What the hell is a futures contract?

Andrew Pegler – 21 May 2010

Right now Barrack Obama is turning his steely gaze to Wall Street. Specifically how to rein in the use of what are called derivatives and today I want to take a plain English gander at one derivative called a futures contract.

Very simply, a derivative is a financial instrument (not always in tune) designed to reduce risk. The most common types are futures, which are the right to buy or sell something at a future date at a set price; and swaps, which involve a swap of assets or payments. They’re called derivatives because they “derive” their value from stocks, bonds and commodities.

Let’s think of futures contracts in terms of bananas (as you do).

Say Bill the banana grower makes a deal with Fred the fruit buyer. One day Fred says to Bill “Mate, tell ya what, in six months I’ll buy a tonne of your ripe bananas for 100 bucks”. Bill thinks for a sec, swats a fly, tugs at his Akubra and says “Yeah, OK, deal”. Although probably unaware of it, Bill and Ted have just created a futures contract because they have both bet on the future.

Bill’s happy because with a set price now in place he is protected from banana prices going south but he could lose out if prices go up. Fred is happy because not only does he know what he is going to pay in six months, he’s also set to clean up if the price goes up because he’s locked in to pay only $100. Conversely, he’ll take a bath if the price falls to $50.

The point is both parties have used a financial instrument (in this case a futures contract) to reduce risk. Pretty clever stuff eh? But that’s just the half of it because that particular banana futures contract now has a value in and of itself, one that will rise and fall with the price of bananas. When bananas go up so does the value of a contract for bananas at a cheaper price. So Fred could sell it to any Tom, Dick or Harry and make a profit.

Well that’s it. Class dismissed. Time for a banana break.

And in other news… noticed the $AUD getting a hammering? The reason is jitters from the Euro debacle have scared the investors, who have taken their money out of anything that’s not US related, which, despite its problems, is still the safest place to park your hard-earned. This run towards the US is driving up the $US relative to all currencies including ours.