The Hindu Business Line : Going forward is one option

The following Monday, the MD was the last to arrive in the conference room. Curd Rice was rapidly scribbling on a note pad and Goatee was adjusting the overhead projector.

“Good afternoon everyone,” said the MD as he entered the room. “We will continue with our discussion on foreign exchange risk management strategies. Rahul, last week you had expounded on the differences between forward contracts and futures contracts. I would now like to continue the discussion from where we left off.”

Needed, a clarification

“Before you begin Rahul, I want a clarification,” said Curd Rice. “Last week you mentioned that forward contracts could be customised to suit the requirements of the parties concerned whereas futures contracts could only be traded in accordance with the terms and conditions specified by the exchange. Are there any features that may make a futures contract appeal to an investor? Else, it would appear that everyone should prefer a customised product like a forward contract.”

“There are factors that may make an investor take a position in a futures contract even if he has the option of taking a position in a forward contract,” said Goatee.

“Firstly, forward contracts expose both parties to credit risk. This is because since both parties have an obligation to perform as per the agreement, there is a risk that one of the parties may default. Let me elaborate further. Consider a forward contract to buy an asset at rupees F per unit. If the price of the asset in the spot market at the time of taking delivery is greater, then although the buyer will be happy to take delivery at the original price, the seller would be reluctant since he has to forego the opportunity to sell it at the prevailing spot price.

“On the other hand, if the spot price at the time of taking delivery were to be less than F, the buyer would be reluctant to take delivery at the originally agreed upon price, since he can always acquire it in the spot market at a lower price. Under such circumstances, the seller would be deprived of an opportunity to sell at F. A priori we do not know whether the terminal spot price will be greater or less than the forward price.

“Hence, in the absence of measures to prevent default it is certain that one party, although we do not know who, will default.”

How futures differ

“In what way are futures contracts different? What you have just said would appear to apply to futures contracts as well,” asked Curd Rice.

“In the case of futures contracts there is an entity called the clearinghouse which provides a guarantee to both the parties after a trade has occurred. The clearinghouse effectively becomes the buyer from the standpoint of the seller and the seller from the point of view of the buyer. Consequently, both the parties to the trade need to only concern themselves with the integrity of the clearinghouse.

“The clearinghouse has to ensure that it has enough funds to take care of the interests of the party which is impacted in the event of default. It does so by requiring both parties to deposit a performance bond with it called a margin.”

“So if there is a spectre of a loss, how do parties to a forward contract protect themselves?” asked Curd Rice.

“Forward contracts are restricted to large well known parties that are known to each other and whose integrity and creditworthiness is relatively easy to appraise. In our case, since we have a well-established relationship with our bankers, we should be able to negotiate a forward contract without much difficulty,” said Goatee.

“The second advantage of futures contracts is that they are relatively easy to offset. That is, one or both parties to a position may disengage themselves by a taking a counter-position,” he continued.

Counter-position

“What is a counter-position?” asked Balaji.

“A counter-position is one that is opposite to the position that was initially taken. It entails a sale by the original buyer or a purchase by the original seller. This is easy in the case of futures contracts because after every trade the link between the two parties is effectively broken due to the action of the clearinghouse. Consequently, if a party wants to exit the market all that it has to do is to take a counter-position with another party on the floor of the exchange. This need not be the same as the party with which it has originally transacted.”

“Does that mean that a party can never disengage itself from a forward contract?” asked Balaji.

“No it can,” said Goatee. However, since a forward contract is a customised agreement between two parties a decision to abrogate the original agreement has to be endorsed by both parties.

“We need not worry too much about this since we are going to hedge genuine export transactions and consequently are unlikely to require an agreement to be rescinded.”

Turning to options

“We have covered enough ground on forwards and futures. Let me now turn to options,” he said.

“Unlike forward and futures contracts which impose an obligation on both the buyer and the seller, an option gives a right to one party and imposes an obligation on the other.”

“Who has an obligation, the buyer or the seller?” asked Curd Rice.

“That depends on the nature of the option. Call options give a right to the buyer and impose an obligation on the seller, whereas put options give a right to the seller and impose an obligation on the buyer.”

“Why can’t both parties be given rights?” asked Balaji.

“I am afraid that we are once again running out of time” said the MD. “The more that I learn about these instruments the more fascinated I get. By the way, are foreign exchange options traded on the Indian exchanges?” he asked.

“Not yet sir,” said Goatee. “The authorities seem to have reservations about bringing about changes too rapidly.”

“I guess that is why it is called the Reserve Bank of India. It is bound to have reservations,” said MD breaking into loud laughter. Wilma and Goatee joined in.

“I did not get the joke,” said Balaji.

“Don’t worry Balaji that was just a pun,” said Goatee. He had a reputation since college of being a master of puns. His dream, was to write a book some day called “Pun and Punishment.”

“We need to meet again to take this discussion forward,” said the MD. “How about Friday afternoon?”

“Sir I think that I may have to be in Mumbai on Friday,” said Goatee.

“Well check your schedule and inform Wilma. If you are tied up on Friday then perhaps we can meet on Thursday.”

Racy@TheHindu.co.in http://Racycases.blogspot.com