DERIVATIVE INSTRUMENTS

 Unit 2: 

DERIVATIVE INSTRUMENTS –FORWARD AND FUTURES

Syllabus- Forward Contract: Meaning & Definition, Features, Terminologies, Pricing of Forward, Contract Limitations, and Explanation of Forward Contract with a simple example Futures Contract: Meaning & Definition, Terminologies, Participants, Types of Futures Contract, Futures v/s Forwards, Pricing of Futures: Theoretical Pricing of Derivatives - Cost of Carry Model (Theory Only), Explanation of Future Contract with a simple example, Futures Market in India – Recent Developments

Introduction

Meaning of Forward Contract

 A Forward Contract is a contract made today for delivery of an asset at a pre-specified time in the future at a price agreed upon today. In other words, a forward contract is a contract between two parties who agree to buy/sell a specified quantity of a financial instrument/commodity at a certain price at a certain date in future.

A forward contract is an agreement between two parties to buy or sell underlying assets at a pre determined future date at a price agreed when the contract is entered into. Forward contracts are not standardized products. They are over-the-counter (not traded in recognized stock exchanges) derivatives that are tailored to meet specific user needs. 

The underlying assets of this contract include:

 1. Traditional agricultural or physical commodities 

2. Currencies (foreign exchange forwards) 

3. Interest rates (forward rate agreements or FRAs)

Definition of forward contract

In finance, a forward contract  is defined as  a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument

Classification of Forward Contracts 

Forward contracts in India are broadly governed by the Forward Contracts (regulation) Act, 1952. According to this act, forward contracts are of the following three major categories. 

1. Hedge Contracts: These are freely transferable contracts which do not require specification of a particular lot size, quality or delivery standards for the underlying assets. Most of these are necessary to be settled through delivery of underlying assets. 

2. Transferable Specific Delivery Forward Contracts: Apart from being freely transferable between parties concerned, these forward contracts refer to a specific and predetermined lot size and variety of the underlying asset. It is compulsory for delivery of the underlying assets to take place at expiration of contract. 

3. Non-transferable Specific Delivery Forward Contracts: These contracts are normally exempted from the provision of regulation under Forward Contract Act, 1952 but the Central Government reserves the right to bring them back under the Act when it feels necessary. These are contracts which cannot be transferred to another party. The contracts, the consignment lot size, and quality of underlying asset are required to be settled at expiration through delivery of the assets.

Terminologies used in forward contract

The important terminologies used in forward contracts are described below. 

1. Underlying Asset: This refers to the asset on which forward contract is made i.e., the long position holder buys this asset in future and the short position holder sells this asset in future. The various underlying assets are equity shares, stock indices, commodity, currency, interest rate, etc. For example, in the above case, sugar (a commodity) is the underlying asset. 

2. Long Position: The party that agrees to buy an underlying asset (e.g. stock, commodity, stock index, etc.) in a future date is said to have a long position. For example, in the above case, Mr.Y is said to hold a long position. The long position holder on the contract agrees to buy the underlying asset on the future date because they are betting the price will go up. 

3. Short Position: The party that agrees to sell an underlying asset (e.g. stock, commodity, indices, etc.) in future date is said to have a short position. For example, in the above case, Mr. X is said to hold a short position. The short position on the contract agrees to sell the security on the future date because they are betting the price will go down.

 4. Spot Position: This is the quoted price of the underlying asset for buying and selling at the spot time or immediate delivery. For example, in the above case, the spot price of sugar (underlying asset) is ` 23 per kg. 

5. Future Spot Price: This is the spot price of the underlying asset on the date the forward contract expires and it depends on the market condition prevailing at the expiration date. For example, in the above case, we have considered two situations for futures spot price i.e, ` 30 and ` 20. 

6. Expiration Date: This is the date on which the forward contract expires, or also referred to as maturity date of the contract. For example, in the above case, the expiry date is 1st July, 2006. 

7. Delivery Price: The pre specified price of the underlying assets at which the forward contract is settled on expiration is said to be delivery price. For example, in the above case, the delivery price is ` 25 per kg. of sugar.

  Features of Forward Contracts 

The salient features of forward contracts are: 1. They are bilateral negotiated contract between two parties and hence exposed to counter party risk.

2. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type, quality, etc. 

3. A contract has to be settled in delivery or cash on expiry date.

 4. The contract price is generally not available in the public domain. 

5. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.

Limitations of Forward Markets 

Forward markets world-wide are afflicted by several problems:

 1. Lack of centralization of trading, 

2. Illiquidity, and 

3. Counterparty risk

Example of a Forward Contract

Forward contracts were first used by farmers. Let’s understand how a forward contract works with the help of an example of a rice farmer Mr Iyer who is based out of Madurai. Now, cultivation of crops is not an easy job. A farmer needs to plough the fields, sow the seeds, use fertilisers, ensure adequate irrigation etc. Also, he ends up investing a substantial amount of time, energy and resources. But the farmer earns money or returns on his produce only after selling the rice. His entire income is dependent on the produce.

So, let’s assume that currently rice is being sold at ₹20 per kg. If the price of the rice goes down, he will make losses. And if the price goes up, he stands to gain.

Hence, Mr Iyer would like to eradicate this uncertainty. So, he enters into an agreement with Mr. Raj, who is a wholesaler in Kolkata. The agreement states that Mr Raj will buy 500 kgs of rice at the price of ₹20 per kg, two months from now from Mr Iyer. This quantity of rice will be delivered to Mr Raj’s warehouse through trucks and the cost of transportation will be borne by Mr. Raj.

It means, in this scenario, Mr Iyer is the seller and Mr Raj is the buyer of this forward contract. The predetermined quantity of rice to be sold is 500 kgs and the price at which the rice will be sold is ₹20 per kg. Hence, the price of forward contract is ₹10,000 (500 * 20), which derives its value from the underlying – rice.

Introduction to Futures

 A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities - remember, buyers and sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures are used as financial instruments by not only producers and consumers but also by speculators. 

A future contract is a standardized agreement between the seller (short position) of the contract and the buyer (long position), traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in future, at a pre-set price. 

The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. Thus, futures is a standard contract in which the seller is obligated to deliver a specified asset (security, commodity or foreign exchange) to the buyer on a specified date in future and the buyer is obligated to pay the seller the then prevailing futures price upon delivery

Characteristics of Futures Contracts 

Following are the salient features of futures contracts: 

1. Futures are highly standardised contracts that provide for performance of contracts through either deferred delivery of asset or final cash settlement; 

2. These contracts trade on organized futures exchanges with a clearing association that acts as a middleman between the contracting parties;

 3. Contract seller is called 'short' and purchaser 'long'. Both parties pay margin to the clearing association. This is used as performance bond by contracting parties; 

4. Margins paid are generally marked to market-price everyday; 

5. Each futures contract has an associated month that represents the month of contract delivery or final settlement. These contracts are identified with their delivery months like JulyTreasury bill, December $/DM etc. 

6. Every futures contract represents a specific quantity. It is not negotiated by the parties to the contract. One can buy or sell a number of futures contracts to match one's required quantity. Because of this feature, 100% hedging is not possible. There may be over or under-hedging to some extent.

Types of Future Contracts

 Futures contracts are of three major categories: 

4.2.1 Stock Index Futures These futures contract without actual delivery were introduced only in 1982 and are the most recent major futures contract to emerge. A stock index futures contract is a contract to buy or sell the face value of the underlying stock index where the face value is defined as being the value of index multiplied by the specified monetary amount.

4.2.2 Commodity Futures The commodity futures include: 1. Agricultural futures contracts: These contracts are traded in grains, oil and meal, livestock, forest products, textiles and foodstuff. Several different contracts and months for delivery are available for different grades or types of commodities in question. The contract months depend on the seasonality and trading activity. 2. Metallurgical futures contract: This category includes genuine metal and petroleum contracts. Among the metals, contracts are traded on gold, silver, platinum and copper. Of the petroleum products, only heating oil, crude oil and gasoline are traded. 

4.2.3 Currency Futures Currency future is the price of a particular currency for settlement at a specified future date. Currency futures are traded on future exchanges and the exchanges where the contracts are fungible (or transferable freely) are very popular. The two most popular future exchanges are the Singapore International Monetary Exchange (SIMEX) and the International Money Market, Chicago (IMM). Other exchanges are in London, Sydney, Frankfurt, New York, Philadelphia, 

Distinction between Future and Forward Contracts

The following are the distinguishing features between forwards and futures:

 1. Delivery of the underlying is the hallmark of a forward contract. To the contrary the vast majority of futures contracts – even though they provide for delivery – are satisfied by entering into an offsetting contract or selling the contract on the exchange – namely, no delivery. This is the primary distinguishing feature of the forwards as given by the CFTC. Forwards also typically have been described by reference to the commercial natures of the counter parties which have the capacity to make or take delivery. 

2. A forward contract is entered into for commercial purposes related to the business of the party wanting to enter into the forward. The producer, processor, fabricator, refiner, or merchandiser may want to purchase or sell a commodity for deferred shipment or delivery as part of the conduct of its business. In contrast, futures contracts are undertaken principally to assume or shift price risk without transferring the underlying commodity. 

3. A forward contract is privately and individually negotiated between two principals. A futures contract is an exchange-traded contract, with standardized provisions including: commodity units; margin requirements related to price movements; clearing organizations that guarantee counter party performance; open and competitive trading on exchanges; and public dissemination of price.

 4. A forward contract generally is not assignable without the consent of the contracting parties and does not provide for an exchange-style offset. A futures contract is fungible, because of its standardized form, and hence can be traded on an exchange. 

5. With a forward contract, no clearing house, no settlement system, and – according to CFTC – no variation margining is involved. All of these features apply to a futures contract.

Pricing Principles 

Before discussing valuation of futures contracts, we must make a clear distinction in pricing method used for whether the underlying asset is held for investment or for consumption. Assets underlying individual stock futures are for investment purpose, whereas those like rice futures (commodity) are exclusively for consumption. 

The basic principle of futures pricing involve the requirement of 'no arbitrage opportunities'. The price of a future is determined via arbitrage arguments. The future price represents the expected future value of the underlying discounted at the risk free rate-as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away. Thus, for a simple, non-dividend paying asset, the value of the future, F(t), will be found by discounting the present value S(t) at time t to maturity (T) by the rate of risk-free return (r)

Theoretical Pricing of Derivatives - Cost of Carry Model (Theory Only),

Cost-of-carry model is an arbitrage-free pricing model. Its central theme is that futures contract is so priced as to preclude arbitrage profit. In other words, investors will be indifferent to spot and futures market to execute their buying and selling of underlying asset because the prices they obtain are effectively the same. 

Expectations do influence the price, but they influence the spot price and, through it, the futures price. They do not directly influence the futures price. If the investor does not book a futures contract, the alternative form to him is to buy at the spot market and hold the underlying asset. In such a contingency he would incur a cost equal to the spot price + the cost of carry. 

The theoretical price of a futures contract is spot price of the underlying plus the cost of carry.  This model stipulates that future prices equal to sum of spot prices and carrying costs involved in buying and holding the underlying asset, and less the carry return (if any). We use fair value calculation of futures to decide the no-arbitrage limits on the price of a futures contract. According to the cost-of-carry model, the futures price is given by: Futures price = Spot Price + Carry Cost – Carry Return

Explanation of Future Contract with a simple example,

Let’s understand it with a simple futures contract example:

Luther started a company that consistently requires silver, and his company is already in conversation with a company supplying silver. The silver provider uses a futures contract to bind Luther and his company, promising to sell a fixed quantity of silver at a pre-determined price and the time the delivery will be executed. Luther agrees to the contract. Now both of them are obligated to trade the silver in the future at a set price.

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