Derivatives
This query is : Resolved
05 November 2012
What is the importance of future in economy?
Why is it considered harmful to economy?
Why is it considered harmful to economy?
05 November 2012
Hi
In recent years, derivatives have become increasingly important in the field of finance. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts.
Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The
forward contracts are normally traded outside the exchanges.
The salient 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.
-On the expiration date, the contract has to be settled by delivery of the asset.
-If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to selldollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.
In recent years, derivatives have become increasingly important in the field of finance. While futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. In this chapter we shall study in detail these three derivative contracts.
Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The
forward contracts are normally traded outside the exchanges.
The salient 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.
-On the expiration date, the contract has to be settled by delivery of the asset.
-If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market.
Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to selldollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.
05 November 2012
Limitations of forward markets
Forward markets world-wide are afflicted by several problems:
Lack of centralization of trading,
Illiquidity, and
Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.
Forward markets world-wide are afflicted by several problems:
Lack of centralization of trading,
Illiquidity, and
Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.
05 November 2012
Introduction to Futures
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized
and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered,(or which can be used for reference purposes in settlement) and a standard timing of such settlement.
A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:
Quantity of the underlying
Quality of the underlying
Distinction between futures and forwards contracts:
Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized
and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered,(or which can be used for reference purposes in settlement) and a standard timing of such settlement.
A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:
Quantity of the underlying
Quality of the underlying
Distinction between futures and forwards contracts:
Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.
You need to be the querist or approved CAclub expert to take part in this query .
Click here to login now
Click here to login now
Similar Resolved Queries
Unanswered Queries
- SEC 54 OF IT ACT
- CPC Processing IT Return for AY 2023-24 without recognizing the Taxation Option under New Regime
- REGARDING GST ON COMMERICIAL PROPERTY
- Form 26QB for TDS on property
- Residential status for filling income tax returns in India
- DTCP approval
- GST Annual Returns filing due date
- Whether still royalty
- BLOCKED-INELIGIBLE GST CREDIT
- Amendment of September 2021 Invoice
- What is paid meaning under form
- Consequences of short and excess provision of expenses
- Provision for income tax and adjustment entry
- Short and Excess provision of expenses
- Issue of gst e invoice
- Interchangeable words in accounts
- Adjusted profit/Loss in the case of LLP and Pvt. Ltd.company
- How to adjusted advances given or receipt
- Foreign vendor without PAN unable to to register due to non receipt of OTP on foreign number ?
- 133(6) DIN INVALID format error - ->WHERE TO REPLY 133(6) notice?
Trending Online Classes
-
Excel Mastery Program
CA Rishabh Pugalia
CAclubindia
