Futures and options represent two of the most common form of “Derivatives”. Derivatives are financial instruments that derive their value from an ‘underlying’. The underlying can be a stock issued by a company, a currency, Gold etc. , The derivative instrument can be traded independently of the underlying asset. The value of the derivative instrument changes according to the changes in the value of the underlying. Derivatives are of two types – exchange traded and Over the Counter. Exchange traded derivatives, as the name signifies are traded through organized exchanges around the world.
These instruments can be bought and sold through these exchanges, just like the stock market. Some of the common exchange traded derivative instruments are futures and options. Over the counter (popularly known as OTC) derivatives are not traded through the exchanges. They are not standardized and have varied features. Some of the popular OTC instruments are forwards, swaps, swaptions etc. , Futures A ‘Future’ is a contract to buy or sell the underlying asset for a specific price at a pre-determined time.
If you buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at a particular time. Every futures contract has the following features
Some of the most popular assets on which futures contracts are available are equity stocks, Indices, Commodities and Currency The difference between the price of the underlying asset in the spot market and the futures market is called ‘Basis’. As ‘spot market’ is a market for immediate delivery)
The basis is usually negative, which means that the price of the asset in the futures market is more than the price in the spot market. This is because of the interest cost, storage cost, insurance premium etc. , That is. , if you buy the asset in the spot market, you will be incurring all these expenses which are not needed if you buy a futures contract. This condition of basis being negative is called as “Contango”. Sometimes it is more profitable to hold the asset in physical form than in the form of futures.
For eg: if you hold equity shares in your account you will receive dividends, whereas if you hold equity futures you will not be eligible for any dividend. When these benefits overshadow the expenses associated with the holding of the asset, the basis becomes positive (i. e. , the price of the asset in the spot market is more than in the futures market). This condition is called ‘Backwardation’. Backwardation generally happens if the price of the asset is expected to fall.
It is common that, as the futures contract approaches maturity, the futures price and the spot price tend to close in the gap between them ie. the basis slowly becomes zero Options Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a ‘call’ option or a ‘put’ option. A call option gives the buyer, the right to buy the asset at a given price. This ‘given price’ is called ‘strike price’. It should be noted that while the holder of the call option has a right to demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it.
He does not have a right. Similarly a ‘put’ option gives the buyer a right to sell the asset at the ‘strike price’ to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy. So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as ‘premium’. Therefore the price that is paid for buying an option contract is called as premium
The buyer of a call option will not exercise his option(to buy) if, on expiry, the price of the asset in the spot market is less than the strike price of the call. For eg: A bought a call at a strike price of Rs. 500. On expiry the price of the asset is Rs. 450. A will not exercise his call. Because he can buy the same asset from the market at Rs. 450, rather than paying Rs. 500 to the seller of the option. The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset in the spot market is more than the strike price of the call.
DERIVATIVE CONTRACTS (“VAYADA KABALA”) AND THEIR BENEFITS
What is a Derivative contract? A derivative contract is an enforceable agreement whose value is derived from the value of an underlying asset; the underlying asset can be a commodity, precious metal, currency, bond, stock, or, indices of commodities, stocks etc. Four most common examples of derivative instruments are forwards, futures, options and swaps/spreads
- What is a forward contract? A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract. Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contracts.
- What are customized contracts? Forward contracts (other than a futures) are customized. In other words, the terms of forward contracts are individually agreed between two counter-parties.
- Is delivery mandatory in futures contract trading? The provision for delivery is made in the Byelaws of the Associations so as to ensure that the futures prices in commodities are in conformity with the underlying. Delivery is generally at the option of the sellers. However, provisions vary from Exchange to Exchange. Byelaws of some Associations give both the buyer and seller the right to demand/give delivery.
- What is the t. s. d. contracts ? Transferable Specific Delivery contracts is an enforceable customised agreement where unlike known transferable specific delivery contracts, the right or liabilities under the delivery order, railway receipt, bill of lading, warehouse receipts or any other documents of title to the goods are transferable.
The contract is performed by delivery of goods by first seller to the last buyer. The parties, other than the first seller and the last buyer, perform the contract merely by exchanging money differences.
- What is a futures contract? Futures Contract is specie of forward contract. Futures are exchange – traded contracts to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price. Futures contracts are used generally for protecting against rich of adverse price fluctuation (hedging). As the terms of the contracts are standardized, these are generally not used for merchandizing propose.
- What are the commodities suitable for futures trading ? All the commodities are not suitable for futures trading and for conducting futures trading. For being suitable for futures trading the market for commodity should be competitive, i. e. , there should be large demand for and supply of the commodity – no individual or group of persons acting in concert should be in a position to influence the demand or supply, and consequently the price substantially. There should be fluctuations in price.
- The market for the commodity should be free from substantial government control. The commodity should have long shelf-life and be capable of standardisation and gradation.
- How many commodities are permitted for futures trading ? With the issue of the Notifications dated 1. 4. 2003 futures trading is not prohibited in any commodity. Futures trading can be conducted in any commodity subject to the approval /recognition of the Government of India. 91 commodities are in the regulated list i. e. these commodities have been notified under section 15 of the Forward Contracts (Regulation) Act. Forward trading in these commodities can be conducted only between, with, or through members of recognized associations.
- The commodities other than those listed under Section 15 are conventionally referred to as ‘Free’ commodities. Forward trading in these commodities can be organized by any association after obtaining a certificate of Registration from Forward Markets Commission.
- How are futures prices determined? Futures prices evolve from the interaction of bids and offers emanating from all over the country – which converge in the trading floor or the trading engine. The bid and offer prices are based on the expectations of prices on the maturity date.
- How professionals predict prices in futures? Two methods generally used for predicting futures prices are fundamental analysis and technical analysis. The fundamental analysis is concerned with basic supply and demand information, such as, weather patterns, carryover supplies, relevant policies of the Government and agricultural reports. Technical analysis includes analysis of movement of prices in the past. Many participants use fundamental analysis to determine the direction of the market, and technical analysis to time their entry and exist.
- How is it possible to sell, when one doesn’t own commodity? One doesn’t need to have the physical commodity or own a contract for the commodity to enter into a sale contract in futures market. It is simply agreeing to sell the physical commodity at a later date or selling short. It is possible to repurchase the contract before the maturity, thereby dispensing with delivery of goods.
- What are long position? In simple terms, long position is a net bought position.
- What are short position? Short position is net sold position.
- What is bull spread (futures)? In most commodities and financial derivatives market, the term refers to buying contracts maturing in nereby month, and selling the deferred month contracts, to profit from the wide spread which is larger than the cost of carry.
- What is bear spread (futures)? In most of commodities and financial derivatives market, the term refers to selling the nearby contract month, and buying the distant contract, to profit from saving in the cost of carry.
- What is ‘Contango’? Contango means a situation, where futures contract prices are higher than the spot price and the futures contracts maturing earlier.
- When is futures contract in ‘Contango’? It arises normally when the contract matures during the same crop-season. In an well-integrated market, Contango is equal to the cost of carry viz. Interest rate on investment, loss on account of loss of weight or deterioration in quantity etc.
- What is ‘Backwardation’? When the prices of spot, or contracts maturing earlier are higher than a particular futures contract, it is said to be trading at Backwardation.
- When is futures contract at ‘Backwardation’? It is usual for a contract maturing in the peak season to be in backwardation during the lean period.
- What is ‘basis’? It is normally calculated as cash price minus the futures price. A positive number indicates a futures discount (Backwardation) and a negative number, a futures premium (Contango). Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate the basis.
- What is cash settlement? It is a process for performing a futures contract by payment of money difference rather than by delivering the physical commodity or instrument representing such physical commodity (like, warehouse receipt)
- What is offset? It refers to the liquidation of a futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract.
- What is settlement price? The settlement price is the price at which all the outstanding trades are settled, i. e, profits or losses, if any, are paid. The method of fixing Settlement price is prescribed in the Byelaws of the exchanges; normally it is a weighted average of prices of transactions both in spot and futures market during specified period.
- What is convergence? This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.
- Can one give delivery against futures contract? Futures contract are contracts for delivery of goods. But most of the futures contracts, the world over, are performed otherwise than by physical delivery of goods.
- Why the proportion of futures contracts resulting in delivery is so low? The reason is, futures contracts may not be suitable for merchandising purpose, mainly because these are standardized contracts; hence various aspects of the contracts, viz. quality/grade of the goods, packing, place of delivery, etc. may not meet the specific needs of the buyers/sellers.
- Why delivery of good is permitted when futures contract by their very nature not suitable for merchandising purposes? The threat of delivery helps in dissuading the participants from artificially rigging up or depressing the futures prices. For example, if manipulators rig up the prices of a contract, seller may give his intention to make a delivery instead of settling his outstanding contract by entering into purchase contracts at such artificially high price.
PARTICIPANTS IN DERIVATIVES MARKETS
- Who can be a member of the Exchange ? The Bye-laws and Articles of the Association prescribed the criteria for being a member of the Exchange. Any person desirous of being a member of the Exchange may approach the contact persons whose names, telephone numbers, fax numbers, email addresses etc. are available on the website of fmc: ; www. fmc. gov. in ;. They may also refer to the Bye-law and Articles of Association of the concerned Exchange which contain various criteria for the membership of the Exchange.
- Who are the participants in forward/futures markets? Participants in forward/futures markets are hedgers, speculators, day-traders/scalpers, market makers, and, arbitrageurs .
- Who is hedger? Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in respect of his existing or future asset.
- What is arbitrage? Arbitrage refers to the simultaneous purchase and sale in two markets so that the selling price is higher than the buying price by more than the transaction cost, so that the arbitrageur makes risk-less profit.
- Who are day-traders? Day traders are speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day.
- Who is floor-trader? A floor trader is an Exchange member or employee, who executes trade by being personally present in the trading ring or pit floor trader has no place in electronic trading systems.
- Who is speculator? A trader, who trades or takes position without having exposure in the physical market, with the sole intention of earning profit is a speculator.
- Who is market maker? A market maker is a trader, who simultaneously quotes both bid and offer price for a same commodity throughout the trading session.
- What is credit risk? Credit risk on account of default by counter party: This is very low or almost zeros because the Exchange takes on the responsibility for the performance of contracts.
- What is market risk? Market risk is the risk of loss on account of adverse movement of price.
- What is liquidity risk? Liquidity risks is the risk that unwinding of transactions may be difficult, if the market is illiquid
- What is Legal risk? Legal risk is that legal objections might be raised, regulatory framework might disallow some activities.
- What is operational risk? Operational risk is the risk arising out of some operational difficulties, like, failure of electricity, due to which it becomes difficult to operate in the market.
EXCHANGES AND THEIR ROLE
- How many recognized/registered associations engaged in commodity futures trading? At present 21 Exchanges are recognized/registered for forward/ futures trading in commodities.
- Why are associations required to get recognized? Under the Forward Contracts (Regulation) Act, 1952, forward trading in commodities notified under section 15 of the Act can be conducted only on the Exchanges, which are granted recognition by the Central Government (Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution).
- Which associations are recognized? The list of the Exchanges and the commodities in which they are recognized is given at Annex-I.
- Are the associations organizing forward trading required to get themselves registered? All the Exchanges, which deal with forward contracts, are required to obtain certificate of Registration from the Forward Markets Commission.