Michael Metelits
Futures and options have a bad name in many circles. These financial “derivatives”, so-called because their price is derived from the price of another security, can make sensational amounts of money for the smart and lucky and lose equally spectacular amounts for the smart and unlucky.
Crashes of traditional equity markets get blamed on them and banks collapse because hotshot derivatives traders take imprudent risks.
But what are these financial tools? Who uses them and why? Are they inherently destabilising influences on financial markets, or do they have their place?
One good place to go for answers is the South African Futures Exchange (Safex), where financial derivatives are packaged and traded.
The exchange was created by the Rand Merchant Bank (RMB) in 1987. In 1988, RMB, the Johannesburg Stock Exchange (JSE) and about 20 banks formalised the market in futures contracts by founding Safex.
The exchange initially offered futures contracts on the all share, all gold and industrial indices of the JSE, together with the long bond (R150), and has now added interest rates, commodities, and currencies to its product line.
Safex is the clearing house which guarantees the contracts in futures trading, making sure everyone pays up on a daily basis, or in jargon, “marking-to- market”.
A futures contract is an agreement between two parties to sell a specific amount of something for a set price at a date in the future. If you buy dollars in large quantities every three months, a futures contract would enable you to negotiate the price with your seller well in advance of payment.
Knowing the price three or six months in advance gives you less uncertainty about the price of buying dollars at the market (or “spot”) rate every three months. This makes the accountants in your company happy, because they can predict and control costs better.
Because prices can move up or down (sideways, of course, being financial slang for not moving at all), you can use futures two ways.
If you think the price of dollars is going up, you buy futures to “lock in” the current price and avoid paying the higher price in the future.
If you think the price is going down, you sell futures, buy the commodity or underlying security in the market at the lower price, and make your money by unloading to the poor sap who bought your contract.
Of course you can be wrong. This is not a happy situation, since if you bought contracts and the price of the currency, for example, goes down, you will be forced to pay the higher contract price for the commodity when the market price is cheaper.
If you sold contracts and the price goes up, you will have to buy at the higher market price, and deliver at the lower contract price.
Interestingly, the commodity traded in the futures contract is almost irrelevant. You can bet on the price of dollars, JSE indices or porkbellies. The point is your perception of the market’s direction.
Securities markets are sensitive to perceptions. If enough people buy dollar futures thinking the price of dollars (in rands) is going up, it goes up. Heavy buying of futures creates the perception that traders expect the market to rise. That perception is used by other people making trades, and it can spiral out of control.
By seeking to protect themselves from the fall of the rand (“hedging”), investors can push the rand down along with “speculators”, people who buy dollar futures because they’re just betting the rand will fall.
The difference between a hedger and a speculator is hazy at best, but hedgers use futures to protect the value of their investments or deals, while speculators just bet the markets to make deals on futures trades.
The same trades can be done by each, though, which is how “hedge funds”, designed to allow investors to protect their portfolios, have helped push down the rand recently.
The question of whether derivatives, like futures, are inherently destabilising influences on markets because of this power to affect perceptions is still open.
There are stabilising uses of these tools, such as protecting international trade deals from sharp drops in currencies, or protecting the owner of a stock from a drop in the price of the stock.
There are also plenty of firms out there who live by winning bets on the futures markets, and have no interest at all in the underlying securities, the currencies, commodities and economies they bet on. These trades are often blamed for market volatility.
More information is available at