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Futures contract

Future is a legally binding agreement to buy or sell

something in the future.


Future contracts are promises - the person who
initially sells the contract promises to deliver a
quantity or a standardized commodity to a
designated delivery point during a certain month
called the delivery month. The other party
promises to pay a predetermined price for the
goods upon delivery
Futures are special kind of forward contracts
Forwards are different from futures in two principal
aspects- they are not marketable and they are not
marked to the market

Futures contract
Standardized forward contract, traded on

an exchange where a seller agrees to


deliver the specified quantity of an asset of
defined quality at a predetermined date at
a price fixed in advance with the buyer.
Each exchange lays own the specifications
of the contract
Standardization of the contract pertains to
the asset, size, time, place, and procedure
of delivery, quality of underlying asset,
price adjustments for variations in quality
of the asset being delivered etc.

Specification terms used in futures


contract
Underlying asset
asset on which the futures contract is written
Futures are usually specified by the name of the
underlying asset
Eg. Futures contract in rice at multi Commodity
Exchange(MCX) denoted as RICEDEC09
Contract period
Time when the contract expires, specifies when the
contract will come into force and when will it close
Contract size
Standard contract size that will be traded on the
exchange
Eg. Futures contract for gold on NMCE is for 100gm.

Specification of a futures
contract
Assignment I to be submitted on

25.01.2014
Find out and submit the specifications of
futures contract on any two products in
any derivative market in India

Futures regulation
Legally, futures are not securities, they are

contracts, so they are not under the


jurisdicion of SEBI
Governed by CFTC Commodity Futures
Trading Commission and NFA - National
Futures Association

Forwards Vs Futures
Forwards

Futures

1. Private contract between two


parties
2. Not standardised
3. Usually one specified delivery
date
4. Settled at the end of the contract
5. Delivery or final cash settlement
usually takes place
6. Some credit risk is present
7.Deals are done on OTC market

1. Traded on an exchange
2. Standardised contract
3. Range of delivery dates
4. Settled daily
5. Contract is usually closed
out prior to maturity
6. Virtually no credit risk
7. .Deals are done on
organised exchanges
8.Price risk is eliminated
9.Liquidity is high

8.Price risk is eliminated


9.Liquidity is low

Future contracts
Obligations on the part of both buyer and

seller
Traded on organised exchanges like NSE
and BSE
Exchanges determine the standardised
specifications for traded contracts, set and
enforce trading rules
Futures are always for a specified amount
of a specified security for delivery on a
specific date
The only item negotiated at the time of
entering in to the transaction is price

Futures - types
Commodity futures
Stock futures
Index futures
Interest rate futures
Currency futures

Pricing of futures
The principle of arbitrage links the

relationship between spot and future prices


It is also called law of one price
investment strategies that have the same
pay-offs must have the same current value
Arbitrage involves:
Simultaneous buying and selling
No initial investment
Making risk less profits net of transaction
cost

Future prices
Pricing of futures will be equivalent to

forward pricing
Generally the two prices should not vary
significantly as it will lead to arbitrage
profits
But slight differences are possible due to
mark to market/daily settlement feature of
futures

Marking-to- market - example


Day

Settlement price

Gain/loss

Opening
At close of
At close of
At close of
At close of
At close of
At close of
At close of
At close of
At close of

2,100
2120
1970
1930
1950
1980
2010
2020
2125
2080

20
-150
-40
20
30
30
10
105
-35

day
day
day
day
day
day
day
day
day

0
1
2
3
4
5
6
7
8

Initial margin
A good faith deposit with Clearing House,

as soon as the investor enters into the


contract
Initial margin should be such that it covers
the worst day loss of the traders portfolio
over one trading day
in other words, it is the portfolios one day
VaR
trader is entitled to withdraw any surplus
over the initial margin
If there is deficit, in margin account trader
needs to replenish it margin call

VALUE AT RISK
Worst expected loss of a portolio
VaR is a volatility based measure containing

information on losses during normal market


conditions and the probability in a single number
Used for the first time by J.P Morgan
VaR = TP
= critical value from standard normal
distribution
T = square root of the number of time periods
= standard deviation
P=estimate of initial value of portfolio

Convergence of future and spot


price
As the contract approaches expiry these two

prices (future and spot) will converge, or meet.


Why does this happen? - Cost of carry.
That is the futures price is equal to the cost of
holding the underlying to the period of expiry.
The cost of carry would normally include
interest less dividends (in the case of financial
assets) or storage costs (in the case of a
physical commodity like wool).
As the futures get closer to expiry, the prices
will naturally converge .

Convergence of Futures to Spot

Futures
Price
Spot Price

Spot Price
Futures
Price

Time

(a)

Time

(b)

Futures Pricing
Pricing is a result of convergence to the future - spot

price and arbitrage relations.

In general:

F0 = P0ert
(Add Storage and Transportation for commodities)

F0 =
P0 =
r =
t =

Futures Price at time 0


Spot Price at time 0
cost of carry (risk-free)
Time to expiration

Underlying asset can be


Investment assets(carry type asset) eg,

gold, silver
Consumption assets (non-carry type) eg.
Jute, Corn, Wool

Cost of carry
The cost of carry summarizes the

relationship between the futures price and


the spot price. It is the cost of "carrying" or
holding a position from the date of entering
into the transaction up to the date of
maturity. It measures the storage cost plus
interest that is paid to finance the asset
less the income earned on the asset.
As far as Equity Derivatives are concerned
the Cost of Carry represents the "Interest
Cost".

For example, if I buy $20,000 worth of futures and options

contracts that $20,000 will not earn any interest. So, if I hold
the contracts for six months and the risk free interest rate is
1%, I would make at least a $200 profit to break even. (I would
have made $200 in interest if I had not bought the contracts.)
For contracts that require physical delivery, as opposed to
cash-settled contracts, the cost of maintaining and delivering
the product are also carrying costs.
For example, live cattle futures contracts require physical
delivery. A farmer selling cattle with a futures contract has to
make sure the cattle he is selling meet the contract
specifications, are properly fed and maintained, and that they
are delivered to the proper location at settlement. All of that is
included as part of the cost of carry.

Cost of carry Model


The cost of carry model expresses the

futures price as a function of the spot price


and the cost of carry.
Forward price/future price = Spot price
+Cost of carry
The same model in currency markets is
known as interest rate parity.

Futures Pricing Example

Current Gold Price is Rs. 400 per ounce. Risk-free rate is 5%


Time to expiration of futures contract is 3 months.

F0

F0 =
P0ert
= 400xe0.05x3/12
F0 = 404.91

Cash and Carry & Reverse Cash and


Carry
Cash and Carry
long underlying + short forward
Reverse Cash and Carry
short underlying + long forward

Uses of futures
Speculation traders who have good

knowledge of the market


Hedging protection against adverse price
movements

Hedging with futures


Hedging strategies for different spot

market position
Current status

Concerned about

hedge

Holding the asset


About to buy the asset
Sold short the asset
About to issue a liability

Asset price may fall


Asset price may rise
Asset price may rise
Asset price(interest rate)
may fall(rise)

Short
Long
Long
Short

Have a floating rate liability


Have a floating rate asset

Short
Asset price(interest rate)
may fall(rise)
Asset price(interest rate)
may rise(fall)

Long

Hedging with futures


Taking long and short positions in futures market, to

compensate the loss due to the position in the spot


market and to lock in price
A party holds the asset long on spot
A party requires the asset short on the spot
Steps
One who is long on asset, goes short in the futures
market, One who is short on asset, goes long in the
futures market
Neutralise the position in the futures market at
appropriate time
Buy/sell the underlying asset in the spot market at
prevailing price

Short hedge
Taking short position in futures
Used by those who are long on the underlying asset
Eg. A sugar mill, expected to produce 100MT sugar in

April. Current price (spot) of sugar(in feb) is


Rs.22/kg , April futures price Rs 25 how to hedge?
If April spot price is Rs.22
Short on futures now Rs.25
Before futures contract expires, in April, long on the
futures market, to nullify the position in the futures
market Rs(22), gain in futures market Rs.3
shot in the spot market Rs.22
Effective price realised 3+22= Rs.25

If April spot price is Rs.26


Short on futures now Rs.25
Prior to April, before futures contract
expires, long on the futures market, to
nullify the position in the futures market
Rs(26), loss in futures market Re.1
shot in the spot market Rs.26
Effective price realised (1)+26= Rs.25

Long Hedge
Taking long position in futures market
Used by those who are short on the asset
Eg. A petrochemical plant needs to produce 10,000

barrels of oil in 3 months time. Spot price


=1,950/barrel, 3months futures price
Rs.2,200/barrel. How to hedge?
If spot price after 3 months is Rs.2,400
Long futures now 2,200
Before expiry, shot futures 2,400
Gain 200
long in the spot market (2,400)
Effective price of oil= (2400)+200= 2,200

Long Hedge
If spot price after 3 months is Rs.1,800
Long futures now 2,200
Before expiry, shot futures 1,800
loss (400)
long in the spot market (1,800)
Effective price of oil, barrel =
(1800)+(400)= 2,200

Hedging
Hedging involves assuming a position in the futures

Market, which will benefit if the price moves adversely


against the spot market position
Hedge position will be opposite to a position in the spot
market
If a trader already owns or plans to produce a commodity,
and offer it for sale in the spot market, he will be
concerned about price falls. So a short position in the
futures will be beneficial when prices actually decline.
Hedge will be short position if spot position is long short
hedge
Hedge will be long position if spot position is short Long
hedge

Hedging
Hedge is to remove price risk
If the trader is able to completely remove

the price risk perfect hedge


Practically traders are exposed to basis risk
Basis= cash price future price
Basis can be positive or negative
Positive basis cash price is more than the
futures price, referred as over(over the
futures)
Negative basis cash price is less than the
futures price, referred as under(under the
future)

Hedge ratio
Hedge ratio is defined as the value of

futures contracts to the value of the


underlying assets
when basis risk is present hedge is said to
be imperfect
Optimal hedge ratio ratio that
eliminates or minimises the price risk
Number of futures contract to have
minimum risk
It depends upon the risk in the spot prices,
futures prices, and the coefficient of
correlation between the two.

Minimum variance hedge


Hedge that minimises the variance in the

position

Normal and Inverted markets


If future prices are described by the cost of carry model,

then future prices will be more than cash prices and the
basis will be negative contago market
In contago market distant futures will be priced more
than the near term futures
Most financial markets display contago conditions
Normal Market
If the basis is positive (cash prices more than futures
prices), such market is called inverted market. Also
known as in backwardation
An inverted market exist when the traders are unable to
do reverse cash and carry due to regulatory constraints
on short selling ban on short selling , scarcity of asset in
spot market

Widening and narrowing of


basis
If basis becomes more positive or less

negative basis is said to be widen


Occurs when cash price of the asset
increases relative to future prices
If basis becomes more negative or less
positive basis is said to be narrow
Occurs when cash price of the asset
decreases relative to future prices