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What is the first thing you think about when I say, “Trading in the Stock Market?” Investing in equity shares? Bonds? Making gains out of shares of those companies which you think are going to grow? When I again ask, “What is the purpose behind trade/investment?” what I hear from most people is “speculating on the prices of these financial assets.” But do you know what is traded the most in the market in any given trading session? The answer is derivatives. To be precise, about 85% of the entire volume traded in a day is in derivatives.

Let us first understand the meaning of this term. Derivatives in financial markets have nothing to do with the dy/dx that math enthusiasts get excited on seeing, so we need not be afraid. The dictionary meaning of the term derivative is “a financial instrument that derives its value from the underlying”. Now, this underlying could be anything- a stock, a bond, a commodity, or the currency exchange rate or even the prevailing interest rate in the market, and that is what makes this financial instrument so impressive. Moreover, derivative traders are not restricted to speculators but also include risk hedgers and arbitrageurs.

Let me explain how people hedge, or mitigate, risks through derivatives with the help of a simple example. Consider a wheat farmer who is in the middle of the harvesting season, and expects his crop to be ready in 3 months’ time. The going price of 1 kg of wheat is Rs 20. Now the farmer is afraid that this price might drop in future, which would cause him to suffer losses. Consider the counterparty, a wholesaler, who is expecting the price to rise, in which event he will have to pay more per kilogram of wheat, thus reducing his margins. What these people might do is enter into a contract, typically called a “forward contract”, in which the farmer and the wholesaler agree to trade at a suitable time, in this case, 3 months, at a price that has been agreed upon today. In the event that prices fall, the farmer is very happy that he did not lose out on his profits, but if the prices rise, he has to sell his crop at the agreed lower price. However, he is not too disturbed, because he essentially wanted to reduce his risk, and a prerequisite of reducing risk is reducing profitable opportunities. The same goes for the wholesaler. In this way, both parties are able to “hedge” their risks.

Who are arbitrageurs then? To understand that, we first need to know what arbitrage means. It is pretty simple- arbitrage is profit above the risk-free rate without taking any risk. To earn a return above the risk-free rate offered by banks, you need to be taking risks. If you don’t and you still manage to earn that extra return, then it is called arbitrage. Now arbitrageurs are those people who try and take advantage of mispricing in financial markets, which makes the valuation of derivatives very important. Consider a situation where you have two financial portfolios with the same level of risk and the same cash flows and payoffs in the future but are selling at different prices today. What will happen? People will buy the cheaper portfolio and sell it at the rate of the more expensive one because essentially both portfolios are the same. The arbitrageur happily gets to keep the difference without doing much. This is where we find the principle of pricing a derivative instrument, the “no-arbitrage price” principle, which I shall explain later. Let me first tell you the 4 broad categories of derivatives. They are forwards, futures, options and swaps. Forwards, futures and swaps fall under the category of “forward commitments”. These contracts take place independent of anything. In a nutshell, they are carried out irrespective of their maturity. Options are “contingent claims”. They are dependent on a specific event happening, such as a fall/rise in the price of a stock or the prevailing interest rate. We are primarily focusing on forwards and futures for now.

Forwards and futures are almost the same, with the key difference in them being where they are traded. Let us first understand the principle behind these instruments. The farmer-wholesaler example that we used earlier is a good way of understanding it. Let me first tell you about a few key terms which are used. At present, or time0, the forward contract is made between the two parties, which shall mature at time T. The money amount at which the contract is agreed to be settled at maturity is called the “price” of the forward contract, denoted by F. The underlying here is wheat and its price. The farmer, who has agreed to sell the underlying at maturity(time T) at price F, is said to have taken a “short position” in the contract whereas the wholesaler, who has agreed to buy the underlying at time T at price F is said to have taken a “long position. The party that agrees to go short is called F– and the party that agrees to go long is called F+. The amount exchanged between the two parties at time0, or in other words at the initiation of the contract, is called the value of the contract. Now, since both parties take equal risk, this value shall be equal to zero at initiation. Finally, the market price of the underlying today at time0 is called S0 and the market price at maturity i.e. at time T, is called ST.

What happens at maturity is pretty simple to understand. There are two simple methods of settling the forward contract- one, by physical delivery of the underlying and two, by simply cash settlement of the difference between ST and F. In physical delivery, F+ (wholesaler) shall pay the agreed price F to F-(farmer) and receive the underlying (wheat) from him. It does not matter in the forward contract now what ST is. However, which party has benefitted obviously will have to do with whether F+ has gained or F-. If ST, the market price of wheat at maturity, is more than F, the price at which trade between the two parties will take place, it is easy to assertively say who has gained right? Of course, it’s F+. He gets to buy the underlying at a lower price than the market price, and so he has benefitted out of the forward contract. F-, on the other hand, is obviously losing as the gain of F+ is the loss of F-. He could have sold the underlying in the market at a higher price, but now he has to be satisfied with the forward price. The reverse happens when ST is lower than F. F- is absolutely emphatic, since he gets to sell at a price higher than that in the market, whereas F+ is now the one who lost. This method would be observed among people who have an existing exposure to the business, or in other words, risk hedgers. Trading the underlying is their primary business; all they want is to reduce their business risks.

What will speculators prefer? It’s simple enough; they prefer the other method- cash settlement. These people in contrast to the earlier example of farmers and wholesalers are not in the agriculture or wheat business. They entered into the contract expecting a particular price change and trying to benefit out of it. All they do to settle the contract is exchange the difference in prices. So precisely, if ST>F, F+ gets (ST – F) from F-; and if ST<F, F+ pays (F – ST) to F-. There is no exchange of the underlying in this case, but intuitively the financial implication is the same.

Before moving on, let us make sure that the right idea has been passed. Which party is expecting the price to rise? Which party is expecting the price to fall? Which party wants the ST to be greater than F, and which party wants it to be less. Simply enough, F+ wants and expects the market price to be greater than the forward price whereas the reverse is true for F-.

This leaves us with just one more complexity in understanding how forward commitments work, as many of you might have guessed. F! Who decides what the forward price is going to be. F+ wants it to be as low as possible, whereas F- would want it to be as high as possible. A person with no understanding of finance or the economy might suggest that the forward price should be equal to the spot price today, viz. S0. This is not possible due to reasons such as inflation. The price of every commodity in the economy will rise over a period of time to some extent even if fluctuations are not present. The farmer will not continue to sell wheat for the rest of his life at Rs 20/kg. This price will definitely rise by some amount perpetually since that is the law of inflation. What then decides what F is going to be? I’m hoping that most of you know, since a hint has already been dropped.

IT IS THE NO ARBITRAGE PRICE PRINCIPLE!

The forward contract price is such that any person is not able to make arbitrage gains (remember, free fund profit) out of it. When would that happen? This is the most interesting part. Arbitrage gains can be made both if the forward price is higher than it should be, through a mechanism called the cash and carry arbitrage, and if it is lower than it should be, through the reverse cash and carry arbitrage. This “should be” is given by the risk-free rate of return offered by banks. Let me explain the cash and carry arbitrage with an example (this is going to get you amazed). Consider the risk free rate of banks to be 10% p.a. and S0 to be Rs 500. For the purpose of simplicity, we are ignoring any costs or benefits that the underlying may provide. In the given situation the forward price F should be 500*(1+10%) = Rs 550. What happens if the forward price in the market is Rs 560? A rational (and cunning, yes) person would take a loan of Rs 500 from the bank and buy the underlying. He would take a short position in a forward contract at the same time, i.e. he would agree to sell the underlying to the counterparty at Rs 560, the price in the market for forward contracts. What happens at maturity? Irrespective of what ST is, this person would honour the forward contract and receive Rs 560, out of which he would repay Rs 550 which he owes to the bank (principle + interest) and keep the remaining Rs 10 without any hassle. Amazing, isn’t it? He locks in a profit of Rs 10 to be received after a year without any risk whatsoever! You may be thinking why would someone take so much of trouble for such a meagre sum, but understand that this person would enter into thousands, or even millions, of such contracts at the same time. Hence the price F of the forward contract cannot be any more than Rs 550.

What happens if the price of the forward contract is now Rs 540 with all other conditions being the same as before, is fairly simple to understand. All you need to know is what short selling is. Short selling is when you borrow an asset or a stock from someone and agree to return it to him after an agreed time period. A person who sells short is expecting the price to fall, and so he borrows it from someone (since he himself does not possess it), sells it in the market now and later when the price is down, buys it from the market at this cheaper price and returns it to its owner. Now coming back to reverse cash and carry arbitrage, if F is Rs 540 when it ought to be Rs 550 according to the risk free rate of return of 10%, a person will short sell the underlying, invest the proceeds safely and without any risk of default in the bank at 10% rate and finally, take a long position in the forward contract to buy at F (Rs 540) after a year. At maturity, he would receive Rs 550 from the bank on his deposit. Out of this amount, he would buy the underlying at Rs 540 (again, it does not matter what ST is) and return the underlying to its owner, and go and party hard with the Rs 10 he has gained on the thousands of forward contracts that he would have entered into. Such a prize!

Hence, we understand now how forward contracts work. Of course there have gone some assumptions into this pricing process, such as no costs of storage of the underlying, no transaction costs and majorly, that the bank borrows and lends at the same rate, but these are not bad assumptions to make since we can easily incorporate these effects. I’m sure that now if someone asks you what forwards and futures are, you’ll be pleased to show off your knowledge. Oh wait! What are futures? I never talked about futures!

Don’t worry, I didn’t because forwards and futures are pretty much the same thing. I have earlier told that the difference lies in where they are traded. A forward contract is carried out in an informal environment between two people, whereas a futures contract is traded on the official stock exchange. With forwards the problem is that if the counterparty happens to be a Vijay Mallya or a Nirav Modi, he or she might think it is cool to run away with the money and that would not be so cool for you. Also, it might happen that you want to leave the contract in between, but that is problematic in an illiquid market. Since futures are traded on the official stock exchange, which means that they are backed by a 100% safe clearing house (mind you, in the history of the USA, the exchange has never defaulted), these problems are sorted. The exchange asks for security deposits in actual hard money from both parties rather than being satisfied with a Letter of Credit (okay, sorry for stretching the joke).

That’s that! That’s mostly what you’d want to know about forwards and futures as derivative contracts. So the next time when you come across someone who doesn’t know the dynamics of the stock market or how derivatives work, be sure to correct them and earn that praise that we all like. Knowledge is power, and power is what you need to rule the roost!

By Mridul Sureka




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