Understanding Future as a Derivative Instrument in Financial Domain

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In aditya
Jan 30th, 2012
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Understanding Future as a Derivative Instrument in Financial DomainLet’s talk about the future. Now if ‘tomorrow’ is on your mind than I must tell you ‘Today is beautiful forget about tomorrow‘. Let’s come to the point. We are talking of future in the finance domain. So let’s understand what a ‘Future’ is. Next what you read is the bookish definition of future. 

‘A future is a derivative instrument which is an obligation to deliver or to receive a specified quantity and grade of a commodity/underlier during a designated month at the designated price. Each futures contract is standardized and specifies commodity, quality, quantity, delivery date and settlement.’

Blah blah blah.. What was that? Let’s start from the very basics. Every day we see markets going up and markets going down. What is it that makes the market move? What is the underlying thing that changes and we see that the market rose/declined by so and so many points? Let’s answer these questions first. The primary motive of any buy/sell is to make profit. And a simple math for profit is

Buy low, sell high 
or
Sell high, buy low
Everybody must have heard of a term trading. In the most simplest of the languages it is buying or selling of some ‘things’. Now what are these ‘things’? There are different instruments that are traded in a market. These instruments can be as simple as a share or can be as complex as a derivative like swap. We will leave swap for now but will talk very briefly about shares and derivative. A share or equity is nothing but a person’s stake in a company. You buying shares of an ABC company automatically mean that you have a stake in the company’s performance. If the company does well, the value of the shares goes up and you make profit. It can be as simple as that or can be complex when we dive deeper. But let’s leave the shares here and jump on to derivative. 

A derivative is a financial instrument which derives its value from an underlying asset. 

Each derivative is related to the underlying asset in some way. Underlying asset can be gold, silver, other derivative or in a simple form a share. If a person holds a derivative, he or she may at some point in time receive the underlying asset. There are different derivatives like futures, options, swaps, forwards etc. A derivative defines an obligation or a right. An obligation is a responsibility. A right is the ability to do something, but not the obligation to do it. Futures and forward contracts involve obligations. Options involve rights.

So now let’s concentrate on futures and the rest can be left for the forth coming posts. But before we do that let’s read the definition of a future again. 

‘A future is a derivative instrument which is an obligation to deliver or to receive a specified quantity and grade of an underlier during a designated month at the designated price. Each future contract is standardized and specifies commodity, quality, quantity, delivery date and settlement.’

Well, doesn’t it make some sense now? Now that the ground work is done let’s build up our knowledge on future. Let me share with you a secret here. Having a good knowledge of this instrument can open several new streams of income for you. But the other side of the coin, as there always is, that it can get riskier at times.

Future 

A futures contract is one of the different types of derivative instruments, in which two parties agree to trade (buy/sell remember?) a set of financial instruments (e.g. shares) or physical commodities (e.g. gold) for future delivery at a particular price. Some of the features of a future are standardized quantity, standardized quality, standardized delivery date. Futures are traded only on exchanges. If traded outside an exchange there is a separate but very similar instrument named forwards. In case of futures the counter party is always an exchange.


What is achieved by a future in an economy?

Risk Management

Futures market helps in risk reduction. While making purchases or sales the price is pre-set. A participant who enters the future market to fix the price for a certain commodity that he wants to purchase, does not have to worry about the jacking up of the prices by the supplier at the last moment.

Price Discovery

Futures market is an important economic tool to determine prices based on estimated amount of supply and demand. Futures market prices depend on continuous flow of information from around the world. Factors such as weather, war, economic default, deforestation and many such, hard to list out all here, affects demand and supply and thus present and future price of a commodity. All these factors and the information, and the way people absorb these information makes the price move in any particular direction. Hence the price discovery.


Let’s understand this with an example of a farmer who grows wheat. 

Initial State

He is getting ready to plant. From his last year’s experience he has an approximate idea of how much wheat he will be able to produce by the end of 3 months by now. He also knows the cost that he is going to incur in these 3 months while producing wheat. Costs like seed, labor, equipments fuels etc. He expects to make a decent profit by selling the wheat in 3 months time from now. He calculates that he will make a decent profit if he sells the wheat at Rs 40/unit which is the current spot market price.

Profit/Loss and Risks in Normal Scenario

Suppose he commits 1000 units of wheat to a buyer in 3 months from now in the spot market (at a price prevailing at that time in the market). This puts him to risk. Different factors like weather and demand can hurt his chances of getting Rs 40/ unit after 3 months. If the demand is low, then he might not get Rs40/ unit. 

Managing Risks Using Futures

By committing he has opened a position in the market. He hopes to sell 1000 units of wheat after 3 months in spot market. When he sells the wheat and receive cash he will close his position. To reduce the risk on his expected profit he takes an opposite position in the future market to what he is doing in the spot market. So accordingly today he sells the wheat futures contract and after 3 months he will buy wheat futures to close his position.

Math Behind This Strategy
Suppose the current spot price is Rs 40/unit. With high demand and favorable weather the price can go up to Rs 60/unit in 3 months which is good for the farmer as he will get 50% more that the current price. On the other hand under unfavorable conditions and low demand the price might fall to Rs 20/unit, making 50% less money for the farmer. Now comes the role of a future contract. If the farmer takes an opposite position in futures market he can balance the 50% gain or the 50% loss. 
The current price and the futures price is suppose Rs 40/unit. If the price after 3 months go up to Rs 60/unit the farmer will make Rs 20/unit in the spot market but will lose Rs 20/unit in the futures market(because he sold the futures contract initially at Rs 40/unit and bought back(costly) at Rs 60/unit), thus balancing out. In the other scenario if the prices go down to Rs 20/unit, then the farmer loses Rs 20/unit in the spot market 3 months later but would gain Rs 20/unit in the futures market (because he sold the futures contract initially at Rs 40/unit and bought back(cheap) at Rs 20/unit). 
Hence this balancing out helped the farmer with some price predictability and risk management.
So we come to an end of this discussion hoping the above information was helpful. We will discuss about the other instruments in the posts to come.

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