Financial Derivatives, Forward and Future

Financial Derivatives: Under financial derivatives, the discussion would cover stock futures, stock options, index futures and index options along with their pricing techniques.

1. Forward Contract: Consider a Punjab farmer who grows wheat and has to sell it at a profit. The simplest and the traditional way for him is to harvest the crop in March or April and sell in the spot market then. However, in this way the farmer is exposing himself to risk of a downward movement in the price of wheat which may occur by the time the crop is ready for sale.

In order to avoid this risk, one way could be that the farmer may sell his crop at an agreed upon rate now with a promise to deliver the asset, i.e., crop at a pre-determined date in future.

This will at least ensure to the farmer the input cost and a reasonable profit.

Thus, the farmer would sell wheat forward to secure himself against a possible loss in future. It is true that by this way he is also foreclosing upon him the possibility of a bumper profit in the event of wheat prices going up steeply. But then, more important is that the farmer has played safe and insured himself against any eventuality of closing down his source of livelihood altogether. The transaction which the farmer has entered into is called a forward transaction and the contract which covers such a transaction is called a forward contract.

A forward contract is an agreement between a buyer and a seller obligating the seller to deliver a specified asset of specified quality and quantity to the buyer on a specified date at a specified place and the buyer, in turn, is obligated to pay to the seller a pre-negotiated price in exchange of the delivery.

Financial Derivatives, Forward and Future

2. Future Contract: A futures contract is an agreement between two parties that commits one party to buy an underlying financial instrument (bond, stock or currency) or commodity (gold, soybean or natural gas) and one party to sell a financial instrument or commodity at a specific price at a future date.

The agreement is completed at a specified expiration date by physical delivery or cash settlement or offset prior to the expiration date. In order to initiate a trade in futures contracts, the buyer and seller must put up “good faith money” in a margin account. Regulators, commodity exchanges and brokers doing business on commodity exchanges determine margin levels.

Financial Derivatives, Forward and Future

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