So this module is going to introduce you to futures and options.

Futures and options are derivatives written on a whole bunch of underlying either securities, commodities and they are mainly used for, they were introduced for risk management and hedging. But have been used for speculation as because as you will see in this module using futures, you can control a large amount of wealth by investing a very little capital. Futures came about as a generalization of forward contracts. In the last model, we talked about forward contracts. What are forward contracts? These were contracts that were written that would allow you to buy or sell a certain amount of commodity at a specified point in time at a specified price. The problem with those contracts were that for the same maturity, depending upon when you wrote the contract, the price was different. The forward price was different depending upon exactly when you wrote the contract. As a result, you will have a situation where you have a contract which has the same quality at maturity, but a very different price. So, you can't organize this in an exchange. It's a night or it's an account nightmare. There is, it has to be, and because it's not an exchange, there is no price transparency. Everybody is going to get whatever price that they can negotiate. Yes, no arbitrage tells you what the right fair price should be. But without, remember, the no arbitrage condition behind it assumes there is liquidity. There is free information flow. Because if somebody, and both of these are necessary to force the no arbitrage price to exist. If it's not there, if, Iif there is no information there's asymmetric information, then the price can move away from the no arbitrage price. So, people can be charged different prices for the same quality of a contract because it's not transparent. And that's why one would like the forward contracts to somehow be moved to an exchange. But the problem is that if you want to

move something to an exchange, you better have the same price for a contract that gives you the same deliverable. So, we want to somehow come up with this idea that you want to, you want to have a price that accounts for everything at the same, there is, there's a fixed price for a fixed deliverable. So, we'll see future contracts do that. There's another problem with forward contracts. It's that we need to have for everybody that likes a long contract, long side, takes the long side of the contract, wants to buy the commodity, we need to find somebody who's willing to sell the commodity. We say in the last module that to some extent, this risk can be taken away by looking at financial intermediary. But financial intermediaries just want to be an intermediary. They don't want, they want to guarantee the parties, but they don't want to become the parties themselves. Otherwise, they'd be taking on the counterparty risk and the whole problems counterparties risk comes back again. So, they just want to pass through the quantity. So, this double coincidence of wants, meaning that every time somebody wants a long position, there should be somebody in the short position that has to be somehow removed. And this double coincidence of wants also inevitably leads to something like a default risk of the counterparty, which also has to be removed. All of these things can be done if somehow you can take forward contracts and put them on exchange. And if you put them on exchange, then they are just bought and sold like stocks. And as a result, you don't have to worry about trying to have this double coincidence of once, you don't have to worry about counter-party risk, you don't have to worry about the fact that the price is not part transparent, is high liquidity and so on. So, the idea is to create a contract which takes care of this multitude of prices by just marking to market. You set up a margin account, everything is, is, you can get into a contract paying nothing, just as you did with a forward contract. Don't pay anything, you just go tell your broker that I want to buy 500 long

positions in a future's contract. The broker would say, fine, just put a certain amount into the margin contract, margin account. This is your account, this is your money, and you can take it back at the end of the day. And as the prices of the contract moves, remember in the former contract, the value of the contract moves around. So instead of the contract, just the value moving around, whenever there's a profit or a loss, the broker will simply credit or debit your account. Whenever the, the account, margin account credit becomes too low, you will simply have to put extra money back. We'll give you a details of that in a moment. I'll show you a spreadsheet where all of this gets worked out once you have this idea of putting it on an exchange, you can pretty much write a futures contract on anything. You can write in on commodities, you can write it on broad-based industries such as the S&P 500, the Russell 2000, you can buy it or write it on the volatility of the market, you can pretty much write it on anything that is worth pricing. On the, on the PDF file that you are going to see, the link down here is actually a live link. You can click on that link and go to a website which will allow you to show what are the various futures contracts out. This slide tells you some of the basics of what a futures contract, how a futures contract works. There are not too much details on the slide. I'll walk through the slide, and then I'll show you a spreadsheet which will walk you through the details. The basic setup is that an individual opens a margin account with a broker. Remember, just like in the forward contract, a future contract doesn't exactly require you to buy the contract. The value of the contract is zero, but there are profit and losses associated with the contract. So, the broker wants to hedge the possibility that when you take on too much losses in your contract, you will not have the money to pay. So, he wants to put something in the margin account so that the moment you start losing money they will either cancel your contract or ask you to put more money

in. So, you get into a number of future contracts, defide, decide how many future contracts you want to buy. You put it in, initial margin account. It's about 5 to 10% of the contract value. For the particular example that I'm going to show you, it turns out that it's actually around 2%. This is also some values that I took from a current website. And therefore, these numbers keep fluctuating. Depends on the stability of the future's price and so on. So, you put this money in. Now, you've bought the contracts and the contracts go up and down in price. So, you make profits, you make losses. All the profits go into your margin account. Sometimes you are, are also paid a certain interest on that margin account. All the losses are settled from your margin account. If for some reason your margin account becomes too low, then you're going to get something called a margin call. The broker is going to say, look, your margin account has become too low, it's below a certain minimum balance that you have to maintain. You have to put money in to make it back to the balance and then you can start playing again. If you're unable to do it, you will have to cancel the account. And at that point, you'll have to take all the losses. That's going to be your net quantity. So what I want to do now is go, walk you through a simulation that gives you a little bit more idea of what these future, futures contract, the dynamics of these futures contracts. So, I'm going to walk you through the simulation for the mechanics of corn futures. So, I've shown you on your website that the corn futures are for 5,000 bushels, so here's the contract value of 5,000 bushels. I took the price for these slides were created in February 2nd and the price, on that particular day, the futures price was $720 per contract, so you've bought yourself one futures contract. On that particular day on this particular website, it tells you what is the, these are the number of cents per bushel.

So, it's 22.363 cents per bushel, here is 1750 cents per bushel. For the particular one that I was looking at, it turns out to be 1.688 and 1250 cents per bushel, and I took those numbers from there to populate my website. So, this is the 16.88 and 12.5. So, what happens, you go to the broker, you tell the broker I want to buy one futures contract. The broker ends up telling you, you have to give me a certain, you have to put a certain amount in the margin account. What is the amount in the margin account? You take the initial margin, you multiply it by the total number of bushels you are controlling. So, 16.88 times 5000 bushels is the amount that can put into your margin account. And you're all set. Now, you are starting to play. There's a minimum account that you have to maintain. And what is that minimum amount? It's 12.5 times the position that you've taken. So, 12.5 times 5000, it turns out to be 62,500. So, on day one, you put in this amount, let's, and then the prices of the futures contracts evolves. Instead of trying to actually take the prices there, what I've done is that I've created this worksheet where it simulates it. It's assumed that the price of the underlined is going to simulate at the age of 10, 10 dollars for pay and then the mean underlined is 0, the interest rate is 5%, and that's to compare what happens in the forward contract and the futures contract. But, if you look, if you just click on this cell, it just creates this value. And if I hit Return, let me actually do some simulations here. So, every time you hit Return on this worksheet, you're going to create a new simulation. So, let's walk through what happens in this simulation. You put in a margin account on February 22nd, the price was 720. And on the next day, February 25th, which is the next trading day, it's going to be 716. So, it's a loss. So, so, you lose $15,807, that gets deducted from your margin account. Still, nothing wrong because at this

point, you have still not reached the $62,500 minimum balance so that's fine. Next day, the stock price falls even further. And now, you go below the 62,500 and you've been asked to put in 110,750 to bring the value back to 62,500. Losses again, you have, there's a margin call, you bring it back. Losses, margin call you bring it back. Losses, margin call you bring it back. This time, you make a profit not a margin call, you keep going. You have another loss, is a margin call, you bring it back, and so on. You keep going. And at the end of the day, the net profit and loss that you have on this particular realization was minus, was $256,000. And if you look at what happens to your margin account, it will be exactly the same thing. You look at the final amount in your margin is 172,000. The initial that you put in was 84,000. The difference plus all the margin calls together will give you exactly a loss of 256,000. If you were managing the same thing using a forward contract, the forward contract, the spot price of corn on February 22nd turns out to be $730. And therefore, the forward price, by the formula which is going to be this divided by the interest rate or multiplied by the interest rate, turns out to be $732. If you used the forward contract, your loss would have been $318,000 as opposed to thousand dollars. What are the pros and cons of futures? Pros, high leverage, high profit, very liquid, can be written on anything, any underlying. All of these can be used to hedge risks. The pro is exactly the same thing. High leverage can be allowing you to use very little money to hedge risk. But on the other hand, if you decide to use this for speculation, that is also very high risk. The other problem is that futures prices are approximately linear on the underline, so only linear payoffs can be hedged. If they are nonlinear payoffs, you cannot hedge them and you'll have to go to options for that. Futures are exchange rate. They mature every 3 months. They are for a certain fixed amount so they're not very flexible.

If you, I'll go, I'll show you an example later on. There is a futures contract for soybeans. There is no futures contract for kidney beans. So, if you're interested in hedging that, you might have to construct a contract by yourself. You may have to go back to forwards. And that's, and therefore forwards still exist. They're usually used for situations which are much more complicated as compared to what a futures can do. So, in the next few slides, I'm going to talk about how to price futures, I'm not really going to tell you much. The problem with pricing futures is that in order to price the futures, you need to understand the dynamics. You need to know something called the Martingale pricing formalism. It's not, pricing futures is not as simple as pricing forwards. I can't construct for your portfolio, which is deterministic. There's no way I can remove all the uncertainties. And therefore, I have to look at the dynamics. And in order to understand the dynamics, I'll have talk, talk about something called the Martingale pricing theorem, which will come in a few modules. If the interest rate is deterministic, then this Martingale pricing formula will tell you that the forward price is equal to the futures price. Let's move the, it's equal to the futures price. I know how to price forward so I know how to price futures. At maturity, I know the futures price is exactly equal to the underlying price, and we'll see that this is enough to start talking about some hedging-using futures. So, I want to talk about some examples of how to use futures to hedge certain positions. So, let's say today is September 1st. And a baker needs 500,000 bushels of wheat on December 1st, in 3 months. So, the baker faces the risk of an uncertain price. He doesn't want to buy the bush, the 500,000 bushels of wheat today because it may go bad. They may, they might have to pay storage costs and what not. So, he wants to purchase it on December

1st. But on December 1st, he has a problem that the spot price of wheat could be going anywhere. And he wants to lock in a price of wheat. So, want do you do? So, what do you do is you buy 100 futures contracts for 5,000 bushels each. So these are futures contracts bushels of wheat, and let's see what happens. So at maturity, what will happen to the futures contract? You don't have to pay anything to get into the futures contract. The profit that you get for each of these contracts is going to be FT minus F0. I just told you that at maturity, the futures price is equal to the underlying price, so FT is exactly equal to ST. So, FT minus F0 is ST minus F0. So that's the amount that you will get for every futures contract that you buy, so this minus S0 times 100 times 5,000 is the amount of money that you are going to get. So per, effectively, per 5,000 bushels, or per bushel you're going to get ST minus F0. In the stock market, you can buy at ST. So, what is the effective cash flow that this baker faces? This is the amount that he gets from the futures contract, so that's a positive cash flow. This minus ST is what he needs to pay to the spot market to buy wheat. If you cancel things out, ST cancel with minus ST, you end up getting that the effective cash flow is minus F0. So, effective price, the effective price per bushel is equal to the current futures price F0. So, the price gets fixed at F0 so that's great. You didn't pay anything and yet you were able to fix the price at F0. But did it, effectively, did it cost you anything more than this entire calculation? I'm going to pau, you may want to pause this for a moment here and think about, what are the hidden costs in this calculation? The only thing that I did here was I Iook at the net profit is FT minus F0. And that is definitely what the, what the profit is going to be. And therefore, I'll end up getting the separation, I'll fix it at F0. But, what are the assumptions that went behind this calculation?

The main assumption that went behind this calculation that is, this baker is liquid enough. That whenever there is a margin call, the baker can provide the amount of money that is necessary to keep the current set of, of futures contracts going. If, at any point, the baker runs out of money, then the liquidity ends, the broker cancels the futures contract, and this connection that was there. Ft minus F0 equal to ST minus F0 goes away because the profit will be FT minus F0, and typically this will be a loss. Why? Because the margin cost happen only when you have intermediate losses. You've not been able to give your margin calls, so you just have to eat up this loss. And therefore, there is an implicit assumption made here, that the baker is liquid enough, has liquid cash available. The cash flow is available for them to post all the margin payments that are necessary perfect hedges are not always possible. Why? Multiple reasons. The cash flow is not at a certain time. So, the cash flow that you're looking at is not at maturity time of a futures contract. It may not correspond to a finite integer number of futures contracts. A futures contract may not be available on the underlying. The futures contract may not be liquid enough so you can't get in, you can't buy that futures contract. The payoff might be non-linear. So, any time the spot price of the underlying minus the futures price is different, because the difference between the spot price of the underlying and the futures price is called a basis. And whenever there's a perfect hedge, its base is equal to zero at time T. We say that there's a basis risk when whatever we're trying to do, the cash flow that we are trying to manage, which is a spot price minus the futures price using the futures contract that we are using to hedge this particular thing when there is a difference between these two at time capital T, we call this a basis risk. In this slide, we'll work through trying to solve a hedging problem for a situation where a taco company needs to hedge 500,000 bushels of kidney beans on

December 1st. Today is September 1st. In 90 days, it needs money to buy 500,000 bushels of kidney beans. Why did I pick kidney beans? Because there are no futures available on kidney beans. We'll have to approximate with some other futures. And there is a chance that, because of this mismatch, there will be an error and we'll get basis risk. So, the taco company actually faces the risk or an uncertain price. And also because of the fact there are no futures available, we won't be able to hedge it exactly. So, what we're going to do is we're going to hedge by buying soybean futures. So instead of this one, forget about the 1000, let's call it some general number y. You're going to buy a certain amount of y of soybean futures to hedge these 500,000 bushels of kidney beans. So, what happens in 90 days? In 90 days, the futures position at maturity will give the futures price minus the current price, times the number of contracts. So, FT is per bushel price. Ft minus F0 tells me what is the profit or loss and per bushel off soybean. Y is the number of bushels of soybean that you are controlling using futures contract. So, this is the cash flow that you are going to get from y soybean futures. Now, what happens in the spot market? Spot market, you are going to buy 500,000 bushels of kidney beans. So, PT, the cash flow associated with that, is going to be minus 500,000. These are the number of bushels of kidney beans that you're going to buy times ST. And what is ST? This is the, the spot price. For the underlying quantity, which is kidney beans at maturity time T. So, PT is actually a negative quantity, as the total cash flow that's going out. But I just want to think of that as logically just a sum cash flow P, FT So what is the effective cash flow that you are going to see? It's going to be y FT minus F0. This is from closing the futures position plus PT which is the net outflow that you are going to see from buying kidney beans in the spot market. The problem is that FT, which is the final

position of the soyabean futures, is not equal to SD, and why is that? Because this one is written on soyabeans, and SD is the price of kidney beans. They are not the same commodity. And there is no reason to assume that the final futures price, written on soybeans, will become equal to the spot price on kidney beans. As a result, we can't completely, there isn't, PT is not equal to y times FD for any value of y. Perfect hedge is not possible. And we have to look at trying to figure out how to hedge this position. So, we're going to use an idea called minimum variance hedging. And what happens with this minimum variance? We're going to say that, okay, we're trying to figure out if, what is the minimum possible value that I can drive this CT to. Ideally, I'm going to, to drive this CT to a constant number. I want to completely remove all the risk. I want to be able to say that, like we did in the case of corn futures, I want to be able to fix its value. And there's no randomness left. And that, that amounts to saying that the variance in the cash flow is zero. A deterministic quantity has variance equal to zero. There is no basis risk. I can drive it to zero. But because there is basis risk here, I won't be able to drive it to zero. So, let me make it as small as I can. To expand the expression, so CT remember, is going to be y times FT minus F0 plus PT. F0 is a constant. And because it's a constant, when I'm trying to take the variance, variance of CT, it will just become the variance of its random quantities. It's going to be variance of y times FT plus PT. And now, I'm going to expand this variance formula out. So, I'll get variance of PT which is this term, the variance of y times FT minus F0, but I can ignore that F0 for the moment. It's y times FT minus F0 plus 2 times the covariance of y of FT minus F0. And I'm going to simplify it something further. Variance of PT sits there as it is. This y, I'm going to pull it out from

inside the bracket sign and whenever you pull a constant out of the variance side, it becomes squared. So, you get y squared. And I'm going to use the trick that I'm def, I was just telling you about. F0 is a constant quantity, so the variance of FT minus F0 is the same thing as the variance of FT. That's what I'm going to stick there. Why, when I put it out of the covariance sign, just a straight y comes out. So, you get 2 times y, covariance again. I'm ignoring that constant term FT times PT. Take the derivative of this respect, expression with respect to y. You get the derivative of CT with respect to y, you get 2 y variance of FT, that's the term coming from here, and then you get 2 times, variance is in correct here. 2 times the covariance of FT and PT, that's the term that you get from there. You set that equal to zero. You end up getting that y must be equal to the covariance of FT PT divided by the variance of FT. So, this is also a typo, this should be variance of FT, and that's exactly the amount that you're going to get. These are the number of contracts that you have to buy in order to figure out what is going to happen.