Page 228 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 8: Derivatives

3. Time Spreads: There is a relationship between the spot price and the futures price of Notes
contract. The relationship also exists between prices of futures contracts, which are on the
same commodity or instrument but which have different expiry dates. The difference
between the prices of two contracts is known as the ‘time spread’, which is the basis of
futures market.
4. Margins: Since the clearing house undertakes the default risk, to protect itself from this
risk, the clearing house requires the participants to keep margin money, normally ranging
from 5% to 10% of the face value of the contract.

Uses of Futures Contracting

The uses of futures contracting are as follows:
1. Hedging: The classic hedging application would be that of a wheat farmer futures selling
his harvest at a known price in order to eliminate price risk. Conversely, a bread factory
may want to buy wheat futures in order to assist production planning without the risk of
price fluctuations.
2. Price discovery: Price discovery is the use of futures prices to predict spot price that will
prevail in the future. These predictions are useful for production decisions involving the
various commodities.
3. Speculation: If a speculator has information or analysis which forecasts an upturn in a
price, then he can go long on the futures market instead of the cash market, wait for the
price rise, and then take a reversing transaction. The use of futures market here gives
leverage to the speculator.

Forward Contract vs. Future Contract

!
Caution Many people get confused between Forward Contract and Future Contract.
Forward contracts are private bilateral contracts and have well-established commercial
usage. Future contracts are standardised tradable contracts fixed in terms of size, contract
date and all other features. The differences between forward and futures contracts are
given below:
Forward Contracts Future Contracts
1. The contract price is not publicly disclosed 1. The contract price is transparent.
and hence not transparent.
2. The contract is exposed to default risk by 2. The contract has effective safeguards against
counterparty. defaults in the form of clearing corporation
guarantees for trades and daily mark to
market adjustments to the accounts of
trading members based on daily price
change.
3. Each contract is unique in terms of size, 3. The contracts are standardised in terms of
expiration date and asset type/quality. size, expiration date and all other features.
4. The contract is exposed to the problem of 4. There is no liquidity problem in the contract.
liquidity.
5. Settlement of the contract is done by 5. Settlement of the contract is done on cash
delivery of the asset on the expiration date. basis.

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