Futures and Forwards contract

Derivatives in a Nutshell

By
Shravan Bhumkar
(KH08JUNMBA100)

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
What is a Derivative ?

 Simply defined “a derivative is a price guarantee” .

 Nearly every derivative out there is just “an agreement between future
buyer and future seller specifying a future price at which some item can or
must be sold this item is know as ‘underlier’ might be some physical
commodity or some financial security”.
 Every derivative also specifies a future date on or before which transaction
must occur.
 These are the common elements of all derivatives :
1. Buyer and seller, 2. Underlier, 3. Future price , 4.Future date.

Buyer Seller

physical commodity /financial security

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Types of Derivatives

Forward contract Futures contract

Derivatives

Option contract Swap contract

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
 Forward contract

A forward contract is an agreement to buy something

at a specified price on specified future date.

Spot Price Future Price

Wheat farmer

Today`s date Future date

Duration of the contract

Wheat Trader

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Forwards contract

 Over the counter (OTC) product

 Customized contract terms

 Less liquid

 No margin payment

 Exposed to counter party risk

 Settlement happens at end of contract

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Futures contract

A futures contract is a standardized forward

contract executed at an exchange, a forum that
brings buyers and sellers together.
At an exchange

Wheat farmer

The futures price moves

exactly in tandem with
Market price
Daily settlement

Wheat Trader

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Futures contract

 Trade on an organized exchange

 Standardized contract term

 Daily Settlement, hence more liquid

 Requires margin, counter party risk is minimum

 The interests of buyer and seller are safe guarded to a great extent

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Common Terminologies

Spot price : The price at which an asset trades in the spot market.

Future price : The price at which the futures contract trades in the futures
market.

Contract cycle: The period over which contract trades.

Expiry date: It is the date specified in the futures contract. This is last day on
which the contract will be traded, at the end of which it will cease to exist.

Contract size: The amount of asset that has to be delivered under one
contract.

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Common Terminologies

Basis : In the context of financial futures, basis can be defined as futures price
minus the spot price.

Cost of carry : This is the cost of maintaining or “carrying” a forward position

over time.

Initial margin : That the amount must be deposited in the margin account at
the time a futures contract is first entered into is initial margin.

Mark-to-market : In the futures market, at the end of each trading day, the
margin account is adjusted to reflect the investor`s gain or loss depending
upon the futures closing price. This is called mark to market.

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Distinction between Futures & Forwards

Futures Market Forwards Market

Location Future exchange No fixed location
Size of contract Fixed (standard) Depends on terms of
contract
Maturity/Payment Fixed (standard) Depends on terms of
date contract
Counter party Clearing house Known bank or client
Market place Central exchange floor Over the telephone with
with worldwide network worldwide network/or
anywhere
Valuation Mark-to-market everyday No unique method of
valuation
Variation margins Daily None
Financial & Cost Accounting Batch- XIII (B)
Prof. Hardic Mehta Shravan Bhumkar
Distinction between Futures & Forwards

Futures Market Forwards Market

Credit risk Almost non existent Depends on the
counterparty
Settlement Through clearing house Depends on terms of
contract
Liquidation Mostly by offsetting the Mostly settled by actual
positions; very few by delivery delivery. Some by
cancelation at cost
Transaction Direct costs such as commission, Direct costs are generally
cost clearing charges, exchange fees low, indirect costs are high in
are high; indirect costs, bid risk for of high bid risk spread
spreads are low
Regulations in Regulated by exchanges Self regulated
trading concerned

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Commodities

There are zillion commodities available in the world. But the commodities
that become a good derivative underliers should be fungible (as good as
another) and liquid (there are large number of active buyers and sellers).

Theses commodities are classified into four major categories

1. Commodities
A. Grains
B. Metals
2. Foreign exchange
3. Interest rate
4. Equities

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
How derivatives are used ?

Hedgers use derivatives to manage uncertainty.

(Individuals, Partnership firms, Companies)

Speculators use derivatives to wager on it.

(Individuals, Partnership firms, Companies)

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
How derivatives are used ?

Market-makers are the merchants Arbitrageurs avoid taking risks.

of derivatives. (Individuals, Partnership firms,
(Banks , Finance Houses) Companies)

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
Conclusion

Let the market be

“bullish” or “bearish” if
you know derivatives
you will flourish.

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar
 Thank you.

Financial & Cost Accounting Batch- XIII (B)

Prof. Hardic Mehta Shravan Bhumkar