RISK MANAGEMENT

USING FUTURES
AND FORWARDS

Module 2
 Risk Management using futures and
forwards
2

 Differences-valuation of futures
 Valuation of long and short forward contract.
(5.7)
 Mechanics of buying &selling futures, Margins
 Hedging using futures -specification of futures
-Commodity futures(5.11)
 Index futures(69)
 Interest rate futures(159)
 Arbitrage opportunities.
 Forward Contracts
3

 It is a simple derivative that involves an

agreement to buy/sell an asset on a certain
future date at an agreed price.
 This is a contract between two parties, one
of which takes a long position and agrees to
buy the underlying asset on a specified
future date; for a certain specified price.
 The other party takes a short position,
agreeing to sell the asset at the same date
for the same price.
 Terminology
4

 The party that has agreed to buy has

what is termed a long position
 The party that has agreed to sell has
what is termed a short position
 The mutually agreed price in a forward
contract is known as the delivery price
 Illustration
5

 Suppose silver is currently selling at

Rd.7048 per kg.
 A and B enter into a contract where A
takes a short position and thereby
agrees to deliver 1kg of silver to B on 15
oct of the year at a price of Rs.7200.
 If there is spurt in the market price of
silver, what would happen to both the
parties???
 Forward Price
6

 The forward price for a contract is the

delivery price that would be applicable
to the contract if were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
 The forward price may be different for
contracts of different maturities
 Illustration
7

 A agrees to buy from B, 10 tonnes of

wheat at Rs.650 per tonne in 2 months
time.
 Now, if the wheat is selling at Rs.634 per
ton when the contract matures, the buyer
A would suffer losses (650-634=16 per
tonne).
 Similarly if the spot price happens to be
greater than Rs.650, then the seller B
would lose money.
8
 Symbolically, let ST be the spot price of
an asset at the date of maturity and E be
the delivery price agreed upon in the
contract ST >E ST = E ST <E

Pay off for ST - E Gain Break loss

long even
position

Pay off for E- ST Loss Break gain

short even
position
 Profit from a
9
Long Forward Position

Profit

Price of Underlying
E at Maturity, ST
 Profit from a
10
Short Forward Position

Profit

Price of Underlying
E at Maturity, ST
 Defects in forward contracts
11

 Unique contract- one to one basis

between the parties.
 Not standardized
 Possibility of non performance
 No liquidity
 Futures Contracts
12

 Agreement to buy or sell an asset for

a certain price at a certain time
 Similar to forward contract
 Whereas a forward contract is traded
OTC, a futures contract is traded on
an exchange
 Examples of Futures
13
Contracts
Agreement to:
 Buy 100 oz. of gold @ US$900/oz. in
December (NYMEX)
 Sell £62,500 @ 2.0500 US$/£ in March
(CME)
 Sell 1,000 bbl. of oil @ US$120/bbl. in
April (NYMEX)
 Futures Contracts
14

 Available on a wide range of assets

 Exchange traded
 Guaranteed for performance by an
internediary
 Specifications need to be defined:
 What can be delivered,
 Where it can be delivered, &
 When it can be delivered
 Settled daily
 Other Key Points About
15
Futures
 They are settled daily
 Closing out a futures position
involves entering into an
offsetting trade
 Most contracts are closed out
before maturity
 Forward Contracts vs Futures
16
Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk
 Types of futures contract
17

 There are basically two types of futures

contracts

 Commodity futures
 Financial futures
18

 Commodity futures
 Where the underlying variable is a commodity or
physical asset like wheat ,butter, eggs etc
 These contracts involve a wide range of agricultural
and other commodities including precious metals.

 Financial futures
 Where the underlying variable is a financial asset
such as foreign exchange, interest rate, shares or
stock index
 The financial futures involves financial tools/assets
as against commodities
 Difference between
commodity and financial
19
futures
 Cash settlement
 In some futures the asset which they represent do not
exsist, thus a futures contract on sensex represents only
a hypothetical portfolio of the constituent stocks and it
cannot be physically settled
 Contract life
 The financial futures are generally available with longer
lives than the futures on agricultural or other
commodities
 Maturity dates
 While maturity months for commodity futures contracts
vary depending upon the nature of the underlying
commodities, the maturity dates for financial futures are
standardised
 Trading in futures contract
20

 The futures contract are traded on recognised exchanges

which are similar to stock exchanges
 Trading is done in the same way as other securities like
shares
 Contracts with different delivery months are traded at any
given time
 The exchange determines the size of the contract,how the
price is to be quoted,limits on the amount by which the
futures price can move in any one day,quality of the
product and the delivery location
 The price of the contracts are determined by the forces of
demand and supply
 If more customers want to go long than short,the prices
goes upand conversely if there are more sellers then the
price goes down
 Future prices are regularly reported in financial press
 Delivery
21

 If a futures contract is not closed out

before maturity, it is usually settled
by delivering the assets underlying
the contract. When there are
alternatives about what is delivered,
where it is delivered, and when it is
delivered, the party with the short
position chooses.
 A few contracts (for example, those
on stock indices) are settled in cash
 Some Terminology
22

 Open interest: the total number of

contracts outstanding
 equal to number of long positions or
number of short positions
 Settlement price: the price just
before the final bell each day
 used for the daily settlement process
 Volume of trading: the number of
trades in 1 day
 Margins
23

 A margin is cash or marketable

securities deposited by an investor with
his or her broker
 The balance in the margin account is
adjusted to reflect daily settlement
 Margins minimize the possibility of a loss
through a default on a contract
 Margin…
24

 When a contract is entered into ,both the

buyer and seller are required to deposit a
margin on the contract called as initial
deposit,which is typically 5 to 10 % of the
value of the contract
 The exact amount is determined by the
exchange and the clearing house
,primarily in keeping with the expected
fluctuations which are estimated from the
past data
 Margin…
25

 After the initial margin is deposited ,a

change in the price of the futures contract
would change the percentage relationship
between the margin and contract value
 At the end of each trading day,the margin
account is adjusted to reflect the investors
gain or loss
 The gains or losses are netted against the
initial margin ,this is called marking to
market
 Margin…
26

 Suppose a contract size is 100 quintals and the

futures price is Rs 600 per quintal. The broker
would require the investor to deposit funds
called margin account.
 Assume the initial deposit at Rs 6000
 At the end of the day the futures price declines
from 600 to 598, the investor loses Rs 200
 The balance in the margin account will be
reduced by Rs 200 to Rs 5800
 In a similar manner the margin account would
increase to Rs 6200 if the futures price had
instead been 602 at the end of the day
 Margin…
27

 An investor is required to maintain a

maintenance margin which is typically
¾ of the initial margin .
 If the balance in the margin account falls
below the maintenance margin, the
investor receives a margin call and is
required to deposit additional funds.
 The extra funds deposited are called
variation margin
 Illustration - margin
28

 Marking to market process for 100 kgs wheat

 It is assumed that the initial margin is
Rs.6000, the maintenance margin is Rs.4,500.
 It may be observed when the contract was
entered into Sept 2 the wheat future price
was Rs.600 per kg while on the same day it
closes at Rs.598.20, thus causing loss of
Rs.180 [(598.20-600) x 100 kgs],
 And the balance is reduced to this amount to
Rs.5820 (Rs.6000-Rs180).
 Illustration contd…
29

 Next day again the prices declines to

Rs.593.60 causing a further loss of Rs.460.
 Thus the cumulative loss becomes
Rs180+Rs.460 =Rs640.
 And the balance reduces to Rs.5360
 On Sept 6, the balance falls to Rs.4480
which is below the maintenance margin of
Rs.4500.
 Thus margin call of Rs.6000-Rs4480=
Rs1520 is made.
Tradin Future Daily Cumul Margi Margi
g day price gain/lo ative n n call
ss gain/ accou
loss nt
balan
ce
2 600.0
0
598.2 (180) (180) 5820
0
3 593.6 (460) (640) 5360
0
4 594.0 40 (600) 5400
0
5 589.5 (450) (1050) 4950
0
6 584.8 (470) (1520) 4480 1520
0
9 582.2 (260) (1780) 5740
0
10 583.7 150 (1630) 5890
 Participants in the futures
31
market
 Hedgers
 Speculators
 arbitrageurs
32

 Hedgers
 Hedgers wish to eliminate or reduce the
price risk to which they are already
exposed
 The hedging function solely focuses on
the role of transferring the risk of price
changes to other holder in the futures
market
33

 Speculators
 Speculators are those class of investors
who willingly take price risks to profit
from price changes in the underlying
34

 Arbitrageurs
 They profit from price differential
existing in two markets by
simultaneously operating in two different
markets
 Valuation of forward and
35
futures
 Carry price model

 Valuation concept-
 Continuous compounding
 Carry pricing model
36

 It stipulates that the forward or future price ,is

equal to the sum of the spot price and the
carrying costs incurred by buying and holding
on the deliverable asset ,less the carry return, if
any.
 Forward /futures price=spot price + carry
costs – carry return
 Spot price is the current price
 Carry costs refer to holding costs including
interest cost, opportunity costs and insurance
,obsolescence, storage (physical commodities)
 Carry return refers to income such as dividend
on shares which may accrue to the investors
37

 Continuous compounding
 The calculation of the prices are based
on the concept of continuous
compounding:
 r2= m ln (1 + r1/m)
 Example 1- continuous
38
compounding
An interest rate is quoted as 12% per
annum with quarterly compounding. This
means r1 = 12% and m=4. the
equivalent rate with continuous
compounding would be:
r2= m ln (1 + r1/m)
r2= 4 x ln (1 + 0.12/4)
= 11.82%
 Example 2- continuous
39
compounding
 A bond offers an interest rate of 15%
annum compounded half yearly. Obtain
the equivalent rate with continuous
compounding.
r2= m ln (1 + r1/m)
r2= 2 x ln (1 + 0.15/2)
= 14.646%
 Pricing of forward contracts
40

 Three cases to obtain the prices of

futures contract:

 Securities providing no income

 Securities providing a given amount of
income
 Securities providing a known yield
 Notation for Valuing Futures
41
and Forward Contracts

S0: Spot price today

F0: Futures or forward price today

T: Time until delivery date

r: Risk-free interest rate for maturity

T
The Forward Price of Gold
If the spot price of gold is S and the futures
price is for a contract deliverable in T years is
F, then
F = S (1+r )T
where r is the 1-year (domestic currency) risk-
free rate of interest.
In our examples, S=390, T=1, and r=0.05 so
that
F = 390(1+0.05) = 409.50
 For securities providing no income
 This is the easiest forward contract for
valuation,and is exemplified by a share which
is not expected to pay any dividend
F0 = S0erT

This equation relates the forward price and the

spot price for any investment asset that
provides no income and has no storage costs
e = mathematical symbol whose value is 2.7183
44

Consider a forward contract on a non

dividend paying share which is available
at Rs 70 to mature in 3 months, if the
risk free rate of interest is 8% pa
compounded continuously the contract
should be priced at?
70e^(0.25)(0.08)
70 x 1.020
=71.41
45

Share x is currently available at 100,the

risk free rate of interest is 8%p.a
compounded continuously, what should
be the ideal contract price of one month
futures contract?
F= 100e^(0.08)(0.083)
100(1.0067)
100.67
Share y is currently available at 75,the
risk free rate of interest is 8%p.a
compounded continuously ,what should
be the ideal contract price of 2 month
futures contract?
F=75e^(.09)(2/12)
75(1.0145)
76.09
47

 Securities providing a known cash

income
 Present value of the income receivable is
determined
 F0 = (S- I)0erT

I=Ye-rT
48

 Consider a six month forward contract

on 100 shares with a price of rs 38
each,the risk free int rate is 10% pa,the
share is expected to yield a dividend of
rs 1.50 in 4 months from now,determine
the value of the forward contract
49

Dividend receivable = 100 x 1.50 = 150

Present value = 150e^-(4/12)(0.10)
=150 x 0.9672
=145.08
F=(3800-145.08)e^(0.5)(.10)
=3654.92 x 1.05127
3842.31
 Securities providing a known yield
 F0 = S0e(r-y)T
 Mechanics of buying and
51
selling futures
 The order flow: initiating a trade
 Buyers and sellers begin by contacting their
exchange member, who in turn directs the
customer’s order to a floor broker on the exchange
floor who executes the trade.
 All orders are executed on the floor of the exchange
according to exchange rules.
 All orders require bids and offer to be exposed to
other traders in the pit in order to assure execution
of orders at open and competitive prices.
 The prices at which trades are made are recorded
and electronically disseminated in seconds.
 Contd…
52

 Settling a futures position

 Now, the traders have an obligation under
the terms of the future contract either to
take delivery or to make delivery of the
underlying commodity.
 There are 3 ways of liquidating a future
position:
 Physical delivery
 Offsetting
 Cash delivery
 Hedging using futures
53

 Hedging simply refers to an activity that

reduces risk.
 It helps in reducing market exposure
risk.
 Futures act as a hedge when a position
is taken in them which is opposite to that
of the existing or anticipated cash
position.
 Long & Short Hedges
54

 A long futures hedge is appropriate

when you know you will purchase an
asset in the future and want to lock
in the price
 A short futures hedge is appropriate
when you know you will sell an asset
in the future and want to lock in the
price
 Arguments in Favor of
55
Hedging
Companies should focus on the main
business they are in and take steps
to minimize risks arising from
interest rates, exchange rates, and
other market variables
 Arguments against Hedging
56

 Shareholders are usually well diversified

and can make their own hedging decisions
 It may increase risk to hedge when
competitors do not
 Explaining a situation where there is a loss
on the hedge and a gain on the underlying
can be difficult
 Basis Risk
57

 Basis is the difference between

the spot and futures price
 Basis risk arises because of the
uncertainty about the basis
when the hedge is closed out
Expected basis
 The basis is primarily attributable to
carrying costs of a commodity. If there
were no carrying costs involved and if
there were no uncertainty, then the
futures today would command a price
equal to expected spot price(I. e date of
maturity).
 In conditions of certainty, the expected
basis would be equal to zero in a market.
Expected basis Contd
 In case of uncertainty, there are three
hypothesis to explain expected basis.
They are
 Normal Backwardation (expected basis is
negative)
 Contango (Hedgers buy and speculators
sell)
 Expectation Principle (expected basis is
zero)
 Long Hedge
60

 We define
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
 If you hedge the future purchase of

an asset by entering into a long

futures contract then
Cost of Asset=S2 – (F2 – F1) = F1 + Basis
 Short Hedge
61

 Again we define
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
 If you hedge the future sale of an asset by
entering into a short futures contract then
Price Realized=S2+ (F1 – F2) = F1 + Basis
 Optimal Hedge Ratio (page 55)
62

Proportion of the exposure that should

optimally be hedged is
S

where F
S is the standard deviation of S, the change in
the spot price during the hedging period,
F is the standard deviation of F, the change
in the futures price during the hedging period
 is the coefficient of correlation between S
and F.
 Consumption vs Investment
63
Assets
 Investment assets are assets held by
significant numbers of people purely
for investment purposes (Examples:
gold, silver)
 Consumption assets are assets held
primarily for consumption (Examples:
copper, oil)
 Short Selling
64

 Short selling involves selling

securities you do not own
 Your broker borrows the
securities from another client and
sells them in the market in the
usual way
 Short Selling
(continued)
65

 At some stage you must buy

the securities back so they
can be replaced in the
account of the client
 You must pay dividends and
other benefits the owner of
the securities receives.(with
help of an illustration)
 Notation for Valuing Futures
66
and Forward Contracts

S0: Spot price today

F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T
 1. An Arbitrage
67
Opportunity?
 Suppose that:
 The spot price of a non-dividend
paying stock is $40
 The 3-month forward price is $43
 The 3-month US$ interest rate is 5%
per annum
 Is there an arbitrage opportunity?
 2. Another Arbitrage
68
Opportunity?
 Suppose that:
 The spot price of nondividend-
paying stock is $40
 The 3-month forward price is US$39
 The 3-month US$ interest rate is
5% per annum
 Is there an arbitrage opportunity?
 Valuing a Forward
Contract with delivery
69 price
 Suppose that
K is delivery price in a forward contract and
F0 is forward price that would apply to the
contract today
 The value of a long forward contract, ƒ, is
ƒ = (F0 – K )e–rT
 Similarly, the value of a short forward
contract is
(K – F0 )e–rT
(explained with illustration)
 Forward vs Futures Prices
70

 Forward and futures prices are usually

assumed to be the same. When interest
rates are uncertain they are, in theory,
slightly different:
 A strong positive correlation between
interest rates and the asset price implies
the futures price is slightly higher than
the forward price
 A strong negative correlation implies the
reverse
71
Stock Index
 Can be viewed as an investment
asset paying a dividend yield
 The futures price and spot price
relationship is therefore
F0 = S0 e(r–q )T
where q is the average dividend
yield on the portfolio represented
by the index during life of contract
 Stock Index
(continued)
72

 For the formula to be true it is

important that the index represent
an investment asset
 In other words, changes in the index
must correspond to changes in the
value of a tradable portfolio
 (illustration)
 Index Arbitrage
73

 When F0 > S0e(r-q)T an arbitrageur buys the

stocks underlying the index and sells
futures
 When F0 < S0e(r-q)T an arbitrageur buys
futures and shorts or sells the stocks
underlying the index
 Index Arbitrage
(continued)
74

 Index arbitrage involves simultaneous

trades in futures and many different
stocks
 Very often a computer is used to
generate the trades
 Occasionally simultaneous trades are not
possible
 Futures and Forwards on
75
Currencies
 A foreign currency is analogous to a
security providing a dividend yield
 The continuous dividend yield is the
foreign risk-free interest rate
 It follows that if rf is the foreign risk-
free interest rate
( r rf ) T
F0  S0e
 Futures on Commodities
76

 Income and storage costs

 Storage costs can be treated as negative income. If
U is the present value of all the storage costs, net
income, during the life of a forward contract,
equation is:
 (illustration)
F0  ( S 0  U )e rT
 Futures on Consumption
77
Assets

F0  S0 e(r+u )T
where u is the storage cost per unit
time as a percent of the asset
value.
Alternatively,
F0  (S0+U )erT
where U is the present value of the
storage costs.
 The Cost of Carry
78

 The cost of carry, c, is the storage cost

plus the interest costs less the income
earned
 For an investment asset F0 = S0ecT
 For a consumption asset F0  S0ecT
 The convenience yield on the
consumption asset, y, is defined so that
F0 = S0 e(c–y )T
 Types of Rates
79

 Treasury rates
 LIBOR rates
 Repo rates
 Measuring Interest Rates
80

 The compounding frequency used

for an interest rate is the unit of
measurement
 The difference between quarterly
and annual compounding is
analogous to the difference
between miles and kilometers
 Continuous Compounding
81

 In the limit as we compound more and more

frequently we obtain continuously
compounded interest rates
 Rs.100 grows to Rs.100eRT when invested at a
continuously compounded rate R for time T
 Rs.100 received at time T discounts to
Rs.100e-RT at time zero when the continuously
compounded discount rate is R
 Conversion Formulas
82

Define
Rc : continuously compounded rate
Rm: same rate with compounding m times
per year
 Rm 
Rc  m ln 1  
 m 

 
Rm  m e Rc / m  1
 Zero Rates
83

A zero rate (or spot rate), for maturity T is

the rate of interest earned on an
investment that provides a payoff only at
time T
 Example (Table 4.2, page 79)
84

Maturity Zero Rate

(years) (% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8