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Forwards vs Futures

You use derivatives to reduce risks, not to increase profits.

Introduction

  • 3 segments of any organization dealing with derivatives
    • Front Office
      • Very high tension jobs - don't survive for more than 5 years. If your decisions go wrong \(\implies\) Bankruptcy is on the line (Very high risk)
      • Traders have some limits to manage the risk.
    • Middle Office
      • Looking at the risk for the company as a whole. (Overall exposure of risk)
    • Back Office
      • Record-keeping section
  • Mindsets
    • Hedger
      • He is already exposed to a certain amount of risk
      • He takes a counter position to his original position.
      • Ask rate and bid rate1
      • e.g. Dollar and rupee exchange transactions
    • Speculator
      • "The moment I will let out this information in the market, the price of the stock will fall" \(\implies\) Short sell it.
    • Arbitrager
      • He is able to discover a price differentiation between two markets.
      • Before anyone discovers, he will buy from the market (where cheap) and sell in the market (where expensive). Do it fast enough before anyone discovers and the stock reaches its fair price.
  • Short = sale, long = purchase

A good source

https://zerodha.com/varsity/

Derivative

  • It includes
    • a security derived from a debt instrument, share, loan, risk instrument or contract for differences or any other form of security
    • a contract that derives its value from price/index of prices of underlying securities
  • Economic functions performed by derivative markets
    1. Help in discovery of future and current prices2
    2. Transfer risk: risk averse \(\to\) those with appetite
    3. Underlying cash markets witness high trading volumes
      • The number of participants in the market increases \(\implies\) the liquidity increases \(\implies\) good for the market
    4. Speculative trades \(\to\) more controlled derivative market environment
    5. Help \(\uparrow\) savings & investments in the future.

Forward Contracts

  • An agreement
    • buy/sell an asset
    • on a specified date
    • for a specified price
  • Useful in hedging and speculations
  • Limitation
    • Counterparty risk of default of any one party to the transaction (in case they lose)
  • \(\impliedby\) Lacks centralized trading and facing liquidity risk.
    • There is NO standardized products3
  • Features
    • Bilateral contracts = between two parties
    • \(\implies\) have counterparty risk
    • Customer designed — unique in terms of contract size, expiration date4
    • Contract price is private.
    • On expiry, settled by actual delivery of asset
    • To reverse contract \(\impliedby\) Approach same counterparty (needed)

Futures/Future Contracts

  • An agreement (Bilateral contracts)
    • buy/sell an asset
    • at a certain time in the future at a certain price
    • May be offset prior to maturity by entering into an equal but opposite transaction
  • Features
    • Standardized contracts \(\impliedby\) Underlying instrument is also standardized
    • Traded on an exchange
    • Standard contract terms (not tailor made) \(\to\) Quantity, Quality of underlying
      • Date/month of delivery
      • units of price quotation
      • Minimum price
Forwards Futures
Traded Over the Counter Traded in exchange
Customized contracts Standardized contracts \(\implies\) more liquid
Settlement is physical / in case on maturity date Marked to market5; settlement in cash daily
No collateral requirement. Not a regulated market Margin6 requirement Regulated by SEBI in India
Counterparty risk No counterparty risk \(\impliedby\) Borne by Clearing Corporation
Contracts are not transferable \(\implies\) Liquidity risk Transferable \(\implies\) Tradable
Time bound to just one timeframe Multiple timeframe contracts available.
Participation limited to small number of large traders Large number of participants

Futures Terminology

Term Meaning
Spot Price Price at which instrument/asset trades in the spot market
Future Price Price at which futures contract trade in the future market
Contract Cycle - Period over which contracts trade
- Typically one month, two months and three months
- Expiry cycles that expire on the last Tuesday1 of the month.2
- Now is September, 9/12/2025… the contract that matures this month's last Tuesday: Near-month contract
- Last Tuesday of next month (October) (+30 days) \(\implies\) Mid-month (October is the mid-month)
- Last Tuesday of (+60 days) (November) \(\implies\) Far-month
Expiry date Specified date. Last day on which the future will be traded.
Contract size Amount of asset that has to be delivered under one contract.
Cost of Carry Storage cost + interest rate paid to finance the asset
Market-to-market Margin account is adjusted to reflect investor's gain/loss

  1. Bid rate: Highest price a buyer is willing to pay for an asset. Ask rate: Lowest price a seller is willing to accept. ↩↩

  2. From Arthashastra, when harvest is ready to be sold, how it can be priced if its harvest is delayed. Fix the price today, and delivery five days from now. Amazon ↩↩

  3. I will have to buy someone who is ready to buy this particular amount of the stock. ↩

  4. Try buying 6 kg coffee in the market (you will have to find a seller) ↩

  5. With respect to the market price ↩

  6. Think of margin like an account, when you exit/liquidate the contract, you will get the money in the margin. Some amount of the contract value has to be deposited (initial). Two types: (i) Initial margin, (ii) Maintenance margin, if the price keeps falling from (i) to (ii), we get a margin call (= notification) ↩