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DERIVATIVES - FORWARDS & FUTURES

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DISCLAIMER
The training content and delivery of this presentation is confidential, and cannot be
recorded, or copied and distributed to any third party, without the written consent
of Imarticus Learning Pvt. Ltd.
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DERIVATIVES OVERVIEW

• Derivative is a financial contract that derives its value from the values of an underlying.
• Derivative contracts include Forwards, Futures, Options & Swaps.
• The underlying of a derivative contract could be a stock price, bond price, index level, interest
rate, exchange rate, commodities price, weather etc.
• Basic features of a derivative include the underlying, the price specified in the contract,
contract size, settlement date etc.

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TYPES OF DERIVATIVE CONTRACTS

• Futures & Options are Exchange traded derivative contracts - standardized and backed
by a central clearinghouse guaranteeing the settlements
• Largest exchanges by volume of trades are the National Securities Exchange (India), the B3
market exchange (Brazil), and the CME Group exchange (US)
• Forward & Swaps are OTC traded derivative contracts - customized as per the needs of
the counterparties, largely unregulated and less transparent as compared to exchange traded
contracts.
• These contracts are traded by dealers in a market with no central location

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FORWARD CONTRACTS

• OTC traded derivative contract, wherein two parties agree to buy/sell the underlying asset at a
fixed price in future (forward price) on a fixed future date (settlement date).
Long position
• One who commits to buy the physical or financial asset is said to have taken a long position in
the forward contract.
Short position
• One who commits to sell the physical or financial asset is said to have taken a short position in
the forward contract.
• Gains of one party equal the losses of the other party at settlement.

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FEATURES OF FORWARD CONTRACTS

1. OTC traded - negotiated / customized contracts between counterparties

2. Illiquid in nature
3. Participants - corporates / banks / govt. / Hedge funds
4. No party makes any payment to the other party at the time of trade initiation
5. Counterparty is known
6. Counterparty (default) risk

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EXAMPLE OF A FORWARD CONTRACTS

• On 23 Aug 2023, BlackRock advisors (hedge fund) is bullish on apple shares & expects it to be
much higher than $240 after 3 months (23 Nov 2023)
• On 23 Aug 2023, two sigma investments (hedge fund) is bearish on apple shares & expects it to
be much lower than $240 after 3 months (23 Nov 2023)
• Two parties with opposite views (or needs) on an underlying can enter into the forward contract
by taking opposite positions

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FORWARD CONTRACTS

Long position: “Blackrock advisors"

• Taken by the party which expects value of underlying to go up.
• Makes gains if value of underlying at settlement date is higher than forward price.
• Faces losses if value of underlying at settlement date is lower than forward price.

Short position; “Two sigma investments"

• Taken by the party which expects value of underlying to go down.
• Makes gains if value of underlying at settlement date is lower than forward price.
• Faces losses if value of underlying at settlement date is higher than forward price

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TRADE ECONOMICS OF A FORWARD CONTRACT

• Trade date: 23 Aug 2023

• Settlement date: 23 Nov 2023
• Underlying asset: apple shares
• Contract size (quantity): 1,000 shares
• Forward price: $240
• Direction: “Blackrock advisors" (long); "two sigma investments" (short)
• Contract value = 1000 * 240 = $240,000
• Type of settlement: deliverable or cash settled

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FORWARD CONTRACTS

Deliverable contract
• Actual delivery or transfer of asset takes place on the settlement date
"Blackrock advisors" ------- $240,000 --------> "two sigma investments"
<---- 1,000 shares ------
Cash settled contract
• No delivery (or transfer) of the underlying asset happens from seller to the buyer
• Net gain/loss is calculated and that net amount is transferred from the losing party to the party in gain
Scenario 1: on 23 nov 2023, spot price of apple shares is $280

"Blackrock advisors" <------ $40,000 --------- "two sigma investments"

Scenario 2: on 23 nov 2023, spot price of apple shares is $220

"Blackrock advisors" ------- $20,000 ---------> "two sigma investments"

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DERIVATIVES

Forward Payoff
• Long Position : Spot price – Future Price ( Contract Price )

• Short Position : Future Price ( Contract Price ) - Spot price

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FORWARD CONTRACTS

Speculation
• When a position in the market is taken with the intention to make profits

Example:
• A tile making company expects crude oil prices to go down
• Wants to make profits based on their expectation of decrease in crude oil prices
• Takes a short position in the forward contract of crude oil with a counterparty
• Would opt for cash settlement

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FORWARD CONTRACTS

Hedging
• When a position in the market is taken with the intention to reduce of eliminate the existing risk

Example:
• Infosys would receive $10m from the us client after 6 months
• Infosys is facing risk (uncertainty) about USD/INR exchange rate after 6 months
• To hedge against this risk – they can enter into a currency forward contract to freeze an exchange rate
(let’s say USD/INR = 75 after 6 months) with a counterparty
• Would opt for delivery settlement

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USES OF DERIVATIVE CONTRACTS

• Allow speculation and hedging

• Allow leverage - low cash requirement to enter into a trade of large contract value
• May provide more liquidity than underlying asset
• Allow to gain from expected decrease in value
• Price discovery – give an idea regarding the expected future price

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FUTURES CONTRACTS

• Future contracts are quite similar to a forward contract, but these are standardized, and
exchange traded.
• Exchange traded derivative contract between the two parties, to buy/sell the underlying asset
at a fixed price in future (future price) on a fixed future date (settlement date).

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FEATURES OF A FUTURES CONTRACT

1. Trade on exchange (active secondary market) - More liquid than forward contracts which
trade in OTC markets
2. Standardized contracts (rather than negotiated / customized between counterparties)
3. More transparency as they are subject to greater regulation than forward contracts
4. Backed by a central clearinghouse - Guaranteed settlement - Require daily settlement of
gains and losses, so that counterparty credit risk is minimized
5. Margin requirements which act as collateral (provides protection for clearinghouse)
6. Counterparty is unknown

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FUTURES VS FORWARDS

Futures vs. Forward

Futures Forward
• Buying/Selling based on Order • Buying/Selling based on Quote
• Regulated • Non-regulated
• No Counterparty Risk • Counterparty Risk
• Settlement guaranteed • Settlement not guaranteed
• Highly Liquid • Low Liquid
• Standardized • Customized
• Counterparty is unknown • Counterparty is known

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FUTURES TRADING

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MARGIN REQUIREMENTS IN FUTURES CONTRACT

Futures margin requirements are set by the exchange

Initial margin
• Amount of cash (collateral) both the parties (long & short) need to deposit in the futures
account at the time of entering into a futures contract
Maintenance margin
• Minimum amount of margin that must be maintained in the futures account
• If margin balance falls below the maintenance margin, then margin call gets triggered - party
needs to deposit additional funds to bring the margin balance back up to the initial margin

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MARKING TO MARKET PROCESS IN FUTURES

Marking to market (mark to market) (MTM)

• Process of adjusting the margin balance based on changes in the futures price of the
underlying is known as MTM
• If the futures price of the underlying increases, then the margin balance of the long position
increases and the margin balance of the short position decreases
• If the futures price of the underlying decreases, then the margin balance of the long position
decreases and the margin balance of the short position increases

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BUSINESS & SOCIETY

• Futures contract on co. Alpha shares

• Let’s assume:
• Initial margin = 35%
• Maintenance margin = 20%;
• Lot size = 80 shares

• On 23 Aug 2023, party "x" enters into a long position in futures contracts of co. Alpha shares, that
expire on 30 Sep 2023.

• Futures price at the time of entering into the contract = 7600 per share

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TRADE ECONOMICS OF A FUTURES CONTRACT

• Trade date: 23 Aug 2023

• Settlement date: 30 Sep 2023
• Direction: "x" (long)
• Lot size: 80 shares
• No of lots: 1 lot
• Futures price: 7600
• Total contract value: lot size * no of lots * futures price = 80*1*7600 = 6,08,000
• Initial margin amount: 35%*6,08,000 = 2,12,800
• Maintenance margin amount: 20%*6,08,000 = 1,21,600

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EXAMPLE OF A FUTURES CONTRACT

• Now, let’s assume, on 24 Aug 2023, end of the trading day futures price of co. Alpha shares,
that expire on 30 Sep 2023, is 7,200

• Margin balance of party “x”, which took long position would decline by (400 * 80 = 32,000), i.e.
Now it becomes (= 2,12,800 - 32,000 = 1,80,800)

• Similarly margin balance would be adjusted everyday.

• Now, let’s assume at the end of a trading day, if margin balance of party “x” got reduced to
1,00,000, then party “x” needs to deposit additional funds to bring its margin balance back up
to the initial margin.

• So, in this case, party “x” would need to deposit 1,12,000 (= 2,12,800 - 1,00,000)

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