Lecture 15: Forward and Futures Markets

What this lecture covers

This lecture asks what futures markets actually do and why they matter beyond finance itself. Shiller argues that futures markets are, in effect, markets that price the future, and that this is socially valuable even though speculation carries a poor public reputation. He builds the explanation historically, starting from the world's first true futures market in 17th-century Japan, then moves through modern agricultural, oil, and financial futures.

The lecture also develops the mechanics that separate futures from forward contracts: standardization, daily settlement through margin accounts, and the elimination of counterparty risk. After watching, you should be able to explain why futures markets reduce counterparty risk compared to forward contracts, read a futures curve, and use the fair-value formula to explain when a market is in contango or backwardation.

Key ideas

• Forwards vs. futures: forward contracts are private, non-standardized agreements between two counterparties and carry counterparty risk; futures are standardized, exchange-traded contracts that virtually eliminate that risk.
• Speculation as a social function: Shiller argues, citing Adam Smith and a comparative survey he ran in Moscow and New York, that people widely misunderstand speculative storage of commodities as harmful, when it actually smooths prices and helps prevent shortages.
• Standardization and centralization: the world's first true futures market, in Dojima, Japan (1600s), solved forward contracts' inconsistency and counterparty risk by standardizing contract terms and enforcing common trading hours, which is why futures prices, not messy spot prices, become the reference price for a commodity.
• Margin accounts and daily settlement: a trader posts a fraction of a futures contract's value as margin, and gains or losses are settled daily against that account; if the margin runs out, the broker simply closes the position, which is what removes counterparty risk from futures trading.
• Fair value formula: the futures price approximately equals (1 + r + s) x spot price, where r is the interest cost and s is the storage cost to the contract's maturity, explaining why futures prices are normally above spot prices (contango).
• Contango vs. backwardation: contango is a rising futures curve (the normal case, reflecting storage and interest costs); backwardation is a falling futures curve, which can occur when convenience yield (the benefit of having physical inventory on hand) makes storage effectively cheap or even valuable.
• Financial futures use a different formula: for stock index futures, the fair-value equation becomes (1 + r - y) x spot price, where y is the dividend yield, because stocks have no physical storage cost and are never depleted, so the futures curve mostly reflects interest and dividend rates, not new information about the future.

Walkthrough

Forwards vs. futures contracts and speculation in derivative markets (0:00)

Shiller distinguishes forwards from futures and defines both as derivatives, priced off an underlying market. He addresses the negative public perception of derivatives and speculation, citing a 1991 survey he ran comparing attitudes in Moscow and New York toward grain speculation, in which Americans were, on average, more likely than Russians to believe (incorrectly) that speculative storage worsens shortages.

The first futures market and the role of standardization (12:46)

The lecture traces the origin of futures trading to the Dojima rice market in Osaka, Japan, active from 1673, describing its 91 warehouses, standardized contracts, enforced trading hours (marked by a burning fuse and enforced with buckets of water), and a system of hand signals. Shiller explains that standardization is what let the futures price become the effective reference price for rice, since spot prices for a specific, variable batch of rice are much harder to interpret.

Rice futures and contango vs. backwardation (23:03)

Using a real rice futures curve from March 2011, Shiller shows an upward-sloping (contango) curve and explains why it does not represent an obvious arbitrage profit: storage costs prevent riskless gains from buying spot rice and selling futures. He connects the pattern to real-world food price pressures linked to unrest in the Middle East at the time, and to Adam Smith's argument that self-interested storage, not charity, is what prevents famine.

Counterparty risk and margin accounts (31:47)

Shiller explains how forward contracts expose both parties to counterparty risk, and how futures markets eliminate it through standardized exchange-traded contracts, margin accounts, and daily settlement, where gains and losses are credited or debited each day and a broker simply closes out a position if margin runs low.

Wheat futures and the fair value formula for futures pricing (37:50)

Using a soft red winter wheat futures curve, Shiller derives the fair-value formula futures price = (1 + r + s) x spot price, where r is the interest cost and s is storage cost over the contract horizon, and explains why the curve trends toward the spot price as maturity approaches, and why it typically drops around harvest time when storage is least needed.

Oil futures (47:00)

Shiller examines an oil futures curve from March 2011, showing initial contango followed by backwardation further out, and connects this to real-world supply uncertainty from the Middle East. He introduces the concept of convenience yield: businesses that depend on physical oil (like factories or refineries) may keep storing it even when futures prices are falling, because having oil on hand has its own value.

The history of the oil market (55:04)

The lecture reviews long-run inflation-adjusted oil prices back to 1871, covering early price swings from US discoveries, the Standard Oil monopoly and its breakup, decades of price stability under the Texas Railroad Commission, and then the two major oil crises: 1973-74, tied to OPEC's embargo during the Yom Kippur War, and 1979-80, tied to the Iranian Revolution and Iran-Iraq War. Shiller connects each crisis to a subsequent worldwide recession and notes the 2008 spike above $140 a barrel as a more puzzling episode linked to the broader financial crisis.

Financial futures and the difficulty of forecasting (1:08:16)

Shiller closes with S&P 500 index futures, explained through cash settlement (since delivering 500 stocks physically is impractical) and a modified fair-value formula (1 + r - y) x spot price using the dividend yield instead of storage cost. He emphasizes that because stocks are never "depleted" the way physical commodities are, the S&P 500 futures curve mostly reflects fair value rather than genuine information about future prices, so it should not be read as a market forecast.

Before you watch

• The earlier lecture on forward markets and forward interest rates provides useful groundwork, since this lecture builds directly on the forward-versus-futures distinction.
• Basic familiarity with what a spot price and an interest rate are will help with the fair-value formula.

Check your understanding

1. Why do futures markets eliminate counterparty risk in a way that forward contracts do not?
2. How does the fair-value formula explain why futures curves for storable commodities are usually upward sloping?
3. What is convenience yield, and how does it explain backwardation in a market like oil?
4. Why does Shiller argue that the S&P 500 futures curve is not useful for forecasting the future direction of the stock market, unlike an oil futures curve?
5. Using the historical oil price chart, how does Shiller connect the 1973-74 and 1979-80 oil crises to broader economic events?