Futures and forwards

Futures and Forwards

Portfolio?

Set of all securities held by an investor

It may either consist one security or several securities

Investment in several securities is known as Diversified portfolio

Risk?

To dare …………… in Italian

Danger opportunity ………… in Chinese

Risk?

Eg : returns earned by investors in the past 5 years

Share A : 30% 28% 34% 32% 31%

Share B : 26% 13% 48% 11% 57%

Criteria to decide?

1.Expected return

2.Riskiness of return (measured by variability)

Risk

Few types of risk

1. Credit/ Performance Risk2. Price Risk

3. Political Risk4. Market/ systematic / non diversifiable Risk5. Diversifiable Risk

Derivative securities

Price of the securities that are derived from their underlying assets (goods/ commodities, currencies or shares)

Future and forward contracts and the markets in which they are traded represent one of the most important feature of financial derivatives

Forward contractsTwo parties (buyer and seller)An agreement between two individualsSeller to deliver – certain amount of ‘good’ At a particular price (strike rate) At a specified future date (delivery date) and

place A specified quantity and qualityAgreed at the time of agreementBuyer agrees to make paymentParties assume - Long and short positions

Forward contract / long position?Eg :Mr A is retiring after 6 months He is getting a benefit of Rs 10,00, 000Rs 2,00,000 he wants to invest in shares Now, the price per share is Rs 100 through a

contract (Risk- who knows ?! – price may become Rs 120!)In a way it is an insurance against a future risk –

assume you pay Rs 5,000.A’s position to buy in future is ‘LONG POSITION’

Forward contract / Short position?Eg :Mr B has invested Rs 5,00,000 in shares( 5,000 shares of Rs 100 each)He wants to build a house after 6 monthsHe fears a fall in share price may cause cash

crunch He may fix the share price at Rs 100 through a

contract to sell (pays Rs 10,000 – insurance!)This position to sell -------- ‘SHORT POSITION’

Future contracts?Subset of forward contractsLegally binding forward contractsFacilitate trading at any time prior to the

maturity of the contractParties can ‘undo’ their commitments at a low

cost without breaching any contractual obligations

Interim partial settlementsEnsure high liquidity through standardisaion

Some well known Future Exchanges

Chicago Mercantile Exchange (CME)New York Mercantile Exchange (NYME) London Metal Exchange (LME)International Petroleum Exchange, 1980London International Financial Futures

Exchange, 1982 (futures and options)

Mumbai Stock Exchange

Standardised futures (individuals)Eg:4 different future contracts on a given

securityMarch 31/110June 30/110March 31/90June 30/90

Difference between forwards and futures

forwards futures1. Private

agreement, identity of both compulsory

2. No third party

1. Identity of other need not be known

2. Goes through clearing house/ formal exchange – a third party

forwards

futures

3. No obligation to standardise

4. Normally entertained on maturity, unless the parties decide otherwise

3. Standardised contracts, in terms of quantity, quality, price, date of delivery, location,..

4. Most contracts are offset before maturity, as they are easily tradable

forwards futures

5. Tailor made to meet the specific needs of traders

6. May workout costly to renegotiate

5. Cannot be customised to individual needs

6. On default the clearing house imposes certain obligations