Derivatives and futures

DERIVATIVES AND FUTURES

Stocks and bonds have existed, in various forms, for hundred of years. More recent financial instruments include futures and forward contracts, options and swaps, often being classified under the more general term of financial derivatives. Some of these instruments are rather more difficult to understand than stocks and bonds, which is why they have recently begun to appear regularly in the news, as various banks, companies, and local governments have suffered serious problems, or even bankruptcy, as a result of using derivatives.

A derivative is a financial instrument that derives or gets its value from some real good or stock. It is in its most basic form simply a contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.

A financial derivative is a tradable security whose value is derived from the actual or expected price of some underlying asset, which may be a commodity, a security, or a currency. Derivatives include futures contracts, futures on stock market indices, options, and swaps. Derivatives can be used as a hedge, to reduce risk, or for speculation. A derivative market is a market such as the London International Financial Futures and Options Exchange /LIFFE/ on which derivatives are traded.

The largest appeal of derivatives is that they offer some degree of leverage. Leverage is a financial term that refers to the multiplication that happens when a small amount of money is used to control an item of much larger value. A mortgage is the most common form of leverage. For a small amount of money and taking or. the obligation of a mortqage a person gains control of a property of much larger value than the small amount of money that has exchanged hands.

Derivatives offer the same sort of leverage or multiplication as a mortgage. For a small amount of money, the investor can control a much larger value of company stock than would be possible without use of derivatives. This can work both ways, though. If the investor purchasing the derivative is correct, then more money can be made than if the investment had been made directly into the company itself. However, if the investor is wrong, the losses are multiplied instead.

Derivatives made the news in 1995 when rogue trader Nick Leeson single-handedly caused the failure of the Barings bank of England. Nick Leeson was a derivatives trader whose trades did not work out, and due to the enormous leverage of the trades used, the losses became so large that the bank was bankrupt when the results of his trades become due. Warren Buffet, a much revered and very successful investor, has stated in one of his annual reports that he is very much against the use of derivatives and he expects that they will lead to eventual failure for anyone who uses them. In spite of all this negative press, derivatives have long been a normal part of business and investing and are likely to be so for many more years

Futures and forward contracts are known as financial derivatives.

A futures contract is a contract to buy or sell a good, share, or currency on a future date, at a price decided when the contract is entered into. A futures contract entails for both parties both the right and the obligation to trade; it is contrasted with an option, which confers only the right to trade on one party and only the obligation on the other. A futures contract obligates the seller to provide a commodity or other asset to the buyer at an agreed-upon date. Futures are widely traded for commodities such as sugar, coffee, oil and wheat, as well as for financial instruments such as stock market indexes, government bonds and foreign currencies.

The earliest known futures contract is recorded by Aristotle in the story of Thales, an ancient Greek philosopher. Believing that the upcoming olive harvest would be especially bountiful, Thales entered into agreements with the owners of all the olive oil presses in the region, in exchange for a small deposit months ahead of the harvest, Thales obtained the right to lease the presses at market prices during the harvest. As it turned out, Thales was correct about the harvest, demand for oil presses boomed, and he made a great deal of money.

By the 12th century, futures contracts had become a staple of European trade fairs. At the time, traveling with large quantities of goods was time-consuming and dangerous. Fair vendors instead traveled with display samples and sold futures for larger quantities to be delivered at a later date. By the 17th century, futures contracts were common enough that widespread speculation in them drove the Dutch Tulip Mania, in which prices for tulip bulbs became exorbitant. Most money changing hands during the mania was, in fact, for futures on tulips, not for tulips themselves. In Japan, the first recorded rice futures date from 17th century Osaka. These futures offered the rice seller some protection from bad weather or acts of war. In the United States, the Chicago Board of Trade opened the first futures market in 1868, with contracts for wheat, pork bellies and copper.

Bv the early 1970s, trading in futures and other derivatives had exploded in volume. The pricing models developed by Fischer Black and Myron Scholes allowed investors and speculators to rapidly price futures and options on futures. To supply the demand for new types of futures, major exchanges expanded or opened across the globe, principally in Chicago, New York and London.

Exchanges play a vital role in futures trading. Each futures contract is characterized by a number of factors, including the nature of the underlying asset, when it must be delivered, the currency of the transaction, at what point the contract stops trading, and the tick size, or minimum legal change in price. By standardizing these factors across a wide range of futures contracts, the exchanges create a large, predictable marketplace.

So a futures market is a market organization through which futures contracts are traded. These contracts commit both parties to buy and sell commodities, shares, or currencies on a future date at a price fixed when the contract is made. To ensure that both parties will be able to carry out their side of the bargain, the actual contracts are made between each side and the market organization, which requires both parties to make margin deposits with it of a given percentage of the market price of a contract. In most futures markets no actual delivery is made: the difference between the contract price and the spot price when the contract matures is paid by one party to he market organization, and by the market organization to the other. If the spot price is above the contract price the futures buyer gains and the futures seller loses; the opposite holds if the spot price is below the futures price.

Future contracts can be used to reduce risk by traders who have to hold a good and want protection against a low price, or who know they are going to have to buy and want protection against a high price. The contracts can also be used to speculate by a trader who has a different opinion about expected price movements from that prevailing in the future market. With some futures contracts, each party actually contracts with a market authority, which balances its buying and selling contracts, and collects margin payments from each side to ensure that they will be able to honour their contracts.

Futures trading is not without significant risk. Because futures contracts generally entail high levels of leverage, they have been at the heart of many market blowups. Nick Leeson and Barings Bank, Enron and Metallgesellshaft are just a few of the Infamous names associated with futures-driven financial disasters. The most famous of all may well be Long Term Capital Management (LTCM); despite having both Fischer Black and Myron Scholes on their payroll, both Nobel Laureates, LTCM managed to lose so much money so rapidly that the Federal Reserve Bank of the United States was forced to intervene and arrange a bailout to prevent a meltdown of the entire financial system.

In the United States, futures transactions are regulated by the Commodity Futures Trading Commission.

A forward contract is a contract in which a price is agreed for commodities, securities, or currencies to be delivered at a future date. A forward price is the price at which commodities, securities, or currencies are to be delivered in a forward contract. The forward price and the spot price, that is the price for immediate delivery, may differ, and the same commodity may have different forward prices for delivery ad different dates. Divergencies between these prices are limited by the costs of storage and possibilities of intertemporal substitution. A forward contract is made with an identified counter-party, and the individual or firm entering into a forward contract remains exposed to the risk that the counter-party main fail to carry out their side of the bargain. Forward contracts may be used for hedging, to decrease risk, or as a speculation, taking on risk for the sake of an expected profit.

Дата добавления: 2015-11-04