Rajen Gala

Let’s say there’s a farmer who cultivates wheat and there is a baker who needs wheat as an input for making bread. The farmer thinks that the price of wheat which is currently trading at Rs.100/- could fall to Rs.90/- in 3 months. The baker on the other hand feels that the price of wheat on the other hand might become Rs.120/- in 3 months. In such a case both of them get together and sign a contract which says that at the end of 3 months the farmer would sell wheat to the baker at Rs.110/-. Thus, the farmer is protected against possible fall in prices. And the baker is protected against the price of wheat going beyond Rs.110/-. Such a contract is called a Futures contract. In a Futures contract both parties are obliged to honor the contract and there is no escape route for either party. But what if the contract gives the farmer the “option” of either Selling his produce to the baker at the pre agreed price of  Rs.110/- or choosing to exit the contract and selling the produce in the open market or wherever he deems fit. Thus, he would not be obliged to honor the contract made with the baker on the date of settlement. Such a contract which gives the farmer the option of either executing the contract or exiting it is known as an “Options” contract. But the farmer obviously cannot get this privilege just like that. He obviously has to pay a premium for exercising this facility. Now, let’s say that after 3 months the price of wheat reaches Rs.120/-. In this case the farmer quite obviously will want to exit the contract so that he is free to sell his produce in the open market for Rs.120/-. Thus, while the farmer gets away the baker is left high and dry and has no other option but to buy from the open market at Rs.120/-. But it is not such a bad situation for the baker as it appears as he gets compensated by the farmer for having been a party to the “Options” contract. This compensation  in the form of price is called the “Option premium” that the farmer has to pay for the Options contract and quite evidently it would be a small amount. Let’s say in our case the amount is Rs.2/-. So, the farmer is obliged to pay the baker Rs.2/- as he has chosen to opt out of the contract. Thus, although the baker has no other option left but to go to the open market and purchase wheat at Rs.120/-, he does get the benefit of  Rs.2/- as compensation for being a party to the Options contract. So even if the price is Rs. 120 in the open market, for him the effective price turns out to be Rs.120 – Rs.2 = Rs.118/-. So, by simply participating in the contract he too stands to gain something. As far as the farmer is concerned it is a win – win scenario for him by participating in the contract. Had the prices fallen to Rs.90/- as he had anticipated he would have executed the Options contract. But since prices rose to Rs.120/- he chose to exit the contract. Thus, he is blessed with the Option by signing such a contract. It is important to understand that in an Options contract only one party gets the privilege to exercise the option while the other party is obliged to honor the option chosen. Thus, in our case the farmer has the option to either execute or exit the contract whereas the baker is obliged to honor the decision of the farmer. A contract such as this where only the seller of the commodity gets the option to either exercise or exit the contract is known as “Put” option. There is another option which is called a “Call” option. Even in an Options contract both parties land up achieving their goals and their interest is protected. The farmer stands to gain the most by getting to exercise a choice that benefits him the most. The baker too benefits by being a party to the contract due to the compensation he receives from the farmer for not honoring the contract. The baker due to the compensation receives wheat from the open market at an effective price of Rs.118/- And hence is better off than the ordinary or spot buyer who would have to pay Rs.120/-. Thus, in a sense both parties landed up getting some gains by being parties to the “options contract”. However, unlike in a “Futures” contract, in the “Options” contract one party gains more than the other party. Takeaways, Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed upon price and date. Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation. Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract. Call options allow the holder to buy the asset at a stated price within a specific timeframe. Put options, on the other hand, allow the holder to sell the asset at a stated price within a specific timeframe. Each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller.

Today, we have a loan for just about everything, be it a house, car, foreign trip and even a mobile. The \’loan culture\’ has caught on in a big way. A majority of people have availed of loans at some point or the other. But do we really know how the EMI on the loan is calculated? What is an EMI? An Equated Monthly Installment (EMI) is the amount paid by a borrower each month to lender of the loan. The EMI is an unequal combination of principal (the actual loan you have taken) and interest rate. EMI payments are made every month, generally on a fixed date, for the entire tenure of the loan, till the outstanding amount has been completely repaid. Factors Affecting EMI The key factors affecting your overall EMI amount payable include the following: Loan Principal: The higher the amount borrowed as a loan, the higher will be your EMI as long as the tenure and interest rate remain constant. Interest Rate: The higher the interest rate, the higher will be your individual EMI payout as well as the total interest payable on your loan. Tenure: When a longer tenure is opted for, individual EMI payments will decrease as compared to a shorter tenure for the same loan. But a longer tenure also results in higher total interest payable over the loan tenure. It is important to understand how banks work out the EMI so that you would find it easier to evaluate various loan options. So how does the bank arrive at the future value of a loan & interest to be repaid at future dates? The answer is Time value of money.  The theory of time value of money says that a rupee receivable today is more valuable than a rupee receivable at a future date. This is because the rupee received today can be invested to earn interest. For instance: Rs.100/- receivable today can be invested at, say, 7% interest and therefore enables one to earn additional Rs.7/- in a year. In the earlier years of loan repayment, it is mainly the interest payments that are being made while the principal amount is much less. As the loan matures, and as the principal gradually gets paid, the outstanding loan amount reduces. The interest component thus becomes lower than the principal, and finally minimal. PAYMENT OPTIONS FIXED RATE EMI: Fixed rate loans are those which remain same throughout the tenure. This can be best option only when interest rate has reached bottom, from where upward trend is expected. FLOATING RATE EMI: Floating rates move in tandem with market and RBI measures which are prone to fluctuation depending on the market and economy. Does my EMI stay constant? Yes. Though the EMI is an unequal combination of interest rate and principal, it stays constant. Unless… If you prepay part of the loan, the amount of your remaining EMIs will not remain the same if you leave the duration of your loan constant. In case you have taken a floating rate loan, the EMI will change as the interest rates change. Of course, some have the option of the EMI not changing but the tenure increasing or decreasing. You opt for a loan where the EMI keeps increasing over the years. To give an example, let\’s say you have a 10-year loan. The EMI stays constant for three years, then rises for the next three years and rises again for the last four years. This will help young individuals who cannot afford a huge EMI at this point but can do so as their earnings rise.

Imagine there are several farmers in a market. Some have a view that the price of Wheat is going to fall in the near future (bearish participants) Also, some bakers have a view that the price of wheat is going to rise in the near future (bullish participants) The market place has free flow of information. It provides a platform to both bullish & bearish participants to execute their trades without even knowing each other or hunting for counterparties. So, the expected future price (price of wheat) is known to every farmer and bread manufacturer. Any farmer trying to extract a higher price will not be able to do so because for the bread manufacturer there are several other farmers to buy from and vice versa. Since the price is universally known and there are several farmers and bread manufacturers, there is no need to get into individual contracts. There is no need to know who the options/futures buyer is and who the options/futures seller is for it does not make any difference for either party. The markets also make it possible for either party to deal with several counter parties at the same time. The market thus makes it possible to keep identities of parties to remain confidential with respect to the respective counter parties. If one were to replace the farmer and bread manufacturer by normal people who have opposite views about the future prices of stocks, what we have is a typical Derivatives Market. The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.  Key Takeaways The market provides a platform for several parties and counter parties to come together to trade over stocks about which information is free flowing. This leads to a single future price for all participants, thereby rendering irrelevant the need to know who the buyer for the seller and vice versa. Despite all of the above, the market system independently has all the necessary information about the market participants.

One of the most exotic terms in trading is “Futures”. A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a future exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date. Let’s say there’s is a farmer who cultivates wheat and a baker who needs wheat as an input for making bread. The farmer thinks that the price of wheat which is currently trading at Rs.25/- could fall to Rs.22.50/- in 3 months. The baker on the other hand feels that the price of wheat on the other hand might become Rs.30/- in 3 months. In such a case both get together and sign a contract which says that at the end of 3 months the farmer would sell wheat to the baker at Rs.27.50/-. Thus, the farmer is protected against possible fall in prices. And the baker is protected against the price of his input going up beyond Rs.27.50/- Such a contract is called a “Futures” contract because it is a contract that has to be executed at some future date. Thus “Futures Trading” is nothing but having a point of view about the  direction of the future price of a commodity/stocks/currency. And when two parties have opposite views about future price movements they obviously are open to sign a mutually beneficial deal like the farmer and the baker did in our example. Now, let’s say that after 3 months the price of wheat reaches Rs.30/- In this case the farmer will have to sell for Rs.27.50/- as per the contract and undertake an opportunity loss of Rs.2.50/- as his call that prices would go down was not correct. The baker on the other hand would be happy to receive wheat at Rs.27.50/- due to the “Futures Contract” at a time when the prevailing market price is Rs.30/-. Thus, he clearly makes a profit of Rs.2.50/- because his expectation on price movement turned out to be correct. However, at the end of the period both parties achieve their goals of protecting their interests. While there may be an opportunity loss of the farmer but still he lands up making a profit of Rs.2.50/- At least he would have been at peace for the period of 3 months since he remained protected against any price fall or loss. The baker on the other hand gets wheat at Rs.27.50/- and makes a clear gain of Rs.2.50/-. He can now plan his manufacture more profitably than his competitors who would buy in the market at the spot price of Rs.30/-. Since his call was right about the price movement, he landed up making the gain of Rs.2.50/- due to the futures contract. Thus, in a sense both parties landed up meeting their business objectives and the “futures contract” helped them plan their business well by protecting their interests against unpleasant price fluctuations. Thus, at the end one gains more and one gains less but both are happy that they could plan their business well.

The commodity markets are made up primarily of speculators and hedgers. While speculators are all about taking on risk in the markets to make money, the function of hedgers is to reduce their risk of losing money. Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security. In the world of commodities, both consumers and producers of them can use futures contracts to hedge. Commodity hedging means reducing or controlling risk arising out of fluctuation in raw-material prices Commodity hedging is done by taking a position in the futures market that is opposite to the position in physical market Any buyer or seller facing the risk of volatile commodity prices can do commodity hedging after compliance with regulatory requirements. Hedging is a two-step process. For instance, a wheat farmer can sell wheat futures at current prices to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in the futures position. Thus, the farmer meets his objective of ensuring certainty in his revenue. Example… A farmer who has standing crop of basmati paddy would like to sell the crop in advance. Suppose in the month of August or September, the farmer sees the basmati paddy futures price for October contract and find the price favourable to sell. So, he sells the October futures basmati paddy contract through broker and delivers the material in the exchange designated warehouse before contract expiry, let’s say in September last week. The contract settles on 5th of October and he will get the payment by 7th of October. Delivery process and final settlement usually completed within 5 to 7 days. Similarly, a basmati exporter who requires paddy to make rice for export down the line in the month of October. He will buy basmati paddy futures contract at commodity exchange for October delivery by paying a small margin amount of only 5-10%. Upon contract settlement in the month of October he will make the payment to get the delivery. Key Takeaways Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security. In the world of commodities, both consumers and producers of them can use futures contracts to hedge. Hedging with futures effectively locks in the price of a commodity today, even if it will actually be bought or sold in physical form in the future.