Unit 2

MBA/BBA/B.com/UGC Net

By
Dr. Anand Vyas
Financial Forward Contracts
• A forward contract is a private agreement between two parties giving the buyer
an obligation to purchase an asset (and the seller an obligation to sell an asset) at
a set price at a future point in time.
• The assets often traded in forward contracts include commodities like grain,
precious metals, electricity, oil, beef, orange juice, and natural gas, but foreign
currencies and financial instruments are also part of today’s forward markets.
• How it works (Example):
• If you plan to grow 500 bushels of wheat next year, you could sell your wheat for
whatever the price is when you harvest it, or you could lock in a price now by
selling a forward contract that obligates you to sell 500 bushels of wheat to, say,
Kellogg after the harvest for a fixed price. By locking in the price now, you
eliminate the risk of falling wheat prices. On the other hand, if prices rise later,
you will get only what your contract entitles you to.
• Forward Contracts Are Not the Same as Futures Contracts
Futures and forwards both allow people to buy or sell an asset at a
specific time at a given price, but forward contracts are not
standardized or traded on an exchange. They are private agreements
with terms that may vary from contract to contract.
• Also, settlement occurs at the end of a forward contract. Futures
contracts settle every day, meaning that both parties must have
the money to ride the fluctuations in price over the life of the
contract.
Concepts and Characteristics Financial
Forward Contracts
• In forward contract, two parties (two companies, individual or government
nodal agencies) agree to do a trade at some future date, at a stated price and
quantity. No security deposit is required as no money changes hands when
the deal is signed.

• Forward contracting is very valuable in hedging and speculation. The

classic scenario of hedging application through forward contract is that of a
wheat farmer forward; selling his harvest at a known fixed price in order to
eliminate price risk. Similarly, a bread factory want to buy bread forward in
order to assist production planning without the risk of price fluctuations.
There are speculators, who based on their knowledge or information
forecast an increase in price. They then go long (buy) on the forward market
instead of the cash market.
Disadvantages of forward markets
• Lack of centralization of trading
• Illiquid (because only two parties are involved)
• Counterparty risk (risk of default is always there)
• However, being traded over the counter (OTC), forward contracts
specification can be customized and may include mark-to-market and
daily margin calls. Hence, a forward contract arrangement might call
for the loss party to pledge collateral or additional collateral to better
secure the party at gain. clarification needed] In other words, the terms
of the forward contract will determine the collateral calls based upon
certain “trigger” events relevant to a particular counterparty such as
among other things, credit ratings, value of assets under management
or redemptions over a specific time frame, e.g., quarterly, annually,
etc.
Futures Contract: Types, Functions
• A futures contract is an agreement to either buy or sell an asset on a
publicly-traded exchange. The asset is a commodity, stock, bond, or
currency. The contract specifies when the seller will deliver the asset.
It also sets the price. Some contracts allow a cash settlement instead of
delivery.

• The role of the exchange is important in providing a safer trade. The

contracts go through the exchange’s clearing house. Technically, the
clearinghouse buys and sells all contracts.
• How Futures Contracts Affect the Economy

• Companies use futures contracts to lock in a guaranteed price for raw

materials such as oil. Farmers use them to lock in a sales price for their
livestock or grain. Futures contracts guarantee they can buy or sell the
good at a fixed price. They plan to transfer possession of the goods
under contract. The agreement also allows them to know the revenue
or costs involved. For them, the contracts reduce a significant amount
of risk.
• Depending on the type of underlying asset, there are different types
of futures contract available for trading. They are:

• Individual stock futures.

• Stock index futures.
• Commodity futures.
• Currency futures.
• Interest rate futures.
INDIVIDUAL STOCK FUTURES

• Individual stock futures are the simplest of all derivative instruments. Stock futures were officially
introduced in India on 9th November 2001. Before that, the local version of stock futures called ‘badla’ were
traded which was eventually banned by the Securities Exchange Board of India in July 2001.

• The Badla system: the ‘badla system’ was almost similar to the futures contracts we discussed. In simple
terms- A badla trader can delay the settlement of a trade by one week for payment of a small fee. So if you
bought a particular share for Rs 100 and if you are bullish on that stock, you can delay the settlement by one
week if you pay a fee. This carry over can be done for any number of times. Later on, unlimited carry over
facility was restricted to 90 days at a time.

• Badla system had its downsides – lack of transparency, data regarding volume, rates of badla charges, open
positions etc were not available. There was no margin requirement and badla charges varied from seller to
seller. So, chances of manipulation were more. Badla was pure Indian version of futures but did not provide
the advantages of price discovery or risk management that organized futures market provide.
STOCK INDEX FUTURES
• Understanding stock index futures is quite simple if you have
understood individual stock futures. Here the underlying asset is the
stock index. For example – the S&P CNX Nifty popularly called the
‘nifty futures’. Stock index futures are more useful when speculating
on the general direction of the market rather than the direction of a
particular stock. It can also be used to hedge and protect
a portfolio of shares. So here, the price movement of an index is
tracked and speculated. One more point to note here is that,
although stock index is traded as an asset, it cannot be delivered to a
buyer. Hence, it is always cash settled.
COMMODITY FUTURES

• It’s the same as individual stock futures. The underlying asset

however would be a commodity like gold or silver. In India,
Commodity futures are mainly traded in two exchanges – 1. MCX
(Multi commodity exchange) and NCDEX (National commodities and
derivatives exchange). Unlike stock market futures where a lot of
parameters are measured, the commodity market is predominantly
driven by demand and supply.
INTEREST RATE FUTURES
• Interest rate futures are traded on the NSC. These are futures based
on interest rates. In India, interest rates futures were introduced on
August 31, 2009.The logic of underlying asset is the same as we saw
in commodity or stock futures – in this case , the underlying asset
would be a debt obligation – debts that move in value according to
changes in interest rates (generally government bonds). Companies,
banks, foreign institutional investors, non-resident Indian and retail
investors can trade in interest rate futures. Buying an interest rate
futures contract will allow the buyer to lock in a future investment
rate.
Distinction between Forward and Futures
Pricing Of Futures Contract
• The value of a futures contract is derived from the cash value of the underlying asset.
While a futures contract may have a very high value, a trader can buy or sell the contract
with a much smaller amount, which is known as the initial margin.

• The initial margin is essentially a down payment on the value of the futures contract and
the obligations associated with the contract. Trading futures contracts is different than
trading stocks due to the high degree of leverage involved. This leverage can amplify
profits and losses.

• Initial Margin

• The initial margin is the initial amount of money a trader must place in an account to open
a futures position. The amount is established by the exchange and is a percentage of the
value of the futures contract.
• Maintenance Margin

• The maintenance margin amount is less than the initial margin. This is
the amount the trader must keep in the account due to changes in the
price of the contract.
• Currency Futures
• The global forex market is the largest market in the world with over $4
trillion traded daily, according to Bank for International Settlements (BIS)
data. The forex market, however, is not the only way for investors and
traders to participate in foreign exchange. While not nearly as large as the
forex market, the currency futures market has a respectable daily average
closer to $100 billion.
• Hedging In Currency Futures
• Currency Hedging is an act of entering into a financial contract in order to
protect against anticipated or unexpected changes in currency exchange
rates. Currency hedging is used by businesses to eliminate risks they
encounter when conducting business internationally.
• The concept of Currency hedging is the use of various financial
instruments, like Forward Contract and other Derivative contracts, to
manage financial risk. It involves the designation of one or more financial
instruments (usually a Bank or an Exchange) as a buffer for potential loss.
Speculation:
• Future contracts are extremely attractive for speculators as they
provide tremendous leverage. By paying a small margin amount,
speculators can take higher exposure of the underlying, thereby
increasing their reward potential as well as the risk. A person who is
bullish on the price of the underlying can BUY a future contract while
a person who is bearish would SELL the future contract.
Hedging:
• Hedging is an act of protecting or guarding the investment against an
undesired price movement. Suppose a long term investor owns a
portfolio of stocks worth Rs 10 lacs. Although he is optimistic about
the stocks he has in the portfolio, he is not very comfortable with the
overall movement of the market. The price movement of a stock is
dependent both on the micro (profitability of the company, its growth
potential, business model, management competency etc) and the
macro factors (GDP growth of the country, interest rates, overall state
of economy etc). Such an investor can hedge his portfolio by selling
Index Futures (like Nifty future) and thereby removing the risk of
macro variables from his portfolio.
Arbitrage:
• An arbitrageur gains by buying the stock and going short in its future
contract when the price of the future contract is higher than its
theoretical price. When the price of the future contract is less than
what it should be, the arbitrageur gains by going long in the future
contract and selling the underlying in cash market.
Cost of Carry Model
• This model assumes that arbitrage between the cash market and the
futures market eliminates all imperfections in pricing, i.e.,
unaccounted for differences between the cash price and futures
price. The difference that remains is due to a factor called ‘the cost of
carry’. The model also assumes, for simplicity sake, that the contract
is held till maturity, so that a fair price can be arrived at.

• To put it briefly, once all distortions in the futures price have been
erased by arbitrage, a fair futures price = the spot price + the net cost
of carry of the asset from today to the date on which the contract
expires.
CoC calculated

• Theoretically, Future price fair value=Spot Price+Cost of Carry-Dividend

Payout Cost of Carry = Difference between the futures and spot price at
any time

• CoC is calculated as an annual rate and expressed in percentage values. The

real-time CoC values are available on stock exchange websites.

• The value of CoC is used as an indicator to understand the market

sentiment i.e. Low CoC means there is a fall in the value of the underlying
and vice versa.
Application of Market Index
• People from many walks of life use and are affected by market indexes.
Economists and statisticians use stock-market indexes to study long-term growth
patterns in the economy, to analyze and forecast business-cycle patterns, and to
relate stock indexes to other time- series measures of economic activity.

• Investors, both individual and institutional, use the market index as a benchmark
against which to evaluate the performance of their own or institutional portfolios.
The answer to the question, “Did you beat the market?” has important
ramifications for all types of investors.

• Market technicians in many cases base their decisions to buy and sell on the
patterns that appear in the time series of the market indexes. The final use of the
market index is in portfolio analysis.
Index Futures in The Stock Market
• A contract for stock index futures is based on the level of a particular stock index
such as the S&P 500 or the Dow Jones Industrial Average. The agreement calls for
the contract to be bought or sold at a designated time in the future. Just as
hedgers and speculators buy and sell futures contracts and options based on a
future price of corn, foreign currency, or lumber, they may—for mostly the same
reasons—buy and sell contracts based on the level of a number of stock indexes.

• Stock index futures may be used to either speculate on the equity market’s
general performance or to hedge a stock portfolio against a decline in value. It is
not unheard of for the expiration dates of these contracts to be as much as two
or more years in the future, but like commodity futures contracts most expire
within one year. Unlike commodity futures, however, stock index futures are not
based on tangible goods, thus all settlements are in cash. Because settlements
are in cash, investors usually have to meet liquidity or income requirements to
show that they have money to cover their potential losses.
Indian Derivatives Market
• Derivatives are financial contracts that derive their value from an
underlying asset such as stocks, commodities, currencies etc., and are
set between two or more parties, where the value of the derivative is
derived from price or value fluctuations of the underlying assets.
• Derivatives markets in India have been in existence in one form or the
other for a long time. In the area of commodities, the Bombay Cotton
Trade Association started futures trading way back in 1875. In 1952,
the Government of India banned cash settlement and options trading.