BY Sanjivani Nathani
Derivatives are financial contracts that are primarily characterized by their value being dependent upon some asset or group of assets. These assets could be anything – stocks, bonds, currencies, commodities, or market indices. The value of the underlying asset varies according to the prevailing market conditions. The objective of entering into derivative contracts is to gain or raise profit through speculative analysis of the value of the underlying asset in the future. For example, a farmer expects a sale of 10,000 kilograms of the crop, 6 months from now, at the rate of ₹15 per kg. Yet he is afraid of the political scenario in the county, 6 months hence could alter his production and damage his quantity. To avoid this risk, he enters into a contract with a commodities broker, to whom he would sell his 10,000 kg of the crop at ₹15 per kg after 6 months. Hence, after 6 months the broker would have to pay the farmer ₹15×10,000 irrespective of the market conditions or the market price of the crop. If the market price of the crop (in the future) is lesser than ₹15 per kg, it would be a profit for the farmer but if the market price increased to say, ₹17 per kg, then it would be a loss for the farmer as now he cannot realize payment of ₹17×10,000 but has to settle for ₹15×10,000. This is an excessively prokaryotic example of a derivative contract transaction.
Types of Derivative Contracts:
Derivative contracts are for 4 major kinds – Forward, Future, Option, and Swaps. The Forward Contract or the Forwards is the agreement that takes place between two parties to either buy or sell the asset at the pre-agreed time at a specific price. The Forward contract can entail both the credit risk and the market risk and the profit or loss on such contracts is only known during the time of settlement. This is normally implemented like hedging and does not involve any initial payment.
A Futures contract is a firm legal agreement between a buyer and a seller, in which:
The buyer agrees to take delivery of something at a specified price at the end of a designated period of time.
The seller agrees to make delivery of something at a specified price at the end of a designated period of time.
Future contracts are products created by exchanges. To create a particular futures contract, an exchange must obtain approval from the Commission in Authority – a government regulatory agency.
No physical exchange of commodities or assets takes place while entering into a contract, but happens at the future date decided for the transaction. When we speak of “buyer” and “seller” of a contract, we are adopting the nomenclature which refers to parties of the contract with respect to the future role they would be putting themselves into. The asset which would be traded is called the “underlying”, the price at which the transaction settled is “future price” and the date of the transaction is called “settlement date” or “delivery date”.
Long and Short Positions:
If an investor has long positions, it means that the investor has bought and owns those shares of stocks. By contrast, if the investor has short positions, it means that the investor owes those stocks to someone, but does not actually own them yet. On the flip side of the same equation, an investor with a short position owes stock to another person but has not actually bought them yet. Speaking specifically in terms of futures contracts, when an investor takes a position in the market by agreeing to buy at the future date, the investor is said to be in a long position or to be in the long futures. And if his opening position would be the contractual obligation to sell something in the future, the investor is said to be in a short position or short futures.
If the market conditions alter such that the future price increases, the buyer of a futures contract (the person who would be buying the asset in the future after making a payment or the person in a long position) would be the one to realize a profit and the seller would realize a loss. For example, Ram and Shyam enter into a futures contract and decide that on the settlement date (which would be 2 months from now) Ram would purchase the asset at a futures price of ₹100 from Shyam. Suppose that around the time of settlement of the contract, the futures price of the asset increases to ₹120. Ram, now, can purchase the asset from Shyam by paying (or spending) only at ₹ 100 and can immediately sell the asset again at the prevailing market price of ₹120. This was the person in the long position who realized a profit if and when the futures price of an asset increases.
Similarly, with all other factors of transaction kept constant, if the futures price of the asset declines to say ₹70, the seller of the commodity would realize a profit. Shyam the seller would by selling his asset to Ram, receives payment of ₹100 from him. With ₹100 in hand, while the market price or the futures price of the same asset being just ₹70, he can repurchase the asset to realize a position of profit. Hence, when the futures price of the underlying asset decreases, the person in the long position realizes a loss while the person the short position realizes a profit.
Hope you have got a hint on how to go about investing in the futures market.
ABOUT THE AUTHOR
Sanjivani Nathani is a second-year Statistics student at Kirori Mal College, University of Delhi. She is immensely interested in the fields of finance and economics and hopes to continuously expand her knowledge horizon. When not stressing about academics and placements, she likes to read and paint.
Disclaimer: The views expressed in this article are the author’s own and do not necessarily reflect the views of the organization.
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