Basics of Forward Contracts and Options

What is a forward contract? 

Based on a request by visitors I am writing this part. It is more of information for beginners. A forward contract is one where two parties one agreeing to buy and others agreeing to sell, enter into an agreement. One party agrees to sell a particular amount of quantity of any commodity at a particular price determined at present but at a future o date. The other party agrees to buy the same. Let’s take an example. A farmer who expects the price to go down in near future enters into an agreement with another party that he will supply a certain quantity of rice at a certain price today price after three months. The party will agree to this contract only if his perception of price change is exactly opposite that of the farmer. That is the counterparty will either expect the price to go up and so he agrees to a current price which is prescribed by the farmer. with this type of agreement counterparty default risk is more say it rained and so farmer cant supply the rice and so he defaults or the prices may fall and so the buyer may say I may not buy at the current price. To avoid this counterparty risk a third party is necessary and that is where the exchange plays a role and it is called futures.

What is a futures contract? 

Since the necessity for a third party is here the exchange plays a role. It is the same as a forwarding contract but here it is up to the individual to buy or sell the commodity. Here it’s a notional commitment and there is no obligation to buy. Both can bet on an agreed price and trade. 

How futures work? 

Let us take rice futures. One party agrees to buy 100kg of rice at 20rs per kg on 3 months from today’s date and the other sells it. Here both the parties have to pay an initial margin to the exchange. It will be 10 to 20% of the contract value in the case of stocks and within 10% in the case of commodities. When the next day, if the price goes up to the agreed price the buyer will be credited by the extra amount in his account, and the seller's account, will be detected. Say if the price goes up to 25 the buyer's account will be credited with 25rs per kg and sellers will be deducted. This will be reverse if prices go down. When a deduction is reaching close to maintenance margin which is less than the initial margin which will be determined by the exchange amount a call will be given to the deducted party to maintain the margin amount .this is called a margin call. At the end of the maturity date, he can execute to buy the underlying asset or just come out by writing of and the margin will also be repaid if he has made profits. 

Stock futures: Say an individual is agreeing to buy 100 shares of RPL at 195 rs per share on (if today is a day in April), May (near month contract).and the margin is 10 percent. he has to pay 1950 as his margin. If the price the next day becomes 200 his account will be credited with 5*100 =500 rupees and the sellers will be deducted with 500 rs. like that it goes on as long the buyer wished to hold. This is called mark to market. Every day the profit or loss is added to the account according to the price that day. This minimizes the counterparty risk. About options, I will write in the next article. 

PRABHU S

How US Markets Affect Indian Stock Market

Sub Prime Lending

It is lending to people who are less capable of repaying (More credit risk; Less credit worthiness).

In US some institutions has lend loans like this to such people(less capability to repay). Since they are high risk loans interest rate will be high. These institutions also adopt a process called securitization (conversion of these loans into tradeable securities).

In simple terms the institutions says that i will earn repayment every month from these borrowers and institutions will trade this loan as bonds and investors will invest in it. As most of the housing loans were traded like this in us these borrowers didn't pay back.

So it led to non-performing assets in banks balance sheet. So investors in these bonds started selling their bonds which pull down the us stock market. Everyone wanted to take their money in these bonds as loans are not repaid.

It had an impact on Indian stock market as well some people who lost their money also wanted to compensate their loss by selling shares they holded in Indian companies, this pulled back Indian stock market also for a while.

Note: stock market will come down when sellers are more (bearish). It will go up when buyers are more (bullish)

What did US GOVERNMENT DO to minimize this risk? They cut down the interest rates so that people will borrow at lesser rate and invest. But this helped Indian market also because they borrowed in us at lesser rate and invested in Indian market which is bullish now.thats is why our market adjusted very quickly.

Rupee appreciation

It means i am able to but dollar at a cheaper rate.

That is for a particular amount of rupee I can buy more dollars.

When it happens. When we have sufficient amount of dollars in hand we don't need more. When US depends on Indian goods they have to pay in rupees and they exchange their dollars for rupees with RBI and hence we have more dollars. When investments from US come into India also this exchange takes place and hence we have more dollars and rupee appreciates.

Right now because of last reason our rupee has appreciated.

When rupee appreciated it is bad for exporters because say for every one dollar product they sell in US they will get less rupees.It is good for importers because for a particular amount of rupee in hand they can get more 1 dollar products and sell in India.

But some domestic manufacturers who manufacture and sell in India will get affected by substitute import products because they become cheaper.

What RBI has done to curb appreciation is open up investment opportunities for Indians in US. That means they allow them to invest more in us there by more dollars will be demanded by them to invest and dollar demand will raise and rupee appreciation will come down.

But critics also comment on these that when US market is not good who will invest outside and hence this didn't have much impact on curbing the appreciation.

PRABHU.S
KIAMS

What Are Options?

This is in continuation of my last article on derivatives.

An option is nothing but a "Right Given to the Holder of the Option". It may be a "Right to Sell" Or "Right to Buy". The right to sell option is called a put option and the right to buy option is called a call option. 

When a person buys an option note only the right is transferred. It is not necessary that a person should execute the right on the maturity date. Then the question arises how a seller can make a profit out of it even if it is not executed on the maturity date. The buyer of the option has to necessarily pay a premium called option premium for buying that option. The buyer can buy a put option or a call option. The simple logic is a buyer who expects a price rise will buy a put option for a price determined today and a buyer who expects a price fall will buy a call option. Call and put options are there in stocks, commodities, etc. The next one is Swap which deals with currency rate exchanges that may not be that significant.

  PRABHU.S