UNIT -2

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.
 Financial Forward Contracts
• 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.
 Financial Forward Contracts
• Valuing Forward Contracts
The value of a forward contract usually changes when
the value of the underlying asset changes. So if the
contract requires the buyer to pay $1,000 for 500
bushels of wheat but the market price drops to $600 for
500 bushels of wheat, the contract is worth $400 to the
seller (because he or she would get $400 more than the
market price for his or her wheat). Forward contracts are
a zero-sum game; that is, if one side makes a million
dollars, the other side loses a million dollars.
 Financial Forward Contracts
• Why it Matters:
• There are two kinds of forward-contract participants:
hedgers and speculators. Hedgers do not usually seek
a profit but rather seek to stabilize the revenues or costs
of their business operations. Their gains or losses are
usually offset to some degree by a corresponding loss
or gain in the market for the underlying asset. Speculators
are usually not interested in taking possession of
the underlying assets. They essentially place bets on which
way prices will go. Forward contracts tend to attract more
hedgers than speculators.
 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. Now this speculator would go
long on the forward market, wait for the price to rise and then sell it at
higher prices; thereby, making a profit.
Disadvantages of forward markets
• Lack of centralization of trading
• Illiquid (because only two parties are involved)
• Counterparty risk (risk of default is always
there)
 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. 
• The exchanges make contracts easier to buy and sell by making them
fungible. That means they are interchangeable. But they must be for the
same commodity, quantity, and quality. They must also be for the
same delivery month and location. Fungibility allows the buyers to “offset”
contracts. That’s when they buy and then subsequently sell the contracts. It
allows them to pay off or extinguish the contract before the agreed-upon
date. For that reason, futures contracts are derivatives.
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.
• Hedge funds use futures contracts to gain more leverage in the
commodities market. They have no intention of transferring any
commodity. Instead, they plan to buy an offsetting contract at a
price that will make them money. In a way, they are betting on
the future price of that commodity. Price assessment and price
forecasts for raw materials are how commodities futures affect
the economy. Traders and analysts determine these values.
How Futures Contracts Affect the Economy

• Commodities 
• The most important is the oil futures contract. That’s because
they set current and future oil prices. Those are the basis for all
gasoline prices. Other energy-related futures contracts are
written on natural gas, heating oil, and RBOB gasoline. Crude oil
prices affect gasoline prices directly because 71 percent of the
gasoline price is dependent on the price of crude. A rise in crude
oil prices will raise the pump price as well.
• Commodities contracts are also written on metals, agricultural
products, and livestock. They are also written on financials such
as currencies, interest rates, and stock indices. Investing
in commodities futures is risky because prices are volatile and
fraudulence is prevalent. Investors have to know the market very
well or they risk losing their investment, quickly.
How Futures Contracts Affect the Economy

• Forward Contract
• The forward contract is a more personalized form of a futures
contract. That’s because the delivery time and amount are
customized to address the particular needs of the buyer and
seller. In some forward contracts, the two may agree to wait and
settle the price when the good is delivered. A forward contract is
a cash transaction. It is common in many industries, especially
commodities.
• Futures Option
• A futures option gives the purchaser the right, or option, to buy
or sell a futures contract. It specifies both the date and the price.
Contracts on options are commonly set for a month or more.
Weekly contracts are becoming popular for those who like to
wager on short-term events.
How Futures Contracts Affect the Economy
• Forward Rate Agreement
• A forward rate agreement is an over-the-counter forward contract. It is
written on a short-term interest rate. The buyer of an FRA is a notional
borrower. That means the buyer commits to pay a fixed rate of interest
on some amount that is never actually exchanged. The seller of an FRA
agrees notionally to lend a sum of money to a borrower. Investors use
FRAs to hedge interest rate risk or to speculate on future changes in
interest rates. 
• 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.
• Both individual stock futures and index futures are traded in
the NSE.
 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.
• The term ‘commodity’ is a very broad term and it includes –
• Bullion – gold and silver
• Metals – Aluminum , copper, lead, iron, steel, nickel, tin, zinc
• Energy-crude oil, gasoline, heating oil, electricity, natural gas
• Weather- carbon
• Oil and oil seeds – crude palm oil, kapsica khali,refined Soya oil, Soya bean
• Cereals- barley, wheat, maize
• Fiber- cotton, kapas
• Species-cardamom, coriander, termuric etc
• Pluses – chana
• Others- like potatoes, sugar, almonds, gaur
 CURRENCY FUTURES
• The MCX-SX exchange trades the following
currency futures:
• Euro-Indian Rupee (EURINR),
• Us dollar-Indian rupee (USDINR),
• Pound Sterling-Indian Rupee (GBPINR) and
• Japanese Yen-Indian Rupee (JPYINR).
 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 Futures and Forward
 Pricing of Futures Contract, Currency Futures, Hedging
In Currency 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.
 Pricing of Futures Contract, Currency Futures, Hedging
In Currency Futures

• 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.
• For example, a crude oil contract futures contract is 1,000 barrels
of oil. At $75 per barrel, the notional value of the contract is
$75,000. A trader is not required to place this amount into an
account. Rather, the initial margin for a crude oil contract could
be around $5,000 per contract as determined by the exchange.
This is the initial amount the trader must place in the account to
open a position.
 Pricing of Futures Contract, Currency Futures, Hedging
In Currency Futures

• 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.
• In the oil example, assume the maintenance margin is $4,000.
If a trader buys an oil contract and then the price drops $2,
the value of the contract has fallen $2,000. If the balance in
the account is less than the maintenance margin, the trader
must place additional funds to meet the maintenance margin.
If the trader does not meet the margin call, the broker or
exchange could unilaterally liquidate the position.
 Pricing of Futures Contract, Currency Futures, Hedging
In Currency Futures

• 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.
• Currency futures – futures contracts where the underlying
commodity is a currency exchange rate – provide access to the
foreign exchange market in an environment that is similar to
other futures contracts.
 Pricing of Futures Contract, Currency Futures, Hedging
In Currency Futures

• 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.
Different type of Exposure
 Speculation and Arbitrage in
Currency Futures
• 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.
 Speculation and Arbitrage in
Currency Futures
• 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.
 Speculation and Arbitrage in
Currency Futures
• 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.
 Cost of Carry Model
• How is 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.
• How is it interpreted?
• 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.
 Cost of Carry Model
• How is it calculated?
• Traders often refer to CoC to guage market sentiment.
Analysts interpret a significant fall inCoC as an indicator of
an impending fall in the underlying. For example, CoC of
benchmark index Nifty futures dropped by nearly half a
fortnight ago,and served as an indicator of the consequent
correction in the index.Conversely, when the CoC for a
stock future rises, it means that traders are willing to incur
higher costs for holding the position and,thus,expect a rise
in the underlying. CoC is expressed as an annualized figure
in percentage.
 Cost of Carry Model
• CAN COST OF CARRY BE NEGATIVE?
• Yes. When futures trade at a discount to the
underlying, the resultant cost of carry is
negative. This usually happens for two reasons:
when the stock is expected to pay a dividend,or
when traders are aggressively executing a
“reverse arbitrage” strategy, which involves
buying spot and selling futures. Negative cost
of carry points to bearish sentiment
 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.
 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.
 Evolution and features of Derivatives
• Nature of Financial Derivatives:
• Financial derivatives refer to those financial products or instruments which derive
their prices from the prices of their underlying assets. The underlying assets could
include stocks, bonds, foreign currency, or interest rates.
• The primitive and simplest form of derivative is forward contract. It goes on to take
complex forms like swaps, futures, options, share ratios and their different
variations. Derivative securities are also called contingent claims. There are certain
distinguishing features of financial derivatives.
• In the first instance, value of a financial derivative is derived from some other asset.
• Secondly, derivatives are used as vehicle for transferring risk from risk adverse
investors to risk bearing investors.
• Thirdly, financial derivatives provide commitments to prices or rates for the future
dates or given protection against adverse movements of prices or exchange rates
and thereby reduce the magnitude of financial risk.
• Finally, financial derivatives are highly levered.
 Evolution and features of Derivatives
• Evolution and Growth of Financial Derivatives:
• According to some financial scholars, future trading dates back in
India to around 200 B. C. Evolution of trading methods of futures
can be traced in the medieval fairs of France and England as early
as the 12th century. The first futures contracts were reportedly
done in respect of rice in Japan in the 17th century when forward
agreements were entered into for the trading of commodities in
Japan.
• As per the records, rice was traded for future delivery in Osaka in
the 1730s. Wheat and corn futures were reportedly traded in the
UK and the USA in the 19th century. The Chicago Board of Trade
(CBOT), established in 1848, was an active exchange for handling
commodities, especially corn and wheat.
 Evolution and features of Derivatives
• The history of derivatives has two important milestones.
The first was the establishment of stock options trade in
Chicago — initially OTC and subsequently on the CBOT
market in equity derivatives in 1987. The CBOT was set
up in 1848 as a meeting place for farmers and
merchants. It standardized the quantities and qualities
of the grains that were to be traded. The first future
type contract was known as ‘to arrive’ contract.
• The CBOT now offers futures contract on various assets
like corn, soya bean meal, soya bean oil, wheat, silver,
bonds, treasury notes, stock index, etc.
 Derivatives Market:
• The derivatives market is the financial market for derivatives, financial
instruments like futures contracts or options, which are derived from
other forms of assets.
• Derivative markets are investment markets that are geared toward the
buying and selling of derivatives. Derivatives are securities, or financial
instruments, that get their value, or at least part of then- value, from
the value of another security, which is called the underlier.
• The underlier can come in many forms including, commodities,
mortgages, stocks, bonds, or currency. The reason investors may invest
in a derivative security is to hedge their bet. By investing in something
based on a more stable underlier, the investor is assuming less risk than
if she invested in a risky security without an underlier.
 Derivatives Market:
• Derivatives are usually broadly categorized by the:
• Relationship between the underlying and the derivative
(e.g. forward, option, swap)
• Type of underlying (e.g. equity derivatives, foreign
exchange derivatives, interest rate derivatives,
commodity derivatives or credit derivatives)
• Market in which they trade (e.g., exchange traded or
over-the-counter)
• Pay-off profile (Some derivatives have non-linear payoff
diagrams due to embedded optionality)
 Derivatives Market:
• Types of derivatives:
• 1. Over-the-Counter (OTC) Derivatives
• 2. Exchange-traded derivative contracts (ETD)