 In most cases we acquire assets and pay for it

simultaneously. The price of the asset and the settlement

(exchange of asset and its consideration) are done at the
same point of time.
 Forward contract is an agreement to buy or sell an
asset at a price determined now but is settled later at a
predetermined date.
 Forward contract enables elimination of price risk
faced by both buyer and seller of asset.
  Forward contract is an OTC product tailored to meet
specific needs of counterparties. Features are:
 Price is determined now for settlement at future date
 Mutual obligations on both counterparties to perform

 Counterparty risk is assumed by both

 Cancellation can be done only by mutual consent

 No front-end payment
 No interim cash flows
 Cash flows only on settlement date

.
 By delivery of asset and paying the consideration:
If an exporter sold € 10,000 to a bank 6-m forward at ₹ 66
then at maturity, the contract is settled by delivery of €
10,000 by exporter and bank would pay ₹ 6,60,000;

 By entering into an offsetting contract opposite to the

original at maturity or prior, at a price prevailing then:
For example the exporter having sold 6-m forward €
10,000 at ₹ 66.00 may after 3 months, decide to buy 3-m
forward € 10,000 at ₹ 67.00 per € and settle the difference of
₹ 10,000.
 Forward contracts are subject to high default risk as
the price scenario at maturity can favour only one party and
not both.
 Futures are similar to a forward contract but are
exchange traded.
Futures being exchange traded do not have any such risk
because exchange guarantees settlement.
Exchange serves as counterparty to both buyer and
seller.
  For trading at the exchange the contract needs to be
standardized.
 Standardization of the futures contract is done for
 Size of the contract,
 Delivery of the contract obligations/Time,
 Quotation and tick size,
 Specification of the underlying asset,
 Futures is a standardized forward contract that is
traded on an exchange.

.
 Futures Contract on Gold at National Multi-Commodity Exchange of
Asset Code GOLD
Unit of Trading 100 gms of Fineness .999
Delivery Unit Gold Bars of 100 grams serially numbered and of fineness .999
Quotation/Base Value 10 grams of fineness .999
Tick Size Re.1
Quality Specification The Gold delivered under the contract must be Gold Bars weighing 100 grams each
and assaying not less than .999 fineness bearing a serial number and identifying
origin of the refiner/brander.
No. of delivery Contracts in a year Maximum 12 monthly or minimum 2 monthly contracts running concurrently
Delivery Centres CWC, Cochin
Opening of Contracts Trading in any contract month will open on the 16th day of the month, 12 months prior to
the contract month
Due Date 15th day of the delivery months if 15th happens to be holiday then previous
working day.
Closing of Contract Squaring up of positions will be permitted between 12th and 15th of delivery month.
No fresh positions building will be allowed. From 12th to 15th of delivery month, seller
can tender Warehouse Receipt for settlement and Warehouse Receipt will be
accepted for settlement at closing price of the previous day.
Delivery Logic Compulsory Delivery

.
Features Futures Forwards
Location Exchange Over the Counter
Counterparty Unknown to each other, Counter parties are known to
Exchange serves as counter parties each other
Counterparty risk NIL/Minimal Exists
Initial Cash flow Initial and Variation margins required None
Explicit cost Brokerage required to be paid No intermediary and no cost
Settlement Implicitly daily by marking to the market No marking to the market
Final settlement By delivery or cash settled By delivery
Exit prior to maturity Possible by entering an opposite Generally not possible unless
contract to square up the position both the parties agree.
Quantity specification Fixed standard size/lot Any quantity
Time of Delivery On fixed dates Any time mutually decided by
the parties concerned
Cost of hedging Very nominal High
Period of hedging Contracts available for limited period Unlimited
  Major advantages of the futures as against the forward
contract are
 Elimination of counterparty risk,
 Flexibility of entry and exit at anytime, and
 Possibility of cash settlement.
 Position in futures is mostly settled not by delivery but by
entering into a contract, at maturity or prior, opposite to the initial
one. The difference in the prices of the initial and subsequent
contracts is settled. Alternatively one may also opt for settlement
by delivery.
.
 Open interest and volumes are often thought to be
same. However they are different.
 Open interest is the number of futures contracts outstanding. It
has to be zero on opening and upon maturity of the contract.
 Volume refers to the number of contracts traded in a day.

 Open interest is the number of contracts not settled.

 The contract that offsets initial position does not add to the
open interest but they do add to the volume.
  From cash flow perspective, there are 2 differences in
futures and forward contracts:
1. Initial and Variation Margins
2. Marking-to-market (MTM)
 To cover the default risk the exchange requires initial margin when
futures position is opened.
 The position is also marked-to-market (MTM) on daily basis; i.e.
profit/loss settled on daily basis.
 The margin cannot fall below a minimum level due to MTM and if it
does, then margin call is made to replenish margin at the original
level.

(
 Day Price (₹) Cash Flow (₹) Remarks
Day 1 410 None on MTM A long position opened for one contract
Opening a But Initial Margin (400 shares) valued at ₹
contract paid 1,64,000
Close 420 (420 - 410) x 400 Investor receives ₹ 4,000
Day 1 = + 4,000
Close 400 (400 – 420) x 400 Investor pays ₹ 8,000
Day 2 = - 8,000
Close 390 (390 – 400) x 400 Investor pays ₹ 4,000
Day 3 = - 4,000
Day 4 440 (440 – 390) x 400 Position closed out with contract value of
Closing the = + 20,000 ₹ 1,76,000.
contract Investor gets ₹ 20,000

Net Profit (440 – 410) x 400 It remains the difference of opening

= 12,000 and close prices.

.
 From pricing perspective forward and futures follow
the same principle.
 Futures price is based on spot price and the cost of
carry for the period less benefits of ownership.
F0 = S0 x (1+r)
F0 = S0x ert for continuous compounding

Where F0 is forward/futures price with contract expiring at t = 1, S0 is

spot price at t = 0 and r is the cost of carry for the period 0 to1.
 Cost of carry model eliminates arbitrage. If futures is
mispriced it offers arbitrage one way or the other.
Cash and Carry Arbitrage: When futures is overpriced:
 Spot price of 10 gms gold at ₹ 27,000
 Risk free rate of 10% per annum
 Fair price of 1-year futures contract is 29,700 (spot + Cost of Carry)
 Futures contract for period of 1 year is trading at ₹ 30,000 (overpriced)
 Arbitrageur can take following actions at t = 0:
 Borrow ₹ 27,000,
 Buy gold spot, and
 Sell futures contract at ₹ 30,000.
  At the end of futures contract
Realize cash from futures contract +₹30,000
Pay back the borrowed money
and interest thereon - ₹29,700
Profit ₹300

 Since futures was overpriced by ₹ 300 the arbitrageur

can pocket this profit by selling the futures first and buying
gold by borrowing.
 When futures is underpriced at ₹ 27,300 the
arbitrageur can take following actions:
Borrows gold
Sells gold at ₹ 27,000 and lends at 10% and
Buys a forward contract at ₹ 27,300.

 One year later:

Realize cash from lending activity + ₹ 27,900
Pay for the forward contract & return
borrowed gold - ₹ 27,300
Profit ₹ 600

.
 For investment assets both types of arbitrages - cash
and carry and reverse cash and carry are possible.
 Consumption value associated with commodities tests the
arbitrage argument.
 For consumption assets while strategy of cash and
carry can be implemented, the reverse cash and carry
arbitrage may not be feasible because
 One cannot sell a commodity required for consumption
purposes, and buy futures contract instead.
 For example a refinery cannot go without oil and buy futures
contract instead.
 Short Selling
• Short selling involves selling securities you do not own
• Your broker borrows the securities from another client
and sells them in the market in the usual way
• At some stage you must buy the securities back so they
can be replaced in the account of the client
• You must pay dividends and other benefits the owner of
the securities receives
Notation for Valuing Futures and Forward
Contracts
S0: Spot price today
F0: Futures or forward price today

T: Time until delivery date

r: Risk-free interest rate for maturity T

 1. Gold: An Arbitrage Opportunity?

• Suppose that:
– The spot price of gold is US$390
– The quoted 1-year forward price of gold is US$425
– The 1-year US$ interest rate is 5% per annum
– No income or storage costs for gold
• Is there an arbitrage opportunity?
2. Gold: Another Arbitrage Opportunity?

• Is there an arbitrage opportunity?

• Suppose that:
– The spot price of gold is US$390
– The quoted 1-year forward price of gold is US$390
– The 1-year US$ interest rate is 5% per annum
– No income or storage costs for gold
 The Forward Price of Gold
If the spot price of gold is S and the futures price is for a contract
deliverable in T years is F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-free rate of interest.
In our examples, S=390, T=1, and r=0.05 so that
F = 390(1+0.05) = 409.50
 When Interest Rates are Measured with
Continuous Compounding

F0 = S0erT

This equation relates the forward price and the spot price
for any investment asset that provides no income and has
no storage costs
When an Investment Asset Provides a
Known Dollar Income
F0 = (S0 – I )erT
where I is the present value of the income during life of
forward contract
 When an Investment Asset Provides a
Known Yield

F0 = S0 e(r–q )T
where q is the average yield during the life of the contract
(expressed with continuous compounding)
 Valuing a Forward Contract

• Suppose that
K is delivery price in a forward contract and
F0 is forward price that would apply to the contract today
• The value of a long forward contract, ƒ, is ƒ = (F0 – K )e–rT
• Similarly, the value of a short forward contract is
(K – F0 )e–rT
 Example

• Suppose a long forward contract on a non dividend-paying

stock was entered into some time ago and it will mature 3
months from today. The risk free rate of interest with
continuous compounding is 8% per annum, the stock price is
₹40 and the delivery price is ₹36. Calculate the Value of the
forward contract.
 Solution

• S0 = 40, r = 0.08, T = 0.25, K = 36

• F0 = S0e0.08*0.25 = 40*(2.7183)0.02
• F0 = 40.81
• ƒ = (F0 – K )e–rT

• =(40.81-36)*(2.7183)-0.25*0.08

• =4.71
 Forward vs Futures Prices

• Forward and futures prices are usually assumed to be the same. When
interest rates are uncertain they are, in theory, slightly different:
• A strong positive correlation between interest rates and the asset price
implies the futures price is slightly higher than the forward price
• A strong negative correlation implies the reverse
 Stock Index
• Can be viewed as an investment asset paying a dividend
yield
• The futures price and spot price relationship is therefore

F0 = S0 e(r–q )T
where q is the average dividend yield on the portfolio
represented by the index during life of contract
 Stock Index
(continued)

• For the formula to be true it is important that the index

represent an investment asset
• In other words, changes in the index must correspond to
changes in the value of a tradable portfolio
• The Nikkei index viewed as a dollar number does not
represent an investment asset
 Index Arbitrage
• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the
index and sells futures
• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or
sells the stocks underlying the index
• Index arbitrage involves simultaneous trades in futures and
many different stocks
• Very often a computer is used to generate the trades
• Occasionally (e.g., on Black Monday) simultaneous trades are
not possible and the theoretical no-arbitrage relationship
between F0 and S0 does not hold
 Example

• Suppose spot NIFTY is 5500 and it provides a dividend yield of

2% p.a. The continuously compounded risk free rate of return
is 8% p.a. Calculate the fair value of 3 months NIFTY future
contract.
• F0 = 5500*e*(.08-.02)*0.25

• =5583.11
 Example

• Suppose spot NIFTY is 5500 and the continuously compounded

risk free rate of return is 8% p.a. Calculate the fair value of 3
months NIFTY future contract. Find how you can arbitrage
between spot and Future market if the 3 months future price
on NIFTY is
• A) 5650
• B) 5550
 Solution

• F0 = 5500*e*.08*0.25 = 5611
• a) Borrow ₹5500 @ 8% p.a. for 3 months. You will have to repay
• 5500*e*.08*0.25 = 5611
• Buy one NIFTY spot at ₹5500 ( i.e. buy the 50 shares of NIFTY in
the same ratio in which they appear in NIFTY). Sale a NIFTY 3
months future contract at a price of ₹5650. Therefore you are
booking a profit of (5650-5500) – (5611-5500) = ₹39
• B) Sale NIFTY spot at 5500 ( i.e. sale the 50 shares in NIFTY in
the same proportion in which they appear in NIFTY)
• Invest ₹5500 for 3 months @ 8% p.a.
• After three months you will have
• 5500*e*.08*0.25 = 5611
• Buy 3 months NIFTY future contract at ₹5550. You book a profit
of (5611-5550)
• = ₹61
 Futures and Forwards on Currencies

• A foreign currency is analogous to a security providing a dividend yield

• The continuous dividend yield is the foreign risk-free interest rate
• It follows that if rf is the foreign risk-free interest rate

( r  r f )T
F0  S 0 e
 Why the Relation Must Be True

1000 units of
foreign currency
at time zero

rf T
1000 e 1000S0 dollars
units of foreign at time zero
currency at time T

rf T
1000 F0 e 1000 S 0 e rT
dollars at time T dollars at time T
 Futures on Consumption Assets

F0  S0 e(r+u )T
where u is the storage cost per unit time as a percent of
the asset value.
Alternatively,
F0  (S0+U )erT
where U is the present value of the storage costs.
 The Cost of Carry
• The cost of carry, c, is the storage cost plus the interest costs less the
income earned
• For an investment asset F0 = S0ecT
• For a consumption asset F0  S0ecT
• The convenience yield on the consumption asset, y, is defined so that
F0 = S0 e(c–y )T
 Futures Prices & Expected Future Spot
Prices
• Suppose k is the expected return required by investors on an asset
• We can invest F0e–r T at the risk-free rate and enter into a long futures
contract so that there is a cash inflow of ST at maturity
• This shows that
( F0 e  rT )e kT  E ( ST )
or
F0  E ( ST )e ( r  k )T
 Futures Prices & Future Spot Prices
(continued)
• If the asset has
– no systematic risk, then k = r and F0 is an unbiased
estimate of ST
– positive systematic risk, then k > r and F0 < E (ST )
– negative systematic risk, then k < r and F0 > E (ST )
 The current price of Bharti’s share is ₹ 800. An investor, A goes
long with the 6 months contract at ₹ 900. After one month another investor,
B is prepared to buy Bharti’s share at ₹925 for delivery after 5 months. If
the risk free interest rate is 9% per annum what is the value of the forward
contract?
Solution
 As of now 5 months are left for the expiry with payment of ₹ 900 to
get the delivery of share. If A goes short he would receive ₹925. Therefore
the value of the forward contract, f is PV of the difference of current price
and original contract price
= (925 – 900) x e-0.09 x 5/12 = ₹24.08
A long forward contract on a non-dividend-paying stock
was entered into some time ago. It currently has 6
months to maturity. The risk-free rate of interest (with
continuous compounding) is 10% per annum, the stock
price is $25, and the delivery price is $24. In this case,
S0=25, r=0.10, T = 0.5, and K = 24.
From equation the 6-month forward price, F0 is given by
F0=25e0.1x0.5= $26.28
From equation the value of the forward contract is

f=(26.28-24)e-0.1*0.5 = $2.17
 The difference of futures price and spot price is called basis. As
time progresses basis declines and becomes zero on the day of
maturity i.e. spot and futures prices must converge.
Convergence of Spot and Futures Price
Price
Futures
Net cost of carry Maturity

Spot

Time
 The prices of futures and forward are identical in
perfect markets.
 Futures price would be marginally different from forward
price depending upon the correlation of price with interest
rates.
Correlation of Spot & Interest Relationship of Price
 Positive Correlation Futures Price > Forward Price
 Negative Correlation Futures Price < Forward Price
 No Correlation Futures Price = Forward Price
  Normal backwardation hypothesis states that the
current future price is a downward biased indicator of the
future spot price.
 When futures price is more than the expected future
spot price it is referred as contango.
 Expected hypothesis assumes that the futures price is
an unbiased indicator of the expected spot price.

.
  Futures are broadly of two types;
 Commodity futures, and
 Financial futures
 Commodity futures are those where the underlying
asset is a commodity.
 Contracts are available in India on agricultural commodities like
Wheat, Rice, Soya, Coffee, Sugar, Tea, Jeera, Pepper, Edible oils,
Cotton, Coconut, etc.
 Contracts on metals Gold, Silver, are also available.

 Futures contracts on Crude oil are also commodity futures.

.
 Financial futures are those where underlying asset is a
financial product. These are:
 Currency Futures: where the underlying assets are currencies.
 Stocks/Index futures: where the underlying are stocks or
indices. Stock futures were introduced in India on June 12, 2000 for
Indices and on November 9, 2001 on selected individual securities, at
NSE.
 Interest Rate futures: where underlying assets are interest rates.
In India interest rate futures were launched on June 24, 2003 at
NSE.