DERIVATIVES-

Index
FUTURES
Sr.no Topic Page.no

1 Introduction-Derivatives 3

2 Introduction-Futures 4

3 Futures contract 6

4 Characteristics of futures contract 7

5 Types of futures contract 8

6 Players in the futures market 10

7 Trading of futures 12

8 How futures work 13

9 Settlement of futures contract 15

10 Risk and reward associated with futures 16

11 Economic importance of futures Submitted By:- 17

Chaitali Bharucha 28
12 Bibliography Lilly Geddam 18 36
Sneha Mane 37
Ashwati Nair 38
 Index

Sr.No Topic Page no

1 Introduction - Derivatives 3

2 Introduction - Futures 4

3 Futures Contract 6

4 Characteristics of futures contract 7

5 Types of Futures contract 8

6 Players in the futures contract 10

7 Trading of futures 12

8 How futures work 13

9 Settlement of futures contract 15

10 Risk and reward associated with trading in futures 16

11 Economic importance of futures market 17

12 Bibliography 18

2
 Introduction

The latest buzzword in Indian financial markets is Derivative. Derivatives are wasting
assets, which derive their values from an underlying asset. These underlying assets are
of various categories like equity, bonds, commodities etc. Some simple types of
derivatives are – Forwards, Futures, Options and Swaps. The prices of the derivatives are
driven by the spot prices of these underlying assets. For example, wheat farmers may
wish to sell their harvest at a future date to eliminate the risk of a change in prices by
that date. The transaction in this case would be the derivative, while the spot price of
wheat would be the underlying asset; a dollar forward is a derivative contract, which
gives the buyer a right & an obligation to buy dollars at some future date

Financial markets are, by nature, extremely volatile and hence the risk factor is an
important concern for financial agents. To reduce this risk, the concept of derivatives
comes into the picture. Derivatives have probably been around for as long as people
have been trading with one another. Forward contracting dates back at least to the 12th
century, and may well have been around before then. Merchants entered into contracts
with one another for future delivery of specified amount of commodities at specified
price. A primary motivation for pre-arranging a buyer or seller for a stock of
commodities in early forward contracts was to lessen the possibility that large swings
would inhibit marketing the commodity after a harvest.

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to risk oriented people

2. They help in the discovery of future as well as current prices

3. They catalyze entrepreneurial activity

4. They increase the volume traded in markets because of participation of risk averse
people in greater numbers

5. They increase savings and investment in the long run

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 Futures

Futures contracts are essentially standardized forward contracts, which are traded
on the exchanges and settled through the clearing agency of the exchanges. It is a type
of derivative instrument, or financial contract, in which two parties agree to transact a
set of financial instruments or physical commodities for future delivery at a particular
price. The clearing agency also guarantees the settlement of these trades. In other
words, futures contracts are standardized forward contracts or the futures market is
simply an extension of the forward market. A futures contract requires delivery of a
commodity, bond, currency, stock or index, at a specified price, on a specified future
date. The physical delivery of underlying asset may or may not happen. Instead it may
be squared off before its expiry date. For example, if a person is “long” on index future
i.e. who bought the contract at the beginning of the month may sell it just two days
prior to its expiry. The difference in the value of contract will be paid to him as profit (or
deducted from his account as loss) as the case may be. Similar to trading stocks, a
certain percentage of the traded value will be levied as commission (brokerage), a
service tax (to the brokerage amount) and a securities transaction tax (STT). The
brokerage may vary for different brokers. Some may charge a fixed brokerage; some
may charge based on traded value. The risk involved in trading a futures contract is
equal for both buyer and seller or “symmetrical” Futures trading also comes under the
purview of Securities and Exchange Board of India (SEBI)

In case of short selling equity shares (selling a share one doesn’t possess) the trade
needs to be squared off on the same day, otherwise the short sold equity shares will be
sold in auction. The short seller will be penalized by the exchange for not squaring it off.
But in case of futures no such thing happens, a person can carry a “short” position
overnight. He can continue to do so till the expiry date. However, the minimum margin
requirements need to be maintained. Margin money is defined as the amount, based on
which the broker may allow purchase or sale of a stock or future, this margin also varies
from broker to broker. In case of equity share purchases using margin trading, the buyer
needs to pay the outstanding amount to the broker before a fixed date i.e. before he
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receives delivery of shares. In case of futures, stocks in possession can be used as
margin for trading in futures; however, market to market obligations (such as losses)
need to b met in cash.

Futures contract prices also have the same structure like the cash market prices.
But there is no price band for futures or options. To avoid errors in entering orders the
exchange may fix the price range. Prices in excess of the range will need to be reviewed
by the exchange. In addition, if the “open interest” or the maximum number of
outstanding contracts exceeds a certain value, no fresh positions will be allowed for the
particular scrip.

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 Future contracts

There are 1 month, 2 month and 3 month futures contracts available in India. The
contracts are settled on the last Thursday of every month. If this happens to be a trading
holiday, the previous day would be the expiry date. The contracts are traded as “lots”
meaning a contract will have certain fixed number of instruments. For example, the nifty
shall have 50 instruments and it is called lot size. When a buyer places an order for a
contract he has to bid for 50 or multiples of 50. Stock futures are available for most of
the Nifty and Junior Nifty stocks. The stocks are chosen from amongst top 500 stocks in
terms of average daily market capitalization and average daily traded value in the
previous six months on a rolling basis. The market wide position limit in the stock shall
not be less than Rs. 50 crore. The market wide position limit (number of shares) shall be
valued taking the closing prices of stocks in the underlying cash market on the date of
expiry of contract in the month. The market wide position limit of open position (in
terms of the number of underlying stock) on futures and option contracts on a particular
underlying stock shall be 20% of the number of shares held by non-promoters in the
relevant underlying security i.e. free-float holding.

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 Characteristics of Futures contract

 In the futures market, margin refers to the initial deposit made into an account in
order to enter into a future contract. This margin is used to debt any day-to-day
losses.

 When a person enters into a futures contract, the future exchange will state a
minimum amount of money that he must deposit into his account. This original
deposit of money is called the initial margin. When the contract is liquidated, the
initial margin plus or minus any gains or losses that occur over the span of the
futures contract is refunded.

 Maintenance margin is the lowest an account can reach before needing to be

replenished.

 If the margin account drops to a certain level because of series of daily losses,
brokers are required to make a margin call and request the person to make an
additional deposit in the account to bring the margin back to the initial amount.

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 Types of futures

Currently, India trades in Index futures, single stock futures, interest rate futures and
commodity futures.

 Commodity Futures Contract:-

An agreement to buy or sell a set amount of a commodity at a predetermined price

and date. Buyers use these to avoid the risks associated with the price fluctuations of
the product or raw materials, while sellers try to lock in a price for their products.
Like in all financial markets, others use such contracts to gamble on price
movements.

Trading in commodity futures contracts can be very risky for the inexperienced. One
cause of this risk is the high amount of leverage generally involved in holding futures
contracts. For example, for an initial margin of $ 5,000, an investor can enter into a
futures contract for 100 barrels of oil valued at $ 50,000. Given this large amount of
leverage, even a very small move in the price of a commodity could result in large
gains or losses compared to the initial margin. Unlike options, futures are the
obligations of the purchase or sale of the underlying asset.

 Interest Rate Futures Contract:-

Buying an interest rate futures contract allows the buyer of the contract to lock in a
future investment rate, not a borrowing rate as many believe. Interest rate futures
are based off an underlying security which is a debt obligation and moves in value as
interest rates change.

When interest rates move higher the buyer of the futures contract will pay the seller
in an amount equal to that of the benefit received by investing at a higher rate
versus that of the rate specified in the futures contract. Conversely, when interest

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rates move lower, the seller of the futures contract will compensate the buyer for
the lower interest rate at the time of expiration.

To accurately determine the gain or loss of an interest rate futures contract, an

interest rate futures price index was created. When buying, the index can be
calculated by subtracting the futures interest rate from 100. (100 - futures interest
rate). As rates fluctuate, so does this price index. You can see that as rates increase,
the index moves lower and vice-versa.

 Single Stock Futures:-

Single Stock Futures (also known as SSF) are futures markets that are based upon an
individual stock (such as APA for Apache), rather than an entire stock index . Single
stock futures are exactly the same as any other futures markets, and are traded in
exactly the same way.

Single stock futures are available for many US, European and Asian stocks, and are
offered through futures exchanges.

 Index Futures Contract:-

Stock index futures have recently become very popular and have a large number of
contracts being traded daily. Index futures are created to replicate the performance
of the underlying index that the futures contract represents. Index futures exists for
many global stock markets established worldwide. Index futures can be used to
hedge existing equity positions or even to speculate on the movement of an index.
Gains and losses will be relatively large compared to index ETF’s that trade on the
stock exchanges due to the fact that the leverage in a futures contract is very large.
For example, one S&P 500 futures contract is valued at 250 times the index price.
Assume the S&P is trading at 1300; this would render one contract to be valued at
$325,000 and can be purchased for a fraction of that number.

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 Players in the Future contracts

There are three major players in the derivatives market – Hedgers, speculators and
arbitragers.

Hedgers-Basically hedge their risk of the existing underlying positions. Farmers,

manufacturers, importers and exporters can all be hedgers. A hedger buys or sells in the
future market to secure the future price of a commodity intended to be sold at a later
date in the cash market. This helps protect against price risks. The holders of the long
position in the futures contract will try to secure as low a price as possible, while the
short holders of the contract will want to secure as high a price as possible. The future
contract, however, provides a definite price certainty for both parties, which reduces
the risks associated with price volatility. Hedging by means of future contracts can also
be used as a means to lock in an acceptable price margin between the cost of the raw
material and the retail cost of the final product sold.

Speculators-generally accept risks, in pursuit of profit. This is a highly specialized

business and the success of a speculator is dependent on his ability to forecast correctly,
the future prices of commodities or financial assets. They aim to profit from the very
price change that the hedgers are protecting themselves against. In the futures market,
a speculator buying a contract low in order to sell high in the future would most likely be
buying that contract from a hedge selling a contract low in anticipation of declining
prices in the future. Unlike the hedger, the speculator does not actually seek to own the
commodity in question. Rather the person will enter the market seeking profits by
offsetting rising and declining prices through the buying and selling of contracts.

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 Trader Short Long

Secure a price now to Secure a price now to

The Hedger protect against future protect against future
declining prices rising prices

Secure a price now in Secure a price now in

The Speculator anticipation of declining anticipation of rising
prices prices

Arbitragers-Arbitragers are required in order to establish a link various markets such as

cash and derivatives markets. Arbitragers continuously look for profit opportunities
across the markets and products, and avail of these by executing trades in different
markets and products simultaneously (going long in one market/product and short in
another market/product, depending on the relative advantages). These activities
facilitate the alignment of prices of various assets across the board. Importantly,
arbitragers generally lock in their profits, unlike speculators.

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 Trading of futures

Currently, India trades in Index futures, single stock futures, interest rate futures
and commodity futures. Index futures are the futures contract where the underlying
asset is a cash market index. In India, at the NSE, index futures trading were introduced
in the year 2000. Index options trading were also made available in 2001. Stock futures
were introduced a little later. F & O index contracts are available in Nifty, Junior Nifty,
Bank Nifty, CNX-IT (IT sector index) and CNX 100 (diversified 100 stock index accounting
for 35 sectors of the economy).Similarly, single stock futures are futures contracts with
individual stocks as the underlying assets. As on June 26, 2006, Stock futures are
available only on 118 stocks on the NSE and 77 stocks on the BSE. In keeping with global
practice, Interest rate futures are traded on the NSE with a notional bond (both coupon
and discount) as the underlying asset. Commodity futures are available on a large
number of commodities including gold, silver, rubber, edible oil, steel, etc. on the
National Commodities and Derivatives Exchange (NCDEX) and Multi Commodity
Exchange (MCX).

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 How Futures work

Buy a contract
When you buy shares, you can buy any number you please, even if it is just one share. In
Futures, you buy a contract which will have a specific lot size depending on the stock.
Let's say you want to buy an Infosys Futures contract. This will comprise 100 shares. Or,
you want to buy a HPCL Futures contract. This will be a lot of 650 shares.
In Futures, you buy a lot. The lot size is set for each futures contract and it differs from
stock to stock.
Margin payment
When you buy a Futures contract, you don't pay the entire value of the contract but just
the margin. This margin amount too is prescribed by the exchange.
Let's say you buy a HPCL Futures contract.
And the price of each HPCL share is Rs 311. This will amount to Rs 2,02,150 (Rs 311 x
650 shares).
You don't pay the entire amount of Rs 2,02,150. You only pay 15% to 20% of that
amount and this is called the margin amount.
The margin depends on what the exchange sets for the day. Based on certain
parameters, it declares the margin for each stock.
So the margin for Infosys will vary from, say, HPCL.
Let's say the margin for the HPCL Futures is 15%. So you end up just paying just Rs
30,322 (not Rs 2,02,150).
How you make or lose money?
You purchased a HPCL Futures contract and the underlying price is Rs 311 per share.
Let's say, the next day it moves to Rs 312. The difference is Rs 1 per share (312 – 311)
You get a credit Rs 650 (Rs 1 per share x 650 shares).

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The following day, it dips to Rs 310. The difference is Rs 2 per share (312 – 310) since
the price has dipped, Rs 1,300 (Rs 2 per share x 650 shares) is debited from your
account.
This will go on till you sell the Futures contract or it expires (last Thursday of the month).
So, on a daily basis you make and lose money.

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 Settlement of futures contract

Settlement of derivatives contracts may take place either in cash or in physical

form, i.e. through delivery and receipt of the underlying asset. In India, all derivative
contracts on the equity side are cash settled. However, commodity contracts are
deliverable contracts, i.e. they are physically settled contracts.

While settling in cash, all open futures positions in the market are marked to
market, to the closing value of the underlying asset on the maturity day of the contract.
The resulting losses/profits are settled in cash. The settlement price for a future
contract is the same as its closing price until the second last day. However, on the last
day, the settlement price of the future contract is the settlement price of the underlying
asset in the cash market.

While settling through delivery, actual delivery takes place between the buyer and
seller within a specific time after expiry of the contract. The price paid by the buyer is
the futures settlement price on the day previous to the expiry day. This happens
because the buyer/seller has already settled all gains and losses up to this day-i.e. the
day before the expiry day-over the life of the contract, in the form of MTM gains/losses.

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 Risk and Rewards associated with trading in futures

 Since the F & O positions involve a certain time frame, if the trade is not squared off,
it will be settled at the end of the month. So, open positions with losses in market to
market carry a risk. In case of options, the investor faces the risk losing the entire
premium amount, if the market turns against his position.

 Since contracts are traded in lots, the profits could be higher. Commissions are also
less compared to cash segment. It is possible to remain short on index or stocks
whereas it is possible in cash segment.

 It will be a good strategy to trade in F & O for active traders. They have access to all
the price charts, open interest positions, FII activity etc.

 It aids in the process of proper price discovery and hedging of price risk with
reference to the given commodity.
 It is useful to producer because he can get an idea of the price likely to prevail at a
future point of time and therefore can decide between various competing
commodities.
 It helps the consumer get an idea of the price at which the commodity would be
available at a future point of time. The consumer can do proper costing and also
cover his purchases by making forward contracts.
 It provides the exporters an advance indication of the price likely to prevail and
thereby helps them in quoting a realistic price and secure export contract in a
competitive market.

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 Economic Importance of Futures market

Because the futures market is both highly active and central to the global marketplace,
it’s a good source for vital market information and sentiment indicators.

 Price Discovery-Due to its highly competitive nature, the futures market has
become an important economic tool to determine prices based on today’s and
tomorrow’s estimated amount of supply and demand. Futures market prices
depend on a continuous flow of information from around the world and thus
require a high amount of transparency. Factors such as weather, war, debt default,
refugee displacement, land reclamation and deforestation can all have a major
effect on supply and demand and, as a result, the present and future price of a
commodity. This kind of information and the way people absorb it constantly
changes the price of a commodity.

 Risk Reduction- Futures markets are also a place for people to reduce risk when
making purchases. Risks are reduced because the price is pre-set, therefore letting
participants know how much they will need to buy or sell. This helps reduce the
ultimate cost to retail buyer because with less risk there is less of a chance that
manufacturers will jack up prices to make up for profit losses in the cash market.

 Helps balance in supply and demand position throughout the year

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 Bibliography

www.derivativesindia.com

www.tradingpicks.com

www.futuresindustry.org

www.finance.indiamart.com

www.investopedia.com

Derivatives and Financial innovations- Manish & Navneet Bansal

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