FORWARD Contract

A forward contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today’s pre-agreed price. For example, an Indian car
manufacturer buys auto parts from a Japanese car maker with payment of one million yen due
in 60 days. The importer in India is short of yen and supposes present price of yen is Rs. 68.
Over the next 60 days, yen may rise to Rs. 70. The importer can hedge this exchange risk by
negotiating a 60 days forward contract with a bank at a price of Rs. 70. According to forward
contract, in 60 days the bank will give the importer one million yen and importer will give the
banks 70 million rupees to bank
Features of forward contract:-
Features of forward contract The basic features of a forward contract are given in brief here as
under:
1. Bilateral: Forward contracts are bilateral contracts, and hence, they are exposed to
counter-party risk.
2. More risky than futures: There is risk of non-performance of obligation by either of the
parties, so these are riskier than futures contracts.
3. Customized contracts: Each contract is custom designed, and hence, is unique in terms
of contract size, expiration date, the asset type, quality, etc.
4. Long and short positions: In forward contract, one of the parties takes a long position by
agreeing to buy the asset at a certain specified future date. The other party assumes a
short position by agreeing to sell the same asset at the same date for the same specified
price. A party with no obligation offsetting the forward contract is said to have an open
position. A party with a closed position is, sometimes, called a hedger.
5. Delivery price: The specified price in a forward contract is referred to as the delivery
price. The forward price for a particular forward contract at a particular time is the
delivery price that would apply if the contract were entered into at that time. It is
important to differentiate between the forward price and the delivery price. Both are
equal at the time the contract is entered into. However, as time passes, the forward
price is likely to change whereas the delivery price remains the same.
6. Synthetic assets: In the forward contract, derivative assets can often be contracted from
the combination of underlying assets, such assets are oftenly known as synthetic assets
in the forward market. The forward 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 may dominate and command the price it wants as
being in a monopoly situation.
7. Pricing of arbitrage based forward prices: In the forward contract, covered parity or
cost-of-carry relations are relation between the prices of forward and underlying assets.
Such relations further assist in determining the arbitrage-based forward asset prices.
8. Popular in forex market: Forward contracts are very popular in foreign exchange market
as well as interest rate bearing instruments. Most of the large and international banks
 quote the forward rate through their ‘forward desk’ lying within their foreign exchange
trading room. Forward foreign exchange quotes by these banks are displayed with the
spot rates.

Different types of forward: As per the Indian Forward Contract Act1952, different kinds
of forward contracts can be done like hedge contracts, transferable specific delivery
(TSD) contracts and non-transferable specific delivery (NTSD) contracts.
1. Hedge contracts are freely transferable and do not specify, any particular lot,
consignment or variety for delivery.
2. Transferable specific delivery contracts are though freely transferable from one
party to another, but are concerned with a specific and predetermined consignment.
Delivery is mandatory.
3. Non-transferable specific delivery contracts, as the name indicates, are not
transferable at all, and as such, they are highly specific.
Future contract
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security
at a predetermined price at a specified time in the future. Futures contracts are standardized
for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures
contract is taking on the obligation to buy and receive the underlying asset when the futures
contract expires. The seller of the futures contract is taking on the obligation to provide and
deliver the underlying asset at the expiration date. 
Suppose a farmer produces rice and he expects to have an excellent yield on rice; but he is
worried about the future price fall of that commodity How can he protect himself from falling
price of rice in future? He may enter into a contract on today with some party who wants to
buy rice at a specified future date on a price determined today itself. In the whole process the
Farmer will deliver rice to the party and receive the agreed price and the other party will take
delivery of rice and pay to the farmer. In this illustration there is no exchange of money and the
contract is binding on both the parties. Hence future contracts are forward contracts traded
only on organized exchanges and are in standardized contract-size. The farmer has protected
himself against the risk by selling rice futures and this action is called short hedge while on the
other hand, the other party also protects against-risk by buying rice futures is called long hedge.
The following features are there for future contracts:
1. Future contracts are traded on organised future exchanges. These are forward contracts
traded on organised futures exchanges.
2. Future contracts are standardised contracts in terms of quantity, quality and amount.
3. Margin money is required to be deposited by the buyer or sellers in form of cash or
securities. This practice ensures honour of the deal.
4. In case of future contracts, there is a dairy of opening and closing of position, known as
marked to market. The price differences every day are settled through the exchange
 clearing house. The clearing house pays to the buyer if the price of a futures contract
increases on a particular day and similarly seller pays the money to the clearing house.
The reverse may happen in case of decrease in price.
Types of financial future contracts
Financial futures contracts can be categorised into following types:
1. Interest rate futures: In this type the futures securities traded are interest bearing
instruments like T-bills, bonds, debentures, euro dollar deposits and municipal bonds,
notional gilt-contracts, short term deposit futures and treasury note futures.
2. Stock index futures: Here in this type contracts are based on stock market indices. For
example in US, Dow Jones Industrial Average, Standard and poor's 500 New York Stock
Exchange Index. Other futures of this type include Japanese Nikkei index, TOPIX etc.
3. Foreign currency futures: These future contracts trade in foreign currency generating
used by exporters, importers, bankers, FIs and large companies.
4. Bond index futures: These contracts are based on particular bond indices i.e. indices of
bond prices. Municipal Bond Index futures based on Municipal Bonds are traded on
CBOT (Chicago Board of Trade).
5. Cost of living index future: These are based on inflation measured by CPI and WPI etc.
These can be used to hedge against unanticipated inflationary pressure.
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.
DISTINCTION BETWEEN FUTURES AND FORWARDS
Futures Forwards
Trade on an organised exchange OTC in nature
Standardised contract terms Customised contract terms
Hence more liquid Hence less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period

Settlement of Futures Contracts

Futures contracts have two types of settlements, the Mark-to-Market (MTM) settlement
which happens on a continuous basis at the end of each day, and the final settlement
which happens on the last trading day of the futures contract.
MTM settlement :

All futures contracts for each member are marked-to-market (MTM) to the daily settlement price
of the relevant futures contract at the end of each day. The profits/losses are computed as the
difference between :

1. The trade price and the day’s settlement price for contracts executed during the day but not
squared up.
2. The previous day’s settlement price and the current day’s settlement price for brought forward
contracts
3. The buy price and the sell price for contracts executed during the day and squared up. Table 8.6
explains the MTM calculation for a member. The settlement price for the contract for today is
assumed to be 105.
Table Computation of MTM at the end of the day
Quantity MTM Settlement
Trade Details MTM
Bought/Sold Price

Brought Forward
100@100 105 500
From Previous Day

Traded During Day

200@100 100@102 102 200
Bought Sold

Open Position (Not

100@100 105 500
Squared Up)

Total 1200

The table above gives the MTM on various positions. The MTM on the brought forward contract
is the difference between the previous day’s settlement price of Rs.100 and today’s settlement
price of Rs.105. Hence on account of the position brought forward, the MTM shows a profit of
Rs.500. For contracts executed during the day, the difference between the buy price and the sell
price determines the MTM. In this example, 200 units are bought @ Rs. 100 and 100 units sold
@ Rs. 102 during the day. Hence the MTM for the position closed during the day shows a profit
of Rs.200. Finally, the open position of contracts traded during the day, is margined at the day’s
settlement price and the profit of Rs.500 credited to the MTM account.

So the MTM account shows a profit of Rs. 1200.

The CMs who have a loss are required to pay the mark-to-market (MTM) loss amount in cash
which is in turn passed on to the CMs who have made a MTM profit. This is known as daily
mark-to-market settlement. CMs are responsible to collect and settle the daily MTM
profits/losses incurred by the TMs and their clients clearing and settling through them. Similarly,
TMs are responsible to collect/pay losses/profits from/to their clients by the next day. The pay-in
and pay-out of the mark-to-market settlement are effected on the day following the trade day.
In case a futures contract is not traded on a day, or not traded during the last half hour, a
‘theoretical settlement price’ is computed as per the following formula:

F= Sert

After completion of daily settlement computation, all the open positions are reset to the daily
settlement price. Such positions become the open positions for the next day.

Final settlement for futures :

On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all
positions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Final
settlement loss/profit amount is debited/ credited to the relevant CM’s clearing bank account on
the day following expiry day of the contract.

Settlement prices for futures

Daily settlement price on a trading day is the closing price of the respective futures contracts on
such day. The closing price for a futures contract is currently calculated as the last half an hour
weighted average price of the contract in the F&O Segment of NSE. Final settlement price is the
closing price of the relevant underlying index/security in the capital market segment of NSE, on
the last trading day of the contract.

Determination of Futures Prices

The important factors which affect the pricing of future contract are as follows:-
1. Risk-Free Rate
If a trader buys a non-interest earning asset and immediately sells futures on it, because the
futures cash flow is certain, the trader will have to discount it at a risk-free rate to find the
present value of the asset. No-arbitrage conditions dictate that the result must be equal to
the spot price of the asset. A trader can borrow and lend at the risk-free rate, and with no-
arbitrage conditions, the price of futures with time to maturity of T will be equal to the
following:

F0,T=S0*er*T 

Thus, the futures price of a non-dividend-paying and a non-storable asset is the

function of the risk-free rate, spot price, and time to maturity.

2. Interest Income
If the asset is expected to provide an income, this will decrease the futures price of the
asset. Suppose that the present value of the expected interest (or dividend) income of an
asset is denoted as I, then the theoretical futures price is found as follows:

 F0,T=(S0 - I) erT 
 Or, given the known yield of the asset q, the futures price formula would be:

 F0,T=S0 e(r-q)T 

The futures price decreases when there is a known interest income because the long side
buying the futures does not own the asset and, thus, lose the interest benefit. Otherwise,
the buyer would receive interest if they owned the asset. In the case of stock, the long side
loses the opportunity to get dividends.

Any asset that pays an income will reduce the price of a futures contract because the buying
side does not own the asset and, therefore, loses out on receiving the interest income.

3. Storage Costs
Certain assets such as crude oil and gold must be stored in order to trade or to use in the
future. The owner holding the asset thus incurs storage costs, and these costs are added to
the futures price if the asset is sold through the futures market. The long side does not incur
any storage costs until it actually owns the asset. Therefore, the short side charges the long
side for the compensation of storage costs and the futures price. This includes the storage
cost, which has a present value of C as follows:

 F0,T=(S0 + C) erT 

If the storage cost is expressed as a continuous compounding yield, c, then the formula
would be:

 F0,T=S0 e(r+c)T 

For an asset that provides interest income and also carries a storage cost, the general
formula of the futures price would be:

 F0,T=S0 e(r-q+c)T or F0,T=(S0 - I + C)erT 

4. Convenience Yield
The effect of a convenience yield in futures prices is similar to that of interest income.
Therefore, it decreases the futures prices.

A convenience yield indicates the benefit of owning some other asset rather than buying
futures. A convenience yield can be observed particularly in futures on
commodities because some traders find more benefit from ownership of the physical asset.
For example, with an oil refinery, there is more benefit from owning the asset in a
warehouse than in expecting the delivery through the futures because the inventory can be
put immediately into production and can respond to the increased demand in the markets.
Overall, consider convenience yield, y:
  F0,T=S0 e(r-q+c-y)T

The last formula shows that three components (spot price, risk-free interest rate, and
storage cost) out of five are positively correlated with futures prices.

5. The Bottom Line

There are a few factors that affect change in futures prices (excluding any transaction costs
of trading): a change in the spot price of the underlying, the risk-free interest rate, interest
income, the storage cost of the underlying asset, and the convenience yield. 

Spot price, the risk-free rate, and storage costs have a positive correlation with futures
prices, whereas the rest have a negative correlation on futures. The relationship of risk-free
rates and futures prices is based on a no-arbitrage opportunity assumption, which shall
prevail in markets that are efficient.

Generally, the price of a futures contract is related to its underlying asset by the spot futures
parity theorem, which states that the futures price must be related to the spot price by the
following formula:
Futures Price = Spot Price × (1 + Risk-Free Interest Rate – Income Yield)
Otherwise, the deviation from parity would present a risk-free arbitrage opportunity. Entering a
futures position does not require a payment of cash, so the risk-free rate that can be earned
from the cash is added. (Although margin must be posted, it is much less than the value of the
contract, and margin can be in the form of Treasuries, which earn interest.) The income yield is
subtracted because no income is earned without owning the underlying asset. Applying this
formula to a stock:
Futures Price = Stock Price × (1 + Risk-Free Interest Rate – Dividend Yield)
Example — Futures Market Arbitrage Opportunity If Spot-Futures Parity Violated Suppose that
you pay $2,600 for 1 share of a stock index exchange-traded fund (ETF) that tracks the Nasdaq
100 at the beginning of the year and that it pays $52 in dividends during the year. At the same
time, you sell a futures contract short for the Nasdaq 100 that is cash settled, requiring you to
pay $2,700 at the end of the year. (Note this futures contract is hypothetical since there is no
contract for just 1 share of an ETF or stock, but it simplifies the math while still illustrating the
principle.) Suppose further that: Risk-free rate = 5% Dividend yield = 2% Therefore, the futures
settlement price should be: = ETF Price × (1 + .05 – .02) = $2,600 × 1.03 = $2,678,
To summarize:
F0 = S0(1 + rf – d)
F0 = Initial Futures Price
S0 = Initial Stock Price
rf = Risk-Free Interest Rate
d = Dividend Yield
The parity relationship is also known as the cost-of-carry relationship because it asserts that
the futures price is determined by the relative costs of buying a stock with deferred delivery
in the futures market versus buying it in the spot market with immediate delivery and
carrying it as inventory. When buying the stock, the interest that could be earned with the
money used to buy the stock is forfeited for the duration of the stock ownership. However,
dividend payments may be received. Thus, the net carrying cost advantage of deferring delivery
of the stock is the risk-free interest rate minus the dividend per period, which is why the futures
price differs from the spot price by the amount of the future-parity equation. The parity relation
must also hold for longer contract periods. Because money has time value, there must be a
larger difference between the price of a longer term futures contract and the current spot price
compared to a short-term contract, so for a contract maturity of t periods, the spot-futures
parity equation is modified:
F0 = S0(1 + rf – d)t
This is equivalent to the formula for calculating this future value of an investment, where the
spot price is the initial value, the term (1+ rf – d) is the interest rate, and t represents the
number of compounding periods. The spot-futures parity equation can also be applied to other
futures contracts with different underlying assets by making the appropriate modifications.
Uses of Future contract
Following are the uses of future contract:-
1. Future speculations- A futures contract allows a trader to speculate on the
direction of movement of a commodity's price. If a trader bought a futures
contract and the price of the commodity rose and was trading above the original
contract price at expiration, then they would have a profit. Before expiration, the
buy trade—long position—would be offset or unwound with a sell trade for the
same amount at the current price effectively closing the long position. The
difference between the prices of the two contracts would be cash settled in the
investor's brokerage account, and no physical product will change hands.
However, the trader could also lose if the commodity's price was lower than the
purchase price specified in the futures contract.
Speculators can also take a short or sell speculative position if they predict the
price of the underlying asset will fall. If the price does decline, the trader will
take an offsetting position to close the contract. Again, the net difference would
be settled at the expiration of the contract. An investor would realize a gain if
the underlying asset's price was below the contract price and a loss if the current
price was above the contract price.

2. Futures Hedging- Futures can be used to hedge the price movement of the

underlying asset. Here, the goal is to prevent losses from potentially unfavorable
 price changes rather than to speculate. Many companies that enter hedges are
using—or in many cases producing—the underlying asset.

Advantages and disadvantages of future contract:-

Advantages:-

1. Investors can use futures contracts to speculate on the direction in the price of an
underlying asset

2. Companies can hedge the price of their raw materials or products they sell to protect
from adverse price movements

3. Futures contracts may only require a deposit of a fraction of the contract amount with a
broker

Disadvantages:-
1. Investors have a risk that they can lose more than the initial margin amount since
futures use leverage

2. Investing in a futures contract might cause a company that hedged to miss out on
favorable price movements

3. Margin can be a double-edged sword meaning gains are amplified but so too are losses