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Introduction to forward market

Forward market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

 

learning sharks stock market institute: what is Forward-Market

Introduction to forward market

Firstly, Because the forwards and futures markets are comparable, I believe that understanding the “Forwards market” is the best method to introduce the futures market. Comprehending the forwards market well would lay a strong foundation for understanding the futures market.

Secondly, The universe of financial derivatives includes the futures market in its entirety. When the value of a security is  from another sort of financial asset known as an “Underlying Asset,” it is  to as a “Derivative.” 

Any kind of stock, bond, commodity, or money can serve as the underlying asset. 

Financial derivatives have been in use for quite some time. Around “Kautilya’s Arthashastra,” which was  in 320 BC, the use of derivatives is first discussed in relation to India. According to popular belief, Kautilya wrote about the pricing structure of the standing crops that were awaiting harvest in the ancient Arthashastra (study of Economics) script. He reportedly utilized this technique to pay the farmers well in advance, creating a true “forwards contract.” 

Thirdly, Because the forwards and futures markets are comparable, I believe that understanding the “Forwards market” is the best method to introduce the futures market. Understanding the forwards market well would lay a solid foundation for understanding the futures market.

Forward contracts are the most straightforward type of derivative.Think of the forwards’ contract as the futures contract’s more ancient incarnation. Both futures and forward contracts have a similar transactional structure, but over time, traders have tended to favor futures contracts by default. The forward contracts are still in use, but only by a select group of parties, including businesses and financial institutions. 

This chapter’s main goal is to explain the structure of a typical forward transaction, following which we will dissect it into its component parts and examine its benefits and drawbacks.

A Simple EXAMPLE OF FORWARD MARKET

Importantly, The Forward market was primarily established to safeguard farmers’ interests from unfavorable price changes. Forward market, the parties agree to trade products for money. Besides, The trade takes place on a given future date at a particular price. Both sides agree on a day to establish the price of the items. 

Similar manner, the day and time of delivery of the items are also determined. Without a doubt, the agreement is  in person with the help of a third party. Also known as “Over the Counter” or “OTC,” this agreement. Only the OTC (Over Counter) market, where individuals and institutions transact through one-on-one discussions, allows for the trading of forwarding contracts.

Take into account that there are two parties in this scenario.

For example, One works as a jeweler, designing and creating jewelry. Call him “ABC Jewelers,” please. The other is a gold importer, whose responsibility it is to offer gold to jewelers at a discount. Let’s refer to him as “XYZ Gold Dealers.”

Another, On December 19th, 2014, ABC and XYZ made a deal for ABC to purchase 15 kg of gold at 999 purity from XYZ within three months (19th March 2015). 

They set For gold, a price of Rs. was chosen. per gram or Rs. 3000,000 per kilogram, which is the going rate on the market. Therefore, by this contract, on March 19, 2015, ABC is required to give XYZ a total of Rs. 4.000 Cr. (30,00,000/Kg*15) in exchange for the 15 kg of gold.

Surely, This is a pretty straightforward and typical business agreement that is often used in the sector. A “Forwards Contract” or “Forwards Agreement” is the term used to describe such an agreement.

Furthermore, Keep in mind that due to the fact that the contract was  on December 19, 2014, regardless of the price of gold on March 19, 2015, both ABC and XYZ must comply with its terms. Before proceeding, let’s first review the reasons that each party chose to enter into this Agreement.

Indeed, Why do you think ABC  this contract, in your opinion? Because ABC believes that the price of gold will rise during the following three months, they wish to lock in the present market price. ABC intends to safeguard itself against a downward trend in gold prices.

Obviously, In a forwards contract, the party agreeing to buy the asset at a later time is referred to as the “Buyer of the Forwards Contract”; in this case, that party is ABC Jewelers.

Similar spirit, XYZ wants to benefit from the high price of gold that is now being sold on the market. Also, They predict that the price of gold will decline over the next three months. Forwards contract, the party promising to sell the product at a later date is referred to as the “Seller of the Forwards Contract”; in this case, that party is XYZ Gold Dealers.

Last but not least, Due to their divergent perspectives on gold, both sides consider this agreement to be in keeping with their expectations for the future

3 possible scenarios

Even though each of these parties has a different perspective on gold, there are only three outcomes that could occur after three months. Let’s examine these scenarios and how they might affect each party.
In case 1, the cost of gold rises.

Suppose that on March 19, 2015, the cost of 999-percent pure gold is Rs. 2700 per gramme. It’s obvious that ABC Jeweler’s assessment of the gold price was accurate. The arrangement was worth Rs 4.00 crores at the time of the agreement, but due to the rise in gold prices, it is now worth Rs. 4.38 crores. According to the contract, ABC Jewelers has the right to purchase Gold (999 pure) from XYZ Gold Dealers at the previously agreed-upon price of Rs. 3000 per gramme.

As a result, XYZ Gold Dealers will have to purchase gold at a cost of Rs. 2700 per gramme on the open market and sell it to ABC Jewelers at a cost of Rs. 3000 per gramme, incurring a loss in this transaction.

 

Scenario 2: The cost of gold decreases.

Take into account that on March 19, 2015, the price of 999-percent pure gold is Rs. 2050 per gramme. In these circumstances, the gold price prediction made by XYZ Gold Dealers has come to pass. The arrangement was worth Rs 3.67 Cr at the time of the agreement, but now that gold prices have dropped, it is only worth Rs. 3.075 Cr. 

However, according to the terms of the agreement, ABC Jewelers must buy Gold (999 pure) from XYZ Gold Dealers for Rs. 2450 per gramme.

Despite the fact that gold may be bought on the open market for much less money, ABC Jewelers is compelled to pay more through XYZ Gold Dealers, incurring a loss.

 

Scenario 3: The cost of gold remains unchanged.

If the price is the same on 19 March 2015 as it was on 19 December 2014, neither ABC nor XYZ will profit from the agreement.

A quick note on settlement

On March 19, 2015, let’s assume that the price of gold is Rs. 3000 per gramme. At Rs. 3000 per gramme, it is obvious that ABC Jewelers stands to gain from the agreement, as we have just learned. 15 kg of gold was worth Rs. 4.00 crores on the agreement date (19th December 2014), but as of 19th March 2015, it is worth Rs. 4.38 crores. If both parties uphold the agreement at the end of the three-month period, on March 19, 2015, they have two choices for resolving the dispute:

  1. Physical Settlement: In this scenario, the seller delivers the actual asset after receiving complete payment from the forward contract buyer. XYZ purchases 15 kg of gold on the open market for Rs.4.38 crore and agrees to deliver it to ABC in exchange for Rs.4.00 crore. It’s referred to as a physical settlement.

  2. Cash Settlement: No real delivery or receipt of security occurs in a cash settlement. The buyer and the seller will swap the cash difference in a cash settlement. According to the contract, XYZ must sell Gold to ABC for Rs. 3000 per gramme. To put it another way, ABC pays Rs. 4.00 Crs in exchange for 15 kg of gold, which is worth Rs. 4.38 Cr on the open market. Instead of carrying out this transaction, in which ABC would pay Rs. 4.00 Cr. for gold valued at Rs. 4.38 Cr., the two parties could agree to simply exchange the cash difference. It would be Rs.4.38Cr – Rs.4.00 Cr = Rs.38 Lakhs in this instance. Therefore, in order to close the agreement, XYZ would pay Rs. 38 lakhs to ABC. Known as a cash settlement.

            At a much later time, we shall know a lot more about the colony. However, you still need to be aware that a forwards contract has two fundamental types of  settlement alternatives available: physical and monetary.

What about the risk?

While we are clear on the agreement’s structure (terms and conditions) and how a price variation will affect each party, what about the risk? Keep in mind that there are other significant disadvantages to a forward contract as well, including the following:

  1. Liquidity Risk: For the purposes of our scenario, we have naively assumed that ABC discovers a party XYZ that holds the exact opposite opinion with respect to gold. So they quickly come to an agreement. This is not as simple in reality. In the real world, the parties would go to an investment bank and explain what they wanted. The investment bank would research the market to identify a party with a different viewpoint. Naturally, the investment bank charges a fee for this service.

  2. Counterparty risk and default risk– Think about it. Assume that after three months, gold would cost Rs. 2700. With the financial decision they had taken three months earlier, ABC would be happy. They are anticipating payment from XYZ. But what if XYZ makes a default?

  3. Regulatory Risk: No regulatory body is in charge of overseeing the Forwards contract structure, which is carried out with the agreement of the parties concerned. Without a supervisory body, a perception of anarchy sets in, which in turn makes defaulting more appealing.

  4. Rigidity: On December 19, 2014, both ABC and XZY entered into this agreement with a specific gold view. What would happen, though, if their viewpoint were to drastically alter midway through the agreement? They cannot close the agreement in the middle because of how tight the forward agreement is.

            Future contracts were  to lessen the risks associated with advance agreements because the forward contracts had some drawbacks.

India’s Financial Derivatives Market, which is incredibly active, includes the futures market. We will study more about futures and effective trading strategies during the course of this module!

So let’s get going!

CONCLUSION

  1. A futures contract’s fundamental foundation is by the forwards contract.

  2. A forward is an exchanged off-exchange (OTC) derivative.

  3. Since forwarding contracts are private agreements, each one has a different set of criteria.

  4. A forward contract has a straightforward structure.

  5. The person who commits to buying something in a forward contract is known as the “Buyer of the Forwards Contract.”