Page 41 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes
Example: In the month of August, a rice mill agrees to buy one tonne of paddy from a
farmer in the following February at a price of ` 3000. This is a forward contract. Note that the
farmer will receive ` 3000 in February irrespective of whether the market price in February is
` 2000 or ` 4000.
Legal definitions of forward contracts
Under the Forward Contracts (Regulation) Act, 1952 forward contracts are classified into:

Hedge contracts: These are freely transferable and do not specify any particular lot,
consignment or variety for delivery. Delivery in such contracts (which may be of any of
the approved deliverable varieties) is unnecessary except in a residual or optional sense,
Hedge contracts are subject to the regulatory provisions of the forward Contracts
(Regulation) Act.

Transferable Specific Delivery (TSD) contracts: These are contracts, which, though freely
transferable from one party to another, are concerned with a specific and predetermined
consignment or variety of the commodity. Delivery, of the agreed variety, is mandatory.
Such contracts are normally subject to the regulatory provisions of the Act but may be
exempted from regulation (in specified cases) by the Central Government.
Non-transferable Specific Delivery (NTSD) contracts: These are concerned with a specific
variety or consignment and are not transferable at all. Contract terms are highly specific.
Delivery is mandatory. NTSD contract are normally exempt from the regulatory provisions
of the Act, but may be brought under regulation by the Central Government, wherever
felt necessary (in practice, NTSD contracts in most items have been brought under
regulation).

As will be obvious, the legal definition of hedge contracts corresponds to the analytical definition
of futures contracts, while the latter two categories are not ‘futures’ contracts or hedge contracts
does not specify precisely which variety or consignment will actually be delivered because the
limits are set by the rules of the exchange on which types can or cannot be delivered. Where a
variety superior or inferior to the basis variety is tendered for delivery, prices are adjusted by
means of premia or discounts, as they may be, these are commonly known as tendering
differences.

!
Caution Every futures contract is a forward contract, not every forward contract is a future
contract.

3.1.2 Features of a Forward Contract

The salient features of forward contracts are:
1. Forward contracts are bilateral contracts, and hence, they are exposed to counter party
risk. There is risk of non-performance of obligation either of the parties, so these are
riskier than to futures contracts.

Example: Trade takes place between party A and party B for X kgs. of a commodity.
The pre-specified delivery price is ` 100 per kg., and the maturity is 1 month. After 1
month, the commodity is trading at ` 120 per kg. If A was the buyer, he would gain ` 20
and B suffer have a loss of ` 20. In case B defaults (refuses to sell at ` 100 per kg. as

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