Futures and forwards

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futures and forward contracts

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Futures and forwards

  1. 1. Futures and Forwards
  2. 2. Portfolio? <ul><li>Set of all securities held by an investor </li></ul><ul><li>It may either consist one security or several securities </li></ul><ul><li>Investment in several securities is known as Diversified portfolio </li></ul>
  3. 3. Risk? <ul><li>To dare …………… in Italian </li></ul><ul><li>Danger opportunity ………… in Chinese </li></ul>
  4. 4. Risk? <ul><li>Eg : returns earned by investors in the past 5 years </li></ul><ul><li>Share A : 30% 28% 34% 32% 31% </li></ul><ul><li>Share B : 26% 13% 48% 11% 57% </li></ul>
  5. 5. <ul><li>Criteria to decide? </li></ul><ul><li>Expected return </li></ul><ul><li>Riskiness of return (measured by variability) </li></ul>Risk
  6. 6. Few types of risk <ul><li>Credit/ Performance Risk </li></ul><ul><li>Price Risk </li></ul><ul><li>Political Risk </li></ul><ul><li>Market/ systematic / non diversifiable Risk </li></ul><ul><li>Diversifiable Risk </li></ul>
  7. 7. Derivative securities <ul><li>Price of the securities that are derived from their underlying assets (goods/ commodities, currencies or shares) </li></ul><ul><li>Future and forward contracts and the markets in which they are traded represent one of the most important feature of financial derivatives </li></ul>
  8. 8. Forward contracts <ul><li>Two parties (buyer and seller) </li></ul><ul><li>An agreement between two individuals </li></ul><ul><li>Seller to deliver – certain amount of ‘good’ </li></ul><ul><li>At a particular price (strike rate) </li></ul><ul><li>At a specified future date (delivery date) and place </li></ul><ul><li>A specified quantity and quality </li></ul><ul><li>Agreed at the time of agreement </li></ul><ul><li>Buyer agrees to make payment </li></ul><ul><li>Parties assume - Long and short positions </li></ul>
  9. 9. Forward contract / long position? <ul><li>Eg : </li></ul><ul><li>Mr A is retiring after 6 months </li></ul><ul><li>He is getting a benefit of Rs 10,00, 000 </li></ul><ul><li>Rs 2,00,000 he wants to invest in shares </li></ul><ul><li>Now, the price per share is Rs 100 through a contract ( Risk - who knows ?! – price may become </li></ul><ul><li>Rs 120!) </li></ul><ul><li>In a way it is an insurance against a future risk – assume you pay Rs 5,000. </li></ul><ul><li>A’s position to buy in future is ‘ LONG POSITION’ </li></ul>
  10. 10. Forward contract / Short position? <ul><li>Eg : </li></ul><ul><li>Mr B has invested Rs 5,00,000 in shares </li></ul><ul><li>He wants to build a house after 6 months </li></ul><ul><li>He fears a fall in share price may cause cash crunch </li></ul><ul><li>He may fix the share price at Rs 100 through a contract to sell (pays Rs 10,000 – insurance!) </li></ul><ul><li>This position to sell -------- ‘SHORT POSITION’ </li></ul>
  11. 11. Future contracts? <ul><li>Subset of forward contracts </li></ul><ul><li>Legally binding forward contracts </li></ul><ul><li>Facilitate trading at any time prior to the maturity of the contract </li></ul><ul><li>Parties can ‘undo’ their commitments at a low cost without breaching any contractual obligations </li></ul><ul><li>Interim partial settlements possible </li></ul><ul><li>Ensure high liquidity through standardisaion </li></ul>
  12. 12. Some well known Future Exchanges <ul><li>Chicago Mercantile Exchange (CME) </li></ul><ul><li>New York Mercantile Exchange (NYME) </li></ul><ul><li>London Metal Exchange (LME) </li></ul><ul><li>International Petroleum Exchange, 1980 </li></ul><ul><li>London International Financial Futures Exchange, 1982 (futures and options) </li></ul><ul><li>Mumbai Stock Exchange </li></ul>
  13. 13. Standardised futures (individuals) <ul><li>Eg: </li></ul><ul><li>4 different future contracts on a given security </li></ul><ul><li>March 31/110 </li></ul><ul><li>June 30/110 </li></ul><ul><li>March 31/90 </li></ul><ul><li>June 30/90 </li></ul>
  14. 14. Difference between forwards and futures <ul><li>forwards </li></ul><ul><li>futures </li></ul><ul><li>Private agreement, identity of both parties compulsory </li></ul><ul><li>No third party </li></ul><ul><li>Identity of other need not be known </li></ul><ul><li>Goes through clearing house/ formal exchange – a third party </li></ul>
  15. 15. <ul><li>forwards </li></ul><ul><li>futures </li></ul><ul><li>No obligation to standardise </li></ul><ul><li>Normally entertained on maturity, unless the parties decide otherwise </li></ul><ul><li>Standardised contracts, in terms of quantity, quality, price, date of delivery, location,.. </li></ul><ul><li>Most contracts are offset before maturity, as they are easily tradable </li></ul>
  16. 16. <ul><li>forwards </li></ul><ul><li>futures </li></ul><ul><li>Tailor made to meet the specific needs of traders </li></ul><ul><li>May workout costly to renegotiate </li></ul><ul><li>Cannot be customised to individual needs </li></ul><ul><li>On default the clearing house imposes certain obligations </li></ul>

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