Introduction to Forwards, Futures and Options

Forward Contracts

Forward contract is an over-the-counter (OTC) contract between two parties 

to exchange 

agreed quantity of an asset* 

for cash 

at a certain date in future 

at a predetermined price, specified in that agreement. 

*Asset may be currency, commodity, instrument, etc.

OTC contracts involve only the buyer and the seller. Both the parties have to perform the contract. There is no payment of any initial margin. The maturity and size of the contract may be customized. Settlement takes place only on the date of maturity. Credit or counter party risk is high. Markets for forward contracts are not very liquid. Physical delivery takes place on the maturity date.

Some major forward contracts traded in India are:

a) Currency Forward

One of the most popular examples of a forward market in India is the Dollar Forward Market. In a dollar-forward contract; importers, exporters and foreign currency borrowers hedge their risk. An importer and foreign currency borrower having dollar payables need to hedge against a strengthening of the dollar. On the other hand, an exporter needs to hedge against the weakening of the dollar. While Currency futures are available on the NSE and the BSE to hedge currency risk, the preferred mode for hedging dollar risk is still the dollar forward market. The reasons are two-fold. First, hedging requirements are very unique to the players and hence forward contract matching is much simpler. Secondly, the major participants in the Dollar Forward markets are generally the commercial banks and other financial institutions. Hence the scope for counter-party risk is almost nil in these cases. This is one of the most robust cases of forward trading in India.

b) Forward Rate Agreement (FRA)

A FRA is a forward contract on the interest rate. It is a financial contract to exchange interest payments based on a fixed interest rate with payments based on floating benchmark interest rate like 6 m LIBOR, 3 m MIBOR or some other floating rate. The exchange of payments is based on a notional principal of the FRA.

Suppose a company has an expected requirement for funds after 3 months. It is concerned that the interest rates will increase from the current levels and hence it may have to pay higher interest rate on the loan.

The company can enter into a FRA, where it pays fixed interest rate to hedge or fix its borrowing cost today for a requirement after 3 months. The fixed rate agreed via the FRA will be compared to the benchmark rate at the settlement date to determine the settlement amount.

If a corporate borrowed for a period of 3 months, 3 months from now, it is referred to as a 3 X 6 FRA. If the corporate buys a FRA, then it pays a particular fixed rate and receives a floating rate, hence, it hedges against any rise in the interest rates. If a corporate sells a FRA, then it receives a particular fixed rate and pays a floating rate; hence, it hedges against any fall in the interest rates

Futures Contracts

A futures contract is very similar to a forward contract in all respects except that it is completely a standardized one and traded in an exchange.

A futures contract is one where there is an agreement between two parties to exchange any assets or currency or commodity for cash at a certain future date, at an agreed price. It takes place only in organized futures market and according to well-established standards.

Future contract is traded through an exchange. Buyer, seller and exchange are involved. The contract need not necessarily culminate in the delivery of the underlying. One has to pay initial margin, and also maintain a variation margin account with the exchange. The maturity and size of contracts are standardized. Settlement is done on a daily basis on all the outstanding contracts. The Futures Exchange takes care of credit or counterparty risk. Futures contracts are highly liquid and can be closed easily. Very few contracts are physically delivered.

Payoff in Forward / Futures Contracts

The payoff from a long position in a forward contract on one unit of an asset = ST – K (K = delivery price, ST = Price of the underlying security at maturity)

The payoff from a short position in a forward contract on one unit of an asset = K – ST (K = delivery price, ST = Price of the underlying security at maturity)

Option Contracts

An option contract gives the buyer an option to buy or sell an underlying asset (stock, bond, currency, commodity, etc.) at a predetermined price on or before a specified date in future. The price so predetermined is called the ‘strike price’ or ‘exercise price’.

Standard options are of two types – European and American. European options can be exercised only on the maturity date but American options can be exercised any day till maturity.

Call Option

A call option is one which gives the option holder the right to buy an underlying asset (commodities, foreign exchange, stock shares, etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a case, the seller (also known as writer) of a call option is under an obligation to sell the asset at a specified price, in case the buyer exercises his option to buy. Thus, the obligation to sell arises only when the option is exercised. The buyer of the option has long call position and the seller has short call position.

Payoff of Call Option

The payoff from a long position in a call option at maturity

= Max (ST – K, 0) (K = Strike price, ST = Price of the underlying security at maturity and C = Call option premium)

The payoff diagram is as follows.

The payoff from a short position in a call option at maturity

= – Max (ST – K, 0) = Min (K - ST, 0) (K = Strike price, ST = Price of the underlying security at maturity, C = Call option premium)

The payoff diagram is as follows.

Put Option

A put option is one which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the seller or writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell. The buyer of the option has long put position and the seller has short put position.

Payoff of Put Option

The payoff from a long position in a put option at maturity

= Max (K – ST, 0) (K = Strike price, ST = Price of the underlying security at maturity, P = Put option premium)

The payoff diagram is as follows.

The payoff from a short position in a put option at maturity

= – Max (K – ST, 0) = Min (ST – K, 0) (K = Strike price, ST = Price of the underlying security at maturity, P = Put option premium )

The payoff diagram is as follows.

Swaps Contracts

A swap is an over-the-counter derivative agreement between two counter parties (banks, corporates etc.) to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation involves the future value of an interest rate, an exchange rate or other market variable.

Swaps can be used to hedge certain risks such as interest rate risk, exchange rate risk, or to speculate on changes in the expected direction of underlying prices.

Difference between Exchange-traded and OTC Derivatives

Exchange traded securities trade in major exchanges like NSE, BSE, the New York Stock Exchange and others. The stocks, bonds and other instruments traded on these exchanges are known as listed securities. Over the counter, or OTC, traded securities encompass all other financial securities. Any time a financial security changes hands between two parties outside of the major exchanges, the trade is called an OTC transaction. The major differences are presented below.

Counterparty Risk

When you buy or sell something OTC in a private transaction, there is always the risk of not getting what you bargained for. The other party might not be able to deliver the stock, bond or any other security within the agreed time frame. It might also deliver a different stock or bond than the promised one. These risks are broadly referred to as counterparty risk. In an exchange, however, counterparty risk is not an issue. Trading occurs through brokers who are closely monitored by the exchange. Investors buy exchange traded securities with greater confidence.

Types of Traders - Hedger, Speculator and Arbitrageur

Hedgers

Hedgers are essentially spot market players. Hedgers are interested in reducing price risk (that they already face in the spot market) with derivative contracts. Forward contracts are designed to neutralize risk by fixing the price that hedger will pay or receive for the underlying asset. Futures contracts can be used to undertake minimum variation hedging. Option strategy enables the hedger to insure itself against adverse price movements while still benefiting from favorable movements.

Speculators

Speculation is the purchase or sale of an asset in the expectation of a gain from changes in the price of that asset. Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Day traders are speculators.

While Hedgers look to protect against a price change, speculators look to make profit from a price change. Also, the hedger gives up some opportunity in exchange for a reduced risk. The speculator on the other hand acquires opportunity in exchange for taking on risk. Arbitrageurs They are in business to take advantage of a discrepancy between prices in two different markets (say NSE and BSE). If, for example, 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.

Speculation involves high risk. Arbitrage involves limited risk. Hedging is done to avoid risk.

For example, traders buying and selling foreign exchange can take the role of hedgers, or speculators or arbitrageurs.

Hedgers are traders who undertake forex trading because they have assets or liability in foreign currency. For example, when an importer requiring foreign currency, sells domestic currency to buy foreign currency, he is termed as a hedger. The importer has a foreign currency liability. Similarly, an exporter who sells foreign currency and buys domestic currency is a hedger. The exporter has assets denominated in foreign currency. An MNC enters into a foreign currency forward contract so that it can repatriate its earning to the parent company. An Indian company swaps its foreign currency interest payment obligations to INR interest obligation. All these are examples of hedging. Hedgers use the foreign currency market to hedge the risk associated with volatility in a foreign exchange market.

Speculators are traders who essentially buy and sell foreign currency to make profit from its expected futures movement. They do not have any genuine requirement for trading foreign currency, and do not hold any cash position in it.

Arbitrageurs buy and sell the same currency at two different markets whenever there is price discrepancy.