Derivative
Forward and Future Contract
Prepared by:
Mr. Mohammed Jasir PV
Asst. Professor
MIIMS, Puthanangadi
Contact No: 9605 69 32 66

Topics
• Derivative
• Types with Example

Derivatives
• Derivatives: derivatives are instruments which include
– Security derived from a debt instrument share, loan, risk instrument or contract
for differences of any other form of security and ,
– a contract that derives its value from the price/index of prices of underlying
securities. Derivatives (Definition)
• A financial instrument whose characteristics and value depend upon the
characteristics and value of an underlier, typi- cally a commodity, bond, equity or
currency,

Derivatives (Definition)
• A financial instrument whose characteristics and value depend upon the
characteristics and value of an underlier, typically a commodity, bond, equity
or currency.
• Examples of derivatives include futures and options.
• Advanced investors sometimes purchase or sell derivatives to manage the risk
associated with the underlying security, to protect against fluctuations in value,
or to profit from periods of inactivity or decline.
• These techniques can be quite complicated and quite risky.

Advantages of Derivative Market
• Diversion of speculative instinct form the cash market to the derivatives
• Increased hedge for investors in cash market
• Reduced risk of holding underlying assets
• Lower transactions costs
• Enhance price discovery process
• Increase liquidity for investors and growth of savings flowing into these
markets
• It increase the volume of transactions

Types of Derivatives
Derivatives
Financial
Derivatives
Stock, Bond,
Forex
Commodity
Derivatives
Sugar, Cotton,
gold, silver

Types of Derivatives
There are two types of derivatives
1. Financial derivatives
– Financial Derivatives the underlying instruments is stock, bond,
foreign exchange.
2. Commodity Derivatives
– Commodity derivatives the underlying instruments are a commodity
which may be sugar, cotton, copper, gold, silver.

Types of Financial Derivatives
Financial Derivatives
Basic
Forward
Future
Options
Warrants & Convertibles.
Complex.
Swap
Exotioc

Forward contract
One party commits to buy Other party commits to sell
Specified quantity Pre-determined price Specific date in the future
50 kg
Rs. 5000
An agreement

Farmer
Farmer

Forward contract
• A forward is a contract in which one party commits to buy and the other party
commits to sell a specified quantity of an agreed upon asset for a pre-
determined price at a specific date in the future
• It is a customised contract, in the sense that the terms of the contract are
agreed upon by the individual parties
• A bilateral contract
• Hence, it is traded OTC
• Generally closing with delivery of base asset
• Not need any initial payment when signing the contract

Contd…
• A forward contract is an agreement to buy or sell an asset on a specified
date for a specified price
• One of the parties to the contract assumes a long position and agrees to
buy the underlying asset on a certain specified future date, for a certain
specified price

Over The Counter(OTC) Trading
• In general, the reason for which a stock is traded over-the-counter is usually
because the company is small, making it unable to meet exchange listing
requirements.
• Also known as "unlisted stock", these securities are traded by broker-dealers
who negotiate directly with one another over computer networks and by
phone.
• OTC stocks are generally unlisted stocks which trade on the Over the Counter
Bulletin Board (OTCBB)

Risks in Forward Contracts
• Credit Risk
– Does the other party have the means to pay?
• Operational Risk
– Will the other party make delivery?
– Will the other party accept delivery?
• Liquidity Risk
– Incase either party wants to opt out of the contract, how to find another
counter party?

Terminology
• Long position – Buyer
• Short position – seller
• Spot price – Price of the asset in the spot market.(market price)
• Delivery/forward price – Price of the asset at the delivery date

Features - Forward contract
• It is a customised contract
• A bilateral contract
• It is traded OTC (Unlisted Stocks)
• Generally closing with delivery of base asset
• Not need any initial payment when signing the contract

The salient features of forward contracts
• They are bilateral contracts and hence, exposed to counterparty risk.
• Each contract is customer 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 and If party wishes to reverse the contract

Limitations of Forward contract
• Lack of centralization of trading
• Liquidity and Counterparty risk
• Have too much flexibility and generality
• Counterparty risk (default by any one party)
• Bankruptcy

Limitations of Forward contract
• Forward markets are afflicted by several problems:
– Lack of centralization of trading
– Liquidity and Counterparty risk
• The basic problem in the first two is that they have too much flexibility
and generality
• Counterparty risk arises from the possibility of default by any one party
to the transaction.
• When one of the two sides to the transaction declares bankruptcy, the
other suffers

Future Contract
• A future is a standardised forward contract
• It is traded on an organised exchange
• Future contract is an agreement between two parties to buy or sell an asset at a
certain time in the future, at a certain price
• But unlike forward contract, futures contract are standardized and stock ex-
changed traded
• Futures contracts are special types of forward contracts in the sense that the
former are standardised exchange-traded contracts
• The counter party to a futures is a clearing house on the appropriate futures
exchange
• Settled by cash or cash equivalents rather than physical assets

The standardized items in a futures contract are:
• Quantity of the underlying
• Quality of the underlying
• The date/month of delivery
• The units of price quotation and minimum price change
• Location of settlement

Closing a Futures Position
• Most futures contracts are not held till expiry, but closed before that
• If held till expiry, they are generally settled by delivery. (2-3%)
• By closing a futures contract before expiry, the net difference is settled
between traders, without physical delivery of the underlying.

Terminology
• Contract size (Lots)
• Contract cycle (1m,2m,3m)
• Expiry date
• Strike price
• Cost of carry

Terminology
• Contract size – The amount of the asset that has to be delivered under one
contract. All futures are sold in multiples of lots which is decided by the
exchange board.
– Eg. If the lot size of Tata steel is 500 shares, then one futures contract is necessarily 500
shares.
• Contract cycle – The period for which a contract trades.
– The futures on the NSE have one (near) month, two (next) months, three (far) months expiry
cycles.

Terminology
• Expiry date – usually last Thursday of every month or
previous day if Thursday is public holiday.
• Strike price – The agreed price of the deal is called the
strike price.
• Cost of carry – Difference between strike price and current
price.

Margins
• A margin is an amount of a money that must be deposited with the
clearing house by both buyers and sellers in a margin account in order to
open a futures contract
• Typically only 2 to 10 percent
• It ensures performance of the terms of the contract
• Its aim is to minimise the risk of default by either counterparty

Margins
• Initial Margin - Deposit that a trader must make before trading any futures. Usually,
10% of the contract size
• Maintenance Margin - When margin reaches a minimum maintenance level, the
trader is required to bring the margin back to its initial level. The maintenance
margin is generally about 75% of the initial margin
• Variation Margin - Additional margin required to bring an account up to the
required level
• Margin call – If amt in the margin A/C falls below the maintenance level, a margin
call is made to fill the gap

Marking to Market
• This is the practice of periodically adjusting the margin account by adding
or subtracting funds based on changes in market value to reflect the
investor’s gain or loss
• This leads to changes in margin amounts daily
• This ensures that there are o defaults by the parties

Difference between Forward and Futures
Forward Future
Trade in OTC Only Ex-changes or through CH
Standardised Contract, hence more liquid Customized contract, hence liquid
NO Margin payment required Required margin payment
Settlement by the end of the period Follows daily settlement
Markets are not transparent Markets are transparent
No Marked to market daily Marked to market daily
No prior delivery Closed prior to delivery
No Profits or losses realised daily Profits or losses realised daily

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