Monday, August 01, 2005

Zero-Sum Games

News of oil prices jumping to over $62 per barrel today reminded me of the zero-sum game that does exist in capitalism: options and forward contracts.* An option gives you the right, but not the obligation, to buy or sell a certain number of shares of stock at over a specific time period at price, P. A forward contract binds you to buy or sell at the determined forward price, F, on a specified date. Similar to gambling, in an options or a futures contract, you have a winning side and a losing side. Both options and forward contracts are used to speculate or to hedge risk.

Options and forward contracts, although thought of as a zero sum game, yield benefits to both sides because they are still voluntary contracts. Each side recognizes a potential benefit to entering the agreement. The farmer who cannot afford to risk that the price for his crops might be low may sell a forward contract to the speculator who believes she may have a chance to make a profit by accurately predicting a price increase. In purely monetary terms, options and forward contracts are zero-sum games. For every dollar that one party gains, the other has lost a dollar. Overall, however, speculation acts as an insurance policy for those who wish to reduce their risk and as a mechanism for profit for those willing to bear the risk for them.

* Futures contracts are forward contracts on an organized exchange

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