Derivatives In Trading Market: Forwards And Futures

Do you know what is traded the most in the market in any given trading session? The answer to that is derivatives. To be precise, about 85% of the entire volume traded in a day is in derivatives.

Derivatives in financial markets has nothing to do with the dy/dx that maths enthusiasts get excited on seeing, so we need not be afraid. The dictionary meaning of the term derivative is “a financial instrument that derives its value from the underlying”. Now this underlying could be anything, a stock, a bond, a commodity, or the currency exchange rate or even the prevailing interest rate in the market, and that is what makes this financial instrument so impressive. Moreover, derivative traders are not restricted to speculators but also include risk hedgers and arbitrageurs.

Let me explain how people hedge, or mitigate, risks through derivatives with the help of a simple example. Consider a wheat farmer who is in the middle of the harvesting season, and expects his crop to be ready in 3 months’ time. The going price of 1 kg of wheat is Rs 20. Now the farmer is afraid that this price might drop in future, which would cause him to suffer losses. Consider a counterparty, a wholesaler, who is expecting the price to rise, in which event he’ll have to pay more per kilogram of wheat, thus reducing his margins. What these people might do is enter into a contract, typically called a “forward contract”, in which the farmer and the wholesaler agree to trade at a suitable time, in this case 3 months, at a price that has been agreed upon today. In the event that prices fall, the farmer is very happy that he did not lose out on his profits, but if the prices rise, he has to sell his crop at the agreed lower price. However he isn’t too disturbed, because he essentially wanted to reduce his risk, and a prerequisite of reducing risk is reducing profitable opportunities. The same goes for the wholesaler. In this way, both parties are able to “hedge” their risks. Who are arbitrageurs then? To understand that, we first need to know what arbitrage means. It is pretty simple- arbitrage is profit above the risk free rate without taking any risk. To earn a return above the risk free rate offered by banks, you need to be taking risks. If you don’t and you still manage to earn that extra return, then it is called an arbitrage. Now arbitrageurs are those people who try and take advantage of mispricing in financial markets, which makes valuation of derivatives very important. Consider a situation where you have two financial portfolios with the same level of risk and the same cash flows and payoffs in the future, but are selling at different prices today. What will happen? People will buy the cheaper portfolio and sell it at the rate of the more expensive one, because essentially both portfolios are the same.

The arbitrageur happily gets to keep the difference without doing much. This is where we find the principle of pricing a derivative instrument, the “no arbitrage price” principle, which I shall explain later. Let me first tell you what are the 4 broad categories of derivatives. They are forwards, futures, options and swaps. Forwards, futures and swaps fall under the category of “forward commitments”. These contracts take place independent of anything. In a nutshell, they are carried out irrespective at their maturity. Options are “contingent claims”. They are dependent on a specific event happening, such as a fall/rise in the price of a stock or the prevailing interest rate. We are primarily focusing on forwards and futures for now. Forwards and futures are almost the same, with the key difference in them being where they are traded, which I shall explain. Let us first understand the principle behind these instruments.

The farmer-wholesaler example that I’ve used earlier is a good way of understanding it. Let me first tell you about a few key terms which are used. At present, or time0, the forward contract is made between the two parties, which shall mature at time T. The money amount at which the contract is agreed to be settled at maturity is called the “price” of the forward contract, denoted by F. The underlying here is wheat and its price. The farmer, who has agreed to sell the underlying at maturity(time T) at price F, is said to have taken a “short position” in the contract whereas the wholesaler, who has agreed to buy the underlying at time T at price F is said to have taken a “long position”. The party that agrees to go short is called F- and the party that agrees to go long is called F+. The amount exchanged between the two parties at time0, or in other words at the initiation of the contract, is called the “value” of the contract. Now, since both parties take equal risk, this value shall be equal to zero at initiation. Finally the market price of the underlying today at time0 is called S0 and the market price at maturity, time T, is called ST.

What happens at maturity is pretty simple to understand. There are two simple methods of settling the forward contract- one, by physical delivery of the underlying and two, by simply cash settlement of the difference between ST and F. In physical delivery, F+(wholesaler) shall pay the agreed price F to F-(farmer) and receive the underlying(wheat) from him. It does not matter in the forward contract now what ST is. However, which party has benefitted obviously will have to do with whether F+ has gained or F-. If ST, the market price of wheat at maturity, is more than F, the price at which trade between the two parties will take place, it is easy to assertively say who has gained right? Of course its F+. He gets to buy the underlying at a lower price than the market price, and so he has benefitted out of the forward contract. F- on the other hand, is obviously losing as the gain of F+ is the loss of F-. He could have sold the underlying in the market at a higher price, but now he has to be satisfied with the forward price. Reverse happens when ST is lower than F. F- is absolutely emphatic, since he gets to sell at a price higher than that in the market, whereas F+ is now the one who lost. This method would be observed among people who have an existing exposure to the business, or in other words, risk hedgers. Trading the underlying is their primary business; all they want is to reduce their business risks.

What will speculators prefer? Its simple enough, they prefer the other method- cash settlement. These people in contrast to the earlier example of farmers and wholesalers that I’ve used, are not in the agriculture or wheat business. They entered into the contract expecting a particular price change and trying to benefit out of it. All they do to settle the contract is exchange the difference in prices.