Forward Market Introduction

In the world of financial derivatives, the futures market plays a crucial role. The term ‘derivatives‘ refers to a security whose value is derived from another financial object known as an ‘underlying asset.’  

Anything can serve as the underlying asset, including a stock, bond, money, or commodity. Financial derivatives have been in existence for a while. 

The oldest mention of derivatives in India is found in ‘Kautilya’s Arthashastra,’ written in 320 BC. It is believed that Kautilya detailed the pricing structure of the standing crops set to be harvested at some point in the future in the ancient Arthashastra (study of Economics) script. He structured a legitimate ‘forwards contract’ to pay the farmers well in advance.

As the forwards and futures markets are similar, understanding the ‘Forwards market’ is the best method to introduce the futures market. A solid basis for knowing the futures market would be laid by understanding the forwards market.

The most straightforward kind of derivative is a forwards contract. 

Think of the forwards contract as the futures contract’s ancient form. Both futures and forward contracts have a similar transactional structure, but over time, traders have tended to favour futures contracts by default. Only a select group of parties, including corporations and financial institutions, continue to use forward contracts.

Example 

The Forward market was primarily established to safeguard farmers’ interests from unfavourable price changes. In a forward market, the parties agree to trade products for money. 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. In a similar manner, the time and date for the delivery of the items are also set. 

Without the involvement of a third party, the agreement is reached in person. This agreement is referred to as ‘Over the Counter’ or ‘OTC.’ Only the OTC (Over the Counter) market, in which businesses and individuals conduct one-on-one transactions, allows for the trading of forward contracts.

Here’s an example: 

Let’s consider a scenario where there are 2 parties.

One works as a jeweller, designing and creating jewellery. Let’s refer to him as ‘ABC Jewelers.’

The other is a gold importer, whose responsibility is to offer gold to jewellers at a discount. Let’s call him ‘XYZ Gold Dealers.’

On Nov 10th, 2014, ABC and XYZ made a deal for ABC to purchase 15 kg of gold at 999 purity from XYZ within three months (10th Feb 2015). The price of gold is set at the current market rate, which is Rs. 2450 per gramme or Rs. 2450,000 per kilogramme.

Why do you believe ABC entered into this contract? ABC wants to lock in the current market price for gold because ABC thinks it will increase over the next three months. It is obvious that ABC wants to protect itself from an adverse increase in gold prices. 

The party committing to purchase the asset at a later date is referred to as the ‘Buyer of the Forwards Contract’ in a forwards contract; in this instance, that party is ABC Jewelers.

Similarly, XYZ hopes to profit from the high price of gold currently being offered in the market. They predict that the cost of gold will decline over the next three months.

In a forwards contract, the party promising to sell the asset at a later date is referred to as the ‘Seller of the Forwards Contract’; in this case, that party is XYZ Gold Dealers.

Due to their different viewpoints on gold, both parties consider this agreement to be consistent with their expectations for the future.

Here are the 3 possible scenarios: 

While both parties hold their own perspectives on gold, there are only three possible outcomes that could unfold after three months. Let’s explore these scenarios and their potential impact on both parties.

Scenario 1 – Gold price rises:

Let’s assume that on March 10th, 2015, the price of gold with 999 purity is trading at Rs. 2700/- per gram. In this case, ABC Jeweler’s prediction regarding the gold price has proven to be accurate. At the time of the agreement, the deal was valued at Rs. 3.67 crores. However, with the subsequent increase in gold prices, the deal is now valued at Rs. 4.05 crores. 

As per the agreement, ABC Jewelers has the right to purchase gold with 999 purity from XYZ Gold Dealers at the pre-agreed price of Rs. 2450/- per gram.

The rise in gold price affects both parties in the following manner –

Consequently, XYZ Gold Dealers will need to purchase gold from the open market at Rs. 2050/- per gram and sell it to ABC Jewelers at the agreed rate of Rs. 2450/- per gram, resulting in a loss for XYZ Gold Dealers in this transaction.

Scenario 2 – Gold price declines:

Let’s assume that on March 10th, 2015, the price of gold with 999 purity is trading at Rs. 2050/- per gram. In such a situation, XYZ Gold Dealers’ prediction regarding the gold price has proven to be accurate. At the time of the agreement, the deal was valued at Rs. 3.67 crores. However, with the subsequent decrease in gold prices, the deal is now valued at Rs. 3.075 crores. Nonetheless, as per the agreement, ABC Jewelers is obligated to purchase gold with 999 purity from XYZ Gold Dealers at the pre-agreed price of Rs. 2450/- per gram.

This decrease in gold price would impact both parties in the following manner –

Even though Gold is available at a much cheaper rate in the open market, ABC Jewelers is forced to buy gold at a higher rate from XYZ Gold Dealers hence incurring a loss.

Scenario 3 – The price does not change 

In the third scenario, if the price of gold remains the same as it was on November 10, 2014, both ABC Jewelers and XYZ Gold Dealers would not gain any advantage from the agreement. The value of the deal would remain unchanged, and there would be no impact on either party.

Here’s how the 3 possible scenarios will look in one graph:

As depicted in the chart provided, the financial impact on ABC Jewelers is evident based on the movement of gold prices. When the price of gold is above Rs.2450/- per gram, ABC Jewelers benefits from potential savings or profit. Conversely, when the price of gold falls below Rs.2450/- per gram, ABC Jewellers is obliged to purchase gold from XYZ Gold Dealers at a higher rate, resulting in a loss.

The same observations can be made for XYZ Gold Dealers as well. The movement of gold prices directly affects their profitability. If the price of gold is higher, XYZ Gold Dealers may incur a loss by selling gold to ABC Jewellers at a lower agreed-upon rate. Conversely, if the price of gold decreases, XYZ Gold Dealers can potentially generate more profit by selling gold to ABC Jewelers at the higher agreed-upon rate.

The same can be applied for XYZ 

From the provided information, it can be observed that XYZ Gold Dealers experience a notable financial impact based on the movement of gold prices. When the price of gold exceeds Rs.2450/- per gram, XYZ is compelled to sell gold at a lower rate than the prevailing market price, resulting in a loss. Conversely, when the price of gold decreases and falls below Rs.2450/- per gram, XYZ benefits from selling gold at a higher rate, taking advantage of the lower market rate and generating a profit.

In summary, the financial performance of XYZ Gold Dealers is significantly influenced by the directional movement of gold prices. Higher gold prices may lead to losses when selling at a lower rate, while lower gold prices can be advantageous, allowing for higher selling prices and potential profits for XYZ.

Here’s a note on settlement 

Assuming that on Feb 10th, 2015, the price of gold is Rs.2700/- per gram, ABC Jewelers, as previously discussed, stands to benefit from the agreement. The value of 15 kgs of gold has increased from Rs.3.67 Crs (the value at the time of the agreement on Nov 10th, 2014) to Rs.4.05 Crs.

Upon the completion of the three-month period, both parties have two options for settling the agreement:

1.   Physical Settlement: In this option, XYZ Gold Dealers would purchase 15 kgs of gold from the open market at a cost of Rs.4.05 Crs and deliver it to ABC Jewelers in exchange for the agreed amount of Rs.3.67 Crs. This type of settlement involves the actual exchange of the asset.

2.           Cash Settlement: Alternatively, the parties can opt for cash settlement, which does not involve the physical delivery of the asset. In this case, instead of exchanging the gold for the agreed amount, ABC Jewelers and XYZ Gold Dealers would exchange the cash differential. The value of the gold in the open market is Rs.4.05 Crs, while the agreed amount is Rs.3.67 Crs, resulting in a cash differential of Rs.38 lakhs. XYZ Gold Dealers would pay this amount to ABC Jewelers to settle the deal.

 It’s important to note that these two settlement options, physical and cash, are commonly used in forward contracts. The choice between them depends on the preferences and agreement of the parties involved.

Now, what about the risk? 

 While we have discussed the structure and impact of price variations in a forward contract, it’s important to consider the risks involved as well. Forward contracts come with several drawbacks:

1.   Liquidity Risk: In our example, ABC and XYZ easily found each other as counterparties with opposing views. However, in reality, finding a suitable counterparty can be challenging. Parties often approach investment banks to help find a counterparty, but this comes with additional fees and may not guarantee a perfect match.

2.     Default Risk/Counterparty Risk: In the event that the price of gold reaches Rs.2700/- after 3 months, ABC expects XYZ to fulfil their financial obligations. However, there is a risk of default where XYZ fails to meet its payment obligations. This default risk arises due to various reasons, including financial difficulties or unwillingness to honour the agreement.

3.           Regulatory Risk: Forward contracts are executed based on the mutual consent of the involved parties, without any regulatory authority overseeing the agreement. This lack of regulation creates a sense of lawlessness and increases the risk of default, as there are no legal repercussions for failing to fulfil the contract.

4.           Rigidity: Once ABC and XYZ enter into the forward agreement, they are bound by its terms and conditions. If their views on gold strongly change midway through the agreement, they are unable to terminate or modify the contract. This rigidity can limit their flexibility and ability to adapt to changing market conditions.

Due to these disadvantages, futures contracts were introduced as a way to mitigate the risks associated with forward agreements. In India, the futures market is part of a dynamic financial derivatives market, offering traders more flexibility and risk management tools. Throughout this module, we will delve deeper into futures trading and learn effective methods for trading this instrument.