As explained in a review on financial derivatives titled "Financial derivatives made easy" published in this section last Friday, derivative contracts are formed either to capitalise on the future price direction of an underling asset or hedge price risk.
The contract formation and execution mechanism is largely similar in all derivative contracts.
However, based on differences in few underlying characteristics, derivatives contracts are divided into four main types: forward contracts, futures contracts, options and swaps.
Forward contracts: tailor made A forward contract is the simplest form of a financial derivative contract. It is a private agreement between two parties, under which one party agrees to buy an underlying asset from counterparty at a specific price on a specific future date.
For example: a farmer enters into a forward contract to sell a ton of wheat to an exporter at Rs 2000 per ton after four months, while its current price is $1950. Likewise, a party A agrees to sell 1 million in six months at Rs 88/$ to a party B.
A party that agrees to buy an underlying asset is called "long", whereas the counterparty or seller; is called "short". Another point to note here is that forward contracts are obligatory in nature as both parties have a legal binding to complete an action in the future.
Since forward contracts are created off the market, they are non-standardised or customised contracts and therefore are not traded in any exchange or formal market. And for the same reason; parties to a forward contract face counterparty risk. A user of forward contracts is mainly corporations, manufacturers, traders, bankers and farmers etc. Corporations enter into these contracts to mange and hedge their risk against rise in prices of input materials, fluctuation in foreign exchange rates and drop in prices of their finished goods.
Futures contract: one size fits all Futures contracts are similar to forward contracts, but the main difference between the two is that the futures contracts are standardised contract and traded on formal exchanges. Another difference between the two is that, futures contracts can be executed any time during trading hours, while forwards are executed only on expiration date.
Futures contract is explained as "a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardised to facilitate trading on a futures exchange".
As futures contracts are traded on exchanges; the exchange acts as a seller to every buyer and vice versa. In short, the exchange matches long and short positions. For instance: assume that a party 'A', expected silver prices to increase in the future. In this case, party A will take a long position by purchasing a standardised silver contract trading on a futures exchange.
There is a clearing house within each futures exchange. The clearing house provides a guarantee that both long and short will execute their transactions in future, by clearing trades, collecting and maintaining margins etc. Therefore, this process eliminates counterparty credit risk.
Swaps: series of forward contracts Swaps are series of forward contracts. They differ from futures as the former involves a stream of cash flows over a specific period of time, while the forward contract is executed in a single transaction at a future date. However, like forward contracts, swaps are customised contracts that are traded over the counter (OTC).
Since swaps are "tailor-made" instruments, they come in a wide variety. However, the two familiar types of swaps are interest rate swaps and currency swaps. The most common type of interest swap is called the plain vanilla interest rate swap or fixed for floating rate swap. In such a contract, a party exchanges a fixed interest rate payment against a floating interest rate payment from counterparty at certain intervals over specific period of time. The fixed rate is decided at the time of contract initiation.
Simply put, it can be explained with the help of the following example: A party 'A' enters into a $100, five-year annual-pay, plain vanilla interest rate swap as a fixed-rate payer at seven percent. Whereas, a party 'B' agrees to pay floating rate (LIBOR) in return. Assume that at the end of the first year, LIBOR falls to six percent. Here, party A will pay $7 to party B in exchange for $6.
However, this contract will expire when the two parties will exchange the fifth payment at the end of the fifth year. In essence, by entering into this contract party A has taken an exposure to a variable rate, while party B has taken an exposure to a fixed interest rate. However, the currency swap is a contract to exchange a series of interest payments in one currency for a series of interest payments denominated in another currency at certain intervals over specific period of time.
Options: rights Unlike the three types of the derivative contracts explained above; options are contingent claims. It means that the option buyer has the right, but not an obligation, to exercise a contract at a set price on a specific future date.
An option contract which gives the buyer a right to buy an asset is called a "call", while an option which gives the right to sell is called a "put". It should be noted that option buyers have to pay a premium to purchase an option contract.
However, the two types of options are exchange-traded and over-the-counter. The former is a standardised instrument and traded on exchanges, while the latter is a customised instrument.
Suppose that the price of ABC Ltd stock is trading at Rs 100 per share and an investor is expecting the share price to increase massively in the next few months. Therefore, the investor buys a call option to purchase the company's shares after three months at a fixed price Rs 110 per share- which is called the exercise price. Assume that at the end of three months, ABC's share price fell to Rs 90 in the market. Since the investor has an option to exercise the contact, the buyer will not exercise it as it will result in losses.
Financial derivatives in Pakistan: on the mend As forward and swap contracts are created in an informal market, there is no data available to gauge the size of forward and swap market in Pakistan. However, the forward contract is widely available in foreign currency markets, where banks provide a facility to corporations and traders to lock forward currency rate against their import and export bill payments.
Forward trading has also been available in local cotton markets for many years..Akbarali Hashwani, former chairman of KCA, wrote in a local magazine dated May 2003 that forward facility was available in Karachi Cotton Association (KCA) from 1934 to 1975-1976, and was suspended owing to the nationalisation of the cotton trade by the government of Pakistan.
Karachi stock exchange (KSE) offers futures contract for certain scripts. At present, around 28 scripts are eligible for futures trading at KSE. The average daily turnover of futures is 5.18 million shares since the start of CY11. This represents significant improvement compared to average daily turnover of 4.58 million and 1.03 million in CY10 and CY09, respectively. However, in the face of improvement, the volume is still very low compared to average daily turnover of around 82 million and 61 million in CY06 and CY07, respectively. Moreover, KSE also offers stock index future contract linked to KSE-30 index.
Pakistan Mercantile Exchange Limited (PMEX) is the country's first and only demutualised commodity futures company in Pakistan. The exchange became operational in May 2007. PMEX, offers futures on the following products: gold, silver, crude oil, rice IRRI-6, sugar, palm olein and KIBOR.
The volume and value on the PMEX has been on the rise. The monthly traded value of all contracts traded on PMEX reached Rs 98 billion in August (data till 24th august), up nearly seven times as compared to the same month the last year. At the same time, volume of monthly contracts also increased by eight times to 386,327 lots in August (data till 24th august). The exchange traded options are not available in Pakistan. However, PMEX is aiming to list options within the next two to three years.
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