How do stock futures get a value assigned to them when we can’t even tell where a stock is going the next hour? And why/how do people buy them (financial product wise)?
In: Economics
A futures contract is a hedge against the price volatility of a commodity. Say you’re a company that buys a lot of fuel in a year – such as an airline. Right now fuel is really cheap – say $35 per barrel – but you can’t buy all the fuel you think you need for the whole year right now; you might not have the cash on hand or a place to store that fuel even if you did. But because the price of oil may be volatile, you want to protect yourself in case it sharply rises later in the year. So, you make a deal with a fuel producer: You agree to buy the fuel you need for the end of the year at a set price – say $60 per barrel. The fuel producer agrees to this because it’s a guaranteed sale later in the year and believes the certainty of the sale outweighs the risk that fuel rises above $60, while you’re protected in case the price of fuel rises above $60 by the time you need to buy it. This is a futures contract.
Let’s say, however, that 2 months before the contracts of those futures comes due [and you’re obligated to buy a bunch of fuel at $60 per barrel] fuel looks like it’s still just as cheap as it was when in the beginning of the year. Your airline would like to take advantage of the cheap fuel costs, but it has these futures contracts on the books.
Enter a futures exchange. In order to get those contracts off the books your airline offers to sell those contracts to interested buyers. Say some investment company believes that the current cheap price of fuel is not reflective of true market conditions and expects the price of fuel to rise sharply – say to $80 per barrel – by the time those contracts are due. The investment company buys the airline’s futures contracts and expects to profit when the price of fuel increases.
How much your airline company is able to sell those futures for depends on what other futures contracts are available on the market and how certain investors believe the price of fuel will rise (or fall). If investors are certain fuel will cost $80 per barrel by the time the contracts come due your airline might even make a profit by selling off the contracts for more than the $60-per-barrel original price and make a profit. If on the other hand investors are less certain the price of fuel will rise your airline company may only get $50 or even less if they sell the contracts.
When you combine the collective buying and selling of lots of contracts by lots of companies and lots of investors, eventually the value will settle somewhere in the middle.
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