Part 1- What is the Forwards Contract?
Hi there. Welcome to Part 1 of the course Futures Trading Basics for Beginners. Before we deep dive into the world of futures contact, let us try and understand the history of the future and when futures contracts started trading in India.
According to data published on the website of NSE, The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark Nifty 50 Index.
The Exchange introduced trading in Index Options (also based on Nifty 50) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 140 securities stipulated by SEBI.
On Jan 11, 2021, NSE added Nifty Financial services as another instrument that can be traded in the derivatives segment.
A lot of time, these two terms (Futures and Forwards) are used interchangeably. Both the contract types are structured in a similar way.
In recent times, the concept of trading via futures contracts have gained prominence. But the forward’s contracts are still being used by banks and financial institutions for their day to day operations.
Basics of Forwards Market
The concept of the forward contract came into the picture to protect the interest of farmers from the price uncertainty of the future. Under this method, the price of agricultural produce was pre-fixed. Even the time and volume of agricultural produce to be delivered on a future date was pre-fixed.
The agreement happens face to face and there is no third party involved in it. This is called the “Over the counter (OTC)” agreement. Forward contracts are traded only in the OTC (Over the Counter) market, where individuals and institutions enter into an agreement on one to one basis.
Let us understand it with the help of an example:
On 1st Jan 2021, Mr A entered into an agreement with Mr B to buy 10 kilograms of silver in three months time (30th March 2020). They fix the price of Silver at the current market price, which is Rs.60000/- per kilogram. Hence as per this agreement, on 30th March 2020, Mr A is expected to pay Mr B a sum of Rs. 6,00,000 (60,000/Kg*10) in return for the 10 kgs of Silver.
Now, an important point of consideration here is that the price of silver on 30th March 2020 has no bearing on the forward contract pre-decided price. Both the parties in the agreement will have to honour the contract.
In this example, the buyer of silver is expecting the price of silver to go up in future and the seller of the silver is expecting the price of silver to fall in future.
The outcome of Silver Contract
- If the price of silver goes up: If the price of silver goes up to Rs. 70,000 per kilogram at the time of expiry of the contract, then the buyer of the forward contract stands to gain
Benefit to the buyer = (70,000-60,000) * 10 = Rs. 1,00,000
- If the price of silver goes down: If the price of silver goes down to Rs. 51,000 per kilogram at the time of expiry of the contract, then the seller of the forward contract stands to gain
Benefit of the seller = (60,000-51,000) * 10 = Rs. 90,000
- If the price does not change: Both the involved parties do not gain or lose anything in this contract.
Settlement of Forward Contract
Settlements are generally in two forms: Cash and Physical settlement.
In the case of Physical settlement, the buyer of the silver pays the equivalent amount (the agreed upon) price to the seller and takes the delivery of 10 kg of silver.
But in the case of a Cash settlement, the difference money (or cash differential) will have to be paid by the losing party to the gaining party. As per the agreement, Mr B is obligated to sell Silver at Rs.60000/- per kg to Mr A.
In other words, A pays Rs. 6,00,00o in return for the 10 Kgs of silver which is worth Rs. 7,00,000 (say) in the open market. However, instead of undertaking this transaction i.e., A paying Rs. 6,00,000 in return for the silver worth Rs. 7,00,000, the two parties can agree to exchange only the cash differential.
In this case, the transfer would be for Rs. 7,00,000 – Rs. 6,00,000 = Rs.1,00,000. Hence Mr B would just pay Rs. 1 lakh to A and settle the deal. This is called a cash settlement.
Risks Associated with Forward Contract
Every contract involving counterparties has its own set of risks and challenges. Following are some of the risks associated with trading in Forward contracts:
- Liquidity risks: This is one of the primary reasons as to why people prefer trading futures contracts and not forward contracts. It becomes increasingly difficult to find the parties willing to take a counter position to your views. Say, if i have physical possession of 2 kg of Gold and i am expecting a fall in the prices of gold in near future. So, to hedge myself from the falling price I am willing to sell it in the forward market. But, finding a counterparty willing to take the opposite position can be a challenge in the forward market.
- Default risk: If at the time of the expiry of the contract, the losing party dishonors the agreement and doesn’t pay up, then it becomes difficult to recover the money of the gaining party.
- Absence of Regulatory Authority: As the forward contracts are designed with the consent between two parties, and there is no third party involved in the agreement and it is not governed by any regulatory authority, there is always a sense of lawlessness and chances of default by one of the parties increase.
- Can’t bail out in between the agreement duration: At the time of entering of the contract, both parties involved have counter views but during the midway of the duration of the contract, if the views of one of the parties involved changes, then he/she cant exit the contact as there is no option of foreclosure of the agreement.
Key learnings from this chapter
- Forwards contract is between the parties having counter views on the same underlying asset.
- There is no third party involved in the forward contract.
- A Forward contract is an OTC derivative and is not traded on any exchange.
- Settlement of the forward contract is of two types: Cash Settlement and Physical delivery.
- Lack of liquidity is one of the biggest limitations of the Forward Contract.
Having understood the basics of futures market functioning and its mechanism, now we will move on and focus our discussion on the futures contract. We will cover the various facets of Forward contract in chapters to follow.