Archive for August, 2009


Futures


Suppose you are a wholesale potato trader in Pilani and I run a restaurant in C’not. Every morning I buy my requirements for the day from you at the price fixed by the agricultural commodities wholesalers’ association. Now, potatoes are important to both of us. It is your main business; while I require them to run my business. I hope for low potato prices and you hope for the demand to increase so that the prices go up. One fine day, say two months before OASIS you come to me and say,” Let’s set our potato prices for October and pick a price that allows both of us a reasonable profit. That way neither of us has to worry about the prices around OASIS.” I agree, and we settle on a price of Rs.10 per kg. This agreement is called a ‘forward contract’ – forward because we’re going to make the transaction later.

Good idea, you may feel, but not really. What if the prices rose to Rs.15 a kg due to increased demand? You would want to get out of the contract. Or, say, there’s a bumper crop and the prices fall to Rs.6 a kg. Now I would like to find ways to exit the contract. It may also happen that a storm destroys the seasons’ produce and the contract would fail. ‘Futures’ contracts were devised to solve such problems. A ‘Futures’ contract is simply a forward contract with a few ‘wrinkles’ added.

One of these ‘wrinkles’ is standardization. A forward contract can be written for any commodity, any amount and any delivery time. On the other hand, a futures contract is for a specific grade, quantity, and delivery time. Grade, quantity and the delivery time are specified by the exchange when they design the contract. Only the price is left to be determined. This way futures contracts are interchangeable. Also, futures contracts are traded only on the exchange.

If two parties make a forward contract, no money need change hands until the cash transaction is completed at a later date. If you buy a futures contract, you will have to put up margin moneya good faith deposit. If you buy a futures contract and cash prices go up, so will the price of the futures contract as they tend to move together. In that event you would have an unrealized profit in your futures account. Without closing out in the futures position, you can withdraw this profit in cash.

One of the most important qualities of futures is its escape-ability. If you buy a futures contract and later decide that you don’t want to be a party to it any more, you can close your position and wipe the slate clean by selling the same futures contract. Futures provide other broader economic benefits that probably won’t affect us directly. Because they trade actively, futures markets are constantly “discovering” the current price for the particular commodity.

In many cases, Options are traded on futures. A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised.

Abhishek Upadhyay

BITS – Pilani

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Fiscal Deficit


Fiscal deficit in plain and simple term is the difference between the ever increasing expenditure and small income. Fiscal deficit is the total expenditure (capital and revenue) minus the total income of the government. In a developing country like ours we cannot aim for a utopian situation of zero fiscal deficits but the least we could do was to have a deficit with constitutes more of capital expenditure. Fiscal deficit is measured as a percentage of GDP and for India it stands at a not so pleasant figure. Let’s make the things direct and less of economic mess.

Suppose you have 100 bucks as income and 150 bucks as total expenditure you want to do. For spending 150 bucks you need to raise additional resources like borrowing from friend (if he is that generous after all). Now Rs. 50 will be your fiscal deficit.

Now as always, the devil lies in the details. The problem here is whether you are going to spend the 50 rupees as a onetime expenditure for buying a bike or is it a recurring expenditure like treating your girlfriend. The next month, supposing your income remains flat and you need more money as you are again not able to make ends meet, your friend shows true spirit of altruism and friendship and is providing you “loans” without asking for the principal amount immediately and just demands the interest. Now as it is you are in need of more money and add to that the interest liabilities.

The problems get compounded. You now start curtailing on the capital part (i.e. creating new assets.. no bike modifications !!!). Your new loans are just for running the system (petrol got heck lot expensive dude!).. A scenario is reached when the interest payment by you requires loans from him. And this is the situation when things have got messed up.

To correlate, this is exactly the situation that India is in. We have a huge revenue deficit which is caused when you just don’t have enough money to pay for running the system. So you keep on borrowing even to pay for the interest. The government unlike you has many many friends which are in “compulsion” to provide loans. There is the RBI and banks from which government borrows vigorously and also the government has the supreme power of printing more currency. The government floats bonds – government securities on which it pays interest and these securities are completely risk free (you got to trust them!).

The other form of financing the deficit – deficit financing by printing money has even more damaging results. If the government prints money to finance the deficit and production does not increase immediately, this leads to increased inflation as more money in the economy chases the same amount of goods. This is generally why fiscal deficit is seen as not being good for the economy. Classic example of this is shown by Robert Mugabe led Zimbabwe where inflation is hitting… hold your breath… 300,000%! This shows how rampant printing of currency by government defying all logic can do “wonders” with the economy.

Now in order to contain the draconian devil, the government living up to its reputation of making things too tedious came out with an act – Fiscal Responsibility and Budget Management Act (FRBMA) which mandates the government to reduce the fiscal deficit by at least 0.3 % every year and wipe out revenue deficit – difference between the revenue expenditure and the recurring income by march ‟09. In order to meet these strict guidelines the government took help of some innovative techniques; showing the vastly increasing oil bonds and fertilizer subsidies as an off budget expenditure so as to not include it into the deficit and now it claims that it is going on the target to meet its commitments as mandated by the act…!!

The solution lies in government working more to take subsidized fuel away from someone who is driving imported SUV and not on devising nefarious ways to hide facts from the people.

Savil Gupta

BITS – Pilani