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Published : June 20, 2016 | Author : grishma
Category : Banking and Finance laws | Total Views : 1951 | Unrated

Law student, ILS Law, Pune

Futures and forward derivatives - General Overview

A Derivative is a security deriving its price from underlying assets viz. Stocks, currencies, bonds etc. The value of the underlying asset depends upon the fluctuations of the price of such an asset in the market. As per Section 2(ac) of the Securities Contract (Regulation) Act, 1956 Derivative is defined as:

“Derivatives includes-(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; (B) a contract which derives its value from the prices, or index of prices, of underlying securities”

There are various kinds of derivatives in the market. They are forward, future, option, swaps etc. the object of this article is to examine the features of futures and forwards contracts in detail.

Originally the working of both the contracts are similar in nature. It is important to analyse the working of these types of contracts for risk allocation as well as the valuation technique..

Forward Contract

A forward contract means a contract between parties to buy or sell something on a certain date on a price fixed on the date of the agreement.
Generally speaking a forward contract involves more risk than a futures contract. Forward contracts are entirely customised between private parties. Essentially both contracts have same function. Forward contract is settled at a forward price determined at the start trading date. In a forward contract there is no cash flow until delivery.
A forward contract, in case of physical delivery specifies to whom the delivery should be made to. Forward contracts are usually unregulated.

Futures Contract

In simple terms, a futures contract is an agreement between two parties to buy or sell on a future date.
Futures contracts are generally standardised contracts. They take place in an organised exchange. Futures contracts automatically require credit risk mitigation measures. This kind of contract employs a system where profits and losses are exchanged on the day they occur. Due to these payments, a futures contract has market value at zero at the end of the trading day. This removes credit risk to a great extent.
Futures contract are settled at the settlement price determined at the last trading date. Buyers benefit from price increase whereas sellers benefit from price decrease.

As such fundamentally the function of both the contracts are similar. The important aspect that is lower credit risk exists in futures rather than in forward contracts. Since futures contracts are regulated and standardised there is lower risk of a party defaulting as against an unregulated forward contract. Futures contracts have clearing houses who regulates the parties and probability of default is considerably lower. Moreover, as futures contracts are daily market to market transactions which means exchanges occur at the end of each trading day making it more viable than a forward contract which has only one settlement date.

On the other hand because futures contracts are often employed by persons, who follow the direction in which a price of an asset will move and go ahead, they are generally shut out prior to maturity and delivery usually never happens as against forward contracts that want to eliminate the uncertainity of a the price of the asset and delivery of the asset or seek settlement usually takes place.

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