Revise briefly

1.       We understood that we can enter into a contract to buy or sell something in future.

2.       We can fix the price of those things now itself.

3.       The agreement what we enter either to buy or sell in future is generally known as a “Forward Contract”.

 

Let us take up the yesterday’s scenario once again…to move forward:

Mr X is holding 5000 water bottles
Currently each water bottle is quoted in the market at @$2.00
It is expected that by the end of May, 2016, there can be a shortage of water bottles and Mr Y presumes that the prices of these water bottles may touch $2.50 per bottle.
So Mr Y entered into a forward contract with Mr X to buy 1000 water bottles at $2.25, delivery of the goods being done on: 27.05.2016
Price quoted by Mr X as on 27.04.2016 is		$2.25
Delivery is on:		27.05.2016
Let us assume that we are in May and the date is: 10.05.2016
Prices of water bottles in the market already touched	$2.30
Expected rate of water bottles by 27.05.2016	$2.50

 

What does it mean for us?

Mr Y can buy from Mr X, each water bottle at $2.25, when really in the market prices are likely to be $2.50

Now let us assume one more scenario. We assumed that Mr Y needs 1000 water bottles for a function at his home. Let us assume that function is now cancelled. This implies that Mr Y, instead of using the water bottles for himself, he can buy from Mr X at $2.25 and sell those bottles each at $2.50 per bottle.

Important things to understand: This implies that Mr Y is holding a “Forward Agreement or Forward Contract” that is going to fetch him $250 (1000 X $0.25) after 17 days.

Mr Y is in need of money. Can Mr “Y” sell this “Forward Agreement Contract” to someone else?

The answer is:  YES.

Does it mean that “Forward rate agreements / contracts are traded in the market? The answer is again “YES”.

At what price? That is dependent upon the demand and supply.

The total benefit to Mr Y as on 27.05.2016 would likely to be: (1000 X $0.25) è $250.00

 

 

 

 

 

Let us look into the Counterparty Credit Risk from this Forward Contract Agreement

What is the name of the contract?	Forward Contract
Can Mr X, tell Mr Y, looking into the increase of prices, that “HE WILL NOT SELL”	Yes
Is there any intermediary person / party to see that the Forward Contract conditions are fulfilled?	NO
At the end of the Forward Contract, who is likely to be at gain and who is likely to be at loss?	Mr X is at loss. Because, if he did not agree to sell to Mr Y, he could have sold in the market for $2.50 in the market   Mr Y is at gain. Because, he can buy each bottle at $2.25 and sell at $2.50
What is “mark – to – market”	It is a comparison of the book value to the market value
What is the “Mark – to – Market” or “(MTM)” here for Mr X – Seller as on 27.05.2016?	In the books of Mr X, the value of the Forward Contract is NEGATIVE (Because, the market value of the contract is $2.50 per bottle, but the booked value of the forward contract is: $2.25). The booked value is less than the market value
What is the “Mark – to – Market” or “(MTM)” here for Mr Y (“Buyer”) as on 27.05.2016?	In the books of Mr Y, the value of the Forward Contract is POSITIVE (Because, the booked value of the Forward Contract is $2.25 and its market value is $2.50). The market value is higher than the booked value
How can it be described in Financial Risk Management?	The positive MTM refers to è receivables and it is classified as an ASSET   The negative MTM refers to è payables and it is classified as a LIABILITY
What will happen, if the receivable are not recovered or the asset does not pay us?	We will be running CREDIT RISK
Then can we call “NOT RECEIVING POSITIVE MTM” as CREDIT RISK?	No. This is not credit risk. Because, this positive MTM is not created because of lending. But still there is a chance for not receiving this “POSITIVE MTM”. We call this as “COUNTERPARTY CREDIT RISK”.
When one of the parties (either buyer or seller) is running a negative MTM, can he cancel the contract and run – away?	Yes. Since this is a bi-partite (two party) agreement and there is no “Guarantor” or the intermediary party to see that the contract is fulfilled, the party who is running a negative MTM, can break the contract and run – away.
Then what is the risk to Mr Y, who is running at Positive MTM?	Mr Y is having a risk, because Mr X can break the contract and may Mr Y’s positive MTM may not be realized.
What we learnt today?	We understood about COUNTERPARTY CREDIT RISK

 

Why it is called Derivative?

Date: 27.04.2016

Today, I would like to discuss more about "Derivatives"


Revision in brief:

1. We understood that a forward contract can be entered between two parties without the involvement or need of any other intermediary.

2. We called such contracts as Over The Counter contracts (OTC) contracts.

3. In the previous example, we had discussed is having discussion on two types of assets. The primary asset is WATER BOTTLES and the secondary asset is "FORWARD CONTRACT".

4. Many people may get a doubt, where is the secondary asset. I will explain how it can be treated as a secondary asset.

Scenario

Date: 27.04.2016, the current cash price or spot price of water bottle is: $2.00 each

Date: 27.05.2016, the forward price (agreed between two parties) with a delivery date of 27.05.2016 is: $2.25 per bottle each.

Let us assume that after 10days (say on 10.05.2016) and the price of water bottle in the cash market or the spot market has moved to $2.25 and it is likely to touch $2.50 per bottle by 27.05.2016.

This indicates that the party who agreed to buy the water bottles at $2.25 from other party is likely to benefit because of this contract. This is because, the seller agreed to sell at $2.25, when the outside prices or market prices are likely to be $2.50

(Please understand this contract is transferable, tradable and marketable contract).

This means, that the party who is going to buy 1000 water bottles is likely to gain by $0.50 per bottle or with a total amount of $250 (1000*$0.25) in the next 17 days.

Now, here is the word called TRADING. So, if someone is likely to benefit by $250 in next 15 - 17 days, then he can sell this contract papers to someone for say around $200 or $225 (ignore time value)......right?

This means.....The Forward contract agreement / papers are going to change hands...This particular holder of the Forward Contract is going to sell it to someone...

So, what do we understand?

1. The water bottles are anyways, they are getting traded (bought and sold) in the market.

2. But,  the most important thing is "THE FORWARD CONTRACT...WHICH IS BUILT BASED ON THE WATER BOTTLES ARE ALSO GETTING TRADED.

So, friends....

What is the primary asset: Water Bottles

What is the secondary or derived asset: Forward Contract Agreements

Coming back to the definition of Derivative: The value is derived from the primary or underlying asset.

I think I have made you to understand the concepts....

All the very best...

Don't hesitate to write to me on: CFA.SURYA@GMAIL.COM




 

Date : 26.04.2016

After a very long time, I am writing this post...

Today's Agenda:

Topic - 1: Definition of Derivative
Topic - 2: OTC Markets

What is a Derivative?

If we google, we will get Text Book definition. Let us learn it in a different way.

The dictionary meaning of the derivative is "The Derived Value"...

If the value is derived, then from where it is derived? That is what we need to understand. For example, let us this example:

There are two friends Mr X and Mr Y. Mr X is holding 5000 water bottles. It is a very hot summer and Mr X knows that it is very difficult to get water bottles in the next 1 month in that area. Mr Y requires say around 1000 bottles of water bottles for some function in his house, which will take place after 1 month.

The discussion between Mr X and Mr Y is going like this...

	Date of Discussion: 26.04.2016
Mr Y	Hey..I need 1000 bottles of water as on 27.05.2016. Can you please provide?
Mr X	Yes. I can. But you need water bottles after 1 month…right?
Mr Y	Yes. But we can decide the price today itself?
Mr X	Oh! Okay…That is good. Today in the market one bottle cost is $2. How much you are willing to pay as on 27.05.2016?
Mr Y	I can pay you around $2.25. Is it Okay?
Mr X	That is fine. So, I will have to supply 1000 bottles to you, each bottle at $2.25. Right?
Mr Y	Yes Mr X. That is fine.
Mr Y	Shall we enter into an agreement for this selling and buying between us?
Mr X	Yes…

	What do we understand?
Contract Name	Forward Contract
Why	It is a delivery of the content that is mentioned in the contract will take place in future
Is the contract entered through any Intermediary?	No, It is a contract between two parties, over the counter
OTC contract	This is a contract entered between two parties, over a counter, without involving any third party like Exchange
Who will hold the contract	Logically, the Buyer of the water bottles. That is Mr Y will hold.
Can Mr Y sell this Forward contract to any other party?	Yes. If someone wants to buy, he can sell. This means, the forward contract changes hands. In that case, before the delivery of the 1000 bottles of water, the forward contract also changes many hands. The instrument / paper / contract, if it can be bought and sold, the instrument is tradable, marketable and it has some price.
What do we understand?	The forward contract instrument / paper has its own price, apart from the price of the water bottle price of $2.25
What type of contract it is?	It is an Over The Counter (OTC) contract.
Quick trick to remember?	There is no involvement of any guarantor or exchange between Mr X and Mr Y for this forward contract.

Let us meet tomorrow....to know more...

For any queries...contact me at: cfa.surya@gmail.com