Thursday, 22 May 2008

Futures - Introduction

I used to be a plain, simple software engineer working for Microsoft. Then RBS happened to me. Then everything around me changed. Instead of ASP.Net Futures I was thinking of Futures. And Options. And Equity. And stuff built around money honey!!!

Exploration of Arbitraging and Speculation and Hedging were obvious next. Too many keywords? Never mind, if I got into it, you are better placed than I ever used to be. Reason: This blog never existed when I started.

To all my readers in India, I am sure RBS could be just "another" company for you. But, its just not "just another" company. Its the 4th largest bank in the world, and world's largest company in terms of assets. Almost 4 trillion, to be precise 3.8. Yeah, 12 zeros after 3. Try this: The Global 2000.

The last time we went shopping we bought ABN Amro. Another giant that was about 200 years old, and used to be among top 10 banks in the world. Its part of our group now. You must have heard of NatWest(Remember Sourav Ganguly waving his shirt and his hairy whatever in the Finals against England in 2005? Oh yeah, Cricket, my dear). The last time we went shopping we bought them. The list is long and time is short. We are entering India, and we may be visiting the malls soon!!!

Folks, we were to talk about Futures. Lets get back to it. In simplest terms a "Futures" is a contract between two parties(we call each side a "counterparty") for sale/purchase of an article at a future date but at a price agreed today.

Sounds like a plan? It is. Sounds like its good only for either counterparty? Its not.

When I was in in school, in class IX, in Biology I read about Symbiosis - a natural agreement between two species where each gets benefited. Have you seen Discovery channel's "Planet Earth" kind of shows? Yes, I do remember one such show where small fishes(of a particular type) used to move around Shark's mouth. They eat the dirt from Shark's mouth who in turn avoids bad breath. Now you know bad breath is a turn off even for Sharks.

Lets take a classic example of a Farmer(Hillary), and an owner of an Ice cream shop(Obama) on a beach to explain Futures. Each time it rains it makes Hillary happy, but ice cream sales go down so Obama is sad. When it doesn't rain for some time and the sun is at its best, Hillary is sad and Obama smiles. They continued to do so for a long time(in years) and incur losses, until they met McCain.

McCain told him - Nerds why don't you guys strike a Futures agreement? As usual Hillary and Obama had no clues what he was talking about. They were looking at him with their jaws dropped and eyes wide open. Obama said - What agreement? It seems like there is no Future, sometimes I lose sometimes she does. McCain said - Betel nuts, its not about losing its about winning. Imagine Obama paying you some $ when it doesn't rain and you pay him when it does. So strike a Forward contract with him. Although there are risks involved, but there are a lot of ways to cut risks.

So even whenever Obama makes money you do too, and whenever you make money he also does.

Well, that was some fun. Now some facts.

  • Futures is a Forward contract that is regulated by an Exchange. In Futures, the counterparty is always an Exchange. So, the basic difference between Forwards and Futures is that the previous is bilateral, and works on trust while the latter is more regulated and managed.
  • Futures and Options are traded since middle ages.
  • They are not new by any stretch of imagination. They are immensely successful "Hedging" instruments.
  • Chicago Mercantile Exchange is the largest Futures exchange in the world. In Europe we have LIFFE and Eurex. Its traded in India also. The volume is enormous - in trillions.
  • Futures is an traded over an Exchange and its never traded Over The Counter(OTC).

The next time we meet I will elaborate a lot of fundamental Financial terms so that you can have a head start. I will also write a series on Equities.


Rahul Soni said...

Hey Sanjeet,

Nice to see your new blog man. Really loved the first *typically Sanjeet* blog.

So, what are you upto? Interesting money, honey terms... haan???? Good good.

Write more about these things. You are a good storyteller, and I have already subscribed to this blog, Mr. Alien!!

Saurabh said...

Cool stuff dude, nice to know you are getting half way deep into MONEY :-).
I liked the explanation of the jargon called FUTURES, very nice analogies, Hillary, Obama and McCain. Keep going. I will become a regular reader and improve my financial vocabulary.