Derivatives:Forwards and Futures
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Before understanding what is derivative, let’s learn
what is underlying asset.
Underlying
asset: Underlying asset can be real asset such as
commodities, gold etc or financial assets such as index, interest rates etc.
Derivatives:
·
These are financial instruments who value
depend upon or is derived from some underlying asset.
·
A derivative does not have its own
physical existence, it emerges out of contract between the buyer and seller of
derivative instrument.
·
Its value depends upon the value of
underlying asset. Hence returns from derivative instruments are linked to
returns from underlying assets.
·
The most common underlying assets are
stocks, bonds, commodities, market indices and currencies.
·
Derivatives are mainly used to control
risks. They can be used to reduce risks (a process known as hedging) or to
increase risks in order to enhance returns (speculation)
Classification
of Derivatives:
·
Broadly we can divide it into two
categories: Commodity derivatives and Financial Derivatives
·
In case of commodity derivatives, the
underlying asset is a physical asset such as rice, wheat, pulses etc.
·
In case of Financial derivatives, the
underlying asset is a financial asset such as equity shares, stock index,
exchange rates etc.
·
Financial derivatives are further classifying
into Forwards, Futures, Options, Swaps.
In this
article, we will focus on Forwards and Futures, in the next article we will
focus on Options, swaps.
Forwards:
A
forward contract is a private bilateral contract between two parties to buy and
sell a specified asset at a specified price on a specified date.
Consider a farmer in
Haryana, Mr. Sardana, plans to grow 1000kgs of wheat this year. He can sell his
wheat for whatever the price is when he harvests it, or he could lock in a
price now by selling a forward contract that obligates him to sell 1000kgs of
wheat to ITC ltd. after the harvest for a specified price. By locking the price
now, he is actually eliminating the risk of falling wheat prices. On the
downside, if prices rise later, he is foreclosing the opportunity of future
super profits. The transaction that Mr. Sardana has entered into is known as
Forward Transaction and the contract covering such transaction is known as
Forward Contract.
Let’s take other example
from Financial forward contract point of view, Suppose an Indian Company has to
pay import bills of $150000 after 3 months. So, the company is facing the risks
of rupee depreciation i.e. the price of US dollars may go up (as in $1=Rs.65 to
$1=Rs.70 it means rupee depreciates). To guard against such exchange rate risk,
company may enter into a forward agreement with some other company to buy
$150000 at a specified price after 3 months. This way it has hedged its
position. On the downside, the rupee may appreciate (i.e. $1=Rs.65 to
$1=Rs.60).
·
Each Contract is custom designed and
parties may decide expiration date, asset type etc.
·
Both the parties have equal rights and
obligations. The buyer is obliged to buy and seller is obliged to sell at
maturity.
·
Forward contracts are private and
nonregulated.
·
Being a private contract, there are
chances of default by any party.
·
Contracts are generally held till
maturity.
·
The investor agrees to sell the asset is
said to hold short forward position in the asset, and the buyer is said to hold
a long forward position.
Futures:
A
futures contract is a modified forward contract. It is a contract to buy or
sell a specified asset at a specified price on a specified future date. It is
traded on exchange and is a standardised contract.
·
Futures contract has no default risk
because exchange acts as a counterparty and guarantees delivery with the help
of clearing house.
·
An investor can offset his future position
by engaging in an opposite transaction before the stipulated maturity of the
contract.
·
Margin
Requirement: All futures contracts have margin
requirements. Margin money is required to be deposited with the exchange by
both the parties to safeguard their interests. There are two types of MarginsInitial Margin and Maintenance Margin. Initial
Futures Margin is the amount of money that is required to open a buy or sell
position on a futures contract. The margin rate varies
between 5 and 15% of the total contract value. Maintenance margin
is the amount of money necessary when a loss on a futures position requires one
to allocate more funds to return the margin to the initial or original margin
level.
·
Example
of Margin Requirement: Let’s assume we have a contract
value of Rs.20,00,000 and the initial margin is 5% and maintenance margin is
2%, then both the parties of the contract has to deposit Rs.1,00,000 (i.e. 5%
of 20,00,000). Now margin account is settled on daily basis i.e. mark to market
settlement. If margin amount in the account on any day falls below the
maintenance margin of Rs. 40,000 (i.e. 2% of 20,00,000) then a variable call is
made to replenish the margin amount to the level of initial margin.
Financial Futures are
based on an underlying financial instrument, rather than a physical commodity.
They are categorized as follows:
1.Bond Futures 2. Short
interest Futures 3. Stock index Futures 4. Currency Futures.
Pricing
of Futures (or Forward) Contract:
·
The theoretical or fair price of
the futures contract can be determined through Cost of Carry Model. The actual
price of Futures contract is determined through the forces of supply and demand
in the Futures market.
·
Cost of Carry reflects the cost of holding
the underlying asset or shares over the life of futures contract reduced by the
amount the shareholder would receive in dividends or income on those assets
during that time. There are the following situations:
Situation

Applicable
Pricing Model

When the underlying asset provides no
income (or dividend)

F=Se^{rt}

When the underlying asset provides known
income

F=(SI)e^{rt}

When the underlying asset provides known
income yield (or dividend yield)

F=Se^{(rq)t}

Here F= Futures(or
Forwards) Price, S= Spot Price, r=continuously compounding rate of interest,
t=time duration of Futures in years, I= present value of income or dividend at
r, q= income yield (or dividend yield)
Let’s
see some examples here:
q. Consider the
price of shares of X ltd. is Rs.50 in the spot market. The riskfree rate is
12% per annum continuous compounding. An investor wants to enter into a 6
months forward contract. Calculate the forward price?
a.) F=Se^{rt}
= 50e^{(.12)6/12} = Rs.53.09
q.) Consider 12month
stock index futures contract on NIFTY index. The current value of index is 5200
and continuously compounding risk free rate of return is 10%p.a.. Stock index is expected to provide
Rs.120 at the end of year. Calculate price of one futures contract if lot size
is 100?
a.) Firstly
let’s calculate PV of Dividend that we will receive after one year i.e. 120e^{0.10} = 108.58. Now F= (SI)e^{rt} = 100*(5200108.58)e^{.10} = Rs.562689
Note: The value of
forward and futures contracts is found using risk free investment rate.
Basis

Forwards

Futures

Standardisation
of Contract

Nonstandardised

Standardised

Regulation

They
are not regulated

They
are regulated

Counter
party default risk

Party
may default

Clearing
house guarantees the transaction

Liquidity

Low

High

Settlement

At
the end of contract

They
are marked to market on daily basis which means settled day by day until the
end of contract.

Hedging/speculation

They
are popular among hedgers

They
are popular among speculators.

Margin
requirements

No
requirement

Initial
and maintenance margin

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References:Fundamentals of Investments (Vanita Tripathi)
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