This article was originally published in Postnoon on June 1st, 2012 (Co-Authored with Amulya Chirala)
Prof. Nicky: Srikant, think of a bread factory. They bake hundreds of kilograms of bread every day. This means that they use hundreds of kilograms of wheat every day. The price of wheat fluctuates frequently but the company cannot really change the price of a loaf of bread every time the price of wheat moves up or down. While wheat becoming less expensive may not worry the owner of the factory much, he would constantly worry about rising price of wheat.
Now think of a wheat farmer. He lives in fear of wheat prices dropping when it is finally time to harvest the crop. If they had a mechanism to fix the price of wheat at a certain mutually agreeable price, both of them would be happier people because of the elimination of uncertainty. Sure, the farmer is sacrificing the potential very high profits if the price of wheat were to sky-rocket! Similarly, the bread manufacturer is sacrificing the higher profits he might make if the wheat prices were to nosedive. But they are assured of being in business.
Srikant: Interesting thought. Prof. Nicky, it would indeed be very useful for both of them to enter into such an agreement.
Prof. Nicky: Yes. The elimination of price risk is known as hedging. And it can be done through financial instruments known as ‘Forwards’. Forwards enable the two parties to fix the price, quantity and quality of wheat that will be traded at some point of time in the future. Forwards are highly customisable agreements between two parties, usually via a broker. Since there is not much regulation governing the forwards, there exists a risk of counterparty defaulting on the contract when market prices are more favourable to them.
To eliminate the risk of default, there is a similar class of instruments traded on exchanges. They are known as ‘futures’. The primary difference between futures and forwards is that there is a “margin” or a safety deposit collected by the broker (or clearing house) from the trader which is adjusted daily to reflect the changes in the prices of the asset on which the contract is written (underlying). This process of adjusting the margin is called ‘marking to market’. It is the equivalent of rewriting a forward contract daily.
Srikant: Hold on Professor. Why are you telling me all this? I am neither a farmer, nor a baker.
Prof. Nicky: True. But you are an investor. You recently invested some money in the stock market.
Srikant: Yes. But I am still not able to see the connection between my equity investments and these futures contracts.
Prof. Nicky: You know how volatile the markets are now a days. With the rupee falling, the fiscal deficit increasing, Euro crisis and so on. Wouldn’t it be nice if you could hedge your risk in the stock markets too?
Srikant: Ah! Now I know where you are going!
Prof. Nicky: Just like a farmer and a baker can hedge the price risks involved in their business, an investor too can hedge the risk of her portfolio of stocks being subjected to undue price movements due to external factors. Exchanges like NSE and BSE offer futures contracts on stocks and even the index.
Also, Srikanth, your father owns a jewellery business. You can tell him about futures contracts which can help him hedge the price of Gold. Futures contracts on commodities are traded on exchanges like MCX and NCDEX.
Srikanth: Prof. that reminds me, I’ve got to rush home. Got to take dad for a doctor’s appointment. But this is all very interesting and we’ll continue from where we are leaving, the next week…