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Category: Economics Page 1 of 13

Forwards and Futures Contract

Suppose a farmer grows tomatoes and enters into a contract to supply 5000 kg of tomatoes to the ketchup factory which is situated far away. The ketchup factory arranges to pick up the tomatoes from the farm and transports them to the factory directly. The tomatoes are supplied at the market prices prevailing on the date of supply. Having said that, both the farmer and the ketchup factory have to face the price risk, as neither of them is sure about the prevailing market prices on the day of supply. This is where a basic forward contract comes into picture. 

A forward contract is an agreement between a buyer and seller wherein an asset is traded at a future date. Settlement of the price of the asset is done when the contract is drawn up. Forward contracts are settled at a particular date at the end of the contract. These contracts are not traded on an exchange as these are private agreements between two parties. Because of the nature of the contract, these aren’t as rigid in their terms and conditions.

Going back to the above example, the farmer needs a minimum price of Rs.30 per kg to cover his costs and make a profit. So he wishes to sell tomatoes to the ketchup factory at a minimum price of Rs.30 per kg exactly 3 months from now. But the Ketchup factory can buy tomatoes from the farmer at Rs.33 per kg at the end of 3 months. At this price, the ketchup factory can cover all its costs including transportation and also make a margin.

A 3-months forward contract is initiated under which the farmer will supply 5000 kg of tomatoes to the ketchup factory at the end of the 3 month period at a price of Rs.31.5 per kg. Both the parties can be benefitted at this price. For the farmer it is Rs.1.5 better than the minimum price that he is expecting to be profitable in the market. Whereas, for the ketchup factory it is Rs.1.5 lower than the cost at which the factory can be profitable.

There can be three possibilities on the date of maturity of the forward contract: 

  1. The price of tomatoes in the market on the maturity date may be Rs.31.5. In this case, both the parties will fulfill their obligations and execute the contract.
  2. The price of tomatoes may fall. Say, the price is Rs.27. Under this forward contract, the farmer will make a profit of Rs.4.5 per kg as he will get Rs.31.5 per kg instead of the market price of Rs.27. However, the ketchup factory will be in a loss as they have to honour their part of the forward contract at Rs.31.5, when they could have bought it in the open market at Rs.27.
  3. The price of tomatoes may rise. Say, the price is Rs.35. Now the farmer makes notional loss of Rs.3.5 per kg as he will get only Rs.31.5 per kg instead of the market price of Rs.35. Whereas, the ketchup factory can procure the tomatoes at Rs.31.5, for which they would have had to otherwise pay Rs.35 per kg.

It is important to note here that although the forward contract is the right and the obligation for the parties, the profits or losses can also be unlimited to both. But it gives a degree of certainty to the farmer and the ketchup factory. The farmer gets assurance of his income irrespective of market conditions and the ketchup factory knows its costs of procurement and can plan its budgets accordingly. 

Forward contracts do sound good, but there are a lot practical difficulties. What if any of the party is unable to honour their side of the contract? The default may be intended or unintended. Either ways, the other party will be put through a lot of trouble. Of course, forward contracts are regulated under the Contracts Act and hence the contract can be enforced in the court of law. But, that is a very long and cumbersome process and the parties to a forward contract may have neither the time nor the resources to pursue prolonged legal recourse.

There may also be a case where either of the party wants to exit the contract midway for some genuine reasons. After entering into a forward contract, parties are under an obligation and cannot exit the contract. They can do so if they are able to find another similar party who is willing to honour the contract on their behalf. Forward contracts tend to become illiquid due to their uniqueness to specific circumstances. It is to address these problems that the concept of futures transaction comes into play.

Just like forwards, futures contracts involve an agreement to buy and sell an asset at a specific price at a future date. But the two aren’t exactly the same.

Futures contracts are marked-to-market daily. Daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of future dates.

As futures are traded on an exchange, they have clearing houses that guarantee the transactions. This lowers the probability of default. Future contracts are available on stock exchange indexes, commodities and currencies. Crops such as wheat and maize, and oil and gas are the most popular assets for future contracts. The market for such contracts being highly liquid gives an option to the investors to enter and exit at their own will. 

These contracts are often used by speculators who bet the price movement of an asset. Such contracts are closed before maturity and generally never delivered. There is usually a cash settlement in this case.

To sum up, forwards are private contracts so they work on good faith. However, when you enter into an exchange-traded futures contract, you get a real idea of the costs. There is a margin that the exchange collects in advance when you enter into a future contract. The exchange margins are defined as the initial margins consisting of the VAR margin and the extreme loss margins. In addition, if prices move against the Party, the exchange also collects mark-to-market margins (MTM). Whether you are a buyer or a seller in a future contract, the initial margins are similar. Only the MTM margins vary depending on which side of the contract you are on. 


Article on Forwards and futures in commodities 

Article on Forwards Vs futures contract dated Jan 18, 2020

Options Contract


When it comes to the trading of securities in the financial market, our imagination may restrict us to believe that it’s all about trading of equity with profit and loss dependent upon share price of different companies. However, in practice, a significant portion of the financial market trading is also managed through derivatives. A derivative in the ordinary term refers to any financial security/contract, the value of which is dependent on or derived from an underlying asset/assets (commonly referred to as only “underlying”). It is, therefore, an agreement between two or more parties that is completely dependent upon the underlying asset, the value of which is bound to change over time due to one or several factors. This change in value leads to profit/loss. Currency, commodities, market indexes, stocks, bonds, etc. form the underlying asset. Various types of derivatives that are useful for hedging from loss, risk management, speculation gains, etc. are forwards, futures, swaps and options. This article will be restricted to options.

The Mexican Peso Crisis of 1994

The Mexican peso crisis, also known as the tequila crisis, is a slang term that is used for financial fallout resulting from the Mexican economy. It was one of the first major currency crises in the South American continent. The value of the Mexican peso almost collapsed as a result of this crisis. The number of foreign reserves in the country rapidly decreased to extremely low levels and in the end, the Mexican government had no other option left so they required a bailout to save the country from this crisis. Foreign investors who had invested in Mexican bonds ended up losing 15% of the value of their investments in a single day and over 40% of the value in the long term. These rates look disastrous considering that bonds are fixed-income investments and losing money on bonds is considered to be a very rare possibility. So, what led the nation to this nightmarish disaster? Let’s delve into it. 



Let’s think of a typical day in our lives in this globalized world. We tune in to a news channel broadcasting from the United States on our television sets manufactured in China. We check our phones, most of which were assembled in China and Taiwan. We wear garments that are sewn in Bangladesh or Thailand. We then move to our workplaces in a car made up of parts that were manufactured in more than a dozen countries. All these exemplify global interconnectedness and our indispensable global economic interdependence. Trade is the major factor propelling the interconnectedness between nations.  International trade has transformed the entire global economic landscape. Today approximately, one-fourth of global production is exported. Countries not only trade in finished products but also in intermediate inputs as well. According to a European Commission Report, trade may increase employment and can produce higher income in some sectors, thereby improving people’s standards of living. It provides consumers greater choices and lower prices, thanks to a wider supply of goods and services.  Trade has grown in volumes, contributing significantly to the rise in the world’s GDP. 

Icarus Paradox

Icarus Paradox

A figure in Greek mythology, Icarus was given a pair of wings fashioned by his father Daedalus made out of some feathers and beeswax to escape an island he was stuck at. Enthralled by his ability to fly, he hardly took notice of the warnings not to fly too close to the sun and went way ahead in proximity to the hottest star ever discovered. The obvious happened. The beeswax melted and with no wings stuck to his body, he let himself down to his death. 

Danny Miller hence coined the term “Icarus Paradox” and finds its application at companies and in businesses, eminent and big. He mentions, “their victories and their strengths so often seduce them into the excesses that cause their downfall. Success leads to specialization and exaggeration, to confidence and complacency, to dogma and ritual.”. 

Super Bowl

Super Bowl Indicator

For all those people who have heard of Super Bowl in passing conversations but never really decided to delve into understanding what it is, Super Bowl is the annual championship game of the National Football League (NFL). The NFL is divided into two conferences – the National Football Conference (NFC) and the American Football Conference (AFC). In 1966, the merger agreement between the NFC and the AFC stated that there would be a championship game that decided the champion of the NFL as a whole, and hence Super Bowl came into being.

Men’s Underwear Index

Can Men’s Underwear Indicate the State of an Economy?

History has witnessed the emergence of multiple unconventional and head-scratching economic indicators which study the condition of the economy. Whether it was the lipstick sales, revenue out of buttered popcorn sales at cinema calls or something as bizarre as the trend of haircuts in a nation, all have been deemed as accurate indices to take an in-depth study of the economy. Something along the same lines has emerged over the recent years and it has been given the name of Men’s Underwear Index (MUI). 


Yes, you read it right. The trend line of the sales of men’s underwear within a particular period in an economy can paint a picture of the economy’s condition. If men’s underwear sales are falling, then that indicates that the economy is functioning poorly and help is needed. If, however, the sales are booming, then there’s nothing to really worry about. This concept was birthed by former Fed Chairman Alan Greenspan, who popularized this theory from the 1970s. The underlying assumption according to Greenspan is that underwear is a necessary item for consumers instead of being a luxury for them, and so their demand tends to remain elastic, except in severe economic downturns. 



Oligopoly definition

In an oligopoly market structure, few firms are interdependent. They collectively dominate the market. These firms are individually powerful in controlling the market yet these firms also depend upon other firms as they could bring some change in the market control.

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