Mod2 FWD Fut

Module 2: Forwards & Futures
Contracts
CONTENTS
Basic hedging practices with Forwards
Futures contracts specifications & details,
terminology
Differences: Forwards vs. Futures
Pricing principles for forwards & futures for
various types of assets
Arbitrage opportunities
Hedging with futures contracts Optimal
hedge ratio
Stock futures & Stock index futures
Arbitrage with stock futures
2
Basic Hedging Practices with Forwards
Why should one Hedge?

A forward/futures contract enables the parties
involved to buy and sell a certain quantity of
the underlying asset at a certain price at a
certain time in future
It locks up the transaction price
notwithstanding the market price at maturity
This fixes the receipts & payments of the seller
& buyer involved
Demerit: If the market prices move to the
advantage of any of the parties he cannot avail
of that opportunity because the price is locked
in
4
The party in the buying position is said

to have a long hedge
The party in the selling position is said
to have a short hedge
The long hedger fears a price rise &
wants to protect the costs
The short hedger fears a price fall &
wants to protect the revenues
The Hedge fixes the price for both buyer
& seller
5
Example 1
Two parties enter into a forward contract
on an agricultural commodity. The forward
price is Rs. 101.51 per unit and maturity
period is 3 months. What are the payoffs
for the long hedge & short hedge aspects
of the transaction? Assume that the
transaction is cash settled. Calculate the
total proceeds with break-up for the long
hedger & short hedger, if the spot price at
maturity ranges from Rs. 97 to 106.
(Source: Adapted from N.R. Parasuraman,
Fundamentals of Financial derivatives)
6
Total Proceeds from Long Hedge

(Rs.)
Price after 3
months
Gain (Loss) in
Forwards = Spot
price after 3 months
Forward price
Total Proceeds = Spot

Price after 3 months
Gain OR + Loss
97
(4.51)
101.51
98
(3.51)
101.51
99
(2.51)
101.51
100
(1.51)
101.51
101
(0.51)
101.51
102
0.49
101.51
103
1.49
101.51
104
2.49
101.51
105
3.49
101.51
106
4.49
101.51
7
Total Proceeds from Short Hedge (Rs.)

Price after 3
months
Gain (Loss) in
Forwards = Forward
price Spot price
after 3 months
Total Proceeds = Spot

Price after 3 months +
Gain OR - Loss
95
6.51
101.51
96
5.51
101.51
97
4.51
101.51
98
3.51
101.51
99
2.51
101.51
100
1.51
101.51
101
0.51
101.51
102
(0.49)
101.51
103
(1.49)
101.51
104
(2.49)
101.51
105
(3.49)
101.51
106
(4.49)
101.51 8
Example 1: Conclusion
Total proceeds is the total cost incurred
by the long hedger or the total
revenues earned by the short hedger
At each price level total proceeds for
the long & short hedger are of equal
monetary amount
For long hedger it is an outflow while
for short hedger it is an inflow
Total proceeds will always be equal to
the forward price
9
Profit from a Long Forward Position

Forward price, ST = Price at maturity) = ST - K
Profit
Price of Underlying
at Maturity, ST
10
(K=
Profit from a Short Forward Position

Forward price, ST = Price at maturity) = K - ST
Profit
Price of
Underlying
at Maturity,
ST
11
(K=
Profit from Long/Short Forward

Positions
Party in Long position gains

when spot price at maturity is >
Forward price
Party in Short position gains
when Spot price at maturity is <
Forward price
12
Futures Contracts
Futures contract is a standardised forward
contract
It is standardised in terms of asset type,
quantity, quality, delivery, time period
A forward contract is OTC in nature; hence there
is NO performance guarantee default risk
A futures contract is traded in an exchange;
hence guaranteed by it
The exchange ensures this by a practice of
margins & levies marking-to-market & daily
settlement
Settlement is mostly done by closing out & not
13
by physical delivery
Futures Contracts - Specifications

A futures contract is created by an
exchange
The specifications relate to the:
1. Asset
2. Contract size
3. Delivery arrangements
4. Delivery months
5. Price quotes
6. Price limits
7. Positions limits
14

1. Asset:
Refers to the quality/grade of the asset
Matters mainly for commodity futures
Quality is specified in terms of a suitable
parameter which may be fixed or may
vary within a specified range with
adjustment in price
For financial assets quality may imply
maturity or credit rating of the asset
15
Futures Contracts Specifications

2. Contract Size:
Quantity of asset to be delivered under one
contract
Quantity is critical: should balance the
needs for hedging/speculating with small &
large positions
3. Delivery Arrangements:
Place of delivery
Matters for commodities because
transportation costs are involved
16

4. Delivery Month:
Futures contract is referred to by delivery
month
Exchange may specify the precise time
interval in the month for delivery - may be
whole month
At any time contracts trade for the nearest
delivery month & a no. of subsequent delivery
months
Exchange specifies when the trading for a
specific months contract will start & stop
Decided to meet the needs of the 17participants

5. Price Quotes:
These are conventions for price quotations defined
by the exchange
Varies on the nature of underlying asset
6. Price Limits & Position Limits:
Price limits are the daily limits for price change + / Once these limits are touched trading for a contract
ceases for the day to prevent excessive speculation
Position limits are the maximum no. of contracts
that a party can hold to prevent undue influence on
the market by accumulating large positions
18
Futures Media Quotes (Stock Futures)
Prices Opening, highest, lowest,

closing / settlement price; daily
change in price is obtained by
comparing the current days closing
price with the previous days closing
price
No. of contracts This is the no. of
contracts traded in a single day;
indicates trading volume
Open interest Cumulative no. of
19
Convergence of Futures & Spot Prices

As the delivery period in a futures contract
approaches the futures price approaches
the spot price
On reaching the delivery period the futures
price converges with the spot price
If they do not converge then there will be
an arbitrage opportunity in the delivery
period
As players exploit this arbitrage opportunity
the futures price will increase/decrease to
fall in line with the spot price in the delivery
period
20
Convergence of Futures & Spot Prices
1.What happens when the

futures price is > spot price
during the delivery period?
2.What happens when the
futures price is < spot price
during the delivery period?
21
Futures Curves & Price

Patterns
A pattern of consistently increasing
futures prices for futures contracts
with increasing maturities is said to
be a normal market
A pattern of consistently
decreasing futures prices for
futures contracts with increasing
maturities is called an inverted
market
22
Futures Curves & Price

Patterns
For any futures contract if the price is falling
over time as it approaches its maturity the
futures contract is said to be in contango.
This happens when the Futures price >
Expected spot price of asset on delivery
date.
For any futures contract if the price is
increasing over time as it approaches its
maturity the futures contract is said to be in
normal backwardation. This happens when
23
Futures Price Patterns

Why do such price patterns
evolve over time?
How can a contango market
exist?
How can a backwardation
market exist?
24
Futures Prices & Expected Spot

Prices in Future
The average opinion of the market about
the likely spot price of the asset at a future
point of time is called the expected spot
price of the asset at that future point of time
Does the futures price for a certain
delivery date reflect the expected spot
price of the asset at that point of time
in future?
Notations: F0 , E(ST ), T , r , k
Let us assume the stock market to be a proxy for
all markets
25

Prices in Future
Strategy: Assume that a speculator expects the
spot price on maturity to be higher than futures
price. So he does the following transactions:
(Why ?)
1. Take a long position in futures contract today at F 0
2. Invest amount = PV (F0 ) in risk-free investment
Cash flow today: -F0e-rT
Cash flow at maturity: +ST
Value of the investment now = NPV of cash flows
Cash flow at maturity to be discounted at
investors required return (k)
26

Prices in Future
Cash flow today: -F0e-rT
Cash flow at maturity: +ST E(ST ), T , r , k
Value of the investment now = NPV of cash flows
NPV = -F0e-rT + E(ST )e-kT [E is expected
value]
Due market efficiency all investments in
securities markets are so priced that their NPV =
0
So: -F0e-rT + E(ST )e-kT = 0
or
F0 = {E(ST )e-kT / e-rT }
= E(ST )e(r-k)T
27

Prices in Future
F0 = E(ST )e(r-k)T
Case 1: Asset returns are uncorrelated with
market
So asset has zero unsystematic risk it should by
priced = risk-free asset. k = r Hence F0 = E(ST )
Case 2: Asset returns are +vely correlated with
market asset has +ve systematic risk. k > r
So F0 < E(ST )
Case 3: Asset returns are -vely correlated with
market asset has -ve systematic risk. k < r
So F0 > E(ST )
28

Prices in Future - Conclusions
When the returns from the underlying asset are
not correlated (zero beta) with the stock market,
the futures price is an unbiased estimate of the
expected spot price in future
When the asset returns are positively correlated
with the stock market (+ve beta) the futures
price understates the expected spot price in
future
When the asset returns are negatively correlated
with stock market (-ve beta) the futures price
overstates expected stock price in future
29
Forwards Vs. Futures Contracts

1. Standardisation: Futures All elements except
price are standardised only price is
negotiated. Forwards All elements of the
contract are negotiated.
2. Liquidity: Futures Generally more liquid than
forwards exchange traded & can be closed
out by offsetting. Forwards Mostly illiquid.
3. Default Risk: Futures Nearly free from
default risk; counterparty to both long side &
short side is the Clearing House of the futures
exchange. Forwards High possibility of
default risk
30
Forwards Vs. Futures Contracts

4. Settlement: Futures Most futures positions are
closed out before maturity by entering into
offsetting positions; some are cash settled; only a
small proportion are settled by physical delivery.
Forwards End up with physical delivery or cash
settlement as agreed to by the parties.
5. Marking to Market: Futures Security deposits
(margins) are taken by exchange by daily
settlement / marking to market; daily change in
value of a futures contract is exchanged .
Forwards : Difference between forward price &
spot price on delivery date = Profit, to be
exchanged that day
31
Marking To Market Example
32
33
34

There are two A/c: Equity & Cash
Initial balance in Equity A/c is set equal to Initial
Cash balance when the mark-to-market process is
started
Equity col. on a day = Value in Final Equity col. in
previous day Mark-to-Market Loss OR + Mark-toMarket Gain on that day
Final Equity col. on a day = Value in Equity col. on
that day + Maintenance Margin Call for that day
Initial Cash Balance on a day = Final Cash Balance
on previous day
Final Cash Bal. on a day = Initial Cash Balance on
the day + Maintenance Margin Call
35

At least 3 ways to calculate profit/loss in
this example
1. (Futures price on closing out day minus
Futures price at the beginning) x
Contract size
2. Initial Cash Balance Column Minus Equity
column on the closing out day
3. Add up the daily Mark-to-Market cash
flows into & out of Margin A/c
36
Calculating rate of return on

Forward/Futures contract is
complicated due to following
reasons
If the transactions are settled in
cash & there is no initial margin
(which may happen in case of a
forward) then there is actually
infinite +ve or ve rate of return
37

In futures if the Initial Margin money
contributed is considered to be the initial
investment then a rate of return can be
calculated by dividing the final net
profit/loss by the Initial Margin. Problems:
1. Final Net Profit/Loss is calculated by
aggregating cash flows at different points
of time 2. You may get a return of less
than -100%.
IRR cannot be calculated on the basis of
Initial Margin & subsequent cash flows
because there are multiple sign changes
38
Collaterisation
A practice followed in OTC segment
of forwards to reduce credit risk
Similar in nature to the marking-tomarket & margining system
followed in futures market
Interest is paid on the outstanding
cash balances of the parties
involved
39
Pricing Principles for Forwards/Futures

No Arbitrage Assumption: If the forward price
is incorrect then there will be arbitrage
opportunities which will restore market
equilibrium.
Perfect Markets Assumption No transaction
costs (No bid-ask spreads, No commissions),
No taxes
Short selling Assumption: Short selling of the
underlying asset is possible.
Risk-free rate Assumption: Risk-free rate of
interest is same for all participants & same
40
for borrowing & lending transactions.
Pricing Principles for Forwards/Futures

In general there are two categories of assets:
Investment assets & Consumption assets
Investment assets are primarily held by
majority of investors for investment purposes
stocks, bonds, gold, silver: to earn a return
Consumption assets are primarily held by
majority for consumption crude oil, copper,
lead, gas
This distinction is important because the
pricing principles for futures/forwards are
differently applicable to investment assets &
consumption assets.
41
Forward Price For An Investment Asset
3 possible types of Investment

Assets:
1.No Income assets: eg. Nondividend paying stocks, DDB /
ZCB
2.Known Income assets: eg. Stocks
paying stable dividends, Coupon
bearing bonds
3.Known Yield assets: eg. The
42
Forward Price For An Investment Asset
Pricing Principle: Cost of Carry

Hence Cost-of-Carry Model
A base case pricing model for the
asset type 1
This can be adjusted to develop
the pricing models for asset
types 2 & 3
43
1. No Income Asset
Basic Model:
Forward Price = Spot Price + Cost of
Carry
F =
S
+
C
C is the cost of carrying the asset in
stock for future delivery
Generally C includes: cost of
financing the purchase & storage
cost of asset
44
1. No Income Asset
Forward Price = Spot Price + Cost of
Carry
F =
S
+
C
As long as forward price is as per this
equation an investor will be
indifferent between buying the asset
spot or forward (or selling the asset
spot or forward)
Note: Because borrowing & lending
45
1. No Income Asset
If forward price differs from the
above equation there will be
arbitrage 2 cases:
A. F > S + C : It is cheaper in spot
market & dearer in forward
market
B. F < S + C : It is cheaper in
forward market & dearer in spot
market
46
1. No Income Asset
Arbitrage Strategy: Case A: F > S
+C
Buy Spot & Sell Forward Borrow
an amount equal to S at risk-free
rate for a period equal to
maturity of forward, use S to buy
asset spot, sell asset forward at
F, service the debt at maturity
using proceeds of forward sale
47
1. No Income Asset
Arbitrage Strategy: Case B: F < S
+C
(Short) Sell Spot & Buy Forward
Short Sell asset spot at S, Invest
proceeds of spot sale (S) at riskfree rate for a period equal to
maturity of forward contract, Buy
asset forward at F, at maturity
Close out short position by
48
1. No Income Asset
Arbitrage can be precluded when
there is no arbitrage profit
Case A: F not > S +CF S C
Case B: F not < S +CF S C
In equilibrium both types of arbitrage
will be precluded
This can only happen if: F = S + C
Thus forward price = spot price +
cost of carry
49
1. No Income Asset
How to calculate S + C ?
Spot Price + Cost of
Carry
Notations:
F0 = Forward/Futures price today
S0 = Spot price today
r = Risk-free interest rate with
continuous compounding
e = Exponential constant
50
1. No Income Asset
How to calculate Spot Price + Cost
of Carry?
rT
Mathematically u/ continuous
S0 e
rTPrice + Cost of
compounding:FSpot
0 S0 e
Carry
Therefore:
Cost of Carry is the cost of financing
the spot purchase of the asset &
holding it to the maturity of the
forward contract (this is applicable
51
1. No Income Asset
Note:
In the condition of the forward price
being lower than the cost-of-carry
price, short selling the asset in the
spot market is just one of the
possible forms of arbitrage.
The other form of arbitrage is that
under such conditions sufficient no.
of investors who hold the asset at
present are ready to sell the asset in
52
1. No Income Asset
Example 1: Determine the forward
price of a no income paying asset for
a 3 month maturity. The current price
of the asset is INR 40 and risk-free
interest rate for 3 months is 5% pa.
Analyse the situations if the forward
price is INR 43 and INR 39.
53
2. Known Income Asset

Assumption: The investment asset provides
perfectly predictable income in cash to holder
during the lifetime of the forward contract
The income earned by the holder of the asset
during the tenure of the forward contract is
called Carry Return; it is the return from
carrying the asset. So it reduces the cost of
carry.
Forward Price = Spot Price + Cost of Carry
Carry
Return
Or F = S + C R
54

Carry return reduces the cost of carrying the
asset up to the maturity of the forward
contract
There are two ways of making this
adjustment:
A. (S + Cost of Carry) Future Value of Carry
Return OR
B. (S Present Value of Carry Return) + Cost of
Carry
Of the above two approaches the second
one (B) is applied
55

What if the Forward price
differs from S + C R ?
Case A: F > S + C R
Case B: F < S + C R
In both cases there will be
arbitrage involving the spot
& forward markets
56

Arbitrage Strategy: Case A: F > S + C R
Buy Spot & Sell Forward Borrow an
amount = S at risk-free rate for a
period equal to maturity of forward,
Use S to buy asset spot, Sell asset
forward at F, Use income received to
repay part of debt, Service remaining
debt at maturity using proceeds of
forward sale (F)
Your arbitrage profit: F (S + C R)
57

Arbitrage Strategy: Case B: F < S + C R
(Short) Sell Spot & Buy Forward Short
sell asset spot at S, Invest part of the
proceeds of short sale at risk-free rate
for a period at which income is
produced by the asset, Pay an amount
equal to the income produced to the
owner, Invest the remaining part at
risk-free rate for the maturity period of
forward contract, Buy asset forward at
58

How to calculate S + C - R?
Spot Price + Cost of Carry
Carry Return
r = Risk-free rate of interest with
T = Maturity of Forward/Futures (years)
I = Present value of income from asset
during the life of the forward contract
59

Spot Price + Cost of Carry Carry
Return?
Mathematically u/ continuous
rT
compounding: Spot Price
Carry
(S0 - I)e
Return + FCost
of
Carry
rT
(S - I)e
0
Therefore:
Note: The present value of carry
return has been reduced from spot
60
Important Note:
The present value of the income
from the asset may be calculated
with a different risk-free rate
than the one applicable to the
maturity period of the forward /
futures contract
It depends on the risk-free rate
applicable to the time period
61

Example 2: Determine the forward
price of an income paying asset for a
9 month maturity. The asset is a
coupon bearing bond whose current
price is INR 900 and it is supposed to
pay a coupon of INR 40 after 4
months. The continuously
compounded risk free interest rates
applicable to 4 months & 9 months
are 3% & 4% p.a. Analyse the
62
3. Known Yield Asset

Asset provides a known yield instead
of a known income magnitude of
income is not fixed but the income
relative to market price at the time of
payment is fixed
This is the case generally when the
underlying asset is foreign currency or
stock index
The yield is also applied with
continuous compounding. If originally
63

r = Risk-free rate of interest with
T = Maturity of Forward/Futures
(years)
q = Average yield per annum with
continuous compounding during the
64

The expression for Forward price
(r - q)T=
for a known yieldasset
Se
0
F0 S0 e
(r - q)T
65
Example 3: Derive the 6month forward price for an

asset that is expected to
produce an income of 2% of
asset price once within an
interval of 6 months. The
risk-free interest rate is
66
Valuing Forward Contracts

Assuming other things to remain
unchanged the price for a
forward/futures contract with a
specified maturity date is likely to
change over time up to the maturity
because the spot price of the asset
changes
Given that the forward/futures price is
fixed at the time of inception of the
contract, at subsequent points of time
67

Hence at each point of time after its
inception, a forward/futures contract has
a different price (F0 )
Given the forward price (F0 ) at any point
of time after inception, one can assess
the value of the forward / futures
contract by comparing the same with
the forward price at the inception (K) of
the contract
Assumption: The expected spot price of
asset at maturity is equal to the
68

So at later points of time a different
forward / futures price can be calculated
for the same maturity hence there will
be a positive or negative difference
between the forward price later & the
forward price at the inception
This difference is the basis of the value of
a forward / futures contract at any time
between inception & maturity
It is thus important for banks & financial
institutions to value the contract each
69
Valuing Forward Contracts No Income Asset
Notations:
We are now at a time between inception
& maturity
K = Forward price set at the inception of
the forward / futures contract for specific
maturity
F0 = Price of the forward / futures
contract at the present point of time
(between inception & maturity); S0 = Spot
price at present point of time
T = Remaining time to maturity from
70
F0 S 0 e rT
Forward/Futures price today
= Expected spot price at
the maturity date
At todays forward price Value of a Long
forward contract at maturity = Expected
rT
S 0 e (F
0K
spot price at maturity
) Original
forward price mentioned in contract (K) =
F0 K
Value at Maturity
rT
rT
rT
rT
Value of [the
F0 Long
K ]e contract
[ S 0 e Ktoday
]e S(f)
Ke
0 =
Present Value of Value of the Long
forward contract at Maturity =
71
F0 S 0 e rT
the maturity date
At todays forward price Value of a Short
forward contract at maturity = Original
rT
K S 0 ein contract (K)
forward price mentioned
Expected spot price at maturity (F0) = K
F0
rT
rT
[ K Short
S 0 e ]econtract
Ke today
S 0 (f) =
Value of the
Present Value of the Value of the Short
forward contract at maturity =
rT
72
Valuing Forward Contracts Known Income Asset
F0 ( S 0 I )e
the maturity date
rT
(
S
I
)
e
K
spot price at maturity0 (F0) Original
F0 K
rT
Value of the Long contract today (f) =

rT
rT
rT
rT
Present
Value
of
the
Value
of
the
Long
[ F0 K ]e [( S 0 I )e K ]e S 0 I Ke
73
Valuing Forward Contracts Known Yield Asset
F0 S 0 e ( r q )T
the maturity date
( r q )T
S 0 e (F0) K
spot price at maturity
Original
F0 K
Value of the Long contract today (f) =

rT
( r q )T
rT
qT
rT
[ F0 K Value
]e [of
S 0 ethe Value
K ]e of the
S 0 e Long
Ke
Present
74
Valuing Forward Contracts - Examples
Example 4: The forward price of a

no income paying asset for a 3
month maturity is INR 40.50. One
month after the inception the
price of the asset is INR 41. The
risk-free interest rate for all
periods up to 1 year is 5% pa.
Calculate the value of the long
position in the forward contract.
75

Example 5: The forward price of an
income paying asset at the inception of
a 9 month contract was INR 88.66. The
asset is a coupon bearing bond which
is supposed to pay a coupon of INR 4, 4
months after the inception of the
forward contract. The continuously
compounded risk free interest rates
applicable to 4 months & 9 months are
3% & 4% p.a. Two months after the
inception the price of the bond is INR
76
Example 6: The 6-month forward

price at the inception, for an
asset that is expected to produce
an income of 2% of asset price
once within an interval of 6
months, was INR 25.77. The riskfree interest rate is 10% p.a. Two
months after the inception the
spot price of the asset is INR 25.
77
Cost of Carry & Arbitrage

Issues
Arbitrage requires that information on
spot prices, futures prices etc should be
freely available at all times to all
participants.
In India while information on stock
markets are readily available,
information on commodities & forex is
not easily available which may prevent
arbitrage
Arbitrage requires that money is
available for borrowing at rates feasible
78

Issues
Cost of carry assumes that borrowing &
lending happen at the risk-free rate. Funds
are generally not available at this rate.
Moreover the borrowing & lending rates
are different.
Arbitrage requires that ready stock of
underlying asset is available for trading &
short selling is possible to exploit the
pricing discrepancies. Both these
requirements may not be fulfilled in reality.
79

Issues
The phenomenon of convenience yield
prevents selling the underlying asset
in the spot segment generally
applicable to traders / exporters of
commodities
Regulatory provisions may prevent
arbitrage to take place ban on shortselling, minimum lot size for futures
segment, non-availability of funds to
post margin requirements
80
Forward Vs. Futures Prices

Theoretically they are same for
the same maturity period &
delivery date
Several factors are not reflected
in the theoretical models: Taxes,
Transaction costs, Treatment of
margins
However for practical purposes
the differences in prices are small
81
Basis Risk
Basis refers to the difference between the spot
price of the underlying asset & its futures price
Basis risk is said to exist when this difference
tends to change
It is of particular importance in futures contract
because of its standardised nature the
maturity of the futures contract may not match
with the planning horizon of the hedger
Due to this the futures contract has to be
closed out at the prevailing futures price & this
has an impact on the position being hedged
82
Basis Risk
At any point of time:
Basis = Spot price Futures price
When the value of Basis increases from one
point of time to another: Basis is said to
strengthen
When the value of Basis decreases from one
point of time to another Basis is said to weaken
When the Basis remains unchanged from one
point of time to another the hedge is said to be
perfect & the value of the hedgers position at
the time of closing out is same as the value of
his position before entering into the futures
83
contract
Basis Risk
A short hedger expects prices to
decrease & sells futures for protection
If the basis remains same, value of
hedgers position at the time of closing
out is same as the asset value before
entering into the futures contract
If the basis increases the value of short
out increases & vice versa
Hence: a short hedger gains when basis
strengthens & loses when basis weakens
84
Basis Risk
A long hedger expects prices to increase
& buys futures for protection
If the basis remains same, value of
out is same as the asset value before
entering into the futures contract
If the basis increases the value of long
out decreases & vice versa
Hence: a long hedger gains when basis
weakens & loses when basis strengthens
85
Basis Risk
Let the following notations be used:
S1 = Spot price at time 1
S2 = Spot price at time 2
F1 = Futures price at time 1
F2 = Futures price at time 2
B2 = S2 F2 = Basis at time 2
Final payoff (Price paid/recd. for the asset) =
Spot price of asset at time 2 + Cash flow
due to closing out the futures contract = S2
+ F1 F2 = F1 + S2 F2 = F1 + B2
Short hedge: Gain occurs when B2 Increases
86
Basis Risk
Final payoff (Price paid/recd. for the
asset) ,
FPO = S2 + F1 F2
Net Change = FPO S1 = S2 + F1
F2 S1
= (S1
F1) + (S2 F2) = B1 + B2 = B2
B1
Thus: FPO S1 = B2 B1 OR
FPO = S1 + (B2 B1)
Hence Final payoff is the sum of 1.
Spot price at the time of entering the
87
Basis Risk IMPORTANT CONCLUSION
FPO S1 = B2 B1 OR FPO = S1 + (B2

B1)
Short hedger: Gain occurs when FPO >
S1: That is: B2 B1 > 0 OR B2 > B1. So
Gain occurs when Basis increases from
time of entering to time of closing
Long hedger: Gain occurs when FPO <
S1: That is: B2 B1 < 0 OR B2 < B1.
So Gain occurs when Basis decreases
from time of entering to time of closing
Both Long & Short Hedger: No gain / No
88
Basis Risk: Short Hedger

If basis risk acts in favour : Basis
increases from time of entering to time of
closing out: The net value receivable at
the time of closing out is more than the
spot price at the time of entering the
hedge
If basis risk acts against : Basis decreases
out: The net value receivable at the time
of closing out is less than the spot price
at the time of entering the hedge
89
Basis Risk: Example Short

Hedger
At time 1: S1 = 1200, F1 = 1250, B1 =

S1 F1 = -50
Taking two
Scenario
scenarios
1
Scenario
at time
2
2:Scenario 3
S2
1300
1100
1000
F2
1400
1150
1028
Closing out
Adjust.
1250 1400 =
-150 L
1250 1150 =
100 G
1250 1028 = 222

G
Asset value at
time 2
1300
1100
1000
Net receivable
time 2
1300 150 =
1150
1100 + 100 =
1200
1000 + 222 =
1222
Basis at time 1
-50
-50
-50
Basis at time 2
1300 1400 =
1100 1150 =
1000 1028 = -28
-100
-50
Note: Students should
try out withfrom
more1scenarios
having no change
in basis
Basis
Decreases
Unchanged
90 Increases from 1 to
to 2
2
Basis Risk IMPORTANT CONCUSION

FPO S1 = B2 B1 OR FPO = S1 + (B2
B1)
Short hedger: Gain occurs when FPO >
S1: That is: B2 B1 > 0 OR B2 > B1. So
Gain occurs when Basis increases from
time of entering to time of closing
Long hedger: Gain occurs when FPO <
S1: That is: B2 B1 < 0 OR B2 < B1.
So Gain occurs when Basis decreases
Both Long & Short Hedger: No gain / No
91
Basis Risk: Long Hedger

If basis risk acts in favour: Basis
Decreases from time of entering to time
of closing out: The net value payable at
the time of closing out is less than the
spot price at the time of entering into the
hedge
If basis risk acts against: Basis Increases
out: The net value payable at the time of
closing out is more than the spot price at
the time of entering into the hedge
92
Basis Risk: Example Long

Hedger
At time 1: S1 = 1200, F1 = 1250, B1 =

S1 F1 = -50
Taking two
Scenario
scenarios
1
Scenario
at time
2
2:
Scenario 3
S2
1300
1100
1000
F2
1400
1150
1028
Closing out
Adjust.
1400 1250 =
150 G
1150 - 1250 =
100 L
1028 - 1250 = 222

L
Asset value at
time 2
1300
1100
1000
Net payable at
time 2
1300 150 =
1150
1100 + 100 =
1200
1000 + 222 = 1222
Basis at time 1
-50
-50
-50
Basis at time 2
-100
-50
-28
Basis
Decreases from 1 Unchanged
Increases from 1 to
Note: Students should
in basis
to try
2 out with more scenarios having no change
2
93
Basis Risk: Some Reasons

Asset to be hedged different
from the one underlying the
futures contract
Hedger uncertain about the
exact date of buying / selling
the asset
Hedging horizon is less than
maturity of futures so
94
Basis Risk & Choice of

Contract
Choice of contract critically affects basis risk

2 aspects: 1. Choice of underlying asset 2.
Choice of delivery month
Futures contracts available may/not have
the required underlying asset; if the asset to
be hedged is not the underlying then the
hedger has to find out which of the
underlying assets has futures prices most
closely correlated with the asset to be
hedged
Choice of delivery month is generally
influenced by the closeness of time horizon
95
Basis Risk: Choice of

Contract
Basis risk tends to increase with the time

gap between hedge expiration and futures
delivery month
Thumb rule:
Choose a delivery month that is closest &
later than the time horizon for hedge
The time period of hedge expiration should
not coincide with the delivery month of
futures futures prices tend to be
inconsistent in the delivery month; the
long hedger will face the risk of taking
96
Basis Risk: Choice of

Contract
In practice liquidity differs for
different contracts
Liquidity is highest for
contracts with shortest time
to maturity
So many hedgers use shorter
maturity contracts & roll them
over
97
Following Topics
Cross Hedging Concepts, Steps & Issues,
Hedge Ratio & Optimal Hedge Ratio
Optimal Hedge Ratio Technical aspects
Optimal No. of Futures Contracts Without
& With Tailing Adjustments
Rolling the Hedge
Stock Index Futures
Hedging Equity Portfolios Using Index
Futures Index & Non-Index Portfolios
Changing Beta of a Equity Portfolio
Stock Index Futures Pricing & Arbitrage
98
Cross Hedging
This situation occurs when the asset
underlying the futures contract differs from
the one that is being hedged
This happens because sometimes the
hedger may not find a futures/forward
contract for the asset of interest most
hedges are cross hedges
Observed in case of commodities &
financial futures covering debt securities
Hedger has to identify an underlying asset
that is correlated significantly with the asset
being hedged
99
Cross Hedging Steps &

Issues
1. Identify another asset similar in nature

to the relevant asset
2. Estimate the exact extent of relationship
on the basis of historical data
3. If the extent of correlation is less than
perfect then the quantity to be hedged
should be adjusted to get a near perfect
hedge
4. Cross hedges are exposed to basis risk
5. Time horizon of hedge may not conform
with the maturity of futures contract
100
Cross Hedging Hedge

Ratio
It is the Ratio of size of position taken in Futures

contracts to the size of the Exposure
So: Required position in Futures = Hedge Ratio x
Size of Exposure
When the asset being hedged is same as the
asset underlying the futures contract hedge ratio
is supposed to be 1.0
In cross hedging the hedge ratio should differ
from 1.0 because there may be less than perfect
correlation between the prices of the hedged
asset and the underlying asset in futures contract
the hedge ratio should be fixed to minimise the
variance of the value of the hedged position
101
Cross Hedging Optimal Hedge Ratio

It is the hedge ratio that minimises the
variance of the value of the hedged position
It helps to decide on the no. of futures
contracts to be used for hedging a position in
a different asset given the current value of
the position to be hedged & the current value
of a typical futures contract
It is the slope of the regression line of the
changes in spot price (S ) of the hedged
asset against changes in futures price (F )
102
Optimal Hedge Ratio
(page 57)
Proportion of the exposure that should optimally be hedged is

S
where
*
h
S is the standard deviation of S,the
change in the spot price
F
during the hedging period,
F is the standard deviation of F, the change in the futures
price during the hedging period
is the coefficient of correlation between S and F,
S is change in spot price asset being hedged, S, during
a time interval equal to the maturity of hedge
F is change in futures price of underlying asset, F,
during a time interval equal to the maturity of hedge
h* is Hedge ratio that minimises variance of hedgers
position
103
Optimal Hedge Ratio

Example 6A: An exposure in a certain
financial asset is to be hedged by taking a
position in a futures contract on another
asset. The size of the position to be hedged
is INR 1000000, correlation between the
changes in spot price of the asset & futures
price of the underlying asset is 0.80, the
S.D. of changes in spot price is 5.50 and
S.D. of changes in futures price is 6.25.
Calculate the position to be taken in futures
contract that will minimise the variance in
the value of the hedged position.104
Optimal Hedge Ratio

Example 6A Sol:
1. Calculate the optimal hedge ratio
2. Multiply the optimal hedge ratio with
the size of the exposure
3. How should we derive the No. of
futures contracts to be used for the
purpose ??
105
Optimal Hedge Ratio

Example 6B: An exposure in a certain
commodity is to be hedged by taking a
position in a futures contract on another
commodity. The size of the position to be
hedged is 2000000 tons, correlation
between the changes in spot price of the
asset & futures price of the underlying asset
is 0.60, the S.D. of changes in spot price is
0.75 and S.D. of changes in futures price is
1.25. Calculate the position to be taken in
futures contract that will minimise the
variance in the value of the hedged
position.
106
Optimal Hedge Ratio

Example 6B Sol:
1. Calculate the optimal hedge ratio
2. Multiply the optimal hedge ratio with
the size of the exposure
3. How should we derive the No. of
futures contracts to be used for the
purpose ??
107
Cross Hedging Effectiveness

Effectiveness of the hedge:
Represents the proportion of the
Variance in the value of the hedged
position that is eliminated by
hedging
It is the coefficient of determination
( of the regression of changes in
spot price (S ) against
the
changes
in futures price(hF)
*2
2
F
2
S
108
Optimal Hedge Ratio

Example 6C: Calculate the effectiveness
of the hedge for the assets in Examples
6A & 6B.
109
Optimal Number of Contracts With

NO Adjustment for Marking-to-Market
QA
Size of position being hedged (units)
QF
Size of one futures contract (units)
VA
Value of position being hedged (=spot price times QA)
VF
Value of one futures contract (=futures price times QF)
Optimal number of contracts if no Tailing adjustment is made (N*)
h *Q A
QF
110

NO Adjustment for Marking-to-Market
Example 3.3, p.67, c.3;

Options, Futures & Other
Derivatives, John C. Hull &
Sankarshan Basu
111
Tailing the Hedge

Margin requirements & marking-to-market
mechanism associated with futures contracts
often entail cash outflows for the traders
Cash outflows have an associated cost
because either funds have to be borrowed to
that extent or there will be an opportunity
cost if trader uses own funds
Tailing the hedge is a strategy that is used
for overcoming the problem of cash outflows
Tailing is especially important when interest
rates are high & time horizon for hedging is
112
long
Tailing the Hedge

This involves hedging with the no. of futures
contracts determined by the Spot Value of
the position being hedged & Value of 1
futures contract (and NOT hedging with the
exact no. of futures contracts arrived at by
the Optimal Hedge Ratio)
Tailing reduces the Optimal No. of Contracts
This reduces the margin requirements & so
reduces the financing costs on outflows
113
Tailing the Hedge: Effect

It removes the impact of marking to
market of futures contracts
It converts a futures position into a
forward position by eliminating the
effect of marking to market / daily
resettlement (wherein profits/losses
are realised prior to the day the
hedge is closed out)
114

Tailing Adjustment
QA
Size of position being hedged (units)
QF
Size of one futures contract (units)
VA
Value of position being hedged (=spot price times QA)
VF
Value of one futures contract (=futures price times QF)
Optimal number of contracts after Tailing adjustment to allow for daily settlement of
futures
h *V A
VF
115
Rolling the Hedge Forward

When the time horizon required by the
hedger is longer than the maturity of the
futures contract, the holder has to roll the
hedge forward
Rolling over the hedge involves taking the
futures position initially and closing it out
just before its expiry; and entering into a
new futures contract for the remaining
period
Demerit: High transaction costs that are
likely to be incurred in the roll over process;
price changes may not be as anticipated
116
Rolling the Hedge Forward Example 7
Spot price of asset:

100
Risk-free rate
:
6%
Maturity of futures: 3 months from now
Futures price for a 3 month contract now:
101.51
The trader wants to buy the asset after 6
months and wants to hedge his position by a
long hedge
Spot price after 3 months: 110
3 month futures price 3 months hence: 111.66
Spot price after 6 months: 120
Show by calculations whether the hedge
worked
117

After 3 months: Square off & roll over
Profit on squaring off old futures =
Closing out price for old futures
Original price of old futures = 110
101.51 = 8.49 = A
Roll over: Long new futures at 111.66
After 6 months: Close out new futures
Profit on closing out new futures =
Closing out price of new futures
Original price of new futures = 120
111.66 = 8.34 = B
118

Interest saved: Hedger could have
borrowed 100 & bought the asset spot,
and repaid the same after 6 months (time
horizon of hedger for purchase
0.06of
0.5 asset)
100e
100 3.05
=C=
Total profit = A + B + C = 8.49 + 8.34 +
3.05 = 19.88
Amount payable to buy asset after 6
months = Spot price after 6 months
Total Profit from Futures settlement = 120
19.88 = 100.12 (negligible loss of 0.12)
119
Stock Futures
Also traded in the stock
exchanges
The underlying assets are
individual equity shares
Each futures contract is for a prespecified quantity of the stock
(marketable lot)
120
Stock Index Futures Indian Markets

Traded at BSE & NSE
At any point of time three futures are
traded :
1. Expiring on the last Thursday of the 3rd
month following the date of trade
2. Expiring on the last Thursday of the 2nd
month following the date of trade
3. Expiring on the last Thursday of the
month succeeding the date of trade
. BSE: Sensex Futures
. NSE: S&P CNX Nifty Futures, Nifty Mini etc.
121
Stock Index Futures

A stock index is a hypothetical portfolio of stocks
that is supposed to represent the market portfolio
It shows changes in the value of the hypothetical
portfolio
A stock index future is one in which the underlying
asset is the stock market index
Settled in cash, not by physical delivery of the
underlying portfolio
All index futures contracts are marked to market
to either the opening/closing price of the index on
the last trading day & positions are then closed
122
Stock Index Futures

Used for hedging exposures to stock
price volatility
Nifty futures are closed out at the
closing value of the corresponding
index on the last Thursday of delivery
month
Each contract is based on a specified
multiple (quantity) of the index value
on a particular day
Price change is also measured with in
123
Hedging an Equity Portfolio

Stock index futures can be used to
hedge diversified equity portfolios
If the equity portfolio is an index
portfolio then optimal hedge ratio (h*)
P
= 1.0; Optimal No. of futures
to be
F
shorted (N*)
Where,
P = Current value of the portfolio
F= Current value of one futures
124
Hedging an Equity Portfolio

For non-index type equity portfolios the
No. of index futures contracts to be
shorted is determined on the basis of
the of the portfolio
Hence for equity portfolios optimal
hedge ratio (h*) =
P
Therefore optimal
no.
of index futures
F
contracts to be used (N*)
P = Current value of portfolio, F =
Current value of 1 futures contract
125
Eg.8:Hedging an Equity Portfolio

Hull/p71
Assume an index futures contract
with 4 months to maturity is used to
hedge the value of a portfolio over
next 3 months. One futures contract
is for the delivery of Rs. 250 times
the index.
Calculate the expected value of the
position of an investor in the
portfolio if the index has a value of
900 & index futures has a value of
126
Hedging an Equity Portfolio Example 8
Value of index now = 1000

Value of index futures now
= 1010
Value of portfolio = Rs.
5050000
Risk-free rate = 4% pa
Dividend yield on index =
127
Reasons for Hedging Equity Portfolio

using Index Futures
In a perfectly hedged situation the

hedgers position at the end of the
period of hedging should be at
least equal to the value of the
portfolio when the hedge was
initiated
If the hedge using index futures
can eliminate all the market risk, it
may be possible that the portfolio
128

using Index Futures
Hence the alternative to hedging

by Index Futures could be to sell
the portfolio at the beginning of
the period of hedging, invest the
proceeds in the risk-free assets for
the time horizon of hedge and buy
back the portfolio at the end of the
period.
So there could be two alternative
129

using Index Futures
Hedging by index portfolio can be
adopted for well-diversified portfolios
Why?
Hedging by index portfolio will remove
the impact of market volatility
If the hedger plans to hold the portfolio
for a long time & wants protection from
short term market volatility then hedging
can be done by index futures
The alternative strategy of selling the
130
Changing the Beta of a Equity Portfolio
Hedging an equity portfolio by

shorting the optimal no. index
futures reduces the portfolio beta to
zero
Hence the portfolio beta can be
altered to any other value by
manipulating the no. & position in
the index futures contracts
To reduce portfolio beta short index
futures
131
Changing Beta of a Equity Portfolio

Changing portfolio beta from
such that > * - Decreasing
P
portfolio beta:
( *)
F
Take short position in
futures contracts
Changing portfolio beta from
P
such that < * -(Increasing
* )
F
portfolio beta:
Take long position in
futures contracts
132
to *
index
to *
index
Changing Beta of a Equity Portfolio Example 9
Value of index now = 1000

Value of index futures now = 1010
1 index futures contract = 250 times
Value of portfolio now = 5050000
Beta of portfolio = 1.5
Suggest the index futures strategy to
be used to: (a) reduce the beta to 0,
(b) reduce the beta to 0.75, (c)
increase the beta to 2.0
133
Pricing of Stock Index

Futures
A stock index can be considered to be

an investment asset that pays
dividends
Generally it is assumed that the
constituent stocks will provide a
( r q )T
known dividend
yield
rather
than a
F0 S 0 e
known dividend income
q represents the average annualised
dividend yield during the life of the
134
Example 10
A 3-month futures contract on a
popular index has to be priced. The
following info. is available:
Current value of index = 2700
Dividend yield = 1% pa
Risk-free interest rate = 5% pa
Compute the futures price for this
index.
135
Index Arbitrage
Arbitrage transactions involving a stock
index for which index futures are traded
Can be carried out when there is a
deviation between the theoretical price
of the index future and the actual price
If the actual price of the index futures is
more than the theoretical price then it
means that the index future is
overvalued so sell it to earn profit
If the actual price of the index futures is
less than the theoretical price then it
136
Index Arbitrage
If the actual price of the index
futures is greater than its
theoretical price then arbitrage can
be done by shorting the index
futures and buying the stocks
underlying the index at the spot
price
If actual price of the index futures is
less than its theoretical price then
arbitrage can be done by buying
137
Index Arbitrage
Index arbitrage requires that a trader is
able to trade swiftly on the portfolio of
stocks underlying the index at their
current prices quoted in the market, as
well as trade on the index futures
contract
Generally this is carried out through
program trading and under normal
market conditions this results in prices of
index futures close to their theoretical
values
Program trading fails to generate correct
138
Forwards & Futures on Currencies
Underlying Unit(s) of a
currency
Holder of the foreign
currency earns risk free
interest prevailing on that
currency on the balance held
139

Hence foreign currency is like an
investment asset that earns a
known yield (risk free foreign
currency interest rate)
Effectively the investor in the
foreign currency earns the above
yield on the investment made in
terms of home currency
So we apply the futures valuation
140

Forward price of foreign currency in
terms of home currency ( r r f )T
F0 S 0 e
F0 = Forward price of foreign currency

in terms of home currency
S0 = Spot price of foreign currency in
terms of home currency
r = Risk-free interest rate on home
currency for period T
rf = Risk-free interest rate on foreign
currency
141

Example 11:
Spot exchange rate between USD & AUD: USD
0.6200 per AUD
2-year risk free interest rate in Australia: 5%
2-year risk free interest rate in US: 7%
Current spot exchange rate: USD 0.6200 per
AUD
Calculate the 2-year forward exchange rate for
AUD
What will happen when the actual 2-year
forward exchange rate is (a) less than this rate
& (b) more than this rate?
142
Clues to Example 11 (a):

When the actual forward rate for the
foreign currency is less than the
theoretical rate the foreign currency
is cheaper forward than spot so buy
it forward & sell it spot; in order to
sell it spot create a borrowing
(conversely: in order to square off
the forward buy of foreign currency a
borrowing of foreign currency must
143

Example 11: Arbitrage for (a)
Borrow AUD 1000 (say) at 5% pa for 2
years
Sell AUD spot & Convert to USD
Buy AUD 2 year forward
Invest USD now for 2 years at 7%
After 2 years use invested value of USD to
buy AUD at forward rate contracted now
Use the AUD bought after 2 years to repay
borrowing done now
144
Clues to Example 11 (b):

When the actual forward rate for the
foreign currency is more than the
theoretical rate the foreign currency
is dearer forward than spot so sell
it forward & buy it spot; in order to
sell it forward create an investment
in the foreign currency now by
buying it spot (conversely: in order to
square off the forward sell of foreign
145

Example 11: Arbitrage for (b)
Borrow USD 1000 (say) at 7% pa for 2 years
Buy AUD spot now by using borrowed USD
Invest AUD now at 5% pa for 2 years
Sell AUD 2 year forward
After 2 years use invested proceeds of AUD
to sell at forward rate contracted now
Use USD obtained by selling AUD after 2
years to repay borrowing done now
146
Commodity Futures
2 types of Commodities:
Commodities that are
investment assets gold,
silver etc.
Commodities that are
consumption assets crude
oil, base metals
147
Commodity Futures
Characteristics of commodities that are

investment assets:
Income: Investment assets like gold &
silver can be borrowed/lent as part of
the activities in the hedging practices
of the players. Accordingly such assets
generate an interest income (called
gold lease rate) to the owner/lender &
a cost to the borrowing party.
Storage Costs: Because they occupy
physical space & have to be protected,
148
Commodity Futures
Consumption assets:
Storage costs tend to increase the cost
of carry
Hence a storage cost is akin to a
negative income
So the basic formula for futures pricing
with known income can be modified by
rT
F
(
S
U
)
e
replacing the income
0
0 component with a
ve income term:
149
Commodity Futures
Example 12: An asset does not provide

any income to the holder. It however
entails a storage cost amounting to Rs.
2 per unit of asset, payable at the end
of the year. The spot price of the
underlying asset currently is Rs. 450
per unit & risk free interest rate is 7%
pa (all maturities). Calculate the
forward price for a contract with 1 year
maturity.
150
Commodity Futures
If storage costs net of any income at

any time are proportional to the price
of the commodity at that time then it is
like a negative yield
Accordingly we can modify the formula
for known yield
to
incorporate
this
( r u )T
F S e
0
Where:
u is the storage costs per annum as a
proportion of the spot price net of any
yield earned on the asset
151
Commodity Futures Consumption

Assets
Consumption commodities tend to
incur, unlike the investment
commodities significant amounts of
storage costs and provide no income
The arbitrage strategies that make sure
that the actual forward price remains
close to the theoretical price, tend to
differ for investment assets &
consumption assets
152

Assets
Arbitrage happens in two conditions:
(a) Actual Forward price > Theoretical
price; (b) Actual Forward price <
Theoretical price
In condition (a) arbitrage will be:
traders will hold the asset by borrowing
& buying it spot, and sell it forward for
both types of asset
In condition (b) for investment assets
arbitrage occurs by selling the asset
spot & investing the proceeds, and
153

Assets
Holders of consumption assets have

plans to consume the asset
They do not want to sell the commodity
in the spot market & buy it in the
forward/futures market
Selling it in spot market results in
giving up present consumption needs;
Buying it in forward/futures market
does not fulfill their present
consumption needs
154

Assets
Arbitrage will happen in condition (a)
but not in condition (b)
Arbitrage happening in (a) will
ensure that Actual forward price =
Theoretical price
Arbitrage not happening in (b)
implies that Actual forward price < or
= Theoretical price
Putting together: for consumption
commodities the Actual forward price
155

Assets
What then is the Theoretical Price for
forwards/futures on Commodities
that are Consumption assets?
By using the same pricing principles
applicable to the Commodities that
are Investment assets we can
calculate the theoretical upper limit
of the forward/futures price of
commodities that are consumption
assets
156
Consumption Assets
F0 S0 e(r+u )T
where u is the storage cost as a proportion of
the asset price
Alternatively,
F0 (S0+U )erT
where U is the present value of the storage
costs
157
Consumption Assets Convenience

Yields
Holding a consumption commodity
physically can provide benefits that
cannot be obtained by holding futures
contracts on the commodity
For an oil refinery holding crude oil in
physical form in stock is beneficial
than holding a futures/forward
contract because the former can be
used as inputs for the refining process
whereas latter cannot be used
158

Yields
Convenience yield can be estimated
by the extent to which the actual
futures price is less than the
theoretical price as shown in the
earlier inequalities for the
consumption assets
F0 e yT ( S 0 U )e rT
Thus for commodities with known
present value of storage costs:
where y denotes
F0 e yTthe
S 0 e ( r u )T
convenience yield
159

Yields
Convenience yields indicate the
market expectations of the future
supply of the commodity
Higher the likelihood of shortages the
higher the convenience yield & vice
versa
If users of the commodity hold large
inventories then likelihood of
shortages is low; so convenience yield
is low
160
Cost of Carry: A Generalisation

Cost of carry (c) is the fundamental
logical basis for the pricing principles
of forwards & futures contracts
For non-dividend paying stocks: c = r
For stock indexes & stocks with known
dividend yield (q): c = r q
For a currency: c = r rF
For a commodity that provides income
at the rate q & incurs storage costs at
the rate u:
161
A Generalised Model for Futures

Price
For cost of carry c & convenience
( c y )T
F
S
e
yield y with reference to a 0 0
consumption asset:
cT
For cost of carry
reference to
F0 c
Swith
e
0
an investment asset:
162
Delivery Options
A forward contract specifies a
particular delivery date whereas a
futures contract specifies a delivery
period during which the party with the
short position can choose to make
delivery
Knowing the delivery date is essential
for arriving at the theoretical price of
the futures contract whether at the
beginning, middle or end of delivery
period
163
Delivery Options
Given the generalised model of
forward/ futures pricing, the
forward/futures price may be an
increasing or decreasing function of
time to maturity
If the cost of carry is more than the
convenience yield then it will be
increasing function of time to maturity
If the cost of carry is less than the
convenience yield then it will be
164
Delivery Options
If the futures price is an increasing
function of time to maturity then it is
optimal for the seller of the futures to
deliver at the earliest possible time in
the delivery period because the
interest earned on the cash inflow
from settlement exceeds the benefits
of holding the asset
So in such cases, as a rule, the futures
price should be calculated by the
assumption that delivery will take
165
Delivery Options
If the futures price is a decreasing
function of time to maturity then it is
optimal for the seller of the futures to
deliver at the latest possible time in
the delivery period because the
benefits of holding the asset exceeds
the interest earned on cash inflow
from settlement
So in such cases, as a rule, the futures
price should be calculated by the
assumption that delivery will take
166

Mod2 FWD Fut

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Mod2 FWD Fut

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Module 2: Forwards & Futures

Basic Hedging Practices with Forwards

Why should one Hedge?

Basic Hedging Practices with Forwards

Basic Hedging Practices with Forwards

The party in the buying position is said

Total Proceeds from Long Hedge

Total Proceeds = Spot

Total Proceeds from Short Hedge (Rs.)

Total Proceeds = Spot

Profit from a Long Forward Position

Profit from a Short Forward Position

Profit from Long/Short Forward

Party in Long position gains

Futures Contracts - Specifications

Futures Contracts - Specifications

Futures Contracts Specifications

Futures Contracts - Specifications

Futures Contracts - Specifications

Futures Media Quotes (Stock Futures)

Prices Opening, highest, lowest,

Convergence of Futures & Spot Prices

Convergence of Futures & Spot Prices

1.What happens when the

Futures Curves & Price

Futures Curves & Price

Futures Price Patterns

Futures Prices & Expected Spot

Futures Prices & Expected Spot

Futures Prices & Expected Spot

Futures Prices & Expected Spot

Futures Prices & Expected Spot

Forwards Vs. Futures Contracts

Forwards Vs. Futures Contracts

Marking To Market Example

Marking To Market Example

Marking To Market Example

Marking To Market Example

Marking To Market Example

Marking To Market Example

Calculating rate of return on

Marking To Market Example

Pricing Principles for Forwards/Futures

Pricing Principles for Forwards/Futures

Forward Price For An Investment Asset

3 possible types of Investment

Forward Price For An Investment Asset

Pricing Principle: Cost of Carry

2. Known Income Asset

2. Known Income Asset

2. Known Income Asset

2. Known Income Asset

2. Known Income Asset

2. Known Income Asset

2. Known Income Asset

2. Known Income Asset

2. Known Income Asset

3. Known Yield Asset

3. Known Yield Asset

3. Known Yield Asset

3. Known Yield Asset

Example 3: Derive the 6month forward price for an