Forwards & Futures

Session 2 – Derivatives & Risk Management

Prof. Aparna Bhat
Forward Contracts
 Definition – an agreement between two parties that calls for the
delivery of an asset at a future point in time with a price agreed
upon today
 Features
Existence of two parties
OTC contract
Price determination takes place today
Mutual obligation to perform
Counterparty risk
Mutual consent for cancellation
No upfront payment
Normally settled by delivery of the underlying asset
Forward Contracts v/s Spot contracts
Spot contracts require immediate payment ; forward
buyer gains in terms of interest
Spot contracts require immediate delivery; forward
seller earns income on asset and incurs storage cost;
short-selling possible
Spot contract possible between unknown persons;
forward contracts possible only between known
counterparties or require mechanisms to protect
against default
Futures contracts
Why futures contracts?
Forwards involve credit risk hence unsuitable for small investors
Lack of widespread investor participation leads to low liquidity
and poor price discovery
Trading through an exchange can mitigate credit risk
which however requires standardization of contracts
Futures contract is “a forward contract with standardized
terms traded on an organized exchange and follows a
daily settlement procedure whereby losses of one party to
the contract are paid to the other party”
Forwards and futures - distinction
Forwards Futures
Traded Over the counter  Exchange traded
Custom-made contracts  Standardized contracts
Credit risk borne by  Credit risk borne by the
parties CCP
No margins  Initial margin and daily
MTM margins
Settled by delivery;
 Delivery rare; close-out
close-out difficult easy
No published price-  Published price-volume
volume information data
Specifications of a futures contract
Contract Size
Quotation unit
Minimum price fluctuation (tick size)
Contract grade
Trading hours
Settlement Price
Delivery terms
Daily price limits and trading halts
Settlement of a futures contract
Offsetting or ‘Squaring off’ the position
Delivery-based or ‘physical’ settlement
Cash-based settlement
Why cash-settlement
 A solution to problems associated with physical settlement
Parties settle difference in cash
Futures only for price-fixing and not for delivery
 Cash settlement common for
Stock index futures
Weather derivatives
Single stock futures in some countries
 All equity stock futures and options were cash-settled in
India till recently
 SEBI now plans to move to physical settlement for all
equity derivatives
Equity derivatives specifications -
India
 The two products popular in India are Index Futures and
Futures on Individual Securities
Index Futures: The underlying are the 4 indices – S&P CNX
Nifty, S&P CNX Nifty Mini, CNX IT and Bank Nifty
Futures on Individual Securities: The underlying could be any of
the 186 approved securities, approved by the National Stock
Exchange of India (NSE)
 The trading cycle is a 3-month trading cycle – the near
month (one), the next month (two) and the far month (three)
 The expiry date is always the last Thursday of the expiry
month (or the previous trading day if the last Thursday is a
holiday)
 The price bands are “Operating Range of 10% of the base
price” in case of Index Futures and “Operating Range of
20% of the base price” in case of Futures on Individual
Securities
 Currency futures – contract
specifications (NSE)
Symbol USDINR EURINR GBPINR JPYINR
Market Type N N N N
1 - 1 unit
1 - 1 unit 1 - 1 unit denotes
1 - 1 unit denotes 1000 denotes 1000
Unit of trading denotes 1000 100000
USD. POUND
EURO. JAPANESE YEN.
STERLING.
The exchange The exchange The exchange rate
The exchange rate in
Underlying / Order rate in Indian rate in Indian in Indian Rupees
Indian Rupees for US
Quotation Rupees for Rupees for for 100 Japanese
Dollars
Euro. Pound Sterling. Yen.
Tick size 0.25 paise  or INR 0.0025
Monday to Friday 
Trading hours
9:00 a.m. to 5:00 p.m.
Contract trading cycle 12 month trading cycle.
Two working days prior to the last business day of the expiry month at
Last trading day
12:30 pm.
Last working day (excluding Saturdays) of the expiry month. 
Final settlement day The last working day will be the same as that for Interbank Settlements in
Mumbai.
Homework
Which are the exchanges on which commodity futures
are traded in India?
Study the contract specifications of futures contracts
on one agri-commodity, one base metal and one
energy commodity
Study the delivery mechanism of commodity futures
contracts that are settled by physical delivery
Snapshot of a futures quote
How the exchange manages the
risk of futures contracts
Futures settlement will always result in loss to one
party
How to ensure that losing party does not default?
Tools to manage the default risk
Clearing House
Margin deposits
Marking to market
Clearing House
Clearing house a part of the stock exchange
Concept of Novation
Ensures settlement of the trade in case of default
by either party
If buyer defaults, CH ensures that seller receives the
funds payout
If seller defaults CH ensures that buyer gets the
securities pay-out through auction mechanism
Margin Requirements
Why are margins necessary?
Margins charged by Indian futures exchanges
Initial margin
Exposure margin
Daily Mark-to-market margin
‘Marking-to- market’ is an accounting procedure that forces
both sides of the contract to take their gains/ losses daily
Prevents build-up of large unrealized “paper losses”
At the end of each day the position is re-priced at the day’s
settlement price and the contract is re-started with a new
base price
MTM computation - example
 On June 15, 2015 a trader takes a long position in 10 contracts of Nifty
futures expiring on July 30, 2015 at 8095. Calculate his daily MTM
pay-in/pay-out on the basis of the following data
Date Settlement Price
15-06-2015 8040.45
16-06-2015 8076.25
17-06-2015 8103.35
18-06-2015 8177.55
19-06-2015 8258.40
22-06-2015 8375.60
23-06-2015 8402.10
 Compute the gain or loss for the trader if the position is closed on June
23 at 8410.10
Applications of Forwards and
Futures
Trading or speculation – taking a position in a
forward or futures contract without any underlying
exposure and trying to profit from a directional
view
Hedging – taking an opposite position in a
forward/futures contract in order to mitigate risks
to the underlying
Arbitrage – taking a combined position in the
forward/futures and the underlying in order to
profit from the mispricing of the forward/futures
Speculation in spot market : Bullish
view on underlying
Bullish view – price expected to rise
Buy the underlying asset at the spot price and receive delivery
Sell the underlying asset after price goes up
Example – Mr A is bullish on ICICIBANK. On July 2 Mr A
buys 5500 shares at the spot price of Rs.277.40.
On July 4, Mr A makes payment of Rs.15,25,700 and receives
delivery of 5500 shares
On July 26, Mr A sells off his 5500 shares at the spot price of
Rs.285.65.
On July 30, Mr A receives consideration of Rs.15,71,075 and
delivers 5500 shares
Profit on the transaction: Rs.45,375
Return on investment:2.97% over 24 days
Speculation in futures market:
Bullish view on underlying
Buying shares in spot market requires payment of full
consideration and thus involves large investment
outlay
If the expected upward movement in the price does not
happen, substantial cash is locked up in the investment
and there is opportunity loss
Going long in the futures contract on the stock is a
viable alternative to buying shares in the spot market
Going long in a futures contract only requires deposit
of margins with the broker and payment of daily MTM
Speculation in futures market:
Bullish view on underlying
Take a long position in the underlying futures contract at the
futures price
Square up the position, i.e. reverse the position after the price
goes up
Example – Mr A is bullish on ICICIBANK. The futures price
for the July futures contract on July 2 is Rs.277.55 and lot size
is 2750. Mr A buys 2 lots at Rs.277.55 by paying an initial
margin of Rs.115000
Daily MTM on the long position starts from July 2
On July 26, the futures contract expires at the settlement price
of Rs.285.65.
Mr A’s profit on the transaction: Rs.44,550
Return on investment:38.74% over 24 days
Speculation in spot market – Bearish
view on underlying
Bearish view – price is expected to fall
On July 2, Mr B believes that share price of Bajaj Auto
will decline over the next few weeks
Two cases are possible:
 Mr B owns 1000 shares of Bajaj Auto Ltd
 Mr B does not own any shares of Bajaj Auto Ltd
When Mr B sells shares that he owns, it is a normal spot
sale
When Mr B sells shares that he does not own, it is
known as ‘short sale’ or ‘short-selling’
Treatment of normal sale and ‘short
sale’
Mr B owns 1000 shares of Bajaj Auto Mr B does not own any shares of Bajaj
Auto
Sell 1000 shares at spot price of Rs.2835.15 Borrow 1000 shares from a lender and pay
on July 2 him lending fees – wait for shares to be
credited to demat account
Deliver 1000 shares to the exchange and Sell 1000 shares at spot price of Rs.2835.15
receive sales consideration of Rs.28,35,150 on July 2
on July 4 (T+2 day)
On July 26, buy 1000 shares at spot price of Deliver 1000 shares to the exchange and
Rs.2618.50 receive sales consideration of Rs.28,35,150
on July 4 (T+2 day)
Make payment of Rs.26,18,500 and receive On July 26, buy 1000 shares at spot price of
1000 shares on July 30 (T+2 day) Rs.2618.50

  Make payment of Rs.26,18,500 and receive

1000 shares on July 30 (T+2 day)

  Return the 1000 shares to stock lender

Profit: Rs.2,16,650 or 8.27% over 24 days Profit: Rs.2,16,650 or 8.27% over 24 days
(excluding transaction costs) (excluding transaction costs)
Speculation in futures market –
Bearish view on underlying
Selling owned shares involves opportunity cost apart
from high transaction costs (what if the share price
does not fall and the seller is unable to replace the
shares at a lower cost?)
Short-selling is possible only if there are willing
lenders of the stock
Shorting futures contract on the stock is a viable
alternative to selling/short-selling in the spot market
Shorting a futures contract only requires deposit of
margins with the broker and payment of daily MTM
Speculation in futures market –
Bearish view on underlying
 On July 2, Mr B believes that share price of Bajaj Auto will
decline over the next few weeks; July futures trade at
Rs.2782.50 with a lot size of 250
He shorts 4 July futures contracts at the futures price
of Rs.2782.50 and pays an initial margin of Rs.83000
Daily MTM on the short position starts from July 2.
On July 26, the futures contract expires at the
settlement price of Rs.2618.50
Mr B’s profit on the transaction: Rs.164,000
 Return on investment:197.59% over 24 days
Trading in futures
Party entering into a buy contract = “long”
Party entering into a sell contract = “short”
A long position benefits from a rise in price of the
underlying
Profit to long = Spot price at maturity – Original futures
price
A short position benefits from a fall in price of underlying
Profit to short = Original futures price – Spot price at
maturity
Forwards and futures have ‘linear’ payoffs
 Open Interest V/s Volume
Date Trade Open Interest as Trading Volume
on date for the day
Jan 1 A shorts 50 contracts 50 50
B goes long in 50 contracts
Jan 2 C goes long in 100 contracts OI increases to 50
D goes short in 100 contracts 150 as new long
and short position
are created
Jan 3 A closes short position by OI remains at 150 50
buying back 50 contracts because A’s short
E shorts 50 contracts position is
replaced by E’s
short position
Jan 4 C closes long position by OI falls to 50 as 100
selling 100 contracts and D existing long and
closes short position by short positions are
buying back 100 contracts closed
Interpreting changes in OI
Open Interest Price Interpretation
OI is increasing Price is increasing New buyers are coming
in and technically strong
market
OI is increasing Price is declining Indicates short-selling
and technically weak
market
OI is declining Price is declining Indicates long liquidation
and technically strong
market
OI is declining Price is increasing Indicates short-covering
and technically weak
market
 OI increasing; Price increasing
 Increasing OI suggests creation of new positions. Also rising price
shows that new buyers are stronger than new sellers. Hence bullish
for the scrip

Scrip Date SettPrice OI Change in OI

IDEA 14-Nov 96.05 8492000
IDEA 15-Nov 94.50 8688000 196000
IDEA 16-Nov 98.55 10804000 2116000
IDEA 17-Nov 97.80 11452000 648000
 OI increasing; Price declining
 Increasing OI suggests addition of new positions. Falling price
suggests that new sellers are stronger than new buyers. Hence
suggests short-selling in the scrip

Scrip Date SettPrice OI Change in OI

MUNDRAPORT 11-Nov 151.60 2766000
MUNDRAPORT 14-Nov 155.55 2562000 -204000
MUNDRAPORT 15-Nov 144.05 2784000 222000
MUNDRAPORT 16-Nov 132.05 4420000 1636000
MUNDRAPORT 17-Nov 131.55 5918000 1498000
 OI declining; Price declining
 Declining OI suggests closure of existing positions, i.e. old buyers
are now selling and old sellers covering up their short positions.
Falling price suggests that sellers (old buyers) are stronger than
buyers (old sellers). Hence implies liquidation of old long positions
in the scrip

Scrip Date SettPrice OI Change in OI

IGL 11-Nov 428.65 213000
IGL 14-Nov 425.80 206500 -6500
IGL 15-Nov 419.55 204000 -2500
IGL 16-Nov 413.40 180500 -23500
 OI declining; Price increasing
 Declining OI suggests closure of existing positions, i.e. old buyers
are now selling and old sellers covering up their short positions.
Rising price suggests that buyers (old sellers) are stronger than
sellers (old buyers). Hence implies short-covering in the scrip

Scrip Date SettPrice OI Change in OI

PATNI 16-Nov 391.15 806500
PATNI 17-Nov 422.45 564000 -242500
Pricing of a forward contract
‘No arbitrage’ is the main assumption
The principle of ‘replication’
Cost of the ‘replicating portfolio’ = cost of the
derivative
Example – Forward price of a painting
Cost of carry model
Spot price of gold is S and current interest rate is denoted
by r
What should be the price for buying or selling gold at the
end of six months from today?
 The forward price ‘F’ will be received only on the maturity
date, i.e. at the end of six months
 If the seller sells at the spot price S and invests the proceeds
at the current interest rate r, he will receive S*(1 + r*t)
The minimum price F is therefore S *(1 + r*t)
This is the price at which there will be no arbitrage
opportunity
Assumptions of cost-of-carry model
No transaction costs
No restrictions on short sales
Same risk-free rate for borrowing and lending
 Violations of forward pricing formula….
 Consider a non-dividend paying stock with spot price = 120,
risk-free rate=5%, period= 1 year
 As F= S*(1+rt) , F = 126
 If actual F = 128 cash-carry arbitrage possible
Buy stock today at 120 by borrowing at 5%
Sell stock one-year forward at 128
Hold stock for 1 year
At maturity, sell stock at 128
Repay borrowing with interest at 126
Net gain is Rs.2 (free lunch ?)
 Hence F cannot be greater than S*(1+rt)
 Violations of forward pricing formula….
 Consider a non-dividend paying stock with spot price = 120,
risk-free rate=5%, period= 1 year
 As F= S*(1+rt) , F = 126
 If actual F = 123 reverse cash-carry arbitrage possible
Sell stock today at 120 and lend proceeds at 5%
Buy stock one-year forward at 123
At maturity, get back loan with interest at 126
Receive delivery of stock at 123
Net gain is Rs.3 (free lunch ?)
 Hence F cannot be less than S*(1+rt)
Pricing with continuous
compounding

Where F= forward price,

S=spot price, r=continuously
compounded interest rate, q=
dividend yield, I= PV of
known cash flow, u=storage
costs per unit of time, y=
convenience yield
 Violations of forward pricing formula….
 Fair value of forward =
 Current stock price = 900, known dividend after 4 months =40,
forward maturity =9 months, 4-month int rate= 3%, 9-month int
rate= 4%
 Fair value of forward = (900-39.60)*e^(0.04*9/12) = 886.60
 If actual forward price = 910
 Short forward contract at 910 and borrow to buy stock today
 Borrow 39.60 for 4 months and 860.40 (900-39.60) for 9 months
 After 4 months, pay off loan of 39.60 from dividend inflow
 At end of 9 months receive forward price of 910 and repay loan of 886.60
 Gain = 23.40
 If actual forward price is lower, reverse cash-carry arbitrage
Violations of forward pricing formula….
 Cost of carry is offset by the known income yield q (q is
continuously compounded)
 Hence
 Stock index futures priced as above
 What is Index arbitrage?
When F > Se(r−q)T an arbitrageur buys the stocks
underlying the index and shorts futures
When F < Se(r−q)T an arbitrageur goes long in futures
and shorts the stocks underlying the index
 Index Arb involves simultaneous trades in futures and
many different stocks; hence programmed trades
Pricing of currency forwards
 Pricing requires knowledge of spot exchange rate, domestic
interest rate and foreign currency interest rate
 Interest rate parity requires that

 Where rd=domestic interest rate and rf=foreign currency interest rate

 Expressed in continuous compounding
 Example:
Spot USD/INR =44.70, 1-year USD-libor = 5%, 1-year
INR rate =10%, 1-year USD/INR forward rate = 47.10
What is the arbitrage implied?
Forwards on consumption assets
Convenience yield measures benefit of holding
physical inventory of consumption asset instead of
forward contract on that asset
Is not observable or measurable directly
Can be estimated from past data
Sophisticated models to determine it
Why arbitrage not always feasible?
Implementing cash-carry arbitrage requires ability to
borrow at risk-free rate
Only large institutional players have that ability
Reverse cash-carry arbitrage requires ability to borrow
the security
Owners may be unwilling to sell or lend especially in
case of consumption assets
Regulatory restrictions on short selling
Contango and Backwardation
Normally futures price > spot price
Known as “Contango” market
Non-income earning financial assets normally in
contango
Sometimes spot price > futures price
Known as “backwardation” or inverted market
Consumption assets in backwardation when
“convenience yield” exceeds cost of carry
May be due to anticipated disruption in supply
Could be due to “short squeeze”
Implied repo rate (IRR)
It is ‘that interest rate which would make the observed
forward or futures price equal to the theoretical price
predicted under conditions of no-arbitrage using given
values of the spot price and other variables’
Implied repo rate is the rate at which an investor can
‘borrow synthetically’ by going short spot and long
forward
‘invest synthetically’ by going long spot and short
forward
There will be no arbitrage when
Lending rate < IRR < Borrowing rate
Forward price and value
Value of a forward contract different from the forward
price
Forward price = S*e^rt
Initial value of forward contract is zero
Contract gains or loses value at later stage
Value of forward on an non-income asset
f = (S – K)*e^(-rt)
Risk management with futures
Concept of hedging
Why do companies hedge?
To reduce risk of bankruptcy
To enable company to focus on its core competence
Shareholders cannot hedge effectively
When hedging not profitable
When competitors don’t hedge
When hedging is not selective
Decisions in hedging
Whether a long hedge or short hedge
Which futures contract
Which expiry month
Number of futures contracts to be used
Short hedge and long hedge
 Basis risk
 What is basis?
Spot price of asset to be hedged less futures price of
contract used
 Hedging substitutes basis risk for price risk
 P/L on hedged position = change in basis
 Under a short hedge
Future sale price = Current futures price + future basis
 Under a long hedge
Future buy price = Current futures price + future basis
 Hedge held till expiry results in perfect hedge
 Examples
Hedging profitability and basis
Example of short hedge
An investor holds 10000 shares of X co. Spot price on
May 1 is Rs.100. Investor needs funds on June 11 to
meet his Advance tax liability on June 15. How can he
hedge against the volatility in the interim period? June
X Co. futures quoting at Rs.97 on May 1. (consider
both strengthening and weakening of the basis)
Example of long hedge
A businessman planning to travel to the US on Aug 22
needs 50,000 USD for his trip. As on Aug 3 the
USD/INR spot rate is 59.23 and the Dollar-rupee
futures on NSE are quoting at 59.20. How can he
hedge against the dollar-rupee volatility?
Computing the Hedge ratio
What is Cross hedging ?
Hedge ratio = ratio of size of exposure to size of
futures position
Minimum Variance Hedge Ratio
Objective is to minimize the variance of hedger’s
position
= Correlation between spot & future * (Std Dev of spot/
Std Dev
of future)
Hedging an equity portfolio
Compute beta of the portfolio
Nifty future lot size 50
Nifty future price 5400
Portfolio to be hedged = Rs.10 lacs
Portfolio Beta = 1.05
 Controlling Risk in Equity Portfolio
 Diversification eliminates unsystematic risk in portfolio
 Systematic risk remains; i.e. portfolio is sensitive to market risk
alone
 Strategy to outperform the overall market
Increase portfolio beta to more than 1 when market is
expected to rise; will ensure that portfolio will yield higher
return than market
Reduce portfolio beta to less than 1 when market is expected
to decline; will ensure that portfolio will suffer lower loss
than overall market
 Portfolio beta needs to be changed when market trend is
expected to change
How to alter portfolio beta
 Portfolio rebalancing
 Involves replacing low-beta stocks with high-beta stocks when
market is expected to rise or vice-versa
 Requires frequent buying and selling of stocks resulting in higher
transaction costs
 Lending or borrowing
 Switching between capital market and debt market
 Reducing or increasing the debt component of the portfolio in order
to increase or reduce beta of overall portfolio
 Using index futures
 Sell index futures to reduce beta
 Buy index futures to increase beta
Changing portfolio beta using Index
futures
Target Dollar beta = Portfolio Dollar beta + Number of
futures contracts * (Futures
Dollar beta)
Number of futures contracts = (Target dollar beta-
Portfolio dollar beta)/(Futures
Dollar
beta)*(Portfolio value/Futures
value)
 Case study - Metellgesellschaft
 MG entered into long-term forward contracts to supply oil at
fixed prices to its customers
 A fixed quantity to be supplied every month over a period of
10 years at prices fixed in 1992
 Due to long-term short forward contracts the company faced
the risk of a rise in oil prices
 Hedged the above risk by a “stack and roll hedge”
 Entered into a long position in near-month oil futures contracts
for the entire quantity to be supplied over the 10 year period
 On expiry of near-month contract the position was rolled over
to the next near-month contract for the remaining quantity of
exposure
Case study –contd..
 Oil prices were in normal backwardation when strategy was
adopted – backwardation was expected to continue
 Under conditions of backwardation futures price is below
the “expected future spot price” and hence futures prices
rise to converge with the spot at expiry
 Hence MG expected to make MTM gains on its long futures
positions even as it lost on its forward sale commitments
 However oil market changed to contango, i.e. spot prices
started declining and fell below the futures prices
 Hence as MG’s long futures contracts approached expiry,
the futures prices were declining and MG incurred huge
MTM losses
Case study –contd
 Due to its huge long position in the futures market, MG
faced margin calls and ran into funding problems
 Although MG was making profits on its actual sales under
the forward contracts, these gains could not be recognized
in P&L under the German accounting rules while MTM
losses on the long futures position had to be recognized
 As a result MG’s P&L was in a mess and adverse
consequences in the market
 Eventual losses $1.5 billion
 Risks faced by MG – basis risk, liquidity risk and
operational risk