Category: University of Mumbai BMS Notes

Convergence is the movement of the price of a futures contract toward the spot price of the underlying cash commodity as the delivery date approaches. It simply means that, on the last day that a futures contract can be delivered to fulfill the terms of the contract, the price of the futures and the price of the underlying commodity will be nearly equal. The two prices must converge. If not, an arbitrage opportunity exists and the possibility for a risk-free profit.

Convergence happens because the market will not allow the same commodity to trade at two different prices at the same place at the same time. For example, you rarely see two gasoline stations on the same block with two very different prices for gas at the pump. Car owners will simply drive to the place with the lower price.

In the world of futures and commodities trading, big differences between the futures contract (near the delivery date) and the price of the actual commodity are illogical and contrary to the idea that the market is efficient with intelligent buyers and sellers. If significant price differences did exist on the delivery date, there would be an arbitrage opportunity and the potential for profits with zero risk.

Arbitrage

The idea that the spot price of a commodity should equal the futures price on the delivery date is straightforward. Purchasing the commodity outright on Day X (paying the spot price) and purchasing a contract that requires delivery of the commodity on Day X (paying the futures price) are essentially the same thing. Buying the futures contract adds an extra step to the process: step one is to buy the futures contract, and step two is to take delivery of the commodity. Still, the futures contract should trade at or near the price of the actual commodity on the delivery date.

If these prices somehow diverged on the delivery date, there is probably an opportunity for arbitrage. That is, there is the potential to make a functionally risk-free profit by purchasing the lower-priced commodity and selling the higher-priced futures contract assuming the market is in contango. It would be the opposite if the market were in backwardation.

• Convergence is the movement in the price of a futures contract toward the spot or cash price of the underlying commodity over time.
• The price of the futures contract and the spot price will be roughly equal on the delivery date.
• If there are significant differences between the price of the futures contract and the underlying commodity price on the last day of delivery, the price difference creates a risk-free arbitrage opportunity.
• Risk-free arbitrage opportunities rarely exist because the price of the futures contract converges toward the cash price as the delivery date approaches.

Convergence trade is a trading strategy consisting of two positions: buying one asset forward i.e., for delivery in future (going long the asset) and selling a similar asset forward (going short the asset) for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal (will have converged), and thus one profits by the amount of convergence.

Convergence trades are often referred to as arbitrage, though in careful use arbitrage only refers to trading in the same or identical assets or cash flows, rather than in similar assets.

Formally, convergence trades refer to trading in similar assets in the expectation that they will converge in value. Arbitrage is a stricter notion, referring to trading in identical assets or cash flows, while relative value is a looser notion, referring to using valuation methods (value investing) to take long-short positions in similar assets without necessarily assuming convergence, and is more associated with equities. For example, in relative value investing one may believe that the stock of one mining company is undervalued relative to some valuation, while another stock is overvalued (relative to this or another valuation), and thus one will expect the undervalued stock to outperform the overvalued stock, even if these are quite different companies.

Risks

The risk of a convergence trade is that the expected convergence does not happen, or that it takes too long, possibly diverging before converging. Price divergence is particularly dangerous because convergence trades are necessarily synthetic, leveraged trades, as they involve a short position. Thus if prices diverge so that the trade temporarily loses money, and the trader is accordingly required to post margin (faces a margin call), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, convergence traders synthesize a put option on their ability to finance themselves.

Prices may diverge during a financial crisis, often termed a “flight to quality”; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.

Further, if other market participants are aware of the positions, they can engineer such price divergences, driving the convergence trader into bankruptcy compare short squeeze.

As with arbitrage, convergence trading has negative skew in return distributions it produces, resulting from the concave payoff characteristic of most such high-probability low-return strategies. Operators engaging in such trades will usually make consistent but relatively small profits, occasionally offset by significant losses, consuming previous profits earned over a long period of time. The low probability of encountering a loss in such strategies can lead inexperienced traders to underestimate the severity of such a loss, and assume excessive levels of leverage, potentially leading to bankruptcy.

On the run/off the run

On the run bonds (the most recently issued) generally trade at a premium over otherwise similar bonds, because they are more liquid there is a liquidity premium. Once a newer bond is issued, this liquidity premium will generally decrease or disappear.

Junk Bond/Treasury convergence

Typically junk bonds, given their speculative grade, are undervalued as people avoid them. Therefore the spread over treasuries is more than the risk of default, by buying junk bonds and selling treasuries, to hedge interest rate risk. Often profits can be achieved by buying junk bonds and selling treasuries, unless the junk bond defaults.

Reverse

A reverse version of this strategy also exists. This is when a trader believes that the futures contract is undervalued and the underlying asset overvalued. Instead of shorting the futures contract the trader would long this, and short the underlying asset.

A futures contract is nothing more than a standardized forwards contract. The price of a futures contract is determined by the spot price of the underlying asset, adjusted for time and dividend accrued till the expiry of the contract. When the futures contract is initially agreed to, the net present value must be equal for both the buyer and the seller else there would be no consensus between the two. This difference in price between the futures price and the spot price is called the “basis or spread”.

The futures pricing formula is used to determine the price of the futures contract and it is the main reason for the difference in price between the spot and the futures market. The spread between the two is the maximum at the start of the series and tends to converge as the settlement date approaches. The price of the futures contract and its underlying asset must necessarily converge on the expiry date.

The spot future parity i.e. difference between the spot and futures price arises due to variables such as interest rates, dividends, time to expiry, etc. It is a mathematical expression to equate the underlying price and its corresponding futures price.

According to the futures pricing formula:

Futures price = (Spot Price*(1+rf))- Div)

Where,

Spot Price is the price of the stock in the cash market.

rf = Risk free rate (T Bill/ Government securities)

d: Dividend paid by the company

A key point to take note of is ‘r’ is the risk free interest that we can earn for the entire year but since the future contracts expires in 1, 2 or 3 months, we require to adjust the formula proportionately.

Futures price = Spot price * [1+ rf*(x/365) – d]

x = number of days to expiry

One can take the RBI’s 91 or 182 days Treasury bill as a proxy for the short term risk free rate. The ongoing rate can be referred from RBI’s website. The prevailing rate in the market for 91 and 182 day t bill is ~6.68% and ~6.92% respectively.

Buying vs. selling futures contracts: Futures are a standardized legal agreements. The buyer has a long position, and a seller has a short position in the futures.

Clearing house: Futures are traded in an active market through an exchange, also called a clearing house. In India, the National Stock Exchange of India Limited (NSE) partakes in futures trading through futures index.

Margin requirement: Margin is the amount deposited in the clearing house by the parties. It acts as an assurance that parties will honor the contract when the time comes. Both parties need to deposit a margin at the beginning of the trade. Due to marking to market process, if the initial margin falls below the maintenance amount, the party receives a margin call.

Marking to market:  It is a process to settle future prices daily. The futures price rise or fall daily because of active trading. Clearing houses have adopted a means to pay the price difference after each trading by debiting and crediting the differential amount from the margin amount deposited by the parties.

Expected Spot Price

The market’s average opinion about what the spot price of an asset will be at a specific time in the future. This is usually based on the returns investors require on an investment in the asset underlying a futures contract. In turn, these returns depend on the systematic risk of an investment. When the return from the underlying asset is uncorrelated with the broader stock market, the futures price can be viewed as an unbiased estimate of the expected future spot price. If the return is positively correlated with the broader market, the asset underlying the futures contract has positive systematic risk, and the futures price is lower than the expected future spot price. This situation is known as normal backwardation.

However, if the return from the asset is negatively correlated with the broader market, then the asset underlying the futures contract has negative systematic risk, and the futures price is higher than the expected future spot price. This situation is known as contango.

When the securities are bought with the sole object of selling them in future at higher prices or these are sold now with the intention of buying at a lower price in future, are called speculation transactions. The main objective of such transactions is to take advantage of price differential at different times. The stock exchange also provides for settlement of such transactions even by receiving or paying, as the case may be, just the difference in prices.

For example, Ramu bought 200 shares of Tata Steel Ltd. at Rs. 210 per share and sold them at Rs. 235 per share. He does not take and give delivery of the shares but settles the transactions by receiving the difference in prices amounting to Rs. 5,000 minus brokerage. In another case, Manu bought 200 shares of ONGC Ltd. at Rs. 87 per share and sold them at Rs. 69 per share. He settles these transactions by simply paying the difference amounting to Rs. 3600 plus brokerage. However, now-a days stock exchanges have a system of rolling settlement. Such facility is limited only to transactions of purchase and sale made on the same day, as no carry forward is allowed.

Speculation: As a matter of basic intention

Though speculation and investment are different in some respects, in practice it is difficult to say who is a genuine investor and who is a pure speculator. Sometimes even a person who has purchased the shares as a long-term investment may suddenly decide to sell to reap the benefit if the price of the share goes up too high or do it to avoid heavy loss if the prices starts declining steeply. But he cannot be called a speculator because his basic intention has been to invest. It is only when a person’s basic intention is to take advantage of a change in prices, and not to invest, then the transaction may be termed as speculation.

Speculation = Settlement by paying difference in price without delivery of securities

In strict technical terms, however, the transaction is regarded as speculative only if it is settled by receiving or paying the difference in prices without involving the delivery of securities. It is so because, in practice, it is quite difficult to ascertain the intention. Some people regard speculation as nothing but gambling and consider it as an evil. But it is not true because while speculation is based on foresight and hard calculation, gambling is a kind of blind and reckless activity involving high degree of chance element. No only that, speculation is a legal activity duly recognised as a prerequisite for the success of stock exchange operations while gambling is regarded as an evil and a punishable activity. However, reckless speculation may take the form of gambling and should be avoided.

Arbitrageurs

Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which guarantee a fixed profit at the time of the transactions, although the life of the assets and, hence, the consummation of the profit may be delayed until some future date. The key element in the definition is that the amount of profit be determined with certainty. It specifically excludes transactions which guarantee a minimum rate of return but which also offer an option for increased profits. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets (Eg : NSE and BSE) . If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

This is the most important part of the arbitrage transaction. You have locked in a riskless arbitrage profit but how do you actually realize the profits that you have locked. In the cash market you can actually realize profits by selling your shares. In the arbitrage market there are actually two ways of realizing the lock-in profit on the arbitrage transaction.

You can realize the profit on arbitrage by unwinding your trade; that means you reverse your long position in equity and your short position in futures simultaneously

You can hold on to your cash market position in your portfolio, but you can roll over your futures position to the next contract based on the spread

Unwinding your arbitrage trade:

As we are aware, in an arbitrage trade you buy in the cash market and sell in the futures market. That means you are long in cash market and short in the futures market on the same stock and in the same quantity. What is interesting to note is that you do not have to wait till the date of expiry to unwind your position. You can even unwind your arbitrage earlier if the spread has come down substantially.

Hedging can be performed by using different derivatives. The first method is by using futures. Both producers and end-users can use futures to protect themselves against adverse price movements. They offset their price risk by obtaining a futures contract on a futures exchange, hereby securing themselves of a pre-determined price for their product.

An important factor in determining the eventual price, is the basis. The basis is calculated by deducting the futures price form the spot price. By successfully predicting the basis of a commodity, the eventual price of a commodity can be calculated at the moment the hedge is placed.

Long Hedge

End-users take a long position when they are hedging their price risks. By buying a futures contract, they agree to buy a commodity at some point in the future. These contracts are rarely executed, but are mostly offset before their maturity date. Offsetting a position is done by obtaining an equal opposite on the futures market on your current futures position. The profit or loss made on this transaction is then settled with the spot price, where the producer will buy his commodity.

A long hedge refers to a futures position that is entered into for the purpose of price stability on a purchase. Long hedges are often used by manufacturers and processors to remove price volatility from the purchase of required inputs. These input-dependent companies know they will require materials several times a year, so they enter futures positions to stabilize the purchase price throughout the year.

For this reason, a long hedge may also be referred to as an input hedge, a buyer’s hedge, a buy hedge, a purchaser’s hedge, or a purchasing hedge.

A long hedge represents a smart cost control strategy for a company that knows it needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long futures position. A long position means the buyer of the commodity is making a bet that the price of the commodity will rise in the future. If the good rises in price, the profit from the futures position helps to offset the greater cost of the commodity.

Futures price – Basis + broker commission = Net Purchasing price

Short Hedge

Producers of commodities take a short position when hedging their price risks. They sell their product using a futures contract, for a delivery somewhere later in the future. They hedge their price risk similar to long hedgers. They sell a futures contract, which they offset come the maturity date by buying an equal futures contract. The profit or loss made by offsetting the position is then settled with the price obtained at the spot market. This will be the actual price the producer has obtained for selling their product. Just like a long hedge, the prediction of the basis is a crucial factor for determining the price a producer will receive before hedging the commodity. This price can be calculated using the following formula

Futures price + basis – broker commission = net selling price

A short hedge is an investment strategy used to protect (hedge) against the risk of a declining asset price in the future. Companies typically use the strategy to mitigate risk on assets they produce and/or sell. A short hedge involves shorting an asset or using a derivative contract that hedges against potential losses in an owned investment by selling at a specified price.

A short hedge can be used to protect against losses and potentially earn a profit in the future. Agriculture businesses may use a short hedge, where “anticipatory hedging” is often prevalent.

Anticipatory hedging facilitates long and short contracts in the agriculture market. Entities producing a commodity can hedge by taking a short position. Firms in need of the commodity to manufacture a product will seek to take a long position.

Companies use anticipatory hedging strategies to manage their inventory prudently. Entities may also seek to add additional profit through anticipatory hedging. In a short-hedged position, the entity is seeking to sell a commodity in the future at a specified price. The firm seeking to buy the commodity takes the opposite position on the contract known as the long-hedged position. Companies use a short hedge in many commodity markets, including copper, silver, gold, oil, natural gas, corn, and wheat.

Commodity Price Hedging

Commodity producers can seek to lock in a preferred rate of sale in the future by taking a short position. In this case, a company enters into a derivative contract to sell a commodity at a specified price in the future. The company then determines the derivative contract price at which they seek to sell and the specific contract terms. The company typically monitors this position throughout the holding period for daily requirements.

A producer can use a forward hedge to lock in the current market price of the commodity that they are producing, by selling a forward or futures contract today, in order to negate price fluctuations that may occur between today and when the product is harvested or sold. At the time of sale, the hedger would close out their short position by buying back the forward or futures contract while selling their physical good.

• A short hedge protects investors or traders against price declines.
• It is a trading strategy that takes a short position in an asset where the investor or trader is already long.
• Commodity producers can similarly use a short hedge to lock in a known selling price today so that future price fluctuations will not matter for their operations.

Long Hedges vs. Short Hedges

Basis risk makes it very difficult to offset all pricing risk, but a high hedge ratio on a long hedge will remove a lot of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or asset by locking in the sale price.

Hedges, both long and short, can be thought of as a form of insurance. There is a cost to setting them up, but they can save a company a large amount in an adverse situation.

Cash and carry arbitrage is a financial arbitrage strategy that involves the exploitation of the mispricing between an underlying asset and the financial derivative corresponding to it. Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing. The strategy is sometimes also referred to as basis trading.

This is a term used often in cash and carry and reverse cash and carry arbitrages. The cost of carry or CoC is the cost that a trader or investor has to bear for holding a position in the underlying market till the future contract’s expiration date arrives. Typically, cost of carry is expressed as a percentage.

Contango and backwardation

• When a market is said to be in contango when the future price is higher than the spot price of the asset. It is when the market is in contango that cash and carry arbitrage occurs.
• The term contango is largely used in the commodities market while the term premium is used in the equity derivatives market.
• Backwardation happens in an exactly reverse scenario, and that’s when reverse cash and carry arbitrage comes into play. Backwardation is also termed discount in the equity derivatives market.
• When the premium widens, it is indicative of a bullish market and when the discount widens, it may be a sign of a bearish market.

Example of cash and carry arbitrage

Assume that an underlying asset is trading at Rs 102, with a cash or carry of Rs 3. The futures contract is at Rs 109. The trader buys the underlying and goes long while also shorting the future and selling it at Rs 109. The cost of the underlying is Rs 105 (cost of carry included) but the sale that the trader has locked is at Rs 109. Hence, the profit is Rs 4, and that has happened by making use of the pricing difference between the securities in the two markets.

In a nutshell

Cash & carry arbitrage occurs when the price of an asset in a future contract is greater than the price of the underlying in the spot or cash market. In such a scenario, the investor shorts the future and takes a long position in the cash market. Getting a fair understanding of how futures contracts work is important before you take the step towards arbitrage strategies.

Arbitrage strategies help traders benefit in a risk-free manner. Understanding cash and carry arbitrage definition helps you practice it, and get a better grip on the arbitrage strategy.

How It Works

A trader implements a cash and carry arbitrage strategy by identifying lucrative arbitrage opportunities in the market. They identify and invest in securities that they identify as mispriced in relation to each other. The trader opts to go long in a commodity, while, at the same time, taking a short position for the corresponding financial derivative and selling it off.

The commodity purchased is held until the expiration date, i.e., the delivery date of the corresponding contract. The trader then delivers the underlying against the corresponding contract and locks in a riskless profit. The profit earned by the trader is determined by the purchase price of the underlying plus its total carrying cost.

By shorting the corresponding contract, the investor locks in a sale at the price at which the contract is priced at. Hence, the investor will already have determined the sale price. If the purchase price of the underlying plus its carrying cost is less than the price at which the contract is sold, the trader makes a riskless profit by exploiting this mismatch of prices.

Risks Associated with Cash and Carry Arbitrage

In the cash and carry arbitrage strategy, the acquisition cost of the underlying is certain; however, there is no certainty with regards to its carrying costs. In the event that the carrying costs of the underlying increase and rise beyond the locked-in sale price of the corresponding contract, the investor incurs a loss instead of a profit. An example of an increase in carrying costs is the rising margin rates by brokerage firms.

Summary:

• Cash and carry arbitrage is a financial arbitrage strategy that involves the exploitation of the mispricing between an underlying asset and the financial derivative corresponding to it.
• Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing.
• Traders secure a profit by taking a long position on the financial commodity and shorting the corresponding contract.

Reverse Cash and Carry arbitrage is a combination of short position in underlying asset (cash) and long position in underlying future. It is initiated when future is trading at a discount as compared to cash market price. In other words, the cash market price is trading higher as compared to future. The arbitrageur/ trader can take position by selling his delivery of stocks in cash and simultaneously buying futures of same underlying assets of equal quantity. A trader must have delivery in that particular stock when there is such an opportunity available in the market.

Reverse cash and carry arbitrage occurs when market is in “Backwardation”, which means future contracts are trading at a discount to the spot price.

Reverse cash and carry arbitrage is performed when the futures is trading at a discount to the cash market price.

Lets assume the following data:

Cash market price:         Rs.100

December futures price:  Rs.90

This reflects a negative cost of carry which is bound to reverse to positive at some point in time during contract’s life and this reversal is an opportunity for traders to execute reverse cash and carry arbitrage.

Lets assume a contract multiplier for futures contract on Stock A is 200 shares. To execute reverse cash and carry, arbitrageur will buy one Dec Fut at Rs.90 and sell 200 shares of Stock A at Rs.100 in cash market. This would result in the arbitrage profit of Rs. 2000 (200 X Rs.10). Position of the arbitrager in various scenarios of stock price would be as follows:

Case I: Stock rises to Rs. 110

Loss on underlying = (110 – 100) x 200 = Rs. 2000

Profit on futures = (110 – 90) x 200 = Rs. 4000

Net gain out of arbitrage = Rs. 2000

Case II: Stock falls to Rs. 85

Profit on underlying = (100 – 85) x 200 = Rs. 3000

Loss on futures = (90 – 85) x 200 = Rs. 1000

Net gain out of arbitrage = Rs. 2000

On maturity, when the futures price converges with the spot price of underlying, the arbitrageur is in a position to buy the stock back at the closing price/ settlement price of the day.

Before entering the world of futures trading, investors must take the time to understand how contracts in the sector work and how they differ from trading in other, more mainstream asset classes, such as stocks and bonds.

The contract legally obligates a buyer to acquire an asset, or a seller to sell an underlying asset, at a predetermined date and price in the future. The asset involved can be anything from physical commodities gold, oil, corn, etc. to financial instruments, such as stock indices, interest rates and currencies.

Now before entering into a futures contract known as taking a position an investor should be aware of the four main elements of a futures contract. These instruments are much different from buying shares in companies on stock exchanges. In that type of trade, an investor immediately takes ownership of the underlying asset.

The four elements in a futures contract are:

Asset Class

The contract will specify the asset that underlies the contract, which is crucial in measuring the value of the trade. Some of the most highly traded assets in futures trading include energy products, agricultural commodities, precious metals, equities indices, and forex.

Quantity

The quantity explains the size of the contract, which typically outlines the specific number of the units being bought or sold. For example, one contract in WTI crude oil futures gives the holder the right to acquire 1,000 barrels of oil. If trading gold futures, one contract would give a market player the right to buy 100 troy ounces of gold.

Expiration

Futures contracts must have an end date an expiration on a set day in the future. The expiry date is the final day the contract can be traded. After that date, the contract must be settled under the terms of the agreement.

Price

The price of a contract is ultimately determined by the open market, reflecting the value of the asset involved. A futures contract, however, will contain a specific price, usually tied to the spot or cash price of the underlying commodity. The contract will also make clear what currency is being used in the contract, such as whether the asset is priced in U.S. dollars or another denomination.

Other Considerations

There are details involved in futures contracts, including delivery terms. Although most futures contracts are closed out before expiration, it’s still important to know the contract’s delivery terms. This involves knowing whether delivery will be in the physical commodity or will involve a cash settlement. Trading in gold, soybeans or oil often means a physical delivery, while other instruments, such as contracts based on S&P 500 Futures, are settled in cash.

Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are:

• Increased volatility in asset prices in financial markets

A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies.   The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one’s own currency for a unit of another currency is called as an exchange rate.

The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization of the markets and rapid industrialization of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990’s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly.

This price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds.

• Increased integration of national financial markets with the international markets

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-Ã -vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

• Marked improvement in communication facilities and sharp decline in their costs.
• Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies

A significant growth of derivative instruments has been driven by technological break through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous world wide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmed without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important.

• Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over-the-counter, not on an exchange.

A futures contract often referred to as futures is a standardized version of a forward contract that is publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon price and time in the future to buy or sell an asset usually stocks, bonds, or commodities, like gold.

The main differentiating feature between futures and forward contracts that futures are publicly traded on an exchange while forwards are privately traded results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.