Investor Protection

     ...Closing Rates...



FAQ's on Introduction to Derivatives

1    What are derivative instruments ?

2    Why Derivatives ?

3    What are Forward contracts ?

4    What are Futures ?

4.1 What are the Standardized Terms in Futures ?

5    What is the difference between Forward contracts and Futures contracts ?

6    Can there be Futures on individual stocks ?

7    What is the difference between Commodity and Financial Futures ?

8    What do you mean by Closing out contracts ?

9    Is the settlement mechanism different for Cash and Physical Delivery ?

10  Is there a theoretical way of pricing Index Future ?

11  What is the concept of Basis ?

12  What is Contango ?

13  What is Backwardation ?


1 What are derivative instruments ?

A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.


2 Why Derivatives ?

There are several risks inherent in financial transactions. Derivatives allow you to manage these risks more efficiently by unbundling the risks and allowing either hedging or taking only one (or more if desired) risk at a time (please see risk management for more details).

For instance, if we buy a share of TISCO from our broker, we take following risks

1.      Price risk that TISCO may go up or down due to company specific reasons (unsystematic risk).

2.      Price risk that TISCO may go up or down due to reasons affecting the sentiments of the whole market (systematic risk).

3.      Liquidity risk, if our position is very large, that we may not be able to cover our position at the prevailing price (called impact cost).

4.      Counterparty (credit) risk on the broker in case he takes money from us but before giving delivery of shares goes bankrupt.

5.      Counterparty (credit) risk on the exchange - in case of default of the broker, we may get partial or full compensation from the exchange.

6.      Cash out-flow risk that we may not able to arrange the full settlement value at the time of delivery, resulting in default, auction and subsequent losses.

7.      Operating risks like errors, omissions, loss of important documents, frauds, forgeries, delays in settlement, loss of dividends & other corporate actions etc.

Once we are long on TISCO we can hedge the systematic risk by going short on index futures. On the other hand, if we do not want to take unsystematic risk on any one share, but wish to take only systematic risk - we can go long on index futures, without buying any individual share. The credit risk, cash outflow risk and operating risks are much easier to manage in this case.


3 What are Forward contracts ?

A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today.

The main features of forward contracts are

         They are bilateral contracts and hence exposed to counter-party risk.

         Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

         The contract price is generally not available in public domain.

         The contract has to be settled by delivery of the asset on expiration date.

         In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.


4 What are Futures ?

Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for Future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/ commodity in a designated Future month at a price agreed upon by the buyer and seller. The contracts have certain standardized specifications.

4.1 What are the Standardized Terms in Futures ?

The standardized items in any Futures contract are

         Quantity of the underlying

         Quality of the underlying (not required in financial Futures)

         The date and month of delivery

         The units of price quotation (not the price itself) and minimum change in price (tick-size)

         Location of Settlement

5 What is the difference between Forward contracts and Futures contracts ?

Futures is a type of forward contract.

1.      Standardized Vs Customized Contract - Forward contract is customized while the future is standardized. To be more specific, the terms of a Forward Contracts are individually agreed between two counter-parties, while Futures being traded on exchanges have terms standardized by the exchange.

2.      Counter party risk - In case of Futures, after a trade is confirmed by two members of exchange, the exchange / clearing house itself becomes the counter-party (or guarantees) to every trade. The credit risk, which in case of forward contracts was on the counter-party, gets transferred to exchange / clearing house, reducing the risk to almost nil.

3.      Liquidity - Futures contracts are much more liquid and their price is much more transparent due to standardization and market reporting of volumes and price.

Squaring off - A forward contract can be reversed only with the same counter-party with whom it was entered into. A Futures contract can be reversed with any member of the exchange.

6 Can there be Futures on individual stocks ?

Such instruments exist in some countries (example Sydney Futures Exchange) but in general are not very popular. Price volatility in individual stocks is much higher than Index. This results in higher risk of clearing corporation and margin requirements. In addition, such instruments suffer from lack of depth and liquidity in trading. In most cases, Futures based on individual stocks often have a physical settlement, resulting in more complex regulatory requirements. It is much more difficult to manipulate an Index than individual stock, resulting in price manipulations. In India, Dr. L. C. Gupta committee has not mentioned Futures on Individual Stocks as a possible derivative contract.

7 What is the difference between Commodity and Financial Futures ?

The basic difference between commodity and financial Futures is the nature of the underlying instrument. In a commodity Futures, the underlying is a commodity which may be Wheat, Cotton, Pepper, Turmeric, corn, oats, soybeans, orange juice, crude oil, natural gas, gold, silver, pork-bellies etc. In a financial instrument, the underlying can be Treasuries, Bonds, Stocks, Stock-Index, Foreign Exchange, Euro-dollar deposits etc.

As is evident, a financial Future is fairly standard and there are no quality issues while a commodity instrument, quality of the underlying matters

8 What do you mean by Closing out contracts ?

A long position in futures can be closed out by selling futures, while a short position in futures can be closed out by buying futures on the exchange. Once position is closed out, only the net difference needs to be settled in cash, without any delivery of underlying. Most contracts are not held to expiry but closed out before that. If held until expiry, some are settled for cash and others for physical delivery.

9 Is the settlement mechanism different for Cash and Physical Delivery ?

In case it is impossible, or impractical, to effect physical delivery, open positions (open long positions always being equal to open short positions) are closed out on the last day of trading at a price determined by the spot "cash" market price of the underlying asset. This price is called "Exchange Delivery Settlement Price" or EDSP.

In case of physical settlement short side delivers to the specified location while long side takes delivery from the specified location of the specified quantity / quality of underlying asset. The long side pays the EDSP to clearing house/ corporation which is received by the short side.

10 Is there a theoretical way of pricing Index Future ?

The theoretical way of pricing any Future is to factor in the current price and holding costs or cost of carry.

In general, the Futures Price = Spot Price + Cost of Carry

Cost of carry is the sum of all costs incurred if a similar position is taken in cash market and carried to maturity of the futures contract less any revenue which may result in this period. The costs typically include interest in case of financial futures (also insurance and storage costs in case of commodity futures). The revenue may be dividends in case of index futures.

Apart from the theoretical value, the actual value may vary depending on demand and supply of the underlying at present and expectations about the future. These factors play a much more important role in commodities, specially perishable commodities than in financial futures.

In general, the Futures price is greater than the spot price. In special cases, when cost of carry is negative, the Futures price may be lower than Spot prices.


11 What is the concept of Basis ?

The difference between spot price and Futures price is known as basis. Although the spot price and Futures prices generally move in line with each other, the basis is not constant. Generally basis will decrease with time. And on expiry, the basis is zero and Futures price equals spot price.

12 What is Contango ?

Under normal market conditions, Futures contracts are priced above the spot price. This is known as the Contango Market.

13 What is Backwardation ?

It is possible for the Futures price to prevail below the spot price. Such a situation is known as backwardation. This may happen when the cost of carry is negative, or when the underlying asset is in short supply in the cash market but there is an expectation of increased supply in future - example agricultural products

Cochin Stock Exchange, Kochi, India