Futures
The development of futures is deeply and closely associated with
agricultural farming and can probably best be described by an
example:
Each year a farmer ploughs his field and sows his seeds. However,
the farmer doesn’t know what price he will get for his crop
once it comes to harvest time. As such, he has to live with the
uncertainty of not knowing whether this year will be his last
in farming, or whether his crop is going to be worth its weight
in gold. What’s more, he is at the mercy of the weather.
In order to lessen his risk exposure, the farmer will look at
what crop he is growing and what the price of that crop is selling
for on the futures market in Chicago. He will then need to make
the decision of whether to sell his crop ahead of harvest time
on the Chicago futures exchange. Now, in the event that this year
there is a bumper harvest of his crop and supply out does demand,
he’ll make on the deal as he’ll have the future to
fall back on. On the other hand, if this year demand outs supply,
he’ll likely lose on the deal as he has to sell his crop
at the price he fixed in the future. Either way, he can live through
the growing period safely in the knowledge that he has fixed the
price he’ll sell his crop at when it comes to time to sell
it.
Now, the above is a very simplistic example as most farmers deal
with farming cooperatives, who then deal with Chicago in bulk,
rather than lots of individual farmers dealing directly with Chicago.
Also, in the interim period between the farmer making the deal
with the investor in Chicago, other investors can trade the future
among themselves. As such, it is extremely unlikely the farmer
is going to sell his crop to the person with whom he made the
initial deal.
On this basis, today it possible to trade futures in almost any
product.
Option
An option is very similar to a future, only here you are not actually
obligated to purchase the item, but are giving yourself the option
to purchase. Today options are very closely associated with foreign
exchange rates and work something like this:
You are a US corporation and want to buy some good from the UK.
Today the exchange rate between the US dollar and British pound
is 1 pound to 1 dollar 20 cents. You have to pay for you goods
in 30 days time, and trying to minimize what you believe to be
an exchange rate risk you purchase an option to buy US dollars
at 1 dollar 25 cents to every pound in 30 days time. Now, if the
exchange rate in 30 days time is 1 dollar 50 cents to 1 pound,
you are “in the money” and you exercise the option
– and win big! Alternatively, if the exchange rate is 1
dollar 25 cents to 1 pound you are “even” and you
can either exercise the option or not, up to you. Finally, if
the exchange rate is 1 dollar 10 cents to 1 pound, then you are
“out of the money” and may wish to let the option
lapse, taking a small loss with it.
The basic example above is known as a call option, i.e. you have
the right to exercise the option. A put option works the same
way, only the counterparty to the option contract has the right
to exercise the option against you.
Derivatives
As well as options and futures, from time-to-time you will also
hear the term ‘derivatives’ bounded about. As with
debentures earlier, derivatives is the more technical legal term
by which options and futures are known by and signifies that futures
and options are instruments whose price is determined by the price
movement of an underlying security or assets. In other words,
the value of a derivative derives from an underlying contract
– hence its name. But it is, in fact, the collective term
for options and futures, so don’t be put off if you hear
this term in the future.
