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Futures and Forwards
Futures
Price
Spot price of
underlying assets
Seller’s pay-offs
Why Forwards?
They are customized contracts unlike Futures
and they are:
Tailor-made and more suited for certain
purposes.
Useful when futures do not exist for
commodities and financials being considered.
Useful in cases futures’ standard may be
different from the actual.
Futures & Forwards
Distinguished
FUTURES FORWARDS
They trade on exchanges Trade in OTC markets
Are standardized Are customized
Identity of counterparties is Identity is relevant
irrelevant
Regulated Not regulated
Marked to market No marking to market
Easy to terminate Difficult to terminate
Less costly More costly
Important Terms
Spot Markets: Where contracts for
immediate delivery are traded.
Forward or Futures markets: Where
contracts for later delivery are traded.
Both the above taken together constitute
cash markets.
Important Terms
Futures Series: All with same delivery
month with same underlying asset.
Front month and Back month.
Offering lags.
Important Terms
Variation Margin
Deliverables
InterestRate Risk
Exchange Rate Risk
8a 4 8b
9a Futures 9b
Buyer’s Broker’s Clearing Buyer’s Broker’s
Clearing Firm Clearing Firm
House
1a 1b Buyer and seller instruct their respective brokers to conduct a futures transaction.
2a 2b Buyer’s and seller’s brokers request their firm’s commission brokers execute the transaction.
3 Note: Either
Both floor brokers meet in the pit on the floor of the futures exchange and agree on a price.
4 Information on the trade is reported to the clearinghouse. buyer or seller
5a 5b Both commission brokers report the price obtained to the buyer’s and seller’s brokers. (or both) could
6a 6b Buyer’s and seller’s brokers report the price obtained to the buyer and seller. be a floor trader,
7a 7b Buyer and seller deposit margin with their brokers.
eliminating the
8a 8b Buyer’s and seller’s brokers deposit margin with their clearing firms.
9a 9b Buyer’s and seller’s brokers’ clearing firms deposit premium and margin with clearinghouse.broker and
commission
broker.
Exchange Rate Risk
Hedging
Short Position:
Day Sett. Price Op. Bal. M-T-M CF Margin Call Cl. Bal
1 1125 7500 - 3750 2250 6000
2 1095 6000 + 4500 - 10500
3 1100 10500 - 750 - 9750
4 1140 9750 - 6000 2250 6000
Net Profit/(loss) = -3750+4500-750-6000 = (-) Rs. 6000
Pricing of Index Futures
Contracts
RI = RIF
i.e. (IE-IC) + D = (FE-FC) + RF
Since IE = FE
FC = IC + (RF – D)
(RF – D) is the ‘cost of carry’ or ‘basis’ and the
futures contract must be priced to reflect ‘cost
of carry’.
Stock Index Arbitrage
When index futures price is out of
sync with the theoretical price, the an
investor can earn abnormal risk-less
profits by trading simultaneously in
spot and futures market. This process
is called stock index arbitrage or
basis trading or program trading.
Stock Index Arbitrage: Illustration
A. = (-) 10,500
B. = 2,300
C. = 15,000
D. = 6,800 = 12.17% p.a.
Application of Index Futures
In passive Portfolio Management:
An investor willing to invest Rs.1 crore can buy
futures contracts instead of a portfolio, which mimics
the index.
Number of contracts (if Nifty is 5000)
= 1,00,00,000/5000 ×100 = 20 contracts
Advantages:
Periodic rebalancing will not be required.