Fr.

C Rodrigues Institute of Management Studies, Vashi

Finance || Sem III || 2021

Notes

Lecture 2

Introduction To Forwards & Futures

In the world of derivatives trading, risks are often mitigated by traders with the
aid of a concept known as a forward contract. These forward contracts are
agreements that serve the purpose of hedging and are an essential concept to
understand if you are new to trading in derivatives.

What Is a Forward Contract?

The simple understanding of a forward contract is that it is a specific type of
agreement entered into by two parties to purchase or sell an asset at a particular
price on a future date. By the virtue of this agreement, the two parties agree to
conduct the said transaction in the future, hence the term ‘forward’. Similar to
a futures contract, the value of the forward contract is derived from the value
of the underlying asset, which is why it acts as a derivative. However, it must be
noted that unlike an options contract, the two parties involved in forward
derivatives contracts are obligated to fulfill the specified transaction.
Forward contracts are not traded on a centralized exchange, which is why they
are essentially considered over the counter, or OTC derivatives. This also means
that since forward contracts are negotiated privately and without an
intermediary, they are more customizable than standard derivative contracts.
Forward Contracts is a contract between two parties for the delivery of a specific
quantity, at a specific price with a specified quality at a specified time in the
future

How Is Forward Trading Done?

The two parties typically enter into a forward contract because of their opposing
views on a particular asset. One party believes that the price of a particular asset
is set to rise in the future and therefore wishes to purchase it at a lower,
Sachin Nachnani
 Fr. C Rodrigues Institute of Management Studies, Vashi
Finance || Sem III || 2021

predetermined price to make his profit. Hence, this party offers to be the buyer.
The other party, on the other hand, believes that the price of the asset will fall
in the coming future and therefore wishes to profit from a predetermined high
price for it. This party, therefore, offers to be the seller. Based on how the
market performs and the price of the asset changes, the actual result of the
forward contract can typically go in three different ways

1. The Price of The Asset Rises in The Future

In this scenario, the buyer’s prediction is proven to be correct and is rewarded
with regards to the purchase they make with the forward contract. The profit
made by the buyer in this scenario is the difference between the actual current
price of the asset and the locked-in price at which the buyer bought it.
2. The Price of The Asset Falls in The Future
In this scenario, the seller’s prediction is proven to be correct and hence benefits
from the sale made through the forward contract. Even though the price of the
asset has fallen, the seller gets to sell it at a price higher than its current value.
The profit made by the seller in this scenario is the difference between the price
at which the seller sells the asset and the actual current price of the asset.
3. The Price of The Asset Remains Unchanged in The Future
In this scenario, the prediction of neither the buyer nor the seller is proven
correct. Therefore, there is no profit made or loss incurred by either party in this
transaction.
Because of the nature of these contracts, forwards are not readily available to
retail investors. The market for forward contracts is often hard to predict. That's
because the agreements and their details are generally kept between the buyer
and seller, and are not made public. Because they are private agreements, there
is a high counterparty risk. This means there may be a chance that one party will
default.

Example Of Forward Contract

To understand the concept better, let us take a forward contract example. Let’s
say a farmer is on track to harvest 20 tons of maize by next year. In order to

Sachin Nachnani
 Fr. C Rodrigues Institute of Management Studies, Vashi
Finance || Sem III || 2021

make a profit on his harvest, he must be able to sell it at a price of at least Rs

10,000 per ton. If the farmer chooses to wait till next year to sell his maize
harvest, he may or may not be able to make a profit on the transaction. This is
because as the price of the asset, in this case maize, changes, it cannot be
guaranteed that his produce will sell at that desired price.
However, if the farmer chooses to enter into a forward contract with a food
manufacturing company that guarantees to pay him his desired price in
exchange for his harvest next year, his risk is minimized. Therefore, even if the
price of maize falls by next year, he will be protected by the obligation of the
forward contract and the locked-in selling prices

Features Of Forward Contracts

Now that you have a better understanding of forward contracts, let us take a
look at some of their most essential features:
▪ There are a number of similarities between forward contracts and future
contracts. However, it can be useful to keep a few of their major
differences in mind when trading in derivatives. While futures contracts
are traded on exchanges, forward contracts are not. As a result, they are
also more customisable and allow for specific changes in the agreements
with regards to the asset traded, amount and date of delivery.
▪ Forward derivatives can most often be settled in one of two ways.
▪ They can either result in physical settlement whereby the seller makes
physical delivery of the assets and receives the agreed upon payment by
the buyer.
▪ Alternatively, they can result in cash settlement whereby there is no
actual physical delivery of the asset in question. Instead, one of the two
parties settles the contract by paying the other an appropriate differential
in cash.
▪ Forward contracts are some of the most commonly employed tools for
corporations to minimize and hedge interest rate related risks. They are
not as commonly used, however, by individual retail investors and the
market remains quite inaccessible to most.
▪ The market of forward derivatives is essential to various sectors of the
country’s economy as not only do they provide price protection but are

Sachin Nachnani
 Fr. C Rodrigues Institute of Management Studies, Vashi
Finance || Sem III || 2021

also simpler to understand and trade with than many other forms of
contracts.
▪ Forward trading typically requires no margin amount and is unregulated
by the Securities and Exchange Board of India i.e., SEBI.

Futures
What Are Future Contracts And How Do They Work?

What Are Futures Contracts?

A legal agreement involving the sale and purchase of a certain commodity, asset,
or security at a predetermined price at some point in the future is known as a
future contract. To facilitate their trade on the futures exchange, future
contracts are standardized to check for quantity and quality. The individual who
will purchase the future contract will take on the obligation to both purchase
and/or receive the underlying asset, once the future contract will expire. The
seller of this contract takes on the obligation to provide and deliver the asset
that is underlying it by the time the expiration date comes around.
Hence, in simpler words, futures are financial derivatives that oblige the buyer
to purchase some security, or a seller to sell that security, to some
predetermined future date and price. Future contracts allow an investor to
speculate what direction a commodity, security, or financial instrument,
whether short or long, will move in with the help of leverage. Future contracts
are also often employed with the goal of heading price movements of the
underlying asset so one can aid in preventing losses from price changes that are
rather unfavourable.

What Is Futures Trading?

Future contracts are financial contracts that are derivative in nature, where both
parties involved are meant to transact an asset at a predetermined future date
and price. Underlying assets include financial instruments or physical
commodities. Future contracts also detail the quantity at which the underlying
asset is standardized to facilitate trading using a futures exchange.

Futures can be employed with the goal of trade speculation or hedging. When
one says, “futures” and “future contract,” these are both referring to the same
thing. As an instance, you may hear somebody claim that they purchased oil

Sachin Nachnani
 Fr. C Rodrigues Institute of Management Studies, Vashi
Finance || Sem III || 2021

futures, which means the same thing as buying an oil future contract. In fact,
when someone uses the term ‘future contract,’ they are often referring to a
certain type of future like gold, bonds, oil, or S&P 500 index futures.

When it comes to investing in oil, future contracts may also be among the most
direct ways to invest. The term futures is a rather general way often used to
refer to the entire market. Unlike forward contracts, as mentioned earlier,
future contracts are standardized. In fact, forwards or forward contracts are
similar types of agreements that lock in a future price in the present. However,
forwards are traded over-the-counter (OTC) and have terms that are
customizable which both counter-parties arrive at. Alternatively, a future
contract will have the same terms of selling and purchase, irrespective of who
the counter-party is.

Features Of Future Contract

Now that we understand how future contracts work, here are some features of
future contracts.
• Commodity futures markets in India are regulated by the FMC — Forward
Markets Commission. This governing body regulates aspects such as
withdrawing or granting recognition of any commodity markets engaged
in forward dealings.
• Available for many different types of asset classes. A future contract can
work across exchanges, commodities or currencies, and indices.
• Unlike a forward contract, a future contract is standardized. As an
example, once a contract states that it applies to 1000 barrels of oil, one
will have to lock in their price as per that unit or in multiples of it. If one
wanted to lock in a price, they would need to sell or purchase a hundred
separate contracts. To lock in the price of a million barrels of oil, one
would need to buy or sell a thousand such contracts. Future contracts
allow a hedge to shift risks toward speculators.
• Traders also get an efficient idea of what the futures price of a stock or
the value of its index is likely to become.
• Future contracts can mainly aid in determining the future supply and
demand of shares, which will be based on their current future price.
• Since futures are traded on margin trading, they allow those without
sufficient funds to carry out and participate in trades. One can do so by
paying a smaller margin rather than the entire value of the physical
holdings.

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 Fr. C Rodrigues Institute of Management Studies, Vashi
Finance || Sem III || 2021

• Future contracts are employed by two types of market participants:

speculators and hedgers. Those who produce or purchase an underlying
asset hedge are known as producers or purchases. These individuals also
guarantee the price at which the commodity will be purchased or sold.
Alternatively, those who may bet on the price movements of the
underlying asset through the use of futures.
Future Contract Example
To put this into perspective, an oil producer is required to sell their oil, and they
can use a future contract to do so. With the aid of future contracts, the oil
producer can lock in the price at which they will sell, and thereby deliver the oil
to their buyer, once the future contract expires. On the other hand, a
manufacturing company may require oil to use for making widgets.
Since this company prepares well by planning ahead and prefers to have oil
coming in each month, they may also employ the use of a future contract. This
way the company knows the price at which they will receive oil, based on the
price set in their future contract. They know that they will be taking up the
delivery of that oil once their contract expires.

A Manufacturing Company May Require Oil to Use For Producing Output.

E.g., Asian Paints, Pidilite, ONGC, Reliance

Differences between Forwards & Futures

Like forward contracts, futures contracts involve the agreement to buy and sell
an asset at a specific price at a future date. The futures contract, however, has
some differences from the forward contract.

First, futures contracts—also known as futures—are marked-to-market daily,

which means that daily changes are settled day by day until the end of the
contract. Furthermore, a settlement for futures contracts can occur over a range
of dates.

Because they are traded on an exchange, they have clearing houses that
guarantee the transactions. This drastically lowers the probability of default to
almost never. Contracts are available on stock exchange indexes, commodities,
and currencies. The most popular assets for futures contracts include crops like
wheat and corn, and oil and gas.

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 Fr. C Rodrigues Institute of Management Studies, Vashi
Finance || Sem III || 2021

The market for futures contracts is highly liquid, giving investors the ability to
enter and exit whenever they choose to do so.

These contracts are frequently used by speculators, who bet on the direction in
which an asset's price will move, they are usually closed out prior
to maturity and delivery usually never happens. In this case, a cash settlement
usually takes place.

Difference Between Forward and Future Contract

Future Contract Forward Contract

On the maturity date as negotiated

Settlement On a daily basis by the stock exchange.
between the parties.

Regulated by market regulators such as

Regulation the Stock Exchange Board of India Self-regulated.
(SEBI).

Margin requirements as per the stock

Collateral Zero requirement of initial margin
exchange rules.

According to the terms of the private

Maturity On a predetermined date.
contract.

Now here is a look at the other important differences between future and
forward contracts in detail:
Structure, Scope And Purpose
A futures contract is subject to standardization and uniformity, besides the
requirement of margin payments. Conversely, the terms of trade are flexible in
a forward contract, and can be negotiated to fit the requirements of the trading
parties. While futures are highly liquid, forwards are typically illiquid, or low on
liquidity. ETF Futures are typically more active in segments, like stocks, indices,
currencies and commodities, while OTC Forwards usually sees larger
participation in currency and commodity segments.

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 Fr. C Rodrigues Institute of Management Studies, Vashi
Finance || Sem III || 2021

Transaction Method
While a future contract is regulated by the framework or rules provided by the
government, a forward contract is directly negotiated between the buyer and
the seller, without the involvement of any government-approved intermediary.
Future contracts are ETF contracts, thereby implying the requirement of being
quoted and traded via stock exchanges, while futures contracts are essentially
over the counter contracts.
Price Discovery Mechanism/Pricing
The in-built feature of standardization allows for an efficient price discovery
mechanism for future contracts, while the absence of a centralized framework
allows for an inefficient price discovery mechanism for forward contracts, in a
completely informal market. While the price of futures is transparent, forwards
have opaque and arbitrary pricing.

Risks Involved
Forwards are subject to counter-party risks. This is a type of risk accruing from
the very nature of the private terms and agreements, that are negotiated. For
instance, one of the parties can refuse to honour the terms of the agreement at
the time of settlement. Besides, the forward contracts are also subject to default
risk, in the case of the trading party not settling the dues on the specified date.
Future contracts, however, don't pose any counter-party risks because the stock
exchange acts as a counter-party for all parties. Alongside, all the market
positions are recorded by the stock exchange after the end of the daily trading
session, known as Marked-to-Market settlement. As the trading parties are
bound by the terms of the contract - through the stock exchange - there is no
risk of default in payment on the maturity date.

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