Unit 2: Forwards and Futures Contracts

Forwards and Futures Contracts

A Forward Contract is a customized, private agreement between two parties to buy or sell an asset at a specific price on a future date. It is commonly used for hedging or speculation in financial markets.

Unlike futures contracts, forwards are not traded on exchanges, which makes them over-the-counter (OTC) contracts. This allows flexibility but also introduces risk (e.g., counterparty default).

Features of Forward Contracts

A Futures Contract is a standardized agreement traded on a formal exchange to buy or sell an asset at a specified price on a future date. Unlike forwards, futures are regulated, involve daily settlement, and minimize counterparty risk.

Types of Futures Contracts

Functions of Futures Contracts

Distinction Between Forward and Futures Contracts

Pricing of Futures Contracts

The price of a futures contract is determined based on the spot price (current market price) of the underlying asset plus the cost of carry (which includes interest, storage, insurance, etc.).

Formula

Example: If spot price = ₹100, r = 10% annually, and t = 0.5 years, then Futures Price = ₹100 × (1 + 0.10)^0.5 ≈ ₹104.88

Currency Futures

Currency futures are contracts to buy or sell a specific amount of foreign currency at a future date at a pre-agreed price. These contracts are standardized and traded on exchanges like NSE (India) or CME (USA).

Common Currency Futures Contracts in India:

• USD-INR (US Dollar vs Indian Rupee)
• EUR-INR (Euro vs INR)
• GBP-INR (British Pound vs INR)
• JPY-INR (Japanese Yen vs INR)

Hedging in Currency Futures

Hedging is used to protect against losses due to unfavorable currency movements. 

Example: An Indian importer expecting to pay $10,000 after 3 months may buy USD futures now to lock in the exchange rate, avoiding potential rupee depreciation.

Speculation in Currency Futures

Speculators aim to profit from fluctuations in currency exchange rates.

Example: A trader expects USD to rise against INR. He buys USD-INR futures today and sells them at a higher price later to earn profit.

Arbitrage in Currency Futures

Arbitrage is the process of earning risk-free profit by exploiting price differences in different markets.

Example: Spot rate of USD-INR = ₹83, Futures price = ₹85

A trader can:

• Buy USD in the spot market at ₹83
• Sell USD futures at ₹85
• On delivery, deliver USD bought at ₹83, earn ₹2 profit per USD

This continues until prices align (no arbitrage condition).

Summary Table

Pricing of Futures

Futures price depends on the current spot price of the underlying asset and the cost of carry (i.e., the cost of holding the asset until the futures contract matures).

Formula

Note: If the asset pays no income (y = 0), the formula becomes: F = S × e^(rt)

Cost of Carry Model

The Cost of Carry Model explains the difference between spot price and futures price due to the cost of holding the asset.

Components of Cost of Carry

Application of Market Index

A market index (like Nifty 50 or Sensex) is used to:

Index Futures in the Stock Market

These are futures contracts where the underlying asset is a stock market index (e.g., Nifty 50, Sensex).

Uses:

Example: If you expect the Nifty 50 to rise, you can buy Nifty Futures. If it rises, you profit from the price difference.

Indian Derivatives Market

India has a well-regulated and fast-growing derivatives market, especially in equity and currency segments.

Key Features

Summary Table