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Thursday, 7 February, 2002, 09:28 GMT
What are futures and options?
The Nymex exchange in New York
The world of futures looks complicated, and is
The world of derivatives, financial instruments such as futures and options, is notoriously complicated. BBC News Online presents a - relatively - simple guide to how these poorly understood investments function.

  • Futures

    The original derivative was a future used by farmers to set the price of their produce in advance.

    Before they started sowing they would make a deal to sell their goods at a certain price come harvest time.

    This enabled them to work out how much they could spend on planting and tending their crops.

    After the harvest, goods would be sold at the pre-agreed price no matter what the movements of the market.

    Sometimes the future contract would earn a profit compared to the market price, other times it would generate a loss - but it allowed the farmer to eradicate uncertainty.

    Futures on agricultural goods, metals, oil and gas, bonds and currencies are traded on exchanges round the world.

    The value of a future is determined by the relationship between the price set in the contract and the market price, the length of time until the contract is due - and supply and demand in the market.

    Futures contracts specify the quality, quantity and location for goods to be delivered, but not many are used to actually sell goods.

    Most are settled by cash payment on the date that delivery is due, with the holder paying or receiving the difference between the price set in the contract and the market price.

  • Options

    Options were invented because people liked the security of knowing they could buy or sell at a certain price, but wanted the chance to profit if the market price suited them better at the time of delivery.

    So for a certain fee - called the premium - an option gave them the right, but not the obligation, to buy or sell at a certain price.

    An option to sell, known as a put option, would only be exercised if the price set in the futures contract was higher than the market price at the time of harvest, and vice versa for an option to buy, or call option.

    Working out the cost of an option is extraordinarily complicated.

    There are many pricing mechanisms in use, most involving complex mathematical formulas.

    The most famous options pricing model is known as Black-Scholes.

    There are also many different types of option - with exotic and alarming names such as knock-in and knock-out, barrier, binary and Asian options - most of which vary either the time or the price at which the options can be exercised.

  • See also:

    22 Jun 99 | The Economy
    How Leeson broke the bank
    22 Jun 99 | The Economy
    Leeson scandal 'could happen again'
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