Thursday, January 22, 2009




Future/Forward Markets, Options and Derivatives



Futures Market is a place where future contracts are traded. Future contract is an agreement between two parties (buyers and sellers) to buy/sell an asset at a certain future time at a certain price. Consider the following example. A paddy cultivator, whose crop will mature with in four months, is eager to get a remunerative price but has no means to ensure it. Suppose the current paddy price is Rs.8/kg but Rs.10/kg is the remunerative price. Now consider a rice mill owner who finds that if only paddy is available for a maximum of Rs.10/kg he could continue milling in a profitable manner. But he also has no means which will ensure a predictable and reasonable price for paddy.

It is in this context futures market will help both. Both have no mechanism to monitor and ensure a price which is profitable for both. A price rise would help the cultivator while it would hurt the miller and vice versa. Thus both face uncertainty regarding future prices. Moreover, if they take decisions in such an uncertain environment, the associated risk with such decisions would be very high. So both have an incentive to enter in a contract—which is called as “futures contract”—which would ensure reasonable price for both.

Suppose both enters in a futures contract where the cultivator is ready to supply paddy for Rs.10/kg by the time of harvest and the miller is ready to purchase it at the same price at that time. The price mutually agreed upon is called as the futures’ price of paddy.

In this way they can ink contacts for any period, say for instance, after six month, after one year and so on. Note that, it is the absence of information about the future prices and the consequent uncertainty and the lack of mechanism which would ensure a stable and remunerative/reasonable price that compelled both parties to enter in a contract like this. Put other wise, futures market is a mechanism devised by the market to deal with uncertainty in prices and also to allocate and reduce risks.

Hedgers and Speculators



Hedgers are participants of futures market who want to protect or hedge against the adverse movements in price. In our example the cultivator and the miller are the hedgers. They hedge against the adverse movements in price by entering into future contracts.

Speculators are people whose main role is to widen the market for futures. They ensure that people who want to purchase futures find sellers of futures. They believe that they have enough skills to acquire all the relevant information for conducting the trade on futures. They are ready to take the risks also.

How future prices increase current prices?

Those who hold inventories of goods reduce the supply to the market when they see that future prices are moving up in order to take benefit in future from the higher prices. Thus supply in the current period falls and consequently current prices also increase.

Disadvantages of Futures

If prices are higher than what is agreed in the future contract, sellers would feel that they did not get benefit from the favourable movement in price. The buyers would feel same when the actual price is below the agreed price in the contract. In short, futures trading prevent the parties to take benefit from the favourable price movements even though the contract gives them excellent cover from uncertainty.

Delivery

It is surprising to know that majority of futures contracts do not lead to delivery or cash settlement. Most of the parties ‘close out’ their contracts before the contract date by executing opposite contracts to that of the original ones.

Options

I help to take advantage from favourable price movements and also give a protective cover from adverse movements of price. Moreover, options have been traded for a shorter period than that of futures. The option signifies the fact that it involves an option; i.e. the option holder has the—option to execute or not what is involved in it. Put otherwise, options give the holder a right to do some thing. Whether to use that right or not, is the discretion of the holder.

There are two types of options. They are call option and put option. Call option gives the holder the right to buy an asset at a certain time for a certain price. Similarly, put option gives the holder the right to sell an asset at a certain time for a certain price. To buy an option a mutually agreed price must be paid.

Illustration

Suppose the current price of oil is Rs.60/kg. A baker wants to purchase oil in bulk quantity after six months and he finds that if the price moves above Rs.65/kg, it would be unprofitable to him. So he purchases call option for Rs.65/kg at an option price of Rs.3 per option. Now, after six months, the price became Rs.70/kg, he exercises the option and purchases for Rs.65/kg. But his effective price would be 65 + option price 3 = Rs.68/kg. With out option he had to spend Rs.5 more and thus reduced the possible loss by Rs.2.

Similarly, if the price is Rs.61/kg after six months, there is no need to exercise the option and he buys directly from the market. But his actual profit is not Rs.4/kg but 4-3=1 rupees only.

Thus if the price is lower than Rs.62/kg the option holder takes benefit from the favourable movement in price and if the price is above Rs.68/kg, he benefits through the execution of the contract.

Outflow Minimising Price Range

Up to a price of Rs.68/kg he is reducing the outflow of money from him. If price is Rs.67/kg, he exercises the option and thus saves Rs.2/kg. But he already spent Rs.3/kg for buying the option. Thus the net saving or outflow of money is only one rupee.

Also, consider the opposite case where the price is Rs.63/kg. Then he purchases directly from the market with out exercising the option. But the benefit is not Rs.2/kg as he already spent Rs.3/kg as option price. Thus the outflow is reduced and is only one rupee.

In between the range of Rs.62/kg-- Rs.68/kg, the option holder minimises the outflow of money from him through the purchase of options.

Forward Contracts

Similar to that of Futures Contracts. But it is custom made one between parties and is not traded in an exchange. It does not have a standardised form like futures and are private agreements or contract between the parties. Unlike futures contracts, most of the forward contracts do lead to delivery in terms of assets or cash settlement.

Derivatives

Derivatives are financial instruments whose value depends upon the values of the underlying basic variables or assets. Options, futures all are examples of derivatives.

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