Forward & Futures Market

Forward Contract

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.
But if parties want to protect against future
movement of the price can they do
anything….??
 Forward Contract

 First let us take example….

 Meaning - Forward : 1.It is financial derivative. 2. Customized
contract( Over the counter – OTC)
   Where two or more parties agree to buy & sell any asset for price decided
today, which will be paid at specified future time.
 Features : 
 Non-standardized contract by nature.(Customized for quantity, quality
etc.)
 Not exchange-traded (we can call it OTC product)
 No margin /Money required OR no mark to market
 Settled only on settlement date
 Liquidity is less: No ease of buy/sell
 Cancellation can be done only by mutual consent
 Mutual obligations on both counterparties to perform
 Forward Contract

 Biggest disadvantage : Counter party default risk

 Biggest advantage : As forward is completely customized by

parties involved. It can match perfect requirement of parties.

 Purpose : Hedging, speculation, customization, when there is

no exchange available or possible.

 Settlement : Forward are generally settle on settlement date as

agreed upon by parties involved at the specified price decided
while entering into forward contract.
 Settlement –Forward contract

By delivery of asset and paying the

consideration:

By entering into an offsetting contract

opposite to the original at maturity or prior:
 Can anything be a forward contract…?

Example: Let us say Tata Steel buys iron ore raw

material from supplier called Delight ltd.

Agreement between Tata steel &

Delight Ltd.
• To buy 10 MT of Iron ore from
Tata steel Delight Ltd. on 12th/Jan./2021 at Delight ltd.
price of Rs.1,00,000/MT, having
“A” grade quality of iron ore.

Price of iron ore

changes as per
demand /supply
scenario.
 Can anything be a forward contract…?

 Example: Let us say M&M buys spare parts from supplier called Bharat
Forge ltd.

Agreement between M&M and

Bharat Forge Ltd.
• To buy 10,000 units of spare
M&M Bharat Forge Ltd.
parts from Bharat Forge Ltd. on
18th/Feb/2021 at price of
Rs.1050/spare part, having “A”
grade quality of spare parts.

But it seems spare parts Can you think

price is not fluctuating like of factors
Agri/metal commodities affecting
then why to enter into this pricing of spare
agreement…??? parts…???
 So what is forward……???

Whenever fluctuation of price in future is the biggest worry to

the parties involved, they will try to enter into forward
contract to lock in the price.

But when price is not the key factor OR very less fluctuation is
there, then the purpose of the parties involved is just legal
agreement but not typical forward contract to hedge against
future fluctuation of price.

Eg.: Customer enters into agreement to buy Refrigerator after

15 days at price mentioned in agreement. Here fluctuation of
the price is not the worry it may be termed as just an
agreement.
 Futures Contract

 First let us take example….

 Meaning-Futures:  1.It is financial derivative.2. Standardized contract.

Where two parties agree to buy & sell particular asset for standardized
quantity & quality for agreed price which will close/expire on specific
future date done through exchange.

 Features/specifications : 
 Standardized contract by nature
 Exchange -traded 
 margin /Money required  & mark to market on daily basis: profit/loss
calculation on daily basis
 Futures Contract

 No counter party default risk

 Can be settled on or before settlement date
 Cash settled OR physical -delivery settled 
 High Liquidity: ease of buy/sell & transaction cost
 Selling /short selling is possible
 Futures at premium or at discount : difference between spot
price & futures price.
 Examples : Bonds, Equity, currency, commodity, interest rate
etc.
 Purpose: Hedging, speculation, arbitrage  
 Futures Contract

Forward contracts are subject to high default risk.

To remove counter party default risk from

Forward……futures contract came into as an
alternative.
Futures being exchange traded do not have any such
risk because exchange guarantees settlement.
Exchange serves as counterparty to both buyer and
seller.
 Standardization – Futures Contract

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,
 Quotation and tick size,
 Specification of the underlying asset,

Futures is a standardized forward contract that is

traded on an exchange.
 Forward V/S Futures

Points Forward Futures

Definition A forward contract is an A futures contract is a
agreement between two standardized contract,
parties to buy or sell an traded on a futures
asset (which can be of any exchange, to buy or sell a
kind) at a pre-agreed certain underlying
future point in time at a instrument at a certain
specified price. date in the future, at a
specified price.
Market regulation Not regulated regulated market
method Of Transaction Negotiated directly by the Quoted and traded on the
buyer and seller Exchange
Structure & Purpose Customized to customer Standardized. Initial
needs. No initial payment margin payment required.
required. Used for Usually used for
hedging. speculation, hedging,
arbitrage.
 Forward V/S Futures
Points Forward
Contract Maturity Forward contracts generally
mature by actual delivery.
Expiry date Depending on the transaction
Risk High counterparty default
risk
Institutional guarantee The contracting party
Guarantees No guarantee of settlement
until the date of maturity only
the forward price, based on
the spot price of the
underlying asset is paid
Contract size Depending on the transaction
and the requirements of the
contracting parties
Futures
Future contracts may not
necessarily mature by actual
delivery.
Standardized
Generally No counter party
default risk
Clearing House
Both parties must deposit an
initial guarantee (margin).
The value of the operation is
marked to market with daily
settlement of profits and
losses
Standardized
 Forward V/S Futures

Points Forward Futures

Method of pre- Opposite contract with Opposite contract on the

termination same or different exchange.
counterparty.
Counterparty risk remains
while terminating with
different counterparty.
 Advantages – Futures

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.
Spot price of the stock
Futures price of the stock
 Open Interest & Volume

Open interest and volumes are often thought to be same.

However they are different.

Open interest is the number of futures contracts outstanding means

not closed on given particular day.

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

Open interest has to be zero upon maturity of the contract.

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.
 Initial Margin & Maintenance Margin

Futures contract will have margin requirement as

under:

Initial Margin and Maintenance Margin

Initial Margin:
To cover the default risk the exchange requires initial
margin(Monetary value/Securities) when futures
position is opened.
 Initial Margin & Maintenance Margin

Maintenance Margin:
It is the minimum monetary value (balance OR
minimum level) which should be maintained in
client’ margin account.
If client’s margin account balance goes below
maintenance margin level “Margin Call” is made
from broker to client asking within time limit to refill
the account to Initial margin level.
 Marked To Market (MTM)

Question might arise that why the margin account of

the client fluctuates on daily basis…….??

Because, client’s account on daily basis is updated as

per market price (settlement price).

So, on daily basis account is updated as per

settlement price of the underlying asset.
 The act of Daily Resettlement : Marked to Market

The activity of margin account being

adjusted (increase due to profit & decrease
due to loss) as per daily settlement price is
called marked to market.

Marked to market simply means your

account is updated as per latest market
settlement price.
 Example of MTM
Assume you have bought a futures contract on stock of MarutiSuzuki on NSE at price of Rs.
410. Each futures contract = 400 shares. So, total exposure is Rs. 1,64,000. Let’s say Initial
margin is 10% of total exposure. Maintenance margin requires to be 80% of initial margin.
Initial Margin = 16,400 & Maintenance margin= 13,120
Day Settlement Gain/Loss Account Action
Price(Rs) balance(Rs.)
Start of the day 1 - - 16,400
End of the day 1 420 (420-410)* 400 = 20,400
4000
2 400 (400-420)*400= 12,400 + 4000 = Margin call as a/c
- 8,000 16,400. balance is lower
Here, 4000 has to than maintenance
be deposited by margin
client with time
limit.
3 390 (390-400) * 400 = 12,400 + 4000 = Margin call as a/c
- 4,000 16,400. balance is lower
than maintenance
Here, 4000 has to
margin
be deposited by
client with time
limit.
4 440 (440-390) 36,400 Client closed the
*400=20,000 position.
 Example of MTM

Find out on day 1 at what settlement price, account

balance will be same as maintenance margin level?
So, if price fall beyond this level it will trigger margin
call.
 Practice –Example MTM

An investor buys 5 futures contract on gold at MCX

Exchange, where each contract is of 100 Grams. The
price quotation is Rs. 15,550 per 10 gram. Initial
margin is set at 4% & maintenance margin is 90% of
initial margin.
1. What amount of initial margin has to be deposited
by investor?
2. On the first day, below what price investor will get
margin call?
 Practice –Example MTM

So, if 15,550 is the price per 10 gram, then for 100 grams
price is Rs. 15,550/10 * 100 = Rs.1,55,500
Initial margin = 5 contract * 1,55,500 * 4%
IM = Rs. 31,100
MM = Rs. 31,100 *90%
MM = Rs. 27,990
IM –MM = Rs. 3110
So, per contract loss of Rs 622 for 100 grams ( 3110/5
contract). Hence loss of Rs. 62.2 per 10 grams.
So, if gold price goes down from 15,500 -62.2 = 15437.8.
Below Rs. 15437.8 if gold price goes on the first day then it
will trigger a margin call.
 Pricing - Forward & Futures

From pricing perspective forward and futures follow the

same principle.
Let us take an example:
 You have Gold (assuming no additional income from the asset)
which has current price (spot price= S0) of Rs. 7,000 per 10 g. you
want to sell this gold after 12 months at price F1 (Forward price).
Once the time period is over ownership is going to transfer from
seller to buyer upon payment of contracted price F1.
 If you are seller what is the minimum price as F1 price you would
like to quote to the buyer?
 Think…….If you would have sold gold at Rs. 7,000 right now &
invested that amount at risk free rate for 1 year….then….
 Pricing - Forward & Futures

 So, you will ask certainly minimum price as F1 after 12

months Current Price + interest @ risk free rate
MEANS S0 * (1+r) where, r = risk free rate.

 F1 = S0 * (1+r)
 Pricing - Forward & Futures

For annual compounding interest:

F1 = S0 * (1+r)

For continuous compounding interest:

 e = exponential value that is 2. 718

For compounding at periodical interval interest:

Where,
n = no. of times p.a.
 t = no. of years
r = Cost of carry
 Cash and Carry Arbitrage

 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 Rs 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 Rs 30,000

(overpriced)
 Arbitrageur can take following actions at t = 0:
 Borrow Rs 27,000,
 Buy gold spot, and
 Sell futures contract at Rs 30,000.
 Cash and Carry Arbitrage

 At the end of futures contract, t= 12 months;

 Realize cash from futures contract….. + Rs 30,000
 Pay back the borrowed money & interest there on…… - Rs 29,700
 Profit….. Rs 300

 Since futures was overpriced by Rs 300 the arbitrageur can

pocket this profit by selling the futures first and buying gold
by borrowing.
 Reverse Cash and Carry Arbitrage

 Let us say futures is priced at Rs 29,000. But we know fair price

of futures should be Rs.29,700. So futures is under priced.
 The arbitrageur can take following actions at t=0;
 Borrows gold
 Sells gold at Rs 27,000 and lends at 10% and
 Buys a futures contract at Rs 29,000.
 One year later at t = 12 months;
 Realize cash from lending activity…… + Rs 29,700
 Pay for the futures contract & return borrowed gold… - Rs 29,000

Profit from arbitrage Rs 700

 Arbitrage: Investment V/S Consumption Assets

 For investment assets(like Gold, silver, stocks, currency etc.) 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/possible 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.
 The benefits enjoyed by the owner of the asset due to its
possession & consumption is referred as “convenience yield”.
Convergence of Futures price with Spot price

As per cost of carry model, the difference between

the futures price & spot price represents the cost of
carry for remaining period before the expiry of the
contract.
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 Futures price with Spot price

On the date of delivery/expiry of the futures contract(zero

cost of carry), the prices in physical(spot/cash market)
market must essentially converge to one price.
If prices do not converge arbitrage activity will drive them
to single common price.
Means arbitrageurs will try to simultaneously buy at low
price & sell at high price and difference is locked as
arbitrage profit.
This buying-selling pressure eventually be so much that it
will drive futures & spot price to common price.
Eg. John Meriwether traded convergence trade (fixed
income arbitrage) @ Saloman brothers.
Convergence of Futures price with Spot price
 Normal Market & Inverted Market

Normal Market: A market where the futures price

exceeds the spot price is referred to as a normal
market, as the cost of carry is positive.

Inverted market: A market where the futures price is

less than the spot price is referred to as inverted
market.

In both above markets, convergence rule holds true.

 Relationship of Futures price & Expected Spot price

It is observed that on maturity date, irrespective of

whether the market is normal OR inverted , the futures
price & the spot price must converge.
So, does this mean that we can take today’s futures
price to be the expected spot price on the date of
maturity……?
There are three theories which try to establish
relationship between futures price & expected Spot
price.
 Normal Backwardation Hypothesis
 Contango
 Expectation Hypothesis
 Normal Backwardation hypothesis

This was proposed by economist Lord Keynes.

Normal backwardation hypothesis states that the

current futures price is a downward biased indicator
of the future spot price.
Backwardation is the market condition where price
of the futures contract is trading lower than
expected spot price at the maturity.
In simpler words, backwardation is where
Spot price is trading higher than futures
price.
 Contango

Contango assumes the opposite of the Keynes’

hypothesis of backwardation.
Contango is the market condition where price of the
futures contract is trading higher than expected spot
price at the maturity.
 In simpler words, contango is where Futures price
is trading higher than spot price.
 This can happen because it is assumed that speculators are
better informed about the condition & inefficiencies of the
market and so they become enthusiastic about buying &
pulling up the price.
Graph
 Expectation Hypothesis

Expectation hypothesis assumes that the futures

price is an unbiased indicator of the expected spot
price.
This would be the case when markets are efficient
and hedgers & speculators correctly read the minds
each other.
So, under efficient market condition all factors
determining futures price are well known. As there is
no element of surprise, the future price must
genuinely reflect the future spot price.
 Types of Futures

Futures are broadly of two types;

 Commodity futures(Agri. & Metal), 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.
 Practice - Example

The price of SBI share at NSE is Rs. 85, while 3-m

futures contract on SBI is being traded at Rs. 86. If
you can borrow at 12% & SBI is not paying any
dividend in the next 3-m. Assume the size of the
futures contract is 1000 shares.
is there any arbitrage opportunity available? If yes,
What will be profit out of it.?
 Practice - Example

 Solution :
The cost of carry is 1% per month. For 3-m it will be
3%.
Fair price should be; F = S0 * (1+r)
F = 85 *( 1.03) = Rs.87.55
So, Fair futures price should be Rs.87.55 but actual
price in the market is Rs.86, means futures is
underpriced.
So, you have to buy futures at Rs.86 & sell shares in
spot market at Rs.85 means Reverse cash & carry
arbitrage.
 Practice - Example

 Construct Arbitrage in following manner;

 Below activity will be done today, t=0;
 1.Short 1000 shares of SBI at Rs.85 & realize Rs. 85,000.
 2. Invest this Rs.85,000 at 3% for 3-m.
 3.Buy 1 futures contract at Rs.86 with exposure of (1000 shares * 86)
Rs.86,000.

 Below activity will be done at maturity, t=3

months;
 1.Realised cash from lending activity Rs. 87,550
 2.Pay against futures contract - Rs.86,000
 3.Profit Rs.1550
 Practice - Example

 RIL as refinery uses crude oil as major input. The current

price of the crude oil is Rs.3000 per barrel. Futures
contract on crude oil for 100 barrels each are being traded
at Rs.3100 per barrel with 3-months to expiry.
 The cost of capital for the refinery is 12%, while for storage
of oil, it incurs an annual cost of 3%.
 1. Do you find the futures & spot markets are consistent –
no arbitrage opportunity?
 2.If arbitrage opportunity is there how it can be executed?
 3. What might constrain the RIL from executing the
arbitrage?
 Practice - Example

Solution :
The cost of carry including storage is 15%p.a.
Fair price of futures for 3-months is
F = 3000 * (1+0.15*3/12)
F= 3112.5
Actual futures is trading at Rs. 3100 as compared to
fair futures price 3112.5.
So, to do arbitrage buy futures at Rs.3100 & sell
crude oil at Rs. 3,000 in spot market means Reverse
cash & carry arbitrage.
 Practice - Example

 Construct Arbitrage in following manner;

 Below activity will be done today, t=0;
 1.Short 100 barrels of crude oil in spot market Rs.3,00,000
 2. Invest proceeds from for 3-m & save storage cost.
 3.Buy 1 futures 3-m contract at Rs. 3100

 Below activity will be done at maturity, t=3

months;
 1.Realised cash from lending activity(Rs.3,00,000*1.03) Rs. 3,09,000
 2.Saving on Storage cost (Rs.3,00,000*0.0075) Rs.2250
 3.Pay against futures contract(Rs.3100*100) - Rs.3,10,000
 4.Profit Rs.1250
 Practice - Example

The constraining factor for the RIL is the inability to

execute reverse cash & carry arbitrage. As it would
have to go without the level of stock of crude oil
required for production purpose. So,, if RIL tries to
sell stock of crude oil in actual (spot) market it have
to close the refinery.
So, it won’t be possible to do reverse cash & carry for
consumption asset in this case.