MODULE – 2

FORWARD AND FUTURE

MARKETS
Dr. Hiren Patel
Session – 10
Introduction
Forward Contract
 Introduction to forwards
Contracts
1. Forward contract is an agreement made directly between two parties to buy or
sell an asset on a specific date in the future, at the terms decided today.

2. Forwards are widely used in commodities, foreign exchange, equity and interest
rate markets.

3. Let us understand with the help of an example. What is the basic difference
between cash market and forwards? Assume on March 9, 2009 you wanted to
purchase gold from a goldsmith. The market price for gold on March 9, 2009 was
Rs. 15,425 for 10 gram and goldsmith agrees to sell you gold at market price. You
paid him Rs. 18,510 for 12 gram of gold and took gold.

4. This is a cash market transaction at a price (in this case Rs.15, 425) referred to as
Spot Price.
 Introduction to forwards
Contracts
1. Now suppose you do not want to buy gold on March 9, 2009, but only after 1
month. Goldsmith quotes you Rs.15, 450 for 10 grams of gold.

2. You agree to the forward price for 12 grams of gold and go away. Here, in this

example, you have bought forward or you are long forward, whereas the

goldsmith has sold forwards or short forwards.

3. There is no exchange of money or gold at this point of time.

4. After 1 month, you come back to the goldsmith pay him Rs. 18,540 and collect

your 12 grams of gold. This is a forward, where both the parties are obliged to go
through with the contract irrespective of the value of the underlying asset (in
this case gold) at the point of delivery.
 Features of Forwards Contracts
1. It is a contract between two parties (Bilateral contract).

2. All terms of the contract like price, quantity and quality of underlying, delivery

terms like place, settlement procedure etc. are fixed on the day of entering
into the contract.

3. Forwards are bilateral over the counter (OTC) transactions where the terms of

the contract, such as price, quantity, quality, time and place are negotiated
between two parties to the contract.

4. Any alteration in the terms of the contract is possible if both parties agree to
it.

5. Corporations, traders and investing institutions extensively use OTC

transactions to meet their specific requirements.
 Concerns with Forward Contract
• Liquidity Risk

➢ Liquidity is nothing but the ability of the market participants to buy or sell the desired quantity
of an underlying asset. As forwards are tailor made contracts i.e. the terms of the contract are
according to the specific requirements of the parties, other market participants may not be
interested in these contracts

• Counterparty risk

➢ Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfill its
contractual obligation.

• Lack of transparency

• Settlement complication

Simple solution to all these issues lies in bringing these

contracts to the centralized trading platform.
 Session –
11, 12 & 13
Forward Contract Pricing
Cost of Carry (CoC) Model
 Forward Contract Pricing (Cost of
Carry – CoC Model)
• Cost of Carry : Cost of Carry is the relationship between futures prices and spot prices. It
measures the storage cost (in commodity markets) plus the interest that is paid to
finance or ‘carry’ the asset till delivery less the income earned on the asset during the
holding period.

For equity derivatives, carrying cost is the interest paid to finance the purchase less
(minus) dividend earned.

For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A person
wishes to buy the share, but does not have money. In that case he would have to borrow Rs.
100 at the rate of, say, 6% per annum. Suppose that he holds this share for one year and in
that year he expects the company to give 200% dividend on its face value of Rs. 1 i.e.
dividend of Rs. 2. Thus his net cost of carry = Interest paid – dividend received = 6 – 2 = Rs.
4. Therefore, break even futures price for him should be Rs. 104
 Forward Contract Pricing (Cost of
Carry – CoC Model)
• Forward / Futures price is based on spot price and the cost of carry for the period
less benefits of ownership.

• Simple interest

Ft = S0 * (1+r)t (For 1 year, if compounded yearly)

Ft = S0 * (1+r/2)2t (if compounded half yearly)

Ft = S0 * (1+r/4)4t (if compounded quarterly)

Ft = S0 * ert (For continuous compounding/daily compounding)

Where Ft = Future price at time t

S0 = Spot Price, r = Rate of interest, t= time to maturity (in No. of days)

• What is future price if spot price is Rs. 465.50 and days to

maturity are 14? Assume rate of interest of 6% PA.

• Should Ms. Mecwan buy this share if it is available at Rs.

467.5 on NSE?

Ft = S0 * ert = 465.50 * e(0.06*14/365)

= 465.50 * e(0.0023)

= 465.50 * 1.0023
= 466.57
PRICING FORWARD & FUTURE
• There are three possible cases for Future/Forward Pricing
1. For securities providing No income but storage cost (s)

Ft = (S0 + s) * ert (Ex. Commodities, Currencies and Indices)

2. For securities providing Known Cash Income (I) and storage cost (s)

Ft = (S0 – I + s) * ert (Ex. Equity shares)

3. For securities providing Known Yield (y) and storage cost in percentage
(%)
(Ex. Bonds)
Ft = S0 * e(r –y + s) t
Spot price of Reliance equity share is 2150.90 and Mr.
Shah wants to take long position in Reliance future to
be expired after 13 days. What price should he be ready
to pay, if risk-free interest rate is 7.5%?

Ft = Rs. 2156.70
Spot price of Reliance equity share is 2150.90 and Mr. Shah wants to take
long position in Reliance future to be expired after 13 days. What price should
he be ready to pay, if risk-free interest rate is 7.5%? Also, assume Reliance
will declare dividend of Rs. 12 per share on 8th day from now.
Ft = (S0 - Div) * ert
= (2150.90 – 11.98)*e(0.075*13/365)
= Rs. 2144.70
Time
F = P * ert ➔ P = F/ert = 12/e(0.075*8/365) = Rs. 11.98

Rs. 12

1 2 8
Spot price of Reliance equity share is 2150.90 and Mr.
Shah wants to take long position in Reliance future to
be expired after 13 days. What price should he be ready
to pay, if risk-free interest rate is 7.5%? Also, assume
Reliance will declare dividend of Rs. 12 per share on 8th
day from now. The per day Demat account charges is
Rs. 1.80. If Reliance future is available for Rs. 2170.50,
What should be strategy of Mr. Shah?

F = (So – I + s) * ert
= (2150.90 – 11.98 + 23.4) *e(0.075*13/365)
= Rs. 2168.16
Spot price of Reliance equity share is 2150.90 and Mr. Shah
wants to take long position in Reliance future to be expired
after 13 days. What price should he be ready to pay, if risk-
free interest rate is 7.5%? Also, assume Reliance pays 5.2%
Dividend yield. The per day Demat account charges are
0.025% of the price of the security.

2151.52, 2152.62

Ft = 2150.90 * e(7.5 – 5.2 + 0.325)/100 * 13/365

Refer Examples as under
Future and Options by Vohra and Bagri

Example 2.5, 2.6 and 2.7

on
Page No. 60, 61, 62
Exercise Page No. 71, 72
 Session – 14
Specifications of Future Contract
 Introduction of Future Contracts
• Futures markets were innovated to overcome the limitations of forwards.

•A futures contract is an agreement made through an organized exchange to

buy or sell a fixed amount of a commodity or a financial asset on a future date
at an agreed price.

• Simply, futures are standardised forward contracts that are traded on an

exchange.

• The clearinghouse associated with the exchange guarantees settlement of

these trades.

•A trader, who buys futures contract, takes a long position and the one, who
sells futures, takes a short position.

• The words buy and sell are figurative only because no money or underlying
asset changes hand, between buyer and seller, when the deal is signed.
 Difference between Forward and Future
Specification Forward Future
Standardization No standardization in-terms Future contract are
of quantity, maturity date, standardize for quality,
quality place of delivery, etc quantity, price, maturity date
and place of delivery
Liquidity There is no liquidity or High liquidity with secondary
secondary market for this market in this
Conclusion of Generally forward contracts are Future contracts can be
Contract concluded with delivery of the concluded with either
asset delivery or cash
Margins Forward contracts does not Future contracts requires
require margins margins
Third party No existence Existence

Operational It is not traded on the It is an exchange-traded

mechanism exchanges contract
Counter-party risk Exists The clearing agency
associated with exchanges
becomes the counter-party to
all trades assuring guarantee
Specification Forward Future
Price discovery Not Efficient, as Efficient, centralised trading
markets are scattered
platform helps all buyers and sellers
to come together and discover the
price through common order book
Quality of Quality of information Futures are traded nationwide.
information and its may be poor. Speed of Every bit of decision related
dissemination information information is distributed very fast.
dissemination is week.

Location OTC Exchange

Explicit Cost No Brokerage Brokerage needs to be paid
Exit prior to maturity Not Possible Possible by taking position opposite
to original
Period of hedging For unlimited period Contracts are limited for some
period (For Maximum 3 months in
case of Equity)
Settlement Only Final settlement Both Daily MTM Settlement and
Final settlement
Settlement by Only delivery Both delivery and cash
 Session – 15
Specifications of Future Contract
Important terminologies of Future Contracts

• Spot Price: The price at which an asset trades in the cash market. This is the
underlying value of Nifty on 4th Febuary, 2015 which is 8912.50.

• Futures Price: The price of the futures contract in the futures market. The closing
price of Nifty in futures trading is Rs. 8930. Thus Rs. 8930 is the future price of Nifty,
on a closing basis.

• Contract Cycle: It is a period over which a contract trades. On 4th February, 2015
the maximum number of index futures contracts is of 3 months contract cycle- the
near month (Febuary, 2015), the next month (March, 2015) and the far month (April,
2015)

• Expiration Day: The day on which a derivative contract ceases to exist. It is last
trading day of the contract. The expiry date in the quotes given is February 26, 2015.
It is the last Thursday of the expiry month. If the last Thursday is a trading holiday,
the contracts expire on the previous trading day
Important terminologies of Future Contracts

• Tick Size (Price Step) : It is minimum move allowed in the price quotations.
Exchanges decide the tick sizes on traded contracts as part of contract specification.
Tick size for Nifty futures is 5 paisa. Bid price is the price buyer is willing to pay and
ask price is the price seller is willing to sell.

• Contract Size (Lot size) and contract value: Futures contracts are traded in lots and
to arrive at the contract value we have to multiply the price with contract multiplier
or lot size or contract size. For Ex. Lot size/Contract size for Reliance is 505 and at
price of Rs. 2130, Contract value is (2130 * 505 ) = Rs. 10.67 Lacs
Important terminologies of Future Contracts

• Basis: The difference between the spot price and the futures price is called basis.

• Basis = Sp - Ft

• If the futures price is greater than spot price, basis for the asset is negative. If basis
is negative it is known as “Premium” (Ft > Sp )

Similarly, if the spot price is greater than futures price, basis for the asset is
positive, it is known as “Discount” (Ft < Sp )
CONVERGENCE
 Session –
16 & 17
Specifications of Future Contract
Important terminologies of Future Contracts

• Margin Account As exchange guarantees the settlement of all the trades, to protect
itself against default by either counterparty, it charges various margins from
brokers. Brokers in turn charge margins from their customers.

1.Initial Margin

2.Marking to Market Margin (MTM)

Important terminologies of Future Contracts
• Initial Margin The amount one needs to deposit in the margin account at
the time entering a futures contract is known as the initial margin

• Let us take an example - On February 7, 2015 Mohan decided to enter

into a futures contract. He expects the market to go up so he takes a
long Nifty Futures position for February expiry at 8739.25. Assume Nifty
future lot size as 25 and margin is 10%. Calculate Initial Margin for Mr.
Mohan.

• Initial margin, Mohan has to pay = Price * Lot Size * Margin percentage *
No. of lots = 8739.25 * 25 * 10% * 1 = 21848.12

• Both buyers and sellers pay initial margin, as there is an obligation on both

the parties to honour the contract

Important terminologies of Future Contracts
• In futures market, while contracts have maturity of several days, profits and

losses are settled on day-to-day basis – called mark to market (MTM)

settlement

• The exchange collects these margins (MTM margins) from the loss
making participants and pays to the gainers on day-to-day basis

• Let us understand MTM with the help of the example. Suppose a person
bought a futures contract on February 7, 2015, when Nifty was 8739.25
while Nifty closes at 8759.75 on February 7, 2015

• This means that he benefits due to the 20.50 (8759.75 – 8739.25) points gain

on Nifty futures contract. Thus, his net gain is of Rs. 512.50(20.50 * 25)

• This money will be credited to his account and next day the position will
start from 8759.75
 Important terminologies of Future Contracts
Example : Assume Mr. Mohan buys Nifty Future Contract on February 7th at
8739.25. Assuming Initial margin of 10%, and price movement of nifty is given
below. On 11th February, Mr. Mohan sells his contract at Rs. 8756.50.

Buyer’ MTM Margin

Open Price / Close Price / Total Margin Account Margin Margin Margin Call
Buy Price Sell Price Profit/Loss (Open) Account Account (>21848.12)
(Plus/Minus) (Close)

8739.25 8759.75 +512.50 21.848.12 +512.50 22360.62 No

8759.75 8802.25 +1062.50 22360.62 +1062.50 23423.12 No
8802.25 8780.60 -541.25 23423.12 -541.25 22881.87 No
8780.60 8720.80 -1495.00 22881.87 -1495.00 21386.87 Yes
(461.25)
8720.80 8756.50 +892.50 21848.12 +892.50 22740.62
 Few Examples
• Mr. Raman a wheat merchant took long position for 2 lot of wheat
for 1 month future contract. The price of Wheat for 1 month future is
Rs. 5.60 per Kg. Each lot of wheat consists of 2000 Kg. of wheat.
Calculate his MTM if the wheat price on the same day of contract
closed at Rs. 5.25 per Kg.

Position (Buy), Lot size (2000), No. of lots (2), Opening Price per unit
(5.60), Closing price per unit (5.25)
Loss = 5.25 – 5.60 = 0.35 Per unit
Total MTM = Per unit profit/loss * Lot size * No. of lots
= -0.35 * 2000 * 2 = Rs. -1400

Few Examples
• Rekha Menon believes the market to crash
and short 4 lot of Nifty at 11450.50 on 5th
August, 2020. Calculate her MTM, Total P/L
and Initial Margin, if each lot of nifty is of
75 and NSE charge 8.5% initial margin.
Loss = Per unit * Lot size * N
= (11230.30-11289.90) * 75 * 4
= - 59.60 * 75 * 4
= Rs. - 17880
Initial Margin = Open * L * N * M
= 11450.50 * 75 * 4 * 8.5 / 100
= Rs. 291987.75

Date Closing Total MTM

Price/Sell Price
Total P/L = Sum up of all MTM
5th August 11230.30 +66060
= Rs. - 51000 ---------- (1)
6th August 11289.90 - 17880
Total P/L = (Open – Close) * L *N
7th August 11590.50 -90180
= (11450.50 – 11620.50) *75 * 4
8th August 11620.50 -9000 = Rs. -51000 --------------------------(2)
Few Examples
• Ifan investor buys 1 lot (200 shares) of Futures on Stock A on 10th
September 2019, when the price was Rs 2510.50, he was suppose to give a
margin of 15%. On 11th September, next trading day, the Futures prices
closes on Rs 2530. What is his MTM P/L? Also calculate initial margin to be
paid.

Profit/Loss = (Open – Close) * L * N

= (2510.50 – 2530) * 200 * 1 = Rs. 3900
Initial Margin = Open * L * N * Margin
=2510.5 * 200* 1 * 15/100
= Rs. 75315
Numerical for MTM and Initial Margin

• Sums from Rajiv Srivastava

• Ex. 2.1 page No. 34

• Ex. 2.2 page No. 35

• Sums from Jankiraman

• Ex. 5.5 page No. 90

• Ex. 5.6 page No. 91

 Session – 18
Specifications of Future Contract
-
Open Interest and Volume
Open interest and volume
• Open interest and volumes are often thought to be same. However they are
different.

• Open interest is the number of futures contracts outstanding.

• It reduces to zero upon maturity of the contract.

• Volume refers to the number of contracts traded in a day.

• Open interest is the number of new contracts opened. The contracts that offset
initial position do not add to the open interest but they do add to the volume.
 Open interest and volume (calculation)
Date Total Open Open Volume
Transaction / Trading (If lot size is 500 shares) Interest Interest
Change

12th Feb

5000 5000 5000

+ 10 lots - 10 lots

13th Feb 15000

(30 lots = 10000 10000
20+10)
+ 20 lots - 20 lots

14th Feb
15000 0 5000

+ 10 lots - 10 lots

15th Feb 10000 -5000 5000

+ 10 lots - 10 lots
 Session
19, 20 & 21
Hedging Strategy
using Future Contract
Hedging Strategies
Using Futures
 PC Jewellers (on 12th Spet.) with 1 Kg.
(Spot Price 51000). What if the Price
will go down by 30th Decemer????
Option -1 Option -2
• Sell Gold to Buyer @
51000 NOW • Sell Gold Future @ 51200 on
• PC Jewellers can not MCX
open shop till
December (They don’t
have Gold) On 9th September
Available with PC Future Sell on MCX
Rs. 51000 Rs. 51200
On 30th December
Rs. 52000/Rs. 54000/48000/ 40000
Profit of Rs. 2K/4K Loss of Rs. 1.8K/3.8K
Loss of Rs. 3K/11K Profit of Rs. 3.2K/11.2K
Payoff for Future
• Payoff means graphical/tabular representation of profit/loss on
account of change in price

• Payoff for Future Long

• Example : Mr. Dalal buys Reliance Future Contract of October,

2020 expiry, at Rs. 2160 per share. The contract includes 505
shares of Reliance. Identify Payoff for Mr. Dalal for various prices.

• Payoff for Future Short

• Example : Mr. Brokar shorts Infosys Tech. Ltd. Future contract of

October, 2020 expiry at Rs. 980 per share. The contract includes
1200 shares of Infosys Tech. Ltd. Identify Payoff for Mr. Brokar for
various prices.
Payoff for Reliance – Long (Mr. Dalal)
On 26th October 2020 (Expiry)
Price (on 26th Per unit Total Profit
Oct.) Profit/Loss Loss
2000 -160 -80800
2100 -60 -30300
2200 40 20200
2300 140 70700
2350 190 95950
2390 230 116150
 Long Chart
200000

150000

100000

50000

0
2000 2100 2200 2300 2400 2500

-50000

-100000
 Short Chart
400000

300000

200000

100000

0
680 730 780 830 880 930 980 1030 1080 1130 1180

-100000

-200000

-300000
 Chart Title
400000

300000

200000

100000

0
680 730 780 830 880 930 980 1030 1080 1130 1180

-100000

-200000

-300000

-400000

Series1 Series2
Hedging
•A party faces a loss when the price of some asset changes—they
want to reduce this loss by trading futures contracts

• Hedging is done to lock in a price at the current time for a future

transaction

IMPORTANT???Surety of Payment or Receipt

• Hedging helps in forecasting future cash flows with some certainty

• Issues with Hedging

 What quantity of assets would be subjected to loss if the price
changes?
 When would losses accrue, i.e. when prices increase or decrease?
 Which futures contract would provide a hedge against this loss?
 How many futures contracts would be needed to hedge?
Deciding the Hedge
• Thehedger needs to decide the type of hedge, depending upon
whether increases or decreases in the asset price will result in a loss

• Undera hedge, any loss arising from the asset would be

compensated by gain from the futures contract

• The hedger will take an opposite position to the position he has in

the asset

• Based, on positions to be taken, there are two types of hedging

1. Long Hedge (When Hedger takes Long/Buy position in Future
contract)
2. Short Hedge (When Hedger takes Short/Sell position in Future
contract)
Long Hedge

 A long hedge is one in which the hedger has a short position in an

asset and takes a long position in futures
 Traders who need to buy the asset at a future time will use long
hedge through commodity futures
 Importers who need to buy foreign currency at a future time will

use long hedge through currency futures

 Borrowers who need to borrow at a future time will use long
hedge through interest rate futures
 Investors who need to invest at a future time will use long
hedge through government bond futures
Short Hedge

 Short hedges are ones in which hedgers take a long position in

assets and a short position in futures
 Traders who own the asset now and need to sell at a future time

will use short hedge through commodity futures

 Exporters who will receive foreign currency cash flows at a
future time and need to sell the received currency at some
future time
 Lenders who will lent at a future time will use short hedge
through interest rate futures
 Investors who own the asset now and need to protect against
future price down, they will sell future
Hedging : Example I
 A rice merchant estimates that he will require 50 MT of rice on July 31,
2015.

 Since he needs to buy rice at a future time, he will enter into a long hedge
in rice futures for a total value of 50 MT today (on 3rd March, 2015) @
Rs. 50,000 per MTSurety of Payment

 Even if the price of Rice on July 31, 2015 is Rs. 65,000/MT or Rs.
45,000/MT, he will require to pay for Rice @ Rs. 50,000/ MT only.

 It means net payment of 50,000*50 = Rs. 2,500,000 on July 31 and receive

50 MT of rice
Hedging : Example II
 On January 1, 2005, SAL Steel – A producer of steel estimates that
he will need to sell 30 MT of steel on March 31, 2015.

 Since he must sell steel at a future time, he will enter into a short
hedge for a total Surety
value of 30of
MTReceipt
@ INR 45,000 / MT.

 Even if the steel ingot price on March 31, 2015 will be INR
35,000/MT or INR 47,000/MT, he will need to provide 30 MT of steel
at Rs. 45,000/MT only and will receive INR 13,500,000 on March 31,
2015
Hedging : Example III

• On Jan 1, 2015, TRUST India - An importer of App Mobile buys App - 3 from

the USA for USD 1 million, on credit and to be paid on March 31, 2015

• Since Surety of Payment

he needs to buy USD on March 31, 2015 from Indian Bank, he will
enter into a long hedge to buy USD futures on Jan 1, 2015 @ USDINR.
61.2450.

• Even if the futures price is USDINR 65.3000 or 59.4500, TRUST India needs
to pay INR 61.2450 million to receive USD 1 million from Indian Bank and
pay the same to App Mobile
Hedging : Example IV

• On March 1, 2015, KEJRI Export House - An exporter sells Designer

Mufflers to Germany for EUR 800, on credit. Co. will receive
payment on March 31, 2015.

Surety of Receipt
• Since he needs to sell EUR on March 31, 2015 (once received from
Germany), Co. would enter into a short hedge (Sell future) on EURO
futures @ 70.3000 on March 1, 2015.

• Even if the futures price of EURINR is 71.5050 or 69.4500, the

exporter will receive INR 56240 (800 * 70.3000) on March 31, 2015
Perfect and Imperfect Hedges

•A perfect hedge is achieved when price uncertainty is fully

eliminated and the hedger knows for certain what the future cash
flow will be

• An imperfect hedge is a partial hedge in which the price uncertainty

is reduced but not fully eliminated

Perfect Hedge

 A hedge, whether long or short, is considered as a perfect hedge if

the cash flow that is to be paid or received at the future time is
known with certainty at the current time

 In a perfect hedge, any loss or gain from the underlying asset

position will be exactly offset by gains or losses from the future

 The price that will be either paid or received will be the same as the
futures price contracted, irrespective of the price movement of the
underlying asset
 Hedge Ratio
Size of exposure
Hedge ratio =
Size of position in futures

• Size of exposure = quantity of asset * spot price of asset

• Size of position in futures = Lot Size * Fut Price

s
Optimal hedge ratio : h* =  *
f
2*F2
Hedging effectiveness : h * 2
s
Example of Using Hedge Ratio
 A company requires 20 tonnes of wheat on 31st March. On March

1, wheat sells at INR 1200/ton, and March futures are at INR

1240. The contract size for futures is 10 tonnes. How to hedge?

How much contract to buy/sell for hedging?

 Size of exposure = Qty * Spot price = 20 * 1200 = 240,000

 Futures value = 10 * 1240 = 124,000

 Hedge Ratio= Size of Exp. / Future value = 240000 / 124000 = 1.94

 Take a long position in 1.94 contracts

THANK
YOU