Page 43 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes
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Caution These contracts are not standardised; each one is usually being customised to its
owner’s specifications.

Did u know? In essence, a forward transaction typically involves a contract, most often
with a bank, under which both the buyer and holder of the contract and the seller (or
writer) of the contract are obligated to execute a transaction at a specified price on a pre-
specified date. This means that the seller is ‘obligated’ to deliver a specified asset to the
buyer on a specified date in the future, and the buyer is ‘obligated’ to pay the seller a
specified price upon delivery. This specified price is known as the ‘forward price’.
At the inception of the contract, the contract value is zero in the eyes of both the buyer and the
seller. But the value of the underlying asset changes throughout the life of the contract, and as
such there is a change in the value of the contract vis-à-vis the buyer and the seller. The value
changes for the benefit of one party and at the expense of the other. This property of the forward
contract makes it a “zero-sum-game” for the buyer and seller.
This zero-sum characteristic can be better understood through an example.

Example: Consider a forward contract written on a specified asset with a forward
exercise price for the asset of ` 50. If there is a sudden upswing in the asset’s price to ` 55, how
will it affect both parties’ views of the value of the contract? The seller of the forward contract
views the contract to have lost value because the price at which he is obligated to sell the asset
(` 50) is lesser than that which could be received in the spot market (` 55). On the other hand; the
buyer of the contract views the contact as having gained value. As the spot price of the asset
increases, there is a better chance that the forward exercise price will be below the prevailing
spot market price in the future when the forward contract matures and the asset is delivered. If
this market condition prevails until the specified delivery date, the seller’s loss equals the
buyer’s gain.

3.1.3 Classification of Forward Contracts

Forward contracts in India are broadly governed by the Forward Contracts (Regulation) Act,
1952. According to this Act, forward contracts are of the following three major categories.

1. Hedge Contracts: These are freely transferable contracts which do not require specification
of a particular lot size, quality or delivery standards for the underlying assets. Most of
these are necessary to be settled through delivery of underlying assets.
2. Transferable Specific Delivery Forward Contracts: Apart from being freely transferable
between parties concerned, these forward contracts refer to a specific and predetermined
lot size and variety of the underlying asset. It is compulsory for delivery of the underlying
assets to take place at expiration of contract.

3. Non-transferable Specific Delivery Forward Contracts: These contracts are normally
exempted from the provision of regulation under Forward Contract Act, 1952 but the
Central Government reserves the right to bring them back under the Act when it feels
necessary. These are contracts which cannot be transferred to another party. The contracts,
the consignment lot size, and quality of underlying asset are required to be settled at
expiration through delivery of the assets.

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