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DERIVATIVES

Futures

What are future contracts


Future contracts are the organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. In a nutshell futures markets are the extension of the forward contracts.

Characteristics of futures
They are traded on an exchange Standardised liquidity problem, which persists in the forward market, does not exist in the futures market credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

How can futures be understood?


Futures are hedging instruments and are used to reduce the risk of price fluctuations in the underlying assets.

How to use futures


You can "open" a futures position by either buying or selling a future. You can "close" your futures position by doing the opposite - either selling or buying the same future. In practice, most futures contract positions are "closed out" before they expire.

Positions in futures
Long Short

Long Position
If you hold a view that the underlying asset will rise you could buy futures - known as a LONG futures position - which commits you to take delivery of the underlying shares, or equivalent cash value, at a pre-arranged price and by a certain date.

Short Position
If your view is that the share prices for the underlying asset will fall, you could sell futures - known as a SHORT futures position - which commits you to deliver the underlying shares, or equivalent cash value, at a prearranged price and by a certain date

Why use futures?


You can profit in a falling market as well as a rising market Cost efficiency

How are futures priced?


Fair equity futures price = today's share price + interest costs - dividends received

Standardisation in Futures
Each futures contract has a standard set of specifications: Underlying asset - what does the futures contract represent? Is it a commodity, currency, financial instrument, or index.

Standardisation in Futures
Size - the amount of the underlying commodity which is represented by the contract. For instance, 1 corn futures represents 5,000 bushels, while 1 crude oil futures contract usually represents 1,000 barrels. Price Fluctuation - this is the maximum and minimum fluctuations that the contract can take. To prevent massive volatility many futures contracts are limited in the amount their price can fluctuate in one trading day, if the price reaches the upper or lower limit then the contract will be halted until the next trading day.

Standardisation in Futures
Trading Months - this is the specified months for which the particular futures contract can be traded, this varies. Expiration Date - the date by which the futures trading month ceases to exist at which all obligations are terminated.

Standardisation in Futures
Deliverable Grade - the quality of commodity that is to be delivered. For example many crude contracts specify the amount of sulfur that can be in the oil. Delivery Location - where the physical commodity is to be delivered.

Standardisation in Futures
Settlement Mechanism - the terms of the physical delivery of the underlying item or of the cash payment.

Users of futures
Producers Commodity users/ sellers Speculators

Forward Contracts Vs Futures (1)


No counter-party risk: Since the exchange takes the responsibility of settling every trade, each party to the contract will have his portion settled, irrespective of whether the other party settles or not. But in forward contracts, the failure of one party to the contract can lead to nonsettlement of the contract itself.

Forward Contracts Vs Futures (2)


Liquidity: Since futures are traded on an exchange, they are very liquid. It is possible to get in and out of futures positions pretty fast. This feature does not exist in forward contracts since they are not traded on any exchange.

Forward Contracts Vs Futures (3)


Uniformity: Futures contracts are standardised in terms of the size of the contract, the delivery date and the quality of the commodity itself. Such standardisation does not exist in the case of forward contracts.

Differences bet futures and forwards


Futures contracts 1. Are traded on an exchange 2. Use a Clearing House which provides protection for both parties 3. Require a margin to be paid 4. Are used for hedging and speculating 5. Are standardised and published 6. Are transparent - futures contracts are reported by the exchange.

Differences bet futures and forwards


Forwards contracts 1. Are not traded on an exchange 2. Are private and are negotiated between the parties with no exchange guarantees 3. Involve no margin payments 4. Are used for hedging and physical delivery 5. Are dependent on the negotiated contract conditions 6. Are not transparent as they are all private deals

What is a derivative
Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities

Features of derivatives
Derivatives are contracts that have no independent value They derive their value from their underlying assets They are used as risk shifting or hedging instruments

Functions of futures
Help to determine the future prices Help transfer risk Higher trading volumes in underlying securities Reduces speculation in the cash market Increase saving and investment.

Players in the derivative market (1)


Hedgers: Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.

Players in the derivative market (2)


Speculators : They are people who wish to bet on future movements in the price of the asset. Future and Options contracts can give them an extra leverage; that is, they can increase both the potential gains and losses in a speculative venture.

Players in the derivative market (3)


Arbitrageurs: Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. For eg. If they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Kinds of derivatives
On the basis of underlying assets Financial derivatives Commodity derivatives Index derivatives

Kinds of financial derivatives


Equity Derivative Interest Rate Derivative Currency Derivative

Common financial derivatives


forward contracts futures options swaps

Developments in the derivative market


have been around for as long as the people have been trading with one another. a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The first stock index futures contract was trades at Kansas City Board of Trade. Currently the most popular futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange.

Derivative market in India


SEBI set up a committee in 1996 to develop appropriate regulatory framework for derivatives trading in India. SEBI constituted another group in June 1998 under the Chairmanship of Prof. J. R. Varma, to recommend measures for risk containment in the derivatives market. Derivatives trading on the Exchange commenced on June 12, 2000.

Derivatives in India
The futures contract at NSE is based on S&P CNX Nifty # Index. It has a maximum of 3-month expiration cycle. Three contracts are available for trading I.e. with 1 month, 2 months and 3 months expiry.

Forward Contracts
A forward contract is an agreement to buy or sell an asset/underlying on a specific date for a specified price.

Features of Forward Contracts


They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged

Limitations of Forward Contracts


Lack of centralization of trading Illiquidity Counterparty risk

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