Chapter-2

Forwards and Futures

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Introduction

A contract to buy or sell an asset underlying (i.e.

stock/commodity/currency) for future delivery at predetermined
price is known as forward contract.

Types of Forward contracts

(Based on underlying asset)

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Salient features of Forward Contract
Two parties: one takes long and another short position
Both the parties are under obligation to buy or sell the
underlying asset
Both the parties of the contract know each other
Underlying asset may be share/commodity/currency/index.
It is OTC traded by telephone or telex .
It is customized to suit the needs of the parties
It does not insist upon payment of margins.
There is no performance guarantee and hence there is
always counterparty risk.

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Futures Contract
A contract to buy or sell stock/commodity/
currency/index for a future delivery at predetermined
price is known as futures contract.

4
Types of Futures Contracts

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Salient features of Futures Contracts
•Two parties: one on long and another on short position.
•Both the parties are under obligation to buy or sell the
underlying asset
•The parties to the contract do not know each other
•The underlying asset of the futures may be shares/
commodity/currency/index
•Traded in limited number of stocks/commodities/currencies.
•It is traded on organized exchanges
•It offers a high degree of liquidity.
•The future contract is standardized
•It insists upon payment of margin by both the parties
•The margin paid is marked to the market every day.
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Terminologies of Futures Contracts
Underlying asset is defined as a financial instrument such as share,
commodity, currency, index etc. on which derivative contracts such as
forwards, futures and options are based upon.

Contract Size: Since futures and options are standardized, they are
bought and sold in definite quantity known as contract size or market lot
or contract multiplier.

Tick Value: A minimum price movement in the futures and options price is
known as tick value or tick size or simply called as tick.

Trading Cycle: The contracts available for trading in futures and options
at a particularly time is known as trading cycle.

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Open Interest
.
Open interest also known as open contracts or open
commitments refers to the total number of futures/options
contracts outstanding (i.e. the contracts which are not yet
settled).
Price Open Interest Market Condition
Increase Increase Strong market
Increase Decrease Market is weakening
Decrease Increase Weak market
Decrease Decrease Market is strengthening

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 Futures Trading Process
.

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Types of Traders
Floor Traders (locals) trade on their own account
 
Floor Brokers (commission brokers) trade on behalf of the others
 
Dual Traders trade on behalf of the others in addition to trading on their
own.
 
Runners act as intermediary between clients and floor traders by
passing on the orders given by the clients to the floor traders.
 
Scalpers hold long or short position for not more than a few minutes.

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Types of Orders
Market Order is placed to buy or sell a certain quantity of underlying
asset at the best available price
 
Limit Order is placed to buy or sell a certain quantity of underlying asset
at the specified price
 
Stop-loss Order limits the losses by instructing the broker to liquidate
the position if the price falls below specified level (in case of long
position) or rises above specified level (in case of short position)

Stop-limit Order combines stop-loss order with limit orders by stating

that execution is restricted to the specified limit price or better.

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Clearing House
Clearing house also known as Clearing
Corporation acts as an intermediary between
buyers and sellers of futures contracts.

The clearing house guarantees performance

of the contracts by ensuring that the buyer
will get delivery of the underlying asset and
seller will get paid for the delivery of the
asset.
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Custodian/Warehouse

The need of custodial arises for the stock

F&O and warehouse for commodity F&O.

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Marking-to-Market (MTM)

Margin account of each party to the futures

contract is adjusted to reflect the investors’
gain or loss arising out of daily price
fluctuations of the underlying asset which is
known as MTM.

The amount of money deposited by the seller

and buyer at the time of signing of the
contract is known as initial margin. 14 14
Marking-to-Market (MTM) contd..

The minimum level to which the margin is allowed

to fall in the sequel of loss is known as
Maintenance Margin.

The additional funds deposited by the investor on

receiving the margin call is called variation
margin.

Margin money deposited by the clearing member

with clearing house is known as clearing margin.
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SPAN based Margin

A system of determining the amount of

margin to be deposited by the traders on
F&O in order to cover potential losses in the
margin account is known as Standardised
Portfolio Analysis of Risk Margin (SPAN).

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Clearing Margin: Every clearing member is
required to maintain a margin account with clearing
house which is known as clearing margin

Collateralisation: In an attempt to reduce credit

risk, the OTC market has also imitated the margin
system to be adopted by the exchanges with a
procedure known as collateralization.

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 Futures vs Options
Basis of Difference Forwards Futures
Method of Transaction OTC traded Exchange traded
Traded in many Traded only in limited
No. of assets traded
Underlying assets number of underlying assets
Terms of the contract
Customized Standardised
(size, delivery date etc.)
Regulation Self Regulated Regulated by the recognized exchange
Margin money not Margin money to be deposited
Security Deposits
required With clearing house
MTM Does not exist Exists
Performance guarantee Does not exist Exists
Default risk Exists Eliminated
Mostly settled by actual delivery a Mostly by offsetting contract and a few by
Method of Settlement
few by offsetting contract actual delivery
Open to anyone who needs
Access Limited to very large customers
hedging or speculation
No. of contracts in a year Any no. of contracts Fixed 4 - 12
Liquidity Low High
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Cost of Futures Contract

Brokerage Commission is charged by the

commission brokers on both opening and reversing
trade. Max 2.5%
 
Floor Trading and Clearing Fee is is charged by
the stock exchange and its associated clearing
house.
 
Delivery Cost is incurred only on the delivery of the
underlying asset.
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Valuation of Forwards/Futures
The forwards and futures pricing is based on the cost of carry model.

According to the model, the forwards/futures price is a function of the spot

rate and the cost of carrying the underlying asset.

The cost of carry model does not apply to non-carry type commodities.

Valuation of Stock/Index Futures:

Ft = S0e(r-y)t

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Valuation of Forwards/Futures contd..
When dividend amount is given:

Ft = (S0 - I)ert
I = D1e-rt1 + D2e-rt2 +…
Valuation of Commodity Forwards/Futures:

Ft = S0e(r+s)*t
OR
Ft = (S0+ s)ert

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Valuation of Forwards/Futures contd..

The cost of carry model is based on the concept of

continuous compounding.

r = ln(1+R/c)c OR c*ln(1+R/c)

Convenience Yield: The profit made on holding the

commodity to be used for consumption purpose and not for
trading purpose is known as convenience yield.

Convenience Yield: Yt = ln(Theoretical Price/Actual Futures Price)/t

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Valuation of Forwards/Futures contd..

Valuation of Currency Futures:

Valuation of currency futures is also based on the cost of carry model.

Ft = S0e(rA – rB * t)
The currency futures price will be higher than the current spot rate when
the cost of carry is positive, which will occur when the domestic interest
rate is greater than foreign interest rate. Conversely the the futures price
will be lower than the current spot rate when the cost of carry is negative,
which will occur when domestic interest rate is lower than the foreign
interest rate.

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Assumptions of Cost of Carry Model

•The market is assumed to be perfect competition

•Market participants have no influence over price
•No transaction costs and no tax
•All the assets are infinitely divisible
•No Bid-Ask spread.
•No restrictions on Short selling or Shorting
•No restrictions for borrowing & lending
•Borrowing & lending is done at the same rate of interest

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Contango & Backwardation

Condition of market where the futures price is

higher than the cash price (due to cost of
carry model) is known as Contango Market
and when futures price is lower than cash
price (due to the factors other than cost of
carry model) is known as Backwardation
market.

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Arbitrage
The opportunity for arbitrage exists only when actual
forward/futures price is either greater or less than the
theoretical value.

Cash and carry arbitrage exists when actual forward/futures

price is greater than theoretical price, (which exists in
contango market).

Reverse cash and carry arbitrage exists when actual

forward/futures price is lower than theoretical price, (which
exists in backwardation market).

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Arbitrage Process
Cash and carry arbitrage:
On the date of contract:
1. Borrowing sum equivalent to the amount required for
buying underlying asset in cash market
2. Buying the underlying asset at the spot rate in the cash
market
3. Shorting forward/futures contract
 
On the date of maturity:
1. Selling the underlying asset at the forward/futures price
2. Repayment of the borrowed money with interest

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Arbitrage Process contd..
Reverse Cash and Carry Arbitrage
On the date of contract:
1. Selling the asset at the spot rate in the cash market
2. Investing the sales proceeds till the maturity
3. Taking long position in forwards/futures contract
 
On the date of maturity:
1. Realising the investment on the maturity
2. Buying the asset at forwards/futures price

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Securities Lending & Borrowing Mechanism

It involves lending of eligible securities by

holder (i.e. lender or owner) to a person who
has short sold (i.e. borrower) in return for a
fee to cover short sales (i.e. selling a
security without possessing it).

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Hedging Strategies

Short and long hedging

Cross hedging and Delta hedging
Static and Dynamic Hedging
Perfect Hedging

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Hedging Strategies contd..

Short and long hedging:

Short hedge involves taking a short position
(i.e. selling underlying asset) and Long
hedge involves taking a long position (i.e.
buying underlying asset) in forward/futures
contracts.

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Hedging Strategies contd..
Cross & Delta Hedging
A mismatch between the underlying asset to be
hedged and underlying asset of futures contract
available gives rise to cross hedging.

A mismatch between maturity of the underlying

cash flows and that of futures contract necessitates
for delta hedging.

The combination of both delta and cross hedging is

known as delta cross hedging. 32
Hedging Strategies contd..

Static, Dynamic & Perfect Hedging

Static hedging once set up is never adjusted in the
short run.

In the long run hedge position has to be adjusted

periodically which is known as dynamic hedging.

A position that eliminates entire market risk of a

portfolio is known as perfect hedging.

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Hedge Ratio

A ratio comparing value of a position

protected via a hedge with a size of the entire
position itself is known as minimum
variance hedge ratio or simply hedge ratio.

Minimum Variance Hedge Ratio = Change in spot price/Change in futures

price
or
Minimum Variance Hedge Ratio = r *σs/σi

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