Financial Derivatives: Stock Index Futures Currency Futures

Group 4

Aayush Aggarwal (191002) Ankit Aggarwal (191007) Ankur Ahuja (191012) Arun Bansal (191017)

Stock Index Future

y Stock index future is a derivative with Stock Index as underlying

asset.
y Cash settled.
y Since stock index is a hypothetical product and does not have a

physical form it is non-deliverable asset

y The turnover for the global market in exchange-traded equity

index futures by the Bank for International Settlements (BIS) at $ 130 trillion (notional value, 2008)
y In the Index Future Arbitrage:
y Know how the futures are trading versus their "fair value.

Terminology
y Strike Price y Contract Size y Contract Value y Tick Size: Minimum increment in which prices can change y Tick Value: Amount by which value of index future changes. y No of Contract y Maturity/ Expiry y Cost to Carry
y Opportunity Cost y Interest Cost

Concepts
y Backwardation:
y Longer dated futures (Jun 2011 NIFTY future) contracts are trading at

a discount to the near contracts (Dec 2010 NIFTY future).

y Carry Effect: Inputs derived from interest rates, the index level,

and time to maturity.

y Dividend Effect: Derived from the dividends that the companies

in the index will pay between now and the expiration date on the futures.
y Basis: Difference between the futures and the cash index

(underlying stock basket)

Future Index

Cash and Carry Arbitrage

y A combination of a
y Long position in asset (stock), carry until expiration. y Short position in the underlying futures.

y Viable: if the cash inflow from the short futures position

exceeds the acquisition cost and carrying costs on the long asset position.
y If index futures is overpriced:
 Sell futures (Short)  Buy underlying assets at the current value of index (Long)  Borrow the required amount (pay interest while paying back)

Reverse Cash & Carry Arbitrage

y A combination of:
y Short position in an asset y Long position in the futures for that asset

y When the futures is under priced:

 Selling the underlying asset.  Lend the funds so realised till the maturity date of the futures

contract.
y On the date of maturity:
 Offset long position in futures,  Buy the underlying asset back  Realise the lent funds along with interest.

PRICING & ARBITRAGE

y Current value of Nifty is 1,990 with a dividend yield of 4% (semi

annually), 3 months future contract is selling at 2,030 and the riskfree interest rate is 10 % . Half of the stocks in index will pay dividend in next 3 months . Spell out the strategy Fair value = Spot Value + Cost of Carry - Dividend = 1,990 + 1990 * 0.10 /4 1,990 * .04 /2 = 1,999.95
y The future at 2,030 is overpriced . The strategy that would yield profit

will be
y Sell future, borrow funds at 10% and invest in index securities y At maturity, buy back future and sell the securities and refund the loans

with interest

Example:

Hedging : Long Position

y A Bureaucrat retiring in 3 Months time is planning to invest 20 Lakhs

out of his superannuation benefits in equity portfolio. He has identified following lowing portfolios at current market prices The market as measured by Index is 4,060. Market is expected to rise as reflected in the 3 Months future trading at 45 points premium to spot at 4,115. Index is likely to go up by 10% by the end of 3 months , Having chosen an aggressive portfolio the bureaucrat is worried that he would have to spend shares accordingly . What strategy can be suggested to the bureaucrat to hedge? Demonstrate that hedging would enable him to acquire same number of shares within his target of Rs 20 lakh even at increased prices.

Beta would be calculated as

Stock Hind Unilever Infosys Indian Hotels Dlf Ltd Reliance Ind Total No. 1,000 100 5,000 2,000 500 Price (RS) 230 1700 60 175 1,900 Value (Rs) 2,30,000 1,70,000 3,00,000 3,50,000 9,50,000 20,00,000 Beta 1.10 1.25 0.90 0.135 1.40 0.245 1.15 0.546 1.159 Wt Beta 0.127 0.106

Hedging can be achieved by going long on index future currently trading at 4,115. The number of future to be brought are : y Current value of portfolio = Rs 20,00,000 y Beta of the portfolio = 1.159 y Exposure to be covered by index future = 1.159 * 20,00,000 = Rs 23,18,000 y Current market Price of Index = 4115 y Value of one future contract (on spot Basis) = 50 * 4060 = Rs 2,03,000 No of contract bought and adjusted for the basis = 23,18,000*4060/2,03,000*4115 = 12 As market went up by 10% Gain in the position of index future = (4,466 - 4,115) * 12 * 50 = Rs 2,10,600 Increase in the value of the portfolio = 10 % *1.159 * 20,00,000 = Rs 2,31,800 The increased cost of acquiring portfolio of Rs 2,31,800 is almost fully compensated by the gain of Rs 2,10,600 . The bureaucrat would need extra Rs 21,200 only .

Example Hedging: Short Position

An investor owns a mutual fund, highly correlated with the S&P 500 (Value: 1415 & Contract Size: 50) index. Portfolio:The current value is $140,000 Time: 1 month Outlook: Case A: Short term bearish. Looking for a decline of : 10%. (1273.5) Case B: Short term bullish. Looking for increase of: 10% (1556.50) Strategy: Sell two S&P 500 futures contracts to hedge portfolio. Number of contracts: 140,000/1415*50 = 2.

Profit/Loss picture: Value of portfolio initially: after one month: (down by 10%) after one month: (up by 10%) Loss on Portfolio Gain on Portfolio

$140,000.00 $126,000.00 $154,000.00 $14,000 $14,000

Value of E-mini S&P 500 initially: $70,750 (1415 x 50)= $70,750 Value of E-mini S&P 500 after one month: $63,675 (12 73.5x 50)= $63,675 Gain on short hedge per contract +$7,075 Value of E-mini S&P 500 after one month: $77,825(1556.5x 50)= Loss on short hedge per contract Hedged Portfolio: Loss on portfolio Gain from futures hedge Overall profit/loss Gain on portfolio Loss from futures hedge Overall profit/loss

(+ $14,150)

$77,825 - $7,075

(- $14,150)

$14,000 + $14,150 + $ 150 + $14,000 - $14,150 - $ 150

Currency Forward and Future

Foreign Exchange Rates

y Foreign exchange rates are always a two-way quote, one for

buying foreign currency the bid rate, and y other for selling the ask rate.
Spread =
Ask Price - Bid Rate Mid Rate

y The difference between ask and bid rate is the profit for the

bank, called spread. It is the amount of money that bank would earn in buying one unit of foreign currency and selling it.

y Forward Rate y Forward contracts in foreign exchange, like any other

forward contract, fix the exchange rate today for settlement at some future date. y Foreign currency at premium/discount means that forward rate is higher/lower than the spot rate (when quoted under direct rate convention).

SWAPS
y A swap transaction consists of two legs, usually one spot and

another forward. The contracts are equal in size but opposite to one another i.e. spot buy followed by forward sell, or y A spot sell followed by forward buy. y It is a composite transaction that is equivalent to two independent contracts -one spot and another forward on outright basis.

Non-Deliverable Forward
y Governments of some nations exercise capital controls in order to

prevent volatility in the exchange rates of their currencies or for any other political or economic reason. y Non-Deliverable Forwards (NDFs) are forward contracts normally entered off-shore and cash settled for currencies that have capital control. y NDF enables hedging by foreign participant who are not allowed to access onshore markets. y Features
y Here since delivery is not possible settlement of forward contract is done

on basis of difference of spot and forward prices y It has to be done in different currency that is freely acceptable .Such contract have notional amount

Arbitrage with Currency Futures

y When future is overpriced y Actions NowBorrow local currency for period of futures maturity
y Convert to foreign currency using spot market y Invest in foreign currency for the period of futures y Sell futures equal to the matured foreign currency investment

y At maturity of futuresDeliver foreign currency against the

futures sold
y Receive local currency against the futures sold y Pay for the borrowed local currency

Arbitrage with Currency Futures

y When future is underpriced y Actions NowBorrow foreign currency for period of futures maturity
y Convert to local currency using spot market y Invest in local currency for the period of futures y Buy futures equal to the matured local currency investment

y At maturity of futuresDeliver local currency against the

futures sold
y Receive foreign currency against the futures bought y Pay for the borrowed foreign currency

Example- Arbitrage with Currency

Following data from financial markets is available . y Spot exchange rate (Rs/$)49.5000 y 180-day futures 50.4000 y Rupee interest rate (T-bill yield)10% y Dollar interest rate (T-bill yield)5%
y The fair price of 6-m futures is Rs 50.6912. Is there any

arbitrage opportunity? If yes how the arbitrage can be executed?

Fair Price can be calculated as

Fair Price of Future = Spot X
1Rupee Interest Rate X (Days/ 365) 1  Dollar Interest rate X (Days/365)

= Rs 50.6912 (Underpriced)

Cash Flows

Now Borrow US dollar Convert to rupee in spot Invest rupee at 10% for 180 days

Rs

1,000.00 -1,000.00 49,500.00 -49,500.00

Cash Flow at t=0 At maturity Receive invested rupee Deliver rupee against futuresy

51,941.00 -51,941.00 1,030.58 -1,024.66 5.92 0

Receive dollars against futures(51,941/50.40) Pay dollar borrowed at 5% Cash Flow at maturity of future

At the maturity of the futures contract the arbitrageur can make a profit of $ 5.92 for every $ 1,000 borrowed.

Example- Determining Forward Rates

Arbitrage argument is used in finding the
a) lower bound for the ask rate, and b) upper bound for the bid rate.

Consider the following spot rates and interest rates: Spot rate (Rs/) Interest rate Rs: : 60.00 8.00% 5.00% 61.00 8.50% 5.50%

Find out a) lower bound to 6-m forward ask rate. b) upper bound to 6-m forward bid rate.

Determining Forward Rates

y To find lower Bound on the risk we do: 1. Borrow foreign money at borrowing rate 2. Convert spot into local currency (Rs) at bid rate 3. Invest local currency at lending rate for the period of forward 4. Sell the matured amount at forward ask rate to reconvert to foreign

currency

Borrow 1.00 at 5.50% for 6 months ; Amount to repay = 1.0275 Convert to rupees at spot bid and get = Rs 60.00 Invest for 6 months at 8% and get Rs 1.04 x 60 = Rs 62.40 Sell at forward ask rate Fa to get = 62.40/Fa For no arbitrage 62.40/Fa 1.0275 Or Fa Rs 60.7299

Determining Forward Rates

y To find upper bound on the bid rate we do as follows:
1. 2. 3. 4. 5.

Borrow local currency (Rs) at borrowing rate Convert spot into foreign currency () at ask rate Invest foreign currency at lending rate for the period of forward Sell the matured amount at forward bid rate to reconvert local currency For no arbitrage , the matured amount through forward must be less than the borrowing

Borrow Rs 1.00 at 8.50% for 6 months Amount to repay = Rs 1.0425 Convert to euro at spot ask, get 1/61.00 = 0.0164 Invest for 6 months at 5% and get 1.025 x 1/61 = 0.0168 Sell at forward bid rate Fbto get = Fb X 0.0168 For no arbitrage we must have Fb X 0.0168 1.0425 Fb Rs 62.0415x

Thank You