Definitions don’t make sense unless they’re applied, and applications aren’t useful unless they’re relatable. So to understand forward markets, let’s work the other way around. Let’s start with a relatable example, and work backwards to arrive at the definition.
And what, pray tell, is more relatable than placements for students?
That is, after all, the point of an education. No?
So, anyways, placements. Here is how placements work: a company lands up on campus in the month of (say) October 2021, interviews a bunch of students, selects some of them, and offers them a job. Let’s say one of these students, who’ve been offered a job, accepts the offer.
Does the job start in October 2021? Of course not! It begins in June 2022.
In other words, a company and a student have entered into a contract. This contract says that the student will give the company eight hours of her day, Monday to Friday, in return for which the company will pay her a salary.
But the deal has not been struck for immediate delivery. The student doesn’t start work in October 2021. A price has been agreed, the terms of the contract have been agreed, and both the student and the company have signed on the dotted line – but for a transaction that will take place in June 2022. That, my friends, is a forward contract.
Now, having gotten the point, let’s learn the language that the beasts of this jungle like to use. The student, because she is selling eight hours of her time, five days a week, is the party with the short contract. The firm, because it is buying eight hours of the student’s time, five days a week, is the party with the long contract.
(Why the hell don’t they just say buy and sell, then, these financial folks? Lyk, srsly, ryt? Lmao. Brb.)
The price that the two parties have agreed upon is known as the strike price, because it is the price at which the deal has been struck.
So, quick recap: going long | going short | strike price | forward contract.
Here is how the placement process works in almost all colleges in India. If you sit for an interview, and you’re made an offer, you’re “out” of the placement process. There are variations to this rule, but in essence, the logic is that once you and the company have struck a deal, you can’t sit for any other firm that comes on campus later.
So here’s a conundrum for you: what if the company in October is a firm called HDFC, and it is offering you a package worth 8 lakh rupees (INR 800,000). The conundrum is that there is a very strong rumor (but it is, unfortunately, a rumor) that Google will be on campus next month, and they’ll be offering 20 lakh rupees (INR 2,000,000).
HDFC will pick up 20 students, but Google will pick up only 5.
Do you sit for the HDFC process or not?
There’s no right answer to this question, of course, and because of the uncertainty, cases such as these cause a lot of angst among students every year. But let’s assume that a student decides to “play it safe” and does sit for the HDFC process.
Here is what the student is thinking: sure, lower salary, and sure, no Google. But hey, a bird in hand is worth two in the bush, no? Better a low paying job for sure than the risk of not being placed by June 2022. Us economists would say the student is being risk-averse. Those finance guys would call her a hedger.
A hedger is somebody who ain’t worried about missing out on a high-paying job later. A hedger prizes certainty. A hedger mitigates risk. The price you pay for mitigating risk – the opportunity cost of risk mitigation – is that you lose the potential upside.
Choosing to put money in an FD rather that investing in stocks is hedging. Doing an MBA rather than starting a business is hedging. Locking in a job, even at a lower price, rather than waiting for a better one that may or may not come along – that is hedging. You’ll sleep soundly at night, knowing that HDFC is waiting for you in June 2022. You’ll feel a twinge of regret when your BFF lands that job at Google (of course you will), but hey – you played it safe, and that’s no bad thing.
OK, so you’re the hedger. What about HDFC, or Google? What should we call them?
Well, how much does a recruiter learn about you in a 15 minute interview anyway? All that they have to go on is that interview, and your CV. We know all about CV’s!
So when Google, or HDFC, or whoever, really – when they give you a job offer, they’re taking a bet on you. You may be the next CEO of those firms, who’s to say? Or you may be fired six months after starting your job. Who’s to say? Like I said: they’re taking a bet on you. They’re speculating.
Folks who take risks in financial markets: they’re called speculators.
Me, personally, I always get a little nervous when folks start to talk about excessive speculation, or banning speculation. Because, as an economist, I think about the student and HDFC as entering into a transaction in which the student sells the risk of being unemployed, and buys peace of mind in return. HDFC, on the other hand, sells the peace of mind of having money in the bank, and speculates on the student.
If you ban speculation, where’s the hedger to go?
A market needs people on the sell side, but also on the buy side. Without both of these animals – the hedger and the speculator – the jungle called financial markets can’t function. Just like without firms willing to punt on students, the market called placements can’t function.
I’ve yet to meet a student, past or present, who complained about “too many firms coming on campus”. And what’s good for one market, is also good for the other.