Forwards & Futures

Session 2 Derivatives & Risk Mgt

Forward Contracts- Meaning

Definition an agreement between two parties that calls for the

delivery of an asset at a future point in time with a price agreed upon today
Differ from spot contracts Spot contracts require immediate payment ; forward buyer gains in terms of interest Spot contracts require immediate delivery; forward seller earns income on asset and incurs storage cost; short-selling possible Spot contract possible between unknown persons; forward contracts possible only between known counterparties or require mechanisms to protect against default

Futures contracts
Why futures contracts? Forwards involve credit risk Hence not suitable to small investors (example of Milton Friedman) Trading through an exchange can mitigate credit risk which however requires standardization of contracts Futures contract is a forward contract with standardized terms traded on an organized exchange and follows a daily settlement procedure whereby losses of one party to the contract are paid to the other party

Forwards and futures - distinction

Forwards
Traded Over the counter Custom-made contracts Credit risk borne by parties No margins Settled by delivery; close-out difficult No published price-volume information

Futures
Exchange traded Standardized contracts Credit risk borne by the CCP Initial margin and daily MTM margins Delivery rare; close-out easy Published price-volume data

Specifications of a futures contract

Contract Size Quotation unit Minimum price fluctuation (tick size) Contract grade Trading hours Settlement Price Delivery terms Daily price limits and trading halts

Snapshot of a futures quote

nstrument Type FUTIDX Underlying NIFTY Expiry Date 28JUL2011 Option Type Strike Price Market Lot 50

Price Information
Open Price High Price Low Price Last Price Prev Close Close Price Change from prev close % Change from prev close VWAP Underlying Value Number of contracts traded Turnover (In Lakhs) Open Interest Change in Open Interest % Change 5668.00 5670.00 5632.10 5636.95 5665.85 -28.90 -0.51 5645.09 5621.50 93518 263958.76 22744350 914950 4.19 Price Cost Of Carry Buy Qty 150 100 100 100 50 719500

Order Book
Buy Price 5636.65 5636.60 5636.40 5636.25 5636.20 Total Buy Qty Sell Price 5637.00 5637.45 5637.80 5637.90 5637.95 Total Sell Qty Sell Qty 29250 50 400 450 50 573500

Cost of Carry
Best Buy 5636.65 4.27 Best Sell 5637.00 4.37 Last Price 5636.95 4.36

Other Information
Settlement Price 5665.85 Daily Volatility 1.06 Annualised Volatility 20.18 Client Wise Position Limits 17851965 Market Wide Position Limits -

Options given to the seller

Sellers are allowed various options in some futures contracts (permissible variations in the specifications)
Timing option Quality option Location option Quantity variation

Such options aimed at preventing market manipulation of the deliverable through a short squeeze Contract design requires a reconciliation of hedging effectiveness with need to prevent market manipulation

Why cash-settlement
A solution to problems associated with physical settlement Parties settle difference in cash Futures only for price-fixing and not for delivery Cash settlement common for Stock index futures Weather derivatives Single stock futures in some countries

Applications of Forwards and Futures

Trading or speculation taking a position in a forward or futures contract without any underlying exposure and trying to profit from a directional view Hedging taking an opposite position in a forward/futures contract in order to mitigate risks to the underlying Arbitrage taking a combined position in the forward/futures and the underlying in order to profit from the mispricing of the forward/futures

Trading in forwards and futures

Party entering into a buy contract = long Party entering into a sell contract = short A long position benefits from a rise in price of the underlying Profit to long = Spot price at maturity Original futures price A short position benefits from a fall in price of underlying Profit to short = Original futures price Spot price at maturity Forwards and futures have linear payoffs

Pricing of a futures contract

An asset bought from 2 sources (spot market and futures market) must be priced identically on delivery date; else arbitrage Hence futures and spot price must converge on maturity date A portfolio hedged with futures and both portfolio and hedge held till maturity will be risk-less Eg- Consider an investment in Tata Motors today at Rs.304 hedged with short 1-month future at Rs.305. Assume that Tata Motors pays a dividend of Rs.2 in the next one month
Final share price Pay-off from short future Dividend income Value of hedged portfolio Current futures price + dividend 280 25 2 307 307 290 15 2 307 307 300 5 2 307 307 310 -5 2 307 307 320 -15 2 307 307 330 -25 2 307 307

Cost of Carry Model for pricing

In the example the final value of hedged portfolio = Current futures price + Dividend income Portfolio value does not depend upon spot price at maturity; i.e. overall position is riskless A riskless position should earn the risk-free rate of return Hence
Or
Where F0 =current futures price, S0 = current spot price and D= income on the underlying

Thus forward price = Spot price + net cost of carry

Pricing with continuous compounding

Investment assets with no interim cash flows Investment assets with known interim cash flows

Investment assets with known dividend yield

Consumption assets
Where F= forward price, S=spot price, r=continuously compounded interest rate, q= dividend yield, I= PV of known cash flow, u=storage costs per unit of time, y= convenience yield

When asset pays no interim income..

Consider a non-dividend paying stock with spot price = 120, risk-free rate=5%, period= 1 year As F= S*e^ rt , F = 126.15 If actual F = 128 cash-carry arbitrage possible Buy stock today at 120 by borrowing at 5% Sell stock one-year forward at 128 Hold stock for 1 year At maturity, sell stock at 128 Repay borrowing with interest at 126 Net gain is Rs.2 (free lunch ?) Hence F cannot be greater than S*e^rt

When asset pays no interim income

Consider a non-dividend paying stock with spot price = 120, risk-free rate=5%, period= 1 year As F= S*e^ rt , F = 126.15 If actual F = 123 reverse cash-carry arbitrage possible Sell stock today at 120 and lend proceeds at 5% Buy stock one-year forward at 123 At maturity, get back loan with interest at 126 Receive delivery of stock at 123 Net gain is Rs.3 (free lunch ?) Hence F cannot be less than S*e^rt

When asset pays known cash flow

Fair value of forward = Current stock price = 900, known dividend after 4 months =40, forward maturity =9 months, 4-month int rate= 3%, 9-month int rate= 4% Fair value of forward = (900-39.60)*e^(0.04*9/12) = 886.60 If actual forward price = 910
Short forward contract at 910 and borrow to buy stock today Borrow 39.60 for 4 months and 860.40 (900-39.60) for 9 months After 4 months, pay off loan of 39.60 from dividend inflow At end of 9 months receive forward price of 910 and repay loan of 886.60 Gain = 23.40

If actual forward price is lower, reverse cash-carry arbitrage

When asset pays known yield

Cost of carry is offset by the known income yield q (q is continuously compounded) Hence Stock index futures priced as above What is Index arbitrage? When F > Se(rq)T an arbitrageur buys the stocks underlying the index and shorts futures When F < Se(rq)T an arbitrageur goes long in futures and shorts the stocks underlying the index Index Arb involves simultaneous trades in futures and many different stocks; hence programmed trades

Pricing of currency forwards

Pricing requires knowledge of spot exchange rate, domestic interest rate and foreign currency interest rate Interest rate parity requires that
Where rd=domestic interest rate and rf=foreign currency interest rate

Expressed in continuous compounding Example: Spot USD/INR =44.70, 1-year USD-libor = 5%, 1-year INR rate =10%, 1-year USD/INR forward rate = 47.10 What is the arbitrage implied?

Forwards on consumption assets

Fair value of forward = Where u = storage costs as a % of value of asset and y = convenience yield Convenience yield measures benefit of holding physical inventory of consumption asset instead of forward contract on that asset Is not observable or measurable directly Can be estimated from past data Sophisticated models to determine it

Why arbitrage not always feasible?

Implementing cash-carry arbitrage requires ability to borrow at risk-free rate Only large institutional players have that ability Reverse cash-carry arbitrage requires ability to borrow the security Owners may be unwilling to sell or lend especially in case of consumption assets Regulatory restrictions on short selling

Contango and Backwardation

Normally futures price > spot price Known as Contango market Non-income earning financial assets normally in contango Sometimes spot price > futures price Known as backwardation or inverted market Consumption assets in backwardation when convenience yield exceeds cost of carry May be due to anticipated disruption in supply Could be due to short squeeze

Forward price and value

Value of a forward contract different from the forward price Forward price = S*e^rt Initial value of forward contract is zero Contract gains or loses value at later stage Value of forward on an non-income asset
f = (S K)*e^(-rt)

Risk management with futures

Concept of hedging Why do companies hedge?
To reduce risk of bankruptcy To enable company to focus on its core competence Shareholders cannot hedge effectively

When hedging not profitable

When competitors dont hedge When hedging is not selective

Decisions in hedging
Whether a long hedge or short hedge Which futures contract Which expiry month Number of futures contracts to be used

Short hedge and long hedge

Basis risk
What is basis? Spot price of asset to be hedged less futures price of contract used Hedging substitutes basis risk for price risk P/L on hedged position = change in basis Under a short hedge Future sale price = Current futures price + future basis Under a long hedge Future buy price = Current futures price + future basis Hedge held till expiry results in perfect hedge Examples

Hedging profitability and basis

Example of short hedge

An investor holds 10000 shares of X co. Spot price on May 1 is Rs.100. Investor needs funds on June 11 to meet his Advance tax liability on June 15. How can he hedge against the volatility in the interim period? June X Co. futures quoting at Rs.97 on May 1. (consider both strengthening and weakening of the basis)

Example of long hedge

A businessman planning to travel to the US on Aug 22 needs 50,000 USD for his trip. As on Aug 3 the USD/INR spot rate is 44.23 and the Dollar-rupee futures on NSE are quoting at 44.20. How can he hedge against the dollarrupee volatility?

Computing the Hedge ratio

What is Cross hedging ? Hedge ratio = ratio of size of exposure to size of futures position Minimum Variance Hedge Ratio
Objective is to minimize the variance of hedgers position = Correlation between spot & future * (Std Dev of spot/ Std Dev of future)

Hedging an equity portfolio

Compute beta of the portfolio Nifty future lot size 50 Nifty future price 5400 Portfolio to be hedged = Rs.10 lacs Portfolio Beta = 1.05

Controlling Risk in Equity Portfolio

Diversification eliminates unsystematic risk in portfolio Systematic risk remains; i.e. portfolio is sensitive to market risk alone Strategy to outperform the overall market Increase portfolio beta to more than 1 when market is expected to rise; will ensure that portfolio will yield higher return than market Reduce portfolio beta to less than 1 when market is expected to decline; will ensure that portfolio will suffer lower loss than overall market Portfolio beta needs to be changed when market trend is expected to change

How to alter portfolio beta

Portfolio rebalancing
Involves replacing low-beta stocks with high-beta stocks when market is expected to rise or vice-versa Requires frequent buying and selling of stocks resulting in higher transaction costs

Lending or borrowing
Switching between capital market and debt market Reducing or increasing the debt component of the portfolio in order to increase or reduce beta of overall portfolio

Using index futures

Sell index futures to reduce beta Buy index futures to increase beta

Managing risk of futures contracts

Futures settlement will always result in loss to one party How to ensure that losing party does not default? Tools to manage the default risk
Clearing House Margin deposits Marking to market

Clearing House
Clearing house a part of the stock exchange Concept of Novation Ensures settlement of the trade in case of default by either party If buyer defaults, CH ensures that seller receives the funds payout If seller defaults CH ensures that buyer gets the securities pay-out through auction mechanism

Margin deposits
Both buyer and seller have to post margin Margins consist of initial margin and maintenance margin Margins determined in accordance with market volatility The stock exchanges in India charge initial margin and exposure margin for each contract and margins are changed on an intra-day basis

Marking to market
Accounting procedure that forces both sides of the contract to take their gains/ losses daily Prevents build-up of large unrealized paper losses Example:
A is long one lot of Nifty July future at 5560 and B is short the same That day Nifty future closes at 5508 As loss of Rs.2600 ((5560-5508)*50) is taken from his account and moved to Bs account As long position and Bs short position now re-priced at 5508 Repricing restarts the contract with a new base for determining subsequent P&L.

Case study - Metellgesellschaft

MG entered into long-term forward contracts to supply oil at fixed prices to its customers A fixed quantity to be supplied every month over a period of 10 years at prices fixed in 1992 Due to long-term short forward contracts the company faced the risk of a rise in oil prices Hedged the above risk by a stack and roll hedge Entered into a long position in near-month oil futures contracts for the entire quantity to be supplied over the 10 year period On expiry of near-month contract the position was rolled over to the next near-month contract for the remaining quantity of exposure

Case study contd..

Oil prices were in normal backwardation when strategy was adopted backwardation was expected to continue Under conditions of backwardation futures price is below the expected future spot price and hence futures prices rise to converge with the spot at expiry Hence MG expected to make MTM gains on its long futures positions even as it lost on its forward sale commitments However oil market changed to contango, i.e. spot prices started declining and fell below the futures prices Hence as MGs long futures contracts approached expiry, the futures prices were declining and MG incurred huge MTM losses

Case study contd

Due to its huge long position in the futures market, MG faced margin calls and ran into funding problems Although MG was making profits on its actual sales under the forward contracts, these gains could not be recognized in P&L under the German accounting rules while MTM losses on the long futures position had to be recognized As a result MGs P&L was in a mess and adverse consequences in the market Eventual losses $1.5 billion Risks faced by MG basis risk, liquidity risk and operational risk

Open Interest V/s Volume

Date Trade Open Interest as on date Trading Volume for the day

Jan 1
Jan 2

A shorts 50 contracts B goes long in 50 contracts

C goes long in 100 contracts D goes short in 100 contracts

50

50

OI increases to 150 50 as new long and short position are created OI remains at 150 because As short position is replaced by Es short position OI falls to 50 as existing long and short positions are closed 50

Jan 3

A closes short position by buying back 50 contracts E shorts 50 contracts

Jan 4

C closes long position by selling 100 contracts and D closes short position by buying back 100 contracts

100

Interpreting changes in OI
Open Interest OI is increasing Price Price is increasing Interpretation New buyers are coming in and technically strong market Indicates short-selling and technically weak market Indicates long liquidation and technically strong market Indicates short-covering and technically weak market

OI is increasing OI is declining

Price is declining Price is declining

OI is declining

Price is increasing

OI increasing; Price increasing

Increasing OI suggests creation of new positions. Also rising price shows that new buyers are stronger than new sellers. Hence bullish for the scrip

Scrip IDEA IDEA IDEA IDEA

Date SettPrice OI Change in OI 14-Nov 96.05 8492000 15-Nov 94.50 8688000 196000 16-Nov 98.55 10804000 2116000 17-Nov 97.80 11452000 648000

OI increasing; Price declining

Increasing OI suggests addition of new positions. Falling price suggests that new sellers are stronger than new buyers. Hence suggests short-selling in the scrip
Scrip Date SettPrice OI MUNDRAPORT 11-Nov 151.60 MUNDRAPORT 14-Nov 155.55 MUNDRAPORT 15-Nov 144.05 MUNDRAPORT 16-Nov 132.05 MUNDRAPORT 17-Nov 131.55 Change in OI 2766000 2562000 2784000 4420000 5918000 -204000 222000 1636000 1498000

OI declining; Price declining

Declining OI suggests closure of existing positions, i.e. old buyers are now selling and old sellers covering up their short positions. Falling price suggests that sellers (old buyers) are stronger than buyers (old sellers). Hence implies liquidation of old long positions in the scrip

Scrip IGL IGL IGL IGL

Date SettPrice OI Change in OI 11-Nov 428.65 213000 14-Nov 425.80 206500 -6500 15-Nov 419.55 204000 -2500 16-Nov 413.40 180500 -23500

OI declining; Price increasing

Declining OI suggests closure of existing positions, i.e. old buyers are now selling and old sellers covering up their short positions. Rising price suggests that buyers (old sellers) are stronger than sellers (old buyers). Hence implies short-covering in the scrip
Scrip PATNI PATNI Date SettPrice OI Change in OI 16-Nov 391.15 806500 17-Nov 422.45 564000 -242500