Derivative market instruments: futures and options
We said earlier that futures and options can be seen as substitutes for outright investments. These terms may appear intimidating, but the instruments are not. If on T+0 you buy a futures contract that expires on T+180 on 1 000 shares of Blaauwbank United Gold Mining Company Limited (BUGMIC) at £ 2.20 (when the share is trading at £ 2.0), it means that you have an obligation to buy 1 000 BUGMIC shares on T+180 at the stipulated price of £ 2.20, i.e. you have to pay £ 2 200 for the shares on T+180. In the meantime (on T+0) you only need to pay a "good faith deposit" (called a margin) of around 5% of the value of the contract = £ 110 (0.05 x 1 000 x 2.2).
You will buy the future because you believe on date T+0 that the price of BUGMIC shares will be higher than £ 2.20 on T+180. If you are right, and the price on T+180 is £ 2.50 per share, you will take delivery of 1 000 BUGMIC shares on T+180 and pay £ 2.20 per share for them. You will then be able to sell them at the market price of £ 2.50 per share, and make a £ 0.30 profit per share, i.e. a £ 300 profit (£ 0.3 x 1 000). You get the margin back plus interest.
The principle will be clear: you have a choice of buying the futures contract or borrowing funds at the going interest rate for 180 days and buying the shares outright. In other words, the FVP of the futures contract will be equal to the spot price of the share, escalated by the rate of interest of 180 days, less any dividends. If it is not, arbitrage opportunities exist. If it is, then it makes no difference to you to buy the future on BUGMIC shares or the shares themselves. We will return to this.
Another example of a futures deal is presented in Figure 8. It is self-explanatory. Note that the 90-day futures contract was sold and bought via the exchange at LCC 1 100, when the spot price was LCC 1 000. The latter is important for determining the futures contract price (discussed later), but becomes irrelevant once the deal is done. The wheat is delivered at LCC 1 100 on T + 90 (in this example when the spot price is much higher - see chart in Figure 8). The deal gave both parties price-certainty, but the flour miller gets the better deal (with hindsight).
Figure 8: example of future contract
Options are similar to futures, the difference being that you have the option (not the obligation) to buy (call option) or sell (put option) the shares between now (T+0) and expiry of the option contract (T+90). You will only exercise the option if it pays you to do so. You pay a price (called a premium as in the case of an insurance contract) for this right to buy or sell at a price determined on T+0.
Futures and options contracts are written on most of the instruments covered here, and retail-sized futures and options are also found in many markets. In many countries individuals can buy / sell futures and options on all the main currencies and many of the shares.
As we have seen, real investments are usually categorized into:
- Other (art, antiques, rare coins, rare stamps, etc.).
There are of course many subcategories to be found under each (see below). Real investments have many characteristics that differentiate them from financial assets such as:
- Zero recurring return (with exception of commercial property).
- Inflation hedge.
- Inefficient (illiquid) markets.
- High transactions costs.
- Insurance and storage (in the case of commodities and "other").
- High price volatility.
- Tangibility and pleasure (art, rare books, antiques).