Understanding Financial Markets : The Rundown Part 1

Most of the Eurozone leaders used their New Year’s message to highlight the risks to Europe’s economy this year.  So 2012 is going to be a tough year. Really? why?

I do not understand economics. I missed my chance when I chose to study Civil Engineering rather than Economics.

These days I wish I had. It is hard for me to understand financial news much less its impact on me (or my business).

For instance, today the FTSE 100 is up by 0.1%. What the heck does that mean? Is it some kind of a score? A way to track winners and losers in some financial game?

I do not know. Neither does my wife and we are both engineers with Masters Degree.

I understand terms like callbacks, classes, objects, inheritance but the other terms like Futures, Options, Swaps, Derivatives and Hedging are completely foreign to me.

So this year, I have resolved as part of the many things I am going to learn, (e.g. Objective-C, PRINCE2), I will understand  financial stuff.

I say “stuff” because I do not even know what it entails yet. I am just going to learn about this “stuff”. Any help will be gratefully appreciated. I am going to read some books about this stuff and summarize it for folks who are in the same situation as I am.

So in this series of posts (in addition to the JavaScript posts), I will be giving developers a rundown on financial stuff. Read on at your own peril.

Derivatives

This is an evil word. It has the potential to cause another “Great Depression” whiles making a select group of individuals (in the know) a whole lot of money.

So what exactly is it?

It is an agreement between two parties that has a value which is determined by the price of something else.

Makes sense. Hell no. Let's try again.

It is a financial agreement whose value depends on the values of other more basic underlying variables.

Still foggy. Ok let us have an example.

Let us say that current price of Gold is US$ 50 per gram today.

If I enter into an agreement with some Joe Blocks that says:

If the price of a gram of gold is greater than US$ 60 next year, I will pay him US$ 10. If not, he will pay me US$10.

In simplistic sense, this is a derivative because I have an agreement with a value depending on the price of something else. (that is the price of gold).

It is a bet. Plain and Simple.

Not on the outcome of a football match but on the price of something.

You might be thinking "hey wait. Is this not some kind of gambling?".

How different is this from going on BET365.com and picking on England to win the European cup? (Yeah right).

Well it is and it isn’t.

It turns out that derivatives provides some kind in insurance.

Supposing I owned a gold mine and Joe Blocks is a goldsmith who specializes in making custom Indian gold jewellery. If the price of the gold that he buys is expensive (say more than US$ 60) he earns an additional US$10; offsetting the high cost of gold. On the other hand, if the price is cheaper, I earn an additional income of US$10.

The derivate has become a contract which reduces risk for both parties.

Simple.  Yes but why? It turns out there are a lot of reasons for using derivatives.

Amongst these include speculation and risk management.

Speculation:

Derivatives can be used to make bets that are custom made to fit a specific view. So for instance, if I want to bet that the FTSE 250 will be between 10,000 and 11,000 next year, a derivative can be created to let me do that.

Risk Management:

As in the previous example, it reduces the risk of loss for my fictitious gold mining business. In this case it can be said that I am hedging. (Another term we will come across later).

That is enough financial “stuff” for now. I must admit it is becoming as interesting as programming. I can begin to see how it can quickly become as complex as software engineering.

I will continue with this when I know a bit more.

Regards

James