Risk MGMT Mod 2.

RISK MANAGEMENT
FUTURES AND FORWARDS

A DERIVATIVE INSTRUMENT IS A FINANCIAL
CONTRACT WHOSE PAYOFF STRUCTURE IS
DETERMINED BY THE VALUE OF AN UNDER-
LYING COMMODITY, SECURITY, INTEREST
RATE, SHARE PRICE INDEX EXCHANGE, OIL
PRICE AND LIKE. SO A DERIVATIVE INSTR-
UMENT DERIVES ITS VALUE FROM SOME
UNDERLYING VARIABLE. A DERIVATIVE
INSTRUMENT PROMISES TO CONVEY
OWNERSHIP.
7/11/2013 Prof. D. Gopinath 1
DERIVATIVES
ALL DERIVATIVES ARE BASED ON SOME
CASH PRODUCTS. IT INCLUDES COMMO-
DITIES,METALS, FOREIGN EXCHANGE,
BONDS,SHORTTERM DEBT SECURITIES
SUCH AS T- BILLS, OVER THE COUNTER
MONEY MARKET PRODUCTS LIKE LOAN
OR DEPOSITS.THE PURPOSES FOR
WHICH DERIVATIVES ARE USED ARE:-

DERIVATIVES- PURPOSES
1. REDUCTION OF FUNDING COSTS.
2. ENHANCING THE YIELD ON ASSETS.
3. MODIFYING THE PAYMENTS STRUCT-
URE OF ASSETS TO CORRESPOND TO
THE INVESTORS MARKET VIEW. BUT
THE MOST IMPORTANT USE OF DERIVA-
TIVES IS IN TRANSFERING MARKET
RISK CALLED AS HEDGING WHICH IS
PROTECTION OF LOSSES .

DERIVATIVES
HEDGING IS PROTECTION AGAINST
LOSSES RESULTING FROM UNFORESEEN
PRICE OR VOLATILITY CHANGES.SO
HEDGING IS A VERY IMPORTANT TOOL
OF RISK MANAGEMENT.
THERE ARE MANY KINDS OF DERIVATIVES:
FUTURES, OPTIONS, INTEREST RATE
SWAPS AND MORTGAGE DERIVATIVES.

FORWARD CONTRACTS
A DEAL FOR THE PURCHASE OR SALE OF A
COMMODITY SECURITY OR OTHER ASSET
CAN BE IN THE SPOT OR FORWARD
MARKETS. A SPOT OR CASH MARKET IS
MOST COMMONLY USED FOR TRADING.
IN A FORWARD CONTRACT THE BUYER
AGREES TO PAY CASH AT A LATER DATE
WHEN THE SELLER DELIVERS GOODS.

FORWARD CONTRACTS.
USUALLY NO MONEY CHANGES HANDS
WHEN FORWARD CONTRACTS ARE MADE.
NORMALLY ONE OF THE PARTIES MAY
ASK FOR SOME INITIAL GOOD FAITH
DEPOSIT TO ENSURE THAT THE
CONTRACT IS HONOURED.HERE THE
PRICE AT WHICH THE CONTRACT IS
ENTERED IS DECIDED AT THE TIME OF
ENTERING INTO THE CONTRACT.
FORWARD CONTRACT.
THE ESSENTIAL IDEA OF ENTERING INTO A
FORWARD CONTRACT IS TO PEG THE
PRICE AND THEREBY AVOID THE PRICE
RISK.SO ONE IS ASSURED OF THE PRICE
AT WHICH ONE CAN BUY/SELL GOODS
OR OTHER ASSETS.SO THE RISK OF
PRICE MOVING ADVERSELY IS AVOIDED.
AT THE MATURITY OF A CONTRACT IF
THE MARKET PRICE IS GREATER THAN
THE AGREED PRICE THE BUYER GAINS.
FORWARD CONTRACTS.
FORWARD CONTRACTS HAVE BEEN IN EXI-
STANCE FOR SOME TIME. THE FORMAL
START TO IT HAPPENED IN 1848 WHEN
THE CHICAGO BOARD OF TRADE WAS
ESTABLISHED AS A COMMODITIES
EXCHANGE.A FORWARD CONTRACT IS A
GOOD MEANS OF AVOIDING PRICE RISK.
EACH PARTY FACES THE RISK OF
DEFAULT.
FORWARED CONTRACT.
ONCE A POSITION OF BUY/SELL IS TAKEN
AN INVESTOR CANNOT RETREAT WITH-
OUT THE CONSENT OF THE OTHER
PARTY OR BY TAKING A REVERSE POSIT-
ION OF THE EARLIER CONTRACT.THESE
ARE CONTRACTS ENTERED ON A ONE TO
ONE BASIS AND WITH NO STANDARDIS-
ATION.THE PROBLEMS OF CREDIT RISK
AND NO LIQUIDITY LED TO THE
FORMATION OF FUTURES CONTRACTS.
FUTURES CONTRACTS.
A FUTURES CONTRACT REPRESENTS AN
IMPROVEMENT OVER THE FORWARD
CONTRACTS IN TERMS OF 1. STANDARD-
ISATION, 2.PERFORMANCE AND 3. LIQUI-
DITY.
A FUTURES CONTRACT IS A STANDARDI-
ZED CONTRACT BETWEEN TWO PARTIES
WHERE ONE OF THE PARTIES COMMITS
TO SELL AND THE OTHER TO BUY .

FUTURES CONTRACTS.
THIS IS DONE FOR A STIPULATED QUANTI-
TY,QUALITY OF A COMMODITY, CURREN-
CY,SECURITY, INDEX OR SOME OTHER
SPECIFIED ITEM AT AN AGREED PRICE ON A
GIVEN DATE IN THE FUTURE. THE FUTURE
CONTRACTS ARE STANDARDIS-ED ONES SO
THAT :-
1. THE QUANTITY OF THE COMMODITY COULD
BE TRANSFERRED OR WOULD FORM A BASIS
OF GAIN/LOSS ON MATURITY OF CONTRACT.
FUTURE CONTRACTS
2. THE QUALITY OF A COMMODITY, AND
THE PLACE OF ITS DELIVERY WOULD BE
MADE.
3. THE DATE AND MONTH OF DELIVERY.
4.THE UNITS OF PRICE QUOTATION.
5. THE MINIMUM AMOUNT BY WHICH THE
PRICE WOULD CHANGE AND THE PRICE
LIMITS FOR A DAYS OPERATIONS ARE
SPECIFIED.

FUTURES CONTRACTS.
FUTURES CONTRACTS ARE TRADED ON
COMMODITY OR OTHER FUTURE EXCHA-
GES.PEOPLE BUY AND SELL FUTURES AS LIKE
OTHER COMMODITIES.
WHEN AN INVESTOR BUYS A FUTURES CO-
NTRACT ( HE TAKESA LONG POSITION) ON AN
ORGANISED EXCHANGE HE IS IN FACT
ASSUMING THE RIGHT AND OBLIGATION OF
TAKING THE DELIVERY OF THE ITEM ON THE
SPECIFIED DATE.
FUTURES CONTRACTS.
WHEN AN INVESTOR TAKES A SHORT
POSITION ONE ASSUMES THE RIGHT
AND OBLIGATION TO MAKE DELIVERY OF
THE UNDERLYING ASSET.THERE IS NO
RISK OF NON PERFORMANCE IN THE
CASE OF TRADING IN FUTURES
CONTRACT.THIS IS BECAUSE OF THE
CLEARING HOUSE WHICH PLAYS A
PIVOTAL ROLE IN THE CLEARING.
FUTURES CONTRACTS
A CLEARING HOUSE TAKES THE OPPOSITE
POSITION IN EACH TRADE, SO THAT IT
BECOMES A BUYER TO A SELLER AND A
SELLER TO A BUYER.WHEN A PARTY
TAKES A SHORT POSITIONIT IS OBLIGED
TO SELL THE COMMODITY AT THE
STIPULATED PRICE TO THE CLEARING
HOUSE ON THE MATURITY OF THE
CONTRACT.
FUTURES CONTRACTS
THE CLEARING HOUSE GUARANTEES THE
PERFORMANCE OF THE FUTURES
CONTRACTS, THE PARTIES IN THE
CONTRACTS ARE REQUIRED TO KEEP
MARGINS WITH IT.THE MARGINS ARE
TAKEN TO ENSURE THAT EACH PARTY TO
A CONTRACT PERFORMS IT.THE MARGI-
NS ARE ADJUSTED ON A DAILY BASIS TO
ACCOUNT FOR GAINS AND LOSSES.
FUTURES CONTRACTS
THIS DEPENDS ON THE PRICE AT WHICH
THE FUTURES CONTRACTS ARE BEING
TRADED IN THE MARKET.THIS IS KNOWN
AS MARKING TO THE MARKET AND INVO-
LVES GIVING A CREDIT TO THE BUYER
OF THE CONTRACT IF THE PRICE OF THE
CONTRACT RISES AND DEBITING THE
SELLER‟S ACCOUNT BY AN EQUAL
AMOUNT.
FUTURES CONTRACTS.
SIMILARLY THE BUYERS BALANCE IS REDU-
CED WHEN THE CONTRACT PRICE DECLI-
NES AND THE SELLERS ACCOUNT IS ACC-
ORDINGLY UPDATED. IN EFFECT THE
PROFIT/LOSS ON A FUTURES CONTRACT
IS SETTLED DAILY AND NOT ON MATUR-
ITY OF THE CONTRACT AS FOR A
FORWARD CONTRACT.

FUTURES CONTRACT.
IT IS NOT NECESSARY TO HOLD ON TO A
FUTURES CONTRACT UNTIL MATURITY
AND ONE CAN EASILY CLOSE OUT A
POSITION. EITHER OF THE PARTIES MAY
REVERSE THEIR POSITION BY INITIATI-
NG A REVERSE TRADE SO THAT THE
ORIGINAL BUYER OF A CONTRACT CAN
SELL AN IDENTICAL CONTRACT AT A
LATER DATE CANCELLING THE EARLIER.
FUTURES CONTRACTS
THE FACT THAT THE BUYER AS WELL THE
SELLER OF A FUTURES CONTRACT ARE
FREE TO TRANSFER THEIR INTEREST IN
THE CONTRACT TO ANOTHER PARTY
MAKES SUCH CONTRACTS ESSENTIALLY
MARKETABLE INSTRUMENTS.FUTURES
CONTRACTS ARE HIGHLY LIQUID IN
NATURE.HERE A SMALL NUMBER OF
CONTRACTS ARE HELD FOR DELIVERY.
DIFFERENCES FORWARDS AND
FUTURES CONTRACTS.
1. STANDARDIZATION:-
A FORWARD CONTRACT IS MADE BY
THE SELLER AND THE BUYER WHERE
THE TERMS ARE SETTLED MUTUALLY.
IN A FUTURES CONTRACT THE
TRANSACTION AS REGARDS QUANTITY
/ QUALITY / PLACE ETC ARE
STANDARDIZED.ONLY THE PRICE IS
NEGOTIATED.

DIFFERENCES –
FORWARDS/FUTURES
2.LIQUIDITY:-
THERE ARE NO SECONDARY MARKETS FOR
FORWARD CONTRACTS WHILE THE
FUTURES ARE TRADED ON ORGANIZED
EXCHANGES. SO FUTURES CONTRACTS
ARE MORE LIQUID THAN THE FORWARD
CONTRACTS.

DIFFERENCES-
FORWARDS/FUTURES
3. CONCLUSION OF CONTRACT:-
A FORWARD CONTRACT IS GENERALLY
CONCLUDED WITH A DELIVERY OF THE ASSET
IN QUESTION WHEREAS A FUTUR-ES
CONTRACT IS CONCLUDED EITHER WITH
DELIVERY OF GOODS OR BY PAYI-NG UP OF
PRICE DIFFERENCES. THIS HAS TO BE DONE
BEFORE THE CONCLUSION OF THE MATURITY
OF THE FIRST CONTRACT AND IS CALLED AS
OFFSETTING A TRADE.
DIFFERENCES-
FORWARDS/FUTURES.
4. MARGINS:-
A FORWARD CONTRACT HAS ZERO VALUE
FOR BOTH THE PARTIES AS NO COLLATE-
RAL IS REQUIRED.BUT IN A FUTURES
CONTRACT A THIRD PARTY CALLED
CLEARING CORP IS ALSO INVOLVED
WITH WHICH MARGIN IS REQUIRED TO
BE KEPT BY BOTH PARTIES.

DIFFERENCES-
FORWARDS/FUTURES
5. PROFIT/LOSS SETTLEMENT:-
THE SETTLEMENT OF A FORWARD
CONTRACT TAKES PLACE ON THE DATE
OF MATURITY SO THAT PROFIT/LOSS IS
BOOKED ON MATURITY.FUTURES
CONTRACTS ARE MARKED TO DAILY SO
THAT THE PROFITS OR LOSSES ARE
SETTLED DAILY.

CLASSIFICATION OF DERIVATIVES
BASED ON FEATURES
1.NATURE OF CONTRACTS:-
a) FORWARD RATE CONTRACTS AND
FUTURES.
b) OPTIONS.
c) SWAPS.
THE NATURE OF THE CONTRACT SETS
UPON THE RIGHTS AND OBLIGATIONS
OF BOTH THE POSITION TO THE
CONTRACT.
BASED ON FEATURES
2. UNDERLYING ASSET:- THERE CAN BE A
CONTRACT WHICH IS SIMILAR IN ALL
ASPECTS EXCEPT FOR THE UNDERLYING
ASSET.
a) FOREIGN EXCHANGE. b) EQUITIES.
c) INTEREST BEARING FINANCIAL ASSETS.
d) COMMODITIES.
EX:- OPTIONS IN CURRENCY/STOCK.
BASED ON FEATURES.
3. MARKET MECHANISM:-
a) OTC PRODUCTS.
b) EXCHANGE TRADED PRODUCTS.
ROLE OF A CLEARING HOUSE:- IT
PERFORMS TWO CRITICAL FUNCTIONS.
1.OFFSETTING CUSTOMERS DEALINGS.
2. ASSURING THE FINANCIAL INTEGRITY
OF THE TRANSACTIONS IN EXCHANGE.
IMPORTANT FEATURES OF
DERIVATIVES.
DERIVATIVES BECAME VERY POPULAR
BECAUSE OF THEIR UNIQUE NATURE.
THEY OFFER A COMBINATION OF CHAR-
ACTERISTICS WHICH ARE NOT FOUND IN
OTHER ASSETS. THERE ARE FOUR IMPO-
RTANT FEATURES THAT DISTINGUISH
DERIVATIVES FROM THE UNDERLYING
ASSETS AND MAKE THEM USEFUL FOR A
VARIETY OF PURPOSES.
FEATURES OF DERIVATIVES
1.RELATION BETWEEN THE VALUES OF
DERIVATIVES AND THEIR UNDERLYING
ASSETS:-
WHEN THE VALUE OF UNDERLYING ASSETS
CHANGE SO DO THE VALUE OF DERIVATIVES
BASED ON THEM. EX:- IF THE PRODUCT PRICE
CHANGES THE INSTRUMENT PRICE ALSO
CHANGES.IN A CURRENCY FUTURE CONTRACT
PRICE TO BE PAID IS FIXED BY THE FUTURE
CONTRACT.
DERIVATIVES.
THIS IS DONE BY DEPENDING ON THE
MOVEMENT OF THE UNDERLYING
CURRENCY.THE RELATION BETWEEN
VALUES OF THE UNDERLYING ASSETS
AND OPTIONS ARE MORE COMPLICATED
BUT THE VALUES OF THE OPTION AND
THE UNDERLYING ASSETS ARE STILL TO
BE RELATED SO DERIVATIVES APPEAR
SIMILAR TO REAL COMMODITIES.
DERIVATIVES.
2. IT IS EASIER TO TAKE SHORT POSITION
IN DERIVATIVES THAN IN OTHER
ASSETS:- AS ALL TRANSACTIONS IN
DERIVATIVES TAKE PLACE IN FUTURE
SPECIFIC DATE IT IS EASY FOR THE
INVESTOR TO SELL THE UNDERLYING
ASSETS. HE CAN TAKE VIEW OF THE
MARKET /PRODUCT WHICH IS NOT
POSSIBLE IN ANY OTHER ASSETS.
DERIVATIVES.
3. EXCHANGE TRADED DERIVATIVES ARE
LIQUID AND HAVE LOW TRANSACTION
COST:- THIS IS BECAUSE OF STANDARD-
IZED TERMS AND LOW CREDIT RISK.
TRANSACTION COST IS LOW BECAUSE
OF HIGH VOLUME OF TRADE AND DUE
TO HIGH COMPETITION. ALSO MARGIN
REQUIREMENTS IN EXCHANGE TRADED
DERIVATIVES ARE VERY LOW SO RISK
ASSOCIATED IS VERY LOW.
DERIVATIVES.
4. IT IS POSSIBLE TO CONSTRUCT A POR-
TFOLIO WHICH IS EXACTLY NEEDED WITHOUT
HAVING THE UNDERLYING ASSETS:- EX:- A
PERSON WITH A FLOATING RATE OF INTEREST
CAN LIMIT HIS EXPOSURE BY BUYING
INTEREST RATE CAP.THIS DERIVATIVE PAYS
THE FIRM THE DIFFERENCE BETWEEN THE
FLOATING RATE AND PREDETERMINED MAX
CAP RATE WHENEVER THE RATE INCREASES
EXCEEDING THE CAP.

PARTICIPANTS IN DERIVATIVES
MARKET.
THE PARTICIPANTS CAN BE BANKS, FI‟s,
BROKERS, CORPORATES,INDIVIDUALS ETC.
THE PARTICIPANTS ARE:-
1. HEDGERS:-
A TRANSCTION IN WHICH AN INVESTOR SEEKS
TO PROTECT A POSITION IN THE SPOT
MARKET BY USING AN OPPOSITE POSITION
IN THE DERIVATIVES IS KNOWN AS HEDGE.
THESE ARE PEOPLE WHO WANT TO REDUCE
RISK OR ELIMINATE RISK. THESE ARE PEOP-
LE EXPOSED TO RISK IN NORMAL BUSINESS
OPERATIONS AND TRY TO ELIMINATE RISK.

MARKET.
2. SPECULATORS:- A PERSON WHO TRADES
EXPECTING TO MAKE PROFIT OUT OF
PRICE CHANGES. THESE ARE PEOPLE
WHO VOLUNTARILY ACCEPT WHAT
HEDGERS WANT TO AVOID. HE HAS A
VIEW ON THE MARKET AND BASED ON
THE FORECAST HE TAKES A LONG
/SHORT POSITION IN THE DERIVATIVES.

MARKET
3. ARBITRAGEURS:- ARBITRAGE MEANS
OBTAINING RISK FREE PROFITS BY SIM-
ULTANEOUSLY BUYING AND SELLING
IDENTICAL INSTRUMENTS IN DIFFERENT
MARKETS. THEY CONSISTENTLY KEEP
TRACK OF THE DIFFERENT MARKETS.
WHENEVER THERE IS ANY CHANCE OF
GETTING PROFIT WITHOUT ANY RISK
THEY WILL TAKE THE POSITION AND
MAKE RISKLESS PROFITS.
MARKET.
THEY PERFORM A VERY VALUABLE ECONO-
MIC FUNCTION BY KEEPING THE
DERIVATIVES PRICES AND CURRENT
UNDERLYING ASSETS PRICE CLOSELY
CONSISTENT. ARBITRAGEURS ARE IN
THE SAME CLASS AS THAT OF
SPECULATORS TO THE EXTENT THAT
THEY HAVE NO RISK TO HEDGE.THEY
MAKE MONEY OUT OF CHANGES IN PRICE
IN DIFFERENT MARKETS.
DERIVATIVE MARKET IN INDIA
IN DECEMBER THE SECURITIES CONTRACT
REGULATION ACT WAS AMENDED TO
INCLUDE DERIVATIVES WITHIN THE
SPHERE OF SECURITIES AND THE
REGULATORY FRAMEWORK WAS DEVEL-
OPED FOR GOVERNING DERIVATIVES TR-
ADING.THE ACT ALSO SPECIFIED THAT
DERIVATIVES SHALL BE LEGAL AND
VALID ONLY WHEN TRADED ON RECOGN-
IZED STOCK EXCHANGES.
DERIVATIVES MARKET IN INDIA
DERIVTIVES TRADING COMMENCED IN
INDIA IN JUNE 2000 AFTER THE GRANT
OF FINAL APPROVAL BY SEBI TO THIS
EFFECT IN MAY 2000. SEBI PERMITTED
THE DERIVATIVES SEGMENTS OF TWO
STOCK EXCHANGES :- NSE AND BSE AND
THEIR CLEARING HOUSES TO COMMENCE
TRADING AND SETTLEMENT IN APPROV-
ED DERIVATIVES CONTRACTS.
DERIVATIVE MARKETS IN INDIA
INITIALLY SEBI APPROVED TRADING IN
INDEX FUTURES CONTRACTS BASED ON
S&P CNX NIFTY AND BSE-30(SENSEX)
INDEX.THIS WAS FOLLOWED BY
APPROVAL FOR TRADING IN OPTIONS
BASED ON THESE TWO INDEXES AND
OPTIONS ON INDIVIDUAL SECURITIES.
THE TRADING IN SENSEX OPTIONS AND
TRADING IN OPTIONS ON INDIVIDUAL
SECURITIES STARTED JUNE 2001.
DERIVATIVES TRADING ON NSE STARTED
WITH S&P CNX NIFTY INDEX FUTURES IN
JUNE 2000.FUTURES CONTRACTS ON
INDIVIDUAL STOCKS WERE LAUNCHED
IN NOV 2001 WHILE THE TRADING IN
INDEX OPTIONS COMMENCED IN JUNE
2001 AND TRADING IN OPTIONS ON
INDIVIDUAL SECURITIES BEGAN IN JULY
2001.
TYPES OF DERIVATIVE INSTRUMENTS
AVAILABLE IN INDIA:-
1. FORWARDS.:-
A FORWARD COMTRACT IS A CONTRACT
BETWEEN TWO PARTIES TO BUY OR
SELL AN UNDERLYING ASSET AT TODA-
Y‟S PRE-AGREED PRICE ON A SPECIFIED
DATE IN THE FUTURE.

DERIVATIVE MARKET
INSTRUMENT IN INDIA
FORWARD CONTRACTS IN INDIA CAN BE
BOOKED BY COMPANIES, FIRMS AND ANY
PERSON HAVING AUTHENTIC FOREIGN
EXCHANGE EXPOSURES ONLY TO THE
EXTENT AND IN THE MANNER ALLOWED
BY RBI. FOREIGN EXCHANGE BROKERS
ARE NOT ALLOWED TO BOOK THE
CONTRACT.
2. FUTURES. 3. OPTIONS.

DERIVATIVE MARKET
INSTRUMENT IN INDIA.
4. SWAPS:-
THESE ARE DERIVATIVE PRODUCTS WHICH
ARE TRADED BETWEEN TWO PARTIES AS
A PRIVATE AGREEMENT AND NOT ON
EXCHANGES. THESE ARE TRADED BETW-
EEN DEALERS. THE SWAPS NORMALLY
DEALT ARE CURRENCY SWAPS AMD
INTEREST RATE SWAPS.

MECHANISM OF FUTURES
MARKETS
FUTURES CONTRACTS ARE TRADED IN
AUCTION MARKETS WHERE THE PRICES
ARE ORDER DRIVEN. IN THESE MARKETS
EACH BROKER AND TRADER CAN BUY AT
THE LOWEST OFFERED PRICE AND SELL
AT THE HIGHEST BID PRICE AND THE
LIQUIDITY IS MAINTAINED BY THE
PARTICIPATION OF THESE BUYERS AND
SELLERS.
MARKETS
SOME OF THESE BUYERS AND SELLERS
ARE HEDGERS SEEKING TO PROTECT
THEIR INVESTMENTS, SOME ARE
SPECULATORS WHO ARE RISK-TAKERS
SEEKING TO TRADE IN PURSUIT OF
PROFIT INCIDENTALLY KEEP BID AND
ASK PRICES CLOSE TOGETHER AND TO
PROVIDE EFFICIENT TRADING IN THE
SYSTEM.
MECHANNISM OF FUTURES
MARKET
FUTURES CONTRACTS ARE DESIGNED IN
SUCH A WAY SO THAT THEIR PRICES
SHOULD ALWAYS REFLECT THE PRICES
OF THE UNDERLYING CASH MARKET. THE
ACTIVITIES OF SPECULATORS AND
ARBITRAGEURS ALSO BRING IN PRICE
ALIGNMENT. IN “CALENDER SPREADING”
TRADERS SELL THE CURRENT DELIVERY
MONTH CONTRACT AND BUY A LATER
DELIVERY MONTH CONTRACT.
MARKETS
THIS REDUCES THE PRICE VARIANCE
BETWEEN THE FUTURES CONTRACTS.
ARBITRAGE ALSO HELPS KEEP THE CASH
AND FUTURES PRICES ALIGNED. EX:-
FUTURES CONTRACTS SEEM TO BE
OVERPRICED IN RELATION TO THE
UNDERLYING COMMODITY, ARBITRAGU-
ERS WILL SELL THE FUTURES CONTRACT
AND SIMULTANEOUSLY BUY THE
COMMODITY MAKING PROFIT.
HISTORY OF FUTURESMARKETS
THIS WAS ORIGINALLY ESTABLISHED TO
MEET THE NEEDS OF THE FARMERS AND
MERCHANTS.FARMERS HAVE TO FACE
RISK OF PRICES AND THIS DEPENDS ON
THE VAGARIES OF VARIOUS KINDS. THE
COMPANIES WHO BUY GRAIN ALSO FACE
THE UNCERTAINITY AND PRICE RISK.
THIS IS ON ACCOUNT OF OVER SUPPLY
AND SCARCITY IN THE MARKET.
HISTORY OF FUTURES MARKETS
IT MAKES SENSE TO MAKE SOME SORT OF
FUTURES CONTRACTS.THE CONTRACTS
PROVIDE A WAY FOR EACH SIDE TO
ELIMINATE THE RISK IT FACES BECAUSE
OF THE UNCERTAIN FUTURE PRICE OF
GRAIN.IN 1848 THE CHICAGO BOARD OF
TRADE WAS ESTABLISHED TO BRING
FARMERS AND MERCHANTS TOGETHER.
THIS WAS DONE TO STANDARDISE THE
QUANTITY AND QUALITY OF TRADE.
CHICAGO BOARD OF TRADE
WITHIN A FEW YEARS THE FIRST FUTURES TYPE
CONTRACT WAS ESTABLISHED AND CALLED AS
“ TO ARRIVE” CONTRACT. SPECULATORS
BECAME INTERESTED IN CONTRACT AND
FOUND TRADING THE CONTRACT TO BE A
BETTER ALTERNAT-IVE THAN TRADING IN THE
GRAINS. THE CHICAGO BOARD OF TRADE NOW
OFFE-RS FUTURES CONTRACTS ON OTHER
UNDERLYING ASSETS INCLUDING SOYA PROD-
UCTS AND TREASURY BONDS AND NOTES.

THE CHICAGO MERCHANTILE
EXCHANGE.
IN 1874 THE CHICAGO PRODUCE EXCHAN-GE
WAS ESTABLISHED PRIVIDING A MARKET FOR
BUTTER, EGG, POULTRY, AND OTHER
PERISHABLE AGRICULTURAL PRODUCT. IN
1919 IT WAS RENAMED AS THE CHICAGO
MERCHANTILE EXCHANGE AND WAS
REORGANISED FOR FUTURES TRADING.SINCE
THEN IT HAS TAKEN CARE OF VARIOUS
PRODUCTS AND IN 1982 IT INTRODUCED
FUTURES ON S&P 500 STOCK INDEX.

THE CHICAGO MERCANTILE
EXCHANGE
TRADITIONALLY FUTURES HAVE BEEN
TRADED BY “OPEN OUTCRY” SYSTEM.
THIS INVOLVES USING A COMPLICATED
SYSTEM OF HAND SYMBOLS FOR PHYSI-
CAL TRADING ON THE FLOOR. IN 1981
CME INTRODUCED EURODOLLAR FUTURE
WHICH GAVE WAY TO FUTURES ON
STOCK INDEXES AND OPTION PRODUC-
TS.IN 1992 IT WENT ELECTRONIC.
OTHER EXCHANGES
MANY OTHER EXCHANGES THROUGHOUT
THE WORLD TRADE FUTURES CONTRA-
CTS. AMONG THEM THE POPULAR EXCH-
ANGES ARE 1. LONDON INTERNATIONAL
FINANCIAL FUTURES EXCHANGES (LIFFE)
TOKYO INTERNATIONAL FINANCIAL
FUTURES EXCHANGE (TIFFE), SINGAPO-
RE INTERNATIONAL MONETARY EXCHAN-
GE (SIMEX), SYDNEY FUTURES
EXCHANGE (SFE).
CLEARING HOUSE.
A CLEARING HOUSE IS AN INTITUTION
THAT CLEARS ALL THE TRANSACTION
UNDERTAKEN BY A FUTURES EXCHANGE.
IT COULD BE PART OF THE SAME
EXCHANGE OR A SEPARATE ENTITY. IT
COMPUTES THE DAILY SETTLEMENT
AMOUNT DUE TO OR FROM EACH OF THE
MEMBERS AND FROM OTHER CLEARING
HOUSES AMD MATCH THE SAME.
CLEARING HOUSES.
MEMBERS WHO EXECUTE TRADE ON THE
EXCHANGE FLOOR ARE OF TWO TYPES.
1. FLOOR BROKERS:- THESE BROKERS WILL
EXECUTE THE ORDERS ON OTHERS
ACCOUNT. THESE PEOPLE ARE NORMAL-LY
SELF EMPLOYED INDIVIDUAL MEMBER OF
THE EXCHANGE.
2. FLOOR TRADERS:- THESE TRADERS EXECUTE
TRADES ON THEIR OWN ACCOUNT.SOME
ALSO EXECUTE THE ORDERS FOR THE
ACCOUNT OF OTHERS.
FLOOR TRADERS
THIS MECHANISM IS KNOWN AS DUAL TRADING
AND SUCH TRADERS ARE KNOWN AS DUAL
TRADERS. SOME OF THE FLOOR TRADERS ARE
CLASSIFIED AS „SCALPERS‟. A SCALPER IS A
PERSON WHO STANDS READY EITHER TO BUY
OR SELL.THEY ADD TO THE LIQUIDITY TO THE
MARKET AS THEY ARE MARKET MAKERS.THEY
ARE ALSO CALLED AS „POSITION TRADERS‟
THEY TEND TO CARRY THE POSITIONS FOR
LONGER PERIOD OF TIME THEREBY ADDING
LIQUIDITY TO THE MARKET.

CONTRACT SPECIFICATION FOR
THE FUTURES.
A FUTURES CONTRACTS BETWEEN THE TWO
PARTIES SHOULD SPECIFY IN SOME DETAIL
THE EXACT NATURE OF THE ASSET , PRICE,
CONTRACT SIZE, DELIVE-RY ARRANGEMENTS,
DELIVERY MONTHS, TICK SIZE, LIMITS ON
DAILY PRICE FLU-CTUATION AND THE
TRADING UNIT.
1. THE ASSET:-THE DELIVERY OF THE ASSET
NEEDS TO BE SPECIFIED AT THE TIME OF
ENTERING INTO A CONTRACT.
FUTURES
IF THE UNDERLYING ASSET IS A COMMO-DITY
THERE MAY BE VARIATIONS IN THE QUALITY
AND GRADE.
2. PRICE:-
THE PRICE AGREEABLE TO THE BUYER AND
SELLER AT THE TIME OF DELIVERY OF THE
CONTRACT IS SPECIFIED AT THE TIME OF
AGREEMENT.THE FUTURES PRICES IF QUOTED
ARE CONVIENIENT AND EASY TO UNDERSTAND

FUTURES.
3. THE CONTRACT SIZE:-
IT SPECIFIES THE AMOUNT OF ASSET TO
BE DELIVERED UNDER ONE CONTRACT.
IF THE SIZE IS TOO LARGE MANY INVES-
TORS CANNOT USE IT FOR HEDGING/
SPECULATION AS THE RISK INVOLVED IS
TOO LARGE. IF IT IS TOO SMALL THEN
THE COAT OF TRADING IS TOO MUCH.

CONTRACT SPECIFICATION OF
FUTURES.
4. DELIVERY ARRANGEMENTS:-
THE PLACE OF DELIVERY IS VERY IMPORT-
ANT WHEN TRANSPORT COST IS SIGNI-
FICANT.
5. DELIVERY MONTHS:-
A FUTURES CONTRACT IS REFERRED TO BY
ITS DELIVERY MONTH.THE PERIOD VAR-
IES FROM ITEM TO ITEM.

FUTURES
FOR EXAMPLE JULY CORN ,MEANS THAT
THE CONTRACT IS FOR DELIVERY IN
JULY.FOR CERTAIN CONTRACTS THE DE-
LIVERY PERIOD RUNS THROUGHOUT THE
MONTH. THE DATE ON WHICH THE
CONTRACT CEASES TO TRADE IS
SPECIFIED BY THE EXCHANGE.

CONTRACT SPECIFICATIONS FOR
THE FUTURES.
6. TICK SIZE:-
THE CONTRACT ALSO SPECIFIES THE MI-
NIMUM PRICE FLUCTUATION OR TICK
SIZE. FOR EXAMPLE IN SOYABEAN CON-
TRACT, ONE TICK IS ¼ CENT PER
BUSHEL AS THE MINIMUM SIZE OF
CONTRACT FOR SOYABEAN IS 5000
BUSHEL.

CONTRACT SPECIFICATIONS FOR
FUTURES.
7. LIMITS ON DAILY PRICE MOVEMENTS:-
THE DAILY PRICE MOVEMENTS LIMITS ARE
SPECIFIED BY THE EXCHANGE. IF THE
PRICE MOVES UP BY A LIMIT IT IS REFE-
RRED TO AS LIMIT UP AND VICE VERSA.
THE PRIME PURPOSE OF THE DAILY
PRICE LIMIT IS TO PREVENT LARGE PRI-
CE FLUCTUATIONS AND TO SAFEGUARD
THE INTEREST OF GENUINE TRADERS.

BASIS
THE BASIS IS THE RELATIONSHIP BETWE-
EN THE CASH PRICE OF A GOOD AND
THE FUTURES PRICE OF THAT GOOD. IT
REPRESENTS THE DIFFERENCE BETWEEN
THE CASH PRICE AND FUTURE PRICE OF
A SINGLE COMMODITY.
BASIS=CURRENT PRICE-FUTURES PRICE.
THE FUTURES MARKET CAN PORTRAY A
PATTERN OF EITHER NORMAL/INVERTED.

BASIS
IF THE PRICES FOR MORE DISTANT FUTURES
ARE HIGHER THAN THE NEARBY FUTURES IT IS
REFERRED TO AS „NORMAL‟ MARKET
CONDITION.
IN AN „INVERTED MARKET‟ THE DISTANT
FUTURES ARE LOWER THAN THE PRICES THAT
ARE NEAR TO EXPIRATION. WHEN THE FUTURE
CONTRACT IS AT EXPIRATION THE FUTURES
PRICE AND SPOT PRICE OF A COMMODITY IS
THE SAME. SO THE BASIS MUST BE ZERO.
BASIS
THIS BEHAVIOUR PATTERN OF THE BASIS OVER
A PERIOD OF TIME IS REFERRED TO AS
„CONVERGENCE‟. IF THE CURRENT PRICE LIES
ABOVE THE FUTURES PRICE AND AS THE TIME
ELAPSES AND FUTURE CONTRACT IS NEARING
MATURITY, THE BASIS NARROWS AND AT THE
TIME OF MATURITY THE FUTURES PRICE
SHOULD BE EQUIVALENT TO CASH PRICE.THUS
BASIS WOULD BE ZERO LEADING TO NO
ARBITRAGE SITUATION.

BASIS RISK.
IF THE HEDGE CAN ELIMINATE THE FULL RISK IT
IS A SITUATION KNOWN AS PERFECT
HEDGING, BUT AS SOME UNCERTAINTY IS
ASSOCIATED ALWAYS WITH THE FUTURE AND
THE DIFFERENCE BETWEEN THE SPOT PRICES
AND FUTURE PRICES MAY CHANGE, THERE ARE
CHANCES OF BASIS RISK.SO BASIS RISK MAY
ARISE BECAUSE OF IMPERFECT HEDGING
BETWEEN SPOT PRICE OF THE ASSET AND THE
FUTURES PRICE OF THE CONTRACT USED.

SPREADS.
A SPREAD IS THE DIFFERENCE BETWEEN
TWO FUTURES PRICES. FOR THE SAME
UNDERLYING GOOD IF THERE ARE TWO
DIFFERENT PRICES ON TWO DIFFERENT
EXPIRATION DATES THE UNDERLYING
SPREAD IS KNOWN „INTRA COMMODITY‟
SPREAD.(OR TIME SPREAD)IF THE
SPREAD IS BETWEEN TWO DIFFERENT
BUT RELATED PRODUCTS THEN IT IS
KNOWN AS INTER-COMMODITY SPREAD.
CONCEPT OF COST OF CARRY
THE EXTENT TO WHICH THE FUTURES PRICE
EXCEEDS THE CASH PRICE AT ONE POINT OF
TIME IS DETERMINED BY THE CONCEPT OF
COST OF CARRY THAT REFERS TO THE
CARRYING CHARGES. THE CARRYING CHARGES
CAN BE FURTHER CLASSIFIED INTO STORAGE,
INSURANCE,TRANSPORTATION,AND
FINANCING COST.CARRYING COST PLAYS A
CRUCIAL ROLE IN DETERMINING PRICING
RELATIONSHIPS BETWEEN SPOT AND FUTURES

CONVENIENCE YIELD,CONTANGO
AND BACKWARDATION.
THE SHORTAGE OF THE PHYSICAL COMMO-
DITY IS PROBABLY ONE OF THE REASON
FOR HAVING ADDITIONAL COST OTHER
THAN COST OF CARRYING. WHEN THERE
IS A SHORTAGE IN A COMMODITY THERE
IS AN IMPLIED YIELD (RETURN) BY
HOLDING THE COMMODITY. THIS YIELD
IS REFERRED TO AS CONVENIENCE
YIELD.
CONTANGO AND
BACKWARDATION.
IF THE FUTURES PRICES OBTAINED BY FULL
CARRY RELATIONSHIP( COST OF CARRY i.e.
THE ESTIMATED COST OF FUTURES PRICES)
ARE ACCURATELY PROJECTED THE BASIS IS
NEGATIVE AS THE FUTURE PRICES ARE
HIGHER THAN THE CASH PRICES.THIS
CONDITION IS REFERRED TO AS „CONTANGO‟
MARKET (WHICH MEANS THE PRICES OF
FUTURES MARKET ARE DETERMINED BY COST
OF CARRY).

CONTANGO AND
BACKWARDATION
THIS SORT OF MARKET IS FEATURED BY
PROGRESSIVELY RISING FUTURE PRICES AS
THE TIME TO DELIVERY BECOMES MORE
DISTANT.IF THE FUTURES PRICE IS LESS THAN
THE CASH PRICE THE BASIS IS POSITIVE. THIS
CONDITION PREVAILS ONLY IF THE FUTURES
PRICES ARE DETERMINED BY SOME OTHER
FACTORS OTHER THAN COST OF CARRYING.
WHEN THE FUTURE PRICES ARE LOWER THAN
THE CASH PRICES IT IS KNOWN AS BACKWAR-
DATION. IT IS FEATURED BY LOWER FUTURES
PRICES AS DELIVERY BECOMES MORE DISTANT

EXPECTATION PRINCIPLE
THIS THEORY POSTULATES THAT THE
EXPECTED BASIS WOULD BE EQUAL TO
ZERO.THIS IS BASED ON THE ARGUMENT
THAT FUTURES PRICES ARE AN UNBIA-
SED ESTIMATE OF EXPECTED FUTURE
SPOT PRICES AS WOULD BE EXPECTED
IN AN EFFICIENT MARKET.THUS THERE
IS NO ROOM FOR ANY EXCESS RETURNS
FOR EITHER THE HEDGERS/SPECULATOR
HEDGING USING FUTURES
HEDGING IS THE PROCESS OF REDUCING
EXPOSURE TO RISK.HEDGE IS ANY ACT
THAT REDUCES THE PRICE RISK OF A
CERTAIN POSITION IN THE CASH MARK-
ET.SIMILARLY EXPORTS AND IMPORTS
ARE EXPOSED TO CURRENCY RISK. THIS
EXPOSURE CAN BE HEDGED THROUGH
DERIVATIVES LIKE FUTURES, OPTIONS
ETC.
HEDGING WITH CURRENCY
FUTURES
FUTURES ARE ONE OF THE DERIVATIVES
WHERE AN EXPORTER AND IMPORTER
CAN HEDGE THEIR POSITIONS BY
SELLING/BUYING FUTURES.AS THE FUTU-
RES MARKET DOES NOT REQUIRE UPFR-
ONT PREMIUM FOR ENTERING INTO
CONTRACT AS IN THE CASE OF OPTIONS
IT PROVIDES AN A COST EFFECTIVE WAY
FOR HEDGING THE EXCHANGE RISK.
FUTURES
CURRENCY FUTURES PROVIDES A MEANS
TO HEDGE THE TRADERS POSITION WHO
WISHES TO LOCK IN EXCHANGE RATES
ON FUTURE CURRENCY TRANSACTIONS.
BY PURCHASING (LONG HEDGE) OR
SELLING (SHORT HEDGE) FOREIGN
EXCHANGE FUTURES A CORPORATE OR
INDIVIDUAL CAN FIX THE INCOMING
AND OUTGOING CASHFLOWS IN ONE
CURRENCY WITH ANOTHER.
FUTURES
ANY ONE WHO IS DEALING WITH A FORE-
IGN CURRENCY IS FACCED WITH AN
EXCHANGE RISK SINCE THE CASH FLOWS
IN TERMS OF DOMESTIC CURRENCY ARE
KNOWN ONLY AT THE TIME OF CONVER-
SION. A PERSON WHO IS LONG OR IS
EXPECTED TO GO LONG IN A FOREIGN
CURRENCY WILL HAVE TO SELL THE
SAME ON A GIVEN DAY.
FUTURES
A HEDGE CAN BE OBTAINED NOW BY SELLING
FUTURES IN THAT CURRENCY AGAINST A
DOMESTIC CURRENCY. SIMI-LARLY A PERSON
WHO IS SHORT OR IS ESPECTED TO GO SHORT
IN A FOREIGN CURRENCY WILL HAVE TO GO
LONG ON THE SAME ON A GIVEN DAY.A HEDGE
MAY BE OBTAINED BY BUYING FUTURES IN
THAT CURRENCY AGAINST A DOMES-TIC
CURRENCY INSTEAD OF BUYING THE CURREN-
CY LATER IN THE SPOT MARKET.

DETERMINING THE EFFECTIVE
PRICE USING FUTURES
LET Sp1 BE THE SPOT PRICE AT TIME T1.
Sp2 BE THE SPOT PRICE AT TIME T2.
Ft1 BE THE FUTURES PRICE AT TIME T1.
Ft2 BE THE FUTURES PRICE AT TIME T2.
Sp1 – Ft1= BASIS AT T1
Sp2 – Ft2 =BASIS AT T2.
LET US ASSUME THAT A TRANSACTION TOOK
PLACE AT T1 AND CLOSED AT T2. PROFITS
MADE IN FUTURES MARKET BY CLOSING OUT
POSITION AT T2= Ft1- Ft2.
PRICE USING FUTURES
PRICE RECEIVED FOR ASSET WHILE SELLI-
NG IN THE SPOT MARKET =Sp2.
=Sp2+(FT1-Ft2)
=Ft1+(Sp2-Ft2)
=Ft1+b2….. WHERE b2 REPRESENTS BASIS
AT t2. AS b2 IS UNKNOWN THE FUTURES
TRANSACTION IS EXPOSED TO BASIS
RISK.

PRICE USING FUTURES.
IF b2=b1 THEN THE EFFECTIVE PRICE AT
CURRENCY SOLD WILL BE :-
Ft1 +Sp1 – Ft1 =Sp1.
HEDGE RATIO:-A HEDGER HAS TO DETERMINE
THE NUMBER OF FUTURES CONTRACTS THAT
PROVIDE BEST HEDGE FOR HIS RISK RETURN
PROFILE. IT ALLOWS THE HEDGER TO
DETERMINE THE NUMBER OF CONTRACTS
THAT MUST BE EMPLOYED TO MINIMISE THE
RISK OF THE COMBINED CASH/FUTURES
POSITION.
PRICE USING FUTURES.
THAT MEANS THE HEDGER HAS TO TAKE A
FUTURES POSITION i.e. THE NUMBER OF THE
FUTURES CONTRACTS TIMES THE QUANTITY
REPRESENTED BY EACH CONTRACT WHICH
WILL RESULT IN THE MAXIMUM REDUCTION IN
THE VARIABILITY OF THE VALUE OF HIS TOTAL
HEDGED POSITION.IN SIMPLE FORM THE
HEDGE RATIO HR IS THE RATIO OF SIZE OF
THE POSITION TAKEN IN FUTURES CONTRACTS
TO THE SIZE OF THE EXPOSURE.

HEDGE RATIO
THE GENERAL DEFINATION OF HEDGE
RATIO IS:-
HR= FUTURES POSITION = Qf
CASH MARKET POSITION Qs WHERE
HR IS THE HEDGING RATIO, Qf IS
QUANTITY (UNITS) OF THE ASSET
REPRESENTED BY FUTURES POSITION
AND Qs IS QUANTITY OF SPOT CASH
ASSET THAT IS BEING HEDGED.

THE BASIC LONG AND SHORT
HEDGES
HEDGING REFERS TO BY TAKING A POSIT-
ION IN THE FUTURES THAT IS
OPPOSITE TO A POSITION TAKEN IN
THE CASH MARKET OR TO A FUTURE
CASH OBLIGA-TION THAT ONE HAS OR
WILL INCUR. HEDGING CAN BE
CLASSIFIED INTO TWO CATEGORIES:-
1. SHORT HEDGE. 2. LONG HEDGE.

SHORT AND LONG HEDGE.
SHORT HEDGE:- ( SELLING HEDGE)
IS A HEDGE THAT INVOLVES TAKING A
SHORT POSITION IN FUTURES CONTRA-
CT. IN NOTHER WORDS IT OCCURS
WHEN A TRADER PLANS TO PURCHASE
OR PRODUCE A CASH COMMODITY SELLS
FUTURE TO HEDGE THE CASH POSITION.
IT MEANS HAVING A SOLD POSITION.

SHORT AND LONG HEDGE
IT IS A COMMITMENT TO DELIVER. THE MAIN
OBJECTIVE IS TO PROTECT THE VALUE OF THE
CASH POSITION AGAINST A DECLINE IN CASH
PRICES.A SHORT HEDGE IS APPROPRIATE
WHEN THE HEDGER ALREADY OWNS AN ASSET
AND EXPECTS TO SELL IT AT SOME TIME IN
THE FUTURES. ONCE THE SHORT FUTU-RES IS
ESTABLISHED IT IS EXPECTED THAT A
DECREASE (INCREASE) IN THE VALUE OF THE
CASH POSITION WILL BE FULLY OR PARTIALLY
COMPENSATED BY A GAIN (LOSS) IN SHORT
FUTURES POSITION.

LONG HEDGE.
A LONG HEDGE ( OR A BUYING HEDGE)
INVOLVES TAKING A LONG POSITION IN THE
FUTURES CONTRACT.THE BASIC OB-JECTIVE
HERE IS TO PROTECT ITSELF AGAINST A PRICE
INCREASE IN THE UN-DERLYING ASSET PRIOR
TO PURCHASING IT IN EITHER THE SPOT
/FORWARD MARKET.A LONG HEDGE IS
APPROPRIATE WHEN A FIRM HAS TO
PURCHASE A CERTAIN ASSET IN FUTURES AND
WANTS TO LOCK IN A PRICE NOW.

LONG HEDGE
IT IS ALSO CALLED AS „BEING LONG‟ OR
HAVING A NET BOUGHT POSITION OR AN
HOLDING OF THE ASSET.IT IS ALSO
KNOWN AS INVENTORY HEDGE BECAUSE
THE FIRM ALREADY HOLDS THE ASSET
IN INVENTORY.THE TERMS „LONG‟ AND
„SHORT‟ APPLY TO BOTH THE SPOT AND
FUTURES MARKET AND ARE WIDELY
USED IN THE FUTURES TRADING.
LONG AND SHORT HEDGE.
A PERSON WHO HOLDS STOCKS OF AN
ASSET IS OBVIOUSLY REGARDED AS „BEI-
NG LONG‟ IN THE SPOT MARKET BUT IT
IS NOT NECESSARY TO ACTUALLY HOLD
STOCK. SIMILARLY IT IS IN THE CASE
OF „SHORT‟ WHERE ONE WHO HAS MADE
A FORWARD SALE REGARDED AS „BEING
SHORT‟ ON THE SPOT MARKET.

CROSS HEDGING
SOMETIMES IT IS SEEN THAT THE FIRMS
WISH TO HEDGE AGAINST A PARTICULAR
ASSET BUT NO FUTURES CONTRACT ARE
AVAILABLE. THIS SITUATION IS CALLED
AS ASSET MISMATCH. FURTHER IN MANY
CASES SAME FUTURES PERIOD ON A
PARTICULAR ASSET IS NOT AVAILABLE,
IT IS CALLED AS MATURITY MISMATCH.

CROSS HEDGING
REFERING TO DIFFERENT SITUATIONS AS
COULD BE SEEN THERE IS STILL A POSS-
IBILITY TO HEDGE AGAINST A PRICE
RISK IN RELATED ASSETS (COMMODITI-
ES OR SECURITIES) OR BY USING FUTU-
RES CONTRACTS THAT EXPIRE ON DATES
OTHER THAN THOSE ON WHICH HEDGES
ARE LIFTED.SUCH HEDGES ARE CALLED
AS CROSS HEDGES.
CROSS HEDGING
IN ACTUAL PRACTICE AND IN REAL BUSIN-
ESS WORLD IT WILL BE RARE FOR ALL
FACTORS TO MATCH SO WELL. THUS A
CROSS HEDGE IS A HEDGE IN WHICH
THE CHARACTERISTICS OF THE SPOT
AND FUTURES POSITIONS DO NOT
MATCH PERFECTLY, EITHER IN QUANTI-
TY, QUALITY, MATURITY, OR PHYSICAL
ASSETS CHANGE BETWEEN SPOT AND
FUTURES MARKETS.
CURRENCY FUTURES
IN 1972 CHICAGO MERCANTILE EXCHANGE
WAS THE FIRST EXCHANGE TO INTROD-
UCE THE FINANCIAL FUTURES CONTRA-
CTS. ALL DEVELOPED COUNTRIES START-
ED IMPORTING A PLETHORA OF FOREIGN
GOODS WHICH IN TURN CREATED A
DEMAND FOR FOREIGN CURRENCIES. SO
HUGE INTERNATIONAL TRANSACTIONS
LED TO THE DEVELOPMENT OF FOREIGN
CURRENCY MARKETS AND FUTURES.
CURRENCY FUTURES
THE FOREIGN CURRENCY FUTURES CONT-
RACTS NEED TO SPECIFY A TRADING
UNIT (DOLLAR, POUND ETC), QUOTATI-
ON (SAY,US$ PER POUND),MINIMUM
PRICE CHANGE, CONTRACT MONTHS,
US$ VALUE OF CURRENCY AS ON A DAY,
AND THE DELIVERY DATE.PRESENTLY
EURO, YEN, SWISS FRANC, BRITISH
POUND CANADIAN POUND AND AUSTRA-
LIAN DOLLAR ARE TRADED ON CME.
CURRENCY FUTURES
CURRENCY FUTURES CAN BE DEFINED AS
“A BINDING OBLIGATION TO BUY OR
SELL A PARTICULAR CURRENCY AGAINST
ANOTHER AT A DESIGNATED RATE OF
EXCHANGE ON A SPECIFIED FUTURE
DATE.”THE CONTRACT SIZE SPECIFICAT-
IONS FOR THE FEW CURRENCIES
TRADED IN THE CME ARE AS FOLLOWS:-

CURRENCY FUTURES
1. BRITISH POUND- 62,500 AS MINIMUM
TRADING QTY.
2. CANADIAN DOLARS- 1,00,000 MINIMUM
3. JAPANESE YEN-12,500,000 AS MINIMUM
4. SWISS FRANCS-1,25,000 AS MINIMUM.
5. AUSRALIAN DOLLAR- 1,00,000 AS MIN

INVESTMENT AND CONSUMPTION
ASSETS.
INVESTMENT ASSET IS AN ASSET THAT IS
HELD FOR INVESTMENT PURPOSES BY
SIGNIFICANT NUMBER OF INVESTORS.
GOLD, SILVER, STOCKS AND BONDS ARE
EXAMPLES. A CONSUMPTION ASSET IS
HELD PURELY FOR CONSUMPTION.EX:-
COPPER, FOOD ARTICLES ETC. WE CAN
DETERMINE FORWARD AND FUTURES
PRICES FOR AN INVESTMENT ASSET FOR
BOTH SPOT AND OTHER VARIABLES.
SHORT SELLING.
SHORT SELLING OR SHORTING INVOLVES
SELLING AS ASSET THAT IS NOT OWNED. IT IS
SOMETHING THAT IS POSSIBLE FOR SOME BUT
NOT FOR ALL INVESTMENT ASSETS.THIS IS
DONE BY BORROWING FROM ANOTHER OR
INVESTOR. AT SOME STAGE THE INVESTOR
HAS TO PURCHASE THE SHARE TO CLOSE THE
DEAL.THIS IS REPLACED WITH BORROWED
SHARES AND PROFIT IS MADE IF PRICE FALLS.

SHORT SELLING AND SHORT
SQUEEZED.
IF AT ANY TIME WHILE THE CONTRACT IS OPEN
THE BROKER RUNS OUT OF SHARES TO
BORROW THE INVESTOR IS SHORT SQUEEZED
AND IS FORCED TO CLOSE OUT THE POSITION
IMMEDIATELY EVEN IF NOT READY TO DO SO.
AN INVESTOR WITH A SHORT POSITION MUST
PAY TO THE BROKER ANY INCOME SUCH AS
DIVIDEND/INTEREST THAT WOULD NORMALLY
BE RECEIVED ON THE SECURITIES THAT HAVE
BEEN SHORTED.

DETERMINATION OF FORWARD
PRICES
REPO RATE:- IT REFERS TO THE RISK FREE
RATE OF INTEREST FOR MANY ARBITRA-
GEURS OPERATING IN THE FUTURES
MARKET. REPURCHASE AGREEMENT
REFERS TO THE AGREEMENT WHERE THE
OWNER OF THE SECURITIES AGREES TO
SELL THEM TO A FINANCIAL INSTITUTI-
ON AND BUY THE SAME BACK LATER.THE
REPURCHASE PRICE IS SLIGHTLY HIGHER
THAN THE TREASURY BILL RATE.
ASSUMPTIONS AND NOTATIONS
1. THERE ARE NO TRANSACTION COSTS.
2. SAME TAX RATE FOR ALL TRADING P/L.
3. LENDING/BORROWING AT RISK FREE
INTEREST RATE.
4. TRADERS ARE READY TO TAKE ADVAN-
TAGE OF ARBITRAGE OPPORTUNITIES
AS AND WHEN ARISE.THESE ASSUMPTI-
ONS ARE EQUALLY AVAILABLE FOR ALL
MARKET PARTICIPANTS (LARGE/SMALL.

NOTATIONS
1. T=TIME REMAINED UPTO DELIVERY
DATE IN THE CONTRACT.
2. S= SPOT MARKET/CASH MARKET.
3. K= DELIVERY PRICE AT TIME T.
4. F= FORWARD/FUTURE PRICE TODAY.
5. f = VALUE OF LONG FORWARD TODAY.
6. r = RISK FREE RATE OF INTEREST.
7. t = CURRENT OR PRESENT PERIOD.

THE FORWARD PRICE
WE CONSIDER THREE SITUATIONS :-
1. INVESTMENT ASSETS PROVIDING NO
INCOME.
2. INVESTMENT ASSETS PROVIDING
KNOWN INCOME.
3. INVESTMENT ASSETS PROVIDING
KNOWN YIELD/INCOME ( DIVIDENDS.)

FORWARD PRICE.
1. ASSET THAT PROVIDES NO INCOME.
THIS IS THE EASIEST FORWARD CONTRA-CT TO
VALUE BECAUSE SUCH ASSETS DO NOT GIVE
ANY INCOME TO THE HOLDER.THESE ARE
USUALLY NON-DIVIDEND PAYING EQUITY
SHARES AND DISCOUNT BONDS.EX:-
CONSIDER A LONG FORWARD CONTRACT TO
PURCHASE A SHARE(NON DIV PAYING) IN
THREE MONTHS. ASSUME THAT THE CURRE-
NT STOCK PRICE IS RS 100 .
FORWARD PRICE – OF AN ASSET
PROVIDING NO INCOME
THE THREE MONTH RISK FREE RATE OF
INTEREST IS 6%P.A. ASSUME THAT THE
THREE MONTH FORWARD PRICE IS RS
105:- THE ARBITRAGUER CAN BORROW
RS 100 @ 6% FOR 3 MONTHS,BUY ONE
SHARE AT RS 100 AND SHORT A FORWA-
RD CONTRACT FOR RS 105, THE SUM OF
MONEY REQUIRED TO PAY OFF THE
LOAN IS 100e 0.06*0.25 =101.50
FORWARD PRICE OF AN ASSET
THAT PROVIDES NO INCOME
THIS WAY HE WILL BOOK A PROFIT OF RS
3.50 i.e. 105-101.50.WE CAN GENERALISE
AS :-
F = SerT
where F= FORWARD PRICE OF STOCK, S=
SPOT PRICE, T= MATURITY PERIOD, AND
r= RISK FREE RATE ,
e= EXPIRATIONPERIOD.

FORWARD PRICE FOR AN ASSET
WHICH GIVES NO INCOME
IF F > SerT THEN THE ARBITRAGUER CAN
BUY THE ASSET AND WIL GO FOR A
SHORT FORWARD CONTRACT ON THE
ASSET.
IF F < SerT THEN HE CAN SHORT AND GO
FOR LONG FORWARD CONTRACT ON IT.

FORWARD PRICES THAT PROVID-
ES A KNOWN CASH INCOME
THESE ARE FOR COUPON BEARING BONDS,
TREASURY SECURITIES ETC:-
CONSIDER A LONG FORWARD TO PURCHA-SE A
COUPON BOND WHOSE CURRENT PRICE IS RS
900 MATURING IN 5 YEARS. WE ASSUME THAT
THE FORWARD CONTRACT MATURES IN ONE
YEAR SO THAT THE FORWARD CONTRACT IS
TO PURCHASE A FOUR YEAR BOND IN ONE
YEAR. ASSUME THAT THE COUPON PAYMENTS
ARE RS 40, 6MONTHLY AND 12MONTHLY.
FORWARD PRICE WITH KNOWN
CASH INCOME
ALSO 6MONTHLY AND 12 MONTHLY RISK
FREE INTEREST IS 9% AND 10%.
WE ASSUME THAT THE FORWARD PRICE IS
HIGH AT Rs 930. IN THIS CASE THE
ARBITRAGEUR CAN BORROW Rs 900 TO
BUY THE BOND AND SHORT A FORWARD
CONTRACT.THEN THE FIRST COUPON
PAYMENT HAS A PRESENT VALUE OF:-

FORWARD PRICES WITH KNOWN
CASH INCOME
40e-0.09*0.5 = Rs= 38.24. SO THE BALANCE AMT
Rs 861.76 (900-38.24) IS BORROW-ED @ 10%
FOR YEAR.THE AMOUNT OWI-NG AT THE END
OF THE YEAR IS:-
861.76e 0.1*1 =952.39. THE SECOND COUPON
PROVIDES Rs 40 TOWARDS THIS AMOUNT AND
RS 930 IS RECEIVED FOR THE BOND UNDER
THE TERMS OF THE FORWARD CONTRACT .THE
ARBITRAGEUR WILL EARN (Rs 40 + 930) -
952.39 = 17.61
FORWARD PRICES WITH KNOWN
CASH INCOME.
SO IT CAN BE GENERALISED THAT FOR
SUCH ASSETS WHERE THE INCOME IS
KNOWN THE FORWARD PRICE WOULD BE
F = (S – I) erT.
IF F>(S-I)erT THE INVESTOR CAN EARN
THE PROFIT BY BUYING THE ASSET AND
SHORTING THE ASSET FORWARD AND
TAKING A LONG POSITION IN A FORWA-
RD CONTRACT AND VICE VERSA.

FORWARD PRICE WHERE THE
INCOME IS A KNOWN DIV. YIELD
A KNOWN DIVIDEND YIELD MEANS THAT
WHEN INCOME EXPRESSED AS A PERCE-
NTAGE OF THE ASSET LIFE IS KNOWN.
HERE WE ASSUME THAT DIVIDEND
YIELD IS PAID CONTINOUSLY AS A CON-
STANT ANNUAL RATE AT q THEN THE
FORWARD PRICE FOR A ASSET WOULD
BE :- F = Se (r- q) T

FORWARD PRICE WHERE THE
INCOME IS A KNOWN DIV YIELD
LET US CONSIDER A 6 MONTH FORWARD
CONTRACT ON A SECURITY WHERE 4% P.A.
CONTINOUS DIV IS EXPECTED. THE RISK FREE
RETURN IS 10%, THE CURRE-NT PRICE IS Rs
25. THE FORWARD PRICE IS F=Se(r-q)T F=Se
(0.1-.04)*0.5 =25.76. IF THE FORWARD PRICE IS
> THAN THE SPOT PRICE THEN HE CAN BUY

THE ASSET AND ENTER INTO A SHORT FORW-
ARD CONTRACT TO ENTER A LOCK IN A
RISKLESS PROFIT AND VICE VERSA.
(
VALUING FORWARD CONTRACT
THE VALUE OF A FORWARD CONTRACT AT THE
TIME OF ITS WRITING IS ZERO. HOWEVER AT
A LATER DATE IT MAY PROVE TO BE A +VE / -
VE VALUE.IT MAY BE DETERMINED AS
FOLLOWS:-
f = (F-K) e-Rt where f=VALUE OF FORWARD
CONTRACT. F= FORWARD PRICE AND K =
DELIVERY PRICE OF THE ASSET, T = TIME TO
MATURITY AND r= RISK FREE RETURN/RISK
FREE RATE OF INTEREST.
WE COMPARE A LONG FORWARD CONTR-
ACT THAT HAS A DELIVERY PRICE OF „F‟
WITH AN OTHERWISE IDENTICAL LONG
FORWARD CONRACT WITH A DELIVERY
PRICE OF „K‟.WE KNOW THAT THE FOR-
WARD PRICE IS CHANGING WITH THE
PASSAGE OF TIME AND THAT IS WHY
LATER ON F AND K MAY NOT BE EQUAL
WHICH WERE OTHERWISE EQUAL AT
THE TIME OF ENTRANCE OF CONTRACT.
THE DIFFERENCE BETWEEN THE TWO IS
ONLY IN THE AMOUNT THAT WILL BE
PAID FOR THE SECURITY AT THE TIME „T‟
UNDER THE FIRST CONTRACT THIS
AMOUNT IS „F‟, AND UNDER THE SECOND
CONTRACT IT IS „K‟. A CASH OUTFLOW
DIFFERENCE OF F-T AT THE TIME T
TRANSLATES TO A DIFFERENCE OF
(F-T)e-rT TODAY.
VALUING FORWARD CONTRACTS
THEREFORE THE CONTRACT WITH A
DELIVERY PRICE OF F IS LESS VALUABLE
THAN THE CONTRACT WITH A DELIVERY
PRICE OF K BY AN AMOUNT OF (F-K)e-rT.
THE VALUE OF CONTRACT THAT HAS A
DELIVERY PRICE OF F IS BY DEFINITION
ZERO.SIMILARLY THE VALUE OF A SHORT
FORWARD CONTRACT WITH THE
DELIVERY PRICE K IS f=(K-F)e-rT.
VALUING FORWARD CONTRACT.
CONSIDER A SIX MONTH LONG CONTRACT OF A
NON INCOME PAYING SECURITY. THE RISK
FREE RATE OF INTEREST IS 6% P.A. THE
STOCK PRICE IS RS 30 AND THE DELIVERY
PRICE IS RS 28. COMPUTE THE VALUE OF THE
FORWAD CONTRACT.
FORWARD PRICE F=30e 0.06*.05 =Rs30.90
VALUE OF FORWARD CONTRACT=
f= (F-K)e-rT (30.90-28)e -0.06*.5 =2.9-0.09=
2.81 APP. OR f=30-28 -0.06*0.5 =2.84 APP.

VALUE OF A FORWARD CONTRACT
WE CAN SHOW THE VALUE OF LONG FORWARD
CONTRACT AS:-
1. ASSET WITH NO INCOME =f=S-Ke-rT
2. ASSET WITH KNOWN INCOME:-
f=S-I-Ke-rT.
3. ASSET WITH KNOWN DIVIDEND YIELD.
AT THE RATE q:- f=Se-qT –Ke-Rt .so in each case
the forward price F is the value of K which
makes f equal to zero.

GAIN ON LONG AND SHORT
POSITION PER CONTRACT
THE CONCEPT OF THE FORWARD PRICE FOR A
FORWARD CONTRACT IS JUST LIKE THE
FUTURE PRICE FOR A FUTURE CONTRACT. A
CONTRACT‟S CURRENT FO-RWARD PRICE IS
THE DELIVERY PRICE THAT WOULD APPLY IF
THE CONTRACT WERE NEGOTIATED TODAY.
THE FORW-RD PRICE IS THE DELIVERY PRICE
WHI-CH WOULD MAKE THAT CONTRACT TO
ZERO VALUE.THAT MEANS THE FORWARD
PRICE AND THE DELIVERY PRICE ARE EQUAL
AT THE TIME THE CONTRACT IS WRITTEN.

GAIN ON LONG AND SHORT
POSITION PER CONTRACT.
HOWEVER IN PRACTICE AS THE TIME
PASSES THE FORWARD PRICE IS LIABLE
TO CHANGE WHEREAS THE DELIVERY
PRICE REMAINS SAME.IT MEANS THE
FORWARD PRICE AND DELIVERY PRICE
MAY NOT BE EQUAL AT ANY TIME AFTER
THE START OF THE CONTRACT EXCEPT
BY CHANCE.IN FACT THE FORWARD
PRICE AT ANY GIVEN TIME VARIES WITH
THE MATURITY OF THE CONTRACT.
GAINS ON LONG AND SHORT
POSITIONS PER CONTRACT.
THE FORWARD PRICE OF A CONTRACT
USUALLY DEPENDS UPON THE SPOT AND
FOREIGN EXCHANGE QUOTATIONS
GIVEN BY VARIOUS BANKS. AS THE FOR-
WARD RATES ARE NORMALLY QUOTED
FOR A YEAR AND AVAILABLE IN FORWA-
RD EXCHANGE MARKET THE TRADER CAN
EASILY MAKE THE ADJUSTMENTS IN
THEIR FORWARD RATES.
GAINS ON LONG AND SPOT
POSITIONS PER CONTRACT
NOTATIONS:-
1. Ft T=FORWARD PRICE AT TIME t OF A
CONTRACT THAT EXPIRES AT TIME T.
2. St =SPOT PRICE AT t (ENTER PERIOD).
3. ST = FUTURE SPOT PRICE AT T
4. K = DELIVERY PRICE.
THE PROFIT AND LOSS ON A FORWARD
CONTRACT IS DETERMINED BY FUTURE SPOT
RATE ST.

POSITIONS PER CONTRACT.
THOSE HOLDING LONG FORWARD POSITI-
ONS, THE PROFIT WILL ARISE ON THE
FUTURES SPOT PRICE IS HIGHER THAN
THE DELIVERY PRICE. (ASSUME THAT
THE FORWARD PRICE AND DELIVERY
PRICE ARE THE SAME) SINCE THE MARK-
ET PRICE OF THE ASSET IS HIGHER
THAN THE PRICE AT WHICH THE BUYERS
(LONG) HAVE CONTRACTED TO BUY.
GAINS ON LONG POSITION PER CONTRACT
=NO OF UNITS*(FUTURE SPOT PRICE –
FORWARD PRICE OR DELIVERY PRICE.)
= NO OF UNITS [ST-K(OR Ft T)]
WHERE THE NO OF UNITS IS PER CONTR-
ACT. (Those holding short forward positi-
ons the gain will incur to them of the futu-
res spot price falls below the forward
price.)

GAINS ON SHORT POSITION PER CONTRA-
CT:-
= NO OF UNITS*(FORWARD PRICE-FUTU-
RES SPOT PRICE)
=NO OF UNITS * [Ft T(OR K) –ST]
WHERE THE NUMBER OF UNITS IS PER
CONTRACT.

THEORIES OF FUTURES PRICES
THERE ARE TWO IMPORTANT THEORIES
WHICH HAVE MADE EFFORTS TO
EXPLAIN THE RELATIONSHIP BETWEEN
SPOT AND FUTURES PRICES.THEY ARE:-
1. THE COST OF CARRY APPROACH.
2. THE EXPECTATION APPROACH.

1. THE COST OF CARRY APPROACH
TOP ECONOMISTS LIKE KEYNES AND HICKS
HAVE ARGUED THAT FUTURES PRICES
ESSENTIALLY REFLECT THE CARRYING
COST OF THE UNDERLYING ASSETS. THE
INTERRELATIONSHIP BETWEEN THE
SPOT AND FUTURES PRICES REFLECT
THE CARRYING COSTS i.e. THE AMOUNT
TO BE PAID TO STORE THE ASSET FROM
THE PRESENT TIME TO THE FUTURE
MATURITY TIME/ DATE.
THE COST OF CARRY APPROACH
CARRYING COSTS ARE OF SEVERAL TYPES:
1. STORAGE COSTS.
2. INSURANCE COSTS.
3. TRANSPORTATION COSTS.
4. FINANCING COSTS.
1. STORAGE COSTS:- THESE ARE COSTS OF
STORING AND MAINTAINING THE ASSET
IN SAFE CUSTODY. RENT, PILFERAGE,
DETERIORATION IN QUALITY ETC.
THE COST OF CARRY
2 INSURANCE COSTS:- AMOUNT INCURRED
ON SAFETY OF ASSETS AGAINST FIRE,
DAMAGE, ACCIDENTS ETC.THE PREMIUM
PAID IS CALLED AS INSURANC COSTS.
3. TRANSPORTATION COSTS:- WHEN THE
FUTURES CONTRACT MATURES THEN
THE DELIVERY IS TO BE GIVEN AT A PA-
RTICULAR PLACE AND TIME AT VARIOUS
LOCATIONS.

THE COST OF CARRY
4. COST OF FINANCING THE UNDERLYING
ASSET:-IF GLD COSTS RS 5,000 PER 10
GRAMS AND THE COST OF FINANCING IS
1% PER MONTH THEN RS 50 IS THE
FINANCING CHARGE.
APART FROM THE CARRYING COST WE
MAY ALSO HAVE THE POSSIBILITY OF
EARNING A YIELD ON STORING THE
ASSET CALLED AS CONVENIENCE YIELD.

THE COST O CARRY APPROACH
THE MARGINAL COST OF CARRYING OF AN
ASSET IS:-
Ct = Cgt - Yt WHERE:-
Ct = NET COST OF CARRYING THE ASSET.
Cgt = GROSS CARRYING COST OF THAT
QUANTITY.
Yt = CONVINIENCE YIELD.

THE COST OF CARRY MODEL
THE COST OF CARRY MODEL IN PERFECT
MARKET:-
FUTURE PRICE= SPOT PRICE +CARRYING COST.
CONDITIONS OF A PERFECT MARKET:-
NO TRANSACTION COST,UNLIMITED CAPACITY
TO BORROW/LEND, BORROWING RATES ARE
SAME,NO CREDIT RISK, NO MARGIN FOR
TRADING, NO TAXES, AND GOODS CAN BE
STORED WITHOUT LOSS IN QUALITY.

THE EXPECTATION APPROACH
THE ECONOMISTS ARGUED THAT THE
FUTURES PRICES AS THE MARKET EXPE-
CTATION OF THE PRICE AT THE FUTURES
DATE.TRADERS WHO USE THE FUTURES
MARKET TO HEDGE WOULD LIKE TO
STUDY HOW TODAYS FUTURES PRICES
ARE RELATED TO MARKET EXPECTATIO-
NS ABOUT FUTURES PRICES.

THE EXPECTATION APPROACH
EXPECTED FUTURES PROFIT = EXPECTED
FUTURES PRICE – INITIAL FUTURE PRICE
ANY MAJOR DEVIATION OF THE FUTURES
PRICES FROM THE EXPECTED PRICES
WILL BE CORRECTED BY SPECULATIVE
ACTIVITY.PROFIT SEEKING TRADERS
WILL TRADE AS LONG AS THE FUTURES
PRICE IS SUFFICIENTLY FAR AWAY FROM
THE EXPECTED FUTURES SPOT PRICE.
STOCK INDEX FUTURES
 A STOCK INDEX OR STOCK MARKET INDEX IS A
PORTFOLIO CONSISTING OF A COLLECTION OF
DIFFERENT STOCKS. THAT MEANS A STOCK
INDEX IS JUST LIKE A PORTFOLIO CONSISTING
OF A COLLECTION OF DIFFERENT SECURITIES
PROPORTIONS TRADED ON A PARTICULAR
STOCK EXCHANGE LIKE NIFTY S&P CNX,
TRADED ON NSE, THE S&P 500 INDEX IS
COMPOSED OF 500 COMMON STOCKS.

STOCK INDEX FUTURES
THESE INDICES PROVIDE SUMMARY MEAS-
URE OF CHANGES IN THE VALUE OF A
PARTICULAR SEGMENTS OF THE STOCK
MARKETS WHICH IS COVERED BY THE
SPECIFIC INDEX. THIS MEANS THAT A
CHANGE IN A PARTICULAR INDEX
REFLECTS THE CHANGE IN THE AVERAGE
VALUE OF THE STOCKS INCLUDED IN
THE INDEX.
STOCK INDEX FUTURES
THE NUMBER OF STOCKS INCLUDED IN A
PARTICULAR INDEX MAY DEPEND UPON ITS
OBJECTIVES AND THUS THE SIZE VARIES
INDEX TO INDEX. FOR EXAMPLE THE SENSEX
HAS 30 STOCKS WHEREAS 500 STOCKS ARE
COVERED UNDER STANDARDS AND POOR‟S
500.
COMMON FEATURES:-
1. A STOCK INDEX COVERS A SPECIFIC NO OF
STOCKS LIKE 30, 50, 100, 500 ETC.

STOCK INDEX FUTURES
2. SELECTION OF A BASE PERIOD ON
WHICH INDEX IS BASED. STARTING
VALUE OF BASE IS 100, 1000 ETC.
3. THE METHOD OR RULE OF SELECTION
OF A STOCK FOR INCLUSION IN THE
INDEX TO DETERMINE THE VALUE OF
THE INDEX.
4.THERE ARE VARIOUS METHODS USED TO
CALCULATE LIKE ARITHMETIC MEAN ETC

STOCK INDEX FUTURES
5. THERE ARE THREE TYPES OF INDEX
CONSTRUCTIONS LIKE PRICE WEIGHTED,
RETURN WEIGHTED AND MARKET CAPIT-
ALISATION WEIGHTED INDEX.
6. A STOCK INDEX REPRESENTS THE
CHANGE IN THE VALUE OF A SET OF
STOCKS WHICH CONSTITUTE THE
INDEX.

STOCK INDEX FUTURES
7. THE INDEX SHOULD REPRESENT THE
MARKET AND BE ABLE TO REPRESENT
THE RETURNS OBTAINED BY A TYPICAL
PORTFOLIO OF THAT MARKET.
8.A STOCK INDEX ALSO ACTS AS THE BAR-
OMETER FOR MARKET BEHAVIOUR, A
BENCHMARK FOR THE PORTFOLIO PER-
FORMANCE. IT ALSO REFLECTS THE CHA-
NGING EXPECTATIONS OF THE MARKET.

STOCK INDEX FUTURES.
9. THE INDEX COMPONENTS SHOULD BE
HIGHLY LIQUID, PROFESSIONALLY
MAINTAINED AND ACCURTELY CALCULA-
TED.
A STOCK INDEX FUTURES CONTRACT IS A
FUTURE IS A CONTRACT TO BUY/SELL
THE FACE VALUE OF A STOCK INDEX.THE
MOST ACTIVELY TRADED INDEX IS THE
AMERICAN S&P 500 INDEX.

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RISK MANAGEMENT

FUTURES AND FORWARDS

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> THAN THE SPOT PRICE THEN HE CAN BUY

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