INTRODUCTION TO FORWARDS AND FUTURES

Introduction to Forward Contracts

Definition: A forward contract is an agreement between two parties to buy or sell an asset on a specific date in the future, at the terms decided today.
Details: Forwards are widely used in commodities, foreign exchange, equity, and interest rate markets. They are bilateral over-the-counter (OTC) transactions where the terms of the contract, such as price, quantity, quality, time, and place, are negotiated between two parties.

Key Features of Forward Contracts

Bilateral Contract: It is a contract between two parties.
Fixed Terms: All terms of the contract, like price, quantity, and quality of the underlying asset, delivery terms, and settlement procedure, are fixed on the day of entering into the contract.
Customization: Forwards are tailor-made contracts according to the specific requirements of the parties.
Price Risk Management: The essential idea of entering into a forward is to fix the price and thereby avoid the price risk.

Example of a Forward Contract

Buyer's Perspective: If you buy a forward contract to purchase gold at a fixed price and the market price increases, you can buy the gold at the lower fixed price and sell it at the higher market price, making a profit.
Seller's Perspective: If you sell a forward contract to sell gold at a fixed price and the market price decreases, you can buy the gold at the lower market price and sell it at the higher fixed price, making a profit.

Limitations of Forward Contracts

Liquidity Risk: Forwards are not listed or traded on exchanges, making it difficult for parties to exit from the contract before maturity.
Counterparty Risk: The risk of an economic loss from the failure of the counterparty to fulfill its contractual obligation.
Other Issues: Lack of transparency, settlement complications, and default risk are other issues associated with forward contracts.

Conclusion

Need for Centralized Trading: The limitations of forward contracts can be addressed by bringing these contracts to a centralized trading platform, which is what futures contracts do.

3. Futures Contracts

Definition: A futures contract is an agreement made through an organized exchange to buy or sell a fixed amount of a commodity or a financial asset on a future date at an agreed price.
Details: It is a standardized forward contract that is traded on an exchange, with the clearing corporation guaranteeing settlement of these trades.

Key Features of Futures Contracts

Contract Terms: The exchange decides all the terms of the contract other than price.
Key Characteristics:
- Contract between two parties through an exchange
- Centralised trading platform (i.e., exchange)
- Price discovery through free interaction of buyers and sellers
- Margins payable by both parties
- Quality and quantity decided today (standardized)

Limitations of Futures Contracts

Standardization Limitations: Futures contracts have limited maturities, a limited underlying set, and lack flexibility in contract design.
Administrative Costs: Increased administrative costs due to Mark-to-Market (MTM) settlement.

Contract Specifications of Futures Contracts

Definition: Contract specifications refer to the terms and conditions of futures contracts, excluding the price, which are decided by the exchange.
Details: These specifications include contract maturity, contract multiplier or contract size, tick size, and other salient features of a derivatives contract.

Key Components of Contract Specifications

Underlying Instrument and Underlying Price: The underlying instrument is the index or stock on which the futures contract is traded, while the underlying price is the spot price of the underlying asset in the cash market.
Contract Multiplier or Contract Size: The contract size is determined by the exchange and can be changed from time to time. It is used to calculate the contract value by multiplying it with the futures price.
Contract Cycle: Index and stock futures contracts on the NSE follow a three-month trading cycle, with contracts available for the near month, next month, and far month.
Expiration Day: The expiration day is the last trading day of the contract, on which all open positions are compulsorily settled.

Additional Contract Specifications

Tick Size: The minimum move allowed in price quotations, decided by the exchange. For Nifty futures, the tick size is 5 paisa.
Daily Settlement Price: The exchange calculates a daily settlement price for open positions in equity index and stock futures contracts, based on the last half-an-hour weighted average price.
Final Settlement Price: The price at which all open positions in the near-month futures contracts are finally settled on the expiration day, which is the closing price of the underlying index or stock in the cash segment.
Trading Hours: Equity futures contracts can be traded during normal market hours, from 9:15 am to 3:30 pm, Monday to Friday.

Example: Nifty Futures Contract

Instrument Type: Index futures
Underlying Asset: Nifty 50
Expiry Date: October 28, 2025
Contract Size: 65 (example value)
Tick Size: 5 paisa
Contract Cycle: Three-month trading cycle
Expiration Day: Last Tuesday of the expiry month

Example: BSE Sensex Futures Contract

Underlying Asset: BSE Sensex
Contract Size: 20
Tick Size: Rs. 0.05
Contract Cycle: 7 serial weekly and 3 serial monthly contracts
Expiration Day: Monthly contracts: last Thursday of the contract month; Weekly contracts: Thursday expiry
Final Settlement: Cash settlement based on the closing price of the underlying index on the expiration day

Some important terminology associated with futures contracts

Basis: The difference between the spot price and the futures price. It can be negative (futures price > spot price) or positive (spot price > futures price).
Cost of Carry: The relationship between futures prices and spot prices, measuring storage cost, interest, and income earned on the asset.
Margin Account: An account where brokers charge margins from clients to protect against default, including:
- Initial Margin: The amount deposited at the time of entering a futures contract, dependent on price movement and volatility.
- Marking to Market (MTM): Day-to-day settlement of profits and losses, where the exchange collects margins from loss-making participants and pays to gainers.
Open Interest and Volumes Traded:
- Open Interest: The total number of contracts outstanding, indicating market depth.
- Volumes Traded: The number of contracts traded over a given period, indicating market activity.
Price Band: The price range within which a contract can trade during a day, calculated with respect to the previous day's closing price.
Positions in derivatives market:
- Long Position: An outstanding buy position in a contract.
- Short Position: An outstanding sell position in a contract.
- Open Position: An outstanding long or short position in various derivative contracts.
- Naked and Calendar Spread Positions: A long or short position without an underlying asset, or a combination of positions in futures on the same underlying with different maturities.
Opening and Closing a Position:
- Opening a Position: Buying or selling a contract to increase open position.
- Closing a Position: Buying or selling a contract to reduce open position.

Differences between Forwards and Futures

Operational Mechanism:
- Forward contracts: Not traded on exchanges.
- Futures contracts: Exchange-traded contract.
Contract Specifications:
- Forward contracts: Tailor-made, terms differ from trade to trade according to the need of the participants.
- Futures contracts: Standardized, except for the price, all other terms are fixed.
Counter-party Risk:
- Forward contracts: Exists, but can be reduced by a guarantor.
- Futures contracts: Clearing agency associated with the exchange becomes the counter-party, providing a guarantee on settlement.
Liquidity Profile:
- Forward contracts: Low liquidity, as contracts are tailor-made and not easily accessible to other market participants.
- Futures contracts: High liquidity, due to standardized and exchange-traded contracts.
Price Discovery:
- Forward contracts: Inefficient, as markets are scattered.
- Futures contracts: Efficient, with a centralized trading platform allowing buyers and sellers to discover prices through a common order book.
Quality of Information and Dissemination:
- Forward contracts: Poor quality of information, with slow dissemination.
- Futures contracts: High-quality information, with quick dissemination of relevant information nationwide.

Payoff Charts for Futures Contracts

Definition: A payoff chart is a graphical representation showing the price of the underlying asset on the X-axis and profits/losses on the Y-axis, representing the likely profit/loss that would accrue to a market participant with a change in the price of the underlying asset at expiry.
Details: Payoff charts for futures contracts are linear, with both long and short positions having unlimited profit or loss potential.

Key Concepts for Payoff Charts

Long Futures Position: The buyer of a futures contract agrees to buy the underlying asset at a fixed price on expiry. If the market price at expiry is higher than the contract price, the buyer makes a profit; if it's lower, they incur a loss.
Short Futures Position: The seller of a futures contract agrees to sell the underlying asset at a fixed price on expiry. If the market price at expiry is lower than the contract price, the seller makes a profit; if it's higher, they incur a loss.
Payoff Chart Characteristics:
- The X-axis represents the market price of the underlying asset at expiry, increasing to the right.
- The Y-axis represents profit and loss, with profits shown in the upward direction and losses in the downward direction.
- The payoff chart for a long futures position shows a linear relationship between the market price at expiry and the profit/loss.
- The payoff chart for a short futures position is the exact opposite of the long futures position, with profits and losses reversed.

Example of Payoff Charts

Long Futures at 100: If the market price at expiry is 150, the buyer makes a profit of 50. If the market price at expiry is 70, the buyer incurs a loss of 30.
Short Futures at 100: If the market price at expiry is 50, the seller makes a profit of 50. If the market price at expiry is 150, the seller incurs a loss of 50.

Futures Pricing

Definition: Futures pricing depends on the characteristics of the underlying asset, with no single methodology applicable to all assets due to varying demand and supply patterns, characteristics, and cash flow patterns.
Key Models: Two popular models for pricing futures contracts are the Cost of Carry model and the Expectations model.

Cost of Carry Model

Definition: The Cost of Carry model, also known as the no-arbitrage model, assumes that in an efficient market, arbitrage opportunities cannot exist, and prices are aligned across products/markets for replicating assets.
Fair Price Calculation: The fair price of a futures contract is the sum of the spot price of the underlying asset and the cost of carrying the asset from today until delivery, considering costs like transaction costs, custodial charges, financing costs, etc.
Example: If the spot price of gold is Rs 62,130 per 10 grams and the cost of financing, storage, and insurance for carrying the gold for three months is Rs 100 per 10 grams, the expected value of the gold after three months would be Rs 62,230 per 10 grams.
Arbitrage Opportunity: If the 3-month futures contract on gold is trading at Rs 62,280 per 10 grams, one can exploit the arbitrage opportunity by buying gold in the cash market and selling 3-month gold futures simultaneously.

Cost of Transaction and No-Arbitrage Bounds

Definition: Cost components of futures transactions, like margins, transaction costs, and taxes, create distortions and move markets away from equilibrium, establishing no-arbitrage bounds.
Fair Price and No-Arbitrage Bounds: The fair price of a futures contract is the sum of the spot price and the cost of carrying the asset, while no-arbitrage bounds are the ranges within which futures prices can fluctuate without triggering arbitrage.

Extension of Cost of Carry Model

Assets Generating Returns: The Cost of Carry model can be extended to assets generating returns, like securities, by adjusting the computation of the fair futures price to include inflows during the holding period.
Formula: The modified formula for fair futures price is F = S (1+r-q)T, where F is the fair price of the futures contract, S is the spot price, q is the expected return, r is the cost of carry, and T is the time to expiration.

Assumptions of the Cost of Carry Model

Key Assumptions: The model assumes the underlying asset is available in abundance, demand and supply are not seasonal, holding and maintaining the asset is easy, the asset can be sold short, and there are no transaction costs or taxes.
Limitations: The model is not applicable to assets with seasonal demand-supply patterns, non-storable assets, or assets that cannot be sold short.

Convenience Yield

Definition: Convenience yield refers to the intangible inflows or values perceived by market participants by holding an asset, such as the convenience or mental comfort derived from holding a commodity during a crisis.
Impact on Futures Pricing: Convenience yield can dominate the cost of carry, leading futures to trade at a discount to the cash market, and reverse arbitrage may not be possible.

Expectations Model

Definition: The Expectations model states that futures price is the expected spot price of an asset in the future, and market participants price futures based on their estimates of future spot prices.
Key Points: Futures can trade at a premium or discount to the spot price, and futures price indicates the expected direction of movement of the spot price in the future, with Contango market indicating an expected rise and Backwardation market indicating an expected fall.

Price Discovery and Convergence of Cash and Futures Prices on Expiry

Expectations Hypothesis: The market expectation of the spot index level at the closure of the market on the last trading day of the contract.
Price Discovery: The process of predicting the spot index level at a specific point in time, resulting in the discovery of the spot index price.
Convergence of Prices: The phenomenon where futures prices and spot prices converge at the maturity of the futures contract, with no difference between the two prices.
Key Principle: Futures contracts on expiry settle at the underlying cash market price, applicable to all underlying assets.
Important Concept: The futures price is essentially the expected spot price of the underlying asset at the maturity of the futures contract, leading to convergence of prices at expiry.

Uses of Futures

Hedgers: Corporations, investing institutions, banks, and governments use derivative products to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates, and commodity prices.
Speculators/Traders: Futures contracts are well-suited for trading on the prices of financial assets and commodities, offering a less expensive way to create a speculative position compared to trading the underlying asset.
Arbitrageurs: Arbitrageurs exploit mispricings in the market by buying an asset cheaply in one location/exchange and selling it at a higher price in another location/exchange, thus establishing an efficient link between different markets.

Key Participants and Their Roles

Hedgers: Aim to hedge their risk by transferring it to traders.
Traders: Take naked positions in the futures market, acting as counter-parties to hedgers and providing depth to the market.
Arbitrageurs: Establish an efficient link between different markets by exploiting mispricings, contributing to market liquidity and efficient price discovery.

Risks and Considerations

Leverage: Acts as a double-edged sword, amplifying both potential returns and risks in futures contracts.
Transaction Costs: Include brokerage, service tax, securities transaction tax, etc., which must be considered in arbitrage deals.
Time Lag: Can pose a risk to arbitrageurs if there is a delay in executing both legs of a transaction.

Hedging Strategies

Long Hedge: Involves going long in the futures market to hedge a position in the cash market.
Short Hedge: Involves going short in the futures market to hedge a position in the cash market.
Cross Hedge: Involves using a futures contract on a closely related asset to hedge the risk of an asset without a available futures contract.

Trading in Futures Market

Naked Positions: Traders take long or short positions in futures contracts based on their expectations of price movements.
Spread Positions: Involve taking opposite positions in two contracts, either on different products or with different maturities.
Calendar Spreads: Are computed with respect to the near month series and become naked positions when the near month contract expires.

Arbitrage Opportunities

Cash and Carry Arbitrage: Involves a long position in the cash market and a short position in the futures market.
Reverse Cash and Carry Arbitrage: Involves a long position in the futures market and a short position in the cash market.
Inter-Exchange Arbitrage: Entails taking positions on the same contract in two different markets/exchanges.

Fair Futures Price

Formula: F = S + C, where F is the fair futures price, S is the spot price, and C is the carrying cost.
Alternative Formula: F = S(1+r)T, where r is the carrying cost as a percentage and T is the time to expiration in years.

Conclusion

Futures contracts provide market participants with a quick and less expensive mode to alter their portfolio composition and manage risk.
They can be used to either add risk to existing portfolios or reduce risk, making them essential risk management and portfolio restructuring tools.