introduction to Derivatives

 

FINANCIAL DERIVATIVES -   FORWARD MARKET

 

 

Overview

The Futures market is an integral part of the Financial Derivatives world. ‘Derivatives’ as they are called is a security, whose value is derived from another financial entity referred to as an ‘Underlying Asset’. The underlying asset can be anything a stock, bond, commodity or currency. The financial derivatives have been around for a long time now. The earliest reference to the application of derivatives in India dates back to 320 BC in ‘Kautilya’s Arthashastra’. It is believed that in the ancient Arthashastra (study of Economics) script, Kautilya described the pricing mechanism of the standing crops ready to be harvested at some point in the future. Apparently he used this method to pay the farmers much in advance, thereby structuring a true ‘forwards contract’.

Given the similarities between the forwards and the futures market, I think the best possible way to introduce the futures market is by first understanding the ‘Forwards market’. The Understanding of Forwards Market would lay a strong foundation for learning the Futures Market.

The forwards contract is the simplest form of derivative. Consider the forwards contract as the older avatar of the futures contract. Both the futures and the forward contracts share a common transnational structure, except that over the years the futures contracts have become the default choice of a trader. The forward contracts are still in use, but are limited to a few participants such as the industries and banks. 

This chapter is to help you understand the structure of a typical forwards transaction, after which we will break it down to its elements, and understand its advantages and disadvantages.

 

 A simple Forwards example

The Forward market was primarily started to protect the interest of the farmers from adverse price movements. In a forward market, the buyer and seller enter into an agreement to exchange the goods for cash. The exchange happens at a specific price on a specific future date. The price of the goods is fixed by both the parties on the day they enter into the agreement. Similarly the date and time of the goods to be delivered is also fixed. The agreement happens face to face with no intervention of a third party. This is called “Over the Counter or OTC” agreement. Forward contracts are traded only in the OTC (Over the Counter) market, where individuals/ institutions trade through negotiations on a one to one basis.

Consider this example, there are two parties involved here.

One is a jeweler whose job is to design and manufacture jewelry. Let us call him ‘ABC Jewelers’. The other is a gold importer whose job is to sell gold at a whole sale price to jewelers, let us call him’ XYZ Gold Dealers’.

On 9^th Sept 2020, ABC enters into an agreement with XYZ to buy 15 kilograms of gold at a certain purity (say 999 purity) in three months time (9^th DEC 2020).

They fix the price of Gold at the current market price, which is Rs.2450/- per gram (Hypothetic  price for the sake of simplicity) or Rs.24,50,000/- per kilogram. Hence as per this agreement, on 9^th Sept 2020, ABC is expected to pay XYZ a sum of Rs.3.675 Crs (24,50,000/Kg*15) in return for the 15 kgs of Gold.

This is a very straightforward and typical business agreement that is prevalent in the market. An agreement of this sort is called a ‘Forwards Contract’ or a ‘Forwards Agreement’.

Pleas note that  the agreement is executed on 9^th  Sept 2020, hence irresctive of the price of gold 3 months later i.e 9^th Dec 2020, both ABC and XYZ are obligated to honor the agreement. Before we proceed further, let us understand the thought process of each party and understand what compelled them to enter into this agreement.

Why do think ABC JEWELLER  entered into this agreement? Well, ABC believes the price of gold would go up over the next 3 months, hence they would want to lock in today’s market price for the gold. Clearly, ABC wants to insulate itself form an adverse increase in gold prices.

In a forwards contract, the party agreeing to buy the asset at some point in the future is called the “Buyer of the Forwards Contract”, in this case it is ABC Jewelers.

Likewise, XYZ GOLD DEALER  believes the price of gold would go down over the next 3 months and hence they want to cash in on the high price of gold which is available in the market today. In a forwards contract, the party agreeing to sell the asset at some point in the future is called the “Seller of the Forwards Contract”, in this case it is XYZ Gold Dealers.Both the parties have an opposing view on gold; hence they see this agreement to be in line with their future expectation.

possible scenarios

While both these parties have their own view on gold, there are only three possible scenarios that could pan out at the end of 3 months. Let us understand these scenarios and how it could impact both the parties.

Scenario 1 – The price of Gold goes higher  -

Assume on 9^th DECEMBER 2020, the price of gold (999 purity) is trading at Rs.2700/- per gram. Clearly, ABC Jeweler’s view on the gold price has come true. At the time of the agreement the deal was valued at Rs 3.67 Crs but now with the increase in Gold prices, the deal is valued at Rs.4.05 Crs. As per the agreement, ABC Jewelers is entitled to buy Gold (999 purity) from XYZ Gold Dealers at a price they had previously agreed upon i.e Rs.2450/- per gram.

The increase in Gold price impacts both the parties in the following way –

Party	Action	Financial Impact
ABC Jewelers	Buys gold from XYZ Gold Dealers @ Rs.2450/- per gram	ABC saves Rs.38 Lakhs ( 4.05 Crs – 3.67 Crs) by virtue of this agreement
XYZ Gold Dealers	Obligated to sell Gold to ABC @ Rs.2450/- per gram

Hence, XYZ Gold Dealers will have to buy Gold from the open market at Rs.2700/- per gram and would have to sell it to ABC Jewelers at the rate of Rs.2450/- per gram thereby facing a loss in this transaction.

cenario 2 – The price of Gold goes down

Assume on 9^th Decembe  2020, the price of gold (999 purity) is trading at Rs.2050/- per gram. Under such circumstances, XYZ Gold Dealers view on the gold price has come true. At the time of the agreement the deal was valued at Rs 3.67 Cr but now with the decrease in gold prices, the deal is valued at Rs.3.075 Cr. However, according to the agreement, ABC Jewelers is obligated to buy Gold (999 purity) from XYZ Gold Dealers at a price they had previously agreed upon i.e Rs.2450/- per gram.

This decrease in the gold price would impact both the parties in the following way –

Party	Action	Financial Impact
ABC Jewelers	Is obligated to buy gold from XYZ Gold Dealers @ Rs.2450/- per gram	ABC Jewler loses Rs.59.5 Lakhs ( 3.67 Crs – 3.075 Crs) by virtue of this agreement
XYZ Gold Dealers	Entitled to sell Gold to ABC @ Rs.2450/- per gram	XYZ Dealer enjoys a profit of Rs.59.5 Lakhs.

Do note, even though Gold is available at a much cheaper rate in the open market, ABC Jewelers is forced to buy gold at a higher rate from XYZ Gold Dealers hence incurring a loss.