Professional Documents
Culture Documents
Forward - an agreement calling for a future delivery of an asset at an agreed-upon price Futures - similar to forward but feature formalized and standardized characteristics Key difference in futures Secondary trading - liquidity Marked to market Standardized contract units Clearinghouse warrants performance
Forward contracts
They are bilateral contracts Each contract is custom designed The contract price is generally not available in public domain The contract has to be settled by delivery of asset on expiry In case, the party wishes to reverse the contract , it has to compulsorily go to same counter party, which ,being in monopoly situation, can command the price it wants
Futures contracts
The standardised items in any futures contract are: Quantity of the underlying Quality of underlying Date and month of delivery Units of price quotation Location of settlement
Underlying asset:NCDEX gold contract, quality is stated as not more than 999.9 fineness bearing a serial number and identifying the stamp of refiner approved by the exchange Contract size: cashew contract size is 50 cartons and net weight of each carton should be 22.68 kg Delivery arrangement: Location; price of contract adjusted according to location. Alternative delivery location choice given to seller Eg cashew delivery centre is Kollam and alternate is Mangalore.Gold contract - Mumbai and alternate is Ahemdabad
Delivery arrangement: Alternative grade NCDEX gold contract specification is gold bars of 999.9/995 fineness Settlement price for fineness above 995 is (actual fineness/995)* Final settlement price. Delivery month: NCDEX- 20th day of each month Delivery notification: Tender period Daily Price Movement limits : Limit down and limit up Position limits- cornering the market Closing out the positions: speculators or hedgers
Forwards Vs futures
Are not traded on an exchange Are private Involve no margin payments Physical delivery Terms of contract dependent on negotiated contract Not transparent Used for hedging Exchange traded Clearing house Requires margin payment 98% cash settled Terms of contract standardised Transparent
Delivery of agricultural commodities is made by transfer of warehouse receipts issued by approved warehouses
Unlike options , in case of futures there is no need to distinguish payoffs from net profits
Trading Mechanics
Clearinghouse - acts as a party to all buyers and sellers
Obligated to deliver or supply delivery
Open Interest
Open interest
When contract begins to trade open interest is zero If a contract is approaching maturity ,open interest is small Again more distant the maturity little is the open interest If one party to trade is closing out the position , then there will be no change in the open interest If both parties closing their positions, the open interest will decrease.
Clearing house
Acts as a central counter party to all trades Clearing house has adequate resources to cover any losses, and to meet its own payment without any delay Financial and operational requirements for membership Margin requirements Close out positions in reaction to a default Practice by which exchange becomes counter party for all trades is Novation
Exchange membership
Min prescribed networth Annual subscription charges Following deposits to be maintained with the exchange Non refundable admission fees Contibution to TGF Initial base capital Additional base capital Annual subscription charges
Commodity brokerage
Day traders Floor traders Market markers Trading Systems on commodity Exchanges Open outcry system/Pit (NYME,CME,CBOT,LME) Specific dialect, hand signals, and clothing to communicate Chicago , Newyork ,London India and Singapore use almost identical hand signals to communicate trading transactions
Market order Market on opening Market on close Market if touched Spread Price condition Limit order Stop order Stop limit order
Order types
Order types
Time condition Good-till day , good- till- cancelled(open orders), Good-till-date orders Fill or kill order (Immediate or cancel orders)
Commodity Funds
Commodity funds help an investor participate in commodity-led inflation. India is a net importer of commodities, so in general, Indian assets are negatively correlated with inflation . "When the investor allocates a part of the portfolio to commodity funds, he partly hedges his portfolio. If commodity prices go up, inflation would increase . Increase in commodity prices would result in positive returns on commodity funds. Increase in inflation would result in fall in Indian equity and Indian fixed portfolio In the past one year, commodity funds have outperformed Indian equities and fixed income as an increase in commodity prices have resulted in 20%-plus returns from diversified commodity funds while Indian equities/fixed income have give single-digit returns.
Base price
On introduction of new contract the base price is the previous days closing price of the underlying commodity in the prevailing spot markets. The base price of contracts on all subsequent trading days is the daily settlement price of the futures contract on previous trading day
Margins(futures)
A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
A Possible Outcome
Futures Price (US$) 600.00 5-Jun 597.00 . . .6-Jun .596.10 . . 12-Jun 595.40 13-Jun 593.30 . . . . 18- .Jun 592.70 19-Jun 587.00 . . . . . . 26-Jun 592.30 (600) . .(180) . (260) (420) . . . 180 (1,140) . . . 260 Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 (600) 3,400 0 . . . .(780) 3220. . . . . 3080 (920) (1,340) 2,660 + 1,340 = 4,000 . . . . . . . . < 3,000 (1460) 3880 (2,600) . . . (1,540) 2,740 + 1,260 = 4,000 . . . . . . 5,060 0
Day
Question
The settlement price of December Nifty futures contract on a particular day was 1310 The minimum trading lot on Nifty futures is 100. The initial Margin is 8% and maintenance Margin is 6% The Index closed at following levels on the next five days
Day
Closing price
1 2 3 4 5
Calculate Mark to market cash flows and closing balances if an investor has gone long at 1310 and calculate the net profit or loss.
Charges
Transaction charge- Rs 4 per Rs 1,00,000 worth of trade done. Rate applicable upto Rs 20 crores. Reduced rate for increased turnover. Avg daily turnover = Total value traded by a member in month/No. of trading days including saturdays Due date Collection: Exchange dues account with clearing banks Adjustment against advance transaction charge Penalty for delayed payment
NWRs
NWRs can be traded and used to obtain finance This leads to increase in flow of credit to rural areas, reduces cost of credit and spurs activities like standardisation , grading , packaging and insurance to agriculture sector Dematerialization of warehouse receipts(risk of theft,mutilation,forgery,transferor and transferee are at two different locations) National level exchanges have empanelled DPs and demat account can be opened only with them.
Two cases
Case I (Trader offsets his position before the delivery notice period starts) Reversing trade CH releases the CMs margin money deposit CM releases Traders margin Capital Gain are paid to customers while losses are deducted If losses exceed the margin fund deposited, CM collects the difference from trader in the form of margin call The exchange adjusts the open position
Case 2
a) Physical delivery Cash settlement When open contracts run into delivery period ,previously discussed delivery process is followed The period during which delivery can be made is decided by exchange. Exact delivery time is determined by party with short position Seller informs the broker of its intention which is further conveyed to Clearing House through a notice The notice states : Number of contracts , location and grade. Exchange randomly choses a party with a long position If the party with long position wants to take the delivery . The exchange randomly choses a party with short position. Seller will decide the place of delivery , quality to be delivered The exchange will then adjust the price of the contract
Case 2
b) When neither buyer or seller intends to give or take the delivery, open contracts are cash settled and due rates are notified by the exchange
Trading Strategies
Speculation short - believe price will fall long - believe price will rise
Hedging long hedge - protecting against a rise in price short hedge - protecting against a fall in price Cross hedging
$95.15
Revenue $9,515,000 from oil sale (100000*Pt) Prices on 2,00,000 futures:1000 000*(F0-Pt) Total 9715,000 Proceeds
$97.15
9715,000
$99.15
9915,000
-2,00,000
9715000
9715000
Figure 22.4 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $97.15)
Concept check
Suppose in previous example that oil will be selling at $95.15, $97.15,$99.15 per barrel. Consider a firm such as an electric utility that plans to buy 1,00,000 barrels of oil in Feb. Show that if the firm buys 100 oil contracts today ,its net expenditures in Feb will be hedged and equal to $9715,000
Solution
Oil prices in Feb,Pt $95.15 $97.15 $99.15 -$9915,000
Cash flow to -$9,515,000 -$9715,000 purchase oil (100000*Pt) Prices on -2,00,000 0 futures:100,00 0*(Pt-F0) Total cashflows -$9715,000 -$9715000
2,00,000
-$9715000
Futures Pricing
Spot-futures parity theorem - two ways to acquire an asset for some date in the future Purchase it now and store it Take a long position in futures These two strategies must have the same market determined costs
Hedge Example:
Investor owns an S&P 500 fund that has a current value equal to the index of $1,500 Assume dividends of $25 will be paid on the index at the end of the year Assume futures contract that calls for delivery in one year is available for $1,550 Assume the investor hedges by selling or shorting one contract
1,510
1,550
1,610
Dividend Income
25
25
25
Total (F0+D)
1,575
1,575
1,575
F0 S0 (1 rf ) D S0 (1 rf d ) dD S0
This equation applies to well functioning markets in which arbitrage opportunitie are competed away
Action
Action Initial cash flows Cash flows in 1 year
Borrow $1500 +1500 repay with interest in 1 year Buy stock for -1500 $1500
Enter short futures 0 position (F0= $1550) Total 0
-1500(1.04)=$1560
St+ $25 dividend $1550- St
$15
Arbitrage strategy
Action Initial cash flows Cash flows in 1 year -S0(1+rf) Borrow $1500 So repay with interest in 1 year Buy stock for -S0 $1500 Enter short futures 0 position (F0= $1550) Total 0
St+ D $F0- St
F- S0(1+rf)+D
Arbitrage Possibilities
If spot-futures parity is not observed, then arbitrage is possible If the futures price is too high, short the futures and acquire the stock by borrowing the money at the risk free rate If the futures price is too low, go long futures, short the stock and invest the proceeds at the risk free rate
(T 2 T 1)
If the risk free rate is greater than dividend yield, then future price will be higher on longer maturity contracts. For future on assets like gold, which pay no dividend yield We can set d=0 and conclude that F must increase as time to maturity increases. The major difference is in the substitution of F(T1) for current spot price. Delaying delivery from T1 until T2 frees up F(T1 ) dollars ,which can earn risk free interest at rf.The delayed stock delivery also results in lost dividend yield between T1 and T2.Thus the net cost of carry rf - d
Spread pricing
Contract Maturity data Futures price
Jan 15
March 15
$105
$105.10
Suppose that the effective annual T bill rate is expected to persist at 5% and that the dividend yield is 4% per year. The correct futures price = 105(1+.05-.04)1/6 =105.174 The correct March future price is slightly Under priced compared to January futures and that aside from transaction costs , an arbitrage opportunity seems to be present
Example
Sun jewellers require 1000 grams of gold on July1 .On April 1, the price of gold is Rs 12000 per gram. It plans to enter into a forward contract to buy gold with delivery date of July. Storage cost =Rs 80,000 and it can invest its funds elsewhere at 8%. Calculate forward price of gold on April 1 for delivery on July 1. Opportunity cost for 3 months = 2% Interest lost = 12,000,000 *2%= Rs 2,40,000 Storage cost = Rs. 80,000 Total cost of carry= Rs. 3,20,000 Cost of carry per gram of gold = Rs 320 Forward price =Rs 12320
Carrying cost
Includes interest on capital , cost of storage , insurance etc Eg. Carrying charge for wheat is Rs 200 per tonne per month, and that mid April ,spot wheat is trading at Rs 12,000 per tonne The miller wishes to use wheat in mid May The total cost of procuring wheat works out to be Rs 12,200 per tonne. Assume that contract is trading at Rs 12180 per tonne (May) NCDEX Buying in the futures market rather than buy in spot market Buying in near future market will cause the prices to rise The twin effect of this balancing will continue until price difference equals carrying cost
Spot rate Risk free rate of return Storage costs Convenience yield (inventory level is low ,scarcity now greater than in future) eg. Wheat during scarcity can be sold at substantial premium. Carrying cost =interest on capital+cost of storage and insurance etc. Carrying cost of grain is expressed as cost per tonne per month while for gold it would be cost per 10 grams per month
Convenience yield
Benefit or premium derived from directly owning a particular good Based on actual possession and not owning a futures contract Depends on current market conditions
F0 P0 (1 rf ) C
Where; F0 = futures price P0 = cash price of the asset C = Carrying cost c = C/P0
F0 P0 (1 rf c)
Two kinds of goods cannot be expected to be stored; Storage not technologically feasible Perishable goods that are available only in season
Arbitrage strategy
Action Initial cash flows Buy asset: pay the -Po carrying cost at T Borrow P0; repay with interest at time T Short future position P0 Cash flows in 1 year PT-C -P0(1+rf)
$F0- PT
Total
F0- P0(1+rf)-C
Futures Price Over Time, in the Special Case that the Expected Spot Price Remains Unchanged
Near futures
Deferred futures
Buying pressure severe /shortage of commodity in spot market (backwardation) Oversupply in cash market (contango)
Backwardation/contango
Contango: Hedgers are purchasers (millers and grain processors) of a commodity rather than suppliers. Long hedge Speculators would be induced for short position F0 > E(Pt) Backwardation: Farmers are hedgers Short hedge Speculators would take long position F0 < E(Pt)
Example
Assume producer asks for a 6 months forward price (182 day) Cash market gold is trading at USD 425.30 per ounce In order to complete the spot delivery he borrows the same amount from from Central bank for 6 months at a lease rate of .11570% p.a.The dollar received from spot sale are put on deposit for 6 months at a LIBOR to earn ,say 3.39% p.a Interest cost of borrowing the metal is USD .2488(spot* lease rate*182/360) Earned from cash deposit =USD 7.29(spot sale proceeds*6month LIBOR*182/360)
Example
Max amount he can afford to pay the producer is USD 432.4418 This is calculated as spot sale proceeds+interest on LIBOR deposit borrowing fee(USD 425.40+USD 7.29-USD .2488) The fair value is a breakeven price for the trader The shorter the time to maturity the smaller would be the differential between spot and forward price
If the fair value of gold for 6 month delivery was USD 432.44 Assume that market price of USD 425 was observed. Commodity would be described as cheap to fair value Arbitrager could: Buy the commodity forward ,paying USD 425 upon delivery Short the underlying in spot market to earn USD 425.40 Invest the cash proceeds at LIBOR ,earning 3.39% for 6 months to earn USD 7.29 Borrow gold in the lease market in order to fulfill the short spot sale paying a 6 month lease rate ,which equates to a cash amount of USD .2488
Example contd..
Example contd..
Repay the gold borrowing upon the receipt of metal under the terms of forward contract. Net profit USD 7.44
Markets in backwardation
If Forward price = spot price+LIBOR+warehousing/insurance costs Many commodities move in backwardation (eg. Base metals and crude oil) Forward price = spot price+LIBOR+warehousing/insurance costsconvenience yield If the commodity is in very short supply,its value will rise,moving towards zero in normal supply conditions
Markets in backwardation
Incase of backwardation futures price is lower than spot price Contract is mispriced Speculators should be able to buy the cheap future contract sell it for spot value and hold the combined position till maturity Since the availability of the commodity in the spot market is very scarce , these supplies simply cannot be obtained Hence ,this apparent mispricing will persist for prolonged periods,as there is no mechanism to exploit potential arbitrage
spot
Near future
Deferred futures
spot
Near futures
Deferred futures
Example
Consider this arbitrage strategy to derive the parity relationships for spreads: Enter a long futures position with maturity date T1 and Futures price F(T1) Enter a short position with maturity T2 and futures price F(T2) At T1 when the first contract expires ,buy asset and borrow F(T1)dollars at rate rf Payback the loan with interest at time T2 What are the total cashflows to this strategy at times 0,T1 and T2
Naturally short position Buying hedge/long hedge/input hedge Eg. In Nov, a wheat miller has finalised a contract to supply flour to a bread maker in March.Amt needed to produce the flour is 5000 quintals (500 tonnes) At time of contracting wheat is selling for Rs 11,900 per tonne .March wheat futures trading at Rs 12,000 per tonne . Each future contract covers 10 tonne(100 quintals);he buys 50 future contracts In March spot price has risen to Rs 12200 and March future trading at Rs 12300 per tonne
Feb
Change
Feb
Buy wheat in spot market at Rs 11,700 per tonne Rs 200 per tonne gain
Change
Feb
Change
Feb
Sell wheat in spot market at Rs 12,000 per tonne Rs 200 per tonne gain
Change
Spot price 0
0 Long physical payoff losses When spot /future prices are decreasing
Spot price
Logic: Do now what has to be done in future, so as to lock in the prices now. Assumption: constant basis
Mismatches in basis and basis risk hedging(copper- based Commodity mismatch : proxy
electric cable cannot be hedged,since there is no future contract offered on such cable) Delivery date Mismatch(If the delivery date is not the same as the date on which the futures mature) Strengthening and weakening of basis Hedge basis The basis that concerns the hedger is the basis that will exist at the time the hedge is lifted. If there is no move, hedge is perfect. Second basis is established The difference between the original hedge basis and second basis will determine the outcome of hedges
Feb.
Change
50(strengthen ed or narrowed)
Feb.
Change
November
Feb.
Change
Sell April Wheat Futures at Rs 12,000 per tonne Buy April wheat futures at Rs 11,650 per tonne Rs 350 per tonne gain
-200
-150
50(strengthen ed or narrowed)
Feb.
Change
Solution
Optimal hedge ratio (h) = .9* (.040/.050) =.9* .8 = .72 Number of wheat contracts the company should buy .72*10,000/10 = 720 contracts
0
4
12
The uncertainty about the difference of future price of contract that is closed and new contract that is opened when hedge is rolled forward is referred to as rollover basis. There will be n-1 rollover basis on any rolling over hedge Stack- rolling hedge Vs strip hedge
Spreads
Spread traders Less risky and less expensive way to participate in future market Margin requirements are low
If heavy rains in North India during April damages the wheat harvest.The May contract can trade at premium to the August contract In situation of perceived tightness of stocks , the nearby futures contract will rise faster than distant months This is a bull spread Conversely, in situation of over abundance. Nearby months will fall faster than distant months A bear spread would be created