Forward

Forward
&
&
Futures
Futures
 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.
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
Meaning of Forwards
contracts
 Forward contract is an agreement made directly between two parties to
buy or sell an asset on a specific date in the future, at the terms decided
today.
Forwards are widely used in commodities, foreign exchange, equity and
interest rate markets.
What is the basic difference between cash market and forwards?
Case 1..Assume on March 9, 2015 you wanted to purchase gold from a
goldsmith. The market price for gold on March 9, 2015 was Rs. 15,425 for
Forward Contract
10 gram and goldsmith agrees to sell you gold at market price. You paid
him Rs.15,425 for 10 gram of gold and took gold. This is a cash market
transaction at a price (in this case Rs.15,425) referred to as spot price.
 Case 2.
Now suppose you do not want to buy gold on March 9, 2015, but only after
1 month. Goldsmith quotes you Rs.15,450 for 10 grams of gold. You agree
to the forward price for 10 grams of gold and go away. Here, in this
example, you have bought forward whereas the goldsmith has sold
forwards .There is no exchange of money or gold at this point of time.
After 1 month, you come back to the goldsmith pay him Rs. 15,450 and
collect your gold. This is a forward, where both the parties are obliged to
Forward Contract Cont..,
go through with the contract irrespective of the value of the underlying
asset (in this case gold) at the point of delivery.  
 • Traditional agricultural or physical commodities
• Currencies (Foreign exchange forward)
• Interest rates (Forward rate agreements FRA)

Underlying Assets of
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

Why Forwards contracts

Example of how a Forward Contract
works
 A leading beverage company enters into a contract with a coffee estate for exporting 10,000 kg
coffee beans three months from now. The current price of coffee beans is INR 500/Kg. However, the
estate is concerned about the declining coffee prices and wants to ensure that they make sizable
profits from the deal. Hence, the estate enters into a forward contract with the beverage company
to sell the 10,000 kg coffee beans after three months at a rate of INR 480 per kg, irrespective of the
market price at that point.
After three months, the beverage company will procure the same amount of coffee beans from the
estate at an agreed price as per the forward contract.
There are three possibilities:
1.If the current market price is less than the contract price, the beverage company makes a
Example of how a Forward Contract potential loss, in that had it not entered into a forward contract, it could have procured the same
works amount at the market price. In this case, the estate saves itself from the eroding costs.
2.If the market price is greater than the contract price, it’s the estate that makes a potential loss
since they could have sold the beans at an increased rate had they not entered into the hedge
contract.
3.The market price is the same as the contract price. In that case, there is zero potential profit or
loss to both parties.
  Specifically made for particular purposes. Each items unique
in terms of;

 Quantity
 Price
 Date
 Region to region
Tailored made
  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
FEATURES OF FORWARD CONTRACTS
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.
 Forward contract is a non-standardized contract between two
parties to buy or sell an asset at a specified time at an agreed
price.
The advantages of forward contracts are as follows:
1) They can be matched against the time period of exposure
as well as for the cash size of the exposure
2) Forwards are tailor made and can be written for any
amount and term.
3) It offers a complete hedge.
Advantages 4) Forwards are over-the-counter products.
& 5) The use of forwards provide price protection.
Disadvantages of Forward Contract 6) They are easy to understand.
 The disadvantages of forward contracts are:
1) It requires tying up capital. There are no
intermediate cash flows before settlement.
2) It is subject to default risk.
3) Contracts may be difficult to cancel.
4) There may be difficult to find a counter-party
Advantages
&
Disadvantages of Forward Contract Cont…
 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.

FUTURES CONTRAC
 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

FUTURES CONTRACT 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
 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
What is A Futures Contract
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.
  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;

Characteristics of Futures contracts  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.
 • 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

FUTURES CONTRACT

standardized
 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
Mechanism of Trading in Futures Market enter reversing trades to cancel their original positions, then open interest will be
considered.
  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.
Continued………. 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.
  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
Marking-to-market (M2M)
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.
 Futures contracts can be broadly classified into two
categories
• Commodities Futures
• Financial Futures

Types of Future contracts

  Futures terminologies Let us understand various terms in the futures
market with the help of quotes on Nifty futures from NSE: Quotes
given on the NSE website for Nifty futures as on September 16, 2015  
 1. Instrument type    : Future Index
 2. Underlying asset    : Nifty
 3. Expiry date     : September 24, 2015  
 4. Open price (in Rs.)    : 7897.00 
   5. High price (in Rs.)    : 7919.00
 6. Low price (in Rs.)    : 7852.45
 7. Closing price (in Rs.) : 7,897.65
 8. No of contracts traded : 4,48,314
 9. Turnover in lakhs    : 8,84,278.07
Features of futures  10. Underlying value (in Rs.) : 7899.15
Commodity Futures
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Forward vs Futures
FUTURES CONTRACT
 How do differentiate Cash
Market Vs Derivative Market
How do differentiate Forward
Contracts Market Vs Futures
Contracts