Professional Documents
Culture Documents
Mechanism, Hedging,
and Pricing
DERIVATIVES
A product whose value is derived from the
value of another asset referred as
underlying asset.
Underlying Asset can be
COMMODITIES,
T-BILLS,
STOCKS,
CURRENCIES,
INDICES, etc.
FORWARD CONTRACT
Spot transaction is characterised by simultaneous
negotiation of price and settlement by exchange of
consideration and delivery of asset.
Forward contract is a contract between two parties
to deliver the asset at a predetermined price at a
future date.
First phase is fixing of price, and
Second phase is settlement,
Both phases are at different times.
Farmer
Supplier of Rice
Rice Mill
User of Rice
LIMITATIONS OF FORWARD
SIZE OF MARKET
OTC products have limited market size.
There will be few hedgers.
Finding counterparties with matching needs of timing, quality,
quantity and price is extremely difficult.
FAIR PRICE??
Price discovery is not likely to be true.
( Price of Rs 20/Kg would depend upon the negotiation power of
buyer and seller. It is likely to be an unequal market for buyer and
seller)
Exit Route:
Once entered it is difficult to make an early exit; requires consent of
the counterparty
COUNTERPARTY RISK
Settlement is by delivery
One of the parties would have strong incentive to default depending
upon the price at the time of harvest, the end of forward period.
Derivatives and Risk Management
Rajiv Srivastava
Buyer
Exchange
Derivatives and Risk Management
Rajiv Srivastava
Seller
FEATURES OF FUTURES
Organised Exchange: Forwards are OTC while
for Futures there exist an organised exchange.
Standardisation: Delivery and quantity of the
asset are not fixed in forward contract. They are
tailor made. Futures contracts are standardised
quantity,
quality,
delivery time,
delivery centres.
Price quotation vs. Contract size
Tick size: Minimum movement of price.
FEATURES OF FUTURES
Clearing House: Futures are through a clearing
house, while forward contracts are done directly.
Margin Requirements: Margins have to be
deposited with clearing house. No margins are
required in a forward contract.
Commission: to be paid separately. In forward
contracts spread between Bid Ask exists.
Mark to the market: Futures contracts are marked
to the market. Forwards are settled only once upon
maturity.
Actual delivery is rare in futures while most
forward contracts are settled with delivery.
Derivatives and Risk Management
Rajiv Srivastava
10
FUTURES
Futures are forward contracts that are traded on
EXCHANGE.
It is a contract between two parties (not known to
each other as Exchange works as interface) to
deliver the asset at a predetermined price at a
future date.
Fundamentally, futures contract is same as forward
in terms of pricing, applications etc but
mechanisms of trading, and settlement are
substantially different.
11
FUTURES Vs FORWARD
PARAMETER
Place
FUTURES
Exchange
FORWARD
OTC
Product
Initial Cash
flow
Settlement
Closing out
Standardised
Margin required
Tailor-made
Nil
Daily by MTM
Offsetting, Easy,
Any time
Rare
Very high
Final
Difficult
Delivery
Liquidity
Mostly
Very low
12
TYPES OF FUTURES
Initially futures were used in merchandise business
only. Financial futures came in to being in 1972 on
the International Money Exchange at CME.
Commodity:
Where the underlying asset is a commodity
Agricultural commodities like Wheat, Rice, Soya,
Coffee, Sugar, Rubber, Coconut, or
Metals like Gold, Silver, Copper, Tin, Aluminum
Financial:
Where the underlying is a financial asset.
Stocks/Indices/Currencies/Interest Rate
Derivatives and Risk Management
Rajiv Srivastava
13
FINANCIAL FUTURES
Currency:
Where the underlying asset is a currency like $, Euro, , ,
Rs. etc.
Currency futures trading started in August 2008.
Stocks:
Where the underlying is a stock or index. Introduced in
India on June 12, 2000 for Indices and on November 9,
2001 on select individual securities, at NSE.
Interest Rate:
Underlying is a Interest Rate (LIBOR, MIBOR). In India
launched on June 24, 2003 at NSE. Failed. Re-introduced
with a notional GOI security as underlying.
Short term interest rate futures began trading on July 4,
2011 at NSE with 91-day T Bill as underlying.
Derivatives and Risk Management
Rajiv Srivastava
14
15
COMMODITY FUTURES
Commodity futures exist on vast range of
commodities Agriculture, Energy, Metals,
16
Time conditions
Good for the Day, GTD
Good Till Cancelled, GTC
Immediate or Cancel, I/C (Partial match possible)
Quantity
Minimum Fill
All or None
Derivatives and Risk Management
Rajiv Srivastava
17
SETTLEMENT
Three ways to Settle
Physical Settlement Settlement by giving/
taking delivery
Prior intimation required.
Settlement is done on the basis of warehouse receipt.
Warehouses are designated.
18
SETTLEMENT BY DELIVERY
Delivery Notice Period
Some days prior to maturity of the contract (usually
2 weeks) buyers/sellers must declare intentions to
take/make delivery.
Delivery Notice Period required for delivery
preparation.
DELIVERY LOGIC: Who can force delivery
Specified in the contract and determined by the
exchange.
19
SETTLEMENT BY DELIVERY
MECHANISM/LOGISTICS
WAREHOUSE:
Warehouses and places of delivery are designated.
ASSAYERS
Suitable arrangement made for quality and quantity check,
(Assayers)
TRANSFER
Warehouse receipts are issued if quality/quantity found
acceptable.
Warehouse receipts would be given to intending buyer to
receive delivery.
Warehouse receipts are negotiable instruments.
20
ASSIGNMENT
Mismatch between deliverable quantity among buyers and
sellers gives rise to problem of assignment.
Process of finding willing counterparty (buyer willing to take
delivery) is called ASSIGNMENT. Exchange has to find some
buyer /seller who accepts delivery against the futures contract.
Delivery notice to be assigned only to open positions.
METHODS OF ASSIGNMENT
1. Display Notice and call for bids from willing buyers
(CBOT, Brazil, CME)
2. Assign on some basis (COMEX, India)
Random
First in first out (FIFO)
Longest contract period
21
SETTLEMENT BY DELIVERY
OPTIONS TO SELLER/BUYER
Those not needing delivery are expected to square up.
Both seller/buyer have option to square up even after
intention to deliver/assignment till the last day of Delivery
Notice Period. This is not the case in stocks futures.
After expiry of Delivery Notice Period, delivery is assigned to
open long positions.
DELIVERY RATE
Delivery rate depends upon the spot price.
Adjustment to the delivery price for quality, freight etc done.
These are already specified in the contract before-hand.
Warehouse receipt is given to assigned buyer, who pays to
the exchange.
Against receipt warehouse delivers.
Exchange makes payment to seller.
World over delivery is about 1% of the contracts
Derivatives and Risk Management
Rajiv Srivastava
22
SETTLEMENT BY
OFFSETTING
Normally settlement is done by offsetting contracts,
before expiry of the contract, permitting participants
to nullify positions.
Buy first sell later or sell first and buy later.
10 Dec Buy Gold Futures contract
32,680
15 Dec Sell Gold Futures contract
32,780
Net Profit = 100 x Size of the contract
(in terms of price quotation)
23
CASH SETTLEMENT
Last day of trading all open positions are closed automatically
All long positions are nullified by selling
All short positions are nullified by buying
The closing price is the spot price, ensuring that futures price
is equal to the spot price in the physical market
The difference of price of the initial contract and closing
contract are settled in cash.
Spot price may be determined by polling and bootstrapping
Buy first sell later or sell first and buy later.
10 Dec Initial position
Buy Gold Futures contract 32,680 (Remains open till last day)
20 Dec Last trading day
Exchange Sells Gold Futures contract at spot price 32,880
Net Profit = 200 x Size of the contract (in terms of price
quotation)
24
MARGIN
Initial margin is deposited to open trade to cover
the settlement risk, the onus for which lies of the
exchange. It is performance bond/good faith money
Payable upfront, refunded on closing out.
Margin is commodity specific, exchange specific
and depends upon the volatility of asset price.
Initial Margin:
Meant to cover the largest possible loss in a day.
Normally of the order of 5% 10%.
Maintenance Margin: Margin Call
Profit/loss on daily basis are credited/debited to the
margin account.
Cant fall below certain level: Maintenance Margin
Derivatives and Risk Management
Rajiv Srivastava
25
MARKING-TO-MARKET
(MTM MARGIN)
Exchange settles the contracts on daily basis.
Computation of profit/loss as if the positions were
closed out. Actually the open position remains.
Futures contracts are deemed settled and rewritten every day.
All positions are brought to the same price each
day.
Making good the loss or payment of profit on daily
basis.
Daily clearing price (different than closing price) is
used in calculating the daily profit/loss.
Final settlement price and daily settlement price
may be different. (Futures on currencies).
Derivatives and Risk Management
Rajiv Srivastava
26
MARKING-TO-MARKET
EXAMPLE
Gold Contract Size
Price quotation
Initial Margin
DAY
Day 1
Day 1
Day 2
Day 3
Day 4
ACTION
Bought 1 Gold Contract
Clearing Price
Clearing Price
Clearing Price
Sold 1 Gold Contract
1 Kg
per 10 gms For Gold in India
5%
Price
32,300
32,450
32,310
32,470
32,600
Margin
1,61,500
+15,000 1,76,500
- 14,000 1,62,500
+16,000 1,78,500
+13,000 1,91,500
27
OPEN INTEREST
Open Interest is the number of contracts
that are open on any given day.
It is an indicator of investors interest in the
contract.
It rises initially and has to become zero on
the last day.
New positions are added to open interest
Offsetting position (closing the open
position) reduces open interest
Derivatives and Risk Management
Rajiv Srivastava
28
OPEN INTEREST
Open Interest is different than Volume.
Day
ACTIONS
50
100
Open
Interest
Volume
150
150
250
100
250
50
150
100
29
PRICING AND
HEDGING
PRICING
FORWARDS & FUTURES
A derivative derives its price from the value of
another asset referred as underlying asset
Underlying assets can be commodities, T-bills,
stocks, currencies, indices, etc.
The spot price in the physical market must
determine the price of its futures contract
For pricing purpose there is no difference between
a forward contract and futures; both being
contracts for future delivery
31
PRICING FORWARD
Cost of Carry
Suppose you needed 10 gms of Gold 3 months
later.
The current price (called spot price, S0) of gold is
Rs 30,000 per 10 gms.
If you were to buy and the goldsmith were to sell
today cash would be paid against delivery.
Instead you wish to firm up the price today for
delivery of gold 3 months later (entering a forward
contract) what price is appropriate?
32
PRICING FORWARD
Cost of Carry
SELLER
Asset is committed to be
delivered 3 months later
If he sold spot he would realise
Rs 30,000
It would have grown to Rs
30,900 (assuming 1% return
per month) after 3 months, if
he invested the sum
He would also incur some
costs in holding the asset for
prospective buyer like
insurance, rent etc for 3
months, say % per month
Therefore he would charge a
minimum of Rs 31,350 (30,000
+ 900 + 450) to agree to enter
in the forward deal and be
indifferent
BUYER
Asset is assured for delivery 3
months later
If he bought spot he would part
away with Rs 30,000
If payment is deferred the
amount would grow to Rs
30,900 (assuming 1% return
per month) after 3 months, if
he invested
The buyer would also save
some costs like insurance, rent
etc for 3 months, say % per
month
Therefore buyer would be
indifferent to pay a maximum
of Rs 31,350 (30,000 + 900 +
450) to agree to enter in the
forward deal.
33
COST OF CARRY
PRICING FORWARD
Cost of Carry
For Seller
34
ARBITRAGE
Cash and Carry
35
ARBITRAGE
Reverse Cash and Carry
REVERSE CASH AND CARRY
(If actual price were 31,250 ( < Theoretical Forward Price 31,350)
ACTIONS
Cash flow (Rs)
Today
Sell spot 10 gms Gold
+30,000
Invest at 1% pm for 3 months
-30,000
Buy Gold 3-m forward contract at 18,500
Initial cash flow
0
After 3 months
Realise gold from forward contract and pay cash
-31,250
Saved expenses
+450
Realise investment and Interest
+30,900
Net cash flow
+100
36
PRICING FORWARD
Process of arbitrage will govern the price of the
forward contract for period t (With short selling
permitted)
Ft = S0 ert
If there is any dividend (benefit) accruing during the
period then
Ft = (S0 D) ert
where D = Present value of the benefit.
For securities providing known yield y (income
expressed as % of price),
Ft = S0 e(r - y)t
Derivatives and Risk Management
Rajiv Srivastava
37
CONVERGENCE
Contango or backwardation, in either case the
futures price must converge to the spot price as
maturity approaches, as all cost of carry, benefits of
ownership, storage costs, convenience yields etc.
tend to become zero.
Convergence of price- Contango
Price
Price
Futures
Spot
Spot
Futures
Maturity
Time
Maturity
Time
38
39
Profit
S0
Loss
S0
Loss
40
Profit
F0
Loss
F0
Loss
41
HEDGING PRINCIPLE
Futures offset the risk by taking of an opposite
position in the future contracts to that of in the
physical market.
SHORT HEDGE
LONG on asset Go SHORT on futures
LONG HEDGE
SHORT on asset Go LONG of futures
Loss in the physical market is expected to be
compensated in the futures position, and vice
versa,
This assures almost a steady and assured price.
42
SHORT HEDGE
Asset and Futures
PAY OFF SHORT HEDGE
Long on Asset
Short on Futures
Bought at S0, Sold at S
Sold at F0 Bought at F
If S > S0 Gain S S0
If F > F0 Loss F F0
If F < F0 Gain F0 F
If S < S0 Loss S0 S
Profit
Profit
S0
Loss
F0
Loss
43
SHORT HEDGE
EXAMPLE
SITUATION
Owned asset
1 Kg of Gold
Need to sell after 3 months
Risk falling price of asset, Need to cover risk and
protect value
MARKET SCENARIO
= Rs 30,000
Spot price of Gold, S0
Futures price at Exchange F0 = Rs 31,350
HEDGING STRATEGY
Long on Asset - Go Short of Futures
Sell 3-m futures contract on gold now (Size 1 Kg)
with intentions of buy the same futures contract at
the end of hedging period, after 3 months.
Derivatives and Risk Management
Rajiv Srivastava
44
SHORT HEDGE
OUTCOME
After 3 months
Sell gold in spot market and offset position in futures.
The price of the futures now would be same as spot due to
convergence.
ACTIONS
29,000
33,000
29,000
33,000
31,350
31,350
2,350
31,350
-1,650
31,350
45
LONG HEDGE
Asset and Futures
PAY OFF LONG HEDGE
Long on Futures
Short on Asset
Bought at F0, Sold at F
Sold at S0 Bought at S
If F > F0 Gain F F0
If S > S0 Loss S S0
If S < S0 Gain S0 S
If F < F0 Loss F0 F
Profit
Profit
F0
Loss
S0
Loss
46
LONG HEDGE
EXAMPLE
SITUATION
Short on asset, To buy
1 Kg of Gold
Need to buy after 3 months
Risk rising price of asset, Need to cover risk and
protect value
MARKET SCENARIO
= Rs 30,000
Spot price of Gold, S0
Futures price at Exchange F0 = Rs 31,350
HEDGING STRATEGY
Short on Asset - Go Long of Futures
Buy 3-m futures contract on gold now (Size 1 Kg)
with intentions of sell the same futures contract at
the end of hedging period, after 3months.
Derivatives and Risk Management
Rajiv Srivastava
47
LONG HEDGE
OUTCOME
After 3 months
Buy gold in spot market and offset position in futures.
The price of the futures now would be same as spot due to
convergence.
ACTIONS
- 29,000
- 33,000
+ 29,000
+ 33,000
- 31,350
- 31,350
- 1,350
+1,650
Effective Price
31,350
Derivatives and Risk Management
Rajiv Srivastava
31,350
48
PAYOFF AND
EFFECTIVE PRICE
SHORT HEDGE
S
Value of asset owned S0 Sell Asset
Sold futures
F0 Bought back futures F
Pay off = (S S0) + (F0 F) = (S F) - (S0 F0)
Price realised = S + (F0 F) = F0
LONG HEDGE
Value of asset short
S0 Buy Asset
S
Bought futures
F0 Sold futures
F
Pay off = (S S0) + (F0 F) = (S F) - (S0 F0)
Price paid = S + (F0 F) = F0
(F = S due to convergence)
Derivatives and Risk Management
Rajiv Srivastava
49
PERFECT HEDGE
Profit/loss in position of asset is completely offset
loss/profit in position on futures.
PERFECT HEDGE
Long Hedge
Short Hedge
Profit
Long Future
F0
Profit
Price
F0
Short Asset
Loss
Long Asset
Price
Short Future
Loss
50
51
HEDGE
FORWARD Vs FUTURES
Forward hedge is always a perfect hedge as it is a
customised contract. Price is fixed now.
Futures hedge is seldom perfect. Hedging through
the futures does not exactly and completely offsets
the gains/losses in the cash asset.
Perfect hedge is not possible due to
Difference in the asset: The underlying asset may not be
same as that of the futures. (Gold Ornaments vs. Gold)
Differences in timing: maturity of cash position and
futures contract may not coincide exactly. (Need to
buy/sell Gold at 2.5 m Contract available for 2 or 3 m)
Differences in quantity/amount: The amount of
exposure may not match with amount of futures contract.
(Need to buy/sell 2.50 Kg Gold Contract available in
multiples of 1 Kg.)
Derivatives and Risk Management
Rajiv Srivastava
52
53
Rajiv Srivastava
rajiv@iift.ac.in
rajiv1234@hotmail.com
Derivatives and Risk Management
Rajiv Srivastava
54