Derivatives and Risk

Management
Examination Marks
Final Examination 60
Mid Term Examination 20
Presentation 10
Attendance / Class Participation 10
Total 100
Introduction to Futures
Types of Derivatives
 Forward

 Futures

 Options

 Swaps
Forward

 The salient features of forward contracts are:

 They are bilateral contracts and hence
exposed to counter-party risk.
 Each contract is custom designed, and hence
is unique in terms of contract size, expiration
date and the asset type and quality.
 On the expiration date, the contract has to be
settled by delivery of the asset.
OTC Derivatives
Characteristics of OTC Derivatives market:

 The management of counter-party (credit) risk is located

within individual institutions. No formal limit on individual
positions, leverage, or margining.
 No formal rules of risk and burden sharing
 No formal rules for ensuring market stability and integrity
 Lack of regulator, although they are affected indirectly by
national legal systems, banking supervision and market
surveillance.
 The OTC derivatives markets have the following features compared to
exchange traded derivatives:
 The management of counter-party (credit) risk is decentralized and
located within individual institutions,
 There are no formal centralized limits on individual positions,
leverage,or margining,
 There are no formal rules for risk and burden-sharing,
 There are no formal rules or mechanisms for ensuring market stability
and integrity, and for safeguarding the collective interests of market
participants, and
 The OTC contracts are generally not regulated by a regulatory authority
and the exchange's self-regulatory organization, although they are
affected indirectly by national legal systems, banking supervision and
market surveillance.
Futures
• A future is similar to a forward rate agreement,
except that it is not a negotiated contracted but a
standard instrument.
• A future is a contract to buy or sell an asset at a
specified future date at a specified price. These
contracts are traded on the stock exchanges and it
can change many hands before final settlement is
made.
• The advantage of a future is that it eliminates
counterparty risk. Since there is an exchange
involved in between, and the exchange guarantees
each trade, the buyer or seller does not get affected
with the opposite party defaulting.
Difference Between Futures and
Forwards
Futures
Futures are traded on a stock
Forwards
Forwards are non tradable, negotiated
exchange Instruments
Futures are contracts having standard Forwards are contracts customized by
terms and conditions the buyer and seller
No default risk as the exchange High risk of default by either party
provides a counter guarantee
Exit route is provided because of high No exit route for these contracts
liquidity on the stock exchange
Highly regulated with strong margining No such systems are present in a
and surveillance systems forward market.
Types of Futures

• Index futures
• S&P CNX Nifty Index
• CNX-IT
• Bank Nifty
• Nifty MIDCAP 50

• Stock index
• 203 securities
Futures Contract

 Agreement between two parties to exchange

an asset at a certain date in future at a
certain price.
 It is a standardized forward contract that is
traded on an exchange.
 The standardized items in a futures contract
are:
 Quantity of the underlying
 Quality of the underlying
 The date and the month of delivery
 The units of price quotation and minimum
price change
 Location of settlement
Futures Terminology
 Spot Price

 Futures Price

 Contract cycle

 Expiry date

 Contract size

 Initial margin
Types of Margin

 Initial Margin

 Maintenance Margin

 Margin call
 Basis
 B= Spot price – Future Price

 Cost of carry

 Mark-to-market
How do they settle the contract?
 Mark to Market
Eg: Mr. X buys Nifty futures at 1050
Date Closing MTM a/c
23rd July 1100 +50
24th July 1000 -100
25th July 1200 +200
26th July 1250 +50
27th July 1200 -50
TOTAL +150
 Beta:
 Beta measures the relationship between movement of the index to
the movement of the stock. The beta measures the percentage
impact on the stock prices for 1% change in the index. Therefore, for
a portfolio whose value goes down by 11% when the index goes
down by 10%, the beta would be 1.1. When the index increases by
10%, the value of the portfolio increases 11%. The idea is to make
beta of your portfolio zero to nullify your losses.
 Example
 The beta of infosys is 1.32. Assuming you have a
position of Rs 5,00,000 of infosys. How will you hedge
your position?

 The complete hedge can be arrived at by

   1.32*5,00,000 = 6,60,000 of Nifty sell.
Settlement of Futures Position

 Physical delivery
 Cash settlement
Futures Buyer

 Mr. X buys a Nifty futures at 1250.

Nifty Payoff
1,000 -250
1,100 -150
1,200 -50
1,300 50
1,400 150
Payoff for Long Future

Profit

Asset price

Loss

Unlimited Upside
Unlimited Downside
Futures Seller

 Mr. X sells a Nifty futures at 1250.

Nifty Payoff
1,000 250
1,100 150
1,200 50
1,300 -50
1,400 -150
Pay off for Short Future

Profit

1250 Asset price

Loss
Unlimited Upside
Unlimited Downside
Cost Of Carry
Hedging strategies using
Futures
Session 3
COST OF CARRY
Cost of carry

 Cost can be storage cost, insurance cost,

transportation cost, cost of financing etc
 F=S+C
OR
 F = S(1+r)t
 F= future price
 S = Spot price
 r = rate of interest
 t = time in days
where:
r =Cost of financing (using continuously
compounded interest rate)
T = Time till expiration in years
e 2.71828
Example I
 The spot price of Reliance is Rs 300. The bank rate prevailing
is 10%. What will be the price of one-month future?
Solution
 The price of a future is F= S (1+r)T
 The one-month Reliance future would be the spot price plus
the cost of carry.
 Since the bank rate is 10 %, we can take that as the market
rate.
 This rate is an annualized rate and hence we recalculate it on
a monthly basis.
F=300 (1+0.10)(1/12)
F= Rs 302.39
Example II
 The shares of Infosys are trading at Rs 3000. The 1
month future of Infosys is of Rs 3100. The returns
expected from the Gsec funds for the same period
is 10%. Is the future of Infosys overpriced or under
priced?
Solution
 The 1 month Future of Infosys will be

F= 3000(1+ 0.10) (1/12)

F= Rs 3023.90
 But the price at which Infosys is traded is Rs 3100.
Thus it is overpriced by Rs 76.
Pricing equity index futures
Pricing Index Futures Given Expected
Dividend Amount
PRICING STOCK FUTURES

 Pricing stock futures when no dividend

expected
 Pricing stock futures when dividends are
expected
Pricing stock futures when dividends
are expected
 Dividend is an income to the seller of the
future. It reduces his cost of carry to that
extent. If dividend is going to be declared, the
same has to be deducted from the cost of
carry
 Thus the price of the future in this case
becomes,
F= S (1+r-d) T

Where d is the dividend.
Example
 The spot price of Reliance is Rs 300. The bank
rate prevailing is 10%. What will be the price of
one-month future? Reliance will be paying a
dividend of 50 paise per share.
Solution:
 Since Reliance is paying 50 paisa per share and
the face value of reliance is Rs 10, the dividend
rate is 5%.
 So while calculating futures,

F=300(1+0.10-0.05) (1/12)
F= Rs. 301.22
What happens if dividend is declared
after buying a future?
• If the dividend is declared after buying a one month future,
the cost of carry will be reduced by a pro rata amount.
• For example, if there is a one month future ending July
30th and dividend is declared on July 15th, then dividend
benefit will be reduced from the cost of carry for 15 days.
• Since the seller is holding the shares and will transfer the
shares to the buyer only after a month, the dividend benefit
goes to the seller. The seller will enjoy the benefit to the
extent of interest on dividend.

• Thus net cost of carry = cost of carry – dividend benefits

Example
• The spot price of Reliance is Rs 300. The bank rate prevailing is
10%. Reliance declares a dividend of 5% after 15 days. What will be
the price of one-month future?
Solution:
• The benefit accrued due to the dividend will be reduced from the
cost of the future.
• One month future will be priced at
• F= 300(1+0.10) (1/12)
• F = 302.39
• Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39
• The interest benefit of the dividend is available for 15 days, i.e. 0.5
months.
• Dividend for 15 days = 300(1+0.05) (0.5/12)
• Dividend Benefit = Rs300.61- Rs 300= Rs0.61
• Therefore, net cost of the carry is,
• Rs2.39-Rs0.61 = Rs 1.78
• Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78
Is the futures price always higher than
the spot price?
 The futures price can be lower than the spot
price too. This depends on the fundamentals
of the stock. If the stock is not expected to
perform well and the market takes a bearish
view on them, then the futures price can be
lower than the spot price.
BASIS

 Basis = Spot price – future price

 As expiry comes near basis decreases
Convergence of Future Price and Spot
Price

Future price Spot price

Basis
Basis
Future price
Spot price

Time Time
Contango Backwardation
Why spot price and future price equals at
expiration?
 If future price is above spot price, this will
give rise to a clear arbitrage opportunity:
 Short a future contract
 Buy the underlying asset
 Make delivery
 If future price is below spot price:
 Acquiring the asset and take long position.
Futures strategies

Session 3
Hedging concept
Perfect Hedging
Following conditions should be fulfilled before a perfect
hedging is possible:
 The price change taken should be perfect

 Future contract should be available for the underlying

asset
 The expiration date of the contract should be same on

which the firm’s profit will be affected by the price of the

asset.
 Quantity to be hedge and the contract size of future

contract should be same.

Short Hedge

 It involves the short position in futures

contract.

 When u have a stock and you think that price

is undervalued and market can go down.

 Main objective is to protect against the fall in

cash price.
Long Hedge
 It involves the Long position in futures contract.

 When u have a stock and you think that price of the stock
is overvalued and market can go up.

 A Long hedge is appropriate when a firm has to purchase

a certain asset in future and wants to lock in a price now.

 Main objective is to protect against a price increase in

the underlying asset.
Long Vs Short Hedging
Short Hedger Long Hedger
Position in Long Short
Spot Market
Protection Price fall Price Rise
need against
Position in Short Long
futures market
Long & Short Hedges
 A hedge is a position in a derivative that
reduces (or eliminate) the exposure to a
market risk from a future purchase or sale of
an asset.
 A long futures hedge is appropriate when you
know you will purchase an asset in the future
and want to lock in the price
 A short futures hedge is appropriate when
you know you will sell an asset in the future &
want to lock in the price
Portfolio Hedging
 Investment amount
 Beta
 Market view
Example

 A portfolio manager has following assets:

Company No of Share price Share beta
shares
ACC 5000 129 0.8
Airtel 5000 2200 1.2
Reliance 4000 650 0.5
Tata 8000 800 1.8
Perfect Hedging Model

 This position completely eliminate the risk

 Suppose a firm has an inventory of 1000 kg
of Gold which they want to sell in Oct 10. the
current price of gold is Rs 8000 per Kg.
 To avoid price risk firm enters in to a futures
contract short position of Gold 1000 kg at FP
of Rs 8100 per Kg.
 Senario A price will rise to Rs 8200
 Senario B price will fall to Rs 7900

Senario Spot mkt Profit or loss Net revenue

revenue
A Price Rs 8200 82,00,000 1000(8100- 81,00,000
8200)
= Rs 1,00,000
loss
B price Rs7900 79,00,000 1000(8100- 81,00,000
7900)
=Rs 2,00,000
Profit
Example of Imperfect Hedging
 Suppose u have a position of Rs 3,20,000 long ACC on 1st Aug.
you plan to hold it till 20th Aug.
 Suppose beta of ACC is 1.25
 Hence you need a short position of Rs 4,00,000 on the index futures
market to totally remove your nifty exposure.
 On 1st Aug Nifty is 3950 and nearest futures contract is trading at
4000. lot size is 50 is worth Rs 2,00,000
 You need to short 2 lot of nifty futures.
 Long ACC Rs 3,20,000
 Short Nifty Rs 4,00,000
Cross Hedging
 Asset Mismatch
 Maturity Mismatch
 There is still possibility to hedge against price risk in related assets
or by using future contacts that expire on dates other than those on
which the hedges are lifted. Such hedger are known as Cross
hedges.
 For example, peanut oil may be hedged by taking a futures position
involving olive oil. In the event that peanut oil begins to falter, there
is a good chance that the olive oil will remain strong and may even
begin to experience an upswing in market value. As a result, the
investor may lose money on the peanut oil cash commodity, but the
performance of the olive oil futures helps to offset the loss.
 In order for cross-hedging to work, it is imperative to make sure
there is some type of logical connection between the two separate
investment opportunities. Without some type of correlation, the two
investments are nothing more than two investments.
Mismatch situation which makes the
hedge a cross hedge:
 The hedging maturity may not match the futures
expiration date.
 The quantity to be hedged may not match with the
quantity of the futures contract.
 The physical features of the asset to be hedged may
differ from the futures contract asset.
 Cross hedging can not be effective in reducing risk as a
direct hedge
 Eg if u want to hedge a portfolio of gold coins then the
gold future contract will be more effective cross hedging
rather than any other metal.
Basis Risk, Spread Trading

Session 4
Questions 1

 XYZ buys 1000 shares of SBI at Rs 150 and

obtains a complete hedge by shorting Nifty at
4000 (lot size 50) . He closes out his position
at closing price of the next day; at this point
SBI has dropped 5% and Nifty futures have
dropped 4%. What is the overall profit/loss?
 Profit 500
Questions 2

 X buys 3000 shares of BOB at Rs 250 and

obtains a complete hedge by shorting
nifity at Rs 4000, lot size is 50.
 He closes his position next day, at that time BoB

dropped 2% and the nifty futures have risen 1%.

What is the overall profit/loss?
 3000*250 = 750000 *2% = -15000

4000*50*4 =800000* 1% = -8000

Loss of Rs 23000
Question 3

 Z sells 1000 shares of ACC at Rs 380 and

obtains a complete hedge by Long 100 Nifty
at Rs 4000 each. At the time of closing. ACC
has risen 3% and Nifty futures have risen 4%.
What is the overall profit/loss?

 -11400
 +16000 = 4600 Profit
Questions 4

 X sells 2000 shares of ACC 280 and obtains

complete hedge by buying 150 nifty at Rs
4000 each. At the time of closing price ACC
has risen 2% and Nifty futures have fallen
1%. What is the overall profit

 -11200
 -6000 =17200 Loss
Basis Risk

 Basis is the difference between spot &

futures
 Basis risk arises because of the

uncertainty about the basis when the

hedge is closed out
 There is NO basis risk if:

maturity of future = maturity of position.

 Basis = Spot price – Futures price
 If spot price is higher than the futures price
then the basis will be called as Positive
 If spot price is less than the futures price then
the basis will be called as Negative.
 If futures price and spot price changes by
same amount than the basis will not change
and it will be zero.
Basis risk in Short Hedging

 Assuming that Future price is above Cash

price

 Profit if basis is narrowing

 Loss if basis is widening
Basis Risk in Long Hedging

 Assuming that Future price is above Cash

price

 Profit if basis is Widening

 Loss if basis is Narrowing
Spread Trading
 Difference between two futures contracts is referred as
spread.
 A futures spread (or spread) is a long-short futures
position that provides exposure to a spread or difference in
two prices. If both futures are traded on the same
exchange, two types of spreads are possible:
     An intra commodity spread (or calendar spread) is
long one future and short another. Both have the same
underlie, but they have different maturities.
 An inter commodity spread is a long-short position in
futures on different underlie. Both typically have the same
maturity.
Example
Spot Contra Fair Fair Fair Mkt Basis Spread
ct price basis spread price
1000 F1 1010 10 1012 12
F2 1020 20 10 1018 18 6
F3 1030 30 10 1032 32 14