Page 55 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes into an offsetting contract or selling the contract on the exchange namely, no delivery.
This is the primary distinguishing feature of the forwards as given by the CFTC. Forwards
also typically have been described by reference to the commercial natures of the
counterparties which have the capacity to make or take delivery.
2. A forward contract is entered into for commercial purposes related to the business of the
party wanting to enter into the forward. The producer, processor, fabricator, refiner, or
merchandiser may want to purchase or sell a commodity for deferred shipment or delivery
as part of the conduct of its business. In contrast, futures contracts are undertaken principally
to assume or shift price risk without transferring the underlying commodity.

3. A forward contract is privately and individually negotiated between two principals. A
futures contract is an exchange-traded contract, with standardised provisions including:
commodity units; margin requirements related to price movements; clearing organisations
that guarantee counterparty performance; open and competitive trading on exchanges;
and public dissemination of price.
4. A forward contract generally is not assignable without the consent of the contracting
parties and does not provide for an exchange-style offset. A futures contract is fungible,
because of its standardised form, and hence can be traded on an exchange.
5. With a forward contract, no clearing house, no settlement system, and — according to
CFTC—no variation margining is involved. All of these features apply to a futures contract.

Caselet Hedging-Long Security, Sell Futures

ake the case of an investor who holds the shares of a company and gets uncomfortable
with market movements in the short run. He sees the value of his security falling
Tfrom ` 450 to ` 390. In the absence of stock futures, he would either suffer the
discomfort of a price fall or sell the security in anticipation of a market upheaval. With
security futures he can minimise his price risk. All he need do is enter into an offsetting
stock futures position, in this case, take on a short futures position. Assume that the spot
price of the security he holds is ` 390. Two-month futures cost him ` 402. For this he pays
an initial margin. Now if the price of the security falls any further, he will suffer losses on
the security he holds. However, the losses he suffers on the security will be offset by the
profits he makes on his short futures position. Take for instance that the price of his
security falls to ` 350. The fall in the price of the security will result in a fall in the price of
futures. Futures will now trade at a price lower than the price at which he entered into a
short futures position. Hence his short futures position will start making profits. The loss
of ` 40 incurred on the security he holds, will be made up by the profits on his short futures
position.

Source: Bishnupriya M., Sathya S. D. “Financial Derivatives”. Excel Books (2007).
Futures contracts are standardised contracts that are traded on organised futures markets. Because
contract sizes and maturities are standardised, all participants in the market are familiar with
the types of contracts available, and trading is facilitated. Forward contracts, on the other hand,
are private deals between two individuals who can sign any type of contract they agree on.
The organisation of futures trading with a clearing house reduces the default risks of trading.
The exchange members, in effect, guarantee both sides of a contract. In contrast, a forward
contract is a private deal between two parties and is subject to the risk that either side may
default on the terms of the agreement.

50 LOVELY PROFESSIONAL UNIVERSITY