India has caught the attention of global players in commodities trading. Among the other sectors that have witnessed a sea change since the liberalisation process began in 1991, the commodities market is one such undergoing a process of change. With a view to update our readers on this front, The Financial Express will regularly bring out a column written by eminent experts from the field. In our first step toward this path, Kushal Thaker of Prophecy Investments, an active player in most of the commodities traded, writes about the principles of derivative trading and its terminology.Forward contractsForward contracts are agreements to purchase or sell a specified amount of a commodity on a fixed future date at a pre-determined price. Physical delivery is expected. If, at maturity (the future date that has been agreed to in the contract), the actual price (the spot price) is higher than the price in the forward contract, the buyer makes a profit and the seller suffers a correspondingloss.
If on the other hand the spot price is lower, the reverse is the seller is in a winning position. The important point here is that having a pre-determined price eliminates the risk of price changes for both the buyer and the seller.
Most forward trades are over-the-counter, with transactions made directly or through brokers and dealers by telephone, telex and fax. Example : forward market for crude oil and those for several fuel products.
Forward contracts are used mainly by commercial enterprises to lock in the price of products to be delivered in the future, most often they are used to hedge the risk of holding a certain commodity or having the obligation to deliver it. This is called "forward cover" and involves the execution of a set-off (offsetting) transactions simultaneously in the spot and the forward markets. Example : If a trader holds (or purchases in the spot market) a certain commodity, he can insure against adverse price movements by selling the same amount of that commodity in theforward market at the prevailing forward price. When the forward contract matures, the trader sells that commodity at the specified price, thereby avoiding the risk of a price decline in the intervening period. This enables him to fix the amount of revenue from the future sale of the commodity at the time the forward contract is signed. Effectively the trader is locking in the price - and his profit margin.
Features of a forward contract.
No cash transfer occurs when the contract is signed. The seller of the commodity is obliged to deliver the commodity at maturity, but the buyer pays no money up front (except for transaction fees). Since, a forward contract is an agreement between two parties whose own reputations are the sole guarantee that the contract will be honoured, there is an inherent credit or default risk.Futures contract
Like forward contracts they are agreements to purchase or sell a given quantity of a commodity at a predetermined price.
But, unlike forwardcontracts, physical delivery in fulfilment of this agreement is not necessarily implied: the contract can be used to make or to take physical delivery, but usually, it is offset on or before maturity (the closing date of the contract) by an equivalent reverse transaction.
On organised commodity exchanges, where most futures contracts are traded, this involves the buying at different times of two identical contracts for the purchase and sale of the commodity in question, each cancelling the other out. This is called the closing out of the position and is possible because all transactions are guaranteed through a central organism, the clearing house, which automatically assumes the position of the counterpart to both sides of the transaction. Thus, a producer who wishes to hedge has an obligation not vis-s-vis a consumer or a speculator, but vis-a-vis a clearing house. Likewise, consumers obtain a position vis-a-vis the clearing house.
Like forward contracts future contracts more or less lock in the pricethe hedger is going to receive or to pay, but this mechanism is indirect. To hedge, a producer planning a future physical sale, would sell a futures contract. This is also called price fixing. When he actually sells his physical goods, he receives the market price for that day. If this price is lower than the price in the futures contract, the loss on the physical market is compensated by the higher price on the futures contract.
This happens because the futures contract that he had sold earlier should have declined in value (in harmony with the physical market) enabling him to re-purchase the contract at the lower price.
On the other hand, if the price in the physical market is higher than the futures contract, the gain on the physical market is offset by the loss on the re-purchase of the futures contract. Hence, the mechanism being indirect, the hedging is also less secure; there is no guarantee that the profit or loss on the futures contracts will fully offset the loss or profit on the physicaltransaction.
This is caused due to a variety of reasons. For example the markets to which a company exports are not necessarily the same as where the futures markets are located. Also, the product specified in the futures contract may not be the same as the product exported (quality and specifications), and have a different price development. Moreover the relationship between futures price and spot market prices can be temporarily disturbed by attempts to manipulate the market or by technical squeezes caused by a shortage of supply.
Four important features that distinguish a futures contract from a forward contract:
Contract terms (amounts, grades and delivery terms) are standardised.
Transactions are almost always handled by organised exchanges through clearing house systems.
Most futures contracts are "marked to market" everyday, using the settlement price of the day. Hence, if the futures price moves adversely for a holder of a futures contract, that holder is obliged to pay intothe clearing house a sum equal to the value of the adverse movement (a margin call).This prohibits users of the market from carrying large unrealised losses over a long period, and thus reduces the risk of default. In the case of profitable price movements, clearing members (including intermediaries such as brokerages), but not necessarily their clients, receive the profits of the day's future trading.
Futures contracts require depositing small amounts of "initial margin" money in the exchange as collateral. Due to this, futures contracts significantly reduce the credit of default risk contained in the forward transactions.Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
