Different financial instruments and who’s who in manipulating them? (Derivatives, futures, options, etc)
In: Economics
Derivatives are financial instruments whose value depends on something else. They can get quite complicated but you asked about futures and options.. All of them are essentially contracts.
With a future you agree today to buy or sell something at a price fixed today at some point in the future. These actually originated in commodities. As an example let’s say you are a company that makes hot dogs. For those hot dogs you need pork. I happen to be a pork farmer. I raise pigs.
Now a thing with commodities is that the price for them tends to fluctuate sometimes quite a lot and that is a risk for both of us. If the price of pork goes down a lot I am in shit as a farmer because I may have to sell my pigs at less than they cost me to raise at some point. If the price of pork happens to go up a lot though that’s good for me but very bad for you because now the pork you need to make your hot dogs becomes very expensive.
So we set up a contract between us. I will start raising 200 pigs and we agree between us that you will buy them at the current price of pork in 6 months time. We both eliminate risk. I am certain I can sell my pigs at a decent price. You are certain you can buy pork at a decent price for you in 6 months time.
That is the essence of a future. A contract for a trade to occur in the future at a specific price on a specific date. You bought the pork future so you will have to buy 200 pigs at date X 6 months in the future. I sold the future so I will have to sell you 200 pigs at that price in six months.
But then a month later a catastrophy happens! The Super Bowl is cancelled. This will dramatically lower how many hot dogs you can sell in half a year’s time… So you no longer want to be obligated to buy 200 pigs in 6 month’s time because you won’t need them. So you go to the banks. And you sell your contract to a banker. The bank goes oh yeah sure we’ll buy that contract from you to buy 200 pigs in now 5 month’s time. Why? Because that bank thinks the price for pork will go up anyway because they have noticed that the consumption of pork in China is rising rapidly and hence they think they will make a profit on that contract by eventually passing it off to a Chinese dumpling factory. So people start trading these futures EVEN IF they really have nothing to do with pigs.
That’s essentially how commodity futures work. If you got this one down I’ll expand in a next post how we then get to financial futures.
The economy is a self-actualising phenomena. If the global economy didn’t exist, it would be recreated very quickly just by people trying to trade goods and services. Many parts aren’t directly manipulated at all but are measurements of what’s happening. We actually have very few tools to direct it to do what we want – interest rates being the only one I can think of right now.
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