Session 1 Derivatives & Risk Management

Aparna Bhat
Forwards & Futures
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 Futures
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
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 Underlying Expiry Date Option Type Strike Price Market Lot
FUTIDX
NIFTY
28JUL2011 - - 50
Price Information
Open Price 5668.00
High Price 5670.00
Low Price 5632.10
Last Price 5636.95
Prev Close 5665.85
Close Price -
Change from prev close -28.90
% Change from prev close -0.51
VWAP 5645.09
Underlying Value 5621.50
Number of contracts traded 93518
Turnover (In Lakhs) 263958.76
Open Interest 22744350
Change in Open Interest 914950
% Change 4.19
Order Book
Buy Qty Buy Price Sell Price Sell Qty
150 5636.65 5637.00 29250
100 5636.60 5637.45 50
100 5636.40 5637.80 400
100 5636.25 5637.90 450
50 5636.20 5637.95 50
719500 Total Buy Qty Total Sell Qty 573500

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

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

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 forward contract
No arbitrage is the main assumption
The principle of replication
Cost of the replicating portfolio = cost of the
derivative



Replicating a forward contract
Suppose you enter into a forward contract to buy
gold at time t at a delivery price F. What should be
the fair price at which to enter into this long
position?
At maturity of the forward contract you will receive
gold at price F
This position can be replicated by buying gold
today at spot price S by borrowing at a rate r%
p.a. and holding the gold till time t
The cost of buying and holding gold till time t is
S*e^rt
No-arbitrage condition dictates that the forward
price F should be equal to S*e^rt

Another argument
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 riskless
Eg- Consider an investment in Tata Motors today at Rs.304 hedged
with short 1-month future at Rs.305.

Final share price 280 290 300 310 320 330
Pay-off from short future 25 15 5 -5 -15 -25
Value of hedged portfolio 305 305 305 305 305 305
Current futures price 305 305 305 305 305 305
Cost of Carry Model for pricing
In the example the final value of hedged portfolio = Current
futures price
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 and S0 = current spot price
Thus forward price = Spot price + 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
Assumptions of cost-of-carry model
No transaction costs
No restrictions on short sales
Same risk-free rate for borrowing and lending
Violations of forward pricing formula.
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


Violations of forward pricing formula.
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
Violations of forward pricing formula.
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

Violations of forward pricing formula.
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
Implied repo rate (IRR)
It is that interest rate which would make the observed
forward or futures price equal to the theoretical price
predicted under conditions of no-arbitrage using given
values of the spot price and other variables
Implied repo rate is the rate at which an investor can
borrow synthetically by going short spot and long forward
invest synthetically by going long spot and short forward
There will be no arbitrage when
Lending rate < IRR < Borrowing rate

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 59.23 and the Dollar-rupee
futures on NSE are quoting at 59.20. How can he hedge
against the dollar-rupee 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 A shorts 50 contracts
B goes long in 50 contracts
50 50
Jan 2 C goes long in 100 contracts
D goes short in 100 contracts
OI increases to 150
as new long and
short position are
created
50
Jan 3 A closes short position by
buying back 50 contracts
E shorts 50 contracts
OI remains at 150
because As short
position is replaced
by Es short
position
50
Jan 4 C closes long position by
selling 100 contracts and D
closes short position by
buying back 100 contracts
OI falls to 50 as
existing long and
short positions are
closed
100
Interpreting changes in OI
Open Interest Price Interpretation
OI is increasing Price is increasing New buyers are coming in
and technically strong
market
OI is increasing

Price is declining Indicates short-selling and
technically weak market
OI is declining Price is declining Indicates long liquidation
and technically strong
market
OI is declining

Price is increasing

Indicates short-covering
and technically weak
market
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 Date SettPrice OI Change in OI
IDEA 14-Nov 96.05 8492000
IDEA 15-Nov 94.50 8688000 196000
IDEA 16-Nov 98.55 10804000 2116000
IDEA 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 Change in OI
MUNDRAPORT 11-Nov 151.60 2766000
MUNDRAPORT 14-Nov 155.55 2562000 -204000
MUNDRAPORT 15-Nov 144.05 2784000 222000
MUNDRAPORT 16-Nov 132.05 4420000 1636000
MUNDRAPORT 17-Nov 131.55 5918000 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 Date SettPrice OI Change in OI
IGL 11-Nov 428.65 213000
IGL 14-Nov 425.80 206500 -6500
IGL 15-Nov 419.55 204000 -2500
IGL 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 Date SettPrice OI Change in OI
PATNI 16-Nov 391.15 806500
PATNI 17-Nov 422.45 564000 -242500