Futures: Distinction in Between Futures Contract and Forward Contract

PSG Institute of Management -2010 1
Futures
Distinction in between Futures contract
and Forward contract

Futures contract

Standardised norms promotes liquidity
in the futures market over the forward
market

Distinction in between Forwards
and Futures
Futures Forwards
Trade on an organised
exchange
OTC in nature
Standardised norms Customised features
More liquid Less liquid
Margin payments are
present
Not present
Follows daily settlement Only at the end of the
period
Counter party risk-
clearing corporation
To be borne by the client
Types of Future contracts
Buy a future : Agreement to take
delivery during the future date at
agreed future price
Sell a future : Agreement to make
delivery during the future date at a
agreed future price
Example (in both directions) Cash
settlement-Speculators Vs Hedgers
Both
Features of Futures
Spot price
Futures price
Contract date
Contract period
Quantity of the asset
Name of the underlying asset
Contract size Also Called Lot size
Futures terminology
Spot price
Futures price
Contract cycle
Expiry date
Contract /lot size Revisit
Basis :Spot price-Futures price
Cost of carry-relationship between
future price and spot price- cost of
storage+Interest benefit accrued
from the asset
Basis
Short hedge-Spot 1 : Rs 100
Spot 2: 85 Futures 1: Rs102 Futures
2:Rs87
When basis strengthens Gain ?
When basis weakens Loss?
Long hedge Spot 1:Rs.200 Futures
1-Rs.203 Spot 2:Rs.240
Futures2:Rs243
Why spot price= future price @
expiry? Arbitrage opportunity
Futures -terminology
Price limit :maximum price limit posed by the
exchange-sets the day price movement limit of
underlying-initial margin money collected Price
increases = the daily price limit i-e limit up ;
Price decreases=the daily price limit i-e limit
down
Price Band : For FUTSTK-20%;INXSTK-10%
Limit up /down : circuit breaker for Index based
Position limit: prescribed by the exchange-1995
Sumitomo Corporation and Hamanaka
Circuit breaker-NSE
Sl.No Before 1.00
P.m of trading
Between 1.00
P.M-2.30 P.M
After 2.30 P.M
10% 1.00 Hour Halt 30 Minutes Halt No halt
thereafter at
10%
15%

2 Hours Halt 1.00 P.M-200 P.M
1.00 Hour Halt
After 2.00 P.M
Halt for the
remaining
trading day
20% Shall be halted for remainder of trading day
Position limit
Category Position limit
Option
Position limit
Futures
Position limit
Combined
Trading
member
Equity index
option contracts
Rs.500 cr/15%
of total open
interest
Equity index
futures contracts
Rs.500 cr/15%
of total open
interest
Stocks having
market wide
position limits
Rs.500 cr or
above
combined limit
20% of MWPL
or Rs.300 cr
which ever is
lower ;with in
the stock futures
10%MWPL or
Rs150 cr
Client Level
Derivative contracts on underlying Should not
exceed 1% of free float market capitalization in
terms of shares and 5% of open interest in all
derivative contracts in terms of shares : which ever
is higher
9
Contract specifications stock
futures
-Nov,2001
Contract-underlying securities /S&P
CNX Nifty
Exchange-NSE
Security descriptor N FUTSTK
Contract size-as specified by
exchange- Rs.2 lakh
Price steps-.05* respective lot size
Trading cycle-three month trading
cycle


futures
Near month(one); next month(two);
far month(three)-New contract will
be introduced on next trading day
following the expiry of near month
contract
Expiry day-last Thursday of the
expiry month/previous trading day
if the last Thursday is a trading
holiday

Open interest and Settlement
price
Open interest:-Outstanding positions in
the contract at that point of time and
Liquidity of the contract . Next video
Closing out position easier at when open
interest is high and vice versa
Settlement price:-average of the prices at
which the contract is traded-NSE:
average price of Last half an hour and
when trade is not taking place
theoretical price will be taken to
consideration
Open Interest
Consider the following transactions in ICICI single stock
futures that took place in one of the exchanges .
ON Jan2 When the contract started trading , Megafund took a
long position in 10 contracts .Minifund took a long position in
12 contracts . Ram took a short position in 7 contracts and
Interfund took a short position in 15 contracts
On Jan3 Megafund took a short position in 5 contracts
.Minifund took a long position in 8 contracts .Ram took a long
position in 3 contracts and Interfund took a short position iin 6
contracts
On Jan 4 Megafund took a short position is 10 contracts
.Minifund took a short position in 5 contracts . Ram took a long
position in 8 contracts and Interfund took a long position in 7
contracts
Open interest
Currently Karthik is long on 1000 contracts Prakash on
another 4200 contracts and sanjay is short on 5200
contracts .If they undertake trading on following four
days
Day1: Karthik sells 500 contracts &prakash buys 500
contracts
Day2:Karthik buys 700 contracts and Prakash sells 700
contracts
Day3- Karthik buy 200 contracts &Sanjay sells 200
contracts
Karthik sells 800 contracts & sanjay buys 800 contracts
Open Interest
Price Volume Open
Interest
Market Change in
market
Rising Up Up Strong Bullish-
Strong
New money
entering into the
market
Rising Down Down Bearish-Weak Money leaving
the market
Declining Up Up Weak Bearish Aggressive new
short selling
Declining Down Down Bullish-Strong Seller will
liquidate his
positions
causing an end
to downward
trend



futures
Settlement basis:Mark to market
and final settlement T+1 basis
Daily settlement closing price of
futures contracts for the trading
day
Final settlement price- closing price
of underlying security on the last
trading day
Contract cycle2013
Jan Feb Mar Apr
Jan 31 Contract
Feb 28 Contract
Mar 28 Contract
Apr 25 Contract
May 30 Contract
June 27 Contract

Contract Lot size
Index future Market
Multiplier
On September 3
BSE sensex 30
is at 16,140.BSE
sensex 30
expiry on Oct,27
are at 16,311.
Multiplier 15
.Calculate the
cash flow for the
folloiwng if the
BSE sensex 30
has value of
16,660
BSE 30 Sensex futures 15
BSE Sensex Mini futures 5
BSE Teck futures 124
BSE Bankex futures 25
BSE Oil and Gas futures 38
NSE CNX Nifty futures 50
NSE CNX Nifty mini futures 20
CNX IT futures 100
Bank Nifty futures 50
Nifty Mid cap 50 futures 150
Futures-Terminology
Initial margin: Deposit which is to
be made at the moment of entering
into the futures contract
Marking to market:gain or loss can
be calculated from the futures
closing price
Maintenance margin :To ensure in
the margin account never negative
margin call to top up initial
margin
Price quotes
Asset underlying the futures market
Contract size
How the price is quoted
Maturity of the contract
Opening price
Highest price traded
Lowest price traded
Settlement price
Change in settlement price
Open interest
Volume of trading
key advantages &Major types
Key advantages
Highly liquid market-easy to open
and close position
Gearing-buying large exposure with
the help of 10% of the total
exposure
Long futures buying futures
Bullish
Short futures selling futures
Bearish
Features Geared instruments
Facilitates to buy the large
exposure with small outlay is
known gearing process
Futures to trade without owning
stocks
Futures are used as hedging
instruments
Futures for portfolio adjustments
Gearing process example
Share A is currently priced Rs.100
and the December future on that
share is priced at Rs.102
A few days later the share price has
risen to Rs.110 and the future has
risen to Rs.112
Futures-Features
Futures to trade without
stocks
Moving out of the
existing futures by
entering into counter
positions

Futures-Pairs(Spread)
trading
To take position on
relative performance of
two shares pairs
trading
Studying the movement
of prices of two stocks
entering into the
futures
Determiining the net
gains
Futures Pairs Trading
Investor thinks that A will outperform the
B stock over the next few months . He
buys 2 futures of A and sells 3 futures of
B (1000 shares)
Share A
Rs
Share B Rs
Share
price
600 400
Future
price
675 450
Price
after
Share A
Rs
Share B
Rs
Share
price
540 340
Future
price
546 344
Port folio adjustments
Assume investor
holds 10,000
shares of A . B is
considered as
outperforming
stock over the A
stock. (futures-
1000)
He sells 10
futures of A and
buys 13 futures B
price A B
Share 320 250
future 325 254
Price
2months
A B
Share 336 275
Futur
e
338 277
Type of orders
Type of
Orders
Time Price Other
Time orders
Time
Day
Immediate
or Cancel
Price condition
Stop loss order : This facility allows
the user to release an order into the
system , after the market price
reaches or crosses threshold price
Market order : Price of execution is
not known
Limit order: Price is known but no
certainity involved to execute order
Index future
Index is a number represents the changes in
between two periods
Stock index change in the value of a set of
stocks over a base period
Example
Importance of Index
As a barometer of market index
As a benchmark of portfolio performance
As an underlying derivative instruments Index
futures
In passive fund management of funds
Types of index
Price weighted index: weight given
in accordance to the stock price
Market capitalisation index: equity
price is weighted by the market
capitalisation of the company(share
price* shares outstanding)
Index=
Current market capitalisation * Base value
Base market capitalisation
Index derivatives /Index
fund/ETF
Index derivatives are derivative
contracts which have the index as
the underlying
Index fund: Tries to replicate the
index returns-investing in the index
stocksin the proportions
ETF: exposure to index or the
portfolio of securities as single
stock traded in the stock exchange.

Hedge ratio
=Futures position
Underlying asset position
=Value of hedged portfolio
Price of the futures contract

Features of futures
Quick and low cost
Price discovery function
Advantages to informed individuals
Protection through index futures
Flexibility
Integrity protects through market
margins
Leverage marking to market
Maintenance margin
Variation margin
Margin Role of Clearing House/
corporation
Central counter party
Seller to buyer
Buyer to seller
Deposit of funds-with the clearing
corporation
Initial margin a deposit for meeting out
the potential loss on the position based
on maximum expected movement
overnight in price
Margin
Initial margin: on previous
experience, collected from both
buyer and seller , subject to
revision,10% value of the contract,
calculated on the Value at
Risk(VaR)=To cover the one day
loss through 99% of the days .
VaR- value of the portfolio which is
expected to lose due to potential
changes in the underlying asset
(Clearing Corporation)
Maintenance margin
Maintenance Margin to support the daily
settlement process mark to market-losses
already are collected
Initial margin- to safeguard against potential
losses on outstanding positions.
Maintenance margin-75-80% of initial margin
adequate cash resources should be deposited
transactions will be with held- to maintain the
margin shorting is done and profits are realised
and set the balances in the margin deposit and
the remaining are withdrawn by the investor
Marking to market
- to evade credit risk margin is
maintained by the exchange- from the
players- to overcome counterparty risk.
-Contract is marked to its present market
value.
On every day- contract is marked to
market
Trader vs Exchange
If trader earns profit- exchange is liable-
profit will be credited
Unless otherwise vice versa

Variation margin
To restore the initial margin- through margin
call from the exchange
Exercise
On November 15, the spot price for Telco is
Rs.473 per share , Mr. X buys 15 contracts of
Jan Telco futures of Rs.491.Assume that initial
margin is Rs.800 per contract and the
maintenance margin is Rs.600 per contract
.Given the each contract 50 shares .Daily
settlement of prices are given
Nove15 Rs.496;Nove16 Rs.503; Nove 17 Rs.488;
Nove 18 Rs.485; Nov19 Rs.491
November16th Mr.X withdraws the profit from the
maximum allowed on Nov16 and half the
maximum amount allowed
Futures pricing
S= F-s-rs
Under the no uncertainty and
uncertainty
Investors are neutral , without any
expectations they are bearing risk-
Spot price = FP-s-rs
If the investors are risk averse
Spot price= FP-s-rs-
For financial asset s=0; rS= dividends
or interest coupon , exceeds
opportunity cost ,lead to negative
S+rS= cost of carry=> Theta
F1=S+
Arbitrage Pricing of futures
Borrow money to
buy shares
Buy shares
Sell futures contract =
to the shares bought
Hold shares and
receive dividends
Deliver shares in
fulfillment of futures
contract
Borrowing Rs 100
Buying of shares

Rs.100
Interest rate Rs.6
Dividends Rs.2
Arbitrage Pricing of futures-
cash and carry
Borrow money to buy shares + Rs100
Buy shares - Rs.100
Payment of Interest -Rs.6
Receipt of Dividends +Rs.2
Sell futures +Rs 104
Repayment of loan -Rs100
Pay off Zero
Pricing of futures
Cost of carry=?????
Fair value=?????
When will be the risk less profit
sell futures ?
Premium=?
Components of premium=?
Early future contract slides

Pricing of futures-Reverse cash
and carry
1 Sellsharees
2 lend proceeds from
sale and receive
interest
3 Buy futures
equivalent to the
shares sold
4 Wait until the delivery
date
5 Receive shares
through transaction
Sell shares +Rs100
Deposit of funds -Rs.100
Receive interest (net) +Rs.4
Surrender dividends -Rs.2
Return of
loan/Deposit
+Rs.100
Buy futures -Rs102
Profit/Loss Zero
Pricing of futures
If FP>Fair value cash and carry
If FP<Fair value-reverse cash and
carry
Acc J M Keynes JR Hicks (1930)-
futures price reflects futures spot
price
Speculators(Buyers) Vs Hedgers
FP<SP-Backwardation position
Speculators( sellers)FP>SP-Contango
-presences of producers and
consumers
Future price
Financial futures=
Spot price+Cost of carry-Returns
(dividends, interest etc)
Commodity
=Spot price+Cost of carry +Storage,
Insurance etc
If an equity share of ACC (face
valueof Rs.10) quotes Rs.220 on
31.12.2004 in the cash market and
the futures price with March2005
expiration date ,quotes at Rs.230
and the borrowing rate is given as
15% and the annual expected
dividend rate is 25% payable before
31.3.2005. the futures price of ACC
as on 31.12.2004
Cost of carry
=s+rS
Spot price = Future spot price of
the asset
F=S+
Future price= Spot price+ cost of
carry+ insurance and other charges
Returns
A=Pe
m
e
m=
2.72
(2.71828)

Pricing of the index future
Future price of the index= spot
index + cost of carry-Dividends of
the basket of stocks

If the NSE spot index is 1200 , the
one month MIBOR rate is 10.50%
and the expected dividend yield is
2% p.a , the fair value of the futures
contract with a one month
expiration

Currency futures Introduction
to currency market
Type of currencies Base and
counter currencies
USD-INR
GBP-INR
Japanese yen USD
First currency Base currency
Second currency Counter /terms
/qoute currency
Exchange rate regimes
Exchange
Rate
Fixed
Floating
Fixed and Floating exchange
rates
Govt action
towards buying
and selling of
domestic
currency-in open
market
Buying at value is
coming down
Selling at value is
going up
Self correcting
mechanism
Demand and supply
of the currency
Demand for
currency is low-
import is costlier
and export is
cheaper
When exports-
payment leads to
appreciation of
domestic currency

Factors Exchange rates
Fundamental factors : inflation,
BOP, unemployment , capacity
utilisation , trends in import and
exports-BOP surplus- Favourable
exchange rate and vice versa
Technical factors : Interest rates
,Inflation rate and Exchange rate
policy
Political factors
Speculation-over valuation

Important reasons for Rupee
Depreciation

PSG Institute of Management -2010
62
Quotes
Direct quote : in the expression of
USD ;1USD =INR 45.000
Indirect quote : in the expression of
terms currency ; 1INR=.021 USD
Tick size
NSE tick size :.0025
Value of one on each contract =Rs
2.5
Example 4 ticks improvement and 5
contracts
Bid price willing of the buyer to
pay
Ask price- willing of the price to sell
Spread
PSG Institute of Management -2010
64
Margin-Mark to market
Example X buys a March delivery
pound sterling futures on say
,January 15 at the price of $1.65
per british pound per contract
.62500 units (CME)
What is the price of futures
contract?
If On Jan 16 the price increases at
1.68 or 3 cents .How much profit of
X?
Contract specifications
Underlying-Rate of Exchange between
USD and INR
Trading hours :9.00 A.M to 5.00 p.m
Contract size USE1000
Tick size :.25 paise of INR .0025
Contract months:12 near calendar
months
Final settlement date/value date:Last
working day of the month (subject to
holiday calendars)
Highlight Forex Futures
Contract
Currency Future-Contract cycle
Contract specification
Last trading day :Two working days
prior to final settelment
Settlement :Cash settlement
Final settlement price: The
reference rate fixed by RBI two
working days prior to the final
settlement date will be used for
final settlement .
RBI Reference rate
Currency futures contract
trading process
Trader
seller

Trader
Buyer
Member
Broker
Member
Broker
Clearing
house
Pricing of futures contract-
interest rate parity

A theory in which the interest rate differential
between two countries is equal to the differential
between the forward exchange rate and the spot
exchange rate. Interest rate parity plays an
essential role in foreign exchange markets,
connecting interest rates, spot exchange rates and
foreign exchange rates.
F/S= (1+Rh)/(1+Rf)
F=S *e
(rh-rf)*r

Example problems
Assume on March10,2002 annual
interest rate was 10% p.a on indian
rupees and US dollar was 7% per
annum . The spot Re/$ exchange
rate was 44 using the above futures
,calculate the theoretical futures
price on one year forward exchange
rate
Interest rates influences
If foreign interest rate is more than
If domestic interest rate more than
Interest rate parity theory
Spot rate Rs48.000 per USD
2years
Interest rate in India 7%
Interest rate in USA 5%
49.50
50.25

Hedging with currency futures
Importer and Exporter
Long hedge against the
appreciation of foregin currency
/depreciation of indian currency
Short hedge against the
appreciation of indian
currency/depreciation of foregin
currency
Risks in Hedging
The asset that is to be hedged may
not be exactly as the asset on
which the futures contracts are
written-Cash settlement in advance
Mis match of future contract
delivery period and demands of the
hedger i-e before the delivery
period
The quantity bought and sold may
be different from the futures
contract size
Determinants of hedging
Choice of underlying currency
Choice of the maturity contracts
Hedge ratio
Hedge ratio-Future
contracts(General)

| |
ize of the exposure
Hedge *
Size of the position taken in the futures contract
S
h
(
=
(

Size of position contract size* Number of future contracts =
Size of the exposure Quantity of assets exposed
*
spot price of the asset exposed
=
Hedge ratio contd.
It is known minimum variance hedge ration
ASChange in spot price during a period of time
equal to the life of the hedge
AFChange in futures price during a period of
time equal to the life of the hedge
osstandard deviation of AS
ofStandard deviation of AF
coefficient correlation between AS and AF
Hedge optimal ratio:

*
s
h
f
o
o
(
=
(

Hedge ration
On May 10,Meenakshi Rolling flour mills estimates that
it will require 5MT of wheat on June 20.It wants to hedge
the risk of increase in the price of wheat in the future and
decides to hedge the price risk using wheat futures in
MCX Indian. Futures contracts are available with delivery
on June 20 , with a futures price of INR 1,205. Since the
hedge lasts from May 10 to June 20 for a period of 42
days , the manager of mills find the following with
respect to the spot price and futures price of wheat
Standard deviation of changes in spot price =`105
Standard deviation of changes in futures price =`120
Correlation between spot price and futures price changes
=.96

Hedging Effectiveness
2
2
2
Hedging effectiveness
F
s
o
o
(
=
(

On November 20 the
spot price of Jute is
`2,198 per 100kg and the
price of December jute
futures with expiry on
December 15 is `2,276.
The standard deviation of
`260 and standard
deviation of futures price
`248 . The correlation is
.99 what is hedge ration
and hedge
effectiveness?
Number of contracts used to
hedge
NA=Size of the position being hedged
QF=Size of the futures contract
N*=Optimal number futures contracts is for hedging

h=.8 Na=10,000 and Qf=1,000
*
*
A
F
N
N h
Q
(
=
(

Hedging problem:
On May 10 Meenakshi Rolling Flour Mills
50Mt of wheat on June 20.The spot price
of wheat on May 10 is INR 1,214(100kg)
.Futures contracts for delivery on
June20. with a futures price of INR 1,205.
Hedge lasts from May 10 to June 20 (42
days) contract futures is available for
10MT
Standard deviation in spot price INR 105
standard deviation of futures price 120
correlation .96 How much Meenakshi
mills should hedge its exposure?
Short hedge &Long Hedge
Comparision between the futures
contract price and exchange rates

Futures: Distinction in Between Futures Contract and Forward Contract

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