FD – Unit – 2

1. Forward Contracts
o A forward contract is a customizable derivative contract between two parties to buy or sell an
asset at a specified price on a future date.
o Forward contracts can be tailored to a specific commodity, amount, and delivery date.
o Forward contracts do not trade on a centralized exchange and are considered over-the-counter
(OTC) instruments.
o For example, forward contracts can help producers and users of agricultural products hedge
against a change in the price of an underlying asset or commodity.
o Often, they are used in the commodity or foreign exchange market to let companies hedge
against future price changes.
o The two parties to the contract agree to complete a specified transaction at a set price on a set
date.

2. Features of Forward Contracts

o A forward contract does not trade on any centralized exchange. It is also not regulated by a
third-party authority.
o Forward contracts are bilateral hence are prone to counterparty risks.
o A forward contract is a tailor-made contract, with the terms and conditions that both the parties
agree.
o It contains details like the expiration date, asset type, and quantity, etc.
o Generally, the general public is not aware of the price of a futures contract.
o The contract price is not available in the public domain.

3. How Forward Contracts Work

o Forward contracts exist mostly to give large businesses a way to hedge against changing
market values for commodities and currencies.
o Imagine a company that refines oil into gasoline and other products. The success of the
company will depend largely on the price of oil. If oil is cheap, the company can make its
products at a lower cost and secure higher profits. If the oil price rises, the company will need
to accept less profit or raise its prices.
o Because commodity prices can be volatile, it can be hard for a business to predict future prices
and make long-term production decisions. Forward contracts let these businesses lock in their
raw-material prices ahead of time.

4. What Advantages Do Futures Contracts Have Over Forward Contracts?

Details of futures contracts are made public because they are traded on exchanges, unlike forwards,
which are negotiated privately between counterparties. Because futures are regulated, they come
with less counterparty risk that forward contracts. These contracts are also standardized, which
means, they come with a set terms and expiry date. Forwards, on the other hand, are customized
to the needs of the parties involved.

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5. Classifications of Forward Contracts

There are a few different types of forward contracts for investors to be aware of.

o Closed outright: This is the standard type of forward. Two parties agree to complete a
transaction at a set price on a specific date.

o Flexible: With a flexible forward, the two parties can settle the contract prior to the date set in
the contract. The settlement can happen in one transaction or over several payments.

o Long-dated: Most forwards mature in a short amount of time, such as three months. Long-date
forwards can last much longer, sometimes a year or more.

o Non-deliverable: These forwards don’t involve the physical exchange of funds. Instead, the
two parties simply exchange cash to settle the contract, with the amount paid depending on the
contracted price and the market price of the underlying commodity or currency.

6. Pros and Cons of Forward Contracts

o Let’s companies hedge against changing commodity prices: Companies that rely on
commodities as raw materials can better plan for the future by locking in prices ahead of time.

o Flexible and customizable: Unlike futures, forward contracts can be customized when it comes
to things such as the settlement dates or the amounts of commodities exchanged.

o Great way to hedge against the fluctuations of the market.

o Lowers international trade-related risks.

o Riskier than futures contracts: Because forwards are traded over-the-counter, there’s more risk
that one party won’t complete the transaction, and the contract can be harder to sell before the
settlement date.

o Can be highly complicated: Forwards are derivatives that have a lot of moving parts, so they
can be complicated and difficult to understand for beginners.

o Very little public information about the market cap due to lack of regularization.

o Prone to counterparty risks such as non-payment due to defaults.

o In a highly volatile market, forward contracts may hurt a company that miscalculated the
movement of the prices.

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7. Difference Between Forward & Futures

o Regulation in Forward Vs. Future Contracts

A futures contract operates under regulations from the mandated authorities while forward
contracts have no exchange regulations.

o Standardization
A future contract is usually standardized while a forward contract is not standardized. That means
that with a future contract, you can look at the historical trends of the market and identify trading
opportunities. For the non-standardized contracts, the contract is usually unique to the agreed upon
terms.

o Exchanges
A future contract trades on exchanges and is more liquid. This means that a speculator can trade
futures markets by employing large contract sizes and not worry about meeting someone on the
other side of the trade.

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In a forward contract, on the other hand, parties privately determine the terms of the contract. An
exchange is, therefore, not required for them to execute a transaction. That will mean no price
transparency outside the parties.

o Upfront Risks
Futures contracts have upfront costs. This is dependent on the brokerage firm as well as the
exchange you trade in which means you must have some cash in your account.
For the forward contracts, there are no upfront costs. All the parties need in this case is agreeing
on the price with no financial obligations.

o Settlement of Contracts
The settlement of deals in forward contracts occurs at the end of the signed pact. On the other
hand, futures contracts are usually marked-to-market daily. This means that all the daily changes
are settled by the day until the contract comes to an end.
Also, the settlement of forward contracts happens on the agreed date while settlements for futures
contracts can happen over a range of dates.

8. Financial Future Contracts

o Futures are derivative financial contracts that obligate the parties to transact an asset at a
predetermined future date and price. Here, the buyer must purchase or the seller must sell
the underlying asset at the set price, regardless of the current market price at the expiration
date.
o Underlying assets include physical commodities or other financial instruments. Futures
contracts detail the quantity of the underlying asset and are standardized to facilitate trading
on a futures exchange. Futures can be used for hedging or trade speculation.
o "Futures contract" and "futures" refer to the same thing. For example, you might hear
somebody say they bought oil futures, which means the same thing as an oil futures contract.
o A futures contract gets its name from the fact that the buyer and seller of the contract are
agreeing to a price today for some asset or security that is to be delivered in the future.

9. Examples of Future Contracts

Futures contracts are used by two categories of market participants: hedgers and speculators.
Producers or purchasers of an underlying asset hedge or guarantee the price at which the
commodity is sold or purchased, while portfolio managers and traders may also make a bet on the
price movements of an underlying asset using futures.

An oil producer needs to sell its oil. They may use futures contracts to do it. This way they can
lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract
expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to
plan ahead and always have oil coming in each month, they too may use futures contracts. This
way they know in advance the price they will pay for oil (the futures contract price) and they know
they will be taking delivery of the oil once the contract expires.

Futures are available on many different types of assets. There are futures contracts on stock
exchange indexes, commodities, and currencies.
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10.Types of Financial Future Contracts

o Foreign Currency Futures:

Currency futures are contracts on the exchange price of currencies. The parties to the contract fix
an exchange rate for the exchange of two currencies on a specific date in the future. Such contracts
help to nullify the exchange rate risk that may arise in the case of international trade over a period
of time. Usually, the parties close these contracts before the date of expiry as per their need.

o Interest rate futures

Interest rate futures are a sort of hedging against the risk that may arise due to fluctuations in the
rate of interest of a financial instrument at a future date. Uncertain interest rates may create an
extra interest burden on companies and result in heavy losses. We usually use interest rates futures
with a money market or bond market instruments such as government bonds, bills, etc. They are
the underlying assets for such futures contracts.

Whenever there is a rise in the rate of interest, the prices of the bonds fall. Similarly, bond prices
rise with a fall in the rate of interest. An investor can sell interest rates futures contract when the
interest rates rise and the price of his bonds fall. They can then repurchase the bonds at a lower
rate from the market. This will help them to offset some of the losses they will suffer by a fall in
the price of the bonds.

o Stock Index Futures

Stock index futures, also referred to as equity index futures or just index futures, are futures
contracts based on a stock index. Futures contracts are an agreement to buy or sell the value of the
underlying asset at a specific price on a specific date. In this case, the underlying asset is tied to a
stock index. Index futures, however, are not delivered at the expiration date. They are settled in
cash on a daily basis, which means that investors and traders pay or collect the difference in value
daily.

o Bond index Futures

Bond futures are contracts that entitle the contract holder to purchase a bond on a specified date at
a price determined today.
A bond futures contract trades on a futures exchange and is bought and sold through a brokerage
firm that offers futures trading.
Bond futures are used by speculators to bet on the price of a bond or by hedgers to protect bond
holdings
Bond futures indirectly are used to trade or hedge interest rate moves.
Bond futures are contractual agreements where the asset to be delivered is a government or
Treasury bond. Bond futures are standardized by the futures exchanges and are considered among
the most liquid financial products. A liquid market means that there are plenty of buyers and
sellers, allowing for the free flow of trades without delays.2
The bond futures contract is used for hedging, speculating, or arbitrage purposes

o Cost of living index Futures

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11.Traders in Future Markets

There are 2 major types of investors in futures contracts – speculator and hedgers. Speculators
account for almost 97% of the total futures trading.

o Hedger: Hedgers are producers of commodities such as mining company or a farmer. These
entities trade in futures contracts to shield themselves from price volatility in the future. For
instance, a cocoa farmer may feel that the prices of the commodity may fall by the harvest
time. To hedge against perceived losses, he can sell a futures contract at the present rates, and
then exit the trade by buying cocoa at lower prices during the harvest time. In essence, he sold
the cocoa first at higher rates, and then when the product was actually harvested, he purchased
it at lower rates, profiting from the difference between selling and buying prices. Pension fund
companies, insurance companies and banks are some of the other hedgers.

o Speculator: This group includes private investors and independent floor traders. These entities
concentrate on making profits by buying a contract that is expected to rise in future and selling
a contract expected to fall in future. This type of investors trade futures contracts similar to
shares and stocks by purchasing at lower rates and selling when prices climb.

o Arbitrageurs: Arbitrage involves the simultaneous buying and selling of an asset in order to
profit from small differences in price. Arbitrage is possible because of inefficiencies in the
market. An arbitrageur is a type of investor who attempts to profit from market inefficiencies.
These inefficiencies can relate to any aspect of the markets, whether it is price, dividends, or
regulation. The most common form of arbitrage is price. Arbitrageurs tend to be experienced
investors, and need to be detail-oriented and comfortable with risk.
Arbitrageurs most commonly benefit from price discrepancies between stocks or other assets
listed on multiple exchanges.
In such a scenario, the arbitrageur might buy the issue on one exchange and short sell it on the
second exchange, where the price is higher.

12.Meaning of Future Pricing

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13.Functions of Future Market

o Hedging
o Price discovery
o Financing function
o Liquidity function
o Price stability function
o Disseminating information