CHAPTER CONTENTS PG.NO.

1 EXECUTIVE SUMMARY 3
OBJECTIVE OF THE STUDY

2 REVIEW OF LITERATURE 4

3 INTRODUCTION (DERIVATIVE) 5
Definition 6
Types

4 FORWARD MARKET 8
Why Forward Contract 9
Terminology 9
Features 10
Risk In Forward 10
Otc Trading 10
Advantages 11
Disadvantages 11
Limitation 11

5 FUTURE MARKET 12
Meaning 12
Terminology 13
Mechanism Of Trading In Futures 13
Parties In The Future Contract 14-15
Margin Requirement 16
Advantages 16
Disadvantages 17-18
Characteristics 19
Major Player 19+
Types 20

6 DIFFERENCE BETWEEN FORWARD AND FUTURES 21

7 DATA ANALYSIS AND INTERPRETATION 22-26

8 SUMMARY 27

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9 References 28
EXECUTIVE SUMMARY

In recent time derivative gain a attraction of many investors like future, forward Derivatives
are risk management instruments, which derive their value from an underlying asset. The
following are three broad categories of participants in the derivatives market Hedgers,
Speculators and Arbitragers.

In recent times, the Derivative markets have gained importance in terms of their important
role in the economy. The increasing investments in stocks have attracted my interest in this
area. Numerous studies on the effects of futures, forward listing on the underlying cash
market volatility have been done in the developed markets. The derivative market is newly
started in India and it is not known by every investor, so SEBI has to take steps to create
awareness among the investors about the derivative segment.

In cash market, the profit/loss of the investor depends on the market price of the underlying
asset. The investor may incur huge profit or he may incur huge loss. But in derivatives
segment the investor enjoys huge profits with limited downside. Derivatives are mostly used
for hedging purpose

OBJECTIVE OF THE STUDY

 To analyze the operation of the derivative

 To study the function of future and forward
 To study the hedging with the help of derivative
 To find profit/loss position of future buyer and seller

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REVIEW OF LITERATURE
Review of literature is body of knowledge that aim to review the important aspects of current
and previous knowledge

 Derivatives, as explained are financial contracts, which “value depends on the values
of one or more underlying assets or indexes” (Adams and Runkle, 2000)
 McClintock, 1996 notes that derivatives are widely perceived as financial instruments
that have led to financial losses or failures of firms. Moreover, he states that it is
believed that their (derivatives) market has brought increased international financial
fragility to the global economy.
 Factors according to Brenner (2002) was profoundly felt. This increased need for

controls such as regulation, risk management and audits, has been noted in literature

as being the main reason for the increased global use of derivatives (Brenner, 2002)

(Bezzina et. al., 2013).

 A forward contract “is an agreement between two parties, in buying or selling an

underlying asset at a specified price and future date (Goldman, 1995), in which the
buyer is obligated to purchase the underlying asset from the seller at the contract's
maturity date and the seller must sell the asset to the buyer at the agreed-upon price
regardless of current fair market value” (Romano, 1996).
 These contracts are typically traded OTC, they are tailored to the needs of the client
and are generally held till expiry Jorion (1995).

 Backstrand (1997) on the other hand, illustrated a more formal definition of a

derivative depicting it as a “financial instrument, or contract, between two parties that

derives its value from some other underlying asset or underlying reference price,

interest rate, or index.”

 Futures contracts differ in that they are standardised and must be traded on an
organised exchange, providing a central location where buyers and sellers of
standardised contracts trade (General Accounting Office Report, 1994). Thus, it is
easier for a trader to close out a futures position than a forward position (Eatwell,
Milgate, and Newman, 1998).

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INTRODUCTION
 Derivatives are one of the most complex instruments. The word derivative
Comes from the word „to derive‟.
 It indicates that it has no independent value. A derivative is a contract whose value
is derived from the value of another asset, known as the underlying asset,
which could be a share, a stock market index, an interest rate, a commodity,
or a currency.
 The underlying is the identification tag for a derivative contract. When the price of the
underlying changes, the value of the derivative also changes. Without an
underlying asset, derivatives do not have any meaning.
 For example, the value of a gold futures contract derives from the value of the
underlying asset i.e., gold.

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DEFINITION OF DERIVATIVES

Derivative is a product whose value is derived from the value of one or more
basic variables, called bases (underlying asset, index, or reference rate), in a
contractual manner. The underlying asset can be equity, forex, commodity or any other asset.

According to Securities Contracts (Regulation) Act, 1956 {SC(R)A}

 Derivatives is a security derived from a debt instrument, share, loan, whether
secured or unsecured, risk instrument or contract for differences or any other form of
security.
 A contract which derives its value from the prices, or index of prices, of
underlying securities.

Derivatives are securities under the Securities Contract (Regulation) Act and
hence the trading of derivatives is governed by the regulatory framework under the Securities
Contract (Regulation) Act.

TYPES OF DERIVATIVES

There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps.

DERIVATIVES

FORWARDS FUTURES OPTIONS SWAPS

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PRODUCTS IN DERIVATIVE MARKET

 Forwards
It is a contractual agreement between two parties to buy/sell an underlying asset at a
certain future date for a particular price that is pre decided on the date of contract.
Both the
contracting parties are committed and are obliged to honour the transaction irrespectiv
e of price of theunderlying asset at the time of delivery. Since forwards are negotiated
between two parties, the terms and conditions of contracts are customized. These are
over the counter (OTC) contracts.
 Futures
A futures contract is similar to a forward, except that the deal is made through an
organized and regulated exchange rather than being negotiated directly between two
parties. Indeed, we may say futures are exchange traded forward contracts.
 Options
An Option is a contract that gives the right, but not an obligation, to buy or sell the
underlying on or before a stated date and at a stated price. While buyer of option pays
the premium
and buys the right, writer/seller of option receives the premium with obligation to sell/
buy theunderlying asset, if the buyer exercises his right.
 Swaps
A swap is an agreement made between two parties to exchange cash flows in the
future according to a prearranged formula. Swaps are, broadly speaking, series of
forward contracts. Swaps help market participants manage risk associated with
volatile interest rates, currency exchange rates and commodity prices.

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FORWARD CONTRACT
A forward contract is a customized contract between two parties to buy or sell an asset at a
specified price on a future date. A forward contract can be used for hedging or speculation,

KEY POINTS

 A forward contract is a customizable derivative contract between two parties to buy or

sell an asset at a specified price on a future date.
 Forward contracts can be tailored to a specific commodity, amount, and delivery date.
 Forward contracts do not trade on a centralized exchange and are considered over-the-
counter (OTC) instruments.
 For example, forward contracts can help producers and users of agricultural products
hedge against a change in the price of an underlying asset or commodity.
 Financial institutions that initiate forward contracts are exposed to a greater degree of
settlement and default risk compared to contracts that are marked-to-market regularly.
 Forward contract are not standardized contract they are OTC (not recognized in stock
exchange ) derivatives that are tailored to meet specific user needs

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WHY FORWARD CONTRACT

 They are customized contract unlike future

 Tailor made and more suitable for certain purpose
 Useful in cases where future standard may be different from actual

TERMINLOGY

 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

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FEATURES OF FORWARD CONTRACT

 They are bilateral negotiated contract between two parties and hence exposed to
counter party risk.
 Each contract is custom designed and hence is unique in terms of contract size,
expiration date, and the asset type, quality etc.
 A contract has to be settled in delivery or cash on expiry date.
 The contract price is generally not available in the public domain.
 If the party wishes to reverse the contract, it has to compulsory go to the same
counter-party, which often results in high prices being charged.

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?

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)

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 ADVANTAGES

• No upfront fees
• No risk due to currency fluctuations completely eliminated
• Forward are over the counter OTC products
• Forward offers a complete hedge
• The use of forward provide complete price protection
• They are easy to understand
• Buy now, pay later
• Lock in the current exchange rate for a future purchase/receipt
• Hedge your exposure and reduce your risk
• Inexpensive to maintain

DISADVANTAGES

• It requires tying up capital. there are no intermediate cash flow before settlement
• It is subject to default risk
• Contract may be difficult to cancel
• There may be difficult find counter party

LIMITATIONS OF FORWARD CONTRACT

• Lack of centralization of trading

• Liquidity and Counterparty risk

• Have too much flexibility and generality

• 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

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FUTURES CONTRACT

Unlike forwards contracts, Futures are standardized contracts traded on exchanges through a
clearing house and avoids counter party risk through margin money and much more.

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

Today‟s futures market is a global marketplace for not only agricultural goods but also for
currencies and financial instruments such as treasury bonds and securities. It is a diverse
meeting place of formers, exporters, importers, manufacturers and speculators

WHAT IS A FUTURES CONTRACT?

A futures contract is a standardized agreement between the seller (short position)of the
contract and the buyer ( long position ), traded on a futures exchange, to buy or sell a certain
underlying instruments at a certain date in future, at a prespecified price.

The future date is called the delivery date or final settlement date. The pre-set price is called
the futures price.

The price of the underlying asset on the delivery date is called the settlement price. (Thus,
futures is a standard contract in which the seller is obligated to deliver a specified asset
(security, commodity or foreign exchange) to the buyer on a specified date in future and the
buyer is obligated to pay the seller the then prevailing futures price upon delivery. Pricing can
be based on an „open outcry system‟, or bids and offers can be matched electronically

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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.
• 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
 Spot price-The spot price is the current price in the marketplace at which a given
asset

MECHANISM OF TRADING IN FUTURES MARKET

• Clearing House

Also known as clearing corporation, plays an important role in the trading of futures
contracts. It acts as an intermediary for the parties who trade in futures contracts. It becomes
the seller of the contract for the long position and buyer of the contract for the short position.

• Open Interest

Open interest on the contract is the number of contract outstanding (No. of either long or
short positions). When contracts begin trading, open interest is zero. As time passes, open
interest increases as progressively more contracts are entered. Instead of actually taking or
making delivery of the commodity, virtually all market participants enter reversing trades to
cancel their original positions, then open interest will be considered

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PARTIES IN THE FUTURES CONTRACT
There are two parties in a futures contract, the buyers and the seller. The buyer of the futures
contract is one who is LONG on the futures contract and the seller of the futures contract is
who is SHORT on the futures contract. The pay-off for the buyers and the seller of the futures
of the contracts are as follows:

PAY-OFF FOR A BUYER OF FUTURES

F = FUTURES PRICE

E 1, E2 = SATTLEMENT PRICE

CASE 1: -

The buyers bought the futures contract at (F);

If the futures Price Goes to E1 then the buyer gets the profit of (FP)

CASE 2: -

The buyers get loss when the futures price less then (F);

If The Futures price goes to E2 then the buyer the loss of (FL).

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.

PAY OFF SELLER FUTURES

F=FUTURES PRICEE

E1, E2 = SATTLEMENT PRICE

CASE 1: -

The seller sold the future contract at (F);

if the future goes toE1 Then the seller gets the profit of (FP).

CASE 2: -

The seller gets loss when the future price goes greater than (F);

If the future price goes to E2 then the seller gets the loss of (FL)

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MARGIN REQUIREMENT

A margin is an amount of 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

• It ensures performance of the terms of the contract

• Its aim is to minimize the risk of default by either counterparty

The futures exchange requires some good faith money from both, to act as a guarantee
that each will abide by the terms of the contract, this is margin.

• Initial Margin
Initial margin is required at the start of a new transaction. For example in NSE they
maintain % as initial margin for the initial transactions. An exchange can change the
required margin anytime. If price volatility increases or if the price of the underlying
commodity rises substantially, the initial margin will be increased usually 10% of
contract size

• Maintenance Margin
The maintenance margin represents the minimum margin which needs to be
maintained by individual margin accounts. It is akin to the minimum balance
prescribed by banks in the case of saving deposit accounts. The maintenance margin
is 75% of initial margin

• Variable Margin
Variable margin is calculated on a daily basis for the purpose of marking-to-market
all outstanding positions at the end of each day. This is to be deposited most often in
cash only. The day‟s closing price is generally used as the basis for the purpose of
marking-to-market.

• Margin call
If amt in the margin A/C falls below the maintenance level, a margin call is made to
fill the gap

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 • Marking-to-market (M2M)
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
The process of marking profits or losses that accrue to traders on daily basis is called
M2M. Futures prices may rise or fall everyday. Instead of waiting until the maturity
date for traders to realize all gains and losses, the clearing house requires all positions
to recognize profits as they accrue daily

ADVANTAGES OF FUTURE CONTRACTS

• Opens the Markets to Investors

Futures contracts are useful for risk-tolerant investors. Investors get to participate in markets
they would otherwise not have access to.

• Stable Margin Requirements

Margin requirements for most of the commodities and currencies are well-established in the
futures market. Thus, a trader knows how much margin he should put up in a contract.

• No Time Decay Involved

In options, the value of assets declines over time and severely reduces the profitability for the
trader. This is known as time decay. A futures trader does not have to worry about time
decay.

• High Liquidity
Most of the futures markets offer high liquidity, especially in case of currencies, indexes, and
commonly traded commodities. This allows traders to enter and exit the market when they
wish to.

• Simple Pricing
futures pricing is quite easy to understand. It's usually based on the cost-of-carry model,
under which the futures price is determined by adding the cost of carrying to the spot price of
the asset.

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• Protection against Price Fluctuations
Forward contracts are used as a hedging tool in industries with high level of price
fluctuations. For example, farmers use these contracts to protect themselves against the risk
of drop in crop prices.

• Hedging Against Future Risks

Many people enter into forward contracts for better risk management. Companies often use
these contracts to limit risk that may arise from foreign currency exchange.

 DISADVANTAGES OF FUTURES CONTRACTS

• No Control over Future Events

One common drawback of investing in futures trading is that you don't have any
control over future events. Natural disasters, unexpected weather conditions, political
issues, etc. can completely disrupt the estimated demand-supply equilibrium.

• Leverage Issues
High leverage can result in rapid fluctuations of futures prices. The prices can go up
and down daily or even within minutes.

• Expiration Dates
Future contracts involve a certain expiration date. The contracted prices for the given assets
can become less attractive as the expiration date comes nearer. Due to this, sometimes, a
futures contract may even expire as a worthless investment.

Example of a forward or futures contract

• ABC Ltd., a sugar producer, goes long in a contract with a price specified as
rs.5,00,000 per metric tone for 20 metric tones to be delivered in September.
• The long position means COP has a contract to buy the sugarcane. The
payment of Rs.5,00,000 tone
• 20 tones will be made in September when the sugarcane is delivered

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  CHARACTERISTICS OF FUTURES CONTRACTS
• Futures are highly standardized contracts that provide for performance of contracts
through either deferred delivery of asset or final cash settlement.
• These contracts trade on organized futures exchanges with a clearing association that
acts as a middleman between the contracting parties.
• Contract seller is called „short‟ and buyer „long‟. Both parties pay margin to the
clearing association. This is used as performance bond by contracting parties
• Margins paid are generally marked to market price everyday
• Each Futures contract has an associated month that represents the month of contract
delivery or final settlement. These contracts are identified with their delivery months
like July-T-Bill, December derivative etc.
• Every futures contract represents a specific quantity. It is not negotiated by the parties
to the contract

MAJOR PLAYERS
o HEDGER

A hedger is someone who faces risk associated with price movement of an asset
and who uses derivatives as means of reducing risk

They provide economic balance to the market.

o SPECULATOR

A trader who enters the futures market for pursuit of profits, accepting risk in the
endeavor.

They provide liquidity and depth to the market.

o ARBITRAGEUR

A person who simultaneously enters into transactions in two or more markets to

take advantage of the discrepancies between prices in these markets.

When price of security is low in one market, they purchases securities & sells the
same in anoccasion of high security price.

They help in bringing about price uniformity and discovery.

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DIFFERENT TYPES OF FUTURES CONTRACTS
 Stock futures.

 Currency futures.

 Index futures.

 Commodity futures.

 Interest rate futures.

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DIFFERENCE BETWEEN FORWARD AND FUTURE
Basic of difference Forward contract
Definition A forward contract is a
agreement between two
parties to buy/sell asset at
pre agreed future point at
specific price
Structure Customized /usually no
initial payment /used to
reduce risk
Transaction method Negotiated directly by the
buyer and seller
Market speculation Not regulated
Institutional guarantee The contracting parties
Risk High risk
Guarantees No guarantee of settlement
until the date of maturity
only the forward price
based on the spot of the
underlying asset is paid
Expiry date Depending on the
transaction
Contract size Depending on the
transaction and the
requirements of the
contracting parties
Market Primary and secondary
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Future contract
A Future contract is a
standardized contract on
future exchange to buy or
sell a certain underlying
instrument at a certain date
in the future at a specified
price
Standardized / initial margin
payment
Quoted and traded on the
exchange
Govt. regulated market
Clearing house
Low risk
Both parties must deposit an
initial guarantee margin
value. The value of the
operation is marked to
market rates with daily
settlement of profit & loss
Standardized
Standardized
Primary
DATA ANALYSIS & INTERPRETATION OF FUTURES
ANALYSIS OF WIPRO:

The objective of this analysis is to evaluate the profit/loss position of futures. This analysis
is based on sample data taken of WIPRO scrip. This analysis considered the May 2017
contract of WIPRO. The lot size of WIPRO is 2400, the time period in which this analysis
done is from 01-05-2017 to 25-05-2017

Table-1:

DATE UNDERLYING FUTURE PRICE NO OF

VALUE CONTRACTS
2-MAY-17 494.9 493.7 1609
3-MAY-17 496.45 495.85 1829
4-MAY-17 499.95 498.25 1246
5-MAY-17 499.3 497.85 1079
8-MAY-17 502.6 503.12 1715
9-MAY-17 508.9 511.05 2583
10-MAY-17 499.65 502 1772
11-MAY-17 504.65 508 1235
12-MAY-17 507.05 507.84 1451
15-MAY-17 506.3 516.45 1148
16-MAY-17 515.35 509.75 2130
17-MAY-17 510.55 524 2372
18-MAY-17 525.4 520.44 5794
19-MAY-17 519.75 521.6 2036
22-MAY-17 521.2 526.45 2428
23-MAY-17 526.45 525.4 6636
24-MAY-17 525 527.46 5393
25-MAY-17 536.45 536.45 3673

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OBSERVATIONS AND FINDINGS:
 If a person buys 1 lot i.e. 2400 futures of WIPRO on 1st May, 2017 and sells on 25th
May,2017 then he will get a Profit of Rs536.45 -Rs493.7 = Rs 42.75 per share. So, he
will get Profit of Rs.102600 i.e., 42.75*2400.
 The trading week showed a high and low strike prices or exercising prices for the
WIPRO futures.
 There always exist an impact of price movements on open interest and contracts
traded. The futures market is also influenced by cash market, NIFTY index future,
and news
 Related to the underlying assed or sector (industry), FII‟S involvement, national and
International affairs etc
 The closing price of WIPRO at the end of the contract period is Rs 536.45 and this is
considered as settlement price

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TABLE SHOWING MARK TO MARKET PROFIT & LOSS OF WIPRO
FUTURES

DATE MARK TO MARKET SETTLEMENT PRICE

2-MAY-17 0 493.7
3-MAY-17 5160 495.85
4-MAY-17 5760 498.25
5-MAY-17 -960 497.85
8-MAY-17 12960 503.25
9-MAY-17 18270 211.05
10-MAY-17 -21720 502
11-MAY-17 10920 506.55
12-MAY-17 5400 508.8
15-MAY-17 -3240 507.45
16-MAY-17 21600 516.45
17-MAY-17 -16080 509.75
18-MAY-17 34200 524
19-MAY-17 -8280 520.44
22-MAY-17 2520 521.6
23-MAY-17 11640 526.45
24-MAY1-17 -2520 525.5
25-MAY-17 26250 536.45

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OBSERVATIONS AND FINDINGS

 The future price of WIPRO is moving along with the market price.
 If the buy price of the future is less than the settlement price, than the buyer of a
future gets profit.
 If the selling price of the future is less than the settlement price, than the seller incurs
losses

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RELATIONSHIP OF FUTURE PRICE WITH SPOT PRICE IF
FUTUREPRICE HIGHER THAN THE CASH PRICE
Here futures price exceeds the cash price which indicates that the cost of carry is negative and
the market under such circumstances is termed as a backwardation market or inverted market.

EXAMPLE: Suppose the RELIANCE share is trading at Rs.400 in the spot market. While
RELIANCEFUTURES are trading at Rs. 406.Thus in this circumstance the normal strategy
followed by investors is buy the RELIANCE in the spot market and sell in the futures. On
expiry, assuming RELIANCE closes at Rs 450; you make Rs.50 by selling the RELIANCE
stock and lose Rs.44 by buying back the futures, which is Rs 6 overall profit in a month.
Thus, Futures prices are generally higher than the cash prices, in an overbought market.

IF CASH PRICE HIGHER THAN THE FUTURE PRICE

Here cash price exceeds the futures price which indicates that the cost of carry is positive and
this market is termed as oversold market. This may be due to the fact that the market is cash
settled and not delivery settled, so the futures price is more a reflection of sentiment, rather
than that of the financing cost.

EXAMPLE: now let us assume that the RELIANCE share is trading at Rs.406 in the spot
market. While RELIANCE FUTURES is trading at Rs. 400.Thus in this circumstance the
normal strategy followed by investors is buy the RELIANCE FUTURES and sell the
RELIANCE in the spot market. So at expiry if Reliance closes at Rs 450, the investor will
buy back the stock at a loss of Rs 44 and make Rs 50 the settlement of the futures position.
This is applied when the cost of carry is high

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SUMMARY AND CONCLUSIONS

• Derivatives have totally changed the working scenario of financial markets.

Derivatives are those hedging tools that help an organization or an individual to
transfer risk.
• Forward and future contract can be used to essentially lock in the final purchase or
sale price of the asset
• Futures and forward contracts have earned a place among all the financial products.
They are easy to trade and provide an opportunity to transfer risk, from those who
want to avoid it and to those who want to accept it.
• Although there are certain disadvantages of futures but at the same time the
advantages they have, make them essential to be traded in the market.
• Forward and future are beneficial for investor but if they have full in-depth
knowledge about it
• Forward contract are between individual parties and thus rely on the integrity of each.
futures contracts are though organized exchanges and include margin requirements
and marking to market thus marking the risk of default minimal
• Using futures and forward contracts, an individual can reduce various types of risks
like, interest rate risk
• The role of derivatives as hedging tool assumes that derivatives trading do not
increase market volatility and risk

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REFERENCES

http://www.nseindia.com/

https://www.academia.edu/34842501_

https://www.scribd.com/oauth/authorize

https://in.investing.com/news/

https://virtusinterpress.org/IMG/pdf/10-22495_rgcv5i4art6.pdf

https://keydifferences.com/difference-between-forward-and-futures-contract.html

https://www.slideshare.net/SundarShetty2/forward-and-futures-a-detailed-pPT

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