Forwards & Futures

Session 2 Derivatives & Risk

Management
Prof. Aparna Bhat

Forward Contracts
Definition an agreement between two parties that

calls for the delivery of an asset at a future point in

time with a price agreed upon today
Features
Existence of two parties
OTC contract
Price determination takes place today
Mutual obligation to perform
Counterparty risk
Mutual consent for cancellation
No upfront payment
Normally settled by delivery of the underlying asset

Forward Contracts v/s Spot

contracts
Spot contracts require immediate

payment ; forward buyer gains in terms

of interest
Spot contracts require immediate
delivery; forward seller earns income on
asset and incurs storage cost; shortselling possible
Spot contract possible between unknown
persons; forward contracts possible only
between known counterparties or require
mechanisms to protect against default

Futures contracts
Why futures contracts?
Forwards involve credit risk hence unsuitable for small
investors
Lack of widespread investor participation leads to low
liquidity and poor price discovery
Trading through an exchange can mitigate credit risk

which however requires standardization of contracts

Futures contract is a forward contract with
standardized terms traded on an organized exchange
and follows a daily settlement procedure whereby
losses of one party to the contract are paid to the
other party

Specifications of a futures
contract
Contract Size
Quotation unit

Minimum price fluctuation (tick size)

Contract grade
Trading hours
Settlement Price
Delivery terms
Daily price limits and trading halts

Settlement of a futures
contract

Offsetting or Squaring off the position

Delivery-based or physical settlement
Cash-based settlement

Forwards and futures distinction

Forwards
Traded Over the

counter
Custom-made
contracts
Credit risk borne by
parties
No margins
Settled by delivery;
close-out difficult
No published pricevolume information

Futures
Exchange traded
Standardized

contracts
Credit risk borne by
the CCP
Initial margin and
daily MTM margins
Delivery rare; closeout easy
Published pricevolume data

Snapshot of a futures quote

Open Interest V/s Volume

Date

Trade

Open
Interest as
on date

Trading
Volume for
the day

Jan 1

A shorts 50 contracts
B goes long in 50
contracts

50

50

Jan 2

C goes long in 100

contracts
D goes short in 100
contracts

OI increases to 50
150 as new
long and short
position are
created

Jan 3

A closes short position

by buying back 50
contracts
E shorts 50 contracts

OI remains at
150 because
As short
position is
replaced by
Es short
position

50

Interpreting changes in OI
Open Interest

Price

Interpretation

OI is increasing

Price is increasing

New buyers are

coming in and
technically strong
market

OI is increasing

Price is declining

Indicates shortselling and

technically weak
market

OI is declining

Price is declining

Indicates long
liquidation and
technically strong
market

OI is declining

Price is increasing

Indicates shortcovering and

technically weak
market

OI increasing; Price
increasing
Increasing OI suggests creation of new positions. Also

rising price shows that new buyers are stronger than

new sellers. Hence bullish for the scrip

OI increasing; Price
declining
Increasing OI suggests addition of new positions.

Falling price suggests that new sellers are stronger

than new buyers. Hence suggests short-selling in the
scrip

OI declining; Price declining

Declining OI suggests closure of existing positions, i.e.

old buyers are now selling and old sellers covering up

their short positions. Falling price suggests that
sellers (old buyers) are stronger than buyers (old
sellers). Hence implies liquidation of old long positions
in the scrip

OI declining; Price
increasing
Declining OI suggests closure of existing positions, i.e.

old buyers are now selling and old sellers covering up

their short positions. Rising price suggests that
buyers (old sellers) are stronger than sellers (old
buyers). Hence implies short-covering in the scrip

Margin Requirements
Why are margins necessary?
Margins charged by Indian futures exchanges
Initial margin
Exposure margin
Daily Mark-to-market margin

Marking-to- market is an accounting procedure

that forces both sides of the contract to take their

gains/ losses daily
Prevents build-up of large unrealized paper losses
At the end of each day the position is re-priced at
the days settlement price and the contract is restarted with a new base price

MTM computation - example

On June 15, 2015 a trader takes a long position in 10

contracts of Nifty futures expiring on July 30, 2015 at

8095. Calculate his daily MTM pay-in/pay-out on the
basis
Dateof the following dataSettlement Price
15-06-2015

8040.45

16-06-2015

8076.25

17-06-2015

8103.35

18-06-2015

8177.55

19-06-2015

8258.40

22-06-2015

8375.60

23-06-2015

8402.10

Compute the gain or loss for the trader if the position is

closed on June 23 at 8410.10

Applications of Forwards and

Futures

Trading or speculation taking a position

in a forward or futures contract without

any underlying exposure and trying to
profit from a directional view
Hedging taking an opposite position in a
forward/futures contract in order to
mitigate risks to the underlying
Arbitrage taking a combined position in
the forward/futures and the underlying in
order to profit from the mispricing of the
forward/futures

Trading in forwards and

futures
Party entering into a buy contract = long
Party entering into a sell contract = short
A long position benefits from a rise in price of

the underlying
Profit to long = Spot price at maturity
Original futures price
A short position benefits from a fall in price of
underlying
Profit to short = Original futures price
Spot price at maturity
Forwards and futures have linear payoffs

Pricing of a forward contract

No arbitrage is the main assumption
The principle of replication
Cost of the replicating portfolio = cost

of the derivative
Example Forward price of a painting

Cost of carry model

Spot price of gold is S and current interest

rate is denoted by r
What should be the price for buying or selling
gold at the end of six months from today?
The forward price F will be received only on the

maturity date, i.e. at the end of six months

If the seller sells at the spot price S and invests
the proceeds at the current interest rate r, he
will receive S*(1 + r*t)

The minimum price F is therefore S *(1 + r*t)

This is the price at which there will be no

arbitrage opportunity

Assumptions of cost-of-carry
model
No transaction costs
No restrictions on short sales
Same risk-free rate for borrowing and

lending

Violations of forward pricing

formula.
Consider a non-dividend paying stock with spot

price = 120, risk-free rate=5%, period= 1 year

As F= S*(1+rt) , F = 126
If actual F = 128 cash-carry arbitrage possible
Buy stock today at 120 by borrowing at 5%
Sell stock one-year forward at 128
Hold stock for 1 year
At maturity, sell stock at 128
Repay borrowing with interest at 126
Net gain is Rs.2 (free lunch ?)
Hence F cannot be greater than S*(1+rt)

Violations of forward pricing

formula.
Consider a non-dividend paying stock with spot

price = 120, risk-free rate=5%, period= 1 year

As F= S*(1+rt) , F = 126
If actual F = 123 reverse cash-carry arbitrage
possible
Sell stock today at 120 and lend proceeds at 5%
Buy stock one-year forward at 123
At maturity, get back loan with interest at 126
Receive delivery of stock at 123
Net gain is Rs.3 (free lunch ?)
Hence F cannot be less than S*(1+rt)

Pricing with continuous

compounding
Investment assets with no interim cash flows
Investment assets with known interim cash

flows
Investment assets with known dividend yield
Consumption assets

Where F= forward
price, S=spot price,
r=continuously
compounded interest
rate, q= dividend yield,
I= PV of known cash
flow, u=storage costs
per unit of time, y=

Violations of forward pricing

formula.
Fair value of forward =
Current stock price = 900, known dividend after 4 months

=40, forward maturity =9 months, 4-month int rate= 3%, 9month int rate= 4%
Fair value of forward = (900-39.60)*e^(0.04*9/12) = 886.60
If actual forward price = 910
Short forward contract at 910 and borrow to buy stock today
Borrow 39.60 for 4 months and 860.40 (900-39.60) for 9 months
After 4 months, pay off loan of 39.60 from dividend inflow
At end of 9 months receive forward price of 910 and repay loan of

886.60
Gain = 23.40

If actual forward price is lower, reverse cash-carry arbitrage

Violations of forward pricing

formula.
Cost of carry is offset by the known income yield q

(q is continuously compounded)
Hence
Stock index futures priced as above
What is Index arbitrage?
When F > Se(rq)T an arbitrageur buys the
stocks underlying the index and shorts futures
When F < Se(rq)T an arbitrageur goes long in
futures and shorts the stocks underlying the index
Index Arb involves simultaneous trades in futures
and many different stocks; hence programmed
trades

Pricing of currency forwards

Pricing requires knowledge of spot exchange rate,

domestic interest rate and foreign currency interest

rate
Interest rate parity requires that
Where rd=domestic interest rate and rf=foreign currency

interest rate

Expressed in continuous compounding

Example:
Spot USD/INR =44.70, 1-year USD-libor = 5%, 1-

year INR rate =10%, 1-year USD/INR forward rate

= 47.10
What is the arbitrage implied?

Forwards on consumption
assets

Fair value of forward =

Where u = storage costs as a % of value of
asset and y = convenience yield
Convenience yield measures benefit of

holding physical inventory of

consumption asset instead of forward
contract on that asset
Is not observable or measurable directly
Can be estimated from past data
Sophisticated models to determine it

Why arbitrage not always

feasible?
Implementing cash-carry arbitrage

requires ability to borrow at risk-free rate

Only large institutional players have that
ability
Reverse cash-carry arbitrage requires
ability to borrow the security
Owners may be unwilling to sell or lend
especially in case of consumption assets
Regulatory restrictions on short selling

Contango and
Backwardation

Normally futures price > spot price

Known as Contango market
Non-income earning financial assets normally

in contango
Sometimes spot price > futures price
Known as backwardation or inverted market
Consumption assets in backwardation when
convenience yield exceeds cost of carry
May be due to anticipated disruption in
supply
Could be due to short squeeze

Implied repo rate (IRR)

It is that interest rate which would make the

observed forward or futures price equal to the

theoretical price predicted under conditions of noarbitrage using given values of the spot price and
other variables
Implied repo rate is the rate at which an investor
can
borrow synthetically by going short spot and long

forward
invest synthetically by going long spot and short
forward
There will be no arbitrage when
Lending rate < IRR < Borrowing rate

Forward price and value

Value of a forward contract different from

the forward price

Forward price = S*e^rt
Initial value of forward contract is zero
Contract gains or loses value at later stage
Value of forward on an non-income asset
f = (S K)*e^(-rt)

Risk management with

futures
Concept of hedging

Why do companies hedge?

To reduce risk of bankruptcy
To enable company to focus on its core

competence
Shareholders cannot hedge effectively
When hedging not profitable
When competitors dont hedge
When hedging is not selective

Decisions in hedging
Whether a long hedge or short hedge
Which futures contract
Which expiry month
Number of futures contracts to be used

Short hedge and long hedge

Basis risk
What is basis?
Spot price of asset to be hedged less futures price of

contract used
Hedging substitutes basis risk for price risk
P/L on hedged position = change in basis
Under a short hedge
Future sale price = Current futures price + future
basis
Under a long hedge
Future buy price = Current futures price + future basis
Hedge held till expiry results in perfect hedge
Examples

Hedging profitability and

basis

Example of short hedge

An investor holds 10000 shares of X co.

Spot price on May 1 is Rs.100. Investor

needs funds on June 11 to meet his
Advance tax liability on June 15. How can
he hedge against the volatility in the
interim period? June X Co. futures quoting
at Rs.97 on May 1. (consider both
strengthening and weakening of the basis)

Example of long hedge

A businessman planning to travel to the US

on Aug 22 needs 50,000 USD for his trip.

As on Aug 3 the USD/INR spot rate is
59.23 and the Dollar-rupee futures on NSE
are quoting at 59.20. How can he hedge
against the dollar-rupee volatility?

Another argument
An asset bought from 2 sources (spot market and futures

market) must be priced identically on delivery date; else

arbitrage
Hence futures and spot price must converge on maturity date
A portfolio hedged with futures and both portfolio and hedge
held till maturity will be riskless
Eg- Consider an investment in Tata Motors today at Rs.304
hedged with short 1-month future at Rs.305.

Computing the Hedge ratio

What is Cross hedging ?
Hedge ratio = ratio of size of exposure to

size of futures position

Minimum Variance Hedge Ratio
Objective is to minimize the variance of

hedgers position
= Correlation between spot & future * (Std
Dev of spot/
Std Dev of future)

Hedging an equity portfolio

Compute beta of the portfolio
Nifty future lot size 50
Nifty future price 5400
Portfolio to be hedged = Rs.10 lacs
Portfolio Beta = 1.05

Controlling Risk in Equity

Portfolio
Diversification eliminates unsystematic risk in

portfolio
Systematic risk remains; i.e. portfolio is sensitive
to market risk alone
Strategy to outperform the overall market
Increase portfolio beta to more than 1 when
market is expected to rise; will ensure that
portfolio will yield higher return than market
Reduce portfolio beta to less than 1 when market
is expected to decline; will ensure that portfolio
will suffer lower loss than overall market
Portfolio beta needs to be changed when market
trend is expected to change

How to alter portfolio beta

Portfolio rebalancing
Involves replacing low-beta stocks with high-beta
stocks when market is expected to rise or vice-versa
Requires frequent buying and selling of stocks
resulting in higher transaction costs
Lending or borrowing
Switching between capital market and debt market
Reducing or increasing the debt component of the

portfolio in order to increase or reduce beta of overall

portfolio

Using index futures

Sell index futures to reduce beta
Buy index futures to increase beta

Changing portfolio beta

using Index futures

Target Dollar beta = Portfolio Dollar beta +

Number of
futures
contracts * (Futures Dollar beta)
Number of futures contracts = (Target
dollar beta-Portfolio
dollar
beta)/(Futures Dollar
beta)*(Portfolio value/Futures
value)

Case study Metellgesellschaft

MG entered into long-term forward contracts to

supply oil at fixed prices to its customers

A fixed quantity to be supplied every month over a
period of 10 years at prices fixed in 1992
Due to long-term short forward contracts the
company faced the risk of a rise in oil prices
Hedged the above risk by a stack and roll hedge
Entered into a long position in near-month oil futures
contracts for the entire quantity to be supplied over
the 10 year period
On expiry of near-month contract the position was
rolled over to the next near-month contract for the
remaining quantity of exposure

Case study contd..

Oil prices were in normal backwardation when strategy

was adopted backwardation was expected to continue

Under conditions of backwardation futures price is
below the expected future spot price and hence
futures prices rise to converge with the spot at expiry
Hence MG expected to make MTM gains on its long
futures positions even as it lost on its forward sale
commitments
However oil market changed to contango, i.e. spot
prices started declining and fell below the futures
prices
Hence as MGs long futures contracts approached
expiry, the futures prices were declining and MG
incurred huge MTM losses

Case study contd

Due to its huge long position in the futures market,

MG faced margin calls and ran into funding

problems
Although MG was making profits on its actual sales
under the forward contracts, these gains could not
be recognized in P&L under the German accounting
rules while MTM losses on the long futures position
had to be recognized
As a result MGs P&L was in a mess and adverse
consequences in the market
Eventual losses $1.5 billion
Risks faced by MG basis risk, liquidity risk and
operational risk