Let’s have glimpse of the

problems…
We normally face as a student of
Finance and we need to answer them in
SCIENTIFIC MANNER!!!!!!!!!!!!!
 What is Futures
and options????
 How do we know
that a option price
is undervalued or
over valued!!!!!
Which model of option
pricing is better
binominal or BSM
 Who are
arbitrageurs
 Who are
speculators
Who are hedgers
Is it possible for me to
know at what time I
should buy or sell
If you are looking forward to
answer the issues raised, then
you have to enter into the
world of……
This Class will take you to the
WORLD of Stock market
first!!!!
Look!!! I am having lot of
money with me and want
to invest. I really do not
know - should I look for
investment in bonds or
equity? Can you help me?

He is a high net
worth person and
looking for some who
can manage his
wealth.
If you are given a sum of Rs. 10 lakhs, then how you
will decide where to put the money? - in Bonds? In
Shares? In both? How much in each?
IS 2022 a YEAR of Bonds or
Equity?
During the phase of rapid growth
in an economy, should you invest
in bonds or shares?
How to safeguard
oneself against
Business Cycles?
This man is having RBI Bonds. Is he exposed to any kind of
risk?

RB
8% I B o n
, 2 0 ds
18
This man has read in a newspaper that the Indian Economy is expected
to grow at 3.50% for 2022-23 and the inflation rate ending last week is
more than 1% of the previous week. The Fed is thinking to increase its
bank rate in near future. He has huge exposure in long-term
Government Bonds.

Feeling I think he has become crazy!! One

very upset should feel happy about higher
due to the growth rate and increasing inflation
news. rate as it shows increasing optimism
in the economy which is badly
required by all of us.
Should you hold individual securities or
hold them as a portfolio?
These issues are bothering
me and I believe that they
may be bothering you too!!!!,
If not today then may be in
near future.
As a man of finance, we have to address and
understand all such issues. And, the todays class
will definitely help us in this regard.
WELCOME TO
THE
Objective of Today’s session - Putting the things in RIGHT PLACES
 Structure

Real Assets Financial Assets

Money Equity and FX Bond

Market Derivatives Market Market

Primary Secondary
Market Market
 What is
investment?

Issue#1
Investment

“A sacrifice of current money or

other resources for future

benefits”.
 Why should
we
investment?

Issue#2
OBJECTIVES OF INVESTMENT
Togenerate maximum RETURN/INCOME/
PROFIT/ BENEFITS.

To minimise the risk involved.

To ensure sufficient liquidity(?).

To get tax-benefits.

To safeguard against rising prices (hedging).

 Where should
we
investment?

Issue#3
 Real Assets
Vs.
Financial Assets
We should investment in a financial assets
…

We shall restrict ourselves to TWO KINDS

of financial assets –

◦ FIXED INCOME SECURITY – BOND

◦ VARIABLE INCOME SECURITY - EQUITY

 Where should
one
investment?

Issue#4
One should invest in Financial Markets!

• Primary Market –
• IPOs and FPOs

• Secondary Market –
• Stock Exchanges
IPO AND FPO
Secondary Market – Stock Exchanges
First - Few basic of stock market
Spot or equity

The spot market or cash market is a financial

market in which securities are traded
for immediate delivery.
In a spot market, settlement normally happens
in T+1 working days, i.e., delivery of cash and
commodity must be done after two working days
of the trade date.
 Seller Bank
Your Bank A/C A/C

Buyer Stock Market Seller

Your Demat Seller Demat

A/C A/C
 Before After
 Bank A/C = 200000  Bank A/C = 100000*

 Demat A/C = NIL  Demat A/C = 400 SBI#

Assuming Share worth rupees 100000

# SBI @ 250 at the time of trade
DERIVATIVES
Problem of a student…

What is DERIVATIVES sir!!!!

DERIVATIVES
In the Indian context the Securities Contracts
(Regulation) Act, 1956 (SC(R)A) defines
"derivative" to include-
 A security derived from a debt instrument, share,
loan whether secured or unsecured, risk instrument
or contract for differences or any other form of
security.
 A contract which derives its value from the prices,
or index of prices, of underlying securities.
Derivatives are securities under the SC(R)A and
hence the trading of derivatives is governed by
the regulatory framework under the SC(R)A.
DERIVATIVE PRODUCTS
 Forwards:

A forward contract is a

customized
contract between two entities,
where settlement takes place
on a specific date in the future
at today's pre agreed price.
DERIVATIVE PRODUCTS
 Meet Mr. X. Currently he
exports 100 tones of wheat
to the USA and he will
receive 100000$ in the
month of Aug.
Current USDINR
rate is 80 per $
But Que. is what will
be the rate of USDINR
in the month of
Aug??????????
Now Mr. X. will go to
bank and enter into a
contract which is
called a forwards
contract.
Contract details

Forwards:

A contract between Mr. X and Bank, where

settlement takes place on Aug at today's pre agreed
price that may be 82 per $, Quantity is 1 Lakh $,
place of delivery will be Mumbai.
Contract details

Forwards: can be for commodity, stock, interest

rate, etc.
Such as

A contract between Mr. X and Mr. Y, where

settlement takes place on a Aug at today’s pre agreed
price 28500 per 10 gram of gold, Quantity is 1 kg,
the currency will be Rupee, place of delivery will be
Say, Mumbai. etc.
Example
Where,
◦ Time of Delivery -----You decide
◦ Place of delivery -----You decide
◦ Quantity -----You decide
◦ Quality -----You decide
◦ Currency -----You decide
DERIVATIVE PRODUCTS
 Futures:

A futures contract is a
standardized contract
between two parties to buy or
sell an asset at a certain time
in the future at a certain
price.
Example
Stock exchange,
Where,
◦ Time of Delivery is Fixed
◦ Place of delivery is Fixed,
◦ Quantity per lot is Fixed,
◦ Quality is Fixed,
◦ Currency is Fixed,
◦ Price is driven by Demand and Supply.
DERIVATIVE PRODUCTS (continued…)
 Options: Option means choice.
 In stock market option also means
choice between buy or not to buy
(sell or not to sell)

1. Option - Option give the right to

buy/sell but not the obligation to
buy/sell a given quantity of the
underlying asset, at a given price
on or before a given future date.
DERIVATIVE PRODUCTS (continued…)
 Options: Options are of two types –

1. Call Option - Calls option give the buyer the right to

buy but not the obligation to buy a given quantity of the
underlying asset, at a given price on or before a given
future date.

2. Put option - Puts option give the buyer the right to sell,
but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given
date.
Features of derivative markets

Derivative are of three kinds

◦ Future or forward contract
◦ Options
◦ Swaps.
Features of derivative markets

Low counterparty risk,

Transactions costs are low.
Contract has to be settled by delivery or cash.
By taking just opposite position party can
reverse the contract.
When value of underlying assets change then
value of derivatives also changes.
FORWARD CONTRACTS
The salient features of forward contracts are:

1. Each contract is customized.

2. Contract has to be settled by delivery.

3. Contract price is not available in public domain.

4. If the party wishes to reverse the contract, it has to

compulsorily go to the same counter-party.

5. Counter-party risk.
LIMITATIONS OF FORWARD MARKETS

 Forward markets world-wide are afflicted by several

problems:

1. Lack of centralization of trading.

2. Illiquidity.

3. Counterparty risk.
Why Forwards?

They are customized contracts unlike

Futures and they are:
Tailor-made and more suited for certain
purposes.
Useful when futures do not exist for
commodities and financials being
considered.
Types of Futures Contracts
Physical commodities
◦ Agricultural (e.g., corn, livestock)
◦ Non-agricultural (e.g., lumber, oil, gold)
Financial futures
◦ Currency futures
◦ Stock index / Stock futures
◦ Interest rate futures
Futures & Forwards Distinguished
FUTURES FORWARDS
They trade on exchanges Trade in OTC markets
Are standardized Are customized
Identity of counterparties is Identity is relevant
irrelevant
Regulated Not regulated
Marked to market No marking to market
Easy to terminate Difficult to terminate
Less costly More costly
FUTURES TERMINOLOGY
Spot price: The price at which an asset trades
in the spot market.(delivery in t+2 basis)
Futures price: The price at which the futures
contract trades in the futures
market. (delivery in t+n basis)
Contract cycle: The period over which a
contract trades. The index futures contracts
FUTURES TERMINOLOGY
Expiry date: This is the last day on which the
future contract will be traded, at the end of
which it will cease to exist.
Contract size: The amount of asset that has
to be delivered under one contract. Also
called as lot size.
Margins
Margins

A margin is cash or marketable securities

deposited by an investor with his or her
broker.

Buyer or seller both have to deposit a

token payment to broker and broker will
deposit this money to exchange. This
Why should
there be
margins?
Margins
 Suppose a Buyer,

◦ On January 1, 2019 - Purchases 1000 shares

of ‘xyz’ company at Rs.100/-.

◦ Then buyer has to give the purchase amount

of Rs.1,00,000/- (1000 x 100) to his broker on
or before next day.

◦ Broker, in turn, has to give this money to

stock exchange.
Margins
 There is always chance that the buyer may not
be able to bring the required money by required
date.

◦ Hence, buyer is required to pay a portion of

Rs.1,00,000/- to the broker at the time of
placing the buy order.

◦ This initial token payment is called

margin.
Remember, for every buyer there is a
seller
◦ If the buyer does not bring the money,
seller may not get his / her money and
vice versa.
Therefore, margin is levied on the seller
also.
◦ To ensure that seller gives the 100
shares.
◦Margin payments ensure
that each investor is
serious about buying or
selling shares.
 Sir!!!
Are margins same
across cash and
derivatives
markets?
No!!!!!!!!!!
◦ Shares traded on cash market are
settled in two days
◦ Whereas derivative contracts may
have longer time to expiry.

Therefore, types of margins levied

in the cash market segment and
derivative are different
 Cash
Market
Cash Market Margins

Margins in the cash market

segment comprise of the following
three types:
◦ Initial Margin
 Value at Risk (VaR) margin
 Extreme loss margin
◦ Mark to market Margin
Value at Risk (VaR) margin
 VaR is a technique used to estimate the
probability of loss of value of a security, based
on the statistical analysis.
A VaR statistic has three components:

◦ Time period,

◦ Confidence level

◦ Loss amount (or loss percentage)

Value at Risk (VaR) margin
 For example,

 VaR1,99 = 1000

◦ There is only 1% chance, loss this security

will exceed 1000 in 1 Day.

 VaR10,95 = 10000

◦ There is only 5% chance, loss this security

will exceed 10000 in 10 Day.
Calculation of VaR margin.
Ithas two components
◦ Volatility
◦ Ln return
Formula to calculate volatility:
Calculation of VaR margin.
Example: Share of ABC Ltd:
◦ Volatility on July 1, 2019 = 0.0214
◦ Closing price on June 30, 2019 = Rs. 100
◦ Closing price on July 1, 2019 = Rs. 108
 Log return = ln(108/100) = 0.076961

July 1, 2019 volatility

◦ This is
◦ = 0.028033 Volatility
not VaR
Margin
 Sir!!!
How to
calculate
Volatility?
 Date Price Formulas Value
Jul 26, 2019 1213.8 =LN(B2/B3) -0.0144770041588379
Jul 25, 2019 1231.5 =LN(B3/B4) -0.0221642414470621
Jul 24, 2019 1259.1 =LN(B4/B5) -0.0114110965178472
Jul 23, 2019 1273.55 =LN(B5/B6) -0.00544235011407788
Jul 22, 2019 1280.5 =LN(B6/B7) 0.0249073955140023
Jul 19, 2019 1249 =LN(B7/B8) -0.0102356669572542
Jul 18, 2019 1261.85 =LN(B8/B9) -0.0157254488720146
Jul 17, 2019 1281.85 =LN(B9/B10) -0.00866075281701096
Jul 16, 2019 1293 =LN(B10/B11) 0.013156548031927
Jul 15, 2019 1276.1 =LN(B11/B12) -0.0034420748996494
Jul 12, 2019 1280.5 =LN(B12/B13) -0.000819656180625368
Jul 11, 2019 1281.55 =LN(B13/B14) 0.00210904624341277
Jul 10, 2019 1278.85 =LN(B14/B15) -0.000976963285271456
Jul 09, 2019 1280.1 =LN(B15/B16) 0.0221559918972086
Jul 08, 2019 1252.05 =LN(B16/B17) -0.00898471496862236
Jul 05, 2019 1263.35 =LN(B17/B18) -0.0162132823164288
Jul 04, 2019 1284 =LN(B18/B19) 0.0011299216101542
Jul 03, 2019 1282.55 =LN(B19/B20) 0.00316276790851098
Jul 02, 2019 1278.5 =LN(B20/B21) 0.00757653731310811
Jul 01, 2019 1268.85 =LN(B21/B22) 0.0124904972468938
Jun 28, 2019 1253.1 =STDEV.P(C2:C21) 0.0124650402372948
Value at Risk (VaR) margin
 To Calculate at VaR margin rate, companies are
divided into 3 categories based on

◦ Shares trade

◦ Liquidity
 How much a large buy or sell order changes the price of the
scrip, what is technically called ‘impact cost’.
Value at Risk (VaR) margin
 These 3 categories are:
◦ Group 1
 Regularly traded (more than 80% of the trading days in the
previous six months)
 High liquidity (Impact cost less than 1%)
◦ Group 2
 Regularly traded (more than 80% of the trading days in the
previous six months)
 Moderate liquidity (Impact cost more than 1%)
◦ Group 3
 All other shares
Value at Risk (VaR) margin for group 1
shares
 Group 1, the VaR margin rate would be higher of

◦ 3.5 times volatility or

◦ 7.5%
 For example,

◦ Volatility was 0.028033% or 2.8033 (in our

example, slide 21)

◦ 3.5*2.8033 = 9.81155%
Value at Risk (VaR) margin for group 2
shares
 Group 2, the VaR margin rate would be
 First higher of
◦ 3.5 times volatility x 1.732051

◦ 3.0 times volatility of index (minimum value of volatility

of index is taken as 0.05%) x 1.732051

 For example, margin rate for group 2 shares will be

◦ 3.5*2.8033*1.732051 = 16.9941%
Value at Risk (VaR) margin for group 3
shares
 Group 3, the VaR margin rate would be

◦ 5 times Index volatility x 1.732051

 For example, Then rate for group 3 shares will be

◦ 5*5*1.732051 = 43.30%
Calculation of Extreme Loss Margin
 The extreme loss margin aims at covering the
losses that could occur outside the coverage of
VaR margins.

 The Extreme loss margin for any stock is higher

of 1.5 times the standard deviation of daily LN
returns of the stock price in the last six months
or 5% of the value of the position.
Calculation of Extreme Loss Margin
 Suppose standard deviation of daily LN returns
of the a stock in the last six months is 3%

◦ Then Extreme loss Margin will be

 1.5*3 = 4.5%

◦ Then exchange will take it 5%.

Calculation Mark-to-Market (MTM)
margin
 In securities trading, Each security price is recorded based on the
current market value rather than book value.
 This is done most often in futures accounts to ensure that margin
requirements are being met.
 MTM is the P/L calculated at the end of the day on all open positions.
Amount require to deposit w.r.t MTM is called as MTM margin.
MTM margin

Suppose,

◦ A buyer purchased 1000 shares @ Rs.100/-

on July 1, 2022.
 Initial Margin was 22% (VaR+ELM) =22000

◦ If Share close at Rs.75/-, then the buyer faces

a notional loss of Rs.75,000.
 In such case, chance that the buyer may not be able to
bring the required money by required date.

◦ Hence, MTM margin is required.

Example of a Futures Trade
An investor takes a long position in 2
December gold futures contracts on
June 5
◦ Contract size is 100 oz.
◦ Futures price is US$400/oz
◦ Margin requirement is US$2,000/contract
(US$4,000 in total)
◦ Maintenance margin is US$1,500/contract
(US$3,000 in total)
Example of a Futures Trade
Total margin requirement
= 2 x 2000 = $ 4000
Maintenance margin requirement
= 2 x 1000 = $ 3000
Suppose the price goes down to 397 the
next day
Loss = (397-400) x 2 x 100 = (600)
Day Futures Daily Cumulative Margin Margin
price gains ($) gains ($) account call
balance
400.00 4000
5-Jun 397.00 (600) (600) 3400
6-Jun 396.10 (180) (780) 3220
9-Jun 398.20 420 (360) 3640
10-Jun 397.10 (220) (580) 3420
11-Jun 396.70 (80) (660) 3340
12-Jun 395.40 (260) (920) 3080
13-Jun 393.30 (420) (1340) 2660 1340
16-Jun 393.60 60 (1280) 4060
17-Jun 391.80 (360) (1640) 3700
18-Jun 392.70 180 (1460) 3880
19-Jun 387.00 (1140) (2600) 2740 1260
20-Jun 387.00 0 (2600) 4000
23-Jun 388.10 220 (2380) 4220
24-Jun 388.70 120 (2260) 4340
25-Jun 391.00 460 (1800) 4800
26-Jun 392.30 260 (1540) 5060
Participants and functions
• Self Clearing Member: A SCM clears and settles trades
executed by him only either on his own account or on
account of his clients.

• Trading Member Clearing Member: TM-CM is a CM

who is also a TM. TM-CM may clear and settle his own
proprietary trades and client's trades as well as clear and
settle for other TMs.
Participants and functions
• Professional Clearing Member PCM is a CM who is not
a TM. Typically, banks or custodians could become a PCM
and clear and settle for TMs.
Convergence of Futures Price to Spot Price
Convergence of Futures Price to Spot Price

As the delivery month of futures contract is

approached , the future price converges to
the spot price of the underlying asset.
When the delivery period is reached , the
future price equals – or is very close to - the
spot price.
Convergence of Prices
Prices

Futures Price

Spot Price

Time
Convergence of Futures to Spot

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
Convergence of Futures to Spot on real
data
Futures
Data:-https://www1.nseindia.com/products/conten
t/derivatives/equities/historical_fo.htm
Spot Data:-
https://www1.nseindia.com/products/content/equit
ies/equities/eq_security.htm
Symbol Expiry Date SBI-Futures
SBI Spot Di ff
SBIN ######## 01-Oct-20 192 190.3 1.7
SBIN ######## 05-Oct-20 190.6 188.75 1.85
SBIN ######## 06-Oct-20 193.3 191.6 1.7
SBIN ######## 07-Oct-20 192.2 190.7 1.5
SBIN ######## 08-Oct-20 193.15 191.5 1.65
SBIN ######## 09-Oct-20 199.85 198.3 1.55
SBIN ######## 12-Oct-20 200.15 198.7 1.45
SBIN ######## 13-Oct-20 197 195.7 1.3
SBIN ######## 14-Oct-20 201.45 200.05 1.4
SBIN ######## 15-Oct-20 193.8 192.85 0.95
SBIN ######## 16-Oct-20 197.1 195.95 1.15
SBIN ######## 19-Oct-20 205.35 204 1.35
SBIN ######## 20-Oct-20 204.05 203.05 1
SBIN ######## 21-Oct-20 204.7 203.75 0.95
SBIN ######## 22-Oct-20 204.65 203.3 1.35
SBIN ######## 23-Oct-20 203.85 202.8 1.05
SBIN ######## 26-Oct-20 197.55 196.7 0.85
SBIN ######## 27-Oct-20 195.5 194.65 0.85
SBIN ######## 28-Oct-20 191 190.45 0.55
SBIN ######## 29-Oct-20 189.35 188.7 0.65
SBIN ######## 30-Oct-20 189.95 189.25 0.7
SBIN ######## ######## 196.85 196.05 0.8
SBIN ######## ######## 205.35 204.75 0.6
SBIN ######## ######## 208.15 207 1.15
SBIN ######## ######## 219.15 218.65 0.5
SBIN ######## ######## 219.25 219.2 0.05
SBIN ######## ######## 220.5 219.5 1
SBIN ######## ######## 232.6 231.7 0.9
SBIN ######## ######## 234.55 234.2 0.35
SBIN ######## ######## 227.8 226.8 1
SBIN ######## ######## 230.25 229.45 0.8
SBIN ######## ######## 229.6 229.65 -0.05
SBIN ######## ######## 240.3 240.2 0.1
SBIN ######## ######## 252.2 252 0.2
SBIN ######## ######## 240.35 239.75 0.6
SBIN ######## ######## 242.7 242.75 -0.05
SBIN ######## ######## 238.85 238.7 0.15
SBIN ######## ######## 243.9 243.85 0.05
SBIN ######## ######## 242.7 243 -0.3
SBIN ######## ######## 245.45 245.45 0
Convergence of Futures Price to Spot Price…
“spot price is higher than future price”
 Assume that the spot price is higher than the future
price during the delivery month.
 Arbitrage opportunity:

◦ Sell the asset

◦ Long a futures contract

◦ Get delivery
 Since spot price is greater than the future price the
investor makes a profit
Convergence of Futures Price to Spot Price…
“future price is higher than the spot price”

 Assume that the future price is higher than the spot

price during the delivery month.
 Arbitrage opportunity:

◦ Buy the asset

◦ Short a futures contract

◦ Make delivery
 Since future price is greater than the spot price the
investor makes a profit
Stock Futures Prices
PRICING FUTURES
 Pricing of futures contract is very simple. Using the cost-
of-carry logic, we calculate the fair value of a futures
contract.
 The cost of carry model used for pricing futures is given
below

◦ F = Sert
F = future price R = cost of financing
S = Spot price T = time to expiration
PRICING FUTURES
 Security XYZ Ltd trades in the spot market at Rs. 1150.
Money can be invested at 11% p.a. The fair value of a 1-
month futures contract on XYZ is calculated as follows.

F = Sert
F = 1150 * e 0.11* 1/12
F = 1160.444404
PRICING FUTURES of dividend paying
stock
 Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be
invested at 11% p.a. The fair value of a 1-month futures contract on
XYZ is calculated as follows.
 Let us assume that XYZ Ltd. will be paying a dividend of Rs.20 per
share after 15 days.

F = Sert – DerT ………(T=t-time to pay dividend)

 F = 1150 * e 0.11* 1/12 -20 * e 0.11* 15/365
 F = 1140.353788
Pricing - Index futures
 A futures contract on the stock market index gives its owner the right
and obligation to buy or sell the portfolio of stocks characterized by
the index
 Stock index futures are

◦ Cash settled

◦ There is no delivery of the underlying stocks

 The main differences between commodity and equity index futures are
that:

◦ There are no costs of storage involved in holding equity.

◦ Equity comes with a dividend stream.

Pricing index futures
 Nifty futures trade on NSE as one, two and three-month contracts.
Money can be borrowed at a rate of 10% per annum. What will be the
price of a new two-month futures contract on Nifty?

◦ Current value of Nifty is 4000 and with a multiplier of 100

◦ F = 4000*e0.1*60/365

◦ F = 4066.296837
Pricing index futures given expected
dividend amount
 Nifty futures trade on NSE as one, two and three-month contracts.
Money can be borrowed at a rate of 10% per annum. What will be the
price of a new two-month futures contract on Nifty?

◦ Let us assume that ABC Ltd. will be declaring a dividend of Rs.20

per share after 15 days of purchasing the contract

◦ Current value of Nifty is 4000 and with a multiplier of 100

◦ ABC Ltd. Has a weight of 7% in Nifty.

◦ Market price of ABC Ltd. Is Rs.140

Pricing index futures given expected
dividend amount
 Current value of Nifty is 4000 and with a multiplier of 100, value of
the contract is 100*4000 = Rs.400,000
 If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is
Rs.28,000 i.e.(400,000 * 0.07).
 If the market price of ABC Ltd. Is Rs.140, then a traded unit of Nifty
involves 200 shares of ABC Ltd. i.e. (28,000/140).
 F = Sert - ()
 F = 4000*e0.1*60/365 - () = 4025.8
If expected dividend given in yield
 F = Se(r – q)t
F futures price
 S spot index value
 r cost of financing
 q expected dividend yield
 T holding period
If expected dividend given in yield
A 2 -month futures contract trades on the NSE. The cost of
financing is 10% and the dividend yield on Nifty is 2%
annualized. The spot value of Nifty 4000. What is the fair
value of the futures contract
F = Se(r – q)t
F = 4000e(.1 – .02) 60/365
 Rs.4052.95
PARTICIPANTS IN
THE DERIVATIVES
MARKETS
PARTICIPANTS

PARTICIPANTS

Hedgers Speculators Arbitrageurs

Speculators
 These are individuals who take a view on the future
direction of the markets.
 They take a view whether prices would rise or fall in
future and accordingly buy or sell futures and options to
try and make a profit from the future price movements of
the underlying asset
Arbitrageurs
 They take positions in financial markets to earn riskless
profits. The arbitrageurs take short and long positions in
the same or different contracts at the same time to create a
position which can generate a riskless profit
Hedgers

These are investors with a present or anticipated

exposure to the underlying asset which is subject
to price risks.
Hedgers use the derivatives markets primarily for
price risk management of assets and portfolios
Hedging with futures Vs Forward

Hedging with Benefits Issues

Centralized trading and

Futures Basis Risk
liquidity

Forward Fulfill actual need Default Risk

Basis Risk
Basis risk

 Basis: The Spot price minus future price

 Basis risk: Risk of change in basis

1. Hedger may be uncertain as to the exact date when

asset is bought or sold.

2. Hedge may require the futures contract to be closed out

well before its expiration date.
Long hedge

 Mr. X. is a gold Importer.

 He is expecting to Pay 1,00,000$ in month of March.
 Jan price of spot USDINR is 60 and price in Feb of
march Contract USDINR is 65.
 So he is worried about change in price.
 Now he wants to transfer price risk, means he want to
hedge.
 Basis-up

UP Basis-nc

Basis-
dw

Price NC Basis-nc

Basis-up

DOWN Basis-nc

Basis-
dw
 Long Hedge case 1 (No change in basis)
 Suppose that

S1 : Final Asset Price (60)

5

F1 : Initial Futures Price (65)

S2 : Final Asset Price (65) 5

F2 : Final Futures Price (70)

 You hedge the future purchase of an asset by entering into a

long futures contract

 Cost of Asset= F1 - (F2 - S2) = F1 - Basis (b2) = 65 - (70 – 65)

 Long Hedge case 2 (No change in basis)
 Suppose that

S1 : Final Asset Price (60)

5

F1 : Initial Futures Price (65)

S2 : Final Asset Price (40) 5

F2 : Final Futures Price (45)

 You hedge the future purchase of an asset by entering into a

long futures contract

 Cost of Asset= F1 - (F2 - S2) = F1 - Basis (b2) = 65 - (45 – 40)

 Long Hedge case 3 (Increase in basis)
 Suppose that

S1 : Final Asset Price (60)

5

F1 : Initial Futures Price (65)

S2 : Final Asset Price (65) 10

F2 : Final Futures Price (75)

 You hedge the future purchase of an asset by entering into a

long futures contract

 Cost of Asset= F1 - (F2 - S2) = F1 - Basis (b2) = 65 - (75 – 65)

 Long Hedge case 4 (Increase in basis)
 Suppose that

S1 : Final Asset Price (60)

5

F1 : Initial Futures Price (65)

S2 : Final Asset Price (40) 10

F2 : Final Futures Price (50)

 You hedge the future purchase of an asset by entering into a

long futures contract

 Cost of Asset= F1 - (F2 - S2) = F1 - Basis (b2) = 65 - (50 – 40)

 Long Hedge case 5 (Decrease in basis)
 Suppose that

S1 : Final Asset Price (60)

5

F1 : Initial Futures Price (65)

S2 : Final Asset Price (65) 2

F2 : Final Futures Price (67)

 You hedge the future purchase of an asset by entering into a

long futures contract

 Cost of Asset= F1 - (F2 - S2) = F1 - Basis (b2) = 65 - (67 – 65)

 Long Hedge case 6 (Decrease in basis)
 Suppose that

S1 : Final Asset Price (60)

5

F1 : Initial Futures Price (65)

S2 : Final Asset Price (40) 2

F2 : Final Futures Price (42)

 You hedge the future purchase of an asset by entering into a

long futures contract

 Cost of Asset= F1 - (F2 - S2) = F1 - Basis (b2) = 65 - (67 – 65)

Short hedge

Today is March 1. A US company expects to get 50

million Japanese yen at the end of July.

Contract size= 12.5 million yen

Future price (September ) on March 1= 0.7800 cents/yen

Company enters September Future.

In July when the Yen is received the spot and futures price
are 0.7200 and 0.7250 cents/Yen respectively.

Payoff?
 Short 4 contracts

In the spot market sell Yen @ 0.7200 cents /yen

Gain from futures contract= 0.7800-0.7250 cents/Yen=0.0550

cents/ Yen

Therefore effective price obtained per yen = 0.7200 + 0.0550 =

0.7750 cents/Yen

______________________

Alternatively.

Basis when the contract is closed out = 0.7250 - 0.7200 =

0.0050

F1 - b2= 0.7800-0.0050=0.7750 cents/Yen

Long hedge
 Its June 8. A company needs to purchase 20,000 barrels
of crude in Oct/Nov. Contract size is 1000 barrels
 On June 8, December contract future price is $18.00 per
barrel. Company buys 20 contracts (long)
 On Nov 10 company decides to purchase the crude oil.
The spot and futures price are $20.00 and $19.10 per
barrel respectively.
 payoff
In the spot market buy crude @ $20.00 per barrel

Gain from futures contract= $19.10-$18.00$ per barrel = $1.10

per barrel

Therefore effective price paid per barrel = $20.00 - $1.10= $

18.90 per barrel

_____________________________

Alternatively.

Basis when the contract is closed out = $19.10 - $20.00 =

-$0.90

F1 - b2= $18 + $0.90 =$ 18.90 per barrel

Contango

On account of the cost of carry, futures price is

higher than the spot price of the same underlying
i.e. basis is positive. Such a relative price position
is called contango
Backwardation

Some times, extremely bearish market situations

or any technical factors, the futures price may be
trading lower than the spot price of the same
underlying. In such situations, the stock is said to
be in backwardation
Hedging
Long security, sell futures
Hedging: Long security, sell futures
 Lets take an example:
 An investor who holds the shares of a company and gets
uncomfortable with market movements in the short run.
 He expects that security falling from Rs.450 to Rs.390.

◦ In the absence of stock futures, he would either suffer

the discomfort of a price fall or sell the security in
anticipation of a market upheaval
 With security futures he can minimize his price risk.
Hedging: Long security, sell futures
 Take offsetting stock futures position. Means a short futures
position.
 Assume that spot price is 450 and two month futures is
490.
 Current position of investor is long security @ 450 and
sell futures @ 490.
 Lets take a case price of his security falls to Rs.390, The fall in
the price of the security will result in a fall in the price of futures
 Futures price will be 430 (Approx)
 Loss in spot hedge by futures
 Warning: it also stop our profit
Speculation
Bullish security, buy futures
A speculator who has a view on the direction of the
market.
 He would like to trade based on this view.
 He believes that a particular security that trades at Rs.1000
is undervalued and expect its price to go up in the next
two-three months.
 In the absence of a derivatives product, he would have to
buy the security and hold on to it.
 Lets see how its works
Without derivative
 Assume he buys a 100 shares which cost him one lakh
rupees.
 His hunch proves correct and two months later the security
closes at Rs.1010.
 He makes a profit of Rs.1000 on an investment of Rs.
1,00,000 for a period of two months.
 This works out to an annual return of 6 percent.
With derivative
 Today a speculator can take exactly the same position on the security
by using futures contracts.
 Let us see how this works. The security trades at Rs.1000 and the two-
month futures trades at 1006.
 He buys 100 security futures @ 1006 for which he pays a margin of
Rs.20,000.
 Two months later the security closes at 1010.
 On the day of expiration, the futures price converges to the spot price
and he makes a profit of Rs.400 on an investment of Rs.20,000.
 This works out to an annual return of 12 percent
Speculation
Bearish security, sell futures
Without derivative
 Stock futures can be used by a speculator who believes
that a particular security is over-valued and is likely to see
a fall in price.
 How can he trade based on his opinion?
 In the absence of a derivatives product, he can earn profit
only if he has shares, if yes he can sell shares now and but
after 2 month at a cheaper price
With derivative
 He sells one two-month contract of futures on ABC at
Rs.240 (each contact for 100 underlying shares). He pays a
small margin on the same.
 Two months later, when the futures contract expires, ABC
closes at 220.
 He has made a clean profit of Rs.20 per share.
 For the one contract that he bought, this works out to be
Rs.2000.
Arbitrage
Overpriced futures: buy spot, sell
futures
 If you notice that futures on a security that you have been
observing seem overpriced, how can you cash in on this
opportunity to earn riskless profits
 ABC Ltd. trades at Rs.1000. One-month ABC futures
trade at Rs.1025 and seem overpriced.
 As an arbitrageur, you can make riskless profit by entering
into the following set of transactions.
 On day 1, borrow funds, buy the security on the spot market at 1000.
 Simultaneously, sell the futures on the security at 1025.
 Hold the security for a month.
 On the futures expiration date give delivery at Rs.1025.
 Return the borrowed funds @ 1000
 Profit of Rs.25.
Arbitrage
Underpriced futures: buy futures, sell
spot
 If you notice that futures on a security that you have been
observing seem underpriced, how can you cash in on this
opportunity to earn riskless profits
 ABC Ltd. trades at Rs.1000. One-month ABC futures
trade at Rs.965 and seem underpriced.
 As an arbitrageur, you can make riskless profit by entering
into the following set of transactions.
 Arbitrager can earn profit only if he has shares/commodity
 On day 1, sell the security on the spot market at 1000.
 Simultaneously, buy the futures on the security at 965.
 Invest 1000 rupee in debt market and earn 10 rupee interest (assumed)
 Hold the security for a month.
 On the futures expiration date take delivery at Rs.965. and make a
payment of 965
 Profit of Rs.45.
That’s all for the DAY!!!