Financial

Markets &
Institutions
Module IV: Introduction to Derivatives
 Objective
• To understand definitions and terminologies of
basic derivatives (forwards, futures, options)
• To learn about the need for derivatives
markets
• To know the various participants in this market
and their roles
• To gain an initial overview into derivatives
trading on Indian exchanges, including the
instruments available; the trading, clearing
and settlement mechanism; and the
margining requirements
 DERIVATIVES
Financial Derivatives explained -
https://www.youtube.com/watch?v=nf9ByTdX0aY
 DERIVATIVES
An instrument, that DERIVES its value, from
the price of another underlying asset.
Example:

The value of a Infosys Stock future will derive its value from the value of
the underlying Infosys stock.

Features:

• It is a financial instrument
• It derives its value from another asset
• The other asset is called the underlying asset
• The movement in price of underlying asset directly affects its value.
 Types of Derivatives
Forwards
Futures
Options
 Forward contracts
 Customized contract entered into between
two parties, also called “Over the counter”
contract (OTC contract)
 For the purchase (“long”) or sale (“short”)
 Of an agreed quantity of an asset (“the
underlying”)
 At an agreed price (“Forward rate”)
 To be settled on a specific date in the
future (“expiry date”)
 Forward contracts – example
Long 1 million US Dollar forward at INR 81.45 for settlement on 30
October 2022:

Scenario:
On 1 August 2022, an importer imports goods worth US$ 1 million
on 3 months credit. He has to pay the supplier 1 million USD on
30.10.2022.
To hedge against risk of INR falling against the USD, the importer
will enter into above forward contract.

Key terms explained:

LONG: Indicates buy. He will buy USD on settlement
1 million US Dollar: Underlying asset
INR 81.45/1 USD: Forward rate

On maturity????
Forward contracts – example
Long 1 million US Dollar forward at INR 81.45 for
settlement on 30 October 2022:

On maturity:
Importer’s bank will sell him USD 1 million at INR 81.45
which he will pay to his US supplier. Thus, his outflow is
fixed.

Protection against rate change:

Had the forward contract not been entered into, he
will be liable to buy USD 1 million on 30.10.2022 at
market price, which might be higher than INR 81.45.
He thus hedges his risk.
 Forward contracts - example
SHORT 10 MILLION BARRELS CRUDE OIL FORWARD CONTRACTS @ USD
81.45 PER BARREL 30TH NOVEMBER, 2022

Scenario:
On 1 October 2022, a crude oil producer will be producing 10 million
barrels of crude oil over the next two months. He intends to export this
entire lot to US, and hopes to get at least USD 81.45 per barrel, which
is the current expected market price.
He might enter into shorting the above contract to hedge the risk of
falling prices in the future; he would need a certainty as regards his
selling price.

Key terms explained:

SHORT: Indicates sell. He will sell the crude oil on settlement
10 million barrels crude oil: Underlying asset
INR 81.45 per barrel: Forward rate
 Forward contracts - example
SHORT 10 MILLION BARRELS CRUDE OIL
FORWARD CONTRACTS @ USD 81.45 PER BARREL
ON 30TH NOVEMBER, 2022
On maturity:
The producer will sell the crude oil at the
agreed value of USD 81.45 per barrel,
Protection against price change:
Had the forward contract not been entered
into, he may have to sell the oil barrels at the
prevailing market price, which could be than
the forward rate of USD 81.45. He thus hedges
his price risk.
 Forward contracts - example
Suppose ABC Ltd. has borrowed $ 1,00,000 on 10th
Aug, 2022 for a period of one year from StanC at 10%
p.a. interest payable annually. It wants to hedge its
exposure using forward contracts. Spot rate is Rs.68/$.
Forward cover (9th Aug) Rs.70/$ is available.
Calculate the net cash flow at the time of repayment
of the loan under no hedging and hedging under
forward contracts if following rates prevailed on 9th
Aug, 2023:
Cash 1$=Rs.73
Forward cover (9th Aug) Rs.71/$
 Forward contracts - example
Net cash flow in rupees on 9th Aug, 2022 shall be as
under -
• If $ exposure is unhedged,
1,00,000*(1.10)*73 = Rs. 80,30,000

• If $ exposure is hedged using forward contracts,

1,00,000*(1.10)*70 = Rs. 77,00,000

Thus, the cash outflow on account of hedging is lesser

than the unhedged position.
 Future contracts
Standardised contract entered into between
two parties
For the purchase (“long”) or sale (“short)
Of an agreed quantity of an asset (“the
underlying”)
At an agreed price (“Future rate”)
To be settled on a specific date in the future
(“expiry date”)
https://www.youtube.com/watch?v=FLGRPYAtR
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https://www.youtube.com/watch?v=zeaLB9dIc7
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 Future contracts - example
Long 1 million US Dollar future at INR
81.45: 1 USD for settlement 30 October
2022:

Short 10 million barrels Crude oil future

contracts @ USD 81.45 per barrel on
30th November, 2022
 Forward contracts v/s
Future contracts
Customised contract v/s Standardised contracts
(underlying quantity, dates)
No guarantee or security v/s Backed by
exchange
No daily settlement v/s daily MTM settlement
Not regulated v/s regulated by SEBI
Less liquid / more liquid
Physical settlement v/s cash settlement
https://www.youtube.com/watch?v=3bPRN_Gh
HiY
Live market data – NIFTY INDEX FUTURES
Future contracts – real life example
Future contracts – real life example
Tick size is the minimum price change between
different bid and offer prices of an asset traded on an
exchange platform.
It is the minimum price difference that must exist at all
times between consecutive bid and offer prices.
In other words, it is the minimum increment in which
prices can change.
Key words and nomenclature used
Underlying : The underlying asset on which the Futures
contract is based

Spot price : current market price of the underlying

Future price : current market price of the Futures contract

on the underlying

Expiry date : last day on which the contract is traded

Basis : difference between the current Futures price and

current spot price

Spread : difference between the Futures prices of two

different expiry dates
Futures – Settlement options
Physical settlement
Seller gives physical delivery of the underlying asset at the time of the
expiry

Cash settlement
Difference between the closing price of the future contract at the time
of expiry and the transacted price

To illustrate -
SBIOCT2022 was transacted at Rs 274.45 per unit on 9th Oct, 2022
“B” bought the contract and “S” sold the contract

If the closing price of SBIOCT2022 was Rs 276.65, then

“B” would be credited with Rs 2.2 at the time of settlement
“S” would be debited with Rs 2.2 at the time of settlement
(Additionally both “B” and “S” would be debited for transaction costs)

Equity futures in India are now physically settled only Index Futures are
cash settled
 Illustration 1
o “A” purchased SBI future and held till expiry
• Underlying asset : SBI stock
• Asset purchased : SBI30Jul2022 Future contract
• Quantity : 1000 units
• Date of purchase : 8th July 2022
• Purchase price : Rs 269.8 per unit
• Date of expiry of the futures contract : 30th July 2022
• Closing price of the futures contract on the date of expiry :
Rs 275 per unit
• Transaction costs on purchase and sale : Re 0.2 per unit
o Net gain by “A” : (275 – 269.8 -0.2 = 5)
• Rs 5 per unit * 1000 units = Rs 5,000
 Illustration 2
o “B” sold SBI future and held till expiry
• Underlying asset : SBI stock
• Asset purchased : SBI30Jul2022 Future contract
• Quantity : 1000 units
• Date of purchase : 8th July 2022
• Sale price : Rs 269.8 per unit
• Date of expiry of futures contract : 30th July 2022
• Closing price of the futures contract on the date
of expiry : Rs 275 per unit
• Transaction costs on purchase and sale : Re 0.2
per unit
o Net loss by “B” : (269.8 – 275 – 0.2 = -5.4)
• Rs 5.4 per unit * 1000 units = Rs 5400
Exit before the expiry date
• A buyer has two options. He can choose to:
o Hold on to the Futures contract till expiry date, or
o Sell the contract prior to the expiry date

Futures contracts trade in the secondary market in a manner similar to

the underlying assets

• Likewise a seller can also exit from his ‘sell”

position prior to the expiry by buying Futures
contract
o Note that in the Futures markets, it is allowed to sell first and buy
later
o In case of spot equity markets in India, selling first and buying later is
allowed only on “intra day” basis. Open “sell” positions cannot be
carried to the next trading day without giving delivery of the asset.
 Illustration
o “C” purchased SBI future and sold before expiry
• Underlying asset : SBI stock
• Asset purchased : SBI30Jul2022 Future contract
• Quantity : 1000 units
• Date of purchase : 8th July 2022
• Purchase price : Rs 269.8 per unit
• Date of sale of the futures contract : 23th July 2022
• Sale price : Rs 273 per unit
• Transaction costs on purchase and sale : Re 0.2 per unit
o Net gain by “C” : ( 273 – 269.8 – 0.2= 3)
• Rs 3 per unit * 1000 units = Rs 3000
 Illustration
o “D” sold SBI future and bought back before expiry
• Underlying asset : SBI stock
• Asset purchased : SBI30Jul2022 Future contract
• Quantity : 1000 units
• Date of sale : 8th July 2022
• sale price : Rs 269.8 per unit
• Date of buying back of the futures contract :
22nd July 2022
• Purchase price : Rs 272 per unit
• Transaction costs on purchase and sale : Re 0.2
per unit
o Net loss by “D” : ( 269.8 – 272 – 0.2= -2.4 )
• Rs 2.4 per unit * 1000 units = Rs 2400
 Illustration
“E” buys the underlying stock and sells the future contract
simultaneously, positions are squared off on expiry
 Asset purchased: SBI stock
 Quantity : 1000 shares
 Asset sold : SBI30Jul2022 Future contract
 Quantity : 1000 units
 Date of purchase of the underlying stock: 8th July 2022
 Date of sale of the future contract : 8th July 2022
 Purchase price of the underlying stock: Rs 266.8 per share
 Sale price of the future: Rs 269.8 per unit
 Date of expiry of the futures contract : 30th July 2022
 Closing price of the futures contract on the date of expiry : Rs 275
 Closing price of the underlying stock on the date of expiry : Rs 275
 Transaction costs on the underlying stock : Re 0.8
 Transaction costs on the future contract : Re 0.2
 Illustration (solution)
o “E” buys the underlying stock and sells the future contract
simultaneously, positions are squared off on expiry

• Gain on the underlying stock : ( 275 – 266.8 – 0.8 = 7.4)

o Rs 7.40 per share * 1000 shares = Rs 7400
• Loss on the future contract : ( 269.8 – 275 – 0.2 = -5.4)
o Rs 5.4 per unit * 1000 units = Rs 5400
• Net gain on both the “legs” of the transaction : Rs 7400 – Rs
5400 = Rs 2000

• Simpler way to calculate the net gain : ( 269.8 – 266.8 – 0.8 -

0.2 = 2), ( sale price of the future – purchase price of the stock
– transaction costs)
o Rs 2 per unit/share * 1000 units/shares = Rs 2000

• (note : the closing prices on the date of expiry for both the underlying stock
and the future contract need to be identical)
 Illustration
“F” buys the underlying stock and sells the future contract
simultaneously, positions are squared off prior to expiry
 Asset purchased: SBI stock
 Quantity : 1000 shares
 Asset sold : SBI30Jul2022 Future contract
 Quantity : 1000 units
 Date of purchase of the underlying stock: 8th July 2022
 Date of sale of the future contract : 8th July 2022
 Purchase price of the underlying stock: Rs 266.8 per share
 Sale price of the future: Rs 269.8 per unit
 Date of squaring off : 23rd July 2022
 Purchase price of the futures contract on the date of square off :
Rs 273
 Sale price of the underlying stock on the date of square off : Rs 272
 Transaction costs on the underlying stock : Re 0.8
 Transaction costs on the future contract : Re 0.2
 Illustration (solution)
o “F” buys the underlying stock and sells the future contract
simultaneously, positions are squared off prior to
expiry
• Gain on the underlying stock : ( 272 – 266.8 – 0.8 = 4.4)
o Rs 4.4 per share * 1000 shares = Rs 4400
• Loss on the future contract : ( 269.8 – 273 – 0.2 = -3.4)
o Rs 3.4 per unit * 1000 units = Rs 3400

• Net gain on both the “legs” of the transaction : Rs 4400 –

Rs 3400 = Rs 1000
 Futures on Stocks as well
as Indices
• Exchanges offer Futures contracts on various stocks
as well as indices
• Indices include
o Broad market indices such as Nifty and BSE Sensex
o Sector indices such as Banks, FMCG etc.
o Thematic indices such as volatility linked indices
o Select global indices such as S&P 500
 Contango vs
backwardation
• Usually, price of a future contract is higher than the
expected future spot price of the underlying asset.
This market situation for the asset is called
Contango.

• At times the price of a Future contract is less than

the expected future spot price of the underlying.
Such a market situation is called backwardation.
Contango vs Backwardation
• A contango market simply means that the futures
contracts are trading at a premium to the spot price. For
example, if the price of a crude oil contract today is $100 per
barrel, but the price for delivery in six months is $110 per barrel,
that market would be in contango.
• On the other hand, if crude oil is trading at $100 per barrel for
delivery right now, and the six month contract is trading at $95
per barrel, then that market would be said to be in
backwardation.
• Contango and backwardation are curve structures seen in
futures markets based on several factors. It is important to
remember that the futures price eventually converges on the
spot price. In other words, any gaps between the futures price
and the spot price will close as contract expiration nears.
 Concept of short position and
long position in equity futures
• Creating a short position – selling when
delivery is not required to be given
o Selling a future contract does not require giving delivery, hence
always a “short” position

• Creating a long position – buying when not

required to make full payment
o Buying a future contract does not require making full payment of
the notional value, hence it is creating a “long” position. Only the
margin amount needs to be paid.
 Open position
• Open position is created when
o Either a future contract is bought,
o Or, a future contract is sold

• A “long” open position means a future contract has

been bought
• A “short” open position means a future contract has
been sold
 Open position - examples
• “A” purchases Reliance27AUG2022 on 12th Aug, 2022
and holds it till expiry
o “A” has long open position in reliance future till 27th August 2022
• “B” purchases SUN24Sep2022 on 25th Aug, 2022 and
sells it on 3rd Sep, 2022.
o “B” has long open position in Sun between 25th Aug,2022 and 3rd Sep,2022
• “C” sells TATASTEEL24Sep2022 on 28th Aug, 2022 and
holds it till maturity
o “C” has short open position is Tata Steel from 28th Aug, 2022 till 24th Sep,
2022.
• “D” sells NIFTY27AUG2022 on 20th Aug, 2022 and buys
back on 22nd Aug, 2022
o “D” has short open position in Nifty between 20th Aug, 2022 and 22nd Aug,
2022.
Open position - examples
• “A” purchases 1 lot of Nifty 24Sep22 future
contract (lot size : 25 units) @ Rs 8000 per unit
and holds it till expiry
o “A” has long open position in Nifty till 24th Sep 2022
o Notional value of the contract is 25 * 8000 = Rs 2,00,000
o “A” is not required to pay the total notional value
o “A” is required to keep a certain sum/deposit/margin , which is a
fraction of the notional value ; with the broker while the position
remains open
Open position - examples
• “B” sells 1 lot of Reliance 24Sep22 future @
Rs 1,500 (lot size; 400 units) and holds the
contract till expiry
o “B” has short open position in Reliance till 24th Sep
o Notional value of the contract is 400*1500 = Rs 6,00,000
o “B” is not required to deliver any share of Reliance
o “B” does not receive notional value as consideration for the sale
o “B” is required to keep a certain sum/deposit/margin , which is
fraction of the total value; with the broker while the position
remains open
o Note that in case of short position,
• seller is required to pay for the margin, seller does not receive
any funds ; while the position is remains open
 Closing an open position
or squaring off
• When one position is “open”, taking an offsetting
position is called closing the open position or
squaring off the open position
o “A” purchases NIFTY24SEP2022 on 26th Aug, 2022.
o Now “A” has created open long position in Nifty
o Subsequently, “A” sells NIFTY24SEP2022 on 28th Aug, 2022. This is
called
• “A” has closed the open long position on 28th August, or
• “A” has squared off open long position on 28th August

o Likewise
• if “B” sells Reliance Sep22 future on 26th August, “B” has
created open short position.
• Subsequently, “B” buys Reliance Sep22 future on 28th August.
• B has closed / squared off the short position.
Closing / squaring off on expiry
• On the expiry day of a future contract, all
open positions automatically are closed or
squared off
o “A” created long position in Nifty on 29th Aug with Nifty 24Sep
future
o “A” did not take the offsetting position, ie the short position in
Nifty Sep future; till 24th Sep ie the day of the expiry of the future
contract. In other words, “A” held the long position till expiry
o The future contract expired on 24th Sep, 2022
o In “A” ‘s account, automatically offsetting position ( ie short
position) would get taken on the day of the expiry. The price
would be the settlement price for the future contract, which is
same as the closing price of Nifty on the day of the expiry
 Booking of profits
• When a position is closed, profits/losses get booked
o Long position on Nifty Sep future contract got created for 2 lots ( 25 units
per lot) @ 8012 on 31st Aug.
o The position was closed/ squared off on 5th Sep @ 7912
• Selling price = Rs 7912 per unit
• Purchase price = Rs 8012 per unit
• Loss = Rs 100 per unit
• Quantity = 2 lots * 25 units per lot = 50 units
• Loss = Rs 100 * 50 = Rs 5000
 Booking of profits/losses -
examples
• Short position on a stock future got created @ Rs 102. The position was reversed 3
days later @ Rs 99. What was profit/loss booked per unit?
• Gain of Rs. 3 per unit
• Long position on a Nifty future got created @ Rs 8015 and position was closed with
profit of Rs 102 per unit. At what price was the position closed ?
• Closed at 8117
• Short position on Nifty future was taken @ 8050 and was held till expiry. The closing
value of Nifty on the day of expiry was 7800. What was profit/loss booked per unit?
• Gain Rs. 250 per unit
• Long position on a stock future was held till expiry and resulted in loss of Rs 50 per
unit. What was the closing price of the underlying stock on the day of the expiry , if
the position was created @ Rs 115 per unit?
• Closed at Rs. 65 per unit
• Basis was Rs 4 and the underlying was Rs 100 on a day when a short position was
created. The position was squared off when the basis was Rs 2 and the stock went
down by 10% from the level on the day the position was created. What was
profit/loss booked per unit ?
• Gain Rs. 12
 Initial Margins
• 1000 contracts of SBI30JUL2022 between a buyer (B) and a
seller (S) at Rs 269.8

• The value of the transaction is Rs 2,69,800; called “notional

value”

• Both buyer and seller have to pay a certain percentage of the

notional value to be able to initiate the trade. This is called
initial margin.

• Initial margin consists of

o SPAN margin – SPAN (Standard Portfolio Analysis of Risk) method is
developed Chicago Mercantile Exchange and an accepted norm by
many exchanges globally
o Exposure margin – to cover for additional loss situations not covered
through SPAN margin
o Exchange shares margin calculation with the broker on daily basis for the
trades executed
 Initial margins
• Initial margin for F&O segment is calculated on a portfolio (a collection of futures and
option positions) based approach. The margin calculation is carried out using a software
called - SPAN® (Standard Portfolio Analysis of Risk).
• It is a product developed by Chicago Mercantile Exchange (CME) and is extensively
used by leading stock exchanges of the world.
• SPAN® uses scenario based approach to arrive at margins.
• Value of futures and options positions depend on, among others, price of the security in
the cash market and volatility of the security in cash market.
• As you would agree, both price and volatility keep changing. To put it simply, SPAN®
generates about 16 different scenarios by assuming different values to the price and
volatility.
• For each of these scenarios, possible loss that the portfolio would suffer is calculated.
• The initial margin required to be paid by the investor would be equal to the highest loss
the portfolio would suffer in any of the scenarios considered.
• The margin is monitored and collected at the time of placing the buy / sell order.
• The SPAN® margins are revised 6 times in a day
o – once at the beginning of the day,
o 4 times during market hours and
o finally at the end of the day.

Obviously, higher the volatility, higher the margins.

 Exposure margin
• In addition to initial / SPAN® margin, exposure
margin is also collected.
• Exposure margins in respect of index futures and
index option sell positions is 3% of the notional value.
• For futures on individual securities and sell positions
in options on individual securities, the exposure
margin is higher of 5% or 1.5 standard deviation of
the LN returns of the security (in the underlying cash
market) over the last 6 months period and is applied
on the notional value of position.
 Initial margin - example

• 3 lots of Nifty Sep22 future are purchased @ 8000. If

the initial margin required is 12%, compute the funds
required in client’s account before initiating the
trade.(lot size : 25 units)
o Notional value = 3 * 25 * 8000 = Rs 6,00,000
o Initial margin = 0.12 * 600000 = Rs 72,000
 Initial margin - example
• 2 lots of Reliance Sep22 future are purchased @
1500. If the initial margin required is 25%, compute
the funds required in client’s account before
initiating the trade.(lot size : 400 units)
o Notional value = 2 * 400 * 1500 = Rs 12,00,000
o Initial margin = 0.25 * 12,00,000 = Rs 3,00,000
 “Marking-to-market”
(MTM) of open position
• “A” has purchased NIFTY24SEP2022 on 28th Aug, 2022 for 7950 and will
hold the future contract till expiry.

• “A” has open long position in Nifty from 28th Aug, 2022 onwards.

• If closing price of NIFTY24SEP2022 on

o 10th Sep,2022 is 8020, then the “mark-to-market” profit on the open position of “A” is
Rs 70 per unit.

o 11th Sep,2022 is 8040, then the “mark-to-market” profit on the open position of “A” is
Rs 90 per unit.

o 20th Sep,2022 is 7930, then the “mark-to-market” loss on the open position of “A” is
Rs 20 per unit.

• Note that these profits/losses are notional – not booked as profits or losses
in the books of accounts of “A”.

• This future contract is held till expiry. Hence,

o If the closing price of NIFTY24SEP2022 on the date of expiry is 8010 then the profit booked is
Rs 60 per unit.
 Margins on ongoing basis
• MTM (Marked To Market) margin is levied to cover any
MTM loss on an open position.
• MTM margin is levied/ adjusted daily

• MAINTENANCE MARGIN :
• Minimum margin required to keep a position open at
any point in time.

• MARGIN CALL :
• In case client’s margin drops below the minimum
acceptable level ie the maintenance margin then
broker makes a ‘margin call” on the client. It is also
called ”Variation Margin”
o Client is given a time limit within which to give fresh funds, else
o Broker squares off client’s position to recover the MTM loss
 Example on margin for futures
• “A” buys 10 lots INFY24SEP2022 @Rs.1,100 on 31stAug,
2022. Lot size: 250 units
• Calculate the notional value of the contract
o 10* 250 * 1100 = Rs 27.50 lacs

• If the initial margin on INFY is 25% , how much would “A”

need to pay the broker to initiate the position ?
o Apply margin % on the notional value -- > 0.25* 27.5 = Rs 6,87,500

• Maintenance margin is 15%. What is the minimum credit

balance “A” needs to keep in the margin account with
the broker ?
o .15* 27,50,000 = Rs 4,12,500

• The closing price of the future contract on 1st Sep is 1105.

What is the credit balance in “A” ‘s margin account ?
o Rs 6,87,500 + (1105 – 1100) * 250 * 10 = Rs 7,00,000
 Example on margin for futures (contd)
• The closing price of the future contract on 2nd Sep is
1092. What is the credit balance in “A” ‘s margin
account ?
o Rs 7,00,000 + (1092 – 1105) * 250 * 10 = Rs 6,67,500

• Alternatively, credit balance in the margin account

on 2nd Sep can be calculated as
o Rs 6,87,500 + (1092 – 1100) * 250 * 10 = Rs 6,67,500

• On 5th Sep, price drops to 980. What’s credit balance?

o Rs 6,87,500 + ( 980 – 1100) * 250 * 10 = Rs 3,87,500

• Is the maintenance margin level breached ?

o Yes.

• Will broker make a margin call ?

o Yes.
Example on margin for futures (contd)
• How much does “A” need to pay the broker to make
up the credit balance in the margin account ?
o Rs 6,87,500 – Rs 3,87,500 = Rs 3,00,000

• In case “A” is unable to pay this amount, how many lots

should the broker sell to make the margin account
regular ?
o Just enough to get credit balance @ 25% of the notional value of the open
position
o By selling 4 contracts , open position will reduce to 6 contracts
• Margin required = 0.25 * 6 * 250 * 1100 = Rs 4,12,500
• Balance available is Rs 3,87,500.
• Hence , selling 4 contracts is not enough
o By selling 5 contracts, open position will reduce to 5 contracts
• Margin required = 0.25 * 5 * 250 * 1100 = Rs 3,43,750
• Balance available is Rs 3,87,500.
• Hence , selling 5 contracts is adequate
 Open Interest
• Number of outstanding contracts at any point in time is called
Open Interest
• To illustrate, say the first 5 transactions after a new series ( ie a new
expiry date ) is opened for the Futures contract on SBI
o Buyer B1 buys 1000 units from Seller S1
o Buyer B1 buys 500 units from Seller S2
o Buyer B2 buys 2000 units from Seller S3
o Buyer B3 buys 600 units from Seller S1
o Buyer B3 buys 200 units from Seller S2
o Total Open Interest – 4300 units (1000 + 500 + 2000 + 600 + 200)
• Buy side interest
o B1 : 1500 units
o B2 : 2000 units
o B3 : 800 units
o Total : 4300 units
• Sell side interest
o S1 : 1600 units
o S2 : 700 units
o S3 : 2000 units
o Total : 4300 units
• Total Buy side interest has to be equal to total Sell side interest
Speculation using Futures
contracts
• If a speculator expects short term spurt in the index,
index futures may be bought.
• 100 units of NiftySept2022 future contract are purchased
at 8350 on day 0
• Position is held for 15 days and the average margin
blocked is 15%
o ie margin blocked is 0.15* 100 * 8350 = Rs 125250
• 100 NiftySept2022 are sold at 8475 on day 15
o Profit = 100 * ( 8475 – 8350) = Rs. 12500
o Return of (12500/125250) * 100 = 9.98% for 15 days
o Return of 9.98 * (365/15) = 243% p.a.
• However if Nifty is sold at Rs 8225 on day 15,
• The loss would be 10% of the amount invested within 15
days of the investment
• This is called leveraged profits and losses
 Arbitrage using Futures contracts
• Arbitrage means opportunity of simultaneous purchase
and sell of an asset to profit from the difference in price
• To illustrate,
o Buy 1000 shares of SBI at Rs 266.
o This requires payment of Rs 2,66,000 the next day
o Sell 1000 units of 1 month SBI Future contract Rs 270
o Margin blocked @ 30% => 0.3 * 1000 * 270 = Rs 81,000
o Total funds required for both the trades : Rs 2,66,000 + Rs 81,000 = Rs
3,47,000
o Borrow Rs 3,47,000 (2,66,000 + 81,000 ) @ 1% p.m.
o One month later ( on the expiry day) ; the spot price of SBI is 265. The
Futures contract also closes out at this price.
o 1000 shares of SBI are sold at Rs 265 making loss of Re 1 per share
o 1000 units of 1 month SBI future give gain of Rs 5 per unit (270 –265)
o Net Gain would be Rs 4 per unit ie Rs 4000.
Arbitrage using Futures contracts

o Net Gain would be Rs 4 per unit ie Rs 4000.

o Borrowing repaid on the expiry day. Cost of borrowing for 1 month
= Rs 3470.
o Gain net of borrowing cost = Rs 4000 – Rs 3470 = Rs 530
o Gain net of borrowing cost would be the same irrespective of any
closing price of SBI on the expiry day
o Hence the gain was known the day two simultaneous trades were
taken on the Day 1.
Arbitrage using Futures
contracts
o Funds blocked : Rs 3,47,000
o Net gain Rs 530
o Period : 1 month
o Profit Margin = 530/ 347000 * 100 = 0.15% p.m.
o Cost of borrowing = 1% p.m.
o Gross return = 1.15% p.m.
o Gross return = 13.8% p.a.
 Arbitrage using Futures
contracts
• Arbitrage means opportunity of simultaneous purchase
and sell of an asset to profit from the difference in price

• Recent trend is towards use of high frequency

computerized trading (called HFT) is used to identify
and execute arbitrage opportunities.

• Arbitragers correct price discrepancies and thereby help

in price discovery

• Similar trades can be carried out using the Futures

contracts of the same underlying but different expiry
dates – these are called calendar spreads
 Hedging using Futures
contracts
• A fund manager builds a portfolio of stocks based on their
fundamental valuation
• Fund manager anticipates temporary weakness in the
“broad” markets due to tightening liquidity conditions in the
global markets
• Nifty index Futures can be sold to “hedge” the portfolio
against the anticipated temporary weakness in the broad
market
• Eg: Assuming that tomorrow US declares a war with North
Korea. In such situation investors will move towards safe assets
like Gold, Bonds, etc. and take out money from Equities. In this
process the markets may fall, resulting into fall in the portfolio
value, but because you have sold Nifty Index futures, the fall in
prices will lead to Gain in Nifty Futures. Thus compensate the
loss on your portfolio. This is Hedging using Futures contracts.
 Costs of trading
• “Bid ask” spreads ( best buy and best sell prices are
usually different from the last traded price)
• Impact costs (large quantity may affect the cost of
transaction adversely)
• Transaction costs
• Statutory dues
 Practice examples
1. Calculate the credit balance required in “A” ‘s fund
account to be able to initiate a short position for 20 lots
in NiftySep22 @ 7800 ( lot size : 25), if the initial margin
required is 15%.
20*25*7800*15% = Rs. 5,85,000
2. Continuing with the situation in the example 1 above;
calculate the credit balance in the margin account of
“A”, if the NiftySep22 increases to 8000 three days after
the trade.
5,85,000 + (7800-8000)*20*25 = Rs. 4,85,000
3. Continuing further, if “A”squares off on the day 5 @
7950, Compute the profit/loss made by the client.
(7800-7950)*20*25 = Rs. 75,000 loss
 Practice examples
4. “B” buys 12 lots of NiftySep22 @ 8002 (lot size : 25,
initial margin required 15%) and sells 10 lots of
TATASTEELSep22 @ 240 on the same day (lot size :
1000 , initial margin required 25%)
Compute the funds required to initiate the two positions
(12*25*8002*15%)+(10*1000*240*25%) = 360090+600000 = Rs. 9,60,090
If on day 5, NiftySep22 closes at 8102 and TatasteelSep22 closes at 230;
compute the credit balance in “B”’s account
Rs. 9,60,090+(8102-8002)*12*25+(240-230)*10*1000 = Rs. 10,90,090
If “B” squares off both the positions on day 7 when NiftySep22 closed at 8152
and Tatasteel Sep22 closed at 225; compute the profit/loss made by “B”
(8152-8002)*12*25+(240-225)*10*1000 = Rs. 1,95,000
 Practice examples
5. An investor predicts price increase in the Silver
futures market from the current price of INR 38,000
per Kg. The Market lot being 10 Kgs. He buys 1 lot of
Futures Silver with Initial margin 20%. What is the
amount of Margin money and what will be the
profit/ loss if price of silver increases by 20%?

Margin = 1*10*38000*20% = Rs. 76,000

Profit = (45,600-38,000)*1*10 = Rs. 76,000
 Practice examples
6. On 15th Sept, Mr. Shreeni establishes long position in
200 shares of TISCO Tally to expire on 1st Oct at a
futures price of INR 600 per share. Initial margin is INR
30,000 and maintenance margin is INR 20,000. Draw
a table showing margin and M-T-M for Mr. Shreeni
on 1st Oct with the following information. Mr. Shreeni
needs to maintain minimum margin at all times
October 1st the price is 598 instead of 690.
Date Future Buy Daily Daily Gain Margin Withdrawal/ Balance at
Closing Price Qty Value / Loss Deposit end
15 600 200 120000 0 30000 0 30000
16 550 200 110000 -10000 20000 0 20000
17 650 200 130000 20000 40000 10000 30000
18 600 200 120000 -10000 20000 0 20000
19 605 200 121000 1000 21000 0 21000
21 590 200 118000 -3000 18000 -12000 30000
22 580 200 116000 -2000 28000 0 28000
23 600 200 120000 4000 32000 2000 30000
24 620 200 124000 4000 34000 4000 30000
25 630 200 126000 2000 32000 2000 30000
27 640 200 128000 2000 32000 2000 30000
30 660 200 132000 4000 34000 4000 30000
1 598 200 119600 -12400 17600 -12400 30000
MTM Loss / Profit -400

Amount with ‘-’ sign under withdrawal and deposit column refers to investor depositing that
amount. Amount where no sign is indicated refers to withdrawal of that amount by the
investor.
 Practice Examples
7. Compute total MTM gain / loss and draw a table
showing deposits and withdrawals in case the margin
falls below the minimum margin? Note that the
investor is required to maintain minimum margin each
time the margin falls below the minimum margin
levels.
Company ABC Corp Date Future Closing
Instrument type Futures Price
Expiry Date 28-Sep-20
Purchase Qty (in Lots) 10 20-09-2020 9935.35
Market Lot 75 21-09-2020 9950.00
Futures purchase 9935.35 22-09-2020 9920.00
price 25-09-2020 9225.60
Date of Transaction 20-09-2020 26-09-2020 9025.87
Initial margin 14,90,303 27-09-2020 9349.75
Maintenance margin 12,66,000 28-09-2020 9015.29
 Date Future Buy Daily Daily Gain Margin Withdrawal Balance at
Closing Price Qty Value / Loss / Deposit end

20-09-2020 9935.35 750 74,51,513 0 14,90,303 0 14,90,303

21-09-2020 9950.00 750 74,62,500 10,988 15,01,290 10,988 14,90,303

22-09-2020 9920.00 750 74,40,000 -22,500 14,67,803 0 14,67,803

25-09-2020 9225.60 750 69,19,200 -5,20,800 9,47,002 -5,43,300 14,90,303

26-09-2020 9025.87 750 67,69,403 -1,49,797 13,40,505 0 13,40,505

27-09-2020 9349.75 750 70,12,313 2,42,910 15,83,415 93,113 14,90,303

28-09-2020 9015.29 750

Total M-T-M Profit/ Loss -4,39,200

Amount with ‘-’ sign under withdrawal and deposit column refers to investor depositing that
amount. Amount where no sign is indicated refers to withdrawal of that amount by the
investor.