introduction to deriatives ....2

     

Lesson  dt 9/9

Scenario 3 – The price of Gold stays the same

If on 9^th Dec 2020, the price is the same as on 9^th sept 2020 then neither ABC nor XYZ would benefit from the agreement.

Possible scenarios in one graph

Here is a visual representation of the impact of gold prices on ABC Jewelers –

 

As you can see from the chart above, at Rs.2450/- per gram, there is no financial impact for ABC. However, as per the graph above we can notice that ABC Jewller’s financials are significantly impacted by a directional movement in the gold prices. Higher the price of gold (above Rs.2450/-), higher is ABC JEWLLER’S s savings or the potential profit. Likewise, as and when the gold price lowers (below Rs.2450/-), ABC JEWELER’S is obligated to buy gold at a higher rate from XYZ, thereby incurring a loss.

Similar observations can be made with XYZ –

At Rs.2450/- per gram, there is no financial impact on XYZ. However as per the graph above, XYZ’s financials are significantly impacted by a directional movement in the gold prices. As and when the price of gold increases (above Rs.2450/-), XYZ is forced to sell gold at a lower rate, thereby incurring a loss. However, as and when the price of gold decreases (below Rs.2450/-) XYZ would enjoy the benefit of selling gold at a higher rate, at a time when gold is available at a lower rate in the market thereby making a profit

A quick note on settlement

Assume that on 9^th DEC 2020, the price of Gold is Rs.2700/- per gram. Clearly as we have just understood, at Rs.2700/- per gram ABC Jewelers stands to benefit from the agreement. At the time of the agreement (9^th SEPT 2020) 15 Kgs gold was worth Rs. 3.67Crs, however as on 9^th DEC 2020 15 kgs Gold is  valued at Rs.4.05 Crs. Assuming at the end of 3 months i.e 9^th DEC 2020, both the parties honor the contract, here are two options available to them for settling the agreement –

1.      Physical Settlement – – The full purchase price is paid by the buyer of a forward contract and the actual asset is delivered by the seller. XYZ buys 15 Kgs of gold from the open market by paying Rs.4.05Crs and would deliver the same to ABC on the receipt of Rs.3.67 Crs. This is called physical settlement

2.      Cash Settlement – In a cash settlement there is no actual delivery or receipt of a security. In cash settlement, the buyer and the seller will simply exchange the cash difference. As per the agreement, XYZ is obligated to sell Gold at Rs.2450/- per gram to ABC. In other words, ABC pays Rs.3.67 Crs in return for the 15 Kgs of Gold which is worth Rs.4.05Cr in the open market. However, instead of making this transaction i.e ABC paying Rs.3.67 Crs in return for the gold worth Rs.4.05Crs, the two parties can agree to exchange only the cash differential. In this case it would be Rs.4.05 Crs – Rs.3.67 Crs = Rs.38 Lakhs. Hence XYZ would just pay Rs.38 lakhs to ABC and settle the deal. This is called a cash settlement

We will understand a lot more about settlement at a much later stage, but at this stage you need to be aware that there are basically two basic types of settlement options available in a Forwards Contract – physical and cash.

What about the risk?

While we are clear about the structure (terms and conditions) of the agreement and the impact of the price variation on either party, what about the risk involved? Do note, the risk is not just with price movements, there are other major drawbacks in a forward contract and they are–

1.      Liquidity Risk – In our example we have conveniently assumed that, ABC with a certain view on gold finds a party XYZ who has an exact opposite view. Hence they easily strike a deal. In the real world, this is not so easy. In a real life situation, the parties would approach an investment bank and discuss their intention. The investment bank would scout the market to find a party who has an opposite view. Of course, the investment bank does this for a fee.

2.      Default Risk/ / Counter party risk – Consider this, assume the gold prices have reached Rs.2700/- at the end of 3 months. ABC would feel proud about the financial decision they had taken 3 months ago. They are expecting XYZ to pay up. But what if XYZ defaults?

3.      Regulatory Risk – The Forwards contract agreement is executed by a mutual consent of the parties involved and there is no regulatory authority governing the agreement. In the absence of a regulatory authority, a sense of lawlessness creeps in, which in turn increases the incentive to default

4.      Rigidity – Both ABC and XZY entered into this agreement on 9^th Dec 2020 with a certain view on gold. However what would happen if their view would strongly change when they are half way through the agreement? The rigidity of the forward agreement is such that, they cannot foreclose the agreement half way through.

The forward contracts have a few disadvantages and hence future contracts were designed to reduce the risks of the forward agreements.

In India, the Futures Market is a part of a highly vibrant Financial Derivatives Market. During the course of this module we will learn more about the Futures and methods to efficiently trade this instrument!