What are the futures markets for?

| February 6, 2007 | 0 Comments
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What are the futures markets? Let’s begin with a story about trains. Before trains, the nation was divided into small markets for various commodities, but with trains came the first truly national markets. Now it was cheap for farmers and grain merchants to deliver goods to the places that needed them most - and would pay the most. Chicago became a central location for these grain merchants to deliver their goods and compete for clientele. Now the problem with grain is this. It goes bad. The grain markets were subject to a lot of volatility in price, depending on weather conditions, the ability to export and so forth. A farmer who had a great deal of grain was subject to the risk that the value of their commodity would plummet, and they would be ruined. Farmers and commodity owners needed a way to limit their risk. So they were able to find people who were willing to assume their risk, people with capital to speculate on the price of grains. If these speculators were correct, they would make a profit. If they were incorrect, they would lose.

So we have people with money, and people with risk. The futures markets allows these two groups to match up. What gets traded in these markets are futures contracts. A futures contract is the right, but not the obligation to purchase some asset on a specific future date. The value of such a contract is determined by the market, the net of buyers and sellers interested in trading these assets. When you “buy” a futures contract, you think the asset will increase in value for some time. When you “sell” a futures contract you think the asset will decrease in value. A buyer of a futures contract needs a seller.

The easiest way to understand this is to think of an asset you own. I imagine most people here are homeowners. Your house is an asset. It’s a risky asset. It typically appreciates, but it’s also subject to loss. Real estate is a risky asset. Let’s say you own a house for $500,000 and you want to sell it in a year’s time. You’d really like to get $550,000 in a year’s time, but you’re very concerned with a housing bubble and you don’t want to get stuck with a $400,000 sale. An investor is shopping around, and he wants to buy a house in a year’s time for around $500,000, but he (or she) is concerned the price may get up to $600,000 for that neighborhood. What the two of you can do is enter a contract. You agree to sell the house to the investor in a year’s time for $525,000. You’ve given up some profitability, and so has the investor, but you’ve both limited your risk. The key feature that allowed them to to this was entering a contract to transfer one person’s risk of loss in value in a property to another person who anticipated he couldn’t get a better deal at a later date.

Now this was pretty cumbersome. If you wanted to do this again, it would be an involved process to find another person who’d be interested in this sort of deal. It would be good if there was a whole bunch of people lined up who were interested in buying your house, all in one place. Maybe you get someone to even take you up on a similar contract for $550,000. Or maybe you’d find out other people were cutting deals at $475,000, and so you’d better take sometime around that price. And it would be good if you could standardize the details of the contract so people would know exactly what is being offered, the only issue to discuss is price. This is what the futures market accomplish. By taking standardized contracts for assets that owners need to limit their risk on, futures markets allow speculators to enter the market to trade and invest by assuming this risk.

Khurram Naik is a derivatives broker at Infinity Futures in Chicago. He is a graduate of Carnegie-Mellon and has worked in research in cognitive science and education at Princeton, Harvard and Carnegie-Mellon University. He is also a former field director for a political campaign. He maintains a blog on literature and cognitive science. He can be reached at k.naik@infinitybrokerage.com

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