Forward contract

HI,

They are the simplest form of derivative contracts. Traders and investors who wish to hedge

against their future risks use the forward markets. This market is characterized by actual

delivery of the underlying asset in most cases at the pre-determined date. Such contracts are

used to hedge against price fluctuations.

Example 1: 'A' agrees to purchase from 'B' 100 shares of 'C Ltd.' on a fixed future date for a

pre-determined price of Rs. 100. Here, on the fixed future date, A will pay Rs. 100 to B and B

will deliver the shares of C Ltd. to A.

Futures

A future contract is a contract by which one party agrees to sell to the other party on a

specified future date, a specified asset at a price agreed at the time of the contract and

payable on the maturity date. The agreed price is also known as 'strike price'. The asset may

be a commodity or currency or debt or equity security (or a basket of securities) or a deposit

of money by way of loan or any other category of property. The effect is to guarantee or

hedge the price. The hedging party protects himself against a loss, but also loses the chance

to make a profit. Unlike forward contracts, futures are usually performed (settled) by the

payment of difference between the strike price and the market price on the fixed future date,

and not by physical delivery and payment in full on that date.

Financial futures originated in Chicago in 1972 by the introduction of currency futures by the

International Monetary Market (IMM). This was followed by the introduction of Treasury Bond

futures (interest rate futures) in 1977. Stock index futures soon followed in 1982. The basic

difference between commodity and financial futures is that the asset represented by a

financial future may not exist (for example, futures on a stock index represent only a

hypothetical portfolio of the constituent stocks). Hence, such contracts cannot be settled by

physical delivery of underlying shares and have to be settled by cash on the date of delivery.

Also, financial futures are usually available with a longer life as compared to commodity

futures. Usually, financial futures have standardized maturity dates.

M Veerabhadrappa

Smilax Laboratores Limited

Consultant Compliance