Professor – It is “B” for banking and “I” for information technology…. (Learning 3)

note: contd from the previous post "Learning 2"

We met again yesterday. This meeting was a specific one. “To learn and re-learn derivatives”. Re-learning is a methodology which I believe every professional should imbibe. Re-learning enables better understanding in terms of achieving good clarity, multi dimensional conceptualization, large scale refined introspection and most importantly preservation of the learning for a longer period of time. Thus, I always say that re-learning is indeed the passport for success – which everyone aspires.

Having said this, we settled for a good cup of filter coffee at Ratna Café hotel.

M: I went through a lot of material on derivatives on the web. I was able to grasp some concepts hither and thither – but I was not able to make out as to why there are so many of type of derivatives and what are its specific usages and what made new type of derivatives to evolve?

Me: Yes, that is a very important question. Many of us just accept the concept straight away and mug up the definitions without proper reasoning. A hands-on dealer would be able to explicitly elicit the practical evolvement of different types of derivatives – as he would know the practical implication of each type of trade. Let me take the same route – so that you can also understand and reason the concepts better. Let us go first on forward contracts.

M: Narasimhan, why don’t we go to futures first as they are most used trade in the market.

Me: No, that will not be the correct approach. You wanted to know on the evolution of each type of derivative trading. Think for a moment with proper reasoning. It must now be obvious that new type of trade would have evolved because of something lacking in the previous one and learning step by step would make our understanding better.

M: Oh, Ok.

Me: Previously, we talked about what are derivatives and why it is traded in general. Now, let us come to the first derivative type “Forward contract”.
A forward contract is a type of derivative trading where the buyer and seller mutually agree to buy or sell an asset, on a specified date in future at a specific price. (“The specific price being agreed today”). I hope you have got this definition right.

M: Ok – hmm, can I have an example.

Me: Good. Let us take a simple case – A rice farmer agrees to sell the rice that he is going to harvest at a specific price and on a specific date to the buyer. (Assume that the buyer is a whole sale dealer). Now, “Rice” is the asset, the seller and buyer agree on the price and they fix the settlement date in the future.

Like wise, Assume a scenario, where petrol bunk dealer agrees to buy the oil from the merchant at an agreed price and on an agreed date. The asset – here -being the “Oil”.

Now, tell me what do you see here?

M: It is hedging – as what you told me yesterday and that any fluctuation in the prices in the physical market is negated.

Me: Excellent. You have understood it well. This is forward contract and this is the basic advantage of doing one such derivative trade.

M: Cool- thanks. Now, how did the futures contract arrive then?

Me: (Smiles) Well, there are some disadvantages in doing a forward contract. First and foremost, when I gave you an example for the forward contracts, you would have seen that it is a bi-lateral agreement. This means that it is not governed by any monitoring body. This would mean, there is no obligation on both the sides. One might honor or dishonor the agreement on his whims and fancies. So, to sum it up, the following disadvantages exists in a forward contract

1) No monitoring body – which I call it is as the exchange house which acts as a centralized trading center or console
2) No proper standardization of the contracts.
3) No obligation scenario ( which I would term it as counter party risk)

So, the above following disadvantages gave birth to future contracts.

M: Ok, now I get the picture. I thought Forward contracts are monitored. No wonder, Future contracts are more popular.

Me: Yes, so what are future contracts then? They carry the same definition of forward contracts with some modification. Future contracts are exchange controlled trades happening between a buyer and seller to buy or sell an asset at an agreed price on an agreed future date. (The price is agreed today). The asset can be live stock, bullion, cross currency rate, rice, wheat etc. The advantages here are as follows:

1) There is an obligation for both the buyer and seller and thus, no counter party risk of dishonor
2) The buyer need not know the seller and vice versa as the exchange house takes the responsibility of clearing and settlement
3) Trading is standardized
4) And highly liquid.

M: This is nice. So, what is the protocol that is to be adhered while doing futures in exchange house?

Me: This again is a concept - where you have to understand Margins, Mark to market, basis, expirations, tick size etc. I will let you know on that in our next outing. Let us go slowly – so that we can pick up the concepts better.

M: Ok, so what is the plan for tonight?

Me: I have to complete Irvin wallace’ novel “The second lady”. It is a pretty good novel and off course, to spend some time on the idiot box as well – for there is the super singer finals today.

M: Great.

Me: Chalo, let us catch up later…adios…