Derivatives 101: 7

Here's a depressing truth: the closer we get to the detailed explication of all this shit, the less fun it becomes. Not that it was exactly a night on the tiles to begin with. Morbid curiosity only goes so far: even a public autopsy on the still-alive-and-kicking corpus of human greed only holds one's deficient attention for so long. Perhaps if that body had nerves of any kind the process would be more fun: go on, slice the bastard, let's see it thrash and bleed!

No such luck.

Instead, I find myself sucked ever deeper into the mechanical minutiæ and ever farther from both the intellectual complexities that make the investigation interesting and the impotent rage that drove it in the first place. The evil genius of derivatives, of finance, of Western Capitalism, lies as much in the ability to bury passion beneath an avalanche of tedious detail as in any innate viciousness those things may individually possess.

If you want evidence of the banality of evil, look no further.

Anyway. Where were we?

Oh yes:

The fundamental difference between a forward and a future is that the latter is exchange traded: which is to say it exists in (and because of) a structured (and liquid) market.

If, for reasons better left unexplored, you wish to undertake a forward contract in chocolate-coated marzipan rodents, you'd better find yourself a chocolate-coated marzipan rodent manufacturer and start haggling. Your deal may be for a dozen rodents or a million, delivered next week or in ten years, milk, plain, little string tails, whatever; every forward is its own little universe of details.

If, on the other hand, you want to take out a future in chocolate-coated marzipan rodents, well, you're shit out of luck.

Futures exist only on a limited number of pre-determined assets -- mostly agricultural and mineral commodities and financial metrics like stock indices or interest rates -- and you don't get to define the terms. Futures contracts are standardised: w amount of livestock of grade x delivered to location y at time z; or a US dollars per point of stock index b at time c. Some of the details are highly constrained, some less so -- for example, the deliverer of a commodity may have several choices of delivery location and may be permitted to supply slightly more units of a slightly lower-grade stock -- but overall the contract is pretty clearly delineated in interchangeable quantities. Each unit of any given future is essentially indistinguishable from any other.

The details of a future are set down by the exchange -- a nexus for transactions, usually geographically located, such as the Chicago Board of Trade -- and supported by a collection of market makers -- entities undertaking to always provide both bid and offer prices for a particular contract (meaning they are willing to enter into either side).

This infrastructure means that futures, while highly constrained in terms of contract details, can -- unlike forwards -- be readily traded; signing up to a future is much less of a commitment than signing up to a forward. Having acquired one, you can almost always get another in the opposite direction to cancel it out. This is called closing out.

Let's just take a moment to unpack that:

When you have a future in, eg, pork bellies ("which you might find in a bacon, lettuce and tomato sandwich" as one of the appalling financier brothers says in Trading Places, prompting a wry glance to camera from Eddie Murphy), you're saying you want to take delivery of, for the sake of argument, 1000 pigs. If, some while before the delivery period, you casually close the future out, you're suddenly reneging on that agreement, leaving those porkers in limbo.

Now, the fact that someone has bought the future from you presupposes that they in turn have some use for the truckloads of squealing sows, but in practice that's a fairly meaningless supposition -- the open interest in any given future (meaning, the amount traded) is typically far in excess of both the supply and demand for actual pigs (or whatever).

When it comes to futures, buying and selling does not imply any interest at all in the underlying asset; only in its price.

Futures' disconnection from the realities of the underlying isn't only down to liquidity, though. Oh no. Not by a long way.

Futures themselves are free; both parties are (notionally) committing to an exchange in the future, not now, so the immediate cost for both parties is sweet FA. But the value of each side of a future will fluctuate day to day according to any number of factors, notably the spot price of the underlying. If I undertake either side of a future today and the price of the underlying changes tomorrow (or the time value of money does, or whatever else), I may lose out on the deal; add that up over a few months and it might amount to a large sum, and when it comes to delivery I could decide just to default. This, as mentioned a few episodes back, is known as credit risk.

Futures exchanges combat credit risk by a process known as marking to market, which basically means that any net difference between the price you undertook to pay or receive yesterday and the price you would wind up paying or receiving today is credited or debited at the close of business every day. In other words, if the future price of X goes up by y, then owners of futures on X receive y right now, and the net value of their future is reset to zero (ie, paying the prevailing price for future delivery of X). Thus, all futures on a particular asset for a particular delivery date are always worth the same amount, regardless of when they were originally bought or sold; that value gradually converging on the actual price of the underlying at the time of delivery.

The mechanism for this process is something called a margin account, which everyone trading on a futures exchange is required to maintain. At any time, each participant must keep in their margin account some specified fraction of their outstanding obligations on bought and sold futures. (Please note: some fraction, not the whole amount; we'll return to this shortly.) When the futures price changes (as it must, according to the very same formula discussed in the last episode for forwards), the change is effected for both parties more or less immediately by debiting one margin account and crediting the other.

Meaning: you make or lose money on the fluctuations in price of a future on a day-to-day basis over its lifetime, rather than all in one go at delivery.

Which in turn means that delivery is irrelevant: a future is really a bet on the price fluctuations of the underlying; a bet on which you win or lose every day.

There's one more detail here that's worth examining. As mentioned earlier, in order to trade futures you need to keep some fraction of your exposure on hand in your margin account. What you don't have to do is be good for the entire delivery value of that exposure.

In other words, at a cost of (say) $1,000 in your margin account you can expose yourself to the price variations of (say) $50,000 worth of the underlying asset. This is an example of leverage, one of the key ideas of derivatives trading.

Leverage is a hideous bit of jargon, but its use in finance turns out to correspond pretty well to its more common mechanical meaning: a lever is an amplifier, allowing a small push to have proportionately larger effects. In the case of investments, this means that you can put in a relatively small amount to get the profits or losses you might have got from much more. Futures are a classic example: you can get the day-to-day profits of a huge investment in some asset at the relatively small cost of whatever you have to keep in your margin account. They're a way of raising the stakes.

Generally speaking, asset prices tend to behave as stochastic processes; which is to say they are essentially random. The mean and variance of this randomness will vary between assets and across time, but sooner or later all assets inherit some measure of unpredictability from the sheer cussedness of the universe. No-one really knows what tomorrow will bring.

That being so, owning a future is pretty much the same kind of proposition as putting money on a roll of the dice or a spin of the roulette wheel; both of which may well have a better payoff. Which is pretty much why I keep bleating on about these things being evil: futures, and indeed most derivatives, are just another way of turning real things and real people into idle speculation. A way of making money -- or just as easily losing it -- on other people's suffering.

Having spent all this time railing against futures as an egregious form of gambling, it would be dishonest not to point out the ways in which such gambles make some kind of sense: all of which depend on having some other, more tangible, exposure to the underlying asset.

All of the justifications for forwards can also apply to futures; the two kinds of instrument are psychic twins, after all. If I have a desperate need for pork bellies, it makes at least as much sense to buy futures as forwards, since I get the same potential guarantees for marginally less commitment. Similarly, if I have significant investments in a particular asset -- in itself a blameless condition, since the investee evidently needs my money -- hedging those investments with futures can significantly limit my risks. If I happen to be a pension fund with the retirement wellbeing of a hundred thousand people at my disposal, that sort of risk-reduction has a lot to be said for it.

If, on the other hand, I'm a money-grubbing wanker who just wants to make a fast buck off the bankruptcies of a thousand pig farmers, justification is hard to come by; and in that case futures are my oyster.
Posted by matt at April 7, 2006 11:46 PM