Understanding the "Futures Trading"

Lesson -> The Background – Forwards Market

1.1 - The Overview

The Futures market is an integral component of Financial Derivatives. "Derivatives" is a security that derives its value from an other financial entity, also known as an "Underlying Asset". Any stock, bond or commodity can be used as the underlying asset. Financial derivatives have existed for quite some time. In 'Kautilya’s Arthashastra', 320 BC is the earliest mention of Indian derivatives. Kautilya, an ancient Arthashastra (study on Economics) script, described the pricing mechanism for standing crops that were ready to harvest at some future date. He used this method to pay farmers in advance and thus created a true forwards contract.

Due to the similarities between the futures and forwards markets, it is best to first understand the 'Forwards Market'. Understanding the Forwards Market will provide a solid foundation for learning about the Futures Market.

The forwards' contract, the simplest derivative form, is available. The forwards' contract is the older version of the futures contract. The futures and forward contracts share the same transactional structure. However, the futures have been the default choice of trader over the years. Although forward contracts are still used, they are only available to certain participants such as banks and industries. This chapter will help you to understand the structure and benefits of a typical forwards deal.

1.2 - A simple Forwards example

The Forward market was created to protect farmers' interests from price fluctuations. A forward market is where the seller and buyer agree to exchange goods for cash. The exchange takes place at a fixed price on a future date. Both parties agree to fix the goods' price. The delivery date and time are also set by both parties. Without any intervention by a third party, the agreement is made face-to-face. This is known as an "Over the Counter" or OTC agreement. Forward contracts can only be traded in the OTC market (Over the Counter), where individuals and institutions trade on a one-to-one basis through negotiations.

Take this example as an example. There are two parties.

One is a jeweller, whose job it is to design and make jewellery. Let's call him "ABC Jewelers". The other is a gold dealer who sells gold wholesale to jewellers. Let's call him "XYZ Gold Dealers".

ABC and XYZ agreed to purchase 15 kilograms of gold in a specified purity (9 th February 2015). They set the gold price at the current market rate of Rs.2450/gram or Rs.245,000/kg. As per the agreement, ABC will pay XYZ a total of Rs.3.675 Cros (24.50,000/Kg*15), in exchange for 15 kgs of gold.

This is a common and straightforward business agreement that is widely used in the market. This type of agreement is called a "Forwards Contract" (or a "Forwards Agreement").

Note that the agreement was executed on the 9 th December 2014, regardless of the gold price 3 months later. 9 th February 2015: Both ABC and XYZ must honor the agreement. Let's first understand the thought processes of each party and what motivated them to sign this agreement.

What is the reason ABC signed this agreement? ABC believes that gold prices will rise over the next three months. Therefore, they want to lock in today’s market price. ABC is clearly trying to protect itself against an adverse rise in gold prices.

A forwards contract is where the buyer of the asset agrees to purchase it at some future date. In this case, it's ABC Jewelers.

Similarly, XYZ believes that the price of the gold will fall over the next three months. Therefore, they are looking to capitalize on the current high gold price. A forwards contract is where the seller of the asset agrees to sell it at a future date. In this case, it's XYZ Gold Dealers.

Each party has a different view of gold. Therefore, they consider this agreement in line with their future expectations.

1.3 - The Three possible scenarios

Although each party has their own views on gold, there are only three scenarios that could be possible at the end. These scenarios could have a significant impact on both parties.

Scenario 1: The gold price rises.

On 9 March 2015 the price for gold (999 purity), is Rs.2700/gram. ABC Jeweler's views on the gold price are evident. The deal was initially valued at Rs 3.67 Crs at the time. However, due to the rise in Gold prices, it is now valued at Rs. 4.05 Crs. According to the agreement, ABC Jewelers can buy Gold (999 purity), from XYZ Gold Dealers at a rate they previously agreed upon. Rs.2450/- per gram.

Both parties are affected by the increase in Gold prices in the following ways:

PartyTake ActionFinancial Impact
ABC JewelersPurchase gold at XYZ Gold Dealers starting at Rs.2450/gramThis agreement saves ABC Rs.38 Lakhs (4.05 Crs – 3.67 Crs).
Dealers in XYZ GoldObligated to Sell Gold to ABC @ Rs.2450/gramA financial loss of Rs. 38 Lakhs is possible.

XYZ Gold Dealers must buy Gold on the open market at Rs.2700/gram and then sell it to ABC Jewelers for Rs.2450/gram. This will result in a loss.

Scenario 2: The price of gold falls.

Let's say that the price for gold (999 purity), is Rs.2050/gram on 9 March 2015. XYZ Gold dealers' view of the gold price is now a reality. The deal was initially valued at Rs 3.67 Cr at the time. However, due to the decline in gold prices, it is now valued at Rs.3.075 Cr. According to the agreement, ABC Jewelers will buy Gold (999 purity), from XYZ Gold Dealers at a rate they have previously agreed to, i.e. Rs.2450/- per gram.

The following would be the consequences of a drop in gold prices for both parties:

PartyTake ActionFinancial Impact
ABC JewelersIs obligated buy gold from XYZ Gold Dealers at Rs.2450/gramUnder this agreement, ABC loses Rs.59.5 Lakhs (3.67 Crs - 3.075 Cros).
Dealers in XYZ GoldGold can be sold to ABC at Rs.2450/gramXYZ makes a profit of Rs.59.5 Lakhs

Despite Gold being much more expensive on the open market than it is in the closed market, ABC Jewelers must purchase gold at a higher price from XYZGold Dealers to avoid a loss.

Scenario 3: The price of gold remains the same.

If the 9th February 2015 price is the exact 9th December 2014 price, neither ABC or XYZ will be able to take advantage of this agreement.

1.4 - Three possible scenarios in one graph

This is an image of the impact of gold prices at ABC Jewelers - (image 02)

The chart shows that ABC has no financial impact at Rs.2450/gram. The graph below shows that ABC's financials can be significantly affected by changes in gold prices. The higher the gold price (above Rs.2450 ), the greater the ABC's potential profit or savings. Similarly, if the gold price falls below Rs.2450 /-), ABC will be obligated buy gold at a lower rate from XYZ. This could result in a loss.

Similar observations can also be made about XYZ-
(image 02).

XYZ has no financial impact at Rs.2450/gram As you can see, XYZ's financials will be affected by a directional change in gold prices. If the price of gold rises (above Rs.2450 ), XYZ will have to sell gold at lower rates, incurring a loss. But, when gold prices drop (below Rs.2450 /-),), XYZ will be able to sell gold at a higher price, when gold is more affordable, and thus make a profit.

1.5- A quick note on settlement

Let's say that the price for Gold was Rs.2700/gram on 9 March 2015. As we've seen, ABC Jewelers is in the position to profit from this agreement at Rs.2700/gram. The value of 15 kgs of gold at the time the agreement was signed (9 th Dec 2014) was Rs. 3.67Crs. As of 9 March 2015 15 Kgs Gold was worth Rs.4.05 Crs. Assuming that the contract is valid for 3 months (i.e. 9 th February 2015, both parties honor the contract. There are two options for them to settle the agreement:

  1. Physical Settlement-- A forward contract buyer pays the entire purchase price and the seller delivers actual assets. XYZ purchases 15 kgs of gold on the open market for Rs.4.05Crs. ABC would receive Rs.3.67 Crs. This is known as a physical settlement
  2. Cash Settlement There is no delivery or receipt of security in a cash settlement. Cash settlement is where the seller and buyer exchange the cash difference. XYZ has to sell Gold to ABC at Rs.2450/gram as per the agreement. This means that ABC will pay Rs.3.67 Crs for 15 kgs of gold, which is worth Rs.4.05Cr on the open market. This transaction is not possible, however. In exchange for Rs.3.67 Crs of gold, ABC can pay Rs.4.05Crs to the other party. The cash differential can be exchanged. It would be Rs.4.05 Cros - Rs.3.67 crs = Rs.38 Lakhs. Hence, XYZ would settle the deal by paying Rs.38 lakhs (Rs.3.67 Crs) to ABC. This is cash settlement

At a later stage, we will learn more about settlement. You should be aware, however, that you have two main types of settlement options in a Forwards contract - cash and physical.

1.6 - What about the risks?

We are very clear on the terms and conditions of the agreement, as well as the effect of price variations on each party. But what about the risk? You should be aware that there are many other risks associated with forward contracts.

  1. Liquidity risk - We have assumed in our example that ABC finds party XYZ with an exact opposite view and a view on gold. They quickly reach a deal. This is not always possible in the real world. In real life, both parties would approach an investment bank to discuss their intentions. The investment bank would search the market for a party with a different view. The fee for this service is paid by the investment bank.
  2. Default risk/ / Counterparty risk Let's say that gold prices reached Rs.2700/ at the end 3 months. ABC would be proud of the financial decision that they made 3 months ago. They expect XYZ will pay up. What if XYZ defaults on its obligations?
  3. Regulatory risk - The Forwards contract agreement is entered into by mutual consent between the parties and no regulatory authority. A sense of lawlessness can creep in which increases the incentive for default.
  4. Rigidity –Both ABC & XZY signed this agreement on the 9th December 2014 with a certain golden view. What if their views change after they have completed the agreement halfway? They cannot cancel the agreement halfway because of the rigidity of the forward arrangement.

Forward contracts can have some disadvantages. Future contracts were created to minimize the risk of forward agreements.

India's Futures Market is part of the vibrant Financial Derivatives Market. This module will teach you more about Futures and how to trade it efficiently.

Let's get on the road!

To Summarize

  1. The foundation of a futures contract is laid by the forwards' contract.
  2. A Forward is an OTC derivative that is not traded on any exchange.
  3. Forward contracts are private agreements, whose terms can vary from one contract the next.
  4. A forwards contract structure is quite simple.
  5. The "Buyer" of a Forward Agreement is the party that agrees to purchase the asset.
  6. A forward agreement is where the seller agrees to sell the asset.
  7. Both the buyer and seller would be affected by a variation in the price.
  8. Settlement can be made in two ways when a forward contract is in place: Physical and cash settlements.
  9. Futures contracts reduce the risk associated with forward contracts.
  10. The core of both a futures and forward contract is the exact same.