Introduction
The Futures market is an integral part of the Financial Derivatives world. `Derivatives` as they are called is a security, whose value is derived from another financial entity referred to as an `Underlying Asset`. The underlying asset can be anything a stock, bond, commodity or currency. The financial derivatives have been around for a long time now. The earliest reference to the application of derivatives in India dates back to 320 BC in `Kautilya`s Arthashastra`. Kauutilya of the ancient Arthashastra scripture (economics), A standing plant that can be harvested at some point in the future. Apparently he used this method Paying a large amount of money in advance to the farmer, thereby building a true "forward contract". Given the similarities between futures and futures markets, I think it's the best way possible. To introduce the futures market, you first need to understand the "futures market". Understanding the futures market provides a strong foundation for learning about the futures market.
Forward contracts are the simplest form of derivative. Think of a forward contract as an old avatar of a futures contract. Both futures and forward contracts share a common trading structure, except that futures contracts have been the trader's default choice for many years. Forward contracts will continue to be used, but are limited to a small number of participants such as industry and banks.
Simple Forward Transaction as an Example
The forward market was established mainly to protect the interests of farmers from disadvantages. Price fluctuations. In the futures market, buyers and sellers enter into exchange contracts Goods for cash. The exchange will take place at a specific price on a specific future date. Price, the breakdown of the product will be decided by both parties on the contract conclusion date. Similarly the date and time of the delivered item is also specified. The agreement is face-to-face.
There is no third party intervention. This is called an "over-the-counter or OTC" contract. Futures contracts are only traded in the OTC (over-the-counter) market where individuals / institutions trade. Through one-on-one negotiations. Consider this example. Two parties are involved. One is a jeweler whose job is to design and create jewelery. Let's call it "Company A Jewelers". The other is a gold importer whose job is to sell gold to jewelers at wholesale prices. He `Company B Gold Dealer`
On December 8, 2014, Company A signed an agreement with Company B to purchase 15 kilograms of gold at a specified price in 3 months (March 8, 2015). They fix the gold price at the current market price of say $1200.00 per gram. Therefore, Agreed, March 8, 2015, Company A and B ($42.32 / gm * 15Kg) in exchange for 15kg of gold. This is a very simple and typical business contract that is widely used in the market. This type of contract is called a "forward contract" or "reservation contract". The contract will be signed on December 8, 2014, so regardless of the price of gold. A few months later, On March 8, 2015, both Company A and Company B are obliged to comply with the contract. Next, let's understand each party's thinking process and what to understand.
Why do you think Company A signed this deal? Well, Company A thinks the price of gold will go up for the next three months, they will want to fix the market price of gold today. Obviously, Company A wants to protect itself from the unfavorable rise in gold prices. In a futures contract, a party who agrees to purchase an asset at some point in the future "Forward Contract Buyer", in this case Company A a Jeweler. Similarly, Company B believes that the price of gold will fall in the next three months, so he want to benefit from the high prices of gold available on the market today. At the forward contract he forced him to sign this contract.
Under the terms of the agreement, the party who agrees to sell the asset at some point in the future is referred to as the "seller of the futures contract", in this case Company B the Gold Dealer. Both parties have opposite views on gold. Therefore, they have this agreement their future expectations.
There Are Three Possible Scenarios
Both parties have their own views on gold, but there are only three possible scenarios. It may expire at the end of 3 months. Understand these scenarios and how they are performed by both parties.
Scenario 1 - Gold Price Rises
Suppose on March 8, 2015, the price of gold is trading at per gram. clearly, Company A The Jeweler's view on the price of gold has come true. At the time of the agreement, the transaction is much higher to $42.32. Under the terms of the agreement, Company A The Jewelers have the right to purchase gold from Company B The Gold Dealers. The price they previously agreed on, namely $42.32 / per gram. But company B the Gold Dealer enjoys the price at his favor.
Scenario 2 – Gold Prices Go Down
Suppose on March 8, 2015, the price of gold is trading lower than $42.32 / per gram. Under these circumstances, Company B the Gold Dealer's view on the price of gold has come true. At that time the agreement was valued at $42.32 but the deal was closed due to the fall in gold prices worth $41.17. This time Company A the Jewelers enjoys the price at his favor.
Scenario 3 - Gold Prices Go As Agreed
Suppose on March 8, 2015, the price of gold is trading sideways which means that the price remains $42.32 / per gram. In this case both seller and buyer meet enjoys its favor.
A Brief Note On The Reconciliation
The price of gold on March 8, 2015 suppose it is $41.17 / gram. Certainly for now As you can see, at $42.32 / per gram, Company A The Jewelers are in a position to benefit from the deal. In At the time of the agreement (December 8, 2014), 15 kg of gold was worth $42.32 / gram, but same as 8th March 2015 15kg of gold is valued at $41.17. Approved at the end of 3 months, March 8th. In 2015, both parties will comply with the agreement. Here you have two options for reaching an agreement.
Physical Reconciliation – The full purchase price is paid by the purchaser of the futures contract. The actual asset is provided by the seller. Company B buys 15kg of gold from the open market by paying actual market price, the same will be delivered to Company B upon receipt of the agreed amount. That is called physical processing.
Cash Reconciliation - With cash settlement, there is no actual delivery or acceptance of the security. In cash settlement, the buyer and seller simply exchange the monetary difference. Under the terms of the agreement, Company B The Gold Dealer is obliged to sell gold to Company B for $42.32 / per gram. In other words, Company B pays actual cost in exchange for 15kg of gold on the actual date March 8, 2015. However, instead of making this transaction, Company A will pay $41.17 / per gram. Gold is worth $42.32 and both parties can agree to exchange only the cash difference.
What About The Risks?
The structure (conditions) of the contract and its meaning are clear, What about the price deviations between the two and the risks involved? The risk is Price movements and futures contracts have other major drawbacks.
Liquidity Risk – This example conveniently assumes that Company A carries a certain level of risk. Gold View finds the opposite party Company B. The activity in the real world, it's not that easy. In a realistic situation, the parties will resolve as they approach an investment bank and discuss its intentions. The investment banker will probe the market to find an opposing party. Of course, investment banking does it because of a fee they will get from the buyer or seller.
Default Risk / Counterparty Risk – take this into account and assume that the price of gold has been hit $41.17 / per gram at the end of 3 months. Company A will be proud of their financial decisions. It took 3 months ago. You expect Company B to pay. But what if Company A fails?
Regulatory Risk - Forward contract arrangements are carried out by mutual agreement It is a stakeholder and there is no regulatory body to control the contract. In the absence of regulatory bodies, a sense of lawlessness creeps in, which in turn incentive to default.
Rigidity – Both Company A and Company B signed this agreement on December 8, 2014 under a specific agreement. Look at the gold. However, what if their views changed dramatically when they half of the deal? The rigidity of the term agreement is such that they cannot rule out a midterm agreement.
Forward contracts have a number of disadvantages and therefore futures contracts have been designed to reduce the risk of futures contracts.
Highlights of This Article
- 1. Forward contracts establish the basic foundation of futures contracts
- 2. Forwards are OTC derivatives that are not traded on the exchange.
- 3. The forward contract is a private contract, and the conditions vary from contract to contract.
- 4. The structure of the forward contract is fairly simple.
- 5. In futures contracts, the party who agrees to purchase the asset is called the "future buyer".
- 6. In futures contracts, the party who agrees to sell the asset is called the "futures seller".
- 7. Price changes affect both buyers and sellers of futures contracts. 8. Settlement occurs in two ways with futures contracts. Physical reconciliation and cash reconciliation.
- 9. Future contracts reduce the risk of forward contracts
- 10. Forward contracts and futures contracts have the same essence.
