Futurs and Options - PART 1

There is a whole world of financial securities other than stocks and bonds. One of such securities is Derivatives, which are financial instruments whose “value” are derived from the value of the underlying. Hence, they are called “derivative” i.e. derive from something else. The underlying on which derivative is based could be:
Asset: e.g. stocks, bonds, mortgages, real estate, commodities, real estate properties.
Index: e.g. stock market indices, Consumer Price Index, Foreign Currencies and interest rates
Other items: e.g. Weather (yes- you will derivatives written on rain!!)

For example – a derivative on a stock derive its value from the value of underlying stock! There are three main types of derivatives: Forwards (similar to Futures), Options and Swaps. Futures are very similar to Forwards except for the fact that Futures are traded on exchange while Forwards are traded over the counter (OTC). In this article I am going to concentrate only on Futures (F) and Options (O). So whenever you come across any article on F&O or any reference to it, remember it means Futures & Options.

Why do we need derivatives?

Derivatives are used to either
1. Hedge the risk i.e. lessen the risk which may arise due to changes in the value of underlying – This is known as “hedging”.
2. Increase the profit arising from the changes in the value of underlying in the direction they expect or guess – This is known as “speculation”.

Hence, there should not be any misconception that derivatives or F&O are used only by speculators to make money. These are extremely useful financial instruments which are used by corporate or individuals to mitigate their risk. But unfortunately same instruments can be used by speculators to make money. One simple example is nuclear energy. People can use it to generate 1000s of MW of energy for peaceful purpose whereas others can use the same nuclear energy to make nuclear bombs for mass destruction. Is it fair to blame nuclear energy for this? We cannot. So if you want to blame someone, blame speculators and not derivatives.

How hedging works?
Assuming that our readers are not speculators, I will focus on how futures or future contracts are used for hedging. Suppose I am a petroleum distributor whose job is to sell petroleum products such as Petrol and Diesel in the market while you are an airline owner, say Mr. Vijay Mallya  I am in the business of selling petroleum while you are a net buyer of petroleum products. I will be concerned with drop in prices of petroleum because that would hurt my revenues and profit margin. This is because I am selling petrol, right? While you, an airline owner, would be concerned with any increase in prices of petroleum because it would increase your costs. Thus we two have a common concern – uncertainty in the price of petroleum products.

To reduce our risk and buy a peace of mind, we will sit together and fix a price of petroleum to be sold in the future. Thus, I have reduced the risk of prices going down while you have reduced the risk of prices going up. This is called hedging.

F&O Market in the US and India
You would be surprised to know that the volume of F&O trade is much more than volume of stocks trade in the world. This shows the sheer popularity of F&O instruments among investors. In the US futures are traded primarily on CME (Chicago Mercantile Exchange), which is the largest financial derivatives exchange in the United States and most diversified in the world. CME’s currency market is the world’s largest regulated marketplace for foreign exchange (FX) trading. In the US Options are traded on CBOE (Chicago Board Options Exchange).

In India Futures and Options are traded on both BSE and NSE. The market hasn’t developed to its potential yet due to lot of political and regulatory issues. Hence, the size of derivatives market is much smaller in India as compared to those in developed worlds.

Forward Contract vs. Futures Contract

While futures and forwards are both contracts to deliver an asset at a fixed (pre-arranged) price on a future date, they are different in following respects:

Features	Forward Contracts	Future Contracts
Operational Mechanism	Traded Over The Counter (OTC) and NOT on exchange	Traded on exchange
Contract Specifications	Extremely customized; differs from trade to trade	Standardized contracts
Counterparty Risk	High because of default risk	Less risky because only margins are settled
Liquidation Profile	Poor liquidity due to customized products	Very high because contracts are customized
Price Discovery	Poor; as markets are fragmented	Better because market is on a common platform of an exchange

Source: Derivatives India

Futures
 

Let us now focus only on Future contracts, which are an agreement between two parties to buy or sell an asset (underlying) at a given point of time in the future. They are standardized contract i.e. an agreement, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality at a certain date in the future, at a price (the futures price) determined by the parties involved. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day\'s trading session on the exchange is called the settlement price for that day of business on the exchange.

I have assumed that no cash settlement was done between the two parties. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract. Also both parties of a futures contract must fulfill the contract on the settlement date – it is legally binding. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. Money lost and gained by each party on a futures contract are equal and opposite. In other words, a future trading is a zero-sum game.

Future prices are not definitive statements of prices in the future. In fact they are not even necessarily predictions of the future. But they are important pieces of information about the current state of a market, and futures contracts are powerful tools for managing risks.

Terminology
I will discuss a few terms that are often associated with derivatives. They are following:

Underlying: It is the asset or index on which a derivative is written. For example a futures index has the underlying as an index.

Delivery Date: This is the date at which the underlying will be delivered by the seller to the buyer. It is also known as final settlement date.

Future Price:  This is the agreed upon or prearranged price determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. Simply, the price prearranged between the seller and the buyer.

Standardization
 

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
• The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the notional (fictional) amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies the quality of the underlying goods
• The delivery month
• The last trading date

Types of Futures Contracts
 

There are a large number of futures contracts trading on future exchanges around the world. I have highlighted characteristics of each major group of contracts:

Agricultural Commodities
 

This category is the oldest group of futures contracts. It includes all widely used grains such as wheat, soybeans, corn and rice. Additionally, futures are traded actively on Cocoa, coffee, orange juice, sugar, cotton, wool, wood, and cattle.

Equities
 

Futures are actively traded on individual stocks as well as index. These are generally cash settled i.e. no exchange of stocks happens between the contracted parties; only the party which loose (prices of stocks move against them) gives money to the party which wins. Stock index futures have been quite popular in the market. These contracts are generally indices of a combination of stocks.

Natural Resources
 

Futures contracts are actively traded on metals and natural resources. Metals include gold, silver, copper, aluminum etc while natural resources include crude.

Foreign Currencies
 

There is a very large market of futures contract traded on foreign currencies because a large number of multinational companies are concerned about the volatility (changes) in the value of currencies of different countries where they sell or buy their products. Most popular currencies are Japanese Yen (¥), British Pound (£), Euro (€) and Swiss Franc (CHF).

Disadvantages of futures or derivatives
 

Remember, I gave you an example of Petroleum distributor (me) and airline owner (you). I will be concerned with the drop in prices of petro products while you will be worried about a rise in the prices. Let’s say the current price of petro is Rs. 50 per liter. I think the prices will fall further from Rs. 50 to 40 while you think US might attack Iran and hence prices will go up from Rs. 50 to 60. So you want to fix a price little higher from today’s price (but less than what you expect it to be in 3 months) which is favorable to both of us as per our own calculations and predictions. Two of us decide to exchange 100 liters of petro 3 months later on March 24, 2009 at a price of Rs. 55.

Now, imagine US didn’t attack Iran and global economy sink further. Hence, on May 24, 2009 price of petro products drop to Rs. 45. Here, I, the seller, will sell you petro at a price of Rs. 55 even though the market price is Rs. 45 per liter. Thus, I will make money while you lose it.

Hence, the biggest disadvantage of futures is that one of the parties involved will not be able to take advantage of favorable movement in price i.e. if you have not entered into a futures contract with me, you could have bought petro at Rs. 45 (market price) instead of Rs. 55.

I know this is a complex and difficult concept for beginners to digest in one go but it is worth learning. The best way to learn it is to read it again and again either here or somewhere else on internet. If you have any questions or need clarification, please write to us at vijayaram9@gmail.com