CHAPTER

Introduction

Risk is a characteristic feature of all commodity and capital markets.

Prices of all commodities—be they agricultural like wheat, cotton,
rice, coffee or tea, or non-agricultural like silver, gold etc.—are
subject to fluctuation over time in keeping with prevailing demand
and supply conditions. Producers or possessors of these commodities
obviously cannot be sure of the prices that their produce or
possession may fetch when they have to sell them, in the same way as
the buyers and the processors are not sure what they would have to
pay for their buy. Similarly, prices of shares and debentures or bonds
and other securities are also subject to continuous change. Those who
are charged with the responsibility of managing money, their own or
of others, are therefore constantly exposed to the threat of risk. In the
same way, the foreign exchange rates are also subject to continuous
change. Thus, an importer of a certain piece of machinery is not sure
of the amount he would have to pay in rupee terms when the
payment becomes due.
While examples where risk is seen to exist, can be easily
multiplied, it may be observed that parties involved in all such cases
may see the benefits of, and are likely to desire, having some
contractual form whereby forward prices may be fixed and the price
risk facing them is eliminated. Derivatives came into being primarily
for the reason of the need to eliminate price risk.

WHAT ARE DERIVATIVES ?

A derivative instrument, broadly, is a financial contract whose payoff

structure is determined by the value of an underlying commodity,
 2 Futures and Options

security, interest rate, share price index, exchange rate, oil price, and
the like. Thus, a derivative instrument derives its value from some
underlying variable. A derivative instrument by itself does not
constitute ownership. It is, instead, a promise to convey ownership.
All derivatives are based on some ‘cash’ products. The underlying
basis of a derivative instrument may be any product including
(i)commodities including grain, coffee beans, orange juice etc.
(ii)precious metals like gold and silver
(iii)foreign exchange rate
(iv) bonds of different types, including medium to long-term
negotiable debt securities issued by governments, companies,
etc.
(v) short-term debt securities such as T-bills; and
(vi) over-the-counter (OTC) money market products such as loans
or deposits.
Derivatives are specialized contracts which are employed for a
variety of purposes including reduction of funding costs by
borrowers, enhancing the yield on assets, modifying the payment
structure of assets to correspond to the investor’s market view, etc.
However, the most important use of derivatives is in transferring
market risk, called hedging, which is a protection against losses
resulting from unforeseen price or volatility changes. Thus,
derivatives are a very important tool of risk management. As
awareness about the usefulness of derivatives as a risk management
tool has increased, the markets for derivatives too have grown. Of
late, derivatives have assumed a very significant place in the field of
finance and they seem to be driving global financial markets.
There are many kinds of derivatives including futures, options,
interest rate swaps, and mortgage derivatives. This book seeks to
discuss the nature of futures and options and their trading in the
market.
To understand the nature of futures and options, let us begin with
the idea of forward contracts.

FORWARD CONTRACTS

A deal for the purchase or sale of a commodity, security or other asset

can be in the spot or forward markets. A spot or cash market is the
 Introduction 3

most commonly used for trading. A majority of our day-to-day

transactions are in the cash market, where we pay cash and get the
delivery of the goods. In addition to a cash purchase, another way to
acquire or sell assets is by entering into a forward contract. In a forward
contract, the buyer agrees to pay cash at a later date when the seller
delivers the goods. As an analogy of a forward contract, suppose a
patient calls a doctor for an appointment and sees him after two days
at the appointed hour. After his examination, the patient pays the
doctor. Similarly, if a car is booked with a dealer and the delivery
‘matures’, the car is delivered after its price has been paid.
Usually no money changes hands when forward contracts are
entered into, but sometimes one or both the parties to a contract may
like to ask for some initial, good faith deposit to ensure that the
contract is honoured by the other party.
Typically, in a forward contract, the price at which the underlying
commodity or asset will be traded, is decided at the time of entering
into the contract. The essential idea of entering into a forward
contract is to peg the price and thereby avoid the price risk. Thus, by
entering into a forward contract, one is assured of the price at which
one can buy/sell goods or other assets. A manufacturer using a
certain raw material whose price is subject to variation, can avoid the
risk of the price moving adversely by entering into a forward contract
and plan his operations better. Similarly, by entering into a forward
contract, a farmer can ensure the price he can get for his crop and not
worry about what price would prevail at the time of maturity of the
contract. Of course, at the maturity of a contract, if the market price
of the commodity is greater than the price agreed, then the buyer
stands to gain while the seller is in a losing position. The opposite
holds when the market price happens to be lower than the agreed
price.
Forward contracts have been in existence for quite some time. The
organized commodities exchanges, on which forward contracts are
traded, probably started in Japan in the early eighteenth century,
while the establishment of the Chicago Board of Trade (CBOT) in
1848 led to the start of a formal commodities exchange in the USA.
A forward contract is evidently a good means of avoiding price
risk, but it entails an element of risk in that a party to the contract may
not honour its part of the obligation. Thus, each party faces the risk of
default. There is another problem. Once a position of buy or sell is
 4 Futures and Options

taken in a forward contract, an investor cannot retreat except through

mutual consent with the other party or by entering into an identical
contract and taking a position that is the reverse of the earlier
position. The alternatives are by no means very easy. With forward
contracts entered on a one-to-one basis and with no standardization,
the forward contracts have virtually no liquidity. These problems of
credit risk and no-liquidity associated with forward contracts led to
the emergence of futures contracts. The futures contracts are thus
refined forward contracts.

FUTURES CONTRACTS

As indicated, the futures contracts represent an improvement over

the forward contracts in terms of standardization, performance
guarantee and liquidity. A futures contract is a standardized contract
between two parties where one of the parties commits to sell, and the
other to buy, a stipulated quantity (and quality, where applicable) of
a commodity, currency, security, index or some other specified item
at an agreed price on a given date in the future.
The futures contracts are standardized ones, so that
(i) the quantity of the commodity or the other asset which would
be transferred or would form the basis of gain/loss on maturity
of a contract,
(ii) the quality of the commodity—if a certain commodity is
involved—and the place where delivery of the commodity
would be made,
(iii) the date and month of delivery,
(iv) the units of price quotation,
(v) the minimum amount by which the price would change and
the price limits for a day’s operations, and other relevant details
are all specified in a futures contract. Thus, in a way, it becomes
a standard asset, like any other asset, to be traded.
Futures contracts are traded on commodity exchanges or other
futures exchanges. People can buy or sell futures like other
commodities. When an investor buys a futures contract (so that he
takes a long position) on an organized futures exchange, he/she is in
fact assuming the right and obligation of taking the delivery of the
specified underlying item on a specified date. Similarly, when an
investor sells a contract, to take a short position, one assumes the right
 Introduction 5

and obligation to make the delivery of the underlying asset. There is

no risk of non-performance in the case of trading in futures contracts.
This is because a clearing house, or a clearing corporation is associated
with the futures exchange, which plays a pivotal role in the trading of
futures. A clearing house takes the opposite position in each trade, so
that it becomes the buyer to the seller and the seller to the buyer.
When a party takes a short position in a contract, it is obliged to sell
the underlying commodity in question at the stipulated price to the
clearing house on maturity of the contract. Similarly, an investor who
takes a long position on the contract, can seek its performance
through the clearing house only.
To illustrate, if a futures contract maturing on December 23 and
involving 500 shares of Company X at Rs 375 is bought by investor A
and sold by another investor B, then each of these investors has his
rights and obligations to the clearing corporation. Thus, on
December 23, A shall call upon the clearing corporation for the
delivery of 500 shares of X upon a payment of Rs 375 per share.
Similarly, B is obliged to deliver the shares to the corporation and is
entitled to receive an amount of Rs 187,500 (500 ¥ 375). Note that the
traders are not obliged to each other directly.
A significant point to note is that while a clearing house guarantees
the performance of the futures contracts, the parties in the contracts
are required to keep margins with it. The margins are taken to ensure
that each party to a contract performs its part. The margins are
adjusted on a daily basis to account for the gains or losses, depending
upon the price at which the futures contracts are being traded in the
market. This is known as marking to the market and involves giving a
credit to the buyer of the contract, if the price of the contract rises and
debiting the seller’s account by an equal amount. Similarly, the
buyer’s balance is reduced when the contract price declines, and the
seller’s account is accordingly updated. In the example given above,
while the futures price is Rs 375 when the contract is entered into, it
will change in the course of time much in the same way as the spot
price changes. The investor A would get the credit if the price rules at
more than Rs 375 and a debit if it is lower than that. In effect, the
profit or loss on a futures contract is settled daily and not on maturity
of the contract, as for a forward contract.
It is not necessary to hold on to a futures contract until maturity
and one can easily close out a position. Either of the parties may
 6 Futures and Options

reverse their position by initiating a reverse trade, so that the original

buyer of a contract can sell an identical contract at a later date,
cancelling, in effect, the original contract. Thus, the exchange
facilitates subsequent selling (buying) of a contract so that a party can
offset its position and eliminate the obligation. The fact that the buyer
as well as the seller of a futures contract are free to transfer their
interest in the contract to another party makes such contracts
essentially marketable instruments. Thus, the futures contracts are
highly liquid in nature. In fact, most of the futures contracts are
cancelled by the parties, by engaging into reverse trades: the buyer
cancels a contract by selling another contract, while the seller does so
by buying another contract. Only a very small proportion of them
are held for actual delivery.

Difference between Forward and Futures Contracts

We may now differentiate between forward and futures contracts.
Broadly, a futures contract is different from a forward contract on the
following counts:
(i) Standardization A forward contract is a tailor-made contract
between the buyer and the seller where the terms are settled in
mutual agreement between the parties. On the other hand, a futures
contract is standardized in regard to the quality, quantity, place of
delivery of the asset etc. Only the price is negotiated.
(ii) Liquidity There is no secondary market for forward contracts,
while futures contracts are traded on organized exchanges.
Accordingly, futures contracts are usually much more liquid than the
forward contracts.
(iii) Conclusion of Contract A forward contract is generally concluded
with a delivery of the asset in question whereas the futures contracts
are settled sometimes with delivery of the asset and generally with
the payment of price differences. One who is long a contract can
always eliminate his/her obligation by subsequently selling a contract
for the same asset and same delivery date, before the conclusion of
contract one holds. In the same manner, the seller of a futures
contract can buy a similar contract and offset his/her position before
maturity of the first contract. Each one of these actions is called offset-
ting a trade.
(iv) Margins A forward contract has zero value for both the parties
involved so that no collateral is required for entering into such a