02:49.990 --> 00:02:52.600 We had five presidents in a week. 00:02:52.600 --> 00:02:53.400 We defaulted. 00:02:53.400 --> 00:02:55.150 The government defaulted. 00:02:55.150 --> 00:02:56.940 Half of the public companies defaulted. 00:02:56.940 --> 00:02:58.760 We devalued our currency. 00:02:58.760 --> 00:03:02.170 It was really chaotic. 00:03:02.170 --> 00:03:04.950 And still, I don't know how we survived. 00:03:04.950 --> 00:03:09.090 And two years afterwards, I went into working to this investment 00:03:09.090 --> 00:03:09.960 fund. 00:03:09.960 --> 00:03:12.740 And we just started buying companies 00:03:12.740 --> 00:03:14.840 that were really in sale. 00:03:14.840 --> 00:03:18.710 And when he says that this creates opportunity, 00:03:18.710 --> 00:03:21.880 it sort of feels a little naive or something like that, 00:03:21.880 --> 00:03:23.945 but it really creates opportunities. 00:03:23.945 --> 00:03:30.290 So those who survive can have really good choices afterwards. 00:03:30.290 --> 00:03:31.560 So I don't know. 00:03:31.560 --> 00:03:34.942 What I'm doing now is trying to take a deep breath 00:03:34.942 --> 00:03:37.829 and flow through the crisis. 00:03:37.829 --> 00:03:39.870 ANDREW LO: Yeah, I think that's very good advice. 00:03:39.870 --> 00:03:42.510 And in fact, in terms of opportunities-- 00:03:42.510 --> 00:03:44.600 I think that right now, because everybody 00:03:44.600 --> 00:03:49.082 is transfixed on the problems with the economy, 00:03:49.082 --> 00:03:50.790 people aren't thinking about opportunity, 00:03:50.790 --> 00:03:51.748 because they're scared. 00:03:51.748 --> 00:03:54.210 And I wish I could fast forward and give you 00:03:54.210 --> 00:03:56.737 my last lecture for this course now, 00:03:56.737 --> 00:03:58.320 because it's actually pretty relevant. 00:03:58.320 --> 00:04:00.810 The last lecture of the course is where I actually 00:04:00.810 --> 00:04:04.334 bring in some evidence about psychological biases 00:04:04.334 --> 00:04:05.250 that affect all of us. 00:04:05.250 --> 00:04:07.208 And in particular, there's some recent evidence 00:04:07.208 --> 00:04:09.510 in the neurosciences that explain 00:04:09.510 --> 00:04:13.210 why it is that when we are stricken with fear, 00:04:13.210 --> 00:04:14.610 it almost paralyzes us. 00:04:14.610 --> 00:04:18.329 Actually, physiologically it can paralyze us 00:04:18.329 --> 00:04:20.519 in terms of decision-making ability. 00:04:20.519 --> 00:04:22.350 So I don't want to talk about it now, 00:04:22.350 --> 00:04:24.310 because that's going to be the last lecture. 00:04:24.310 --> 00:04:26.730 And I feel we have to cover the material. 00:04:26.730 --> 00:04:29.490 But it's true that when you're in the midst of it, 00:04:29.490 --> 00:04:33.060 it's very difficult to think rationally. 00:04:33.060 --> 00:04:35.020 But I'll give you one example of, I think, 00:04:35.020 --> 00:04:38.640 a wonderful idea that nobody has mentioned but is 00:04:38.640 --> 00:04:43.440 perfect for an MIT audience or an MIT entrepreneur. 00:04:43.440 --> 00:04:47.560 One of the problems that we face right now is the unknown. 00:04:47.560 --> 00:04:50.880 We don't know what CDOs and CDSes and all 00:04:50.880 --> 00:04:53.950 these complex securities are worth. 00:04:53.950 --> 00:04:57.190 Wouldn't it be wonderful to have a website that did nothing 00:04:57.190 --> 00:05:01.960 more than post the prices of transactions 00:05:01.960 --> 00:05:05.470 in these securities over a period of time, 00:05:05.470 --> 00:05:07.840 really as a means of providing information 00:05:07.840 --> 00:05:11.500 to the marketplace about what kinds of deals are being done 00:05:11.500 --> 00:05:13.360 and at what prices? 00:05:13.360 --> 00:05:15.160 We don't have an organized exchange. 00:05:15.160 --> 00:05:17.110 So that's another idea is to create 00:05:17.110 --> 00:05:20.510 a kind of an eBay for CDOs. 00:05:20.510 --> 00:05:21.340 It may not work. 00:05:21.340 --> 00:05:22.210 It may be naive. 00:05:22.210 --> 00:05:24.340 It may be something that somebody has already 00:05:24.340 --> 00:05:25.060 thought of. 00:05:25.060 --> 00:05:27.040 But these are the kind of innovations 00:05:27.040 --> 00:05:28.720 that the market is crying for. 00:05:28.720 --> 00:05:30.550 And I promise you, if you are the first one 00:05:30.550 --> 00:05:33.280 to the market with one of these innovations, 00:05:33.280 --> 00:05:35.860 my guess is that that's going to be a billion dollar idea, 00:05:35.860 --> 00:05:38.410 because everybody right now is looking 00:05:38.410 --> 00:05:41.980 for some means of getting transparency and liquidity 00:05:41.980 --> 00:05:43.820 into these marketplaces. 00:05:43.820 --> 00:05:46.600 And so if you could be the first, or second or third 00:05:46.600 --> 00:05:49.240 even, to come up with that mechanism for being 00:05:49.240 --> 00:05:52.150 able to provide pricing information just 00:05:52.150 --> 00:05:55.490 a little bit better than nothing at all, 00:05:55.490 --> 00:05:57.042 you can actually do incredibly well. 00:05:57.042 --> 00:05:58.750 That's an example-- very simple example-- 00:05:58.750 --> 00:06:02.260 of how technology can actually transform that market, 00:06:02.260 --> 00:06:03.640 because most of that market right 00:06:03.640 --> 00:06:05.950 now is still paper and pencil. 00:06:05.950 --> 00:06:09.460 It's just really relatively backward, 00:06:09.460 --> 00:06:12.240 from a technological perspective. 00:06:12.240 --> 00:06:12.740 OK. 00:06:12.740 --> 00:06:13.824 Yeah? 00:06:13.824 --> 00:06:16.184 AUDIENCE: [INAUDIBLE] transparency, why do you 00:06:16.184 --> 00:06:19.834 think the banks push to get rid of mark-to-market accounting? 00:06:19.834 --> 00:06:21.750 ANDREW LO: Well, I'm glad you brought that up. 00:06:21.750 --> 00:06:23.708 We're going to talk about that in this lecture. 00:06:23.708 --> 00:06:25.040 That's a very important point. 00:06:25.040 --> 00:06:27.074 First of all, I want to define mark to market. 00:06:27.074 --> 00:06:28.490 And we're going to talk about that 00:06:28.490 --> 00:06:30.949 and the difference between forward and futures contract. 00:06:30.949 --> 00:06:32.490 But let me give you the short answer. 00:06:32.490 --> 00:06:35.390 And then I'm going to spend the rest of this lecture hopefully 00:06:35.390 --> 00:06:37.370 justifying it. 00:06:37.370 --> 00:06:39.830 The idea that some banks have proposed 00:06:39.830 --> 00:06:45.200 to suspend mark-to-market accounting 00:06:45.200 --> 00:06:49.040 is probably the worst idea I've ever 00:06:49.040 --> 00:06:51.515 heard of in this entire crisis. 00:06:54.020 --> 00:06:59.390 Now let me not mince words and explain what-- 00:06:59.390 --> 00:07:02.660 the idea of not marking to market 00:07:02.660 --> 00:07:08.150 is a little bit like telling a crowded theater, where 00:07:08.150 --> 00:07:13.840 you smell smoke and you see flames on the stage-- 00:07:13.840 --> 00:07:16.090 instead of letting people get out of that theater, 00:07:16.090 --> 00:07:18.802 it's like telling everybody in the theater, all right, 00:07:18.802 --> 00:07:21.010 we're not really sure exactly what the smoke is from, 00:07:21.010 --> 00:07:23.530 but we want everybody to sit down, relax, 00:07:23.530 --> 00:07:26.590 take a deep breath, and let us think about it for another half 00:07:26.590 --> 00:07:29.590 an hour, and then we'll decide. 00:07:29.590 --> 00:07:31.983 That's what suspending mark-to-market will do. 00:07:31.983 --> 00:07:34.730 AUDIENCE: So do you think when the SEC has come out 00:07:34.730 --> 00:07:36.813 and said that companies now can use their judgment 00:07:36.813 --> 00:07:40.516 to [INAUDIBLE] sale prices, do you 00:07:40.516 --> 00:07:42.520 think that's going to happen [INAUDIBLE]? 00:07:42.520 --> 00:07:44.520 ANDREW LO: Well, it's a little too soon to tell, 00:07:44.520 --> 00:07:46.480 because we don't know exactly what the treasury will do. 00:07:46.480 --> 00:07:48.240 The SEC can say whatever they want. 00:07:48.240 --> 00:07:49.980 The bottom line is, is there a market 00:07:49.980 --> 00:07:53.580 for these securities at prices that these companies come up 00:07:53.580 --> 00:07:54.480 with? 00:07:54.480 --> 00:07:58.890 I may think that my ideas are the most valuable in the world. 00:07:58.890 --> 00:08:00.510 That doesn't make it so. 00:08:00.510 --> 00:08:01.902 And in the same way, corporations 00:08:01.902 --> 00:08:04.110 that feel that their securities are the most valuable 00:08:04.110 --> 00:08:06.390 in the world, that doesn't make it so. 00:08:06.390 --> 00:08:10.830 What makes it so is what we said on the very first day of class. 00:08:10.830 --> 00:08:11.610 And that is, what? 00:08:11.610 --> 00:08:14.190 What determines the value of security? 00:08:14.190 --> 00:08:14.820 Exactly. 00:08:14.820 --> 00:08:16.660 You all-- the market. 00:08:16.660 --> 00:08:20.550 And so if nobody wants to buy or sell at any price, 00:08:20.550 --> 00:08:22.640 then that's not really a price. 00:08:22.640 --> 00:08:26.370 A price is a number at which two mutually consenting adults 00:08:26.370 --> 00:08:27.924 agree to transact. 00:08:27.924 --> 00:08:30.090 And if you can't find two mutually consenting adults 00:08:30.090 --> 00:08:31.631 to agree to transact, you can come up 00:08:31.631 --> 00:08:33.690 with all sorts of really interesting numbers, 00:08:33.690 --> 00:08:35.549 but those aren't prices. 00:08:35.549 --> 00:08:38.400 So we're going to talk about that exactly in this lecture, 00:08:38.400 --> 00:08:41.460 because what I want to do is to describe to you how 00:08:41.460 --> 00:08:44.400 forward contracts and futures contracts work. 00:08:44.400 --> 00:08:46.961 You've heard of both terms, I think. 00:08:46.961 --> 00:08:48.960 We've talked explicitly about forward contracts, 00:08:48.960 --> 00:08:50.640 but we haven't talked about futures. 00:08:50.640 --> 00:08:52.400 The innovation of futures contracts 00:08:52.400 --> 00:08:55.450 is exactly this mark-to-market issue. 00:08:55.450 --> 00:08:57.810 So let's get to the topic for today 00:08:57.810 --> 00:09:00.990 and talk about forward and futures. 00:09:00.990 --> 00:09:03.240 So in this lecture, what I'm going to cover 00:09:03.240 --> 00:09:05.540 is the definition of forward and futures contracts. 00:09:05.540 --> 00:09:07.290 And then I want to show how to value them. 00:09:07.290 --> 00:09:08.760 The valuations of these contracts 00:09:08.760 --> 00:09:12.210 will also use net present value formulas, 00:09:12.210 --> 00:09:14.490 but it'll be used in a somewhat different way. 00:09:14.490 --> 00:09:16.937 So that's why we want to spend extra time going over 00:09:16.937 --> 00:09:18.020 these kinds of securities. 00:09:18.020 --> 00:09:21.510 They're different from what we've looked at so far. 00:09:21.510 --> 00:09:23.250 There's some motivation from why you 00:09:23.250 --> 00:09:25.800 might want to consider these contracts that I've got up here 00:09:25.800 --> 00:09:26.760 in the slide. 00:09:26.760 --> 00:09:28.860 But really, the motivation is pretty simple. 00:09:28.860 --> 00:09:31.080 And actually, the motivation is brought home 00:09:31.080 --> 00:09:33.870 by current events because of the uncertainty 00:09:33.870 --> 00:09:36.120 in markets right now. 00:09:36.120 --> 00:09:38.690 The first example-- your company, based in the US, 00:09:38.690 --> 00:09:40.320 supplies machine tools to customers 00:09:40.320 --> 00:09:41.940 in Germany and Brazil. 00:09:41.940 --> 00:09:44.250 Prices are quoted in each country's currency, 00:09:44.250 --> 00:09:47.850 so fluctuations in the euro, dollar, and the Real dollar 00:09:47.850 --> 00:09:50.640 exchange rates have a big impact on the firm's revenue. 00:09:50.640 --> 00:09:54.700 How can the firm reduce or hedge these risks? 00:09:54.700 --> 00:09:59.580 This is an example where you're making machine tools. 00:09:59.580 --> 00:10:03.209 You have no idea what exchange rate markets are going to do. 00:10:03.209 --> 00:10:04.500 And that's not really your job. 00:10:04.500 --> 00:10:06.360 You don't really care about that. 00:10:06.360 --> 00:10:07.830 But the fact is that it does have 00:10:07.830 --> 00:10:09.930 an impact on your company's performance, 00:10:09.930 --> 00:10:12.240 because a large part of your revenues 00:10:12.240 --> 00:10:15.540 are going to be coming in in these foreign currencies. 00:10:15.540 --> 00:10:18.780 So what you'd like to do is to figure out 00:10:18.780 --> 00:10:21.720 a way to eliminate that kind of uncertainty, 00:10:21.720 --> 00:10:23.765 or at least reduce it. 00:10:23.765 --> 00:10:25.140 And there are many other examples 00:10:25.140 --> 00:10:29.640 here where an individual has a particular objective in mind, 00:10:29.640 --> 00:10:33.990 and market fluctuations are so extreme that they end up 00:10:33.990 --> 00:10:36.720 being a distraction and, in some cases, a decrement 00:10:36.720 --> 00:10:38.970 to the business opportunity. 00:10:38.970 --> 00:10:40.860 The idea behind a forward contract 00:10:40.860 --> 00:10:43.350 is to try to reduce or, in some cases, 00:10:43.350 --> 00:10:45.690 eliminate that kind of fluctuation 00:10:45.690 --> 00:10:49.530 by finding a counterparty that's willing to deal 00:10:49.530 --> 00:10:51.480 with you to eliminate that uncertainty, 00:10:51.480 --> 00:10:57.750 because that counterparty faces the opposite uncertainty. 00:10:57.750 --> 00:11:03.180 So this is an example of just how big the uncertainty is 00:11:03.180 --> 00:11:04.560 that we're talking about. 00:11:04.560 --> 00:11:09.030 If you take a look at exchange rates from 1995 to 2003, 00:11:09.030 --> 00:11:12.780 you can take a look at the dynamics of these currency 00:11:12.780 --> 00:11:13.410 movements. 00:11:13.410 --> 00:11:16.690 They are extreme in some cases. 00:11:16.690 --> 00:11:20.570 So if you're a company manufacturing machine parts, 00:11:20.570 --> 00:11:23.670 you have no idea how to deal with this. 00:11:23.670 --> 00:11:26.730 You're not a currency forecasting firm. 00:11:26.730 --> 00:11:29.250 And so what you'd like to be able to do 00:11:29.250 --> 00:11:31.650 is just get rid of it, or at least reduce it 00:11:31.650 --> 00:11:36.330 to the point where you actually don't have to think about it. 00:11:36.330 --> 00:11:42.180 And to give you a sense of how significant this problem is, 00:11:42.180 --> 00:11:47.429 this is the sales for Caterpillar from 1980 to 1989. 00:11:47.429 --> 00:11:49.470 And most of you have heard of Caterpillar, right? 00:11:49.470 --> 00:11:54.460 They manufacture tractors and other kind of heavy machinery. 00:11:54.460 --> 00:11:56.730 This is their sales figures. 00:11:56.730 --> 00:11:58.440 But you can take a look at what happens 00:11:58.440 --> 00:12:01.110 when you take their sales figure and you denominate it 00:12:01.110 --> 00:12:02.730 in US dollars. 00:12:02.730 --> 00:12:06.090 That's a pretty big difference between US denominated 00:12:06.090 --> 00:12:10.180 and foreign currency denominated levels. 00:12:10.180 --> 00:12:14.640 So what we want to do is to address that concern 00:12:14.640 --> 00:12:18.690 by using financial markets in a particular way. 00:12:18.690 --> 00:12:22.270 Now there is an issue regarding futures and forwards as to 00:12:22.270 --> 00:12:24.270 whether or not the people who are in the markets 00:12:24.270 --> 00:12:26.827 are hedging or speculating. 00:12:26.827 --> 00:12:29.160 And so we're going to talk a bit about that a little bit 00:12:29.160 --> 00:12:31.410 later on. 00:12:31.410 --> 00:12:34.380 But before we do that, we need to develop some terminology 00:12:34.380 --> 00:12:36.000 for what these contracts are. 00:12:36.000 --> 00:12:37.890 But I want to raise that as an issue upfront, 00:12:37.890 --> 00:12:39.760 because it's very controversial. 00:12:39.760 --> 00:12:41.520 There are some people that argue that it's 00:12:41.520 --> 00:12:45.480 all these evil speculators that are causing market dislocation 00:12:45.480 --> 00:12:47.520 and we ought to just get rid of them. 00:12:47.520 --> 00:12:51.510 And I'm going to argue that you really 00:12:51.510 --> 00:12:54.120 can't, because speculators provide 00:12:54.120 --> 00:12:56.550 an enormously valuable service. 00:12:56.550 --> 00:12:58.860 They are the opposite side of the same coin. 00:12:58.860 --> 00:13:03.350 So it's like trying to do applause with only one hand. 00:13:03.350 --> 00:13:06.930 The sound of one hand clapping is not particularly loud. 00:13:06.930 --> 00:13:11.200 So there are a number of ways of hedging. 00:13:11.200 --> 00:13:15.540 Obviously, using futures, forwards, options, and swaps 00:13:15.540 --> 00:13:18.210 are what we're going to be focusing on in these next three 00:13:18.210 --> 00:13:19.530 lectures. 00:13:19.530 --> 00:13:23.340 But you can also think about insurance, diversification, 00:13:23.340 --> 00:13:25.470 you can match assets and liabilities 00:13:25.470 --> 00:13:28.380 in terms of their duration, or you 00:13:28.380 --> 00:13:31.470 can match sales and expenses across countries 00:13:31.470 --> 00:13:34.030 to try to reduce your currency risk. 00:13:34.030 --> 00:13:37.080 And frankly, that's one of the reasons why companies often set 00:13:37.080 --> 00:13:40.590 up production facilities in countries where they 00:13:40.590 --> 00:13:43.410 do a lot of business, because this is a natural hedge, 00:13:43.410 --> 00:13:46.230 in the sense that they're generating expenses, as well as 00:13:46.230 --> 00:13:48.100 revenues in the same currency. 00:13:48.100 --> 00:13:50.250 And so that cancels itself out. 00:13:50.250 --> 00:13:51.850 But you can't always easily do that. 00:13:51.850 --> 00:13:53.590 And you certainly can't do that quickly. 00:13:53.590 --> 00:13:58.020 And if you're a foreign company trying to do business today, 00:13:58.020 --> 00:14:00.901 life is very, very interesting, shall we say. 00:14:00.901 --> 00:14:02.400 So you want to be able to hedge now. 00:14:02.400 --> 00:14:04.650 You don't want to wait a year or two 00:14:04.650 --> 00:14:09.984 when you are building that plant to be able to do that. 00:14:09.984 --> 00:14:11.400 Now what we're going to talk about 00:14:11.400 --> 00:14:16.050 is whether or not it's possible to hedge with derivatives. 00:14:16.050 --> 00:14:18.870 But there are various different views 00:14:18.870 --> 00:14:24.210 on the impact of derivatives for non-financial firms. 00:14:24.210 --> 00:14:27.300 One extreme is that derivatives are extremely efficient tools 00:14:27.300 --> 00:14:29.430 for risk management. 00:14:29.430 --> 00:14:33.570 And the other, espoused by none other than Warren Buffett, 00:14:33.570 --> 00:14:36.390 is that derivatives are financial weapons 00:14:36.390 --> 00:14:38.250 of mass destruction. 00:14:38.250 --> 00:14:43.500 And the truth is actually both. 00:14:43.500 --> 00:14:47.670 Both of these statements, I think, are correct. 00:14:47.670 --> 00:14:53.070 So from uranium-238, you can get a nuclear power plant 00:14:53.070 --> 00:14:56.620 that can provide power for huge areas of the country 00:14:56.620 --> 00:14:58.320 and that do today. 00:14:58.320 --> 00:15:02.760 Or from uranium-238, you can build a dirty thermonuclear 00:15:02.760 --> 00:15:05.610 bomb that can be very bad. 00:15:05.610 --> 00:15:08.880 So the point is that technology, in and of itself, 00:15:08.880 --> 00:15:12.030 has no particular good or bad properties. 00:15:12.030 --> 00:15:13.410 It's how you use it. 00:15:13.410 --> 00:15:16.260 And so derivatives are definitely more complicated 00:15:16.260 --> 00:15:17.940 and more sophisticated. 00:15:17.940 --> 00:15:20.890 This is not the kind of thing you want to try at home, 00:15:20.890 --> 00:15:23.070 unless you are a professional in how you 00:15:23.070 --> 00:15:24.854 use these kind of instruments. 00:15:24.854 --> 00:15:27.270 And so that's one of the reasons why we want to spend time 00:15:27.270 --> 00:15:30.870 on these particular securities. 00:15:30.870 --> 00:15:31.434 OK. 00:15:31.434 --> 00:15:32.850 There are a couple of other views, 00:15:32.850 --> 00:15:36.780 too, regarding whether or not hedging should be done at all. 00:15:36.780 --> 00:15:41.100 One view, which we'll talk about in more detail 00:15:41.100 --> 00:15:42.690 towards the latter part of the course 00:15:42.690 --> 00:15:45.210 when we get into corporate financing decisions, 00:15:45.210 --> 00:15:49.950 is that hedging for a company should be irrelevant. 00:15:49.950 --> 00:15:53.880 If you're running a company, even if your company's assets 00:15:53.880 --> 00:15:57.780 are in foreign denominated currencies and changes 00:15:57.780 --> 00:16:01.280 in those currencies cause huge swings in your company value, 00:16:01.280 --> 00:16:03.900 there is an argument to be said that you shouldn't bother 00:16:03.900 --> 00:16:08.460 hedging, because as long as shareholders of your company 00:16:08.460 --> 00:16:13.780 have free access to the market, they can hedge. 00:16:13.780 --> 00:16:17.170 So anything you can do, they can do. 00:16:17.170 --> 00:16:18.680 At least, that's the argument. 00:16:18.680 --> 00:16:20.680 Now the counterargument is that that's not true, 00:16:20.680 --> 00:16:22.180 because most people who buy shares, 00:16:22.180 --> 00:16:24.070 they don't know enough about what the company is doing 00:16:24.070 --> 00:16:25.444 to be able to hedge, nor are they 00:16:25.444 --> 00:16:29.150 set up to trade in some of these kinds of hedging vehicles. 00:16:29.150 --> 00:16:31.150 But the frictionless model would say 00:16:31.150 --> 00:16:32.950 that you shouldn't bother hedging, 00:16:32.950 --> 00:16:34.570 because what investors want you to do 00:16:34.570 --> 00:16:36.550 is to focus on your business. 00:16:36.550 --> 00:16:38.730 And hedging is just something that, if they 00:16:38.730 --> 00:16:41.680 are concerned about, they can do on their own. 00:16:41.680 --> 00:16:44.860 The alternative view is that hedging creates a lot of value, 00:16:44.860 --> 00:16:49.030 because it reduces uncertainty for a company's cash flows. 00:16:49.030 --> 00:16:52.450 It focuses the company on its core competencies, 00:16:52.450 --> 00:16:55.240 as opposed to other factors in the marketplace that 00:16:55.240 --> 00:16:57.490 are causing volatility. 00:16:57.490 --> 00:16:59.470 It also reduces the chances of getting 00:16:59.470 --> 00:17:01.090 into financial distress. 00:17:01.090 --> 00:17:03.640 And if we believe that financial distress creates 00:17:03.640 --> 00:17:07.750 these huge costs that can't be easily recoverable, even 00:17:07.750 --> 00:17:12.380 through the bankruptcy process, then you ought to hedge. 00:17:12.380 --> 00:17:15.670 Now there are lots of examples of all of these perspectives 00:17:15.670 --> 00:17:16.569 in the industry. 00:17:16.569 --> 00:17:17.920 I'll give you three of them. 00:17:17.920 --> 00:17:21.160 Homestake Mining is a mining company that 00:17:21.160 --> 00:17:23.950 mines precious and base metals. 00:17:23.950 --> 00:17:25.690 They have an explicit corporate policy 00:17:25.690 --> 00:17:28.930 that says, we do not hedge, because shareholders 00:17:28.930 --> 00:17:32.110 will achieve maximum benefit from such a policy of not 00:17:32.110 --> 00:17:34.370 hedging. 00:17:34.370 --> 00:17:35.660 OK. 00:17:35.660 --> 00:17:36.456 Sorry, yeah. 00:17:36.456 --> 00:17:38.580 AUDIENCE: Is there a difference in hedging strategy 00:17:38.580 --> 00:17:42.923 when it's an input production versus production output? 00:17:42.923 --> 00:17:46.220 For example, an oil company hedging gasoline exposure 00:17:46.220 --> 00:17:49.075 versus [INAUDIBLE] company hedging gas [INAUDIBLE]? 00:17:49.075 --> 00:17:51.200 ANDREW LO: Well, there is a difference in the sense 00:17:51.200 --> 00:17:54.950 that typically when you're producing an output, 00:17:54.950 --> 00:17:56.570 there's no point in hedging that, 00:17:56.570 --> 00:17:58.945 because that's actually the output that you're producing. 00:17:58.945 --> 00:18:00.050 You're a gold company. 00:18:00.050 --> 00:18:01.100 You're producing gold. 00:18:01.100 --> 00:18:03.320 The only question about hedging is whether or not 00:18:03.320 --> 00:18:05.780 you feel that there's some temporary mispricing that you 00:18:05.780 --> 00:18:08.000 want to be able to take advantage of, given where 00:18:08.000 --> 00:18:10.000 markets are today versus where you think they'll 00:18:10.000 --> 00:18:11.330 be three months from now. 00:18:11.330 --> 00:18:13.469 But effectively, the output is what you're 00:18:13.469 --> 00:18:14.510 supposed to be producing. 00:18:14.510 --> 00:18:17.060 So their argument is that we're producing gold, 00:18:17.060 --> 00:18:19.910 why would you want us to hedge the price of gold? 00:18:19.910 --> 00:18:22.790 We're a gold company, so you're supposed 00:18:22.790 --> 00:18:26.817 to be getting the risk of gold with a gold company. 00:18:26.817 --> 00:18:29.150 So it's typically the inputs that they're talking about. 00:18:29.150 --> 00:18:32.270 But on occasion, they may be talking about outputs as well. 00:18:32.270 --> 00:18:35.270 And the argument here is that you shouldn't be hedging that. 00:18:35.270 --> 00:18:37.610 Now the American Barrick has another view. 00:18:37.610 --> 00:18:39.650 Their view is that hedges-- 00:18:39.650 --> 00:18:41.990 they want to provide financial stability. 00:18:41.990 --> 00:18:46.070 And so by hedging their output exposure, 00:18:46.070 --> 00:18:49.130 they're actually providing that stability, because right now, 00:18:49.130 --> 00:18:52.670 for example, gold prices are extremely volatile, 00:18:52.670 --> 00:18:54.734 because there's a flight to quality, 00:18:54.734 --> 00:18:56.150 and then people change their mind, 00:18:56.150 --> 00:18:58.460 or another group decides to sell. 00:18:58.460 --> 00:19:00.350 And so the prices are moving back and forth 00:19:00.350 --> 00:19:01.640 and back and forth. 00:19:01.640 --> 00:19:07.310 That output uncertainty creates volatility in earnings. 00:19:07.310 --> 00:19:09.980 And we all know that shareholders 00:19:09.980 --> 00:19:12.360 like stability in earnings. 00:19:12.360 --> 00:19:13.520 So that's another view. 00:19:13.520 --> 00:19:15.260 Now the first company, Homestake Mining, 00:19:15.260 --> 00:19:17.280 would say, look, if you don't like the heat, 00:19:17.280 --> 00:19:18.860 get out of the kitchen. 00:19:18.860 --> 00:19:19.952 We're a gold company. 00:19:19.952 --> 00:19:21.660 If you don't want the volatility of gold, 00:19:21.660 --> 00:19:23.450 then don't buy a gold company. 00:19:23.450 --> 00:19:25.310 Put your money in T-bills. 00:19:25.310 --> 00:19:27.750 And so that's another view. 00:19:27.750 --> 00:19:30.890 And then, of course, we've got Battle Mountain Gold, 00:19:30.890 --> 00:19:35.670 which is a company that hedges up to 25%. 00:19:35.670 --> 00:19:37.820 So their argument is that a recent study 00:19:37.820 --> 00:19:40.439 indicates that there may be a premium for hedging. 00:19:40.439 --> 00:19:42.230 But they're not quite sure, so they're just 00:19:42.230 --> 00:19:43.063 going to go partway. 00:19:46.180 --> 00:19:51.410 It's not clear what the answer is, because largely, the issues 00:19:51.410 --> 00:19:54.380 depend upon how the public will react 00:19:54.380 --> 00:19:56.060 to this kind of uncertainty. 00:19:56.060 --> 00:19:58.160 There are some people that are quite 00:19:58.160 --> 00:20:00.920 rational about their exposures, and they want 00:20:00.920 --> 00:20:02.357 to have the volatility of gold. 00:20:02.357 --> 00:20:04.190 But they don't put all their assets in gold, 00:20:04.190 --> 00:20:05.810 because they understand that there's 00:20:05.810 --> 00:20:08.101 a limit to how much volatility they're willing to bear. 00:20:08.101 --> 00:20:12.620 So maybe 5% of their portfolio is in precious metals, 10% base 00:20:12.620 --> 00:20:15.020 metals, so on and so forth. 00:20:15.020 --> 00:20:16.730 They do the asset allocation. 00:20:16.730 --> 00:20:18.500 But there are other perspectives that 00:20:18.500 --> 00:20:21.020 say, you've got to worry about volatility of earnings, 00:20:21.020 --> 00:20:23.120 you want to have a stable share price. 00:20:23.120 --> 00:20:26.600 And then they engage in that activity as well. 00:20:29.760 --> 00:20:31.850 There's some empirical evidence that I thought 00:20:31.850 --> 00:20:33.830 you might be interested in. 00:20:33.830 --> 00:20:38.592 A couple of academics, Guay and Kothari-- 00:20:38.592 --> 00:20:41.050 SP Kothari is a faculty member here in our accounting group 00:20:41.050 --> 00:20:42.920 who's on leave-- 00:20:42.920 --> 00:20:45.860 published a paper just about five years ago 00:20:45.860 --> 00:20:50.060 where they took a random sample of 413 large companies 00:20:50.060 --> 00:20:54.110 with average cash flows of about $700 million. 00:20:54.110 --> 00:21:01.470 And 57% of those firms used derivatives in 1997. 00:21:01.470 --> 00:21:03.120 Now that's 11 years ago. 00:21:03.120 --> 00:21:05.510 So this is dated information. 00:21:05.510 --> 00:21:08.060 If you went and re-did the survey today, 00:21:08.060 --> 00:21:10.820 my guess is that that number, 57%, 00:21:10.820 --> 00:21:13.190 will have gone up by quite a bit. 00:21:13.190 --> 00:21:16.400 But I don't know for a fact that it has. 00:21:16.400 --> 00:21:18.942 But the idea behind the survey was just 00:21:18.942 --> 00:21:20.900 to get a sense of how many companies really are 00:21:20.900 --> 00:21:22.760 making use of hedging programs. 00:21:22.760 --> 00:21:27.410 And it's become much, much more significant than before. 00:21:27.410 --> 00:21:30.920 Part of the reason that it's not 100%, I suspect, 00:21:30.920 --> 00:21:35.030 is that it's not that easy to implement some of these hedges, 00:21:35.030 --> 00:21:38.420 because the concepts are rather subtle. 00:21:38.420 --> 00:21:41.960 You'll see, when we go over it in this lecture, how 00:21:41.960 --> 00:21:44.160 straightforward you think it is to hedge. 00:21:44.160 --> 00:21:47.000 Some of the ideas are a little subtle. 00:21:47.000 --> 00:21:51.230 And so it's not a simple asset class purchase decision, 00:21:51.230 --> 00:21:55.490 like I'm going to buy bonds, I'm going to sell stocks. 00:21:55.490 --> 00:21:58.145 It requires a certain level of expertise and comfort. 00:22:00.690 --> 00:22:03.360 So let's talk about that now. 00:22:03.360 --> 00:22:04.841 Let's talk about derivatives. 00:22:04.841 --> 00:22:06.840 There are going to be three kinds of derivatives 00:22:06.840 --> 00:22:09.054 we're going to focus on. 00:22:09.054 --> 00:22:10.470 Forwards and futures-- that's what 00:22:10.470 --> 00:22:13.490 we're going to talk about in this lecture and the next. 00:22:13.490 --> 00:22:16.490 Then in lecture 10, we're going to talk about options. 00:22:16.490 --> 00:22:20.130 And then there's a third class, which we probably won't get to 00:22:20.130 --> 00:22:23.310 in this course, but you will get to in 402, as well as 00:22:23.310 --> 00:22:24.540 in investments. 00:22:24.540 --> 00:22:26.770 And that is swaps. 00:22:26.770 --> 00:22:29.680 The idea behind a forward and futures contract 00:22:29.680 --> 00:22:35.080 is that it's a contract to exchange something 00:22:35.080 --> 00:22:37.390 in the future. 00:22:37.390 --> 00:22:44.110 So today, we agree on engaging in a specific transaction 00:22:44.110 --> 00:22:47.100 sometime in the future. 00:22:47.100 --> 00:22:50.670 And the difference between a forward contract and a futures 00:22:50.670 --> 00:22:54.349 contract really has to do just with the issue that 00:22:54.349 --> 00:22:55.890 was raised the beginning of the class 00:22:55.890 --> 00:22:58.267 by [INAUDIBLE], which is mark-to-market. 00:22:58.267 --> 00:23:00.100 But let's not worry about that for a moment. 00:23:00.100 --> 00:23:02.700 Let's just focus on the contract itself. 00:23:02.700 --> 00:23:06.730 So a forward or futures contract is, as the name suggests, 00:23:06.730 --> 00:23:10.620 an agreement that we enter into today-- you and I-- 00:23:10.620 --> 00:23:16.920 to engage in a transaction, say, six months from now. 00:23:16.920 --> 00:23:22.490 So all we do today is agree to do that transaction. 00:23:22.490 --> 00:23:24.450 And in agreeing to do that transaction, 00:23:24.450 --> 00:23:26.280 we have to specify a couple of things. 00:23:26.280 --> 00:23:30.140 One is we have to specify what we're going to transact 00:23:30.140 --> 00:23:31.854 and at what price. 00:23:31.854 --> 00:23:33.520 And the second thing we have to agree on 00:23:33.520 --> 00:23:36.800 is when we're going to do the transaction. 00:23:36.800 --> 00:23:41.110 Once we sign the document, we are both 00:23:41.110 --> 00:23:43.850 obligated to follow through. 00:23:43.850 --> 00:23:47.830 So this is not an option in the sense 00:23:47.830 --> 00:23:51.850 that we can choose not to do it or to do it. 00:23:51.850 --> 00:23:54.310 Once we sign the forward contract today, 00:23:54.310 --> 00:24:00.220 it is a legal, binding contract so that we are agreeing today 00:24:00.220 --> 00:24:02.630 to engage in that transaction six months from now. 00:24:02.630 --> 00:24:04.930 Now if it ends up that we default-- 00:24:04.930 --> 00:24:08.800 we don't have enough money, we declare bankruptcy-- 00:24:08.800 --> 00:24:11.740 then that contract, like all other contracts, 00:24:11.740 --> 00:24:16.180 will have to go to court and be dealt with by the legal system. 00:24:16.180 --> 00:24:18.790 But assuming that we are not in default, 00:24:18.790 --> 00:24:22.300 we will have to perform-- we are obligated to perform-- 00:24:22.300 --> 00:24:24.340 on that contract, like any other. 00:24:24.340 --> 00:24:25.660 It's a binding agreement. 00:24:25.660 --> 00:24:27.410 With an option, on the other hand-- 00:24:27.410 --> 00:24:29.784 we're going to get to this in more detail in lecture 10-- 00:24:29.784 --> 00:24:32.080 with an option, we do not have to follow through 00:24:32.080 --> 00:24:33.710 with the transaction. 00:24:33.710 --> 00:24:36.820 In other words, the buyer of the contract 00:24:36.820 --> 00:24:41.060 has the right but not the obligation 00:24:41.060 --> 00:24:43.520 to exercise that option. 00:24:43.520 --> 00:24:45.860 That's why it's called an option. 00:24:45.860 --> 00:24:47.690 So that's a key distinction. 00:24:47.690 --> 00:24:50.510 So let me be very explicit now and now focus 00:24:50.510 --> 00:24:51.500 on a forward contract. 00:24:51.500 --> 00:24:53.570 A forward contract is a commitment 00:24:53.570 --> 00:24:56.330 to purchase, at a future date, a given 00:24:56.330 --> 00:24:57.740 amount of a commodity or an asset 00:24:57.740 --> 00:25:00.270 at a price agreed upon today. 00:25:00.270 --> 00:25:03.230 So first thing we do, draw a timeline. 00:25:03.230 --> 00:25:04.950 Today is date zero. 00:25:04.950 --> 00:25:06.740 That's when we enter into the agreement. 00:25:06.740 --> 00:25:11.120 And to be clear, because a forward contract always 00:25:11.120 --> 00:25:12.380 has two parties-- 00:25:12.380 --> 00:25:13.970 a buyer and a seller-- 00:25:13.970 --> 00:25:16.100 let's just use, as the convention, 00:25:16.100 --> 00:25:19.790 that the buyer of the forward contract 00:25:19.790 --> 00:25:27.860 is the party that has agreed to buy whatever in a future date. 00:25:27.860 --> 00:25:34.550 So the price that we agree to is fixed, as of today. 00:25:34.550 --> 00:25:37.670 And that's known as the forward price. 00:25:37.670 --> 00:25:41.240 If the particular commodity that we're talking about 00:25:41.240 --> 00:25:46.580 happens to be alone, then it will be a forward borrowing 00:25:46.580 --> 00:25:49.310 rate that we agree to today. 00:25:49.310 --> 00:25:51.461 So it's either a rate or a price. 00:25:51.461 --> 00:25:53.210 And it's typically called the forward rate 00:25:53.210 --> 00:25:55.160 or the forward price. 00:25:55.160 --> 00:25:57.170 And the buyer of the commodity is 00:25:57.170 --> 00:26:00.560 said to be long the forward contract. 00:26:00.560 --> 00:26:02.900 And the other counterparty-- the counterparty that 00:26:02.900 --> 00:26:05.510 is selling the asset-- is said to be 00:26:05.510 --> 00:26:09.380 short the forward contract. 00:26:09.380 --> 00:26:11.662 Now these terms are, in some sense, arbitrary. 00:26:11.662 --> 00:26:14.120 But there is a logic to them that I'll explain in a minute. 00:26:14.120 --> 00:26:15.734 Yeah, question? 00:26:15.734 --> 00:26:23.480 AUDIENCE: [INAUDIBLE] forward contract? 00:26:23.480 --> 00:26:25.160 ANDREW LO: A revolving loan. 00:26:25.160 --> 00:26:27.410 Well, I would call a revolving loan 00:26:27.410 --> 00:26:31.280 a sequence of forward contracts, because it revolves 00:26:31.280 --> 00:26:32.749 and constantly updates. 00:26:32.749 --> 00:26:33.290 That's right. 00:26:33.290 --> 00:26:34.780 Yeah. 00:26:34.780 --> 00:26:36.860 So for the moment, let's just focus on one, 00:26:36.860 --> 00:26:39.890 and then we'll talk about how we can extend that. 00:26:39.890 --> 00:26:44.270 So this is a very, very standard set-up. 00:26:44.270 --> 00:26:47.690 And in terms of long versus short, 00:26:47.690 --> 00:26:50.960 there's a reason why we use that terminology. 00:26:50.960 --> 00:26:54.170 Obviously, the ambiguity is the fact 00:26:54.170 --> 00:26:58.280 that a forward contract actually has no value on the day 00:26:58.280 --> 00:26:59.480 that it's struck. 00:26:59.480 --> 00:27:02.630 So to say that one side is long and the other side of short 00:27:02.630 --> 00:27:05.360 is, in a way, a little bit unnatural, because in fact, 00:27:05.360 --> 00:27:08.540 the value of the contract that's struck is zero. 00:27:08.540 --> 00:27:10.560 So you're either long zero or short zero. 00:27:10.560 --> 00:27:11.630 Well, who cares? 00:27:11.630 --> 00:27:15.080 But there's a reason why we call the buyer long 00:27:15.080 --> 00:27:19.100 and the reason we call the seller of the asset short. 00:27:19.100 --> 00:27:23.290 It's because tomorrow, if the value of the asset 00:27:23.290 --> 00:27:30.120 goes up beyond where the current price is, then the person who 00:27:30.120 --> 00:27:33.090 has agreed to buy the asset at this price 00:27:33.090 --> 00:27:34.920 is going to make money. 00:27:34.920 --> 00:27:36.690 So when the price goes up-- 00:27:36.690 --> 00:27:39.720 when the spot price, the price today and then 00:27:39.720 --> 00:27:42.570 the price tomorrow spot price-- when that goes up, 00:27:42.570 --> 00:27:46.200 the person who was holding it long will profit. 00:27:46.200 --> 00:27:49.170 And the person who is short will lose. 00:27:49.170 --> 00:27:50.460 And so that makes sense. 00:27:50.460 --> 00:27:52.440 When prices go up, long positions 00:27:52.440 --> 00:27:55.020 tend to be profitable, and short positions 00:27:55.020 --> 00:27:56.340 tend to be unprofitable. 00:27:56.340 --> 00:27:58.325 That's why we use the normalization. 00:27:58.325 --> 00:27:59.700 Now right then and there, I think 00:27:59.700 --> 00:28:01.283 I've described something that may have 00:28:01.283 --> 00:28:02.580 slipped by you a little bit. 00:28:02.580 --> 00:28:07.110 So I want to just beat this down and make sure that we all 00:28:07.110 --> 00:28:09.430 understand it completely. 00:28:09.430 --> 00:28:12.190 The price that I'm talking about going up or down 00:28:12.190 --> 00:28:13.600 is not the forward price. 00:28:13.600 --> 00:28:14.920 It's the futures price. 00:28:14.920 --> 00:28:19.440 Excuse me, it's the future spot price. 00:28:19.440 --> 00:28:24.070 Today's spot price for oil is, let's say, $100 a barrel. 00:28:24.070 --> 00:28:26.800 Suppose that we enter into an agreement six months from now 00:28:26.800 --> 00:28:31.690 to purchase oil at $110 a barrel. 00:28:31.690 --> 00:28:34.930 So the forward price of that contract is 110. 00:28:34.930 --> 00:28:38.560 Today's spot price is 100. 00:28:38.560 --> 00:28:42.400 When we have agreed to that contract, you and I, 00:28:42.400 --> 00:28:46.330 the value of that agreement is worth zero. 00:28:46.330 --> 00:28:47.800 It's got to be worth zero. 00:28:47.800 --> 00:28:51.010 The reason is that if it's not at all worth zero, 00:28:51.010 --> 00:28:52.930 then you and I aren't going to be 00:28:52.930 --> 00:28:54.760 willing to enter into that contract today, 00:28:54.760 --> 00:28:57.280 because that means either I'm losing and you're winning, 00:28:57.280 --> 00:28:58.750 or you're losing and I'm winning. 00:28:58.750 --> 00:29:00.520 So we won't strike that deal. 00:29:00.520 --> 00:29:02.420 Let me give you an example. 00:29:02.420 --> 00:29:08.140 Suppose that I propose to buy oil from you 00:29:08.140 --> 00:29:12.730 six months from now at $40 a barrel. 00:29:12.730 --> 00:29:15.340 Now that's a legitimate contract, right? 00:29:15.340 --> 00:29:17.200 In other words, I can propose that. 00:29:17.200 --> 00:29:19.300 And if you and I, we agree to that, 00:29:19.300 --> 00:29:22.930 that transaction will be carried out. 00:29:22.930 --> 00:29:26.730 How many people would agree to that today? 00:29:26.730 --> 00:29:27.490 Nobody. 00:29:27.490 --> 00:29:28.910 You would? 00:29:28.910 --> 00:29:29.610 All right. 00:29:29.610 --> 00:29:30.920 Seriously? 00:29:30.920 --> 00:29:32.106 No. 00:29:32.106 --> 00:29:33.600 AUDIENCE: You're buying? 00:29:33.600 --> 00:29:36.020 ANDREW LO: I'm buying at $40 a barrel. 00:29:36.020 --> 00:29:36.690 No. 00:29:36.690 --> 00:29:39.900 Because given that oil is at 100 and given that there's 00:29:39.900 --> 00:29:45.030 nothing in the news or in any kind of projection that 00:29:45.030 --> 00:29:48.690 suggests that we're going to find tremendously large, 00:29:48.690 --> 00:29:51.604 untapped oil reserves or that somehow oil 00:29:51.604 --> 00:29:53.520 is going to become less relevant in six months 00:29:53.520 --> 00:29:57.240 time, being able to buy oil at $40 a barrel 00:29:57.240 --> 00:29:59.970 six months from now is an incredibly good deal. 00:29:59.970 --> 00:30:01.800 If I can find a deal like that, it's 00:30:01.800 --> 00:30:07.030 got to have a lot of net present value to me today. 00:30:07.030 --> 00:30:08.610 If I can find a piece of paper that 00:30:08.610 --> 00:30:11.070 allows me to buy oil six months from now at $40 a barrel, 00:30:11.070 --> 00:30:15.460 that piece of paper, we all agree, has positive NPV. 00:30:15.460 --> 00:30:18.470 So in order for you to agree to sell me that piece of paper, 00:30:18.470 --> 00:30:21.760 you're basically giving me money. 00:30:21.760 --> 00:30:23.020 You're not going to do that. 00:30:23.020 --> 00:30:26.359 So we're not going to get that deal done today. 00:30:26.359 --> 00:30:28.900 On the other hand, suppose that we have a piece of paper that 00:30:28.900 --> 00:30:33.730 says, I will buy oil at $250 a barrel six months from now. 00:30:33.730 --> 00:30:36.460 I suspect all of you would be delighted to sell me 00:30:36.460 --> 00:30:38.464 that forward contract. 00:30:38.464 --> 00:30:40.630 I'm not going to do that, because that's ridiculous. 00:30:40.630 --> 00:30:42.127 That price just makes no sense. 00:30:42.127 --> 00:30:44.210 And that means you're going to get a lot of value. 00:30:44.210 --> 00:30:46.990 So if both you and I agree that we want 00:30:46.990 --> 00:30:49.840 to do a deal regarding oil-- 00:30:49.840 --> 00:30:52.690 you're an oil producer, I'm an oil user, 00:30:52.690 --> 00:30:57.730 I want to lock in some price for oil six months from now-- 00:30:57.730 --> 00:31:00.520 we're going to haggle until such time 00:31:00.520 --> 00:31:04.360 as we reach a price for that transaction six months from now 00:31:04.360 --> 00:31:07.930 that seems fair to both you and me. 00:31:07.930 --> 00:31:08.990 When we do that-- 00:31:08.990 --> 00:31:12.880 when we reach that price-- $110, let's say-- 00:31:12.880 --> 00:31:17.200 that's a price where the present value of that contract 00:31:17.200 --> 00:31:19.060 is worth nothing. 00:31:19.060 --> 00:31:22.900 So both you and I have found a price, such 00:31:22.900 --> 00:31:25.930 that we're happy to take it or leave it. 00:31:25.930 --> 00:31:30.040 If we made it 115, then I might not be so willing to do it. 00:31:30.040 --> 00:31:31.480 You might be happy about that. 00:31:31.480 --> 00:31:34.630 If we made it 105, I'm happy to do that, 00:31:34.630 --> 00:31:36.760 but you think that you're not getting a good deal. 00:31:36.760 --> 00:31:39.490 So the way that a forward price is established 00:31:39.490 --> 00:31:40.510 is like any other price. 00:31:40.510 --> 00:31:42.550 We put it up for auction. 00:31:42.550 --> 00:31:46.690 We set a system where supply and demand determines that price. 00:31:46.690 --> 00:31:51.638 And when that price is struck, the contract is worth nothing. 00:31:51.638 --> 00:31:52.610 Question? 00:31:52.610 --> 00:31:54.068 AUDIENCE: Could you argue that it's 00:31:54.068 --> 00:31:56.498 based on the price of a futures contract 00:31:56.498 --> 00:31:59.900 and not of the market [INAUDIBLE]? 00:31:59.900 --> 00:32:03.302 Let's say they're in the range [INAUDIBLE] $130 00:32:03.302 --> 00:32:06.056 and we enter into [INAUDIBLE], wouldn't that 00:32:06.056 --> 00:32:07.710 create a little bit of a problem there? 00:32:07.710 --> 00:32:08.430 ANDREW LO: Yeah, it would. 00:32:08.430 --> 00:32:10.050 Let's not talk about that yet, because we haven't talked 00:32:10.050 --> 00:32:11.670 about futures prices yet. 00:32:11.670 --> 00:32:13.950 So we're only talking about forward prices right now. 00:32:13.950 --> 00:32:15.600 We're going to come back to future prices, 00:32:15.600 --> 00:32:17.224 and arbitrage is going to come into it. 00:32:17.224 --> 00:32:18.656 But I want to do it step by step. 00:32:18.656 --> 00:32:20.280 So let's hold off on that for a minute. 00:32:20.280 --> 00:32:20.780 Yeah? 00:32:20.780 --> 00:32:23.612 AUDIENCE: So when there's like a natural gas company that sells 00:32:23.612 --> 00:32:25.040 [INAUDIBLE] for next year, that's 00:32:25.040 --> 00:32:26.359 forward contract [INAUDIBLE]? 00:32:26.359 --> 00:32:27.150 ANDREW LO: Exactly. 00:32:27.150 --> 00:32:28.260 That's right. 00:32:28.260 --> 00:32:30.990 And companies are delighted to do that, because this way, 00:32:30.990 --> 00:32:33.270 they know what their costs are going to be, 00:32:33.270 --> 00:32:35.910 as opposed to who knows, it depends 00:32:35.910 --> 00:32:37.760 on what happens with this rescue package, 00:32:37.760 --> 00:32:39.510 or it depends on whether or not we get hit 00:32:39.510 --> 00:32:41.340 with a terrorist attack or not. 00:32:41.340 --> 00:32:43.230 That creates so much uncertainty, 00:32:43.230 --> 00:32:44.980 companies don't want to deal with that. 00:32:44.980 --> 00:32:47.400 So if I use oil in my production facilities 00:32:47.400 --> 00:32:51.330 and I can lock in at 110 for a six month period, 00:32:51.330 --> 00:32:52.230 that's OK with me. 00:32:52.230 --> 00:32:53.880 I'm willing to do that. 00:32:53.880 --> 00:32:55.405 Yeah? 00:32:55.405 --> 00:32:57.780 AUDIENCE: Considering that the trend of the global market 00:32:57.780 --> 00:33:02.790 is upwards in the long term, I suspect that it makes sense, 00:33:02.790 --> 00:33:06.050 especially to try to short in the short term, 00:33:06.050 --> 00:33:07.850 that would be there-- 00:33:07.850 --> 00:33:10.600 exceptions when I want to try and do it in the long term 00:33:10.600 --> 00:33:11.507 as well? 00:33:11.507 --> 00:33:13.840 ANDREW LO: Well, that's a very tough question to answer, 00:33:13.840 --> 00:33:16.298 because it depends upon what your forecast is for long term 00:33:16.298 --> 00:33:17.100 prices. 00:33:17.100 --> 00:33:19.140 And the longer the term is for your forecast, 00:33:19.140 --> 00:33:21.215 the more inaccurate your estimate goes. 00:33:21.215 --> 00:33:22.590 So the question is whether or not 00:33:22.590 --> 00:33:23.700 you really want to take that risk 00:33:23.700 --> 00:33:24.825 and make those projections. 00:33:24.825 --> 00:33:27.090 In fact, this is one of the reasons why companies 00:33:27.090 --> 00:33:29.640 don't want to do that and they'd rather lock in the price. 00:33:29.640 --> 00:33:32.940 Companies feel like they're not in the business of forecasting 00:33:32.940 --> 00:33:34.956 prices in the long term. 00:33:34.956 --> 00:33:36.330 They're producing oil, or they're 00:33:36.330 --> 00:33:39.280 using oil as an input to their production process. 00:33:39.280 --> 00:33:41.790 So they basically just want to eliminate that uncertainty 00:33:41.790 --> 00:33:43.260 if they can get a reasonable price. 00:33:43.260 --> 00:33:45.810 And by reasonable-- I just gave you an example-- 00:33:45.810 --> 00:33:48.930 a $10 premium over a six month period 00:33:48.930 --> 00:33:52.170 where we have uncertainty about both supply and demand 00:33:52.170 --> 00:33:55.594 may be reasonable to certain corporations. 00:33:55.594 --> 00:33:57.085 Yeah? 00:33:57.085 --> 00:34:00.067 AUDIENCE: Is there a limit on how much can 00:34:00.067 --> 00:34:03.049 be done in a forward contract? 00:34:03.049 --> 00:34:06.266 And the example I sort of have in mind is over the past few 00:34:06.266 --> 00:34:08.516 years, we keep reading how Southwest has hedged on its 00:34:08.516 --> 00:34:10.842 fuel, but the other airlines haven't. 00:34:10.842 --> 00:34:13.818 So was there some sort of financial or legal perspective 00:34:13.818 --> 00:34:16.300 [INAUDIBLE]? 00:34:16.300 --> 00:34:17.800 ANDREW LO: Certainly not anything 00:34:17.800 --> 00:34:20.925 from a legal perspective. 00:34:20.925 --> 00:34:22.300 For a financial perspective, that 00:34:22.300 --> 00:34:23.830 depends upon the particular company 00:34:23.830 --> 00:34:26.860 and the shareholders and the balance sheet and so on. 00:34:26.860 --> 00:34:28.659 But no, there's no limit, as long 00:34:28.659 --> 00:34:30.987 as you can find a mutually consenting adult that's 00:34:30.987 --> 00:34:32.320 willing to do the deal with you. 00:34:32.320 --> 00:34:33.030 That's it. 00:34:33.030 --> 00:34:33.530 All right. 00:34:33.530 --> 00:34:34.021 Yeah? 00:34:34.021 --> 00:34:35.395 AUDIENCE: Does it have to be more 00:34:35.395 --> 00:34:36.814 expensive than the current price? 00:34:36.814 --> 00:34:39.230 ANDREW LO: Well, no, it doesn't have to be more expensive. 00:34:39.230 --> 00:34:41.050 So the question is, does the forward price always 00:34:41.050 --> 00:34:42.675 have to be more than the current price? 00:34:42.675 --> 00:34:44.420 No, it doesn't. 00:34:44.420 --> 00:34:46.880 It depends upon what the expectation is for what's 00:34:46.880 --> 00:34:48.380 going to happen in the future. 00:34:48.380 --> 00:34:52.550 It turns out with oil, typically it goes the other way-- 00:34:52.550 --> 00:34:56.010 that these oil prices generally are rising over time. 00:34:56.010 --> 00:34:57.870 However, there are situations. 00:34:57.870 --> 00:35:01.340 For example, it may be that within the next few weeks, 00:35:01.340 --> 00:35:03.470 if there is more of an expectation 00:35:03.470 --> 00:35:06.380 that business will slow down worldwide, 00:35:06.380 --> 00:35:09.740 then we would expect oil prices to decline over time, 00:35:09.740 --> 00:35:12.350 because the demand is going to decline. 00:35:12.350 --> 00:35:14.960 If that's the case, then oil producing companies 00:35:14.960 --> 00:35:17.390 may be delighted to do a deal at par. 00:35:17.390 --> 00:35:19.850 So if the current price of oil is $100 a barrel, 00:35:19.850 --> 00:35:22.384 they may be delighted to say, OK, six months from now, 00:35:22.384 --> 00:35:24.050 I think the economy is going to go down, 00:35:24.050 --> 00:35:26.660 I'm willing to sell you oil at $100 a barrel six months 00:35:26.660 --> 00:35:28.640 from now, let's lock it in. 00:35:28.640 --> 00:35:30.090 That's possible. 00:35:30.090 --> 00:35:33.120 So what does that tell you about the price 00:35:33.120 --> 00:35:36.090 of oil today versus the price of oil six months, 00:35:36.090 --> 00:35:37.950 in terms of the forward prices? 00:35:37.950 --> 00:35:41.880 That tells you that the market is providing information 00:35:41.880 --> 00:35:42.630 about the future. 00:35:42.630 --> 00:35:46.080 So future price forecasts are implicit 00:35:46.080 --> 00:35:47.130 in these forward prices. 00:35:47.130 --> 00:35:50.880 In just the same way that when we look at the yield curve 00:35:50.880 --> 00:35:55.710 and we see the implicit forward rates for future borrowing, 00:35:55.710 --> 00:35:58.920 when you look at forward prices of commodities 00:35:58.920 --> 00:36:00.990 and other instruments, that's giving you 00:36:00.990 --> 00:36:04.020 information about what the market is telling you 00:36:04.020 --> 00:36:07.090 that it thinks will happen six months from now. 00:36:07.090 --> 00:36:10.710 So if you see forward prices for oil at $90, 00:36:10.710 --> 00:36:13.470 whereas today it's at 100, that's telling you 00:36:13.470 --> 00:36:16.110 either people are expecting to find lots of oil 00:36:16.110 --> 00:36:18.570 in the next six months, or it's telling you 00:36:18.570 --> 00:36:20.880 that there's a forecast that demand 00:36:20.880 --> 00:36:25.650 will decline precipitously over the next six months. 00:36:25.650 --> 00:36:26.590 OK. 00:36:26.590 --> 00:36:30.550 So the features of forward contracts are the following. 00:36:30.550 --> 00:36:31.990 They're customized. 00:36:31.990 --> 00:36:35.470 So we have to enter into this contract counterparty 00:36:35.470 --> 00:36:36.190 by counterparty. 00:36:36.190 --> 00:36:39.100 In other words, this is not a share of IBM 00:36:39.100 --> 00:36:41.235 that anybody can buy and sell and is the same 00:36:41.235 --> 00:36:43.360 whether you trade it in the New York Stock Exchange 00:36:43.360 --> 00:36:45.660 or in London or anywhere else. 00:36:45.660 --> 00:36:48.430 A forward contract is a customized agreement 00:36:48.430 --> 00:36:50.950 between two parties. 00:36:50.950 --> 00:36:54.910 The second feature is that it's typically nonstandard, 00:36:54.910 --> 00:36:59.240 so we can do as much of it or as little of it as we want. 00:36:59.240 --> 00:37:03.260 And also, it doesn't trade on exchanges. 00:37:03.260 --> 00:37:06.560 These are known as over-the-counter securities. 00:37:06.560 --> 00:37:08.600 It doesn't trade on an organized exchange. 00:37:08.600 --> 00:37:13.010 Two people trade with each other over a counter. 00:37:13.010 --> 00:37:14.280 That's the customization part. 00:37:14.280 --> 00:37:14.883 Yeah? 00:37:14.883 --> 00:37:16.591 AUDIENCE: You said that there's sometimes 00:37:16.591 --> 00:37:20.306 a circular effect on prices on certain commodities. 00:37:20.306 --> 00:37:22.771 For example, if I think that copper 00:37:22.771 --> 00:37:25.564 is going to be more expensive six months from now, 00:37:25.564 --> 00:37:27.824 then I'm going to buy more copper today, which 00:37:27.824 --> 00:37:30.112 is going to drive up the price, then 00:37:30.112 --> 00:37:32.179 it's going to make it lower in the future? 00:37:32.179 --> 00:37:33.720 ANDREW LO: If you drive up the price, 00:37:33.720 --> 00:37:36.774 why would you make it lower in the future? 00:37:36.774 --> 00:37:38.238 AUDIENCE: Because my demand for it 00:37:38.238 --> 00:37:43.120 would be substituted now instead of six months from now. 00:37:43.120 --> 00:37:47.440 ANDREW LO: Well, it's not clear that it would make the price 00:37:47.440 --> 00:37:49.240 lower, because if you're doing it, 00:37:49.240 --> 00:37:50.740 that may indicate that there's going 00:37:50.740 --> 00:37:52.840 to be a shortage, because you're trying 00:37:52.840 --> 00:37:54.500 to get ahead of that curve. 00:37:54.500 --> 00:37:57.200 And therefore, the price may stay that way. 00:37:57.200 --> 00:37:59.860 So I'm not sure I understand your question. 00:37:59.860 --> 00:38:01.870 Are you worried about price manipulation, 00:38:01.870 --> 00:38:03.880 or are you worried about the fact 00:38:03.880 --> 00:38:05.770 that the futures prices or forward prices 00:38:05.770 --> 00:38:09.280 don't reflect current supply and demand conditions? 00:38:09.280 --> 00:38:11.610 AUDIENCE: I'm just trying to think that if I expect 00:38:11.610 --> 00:38:16.040 a certain price to go up in the future, 00:38:16.040 --> 00:38:20.040 rather than hedging against-- 00:38:20.040 --> 00:38:22.040 the inflammation that's in that price 00:38:22.040 --> 00:38:24.574 is based on the inflammation of the price 00:38:24.574 --> 00:38:27.552 right now, so I'm going to substitute my demand for-- 00:38:27.552 --> 00:38:29.010 ANDREW LO: OK, I see what you mean. 00:38:29.010 --> 00:38:30.850 So let me rephrase the question. 00:38:30.850 --> 00:38:34.300 Your question is, if you think the prices are going to go up 00:38:34.300 --> 00:38:36.430 for a particular input-- say, copper-- 00:38:36.430 --> 00:38:39.190 then rather than buy it six months 00:38:39.190 --> 00:38:41.020 from now at the potentially higher price, 00:38:41.020 --> 00:38:45.450 you might decide to do it sooner by buying it now. 00:38:45.450 --> 00:38:46.440 Right. 00:38:46.440 --> 00:38:50.500 That's a perfectly sensible thing to do with one exception. 00:38:50.500 --> 00:38:55.240 And that is that when you buy it now, you have to store it. 00:38:55.240 --> 00:39:00.970 And copper, oil, other kinds of factor inputs 00:39:00.970 --> 00:39:02.470 are typically not the kind of things 00:39:02.470 --> 00:39:05.380 that are costless to store. 00:39:05.380 --> 00:39:09.880 So you can either do that, buy it now, store it, and then use 00:39:09.880 --> 00:39:13.240 it later, or you could do a financial transaction 00:39:13.240 --> 00:39:15.310 that will have the same effect. 00:39:15.310 --> 00:39:20.110 And so that idea is going to be exactly how we 00:39:20.110 --> 00:39:21.514 price these things. 00:39:21.514 --> 00:39:22.930 So I'm going to come back to that. 00:39:22.930 --> 00:39:24.471 Hold onto that thought, because we're 00:39:24.471 --> 00:39:26.800 going to use that approach to figure out how 00:39:26.800 --> 00:39:28.100 to price a forward contract. 00:39:28.100 --> 00:39:30.641 So far, I haven't told you how the forward price comes about. 00:39:30.641 --> 00:39:32.800 All I've said is, the market determines it. 00:39:32.800 --> 00:39:34.750 Like before, we're going to want to work out 00:39:34.750 --> 00:39:38.200 the logic for what the market is doing when it figures out 00:39:38.200 --> 00:39:39.100 what that price is. 00:39:39.100 --> 00:39:41.710 And it will actually be exactly the calculation 00:39:41.710 --> 00:39:43.780 that you just proposed. 00:39:43.780 --> 00:39:47.230 So in other words, either we transact in the forward market, 00:39:47.230 --> 00:39:49.900 or we do it directly in the spot market. 00:39:49.900 --> 00:39:51.500 Those are our two choices. 00:39:51.500 --> 00:39:53.230 And in the end, it's going to have 00:39:53.230 --> 00:39:55.540 to be the case that those two choices, which 00:39:55.540 --> 00:39:57.910 lead to the same cash flows, they 00:39:57.910 --> 00:39:59.180 have to have the same price. 00:39:59.180 --> 00:40:00.982 And that's how we're going to get the forward price. 00:40:00.982 --> 00:40:01.364 Yeah? 00:40:01.364 --> 00:40:02.560 AUDIENCE: Do you have to have cash on hand now 00:40:02.560 --> 00:40:04.167 to enter into a forward contract? 00:40:04.167 --> 00:40:04.750 ANDREW LO: No. 00:40:04.750 --> 00:40:06.458 AUDIENCE: So that could be another reason 00:40:06.458 --> 00:40:08.150 why, if you're an airline, for example, 00:40:08.150 --> 00:40:09.820 you wouldn't want to buy millions 00:40:09.820 --> 00:40:12.760 and millions of dollars worth of gas if you can't afford it now? 00:40:12.760 --> 00:40:13.760 ANDREW LO: That's right. 00:40:13.760 --> 00:40:16.120 But if you can't afford it now, you're 00:40:16.120 --> 00:40:19.810 really talking more about a short term kind of a borrowing 00:40:19.810 --> 00:40:22.270 situation, because presumably, you're 00:40:22.270 --> 00:40:24.020 going to have to pay for it at some point, 00:40:24.020 --> 00:40:25.390 particularly when you use it. 00:40:25.390 --> 00:40:27.610 But you're right that if you don't have the cash now, 00:40:27.610 --> 00:40:30.340 then one way you can do it is enter into a forward contract 00:40:30.340 --> 00:40:31.510 when you know you'll have the cash later. 00:40:31.510 --> 00:40:31.946 AUDIENCE: Right. 00:40:31.946 --> 00:40:33.445 Because American Airlines, I'm sure, 00:40:33.445 --> 00:40:36.520 couldn't afford to buy five years' worth of fuel today, 00:40:36.520 --> 00:40:39.442 because they just don't have enough assets to do that. 00:40:39.442 --> 00:40:40.150 ANDREW LO: Right. 00:40:40.150 --> 00:40:42.630 So you can't buy that-- not only that, 00:40:42.630 --> 00:40:43.900 where are you going to put it? 00:40:43.900 --> 00:40:48.020 Five years' worth of oil is a lot of oil. 00:40:48.020 --> 00:40:50.990 And it's very, very expensive. 00:40:50.990 --> 00:40:52.930 So your consideration is absolutely right. 00:40:52.930 --> 00:40:56.980 The borrowing cost, or the opportunity cost of capital, 00:40:56.980 --> 00:40:58.790 is also part of the equation. 00:40:58.790 --> 00:41:00.730 So if we think about all the ingredients 00:41:00.730 --> 00:41:03.340 that have to go into determining the forward price, 00:41:03.340 --> 00:41:05.750 one is the cost of storage. 00:41:05.750 --> 00:41:08.300 The other is the borrowing cost implicit in that-- the cash-- 00:41:08.300 --> 00:41:11.740 because a forward contract requires no money down. 00:41:11.740 --> 00:41:14.080 So this is one of these true financial deals 00:41:14.080 --> 00:41:15.460 with no money down. 00:41:15.460 --> 00:41:19.040 The problem is that it's not always a short profit. 00:41:19.040 --> 00:41:19.870 Yeah? 00:41:19.870 --> 00:41:22.165 AUDIENCE: You may also not have the product to sell. 00:41:22.165 --> 00:41:25.890 For example, in the case of soybean or food, 00:41:25.890 --> 00:41:27.690 you may enter into a six month forward 00:41:27.690 --> 00:41:30.750 and I still did not harvest a product. 00:41:30.750 --> 00:41:31.750 ANDREW LO: That's right. 00:41:31.750 --> 00:41:33.160 So you may want to wait for the uncertainty 00:41:33.160 --> 00:41:35.590 to resolve and get a better sense of what your needs are. 00:41:35.590 --> 00:41:36.220 Yup? 00:41:36.220 --> 00:41:38.053 AUDIENCE: So if between the buyer and seller 00:41:38.053 --> 00:41:40.750 they have a different or asymmetric information, 00:41:40.750 --> 00:41:43.500 is it possible that the overall forward contract 00:41:43.500 --> 00:41:45.650 has positive NVP? 00:41:45.650 --> 00:41:47.650 ANDREW LO: Well, let me put it to you this way-- 00:41:47.650 --> 00:41:53.020 the forward contract may have an expected value 00:41:53.020 --> 00:41:56.770 for one party or the other based upon what they know. 00:41:56.770 --> 00:41:59.380 But in principle, the NPV-- 00:41:59.380 --> 00:42:02.140 that's an objective NPV-- has to be zero, 00:42:02.140 --> 00:42:05.020 because if it's not zero, then one party can 00:42:05.020 --> 00:42:08.860 take that contract and basically sell it to a third party 00:42:08.860 --> 00:42:11.080 and make money off of it. 00:42:11.080 --> 00:42:11.800 See what I mean? 00:42:11.800 --> 00:42:13.570 In other words, your question is, 00:42:13.570 --> 00:42:16.270 if two parties have different information, 00:42:16.270 --> 00:42:18.830 is it possible that the contract has different value? 00:42:18.830 --> 00:42:21.380 Well, certainly they have different value to each party. 00:42:21.380 --> 00:42:25.690 In other words, if I'm willing to buy oil forward contracts 00:42:25.690 --> 00:42:29.320 from you, I must think either that oil prices 00:42:29.320 --> 00:42:30.490 are going to go way up-- 00:42:30.490 --> 00:42:32.652 that's my view-- or I just need the oil, 00:42:32.652 --> 00:42:34.360 and I want to get rid of the uncertainty. 00:42:34.360 --> 00:42:37.000 But both of those are possible. 00:42:37.000 --> 00:42:40.370 If you're selling me this oil forward contract, 00:42:40.370 --> 00:42:42.370 the two possible reasons you might want to do it 00:42:42.370 --> 00:42:44.200 is because you've got a lot of oil 00:42:44.200 --> 00:42:46.720 and you want to lock in a price for selling 00:42:46.720 --> 00:42:48.550 that oil six months from now-- 00:42:48.550 --> 00:42:51.070 that's one possibility-- or you have 00:42:51.070 --> 00:42:54.070 some asymmetric information-- some private information-- 00:42:54.070 --> 00:42:57.160 that oil prices are going to go down. 00:42:57.160 --> 00:43:01.060 So both of those interpretations are legitimate. 00:43:01.060 --> 00:43:04.390 But the statement that I made that the price of that contract 00:43:04.390 --> 00:43:07.840 has to be zero, that's a statement not about your views 00:43:07.840 --> 00:43:09.310 or my views or her views. 00:43:09.310 --> 00:43:12.970 It's a statement about the market price of that contract 00:43:12.970 --> 00:43:16.247 if we were to auction it off to people in the marketplace. 00:43:16.247 --> 00:43:17.830 If we were to auction it off to people 00:43:17.830 --> 00:43:22.290 in the marketplace in general, it would have to sell for zero, 00:43:22.290 --> 00:43:26.119 because if it were positive, then I would be benefiting 00:43:26.119 --> 00:43:27.660 and the person who's selling it to me 00:43:27.660 --> 00:43:31.050 would be losing out and vice versa. 00:43:31.050 --> 00:43:33.200 So we can have our own speculative motives 00:43:33.200 --> 00:43:34.940 for doing the deal. 00:43:34.940 --> 00:43:37.610 But when the price is set, the way that it's set 00:43:37.610 --> 00:43:44.055 is not just based upon simple expectations of you and me. 00:43:44.055 --> 00:43:46.430 But it's the market that's determining the forward price. 00:43:46.430 --> 00:43:46.873 Yeah? 00:43:46.873 --> 00:43:48.289 AUDIENCE: Then what's the function 00:43:48.289 --> 00:43:52.137 of the over-the-counter market for the forward contract? 00:43:52.137 --> 00:43:53.720 ANDREW LO: The over-the-counter market 00:43:53.720 --> 00:43:55.480 is that you and I are the ones that 00:43:55.480 --> 00:43:57.194 are entering into the deal. 00:43:57.194 --> 00:43:58.610 And so we're signing the contract. 00:43:58.610 --> 00:44:00.260 So it's between us. 00:44:00.260 --> 00:44:03.470 But my point is that if the forward price that we are using 00:44:03.470 --> 00:44:07.010 to strike that deal is so one-sided, 00:44:07.010 --> 00:44:10.010 then it's going to be very clear from the market 00:44:10.010 --> 00:44:13.700 that that's a stupid contract for one of us to enter into. 00:44:13.700 --> 00:44:17.790 So it's a private transaction between you and me. 00:44:17.790 --> 00:44:20.220 And for that matter, if it's a private transaction, 00:44:20.220 --> 00:44:22.170 you're right that it could be the case 00:44:22.170 --> 00:44:24.810 that we can make up any price. 00:44:24.810 --> 00:44:28.560 Let's say $200 a barrel. 00:44:28.560 --> 00:44:34.740 Would you ever see a contract that's at $200 a barrel? 00:44:34.740 --> 00:44:40.350 No, because that would mean that either you or me 00:44:40.350 --> 00:44:42.130 is being really stupid. 00:44:42.130 --> 00:44:44.605 Now we're perfectly allowed to be stupid. 00:44:44.605 --> 00:44:47.970 The Constitution guarantees that right. 00:44:47.970 --> 00:44:51.810 But it's unlikely, because we know, both you and I, 00:44:51.810 --> 00:44:53.100 how oil is doing. 00:44:53.100 --> 00:44:57.450 And therefore, the price will be set to make that contract worth 00:44:57.450 --> 00:44:58.680 nothing. 00:44:58.680 --> 00:45:02.340 If it were not worth nothing, then one of us 00:45:02.340 --> 00:45:04.260 is making a very bad deal. 00:45:04.260 --> 00:45:07.080 And money is going to be exchanged from one party 00:45:07.080 --> 00:45:08.561 to the other. 00:45:08.561 --> 00:45:09.060 Yeah? 00:45:09.060 --> 00:45:11.410 AUDIENCE: Does this always have to happen 00:45:11.410 --> 00:45:14.594 between a buyer and a seller, or could that be in communities? 00:45:14.594 --> 00:45:15.760 ANDREW LO: Could it be what? 00:45:15.760 --> 00:45:17.301 AUDIENCE: Could it be in communities? 00:45:17.301 --> 00:45:19.480 ANDREW LO: I'm going to get to that in two minutes. 00:45:19.480 --> 00:45:21.520 Right now, it's only between buyer and seller. 00:45:21.520 --> 00:45:22.900 That's a forward contract. 00:45:22.900 --> 00:45:25.990 With the futures contract, that's a different story. 00:45:25.990 --> 00:45:27.200 Another question? 00:45:27.200 --> 00:45:29.320 AUDIENCE: I'm just wondering, does this actually 00:45:29.320 --> 00:45:31.141 assume physical delivery of the asset? 00:45:31.141 --> 00:45:32.140 ANDREW LO: Yes, it does. 00:45:32.140 --> 00:45:34.410 Yes, it does, although if it doesn't have to. 00:45:34.410 --> 00:45:36.914 If the contract that you strike as a forward contract 00:45:36.914 --> 00:45:38.830 is one where you don't want physical delivery, 00:45:38.830 --> 00:45:41.110 you can make it a pure bet-- a side bet. 00:45:41.110 --> 00:45:44.290 But in fact, typical forward contracts that are entered into 00:45:44.290 --> 00:45:47.200 are for physical delivery of the actual commodity 00:45:47.200 --> 00:45:49.120 being agreed upon, because that's 00:45:49.120 --> 00:45:50.320 why people enter into them. 00:45:50.320 --> 00:45:54.100 They need the oil or the gas or the copper. 00:45:54.100 --> 00:45:54.692 Yeah? 00:45:54.692 --> 00:45:56.050 AUDIENCE: What does [INAUDIBLE]? 00:45:56.050 --> 00:45:57.430 ANDREW LO: So let me get to that. 00:45:57.430 --> 00:45:59.230 I want to make sure we get all the other questions answered, 00:45:59.230 --> 00:46:00.400 though, before I go down. 00:46:00.400 --> 00:46:02.110 The last point that I want to make 00:46:02.110 --> 00:46:04.960 is that with a forward contract, because it's 00:46:04.960 --> 00:46:08.460 a contract between two parties, there 00:46:08.460 --> 00:46:10.930 is significant counterparty risk, 00:46:10.930 --> 00:46:14.490 meaning there is a risk that you don't pay up 00:46:14.490 --> 00:46:17.434 on your end of the deal or that I don't pay up 00:46:17.434 --> 00:46:18.350 on my end of the deal. 00:46:18.350 --> 00:46:24.270 There is a significant risk that one of the parties reneges. 00:46:24.270 --> 00:46:28.590 So this is not a riskless kind of a contract. 00:46:28.590 --> 00:46:32.100 It has significant default risk. 00:46:32.100 --> 00:46:35.580 How significant depends upon the counterparty. 00:46:35.580 --> 00:46:37.380 If you're dealing with-- 00:46:37.380 --> 00:46:40.420 I hate to say this-- but a AAA counterparty, 00:46:40.420 --> 00:46:42.850 then the risks should be small. 00:46:42.850 --> 00:46:46.286 But we all know what AAA means these days. 00:46:46.286 --> 00:46:47.910 It used to be the case that when you're 00:46:47.910 --> 00:46:50.250 dealing with a AAA counterparty, you had 00:46:50.250 --> 00:46:52.714 very little counterparty risk. 00:46:52.714 --> 00:46:54.630 But if you're dealing with a counterparty that 00:46:54.630 --> 00:46:56.877 doesn't have the same kind of financial wherewithal, 00:46:56.877 --> 00:46:58.710 then you're going to have to bear that risk. 00:46:58.710 --> 00:47:01.770 And it's up to you to decide, is it worth it to you 00:47:01.770 --> 00:47:03.060 to take that risk? 00:47:03.060 --> 00:47:04.120 Yeah? 00:47:04.120 --> 00:47:08.525 AUDIENCE: So in event of the very [INAUDIBLE] market 00:47:08.525 --> 00:47:13.962 fluctuation [INAUDIBLE], somebody will lose in the end 00:47:13.962 --> 00:47:15.270 upon the settlement. 00:47:15.270 --> 00:47:21.027 So is it common for people that participate in this to hedge 00:47:21.027 --> 00:47:23.332 their positions as well? 00:47:23.332 --> 00:47:24.377 [INAUDIBLE] 00:47:24.377 --> 00:47:25.960 ANDREW LO: To hedge counterparty risk? 00:47:25.960 --> 00:47:26.580 AUDIENCE: Yes. 00:47:26.580 --> 00:47:27.580 ANDREW LO: It is common. 00:47:27.580 --> 00:47:29.380 And you know how they do it? 00:47:29.380 --> 00:47:30.850 They don't use a forward contract. 00:47:30.850 --> 00:47:33.080 They use a futures contract. 00:47:33.080 --> 00:47:35.221 So we're going to get there in just a few minutes. 00:47:35.221 --> 00:47:36.970 Maybe I should go faster, given that there 00:47:36.970 --> 00:47:40.130 are all these questions that are anticipating the futures 00:47:40.130 --> 00:47:40.630 contract. 00:47:40.630 --> 00:47:42.046 Or maybe it's just that all of you 00:47:42.046 --> 00:47:43.780 are scared to death of counterparty risk, 00:47:43.780 --> 00:47:46.447 given what's going on, that you just want to get rid of it. 00:47:46.447 --> 00:47:49.030 So let me go quickly through an example of a forward contract. 00:47:49.030 --> 00:47:51.655 Then I'll get to your point, and I"ll show you how you go about 00:47:51.655 --> 00:47:56.172 hedging that risk by essentially doing a transaction every day. 00:47:56.172 --> 00:47:57.880 But I want to make sure we all understand 00:47:57.880 --> 00:47:59.870 the concept of a forward first. 00:47:59.870 --> 00:48:01.300 So here's an example. 00:48:01.300 --> 00:48:05.170 The current price of soybeans is $160 a metric ton. 00:48:05.170 --> 00:48:07.750 That's the current spot price-- 00:48:07.750 --> 00:48:10.590 the price today. 00:48:10.590 --> 00:48:13.150 And there's a tofu manufacturer that 00:48:13.150 --> 00:48:17.335 needs 1,000 tons, not now but three months from now. 00:48:17.335 --> 00:48:18.960 And they want to make sure they can get 00:48:18.960 --> 00:48:21.940 that 100,000 tons at that time. 00:48:21.940 --> 00:48:26.320 So they might enter into a three-month contract 00:48:26.320 --> 00:48:31.570 to buy 1,000 tons at 165 tons. 00:48:31.570 --> 00:48:34.570 So they're going to offer the seller of the soybeans-- 00:48:34.570 --> 00:48:35.580 the soybean farmer-- 00:48:35.580 --> 00:48:38.265 they'll offer them a little bit of a premium-- 00:48:38.265 --> 00:48:43.030 a $5 premium-- in order to lock in that price. 00:48:43.030 --> 00:48:44.980 Now it doesn't have to always be a premium. 00:48:44.980 --> 00:48:47.979 In certain cases, there could be a discount. 00:48:47.979 --> 00:48:50.020 And there are different names for those that I'll 00:48:50.020 --> 00:48:51.890 talk about in a few minutes. 00:48:51.890 --> 00:48:54.180 But for now, it's at 165. 00:48:54.180 --> 00:48:57.070 And it's what the market seems to agree 00:48:57.070 --> 00:49:00.320 is an appropriate price three months from now. 00:49:00.320 --> 00:49:03.370 So you've all identified, I think, 00:49:03.370 --> 00:49:05.080 the issues with a forward contract. 00:49:05.080 --> 00:49:06.020 There are two issues. 00:49:06.020 --> 00:49:09.070 One is illiquidity, and the second is counterparty risk. 00:49:09.070 --> 00:49:11.590 Illiquidity means, suppose that I no longer 00:49:11.590 --> 00:49:12.820 want to be in the contract-- 00:49:12.820 --> 00:49:15.690 I want out. 00:49:15.690 --> 00:49:17.910 Well, it's not easy for me to get out. 00:49:17.910 --> 00:49:20.820 I can't sell my contract unless I 00:49:20.820 --> 00:49:26.550 find somebody else who wants to buy soybeans at 165 tons three 00:49:26.550 --> 00:49:27.442 months from now. 00:49:27.442 --> 00:49:28.650 I can't get out of it easily. 00:49:28.650 --> 00:49:31.110 I can go back to the farmer and say, 00:49:31.110 --> 00:49:33.120 would you mind canceling the contract? 00:49:33.120 --> 00:49:36.020 And they'll probably say, well, it depends, where 00:49:36.020 --> 00:49:37.890 is the price of soybeans today? 00:49:37.890 --> 00:49:40.380 If the price of soybeans is at $180, 00:49:40.380 --> 00:49:42.270 I'm happy to cancel the contract. 00:49:42.270 --> 00:49:44.820 If the price of soybeans is at $50, sorry, 00:49:44.820 --> 00:49:47.250 you're stuck with the agreement. 00:49:47.250 --> 00:49:49.080 So the illiquidity is an issue. 00:49:49.080 --> 00:49:51.780 But then of course, counterparty risk 00:49:51.780 --> 00:49:53.610 is another issue that we have to deal with. 00:49:53.610 --> 00:49:54.360 Yeah, [INAUDIBLE]? 00:49:54.360 --> 00:50:00.120 AUDIENCE: [INAUDIBLE] trying to hedge the quantity. 00:50:00.120 --> 00:50:01.720 It's not the actual price. 00:50:01.720 --> 00:50:03.960 Do companies do that where they want to guarantee 00:50:03.960 --> 00:50:05.784 that there will be a supply? 00:50:05.784 --> 00:50:06.450 ANDREW LO: Yeah. 00:50:06.450 --> 00:50:07.560 Well, it's both. 00:50:07.560 --> 00:50:09.510 They want to guarantee that they have enough 00:50:09.510 --> 00:50:11.676 to be able to produce whatever they need to produce. 00:50:11.676 --> 00:50:14.300 So they need a certain amount of input. 00:50:14.300 --> 00:50:17.450 But they won't want to guarantee it at any price. 00:50:17.450 --> 00:50:20.490 They want to be able to figure out a reasonable price. 00:50:20.490 --> 00:50:23.510 So in this example of the tofu manufacturer, 00:50:23.510 --> 00:50:25.400 they need 1,000 tons in three months. 00:50:25.400 --> 00:50:27.260 That's definite. 00:50:27.260 --> 00:50:29.754 That's the quantity that they need. 00:50:29.754 --> 00:50:31.170 The question is, what's the price? 00:50:31.170 --> 00:50:34.950 If the current spot price is at $160, 00:50:34.950 --> 00:50:37.020 then they need to make a decision. 00:50:37.020 --> 00:50:39.690 In three months time, do they think 00:50:39.690 --> 00:50:44.400 that the price will be greater or less than 165? 00:50:44.400 --> 00:50:48.750 If they think that it may be much more than 165, 00:50:48.750 --> 00:50:50.220 then they'll enter into it. 00:50:50.220 --> 00:50:51.720 But if they think that there's going 00:50:51.720 --> 00:50:54.480 to be a huge crop of soybeans, because we've 00:50:54.480 --> 00:50:57.450 had a lot of rainfall and a lot of sunshine 00:50:57.450 --> 00:50:59.400 and there's no problem and we're going 00:50:59.400 --> 00:51:02.952 to have a glut of soybeans, then they may not do this at all. 00:51:02.952 --> 00:51:04.410 They may just say, huh, we're going 00:51:04.410 --> 00:51:06.550 to wait three months to see what happens. 00:51:06.550 --> 00:51:09.180 Of course, if it turns out that between now and three months 00:51:09.180 --> 00:51:11.590 from now there is some kind of bacteria 00:51:11.590 --> 00:51:17.100 that kills half the soybean crop, now it's $190 a ton, 00:51:17.100 --> 00:51:19.040 then they're in trouble. 00:51:19.040 --> 00:51:22.220 So as a tofu manufacturer, you got 00:51:22.220 --> 00:51:24.950 to ask yourself the question, how well 00:51:24.950 --> 00:51:27.980 do you know the soybean market, how much 00:51:27.980 --> 00:51:31.730 are you willing to bet your firm's franchise on soybeans 00:51:31.730 --> 00:51:33.740 being available at the price that you want 00:51:33.740 --> 00:51:36.570 to pay three months from now? 00:51:36.570 --> 00:51:37.880 OK. 00:51:37.880 --> 00:51:41.160 So it's both price and quantity. 00:51:41.160 --> 00:51:41.660 All right. 00:51:41.660 --> 00:51:44.450 Now we're going to get back to [INAUDIBLE] point 00:51:44.450 --> 00:51:48.290 about being worried about counterparty risk. 00:51:48.290 --> 00:51:50.510 And let's just talk about counterparty risk 00:51:50.510 --> 00:51:53.420 in very, very plain detail. 00:51:53.420 --> 00:51:56.330 Suppose that we enter into that soybean contract. 00:51:56.330 --> 00:51:58.910 So today, we agree to buy soybeans 00:51:58.910 --> 00:52:03.280 three months from now, as a tofu manufacturer, for $165 a ton. 00:52:06.090 --> 00:52:09.490 All right, now let's fast forward one month. 00:52:09.490 --> 00:52:11.500 We've got two months to go in our agreement-- 00:52:11.500 --> 00:52:13.270 in our forward agreement-- 00:52:13.270 --> 00:52:18.790 and all of a sudden, something happens in the soybean market, 00:52:18.790 --> 00:52:24.610 and the spot price for soybeans has now dropped to $100 a ton. 00:52:24.610 --> 00:52:28.750 Huge glut that has hit the market, because the weather 00:52:28.750 --> 00:52:36.790 was unexpectedly nicer, lots of rainfall, just tremendous crop 00:52:36.790 --> 00:52:37.820 output. 00:52:37.820 --> 00:52:42.660 So we got $100 a ton for soybeans. 00:52:42.660 --> 00:52:50.020 Now to the tofu manufacturer who's looking to do this deal, 00:52:50.020 --> 00:52:55.270 is he in better shape or worse shape in that circumstance? 00:52:55.270 --> 00:52:55.770 Why? 00:52:55.770 --> 00:52:59.160 Why is he in worse shape? 00:52:59.160 --> 00:53:03.270 He's agreed to buy it at $165, price is at 100. 00:53:03.270 --> 00:53:04.800 But what's the big deal? 00:53:04.800 --> 00:53:08.670 He was willing to do that a month ago. 00:53:08.670 --> 00:53:09.170 What's that? 00:53:09.170 --> 00:53:10.420 Same shape. 00:53:10.420 --> 00:53:12.240 Same shape. 00:53:12.240 --> 00:53:13.910 We agree? 00:53:13.910 --> 00:53:15.327 Worse-- why is it worse? 00:53:15.327 --> 00:53:17.035 AUDIENCE: Because his competitors already 00:53:17.035 --> 00:53:19.170 have access to [INAUDIBLE]. 00:53:19.170 --> 00:53:20.230 ANDREW LO: Right. 00:53:20.230 --> 00:53:23.310 So what do you think the competitors are going to do? 00:53:23.310 --> 00:53:24.030 Exactly. 00:53:24.030 --> 00:53:28.430 The competitors are going to drop the price of tofu. 00:53:28.430 --> 00:53:30.350 Soybeans have come down in price. 00:53:30.350 --> 00:53:33.260 The competitors are going to cut the price of tofu. 00:53:33.260 --> 00:53:35.570 And here you've got a manufacturer. 00:53:35.570 --> 00:53:37.610 If you argue that he's in the same shape, 00:53:37.610 --> 00:53:40.910 that means that he's going to keep the same price of tofu 00:53:40.910 --> 00:53:44.417 and he's going to pay $165 for what's worth $100. 00:53:44.417 --> 00:53:46.250 Basically, he's going to go out of business, 00:53:46.250 --> 00:53:49.520 because his competitors are going to eat his lunch. 00:53:49.520 --> 00:53:52.010 They're going to charge 40% less, 00:53:52.010 --> 00:53:53.960 and he'll have zero market share. 00:53:53.960 --> 00:53:57.480 And he may be able to withstand that for a period of time, 00:53:57.480 --> 00:53:59.430 but not for a sustained period of time. 00:53:59.430 --> 00:54:03.260 So this particular manufacturer of tofu is thinking, 00:54:03.260 --> 00:54:08.420 well, I could buy soybeans at $100 on the market now 00:54:08.420 --> 00:54:12.540 and I got two months before I have to make good on this, 00:54:12.540 --> 00:54:16.020 what if I just walk away from this forward agreement? 00:54:16.020 --> 00:54:19.870 Now legally, he's not supposed to do that. 00:54:19.870 --> 00:54:25.900 So what that means is that if he does do that, he can be sued. 00:54:25.900 --> 00:54:29.470 And from the tofu manufacturer's point of view, 00:54:29.470 --> 00:54:32.800 he might be thinking, well, they can sue me 00:54:32.800 --> 00:54:36.160 and we can figure it out, or I can follow through the contract 00:54:36.160 --> 00:54:39.130 and I'll go out of business, so if I'm faced with those two 00:54:39.130 --> 00:54:41.290 choices and that's my only choice, 00:54:41.290 --> 00:54:44.340 I'm going to renege on that contract 00:54:44.340 --> 00:54:46.820 and let them sue me and see what they get, 00:54:46.820 --> 00:54:49.470 maybe we'll settle out of court, maybe we 00:54:49.470 --> 00:54:51.240 won't, who knows what will happen, 00:54:51.240 --> 00:54:52.680 I'm willing to take that risk. 00:54:52.680 --> 00:54:53.970 That's a calculation. 00:54:53.970 --> 00:54:58.630 It's a business decision that has consequences. 00:54:58.630 --> 00:55:00.820 But it's got consequences for both parties. 00:55:00.820 --> 00:55:04.720 Now imagine you're the soybean farmer dealing with this tofu 00:55:04.720 --> 00:55:06.160 manufacturer. 00:55:06.160 --> 00:55:09.750 And you're rubbing your hands, because you locked in at $165 00:55:09.750 --> 00:55:11.290 a ton. 00:55:11.290 --> 00:55:13.990 But two months from now when you go 00:55:13.990 --> 00:55:17.860 to deliver these soybeans, you find out the warehouse 00:55:17.860 --> 00:55:19.210 is not accepting it. 00:55:19.210 --> 00:55:22.030 And you can't get this tofu manufacturer on the phone. 00:55:22.030 --> 00:55:23.710 He's not returning your calls. 00:55:23.710 --> 00:55:24.690 What do you do? 00:55:24.690 --> 00:55:25.190 Yeah? 00:55:25.190 --> 00:55:26.810 AUDIENCE: This is currently happening with oil. 00:55:26.810 --> 00:55:29.193 A lot of people locked in at $5.00 a gallon and now 00:55:29.193 --> 00:55:30.296 it's above $4.00. 00:55:30.296 --> 00:55:33.047 So the oil companies are scared that everyone's 00:55:33.047 --> 00:55:33.880 going to stiff them. 00:55:33.880 --> 00:55:34.796 ANDREW LO: Absolutely. 00:55:34.796 --> 00:55:37.150 There's counterparty risk that comes 00:55:37.150 --> 00:55:40.733 about when you've got dramatic changes in economic conditions. 00:55:40.733 --> 00:55:41.719 Yeah? 00:55:41.719 --> 00:55:44.677 AUDIENCE: But as far as I know, the system only 00:55:44.677 --> 00:55:47.873 gave you the [INAUDIBLE] deposit [INAUDIBLE] amount of the risk 00:55:47.873 --> 00:55:48.892 that you want to buy. 00:55:48.892 --> 00:55:49.600 ANDREW LO: Right. 00:55:49.600 --> 00:55:51.880 So now you're talking about collateral. 00:55:51.880 --> 00:55:54.700 In order to be able to enter into a forward agreement, 00:55:54.700 --> 00:55:57.440 you might, before you even start talking, say, 00:55:57.440 --> 00:56:00.700 you know what, I'm not going to do business with you unless you 00:56:00.700 --> 00:56:02.420 put up some money-- 00:56:02.420 --> 00:56:06.880 so money as a kind of collateral for making good on it. 00:56:06.880 --> 00:56:09.070 And if you don't make good on it, 00:56:09.070 --> 00:56:11.270 I get to keep the collateral. 00:56:11.270 --> 00:56:13.386 Now the question is, how big is the collateral, 00:56:13.386 --> 00:56:14.260 and what is it worth? 00:56:14.260 --> 00:56:17.010 AUDIENCE: So you say, what reason do you want to buy? 00:56:17.010 --> 00:56:20.510 If you just want to buy a $30 risk [INAUDIBLE], 00:56:20.510 --> 00:56:22.986 so you put $30 [INAUDIBLE] want to buy. 00:56:22.986 --> 00:56:25.446 But you, from the beginning, can say, how much 00:56:25.446 --> 00:56:26.775 [INAUDIBLE] do you want to buy? 00:56:26.775 --> 00:56:28.900 ANDREW LO: Well, but the thing is that they may not 00:56:28.900 --> 00:56:29.733 be willing to do it. 00:56:29.733 --> 00:56:31.300 So let's do the example of soybeans. 00:56:31.300 --> 00:56:36.090 Soybeans at $165 a ton multiplied by 1,000 tons 00:56:36.090 --> 00:56:38.910 is $165,000. 00:56:38.910 --> 00:56:40.122 Right? 00:56:40.122 --> 00:56:44.280 AUDIENCE: I can put [INAUDIBLE] 00:56:44.280 --> 00:56:46.170 ANDREW LO: Right. 00:56:46.170 --> 00:56:50.280 So in order to do the deal, maybe you would agree to put 00:56:50.280 --> 00:56:53.790 $5.00 a ton of deposit as collateral. 00:56:53.790 --> 00:56:55.410 OK? 00:56:55.410 --> 00:56:56.940 That sounds good, right? 00:56:56.940 --> 00:56:59.860 And as a counterparty, I might be happy with that. 00:56:59.860 --> 00:57:04.370 OK, now say the price of soybeans drops to $100 a ton. 00:57:04.370 --> 00:57:08.680 And you've put $5.00 down as earnest money as collateral. 00:57:08.680 --> 00:57:13.570 And so from your perspective, as long as the price goes down 00:57:13.570 --> 00:57:16.090 by more than $5.00, you're going to walk away. 00:57:16.090 --> 00:57:18.070 AUDIENCE: [INAUDIBLE] but I lose the $5.00. 00:57:18.070 --> 00:57:18.350 ANDREW LO: Right. 00:57:18.350 --> 00:57:19.302 You lose the $5.00. 00:57:19.302 --> 00:57:20.260 I'm the soybean farmer. 00:57:20.260 --> 00:57:21.640 Great, I got $5.00 a ton. 00:57:21.640 --> 00:57:22.640 What's that going to do? 00:57:22.640 --> 00:57:24.700 That pays for my postage. 00:57:24.700 --> 00:57:26.380 That doesn't do anything for me. 00:57:26.380 --> 00:57:31.030 So given that I'm worried about your counterparty risk, 00:57:31.030 --> 00:57:34.960 I'm going to say, you know what, I don't want $5.00 a ton, 00:57:34.960 --> 00:57:37.630 I want you to pay me $160 a ton now, 00:57:37.630 --> 00:57:40.000 I want you to deposit that in the bank and put it 00:57:40.000 --> 00:57:41.530 in collateral. 00:57:41.530 --> 00:57:43.750 Would you be willing to do that? 00:57:43.750 --> 00:57:47.509 AUDIENCE: Depends on the rate and the-- 00:57:47.509 --> 00:57:48.300 ANDREW LO: Exactly. 00:57:48.300 --> 00:57:51.510 It depends upon what you think the risks are that the price is 00:57:51.510 --> 00:57:53.800 going to go down quite a bit. 00:57:53.800 --> 00:57:57.780 But in general, you're not going to want to tie up $160 a ton 00:57:57.780 --> 00:58:01.110 for three months if you don't have to, because that costs you 00:58:01.110 --> 00:58:01.620 something. 00:58:01.620 --> 00:58:04.690 The opportunity cost is the interest rate. 00:58:04.690 --> 00:58:05.219 Yeah? 00:58:05.219 --> 00:58:07.260 AUDIENCE: Why don't I just make a contract saying 00:58:07.260 --> 00:58:10.600 I would buy at a 10% markup instead 00:58:10.600 --> 00:58:12.480 of setting a specific price? 00:58:12.480 --> 00:58:14.830 Does it no longer [INAUDIBLE]? 00:58:14.830 --> 00:58:15.874 ANDREW LO: Well, no. 00:58:15.874 --> 00:58:17.040 You could certainly do that. 00:58:17.040 --> 00:58:19.110 But it's not clear that that really makes any difference. 00:58:19.110 --> 00:58:20.280 10% markup over what? 00:58:20.280 --> 00:58:21.570 You have to define something. 00:58:21.570 --> 00:58:22.903 AUDIENCE: The price at the time. 00:58:22.903 --> 00:58:25.500 ANDREW LO: Over the prevailing market price. 00:58:25.500 --> 00:58:28.320 You could do that. 00:58:28.320 --> 00:58:30.310 [INTERPOSING VOICES] 00:58:30.310 --> 00:58:30.810 Right. 00:58:30.810 --> 00:58:32.050 What's the benefit of that? 00:58:32.050 --> 00:58:34.720 That doesn't lock in anything. 00:58:34.720 --> 00:58:38.120 It may lock in the supply, but it doesn't lock in the price. 00:58:38.120 --> 00:58:39.800 You still have price uncertainty. 00:58:39.800 --> 00:58:42.880 So if you do that, unless you're worried about a shortage, 00:58:42.880 --> 00:58:46.540 you can always get something for 10% above the price, 00:58:46.540 --> 00:58:49.990 at least I think you can. 00:58:49.990 --> 00:58:51.460 Markets are pretty crazy. 00:58:51.460 --> 00:58:54.670 But if I were to tell you that no matter what commodity we're 00:58:54.670 --> 00:58:58.060 talking about, I'm willing to pay 10% more than the market 00:58:58.060 --> 00:59:00.290 price, my guess is that everybody here would 00:59:00.290 --> 00:59:01.540 be pretty happy to sell to me. 00:59:01.540 --> 00:59:03.090 Right? 00:59:03.090 --> 00:59:03.646 Yeah? 00:59:03.646 --> 00:59:06.322 AUDIENCE: But these [INAUDIBLE] evaluated by anybody. 00:59:06.322 --> 00:59:10.275 So are these just contracts between producer and supplier? 00:59:10.275 --> 00:59:10.900 ANDREW LO: Yes. 00:59:10.900 --> 00:59:11.580 AUDIENCE: So they're like longstanding agreements 00:59:11.580 --> 00:59:12.360 and I'm just-- 00:59:12.360 --> 00:59:12.640 ANDREW LO: Right. 00:59:12.640 --> 00:59:13.181 That's right. 00:59:13.181 --> 00:59:15.640 These are not governed by any agency 00:59:15.640 --> 00:59:18.280 or any kind of standardization. 00:59:18.280 --> 00:59:21.640 And you now see the problem with these contracts. 00:59:21.640 --> 00:59:25.900 These contracts work if the two parties know each other, 00:59:25.900 --> 00:59:28.750 they've done business for years, there's a lot of trust, 00:59:28.750 --> 00:59:30.750 you don't have to worry about counterparty risk, 00:59:30.750 --> 00:59:32.500 you've got the right amount of collateral, 00:59:32.500 --> 00:59:36.210 you've got the right rating, on and on. 00:59:36.210 --> 00:59:37.950 It's complicated. 00:59:37.950 --> 00:59:40.351 Isn't there a way to make this simpler? 00:59:40.351 --> 00:59:41.850 And the answer is that there's a way 00:59:41.850 --> 00:59:45.500 to deal with all of your objections-- all of them. 00:59:45.500 --> 00:59:48.390 Let's create a new contract called a futures. 00:59:48.390 --> 00:59:52.290 A futures contract is exactly like a forward 00:59:52.290 --> 00:59:55.360 with a few exceptions. 00:59:55.360 --> 00:59:58.510 Exception number one, we're going to standardize a futures 00:59:58.510 --> 01:00:00.040 contract. 01:00:00.040 --> 01:00:03.490 One contract applies to a fixed amount 01:00:03.490 --> 01:00:06.940 of the commodity of a fixed quality that 01:00:06.940 --> 01:00:11.110 is known in advance and is decided objectively. 01:00:11.110 --> 01:00:16.990 It expires, or it settles, on a fixed date. 01:00:16.990 --> 01:00:21.010 And there is a futures price. 01:00:21.010 --> 01:00:25.470 And the price is determined on an exchange. 01:00:25.470 --> 01:00:29.520 OK, so that's one set of changes. 01:00:29.520 --> 01:00:33.570 But the other set of changes is really important, 01:00:33.570 --> 01:00:40.860 which is that we are going to mark to market every day. 01:00:40.860 --> 01:00:44.980 Now what does mark to market mean? 01:00:44.980 --> 01:00:47.290 If you've got a futures contract-- 01:00:47.290 --> 01:00:49.540 or rather, if you've got a forward contract that 01:00:49.540 --> 01:00:54.520 expires in three months, initially it's worth nothing. 01:00:54.520 --> 01:01:00.110 But over time, as the spot price fluctuates, 01:01:00.110 --> 01:01:03.780 that forward contract has value. 01:01:03.780 --> 01:01:07.200 But no money changes hands. 01:01:07.200 --> 01:01:11.400 And so because no money changes hands, and apart 01:01:11.400 --> 01:01:15.180 from collateral, you can have a really big mismatch 01:01:15.180 --> 01:01:19.480 in the value of the contract to one party or another. 01:01:19.480 --> 01:01:22.020 So let's go back to the soybean example. 01:01:22.020 --> 01:01:24.420 I start out by agreeing to buy soybeans 01:01:24.420 --> 01:01:30.120 from you at $165 a metric ton three months from now. 01:01:30.120 --> 01:01:33.340 And the spot price today is 160. 01:01:33.340 --> 01:01:34.170 All right. 01:01:34.170 --> 01:01:43.600 A month from now, let's say, the spot price is down to 150. 01:01:43.600 --> 01:01:46.180 What do you think that contract is going 01:01:46.180 --> 01:01:48.229 to be worth at that point? 01:01:52.100 --> 01:01:53.172 Yeah? 01:01:53.172 --> 01:01:55.241 AUDIENCE: [INAUDIBLE] 01:01:55.241 --> 01:01:56.240 ANDREW LO: That's right. 01:01:56.240 --> 01:01:56.600 $15. 01:01:56.600 --> 01:01:57.530 How did you get $15? 01:01:57.530 --> 01:02:01.341 AUDIENCE: It's the difference between the future price 01:02:01.341 --> 01:02:03.320 and the spot today. 01:02:03.320 --> 01:02:04.340 ANDREW LO: That's right. 01:02:04.340 --> 01:02:08.140 I've agreed to buy it for $165. 01:02:08.140 --> 01:02:15.530 The spot price two months from maturity is $150. 01:02:15.530 --> 01:02:17.840 That's $15 difference. 01:02:17.840 --> 01:02:21.410 And so this piece of paper obligates me to buy it 01:02:21.410 --> 01:02:24.030 for $15 more than today. 01:02:24.030 --> 01:02:26.900 So from my perspective-- the buyer-- 01:02:26.900 --> 01:02:31.890 the contract is worth not zero, but it's worth negative 01:02:31.890 --> 01:02:34.560 $15 divided by the rate of interest, 01:02:34.560 --> 01:02:36.390 because I don't have to pay the $15 today. 01:02:36.390 --> 01:02:39.450 I have to pay the $15 at maturity, at settlement. 01:02:39.450 --> 01:02:43.530 For you, the farmer who sold me that contract, that contract-- 01:02:43.530 --> 01:02:48.720 to you, it's worth $15 per 1,000 metric tons divided 01:02:48.720 --> 01:02:51.390 by the appropriate discount factor-- the interest rate-- 01:02:51.390 --> 01:02:52.710 for that three months. 01:02:52.710 --> 01:02:56.910 Now to say that it's worth that really means it's worth that. 01:02:56.910 --> 01:02:58.800 For example, if you decide that you 01:02:58.800 --> 01:03:01.380 want to get out of the soybean farming business 01:03:01.380 --> 01:03:02.880 and you want to take that contract 01:03:02.880 --> 01:03:05.880 and sell it to one of your fellow farmers, 01:03:05.880 --> 01:03:10.530 they'll pay you $15 divided by the appropriate interest 01:03:10.530 --> 01:03:13.147 rate per 1,000 metric tons. 01:03:13.147 --> 01:03:14.730 You will be able to sell that contract 01:03:14.730 --> 01:03:15.771 for that amount of money. 01:03:18.600 --> 01:03:22.530 So after date zero, as the spot price fluctuates, 01:03:22.530 --> 01:03:27.800 this forward agreement ends up taking on economic value, 01:03:27.800 --> 01:03:31.520 because the prices fluctuate. 01:03:31.520 --> 01:03:34.100 If we allow that price fluctuation-- 01:03:34.100 --> 01:03:36.350 if we allow the value of that contract 01:03:36.350 --> 01:03:38.880 to get really, really big-- 01:03:38.880 --> 01:03:43.010 in my crazy example, if the spot price goes down to 100-- 01:03:43.010 --> 01:03:45.170 well, then that piece of paper is worth a lot 01:03:45.170 --> 01:03:46.550 to you, the farmer. 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. 01:03:51.230 --> 01:03:52.550 That's a big loss. 01:03:52.550 --> 01:03:57.110 The bigger the loss, the more likely it is that one of us 01:03:57.110 --> 01:03:58.440 is not going to perform. 01:03:58.440 --> 01:03:59.120 Why? 01:03:59.120 --> 01:04:03.020 Because the collateral-- if we have a collateral of $5.00 per 01:04:03.020 --> 01:04:08.120 1,000 metric tons, that $5.00 is going to become meaningless 01:04:08.120 --> 01:04:13.490 pretty soon, because I'm looking at a loss of $50. 01:04:13.490 --> 01:04:17.780 If it goes down from $165 to $100, 01:04:17.780 --> 01:04:20.060 I'm looking at a really big loss-- 01:04:20.060 --> 01:04:22.370 $65 per metric ton. 01:04:22.370 --> 01:04:24.770 $5.00 means nothing to me. 01:04:24.770 --> 01:04:28.220 So the bigger the fluctuations away 01:04:28.220 --> 01:04:33.630 from the initial forward price, the bigger 01:04:33.630 --> 01:04:36.190 the potential for counterparty risk. 01:04:36.190 --> 01:04:40.630 So if that's the case, let's you and I agree on something. 01:04:40.630 --> 01:04:44.510 Why don't we agree that every single day, we 01:04:44.510 --> 01:04:50.350 will strike a new contract with a new forward price, 01:04:50.350 --> 01:04:53.390 and then we'll just pay each other the difference 01:04:53.390 --> 01:04:55.450 day by day? 01:04:55.450 --> 01:04:57.340 So in other words, in your example, 01:04:57.340 --> 01:05:00.760 let's say it's $165 today. 01:05:00.760 --> 01:05:01.750 We agree on that. 01:05:01.750 --> 01:05:05.410 The spot price is at $160. 01:05:05.410 --> 01:05:11.180 Let's say tomorrow the spot price goes down to $155. 01:05:11.180 --> 01:05:15.380 OK, you know what, let's you and I agree I'm going to just pay 01:05:15.380 --> 01:05:21.280 you $5.00 divided by the interest over the next three 01:05:21.280 --> 01:05:26.546 months minus a day, and then let's cancel the contract. 01:05:26.546 --> 01:05:28.980 And let's start a new one. 01:05:28.980 --> 01:05:32.870 And let's say that now, today, we're 01:05:32.870 --> 01:05:37.010 going to agree to not $165, but $160. 01:05:37.010 --> 01:05:38.480 The spot price is at $155. 01:05:38.480 --> 01:05:40.704 Let's agree to $160. 01:05:40.704 --> 01:05:43.690 OK? 01:05:43.690 --> 01:05:46.180 And now another day passes by. 01:05:46.180 --> 01:05:48.970 And let's see the price goes down yet again, now down 01:05:48.970 --> 01:05:52.984 to $155. 01:05:52.984 --> 01:05:54.880 AUDIENCE: [INAUDIBLE] $5.00. 01:05:54.880 --> 01:05:56.170 ANDREW LO: Yes. 01:05:56.170 --> 01:05:57.130 Right. 01:05:57.130 --> 01:06:01.000 Or I give you $5.00, you give me $5.00. 01:06:01.000 --> 01:06:03.430 Every single day, we exchange money. 01:06:03.430 --> 01:06:06.370 And every single day, we get rid of the old contract 01:06:06.370 --> 01:06:11.620 and we do a whole new one with a new forward price that reflects 01:06:11.620 --> 01:06:13.840 current market conditions. 01:06:13.840 --> 01:06:14.587 If we do that-- 01:06:14.587 --> 01:06:16.920 well, first of all, it's going to be a pain in the neck, 01:06:16.920 --> 01:06:19.045 because we have to do a lot of contracts every day. 01:06:19.045 --> 01:06:20.720 But suppose we did that. 01:06:20.720 --> 01:06:24.520 If we did that every day, then what we would be doing 01:06:24.520 --> 01:06:29.860 is essentially always figuring out what today's market 01:06:29.860 --> 01:06:34.840 price is for soybean delivery on that settlement date. 01:06:38.370 --> 01:06:41.740 That's what it means to mark to market. 01:06:41.740 --> 01:06:45.460 At every single day, the price of the contract 01:06:45.460 --> 01:06:49.350 reflects today's market valuation, 01:06:49.350 --> 01:06:52.140 not when we did the contract at the beginning 01:06:52.140 --> 01:06:53.670 of that three-month period. 01:06:53.670 --> 01:06:56.610 Every single day as we get closer and closer 01:06:56.610 --> 01:07:01.410 to settlement, we are revising the forward price 01:07:01.410 --> 01:07:03.360 to reflect all the information that's 01:07:03.360 --> 01:07:05.760 accumulated up to that point. 01:07:05.760 --> 01:07:09.600 And I'm either paying you, or you're paying me. 01:07:09.600 --> 01:07:12.420 We're changing money every day so 01:07:12.420 --> 01:07:20.010 that the value of the agreement is never that far out of sync 01:07:20.010 --> 01:07:23.390 from the market's value. 01:07:23.390 --> 01:07:26.360 That way, we can protect this kind of counterparty risk, 01:07:26.360 --> 01:07:29.920 because then the only risk I'm going to have with you 01:07:29.920 --> 01:07:33.100 is the risk that comes from a one-day fluctuation, not 01:07:33.100 --> 01:07:34.600 three months. 01:07:34.600 --> 01:07:37.040 Prices can move a lot in three months. 01:07:37.040 --> 01:07:41.585 But by that time, we will have changed money back and forth. 01:07:41.585 --> 01:07:42.460 And so you know what? 01:07:42.460 --> 01:07:45.379 When you add up all the money that's changed hands 01:07:45.379 --> 01:07:47.170 over the course of the entire three months, 01:07:47.170 --> 01:07:50.590 if we struck a new forward contract every day 01:07:50.590 --> 01:07:53.050 and then we added up all the money that went back and forth 01:07:53.050 --> 01:07:54.591 and did the interest rate just right, 01:07:54.591 --> 01:07:55.889 you know what we would get? 01:07:55.889 --> 01:07:57.430 We would basically get the same thing 01:07:57.430 --> 01:08:01.240 as if we had gotten a forward contract on day one 01:08:01.240 --> 01:08:03.420 and held it to maturity. 01:08:03.420 --> 01:08:06.440 But the difference is that during that three-month period, 01:08:06.440 --> 01:08:08.420 you and I, we've never had to worry 01:08:08.420 --> 01:08:13.970 about either party reneging, because the amount of cash that 01:08:13.970 --> 01:08:17.779 is owed to one party or another has gotten so big 01:08:17.779 --> 01:08:20.500 that it makes it worthwhile to walk away. 01:08:20.500 --> 01:08:25.470 So a forward contract is a situation 01:08:25.470 --> 01:08:27.990 where you don't mark to market every day. 01:08:27.990 --> 01:08:31.740 You allow the value of that contract to go up and down 01:08:31.740 --> 01:08:34.529 and up and down to wherever the spot 01:08:34.529 --> 01:08:38.069 price determines that it does, in relation 01:08:38.069 --> 01:08:39.750 to that forward price. 01:08:39.750 --> 01:08:41.850 With the futures contract, you can 01:08:41.850 --> 01:08:46.740 think of a futures as a sequence of forward contracts 01:08:46.740 --> 01:08:51.180 where you cancel the forward contract every period 01:08:51.180 --> 01:08:56.381 but pay the difference that was won or lost relative to the day 01:08:56.381 --> 01:08:56.880 before. 01:08:59.689 --> 01:09:03.819 So there's one more piece that I have to tell you about. 01:09:03.819 --> 01:09:06.189 And that is that-- somebody asked about an intermediary 01:09:06.189 --> 01:09:07.490 with forward contracts. 01:09:07.490 --> 01:09:10.910 Forward contracts have no intermediary. 01:09:10.910 --> 01:09:13.500 But futures contracts do. 01:09:13.500 --> 01:09:17.189 Some clever person figured out that all of these other changes 01:09:17.189 --> 01:09:19.859 that we want to implement to create a futures contract 01:09:19.859 --> 01:09:25.010 is great, except that there is still this lingering 01:09:25.010 --> 01:09:29.630 concern that somehow you don't show up tomorrow 01:09:29.630 --> 01:09:35.890 when I want to basically do a deal and update my contract. 01:09:35.890 --> 01:09:38.229 So they came up with a brilliant idea 01:09:38.229 --> 01:09:42.700 of establishing an intermediary called the Futures Clearing 01:09:42.700 --> 01:09:44.229 Corporation. 01:09:44.229 --> 01:09:47.350 The Futures Clearing Corporation is an organization 01:09:47.350 --> 01:09:50.250 that sits between you and me. 01:09:50.250 --> 01:09:56.110 And what it does is simply serve as the counterparty. 01:09:56.110 --> 01:09:59.010 So I'm not dealing with you or you or you. 01:09:59.010 --> 01:10:00.930 I'm dealing with one organization that stands 01:10:00.930 --> 01:10:02.700 in the middle of everybody. 01:10:02.700 --> 01:10:04.650 I'm dealing with that organization, 01:10:04.650 --> 01:10:06.960 and you're dealing with that organization. 01:10:06.960 --> 01:10:10.380 And as long as that organization makes sure 01:10:10.380 --> 01:10:14.970 that there are two sides to every transaction-- 01:10:14.970 --> 01:10:17.790 more or less, two sides to every transaction-- 01:10:17.790 --> 01:10:21.480 then that will reduce the risk even more. 01:10:21.480 --> 01:10:24.630 So not only are the contracts standardized, 01:10:24.630 --> 01:10:28.230 not only are they mark-to-market every day, 01:10:28.230 --> 01:10:32.910 and not only do we re-establish this price every day, 01:10:32.910 --> 01:10:36.510 but we then now have the safety of a clearing corporation 01:10:36.510 --> 01:10:39.150 that we know will always be there to transact with us. 01:10:39.150 --> 01:10:41.790 So the market is highly, highly liquid. 01:10:44.660 --> 01:10:45.160 OK. 01:10:45.160 --> 01:10:45.990 Now-- question? 01:10:45.990 --> 01:10:46.490 Yeah? 01:10:46.490 --> 01:10:48.448 AUDIENCE: Are there any industries or companies 01:10:48.448 --> 01:10:52.420 that use forwards rather than futures? 01:10:52.420 --> 01:10:54.170 ANDREW LO: There are some. 01:10:54.170 --> 01:10:56.870 In fact, oil companies, airline companies, 01:10:56.870 --> 01:11:00.562 and other major producers or suppliers, 01:11:00.562 --> 01:11:02.270 they prefer forwards, simply because they 01:11:02.270 --> 01:11:04.436 don't want to deal with these mark-to-market issues. 01:11:04.436 --> 01:11:06.860 And they've dealt with their suppliers 01:11:06.860 --> 01:11:09.007 long enough that they trust them. 01:11:09.007 --> 01:11:11.090 And so they've got standardized forward agreements 01:11:11.090 --> 01:11:14.520 that are customized to exactly what they want. 01:11:14.520 --> 01:11:17.240 For example, a futures contract has very specific settlement 01:11:17.240 --> 01:11:17.920 dates. 01:11:17.920 --> 01:11:19.670 If those settlement dates don't correspond 01:11:19.670 --> 01:11:22.220 with when you need the particular input, 01:11:22.220 --> 01:11:25.180 then you don't want to use that. 01:11:25.180 --> 01:11:28.320 But by and large, the futures contracts 01:11:28.320 --> 01:11:31.740 eliminates a lot of these issues with forward contracts so that 01:11:31.740 --> 01:11:35.850 for liquidity, for transparency, for safety-- 01:11:35.850 --> 01:11:36.929 all of those reasons-- 01:11:36.929 --> 01:11:38.970 they are actually preferred to forward contracts. 01:11:38.970 --> 01:11:41.580 But forward contracts are still very popular. 01:11:41.580 --> 01:11:43.650 For example, there are some markets 01:11:43.650 --> 01:11:45.450 where forward contracts are actually 01:11:45.450 --> 01:11:47.040 even more popular than futures. 01:11:47.040 --> 01:11:49.410 One example-- currencies. 01:11:49.410 --> 01:11:51.600 For a variety of reasons, currencies-- 01:11:51.600 --> 01:11:57.480 where you trade with banks for different foreign currencies 01:11:57.480 --> 01:12:00.600 in the future, the futures exchanges 01:12:00.600 --> 01:12:05.250 have much lower volume, in terms of dollars traded or yen traded 01:12:05.250 --> 01:12:08.160 or cable traded, than the banks dealing 01:12:08.160 --> 01:12:10.110 with these forward contracts. 01:12:10.110 --> 01:12:11.104 Yeah, [INAUDIBLE]? 01:12:11.104 --> 01:12:12.479 AUDIENCE: Looks like in this case 01:12:12.479 --> 01:12:15.497 the interest rate risk is also a [INAUDIBLE] of the future. 01:12:15.497 --> 01:12:16.080 Is that right? 01:12:16.080 --> 01:12:16.990 ANDREW LO: The interest rate is what? 01:12:16.990 --> 01:12:19.100 AUDIENCE: Interest rate risk is also a risk. 01:12:19.100 --> 01:12:20.220 ANDREW LO: Yes, interest rate risk 01:12:20.220 --> 01:12:22.094 is definitely a part of it, because remember, 01:12:22.094 --> 01:12:24.900 we have to divide implicitly by the interest, 01:12:24.900 --> 01:12:27.960 because we're getting paid not now, but in three months or two 01:12:27.960 --> 01:12:29.690 months or 29 days and so on. 01:12:29.690 --> 01:12:30.940 So we're going to get to that. 01:12:30.940 --> 01:12:34.160 In fact, let me do some examples, 01:12:34.160 --> 01:12:36.660 and then we're going to talk about how interest rates figure 01:12:36.660 --> 01:12:38.580 into this explicitly. 01:12:38.580 --> 01:12:42.200 So here's an example of a futures contract. 01:12:42.200 --> 01:12:46.050 NYMEX-- the New York Mercantile Exchange, it's called NYMEX-- 01:12:46.050 --> 01:12:48.990 trades crude oil futures. 01:12:48.990 --> 01:12:52.310 Now there are lots of different kinds of oil. 01:12:52.310 --> 01:12:55.350 And there are futures contracts that are designated 01:12:55.350 --> 01:12:56.740 for a particular kind. 01:12:56.740 --> 01:13:00.480 So crude oil light is one. 01:13:00.480 --> 01:13:03.360 Another one is Brent crude oil-- 01:13:03.360 --> 01:13:05.190 oil from the Brent Seas. 01:13:05.190 --> 01:13:08.700 And each different kind of oil has a different contract. 01:13:08.700 --> 01:13:12.990 Remember, we have to standardize the underlying commodity. 01:13:12.990 --> 01:13:19.650 So NYMEX crude oil futures with delivery in December 2007 01:13:19.650 --> 01:13:27.090 at a price of $76.06 a barrel on July 27, 2007 where there's 01:13:27.090 --> 01:13:31.620 51,475 contracts traded. 01:13:31.620 --> 01:13:34.410 So this is a simple example of an actual contract that 01:13:34.410 --> 01:13:38.490 was traded in the good old days when oil was only $75 a barrel 01:13:38.490 --> 01:13:40.690 a year ago. 01:13:40.690 --> 01:13:43.270 Each contract is for 1,000 barrels. 01:13:43.270 --> 01:13:46.210 So that's part of the standardization. 01:13:46.210 --> 01:13:49.060 The tick size-- tick size meaning, 01:13:49.060 --> 01:13:53.260 what is the denomination that prices will change when they 01:13:53.260 --> 01:13:54.910 change up and down-- 01:13:54.910 --> 01:13:58.180 it's a penny a barrel. 01:13:58.180 --> 01:14:00.130 So in other words, with 1,000 barrels, 01:14:00.130 --> 01:14:02.350 if it moves a penny a barrel, that 01:14:02.350 --> 01:14:05.290 means the contract, which is for 1,000 barrels, 01:14:05.290 --> 01:14:08.530 moves in $10 increments. 01:14:08.530 --> 01:14:10.990 So when you buy one of these contracts, 01:14:10.990 --> 01:14:15.520 you are buying 1,000 barrels of oil 01:14:15.520 --> 01:14:18.610 to be delivered to you in December. 01:14:18.610 --> 01:14:22.120 That's what one of these contracts means. 01:14:22.120 --> 01:14:26.020 Now you actually have to put up some collateral 01:14:26.020 --> 01:14:28.130 for these as well. 01:14:28.130 --> 01:14:29.700 But think about it. 01:14:29.700 --> 01:14:37.580 If it's $75 a barrel and it's 1,000 barrels per contract, 01:14:37.580 --> 01:14:42.920 then how much oil are you controlling with one contract 01:14:42.920 --> 01:14:44.642 in dollar terms? 01:14:44.642 --> 01:14:46.510 Yeah, it's $75,000. 01:14:46.510 --> 01:14:49.990 That's a lot of money for one contract. 01:14:49.990 --> 01:14:53.050 Look at how much collateral you have to post. 01:14:53.050 --> 01:14:54.490 The amount of collateral that you 01:14:54.490 --> 01:14:58.090 have to give your broker to buy one of these contracts 01:14:58.090 --> 01:15:00.430 is $4,050. 01:15:00.430 --> 01:15:05.290 Now by the way, that collateral has increased by about 50% 01:15:05.290 --> 01:15:06.616 as of this morning. 01:15:06.616 --> 01:15:07.990 The New York Mercantile Exchange, 01:15:07.990 --> 01:15:11.080 Chicago Board of Trade, and other futures companies 01:15:11.080 --> 01:15:13.540 have increased margins across the board 01:15:13.540 --> 01:15:17.230 for most of the futures contracts because of concerns 01:15:17.230 --> 01:15:21.190 about liquidity and viability. 01:15:21.190 --> 01:15:24.340 Maintenance margin says that once you establish an account 01:15:24.340 --> 01:15:26.860 and put the $4,000, they know the money is 01:15:26.860 --> 01:15:30.550 going to go down or up as the price of oil goes down or up. 01:15:30.550 --> 01:15:34.380 But at all points in time, you have to keep at least $3,000 01:15:34.380 --> 01:15:34.880 in there. 01:15:34.880 --> 01:15:38.230 So in other words, the $4,000, you could lose some of that 01:15:38.230 --> 01:15:41.620 and it could go down to $3,500 or $3,250. 01:15:41.620 --> 01:15:45.580 But if it goes below $3,000, you're 01:15:45.580 --> 01:15:47.830 going to get a phone call from your broker that 01:15:47.830 --> 01:15:50.710 says, you need to deposit more money, 01:15:50.710 --> 01:15:52.990 you need to bring it up to $3,000, that's 01:15:52.990 --> 01:15:56.110 what you need to do to maintain the account. 01:15:56.110 --> 01:15:59.782 And you know what happens if you don't return that phone call? 01:15:59.782 --> 01:16:01.600 They get rid of the contract. 01:16:01.600 --> 01:16:03.970 You're out of the market. 01:16:03.970 --> 01:16:06.550 If you don't wire that money into the account by end 01:16:06.550 --> 01:16:09.400 of business on the day you get the margin call, 01:16:09.400 --> 01:16:13.943 they have the right, and they will close out your contract. 01:16:13.943 --> 01:16:17.022 AUDIENCE: [INAUDIBLE] 01:16:17.022 --> 01:16:19.230 ANDREW LO: Well, it depends on what your position is. 01:16:19.230 --> 01:16:21.540 No, you have whatever money you have left. 01:16:21.540 --> 01:16:23.620 But you no longer have the position in oil. 01:16:23.620 --> 01:16:26.100 So if that $3,000 goes down to $2,500, 01:16:26.100 --> 01:16:28.500 that's still your $2,500, but you no longer 01:16:28.500 --> 01:16:33.800 have a position in oil anymore at the end of business. 01:16:33.800 --> 01:16:36.060 That's one of the beauties of a futures contract, 01:16:36.060 --> 01:16:38.704 from the perspective of the counterparty. 01:16:38.704 --> 01:16:40.120 It's that they don't have to worry 01:16:40.120 --> 01:16:41.470 that you're going to run away. 01:16:41.470 --> 01:16:45.822 The most they can lose is one day's worth of fluctuation 01:16:45.822 --> 01:16:47.030 in the value of the contract. 01:16:47.030 --> 01:16:52.180 That's why for a $75,000 agreement, 01:16:52.180 --> 01:16:55.540 you only have to put down $4,000 earnest money. 01:16:55.540 --> 01:16:57.130 In the case of that soybean farmer, 01:16:57.130 --> 01:17:00.340 think about how much money you really would be comfortable 01:17:00.340 --> 01:17:02.770 requiring the counterparty to put down 01:17:02.770 --> 01:17:05.816 if you're going to exchange no money for three months. 01:17:05.816 --> 01:17:07.690 Three months, you never see the other person. 01:17:07.690 --> 01:17:09.010 You don't know whether they're still alive. 01:17:09.010 --> 01:17:11.410 You don't know what's going on with their business. 01:17:11.410 --> 01:17:14.200 You're going to actually have them put up a lot more money. 01:17:14.200 --> 01:17:16.180 With the futures contract, you only 01:17:16.180 --> 01:17:18.280 have to put up enough money to make sure 01:17:18.280 --> 01:17:24.235 that on a daily basis, you're not getting taken advantage of. 01:17:24.235 --> 01:17:24.734 Yeah? 01:17:24.734 --> 01:17:26.435 AUDIENCE: How's that initial margin set? 01:17:26.435 --> 01:17:28.810 ANDREW LO: The initial margin is set exactly the same way 01:17:28.810 --> 01:17:31.720 that the margin was going to be set with collateral 01:17:31.720 --> 01:17:33.440 for that soybean contract. 01:17:33.440 --> 01:17:35.410 It's the amount of money that they 01:17:35.410 --> 01:17:40.300 think is enough to cover any daily fluctuations 01:17:40.300 --> 01:17:43.370 in the underlying futures contract. 01:17:43.370 --> 01:17:46.840 So if the underlying price moves by a lot, 01:17:46.840 --> 01:17:48.940 what do you think that will do to the margin-- 01:17:48.940 --> 01:17:51.572 make it go up or down? 01:17:51.572 --> 01:17:52.500 Up. 01:17:52.500 --> 01:17:54.480 So now do you know why all of the exchanges 01:17:54.480 --> 01:17:57.240 decided to increase their margin? 01:17:57.240 --> 01:18:00.030 Fluctuations have started going up. 01:18:00.030 --> 01:18:04.050 And also, people's credit, in general, have gone down. 01:18:04.050 --> 01:18:04.722 Yeah? 01:18:04.722 --> 01:18:06.388 AUDIENCE: Just going back to your answer 01:18:06.388 --> 01:18:11.118 to [INAUDIBLE] physical goods, if you and I can enter 01:18:11.118 --> 01:18:15.054 into a futures contract [INAUDIBLE] traded, 01:18:15.054 --> 01:18:17.162 isn't physical delivery not really expected, 01:18:17.162 --> 01:18:19.622 especially with the margin cost? 01:18:19.622 --> 01:18:21.580 Just by [INAUDIBLE]. 01:18:21.580 --> 01:18:23.330 ANDREW LO: Yes, so with futures contracts, 01:18:23.330 --> 01:18:26.030 the majority of the people that use futures are not 01:18:26.030 --> 01:18:27.620 looking for physical delivery. 01:18:27.620 --> 01:18:31.550 But with most of the commodity futures contracts, 01:18:31.550 --> 01:18:33.290 you actually have to specify. 01:18:33.290 --> 01:18:38.810 So there have been stories of speculators 01:18:38.810 --> 01:18:44.060 that forgot to check the box that says Cash Settled Only 01:18:44.060 --> 01:18:47.390 that have gotten tons and tons of corn 01:18:47.390 --> 01:18:49.350 dumped on their front lawn. 01:18:49.350 --> 01:18:51.050 That has happened. 01:18:51.050 --> 01:18:53.510 It's been a while, but it's happened. 01:18:53.510 --> 01:18:55.730 Most futures contracts are cash settled. 01:18:55.730 --> 01:18:57.865 Cash settled means no physical delivery. 01:18:57.865 --> 01:18:59.240 But there are certain people that 01:18:59.240 --> 01:19:00.860 actually want the physicals. 01:19:00.860 --> 01:19:03.620 And so they will transact in the future markets 01:19:03.620 --> 01:19:05.900 to get physical delivery. 01:19:05.900 --> 01:19:07.410 OK, that's it for today. 01:19:07.410 --> 01:19:09.860 We will see you not Monday, because that's Columbus Day. 01:19:09.860 --> 01:19:12.800 But I'll see you a week from Monday.