The Sticky Business of Financial Derivatives
In The Classroom…
Broadly defined, a financial derivative is a contract whose value is tied to something else. Such as a stock, bond, commodity or currency. The value of the derivative fluctuates with the price of that underlying asset. For sellers, one common use of derivatives is to hedge, or insure, against an adverse outcome. A simplified example: a farmer might lock in a good price for his corn by selling a futures contract. This contract insulates him from risk, in case the market price for corn crashes. Derivatives can also be used by buyers as bets on the future price of an asset. Consider a speculator who determines corn prices are about to rise dramatically:
A. He buys a futures contract enabling him to buy corn at a low price.
B. When the market soars, he gets to buy the corn at the cheap price guaranteed by his contract and sell it at a profit. However, there’s risk; if he’s wrong and the market price craters, he has to eat the loss.
In The Kitchen…
An agreement to sell your brother a jar of peanut butter is the perfect culinary equivalent of a derivative: The jar’s value is based on what’s going on around it. Say you agree to sell him a jar in a week for $1. The value of that agreement will change depending on what else is in the pantry.
A. If it’s time to make the transaction and you’ve just bought bread and raspberry jam, the peanut butter becomes more desirable and the value of the contract to your brother has increased tremendously. So, it’s a good thing he locked down the low price when he did.
B. If, on the other hand, the sale date arrives and the only thing in the house is celery, the demand for peanut butter may have gone down. In that case, it’s a good thing you decided to sell when you did.
See “Keynesian Economics”
Courtesy of the Australian Financial Review
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