1. Module No. 2: Forwards and Futures
Introduction- meaning of futures and
forward contract, Features of future contracts,
Futures v/s Forwards. Various forms of
futures. Payoff, Equity Index, stock index,
Interest rate futures. Futures trading
strategies: Margins, Hedging, Speculation,
Arbitrage, Spread trading. Forwards market
Commissions and Regulation. Relevant Case
studies and articles.
2. Introduction
• The financial contracts, Forwards and Futures are
quite similar in nature and follow the same
fundamental function; they allow traders to buy
or sell the specific type of asset at a given price at
a given time.
• However, there exist some important differences
between the two. The major difference between
• Futures and Forwards is that Futures are traded
publicly on exchanges and the Forwards are
privately traded.
3. Meaning of Futures
• The Futures Contract The Futures contracts, also referred to
as Futures, are those standardized instruments that are
traded through brokerage firms, on the stock exchange
which trades that specific contract. The terms for the
Futures contract like the volume, delivery dates, credit
procedures and technical specifications are standardized
for each kind of contract. Similar to the ordinary stock
trading, both the parties involved will work through their
brokers and transact in the futures trade. Currency Futures
are one of the most traded futures contracts. It is also
known as FX Future and is a Futures contract using which
the trader can exchange one currency with another on a
said date in the future at the price, which is fixed on the
day of purchase.
4. Meaning of Forwards
The Forward Contract The Forward Contract or the
Forwards is the agreement which takes place between
two parties to either buy or sell the asset at the pre
agreed time at a specific price. The Forward contract
can entail both the credit risk and the market risk and
the profit or loss on such contracts is only known
during the time of settlement. Like in Futures, Currency
Forwards is one binding contract in the foreign
exchange market which locks the exchange rate for a
future date for the sale or buy of a currency. This is
normally implemented like hedging and does not
involve any initial payment. The Currency Risk too is
comparatively low in forwards than the currency
futures.
5. Features of future contracts
1. Organised Exchanges: Unlike forward contracts which
are traded in an over-the-counter market, futures are
traded on organised exchanges with a designated
physical location where trading takes place. This
provides a ready, liquid market in which futures can be
bought and sold at any time like in a stock market.
2. Standardisation: In the case of forward currency
contracts, the amount of commodity to be delivered
and the maturity date are negotiated between the
buyer and seller and can be tailor-made to buyer’s
requirements. In a futures contract, both these are
standardised by the exchange on which the contract is
traded.
6. Cont.
3. Clearing House: The exchange acts as a clearing house to all contracts struck on the
trading floor. For instance, a contract is struck between A and B. Upon entering into
the records of the exchange, this is immediately replaced by two contracts, one
between A and the clearing house and another between B and the clearing house. In
other words, the exchange interposes itself in every contract and deal, where it is a
buyer to every seller and a seller to every buyer. The advantage of this is that A and B
do not have to undertake any exercise to investigate each other’s creditworthiness. It
also guarantees the financial integrity of the market.
4. Margins: Like all exchanges, only members are allowed to trade in futures contracts
on the exchange. Others can use the services of the members as brokers to use this
instrument. Thus, an exchange member can trade on his own account as well as on
behalf of a client. A subset of the members is the “clearing members” or members of
the clearing house and non- clearing members must clear all their transactions
through a clearing member. The exchange requires that a margin must be deposited
with the clearing house by a member who enters into a futures contract. The amount
of the margin is generally between 2.5% to 10% of the value of the contract but can
vary. A member acting on behalf of a client, in turn, requires a margin from the
client. The margin can be in the form of cash or securities like treasury bills or bank
letters of credit.
7. Cont.
5. Marking to Market: The exchange uses a system
called marking to market where, at the end of
each trading session, all outstanding contracts are
reprised at the settlement price of that trading
session. This would mean that some participants
would make a loss while others would stand to
gain. The exchange adjusts this by debiting the
margin accounts of those members who made a
loss and crediting the accounts of those members
who have gained.
10. As per the above discussion, it can be said that there are several dissimilarities
between these two contracts. The credit risk in a forward contract is relatively
higher that in a futures contract. Forward contracts can be used for both hedging
and speculation, but as the contract is tailor made, it is best for hedging.
Conversely, futures contracts are appropriate for speculation.
11. Various forms of Futures
Stock Futures
• Index futures first appeared in India in the year 2000. These
were followed by individual stock futures a couple of years
later. There are several advantages of trading in stock
futures. The biggest one is leverage.
• Before trading in stock futures, you need to deposit an
initial margin with the broker. If the initial margin is, say, 10
per cent, you can trade in Rs 50 lakh worth of futures by
paying just Rs 5 lakh to the broker. The larger the volume of
transactions, the higher your profit. But the risks are also
more significant. Investor can trade stock futures on stock
exchanges like the BSE and NSE. However, they are
available only for a specified list of stocks.
12. Index Futures
• Index futures can be used to speculate on the
movements of indices, like the Sensex or Nifty, in
the future. Let’s say Investor buy BSE Sensex
futures at Rs 40,000 with an expiry date of the
month. If the Sensex rises to 45,000, you stand to
make a profit of Rs 5,000. If it goes down to Rs
30,000, your losses, in that case, would be Rs
5,000. Index futures are used by portfolio
managers to hedge their equity positions should
share prices fall. Some of the index futures in
India include Sensex, Nifty 50, Nifty Bank, Nifty IT
etc.
13. Currency Futures
• One of the different types of financial futures is
currency futures. This futures contract allows you
to buy or sell a currency at a specific rate vis-à-vis
another currency (Euro vs USD, etc.) at a
predetermined date in the future.
• These are used by those who want to hedge risks,
and by speculators. For example, an importer in
India may purchase USD futures to guard against
any appreciation in the currency against the
rupee.
14. Interest rate futures
An interest rate future is one of the
different types of futures. It’s a contract to buy
or sell a debt instrument at a specified price
on a predetermined date. The underlying
assets are government bonds or treasury bills.
Investor can trade these on the NSE and the
BSE.
15. Payoff
A payoff is the likely profit loss that
would accrue to a market participant with
change in the price of the underlying asset.
Futures contracts have linear payoffs. In
simple words, it means that the losses as well
as profits, for the buyer and the seller of
futures contracts, are unlimited. The payoff
for futures, that is, for buyers (long futures)
and sellers (short futures) is discussed below.
16. Payoff for buyer and seller with Long
and Short futures
• Payoff for Buyer of Futures: Long Futures
– The payoffs for a person who buys a futures contract is similar to the
pay off for a person who holds an asset. He has a potentially
unlimited upside as well as downside. Take the case of a speculator
who buys a two month Nifty index futures contract when the Nifty
stands at 1220. The underlying asset in this case is the Nifty portfolio.
When the index moves up the long futures position starts making
profits and when the index moves down it starts making losses.
• Payoff for Seller of Futures: Short Futures
– The payoff for a person who sells a futures contract is similar to the
payoff for a person who shorts an asset. He has a potentially unlimited
upside as well as down side. Take the speculator who sells a two
month Nifty index futures contact when the Nifty stands at 12.20. The
underlying asset in this case is the Nifty portfolio. When the index
moves down the short futures position starts making profits and when
the index moves up, it start making losses.
17. Equity Index
Equity Index Futures are derivatives
instruments that give investors exposure to
price movements on an underlying Index.
Market participants therefore can profit from
the price movements of a basket of equities
without trading the individual constituents. An
index futures contract gives investors the
ability to buy or sell an underlying listed
financial instrument at a fixed price on a
future date.
18. Stock Index
Stock index futures are derivatives,
so no actual stocks change hands. Instead, the
buyer and seller enter a contract with each
other, the terms of which are specific to the
contract. Stocks are generally purchased in
lots, which can become costly, but lots are not
purchased in these contracts.
20. Interest rate futures
• Interest rate futures are futures contracts based on
interest-bearing financial instruments. This futures
contract can be cash-settled or it can involve the
delivery of the underlying security. Like other futures,
this is an agreement for the long position to receive the
interest earned on a notional amount and the short
position to pay this amount.
• Since the value is based on an underlying asset, an
interest rate future is considered a financial derivative.
The underlying asset can be any interest-bearing
instrument, such as Treasury bills, Treasury bonds,
or Eurodollars. These futures can be used for
speculative or hedging purposes.
21. How do interest rate futures work?
• Interest rate futures as mentioned before can have any interest-
bearing security as the underlying asset. These futures contracts are
a legal agreement to either deliver the interest-bearing security at
expiration or settle the contract in cash. Most often, futures are
cash-settled. Interest rate futures are traded on centralized
exchanges and have a few specific components.
– Underlying asset – the interest-bearing security the value of the
interest rate future is dependent on
– Expiration date – the date in which the contract will be settled, either
through physical delivery or if it is cash settled, this will be the last
cash settlement
– Size – the total nominal amount of the contract
– Margin requirement – For cash-settled futures, this is the initial
amount needed to enter into the futures contract, as well as
the maintenance margin that the initial margin will need to stay above
22. Futures trading strategies
1. The Pull back strategy
• This powerful futures trading strategy is based on price pullbacks, which
occur during trending markets when the price breaks below or above a
resistance or support level, reverses and gets back to the broken level.
Resistance levels are price levels at which the price had difficulties
breaking above. Support levels are price points where the market had
difficulties breaking below.
• During an uptrend, the price breaks above an established resistance level,
reverses and retests the resistance level. After the retest is complete, you
may enter with a long position in the direction of the underlying uptrend.
• During a downtrend, the price breaks below an established support level,
reverses and returns to the support level again. This represents a pullback
and you may enter with a short position in the direction of the underlying
downtrend.
• Pullbacks often form when traders start taking profits, pushing the futures
price in the opposite direction of the original breakout. Traders who
missed out on the initial price move can wait for the price to get back to
the resistance or support level to enter a more favorable price, pushing
prices up again.
23. 2. Going Long strategy
• Investor can buy futures contracts if investor can
expect the price of an underlying commodity to
increase over a certain period. If investor forecast
of the direction and timing of the price change is
accurate, can sell the futures contracts later for a
higher price, consequently yielding profit. If the
price decreases, however, investor trade will
result in a loss. Due to leverage, investor gains
and losses could be higher than investor initial
margin deposit.
24. 3. Breakout Trading Strategy
• Breakout trading is a popular approach in day
trading. A breakout occurs when an
underlying asset’s price moves out of an
established trading range. Breakout trading
purposes to catch the market volatility when
the price is breaking out of support and
resistance levels, trend lines and other
technical levels.
25. 4. Spread Trading Strategy
• The spread trading strategy involves the
purchase of 1 futures contract and selling
another futures contract at a different time.
The aim of this strategy is for you to profit
from an unanticipated change in the
relationship between the buying price of 1
contract and the selling price of the other
futures contract.
26. Margins
The buyer or seller of a futures contract is
required to deposit part of the total value of the
specified commodity future that is bought or sold
– this is known as margin money. This deposit is
required by regulations set out by each
commodity exchange, and must be deposited
with a registered futures commission merchant
(RFCM) before a futures contract is bought or
sold. Margin money is essentially a guarantee
that the trader, the customer of the RFCM, will
honour the contract.
27. How margins work
• There are 2 levels of margins: the initial margin and the
maintenance margin. The minimum amount of the initial
margin is set by the exchange and varies depending on the
commodity, the commodity's trading price, and how much
those prices are moving up and down. Exchanges may
increase or decrease initial margin amounts at any time.
• Initial margins higher than the minimums set by the
exchange. The initial margin may be somewhat less for
clients who declare their trading activity as hedge-related
rather than for speculation.
• The maintenance margin is the minimum amount of money
that must be maintained in a margin account after all
potential losses have been accounted for.
28. Margin call
• If a change in the futures contract price causes the open futures
trade to be in a losing position, a "margin call" may be required by
the broker, even though the position has not been offset. A margin
call is required once an account's initial margin has been reduced to
below the maintenance margin level. If this happens, the client
must deposit enough money to re-establish adequate margin in the
account.
• If arrangements are not made to meet the margin call immediately,
the trader's commodity broker may make an offset trade to
terminate the client's futures position. Brokers will offset a position
to protect the brokerage firm, which is legally responsible to cover
losses if a trader does not cover the losses.
• Margin money is a deposit to secure a futures position while it is
open. Margins must be maintained at the level required by the
brokerage firm.
• When the futures position is closed, the remaining margin money
after trade settlement can be returned to the account holder.
29. Speculation
• In the world of finance, speculation, or speculative trading,
refers to the act of conducting a financial transaction that
has substantial risk of losing value but also holds the
expectation of a significant gain or other major value. With
speculation, the risk of loss is more than offset by the
possibility of a substantial gain or other recompense.
• An investor who purchases a speculative investment is
likely focused on price fluctuations. While the risk
associated with the investment is high, the investor is
typically more concerned about generating a profit based
on market value changes for that investment than on long-
term investing. When speculative investing involves the
purchase of a foreign currency, it is known as currency
speculation. In this scenario, an investor buys a currency in
an effort to later sell that currency at an appreciated rate,
as opposed to an investor who buys a currency in order to
pay for an import or to finance a foreign investment.
30. Hedging
• Hedging is a financial strategy that should be
understood and used by investors because of the
advantages it offers. As an investment, it protects an
individual’s finances from being exposed to a risky
situation that may lead to loss of value. However,
hedging doesn’t necessarily mean that the investments
won’t lose value at all. Rather, in the event that
happens, the losses will be mitigated by gains in
another investment.
• Hedging is recognizing the dangers that come with
every investment and choosing to be protected from
any untoward event that can impact one’s finances.
One clear example of this is getting car insurance. In
the event of a car accident, the insurance policy will
shoulder at least part of the repair costs.
31. How do Hedging Strategies Work?
• Hedging is the balance that supports any type of
investment. A common form of hedging is a derivative or a
contract whose value is measured by an underlying asset.
Say, for instance, an investor buys stocks of a company
hoping that the price for such stocks will rise. However, on
the contrary, the price plummets and leaves the investor
with a loss.
• Such incidents can be mitigated if the investor uses an
option to ensure that the impact of such a negative event
will be balanced off. An option is an agreement that lets the
investor buy or sell a stock at an agreed price within a
specific period of time. In this case, a put option would
enable the investor to make a profit from the stock’s
decline in price. That profit would offset at least part of his
loss from buying the stock. This is considered one of the
most effective hedging strategies.
32. Arbitrage
• Arbitrage is an investment strategy in which an investor
simultaneously buys and sells an asset in different
markets to take advantage of a price difference and
generate a profit. While price differences are typically
small and short-lived, the returns can be impressive
when multiplied by a large volume. Arbitrage is
commonly leveraged by hedge funds and other
sophisticated investors.
• There are several types of arbitrage, including pure
arbitrage, merger arbitrage, and convertible arbitrage.
Global macro is another investment strategy related to
arbitrage, but it’s considered a different approach
because it refers to investing in economic changes
between countries.
33. Types of Arbitrage
1. Pure Arbitrage
Pure arbitrage refers to the investment strategy above, in which an
investor simultaneously buys and sells a security in different markets to
take advantage of a price difference. As such, the terms “arbitrage” and
“pure arbitrage” are often used interchangeably.
Many investments can be bought and sold in several markets. For
example, a large multinational company may list its stock on multiple
exchanges, such as the New York Stock Exchange (NYSE) and London Stock
Exchange. Whenever an asset is traded in multiple markets, it’s possible
prices will temporarily fall out of sync. It’s when this price difference exists
that pure arbitrage becomes possible.
Pure arbitrage is also possible in instances where foreign exchange
rates lead to pricing discrepancies, however small.
Ultimately, pure arbitrage is a strategy in which an investor takes
advantage of inefficiencies within the market. As technology has advanced
and trading has become increasingly digitized, it’s grown more difficult to
take advantage of these scenarios, as pricing errors can now be rapidly
identified and resolved. This means the potential for pure arbitrage has
become a rare occurrence.
34. 2. Merger Arbitrage
• Merger arbitrage is a type of arbitrage related to merging entities,
such as two publicly traded businesses.
• Generally speaking, a merger consists of two parties: the acquiring
company and its target. If the target company is a publicly traded
entity, then the acquiring company must purchase the outstanding
share of said company. In most cases, this is at a premium to what
the stock is trading for at the time of the announcement, leading to
a profit for shareholders. As the deal becomes public, traders
looking to profit from the deal purchase the target company’s
stock—driving it closer to the announced deal price.
• The target company’s price rarely matches the deal price, however,
it often trades at a slight discount. This is due to the risk that the
deal may fall through or fail. Deals can fail for several reasons,
including changing market conditions or a refusal of the deal by
regulatory bodies, such as the Federal Trade Commission (FTC) or
Department of Justice (DOJ).
35. 3. Convertible Arbitrage
• Convertible arbitrage is a form of arbitrage related to convertible
bonds, also called convertible notes or convertible debt.
• A convertible bond is, at its heart, just like any other bond: It’s a
form of corporate debt that yields interest payments to the
bondholder. The primary difference between a convertible bond
and a traditional bond is that, with a convertible bond, the
bondholder has the option to convert it into shares of the
underlying company at a later date, often at a discounted rate.
Companies issue convertible bonds because doing so allows them
to offer lower interest payments.
• Investors who engage in convertible arbitrage seek to take
advantage of the difference between the bond’s conversion price
and the current price of the underlying company’s shares. This is
typically achieved by taking simultaneous positions—long and
short—in the convertible note and underlying shares of the
company.
36. Spread trading
• Spread trading – also known as relative value
trading – is a method of trading that involves
an investor simultaneously buying one
security and selling a related security. The
securities being bought and sold, often
referred to as “legs,” are typically executed
with futures contracts or options, though
there are other securities that can be used.
37. Purpose of Spread Trading
• The strategy of spread trading is to yield the investor a net
position with a value (or spread) that is dependent upon
the difference in price between the securities being sold. In
most cases, the legs are not traded independently but
instead, are traded as a unit on futures exchanges.
• The goal for investors is to make a profit off the spread as it
gets wider or grows narrower. With spread trading,
investors aren’t generally looking to benefit from
direct price movements of the legs themselves. Spreads –
because they are executed as a unit – are either bought or
sold. It depends on the investor’s needs as to whether he
believes he will benefit from a wider or narrower spread.
38. Two common types of Spread trading
There are several types of spreads; however, the two most common
are inter-commodity spreads and options spreads.
1. Inter-commodity spread
The inter-commodity spread is created when an investor buys and
sells commodities that are decidedly different, but also related. An
economic relationship exists between the commodities. For example:
A crush spread is the relationship between soybeans and their
byproducts, which reflects the importance of processing soybeans into oil
or meal.
A spark spread is a relationship between electricity and natural gas;
there are many power stations that require gas for fuel.
A crack spread is a relationship between oil and its byproducts, with
the spread showing the inherent value of refining crude oil into gas.
2. Option spread
Another common spread is option spread. Options spreads are
created with different option contracts as legs. Both contracts must
pertain to the same security or commodity.
39. Forwards market Commissions and
Regulation
• Rules are part of everyday human life and we find them in schools,
at work place, and in general society. Rules are like guidelines, and
help people to understand what is acceptable and what is not.
Without rules, the world would probably be chaotic.
• Similarly, our financial system is also regulated by independent
regulators in the field of banking, insurance, capital market,
commodities market and pension funds.
• The Reserve Bank of India regulates the banking system, while
Securities and Exchange Board of India (SEBI) regulates the
securities market. The Insurance Regulatory and Development
Authority (IRDA) regulates the insurance sector.
• However, many of us are not aware about who regulates the
commodity market in India? Just as SEBI regulates the stock market,
Forward Markets Commission (FMC) regulates the commodity
market.
40. FMC as a Commodity Regulator
• Headquartered in Mumbai, FMC is a regulatory authority
for commodity futures market in India. FMC is the chief regulator of
forward and futures markets in India. FMC comes under the
Ministry of Consumer Affairs, Food and Public Distribution because
futures traded in India are traditionally in food commodities.
• FMC is a legal body set up under Forward Contracts (Regulation) Act
1952. The Act provides that the Commission should consist of
minimum two and maximum four members appointed by the
Central Government. The chairman of the FMC is nominated by the
central government.
• At present five national exchanges, viz. Multi Commodity Exchange,
National Commodity and Derivatives Exchange, National Multi
Commodity Exchange, Indian Commodity Exchange Ltd and ACE
Derivatives and Commodity Exchange, regulate forward trading in
113 commodities. Besides, there are 16 commodity specific
exchanges recognised for regulating trade in various commodities
approved by FMC under the Forward Contracts (Regulation) Act,
1952.
41. Commodities traded on these
exchanges comprise:
• Edible oilseeds: Groundnut, mustard seed, cotton
seed, sunflower, rice bran oil, soy oil, etc.
• Food grains: Wheat, gram, dals, bajra, maize etc.
• Metals: Gold, silver, copper, zinc etc.
• Spices: Turmeric, pepper, jeera etc.
• Fibres: Cotton, jute, etc.
• Others: Gur, rubber, natural gas, crude oil etc.
42. Functions of FMC
• To advise the central government in respect of the recognition or
the withdrawal of recognition from any association.
• To advise the central government in respect of issues arising out of
the administration of the Forward Contracts (Regulation) Act 1952.
• To keep forward markets under observation and to take such action
in relation to them, as it may consider necessary, in exercise of the
powers assigned to it under the Act.
• To collect and whenever the Commission thinks it necessary, to
publish information regarding the trading conditions in respect of
goods to which any of the provisions of the Act is made applicable,
including information regarding supply, demand and prices, and to
submit to the central government, periodical reports on the
working of forward markets relating to such goods.
• To make recommendations to improve the organization and
working of forward markets;
• To undertake the inspection of accounts and other documents of
any recognised association, registered association or any member
of such association whenever it considers it necessary.
43. FMC has powers of deemed civil court
for
• Summoning and enforcing the attendance of
any person and examining him on oath.
• Requiring the discovery and production of any
document.
• Receiving evidence on affidavits.
• Requisitioning any public record from any
office.
