Futures and derivatives

Futures & derivatives As you can know companies finance most of their activities by way of internally generated cash flows. If they need more money they can raise them though issuing securities. Security is an instrument that signifies an ownership position in a corporation (in the form of a stock), a creditor relationship with a corporation or governmental body (in case of issuing bonds), or rights to ownership such as those represented by an option, subscription right, & subscription warrant.

Securities can be long term or short term, primary (like shares & bonds) & secondary (like options & warrants). According to the character of concluded contracts we distinguish between two types of markets: spot markets & futures markets. In the spot market the buying & selling of goods, currencies or securities are available for immediate delivery. As for the futures markets, here the buying & selling goods, currencies or securities

are for delivery at a future date for a price fixed in advance. If such a deal is standardized for fixed quantities & time periods, it’s called futures; if not, these individual, non-standard, over-the-counter deals between two parties are called forward contracts. Making contracts to buy or sell a commodity or financial instrument at a pre-arranged price in the future aims to act as a protection against price changes, exchange rates, interest rates & so on

is known as hedging. For example, if the prices of foodstuffs such as wheat, maize, tea or orange juice are frequently affected by droughts, floods & other extreme weather conditions. Consequently many producers & buyers of raw materials want to hedge, in order to guarantee next season’s prices. When commodity prices are expected to rise, future prices are obviously higher than (at a premium on) spot prices; when they are expected to fall, they are at a discount on spot price.

As well as businesses dealing with all these foodstuffs, many businesses want to buy or sell currencies at a guaranteed future price as in recent years exchange rates & interest rates have also fluctuate wildly. But even this step doesn’t protect from speculators, who are also active in currency futures markets, such as the London International Financial Futures Exchange (LIFFE). Buying securities or other assets in the hope of making a capital gain by

selling them at a higher price (or selling them in hope of buying them back at a lower price) is a very lucrative business, therefore, wide-spread. As well as currencies & commodities, there is also a huge futures market in stocks & shares. & here there is a possibility for speculators to profit from movements in a stock’s price without holding the stock itself. I’m speaking about options - securities giving a right – but not the obligation – to buy & sell

assets at a fixed price in the future. Options are classified as either call or put options. A “call” is an option to buy a particular asset whereas a “put” is an option to sell it. These options allow organizations to hedge their equity investments. An investor anticipating a rise in a share can buy a “call” option which, for a specified period, gives him the right to buy this share at an agreed level.

If he expects a fall he will buy a “put” option which entitles him to sell. A premium called “option money” is payable for the privilege. If the rise (or fall) in the share is greater than the premium, he will exercise his option & make a profit; if not, he will let the option lapse. In either case his risk is limited to the premium. In the “bull” market most options will be for the “call”, in a “bear” market most will be for the “put”.

The price at which the holder of a call/put option may buy/sell the underlying security is known as its exercise or strike price. A call (put) option has intrinsic value if its exercise price is below (above –for put option) the current market price of the underlying share. Call options with an exercise price below the underlying share’s current market price, & put options with an exercise price above the share’s market price, are described as being “in-the-money”.

On the contrary, call options with an exercise price higher than a share’s current market price, & put options with an exercise price lower than the share’s market price, are “out-of-money”. Within the past fifteen years the use of options has grown in all financial markets. It seems quite likely that foreign exchange options will grow further in coming years. One more way to profit from an expected drop in the price of a stock is short selling.

It means a sale of borrowed money. Options are merely one type of derivative instrument, I mean those, whose price depends on the movement of another price. Many companies nowadays also arrange currency or interest rate swaps with other companies or financial institutions. Swaps are transactions in which two parties swap financial assets by linking a foreign exchange transaction in cash to an opposite future business in the same currency.

Foreign Exchange Swap Markets have developed since the early 1980s. The oldest type of swap is the conventional foreign exchange deal whereby one currency is simultaneously bought spot & sold forward against another – meaning an immediate exchange of cash followed by a further reverse exchange at a specified date in the future. The idea of swapping has now spread further. By far the largest business volume amongst swaps occurs

in the so-called “vanilla interest rate swap”. A “plain vanilla”, or fixed-to-fixed foreign exchange, or currency swap is an exchange of a principal & interest payments associated with a fixed-rate loan in one currency for the principal & interest payments on a similar loan in a second currency. The first such swap between IBM & the World Bank was done in 1981. Since then the swap market has grown to over $1 billion &, in the process, has evolved several additional

types of currency swaps. All these things I talk about concerned profits one can get from derivatives. But I also have to mention about negative aspects of them. in the mid-1990s, various companies, local governments & financial institutions made spectacular losses with derivatives. The most famous was Barings Bank, which was bankrupted when a single trader in Singapore lost over $1 billion by speculating disastrously on futures & options on the

Nikkei 225 stock index, which is traded in Osaka & Singapore. So managing derivative risk needs strong corporate governance, from the top, & the understanding of derivatives on the part of senior management. Peter Baring of this Barings Bank didn’t understand derivatives. & he doesn’t own a bank any more…