UNIT 1

DERIVATIVES -
FUTURES
DEFINITION OF DERIVATIVES

“ A Derivatives is a financial instrument

whose value depends on the values of
other, more basic underlying variables” -
John C Hull

“ A Financial instrument which has a

value determined by the price of
something else” - Robert L McDonald
DEFINITION OF DERIVATIVES

“A Security derived from a debt

instrument, share, loan whether
secured or unsecured risk
instrument or contract for
difference or any other form of
security”
 ELEMENTS OF DERIVATIVES
CONTRACT
A Derivatives contract need to have a
minimum of the following five elements
A legally binding contract
Involvement of two or more parties
Existence of an ‘Underlying asset’
A determined future date
A determined future price
 EXAMPLE OF DERIVATIVES
CONTRACT
ABC, an airline company needs to buy
fuel for its planes
They are exposed to the risk of changes
in oil price
In case there is an huge increase in the
price, ABC faces huge loss
To overcome this risk, ABC company
can buy Oil Futures Contract
 EXAMPLE OF DERIVATIVES
CONTRACT
With this, they are locking in Oil
prices
Thus, derivative helps them to mitigate
the risk
 EXAMPLE OF DERIVATIVES
CONTRACT
A local farmer harvests and sells mango
There is a time lag between harvest period
and sale of mangoes, during which the price
of mangoes could fail and in turn impact his
earnings
Here the farmer can get into a derivatives
contract by locking in the price of mangoes
today to mitigate the risk that may arise
during the sale
 DERIVATIVES – NEED AND
IMPORTANCE
1. Enhances price discovery process:
Derivatives help in price discovery
by predicating future prices based on
current prices
2. Risk Management: Derivatives help
in risk management and mitigation
 DERIVATIVES – NEED AND
IMPORTANCE
3. Entrepreneurship: It increase the
entrepreneurial activities amongst
participants, it may attract various
investors who are creative, educated and
business minded in nature
4. Trading volumes: It catalyzes economic
growth by increasing trading volumes due
to participation of players from various
sectors
 DERIVATIVES – NEED AND
IMPORTANCE
5. Saving and Investment: It increase
the savings habit in the
investors and also enhances
investment opportunities in long
run
6. Singles of market movements: It
Provides and indicator of how the market
moves
 DERIVATIVES – NEED AND
IMPORTANCE
7. Low transaction: Derivatives
instruments are quite simple to operate
Also all these instruments are low cost
product
8. Increased Liquidity: Participants in the
derivatives contract can get in and come
out of the deals very easily and that too
without high cost
 MAJOR PLAYERS IN DERIVATIVES
MARKET

1. Hedgers: The ‘Hedge’

means “to reduce the risk’
Hedgers are the participants
who look at reducing their
risks in the market
 MAJOR PLAYERS IN DERIVATIVES
MARKET

2. Speculators: Speculators
are the participants who take a
view on the future price
movements in the market and
accordingly make profits
 MAJOR PLAYERS IN DERIVATIVES
MARKET

2. Arbitrageurs: are the

participants who make profits
by taking benefit of
differences in prices of the
same asset in two different
markets
 FEATURES OF DERIVATIVES
CONTRACT
1. Forward: A forward contract is
a customized type of contractual
agreement between two parties
to buy or sell an underlying
asset on a specific future date
at today’s pre agreed price
 FORWARD CONTRACT
 Both buyers as well sellers are
bound to honor the deal irrespective
of the price of underlying asset at
the expiry date of contract
 They are OTC contracts where both
the parties negotiate and customize the
terms and conditions of the contract,
without involvement of stock markets
FEATURES OF FORWARD CONTRACT
 Features of Forward Contract:
1. Bilateral: Forward contracts are bilateral (two-
sided) contracts
It is contract between two parties (without any
exchange between them)
Both the parties are expose to counter party risk
These two parties can be a. A bank and a customer
b. Two banks of same country c. Two banks of
different countries
FEATURES OF FORWARD CONTRACT
 Features of Forward Contract:
2. Counter Party risk: As these are OTC
contracts, there can be a risk of non
performance of obligations by either parties
These are a bit risky in nature
3. Customized Contract: Forward contracts
are quite flexible as they are custom designed
Both the parties can negotiate the terms of
contract
FEATURES OF FORWARD CONTRACT
 Features of Forward
Contract:
4. Not traded on exchange: Forward
contract are not traded on any exchange
They are entered by two parties to meet their
specific needs
Hence the prices of these contracts are not
available on public domain
FEATURES OF FORWARD CONTRACT
 Features of Forward Contract:
5. No premium and margin required: There
is no premium and margin money involved in
forward contract
Premium amount is to paid in case of option
contracts
Whereas margin requirement is a feature of
futures contract
FEATURES OF FORWARD CONTRACT
 Features of Forward
Contract:
6. Physical Delivery: These contracts have
to be settled by delivery of the underlying
asset on expiration date
One party is bound to sell and the other one
to purchase at the pre decided price
FEATURES OF FORWARD CONTRACT
 Features of Forward Contract:
7. All the terms decided today: All the
terms of forward contract are pre
decided at the time of contract
8. Widely used: As they are quite
simpler contracts, they are quite popular
and have been in use
 FUTURE CONTRACT
 Futures contract were designed to
solve the problems with forward
contracts
 Futures contracts are exactly like
forward contract in terms of basic
economics
 FUTURE CONTRACT
 However futures are standardized and
trading in centralized
 Future market are highly liquid
 There is no counterparty risk
 Future contract is defined as a
standardized agreement with an organized
exchange to buy or sell an underlying asset
at a fixed price at pre decided date in future
FEATURES OF FUTURES CONTRACT
 Bilateral
 No Counter party Risk
 Organized Exchange
 Standardized contracts
 Involvement of Clearing House
 Margin Money = 2.5% To 10%
 Mark to Market =
 Actual delivery may not happen
Payoff in Futures Contract: Long Futures
 On 1st Oct 2017 Mr. Ashok buys a future’s
contract at a price of Rs. 60. Expiry date
of the contract is 28th Oct. 2017. If the
spot price, at the time of expiration of the
contract is Rs. 54,56,58,60,62,64,66,68 &
70. What will be the maximum profits or
losses for Mr. Ashok? Also show
graphical representation.
Payoff in Futures Contract: Long Futures
Spot Price Payoff
54 =54-60 = - 6
56 -4
58 -2
60 0
62 2
64 4
66 6
68 8
70 10
Payoff in Futures Contract: Long
Futures
 Payoff in Futures Contract: Long
Futures
 In this case Mr. Ashok is going for
long on future’s contract
 Pay offs of future’s contract is
linear
 If the spot price at expiration is
above Rs.60 he will earn profits and
if the spot price is below Rs. 60, he
will suffer losses
 Payoff in Futures Contract: Short
Futures
 On 1st Oct 2017 Mr. Ashok sells a
future’s contract at a price of Rs. 60.
Expiry date of the contract is 28th Oct.
2017. If the spot price, at the time of
expiration of the contract is Rs.
54,56,58,60,62,64,66,68 & 70. What
will be the maximum profits or losses
for Mr. Ashok? Also show graphical
representation.
Payoff in Futures Contract: Short
Futures
Spot Price Payoff
54 =60 – 54 = 6
56 =60 – 56 = 4
58 2
60 0
62 -2
64 -4
66 -6
68 -8
70 -10
 Payoff in Futures Contract: Long
Futures
 In this case Mr. Ashok is going for
short on future’s contract
 Pay offs of future’s contract is
linear
 If the spot price at expiration is
below Rs.60 he will earn profits and
if the spot price is above Rs. 60, he
will suffer losses
Payoff in Futures Contract: Short
Futures
 DIFFERNCE BETWEEN FORWARD
AND FUTURES
Heading Forward Futures
Nature OTC Exchange Traded
Counter party Exists Non Exists
risk
Contract term Customized Standardized
Guarantee of Does not use Uses clearing
Contract clearing houses to houses to
fulfillment guarantee guarantee
Margin Not required Required
payments
 DIFFERNCE BETWEEN FORWARD
AND FUTURES
Heading Forward Futures
Transparency No transparency in Transparency in
markets markets
MTM Not market to market Marked to market
on a daily basis on a daily basis
Closed prior to No Mostly
delivery
Profit or Losses No Yes
realized daily
Actual Delivery Actual Delivery of Actual delivery of
Assets happens a the asset may or may
end of contract not be happen
 DIFFERNCE BETWEEN FORWARD
AND FUTURES
Heading Forward Futures
Liquidity Less More
Settlement Settlement happens at Follows daily
the end of contract settlement
Price discovery Not efficient Efficient
Mechanism
Market Price On Phone or telex Electronic exchange
 THEORETICAL FUTURE PRICE

 Before understanding Theoretical Futures

price, let us understand the meaning of the
term BASIS
 Futures Prices and Spot Prices are different
they correspond at the time of expiration
of a contract
 THEORETICAL FUTURE PRICE

 Before settlement futures and spot prices

need not be the same
 Different between the prices it called
BASIS
 It converges to zero as the contract
approaches maturity
 Basis is defined as the difference between
spot and futures prices
THEORETICAL FUTURE PRICE

B=S–F

Where,
B is Basis Points
S is Spot Price
F Forward Price
THEORETICAL FUTURE PRICE

On October 12th a foreign exchange

currency is trading at Rs. 45.96 per $ (Spot
Price)
The November futures contract is Rs.
45.99 then basis is -3 cents
B=S–F
= 45.96 – 45.99
= -3 cent
THEORETICAL FUTURE PRICE

If the sport price on 1st

July 2017 is 72 cents,

calculate the basis for
the following futures
contract
THEORETICAL FUTURE PRICE

Settlement Aug Sept Dec Feb

Month 2017 2017 2017 2018

Future Price 75 70 78.5 69.5

B= S – F 72- 72-70 72- 72-

75= = 2 78.5 = 69.5 =
-3 -6.5 2.5
THEORETICAL FUTURE PRICE

Theoretical futures price (TFP) also

known as Fair Price, is the mathematical
calculations of price of a future contract
It is a theoretical equilibrium price of
futures contract
Theoretical price is also known as a Fair
Value of a futures contract
THEORETICAL FUTURE PRICE

Simple put, TFP or Fair Futures Price is

Spot Price + Holding / Carrying cost
Carrying Cost includes the cost of
holding the underlying till maturity any
dividend expected till expiry of the
contract
Cost of carry includes variables like
storage cost and interest rates
THEORETICAL FUTURE PRICE

F=S+C
Where,
F is Fair Price
S is Spot Price
C is Cost of Carry
THEORETICAL FUTURE PRICE

Spot price of 10 gm Gold is Rs. 32000,

Locker storage cost is Rs. 400,
insurance is Rs. 200 and Interest is Rs.
250. Calculate the fair price of 3
months Future Contract
Given: Spot Price (S) = 32, 000,
Storage Cost = 400, Insurance = 200,
Interest = 250, Futures price (f) = ?
THEORETICAL FUTURE PRICE

Cost of Carry (C) = Storage

Cost + Insurance+ Interest Cost
C = 400 + 200 +250 = 850
F=S+C
F = 32000 + 850
F = 32850
THEORETICAL FUTURE PRICE

Silver Current Market Price is Rs.

40000 per kg. Storage cost is Rs. 300
and Interest Cost is Rs. 150. Calculate
is the fair price of 4 months Futures
contract.
THEORETICAL FUTURE PRICE

Spot price of 10 gm Gold is Rs. 32000,

Locker storage cost is Rs. 400,
insurance is Rs. 200 and Interest is
10%. Calculate the fair price of 3
months Future Contract
Given: Spot Price (S) = 32, 000,
Storage Cost = 400, Insurance = 200,
Interest = 10%, Futures price (f) = ?
THEORETICAL FUTURE PRICE

Future Price = Spot Price + Storage

Cost + Insurance + Interest Cost
Future Price = 32000 +400+ 200
[10% x (32000+400+200) x 3/12]
= 32600 X 3/12
F = 32600 + (10% of 8150)
F = 32600+ 815
F = 33145
THEORETICAL FUTURE PRICE

Note: In case of carry is given in %

terms, the problem can be solved with
the below formula
F = S (1+r)n 
Where, F is Fair price, S is Spot price
r is carrying cost (in%)
T is time to expiration (in years)
THEORETICAL FUTURE PRICE

Formula of Theoretical Future

Pricing/Fair Pricing can be Divided
into Three parts
Future price of a contract is dependent
on the income to be generated by the
underlying asset
THEORETICAL FUTURE PRICE

Future price of a stock paying no

dividend will be lesser than the future
price of stock paying dividend before
settlement of the contract
Formula of Future pricing will be
different based on the income yielding
capacity of the underlying assets
 THEORETICAL FUTURE PRICE

There are three variants of such

contracts:
1. Where the underlying assets pays no
income till maturity
2. Where the underlying asset pays fixed
and continuous income till maturity
3. Where the underlying asset pays
irregular income till maturity
 THEORETICAL FUTURE PRICE

Formula for calculations of Futures –

TFP
Sr. Underlying Assets Examples Formula
No
1 underlying assets Gold, Silver F​=S​×
pays no income till
maturity
2 underlying asset pays Bonds, T- F​=S​×
fixed and continuous Bills
income till maturity
 THEORETICAL FUTURE PRICE

Formula for calculations of Futures –

TFP
Sr. Underlying Assets Examples Formula
No
3 underlying asset pays Equity F​=(S​-Y)×
irregular income till Shares
maturity
THEORETICAL FUTURE PRICE

Where, F = Future fair price

S = Spot Price
e= Continuous compounding factor
(2.71828)
r= risk free interest rate
y = % income yield pa
T = Time till maturity
THEORETICAL FUTURE PRICE

‘e’ stands for exponential x function

It is continuous compounding factor
i.e. number called as Napier Number
and its approximate value is
2.718281828
THEORETICAL FUTURE PRICE

To solve the value of e raise to x by a simple

calculator following steps need to be followed
Step 1: 2.7183
Step 2: Press square root (
button 12 times
Step 3: Subtract 1 from the answer at step
2
Step 4: Multiply the answer at step 3 with
power of ‘e’
THEORETICAL FUTURE PRICE

To solve the value of e raise to x by a simple

calculator following steps need to be
followed
Step 5: Add 1 to the answer at step 4
Step 6: Press multiply and equal to button (Z
and =) 12 times
THEORETICAL FUTURE PRICE

Example : find the value of

Step 1: Type 2.7183
button 12
Step 2: Step 2: Press square root
times (Answer is 1.00024417206)
Step 3: Subtract 1 from the above answer
(1 -1.00024417206 = 0.00024417206)
Step 4: Multiply this answer with the
power of ‘e’ (Answer is 0.00024417206. *
2.2 = 0.00053717853)
THEORETICAL FUTURE PRICE

Step 5: Add 1 to this answer (Answer is 1+

0.00053717853 = 1. 00053717853)
Step 6: Press multiply and equals to button
(x and = ) 12 times (Answer is
9.02223862126
Answer is = 9.02
 THEORETICAL FUTURE PRICE
Example
1. A one year long future contract on a non
dividend paying stock is entered into
when the stock price is Rs.60 and the
risk free rate of interest is 10% p.a. with
continuous compounding. What is the
theoretical price of the future’s contract?
S=60, r=10% 0.1 T=1
 THEORETICAL FUTURE PRICE
Example
1.Step 1: Type 2.7183
button 12
Step 2: Step 2: Press square root
times (Answer is 1.00024417206)
Step 3: Subtract 1 from the above answer
(1 -1.00024417206 = 0.00024417206)
Step 4: Multiply this answer with the
power of ‘e’ (Answer is 0.00024417206. *
0.1= 0.0000244172)
 THEORETICAL FUTURE PRICE

Example
Step 5: Add 1 to this answer (Answer is 1+
0.00053717853 = 1.0000244172)
Step 6: Press multiply and equals to button
(x and = ) 12 times (Answer is
1.10518374474
F = 60 * 1.1052
F = 66.312
 THEORETICAL FUTURE PRICE

Example
2. If the spot price of gold is Rs.
20000. Interest rates are 5% and
the contract settles in one year.
Theoretical future price would
be?
THEORETICAL FUTURE PRICE

Example
3. Mr. Tushar enters into a futures
contract to buy bushels of corn at spot
price of Rs. 200000/-. The corn is stored
for use in 3 months time. Storage and
insurance charges of Rs. 200. Interest
expenses are 10% per year continuously
compounded . Calculate the fair price of
the contract
THEORETICAL FUTURE PRICE

Example
4. The share of X Ltd. Is Rs. 250
in spot market. No dividend is
expected. Risk free interest rate
is 8%. What would be the
theoretical price of X Ltd.'s 3
months futures?
THEORETICAL FUTURE PRICE

Example
5. Spot price of a 3 month
zero coupon bond is Rs.
970.87. Risk free interest
rate is 6%. Find the
Theoretical futures price.
 THEORETICAL FUTURE PRICE

Example
6.A T-Bill with a coupon rate of 8%
pa continuously compounded is
issued by Government and is
available in market at spot price of
Rs. 2080. Cost of financing is 12%
pa. What is the fair price of 9
Months future contract?
THEORETICAL FUTURE PRICE

Example
F​=S​×
S = 150, r=7% 0.07 y 3.2% 0.032 t = 6
(6/12)
150 X e (0.07-0.032) 6/12
150 X e 0.019
152.88
 THEORETICAL FUTURE PRICE

Example
7. A Futures contracts for 4 months is entered
into when a spot price is at 1000. if the risk
free interest rate is 3% per year (with
continuous compounding) and the dividend
yield on the index is 2% per year, What is
the future price?
 THEORETICAL FUTURE PRICE

Example
8. Current price of a stock listed on NSE is
Rs. 200. Risk free interest is 10%. Expected
yield is Rs. 2.50. Calculate the fair price of a
three month. Futures contract for an
investor.
 PRICING INDEX FUTURES

Index future are a type of futures

contract on a particular stock or
financial Index
Just the way participants buy/sell
forward, futures and options
contracts, participants also
participate in buying/selling
contracts on a particular Index
 PRICING INDEX FUTURES

Index future are a type of futures

contract on a particular stock or
financial Index
Just the way participants buy/sell
forward, futures and options
contracts, participants also
participate in buying/selling
contracts on a particular Index
 PRICING INDEX FUTURES

A Stock index/stock market index is a

statistical tool used to measure market
value of a section of stock market
Index future are considered a way of
determining market sentiment
Trading/Hedging with the help of
Index futures involves dealing into a
portfolio of shares or equity index
 PRICING INDEX FUTURES

Some famous Stock Index Futures

around the world are mentioned as
below, S&P Index Futures is the
most traded Index Futures
Contracts
 PRICING INDEX FUTURES
Country Index Futures
India Nifty 50 NSE, SENSEX, CNX NIFTY
US S&P500, DIJA, NYSE, NASDAQ, Dow 30
Canada TSE 35
Hong Kong Hang Sang
China China A50, Dj Shanghai
Malaysia Kualalumpur
South Korea Kospi
Germany DAX
UK FTSE 100
Japan Nikkei 225
 PRICING INDEX FUTURES
Sr. Income Formula
No.
1 When Income is F​=S​×
given in %
2 When Income is F​=S​×
given in Amount
 INITIAL MARGIN AND MAINTENANCE
MARGIN

To know the concept Margin we will

take on example
i.e. XYZ taking a flat on rent, before
getting the possession, XYZ has to pay
a security deposit to owner of the flat
In case there are any damages to the flat,
the same is adjusted with security
deposit XYZ pay
 INITIAL MARGIN AND MAINTENANCE
MARGIN

Similarly in Future Contract , a

security deposit is paid which is
known as Margin
If there is any decrease in value of
the underlying asset, the same is
adjusted from margin account
 INITIAL MARGIN AND MAINTENANCE
MARGIN

Margin account allows investors to make

investments in future contract
It ensures that investors are serious
about he buying and selling of stocks
Margin money ascertains the buyers
pays deal amount on time and the
seller also honours his commitment
 INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

1. Initial Margin: Initial Margin means
the minimum amount of capital or equity
provided by investors at time of entering
into a futures contact
It is required in order to avoid overtrading
and excessive trading in futures contract
 INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

x: If a person goes long on futures
contract for ABC stock trading for
100 shares and if the initial margin
required is 20%. The initial margin
will be calculated as 100 X 100 X
20%= Rs. 2000
 INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

2. Maintenance Margin:
Maintenance Margin is the
minimum balance that one needs to
keep in account in order to keep the
futures position valid
 INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

2. Maintenance Margin: It is the
amount that an investor is required
to maintain all the time in his
margin account
MARKING TO MARKET AND VARIATION
MARGIN

Marking to Market: Also known as

“Daily Settlement”, Marking-to-
Market (MTM) is a process of
valuing underlying assets in a futures
contract at the end of each trading day
The profit or loss is settled by the
exchange
MARKING TO MARKET AND VARIATION
MARGIN

Marking to Market: At the end of each

trading session, all outstanding contracts
are calculated at settlement price of that
trading session
The exchange makes an adjustment by
debiting the margin accounts of
members who are at a loss and crediting
the accounts of members who gain
MARKING TO MARKET AND VARIATION
MARGIN

Variation Margin: As the name

suggest, variation margin is the amount
of money required to bring the margin
balance back up to the initial margin
level
In certain cases, there are some losses
that bring the margin below the required
Maintenance margin level
MARKING TO MARKET AND VARIATION
MARGIN