derivatives

1. FORWARDS AND
FUTURES CONTRACT
Before commitment commits you,
Commit to the Commitment
Sundar Shetty
Sundar B. N.
Assistant Professor
Coordinator of M.com

2. Forwards contracts
A Forwards contract is a contract made today for delivery of an assets at a
prespecified time in the future at a price agreed upon today.
The buyer of the Forwards contract agrees to take delivery of an
underlying assets at a future time (T) at a price agreed upon today. No money
changes hands until time expiry. The seller agrees to deliver the underlying
asset at a future time, at a price agreed upon today.

3. Meaning of Forwards
contracts
A Forwards contract is a contract between two
parties who agree to buy/sell a specified quantity of a
financial instruments/commodities at a certain price at a
certain date in future. Forwards contracts are not
standardized contracts, they are OTC (not traded in
recognized stock exchanges) derivatives that are tailored to
meet specific user needs.

4. Underlying Assets of
Forwards contracts
• Traditional agricultural or physical commodities
• Currencies (Foreign exchange forward)
• Interest rates (Forward rate agreements FRA)

5. Why Forwards contracts
They are customized contracts unlike futures
Tailor-made and more suited for certain purpose
Useful when Futures do not exist for commodities and
financial being considered
Useful in cases futures standard may be different from the
actual

6. Tailored made
Specifically made for particular purposes.
Each items unique in terms of;
Quantity
Price
Date
Region to region

7. FEATURES OF FORWARD
CONTRACTS
They are bilateral negotiated contract between two parties and
hence exposed to counter party risk.
Each contract is custom designed and hence is unique in terms
of contract size, expiration date, and the asset type, quality etc.
A contract has to be settled in delivery or cash on expiry date.
The contract price is generally not available in the public
domain.
If the party wishes to reverse the contract, it has to compulsory
go to the same counter-party, which often results in high prices
being charged.

11. FUTURES CONTRACT
Unlike forwards contracts, Futures are standardized
contracts traded on exchanges through a clearing house and
avoids counter party risk through margin money and much more.
What we know as the futures market of today originated
from some humble beginnings.
Trading in futures originated in Japan during the 18th
century and was primarily used for the trading of Rice and silk. It
was not until the 1850 that the US started using futures markets
to buy and sell commodities such as Cotton, Corn and Wheat.
Today’s futures market is a global marketplace for not only
agricultural goods but also for currencies and financial
instruments such as treasury bonds and securities. It is a diverse
meeting place of formers, exporters, importers, manufacturers
and speculators

12. What is A Futures Contract
A futures contract is a standardized agreement between the seller (short
position)of the contract and the buyer ( long position ), traded on a
futures exchange, to buy or sell a certain underlying instruments at a
certain date in future, at a prespecified price.
The future date is called the delivery date or final settlement date.
The pre-set price is called the futures price. The price of the underlying
asset on the delivery date is called the settlement price.
(Thus, futures is a standard contract in which the seller is obligated to
deliver a specified asset (security, commodity or foreign exchange) to the
buyer on a specified date in future and the buyer is obligated to pay the
seller the then prevailing futures price upon delivery. Pricing can be
based on an ‘open outcry system’, or bids and offers can be matched
electronically.

13. Characteristics of Futures contracts
 Futures are highly standardised contracts that provide for
performance of contracts through either deferred delivery of asset or
final cash settlement.
 These contracts trade on organized futures exchanges with a clearing
association that acts as a middleman between the contracting parties.
 Contract seller is called ‘short’ and buyer ‘long’. Both parties pay
margin to the clearing association. This is used as performance bond by
contracting parties
 Margins paid are generally marked to market price everyday;
 Each Futures contract has an associated month that represents the
month of contract delivery or final settlement. These contracts are
identified with their delivery months like July-T-Bill, December $/
derivative etc.
 Every futures contract represents a specific quantity. It is not
negotiated by the parties to the contract.

14. • Identified with Underlying assets
• Identified with contract size
• Delivery arrangements- Place of delivery, Transfer cost
• Identified with Delivery month
• Identified with prespecified price
• Position limits
• Margin requirements

15. Mechanism of Trading in Futures Market
A brief discussion of basic terms and institutions involved in
futures trading is presented below;
Clearing House ; Also known as clearing corporation, plays an
important role in the trading of futures contracts. It acts as an
intermediary for the parties who trade in futures contracts. It becomes
the seller of the contract for the long position and buyer of the contract
for the short position.
Open Interest ; Open interest on the contract is the number of
contract outstanding (No. of either long or short positions). When
contracts begin trading, open interest is zero. As time passes, open
interest increases as progressively more contracts are entered. Instead
of actually taking or making delivery of the commodity, virtually all
market participants enter reversing trades to cancel their original
positions, then open interest will be considered.

16. Continued……….
 Margin requirement ; The futures exchange requires some good faith
money from both, to act as a guarantee that each will abide by the terms
of the contract, this is margin.
The margins are three types;
I. Initial Margin ; is required at the start of a new transaction. For
example in NSE they maintain % as initial margin for the initial
transactions. An exchange can change the required margin anytime. If
price volatility increases or if the price of the underlying commodity
rises substantially, the initial margin will be increased
II. Maintenance Margin ; The maintenance margin represents the
minimum margin which needs to be maintained by individual margin
accounts. It is akin to the minimum balance prescribed by banks in the
case of saving deposit accounts.
III. Variable Margin ; is calculated on a daily basis for the purpose of
marking-to-market all outstanding positions at the end of each day. This
is to be deposited most often in cash only. The day’s closing price is
generally used as the basis for the purpose of marking-to-market.

17.  Marking-to-market (M2M) ; the process of marking profits or losses
that accrue to traders on daily basis is called M2M. Futures prices may
rise or fall everyday. Instead of waiting until the maturity date for traders
to realize all gains and losses, the clearing house requires all positions to
recognize profits as they accrue daily. If the futures price of Cotton rises
from Rs. 4,000 to Rs. 4,100 per quintal, the clearing house credits the
margin account of the long position for 500 Quintals times Rs. 100 per
quintals or Rs. 50,000 per contract.
Conversely, for the short position, the clearing house takes this
amount from the margin account for each contract held. This daily settling is
called marking-to-market. It means we do not need to wait for our losses or
gains until maturity date, it will be settle daily.

18. SETTLING A FUTURE POSITION
Once having established a futures position traders have an obligation
under the terms of the futures contract either to take delivery ( a long
position) or to make delivery ( a short position) of the underlying
commodity. However, making or taking physical delivery is only one
of several ways that futures contracts can be settled.
There are 3 common ways of liquidating a future position;
Physical Delivery ; Liquidating a futures position by making or
taking physical delivery is usually the most cumbersome way to
fulfil contractual obligations. It requires actually purchasing or
selling a commodity. A firm, which deals in commodities, might
very well wish to settle by physical delivery. It imposes obvious
costs on traders; warehousing expenses, insurance costs, possible
shipping costs and brokerage fees.

19. Continued……….
OFFSETTING ; in effect, to reverse the initial transaction which is established
the futures position.
Suppose that on Jan 1, Mr. A takes up a long position in the future market for
1 kg of Gold for April month: for Rs. 2,700/gm of Gold. On 25th Feb, he decides to
close his position, and hence, enters into another future contract.
Now for short position, at Rs. 2,800/gm of gold for the same delivery month i.e, April
Mr. A’s Account Quantity Cash flow on April 30th
To pay for long position +1000gm -27,00,000
To receive for short position -1000 gm +28,00,000
Gain Nil 1,00,000

20. Continued……….
CASH DELIVERY ; This procedure is a substitute for physical
delivery and completely eliminates having to make or take physical
delivery. Contracts on stock index futures use cash delivery to settle
contracts. Exchange have adopted cash delivery as an alternative to
physical delivery for 2 reasons;
1. The nature of underlying commodity may not permit feasible
physical delivery
2. Cash delivery avoids the problem that it may be difficult for traders
to acquire the physical commodity at the time of delivery because
of a temporary shortage of supply.