Observation
The futures market is an important part of financial derivatives. A derivative is a type of security that has a price linked to another product. This second product is commonly referred to as the underlying asset. This underlying asset can be anything such as a share, bond, commodity or currency. It has been practiced for centuries. It is also mentioned in the era of Kautilya/Chanakya in 320 BC. Kautilya in his Arthashastra has discussed the price of the crop which is going to be harvested sometime in the future. It is believed that Kautilya used to pay this price to the farmers before the harvest. It refers to the structure of the forward contract.
Considering the similarities between the forward market and the futures market, I thought we should understand the forward market before talking about the futures market. It can be seen as a strong foundation for understanding the futures market.
Forwards contracts are the most straightforward and simplest form of derivatives. You can think of forward contracts as the oldest incarnation of futures contracts. Although both share a similar transactional structure, in the past few years, futures contracts have become the default option for traders, meaning it has become their first choice. Forward contracts are still used, but now only a few industries or banks use them, whereas futures contracts are widely used in the market. Our focus in this chapter will be that you understand the structure of a forward transaction properly, after that we will see its different part with its merits and demerits.
Simple example of forwards
Forward market was brought to the farmers to save them from price volatility. In the forward market buyer and seller enter into an agreement/contract/agreement to trade or exchange cash for the goods/goods/goods that are being sold. Here there is already an agreement on what date or day in the future this deal will happen and at what price. The date and time of delivery of the item is also decided. This agreement or agreement or deal is between two people face to face and there is no interference of any third party in it. This is called an “Over the Counter or OTC” agreement. Forward contracts are traded only through OTC.
Let’s see an example:
Suppose there is a jewelry maker- ABC Jeweller, whose job is to design and make jewelry. The other is another person whose job is to import gold, that is, to order gold from abroad and sell it to jewelers at wholesale prices in the domestic market. Suppose his name is XYZ Gold Dealer.
Now on 9th December 2014 there is an agreement between ABC Jeweler and XYZ Gold Dealer that ABC will buy 15 kg gold for its work from XYZ after 3 months i.e. on 9th March 2015. In this agreement, the price of gold is fixed at ₹2450 per gram i.e. ₹24,50,000/kg. According to this agreement, ABC is to pay ₹3.675 crore (24,50,000 × 15) to XYZ on March 9, 2015 and get 15 kg of gold.
It is a very simple business deal and such deals are called forward contract or forward agreement or settlement.
Note here that this deal is done on 9th December 2014 while both do not know what will be the price of gold after 3 months. Before moving on let us see why both of them did this?
Why do you think ABC did this deal? Because ABC thinks that the price of gold will increase after 3 months and hence it will be good for him if he buys gold at the current low price i.e. ABC wants to avoid increase in the price of gold.
In a forward contract, the buyer is called the “buyer of the forward contract”, which in this case is the ABC jeweler.
XYZ on the other hand thinks that gold prices will go down in the next 3 months so if he is getting a chance to sell gold at the current price then it is good for him. Since he is the seller in this agreement, he will be called the “Seller of Forward Contract”.
It is clear that both ABC and XYZ have different views on the future of gold and both feel that this agreement is beneficial for them.
3 possible scenarios
Although both of them have different opinion about gold prices but in reality only three things can happen. Let us see what are the possibilities and what will be their impact.
Scenario 1- First possibility gold price will go up
Suppose the price of gold becomes ₹ 2700 per gram on 9th March 2015. This means that ABC Jeweler’s opinion turned out to be correct. He made a gold deal at the right time for Rs 3.67 crore, whereas if he had done the same deal now, he would have had to pay Rs 4.05 crore. Now he will get gold only at the predetermined price i.e. ₹ 2450 per gram.
Let us see how the increase in the price of gold will affect both parties.
| Party | Action |
Financial Impact |
|---|---|---|
| ABC Jeweler | Deal price Rs.2450/- per gram | ABC profits rs 38 lacs |
| XYZ gold dealer | need to sell to ABC @ Rs.2450/- per gram | loses rs 38 lacs |
So XYZ will now have to buy gold at ₹ 2700 per gram and sell it to ABC Jeweler at ₹ 2450 per gram. This will harm him.
Scenario 2- Second possibility Sony gold price goes down
Suppose the price of gold becomes ₹ 2050 per gram on 9th March 2015 i.e. the opinion of XYZ Gold dealer turns out to be correct. When he entered into the settlement, the matter was Rs 3.67 crore. But if he had done this agreement today, he would have got only Rs 3.075 crore. But ABC Jeweler will now have to buy gold only at 2450 per gram.
Let’s see how it affects both the parties.
| Party |
Action | Financial Impact |
|---|---|---|
| ABC jeweler | need to buy gold from xyz @ Rs.2450/- per gram | Abc loses 59.5 lacs Rs. |
| XYZ gold dealer | Has the right to sell gold to ABC @ Rs.2450/- per gram | XYZ makes a profit of 59.5 lac rs. |
Scenario 3 – Third Chance There is no change in the price of gold
If the price of gold on 9th March 2015 remains the same as it was on 9th December 2014, then neither ABC will gain nor XYZ will gain.
1.4 – A graph of all three possibilities
Let us look at a graph which shows these three possibilities keeping in mind ABC –
As you can see that if the price of gold remains ₹ 2450 per gram then it does not affect ABC. But as the price of gold keeps changing, so does its effect on ABC. The more the price of gold increases, the more ABC is saved i.e. it benefits and in the same way, ABC suffers as much as the price of gold falls below ₹ 2450 per gram.
A similar graph can be drawn for XYZ as well.
₹2450 per gram has no effect on XYZ but as the price of gold changes so does its effect on XYZ. When the price of gold rises from ₹2450 per gram, XYZ has to sell the gold cheaply and incur a loss. Similarly, if the price of gold falls below ₹2450 per gram, XYZ gains because that gold Will be able to sell at a higher price.
1.5 – A quick note on settlement
Suppose the price of gold on March 9, 2015 is ₹ 2700 per gram. We know that ABC Jewelers profit at ₹ 2700 per gram. At the time of settlement i.e. on 9 December 2014, the price of 15 kg gold was Rs 3.67 crore whereas after the increase in the price, the price of 15 kg gold on 9 March 2015 becomes Rs 4.05 crore. After 3 months both the parties have to terminate this agreement and make the settlement. There are two options before them:
Physical Settlement – Here the buyer pays the full price as per the agreement and the seller gives the entire goods to him as per the agreement. For example, XYZ buys 15 kg of gold, which he gets for Rs 4.05 crore, gives the same gold to ABC for Rs 3.67 crore. This is called physical settlement.
Cash Settlement – In this type of settlement no goods are delivered i.e. no delivery takes place. In this type of settlement, the seller and the buyer exchange money only on the basis of the difference in price and the agreement is completed. According to this example, XYZ made a deal to sell gold to ABC at ₹ 2450 per gram i.e. ABC was to pay Rs 3.67 crore to XYZ and he was to get 15 kg of gold from XYZ, which is currently priced at ₹ 4.05 crore in the market. Is. Now instead of giving gold to XYZ, ABC will give the difference between ₹3.67 crores and ₹4.05 crores i.e. 4.05-3.67 = ₹38 lakhs to him. So that ABC can buy gold at the current price in the market. Such settlement is called cash settlement.
We will understand more about the settlement further but for now all you need to know is that there are 2 types of settlement, physical settlement and cash settlement.
1.6 Risk
So far we have looked at the deal and the effect of its price on the parties, but we have not talked about the risk till now. The risk is not just about price changes. There are other drawbacks of forward contracts which are important to know.
Liquidity Risk – In our example, we have simply assumed that ABC and XYZ, which have opposite views on gold prices, are present in the market. So a compromise was easily reached between the two. But in reality it is not always possible for this to happen. Usually, one party approaches an investment bank and conveys its opinion to it. The investment bank then looks for another party who has the opposite opinion. The investment bank charges a fee for this service.
Default Risk / Counter Party Risk – Suppose the price of gold increases to ₹ 2700 per gram. If ABC feels then it has taken the right financial decision and it will now benefit. He hopes that now XYZ will give him the money. But what if XYZ defaults, that is, does not fulfill the agreement?
Regulatory Risk – Forward contract agreements are made by sitting among themselves. There is no regulatory or regulatory authority in this. Therefore, the chances of defaulting or breaching the agreement increases.
Rigidity – Both the parties made an agreement on gold prices on 9th December 2014 but what if either of them changes their opinion before 3 months? This agreement is such that it cannot be terminated earlier.
It is because of these drawbacks of forward contracts that futures contracts were introduced so that the risk could be reduced.
The futures market in India has become very big. In this module, we will discuss the futures market and how to trade in it.
Highlights of this chapter
- The futures contract is created on the basis of the forward contract itself.
- A forward contract is an OTC derivative that is not bought or sold on an exchange.
- Forward contracts are private contracts in which the terms of each agreement or contract are different.
- Forward contracts are very simple.
- In a forward contract, the party who wants to buy the goods is called the buyer of the forward contract.
- The party which sells the goods in forward contract is called seller and forward contract.
- Any change in the price affects both the seller and the buyer.
- There are two types of settlement in a forward contract, physical settlement and cash settlement.
- In order to reduce the risk in the forward contract, the futures contract has been introduced.
- Forward contract and futures contract basis is the same.
Gaurav Heera is a well known name in the field of stock market analysis and education. His distinguished career, which spans more than ten years, has cemented his reputation as an expert with unparalleled knowledge and innovative strategies for navigating the intricate landscape of the financial markets.