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Explaining derivatives in local Singapore terms

A friend was asking what are derivatives and what does it have to do with trading.


I explained in local terms and it is something that I feel should be repeated on the blog.


Please note that the supermarkets mentioned here are only used for example sake and they may or may not be involved in derivatives trading. 


Say it takes a year to grow rice. A farmer starts planting rice in January 2011. The price of rice is SGD1 per kg in January 2011. However, the farmer is worried that by January 2012, the price of rice will drop to SGD0.90 per kg. NTUC is worried that the price of rice might increase to SGD1.20 per kg in January 2012. So in January 2011, the rice farmer agree to sell the rice to NTUC at SGD1.10 per kg in January 2012.



When Jan 2012 comes, the price of rice is SGD0.80 per kg, the farmer is protected as he can sell the rice to NTUC at SGD1.10 per kg. The farmer gains, but NTUC loses. The opposite scenario is at Jan 2012, the price of rice is at SGD1.30, NTUC saves, but the farmer loses possible additional income of SGD0.20 per kg.


From Jan 2011 to Dec 2011, NTUC can sell this contract to in the derivative market. For example, by Nov 2011, Giant has news that price of rice will go for SGD2.00 per kg by Jan 2012. Giant can offer to buy that contract from NTUC at a higher price say SGD1.50 per kg. NTUC has found a cheaper source for rice so agrees to sell the contract to Giant. When Jan 2012 comes, and price of rice is SGD2.00 per kg, Giant gets rice at SGD1.10 per kg from the farmer.


Extend this the currency, bond and oil markets.

Comments

jaylen watkins said…
Thank for explaining derivatives to your friend and to all of us thank for this article post.

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