1

Instruments available for Trading

Forward Contracts

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract

The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are

They are bilateral contracts and hence exposed to counterparty risk.

Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the asset. forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. Forward contracts are very useful in hedging and speculation

Limitations of Forward Markets

Forward markets world-wide are afflicted by several problems: Lack of centralization of trading, liquidity and Counterparty risk In the first two of these, the basic problem is that of too much flexibility and generality. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

Introduction to Futures

The futures contracts are standardized and exchange traded To facilitate liquidity in the futures contracts,

The main standardized items in a futures contract are

Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Delivery center

History of future market

The first financial futures market Merton Miller, the 1990 Nobel laureate had said that "financial futures represent the most significant financial innovation of the last twenty years." " The first exchange that traded financial derivatives was launched in Chicago in the year 1972. Chicago Mercantile Exchange, it was called the International Monetary Market (IMM) and traded currency futures. The brain behind this was a man called Leo Melamed, acknowledged as the "father of financial futures" who was then the Chairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value was counted in millions. By 1990, all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollars.

Distinction between futures and forwards

Futures 1.Trade on an organised exchange

Forwards 1. OTC in nature

2.Standardized contract terms

3.hence more liquid 4. Requires margin payments 5. Follows daily settlement

2. Customised contract terms

3. hence less liquid 4. No margin payment 5. Settlement happens at end of period

Futures Terminology

Spot price: The price at which an asset trades in the spot market Futures price: The price at which the futures contract trades in the futures market.

Contract cycle: The period over which a contract trades. The commodity futures contracts on the NCDEX have one month, two months, three months etc (not more than a year) expiry cycles. Most of the agri commodities futures contracts of NCDEX expire on the 20th day of the delivery month. Thus, a January expiration contract expires on the 20th of January and a February expiration contract ceases to exist for trading after the 20th of February.

Conti.

If 20th happens to be a holiday, the expiry date shall be the immediately preceding trading day of the Exchange, other than a Saturday. New contracts for agri commodities are introduced on the 10th of the month. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist

Conti.

Delivery unit: The amount of asset that has to be delivered under one contract. For instance, the delivery unit for futures on Soybean on the NCDEX is 10 MT. The delivery unit for the Gold futures contract is 1 kg. Basis: Basis is the difference between the futures price and the spot price. There will be a different basis for each delivery month for each contract. In a normal market, futures prices exceed spot prices. Generally, for commodities basis is defined as spot price -futures price. However, for financial assets the formula, future price -spot price, is commonly used.

Conti..

Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Marking-to-market (MTM)

Marking-to-market (MTM): In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking to market.

Maintenance margin

Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative.

If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

Thank you