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A PMEX Tutorial
December 2006
NCEL 2007
Definition
Futures are the simplest form of Derivative Products Future: Contractual Agreement to Buy or Sell something in the future at a price which is agreed today Represents an Obligation Derivative, because price depends on spot market
NCEL 2007
Spot v Future
Spot
Agree Price Now Pay Money Now Get Commodity Now
Future
Agree Price Now Pay Money Later Get Commodity Later
NCEL 2007
If Buy Now, Must Pay Money Now If Buy Later, Can Save Money Now to Pay Later
NCEL 2007
No-Arbitrage Principle
Economic Benefit of Buying Now or Buying Later should be the same Eg. Gold Spot is Rs 13,000/10gms 3 month Deposit Rate is 10% (Risk-Free, Market Rate of Return) Strategy A: Buy Gold Now, Pay Rs 13,000. Give up potential to earn 10% interest Strategy B: Agree to Buy Gold in 3 months, Save Rs 13,000 and earn interest for 3 months (Rs 325) Everyone would go for Strategy B if Futures Prices did not adjust for opportunity cost
NCEL 2007
No-Arbitrage Principle
Spot Gold Buyer: Loses 10% interest Spot Gold Seller: Earns 10% interest Futures Gold Buyer: Earns 10% interest Futures Gold Seller: Loses 10% interest Futures seller needs to be compensated for foregoing 10% interest income. He will only sell at a price which brings him at least the market rate of return
NCEL 2007
Fundamental Question
Need to weigh just one equation:
Cost and Benefit of Buying/Selling Now Versus Cost and Benefit of Buying/Selling Later
Opportunity Cost of Futures Seller is 10%. He will lose money if he sells futures at less than opportunity cost Futures Price = Spot Price + Cost of Carry Spot = 13,000 ; CoC = 10% ; Time = 3 months Future Price = 13,325 If F > 13,325: Sell Future and Buy Spot and Lock-in Guaranteed Rate of Return of > 10% If F < 13,325: Buy Future, Sell Spot and Earn 10% on Cash plus extra return from buying future cheaply
NCEL 2007
Time Maturity
Mathematical Representation
F = S x (1 + r)t Does Futures Price Calculation Mean Prediction? NO Futures Price depends on three variables:
Spot Cost of Carry Time
NCEL 2007
International Gold Price is in USD/Fine Troy Oz. Fine Troy Ounces i.e. Pure Gold International Price is for London Delivery All traders have to factor in their specific costs of delivering to locations other than London NCEL Contract is for delivery Karachi Have to include Costs of importing gold into Pakistan Have to determine Cost of Carry
NCEL 2007
3: Time to Expiry
4: F = S x (1+r)t
NCEL 2007
NCEL 2007