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Futures

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One of the financial terms that really puzzled me when I heard it was “derivatives”, which till then was to me only a mathematical concept. Naturally,derivatives would be the next in line for my writeups on finance. Derivatives, by definition are instruments(fancy word for “object”) that derive their value (and price) from an underlying commodity. This post will look at futures contracts which are just one kind of derivatives traded today. As I find a lot of finance rather hand-wavy, I shall stick to my hypothetical situation method.

Futures

Futures are agreements between two parties in which one takes up the obligation to buy a certain commodity(something tangible like gold/oil or intangible like a stock or bond) at a certain price on a certain date in the future. The price is fixed by the two parties depending on their outlook towards the value of the commodity in the future.

For instance, suppose we have a rice farmer and a grain dealer. The farmer produces 100 units of rice, which he sells either in the market or to anyone who offers a better price. Let us also assume for illustration purposes, that the current price of rice in the market is $3/unit and the farmer will be ready to sell in say, 2 weeks time.

So the farmer sits down one day to forecast the price of his grain and decides that in two weeks time, the price would decrease to $2.50/unit. Concurrently, the dealer does his own forecasting and thanks to being privy to some additional information predicts that the price of the grain will go up to $3.5/unit. The dealer also realises that if he waits till harvest time the farmer will not sell at a lower price and the dealer will lose his informational advantage.

To ensure a profit, the dealer approaches the farmer and proposes to buy all 100 units of his produce at $3/unit two weeks from today. The dealer also offers to pay the farmer $10 upfront for the right to buy the rice at $3/unit irrespective of the existing market price. To ensure that no one chickens out on the day of reckoning, the pair sign a contract making it obligatory for the dealer to buy from the farmer at $3/unit and the farmer to sell to the dealer at $3/unit. This is a pretty rough example of a futures contract with a price of $10. It is a derivative as it “derives” its value from the value of the underlying commodity(rice).

Getting back to the two people scenario, we can see that if the farmer was right and the price does settle at $2.5/unit, then through this deal, the farmer has ensured a profit of $60 ($50 on the sale + $10 for the future) while the dealer makes a loss of $60. On the other hand if the dealer is right and the price settles at $3.5, then the dealer makes a profit of $40 ($50 on the sale minus $10 for the future) with the farmer losing $40 ($50 from the crop sale minus the $10 he earned). For prices settling anywhere else, its easy enough to figure out the profit and loss made by either party.

Long and short of it…

This example also illustrates the two strategies prevalent in the futures trading market. Let us, for this section look at the two parties as merely holders of the future contract. The farmer is the original holder of the future (thanks to owning the underlying asset) and the dealer is the buyer. In this scenario we have two strategies, the first when the price is forecasted to fall(farmer’s perspective) and the second when the price is forecasted to rise(dealer’s perspective). When a person sells futures anticipating a fall in commodity price, it is called a “short” futures position, while buying futures anticipating an increase in the asset price is called a “long” futures position.

Futures are also based on the more intangible commodities like shares, wherein traders take long or short positions depending on whether they think the share price will increase or decrease. Futures deriving their value from shares (known as “equity futures”) are more complex in the sense that there is no waiting period as there was for the rice in the example and demand and supply for futures is heavily dependent on what information traders have regarding the company and their share price forecasts.

Futures can therefore be used to make money in both a rising and a falling market by taking a long or short position respectively. Theoretically, one should also be able to minimise the risk by simultaneously buying and selling futures with the same underlying asset, ensuring an income irrespective of the market. There is quite a lot more to futures, but I will leave that to those more interested to read about from the references I have listed. As always, any corrections/additions from those more knowledgeable than me in this regard are welcome…

References:

1) http://www.liffe.com/liffeinvestor/introduction/how/index.htm
2) http://en.wikipedia.org/wiki/Futures_contract

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Written by clueso

April 29, 2008 at 11:23 pm

Posted in Uncategorized

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