Derivatives

The purpose of derivatives is that they serve to reduce the risk inherent in fluctuations of foreign exchange rates, interest rates, and market prices. Derivatives traded on exchanges also are said to serve as a price discovery mechanism. The various types of derivative contracts are Forward Contracts, Options, Futures Contracts, Swaps and related derivatives. FORWARDS A forward contract is an agreement to buy or sell an asset on a specified price. One of the parties to the contract assumes a long position and agree to buy the underlying asset on a certain specified future date or 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, the parties to the contract negotiate price and quantity bilaterally. The forward contracts are normally trade outside the exchanges. Definitions: A forward contract is an agreement between two parties to buy or sells, as the case may be, a commodity (or financial instrument or currency) at a pre determined future date at a price agreed when the contract is entered into. Example in the month of August, a rice mill agrees to buy one tone of paddy from a farmer in the following February at a price of Rs. 3000. This is a forward contract. Note that the farmer will receive Rs. 3000 in February irrespective of whether the market price in February is Rs. 2000 or Rs. 4000. Legal definitions of Forward contracts: Under the Forward Contracts (Regulations) Act, 1952 Forward Contracts are classified into: Hedge Contacts: These are freely transferable and do not specify any particular lot, consignment or variety for delivery. Transferable Specific Delivery (TSD) Contracts: These are contracts, which, though freely transferable from one party to another, are concerned with a specific and pre-determined consignment or variety of the commodity. Non-transferable Specific Delivery (NTSD) Contracts: These are concerned with a specific variety or consignment and are not transferable at all. Contract terms are highly specific. Delivery is mandatory. The salient features of Forward Contracts are: A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (Ex: forward currency market in India)

Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity quality (in case of commodities), delivery time and place. Forward contracts suffer from poor liquidity and default risk. If the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which often results in high prices being charged. However forward contract in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction cost and increasing transactions volume. 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 sell dollars forward, he can lock on to a rate today and reduce his uncertainty. 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 cast market.

Limitations of Forward Markets: Lack of centralization of trading. Ill-liquidity, and Counter party risk

Counter party 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 he problem of ill liquidity, the counter party risk remains a very serious issue.