434 Planning and Forecasting
the early 1980s, derivatives have touched every aspect of corporate finance,
banking, the investments industry, and arguably business in general.
THE INSTRUMENTS
The major derivative instruments are forwards, futures, options, and swaps.
Also available today are hybrid instruments, exotics, and structured or engi-
neered instruments. The hybrids, exotics, and engineered instruments are con-
tracts that combine features of the basic building blocks: the options, futures,
for wards, and swaps. Consequently, familiarity with the basic building blocks
goes a long way toward understanding the whole mélange of derivative instru-
ments available today. We will begin with for wards.
For wards
Imagine the following nearly idyllic scenario. It is late summer. You are a wheat
farmer in Kansas. The hard work of sowing and tending your acreage is about to
pay off. You expect a bumper crop this year, and the harvest is just a few weeks
away. The weather is expected to remain favorable. The crops have been
sprayed to protect them from pests. In fact, you may even have purchased crop
insurance to protect against crop damage.
Still, you cannot relax. One major uncertainty is keeping you awake at
night. You figure that if you are expecting a bumper crop, the likelihood that
your neighbors are also expecting a bumper crop is high. If the market is
f looded with wheat, prices will plummet. If prices drop, you will receive little
revenue for your harvest, and perhaps you will show a loss for the year. A worse
case scenario might be that prices fall so low, that you cannot make the mort-
gage payments on your land or the machinery you bought. You very well might
lose the farm—and through no fault of your own. You farmed well, but if prices
fall, you will fail nevertheless.
Meanwhile, at the same time, another group of businesspeople is feeling
similar anxiety. A baked goods company has recently built a new cookie bak-
ery. The company identified its market niche as a provider of inexpensive,
mass produced, medium quality cookies. The project analysis that led to the
go-ahead for the new bakery assumed that wheat prices would stay fixed at
their current levels. If wheat prices should rise, it is altogether possible that
the firm will not be able to sell its cookies for a profit. The new bakery will
appear to be a failure.
In these scenarios, both the farmers and the bakers are exposed to wheat
price risk. The farmers worry that wheat prices will fall. The bakers worry that
prices will rise. A for ward contract is the obvious solution for both parties.
The farmers and bakers can negotiate a deferred wheat transaction. The
farmers will deliver wheat to the bakers, one month from now, for a price cur-
rently agreed upon. Such a contract for a deferred transaction is a for ward