Page 37 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes
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 promised), party A is exposed
to counter-party risk i.e. risk of foregoing the deserving gain of ` 20 per kg. In case of future
contracts, the stock/commodity exchange (through a clearing house) gives a guarantee even if
the counter party defaults. This is done through a system of daily margins.
2. Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type, quality, etc.
3. A contract has to be settled in delivery or cash on expiry date.
4. The contract price is generally not available in the public domain.

5. If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty,
which often results in high prices being charged.
Forward contracts can be worth less than zero. If I have the long position on an expiring forward
contract for ` 100 and the price is ` 90, this will cost me ` 10. The fact that certain options can go
negative mandates margin requirements, where the owner must put money in escrow to prove
they can cover the losses.

Notes Forward as a Zero-sum-Game
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 illustration.

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.

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