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Journal of Comprehensive Research

Basics of futures and forward contracts discussed from a risk


management perspective
Petros Jecheche
University of Zimbabwe

Abstract

Risk is a characteristic feature of all commodity and capital markets. The last few
decades have witnessed a many-fold increase in the volume of international trade and business
due to the ever growing wave of globalization and liberalization sweeping across the world like a
conflagration. Inter-alia , these strong waves of globalisation and technological advancement
have given rise to some phenomenal growth in both the number of products traded and the sizes
of financial markets in which those products are bought and sold. Amongst the new financial
products introduced in more modern financial markets are derivatives in general and futures and
forward contracts in particular. Among other uses, financial derivatives are used for managing
various forms of risks, especially financial risks. Increased financial risk causes losses to an
otherwise profitable organization. This underlines the importance of risk management to hedge
against uncertainty. Derivatives provide an effective solution to the problem of risk caused by
uncertainty and volatility in underlying assets. This article analyses two types of derivatives
which are futures and forward contracts and how they mitigate against various risks. The
advantages and disadvantages of both types of derivatives are also mentioned together with the
differences between them.

Key words: Derivatives, Futures, Forward contract

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Introduction

Risk is a characteristic feature of all commodity and capital markets. The last few
decades have witnessed a many-fold increase in the volume of international trade and business
due to the ever growing wave of globalization and liberalization sweeping across the world like a
conflagration. As a result, financial markets have experienced rapid variations in interest and
exchange rates, stock market prices; thus, exposing the corporate world to a state of growing
financial risk. Increased financial risk causes losses to an otherwise profitable organisation. This
underlines the importance of risk management to hedge against uncertainty. Derivatives provide
an effective solution to the problem of risk caused by uncertainty and volatility in underlying
assets. Derivatives are risk management tools that help an organisation to effectively transfer
risk. Their value depends upon the underlying assets. The underlying assets may be financial or
non-financial in nature.

Concept of Derivatives

These instruments derive their values from the price and other related variables of the
underlying assets. They do not have worth of their own and derive their values from the claim
they give to their owners to own some other financial assets or securities. A simple example of a
derivative in general is butter, which is a derivative of milk. The price of butter depends upon the
price of milk, which in turn depends upon the demand and supply of milk, ceteris paribus. The
asset underlying a derivative may be a commodity or a financial asset. Derivatives are those
financial instruments that derive their values from the other underlying assets. For example, the
price of gold to be delivered after two months will depend, among so many factors, on the
present and expected price of this commodity.
Financial markets serve six basic functions. These functions are briefly explained below:

Borrowing and Lending - Financial markets permit the transfer of funds (purchasing power)
from one agent to another for either investment or consumption purposes.
Price Determination - Financial markets provide vehicles by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.
Information Aggregation and Coordination - Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from lenders to
borrowers.
Risk Sharing - Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
Liquidity - Financial markets provide the holders of financial assets with a chance to resell or
liquidate these assets.
Efficiency - Financial markets reduce transaction costs and information costs.

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Perspectives on Derivatives

There are three different user perspectives on derivatives:


1. The end-user perspective
End-users include corporations, investment managers, and investors. End-users use
derivatives in order to achieve a specific goal or goals such as managing risk, speculating,
reducing costs, or avoiding regulations.
2. The market-maker perspective
These are traders or intermediaries between different end-users. They buy from end-users
who want to sell and sell to end-users who want to buy. Market-makers charge a commission
for this service.
3. The economic observer
These include regulators or research economists, whose role are to watch and even
sometimes regulate the markets.

Participants in Derivatives Market

1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of
an asset. Majority of the participants in derivatives market belongs to this category.
2. Speculators: They transact futures and options contracts to get extra leverage in betting on
future movements in the price of an asset. They can increase both the potential gains and
potential losses by usage of derivatives in a speculative venture.
3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a discrepancy
between prices of more or less the same assets or competing assets in different markets. If, for
example, they see the futures price of an asset getting out of line with the cash price, they will
take off-setting positions in the two markets to lock in a profit.

Applications of Financial Derivatives

Some of the applications of financial derivatives can be explained as follows:


1. Management of risk: This is the most important function of derivatives. Risk management is
not about the elimination of risk; rather, it is about the management of risk. Financial derivatives
provide a powerful tool for limiting risks that individuals and organizations face in the ordinary
conduct of their businesses. This requires a thorough understanding of the basic principles that
regulate the pricing of financial derivatives. Effective use of derivatives can reduce costs, and it
can increase returns for the organisations.
2. Efficiency in trading: Financial derivatives allow for free trading of risk components and that
leads to improved market efficiency. Traders can use a position in one or more financial
derivatives as a substitute for a position in the underlying instruments. In many instances, traders
find financial derivatives to be a more attractive instrument than the underlying security. This is
mainly because of the greater amount of liquidity in the market offered by derivatives as well as
the lower transaction costs associated with trading a financial derivative as compared to the costs
of trading the underlying instrument in the cash market.
3. Speculation: This is not the only use, and probably not the most important use, of financial
derivatives. Financial derivatives are considered to be risky. If not used properly, these can lead
to financial destruction in an organisation. However, these instruments act as a powerful

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instrument for knowledgeable traders to expose themselves to calculated and well understood
risks in search of a reward, that is, profit.
4. Price discovery: Another important application of derivatives is the price discovery which
means revealing information about future cash market prices through the futures market.
Derivatives markets provide a mechanism by which diverse and scattered opinions of futures are
collected into one readily discernible number which provides a consensus of knowledgeable
thinking.
5 Price stabilization function: Derivatives markets help to keep a stabilising influence on spot
prices by reducing the short-term fluctuations. In other words, derivatives reduce both peaks and
depths and lead to price stabilisation effect in the cash market for underlying asset.

Classification of Derivatives

Broadly speaking, derivatives can be classified in to two categories which are commodity
derivatives and financial derivatives. In case of commodity derivatives, underlying assets can be
commodities like wheat, gold, silver etc., whereas in case of financial derivatives underlying
assets are stocks, currencies, bonds and other interest rates bearing securities etc. Since, the
scope of this case study is limited to only financial derivatives, so we will confine ourselves to
futures and forward contracts only.

Forward Contract

Faure (2006: 21) defines a forward contract as a contract between a buyer and a seller
that obliges the seller to deliver, and the buyer to accept delivery of, an agreed quantity and
quality of an asset at a specified price (now) on a stipulated date in the future.
A forward contract is an agreement between two parties to buy or sell an asset at a
specified point of time in the future. In case of a forward contract, the price which is paid/
received by the parties is decided at the time of entering into contract. It is the simplest form of
derivative contract mostly entered by individuals in day to days life. In a forward contract, the
buyer of the contract agrees to buy a product (which can be a commodity or a currency) at a
fixed price at a specified period in the future. The seller of the contract agrees to deliver the
product in return for the fixed price. If the actual price at the time of the expiration of the forward
contract is greater than the forward price, the buyer of the contract makes a gain equal to the
difference and the seller loses an equivalent amount. If the actual price is lower than the forward
price, the buyer makes a loss and the seller gains. Since forward contracts are between private
parties, however, there is always the possibility that the losing party may default on the
agreement.
In contemporary business world, forward contracts are commonly known as over-the-
counter transactions between two or more parties where both buyer and seller enter into an
agreement for future delivery of specified amount of currency or product at a price agreed today.
They are generally privately negotiated between two parties, not necessarily having standardized
contract size and maturity.
Both parties in the forward contracts are obligated to perform according to the terms and
conditions as negotiated in the contracts even if the parties circumstances have changed. In
other words, once a forward contract has been negotiated, both parties have to wait for the
delivery date to realize the profit or loss on their positions. Nothing happens between the

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contracting date and delivery date. Indeed, a forward contract cannot be resold or marked to
market (where all potential profits and losses are immediately realized), because there is no
secondary market for a forward contract (Solnik and McLeavey, 2004, p.509; Hallwood and
MacDonald, 2000, p.13). The following are the advantages and disadvantages of forward
contracts.

Advantages

- They can be written for any amount and term


- They offer a complete hedge

Disadvantages

- Difficult to find a counterparty (no liquidity)


- Requires tying up capital
- Subject to default risk

Hedging with Forward Contracts: Example

A portfolio manager holds $1million face value 20-year bond, current price is 97%, or
$970,000. Interest rates are 8%, but it is forecast that interest rates will rise to 10% over the next
3 months, causing a large capital loss. D = 9 years. To calculate the possible capital loss:

% PV Bond = -D * [R / (1 + R)]
%P = -9 * (.02 / 1.08) = -.16667 or -16.6667% OR
%P = -9 * (2% / 1.08) = -16.6667%
$970,000 - 16.6667% = $808,333 (or a loss $161,667)
$97 - 16.6667% = $80.8333

The manager can make an off-balance-sheet hedge with a forward contract. He is


worried about interest rates rising and bond prices falling, so would want to take a short position
and sell the bond forward 3 months, and find a buyer to go long at 97 for $1million face value of
T-Bonds in 3 months. The buyer could be someone who is worried about interest rates going
down in the next three months, for example, a life insurance company planning to invest
$1million in three months. Assume that the life insurance does not have the same forecast about
interest rates rising. This is better explained by the following payoff diagram.

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Long
Profit
+ +
F Spot Price Expiration

-- --

Loss Short

Suppose that interest rates do rise and there is a capital loss of 16.67%, or $161,667,
because the P went from 97 to 80.333. However, they can now buy $1million of face value 20-
year bonds in spot market at $80.833 (80.333% of face), or $808,333, and can sell to the forward
contract buyer at 97, or $970,000, for a gain of $161,667 (off-balance-sheet) to exactly offset the
capital loss (on balance sheet). Any other change in interest rates would result in an off-balance-
sheet gain (loss) to exactly offset the loss (gain) on-balance-sheet. Thus naive hedge that
immunizes the financial institution against interest rate risk by using a forward contract perfectly
matched to the asset or transaction being hedged.
Although, technically, the forward contract can be re-negotiated with the original
counterparty, it is usually practically too costly to proceed with. In fact, the counterparty is not
obliged to proceed with the renegotiation. Forward contracts have one obvious limitation: they
lack flexibility, and therefore do not allow companies to react in a timely manner to favourable
market movements. This disadvantage is widely acknowledged and often criticism by authors
and hedgers. However, forward contracts allow the hedging of large volumes of transactions
with extremely low costs.

Payoff on a Forward Contract

A forward contract is privately executed between two parties. The buyer of the
underlying commodity or asset is referred to as the long side whereas the seller is the short side.
The obligation to buy the asset at the agreed price on the specified future date is referred to as the
long position. A long position profits when prices rise. The obligation to sell the asset at the
agreed price on the specified future date is referred to as the short position.
A short position profits when prices go down.
Let T denote the expiration date, K denote the forward price, and PT denote the spot price
at the delivery date. Then
For the long position: the payoff of a forward contract on the delivery date is PT K;
For the short position: the payoff of a forward contract on the delivery date is K PT.

Example

An investor sells 20 million yen forward at a forward price of $0.0090 per yen. At
expiration, the spot price is $0.0083 per yen. The long position and short position payoffs can be
calculated as follows:

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At the expiration date, the long positions payoff is (0.0083 0.009) 20 106 = $14, 000, a
loss of $14,000. The short positions payoff is $14, 000 that is a profit of $14,000
Payoff diagrams show the payoff of a position at expiration. These payoffs do not include
any costs or gains earned when purchasing the assets today. Payoff diagrams are widely used
because they summarize the risk of the position at a glance.
The following graphs show payoff diagrams on a contract forward.

Futures Contract

Futures is a standardized forward contract to buy (long) or sell (short) the underlying
asset at a specified price at a specified future date through a specified exchange. Futures
contracts are traded on exchanges that work as a buyer or seller for the counterparty. The
exchange sets the standardized terms in terms of quality, quantity, price quotation, date and
delivery place (in case of commodity).
Futures contracts being traded on organized exchanges impart liquidity to the transaction.
The clearing house, being the counter party to both sides of a transaction, provides a mechanism
that guarantees the honouring of the contract and ensuring very low level of default (Hirani,
2007).
To give an example of a futures contract, suppose on January 2012, X holds 1000 shares
of ABC Ltd. Current (spot) price of ABC Ltd shares is 115 Rands at Johannesburg Stock
Exchange (JSE). X entertains the fear that the share price of ABC Ltd may fall in next two
months resulting in a substantial loss to him. X decides to enter into futures contract to protect
his position at 115 Rands per share for delivery in March 2012. Each contract in the futures
market is of 100 shares. This is an example of equity futures in which X takes short position on
ABC Ltd.
The futures contract is defined as a legally binding commitment to deliver at a future
date, or take delivery of, a given quantity of a commodity, or a financial instrument at an agreed
price. It is a firm legal agreement between a buyer/seller and an established commodity exchange
in which the trader agrees to deliver or accept delivery, during a designated period, of a specified
amount of a certain commodity. The commodity so traded must adhere to the quality and
delivery conditions prescribed by the commodity exchange on which it is traded. The price is
competitively determined by open outcry on the trading floor or through a computer-based
marketplace.

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Futures trades begin with one basic step: buyers and sellers deposit funds called margin
as a performance bond or good faith deposit with a brokerage firm to ensure that market
participants will meet their contractual obligations. The margin commitment is the same for both
buyers and sellers. There is often a difference, however, between the margins required of hedgers
and the commitments for speculators. This system of initial (or original) margin deposits (usually
a small percentage of the total value of the underlying contract) helps to maintain the financial
integrity of the futures market and provides participants with the leverage that is a major feature
of futures trading. Since a futures contract is not intended for use as a merchandising contract for
transfer of title from seller to buyer, there is no need for the full contract value to change hands.

The clearinghouse

The clearinghouse guarantees contract performance to its members by establishing with


the exchange, minimum margin levels for each market and periodically adjusting them to reflect
current price volatility. The clearinghouse is made up primarily of brokerage firms who serve as
clearing members and must meet certain financial requirements and responsibilities including a
guaranteed deposit at the clearinghouse. The clearinghouse serves as counterparty to every trade
and guarantees the integrity of each contract in the stock markets. The clearinghouse also
oversees the transfer of money among members. At the close of each trading day, each traders
account equity is adjusted (marked-to-the-market) to reflect price movements. If the market has
moved against the traders position, variation margin payments may be required to restore the
traders equity to the required minimum level.
In the traditional exchange, the actual transaction takes place in designated trading rings
(pits) where members meet to make bids and offers to each other by voice and hand signals
(open outcry). Trades are acknowledged by the participants and confirmed in writing or through
an Electronic Order Routing (EOR) system. Since only exchange members can trade on the
floor, customer orders are delivered to floor brokers who execute them according to the
customers instructions. Among the common orders that are filled in the pit are market orders
(executed immediately at the prevailing price in the pit); limit orders (to be executed at the stated
price or better); and stop orders (instructs broker to execute an order at the market if a certain
price is reached).
Once the transaction has taken place, it is entered manually or electronically into Trade
Input Processing System (TIPS) where it is matched, and assigned to a clearing member. Only
clearing members can submit trades for clearing. When the trade is matched and submitted, the
clearinghouse then becomes the buyer to every seller and seller to every buyer. From the moment
the order enters the market, its path is marked clearly in terms of time stamps that record its
progress. This path is called an audit trail that helps to protect the interests of all parties involved
in the trade. The audit trail is one of the key tools of regulation that governs the futures market
and protects the integrity of each trade.

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Examples and Payoff Diagrams of Futures

Payoff Diagram of a trader having long position

The above diagram shows the profits for a long futures position. The trader bought 1 lot
(say 100 futures) when the spot was trading at 2000. The spot went up by 500 points. He made a
profit of $ 50,000 (2500-2000 * 100).

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Payoff Diagram of a trader having short position

The graph shows the profits for a short futures position. The trader short sold futures
when the spot was trading at $2000. The spot went down by 500 points. He made a profit of
$50,000. (If 1 lot = 100 futures).

Hedging Currency Risk using Currency Futures by the Exporter

From the following diagram, if an exporter is likely to receive United States dollars after
three months, there is a risk of US dollar depreciation. To offset this risk, the exporter can hedge
the US dollar receivables by selling US dollars in the futures market.

Short Position

Hedging Currency Risk using Currency Futures by the Importer

An importer who has risk of US dollar appreciation can take a long US dollar position in
the futures market. A long position in the futures market is illustrated on the following payoff
diagram.

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Long Position

Hedging Commodity Risk using Commodity Futures by the Exporter Example

An active exporter in the commodity futures market (e.g. for gold) expects gold price to
fall in the month of May 2012. He already owns the Gold in cash market and wants to hedge
against risk of price fall during his export. On the basis of his view about the gold price
movement, he sells one contract (of 1 kg each) of gold June futures at the price of $780 per 10
gm in April 2012. In May gold June futures actually moves as per his anticipation and decreases
to $760 per 10 gm, which gives him a hedge of $2000 on squaring off the short position of one
contract of gold June futures. This is illustrated on the following payoff diagram.

Short Position in Gold Futures

Hedging Commodity Risk using Commodity Futures by the Importer

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Suppose a jeweler expects gold price to fall in the month of May 2012. He is having
obligation to make jewelry out of Gold and wants to hedge against risk of price fall during his
import. On the basis of his view about the gold price movement, he buys one contract (of 1 kg
each) of gold June futures at the price of $760 per 10 gm in April 2012. In May 2012, gold June
futures actually moves as per his anticipation and increases to $780 per 10 gm, which gives him
a hedge of $2000 on squaring off the long position of one contract of gold June futures.

Long Position in Gold Futures

Some advantages and disadvantages of hedging using futures are summarized below:
Advantages

Liquid and central market. Since futures contracts are traded on a central market, this
increases the liquidity of the futures contracts. There are many market participants and one may
easily buy or sell futures. The problem of double coincidence of wants that could exist in the
forward market is easily solved. A trader who has taken a position in the futures market can
easily make an opposite transaction and close his or her position. Such easy exit is not a feature
of the forward market though.

Leverage. This feature is brought about by the margin system, where a trader takes on a large
position with only a small initial deposit. If the futures contract with a value of $100 000 has an
initial margin of $100 000 then a one percent change in the futures price (i.e. $10 000) would
bring about a 10 percent change relative to the traders initial outlay. This amplification of profit
(or losses) is called leverage. Leverage allows the trader to hedge big amounts with much smaller
outlays.

Position can be easily closed out. Any position taken in the futures market can be easily
closed-out by making an opposite transaction. If a trader had sold 5 dollar futures contracts
expiring in December, then the trader could close out that position by buying 5 December dollars
futures. In hedging, such closing-out of position is done close to the expected physical spot
transaction. Profits or losses from futures would offset losses or profits from the spot transaction.

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Such offsetting may not be perfect though due to the imperfections brought about by the
standardized features of the futures contract.

Convergence. As the futures contract approaches expiration, the futures price and spot price
would tend to converge. On the day of expiration both prices must be equal. Convergence is
brought about by the activities of arbitrageurs who would move in to profit if they observe price
disparity between the futures and the spot; buying in the cheaper market and selling the higher
priced one.

Disadvantages

Legal obligation. The futures contract, just like the forward contract, is a legal obligation.
Being a legal obligation, it can sometimes be a problem to the business community. For example,
if hedging is done through futures for a project that is still in the bidding process, the futures
position can turn into a speculative position in the event the bidding turns out not to be
successful.

Standardized features. As mentioned earlier, since futures contracts have standardized


features with respect to some characteristics like contract size, expiry date etc., perfect hedging
may be impossible. Since over-hedging is also generally not advisable, some part of the spot
transactions will have to go unhedged.

Initial and daily variation margins. This is a unique feature of the futures contract. A trader
who wishes to take a position in the futures market must first pay an initial margin or deposit.
This deposit will be returned when the trader closes his or her position. As mentioned earlier,
futures contracts are marked to market. This mean that the futures position is tracked on a daily
basis. The trader would be required to pay up daily variation margins in the event of daily losses.
The initial and daily variation margins can cause significant cash flow burdens on traders or
hedgers.

Forego favourable movements. In hedging using futures, any losses or profits in the spot
transaction would be offset by profits or losses from the futures transaction.

The actors in futures markets

Hedgers

Futures markets were originally set up to meet the needs of hedgers, namely farmers who
wanted to lock in advance a fixed price for their harvests. Commodity futures are still widely
used by producers and users of commodities for hedging purposes. Suppose that the date of
analysis is January and company XYZ knows that it will have to buy on 25 September (date T)
of the same year one million litres of fuel. In order to hedge against the possible increase in fuel
price between January and the end of September, company XYZ will buy (equivalently, enter a
long position in) futures contracts written on fuel, maturity September and in an amount
corresponding to the necessary quantity of fuel. By doing so, the airline company has locked in

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at the beginning of the year the price FT (0), it will pay in September and has done so with no
cash flow payment at the beginning of the year.

Speculators

While hedgers want to avoid exposure to adverse movements of the price of a commodity
which is part of their manufacturing process in the economy, speculators wish to get exposure to
commodity price movements (i.e., take risks in order to make profits). Using the same example
as before, a bank ABC which has no natural exposure to the price of fuel may decide to take a
position either in a futures contract on fuel or in an option written on fuel and, by doing so, will
create for itself exposure to the fuel price. Obviously, the nature of the position long or short in
either instrument will be determined by the view that bank ABC has on the subsequent
moves of the fuel price. It is in fact betting that this price will go up or will go down and
counting on the corresponding profits the bank will generate. Unsurprisingly, commodities are
becoming increasingly attractive to investors and hedge fund managers who view them as an
alternative asset class allowing one to reduce the overall risk of a financial portfolio and enhance
the return as well. Futures are the obvious instruments because of their liquidity, because of the
low transaction costs on the exchange, because of the absence of credit risk to take positions
reflecting an anticipation of a price rise by purchasing futures or a decline by selling futures.
Most of the liquidity is generated by the combined activity of speculators and hedgers.

Arbitrageurs

Arbitrageurs represent a third important but smaller in size of traders group of


participants in futures markets. An arbitrage is a riskless profit realized by simultaneously
entering into several transactions in two or more markets. Arbitrage opportunities are very
desirable but not easy to uncover and they do not last for long. If a given instrument is
underpriced, buying activity will cause the price to rise up to a value which is viewed by the
market as the fair price and at which there will be no more excess demand.

Price discovery in futures markets

One of the benefits of futures markets is to provide price discovery. The wide variety of
market participants brings the key property of liquidity together with price transparency.
Moreover, the presence of arbitrageurs tends to absorb fairly quickly price abnormalities
between spot and future prices. Futures markets provide highly visible prices against which the
current cash prices of dealers can be compared, any difference being explained by the
transportation costs involved in moving the commodity or the storage costs implied in a cash and
carry relationship. All cash prices, therefore, will somehow reflect the centralization of the
supply and demand for a commodity brought by trading on a futures exchange. The uniformity
and accuracy of current cash prices in reflecting current aggregate supply and demand for a
commodity is socially beneficial because it permits individual consumers to avoid costly
searches in order to pay fair prices.

Regarding futures prices, they are the result of open and competitive trading on the floors
of exchanges and, as such, translate the underlying supply and demand or, rather, their expected

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values at various points in the future. Information about expected future spot prices is valuable
for several reasons. However, the two main reasons are:

In the case of storable commodities, these prices determine the storage decisions of
commercial firms. Higher futures prices signal the need for greater storage and lower futures
prices point to a reduction in current inventory.
Reflecting expectations about future supply and demand. Futures prices trigger decisions
about storage, production and consumption that reallocate the supply and demand for a
commodity over time. Social welfare is increased by the avoidance of disruption in the flow
of goods and services.

Theory of storage, inventory and convenience yield

The theory of storage aims at explaining the differences between spot and futures prices
by analyzing the reasons why agents hold inventories. The models proposed for price
determination of storable commodities have emphasized the importance of the knowledge of
quantities produced and stored for the derivation of testable predictions about price trajectories.
Initiated by famous economists in the 1930s and 1940s, the theory of storage illuminates the
benefit of holding the physical commodity. I inventories have a productive value since they
allow us to meet unexpected demand, avoid the cost of frequent revisions in the production
schedule and eliminate manufacturing disruption. For instance, owning aluminum is a sure way
to avoid disruption in production in the case of a crisis arising in a major producing country of
the raw commodity. In order to represent the advantages attached to the ownership of the
physical good, Kaldor (1939) and Working (1948, 1949) define the notion of convenience yield
as a benefit that accrues to the owner of the physical commodity but not to the holder of a
forward contract.
Brennan and Telser (1958) view the convenience yield as an embedded timing option
attached to the commodity since inventory (e.g., a gas storage facility) allows us to put the
commodity on the market when prices are high and hold it when prices are low. It also avoids the
costs of manufacturing disruption or the nuisance of revisions of the production schedule.
The important implications of theory of storage may be summarized as follows:
 The volatility of a commodity tends to be inversely related to the level of global stocks. In
case of a stock outage, spot prices change dramatically in response to stocks in supply and
demand since inventories are not there to provide a buffering effect.
 The price of a commodity and its volatility are positively correlated since both of them are
negatively related to the inventory level. This is in sharp contrast to the situation of equity
markets where volatility rises sharply when stock prices collapse. This feature was called the
leverage effect by Black (1992) in the case of stocks and is reflected in the prices of
options written on these stocks. Exploiting the dependence between the current price and the
expectation of future prices at a given inventory level, Deaton and Laroque (1992) find that
the conditional variance of prices increases with current price. As long as the current price is
a decreasing function of available inventory, their model implies that price volatility
decreases with higher stocks.
 The volatility of forward prices tends, everything else being equal, to decrease with their
maturity. This property is called the Samuelson effect (Samuelson, 1965) and is explained
by the fact that the arrival of news (e.g., on inventories or reserves) will have an immediate

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impact on short-term forward prices, while long-term contract prices tend to remain
unchanged since production adjustment is likely to take place before the contracts come to
delivery at maturity.
 An inventory-dependent convenience yield has become in the recent literature a popular-state
variable for the explanation of the different shapes of forward curves.

Major Differences between Forward and Futures Contracts

The major differences between the forward contracts and futures contracted are as
follows:

 Nature and size of Contracts: Futures contracts are standardized contracts in that dealings
in such contracts is permissible in standard-size sums, say multiples of 125,000 German
Deutschmark or 12.5 million yen. Apart from standard-size contracts, maturities are also
standardized. In contrast, forward contracts are customized/tailor-made; being so, such
contracts can virtually be of any size or maturity.

 Mode of Trading: In the case of forward contracts, there is a direct link between the firm
and the authorized dealer (normally a bank) both at the time of entering the contract and at
the time of execution. On the other hand, the clearinghouse interposes between the two
parties involved in futures contracts.

 Liquidity: The two positive features of futures contracts, namely their standard-size and
trading at clearinghouse of an organized exchange, provide them relatively more liquidity
vis--vis forward contracts, which are neither standardized nor traded through organized
futures markets. For this reason, the future markets are more liquid than the forward markets.

 Deposits/Margins: while futures contracts require guarantee deposits from the parties, no
such deposits are needed for forward contracts. Besides, the futures contract necessitates
valuation on a daily basis, meaning that gains and losses are noted (the practice is known as
marked-to-market). Valuation results in one of the parties becoming a gainer and the other a
loser. While the loser has to deposit money to cover losses, the winner is entitled to the
withdrawal of excess margin. Such an exercise is conspicuous by its absence in forward
contracts as settlement between the parties concerned is made on the pre-specified date of
maturity.

 Default Risk: As a sequel to the deposit and margin requirements in the case of futures
contracts, default risk is reduced to a marked extent in such contracts compared to forward
contracts.

 Actual Delivery: Forward contracts are normally closed, involving actual delivery of foreign
currency in exchange for home currency/or some other country currency (cross currency
forward contracts). In contrast, very few futures contracts involve actual delivery; buyers and
sellers normally reverse their positions to close the deal. Alternatively, the two parties simply
settle the difference between the contracted price and the actual price with cash on the

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expiration date. This implies that the seller cancels a contract by buying another contract and
the buyer by selling the contract on the date of settlement.

Picking the Right Hedging Tool

Once firms have decided to hedge or manage a specific risk, they have to pick among
competing products to achieve this objective. To make this choice, let us review their costs and
benefits:

Forward contracts provide the most complete risk hedging because they can be designed to a
firms specific needs, but only if the firm knows its future cash flow needs. The customized
design may result in a higher transaction cost for the firm, however, especially if the cash flows
are small, and forward contracts may expose both parties to credit risk.

Futures contracts provide a cheaper alternative to forward contracts, insofar as they are traded
on the exchanges and do not have be customized. They also eliminate credit risk, but they require
margins and cash flows on a daily basis. However, they may not provide complete protection
against risk because they are standardized. Differences between Forward Contracts and Future
Contracts can best be summarized in the form of a table as shown below.
Futures Contracts Forward Contracts
These are traded on exchange-traded markets These are traded on over-the-counter markets
These are standardized contracts These are tailor-made contracts
These are regulated by government through These are self-regulatory because clearing
clearing houses houses are involved
These require marking to market No cash transactions are required until delivery
date
Default risk is normally eliminated since Probability of default is normally high. (The
performance is guaranteed by the clearing buyer may not accept delivery or the seller may
houses not deliver or both)
Despite the above mentioned differences, futures and forwards are very similar financial
derivatives that are normally prices using identical economic principles. Furthermore, one can
look at futures contract and see it as an extension of the forward contract because of the strong
similarities between them.

Summary and Concluding Remarks

Innovations of derivatives have redefined and revolutionized the landscape of financial


industry across the world. Derivatives have earned a well deserved and extremely significant
place among all the financial products. Derivatives are risk management tools that help in
effectively managing risks by various stakeholders either as individuals or corporates.
Derivatives provide an opportunity to transfer risk, from the one who wishes to avoid it; to
another who wishes to accept it.
Derivatives play a very important role in the price discovery process and in the market
function efficiently. Their role in risk management for institutional investors and mutual fund
managers need hardly be overemphasized. This role as a tool for risk management clearly
assumes that derivatives trading do not increase market volatility and risk. Governments and

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authorities planning to promote or facilitate futures and forward contracts trading would need to
pay careful attention to the market restrictions they bring in for the purpose of market
stabilization.

References

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on January 20,2012)
[2] Bodla, B. S. and Jindal, K. (2008), Equity Derivatives in India: Growth Pattern and Trading
Volume Effects, The Icfai Journal of Derivatives Markets, Vol. V, No. 1, pp.62-82.
[3] Growth of Derivatives Market In India, available at:
http://www.valuenotes.com/njain/nj_derivatives_15sep03.asp?ArtCd=33178&Cat=T&Id=10
(accessed on January 20, 2012).
[4] Harish, A. S. (2001) Potential of Derivatives Market in India, The ICFAI Journal of Applied
Finance, Vol. 7, No.5, pp 1-24.
[5] Hirani, Kapil (2007), Understanding Derivatives, available at:
http://kapilhirani.com/News5.php (accessed on January 20,2012)
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January 20,2012)
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(accessed on January 20,2012)
[8] Indian Securities Market, A Review (ISMR)-2008 available at:
http://www.nseindia.com.(accessed on May 27, 2009)
[9] International Options Market Association (IOMA) Derivatives Market Survey 2007,
available at: http://www.world-exchanges.org/ioma (accessed on January 20, 2012).
[10] Introduction to derivatives in India, available at:
http://business.mapsofindia.com/investmentindustry/ introduction-to-derivatives.html (accessed
on January 21, 2012).
[11] Kannan, R. (2008), Onset of Derivatives Trading in Derivatives market, available at:
www.geocities.com/kstability/content/derivatives/first.html (accessed on January 20, 2012).
[12] Kaur, P.(2004), Financial derivatives: Potential of derivative market in India and emerging
derivatives market structure in India available at: www.icwai.org/icwai/knowledgebank
(accessed on December 28, 2011)
[13] Misra Dheeraj and Misra Sangeeta D (2005), Growth of Derivatives in the Indian Stock
Market: Hedging v/s Speculation, The Indian Journal of Economics, Vol. LXXXV, No. 340.
[14] NSE fact book, 2008 Issue, available at: http://www.nseindia.com.(accessed on January 15,
2012)
[15] Reddy, Y. V. and Sebastin, A. (2008), Interaction between Equity and Derivatives Markets
in
India: An Entropy Approach, The Icfai Journal of Derivatives Markets, Vol. V, No.1, pp.18-
32.
[16] Sarkar, A. (2006), Indian Derivatives Markets available at:
www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf (accessed on January
10, 2012).
[17] Srivastava, P. (2004), Financial and legal aspects of derivative trading in. India, available
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