Futures -

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Futures
Distinction in between Futures contract
and Forward contract


Futures contract


Standardised norms promotes liquidity
in the futures market over the forward
market


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Distinction in between Forwards
and Futures
Futures Forwards
Trade on an organised
exchange
OTC in nature
Standardised norms Customised features
More liquid Less liquid
Margin payments are
present
Not present
Follows daily settlement Only at the end of the
period
Counter party risk-
clearing corporation
To be borne by the client
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Types of Future contracts
Buy a future : Agreement to take
delivery during the future date at
agreed future price
Sell a future : Agreement to make
delivery during the future date at a
agreed future price
Example (in both directions) Cash
settlement-Speculators Vs Hedgers
© Both
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Features of Futures
Spot price
Futures price
Contract date
Contract period
Quantity of the asset
Name of the underlying asset
Contract size –Also Called Lot size
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Futures terminology
Spot price
Futures price
Contract cycle
Expiry date
Contract /lot size –Revisit
Basis :Spot price-Futures price
Cost of carry-relationship between
future price and spot price- cost of
storage+Interest –benefit accrued
from the asset
Basis
Short hedge-Spot 1 : Rs 100
Spot 2: 85 Futures 1: Rs102 Futures
2:Rs87
When basis strengthens –Gain ?
When basis weakens –Loss?
• Long hedge –Spot 1:Rs.200 Futures
1-Rs.203 Spot 2:Rs.240
Futures2:Rs243
• Why spot price= future price @
expiry? Arbitrage opportunity
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Futures -terminology
 Price limit :maximum price limit posed by the
exchange-sets the day price movement limit of
underlying-initial margin money collected – Price
increases = the daily price limit i-e limit up ;
 Price decreases=the daily price limit i-e limit
down
 Price Band : For FUTSTK-20%;INXSTK-10%
 Limit –up /down : circuit breaker for Index based
 Position limit: prescribed by the exchange-1995
Sumitomo Corporation and Hamanaka
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Circuit breaker-NSE
Sl.No Before 1.00
P.m of trading
Between 1.00
P.M-2.30 P.M
After 2.30 P.M
10% 1.00 Hour Halt 30 Minutes Halt No halt
thereafter at
10%
15%

2 Hours Halt 1.00 P.M-200 P.M
1.00 Hour Halt
After 2.00 P.M
Halt for the
remaining
trading day
20% Shall be halted for remainder of trading day
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Position limit
Category Position limit
Option
Position limit
Futures
Position limit
Combined
Trading
member
Equity index
option contracts
Rs.500 cr/15%
of total open
interest
Equity index
futures contracts
Rs.500 cr/15%
of total open
interest
Stocks having
market wide
position limits –
Rs.500 cr or
above –
combined limit
20% of MWPL
or Rs.300 cr
which ever is
lower ;with in
the stock futures
10%MWPL or
Rs150 cr
Client Level
Derivative contracts on underlying Should not
exceed 1% of free float market capitalization –in
terms of shares and 5% of open interest in all
derivative contracts –in terms of shares : which ever
is higher
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Contract specifications –stock
futures
-Nov,2001
Contract-underlying securities /S&P
CNX Nifty
Exchange-NSE
Security descriptor –N FUTSTK
Contract size-as specified by
exchange- Rs.2 lakh
Price steps-.05* respective lot size
Trading cycle-three month trading
cycle
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Contract specifications –stock
futures
Near month(one); next month(two);
far month(three)-New contract will
be introduced on next trading day
following the expiry of near month
contract
Expiry day-last Thursday of the
expiry month/previous trading day
if the last Thursday is a trading
holiday

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Open interest and Settlement
price
Open interest:-Outstanding positions in
the contract at that point of time and
Liquidity of the contract . Next video
Closing out position –easier at when open
interest is high and vice versa
Settlement price:-average of the prices at
which the contract is traded-NSE:
average price of Last half an hour and
when trade is not taking place –
theoretical price will be taken to
consideration
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Open Interest
 Consider the following transactions in ICICI single stock
futures that took place in one of the exchanges .
 ON Jan2 When the contract started trading , Megafund took a
long position in 10 contracts .Minifund took a long position in
12 contracts . Ram took a short position in 7 contracts and
Interfund took a short position in 15 contracts
 On Jan3 Megafund took a short position in 5 contracts
.Minifund took a long position in 8 contracts .Ram took a long
position in 3 contracts and Interfund took a short position iin 6
contracts
 On Jan 4 Megafund took a short position is 10 contracts
.Minifund took a short position in 5 contracts . Ram took a long
position in 8 contracts and Interfund took a long position in 7
contracts
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Open interest
 Currently Karthik is long on 1000 contracts Prakash on
another 4200 contracts and sanjay is short on 5200
contracts .If they undertake trading on following four
days
Day1: Karthik sells 500 contracts &prakash buys 500
contracts
 Day2:Karthik buys 700 contracts and Prakash sells 700
contracts
 Day3- Karthik buy 200 contracts &Sanjay sells 200
contracts
 Karthik sells 800 contracts & sanjay buys 800 contracts
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Open Interest
Price Volume Open
Interest
Market Change in
market
Rising Up Up Strong Bullish-
Strong
New money
entering into the
market
Rising Down Down Bearish-Weak Money leaving
the market
Declining Up Up Weak Bearish Aggressive new
short selling
Declining Down Down Bullish-Strong Seller will
liquidate his
positions
causing an end
to downward
trend
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Contract specifications –stock
futures
Settlement basis:Mark to market
and final settlement –T+1 basis
Daily settlement –closing price of
futures contracts for the trading
day
Final settlement price- closing price
of underlying security on the last
trading day
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Contract cycle2013
Jan Feb Mar Apr
Jan 31 Contract
Feb 28 Contract
Mar 28 Contract
Apr 25 Contract
May 30 Contract
June 27 Contract




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Contract Lot size
Index future Market
Multiplier
On September 3
BSE sensex 30
is at 16,140.BSE
sensex 30
expiry on Oct,27
are at 16,311.
Multiplier 15
.Calculate the
cash flow for the
folloiwng if the
BSE sensex 30
has value of
16,660
BSE 30 Sensex futures 15
BSE Sensex Mini futures 5
BSE Teck futures 124
BSE Bankex futures 25
BSE Oil and Gas futures 38
NSE CNX Nifty futures 50
NSE CNX Nifty mini futures 20
CNX IT futures 100
Bank Nifty futures 50
Nifty Mid cap 50 futures 150
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Futures-Terminology
Initial margin: Deposit which is to
be made at the moment of entering
into the futures contract
Marking to market:gain or loss can
be calculated from the futures
closing price
Maintenance margin :To ensure in
the margin account never negative
–margin call –to top up initial
margin
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Price quotes
 Asset underlying the futures market
 Contract size
 How the price is quoted
 Maturity of the contract
 Opening price
 Highest price traded
 Lowest price traded
 Settlement price
 Change in settlement price
 Open interest
 Volume of trading
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key advantages &Major types
Key advantages
Highly liquid market-easy to open
and close position
Gearing-buying large exposure with
the help of 10% of the total
exposure
Long futures –buying futures –
Bullish
Short futures –selling futures –
Bearish
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Features Geared instruments
Facilitates to buy the large
exposure with small outlay is
known gearing process
Futures to trade without owning
stocks
Futures are used as hedging
instruments
Futures for portfolio adjustments
Gearing process –example
Share A is currently priced Rs.100
and the December future on that
share is priced at Rs.102
A few days later the share price has
risen to Rs.110 and the future has
risen to Rs.112
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Futures-Features
Futures to trade without
stocks
 Moving out of the
existing futures by
entering into counter
positions

Futures-Pairs(Spread)
trading
 To take position on
relative performance of
two shares –pairs
trading
 Studying the movement
of prices of two stocks
–entering into the
futures
Determiining the net
gains
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Futures –Pairs Trading
Investor thinks that A will outperform the
B stock over the next few months . He
buys 2 futures of A and sells 3 futures of
B (1000 shares)
Share A
Rs
Share B Rs
Share
price
600 400
Future
price
675 450
Price
after
Share A
Rs
Share B
Rs
Share
price
540 340
Future
price
546 344
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Port folio adjustments
Assume investor
holds 10,000
shares of A . B is
considered as
outperforming
stock over the A
stock. (futures-
1000)
He sells 10
futures of A and
buys 13 futures B
price A B
Share 320 250
future 325 254
Price
2months
A B
Share 336 275
Futur
e
338 277
Type of orders
Type of
Orders
Time Price Other
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Time orders
Time
Day
Immediate
or Cancel
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Price condition
Stop loss order : This facility allows
the user to release an order into the
system , after the market price
reaches or crosses threshold price
Market order : Price of execution is
not known
Limit order: Price is known but no
certainity involved to execute order
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Index future
 Index is a number – represents the changes in
between two periods
 Stock index – change in the value of a set of
stocks over a base period
 Example
 Importance of Index
 As a barometer of market index
 As a benchmark of portfolio performance
 As an underlying derivative instruments –Index
futures
 In passive fund management of funds
Types of index
Price weighted index: weight given
in accordance to the stock price
Market capitalisation index: equity
price is weighted by the market
capitalisation of the company(share
price* shares outstanding)
Index=
Current market capitalisation * Base value
Base market capitalisation
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Index derivatives /Index
fund/ETF
Index derivatives are derivative
contracts which have the index as
the underlying
Index fund: Tries to replicate the
index returns-investing in the index
stocksin the proportions
ETF: exposure to index or the
portfolio of securities –as single
stock traded in the stock exchange.

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Hedge ratio
=Futures position
Underlying asset position
=Value of hedged portfolio
Price of the futures contract

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Features of futures
Quick and low cost
Price discovery function
Advantages to informed individuals
Protection – through index futures
Flexibility
Integrity –protects through market
margins
Leverage –marking to market
Maintenance margin
Variation margin
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Margin – Role of Clearing House/
corporation
Central counter party
Seller to buyer
Buyer to seller
Deposit of funds-with the clearing
corporation
Initial margin –a deposit for meeting out
the potential loss on the position based
on maximum expected movement
overnight in price
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Margin
Initial margin: on previous
experience, collected from both
buyer and seller , subject to
revision,10% value of the contract,
calculated on the Value at
Risk(VaR)=To cover the one day
loss through 99% of the days .
VaR- value of the portfolio which is
expected to lose due to potential
changes in the underlying asset
(Clearing Corporation)
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Maintenance margin
 Maintenance Margin – to support the daily
settlement process “mark to market”-losses
already are collected
 Initial margin- to safeguard against potential
losses on outstanding positions.
 Maintenance margin-75-80% of initial margin –
adequate cash resources should be deposited –
transactions will be with held- to maintain the
margin shorting is done and profits are realised
and set the balances in the margin deposit and
the remaining are withdrawn by the investor
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Marking to market
- to evade credit risk – margin is
maintained by the exchange- from the
players- to overcome counterparty risk.
-Contract is marked to its present market
value.
On every day- contract is marked to
market
Trader vs Exchange
If trader earns profit- exchange is liable-
profit will be credited
Unless otherwise vice versa


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Variation margin
 To restore the initial margin- through margin
call from the exchange
Exercise
On November 15, the spot price for Telco is
Rs.473 per share , Mr. X buys 15 contracts of
Jan Telco futures of Rs.491.Assume that initial
margin is Rs.800 per contract and the
maintenance margin is Rs.600 per contract
.Given the each contract 50 shares .Daily
settlement of prices are given
Nove15 Rs.496;Nove16 Rs.503; Nove 17 Rs.488;
Nove 18 Rs.485; Nov19 Rs.491
November16th Mr.X withdraws the profit from the
maximum allowed on Nov16 and half the
maximum amount allowed
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Futures pricing
S= F-s-rs
Under the no uncertainty and
uncertainty
Investors are neutral , without any
expectations they are bearing risk-
Spot price = FP-s-rs
If the investors are risk averse
Spot price= FP’-s-rs-ф
For financial asset s=0; rS= dividends
or interest coupon , exceeds
opportunity cost ,lead to negative
S+rS= cost of carry=> Ө Theta
F1=S+ Ө
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Arbitrage – Pricing of futures
Borrow money to
buy shares
Buy shares
Sell futures contract =
to the shares bought
Hold shares and
receive dividends
Deliver shares in
fulfillment of futures
contract
Borrowing Rs 100
Buying of shares

Rs.100
Interest rate Rs.6
Dividends Rs.2
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Arbitrage – Pricing of futures-
cash and carry
Borrow money to buy shares + Rs100
Buy shares - Rs.100
Payment of Interest -Rs.6
Receipt of Dividends +Rs.2
Sell futures +Rs 104
Repayment of loan -Rs100
Pay off Zero
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Pricing of futures
Cost of carry=?????
Fair value=?????
When will be the risk less profit –
sell futures ?
Premium=?
Components of premium=?
Early future contract slides…


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Pricing of futures-Reverse cash
and carry
1 Sellsharees
2 lend proceeds from
sale and receive
interest
3 Buy futures
equivalent to the
shares sold
4 Wait until the delivery
date
5 Receive shares
through transaction
Sell shares +Rs100
Deposit of funds -Rs.100
Receive interest (net) +Rs.4
Surrender dividends -Rs.2
Return of
loan/Deposit
+Rs.100
Buy futures -Rs102
Profit/Loss Zero
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Pricing of futures
If FP>Fair value –cash and carry
If FP<Fair value-reverse cash and
carry
Acc J M Keynes JR Hicks (1930)-
futures price reflects futures spot
price
Speculators(Buyers) Vs Hedgers –
FP<SP-Backwardation position
Speculators( sellers)FP>SP-Contango
-presences of producers and
consumers
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Future price
Financial futures=
Spot price+Cost of carry-Returns
(dividends, interest etc)
Commodity
=Spot price+Cost of carry +Storage,
Insurance etc
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If an equity share of ACC (face
valueof Rs.10) quotes Rs.220 on
31.12.2004 in the cash market and
the futures price with March2005
expiration date ,quotes at Rs.230
and the borrowing rate is given as
15% and the annual expected
dividend rate is 25% payable before
31.3.2005. the futures price of ACC
as on 31.12.2004
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Cost of carry
Ө=s+rS
Spot price = Future spot price of
the asset
F=S+ Ө
Future price= Spot price+ cost of
carry+ insurance and other charges
– Returns
A=Pe
m
e
m=
2.72
(2.71828)

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Pricing of the index future
Future price of the index= spot
index + cost of carry-Dividends of
the basket of stocks

If the NSE spot index is 1200 , the
one month MIBOR rate is 10.50%
and the expected dividend yield is
2% p.a , the fair value of the futures
contract with a one month
expiration

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Currency futures –Introduction
to currency market
Type of currencies –Base and
counter currencies
USD-INR
GBP-INR
Japanese yen –USD
First currency – Base currency
Second currency – Counter /terms
/qoute currency
Exchange rate regimes
Exchange
Rate
Fixed
Floating
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Fixed and Floating exchange
rates
Govt action
towards buying
and selling of
domestic
currency-in open
market
Buying at value is
coming down
Selling at value is
going up
 Self correcting
mechanism
 Demand and supply
of the currency
 Demand for
currency is low-
import is costlier
and export is
cheaper
 When exports-
payment leads to
appreciation of
domestic currency

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Factors –Exchange rates
Fundamental factors : inflation,
BOP, unemployment , capacity
utilisation , trends in import and
exports-BOP surplus- Favourable
exchange rate and vice versa
Technical factors : Interest rates
,Inflation rate and Exchange rate
policy
Political factors
Speculation-over valuation

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Important reasons for Rupee
Depreciation

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Quotes
Direct quote : in the expression of
USD ;1USD =INR 45.000
Indirect quote : in the expression of
terms currency ; 1INR=.021 USD
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Tick size
NSE tick size :.0025
Value of one on each contract =Rs
2.5
Example 4 ticks improvement and 5
contracts
Bid price – willing of the buyer to
pay
Ask price- willing of the price to sell
Spread
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Margin-Mark to market
Example X buys a March delivery
pound sterling futures on say
,January 15 at the price of $1.65
per british pound per contract
.62500 units (CME)
What is the price of futures
contract?
If On Jan 16 the price increases at
1.68 or 3 cents .How much profit of
X?
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Contract specifications
Underlying-Rate of Exchange between
USD and INR
Trading hours :9.00 A.M to 5.00 p.m
Contract size USE1000
Tick size :.25 paise of INR .0025
Contract months:12 near calendar
months
Final settlement date/value date:Last
working day of the month (subject to
holiday calendars)
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Highlight –Forex Futures
Contract
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Currency Future-Contract cycle
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Contract specification
Last trading day :Two working days
prior to final settelment
Settlement :Cash settlement
Final settlement price: The
reference rate fixed by RBI two
working days prior to the final
settlement date will be used for
final settlement .
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RBI Reference rate
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Currency futures contract
trading process
Trader
seller

Trader
Buyer
Member
Broker
Member
Broker
Clearing
house
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Pricing of futures contract-
interest rate parity

 A theory in which the interest rate differential
between two countries is equal to the differential
between the forward exchange rate and the spot
exchange rate. Interest rate parity plays an
essential role in foreign exchange markets,
connecting interest rates, spot exchange rates and
foreign exchange rates.
F/S= (1+Rh)/(1+Rf)
F=S *e
(rh-rf)*r



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Example problems
Assume on March10,2002 annual
interest rate was 10% p.a on indian
rupees and US dollar was 7% per
annum . The spot Re/$ exchange
rate was 44 using the above futures
,calculate the theoretical futures
price on one year forward exchange
rate
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Interest rates influences
If foreign interest rate is more than
If domestic interest rate more than
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Interest rate parity theory
Spot rate Rs48.000 per USD
2years
Interest rate in India 7%
Interest rate in USA 5%
49.50
50.25

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Hedging with currency futures
Importer and Exporter
Long hedge – against the
appreciation of foregin currency
/depreciation of indian currency
Short hedge –against the
appreciation of indian
currency/depreciation of foregin
currency
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Risks in Hedging
The asset that is to be hedged may
not be exactly as the asset on
which the futures contracts are
written-Cash settlement in advance
Mis match of future contract
delivery period and demands of the
hedger i-e before the delivery
period
The quantity bought and sold may
be different from the futures
contract size
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Determinants of hedging
Choice of underlying currency
Choice of the maturity contracts
Hedge ratio
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Hedge ratio-Future
contracts(General)






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| |
ize of the exposure
Hedge *
Size of the position taken in the futures contract
S
h
(
=
(
¸ ¸
Size of position contract size* Number of future contracts =
Size of the exposure Quantity of assets exposed
*
spot price of the asset exposed
=
Hedge ratio contd….
 It is known minimum variance hedge ration
 ASChange in spot price during a period of time
equal to the life of the hedge
 AFChange in futures price during a period of
time equal to the life of the hedge
 osstandard deviation of AS
 ofStandard deviation of AF
 µ coefficient correlation between AS and AF
Hedge optimal ratio:



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*
s
h
f
o
µ
o
(
=
(
¸ ¸
Hedge ration
 On May 10,Meenakshi Rolling flour mills estimates that
it will require 5MT of wheat on June 20.It wants to hedge
the risk of increase in the price of wheat in the future and
decides to hedge the price risk using wheat futures in
MCX Indian. Futures contracts are available with delivery
on June 20 , with a futures price of INR 1,205. Since the
hedge lasts from May 10 to June 20 for a period of 42
days , the manager of mills find the following with
respect to the spot price and futures price of wheat
 Standard deviation of changes in spot price =`105
 Standard deviation of changes in futures price =`120
 Correlation between spot price and futures price changes
=.96


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Hedging Effectiveness
2
2
2
Hedging effectiveness
F
s
o
µ
o
(
=
(
¸ ¸
 On November 20 the
spot price of Jute is
`2,198 per 100kg and the
price of December jute
futures with expiry on
December 15 is `2,276.
The standard deviation of
`260 and standard
deviation of futures price
`248 . The correlation is
.99 what is hedge ration
and hedge
effectiveness?
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Number of contracts used to
hedge
NA=Size of the position being hedged
QF=Size of the futures contract
N*=Optimal number futures contracts is for hedging



 h=.8 Na=10,000 and Qf=1,000
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*
*
A
F
N
N h
Q
(
=
(
¸ ¸
Hedging problem:
On May 10 Meenakshi Rolling Flour Mills
50Mt of wheat on June 20.The spot price
of wheat on May 10 is INR 1,214(100kg)
.Futures contracts for delivery on
June20. with a futures price of INR 1,205.
Hedge lasts from May 10 to June 20 (42
days) contract futures is available for
10MT
Standard deviation in spot price INR 105
standard deviation of futures price 120
correlation .96 How much Meenakshi
mills should hedge its exposure?
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Short hedge &Long Hedge
Comparision between the futures
contract price and exchange rates
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