Financial Derivatives: Stock Index Futures Currency Futures

Group 4

Aayush Aggarwal (191002) Ankit Aggarwal (191007) Ankur Ahuja (191012) Arun Bansal (191017)

Stock Index Future
y Stock index future is a derivative with Stock Index as underlying

y Cash settled.
y Since stock index is a hypothetical product and does not have a

physical form it is non-deliverable asset
y The turnover for the global market in exchange-traded equity

index futures by the Bank for International Settlements (BIS) at $ 130 trillion (notional value, 2008)
y In the Index Future Arbitrage:
y Know how the futures are trading versus their "fair value.´

Terminology y Strike Price y Contract Size y Contract Value y Tick Size: Minimum increment in which prices can change y Tick Value: Amount by which value of index future changes. y No of Contract y Maturity/ Expiry y Cost to Carry y Opportunity Cost y Interest Cost .

y Basis: Difference between the futures and the cash index (underlying stock basket) . y Carry Effect: Inputs derived from interest rates. y Dividend Effect: Derived from the dividends that the companies in the index will pay between now and the expiration date on the futures. and time to maturity.Concepts y Backwardation: y Longer dated futures (Jun 2011 NIFTY future) contracts are trading at a discount to the near contracts (Dec 2010 NIFTY future). the index level.

Future Index .

y Viable: if the cash inflow from the short futures position exceeds the acquisition cost and carrying costs on the long asset position.Cash and Carry Arbitrage y A combination of a y Long position in asset (stock). y If index futures is overpriced:  Sell futures (Short)  Buy underlying assets at the current value of index (Long)  Borrow the required amount (pay interest while paying back) . ´carryµ until expiration. y Short position in the underlying futures.

.  Buy the underlying asset back  Realise the lent funds along with interest.  Lend the funds so realised till the maturity date of the futures contract. y On the date of maturity:  Offset long position in futures.Reverse Cash & Carry Arbitrage y A combination of: y Short position in an asset y Long position in the futures for that asset y When the futures is under priced:  Selling the underlying asset.

990 with a dividend yield of 4% (semi annually). Half of the stocks in index will pay dividend in next 3 months .030 and the riskfree interest rate is 10 % . borrow funds at 10% and invest in index securities y At maturity.Dividend = 1. Spell out the strategy Fair value = Spot Value + Cost of Carry .10 /4 ² 1.PRICING & ARBITRAGE y Current value of Nifty is 1.999. 3 months future contract is selling at 2.990 + 1990 * 0.04 /2 = 1. buy back future and sell the securities and refund the loans with interest . The strategy that would yield profit will be y Sell future.95 y The future at 2.990 * .030 is overpriced .

Having chosen an aggressive portfolio the bureaucrat is worried that he would have to spend shares accordingly .Example: Hedging : Long Position y A Bureaucrat retiring in 3 Months time is planning to invest 20 Lakhs out of his superannuation benefits in equity portfolio.060. He has identified following lowing portfolios at current market prices The market as measured by Index is 4. What strategy can be suggested to the bureaucrat to hedge? Demonstrate that hedging would enable him to acquire same number of shares within his target of Rs 20 lakh even at increased prices. Index is likely to go up by 10% by the end of 3 months . Market is expected to rise as reflected in the 3 Months future trading at 45 points premium to spot at 4.115. .

50.900 Value (Rs) 2.000 3.00.135 1.000 2.159 Wt Beta 0.245 1.106 .546 1.25 0.70. 1.000 1.000 100 5.127 0.40 0.15 0.000 500 Price (RS) 230 1700 60 175 1.000 9.30.000 20.Beta would be calculated as Stock Hind Unilever Infosys Indian Hotels Dlf Ltd Reliance Ind Total No.50.10 1.000 Beta 1.00.000 3.90 0.

03.200 only .000 y Beta of the portfolio = 1.800 The increased cost of acquiring portfolio of Rs 2.000 = Rs is almost fully compensated by the gain of Rs 2. The bureaucrat would need extra Rs 21.10.600 Increase in the value of the portfolio = 10 % *1.000*4060/2.Hedging can be achieved by going long on index future currently trading at 4.115. .159 * 20.000 y Current market Price of Index = 4115 y Value of one future contract (on spot Basis) = 50 * 4060 = Rs 2.600 .000 = Rs y Exposure to be covered by index future = 1.10.115) * 12 * 50 = Rs 2. The number of future to be brought are : y Current value of portfolio = Rs 20.000 No of contract bought and adjusted for the basis = 23.159 * 20.000*4115 = 12 As market went up by 10% Gain in the position of index future = (4.466 .00.00.

000 . Number of contracts: 140.000.00 $126.000/1415*50 = 2. Looking for increase of: 10% (1556.00 $14.000 $14. Looking for a decline of : 10%. highly correlated with the S&P 500 (Value: 1415 & Contract Size: 50) index.50) Strategy: Sell two S&P 500 futures contracts to hedge portfolio. Portfolio:The current value is $140.00 $154. (1273.000.000.000 Time: 1 month Outlook: Case A: Short term bearish.Example Hedging: Short Position An investor owns a mutual fund.5) Case B: Short term bullish. Profit/Loss picture: Value of portfolio initially: after one month: (down by 10%) after one month: (up by 10%) Loss on Portfolio Gain on Portfolio $140.

5x 50)= Loss on short hedge per contract Hedged Portfolio: Loss on portfolio Gain from futures hedge Overall profit/loss Gain on portfolio Loss from futures hedge Overall profit/loss (+ $14.825(1556.675 (12 73.675 Gain on short hedge per contract +$7.$14.5x 50)= $63.$14.150) ² $14.825 .$ 150 .000 + $14.150 .150) $77.075 Value of E-mini S&P 500 after one month: $77.$7.150 + $ 150 + $14.000 .750 Value of E-mini S&P 500 after one month: $63.075 (.750 (1415 x 50)= $70.Value of E-mini S&P 500 initially: $70.

Currency Forward and Future .

It is the amount of money that bank would earn in buying one unit of foreign currency and selling it. called spread. and y other for selling ²the ask rate. Spread = Ask Price . one for buying foreign currency ²the bid rate.Foreign Exchange Rates y Foreign exchange rates are always a two-way quote.Bid Rate Mid Rate y The difference between ask and bid rate is the profit for the bank. .

fix the exchange rate today for settlement at some future date. like any other forward contract. . y Foreign currency at premium/discount means that forward rate is higher/lower than the spot rate (when quoted under direct rate convention).y Forward Rate y Forward contracts in foreign exchange.

usually one spot and another forward. y It is a composite transaction that is equivalent to two independent contracts -one spot and another forward on ´outrightµ basis.SWAPS y A swap transaction consists of two legs.e. The contracts are equal in size but opposite to one another i. . or y A spot sell followed by forward buy. spot buy followed by forward sell.

Non-Deliverable Forward y Governments of some nations exercise capital controls in order to prevent volatility in the exchange rates of their currencies or for any other political or economic reason.Such contract have notional amount . y NDF enables hedging by foreign participant who are not allowed to access onshore markets. y Non-Deliverable Forwards (NDFs) are forward contracts normally entered off-shore and cash settled for currencies that have capital control. y Features y Here since delivery is not possible settlement of forward contract is done on basis of difference of spot and forward prices y It has to be done in different currency that is freely acceptable .

Arbitrage with Currency Futures y When future is overpriced y Actions NowBorrow local currency for period of futures maturity y Convert to foreign currency using spot market y Invest in foreign currency for the period of futures y Sell futures equal to the matured foreign currency investment y At maturity of futuresDeliver foreign currency against the futures sold y Receive local currency against the futures sold y Pay for the borrowed local currency .

Arbitrage with Currency Futures y When future is underpriced y Actions NowBorrow foreign currency for period of futures maturity y Convert to local currency using spot market y Invest in local currency for the period of futures y Buy futures equal to the matured local currency investment y At maturity of futuresDeliver local currency against the futures sold y Receive foreign currency against the futures bought y Pay for the borrowed foreign currency .

Example.4000 y Rupee interest rate (T-bill yield)10% y Dollar interest rate (T-bill yield)5% y The fair price of 6-m futures is Rs 50. Is there any arbitrage opportunity? If yes how the arbitrage can be executed? .6912.Arbitrage with Currency Following data from financial markets is available .5000 y 180-day futures 50. y Spot exchange rate (Rs/$)49.

Fair Price can be calculated as Fair Price of Future = Spot X 1Rupee Interest Rate X (Days/ 365) 1  Dollar Interest rate X (Days/365) = Rs 50.6912 (Underpriced) .

92 0 Receive dollars against futures(51.500.00 Cash Flow at t=0 At maturity Receive invested rupee Deliver rupee against futuresy 51.000 borrowed.58 -1.Cash Flows ‡Now Borrow US dollar Convert to rupee in spot Invest rupee at 10% for 180 days $ Rs 1.00 1.500.00 -49.66 5. .941.00 - Pay dollar borrowed at 5% Cash Flow at maturity of future y At the maturity of the futures contract the arbitrageur can make a profit of $ 5.000.00 49.941/50.030.00 -51.941.92 for every $ 1.

b) upper bound to 6-m forward bid rate. Consider the following spot rates and interest rates: Spot rate (Rs/½) Interest rate Rs: ½: 60.50% 5. .00 8.50% Find out a) lower bound to 6-m forward ask rate. and b) upper bound for the bid rate.Determining Forward Rates Arbitrage argument is used in finding the a) lower bound for the ask rate.00 8.00% 61.Example.00% 5.

Amount to repay = ½1.00 at 5.04 x 60 = Rs 62.0275 Convert to rupees at spot bid and get = Rs 60. Borrow foreign money ½ at borrowing rate 2.Determining Forward Rates y To find lower Bound on the risk we do: 1.7299 .00 Invest for 6 months at 8% and get Rs 1. Invest local currency at lending rate for the period of forward 4.40/Fa” 1.40/Fa For no arbitrage 62.50% for 6 months . Convert spot into local currency (Rs) at bid rate 3.0275 Or Fa• Rs 60.40 Sell at forward ask rate Fa to get ½ = 62. Sell the matured amount at forward ask rate to reconvert to foreign currency Borrow ½1.

0164 Invest for 6 months at 5% and get ½1. 5.0425 Fb” Rs 62.00 = ½0. 2. the matured amount through forward must be less than the borrowing Borrow Rs 1. 3.Determining Forward Rates y To find upper bound on the bid rate we do as follows: 1.0168 For no arbitrage we must have Fb X 0. 4. Borrow local currency (Rs) at borrowing rate Convert spot into foreign currency (½) at ask rate Invest foreign currency at lending rate for the period of forward Sell the matured amount at forward bid rate to reconvert local currency For no arbitrage .0168 ” 1.0415x .0168 Sell at forward bid rate Fbto get = Fb X 0.0425 Convert to euro at spot ask.00 at 8.50% for 6 months Amount to repay = Rs 1. get ½ 1/61.025 x 1/61 = ½0.

Thank You .