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± Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today ± Exclusively over-the-counter ± Example: A corn flakes manufacturer (company) and a corn producer (farmer) agreeing to trade in corn produced at a future date at a price agreed upon today.
± Forward Contract traded in an exchange
± Definition: a contract between two parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default
± Exclusively traded on a futures exchange
Organized Futures Trading
Contract Terms and Conditions
± contract size ± quotation unit ± minimum price fluctuation ± contract grade ± trading hours
± delivery date and time ± delivery or cash settlement
Difference between Futures and Forwards
Futures Market Location Size of Contract Maturity Counterparty Valuation Variation Margin Regulations Credit Risk Settlement Liquidation Futures Exchange Fixed (standard) Fixed (standard) Clearing House Marked-to-Market Everyday Daily Regulated by Exchange Almost Non Existent Through Clearing House Mostly by Offsetting the positions Forward Market No fixed Location Depends on Contract Depends on Contract Known Bank or Client No unique Method None Self Regulated Depends on Counterparty Depends on Contract Mostly settled by actual delivery
Open Interest And Volume
Ex-1 Period 1 Trader A Sells one Option Contract and Trader B buys one Options contract Period 2 Trader A buys one option contract and trader C sells one Period 3 Trader C Buys one option contract and Trader B sells one Option Contract.
Time 1 A Sells 1 B Buys 1 C Volume 1 Open interest 1 2 Buys 1 Sells 1 1 1 3 Sells 1 Buys 1 1 0 .
Open Interest And Volume Ex-2 .
Futures contracts are created and destroyed depending on how trades are matched up Volume Simply measures how many trades occurred. It shows the number of long positions not squared off or number of short positions not squared off at any particular point of time. .Open Interest And Volume Open Interest is a measure of how many Futures contract exist at any particular time.
Open high low close Value No of contracts Open Interest and Volume .Newspaper Futures Ex: Reliance-September Delivery Month ± All contracts of a month expire on the last Thursday of the month.
. If you buy the Reliance today. you purchase them in the cash. A person who buys in October a December Reliance futures contract promises to pay a certain price for Reliance in December. or spot market.Futures and Forward Contracts (cont¶d) The futures market deals with transactions that will be made in the future.
Problem On October 1st ± Reliance Spot Price is Rs. 1000 ± Reliance (December Futures/Forward price) = 1050 On November 10th ± reliance spot price is 1200 and futures price is 1275 In December at expiration date ± Reliance trades at 1100 .
Forward Market Date Spot Forward( December contract) 1-Oct 1000 1050 ( Mutually Agreed Price) November 10th 1200 SO what ? December (Maturity) 1100 Honor the contract .
. Your profit or loss gets multiplied by 600 times.Pay Off in Forward Market at Maturity Payoff of Long futures (if you buy Reliance Forward contract) =Sell price ± Buy price = Spot price at expiration ± forward price =1100-1050 =50 Pay off of short futures ( if you sell Reliance Forward contract) =Sell price ± Buy price = Forward Price ± Spot price at expiration =1050-1100= -50 Because One contract is for 600 shares.
Futures Market Date 1-Oct Spot 1000 Futures( December contract) 1050 1275 1100 November 10th 1200 December (Maturity) 1100 .
Payoff on Futures Contract at expiration Payoff of Long futures (if you buy Reliance Forward contract) =Sell price ± Buy price = Spot price at expiration ± forward price =1100-1050 =50 Pay off of short futures ( if you sell Reliance Forward contract) =Sell price ± Buy price = Forward Price ± spot price at expiration =1050-1100= -50 .
Payoff of Futures Contract on November 10th Payoff of Long futures = Sell price ± Buy price = 1275-1050 =225 Pay off of short futures = Sell price ± Buy price = 1050 ± 1275= -225 .
Futures Contracts (cont¶d) A futures contract involves a process known as marking to market ± Money actually moves between accounts each day as prices move up and down A forward contract is functionally similar to a futures contract. however: ± There is no marking to market ± Forward contracts are not marketable .
B) An investor who has gone short at 4600 on day µ0¶. . C) Calculate the net profit/loss on each of the contracts.000 per contract. A) An investor who has gone long at 4600 on day µ0¶. The multiple of each contract is 50. Calculate the mark-to-market cash flows and the daily closing balances in Accounts of. while the maintenance margin is Set at Rs.Problem Day 1 2 3 4 5 Settlement Price 4700 4500 4650 4750 4700 The initial margin is set at Rs. 8000 per contract. 10.
000 and Maintenance margin = 8.000) Day 0 1 2 3 4 5 Total Profit/Loss Settlement Price Bought 50 @ 4600 4700 4500 4650 4750 4700 Opening Balance 10000 10000 15000 10000 17500 22500 Mark-toMarket 5000 -10000 7500 5000 -2500 5000 Is the balance < 8000 NO YES NO NO NO Margin Call - Closing Balance 10000 15000 5000 10000 17500 22500 20000 .Investor Who has gone long at 4600 (initial margin =10.
000 and Maintenance margin = 8.Investor Who has gone Short at 4600 (Initial margin =10.000) Day 0 1 2 3 4 5 Total Profit/Loss Settlement Price Sold 50 @ 4600 4700 4500 4650 4750 4700 Opening Balance 10000 10000 10000 20000 12500 10000 Mark-toMar ket -5000 10000 -7500 -5000 2500 -5000 Is the balance < 8000 Yes NO NO Yes NO Margin Call 5000 Closing Bala nce 10000 10000 20000 12500 2500 10000 12500 .
Basis= Spot Price .BASIS The difference between spot price and futures price is called Basis.Futures Price .
Reliance Spot and Futures Prices Futures a 620 600 580 560 540 520 500 28 27 24 23 22 21 20 17 16 15 14 13 10 9 e to Matur ty t Pr ce Futures_Price S O PR 8 7 6 2 1 .
Behavior of Basis When the futures price is at expiration. That is the basis must be zero. This behavior of basis over time is called convergence . the futures price of reliance and spot price of reliance must be same.
Mat Futures Price 10 20 -10 15 25 10 Basis -5 -5 Before Maturity Profit/Loss . Long in spot and sell in futures Spot Price before maturity before Maturity Profit/Loss 10 20 10 Futures Price 15 25 -10 Basis -5 -5 Hedge 2. Short in spot and buy in futures Spot Price Some time Bef.When basis is constant you get perfect hedge Hedge 1.
At the time of purchase of futures contract the basis is either negative or positive You have either positive or negative basis at start and if you hold the contract until maturity basis will become zero Implies Basis rarely will be constant during the holding period of the contract. .Basis Risk Basis risk arises because basis does not remain constant We know that Basis at maturity is always equal to ZERO.
Basis Risk Nature Of hedge Basis At the start Positive BUY (Futures) and Hold until maturity Negative Favorable Adverse SELL (Futures) Hold Until Maturity Adverse Favorable .
At Maturity Profit/Loss 10 20 -10 Futures Price 15 20 5 Basis -5 0 -5 . Short in spot and buy in futures Spot Price Before Mat. At maturity Profit/Loss 10 20 10 Futures Price 15 20 -5 Basis -5 0 5 Total P/L Hedge 2. Long in spot and sell in futures Spot Price before mat.When Basis is negative at start Hedge 1.
Long in spot and sell in futures Spot Price 20 At maturity Profit/Loss 20 0 Futures Price 15 20 -5 Basis 5 0 -5 Total P/L Hedge 2.When Basis is Positive at start Hedge 1. Short in spot and buy in futures Spot Price 20 At maturity Profit/Loss 20 0 Futures Price 15 20 5 Basis 5 0 5 .
Basis Risk Nature Of hedge Basis At the start Positive Negative BUY (Futures) SELL (Futures) Favorable Adverse Adverse Favorable .
. How are Futures prices related to Spot Price.How are Futures Prices Determined How to determine Futures Prices.
Models of Futures Prices Model No 1 ± Cost of Carry Model According to this model futures price depend on the cash price of a commodity and the cost of storing the underlying goods from the present to the delivery date of the futures contract. .
Cost of Carry Model The cost of carry model in perfect markets. For example. wheat on hand in June can be carried forward to. ± ± ± ± Storage Costs Insurance Costs Transportation Costs Financing Costs . or stored until. December Carrying charges fall into four basic categories. The cost of carry or carrying charge is the total cost to carry a good forward in time.
So. if gold costs $400 per ounce and the financing rate is 1 percent per month (ignoring other costs). the financing charge for carrying the gold forward is $ 4 per month (1%X$400) According to cost of carry model Forward Price( maturing in 1 month) = 400 +4 = $404 .Cost of Carry Model The carrying charge reflects only the charges involved in carrying a commodity from one time or one place to another. The carrying charges do not include the value of commodity itself.
Cost of Carry Model If FP > spot price + cost of carry ± Investors will indulge in cash and carry arbitrage ± Buy underlying now and sell futures and reverse the trades at maturity IF FP < spot price + cost of carry ± Investors will indulge in reverse cash and carry arbitrage ± Short Sell underlying asset and buy futures now and reverse the trades at maturity .
Cost of Carry Model Assuming Perfect markets and no arbitrage conditions FP = spot price + cost to carry .
FP = Spot + cost of carry. Since Futures price is always more than spot price: Basis is always negative according to cost of carry model.Cost of Carry Model If futures price follow cost of carry model then basis is negative. Given FP = Spot price (SP) + Cost to carry (X) Basis = Spot price ± Futures price = Spot price ± (spot price + x) = -x .
Or when Basis is negative then Market is said to be in ³Contango´. Or When the market follows Full cost of carry model then it is called ³Contango´ Market.Contango Market When futures price is higher than cash price then the market is said to be in ³Contango´. .
Can the Basis be Positive? .
.Convenience Yield The benefit or premium associated with holding an underlying product or physical good. But because (say soya beans) has convenience yield there will be no one willing to lend. Convenience Yield is a return on holding an Asset Anybody who has use of an asset for consumption can derive ³Convenience Yield´. When an asset has convenience yield then full cost of carry model does not hold. When Futures price is below cash price or spot price then you need to do reverse cash and carry arbitrage to exploit it. Hence short selling of beans will not be possible. Should their be a sudden drought and the demand for wheat increases. An example would be purchasing physical bales of wheat rather than future contracts. Ex: Food processor might Derive a convenience yield by holding on to commodity. rather than the contract or derivative product. the difference between the first purchase price of the wheat versus the price after the shock would be the convenience yield.
Backwardation When basis is positive then the market is said to be in backwardation. Expectation Model ± The price of the Futures price is the expected Futures Spot Price. Backwardation is the opposite of contango. . the futures contract will trade at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk free rate. Backwardation says that as the contract approaches expiration.
. exceeding the expected Futures spot price of $10. Then speculators would sell futures at $ 15 and on maturity they would buy back the futures at $10 and make a profit.Role of Speculators and Expectation Model If the Futures price were $15 . In effect speculators would make sure that Futures price is equal to expected Future Spot Price.
Speculating 3) Arbitrage 4) Leverage .Who would trade in Futures? Futures trading will be of interest to those who wish to: 1) Price Risk Transfer .Hedging 2) Invest.
Hedging .Currency Futures.
This locks in the exchange rate of 69.9147 for the £1 Million it will pay Company B¶s Hedging Strategy ± Position in the spot (receive=LONG) ± Sell (Short) Position in 48 Futures Contracts.Example ± Hedging (Futures) ± Company A must Pay £1 Million in September for imports from Britain. ± Company B will receive £3 Million in September from exports to Britain Current Exchange Rate Rs/ £ = 70.9147 for the £3 Million it will receive. This locks in an exchange rate of 69.9147 in September at expiration spot price is 71 Size of Futures Contract £ 62500 Company A¶s Hedging Strategy ± Positing in the SPOT (pay=SHORT) ± Buy (Long) Position in 16 Futures Contracts.2039 September Futures Price Rs/ £ = 69. .
2039 69.7961 71 1.289 71 -0.Company A Short position in Cash Market Time Right now At maturity Pay off Spot Long Position in Futures market Futures Basis Profit/Loss 70.0853 0 0.2892 .9147 0.
2039 69.9147 0.2892 71 71 0 -0.Company B Long position in Cash Market Time Right now At maturity Pay off Spot Short Position in Futures market Futures Basis Profit/Loss 70.0853 .7961 -1.2892 0.
255.0853* 48*62500 =-3.300 Total Loss in futures = -1.000.7961*3.388.600 . Total profit in spot = .000 =2.900 Net Loss =867.
Hedge Ratio Can I hedge the loss due to basis Risk ? A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged.5 (50 / 100). your hedge ratio is 0.000 worth of the equity with a currency position. as it will help to identify and minimize basis risk. The hedge ratio is important for investors in futures contracts. which exposes you to currency risk. . This means that 50% of your equity position is sheltered from exchange rate risk. Say you are holding $10. If you hedge $5.000 in foreign equity.
0853 .9147 0.2892 0.2892 71 71 0 -0.7961 -1.Company B Long position in Cash Market Time Right now At maturity Pay off Spot Short Position in Futures market Futures Basis Profit/Loss 70.2039 69.
300 Which is exactly equal to the profit in spot.388.0853) =-2.20943 contracts then it would have resulted in perfect hedge.20943*62500* (-1. Loss in futures =35. Instead of 48 futures contracts If Company B had sold 35. .
0853) =(Change in Spot/Change in futures) Hence: 35.209 = 0. Hedge Ratio = Futures position/Underlying Asset Position Hedge Ratio =35. .7961/1.73* 48 .20944/48 =0.73353 (.
Beta = Covariance (S.F) /variance (F) or Beta = correlation coefficient (S. dev of (F) .F)* standard deviation (S)/ Std.How to estimate Hedge ratio Change (St)= alpha + beta *change (Ft) + error term Change (St) = change in cash price on day t Change (Ft) = change in futures price on day t Beta gives the hedge ratio.
Speculators Exploit the differences in own forecast and market expectations. .
holds the view that the market is wrong and the $ will actually depreciate. a forex dealer.1 March futures = 45. ± Another speculator Mr.34 September futures = 45.30 June Futures = 45. A. N agrees with the market that the dollar will appreciate but thinks that the market is over estimating the extent of appreciation ± What strategy should they adopt .Speculation Using Currency futures Problem ± ± ± ± Rs/$ spot = 45.60 ± Mr.
.4 Assume contract size to be 1 million dollars.3 September Future = 45.70 ± Scenario 2 Spot Rs /$ = 45. Calculate profit and loss if ± if on September 10th following rates prevail. Sell futures now and buy back futures later as they expect the dollar to depreciate. ± Scenario 1 Spot Rs/$ = 45.5 September Future = 45.
6-45.6-45.1 * 1 million = Loss of 1 lakh Scenario 2 Pay off = sell price ± buy price =45..2 * 1 million = profit of 2 lakhs .4 = . Scenario 1 ± Pay off = Sell price ± buy price =45.7 = .
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