Bullish Sentiment

Expectation that price will Rise in upcoming time.

Bearish Sentiment

Expectation that price will Fall in upcoming time.

Consider the following example:

Mr. A expects that the price of shares of X Ltd. will rise over next 3 months.  Mr. B expects that the price of shares of X Ltd. will fall over next 3 months. Mr. A agrees to buy 500 such shares and Mr. B agrees to sell 500 such shares after 3 months. They enter into a speculative contract, whereby they agree to settle the price difference at end of 3 months, by way of cash payment of the net difference. They do not intend for making actual purchase or sale.

If, after 3 months, the price of Shares of X Ltd. turns to be ` 550,

Mr. A loses ` 5,000 & Mr. B gains ` 5,000 [(` 560 – ` 550) X 500 Shares].

For settlement, Mr. A should pay ` 5,000 to Mr. B.

At this point if Mr. A denies to settle the contract, Mr. B can definitely drag Mr. A to the court of law for breach of contract. However, in reality, rarely anyone will have time and patience to do so, especially to recover a small amount like this.

Mr. B had to face the risk of default. They could have overcome such risk by involving an intermediary. This intermediary will ask both the parties to deposit an amount of margin at the beginning. The intermediary will reduce the margin of the losing party by the amount of loss and add the same to the counterparty’s margin balance. Doing so the performance of the contract is guaranteed.

In reality, Futures Contract provide such guaranteed performance.

Meaning of Futures Contract

A futures contract is a standardised contract between two parties where one of the parties commits to sell and the other commits to buy, a specified quantity of a specified asset at an agreed price on a given date in the future.

There are three main features of a futures contract:

1. The contract is standardised with respect to quantity, date and the minimum amount by which price would move.
2. The clearinghouse has a key role in trading of futures contract because it guarantees the performance.
3. As the clearinghouse act as a guarantor, it would require the parties to maintain a deposit (margin) with it. The margin amount changes with changes in daily prices. This process is called marking to market and the margin is called mark to market margin. In effect profits and losses are settled on a day to day basis.

A futures contract simply upgrades a forward contract into a secured riskless marketable instrument.

Differences between Forwards and Futures

1. Forward contracts are OTC (Over the Counter) type, whereas Futures contracts are exchanged regulated.
2. Futures contracts are standardised w.r.t price, quantity and date of settlement. Forward contracts can be customized contracts as required by the parties to contract. In other words, the parties may negotiate price, quantity, settlement date, etc. as per their own choice.
3. Forward contracts are unique because only those parties should settle the contract who have originally entered into the contract. On the other hand, Futures contracts provide flexibility of making entry or exit even before maturity. Due to this flexibility the parties to the contract keep changing.
4. Forward contracts have risk of default as the performance is not guaranteed whereas in Futures contract there is guarantee of performance as the exchange itself regulates the future contract.
5. Forward contracts may or may not require initial margins to be deposited, whereas depositing initial margin is a prerequisite in any Futures contracts.
6. Futures contracts are marketable instruments and therefore allow the party to make entry or exit any date, before or at the maturity. On the other side, Forward contracts are not marketable instruments & therefore do not provide any such flexibility.
7. Forward contracts may provide for actual buying or selling i.e. actual delivery, whereas, Futures contract are settled in cash by receiving or paying the differentials in price necessarily.

Long Position & Short Position

Long Position

A position that indicates “Buying” now, with the intent to sell later at a Higher Price.

Short Position

A position that indicates “Selling” now, with the intent to buy later at a Lower Price.

Pricing the Futures Contract

Pricing the futures contract means to determine FFP (Fair Futures Price). This involves application of two important concepts:

1. Concept of Short Selling
2. Concept of Continuous Compounding

Short Selling

Short selling involves selling a stock which you don’t own and buying it back later to square the position. A short seller resorts to this strategy because he expects prices to fall and wants to benefit from the fall. In a falling market this is a good way to make money.

• The term short selling refers to selling a stock that is not owned.
• When the stock price is at high in the market and is expected to decline in future, one can make gains by short selling.
• This is done by borrowing the stock from someone who holds such stock.
• Thereafter, selling the borrowed stock and waiting for the prices to fall.
• Once the stock price falls repurchase (Buy to Cover) the same stock at such low price and return the borrowed stock to the stock lender along with the stock lending charges.

Continuous Compounding

For Continuous Compounding, the future value is determined as given below:

F = P.e^rt