It has become clear that we all have to gain a better understanding of financial markets. The following is my understanding/interpretation of how futures and derivatives markets work. I’ve reduced this to the basics, but I think you will still get a sense of how complicated this can be. (Ignore commissions and administration fees.) My word of caution to individual investors is that there are sharks in these waters and it might be better to stay on dry land.

Futures Contracts
The purpose of futures contracts is to hedge against risk — that is, to lock in what you will pay or receive regardless of volatility in the value of the underlying “product”.

Say the stock of (fictitious) XYZ Company is presently worth $100. You are Party A, potentially dealing with Party B. You sign an agreement with Party B to buy 10,000 shares of XYZ a year from now for $110. Party B agrees because he or she stands to make $10 per share. You stand to gain if the stock price rises to say $120. Both parties win. This is an ideal futures contract. You can easily imagine a scenario where somebody loses, but my intent for the moment is to show why both parties might stand to gain from a futures contract. According to the foregoing setup, both parties know exactly what their future expenses and revenues are going to be and can plan accordingly.

Short Selling
Again, this example is designed to show why there might be an incentive for both Party A and Party B to enter into a contract to “short” a stock. Assume again that the shares of XYZ Company are currently selling for $100. As Party A, you sign a contract with Party B to sell him or her 10,000 shares in a year’s time for $90 per share. Party B gains if the price stays above $90. You gain if the price falls below $90, since you can buy the stock at the lower price on the open market and sell it to Party B for $90. (Clearly, this can go badly wrong in a lot of ways too, but I’m trying to show the logic for the existence of short selling in the first place.)

Options Market
In the foregoing, there is (in effect) a “buy” contract and a “sell” contract. Both of these can go up for sale in the “options” market. Party C, for a fee, can buy the option to exercise either the buy contract or the sell contract. The former is known as a “call” option, the latter as a “put” option. Then the value of the options contract goes up if it looks like it will eventually be advantageous and down if the opposite is the case. (In fact, options can be allowed to lapse when they will clearly not pay off.) The volatility is magnified because the initial low fee can have a very large payoff.

Derivatives
All “derivatives” products involve hedging by way of futures contracts, as described above. As a concept, derivatives are relatively easy to understand when they involve real assets such as equities, currencies or commodities. Where they start to confound, however, is when they involve esoteric “non-asset” products. For example, futures contracts are now available based on interest rates, house prices, the inflation rate, stock market indices and the weather (e.g., number of heating days).

In these non-asset cases, it’s not clear to me how futures trading differs much from gambling. There is no actual product that will ever be acquired or sold. Therefore, how are such transactions really much different from betting on NFL games based on the point spread?

Actually, there is one service provided by such transactions. They serve as a public referendum on expectations about specific economic indicators.

Interest Rate Swaps
There is one large category of derivatives that stands a little apart from the others — interest rate swaps.

Interest rate swaps are usually arranged between two financial institutions as a means to hedge against future interest rate changes. They usually involve Party A paying Party B a fixed rate of interest and Party B paying A a variable (“floating”) rate. Theoretically, the contract is set up in such a way that the two payouts will be exactly the same over the life of the agreement. However, it is clear that there is potential for one party or the other to gain an advantage based on what happens to the variable interest rate. Again, this becomes quite speculative when the variable interest rate is tied to a broad economic indicator like the federal funds rate or the inflation rate. (LIBOR — the London Inter-bank Offered Rate is often used, as is the European Euribor.)

Once one understands the basic mechanics of “swapping” — i.e., fixed rate exchanged for a variable rate — the actual set-up becomes quite interesting. Since the principal amount is the same for both parties, it becomes “notional” (i.e., a hypothetical amount, say $100 million U.S.) and there is no transfer of that large sum of money. Also, the interest rate paid is “net”, depending on whether Party A owes more at any given time, or Party B.

Caveat Emptor
A version of the interest rate swap has left some public bodies in the U.S. in considerable distress. It is clear that a swapping agreement can be set up in such a way that Party B makes an upfront payment to Party A that is (supposedly) compensated by higher interim payments over the life of the contract.

Some cash-strapped school boards were seduced by the prospect of receiving large upfront payments. The problem was that offsetting (variable) payments from B to A fell way short of initial expectations. The net effect, in many cases, has been to leave Party A (the school boards) owing substantial sums to Party B (the financial institutions). (For more on this, see Bloomberg Markets magazine, March 2008, Martin Braun and William Selway reporters.)

Final Note
What these deals turn on is the interest rate differential. Remember, one is fixed and the other is variable. Ideally, the returns eventually equal each other (i.e., the same present values and a zero sum result). In the real world, however, one party wins and the other party loses depending on what happens to the variable rate.

Each party’s expectation of winning or losing depends on its forecast of the economic indicator that the variable rate is tied to. If Party A’s forecast is right, it wins; if not, Party B wins.

To further complicate matters, sometimes the interest rate swap is based on one variable rate versus a different variable rate, tied to a different economic indicator. Furthermore, the payments can often be in different currencies.

Financial institutions are in the business of forecasting the economy and making the mathematical calculations — all done through complicated computer programs — that will assess their risks and rewards. School boards, other public bodies and the general public (i.e., “innocents abroad”) should be very wary of jumping into these waters.