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Derivative - Forward and future contract
This document provides an overview of derivative contracts, specifically forward and future contracts. It defines derivatives and describes how forward contracts are bilateral agreements between two parties to buy or sell an asset at a future date for a predetermined price. Future contracts are similar to forwards but are standardized and exchange-traded. The key differences between forwards and futures highlighted are that futures are traded on exchanges, require margin payments, follow daily settlement marked to market, and can be closed prior to delivery, whereas forwards are customized OTC contracts.
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Derivative - Forward and future contract
- 1. Derivative Forward and FutureContract Prepared by: Mr. Mohammed Jasir PV Asst. Professor MIIMS, Puthanangadi Contact No: 9605 69 32 66
- 2. Topics • Derivative • Typeswith Example
- 3. Derivatives • Derivatives: derivativesare instruments which include – Security derived from a debt instrument share, loan, risk instrument or contract for differences of any other form of security and , – a contract that derives its value from the price/index of prices of underlying securities. Derivatives (Definition) • A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typi- cally a commodity, bond, equity or currency,
- 4. Derivatives (Definition) • Afinancial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. • Examples of derivatives include futures and options. • Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. • These techniques can be quite complicated and quite risky.
- 5. Advantages of DerivativeMarket • Diversion of speculative instinct form the cash market to the derivatives • Increased hedge for investors in cash market • Reduced risk of holding underlying assets • Lower transactions costs • Enhance price discovery process • Increase liquidity for investors and growth of savings flowing into these markets • It increase the volume of transactions
- 6. Types of Derivatives Derivatives Financial Derivatives Stock,Bond, Forex Commodity Derivatives Sugar, Cotton, gold, silver
- 7. Types of Derivatives Thereare two types of derivatives 1. Financial derivatives – Financial Derivatives the underlying instruments is stock, bond, foreign exchange. 2. Commodity Derivatives – Commodity derivatives the underlying instruments are a commodity which may be sugar, cotton, copper, gold, silver.
- 8. Types of FinancialDerivatives Financial Derivatives Basic Forward Future Options Warrants & Convertibles. Complex. Swap Exotioc
- 9. Forward contract One partycommits to buy Other party commits to sell Specified quantity Pre-determined price Specific date in the future 50 kg Rs. 5000 An agreement
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- 11. Forward contract • Aforward is a contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre- determined price at a specific date in the future • It is a customised contract, in the sense that the terms of the contract are agreed upon by the individual parties • A bilateral contract • Hence, it is traded OTC • Generally closing with delivery of base asset • Not need any initial payment when signing the contract
- 12. Contd… • A forwardcontract is an agreement to buy or sell an asset on a specified date for a specified price • One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date, for a certain specified price
- 13. Over The Counter(OTC)Trading • In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. • Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. • OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB)
- 14. Risks in ForwardContracts • Credit Risk – Does the other party have the means to pay? • Operational Risk – Will the other party make delivery? – Will the other party accept delivery? • Liquidity Risk – Incase either party wants to opt out of the contract, how to find another counter party?
- 15. Terminology • Long position– Buyer • Short position – seller • Spot price – Price of the asset in the spot market.(market price) • Delivery/forward price – Price of the asset at the delivery date
- 16. Features - Forwardcontract • It is a customised contract • A bilateral contract • It is traded OTC (Unlisted Stocks) • Generally closing with delivery of base asset • Not need any initial payment when signing the contract
- 17. The salient featuresof forward contracts • They are bilateral contracts and hence, exposed to counterparty risk. • Each contract is customer designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. • The contract price is generally not available in public domain. • On the expiration date, the contract has to be settled by delivery of the asset and If party wishes to reverse the contract
- 18. Limitations of Forwardcontract • Lack of centralization of trading • Liquidity and Counterparty risk • Have too much flexibility and generality • Counterparty risk (default by any one party) • Bankruptcy
- 19. Limitations of Forwardcontract • Forward markets are afflicted by several problems: – Lack of centralization of trading – Liquidity and Counterparty risk • The basic problem in the first two is that they have too much flexibility and generality • Counterparty risk arises from the possibility of default by any one party to the transaction. • When one of the two sides to the transaction declares bankruptcy, the other suffers
- 20. Future Contract • Afuture is a standardised forward contract • It is traded on an organised exchange • Future contract is an agreement between two parties to buy or sell an asset at a certain time in the future, at a certain price • But unlike forward contract, futures contract are standardized and stock ex- changed traded • Futures contracts are special types of forward contracts in the sense that the former are standardised exchange-traded contracts • The counter party to a futures is a clearing house on the appropriate futures exchange • Settled by cash or cash equivalents rather than physical assets
- 21. The standardized itemsin a futures contract are: • Quantity of the underlying • Quality of the underlying • The date/month of delivery • The units of price quotation and minimum price change • Location of settlement
- 22. Closing a FuturesPosition • Most futures contracts are not held till expiry, but closed before that • If held till expiry, they are generally settled by delivery. (2-3%) • By closing a futures contract before expiry, the net difference is settled between traders, without physical delivery of the underlying.
- 24. Terminology • Contract size(Lots) • Contract cycle (1m,2m,3m) • Expiry date • Strike price • Cost of carry
- 25. Terminology • Contract size– The amount of the asset that has to be delivered under one contract. All futures are sold in multiples of lots which is decided by the exchange board. – Eg. If the lot size of Tata steel is 500 shares, then one futures contract is necessarily 500 shares. • Contract cycle – The period for which a contract trades. – The futures on the NSE have one (near) month, two (next) months, three (far) months expiry cycles.
- 26. Terminology • Expiry date– usually last Thursday of every month or previous day if Thursday is public holiday. • Strike price – The agreed price of the deal is called the strike price. • Cost of carry – Difference between strike price and current price.
- 27. Margins • A marginis an amount of a money that must be deposited with the clearing house by both buyers and sellers in a margin account in order to open a futures contract • Typically only 2 to 10 percent • It ensures performance of the terms of the contract • Its aim is to minimise the risk of default by either counterparty
- 28. Margins • Initial Margin- Deposit that a trader must make before trading any futures. Usually, 10% of the contract size • Maintenance Margin - When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin • Variation Margin - Additional margin required to bring an account up to the required level • Margin call – If amt in the margin A/C falls below the maintenance level, a margin call is made to fill the gap
- 29. Marking to Market •This is the practice of periodically adjusting the margin account by adding or subtracting funds based on changes in market value to reflect the investor’s gain or loss • This leads to changes in margin amounts daily • This ensures that there are o defaults by the parties
- 30. Difference between Forwardand Futures Forward Future Trade in OTC Only Ex-changes or through CH Standardised Contract, hence more liquid Customized contract, hence liquid NO Margin payment required Required margin payment Settlement by the end of the period Follows daily settlement Markets are not transparent Markets are transparent No Marked to market daily Marked to market daily No prior delivery Closed prior to delivery No Profits or losses realised daily Profits or losses realised daily
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