FUTURES MARKET

A futures market is an auction market where participants trade futures and commodities
contracts for delivery on predetermined dates in the future. Futures are exchange-traded
derivatives contracts that guarantee the delivery of a good or asset at a price established today,
regardless of when it is delivered.

Futures are financial contracts that obligate the buyer to purchase an underlying asset, such as a
commodity, currency, or stock index, at a predetermined price and date in the future. They are
used as a tool for hedging against price fluctuations, speculating on market movements, and
managing risk. Futures contracts are standardized and traded on regulated exchanges – known
as the futures market – allowing for easy transfer of obligations between parties. Futures
markets, in contrast to most stock markets, allow trading around-the-clock.

The New York Mercantile Exchange (NYMEX), Chicago Mercantile Exchange (CME), Chicago Board of
Trade (CBoT), Cboe Options Exchange (Cboe), and Minneapolis Grain Exchange are a few examples
of futures markets.

Futures investments are like a high-speed race in which traders try to predict the future
movements of a commodity, stock, or index and make a profit. Futures trading involve high risks
and require expertise and knowledge. Futures trading’, is a game of probabilities where traders
analyze market trends, study economic indicators, and use technical analysis to make informed
decisions about buying and selling futures contracts.

Producers and suppliers of commodities use futures contracts to try to reduce market volatility.
These producers and suppliers negotiate contracts with an investor who agrees to take on both the
risk and reward of a volatile market. These financial instruments are purchased and sold on futures
markets or futures exchanges for delivery at a certain future date with a price set at the time of the
transaction. Futures markets are used for more than only agricultural contracts; they are also used
to buy, sell, and hedge financial products including interest rate futures.

The size of futures markets (which usually increase when the stock market outlook is uncertain)
is larger than that of commodity markets and is a key part of the financial system.

Large futures markets run their own clearinghouses, Futures market exchanges earn revenue
from actual futures trading and the processing of trades, as well as charging traders and firms
membership or access fees to do business.

What is Futures Trading?

The goal of futures investments is to generate a profit by buying low and selling high or selling
high and buying low. But the markets are volatile and can change rapidly, so traders need to be
prepared for the unexpected and be able to adjust their strategies accordingly.
Therefore, futures trading require traders to be courageous and have the ability to make quick
decisions based on analysis and expertise. It’s a world full of risks, rewards, and uncertainties.
Thus, constant adaptation and evolution are vital for success.

Futures work by allowing investors to lock in a price for an asset that they expect to buy or sell in
the future. The buyer of a futures contract agrees to purchase the underlying asset at a
predetermined price (the ‘strike price’) on a specified future date, while the seller of the contract
agrees to deliver the asset at the strike price.

How does Future Trading work?

The futures market works by allowing traders to buy and sell contracts for the purchase or sale
of a particular commodity or financial instrument at a predetermined price and date in the future.
These contracts are traded on organized exchanges, such as the Multi Commodity Exchange
(MCX) and Intercontinental Exchange (ICE).

▪ When a trader buys a futures contract, they are essentially buying the right to purchase a
specific commodity or financial instrument at a certain price at a future date. Similarly, when
a trader sells a futures contract, they are selling the right to sell a commodity or financial
instrument at a certain price at a future date.
▪ The pricing of futures contracts is determined by supply and demand in the market. It can
fluctuate based on a variety of factors, including weather conditions, geopolitical events, and
changes in economic conditions. The price of the contract at the time of purchase is known
as the initial margin.
▪ As the expiration date of the contract approaches, the price of the contract will change as the
underlying asset's price changes. If the price of the underlying asset has gone up, the holder
of the contract will make a profit, while if the price has gone down, the holder will incur a
loss.
▪ Traders can choose to either take delivery of the underlying asset when the contract expires
or close their position by taking an opposing position in the market before the expiration
date.

Types of Futures Traders

There are two types of futures traders – hedgers and speculators.

▪ Hedgers
Hedgers are usually wholesalers, retailers, manufacturers or companies that use futures
contracts to secure themselves against future price volatility. Hedging is suitable for
investors who want to physically own or require the commodity. Therefore, hedgers are
risk averse in nature and aim for protection against price risk. In hedging, there is
negligible profit potential. The only upside is that the hedgers might reduce the risk
associated with price fluctuations.
 ▪ Speculators
A speculator is experienced investors who do not actually seek to own the underlying
asset. Rather, they enter the market seeking profits by offsetting rising and declining
prices. This is achieved through buying and selling of contracts. Thus, speculators are risk-
takers who want to maximise their profits by leveraging the volatility in prices. In addition,
speculators are seasoned traders who are well versed with technical analysis and
fundamental analysis. Speculation has immense profit potential but is also associated
with equally big potential losses.

Advantages of Futures Trading

▪ Hedging: Futures trading provides a mechanism for hedging against price volatility.
Participants can use futures contracts to offset potential losses in the underlying asset.
▪ Price Discovery: Futures markets facilitate the process of price discovery by providing a
platform for buyers and sellers to express their future price expectations.
▪ Leverage: Futures contracts typically require a smaller initial margin compared to the actual
value of the underlying asset. This allows traders to control a larger position with a smaller
investment, thereby magnifying potential returns. However, it is important to note that
leverage also amplifies risks, and traders should exercise caution.
▪ Liquidity: Futures markets in India, such as the National Stock Exchange (NSE) and Multi
Commodity Exchange (MCX), are highly liquid, with a large number of participants and high
trading volumes. This ensures that traders can easily enter or exit positions without
significant price impact.
▪ Speculation: Futures markets provide opportunities for traders to profit from short-term
price movements without the need for physical ownership of the underlying asset.
▪ Flexibility: Futures contracts have standardized terms and expiry dates, making them easily
tradable. Additionally, the availability of different contract sizes and maturities provides
flexibility for participants to tailor their trading strategies according to their specific needs.

Disadvantages of Futures Trading

▪ More complex than trading in stocks

▪ Leveraged positions can lead to magnified losses as well
▪ Daily Mark to Market adjustment requires the traders to have enough capital available to
keep the position intact. So, it is not possible to maintain a futures contract with smaller
capital.
FUTURE PRICE

Spot and Future Price

For traders who rely on technical analysis for devising trading strategies, price movements and past trends
aid in decision making. Some traders use intuition while undertaking trading decisions.

Future price is the price at which asset is bought or sold at a future date. The future price is a
mathematical representation of how future price change if any of the variables in the market changes.
The futures price of an asset is directly dependent upon the price of the underlying asset which is the
current cash cost of purchase [spot price] whereas the futures price fixes the price of the asset at a future
date. The price of the underlying asset forms the base for the futures price. There is a high correlation
between the spot and futures price for any asset which tends to be in the same direction. Therefore, if
the spot price of a security increases, the futures price of the security also increases and vice-versa.

The spot price is the current market price of a security, currency, or commodity available to be bought
/sold for immediate settlement. In other words, it is the price at which the sellers and buyers value an
asset right now.

Although spot prices can vary by time and geographic regions, the prices are fairly homogenous in financial
markets. The uniformity of prices across different financial markets does not allow market participants to
exploit arbitrage opportunities from significant price disparities for the same asset in different markets.

Spot prices are considered in the context of forwards and futures contracts. One of the reasons for the
creation of such financial contracts is to “lock in” the desired spot price of a commodity at some future
date because prices constantly change due to fluctuations in supply and demand.

The spot price is a key variable in determining the price of a futures contract. It can indicate expectations
about fluctuations in future commodity prices.

The main difference between spot prices and futures prices is that spot prices are for immediate buying
and selling, while futures contracts delay payment and delivery to predetermined future dates.

While the spot and futures prices move in the same direction, the spot price and futures price are not
always the same. The difference between the spot and futures price is referred to as Spot-Futures parity.
The reason for such difference can be attributed to multiple factors such as interest rates, dividends and
time to expiry. Cumulatively, these factors aid in calculating the fair value of the futures price. The gap
between the fair value and market value mainly occurs due to other costs such as transaction charges,
taxes, margin, etc.

The formula to calculate futures price is as follows –

Futures Prices = Spot Price * [1 + RF * (X/365) - D]

Where –
 1. RF refers to the rate of risk-free return. A risk-free rate is the rate that can be earned throughout
the year in a perfect market. The interest rate for a Treasury Bill can be the basis for a risk-free
rate which is generally quoted on a per annum basis. Hence, it has to be adjusted proportionately
for the number of days till expiry. The rationale behind adjustment for risk-free interest returns is
to evaluate the minimum return earned if the investment was made on the futures date. Thus, it
is the opportunity cost of investing in security in the present versus the future. The futures price
adjusts for the time value of money.

2. X refers to the number of days till expiry. As suggested by the formula, X is directly proportional
to the futures price. If the number of days to the expiry increase so does the futures price.

3. D refers to dividends paid by the company till expiry. The dividend is not paid to the holder of a
futures contract; it is only paid to the shareholders on the record date. Although the dividend is
not received, the declaration of a dividend has an impact on the price of the securities and
consequently the futures price. After the dividend is paid, the spot price typically reduces to the
extent of the dividend paid. This depicts that new shareholders are not eligible for the dividend
payment. As a result, it is imperative for dividend adjustments to be made to the futures price.

Example 1

The spot price of ABC Corporation is Rs 2,380.5

Risk-free rate = 8.3528 percent
Days to expiry = 7 days
Futures Price = 2380.5 x [1+8.3528 ( 7/365)] – 0
Here, zero is written at the end because the company is not paying any dividend on it, but if the
company pays any dividend, it will be included in the formula.

This futures price formula provides us the ‘fair value.’ The major difference between market prices and
fair value is caused by a margin, taxes, transaction charges, and such.

Using this future pricing formula, it is possible to calculate a fair value for any expiration days.
Mid-month calculation
Number of days to expiry is 34 days
2380.5 x [1+8.3528 ( 34/365)] – 0

Far-month calculation
Number of days to expiry is 80 days
2380.5 x [1+8.3528 ( 80/365)] – 0
Example 2

The spot price for Stock A is Rs. 1280, the risk-free rate of interest is 6.68% per annum and the number of
days to expiry is 22. The company has declared a dividend of Re. 1 to be paid before the expiry of the
contract.

In this case, the futures price is calculated as Rs. 1280 * [1 + 6.68% * (22/365)] – 1 = Rs. 1284.15. According
to this formula, the futures price will increase by Rs. 4.

The difference between the spot and futures price leads to the origination of the concept of premium and
discount. If the futures price is trading at a price higher than the spot, futures are said to be traded at a
premium. Scientifically, the futures price will be more than the spot price. However, in practice, this may
not be the case. If the spot price is higher than the futures price, the future is said to be trading at a
discount. The concept of premium and discount are applied to various trades and strategies.

Future Contracts
The futures contract is a legally binding agreement between two parties to buy or sell an asset at a
predetermined price on a specific future date. The asset can be a commodity, such as oil or gold, or a financial
instrument, such as a stock index or currency pair. The quality and quantity of futures contracts are
standardized in order to facilitate trading on futures exchanges.

When the futures contract expires, the buyer is responsible for buying and receiving the underlying asset. At
the expiration date, the seller of the futures contract is responsible for providing and delivering the underlying
asset.

When we buy a futures contract, we are agreeing to buy the asset at the agreed-upon price on the
expiration date, regardless of the current market price. For example, if we buy a futures contract for 100
barrels of oil at Rs.50 per barrel, we are obligated to buy the oil for Rs.50 per barrel even if the market
price of oil has risen to Rs.60 per barrel by the expiration date.

The opposite is true if we sell a futures contract. If we sell a futures contract for 100 barrels of oil at Rs.50
per barrel, we are obligated to sell the oil for Rs.50 per barrel even if the market price of oil has fallen to
Rs.40 per barrel by the expiration date.

Future contracts allow an investor to speculate the direction in which the underlying assets such as a
commodity, security, or financial instrument will move. These contracts are often purchased with the
goal of hedging price movements of the underlying asset to prevent losses from rather unfavourable price
changes.
Key Highlights

▪ A futures contract is a financial derivative that entails the buyer purchasing some underlying asset
(or the seller selling that asset) at a predetermined future price.

▪ Investors can leverage futures contracts to speculate on the direction of securities, commodities, or
financial instruments.

▪ To help prevent losses from unfavorable price movements, futures are often used to hedge the
underlying asset's price movement.

▪ Almost every commodity can be traded as a futures contract, including grain, energy, currencies, and
even securities.

ATTRIBUTES / FEATURES OF FUTURES CONTRACTS

▪ Regulation: Commodity futures markets in India are regulated by the FMC — Forward Markets
Commission. This governing body regulates aspects such as withdrawing or granting recognition
of any commodity markets engaged in forward dealings.
▪ Availability: Available for many different types of asset classes, a future contract can work across
exchanges, commodities or currencies, and indices.
▪ Standardized: Unlike a forward contract, a futures contract is standardized. As an example, once
a contract states that it applies to 1000 barrels of oil, one will have to lock in their price as per
that unit or in multiples of it. If one wants to lock in a price, they would need to sell or purchase
a hundred separate contracts. To lock in the price of a million barrels of oil, one would need to
buy or sell a thousand such contracts. Traders also get an efficient idea of what the futures price
of a stock or the value of its index is likely to become.
▪ Margin: Due to the margin trading nature of futures, they allow those without sufficient funds to
participate in trades and place orders. One can do so by paying a smaller margin rather than the
entire value of the physical holdings.
▪ Market Participant: Future contracts are employed by two types of market participants:
speculators and hedgers. Those who produce or purchase an underlying asset hedge are known
as producers or hedgers. These individuals also guarantee the price at which the commodity will
be purchased or sold. Alternatively, those who bet on the price movements of the underlying
asset through the use of futures are known as speculators.
▪ Future contracts can mainly aid in determining the future supply and demand of shares, which
is based on their current future price.

TYPES OF FUTURES CONTRACTS

A vast range of financial and commodity-based futures are available to trade, ranging from indices, currencies,
and debt to energy and metals, as well as farm products. The following are some examples of futures
contracts that are available:
 ▪ Financial Futures: Financial future contracts are agreements between two parties to buy or sell an
underlying asset at a predetermined price and time in the future. Financial futures include index
contracts and interest rate (debt) contracts. Index contracts provide exposure to certain market
index values, whereas interest rate contracts provide exposure to a specific debt instrument's
interest rate. Financial futures contracts can be used by investors to hedge against potential losses,
speculate on future price movements, and gain exposure to different asset classes. However, like any
investment, financial futures trading carries risks and investors should carefully consider their
investment objectives and risk tolerance before participating in financial futures trading.

▪ Currency Futures: A currency futures contract is a standardized agreement between two parties to
exchange a specified amount of one currency for another at a predetermined exchange rate and a
specific date in the future. Currency futures contracts are used as a hedging tool by businesses and
investors to manage their foreign exchange risk. For example, an importer can enter into a currency
futures contract to buy a certain amount of foreign currency at a fixed price, thereby locking in the
exchange rate and protecting against potential losses from currency fluctuations.

▪ Energy Futures: An energy futures contract is a financial derivative that allows investors and
businesses to buy or sell a certain amount of energy commodities, such as crude oil, natural gas,
heating oil, or gasoline, at a predetermined price and on a specific date in the future.

▪ Metal Futures: A metal futures contract is a financial agreement between two parties to buy or sell
a specific quantity of metal, such as gold, silver, copper, or platinum, at a predetermined price and
on a specific date in the future.

▪ Grain futures: A grain futures contract is a financial agreement between two parties to buy or sell a
specific quantity of grains, such as wheat, corn, or soybeans, at a predetermined price and on a
specific date in the future.

▪ Livestock futures: A livestock futures contract is a financial agreement between two parties to buy
or sell a specific quantity of livestock, such as cattle, hogs, or feeder cattle, at a predetermined price
and on a specific date in the future.

▪ Food and Fiber Future Contracts: Food and fiber futures contracts are financial agreements between
two parties to buy or sell a specific quantity of agricultural products, such as cotton, sugar, cocoa,
coffee, and various types of grains, at a predetermined price and on a specific date in the future.

ADVANTAGES OF FUTURE CONTRACTS

▪ Hedging: Futures contracts are often used as a hedging tool by investors to reduce their exposure
to market volatility. By locking in a price today, investors can protect themselves against future
price fluctuations
▪ Liquidity: Futures markets are highly liquid, meaning that there are a large number of buyers and
sellers, and it is easy to enter and exit positions.
 ▪ Leverage: Futures contracts allow investors to control a large amount of the underlying asset with
a relatively small amount of capital. This can amplify returns but also increases risk.
▪ Transparency: Futures contracts are standardized and traded on exchanges, making the pricing
and terms of the contract transparent to all market participants.

DISADVANTAGES OF FUTURE CONTRACTS

▪ Risk: Futures contracts are highly leveraged instruments and can be very risky. A small price
movement in the underlying asset can result in a large gain or loss in the value of the futures
contract.
▪ Margin requirements: To trade futures, investors must post a margin, which is a percentage of
the contract value. Margin requirements can be high, and investors may need to maintain a
certain level of margin in their accounts to keep their positions open.
▪ Counterparty risk: Futures contracts are essentially agreements between two parties, and there
is always a risk that one party may not fulfill obligations.
▪ Limited flexibility: Futures contracts are standardized, meaning that investors cannot customize
the terms of the contract. This can be a disadvantage for investors who have specific needs or
strategies.

OPERATION OF STOCK FUTURES

Stock futures are derivative contracts that give you the power to buy or sell a set of stocks at a fixed price by
a certain date. Once you buy the contract, you are obligated to uphold the terms of the agreement.

Operation of stock futures contracts:

▪ Lot/Contract size: In the derivatives market, contracts cannot be traded for a single share. Instead,
every stock futures contract consists of a fixed lot of the underlying share. The size of this lot is
determined by the exchange on which it is traded on. It differs from stock to stock. For instance, a
Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL shares, i.e., when you buy one
futures contract of RIL, you are actually futures trading 250 shares of RIL. Similarly, the lot size for
Infosys is 125 shares.*
▪ Expiry: All three maturities are traded simultaneously on the exchange and expire on the last
Thursday of their respective contract months. If the last Thursday of the month is a holiday, they
expire on the previous business day. In this system, as near-month contracts expire, the middle-
month (2 month) contracts become near-month (1 month) contracts and the far-month (3 month)
contracts become middle-month contracts.
▪ Duration: Contract is an agreement for a transaction in the future. How far in the future is decided
by the contract duration. Futures contracts are available in durations of 1 month, 2 months and 3
months. These are called near month, middle month and far month, respectively. Once the
contracts expire, another contract is introduced for each of the three durations. The month in which
it expires is called the contract month. New contracts are issued on the day after expiry.
Example: If you want to purchase a single July futures contract of ABC Ltd., you would have to do so at the
price at which the July futures contracts are currently available in the derivatives market. Let's say that ABC
Ltd July futures trading are at Rs 1,000 per share. This means, you are agreeing to buy/sell at a fixed price of
Rs 1,000 per share on the last Thursday in July. However, it is not necessary that the price of the stock in the
cash market on Thursday has to be Rs 1,000. It could be Rs 992 or Rs 1,005 or anything else, depending on
the prevailing market conditions. This difference in prices can be taken advantage of to make profits.

OPERATION OF INDEX FUTURES

A stock index is used to measure changes in the prices of a group stocks over a period of time. It is constructed
by selecting stocks of similar companies in terms of an industry or size. Some indices represent a certain
segment or the overall market, thus helping track price movements. For instance, the BSE Sensex is comprised
of 30 liquid and fundamentally strong companies. Since these stocks are market leaders, any change in the
fundamentals of the economy or industries will be reflected in this index through movements in the prices of
these stocks on the BSE. Similarly, there are other popular indices like the CNX Nifty 50, S&P 500, etc, which
represent price movements on different exchanges or in different segments.

Futures contracts are also available on these indices. This helps traders make money on the performance of
the index.

Operation of index futures contracts:

▪ Contract size: Just like stock futures, these contracts are also dealt in lots. But how is that possible
when the index is simply a non-physical number. No, you do not purchase futures of the stocks
belonging to the index. Instead, stock indices points – the value of the index – are converted into
rupees.

For example, suppose the CNX Nifty value was 6500 points. The exchange stipulates that each point
is equivalent to Rs 1 , then you have to pay 100 times the index value – Rs 6,50,000 i.e. 1x6500x100.
This also means each contract has a lot size of 100.

▪ Expiry: Since indices are abstract market concepts, the transaction cannot be settled by actually
buying or selling the underlying asset. Physical settlement is only possible in case of stock futures.
Hence, an open position in index futures can be settled by conducting an opposing transaction on or
before the day of expiry.
▪ Duration: As in the case of stock futures, index futures too have three contract series open for
futures trading at any point in time – the near-month (1 month), middle-month (2 months) and far-
month (3 months) index futures contracts.

Illustration of an index futures contract: If the index stands at 3550 points in the cash market today and you
decide to purchase one Nifty 50 July future, you would have to purchase it at the price prevailing in the futures
market.
This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh (i.e., 3550*100),
depending on the prevailing market conditions. Investors and traders try to profit from the opportunity arising
from this difference in prices

FORWARD MARKET
The forward market, also known as the forward exchange market, refers to an over-the-counter
marketplace which enables investors to identify an asset (read, underlying asset), predict its price on a
future date, and enter into an agreement with the seller of the asset. Similarly, a seller uses the forward
market to connect with a buyer and offer to sell an underlying asset at a pre-decided price on a future
date.
Although buyers and sellers use the forward market for trading a wide range of derivative instruments,
such as stocks, indices, commodities, interest rates, etc., the term is most commonly associated with the
foreign exchange market. The forward market is generally accessed by large financial institutions, banks,
and industries.

FORWARD MARKETS COMMISSION

The Forward Markets Commission (FMC) is a regulatory body for monitoring futures and commodities
market in India. FMC is fully controlled by the Securities and Exchange Board of India (SEBI) under the
Ministry of Finance. The Forward Markets Commission was established in 1953 and is headquartered in
Mumbai, Maharashtra.

FMC controls the regulatory side of the Indian forward market. Presently, five (5) national exchanges,
including Multi Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX),
Indian Commodity Exchange Ltd (ICEX), National Multi Commodity Exchange (NMCE), and ACE Derivatives
and Commodity Exchange, facilitates forward trading in over 110 commodities in India. Moreover, sixteen
(16) other commodity exchanges regulate trades in many commodities specified in the Forward Contracts
(Regulation) Act, 1952.

FORWARD CONTRACT
A forwards contract is a specific agreement by two parties to purchase or sell an asset at a particular
price on a future date. The two parties agree to conduct the said transaction in the future, hence the term
‘forward’. The value of the forward contract is derived from the underlying asset’s value, such as
stocks, commodities, currencies, etc. This is why a forward contract acts as a derivative. However, unlike
an options contract, the two parties involved in a forwards derivative contract are obligated to fulfill
the specified transaction and take the delivery of the underlying asset.

Forward contracts are not traded on a centralized exchange, which is why they are essentially considered
over-the-counter or OTC derivatives. Furthermore, since forward contracts are negotiated privately and
without an intermediary, they are more customizable than standard derivative contracts.

COMPONENTS OF A FORWARD CONTRACT

The basic components of a forward contract include the following –

• The Underlying Asset: This is the security (stock, commodities, index or currency) that is traded.
The value of the forward contract is derived from the value of the underlying asset.
• The Forward Price: The price at which the contract is agreed to be executed. This price is usually
calculated by adding the risk-free rate of return to the market price of the asset.
• Contracting Parties: There are two parties to a forward contract – the buyer and the seller.
• Future Date: The specified date at which the contract is to be executed is called the future date.
TYPES OF FORWARD CONTRACTS

Generally, the forward market facilitates four types of forward trades:

1. Closed Outright Forward - Two parties fix the exchange rate based on the current spot rate and
the premium
2. Flexible Forward - Two parties agree to exchange funds on or before the date of the contract
maturity.
3. Long Dated Forward - These are like short-dated contracts with a distant maturity date.
4. Non-Deliverable Forward - Here, the instrument is not traded physically. Instead, the two parties
agree to settle or pay the difference between the exchange rate and the spot price

TRADING PRINCIPAL OF A FORWARD CONTRACT

How is forward trading done?

The two parties typically enter into a forward contract because of their opposing views on a particular
asset’s future price. One party believes that the price of a particular asset is set to rise in the future and
therefore wishes to purchase it at a lower, predetermined price to make profits based on the price
difference. Hence, this party offers to be the buyer. On the other hand, the other party believes that the
asset’s price will fall in the near future and therefore wishes to cut their losses by locking in a
predetermined price. This party, therefore, offers to be the seller.

Based on how the market performs and the price of the asset changes, the actual result of the forward
contract can typically go in three different ways:

1. The Price of the Asset Rises In The Future

In this scenario, the buyer’s prediction comes true, and they can sell the asset at a higher price. They take
the delivery of the asset by paying the lower predetermined price of the forwards’ contract and sell it on
the open market. The profit made by the buyer in this scenario is the difference between the actual
current price of the asset and the locked-in price at which the buyer bought it.

For example, a forward contract is drawn between the buyer and seller for 100 kgs of wheat at Rs. 30/kg.
The buyer expects the price of the wheat to rise beyond Rs. 30/kg. If, on the contract execution date, the
market price of wheat is Rs. 32/kg, the buyer makes a profit. He can buy 100 kgs at Rs. 30 and then sell
them at Rs. 32, thereby making a profit of Rs. 2/kg.

2. The Price of the Asset Falls In The Future

In this scenario, the seller’s prediction is correct, providing benefits from the sale made through the
forward contract. Even though the price of the asset has fallen, the seller gets to sell it at a price higher
than its current value. The profit made by the seller in this scenario is the difference between the price at
which the seller sells the asset and the actual current price of the asset.

For example, in the aforementioned instance, the seller expects the price of wheat to fall to Rs. 28/kg. If
it happens, the seller would stand to make a gain of Rs. 2/kg as he would be able to sell his wheat at a
price higher than the market price.
3. The Price of the Asset Remains Unchanged In The Future
In this scenario, the prediction of neither the buyer nor the seller is proven correct. Therefore, the
transaction results in no profit made or loss incurred by either party.

FEATURES OF FORWARD CONTRACT

The following are the essential features of a forward contract –

▪ These are not standardized and are not traded on a stock exchange. Also, the parties can make
changes in the agreement with regard to the underlying assets, amount and delivery date. Thus,
they are customizable.
▪ The parties can settle these contracts in one of the two ways. One is where the seller makes the
physical delivery of assets and receives the agreed-upon payment from the buyer. The other is
cash settlement, where there is no actual physical delivery of the asset. Instead, one of the two
parties settles the contract by paying the other an appropriate differential in cash.
▪ Corporations mostly use these contracts to minimize and hedge interest rate risk. This prevents
them from purchasing an asset at a higher price in future.
▪ Forward trading requires no margin amount and is not regulated by the Securities and Exchange
Board of India, i.e. SEBI. Thus, it is easy to trade and customizable.

ADVANTAGES AND RISKS INVOLVED WITH FORWARD CONTRACT

ADVANTAGES

The following are the advantages of a forward contract –

▪ Hedging: The preset specifications in the agreement made by the parties allow them to manage
risks and protect themselves from market fluctuations that can affect the asset price.
▪ Customization: The parties involved in the agreement make specific requirements, including
expiry date, lot size and pricing.
▪ Simplicity: These are simpler to understand the price protection and enable proximity among
traders with less regulation.

RISKS

The following are the risks involved in a forward contract –

▪ Regulatory Risk: These are executed with the mutual consent of both parties involved. Also, they
are not governed by any specific regulatory authority. Because there is no regulatory authority, it
increases the risk ability of either of the parties to default.
 ▪ Liquidity Risk: The trading decision is impacted in these contracts due to low liquidity. Even
though the trader has a strong trading view, they may not be able to execute the strategy because
of low liquidity.
▪ Default Risk: The institution that drafted the agreement is exposed to a high level of risk in the
event of default or non-settlement by the client. Thus, these are risky for both parties as it is over
the counter investments.

DIFFERENCE BETWEEN FORWARD AND FUTURE CONTRACT

A forward contract sounds very much like a futures contract, but it is not the same. While both are types
of derivatives, they are quite different from one another.–

Forwards
They are not traded on the stock exchange.
It can be customized depending on the needs of
the buyer and the seller
A clearinghouse is not involved
They are settled at a specified date
Futures
They are traded on the exchange
Futures are standardized contracts
A clearinghouse is involved in the settlement of
futures
Futures can be traded whenever the exchange is
open

Forward Rate Agreement (FRA) / Interest Rate Standardization

A forward rate agreement (FRA) is an over-the-counter (OTC) contract between parties that determines
the rate of interest to be paid on an agreed-upon date in the future. In other words, an FRA is an
agreement to exchange an interest rate commitment on a notional amount.
The forward rate agreement determines the rates to be used along with the termination
date and notional value [Notional value is a term often used by derivatives traders to refer to the total
value of the underlying asset in a contract]. FRAs are cash-settled. The payment is based on the net
difference between the interest rate of the contract and the floating rate in the market—the reference
rate. The notional amount is not exchanged. It is a cash amount based on the rate differentials and the
notional value of the contract.

KEY TAKEAWAYS

• Forward rate agreements (FRAs) are over-the-counter (OTC) contracts between parties that
determine the rate of interest to be paid on an agreed-upon date in the future.
• The notional amount is not exchanged, but is a cash amount based on the rate differentials and
the notional value of the contract.
• A borrower might want to fix their borrowing costs today by entering into an FRA.

Forward rate agreements typically involve two parties exchanging a fixed interest rate for a variable
one. The party paying the fixed rate is referred to as the borrower, while the party paying the variable
rate is referred to as the lender. The forward rate agreement could have the maturity as long as five
years.

A borrower might enter into a forward rate agreement with the goal of locking in an interest rate if the
borrower believes rates might rise in the future. In other words, a borrower might want to fix their
borrowing costs today by entering into an FRA.

The cash difference between the FRA and the reference rate or floating rate is settled on the value date
or settlement date.

Forward Rate Agreement (FRA) vs. Forward Contract (FWD)

A forward rate agreement is different from a forward contract (FWD). A currency forward is a binding
contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of
a currency on a future date. A currency forward is a hedging tool that does not involve any up-front
payment. The other major benefit of a currency forward is that it can be tailored to a particular amount
and delivery period, unlike standardized currency futures.

The FWD can result in the currency exchange being settled, which would include a wire transfer or a
settling of the funds into an account. There are times when an offsetting contract is entered, which would
be at the prevailing exchange rate. However, offsetting the forward contract results in settling the net
difference between the two exchange rates of the contracts. An FRA results in settling the cash difference
between the interest rate differentials of the two contracts.

A currency forward settlement can be on either a cash or delivery basis, provided that the option is
mutually acceptable and has been specified beforehand in the contract.

Limitations of Forward Rate Agreements

There is a risk to the borrower if they had to unwind the FRA and the rate in the market had moved
adversely so that the borrower would take a loss on the cash settlement. FRAs are very liquid and can be
unwound in the market, but there will be a cash difference settled between the FRA rate and the
prevailing rate in the market.

STEPS FOR CALCULATION

1. Calculate the difference between the forward rate and the floating rate or reference rate.
2. Multiply the rate differential by the notional amount of the contract and by the number of days
in the contract. Divide the result by 360 (days).
3. In the second part of the formula, divide the number of days in the contract by 360 and multiply
by the reference rate. Add this result to 1 and then divide that value into 1.
4. Multiply the result from the right side of the formula by the left side of the formula

Example of a Forward Rate Agreement

Company A enters into an FRA with Company B in which Company A will receive a fixed (reference) rate
of 4% on a principal amount of $5 million in half a year, and the FRA rate will be set at 50 basis points less
than that rate. In return, Company B will receive the one-year London Interbank Offered Rate (LIBOR),
determined in three years’ time, on the principal amount. The agreement will be settled in cash in a
payment made at the beginning of the forward period, discounted by an amount calculated using the
contract rate and the contract period.

The formula for the FRA payment takes into account five variables:

• FRA = the FRA rate

• R = the reference rate
• NP = the notional principal
• P = the period, which is the number of days in the contract period
• Y = the number of days in the year based on the correct day-count convention for the contract

Now putting the values into the formula above:

• FRA = 3.5%
• R = 4%
• NP = $5 million
• P = 181 days
• Y = 360 days

If the payment amount is positive, then the FRA seller pays this amount to the buyer. Otherwise, the buyer
pays the seller. Remember, the day-count convention is typically 360 days in a year. Note also that the
notional amount of $5 million is not exchanged. Instead, the two companies involved in this transaction
are using that figure to calculate the interest rate differential.