So again, when someone buys a futures contract, one agrees with the exchange through a daily settlement procedure. Now on the floor of the exchange, they traditionally used hand signals because, and this goes back to Dojima. This shows that Dojima is really the source of the whole idea of futures trading. So you get all these people together today in a so-called pit, where traders talk to each other. But there's so much noise that you can't hear someone standing right next to you, they're all shouting. So they developed a sign language. So you if wanted to buy futures, you'd put up a hand like this, meaning buy. And then you'd had ways of signaling your number, the price. And if you sell, I guess you have your hand out, meaning I want to sell. The Dojima contract also had some funny features. They wanted to impose a trading hours in Japan, back then, a long time ago. And so they didn't have clocks. So you couldn't put up a nice clock on the wall in those times. So they had a burning fuse. And just before the closing of trading, they would light the fuse and everyone would see the fire. And when the fire went out, that was a warning, like a five minute warning, the market will be closed as of that time. And they wanted to stop trading after the market closed. So they had what were called water men, who came with buckets of water. And they walked around the trading floor, and they looked for someone who was still trading. And they splashed them with water [LAUGH] to stop trading. We don't do that anymore. In fact, now it's all largely electronic. There still are. You can still go to the CME in Chicago and see people on the floor trading with their hand signals. But the last time I heard, I was there on the floor a few years ago. It looked awfully quiet. It's dying down because so much more is electronic. So as I mentioned before, there's Daily Settlement. Every day until expiration, a margin account is credited or debited with an amount equal to the change in the settle price times the contract amount. By the way, the settle price, you might think of that as the last trade of yesterday. But the problem is that they're worried about people trying to manipulate the last trade of yesterday. Because it could be a small trade, and then there would be big settlements based on the trade. So, in order to protect that, they have a settlement committee that looks at the final trades and asks whether they're representative. And they might choose a settle price, which is not the same as the closing price, the last price. All right, but the only difference is the last day. So if it's a physical delivery futures market, the last day is different. If you haven't closed out by the last day, if you're a seller, you'd better be there with your trucks of grains. And if you're a buyer, you'd better be there with empty trucks to load it in. Everyone else is closed out before the last day. The only people who do that are arbitrators. So a farmer in Iowa who's planting a crop expected to yield 50,000 bushels is essentially long 50,000 bushels. And so sells, let's say, ten Chicago September corn contracts for the price on that date and post margin. A corn produced products manufactured plants to buy corn at that time and buys the ten contracts. But again, they never talk to each other or meet each other or worry about each other, because they're both doing this with the exchange. So they locked in the price for both of them. >> I'm really curious about the role of arbitrage in the futures markets. Someone could, for example, take possession of rice or iron ore, but then if the price is too low, sell it at the spot price. However, if the underlying commodities actually index rather than a tangibly traded future, what is the role for arbitrage in creating some of that layer of efficiency? >> Okay, good question. So let me get back to the core idea of a futures market. Let's start with, as you described, physical delivery. So let's talk about a corn futures market. We have that at the Chicago Mercantile, CME Group. 1 contact is 5,000 bushels. You can buy corn for a year in the future. What does it mean to buy corn a year in the future? What it means is, I put up margin today. So 5,000 bushels might cost something like $50,000, depending on the price. So if I agree to buy 5,000 in 1 year at $10 a bushel, do I have to put up $50,000 today? No, you only have to put up margin today. And then your margin account is credited or depleted as the price changes. And at the final, there's a final settlement at the end where you either have to deliver the corn and take the, at the then futures price. And what tends to bring the futures price in line with corn price in the future is, as you say, the fact that if the futures price differed a lot from the price of corn. If the futures price were, let's say, below the spot price of corn on that date, then people would be buying the futures and bringing the corn for delivery and selling it. Which they tend to make the two convert. That's what you understand already. [LAUGH] But the other side is, what if the contract is cash settled? Then you have the same daily resettlement. So if I buy S&P 500 Index futures for delivery in one year, what it means is that the price today, if it never changed, would lead me to a settlement at the end. Well, there's two S&P Index futures. There's one, the regular conventional one, which is $250 times the index. And there's the E-mini, which is $50 times the index. Now there's nothing you can deliver. You can't deliver the S&P 500 Index. It's just a number. But it's the same thing, that you have to put up margin at the beginning. And then the daily resettlement, based on changes in the futures market, will raise or lower your margin account. But when you come to the end, there's a final settlement. Now this is maybe what is a little bit tricky to understand. The final settlement does not involve you coming with 5,000 bushels of corn and arriving at the facility that receives corn. Or 5 empty trucks to receive 5,000 bushels of corn. There's no such thing. But on the last day, there's a final settlement, which is the difference between the last futures price and the actual index. It represents the profit or loss you would've made if you actually delivered the index. So that means that if the future's price is below the S&P 500 Index on the day before the final settlement, you can be an arbitrator just the same. All you have to do is buy a contract, and that's all you need to do because it'll automatically settle at the end as the difference between the index and the futures price. So, it's even easier to arbitrage the financial futures contract. So it happens quite reliably. That is, what's quite reliable is, on the last day, when the delivery day, that corn price future is going to be exactly the same as the price of, well, a bushel of corn. And the S&P 500 Index future is going to be, within a tiny margin of error, the same as the S&P 500 Index. So it's a clever system. I hope that I made that clear. But cash settlement opens up the possibility of doing many more kinds of. I was mentioning my home price future, that's a cash-settled contract. We can't deliver homes. That would be kind of tough. [LAUGH] How would you deliver a home? And also, homes are not standardized. They're all different. When you have a physical delivery as a settlement procedure, it has to be possible to define precisely what it is that's delivered. But homes are so variable, and some of them are beat up and run down. And some of them are beset by crime, and some of them are wonderful neighborhoods. It's all so intangible. So you need cash settled futures. It's kind of remarkable that cash settled futures didn't really occur until a few decades ago, because it's a great idea. It's one of those inventions in finance that I like to talk about.
