In stark contrast to the previous post, I want to talk about the Derivatives Market (see! I take an interest in everything) and some of the things it encompasses (like Interest Rate Derivatives). Have you ever seen one of those documentaries that follow the food from the cultivation to your plate? Have you ever wondered the financial route that food and other commodities take? Well, I have. Economics and commerce make our world go around but what makes them go around? One of those notions is the futures trading through Interest Rate Swap Claims and the engines are clearing houses.
The futures market is a centralized marketplace for both sellers and buyers around the world to meet and enter into futures contracts. As you probably have guessed, the futures contact is an agreement to sell or buy an asset in the future. These contracts will state the price and date of delivery.
The best way to understand this is through a simple and relatable example. Imagine that you decided to subscribe to Internet. As the buyer, you have entered an agreement with the Internet provider to receive a specific speed for a certain price every month for 1 year. This contract is similar to the futures contract that help the global trading economy. You have secured a price and service for the next year, even if the prices were to rise over that duration. By entering into the contract with the Internet provider, you have reduced the risk of your payments increasing.
You simply apply that same concept to the futures contract just with commodities on large scales. Rather than an Internet provider, a producer of peaches may want to secure a selling price for the upcoming seasons crop, while a marmalade producer may be trying to secure a buying price to determine quantity and profit. The marmalade producer and peach famer may enter into a futures contract which requires the delivery of 8,000 peaches to the buyer in July at a price of £4 per dozen. By entering into this contract, the farmer and the marmalade producer secure a price that they believe is fair for the duration of the contract.
The two primary benefits of futures contracts are:
- Price discovery- Futures markets are an important tool that helps determines prices based on today and tomorrow’s speculative prices based on supply and demand.
- Reduce risk – Futures markets help people reduce risk when making purchases because it ensures minimal risk that the manufactures (sellers) will increase prices to make up for losses from other markets.
However, there is still risk that one party might not hold up their end of the deal and entrepreneurs must be innately cautious. Clearing houses help minimize the risk to both parties (the seller and the buyer) by acting as the third party to the Interest Rate Swap or any other financial derivative. A clearinghouse will offer margins, thorough financial background checks of their members, default budgets, etc. This way, both the buyer and seller can conduct their business but the clearing house will assume the role as the safety net to guarantee that they are safe in the event one of the parties defaults.
The futures market has become a vital financial tool to hedge against risk and for price discovery. The simple concept of paying your Internet provider for a yearly contract is applied to multinational operations that help keep goods, services and foods moving smoothly.