Basics of Forward Contracts and Options

What is a forward contract? 

Based on a request by visitors I am writing this part. It is more of information for beginners. A forward contract is one where two parties one agreeing to buy and others agreeing to sell, enter into an agreement. One party agrees to sell a particular amount of quantity of any commodity at a particular price determined at present but at a future o date. The other party agrees to buy the same. Let’s take an example. A farmer who expects the price to go down in near future enters into an agreement with another party that he will supply a certain quantity of rice at a certain price today price after three months. The party will agree to this contract only if his perception of price change is exactly opposite that of the farmer. That is the counterparty will either expect the price to go up and so he agrees to a current price which is prescribed by the farmer. with this type of agreement counterparty default risk is more say it rained and so farmer cant supply the rice and so he defaults or the prices may fall and so the buyer may say I may not buy at the current price. To avoid this counterparty risk a third party is necessary and that is where the exchange plays a role and it is called futures.

What is a futures contract? 

Since the necessity for a third party is here the exchange plays a role. It is the same as a forwarding contract but here it is up to the individual to buy or sell the commodity. Here it’s a notional commitment and there is no obligation to buy. Both can bet on an agreed price and trade. 

How futures work? 

Let us take rice futures. One party agrees to buy 100kg of rice at 20rs per kg on 3 months from today’s date and the other sells it. Here both the parties have to pay an initial margin to the exchange. It will be 10 to 20% of the contract value in the case of stocks and within 10% in the case of commodities. When the next day, if the price goes up to the agreed price the buyer will be credited by the extra amount in his account, and the seller's account, will be detected. Say if the price goes up to 25 the buyer's account will be credited with 25rs per kg and sellers will be deducted. This will be reverse if prices go down. When a deduction is reaching close to maintenance margin which is less than the initial margin which will be determined by the exchange amount a call will be given to the deducted party to maintain the margin amount .this is called a margin call. At the end of the maturity date, he can execute to buy the underlying asset or just come out by writing of and the margin will also be repaid if he has made profits. 

Stock futures: Say an individual is agreeing to buy 100 shares of RPL at 195 rs per share on (if today is a day in April), May (near month contract).and the margin is 10 percent. he has to pay 1950 as his margin. If the price the next day becomes 200 his account will be credited with 5*100 =500 rupees and the sellers will be deducted with 500 rs. like that it goes on as long the buyer wished to hold. This is called mark to market. Every day the profit or loss is added to the account according to the price that day. This minimizes the counterparty risk. About options, I will write in the next article. 

PRABHU S