- Forward Contract: – A forward contract is an agreement between two parties to buy or sell an any asset in the future date at a pre-determined time and price. Forward contracts are mostly done in raw materials, commodity, cash market, currency exchange and interest rate market. Such as raw material, grain, oil, gold, silver, debt etc.
Some essential elements of a forward contract
- Forward contract is an agreement made between two people which is also called bilateral contract
- All the terms and conditions like price, quantity, delivery date and time are decided while making the contract. This is done over the phone or face to face, hence it is also called over the counter or OTC.
Major Limitation of Forward contract
- Liquidity Risk: – Liquidity means the ability for traders in the market to buy and sell assets in the quantity they want. Forward contracts are tailor-made contracts that are made by the parties as per their requirement, hence it is not necessary that everyone needs that contract. It is not traded on the exchange, hence there is difficulty in buying and selling it. Due to not being traded on the exchange, it is difficult to reach other market participants, due to which liquidity risk increases.
- Counterparty risk: – Counterparty risk is the biggest reason for market loss which occurs due to non-fulfilment of obligations made in the contract. In a forward contract, the party can refuse to fulfil its obligation even before the contract is completed, this is also known as default and credit risk. Both the parties act as counter parties to each other, apart from liquidity and counter party risk, there are many other risks, such as lack of transparency, settlement, all these are done by both the parties among themselves. The only way to reduce this risk is to trade them on the exchange where there is no such risk.
2. Futures contracts: – Future contracts were created to overcome the limitations of forward contracts. They are traded on an organized exchange. In this, the exchange is used to buy and sell commodities and financial assets at a fixed price and date. The exchange acts as a counterparty for both parties, which eliminates the counterparty risk. In a future contract, the clearing corporation assures that the contract will definitely be settled.
Features of futures contracts
The terms and duration of the contract are determined by the exchange in the futures market. Some of the features of a futures contract are as follows:
- A contract is made through an exchange between two parties.
- Centralized trading platforms such as exchanges (BSE, NSE or MCX)
- Pricing through free communication between buyer and seller on the exchange.
- Both parties have to pay margin.
- Quality and quantity are decided today.
Limitations of Futures Contract
Futures are standardised contracts created by an exchange and they also have certain limitations such as limited expiry, limited underlying, lack of flexibility and mark to market settlement etc.
3. Contract specifications of futures contracts:-The exchange determines all the terms and conditions of the futures contract apart from its price. Apart from the price of the futures contract, the exchange decides all other terms and conditions which are known as contract specifications. This includes the features of derivative contracts such as contract maturity, contract size, tick size etc.
4. Some important terminology associated with futures contracts
- Basis: – The difference between spot price and future price is called basis. If the future price is greater than the spot price, then the basis is negative, whereas if the spot price is greater than the future price, then the basis is positive. To calculate the basis, the future price is subtracted from the spot price (spot price-future price). On the day of final settlement (monthly expiry), the spot price and future price are equal and the basis is 0.
- Cost of Carry: – The relation between futures price and spot price is called cost of carry. It measures the storage cost and interest incurred in commodity market.
- Margin Accounts: – The settlement of all trades is guaranteed by the exchange, therefore the exchange charges margins from all the broking companies so that they can protect themselves from default by any counterparty, and for this reason the broking companies charge margins from their clients. These margins are as follows.
- Initial Margin: The amount deposited in the margin account while entering the futures market is called initial margin. Initial margin depends on the volatility of the market. If the market is more volatile then there will be high risk, so the exchange charges high initial margin.
- Mark to Market: The futures market has a monthly expiry but the settlement of profit and loss is done on a daily basis, which is called mark to market settlement. The exchange takes margin from the losing participants on a daily basis and pays the profit making participants.
- Open Interest and Volumes Traded
Open interest is the total number of contracts outstanding for an underlying asset that have not been closed yet. It helps in showing the volatility in the market and the number of contracts being traded. It shows the depth of the market
- Price band
Price band is the price range within which a contract is allowed to trade throughout the day, this price range is determined by the previous day’s quoted trading price
- Positions in derivatives market
As market participants we always have to deal with certain terms and conditions which are as follows:
Long position
Short Position
Open position
Naked and calendar spread positions
Opening a position
Closing a position
5. Uses of futures
Market participants have different roles in the derivatives market, these are described as hedgers, speculators, and arbitrageurs but all are important for the derivatives market.
- Hedger: – Market participants create buying and selling positions in the futures market to reduce their risk in the cash market so that they can manage their losses in the cash market.
- Speculator/Trader: – Future contracts are very suitable for trading in financial assets or commodities; the trader makes profits by capturing the price movements in the market.
- Arbitrageurs: – Arbitrageurs takes two positions in the market simultaneously, on one hand he buys the asset at a low price and on the other hand he sells the asset. Arbitrageurs explores risk free products in the market
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