Understanding the Basics of Future Contracts

Indian financial markets have evolved notably over the past three decades. From the ring based Trading, T+14 (with Delivery of shares taking 14 days after trade) settlement and only physical shares, today we have screen based Trading, With T+2 settlement and almost all De-mat shares. Along with this came new financial products as well and the various Derivatives products (Future & Options) were introduced in the Indian equity markets.

Forward Contract

To understand the Futures one must understand the basics of Forward contract.  In a forward market, the buyer and seller agree to exchange the goods for cash. The exchange happens at a specific price on a specific future date. The goods’ price is fixed by both the parties on the day they agree. Similarly, the date and time of the goods to be delivered is also fixed. The agreement happens face to face with no intervention from a third party. This is called “Over the Counter or OTC” agreement.

Here is an example,

Mr. A agrees to buy 10,000 Kg of Soybean on December 30, 2021 at Rs 75 per kg from Mr. X. So as of date the total agreement value is Rs 7,50,000 and would be executed on December 30^th, 2021. Here Mr. A is Buyer of the Forward contract and Mr. B is a Seller of the Forward contract. Now just imagine what happens on December 30, 2021. The price may increase to Rs 80 per kg, it may Decline to Rs 70 per kg or it may not change and remains at Rs 75. So what would be the profit or a loss arising out of the above mentioned forward contact in the above three scenarios.

1. Here if the price of Soybean increases to Rs 80 then the value of the stock purchased by Mr. A Would be as follows.

Current Values of the stock would be Rs 80 per kg * 10,000 kg of Soybean = Rs 8,00,000 lakh. Here Mr. A would be making a profit of Rs 50,000 as Mr. X has to deliver the soybean at Rs 75 per kg. Mr.X makes a loss of Rs 50,000.

2. If the price of Soybean declines to Rs 70 what would be the impact of the same.

Here as the price has declined to Rs 70 the value of the produce will stand at Rs 7,00,000 (Rs 70 *10000 kg). Here Mr. A would make a loss of Rs 50,000. (Mr. X makes a profit of Rs 50,000)

3. If the price remains the same.

There would not be any change in the standing value of the Soybean. And hence no one makes any profit or a loss.

Now here the contract may end on Physical Delivery or Cash Settled. Like Physical Delivery would means, Mr. A receives 10000 kg of Soybean from Mr. X and then Mr A pays Rs 7, 50,000 to Mr.X.

Here one must understand that this is an agreement between two parties and hence it is called OTC trade. There is no third party involved and hence the onus is on both parties to execute the forward contract. However, there would be different kinds of risks faced here. Like liquidity risk as only two parties are involved, default risk (What if Mr. A is not Able to provide settlement amount), what if the Soybean Crop gets affected and eventually the delivery does not happen. This Means there would be some risk borne by both sides. Hence just making a contract is not enough; there should be something committed from both parties to keep them intact. Like a premium should be paid by the buyer to the seller. Like top keep the forward contract of the above example, Rs 7,50,000 is the contract value. And to enter the contract Mr. A would pay some premium to Mr. X of some percentage of the contract value. Now that would be the first step towards understanding the basics of Futures markets. While we have already explained one Example the contract could be for any commodity, Currency, Stocks, equities, or some other assets.

Basically, the idea of the forward contract is a contract between two parties on terms and agreements decided by the parties involved. And here the forwards’ contract lays down the basic foundation for a futures contract. Now let’s understand the basics of Futures contracts.

Future Contracts – The Basics

The Risk Factors like liquidity risk, default risk, regulatory risk, and rigidity of the transactional nature of forward contracts – with some improvisation in the forward contracts the Future contracts got higher importance.  As we mentioned earlier there are two parties in a contract and if one party has a view on some asset class, but does not find a counterparty to get into an agreement. The view cannot be monetised. Hence just imagine if there is a ready market available for commodities or even equity as an asset class. It might be a stock exchange or a commodity exchange offering such contracts. But before we get into the details of future contracts, let’s understand the basic terminologies of the Future Contracts.

Following are a few of the features that differentiate Future Contracts from the Forwards Contracts. A future contract follows the underlying – like in the above forward contract example the underlying was Soybean. Similarly the underlying could be anything like stocks, commodities, or even precious metals. The basic rule here is, the future price mimics the underlying. If the underlying price increases the Future price increases and if the underlying price declines, the future price also declines.

Second factor is the standardisation of contracts. Almost all contracts are standardised and hence it means everyone has got the same contract value and contract size.

Third factor is, future contracts are tradable. In simple terms if the view of the buyer changes in between the security between the time periods of open contracts, one can exit the contract.

Apart from that the best part is it is regulated by the exchanges, regulatory bodies like SEBI. Hence the default risk gets minimised or we can say eliminated. In addition to that the Future contracts are time bound (like one Month, Two Months or three months). The time frame up-to which the contract lasts is called ‘The expiry of the contract.

Last but not the least, the Future contracts are Cash settled. Most of the futures contracts are cash-settled. This means only the cash differential is paid out. There is no worry of moving the physical asset from one place to another.