FORWARD AND FUTURE CONTRACTS-AN APPRAISAL

FORWARD CONTRACTS:

Forward contracts do not have to conform to the standards of a particular exchange. The delivery date in the contract can be any date mutually convenient to the two parties. Usually, in forward contracts, a single delivery date is specified, whereas in futures contracts, there is a range of possible delivery dates. Forward contracts are not marked to market daily like futures contracts. The two parties contract to settle up on the specified delivery date. Whereas most futures contracts are closed out prior to delivery, most forward contracts do lead to delivery of the physical asset or to final settlement in cash.

FUTURE CONTRACTS:

A future contract is an agreement to buy a particular product at a particular price on a particular future date. Apparently, it looks similar to a forward contract. However in futures contract the defects of the forward contracts are removed. A futures contract is an instrument which has particular product as an underlying asset. The buyer of the futures agrees to buy the underlying asset on the specified date. Similarly, the seller of the futures agrees to sell the underlying asset on the specified date.

Future contract is a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized / standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying assets or cash. Cash settlement entails paying / receiving the difference between the prices at which the contract was entered and the price of the underlying asset at the time of expiry of the contract. Further, in futures transactions there is no one to one transaction. All the transactions are routed through exchange and the exchange acts as a counter party to all the contracts i.e. if one of the parties fails to perform the other party would not suffer.

Forward Vs. Futures

Forwards

Futures

Private contract between two parties

Traded on an exchange

Not standardized

Standardized contract

Usually one specified delivery date

Range of delivery dates

Settled at end of contract

Settled daily

Delivery or final cash settlement usually takes place

Contract usually closed out prior to maturity

Types of Futures:

Index Futures:

Index Futures are futures whose value is based on the value of Index i.e. SENSEX in the case of BSE and NIFTY in the case of NSE. Index Futures were introduced for the first time in July 2000. The underlying asset in the case of Index Futures is Index itself. Index Futures work in the same manner as the commodity futures discussed above. However, since the underlying asset i.e. Index can not be delivered the settlement is always in the form of payment of differences in cash.

Specific Scrip Futures:

Futures on specific scrips (i.e., futures on shares of a particular company) were introduced in the market w.e.f., July 2001. The underlying asset in this case is the shares of a particular company. To begin with the settlement of specific scrip futures was cash settlement i.e. by way of payment of difference. However, gradually it would become compulsory to settle contracts by way of actual delivery of underlying shares. Thus futures contracts in the Indian Capital markets can be broadly divided in three categories as follows:

Index Futures

Specific Scrip Futures _ settlement in cash

Specific Scrip Futures - settlement by actual delivery, of underlying shares

Players in futures market

Issuer:

It is interesting to note that the futures are issued by no one. Although it may be futures on shares of a company, the company does not issue such futures. The company only issues shares which are traded in the market. Futures are written by the participants in the market.

Participants:

Participants in futures consist of all types of investors i.e. individuals, financial institutions, mutual funds, foreign institutional investors, banks etc. Since, the amount required to be invested is comparatively low (i.e., only margins) it is possible even for the small investors to participate in the market.

A general view prevailing amongst the investors is that the futures transactions are speculative transactions and various reports appearing in the media also give an impression that futures transactions are speculative. The then requirement for classifying a transaction as speculative transaction is that the transaction for purchase or sale of delivery is settled otherwise than by actual delivery or transfer of the commodity or the scrip.

OPTIONS

Option contract is a type of derivatives contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer/holder of the option, purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc.

Option is a right but not an obligation to do something. The Options can be divided in two parts i.e. Call Option and Put Option. A Call Option is a right but not an obligation to buy the underlying asset at a predetermined price. A Put Option is a right but not an obligation to sell the underlying asset at a predetermined price. The person who buys the Option is called the buyer of the Option. The person who sells the Option i.e. the person who has agreed to perform or who takes up the obligation is called the seller of the Option.

Players in OPTIONS

Issuer: It is interesting to note that the options are issued by no one. Although it may be options on shares of a company, the company does not issue such options. The company only issues shares which are traded in the market. Options are written by the participants in the market.

Participants: Participants in options consists of all types of investors such as individuals, financial institutions, mutual funds, FIIs, banks, etc. Since the amount required to be invested is comparatively low, it is possible even for the small investors to participate in the market.

Utility of options market: It is widely used to hedge instruments and improves quality of market. Worldwide options form integral part of the capital markets and add depth to the market. Further, badlas are withdrawn from the Indian capital market and options are introduced as a sophisticated product.

SWAPS

Swaps are private agreements between two companies to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts. The study of swaps is, therefore, a natural extension of the study of forward and futures contracts. In US the first swap contracts were negotiated in 1981. Since then, the market has grown very rapidly. Hundreds of billions of dollars of contracts are currently negotiated each year.