Futures - Basics

• Futures contracts are very similar to forward

contacts .
• A currency futures contract
– specifies that a ‘specified’ currency will be exchanged for another
‘specified’ currency at a specified time in the future at prices fixed today

• The similarities can be listed as

– Both lock the parties into definite rates
– Both can be settled through delivery or cash settlement (where NDF is okay)
– Both create rights and obligations for both parties to the deal

• Then what are the differences between the two?

Differences between Forwards and Futures
– Markets and liquidity
• Futures contracts are traded on organized exchanges (liquid)
• Forwards are private contracts (OTC) and do not trade. (illiquid)
– Standardisation
• Futures contracts are highly standardized – to the last T
• Forwards are bespoke to satisfy the requirements of contracting parties
– Counter-party
• No counter-party risk due to clearing house mechanism
• Originating parties are counter parties and hence credit risk exists
– Regulation
• There is governmental (Regulatory Agencies) influence in futures markets.
• OTC markets are seldom regulated – Indian Contract Act, 1872, generally
governs all contracts. Of course, forward contracts with banks are subject
to central banks’ dictates)
– Mark to Market and daily margins
Features of Currency Futures
in Indian Futures Markets
Ask for the handout – Important Document
 Importance of understanding Tick-Size
• ‘Tick Size’ refers to the minimum ‘delta’ multiple in price a broker/trader
quote from the prevailing price of the futures contract.
• Each exchange can specify what the tick size is. For example, under NSE the
tick size is 0.0025. Therefore, if the current September futures is quoting at
Rs.67.0550, a trader cannot bid for 67.0565 or 45. He can, of course, bid for
Rs.67.0525 or Rs.67.0575 or in multiples of difference of Rs.0.0025.
• Each contract is worth $1,000. Therefore, the minimum value of a tick for one
contract is Rs.1,000 x 0.0025 = Rs.2.50.
• Suppose an investor buys 100 contracts and the futures contract moves up by
4 ticks (ie., 0.0025 x 4 = one paise), then the investor has gained Rs.100 x
1,000 x 0.01 = Rs.1,000 (or in simple terms, just remember the value of one
tick as Rs.0.0025 and multiply all the rest of the terms with it!)
• You can see the tick size impact in the previous slide which shows the screen
shot of NSE-Currency Futures
 What is Margin and Margin transactions?
• All players are required to deposit a fixed amount as ‘Initial Margin’ with the Exchange before
trading is permitted.
• The margin is fixed by the exchange taking into account various factors such as volatility,
volume of operations, etc.
• Different margin types are established by different exchanges. In India, we have
– Initial Margin and Extreme Loss Margin; In the western markets, there is an ‘Initial
Margin’ and a ‘maintenance margin’
• It is set for each type of underlying asset (currency, shares, indices, commodities, etc)
• Initial margin per contract is relatively low and equals about one day’s maximum price
fluctuation on the total value of the contract’s underlying asset. It is usual to see this at about
1%-5% of the contract value. In India, we have minimum 1.75% on the first day and minimum
1% on the following days. Extreme margin is 1% flat on USD……
• Maintenance margin is the amount of margin that must be maintained in a futures account.
• Price changes of the underlier may erode the Initial Margin – however, it cannot go below the
‘Maintenance Margin’.
• Once the ‘Maintenance Margin’ is breached, the Exchange calls for ‘Variation margin’ which
will go to top up, upto the Initial margin
• Exchanges allow the Margin to be kept in various forms such as Government Securities,
currency deposits, etc.
• Participants’ losses or profits are realized daily instead of at maturity as with a forward
contract.
 What is ‘marking to market’ ?
• Illustration : On Monday next at 12 noon you buy a futures contract in ₤ that matures on Friday
next at Rs.80. The exchange fixes initial margin of Rs.1,400 and extreme loss margin is 1% of
contract value = Rs.800. You deposit the margin money with your broker on your account..
• At the close of business on Monday, the futures price has fallen to Rs.79.7500. There is a ‘loss’
on your position now and the loss is calculated as Rs.(1,000 x 0.25) = Rs.250. The requirement
of your margin now stands at 1% of Rs.79750 = Rs.797.50. Therefore, you will get a net debit of
Rs.250 – Rs.2.50 = Rs.247.50 on the broker’s liquid deposit account. This amount the Exchange
will swipe from the ‘liquid deposit’ placed by the Broker with the exchange. (The
American/European Markets work on a different basis with the concept of ‘maintenance
margin’). We will see that separately.
• At the close of trading on Tuesday the futures price further falls to Rs.79.2500, making a Rs.0.50
loss per ₤ = Rs.500. The amount to be remitted by the broker now is Rs.500 – Rs.5.00 =
Rs.495.00. This amount is again swiped from the liquid deposit of the broker.).
• At Wednesday close the price has fallen further to Rs.78.8000. This is a further loss for the day
of Rs. 0.45 per ₤ = Rs.450. The broker’s liquid deposit account will be debited for Rs.450 – Rs.
4.50 = Rs.445.50
• At Thursday close the price has risen dramatically to Rs.80.2500. This is a profit position of Rs.
1.45 per ₤ = Rs.1,450. The broker will get credit for Rs.1,435.50 (Rs.1,450-14.50) this amount
into his Liq. Deposit A/c. This can be withdrawn by the broker immediately, if he so desires.
• On Friday morning, you sell your contract for Rs.80.10; square off the differential of Rs.0.15 per
₤ and come out of the market; You made a net profit of 10 paise per ₤ that you hedged.
Don’t be pleased with yourself!!.Remember you have lost 10 paise per ₤ on
the underlier liability (in Spot) that you wanted to hedge in the first place!!
What is the basis of the previous statement?
• What is the reason for you to hedge in the first place? You had a liability in GBP
coming up one week (1 month/3 months, etc) which you wanted to hedge; instead of
going to your banker for forward, you go to futures
• When you buy the contract for Rs.80, you agree to buy one GBP for Rs.80 on the
settlement date, just the way you agree with your banker for next Friday at Rs.80 –
except here you agree to purchase GBP from Clearing house
• On the due date (Friday) what happens? You have to buy from your banker on Spot
basis to settle your liability. What rate will the banker give you? He will give you at
Spot (ignore his margin, for the time being). What is the Spot? Spot = Rs.80.10.
• You gained Rs.0.10 on Futures – now you will have to give it away in spot when you
buy the currency from bankers at Rs.80.10.
• So, what is your net outgo? Rs.80.10 minus Rs.0.10 = Rs.80.00
• This is what you had ‘frozen’ your liability at the time of buying the future at Rs.80.00
• Look at the next slide how the two scenarios get captured – either way your liability is
capped at Rs.80.00 per GBP
 Two alternative scenarios
• GBP strengthens against INR
and becomes Rs.82
– Liability GBP 10,000
– Spot markets payment on due
date :
– 10,000 x 82 = 820,000
– Profit per Futures contract =
Rs.82-80=2.00
– Total profit on 10 contracts =
Rs.10x1000x2=Rs.20,000
– Therefore, net outgo = -
Rs.820,000 – Rs.20,000 =
– Rs.800,000
• GBP weakens against INR
and becomes Rs.77
– Liability GBP 10,000
– Spot markets payment on due
date :
– 10,000 x 77 = 770,000
– Loss per Futures contract = Rs.77-
80=3.00
– Total loss on 10 contracts =
Rs.10x1000x3=Rs.30,000
– Therefore, net outgo = -
Rs.770,000 + Rs.30,000 =
– Rs.800,000
 Hedging with Currency Futures
• Hedging implies taking a position in the futures market that is opposite to the
position held in the spot market.
• If you own, or expect to own or buy a currency, you would sell in futures markets.
If exchange rates move adversely during the holding period, you lose in the spot
market but gain in the futures market.
• Profits & losses tend to offset each other but not exactly (why? Will explain later)
• On the other hand, if the exchange rate movements are favourable, you gain in the
spot market but lose in the futures market.
• Similarly, when one needs a currency, say after 3 months, one would buy in futures.
• This means that if the exchange rate moves adversely, he would make a loss in the
spot market but a gain in the futures market where he would be buying low and
selling high. On the other hand, in the event of a favourable exchange rate
movement, he would book a gain in the spot market and a loss in the futures
market.
• Hedging thus reduces the possibility of losses but also eliminates the chances of
making profits. This may be quite acceptable to a normal risk averse individual or
corporate who feels that such potential windfall profits may not be worth the risk
involved.
 What is the catch in the illustration?
• What is the catch for the hedger in the above illustration?
• You will notice that the settlement rate for GBP in the Futures Market is the
same as the spot rate that the banker will charge you. Why?
• Therefore, if you close out the position not on the due date but on any other
earlier date, what will be the risk that you will be carrying?
• The risk that you will be carrying is called the ‘basis risk’
• The difference between spot and futures prices for the same asset at any
given point of time is known as the basis.
• For a hedge to work perfectly during the hedging period, the basis has to
remain constant throughout the period of hedging.
• Because the basis is likely to change with time, the hedge will not be perfect.
• Even in the unlikely event of the basis remaining constant, the quantities
associated with the standardised futures contracts will often not match
exactly the exposure involved.
• Thus, hedging with futures rarely eliminates risk completely.
 Effective price using hedging
• Let S1 be the spot price at time t1 and S2 be the Spot price at time t2 of an underlier
• Let F1 be the Futures price at time t1 and F2 be the Futures price at time t2

• Therefore, lets call basis at time 1 (ie t1) as b1. Therefore, b1 = S1 - F1

• Similarly, b2 = S2 - F2, basis at t2

• Suppose we hedge a receivable by going short in futures at time, t1

• Profits made in futures market by closing out position at time, t2 = F1 - F2
• (If F1 < F2, then it would be a loss, but mathematics wont change )

• Price received by us for the asset while selling in the spot market = S 2
• Then, the effective price at which we sold the asset is
= S2 + ( F1 - F2 ) = S2 + F1 - F2 = F1 + ( S2 - F2 ) = F1 + b2

• But b2 is unknown at time t1. Therefore, all futures transactions suffer from basis risk

• For financial assets, the basis risk will be essentially the interest cost differential to prevent
arbitrage; however, for non-financial assets, the risks of demand and supply and storage costs
pose greater problems – hence basis risk is higher for such non-financial assets
 What is settlement price?
• We have already seen the application of this concept in a previous slide.

• However, the application is not precise. Settlement price is used to make

margin calculations at the end of each trading day.

• The settlement price is similar to the closing price of the underlier but is
not exactly the price of the last trade.

• It is an average of the prices of the trades during the last period of

trading, called the closing period, which is set by the exchange.

• The advantage? - prevents manipulation by traders.

• Marking to market is the process of adjusting the margin balance in a

futures account each day, based on the new settlement price.
 Terminating Futures Contracts
• Forwards are terminated on the due date by exchange of obligations

• Futures are terminated (from the contract holders’ perspective) in four ways :-
There are four ways to terminate a futures contract:

a) Delivery : A short can terminate the contract by delivering the goods, a long
by accepting delivery and paying the contract price to the short. This is called
delivery on the due date
b) Cash-settlement
c) A reverse, or offsetting, trade
d) Exchange for physicals. Here you find a trader with an opposite position to
your own and deliver the goods and settle up between yourselves, off the floor
of the exchange (called an ex-pit transaction – very rare in futures.)
 Speculating with Currency Futures
• “Bigger Bang for the same Buck”

• You will be able to realise multiple times profits with Futures

rather than with Spot markets

• Hence Futures as a product gives the Speculators great options

to take shots at the markets and realise huge profits, if market
movements go as per their beliefs

• If markets move in the opposite way, Speculators would lose

significantly in Futures markets than in spot markets
Theory of Futures Pricing - General
• Moved to annexure – Optional. Will be useful
when you study derivatives in detail
Working out class room illustrations on
Futures (Application problems only)
 Annexure
Theory of Futures Pricing - General
Theory of Futures Pricing - General
• Let ‘S0’ be the spot price of an asset, ‘s’ be its storage costs and from time ‘0’ to T
and ‘i*S0’ is the interest foregone in investing in the asset.

• Let ST be the value of the asset at time T.

• Assume that there is no uncertainty in the future asset price

• Then the current value of the asset will be

ST = S0 + s + i*S0 , which is the same as, S0 = ST – s – i*S0
• We relax the assumption that there is no uncertainty in the future asset price. In
which case, the above valuation would be
– S0 = E(ST) – s – i*S0
– Where E (ST) is the expected value of the future asset price
 Cont..
• However, since most investors are risk averse, you could expect this
transaction not working perfectly, unless you bring in the risk premium
value into the equation

• Therefore, the above valuation becomes

– S0 = E(ST) – s – i*S0 – E (f)
– Where E (f) is the value of risk premium

• For financial assets, one can assume that there are no storage costs and,
therefore, the value of ‘s’ is eliminated from the equation above.

• It is quite possible for a financial instrument (such as a stock or bond) to

pay interest or dividend –
– in which case i*S0 = i*S0 – ie
 Contd..
• In the equation above, (s + i*S0) is referred to the cost carry or simply ‘carry’

• Cost of carry [(s + i*S0)] is positive if ‘s’ is greater than ‘i’ and negative
otherwise.

• Consider the following transaction now

– Buy an asset in spot market at price S 0 and sell a future at price F 0(T)

• On expiration, the spot price ST and futures price FT(T) have to be equal. You
deliver the asset at time T

• The profit on this transaction would be

– P = F0(T) – {S0 + s + i*S0} . If the ‘carry’ is represented by ‘q’, then this equation
becomes P = F0(T) – {S0 + q }
– All terms in the above are known and are not ‘expected’ values

• Hence the profit is riskless and cannot generate risk premium

 Contd..
• Now comes the most important point –

• Since the position is riskless, the profit should be equal to Zero. Otherwise,
arbitrageurs will jump into the fray and wipe out the excess profits.

• Therefore, the equation above is forced-fit to zero value

P = F0(T) – {S0 + q } = 0. Therefore, F0(T) = {S0 + q }

• That is, the futures price at time 0 is equal to the Spot price at time 0 plus the cost
of carry

• Therefore, we can deduce the ‘basis’ to be the cost of carry.

• Caveat : Cost of carry need not always be +ve. It can be -ve too.
THE
END