Forwards and Futures - An introduction: (Understanding Derivatives - Part II) - Views on News from Equitymaster

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  • Jun 8, 2000 - Forwards and Futures - An introduction: (Understanding Derivatives - Part II)

Forwards and Futures - An introduction: (Understanding Derivatives - Part II)

Jun 8, 2000

Let us consider the case of Mr. Chandar. He is a farmer who grows two crops a year. He has planned to get his daughter married after he harvests the winter crop. He is certain that he can harvest 20 tons of rice. Currently, rice is trading at Rs 5/- per kg. At current price levels, he will earn Rs 100,000 that will cover the expenses for his daughter's wedding. But he knows that if there were a bumper crop of rice all over the state, he would be forced to sell his rice at as little as Rs 2 per kg. In that case, he would fall short to meet the expenses. So Chandar goes to the local rice merchant, Thakur, and enters into an agreement that three months hence, he will sell his twenty tons of rice to him at the rate of Rs 5 per kg. Now, our Thakur is not a simpleton and knows that three months hence, all the farmers would be selling their produce, and the rates that would be then would be about 15% - 20% lower than what it is now. So Thakur offers to buy the rice at the price of Rs 4.2 per kg.

At this, Chandar argues that it is equally likely that in event of a poor crop, the price of Rice may be higher than what it is now. Thakur and Chandar finally agree to a price of Rs 5 per kg of rice for 20,000 kgs to be delivered at Thakur's shop after three months.

This is what we know as the most primitive kind of a derivative contract. Such contracts are called "Forwards" or a Forward Contract. Let us now suppose, Chandar has the freedom to transfer the contract. If the price of rice begins to increase, the value of this contract will also increase for Thakur and decrease for Chandar and vice versa.

Now let us contrast the differences between rains and the rice forward.

Rains Rice Forward
There is no asset to drive the value of the betting contract. There is the expected price of Rice which drives the prices of the rice forward
One cannot deliver rains if it does not rain. The parties can only settle in cash. Delivery very much possible. The counter parties may enforce delivery or may choose to settle in cash.

Now, Chandar has entered into the contract with Thakur. Let us see what problems he may now face.

  • Thakur may refuse to honour the contract, either by fraud or because of genuine circumstances.

  • Chandar, if he wishes to exit out of this arrangement, either Thakur or he decide to mutually cancel the deal. If the expected price of rice is higher than the agreed price, then Thakur may command a premium for canceling the contract. Alternatively, Chandar may choose to sell the contract to somebody else. In case Chandar decides to sell his contract to somebody else, he will have to find a person who can meet the exact conditions, which could be very difficult, and thus lead to a loss of value.

    In financial terms, a forward contract is exposed to default risk and can be very illiquid.

    To counter the above problems, the Chicago Board of Trade invented the first futures type contract. They standardized the contract terms like the quantity, quality and the date and location of delivery. In the above example of Chandar, the terms would be of the type "To Deliver One ton of Grade XYZ rice on DDMMYYYY at the Shop of Mr. Thakur." Such standardized forward contracts that are guaranteed by the exchange are called "Futures" or a Future Contract.

    Chandar would sell twenty such contracts to secure his cash flows. Since the terms are standardized into small units, squaring off your contract is not an issue, because they can be done even one ton at a time. So if Chandar feels that he will have 18 tons, he can buy back two futures.

    Index futures, like these rice futures will have similar properties - The terms of the futures contract would be specified in advance. In context to the expected launch of derivatives, the specifications of the first series are:

    Terms BSE Sensex Futures Nifty Futures
    Market Lot 50 200
    Date of Maturity Last Thursday of the Month Last Thursday of the Month
    Underlying Asset BSE Sensex NSE Nifty

    Having seen how Chandar has created a hedge for his situation, let us see how an investor will create a hedge using index futures.

  • This article is one of four articles in a series to understanding derivatives. Read Part I, Part III and Part IV of this series

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