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UNIT- 2 FUTURES CONTRACT SPECIFICATIONS OF FUTURES CONTRACT NORMALLY CONSIST OF: Asset specifications Contract Size Delivery Arrangement Price Quote Daily Price Movement Limits Position Limits Expiry Date

Asset Specifications Quality When the asset is a commodity, there may be variation in the quality of what is available in the market place. Hence Exchange stipulates the grade or grades of the commodity that are acceptable. The financial assets in futures contracts are generally well defined and unambiguous. Contract Size The contract size specifies the amount of the asset that has to be delivered under one contract. Example : 200 shares of Infosys 50 units of Nifty 100 gms of gold 5 Kg of Silver

Delivery Arrangement Delivery arrangement includes the place of delivery and the precise period in the month during which the delivery has to be made. Exchange specifies when the trading in a particular months contract will begin as well as the last day on which the trading can take place for a given contract. Price Quote The futures price is quoted in a way that is convenient and easy to understand. Example: Crude oil future prices on the New York Mercantile Exchange (NYMEX) are quoted in dollars per barrel to two decimal places.(i.e. to the nearest cent)

Daily Price Movement Limits Daily Price limits are specified by the exchange to prevent large price movements occurring because of speculative excesses. If the price moves down by an amount equal to the daily price limit the contract is said to be limit down If the price moves up by an amount equal to the dail price limit the contract is said to be limit up. Position Limits Position limits are the maximum number of contracts that a speculator may hold. The purpose of the limits is to prevent speculators from exercising undue influence on the market. TERMINOLOGY: Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have onemonth, two-months and three months expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. Margin Calls : A margin call on futures contracts is triggered when the value of your account drops below the maintenance level. For example, you hold five futures contracts that have an initial margin of $10,000 and a maintenance margin of $7,000. The value of your account falls to $6,500. You will get a margin call requiring you to add $3,500 to your account to bring it back to the initial margin. You also have the option of closing your positions to eliminate the margin call. MARGIN- Definition The definition of margin includes three important concepts: the Margin Loan, the Margin Deposit and the Margin Requirement. The Margin Loan is the amount of money that an investor borrows from his broker to buy securities. The Margin Deposit is the amount of equity contributed by the investor toward the purchase of securities in a margin account. The Margin Requirement is the minimum amount that a customer must deposit and it is commonly expressed as a percent of the current market value. The Margin Deposit can be greater than or equal to the Margin Requirement. We can express this as an equation:

Margin Loan + Margin Deposit = Market Value of Security Margin Deposit >= Margin Requirement Borrowing money to purchase securities is known as "buying on margin". When an investor borrows money from his broker to buy a stock, he must open a margin account with his broker, sign a related agreement and abide by the broker's margin requirements. The loan in the account is collateralized by investor's securities and cash. If the value of the stock drops too much, the investor must deposit more cash in his account, or sell a portion of the stock. MARGIN REQUIREMENTS Initial Margin The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin Maintenance Margin Maintenance margin is set to ensure that the balance in the margin account never becomes negative. This is somewhat lower than the initial margin If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. Marking to market At the end of the day margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called marking to market. Zero sum game The total number of long in any contract always equals the total number of short in that contract The total number of outstanding contracts (long/short) at any point in time is called Open interest. Open interest is a good indicator of the liquidity in every contract.

OTHER MARGINS: Premium margin The amount of money needed to close out an option position. Premium margin is designed to cover the credit risk associated with a position. If an investor is shorting a stock, this premium would be the amount of money needed to close the position if the investor were to go intodefault. Premium margin and risk margin are the two components comprising the margin requirement.

Clearing margin Financial safeguards enacted in order to ensure that clearing brokers or corporations actually perform the open contracts of their customers. Customer Margin A method of creating an assurance on the part of both buyers and sellers of futures contracts that all contract obligations will be fulfilled. Customer margins are established individually based on the amount of risk exposure and the size of the contract. Future commission merchants are responsible for overseeing customer margin account. Margins are determined on the basis of market risk and contract value. Margin-equity ratio It is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%. However the exchanges require a minimum amount that varies depending on the contract and the trader. He broker may set the requirement higher, but may not set it lower. A trader can set it above, if he does not want to be subject to margin call. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Performance bonds deposits required to ensure that a clearing member can cover potential losses with his or her trading positions help to ensure that clearing members can meet their obligations to their customers and to clearing house Return on margin (ROM)

It is often used to judge performance because it represents the net gain or net loss compared to the exchange's perceived risk as reflected in required margin. ROM may be calculated Realized return Initial margin The annualized ROM is equal to (ROM + 1)(1/trade duration in years) - 1 For example if a trader earns 10% on margin in two months, that would be about 77% annualized Annualized ROM = (ROM +1)1/(2/12) - 1 that is, Annualized ROM = 1.16 - 1 = 77% Sometimes, return on margin will also take into account peripheral charges such as brokerage fees and interest paid on the sum borrowed. The margin interest rate is usually based on the Broker's call. MARKING TO MARKET Once the contract is initiated, the trader faces mark-to-market margins until the trader closes his position. Marking to market means recording the value of a contract at the days settlement price to calculate profits and losses. This is done on a daily basis. Now there are two possibilities after the contract is initiated. Contract can be closed by undertaking a reverse trade before the close of trading on the same day. In this case, Profit/Loss = Contracted Price Closing Price Contact may be carried further to the next day. In this case, at the end of the day, the profits or losses are computed as follows: Profit/Loss = Contracted Price Settlement Price And the traders account will be credited or debited for this amount. If the price movements are favorable, the balance in the traders margin account is increased when it is marked to market. The trader is entitled to withdraw any surplus over the initial margin. Similarly, adverse price movements result in debits and the traders balance will reduce. Therefore, depending on the new, marked-to-market value of the contracts, the trader will realize any gains/losses in the value of their futures positions at the end of the each trading day. At the end of the each trading day, the settlement price defines the price at which outstanding contracts are marked to market. ORDER (Placing an order)

Future contracts are traded in trading pits on the floors of the exchanges only during official trading hours. The classical/traditional type of trading in future contracts is called the open outcry system. An order in a market such as a stock market, bond market, commodity market or financial derivative market is an instruction from customers to brokers to buy or sell on the exchange. These instructions can be simple or complicated. There are some standard instructions for such orders. TYPES OF ORDERS MARKET ORDER A market order is a buy or sells order to be executed immediately at current market prices. As long as there are willing sellers and buyers, market orders are filled. Market orders are therefore used when certainty of execution is a priority over price of execution. A market order is the simplest of the order types. This order type does not allow any control over the price received. The order is filled at the best price available at the relevant time. In fast-moving markets, the price paid or received may be quite different from the last price quoted before the order was entered. A market order may be split across multiple participants on the other side of the transaction, resulting in different prices for some of the shares. LIMIT ORDER A limit order is an order to buy a security at no more than a specific price, or to sell a security at no less than a specific price (called "or better" for either direction). This gives the trader (customer) control over the price at which the trade is executed; however, the order may never be executed ("filled"). Limit orders are used when the trader wishes to control price rather than certainty of execution. A buy limit order can only be executed at the limit price or lower. For example, if an investor wants to buy a stock, but doesn't want to pay more than $20 for it, the investor can place a limit order to buy the stock at $20. By entering a limit order rather than a market order, the investor will not buy the stock at a higher price, but, may get fewer shares than he wants or not get the stock at all. A sell limit order is analogous; it can only be executed at the limit price or higher. Both buy and sell orders can be additionally constrained. Two of the most common additional constraints are Fill Or Kill (FOK) and All Or None (AON). FOK orders are either filled completely on the first attempt or canceled outright, while AON orders stipulate that the order must be filled with the entire

number of shares specified, or not filled at all. If it is not filled, it is still held on the order book for later execution.

STOP ORDER A stop order, also referred to as a stop-loss order, is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the stop price is reached, a stop order becomes a market order. A buy stop order is entered at a stop price above the current market price. Investors generally use a buy stop order to limit a loss or to protect a profit on a stock that they have sold short. A sell stop order is entered at a stop price below the current market price. Investors generally use a sell stop order to limit a loss or to protect a profit on a stock that they own. When the stop price is reached, and the stop order becomes a market order, this means the trade will definitely be executed, but not necessarily at or near the stop price, particularly when the order is placed into a fast-moving market, or if there is insufficient liquidity available relative to the size of the order. The use of stop orders is much more frequent for stocks and futures that trade on an exchange than those that trade in the over-the-counter (OTC) market. [Broker Dependent] Charles Schwab definition: Stop orders and stop-limit orders are very similar, the primary difference being what happens once the stop price is triggered. A standard sell-stop order is triggered when the bid price is equal to or less than the stop price specified or when an execution occurs at the stop price. [Editorial point] Key point is "bid/ask" which are cues and do not represent the stocks value. The broker above moves the stop order to the market queue based on a BID queue not on a completed transaction. For instance, on a stock XYZ closing at $20 the day before with a stop-loss order at $19 and which trades on low volume, the bid/ask at the open can be skewed in that at the open all the market interest is not represented. The bid queue shows $18.5, the market opens, being the highest bid the broker triggers the stoploss and moves the order to the market, for which there has not even been a trade, an agreed value. The stock trades for $20.50, never even trading at or below the stop-loss order. A sell stop order is an instruction to sell at the best available price after the price goes below the stop price. A sell stop price is always below the current market price. For example, if an investor holds a stock currently valued at $50 and is worried that the value may drop, he/she can place a sell stop order at $40. If the share price drops to $40, the broker sells the stock at the

next available price. This can limit the investor's losses (if the stop price is at or above the purchase price) or lock in some of the investor's profits. A buy stop order is typically used to limit a loss (or to protect an existing profit) on a short sale. A buy stop price is always above the current market price. For example, if an investor sells a stock shorthoping for the stock price to go down so they can return the borrowed shares at a lower price (Covering)the investor may use a buy stop order to protect against losses if the price goes too high. It can also be used to advantage in a declining market when you want to enter a long position close to the bottom after turn-around. STOP LIMIT ORDER A stop limit order combines the features of a stop order and a limit order. Once the stop price is reached, the stop-limit order becomes a limit order to buy (or to sell) at no more (or less) than another, prespecified limit price. As with all limit orders, a stop-limit order doesn't get filled if the security's price never reaches the specified limit price STOP LOSS ORDER Probably the most important and most commonly used order. It can be used to establish a new position, limit a loss on an existing position, or protect a profit. A stop order specifies a price at which an order is to be executed. A buy stop is placed above the market and a sell stop is placed below the market. (Which is the opposite of the limit order). Once the stop price is hit, the order becomes a market order and is executed at the best price possible. On a long position, a sell stop is placed below the market to limit a loss. After the market moves higher, the stop can be raised to protect the profit (a trailing stop). You could also use the sell stop to enter the market as the market declines. A buy stop could be placed above the market to initiate a new long position or close an existing short position. Since the stop order becomes a market order, the actual 'fill' price may be beyond the stop price, especially in a fast market. CONDITIONAL ORDER A conditional order is any order other than a limit order which is executed only when a specific condition is satisfied. TRAILING STOP ORDER A trailing stop order is entered with a stop parameter that creates a moving or trailing activation price, hence the name. This parameter is entered as a percentage change or actual specific amount of rise (or

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fall) in the security price. Trailing stop sell orders are used to maximize and protect profit as a stock's price rises and limit losses when its price falls. For example, a trader has bought stock ABC at $10.00 and immediately places a trailing stop sell order to sell ABC with a $1.00 trailing stop. This sets the stop price to $9.00. After placing the order, ABC doesn't exceed $10.00 and falls to a low of $9.01. The trailing stop order is not executed because ABC has not fallen $1.00 from $10.00. Later, the stock rises to a high of $15.00 which resets the stop price to $14.00. It then falls to $14.00 ($1.00 from its high of $15.00) and the trailing stop sell order is entered as a market order. A trailing stop limit order is similar to a trailing stop order. Instead of selling at market price when triggered, the order becomes a limit order. MARKET-IF-TOUCHED ORDER A buy market-if-touched order is an order to buy at the best available price, if the market price goes down to the "if touched" level. As soon as this trigger price is touched the order becomes a market buy order. A sell market-if-touched order is an order to sell at the best available price, if the market price goes up to the "if touched" level. As soon as this trigger price is touched the order becomes a market sell order. Market on Open (MOO) This order as the name implies will be executed at the opening price of the market. As market openings can tend to be volatile it can be difficult for a broker to get the exact opening price and the settlement price may be different from the opening price. Market on Close (MOC) Also as the name implies this order is executed on the close of the market. In some markets the actual closing price may be different from the settlement price particularly if it's a fast moving market. Good Till Canceled This type of order is also know as an 'open order' the order remains in effect until the order is executed or the trader cancels the order. Fill Or Kill (FOK) This order is sent to the pit and should be executed immediately. If the order cannot be filled immediately the order is canceled. All or None

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This is essentially a limit order to buy or sell a security. The important point of this order is that the total order must be filled or none of it. Day Order An order that terminated automatically at the end of the day. If you have placed an order to buy or sell a security at a particular price and it is not filled the order is terminated at the end of the day. The above orders are the most common orders. Some securities may not use all of the above orders, as each market is different. It is important when you first start using orders that you have a chat with your broker and just go over the order procedure with him. HEDGING USING FUTURES Hedging involves assuming a position in futures market, which will benefit if the price moves adversely against his spot market position. Consequently, hedge position will be opposite either to a position that one has in the spot market or expected to have later. So the trader already owns or plans to produce a commodity and offer it for sale in the spot market, he will be concerned about price falls. Therefore a short position in the futures will be beneficial when prices actually decline. Hence the hedge will be short in the futures if spot position is long. This is known as the short hedge and the hedger hopes that a fall in the prices on the spot market will be counter balanced to a large extent by gains on the short futures position. A long hedge (buying futures) will be taken up to safeguard against a price rise in the spot market. Hedging Strategies: Current Status Holding the asset About to buy the asset Sold short the asset About to sell the asset Concerned about Asset price may fall Asset price may rise Asset price may rise Asset price may fall Short Long Long Short Hedge

Short hedge A company that knows that it is due to sell an asset at a particular time in the future can hedge by taking short position This is called short hedge If the price of the asset goes down, the company may not fare well on the sale of the asset but makes gain on the short futures position

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If the price goes up company gains from the sale of the asset, but takes the loss on the futures position.

Long hedge A company that knows that it is due to buy an asset at a particular time in the future can hedge by taking long position This is called long hedge If the price of the asset goes up, the company may not fare well on the sale of the asset but makes gain on the long futures position If the price goes down company gains from the buying of the asset, but takes the loss on the futures position. FUTURES FUNDAMENTALS: STRATEGIES Essentially, futures contracts try to predict what the value of an index or commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long, going short and spreads. Going Long When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase. For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September. By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit! Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.

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Going Short A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator. Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market. Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000. By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss. Spreads As you can see, going long and going short are positions that basically involve the buying or selling of a contract now in order to take advantage of rising or declining prices in the future. Another common strategy used by futures traders is called spreads. Spreads involve taking advantage of the price difference between two different contracts of the same commodity. Spreading is considered to be one of the most conservative forms of trading in the futures market because it is much safer than the trading of long/short (naked) futures contracts. There are many different types of spreads, including: Calendar Spread - This involves the simultaneous purchase and sale of two futures of the same type, having the same price, but different delivery dates. Inter market Spread - Here the investor, with contracts of the same month, goes long in one market and short in another market. For example, the investor may take Short June Wheat and Long June Pork Bellies. Inter-Exchange Spread - This is any type of spread in which each position is created in different futures exchanges. For example, the investor may create a position in the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).

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TYPES OF FUTURES ARBITRAGE TECHNIQUES There are two main futures arbitrage techniques; Long The Basis and Short The Basis. Both techniques require taking a position in the underlying asset as well as its futures contracts, as such, these are techniques possible only for futures traders with a significantly big fund. Both futures arbitrage techniques involve making a risk free profit through the price difference between the underlying asset and its futures contracts, which is known as the "Basis" in futures trading.

Futures Arbitrage Techniques

Futures Arbitrage - Long the Basis Long the Basis isn't only a futures arbitrage technique when held all the way to expiration, but also a futures spread technique for speculation on a short term narrowing of the basis. Being long the basis means being long the price difference between the spot price of the underlying asset and its futures contract. This is possible when the futures price is significantly higher than the spot price. When the price of the futures price is higher than the spot price of the underlying asset, you can reap that price difference as profit risk free by buying the underlying asset and then going short on its futures contract. This technique is particularly useful in normal markets. This is the same as owning a product and then simultaneously going into agreement to sell it at a higher price in future. When the futures contract expires, the price of the underlying asset would converge with the futures price, and no matter if the spot price converge upwards towards the futures price or the futures price converge downwards towards the spot price, you will still make that price difference in profit. Futures Arbitrage - Short The Basis

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Short the Basis isn't only a futures arbitrage technique when held all the way to expiration, but also a futures spread technique for speculation on a short term widening of the basis. Being short the basis means being short the price difference between the spot price of the underlying asset and its futures contract. This is possible when the futures price is significantly lower than the spot price. When the price of the futures price is lower than the spot price of the underlying asset, you can reap that price difference as profit risk free by shorting the underlying asset and then going long on its futures contract. When the futures contract expires, the price of the underlying asset would converge with the futures price, and no matter if the spot price converge downwards towards the futures price or the futures price converge upwards towards the spot price, you will still make that price difference in profit.

TYPES OF FUTURES CONTRACTS Securities, Stock Index Futures, Currencies and Commodities Stock index tracks the changes in the value of a hypothetical portfolio of stocks The weight of a stock in the portfolio equals the proportion of the portfolio invested in the stock The percentage increase in the value of the stock index over a small interval of time is usually defined so that it is equal to the percentage increase in the total value of stocks comprising the portfolio at that time Index derivatives are derivative contracts which have the index as the underlying. The most popular index derivatives contract the world over are index futures and index options. NSE's market index, the S&P CNX Nifty was scientifically designed to enable the launch of index-based products like index derivatives and index funds. The first derivative contract to be traded on NSE's market was the index futures contract with the Nifty as the underlying. This was followed by Nifty options, derivative contracts on sectoral indexes like CNX IT and BANK Nifty contracts. Trading on index derivatives were further introduced on CNX Nifty Junior, CNX 100, Nifty Midcap 50 and Mini Nifty 50. Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Index derivatives have become very popular worldwide. Index derivatives offer various advantages and hence have become very popular.

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Institutional and large equity-holders need portfolio-hedging facility. Index-derivatives are more suited to them and more cost-effective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements. Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates. DELIVERY OPTIONS Whereas a forward contract normally specifies that delivery is to take place on a particular day, the futures contract often allows the party with the short position to choose to deliver at any time during a certain period. Typically, the party has to give few days notice of its intention to deliver.

RELATIONSHIP BETWEEN FUTURE PRICES, FORWARD PRICES AND FUTURE SPOT PRICES. PRICING FUTURES Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below:

F = S erT
where: r Cost of financing (using continuously compounded interest rate) T Time till expiration in years e 2.71828

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Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows: F = S erT = 1150 * e0.11 *1/12 = 1160 Futures Price and Spot Price: The relationship between futures price and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus interest that is paid to finance the asset less the income earned on the asset. For a non-dividend paying stock, the cost of carry is r since there are no storage costs and no income is earned. For a stock index, it is (r-q) since income is earned at the rate q on the asset; For a stock index it is (r-rf) For a commodity with storage costs that are a proportion u of the price it is (r+u) and so on. Define the cost of carry as c. For an investment asset, the future price is

F = Sec(T-t)
For a consumption asset it is

F = Se(c-y)(T-t)
Where y is the convenience yield. Futures Price and Forward Price: In many situations the futures price of a contract with a certain delivery date can be considered to be the same as the forward price for a contract with the same delivery date. It can be shown that, in theory, the two should be exactly the same when interest rates are perfectly predictable and should be close to each other for short life contracts when interest rates vary unpredictably. For the purpose of understanding futures (or forwards) prices, it is convenient to divide futures contracts into two categories: those where underlying asset is held for investment by a significant number of investors and those where the underlying asset is held primarily for consumption purposes. In the case of investment assets, we have considered three different situations: 1. The asset provides no income. 2. The asset provides a known income

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3. The asset provides a known dividend income In the case of consumption assets, it is not possible to obtain the futures price as a function of the spot price and other observable variables. A parameter known as the assets convenience yield becomes important. This measures the extent to which users of the commodity feel that there are benefits from ownership of the physical asset that are not obtained by holders of futures contract. Future Price and the expected Future Spot price The relationship between the futures price and the expected future spot price depends on whether the spot price is positively or negatively correlated with the level of the stock market. Positive correlation will tend to lead to the futures price lower than the expected future spot price. Negative correlation will tend to lead to a futures price higher than the expected future spot price. Only when the correlation is zero will the theoretical futures price be equal to the expected futures spot price. John Maynard Keynes and John Hicks in 1930s argued: If hedgers tend to hold short positions and speculators tend to hold long positions, the futures price will be below the expected future spot price. This is because, Speculators require compensation for the risks they are bearing. They will trade only if there is an expectation that the futures price will rise over time. Hedgers, on the other hand, because they are reducing their risks, are prepared to enter into contracts where the expected payoff is slightly negative. If hedgers tend to hold long positions while speculators hold short positions, the futures price must be above the expected future spot price. To compensate speculators for the risks they are bearing, there must be an expectation that the futures prices will decline over time. The situation where the futures price is below the expected future spot price is known as normal backwardation; the situation where the futures price is above the expected future sport price is known as contango. FUTURES PAYOFFS

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Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: LONG FUTURES The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two month Nifty index futures contract when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses.

Pay off Diagram for Long Futures:

Profit

2220

Nifty

Loss

Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 2220. The

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underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.

Pay off Diagram for Short Futures:

Profit

2220 0

Nifty

Loss