The Hindu Business Line : Into the exotic world of futures

A question you always wanted to ask but were afraid of asking may be, "What are forward contracts and futures contracts, and how do they differ from typical cash or spot transactions?"

For answer to this and 249 more questions, here is Futures Markets: Made Easy with 250 Questions and Answers, by Sunil K. Parameswaran, from Tata McGraw-Hill (www.tatamcgrawhill.com). "In a cash or a spot transaction, as soon as a deal is struck between the buyer and the seller, the buyer has to pay for the asset to the seller, who in turn transfers the rights to the asset to the buyer," explains the author.

What happens in the futures or forward contract? The actual transaction does not take place when the agreement is reached between a buyer and a seller; they only agree "on the terms on which they will transact at a future point in time, including the price to be paid per unit of the underlying asset."

A numerical illustration

A numerical illustration given in the book should make things clearer. "Mitoken Solutions has entered into a forward contract with ICICI Bank to acquire $1,00,000 after 90 days at an exchange rate of Rs 45.50 per dollar," it begins. After 90 days, "the company will be required to pay Rs 45,50,000 to the bank and in lieu accept the dollars." And, "as per the contract, the bank will have to accept the equivalent amount in Indian currency, and deliver the dollars." The underlying asset is the dollar, in this case. The main parties to the deal are `long,' the person who agrees to buy the underlying asset, and the opposite `short,' the one who agrees to sell.

In options contracts, the buyers of options are called `option holders' and the sellers, `option writers.' While in forward and futures contracts, both the long and the short have an obligation, to take and give delivery, the situation in options is different. "The buyer of an options contract, who is also known as the long, has the right to go ahead with the transaction," points out Parameswaran.

The holder may, therefore, exercise his `right' only if he deems appropriate. But the short, the writer, has an obligation. "That is, were the long to decide to exercise the right, the short would have no choice but to carry out his part of the deal." The right and the obligation may be either to buy or sell. "An options contract that gives the long the right to acquire the underlying asset is known as a call option." The opposite is put option, which `gives the long the right to sell the underlying asset'.

Exercise price or strike price, in the case of call option is `the amount payable by the option holder per unit of the underlying asset, if he were to choose to exercise his option at a subsequent date.' In the case of put option, exercise price is `the amount receivable by the option holder.' Option price or option premium is the amount paid by the option buyer to the writer, for `the right to transact at a future date'. In futures contracts, there is no similar value at inception.

However, there can be margin deposit or initial margin, which is `a performance guarantee' to guard against the risk of default. This is deposited with the broker of both long and short, since both the parties have their respective obligations in futures contracts.

The book moves on from `fundamentals' to topics on valuation, hedging and speculation, and orders and exchanges, explaining key concepts through questions such as: What is a short squeeze? What is the unbiased expectations hypothesis of future prices? How do futures contracts help investors hedge their positions? Why is it that the further away the expiration date of the contract, the greater is the basis risk? How is a market-if-touched (MIT) order different from a stop order?

Multiple-choice questions

At the end of each chapter are multiple-choice questions. Check if you know the answer to the following: (1) A calculated risk taker is known as: a) hedger; b) speculator; c) a gambler; d) none of the above.

(2) An exporter in India who is expecting a payment in USD would hedge using: a) a short position in futures; b) a long position in futures; c) a long position in put options; d) a and c.

And (3) "If the 99 per cent Value at Risk of a portfolio over a one-day horizon is Rs 5,000, it means that: a) 99 per cent of the maximum possible loss over a one-day horizon is Rs 5,000; b) the maximum possible loss in a one-day period is 99 per cent of Rs 5,000; c) the portfolio will suffer a loss of Rs 5,000 with a 99 per cent probability; d) the portfolio will suffer a loss exceeding Rs 5,000, over a one-day period, with a probability of only 1 per cent."

Essential read are chapters on `underlying financial assets', and `trading strategies'. An unputdownable book that merits study by those who want to respond to the call of the exotic world of futures.

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