Future & Options

A : Derivatives, such as options or futures, are financial contracts which derive their value off a spot price time-series, which is called “the underlying”. For examples, wheat farmers may wish to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction would take place through a forward or futures market. This market is the “derivative market”, and the prices on this market would be driven by the spot market price of wheat which is the “underlying”. The terms “contracts” or “products” are often applied to denote the specific traded instrument. The world over, derivatives are a key part of the financial system. The most important contract-types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange and real estate.

A : In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.

A : Forward contracting is very valuable in hedging and speculation. The classic hedging application would be that of a wheat farmer forward-selling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she 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 raise, and then take a reversing transaction. The use of forward markets here supplies leverage to the speculator.

A : Forward markets worldwide are afflicted by several problems: (a) lack of centralisation of trading, (b) illiquidity, and (c) counterparty risk. In the first two of these, the basic problem is that of too much exibility and generality. The forward market is like the 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-tradeable. Also the “phone market” here is unlike the centralisation of price discovery that is obtained on an exchange. Counterparty risk in forward markets is a simple idea: when one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counter-party risk. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, the counterparty risk remains a very real problem. A classic example of this was the famous failure on the Tin forward market at LME.

A : Futures markets were designed to solve all the three problems (a, b and c listed in Question 1.4) of forward markets. Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardised and trading is centralised, so that futures markets are highly liquid. There is no counterparty risk (thanks to the institution of a clearinghouse which becomes counterparty to both sides of each transaction and guarantees the trade). In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk.

A : In a true cash market, when a trade takes place today, delivery and payment would also take place today (or a short time later). Settlement procedures like T+3 would qualify as “cash markets” in this sense, and of the equity markets in the country, only OTCEI is cash market by this definition. For the rest, markets like the BSE or the NSE are classic futures market in operation. NSE’s equity market, for example, is a weekly futures market with tuesday expiration. When a person goes long on thursday, he is not obligated to do delivery and payment right away, and this long position can be reversed on friday thus leaving no net obligations with the clearinghouse (this would not be possible in a T+3 market). Like all futures markets, trading at the NSE is centralised, the futures markets are quite liquid, and there is no counterparty risk.

A : An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A “call option” gives one the right to buy; a “put option” gives one the right to sell. Options come in two varieties { european vs. american. In a european option, the holder of the option can only exercise his right (if he should so desire) on the expiration date. In an American option, he can exercise this right anytime between purchase date and the expiration date.

A : Options and futures are the mainstream workhorses of derivatives markets worldwide. However, more complex contracts, often called exotics, are used in more custom situations. For example, a computer hardware company may want a contract that pays them when the rupee has depreciated or when computer memory chip prices have risen. Such contracts are “custom-built” for a client by a large financial house in what is known as the “over the counter” derivatives market. These contracts are not exchange-traded. This area is also called the “OTC Derivatives Industry”. An essential feature of derivatives exchanges is contract standardisation. All kinds of wheat are not tradeable through a futures market, only certain defined grades are. This is a constraint for a farmer who grows a somewhat different grade of wheat. The OTC derivatives industry is an intermediary which sells the farmer insurance which is customised to his needs; the intermediary would in turn use exchange-traded derivatives to strip off as much of his risk as possible.

A : Badla is closer to being a facility for borrowing and lending of shares and funds. Borrowing and lending of shares is a functionality which is part of the cash market. The borrower of shares pays a fee for the borrowing. When badla works without a strong margining system, it generates counterparty risk, the evidence of which is the numerous payments crises which were seen in India. Options are obviously not at all like badla. Futures, in contrast, may seem to be like badla to some. Some of the key differences may be summarised here. Futures markets avoid variability of badla financing charges. Futures markets trade distinctly from the cash market so that each futures prices and cash prices are different things (in contrast with badla, where the cash market and all futures prices are mixed up in one price). Futures markets lack counterparty risk through the institution of the clearinghouse which guarantees the trade coupled with margining, and this elimination of risk eliminates the “risk premium” that is embedded inside badla financing charges, thus reducing the financing cost implicit inside a futures price.

A : The key motivation for such instruments is that they are useful in reallocating risk either across time or among individuals with different risk-bearing preferences.

A Comparison of Futures and Badla

Badla	Futures
Expiration date unclear	Expiration date known
Spot market and different expiration dates are mixed up	Spot market and different expiration dates all trade distinct from each other
Identity of counterparty often known	Clearing corpn. is counterparty
Counterparty risk present	No counterparty risk
Badla financing is additional source of risk	No additional risk.
Badla financing contains default-risk premia	Financing cost at close to riskless thanks to counterparty guarantee
Asymmetry between long and short	Long and short are symmetric
Position can breakdown if borrowing/lending proves infeasible	You can hold till expiration date for sure, if you want to

One kind of passing-on of risk is mutual insurance between two parties who face the opposite kind of risk. For example, in the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This sort of thing also takes place in speculative position taking the person who thinks the price will go up is long a futures and the person who thinks the price will go down is short the futures.

Another style of functioning works by a risk adverse person buying insurance, and a risk tolerant person selling insurance. An example of this may be found on the options market : an investor who tries to protect himself against a drop in the index buys put options on the index, and a risk-taker sells him these options. Obviously, people would be very suspicious about entering into such trades without the institution of the clearing house which is a legal counterparty to both sides of the trade.

In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, it is a considerable gain.

The ultimate importance of a derivatives market hence hinges upon the extent to which it helps investors to reduce the risks that they face. Some of the largest derivatives markets in the world are on treasury bills (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk).

Derivatives are also very convenient in terms of international investment. For example, Japanese insurance companies fund housing loans in the US by buying into derivatives on real estate in the US. Such funding patterns would be harder without derivatives.