Pricing Money: A beginner's guide to money, bonds, futures and swaps

Meaningful prices for the rest of us

This isn't false but it feels reductive. A financial instrument that allows one to bet on the corn harvest is obviously valuable to the corn farmer, as it allows them to use profits from good seasons to hedge against bad seasons. They're also valuable to people whose business is affected by the corn harvest - cereal manufacturers, say. The problem is that they can also be used by people with no exposure at all who simply want to bet on the corn harvest, and from the scale of the finance sector it seems like we are pouring a lot more of our resources and brainpower in to designing exotic new ways to bet on the corn harvest than we are on growing corn.

Speculation is fundamental to price discovery.

Think about it this way, actors in financial markets all have various beliefs about the future, and all of these beliefs are on a scale of accurate to inaccurate. Speculation allows these beliefs to be aggregated into a single market price (which btw implies no arbitrage) for various types of contingencies and risks, and the price will rapidly update to reflect updates to reality and thus updates to everyone’s beliefs.

Sure. You mitigate risk on speculation by hedging. I'll try and give a similarly simple (if not perfectly accurate and far more lengthy) explanation. Someone mentioned farming financials in the comments around this, so we'll use that. It's also something I know well, as I know a lot of farmers.

Let's imagine that a commercial farmer, whom we'll call Jeremy plants 100 acres of wheat on a farm. Market values for wheat (and everything else you can farm, from livestock to grains and so on) vary and move constantly, as a function of supply and demand. We saw this in an extreme form with the invasion of the Ukraine, and the droughts in Italy last year.

Now the problem with farming is your timescales are long compared to the movements of values for your product in the market, so you've no real idea as to what what you're planting will be worth by the time the bloody thing has actually grown and you've got it harvested and into barns to be sold. And once the seed is in the ground, you can't exactly just plough it all over and plant something else (not strictly accurate, but you don't want to go down that route).

So now let's fast forward. Jeremy now harvests his wheat, and let's say the price has moved up a lot between planting and harvest. Jeremy is a happy man, who's going to have a bumper time, even if his crop doesn't produce as much per acre as he might like at the minute, because it's not raining enough. Or conditions are perfect, and the price has gone up, and he makes a huge amount and can reinvest. Jeremy is a happy camper.

However, if the price falls, Jeremy is not going to be quite so chipper. As such, Jeremy can move his risk, through the use of a hedge. Let's say Jeremy hunts around to find someone to buy his wheat at the start of the season. He might sign a contract with a flour producer, stating that they will promise to buy x tonnes of his grain at £y per tonne. Jeremy now has a fixed price, which has hedged his risk profile. Now his risk has moved from financial to productive - he has to be able to provide the x tonnes. If he can't produce it all on the farm, he needs to source the difference. On the other hand, if he's a good farmer, and the farm produces well, and he doesn't over-extend his risk on what he's committing to, he now has a fixed price contract for his goods, which isn't going to fluctuate based on time (assuming the contract is honoured - if he's worried about that, Jeremy could then buy insurance on the risk of a default on the contract, but that then gets complex). This is a very good thing, but means if the market prices his wheat vastly higher than he expected, he'll miss out on that upside.

This is called a forward contract. There's other types of contract which can be used to do similar things (futures, derivatives...) but that gets a bit more complex.