Chapter 2

Futures & Forwards

· Pricing & Valuation of Futures/Forwards

· Risk Management using Futures · Basis Risk
· Introduction to Currencies /Commodity/Interest rate futures

1
 1 Forward

A forward contract or simply a forward is a non-

standardized customised contract between two parties
to buy or to sell an asset at a specified future time at a
price agreed upon today

2
 Forward
●
The party agreeing to buy the underlying asset in the future
assumes a long position, and the party agreeing to sell the asset in
the future assumes a short position.
●
The price agreed upon is called the delivery price or
predetermined price or strike price which is equal to the forward
price at the time the contract is entered into.
●
The forward price of such a contract is commonly contrasted with
the spot price, which is the price at which the asset changes hands
on the spot date.
●
The difference between the spot and the forward price is generally
considered in the form of a profit, or loss, by the purchasing party

3
 Forward- Payoff

Limited loss unlimited profit

●
Unlimited loss limited profit

4
 Forward- Payoff
●
The payoff from a long position in a forward
contract is
P=S-X,
●

●
where S is a spot price of the security at time of
contract maturity, X is the delivery price.
Similarly, the payoff from a short position is
●

P=X-S.
●

5
 Forward- Payoff
●
The current price of a stock is Rs 80.00 and we entered in
forward contract to buy this stock in 3 months time for Rs
81.00. If after three months price is Rs 83.00, What will be the
profit or loss?
●
Solution
●
P = 83.00 - 81.00 = 2.00
●
If at forward maturity the stock price falls to Rs 78.00, than
our loss will be
●
P = 81.00 - 78.00 = 3.00
●
The graphs above illustrate the forward contract payoff patterns
for long and short positions
6
 Currency Forwards

●
Forward contracts with an underlying of currency.
●
Foreign currency forward contracts are used as a foreign currency
hedge when an investor has an obligation to either make or take
a foreign currency payment at some point in the future.
●
If the date of the foreign currency payment and the last trading
date of the foreign currency forwards contract are matched up, the
investor has in effect "locked in" the exchange rate payment
amount.
●
By locking into a forward contract to sell a currency, the seller sets
a future exchange rate with no upfront cost.
●

7
 Currency Forwards

Definition
●
A binding contract in the foreign exchange market that locks in the
exchange rate for the purchase or sale of a currency on a future
date.
●
A currency forward is essentially a hedging tool that does not
involve any upfront payment.
●
The other major benefit of a currency forward is that it can be
tailored to a particular amount and delivery period, unlike
standardized currency futures.
●
Currency forward settlement can either be on a cash or a
delivery basis, provided that the option is mutually acceptable and
has been specified beforehand in the contract.
8
●
Currency forwards are over-the-counter (OTC) instruments
 Currency Forwards

For example, a Indian exporter signs a contract today to sell hardware

(microchip at 70 Rs per chip) to a U.S importer.
●
The terms of the contract require the U.S importer to pay in rupees in
six months' time.
●
The exporter now has a known rupee receivable.
●
Over the next six months, the dollar value of the rupee receivable will rise
or fall depending on fluctuations in the exchange rate.
●
To mitigate his uncertainty about the direction of the exchange rate, the
Indian exporter may elect to lock in the rate at which he will sell the rupee
and buy dollars in six months.
●
To accomplish this, the Indian exporter hedges the amount receivable by
locking in a forward.
9
●
 Currency Forwards

●
This arrangement leaves the Indian exporter( buyer) fully protected
should the currency value change adversely for him.
●
Forwards require the buyer to accurately estimate the future value of the
exposure amount.
●
Foreign currency forwards contracts may have different contract sizes,
time periods and settlement procedures than futures contracts.
●
Foreign currency forwards contracts are considered over-the-counter
(OTC) because there is no centralized trading location and
transactions are conducted directly between parties via telephone and
online trading platforms at thousands of locations worldwide.
●

10
 Pricing/valuation of Forwards
●
The forward price (or sometimes forward rate) is the agreed upon
price of an asset in a forward contract.
●

where:
S0 represents the current spot price of the asset
F0 represents the forward price of the asset at time T
er represents a mathematical exponential function

11
 Pricing/valuation of Forwards

●
Forward price = Spot Price - cost of carry
●
The future value of that asset's dividends ( coupons from bonds,
monthly rent from a house, fruit from a crop, etc.) is calculated using the
risk-free force of interest
●

●
Cost of carry- cost of holding the asset till the futures contract
matures, includes storage cost, interest paid to acquire and hold
the asset, financing costs etc.
●
Carry Return refers to any income derived from the asset while
holding it like dividends, bonuses etc.

12
 Futures
●
Futures contract is a standardized contract between two
parties to buy or sell an asset for a price agreed upon today
(the futures price) with delivery and payment occurring at a
future point, the delivery date.
●
Because it is a function of an underlying asset, a futures contract
is considered a derivative product.
●
Contracts are negotiated at futures exchanges, which act as a
marketplace between buyer and seller.
●
The buyer of the contract is said to be "long", and the party selling
the contract is said to be "short".
●
Eg Index futures

13
 Futures- Payoff
Payoff for futures

Futures contracts have linear payoffs. In simple words, it means that the
losses as well as profits for the buyer and the seller of a futures contract
are unlimited.

These linear payoffs are fascinating as they can be combined with options and
the underlying to generate various complex payoffs.

14
 Futures- Payoff

Payoff for buyer of futures: Long futures ( diag 1)

The payoff for a person who buys a futures contract is similar to the payoff
for a
person who holds an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside.
Payoff for seller of futures: Short futures (diag 2)
The payoff for a person who sells a futures contract is similar to the payoff
for a
person who shorts an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside.
 Futures- Payoff

if you buy (go long) a futures contract and the price goes up, you profit by the amount of
the
price increase times the contract size; if you buy and the price goes down, you lose an
amount equal to the price decrease times the contract size/lot size.
50 to 60 or 50 to 40 difference 10
short futures position. If you sell (go short) a futures contract and the price goes down,
you profit by the amount of the price decrease times the contract size;16if you sell and the
price goes up, you lose an amount equal to the price increase times the contract size.
 Futures- Payoff

Buy Futures – want price to rise Strike price 50

Difference of 10
Rise to 60 then make profit of 10
Fall to 40 a loss of 10

Sell Futures – want price to fall Strike price 50

Difference of 10
Rise to 60 then make loss of 10
Fall to 40 a profit of 10

Potential risk and return -

Whether you buy or sell a futures contract, your 17potential

gain or loss is unlimited ( because of exchange and many
18
19
 Futures – Margin and settlement
●
Future price- price at which future contract trades
●
Contract cycle- cycles expiring period
●
Expiry date- specified on contract
●
Contract size- amount of asset in a contract multiplied by 100
●

●
Initial margin- amt deposited when contract is entered
●
Maintenance margin- ensure balance never negative
●
Mark to market- At end of every trading day margin account is
adjusted to reflect investors gain or loss depending on futures
closing price.
● 20
 Futures – Margin and settlement
Settlement is the act of consummating the contract, and can be done in
one of two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the

contract is delivered by the seller of the contract to the exchange, and by
the exchange to the buyers of the contract.
Physical delivery is common with commodities and bonds.

Cash settlement - The parties settle by paying/receiving the loss/gain

related to the contract in cash when the contract expires.

Cash settled futures are those that, as a practical matter, could not be
settled by delivery of the referenced item--for example, it would be
impossible to deliver an index.
A futures contract might also opt to settle against an index based on
trade in a related spot market.

21
The futures market is most commonly associated with a clearing
house,
since its financial products are leveraged and require a stable
intermediary.

Each exchange has its own clearing house.

All members of an exchange are required to clear their trades

through the clearing house at the end of each trading session and to
deposit with the clearing house a sum of money, based on22 the
clearing
 Clearing mechanism
A clearing house acts as an intermediary between a buyer and seller and seeks to
ensure that the process from trade inception to settlement is smooth.

Its main role is to make certain that the buyer and seller honor their contract
obligations.
Responsibilities include settling trading accounts, clearing trades, collecting and
maintaining margin money, regulating delivery of the bought/sold instrument, and
reporting trading data.

Clearing houses act as third parties to all futures and options contracts, as buyers
to every clearing member seller, and as sellers to every clearing member buyer

Clearing houses take the opposite position of each side of a trade which greatly
reduces the cost and risk of settling multiple transactions among multiple parties.

While their mandate is to reduce risk, the fact that they have to be both buyer and
seller at trade inception means that they are subject to default risk from both
parties.
23
To mitigate this, clearing houses impose margin (initial and maintenance)
requirements.
 Futures- on expiry

Example:
You have purchased a single futures contract of ABC Ltd.in April 2023,
consisting of 200 shares and expiring in the month of July.
the ABC share’s price was Rs 1,000. If on the last Thursday of July, ABC Ltd.
closes at a price of Rs 1,050 in the cash
market, your futures position will be settled at that price. What is your profit?

Solution
You will receive a profit of Rs 50 per share
(the settlement price of Rs 1,050 - Rs 1,000)
which adds up to a neat little sum of Rs 10,000 (Rs 50 x 200 shares).

This amount is adjusted with the margins you have maintained in your
account.
If you receive profits, they will be added to the margins that you have
deposited. 24
If you made a loss, the amount will be deducted from the margins.
 Futures- on expiry
Suppose you purchase two contracts of Nifty future at 6560, say on July 7,
with lot size 50. This particular contract expires on July 27 with Nifty at Rs
6550,
being the last Thursday of the contract series. If you have left India for a
holiday
and are not in a position to sell the future till the day of expiry, who will
settle
the contract ? What is your profit or loss?
Solution
the exchange
will settle your contract at the closing price of the Nifty prevailing on the
expiry day.

So, if on July 27, the Nifty stands at 6550,

you will have made a loss of Rs 1,000
(difference in index levels – 10 x2 lots x lot size of 50 units).

Your broker will deduct the amount from your margins deposited25with him
and forward it to the stock exchange.
The exchange, in turn, will forward it to the seller, who has made that profit.
 Futures- Before expiry
Alvin bought Nifty Futures on April 17, 2023 , expiring in July 2023
when they were trading at Rs. 5,320;
one Nifty lot is of 50 shares.
Now, if this moves up by 20 points on May 6th and reaches 5,340
and you want to sell the Futures what will be the profit ?

Solution
You will net 20 x 50 = Rs. 1,000 as profit.

26
 Pricing and valuation of Futures
The cost of carry model
F= S+C where S= Spot price
C= Cost of carry

The above formula is also expressed as-

F = S+ S(1+r)^T where T= Time till expiration
r=cost of financing

For calculation purposes-

F= Se^rt where e= 2.71828

27
 Pricing and valuation of Futures
The cost of carry model
F= S+C where S= Spot price
C= Cost of carry

The above formula is also expressed as-

F = S+ S(1+r)^T where T= Time till expiration
r=cost of financing

For calculation purposes-

F= Se^rt where e= 2.71828

28
 Futures
The spot price for silver on 1-1-2023 is Rs 7000 per kg. Annual cost
of
financing is 15% and no storage cost. Calculate the fair value of the
future price of 100 gms of silver on 30-1-2023 using cost of carry
method.

Ans-

F= S+ S*r*t/365 7000/kg(1000 gms)

S/ 100 gms

= 700+700( 0.15) (30)

365
= Rs 700 + 8.63

=708.63 Rs
29
 Futures
The SBI Futures trade on NSE for one-, two- and three-month contracts.
Money can be borrowed at 15 % per annum. What will be the price of a unit
of new two month futures contract on the SBI if no dividends are expected
during the period of two months and assuming spot price of the SBI is 228.

Solution-

F= S+ S*r*t/365
F= 228 + 228 * O.15 * 60
365
= Rs 228+ 5.62
Rs 233.62

30
 Pricing of Futures

A crude oil future is bought by the investor for investment. Assume that
on 1st July the investor goes long one July crude oil
contract at a price of Rs 3,500 on the MCX. Contract specifications are as
follows:

Expiry: 19th July

Price on 19th july - 3300

Trading Unit: 100 Barrels

Initial Margin: 5%

What is the total value of the position? Calculate the initial margin amount

31
 Pricing of Futures
When you enter into the contract, the total value of the position is
Rs3,50,000
(price multiplied by number of barrels multiplied by number of contracts).

I have to put up the initial margin which is 5% of the total contract

value,
i.e. Rs. 17,500. This money is held by the exchange as collateral in case
the
position loses money.

At the end of the trading day, the exchange will mark to market the
position.

This means that they will pay me if the contract has increased in the value,
or I will pay them if it has decreased in the value.

The next day, I will again keep a margin deposited with the exchange to
cover potential future losses.

The profit/loss from this position will be the difference between

32 Rs. 3,500
and the final price on 19th July ie 3300 multiplied by 100 barrels.
 Pricing of Futures

A speculator bought December 2021 $/ rupee futures contracts for

5 million dollars at Rs 73.60/ USD. In March 2023 , the $/Rupee rate is
Rs 73.70. What is the amount he earns this position he earns?

Ans

Futures purchase price = Rs 73.60 per US dollar

Futures sale = Rs 73.70 per US dollar

Profit = Rs 0.10 per US Dollar

Total profit =

0.10 * 5 million = Rs 5,00,000 33

 2 Risk management using Futures
The risks associated with futures contracts apply mainly to speculators.

Speculators take positions on their expectations of future price

movement,
often with no intention of either making or taking delivery of the
commodity.

They buy when they anticipate rising prices and sell when they anticipate
declining prices.

The reason futures are so risky is because they are usually bought on
margin, and each futures contract represents a large amount of the
underlying asset.

For example, a bond futures contract might cost $10,000 but

represent $100,000 in bonds.
Futures rules state that you only need to deposit 5-10% down and the rest
of the contract can be purchased through the use of margin.
34
 2 Risk management using Futures
Strengths
Futures are extremely useful in reducing unwanted risk.
Futures markets are very active, so liquidating your contracts is usually
easy.

Weaknesses
Futures are considered one of the riskiest investments in the financial
markets - they are for professionals only.
In volatile markets, it\'s very easy to lose your original investment.
The very high amount of leverage can create enormous capital gains
and losses, you must be fully aware of any tax consequences.

Three Main Uses

Capital Appreciation
Leverage
Hedge Against Risk 35
 WHAT IS BASIS?

The difference between the futures price and the spot price is called the
basis.

Situation 1
If the futures price of an asset is trading higher than its present spot price, then the
basis for the asset is negative. This means, the markets are expected to rise in
future.

Situation 2
On the other hand, if the present spot price of the asset is higher than its futures
price,
the basis for the asset is positive. This is indicative of a bear run on the market in
future.

Eg – Gold prices in future

36
 Basis Risk
Basis risk in finance is the risk associated with imperfect
hedging.

It arises because of the difference between the price of the asset to

be
hedged and the price of the asset serving as the hedge

Under these conditions, the spot price of the asset, and the futures
price,
do not converge on the expiration date of the future.

The amount by which the two quantities differ measures the value
of the basis risk.

37
38
Commodities

The Future spot price of gold (after 6 months is greater than the
current market price of gold i.e. $1300.
When a Future price is greater than the spot price of underlying in the
market then this situation is called as Market is in contango.

This usually happens when people pay a premium for a commodity in the
future instead of paying the costs of storage and carry costs of buying
the commodity today.
-----------------------------------------------------------------------------------------------------------
Mr. Max is ready to sell his underlying after 6 months from today’s date
at pre-agreed price i.e. $1500 however current spot price of underlying is
$2700.
Mr. Unhappy fears that due to some uncertain political event; the prices of
crude oil are likely to go down, so he has secured future price by entering
into the derivative contract.

So if there is a situation like the Future price is lower than spot price then
this situation is said to be market in backwardation.

It refers to phenomena where Future spot price is less than expected

future spot price (Expected market Price) in the market.
39
40
 4 Currency Futures
A transferable futures contract that specifies the price at which a
currency can be bought or sold at a future date.

Currency future contracts allow investors to hedge against

foreign exchange risk.

Contracts are marked-to-market daily, investors can exit their

obligation to buy or sell the currency prior to the contract's delivery
date.
This is done by closing out the position.

With currency futures, the price is determined when the contract is

signed, just as it is in the forex market, only and the currency pair
is exchanged on the delivery date, which is usually some time
in the distant future.

41
 Currency
Currency
Futures-Sum
Futures
A speculator felt that December futures prices are low and March
prices are high. Considering this he buys cheap December futures
contracts at Rs 77.60 per dollar and sells costly March futures
contracts at Rs 77.85 per dollar for total value of $ 5 million each.

As per his expectations , the spot price on these dates are-

December futures- Rs 77.70
March futures – Rs 77.80

Find the gain on each transaction and the profit on spread.

42
 Currency Futures
On squaring up both the transactions the gains are under-
December futures contract
Purchase= Rs 77.60
Sale = Rs 77.70
Gain= 0.10 per dollar.
Total gain= 0.10* 5 million = Rs 5,00,000

March futures contract

Futures sale= Rs 77.85
Futures purchase= Rs 77.80

Gain= 0.05 per dollar

Total Gain= 0.05* 5 million = Rs 2,50,000

Total profit on spread= Rs 7,50,000 43

 Commodity futures

An agreement to buy or sell a set amount of a commodity at

a predetermined price and date.

Buyers use these to avoid the risks associated with the

price fluctuations of the product or raw material, while sellers
try to lock in a price for their products.

Like in all financial markets, others use such contracts to

gamble on price movements.

Eg Britannia with farmer and exchange

44
 Commodity futures
Trading in commodity futures contracts can be very risky for the
inexperienced. One cause of this risk is the high amount of
leverage
generally involved in holding futures contracts.

For example, for an initial margin of $5,000, an investor can enter

into a futures contract for 1,000 barrels of oil valued at $50,000.

Given this large amount of leverage, even a very small move in the
price of a commodity could result in large gains or losses
compared to the initial margin.

Unlike options, futures are the obligation of the purchase or

sale
of the underlying asset.
45

Simply not closing an existing position could result in an

 Interest rate futures
An Interest Rate Futures contract is "an agreement to buy or
sell a
debt instrument at a specified future date at a price
that is fixed today."

The underlying security for Interest Rate Futures is

either Government Bond or T-Bill.

An interest rate future is a financial derivative (a futures contract)

with an interest-bearing instrument as the underlying asset.

Examples include Treasury-bill futures, Treasury-bond futures

46
 Interest rate futures

Futures contract with an underlying instrument that pays interest.

•

•
An interest rate future is a contract between the buyer and seller agreeing
•
to the future delivery of any interest-bearing asset.
•

•
The interest rate future allows the buyer and seller to lock in the price of
•
the interest-bearing asset for a future date.
•

•
When trading Interest rate futures, we are actually trading futures of
•
Bond prices rather than the interest rates
•

47
Example of How a Forward Contract Works
ABC Factory in Edinburgh is looking to buy motorbikes from Taiwan. The
business meets with the supplier, and agrees to pay USD $500,000 in 3
months from now.
The current GBP / USD exchange rate at the time of the deal is GBP
£1.00 = USD $1.32. ABC Factory therefore expects to pay GBP £378,788
for the equipment.
In 3 months’ time, GBP £1.00 = USD $1.25.
Here is what could happen;
Scenario 1: If ABC Factory doesn’t use a Forward contract
In 3 months’ time, when the business is ready to pay for the goods from
Taiwan, the exchange rate has moved adversely for ABC Factory, GBP
£1.00 = USD $1.25. This means that the goods would cost £400,000.
ABC Factory would pay £21,212 more than anticipated originally.
Scenario 2: ABC Factory does use a Forward contract
After 3 months, ABC Factory is ready to purchase the equipment from
Taiwan. The exchange rate has moved adversely, however, as GBP
£1.00 = USD $1.25, ABC Factory negotiated a forward contract with a
currency provider.
The result is that ABC Factory saves £21,212 by thinking ahead and
protecting itself with a forward currency contract.