In this article, we will discuss Forward Derivatives in a simple and easy way, so read this article till the end.
What is Derivatives?
Any instrument that has no value of its own, but derives its value from something else. They are called derivatives. The thing on which its value depends is called the underlying asset. As the value of paneer depends on the milk so here milk is the underlying asset of paneer.
For detailed explaination about derivatives read this article : What is Derivatives? (Share Market)
There are four types of Derivatives – Forward, Future, Option and Swap. In this article we will understand Forward Derivatives:
What is Forward Derivatives?
Let us understand this with an example. Suppose wheat is being sold in the market at Rs 20 per kg. There is a farmer who wants to sell his wheat at this rate but the problem with him is that his wheat is not ready yet, it will be ready after 2 months. The farmer is worried that if the rate of wheat in the market falls below Rs 20 after two months, then what will he do in such a situation.
Similarly, there is a bread making factory which saw that the last time the price of wheat had increased a lot in the market, its bread had become expensive. This time also he is feeling that perhaps the price of wheat will be Rs 30 per kg after two months. Whereas in today’s date its market price is only 20 rupees per kg. If even after two months, 20 rupees per kg of wheat is available, then what to say.
This is the problem which is coming to both of them. The way to solve this is through forward derivatives. how that?
Now that farmer and that factory can do that according to today’s rate of wheat, he can contract for 2 months later. That is, whether the price of wheat in the market increases or decreases, but after 2 months both will deal at the same rate as today. It has the advantage of both because it will reduce the risk of both, this is called hedging.
Overall, the farmer here is afraid that the price may fall even more, because when a lot of wheat comes in the market, then it is natural that the price will come down, while on the other hand the factory thinks that what will happen if the wheat yield is less. So the price of wheat will increase. Both of them have their own opinion. Who knows what will happen after 2 months.
Well, thinking the same, both of them made an agreement at today’s price for 2 months later. Since the deal is done today but the goods will be delivered after two months hence it is called forward. If you do here, you will know that the factor that decides the price of wheat here is production. That’s why it can be called forward derivatives.
Forward Derivatives Problems
Forward derivatives can happen between any two persons but the problem here is that suppose if the contract is signed but when the time comes and the rate of wheat becomes less than Rs 20 and that factory person agrees to take it If you do, what will happen? Similarly, if the rate of wheat increases to Rs 30 after two months and the farmer refuses to sell it. In such a situation there will be a big problem because there is no intermediary in the middle.
That is to say, the stock exchange has no role in this. It is simply a contract made between two parties. That is why there is no guarantee that the contract will be completed even if it is done.
To eliminate this problem, Future and Option were introduced. There is no such problem here as it is under the supervision of the stock exchange and everything happens in a transparent manner.
So overall this is forward derivatives, hope you understand. We will cover futures and options in the next article. You can read it by clicking on the link given below.