9. Futures, options and swaps

Every weekday, enormous amounts of commodities, currencies and financial securities are traded for immediate delivery at their current price on spot markets. There are also futures markets on which contracts can be made to buy and sell commodities, currencies, and various financial assets, at a future date (three, six, or nine months ahead), but with the price fixed at the time of the deal. Standardized deals for fixed quantities and time period (e .g. 25 tons of copper to be delivered next June 30) are called futures; individual, non-standard, “over-the-counter” deals between two parties (e.g. 1.7 billion yen to be exchanged for dollars on September 15, at a rate set today) are called forward contracts.

Futures, options and other derivatives exist in order that companies and individuals may attempt to diminish the effects of future changes in commodity and asset prices, exchange rates, interest rates, and so on. For example the prices of foodstuffs such as wheat, cocoa, coffee, tea and orange juice are frequently effected by drought, floods and other extreme weather conditions.

Consequently many producers and buyers of raw materials want to hedge, in order to guarantee next seasons prices. When commodity prices are expected to rise, future prices are obviously higher than spot prices; when they are expected to fall, they are at a discount on spot prices.

In recent years, exchange rates and interest rates have fluctuated wildly. Many businesses, therefore, want to buy or sell currencies at a guaranteed future price. Speculators, anticipating currency appreciations or depreciations, or interest rate movements, are also active in currency futures markets, such as the London International Financial Futures Exchange (LIFFE, pronounced ‘life’)

As well as currencies and commodities, there is now a huge futures market in stocks and shares. One can buy options giving the right – but not the obligation – to buy and sell securities at a fixed price in the future. A call option gives the right to buy securities (or a currency, or a commodity) at a certain price during a certain period of time. A put option gives the right to sell an asset at a certain price during a certain period of time. These options allow organizations to hedge their equity investments.

For example, if you think a share worth 100 will rise, you can buy a call option giving the right to buy at 100, hoping to sell this option, or to buy and resell the share at a profit.

On the contrary, if you expect the value of a share that you own to fall below its current price of 100, you can buy a put option at 100 or higher: if the price falls, you can still sell shares at this price.

Options are merely one type of derivative instrument. Many companies nowadays also arrange currency swaps and interest rate swaps with other companies or financial institutions. Such currency swaps, designed to achieve interest rate savings, are of course open to the risk of exchange rate fluctuations. Whether they save or lose money will depend on the movement of interest rates.