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Introducing Derivatives: Forward Contracts
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Ram is a baker and he supplies bread to an entire village. He buys wheat from a local farmer, grinds it and uses that flour to make his bread. He has limited storage facilities and buys just enough wheat, which he stores in large sacks in a small storeroom at the back of his house.
For the last few months Ram has been worried because prices of wheat are expected to rise. Apart from lack of storage facilities he cannot afford to buy wheat in large quantities and buys just enough to last him a fortnight. If the price of wheat rises, he will have to increase the price of his bread as well and he is afraid that villagers may well stop buying his bread.
One day he speaks to his friend from the city about his apprehensions. His friend thinks for a bit and tells him that he has to enter into a long-term contract with the farmer.
“If you are very sure that the price of wheat will rise then what you have to do is make an agreement with the farmer that you will buy a specific quantity of wheat from him for the next six months at a specific price.”
“But what is the price we should agree upon and why should the farmer sell me the wheat at that price?” asked Ram.
“Well,” said the friend, “if you are buying the wheat at Rs 40 a kg and you expect the price to rise to Rs 45, you make a deal with the farmer that you will pay Rs 40 plus a small premium (say, 2 or 3 rupees) and lock it at that price for the next six months.”
“If the price rises as you expect then you will know that your price is safely locked in. The farmer is also assured of a steady customer who guarantees to buy a specific quantity from him. After all he must also be worried about falling sales due to higher prices.”
“What happens if the price does not rise?” asked Ram.
“Well, that is the risk you have to take, my friend,” his friend replied.
Ram mulled over his friend’s advice for two days and then approached the farmer with his proposition, not sure if the latter would agree to it. To his surprise the farmer was more than agreeable to enter into such a contract.
The anecdote above is an example of a forward contract entered into between Ram and the farmer. Ram is trying to reduce the risk of rising prices and what he has done is provide a hedge for that risk. He paid the farmer a small premium for agreeing to lock his purchases at a specified price and thus save him from the costs of inflation.
Forward contracts, such as in the example above, are non-standardised contracts between two parties, who agree to buy/sell any asset or commodity at a future date at a price agreed upon today.
When such forward contracts are traded on an exchange, they are called futures and options and are collectively called derivatives. They are named derivatives because they derive their price from the value of the underlying asset or commodity.
Forward contracts, we have explained in our previous segment, are used to reduce the risk from adverse price movements in financial assets and commodities.
When you lock-in the prices, you are protecting yourself from losses arising from price volatilities in prices of assets.
The most common derivatives contracts (which are traded on the exchanges) are futures, options and swaps. We will deal with futures and options first.
Derivatives are mainly used by three categories of participants in the financial (including currency) and commodities markets. They are hedgers, speculators and arbitrageurs.
Hedgers, as stated earlier, seek to eliminate risk associated with the swing in the prices of an asset.
Speculators try to anticipate the swing in prices of assets in the future and take positions accordingly in the derivatives market.
Arbitrageurs take advantage of the price differentials in the derivatives and futures segment and take offsetting positions in the two segments to make profits.
All three types of participants are responsible for the liquidity of the derivatives segment, pricing and the direction in which futures and options move.
Futures: These are standardised forward contracts. So if you want to reduce the risk in your portfolio of assets – stocks, commodities, precious metals – then instead of searching around for another party to enter into a contract, you just need to buy the ready-made, required futures contract through an exchange.
The following items are standardised in a futures contract:
•The quantity of the underlying asset.
•The quality of the underlying asset.
•The date on which the delivery of underlying asset takes place.
•The pricing of the contract and the minimum price change.
Options: In an options contract, the buyer (of the option) gets the right but not the obligation to buy or sell an asset at a predetermined price at or before a future specified date.
The option holder may decide to exercise the option of buying or selling only if the price moves favourably for him. So though he has the right, he may chose not to do it, so he is not obliged to exercise the option.
The main difference between a futures and options contract lies in the obligation of the purchaser. In a futures contract both parties are obliged to stick to the terms of the contract.
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