Futures markets can be traced back to the middle ages. They were originally developed to meet the need of the farmers and merchants.
Consider the position of a farmer in April of a certain year who will harvest grain in June. The farmer is uncertain as to the price he or she will receive for the grain. In years of scarcity, it might be possible to obtain relatively high prices – particularly if the farmer is not in a hurry to sell.
On the other hand, in years of over-supply, the grain might have to be disposed of at fire-sale prices. The farmer and the farmer’s family are clearly exposed to a great deal of risk.
Now consider this: A merchant who has an ongoing requirement for grain. The merchant is also exposed to price risk. In some years, an oversupply situation may create favorable prices; in other years, scarcity may cause the prices to be exorbitant.
It clearly makes sense for the farmer and the merchant to get together in April (or even earlier) and agree on a price for the farmer’s anticipated production of grain in June.
In other words, it makes sense for them to negotiate a type of futures contract. The contract provides a way for each side to eliminate the risk it faces because of the uncertain future price of grain.
One might ask what happens to the merchant’s requirement for grain during the rest of the year. Once the harvest season is over, the grain must be stored until the next season. If the merchant undertakes this storage, he or she does not bear any price risk but does incur the cost of storage. If the farmer or some other party stores the grain, the merchant and the person who stores both face risks associated with the future grain price, and again, these is a clear role for futures contracts.
Would it be brilliant if the Farmer has an option with him –
- of selling to Merchant at a higher (pre-agreed) price if the price of his grain in the local market is less – or
- sell in the local market if the per-determined price to be paid by merchant is lower?
This situation is also possible – using Derivative Options
Some of the above mentioned contracts (Spot, Futures, Forwards, and Options) are traded / listed on an exchange – Hence it is very important to know what a stock exchange is and how they work..
We will be reading more about Global Stock Exchanges in the upcoming modules.