InvestorQ : Can futures and forwards protect me if the price of the underlying asset becomes very volatile?
Nishant Chandani made post

Can futures and forwards protect me if the price of the underlying asset becomes very volatile?

Answer
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Dilmini Mercia answered.
1 year ago


That is perfectly possible. Assume that the farmer and a ketchup factory enter into an agreement wherein the farmer and the ketchup factory enter into an agreement such that the farmer supplies tomatoes to the ketchup factor at Rs.21/kg at a future date. What are the possibilities now? For example, the crop may be hit by bad weather and the price of tomatoes would have gone up to Rs.26/kg. The farmer ends up with a notional loss because he has to sell tomatoes at Rs.21 as against the market price of Rs.26/kg. This 5 rupee loss will be the gain for the ketchup factory. On the other hand, if there is a glut of tomatoes in the market and the price falls to Rs.16/kg then the tomatoes will still be supplied at Rs.21/kg only. In this case, the farmer will gain Rs.5 and the ketchup factory will lose Rs.5. While the price is agreed upon, there could be notional loss based on the market movement.

The question is why are the factory and the farmer getting into a forward contract where one of them could lose. That is because both want certainty. Both are going to be profitable at a price of Rs.21/kg and that is what matters in business. They are not traders who are looking to profit from price movements. They are just looking at protection from price volatility. Forward contract is the most basic form of derivative.