Forward Contract

• Example: A corn flakes manufacturer (company) and a corn producer

(farmer) agreeing to trade in corn produced at a future date at a price
agreed upon today.

• Farmer agreeing to sell 20 tons of wheat at Rs. 20 per kg to a rolling mill to

be delivered in November next.

• An exporter expecting to receive $10,000 after six months may agree to

sell the same to a bank at an exchange rate of Rs. 55 decided today but
foreign exchange delivered only after six months.

• The forward price of the asset is Rs. 20 per kg for wheat, and Rs 55 for
dollars.
Features of a Forward Contract
– Two parties (buyer and seller)
– OTC
– Price is determined today
• (Price is negotiated in advance)
– Mutual Obligation to Perform
• ( on maturity, seller makes the delivery and buyer pays the price)
– Counter Party Risk
– Mutual consent for cancellation
– No front end Payment
• No exchange of money at the time of entering forward contract
though either party can insist on initial deposit against price or
delivery to mitigate risk
 Forward Contract
• Forward Contracts
– Definition: a contract between two parties for one
party to buy something from the other at a later
date at a price agreed upon today
– Exclusively over-the-counter
• Futures Contracts
– Forward Contract traded in an exchange

– Definition: a contract between two parties for one party to

buy something from the other at a later date at a price
agreed upon today; subject to a daily settlement of gains
and losses and guaranteed against the risk that either
party might default
– Exclusively traded on a futures exchange
 Organized Futures Trading
Contract Terms and Conditions
– contract size
– quotation unit
– minimum price fluctuation
– contract grade
– trading hours
• Delivery Terms
– delivery date and time
– delivery or cash settlement
Difference between Futures and Forwards
  Futures Market Forward Market

Location Futures Exchange No fixed Location

Size of Contract Fixed (standard) Depends on Contract

Maturity Fixed (standard) Depends on Contract

Counterparty Clearing House Known Bank or Client

Valuation Marked-to-Market Everyday No unique Method

Variation Margin Daily None

Regulations Regulated by Exchange Self Regulated

Credit Risk Almost Non Existent Depends on Counterparty

Settlement Through Clearing House Depends on Contract

Liquidation Mostly by Offsetting the positions Mostly settled by actual delivery

 Open Interest And Volume
• Ex-1
Period 1
Trader A Sells one Futures Contract and Trader B
buys one Futures contract
Period 2
Trader A buys one Futures contract and trader C sells
one
Period 3
Trader C Buys one Futures contract and Trader B sells
one Futures Contract.
 Open
Time A B C Volume interest

1 Sells 1 Buys 1 1 1

2 Buys 1 Sells 1 1 1

3 Sells 1 Buys 1 1 0
 Open Interest And Volume
• Ex-2
 Open Interest And Volume

• Open Interest is a measure of how many Futures contract

exist at any particular time.

• It shows the number of long positions not squared off or

number of short positions not squared off at any particular
point of time.

• Futures contracts are created and extinguished (expired)

depending on how trades are matched up

• Volume Simply measures how many trades occurred.

 Newspaper
• Futures
• Ex: Reliance-September
• Delivery Month
– All contracts of a month expire on the last Thursday of the
month.

• Open high low close

• Value
• No of contracts
• Open Interest and Volume
 Futures and Forward Contracts
(cont’d)
The futures market deals with transactions that will
be made in the future.

A person who buys in October a December Reliance

futures contract promises to pay a certain price for
Reliance in December.

If you buy the Reliance today, you purchase them in

the cash, or spot market.
 What happens on Expiry date?

• Why at Expiry Futures Price should equal Spot

Price ?
 Law of One Price
[Arbitrageurs] keep the markets honest. They bring perfection to imperfect markets as
their hunger for free lunches prompts them to bid away the discrepancies that attract
them to the lunch counter. In the process, they make certain that prices for the same
assets in different markets will be identical. —Peter L. Bernstein

At Maturity Futures Price is always equal to Spot

Price.
 Problem
• On October 1st
– Reliance Spot Price is Rs. 1000
– Reliance (December Futures/Forward price) = 1050

• On November 10th
– reliance spot price is 1200 and futures price is 1275

• In December at expiration date

– Reliance trades at 1100
 Forward Market

Date Spot Forward( December contract)

1-Oct 1000 1050 ( Mutually Agreed Price)

November 10th 1200 SO what ?

December (Maturity) 1100 Honor the contract

 Pay Off in Forward Market at Maturity
Payoff of Long futures (if you buy Reliance Forward contract)
=Sell price – Buy price
= Spot price at expiration – forward price
=1100-1050 =50

Pay off of short futures ( if you sell Reliance Forward contract)

=Sell price – Buy price
= Forward Price – Spot price at expiration
=1050-1100= -50

• Because One contract is for 600 shares. Your profit or loss gets multiplied
by 600 times.
 Futures Market

Futures( December
Date Spot contract)

1-Oct 1000 1050

November 10th 1200 1275

December
(Maturity) 1100 1100
 Payoff on Futures Contract at
expiration
Payoff of Long futures (if you buy Reliance Forward contract)
=Sell price – Buy price
= Spot price at expiration – forward price
=1100-1050 =50

Pay off of short futures ( if you sell Reliance Forward contract)

=Sell price – Buy price
= Forward Price – spot price at expiration
=1050-1100= -50
 Payoff of Futures Contract on
November 10th
• Payoff of Long futures = Sell price – Buy price
• = 1275-1050 =225

• Pay off of short futures = Sell price – Buy

price
• = 1050 – 1275= -225
 Futures Contracts (cont’d)
• A futures contract involves a process known
as marking to market
– Money actually moves between accounts each
day as prices move up and down

• A forward contract is functionally similar to a

futures contract, however:
– There is no marking to market
– Forward contracts are not marketable
 Problem
Settlement
Day Price
1 4700
2 4500
3 4650
4 4750
5 4700

The initial margin is set at Rs. 10,000 per contract, while the maintenance
margin is Set at Rs. 8000 per contract. The multiple of each contract is 50.

Calculate the mark-to-market cash flows and the daily closing balances in
Accounts of.
A) An investor who has gone long at 4600 on day ‘0’.
B) An investor who has gone short at 4600 on day ‘0’.
C) Calculate the net profit/loss on each of the contracts.
Investor Who has gone long at 4600 (initial margin =10,000 and Maintenance margin = 8,000)

Opening Mark-to- Is the balance Margin Closing

Day Settlement Price Balance Market < 8000 Call Balance
Bought 50 @
0 4600  10000 - - - 10000

1 4700 10000 5000 NO   15000

2 4500 15000 -10000 YES 5000 10000

3 4650 10000 7500 NO   17500

4 4750 17500 5000 NO   22500

5 4700 22500 -2500 NO   20000

Total Profit/Loss     5000      

Investor Who has gone Short at 4600 (Initial margin =10,000 and Maintenance margin = 8,000)

Mark-to- Is the Closing

Settlement Opening Mar balance Margin Bala
Day Price Balance ket < 8000 Call nce
Sold 50 @
0 4600  10000 - - - 10000

1 4700 10000 -5000 Yes 5000 10000

2 4500 10000 10000 NO   20000

3 4650 20000 -7500 NO   12500

4 4750 12500 -5000 Yes 2500 10000

5 4700 10000 2500 NO   12500

Total
Profit/Loss     -5000