MISC/013

IBS Center for Management Research

A Note on Currency and Index Futures

This case was written by Sumit Arora, under the direction of Vivek Gupta, IBS Center for Management Research. It was
compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either
effective or ineffective handling of a management situation.

 2004, IBS Center for Management Research. All rights reserved.

To order copies, call +91-08417-236667/68 or write to IBS Center for Management Research (ICMR), IFHE Campus, Donthanapally,
Sankarapally Road, Hyderabad 501 504, Andhra Pradesh, India or email: info@[Link]

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 MISC/013

A Note on Currency and Index Futures

ABSTRACT:

The note provides some of the basic definitions used in futures contracts. It covers in detail the
application of futures as a derivative instrument, and how market participants like hedgers,
speculators and arbitrageurs use futures. The note also explains the role of the clearing house and
settlement procedures in futures contracts, and why the contracts need to be marked to market. The
objective of this note is to make the reader understand better, the use of futures as a tool for the
purpose of hedging, speculating and arbitraging particularly, in terms of currency and index
futures. The note is intended to provide supporting material for case studies/courseware pertaining
to currency and index futures.

INTRODUCTION:

Futures trading started way back in 1865 on the Chicago Board of Trade (CBOT), but prior to
1972, the underlying asset of futures contracts were agricultural commodities. The futures market
met the needs of farmers and merchants. It overcame a few of the drawbacks related to the
forwards market1 (Refer Exhibit I) like non-standardization of contract and credit risk.
Trading in financial futures started only after the World War II on the two largest exchanges i.e.
the CBOT and the Chicago Mercantile Exchange (CME). Post-1972, there was further
development of futures contracts, with the introduction of a range of financial instruments.
However, it was only in 1994, that these financial products started to be traded electronically.

DEFINING THE TERMS:

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. The underlying asset of a futures contract may be an agricultural
commodity (such as corn, wheat, soybean, or soybean oils), or a financial instrument (such as
treasury bonds, treasury notes and shares). Unlike forward contracts2, futures contracts are
standardized (in terms of contract size, expiration month, trading cycle, etc.) and are traded in an
organized exchange.
In referring to futures contracts, there are number of other terms that are commonly used. Spot
price is the price at which an asset trades in the spot market 3. The price at which the futures
contract trades in the futures market is called the futures price (Refer Exhibit II). A contract
cycle is the period over which a contract trades. An investor can take two positions in a futures
contract, a ‘long futures position’ or a ‘short futures position.’ The investor is said to have taken
a long position when he/she is buying, and is said to have taken a short position when he/she is
selling, a futures contract. Expiry date is the last day on which the contract is traded at the end of

1
A forward market does not have any fixed location and are self regulated.
2
Two parties sign this type of deferred contract where they agree to buy and sell an asset at some point of
time in future under mutually acceptable terms and conditions.
3
Any market in which cash is exchanged for current delivery of an asset.

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 A Note on Currency and Index Futures

which it will cease to exist. The amount of the asset that has to be delivered under a contract is
known as the contract size. The difference between two futures prices is known as spread. The
difference between two futures prices for the same underlying commodity on two different
expiration dates is known as ‘intra commodity’ spread. The difference between two futures
prices for two different but related commodities is known as ‘inter commodity’ spread. The price
difference between the two markets for the same commodity is known as ‘inter market’ spread.
In the context of financial asset futures, basis is defined as the futures price minus the spot price.
In a normal market4, the basis is positive, reflecting the fact that futures prices normally exceed
spot prices. However, in case, the futures prices are less than the spot prices, the difference is
known as backwardation. Another definition of basis is the difference between spot price of the
asset to be hedged and the futures price of the contract of that asset. Cost of carry shows the
relationship between future prices and spot prices. It measures the storage cost plus the interest
paid minus the income earned.
The members who execute the trades on the exchange floor are floor brokers and floor traders. The
brokers who execute the order on others’ account are known as floor brokers. They act according
to the wishes of their customers and are basically agents for public investors. Floor traders
execute trades exclusively on their own account. Those floor traders who also execute trades on
others account are known as dual traders, and the mechanism is known as dual trading. In the
market, some of the floor traders are known as scalpers. They are the individuals who trade on
their own account and stand ready either to buy or sell. They are also called as locals and by their
active participation provide liquidity to the futures market.
The participants in the market are classified as hedgers, speculators and arbitrageurs. Hedgers use
futures market to reduce or eliminate the risk associated with price fluctuations of an asset. For
example, an exporter whose receivables are denominated in another currency (say, Euro) runs a
significant foreign exchange risk, because of the possible adverse movement in the price of the
other currency vis-a-vis the home currency. The exporter can hedge the above risk by selling
futures in Euro. Speculators are those who are willing to take the risk that the hedgers are seeking
to avoid. They use futures contracts to benefit from betting on future movements in the price of an
asset. They seek to make gains by taking long and short positions in futures based on their own
views and forecasts about the market. Arbitrageurs look for profit from the discrepancy between
prices in two different markets.

CLEARING HOUSE:

A clearing house is a part of the futures exchange and acts as an intermediary in futures
transactions. All futures contracts are routed through a clearing house which is a ‘de facto’
guarantor for all futures transactions. A clearing house works closely with the exchange but is an
entity distinct from the exchange. Since all transactions are routed through it, the clearing house
becomes the buyer to every seller and seller to every buyer. Let us understand the process with the
help of following illustration:
There are two parties, A and B, who want to enter into a futures contract. A typical transaction
with, and without, the involvement of a clearing house would be as follows:
In the first case, where the transaction takes place without the clearing house both A and B assume
the counterparty risk5 because on the date of the contract, B may fail to deliver the underlying asset
or A may fail to pay the price. In the second case, the clearing house replaces B as a seller to A,
and A as a buyer to B, and thus the credit risk taken by both A and B becomes insignificant.

4
The futures market can portray a pattern of either a normal market or an inverted market. If the prices of
the distant futures are higher than the near futures, it is referred to as the normal market condition.
5
The risk to each party of a contract that the counterparty will not live up to its contractual obligations.

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 A Note on Currency and Index Futures

Figure I
Transaction without Clearing House

PRICE

A B
Buyer Seller

UNDERLYING ASSET
(T-NOTES)

TRANSACTION INVOLVING CLEARING HOUSE

UNDERLYING ASSET UNDERLYING ASSET

(T-NOTES) (T-NOTES)

A Clearing B
Buyer House Seller

PRICE PRICE

The clearing house assumes many important functions like ensuring smooth trading by
maintaining delivery schedules, minimizing credit risk by becoming counterparty to every
transaction, monitoring speculation margins and more. Since the clearing house undertakes
counterparty risk for all transactions, the total risk assumed by it is high. Thus, it becomes
important for the clearing house to minimize this risk, which is done by collecting margins.
Margins are levied for all transactions depending on the volatility of the underlying asset, and
adjustment is done everyday depending upon the prices, a process known as marking to market.

TYPES OF MARGIN:

The clearing house stipulates the margin to manage the credit risk assumed by it. These margins
are of two types – Initial margin, and Maintenance margin. An example will help us to understand
the different kinds of margin.
Example:
On February 3, 2003, an investor buys two March 2003 gold futures contracts on the New York
Commodity Exchange (COMEX). The current futures price is $500 per ounce and the investor
buys 200 ounces at this price. The minimum contract size is 100 ounces. The investor has to
deposit the money in an account which is termed as the margin account. The amount to be
deposited initially is called the initial margin and varies from one contract to another depending on
the volatility of the underlying asset.
Let us assume that the initial margin is $5000. The investor also has to maintain at least 75% of the
initial margin, also known as maintenance margin, to ensure that the balance in the margin account
does not become negative. The margin account is adjusted at the end of each trading day reflecting
the investor’s gain or loss. The maintenance of these margins ensures that the exchange is
safeguarded against any default risks.
Let us assume that by the end of the first trading day, the futures price of gold has fallen from $500
to $495 resulting in a loss of $1000 (200 X $5) to the investor. The margin account will be
adjusted and the account balance will be reduced by $1000 to $4000 at the end of the first trading
day. Assume that from February 3rd to 10th, the future prices of gold are as follows:

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 A Note on Currency and Index Futures

Day Futures Daily Cumulative Balance in Margin

Price Gain/(loss) in $ Gain/(Loss) in $ Margin A/C Call in $
$500.00 $5000
February 3 $495.00 (1000) (1000) $4000
February 4 $494.00 (200) (1200) $3800
February 5 $492.50 (300) (1500) $3500 1500
February 6 $493.00 100 (1400) $5100
February 7 $494.00 200 (1200) $5300
February 10 $492.00 (400) (1600) $4900

The investor can withdraw any balance in the margin account in excess of the initial margin. When
the balance in the margin account falls below the maintenance margin (75% of the initial margin),
the investor will receive a margin call and will be required to reset the balance to the initial margin
level. The additional money deposited to bring the margin account to the level of initial margin is
known as the variation margin.

SETTLEMENT PROCEDURES

The three common ways in which a futures contract can be settled are by physically exchanging
the assets, cash settlement, and offsetting or closing out position.
Physical delivery
This manner of settlement involves physical delivery of the underlying asset. In case of
commodity futures, if a trader holds the underlying asset, say wheat, the delivery is to be made at a
specified place and time. However, this way of settlement can be a bit cumbersome, in case the
trader does not actually hold the underlying assets, since it would be difficult for him to buy assets
of the exact specifications in terms of quality.
Cash settlement
Index futures are usually settled in cash; this is because the delivery of the underlying asset of any
index (say S&P 500) would involve delivering a portfolio of a number of stocks. In a cash
settlement, the futures contract has to be marked to market at the end of the last trading day and all
outstanding positions are squared. The resulting profit/loss is settled in cash. The settlement price
is set equal to the closing spot price to ensure that the futures price converges with the spot price.
Offsetting
This procedure involves entering into a trade just opposite to the original one. For example, if an
investor is holding a long position on a wheat futures, he/she can sell an identical futures contract
to reverse the initial position. Identical here means contract of the same underlying asset and same
month. The vast majority of the futures contracts that are initiated are closed out in this way.

APPLICATIONS OF FUTURES

Hedging
Futures markets were initially developed to hedge risk. Holding an asset involves some risks 6.
Hedging is a way of insuring an asset against those risks. An example would help to understand
how futures market can be used for hedging.

6
Risks involved are interest rate risk, exchange risk and market risk.

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 A Note on Currency and Index Futures

Example:
A wheat trader anticipates that he will need to buy additional wheat from his supplier in six
months. During the period, however, he fears the price of wheat may increase. That could result in
losses for him because he has already advertised his price for the six-month period.
To lock in the price level at which wheat is presently being quoted for delivery in six months, he
buys a futures contract at a price of, say, $30 per bushel.
If, six months later, the cash market price of wheat has risen to $37, he will have to pay his
supplier that amount to purchase wheat. However, the extra $7 per bushel cost will be offset by a
$7 per bushel profit when the futures contract bought at $30 is sold for $37. In effect, hedging
through futures provided insurance to the trader against an increase in the price of wheat.
However, if the price of wheat had declined, he would have incurred a loss on his futures position
but this would have been offset by the lower cost of acquiring wheat in the cash market.
Speculation
Speculators have no interest in locking in a price to hedge risk. They buy and sell futures contracts
in order to make profits from price volatility. They bet on their anticipation of the price movement,
that is, either upwards or downwards. An example will explain how the futures market is used for
the purpose of speculation.
Example:
In March 2003, an investor ‘A’ expects the price of corn to rise over the next three months. The
price in March is $17 per bushel. Instead of physically purchasing the corn (35,000 bushels) and
taking the risk of storing it for three months and incurring the impact cost (storage, transportation
and protection from pests), A can enter into a three months futures contract.
He will enter into a contract to purchase the corn after three months at a price fixed today, say, $20
per bushel. Three months hence, the price has reached the level of $24 per bushel. A can now
make a profit of $4 per bushel by selling an identical futures contract to reverse his initial position.
Profit if A had bought corn in March from the spot market
Purchase price = $17 + $2 (Storage cost) + $1 (protection from pests) + $1 (transportation cost) =
$21 per bushel
Selling price = $24 per bushel
Profit = 35,000 X ($24 – $21) = $105,000
Profit from a futures contract
= 35,000 X ($24 – $20) = $140,000
Arbitraging
Arbitrageurs profit by taking the advantage of a variance between prices in two different markets.
They primarily look for opportunities to achieve riskless profits by entering into different
transactions in two or more markets simultaneously.
Example:
Consider a GE stock traded on the NYSE and on Toronto Stock exchange with the stock price
being $138 in New York and Can $210 in Toronto. The exchange rate is Can $1.55 per US$. An
arbitrageur would simultaneously buy 100 shares in Toronto stock exchange and sell in NYSE and
thus make a risk-free profit of
100 X [(1.55*138 - 210)] = Can $390

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 A Note on Currency and Index Futures

However, this arbitrage opportunity will not last for long because an increase in demand for the
GE stock in Toronto will push up the prices. Similarly, the prices will fall at NYSE when shares
are offloaded by arbitrageurs over there, thus reducing arbitraging opportunities.

TYPES OF FUTURES

On the basis of the underlying asset, the different types of futures contracts traded can be grouped
into the following four categories:
 Currency Futures (where the underlying asset is a currency such as euro, yen, dollar, etc.).
 Index Futures (where the underlying asset is a stock index).
 Commodity futures (wheat, corn and so on).
 Interest rate futures (underlying asset is an interest earning asset like a debenture or bond).

TRADING USING CURRENCY FUTURES

An investor can limit his/her incoming and outgoing cash flows in one currency with respect to
another currency by purchasing (long hedge) or selling (short hedge) foreign exchange futures. A
person dealing in foreign exchange is exposed to exchange risk, since the cash flow in terms of
domestic currency will be known only at the time of conversion. To hedge, a person who has taken
a long position or is expected to do so in a foreign currency, should sell futures in the foreign
currency against the domestic currency. Similarly, a person who has taken a short position or is
expected to do so in a foreign currency, can create a hedge by buying futures in the foreign
currency against the domestic currency instead of buying the currency later in the spot market.
Example:
A US exporter is exporting goods to his German client. On January 27, 2003, the exporter got the
confirmation from the German importer that the payment of Euro 800,000 will be made on March
1, 2003.
In this case, the US exporter is exposed to currency fluctuations. If the Euro depreciates there will
be loss on his dollar receivables7. To cover this risk the exporter can sell a Euro futures contract.
On January 27, 2003
Spot Market
Importer notifies the exporter that receivables equal to Euro 800,000 will be delivered on March 1,
2003. Spot rate on January 27, 2003 is $/Euro 0.8208; Expected cash inflows are $656,640 (Euro
800,000 X 0.8208) if converted. But the conversion is not possible since the exporter will be
receiving the Euros, only on March 01. However, he can sell the futures contract in Euros.
Futures Market
The March futures rate is $/Euro 0.8243. The exporter sells four March Euro futures contracts (the
size of each contract is Euro 200,000). The equivalent notional amount in US dollars will be
$659,440 (0.8243 X Euro 800,000)
On March 1, 2003
Spot Market
The dollar has appreciated and the spot exchange rate is 0.81919. Therefore, the dollar value of
Euro 800,000 is $655,352. Hence, the loss to the exporter compared to the spot market position is

7
Euro depreciates against dollar means, for the same amount of Euro less dollars will be available.

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 A Note on Currency and Index Futures

= $656,640 – $655,352 = $1288

Futures market
To offset the position, exporter will be required to go long on four March Euro futures contract.
Let the futures rate be 0.82269. This gives the exporter the notional right to buy Euro 800,000 by
paying $658,152 (Euro 800,000 X 0.82269). Profit on the futures contract is
= $659,440 – $658,152 = $1288
The loss resulting in the spot market from the appreciation of dollar is offset by the profit in the
futures market. In the above illustration, the exporter received the same amount of US$ as if he
had sold Euro in the market on January 27, 2003. This is because the change in the spot rate of
Euro during the period and the change in the price of futures during the same period are equal.
Spot Price (t0) – Spot Price (t1)
= 0.8208 – 0.81919 = 0.00161
Futures Price (t0) – Future Price (t1)
= 0.8243 – 0.82269 = 0.00161
Also, in the above illustration, the basis (the difference between the spot price and futures price) at
time t0 and at time t1 is the same i.e. 0.0035.
Thus, when the basis remains unchanged, the gain/loss in both markets, that is, spot and futures, is
equal and, hence the amounts are exactly offset. However, it is unlikely that the basis will remain
the same throughout the period. This is what gives rise to basis risk. To understand basis risk, let:
St0 be the spot price at time t0
St1 be the spot price at time t1
Ft0 be the futures price at time to
Ft1 be the futures price at time t1
St0 – Ft0 = Basis at time t0
St1 – Ft1 = Basis at time t1
In the above example, the US exporter hedged Euro receivables by taking a short position on Euro
futures. Assume that the hedge was created at time t 0 and the position closed out at time t 1. Profits
made in the future markets by closing out position at time t1 = Ft0 – Ft1 (loss if Ft0 < Ft1). Consider
a situation where a hedger knows that the asset will be sold at time t1 and takes a short future
position at time t 0. The price realized for the asset while selling in the spot market = St1, which
implies the effective price at which the US exporter sold the Euro, is
= St1 + (Ft0 – Ft1)
= Ft0 + (St1 – Ft1)
= Ft0 + b1
Where b1 represents basis at time t1.
Since b1 is unknown, the futures transaction is exposed to basis risk. If b1 = b0, then the effective
price at which Euro is sold will be Ft0 + St0 – Ft0 = St0.
Optimal Hedge Ratio
A hedger has to determine the number of futures contracts to buy in order for the best hedge for
his/her return profile. A hedge ratio is the ratio of the size of the future position to the size of the
underlying asset position. In terms of futures, it is be defined as the number of futures contracts to
hold for a given position in an underlying asset.

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 A Note on Currency and Index Futures

A hedge ratio of 1.0 is not always optimal and will give a perfect hedge only when there is no
change in the basis. An illustration will explain the concept better:
Let
 St = Change in the spot price during the period of hedge
 Ft = Change in the futures prices during the period of hedge
 St = Standard deviation of  St
 Ft = Standard deviation of  Ft
 = Coefficient of correlation between  St and  Ft
h = hedge ratio
When the hedger has taken a long position on the asset and is short on futures, the change in the
value of the hedger’s position during the period of the hedge would be:
 St – h  Ft
When the hedger is long on futures it is
h  Ft -  St
Whatever may be the hedge, the variance, v, in either case would be given by:
V = 2 St + h2 2 Ft – 2hStFt
So that, first derivative with respect to the hedge is
= 2h2 Ft - 2StFt………………… (Equation 1)
Setting equation 1 equal to zero and noting that the second derivative is positive, the value of h,
which minimizes the variance, is
St
h=
Ft
Therefore the product of the coefficient of correlation between  St and  Ft and the ratio of the
standard deviation of  St to the standard deviation of  Ft, gives the optimal hedge ratio. If the
spot price and the futures price are perfectly positively correlated and St = Ft, the optimal hedge
ratio would be 1.0.
Example:
A company anticipates that it will be requiring 2 million gallons of heating oil in six months. The
standard deviation of the change in the price per gallon of heating oil over six months period is
calculated as 0.045. The company decides to buy a six months futures contract on unleaded
gasoline to hedge the risk. The standard deviation of the change in the future price over a six-
month period is 0.054 and the coefficient of correlation between the two is 0.12. The optimal
hedge ratio is therefore
0.12 X (0.045/0.054) = 0.10
One unleaded gasoline futures contract is on 42,000 gallons. The number of contracts the company
should therefore buy is
0.10 X 20,00,000/42,000 = 4.76 contracts
Rounding off the decimal places to the nearest whole number, 5 contracts have to be purchased.

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 A Note on Currency and Index Futures

Example:
An investor has a long position on a portfolio of stocks worth $50 million with a beta of 1.2. To
hedge this long position, the investor needs to take a short position on the futures contract (say
S&P 500). The size of an S&P 500 futures contract is 250 times the value of S&P 500 index. The
June 03, 2000, S&P 500 futures contract, was settled at 1427.35 on the last trading day. Therefore,
the value of futures contract is 250 X 1427.35 = $356,837.5
Value of the portfolio
Hedge Ratio = X Beta
Value of the S&P 500 futures contract
$50, 000, 000
= X 1.2
$356,837.5
= 168 contracts

TRADING USING INDEX FUTURES

The following are the fundamental modes of trading on the index futures market:
Hedging
 Long on Security, Going short on Index Futures (say Nifty)8
When investors’ trade, they may be inclined to purchase a security, which they believe is
undervalued. The investors may feel that the profits and the quality of management of a particular
company make it seem worth more than the present market value. However, while purchasing the
security the investor faces two kinds of risks:
a) His understanding of the company is wrong and the stock price goes down.
b) The market moves in the direction opposite to his expectations even though his understanding
of the company was correct.
The probability of the second outcome is high. This is because assuming all other factors constant,
a security constituting the market index gains if the market index rises and vice versa. To
overcome this problem, every time an investor takes a long position on a particular security, he
should sell some amount of index futures. This strategy offsets the index exposure when an
investor takes purchases a security say Infosys. Thus a position Long Infosys + Short Index =
Performance of Infosys.
To follow the above strategy, an investor needs to know the ‘beta of security’9 and the market lot
on the futures market. An example to explain the concept is given below.
Example:
The stock of Carrier Aircon has a beta of 1.3 and an investor has taken a long position of Rs.
200,000 on the share. The size of the position to be taken on Index (Nifty) futures to hedge the
index exposure is 1.3 X 200000 = Rs. 260,000.

8
Nifty is a well-diversified 50 stocks index accounting for 23 sectors of the Indian economy.
9
Beta is a statistical measurement of risk associated with an individual stock or a portfolio. It is the ratio of
the covariance of the security returns and market returns to that of the variance of the market returns.

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 A Note on Currency and Index Futures

The market lot on the futures market is 200 and Nifty is quoting at 1270 with the nearest futures
contract trading at 1300. Hence, one market lot of Nifty is worth Rs. 260,000 (200 X 1300). So
investor can take the following position.
Long Carrier Rs. 200,000
Short Nifty Rs. 260,000.
Assume that 10 days later, Nifty drops by 10% and the investor unwinds his position. His long
position on Carrier led to a loss of Rs. 26000 (200,000 X 0.10 X 1.3). However, his short position
earned him Rs. 31400. Overall he gained Rs. 5,400.
 Short on Security, Going Long on Index Futures
When trading, investors may be inclined to sell a security, which they believe is overvalued. But
while doing so, they face two kinds of risks:
a) The understanding of the company may be wrong.
b) The market moves in the direction opposite to their expectations and generates losses even
though their understanding of the company was correct.
The probability of the second outcome as explained before is high, because every short position
taken on a security is simultaneously a short position on the index. For example, an investor may
sell Infosys at Rs. 4000 expecting that during the period of economic slowdown in the US, Infosys
would not be able to maintain its profits. However, a few days later the index may rise, resulting in
losses for the investor even if his understanding of the company was correct. Hence, in this case,
every time an investor takes a short position on a security, he should buy index futures.
Example:
The stock of Zee Telefilms has a beta of 1.2. An investor on March 03, 2003 takes a short position
of Rs. 500,000 on the Zee’s stock. The size of the position an investor is required to take on Nifty
futures to hedge the index exposure is 1.2 X 500000 = Rs. 6,00,000.
The Nifty market lot is 200. On March 03, the Nifty is quoting at 960 and the nearest futures
contract is trading at 1000. Thus to buy Nifty worth 6,00,000 three lots will be bought since each
market lot is worth Rs. 200,000 (200 X 1000). Now the positions are:
Short Zee Telefilms = Rs. 500000
Long Nifty = Rs. 600000
On March 24, 2003, Nifty rises by 15%. The investor unwinds his position with the following
payoffs:
 His short position on Zee lost him Rs. (500000 X 0.15 X 1.2) = Rs. 90000
 His long position on Nifty earned him Rs. [(200 X 3 X 960 X 1.15) – (200 X 3 X 1000)] =
Rs. 62400.
 Long on portfolio of securities, Short on Index Futures
Investors who own a portfolio of securities often face the risk of adverse market movements.
An investor having a portfolio of securities has the following alternatives:
a) Sell the portfolio of shares immediately.
b) Do nothing i.e. suffer the risk of adverse movement in the stock prices.
c) Use Index futures to overcome the risk related to the exposure of market index fluctuations.

10

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 A Note on Currency and Index Futures

Every portfolio created by an investor is exposed to the index volatility whether the portfolio
consists of index securities or not. In a portfolio, index fluctuations account for most of the risk.
Hence, a position LONG portfolio + SHORT Nifty is less risky than just the long position on
portfolio of securities.
Example:
On February 25, 2003, Ketan has a portfolio comprising five securities. The securities include
Grasim (100 shares, Market Price on Feb. 25, 2003 = Rs. 110), Andhra Bank (200 shares, Market
Price Rs. 48.25), Pfizer (100 share, Market Price Rs. 875.50), Infosys (200 shares, Market Price
Rs. 150.5), and BPL (200 shares, Market Price Rs. 245). The total portfolio value is Rs. 187,300.
Ketan wants to remove the budget-related (Budget to be announced on February 28) volatility
from February 25 to March 10, 2003.
The beta of the portfolio is 0.90. For a complete hedge, Ketan will need to sell futures worth 0.90
X 187,300 = Rs. 168,570. On Feb 25, 2003, Nifty is at 1124.00. So he decides to sell 200 (market
lot) Nifties. Hence, Ketan takes a short position on one March Nifty Futures.
On March 10, 2003, the securities of the portfolio and Nifty traded are as follows:

No. Of Shares Security February 25 March 10 Profit/(Loss)

100 Grasim 110.00 94.70 1530.00

200 Andhra Bank 48.25 26.50 4350.00
100 Pfizer 875.50 742.00 13350.00
200 Infosys 150.50 112.50 7600.00
200 BPL 245.00 212.00 6600.00
PORFOLIO 187,300 153,870 33430.00
NIFTY 1124.00 961.02

Gain on Nifty = 162.98 X 200 = Rs. 32596

On March 10 Ketan offsets his position by buying back futures. His profit on the futures contract is
Rs. 32,596 and his loss on the portfolio was Rs. 33,430. Thus the net loss is Rs. 834. If he had not
hedged he would have lost Rs. 33,430.
 Have Funds, Buy Index Futures
It is a common belief that index futures are used for hedging against a fall in the market index.
However, it is equally important to use index futures to hedge against a rise in the index. Holding
money in hand, when it is to be invested in securities may result in a lost opportunity for profit if
the index rises. An investor having funds may not invest in equities for the following reasons:
a) It takes time to research and select securities to invest. During this time, the investor is
exposed to the risk of losing out on the opportunity if the index rises.
b) Even if a person has selected a portfolio of securities, and placing purchase orders in the
market involves large ‘impact costs’.
The alternatives the investor has are:
a) To buy liquid securities.
b) To hold money and suffer the notional risk of lost opportunity.
c) To buy index futures and obtain the desired equity exposure immediately.

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 A Note on Currency and Index Futures

An investor who expects to realize Rs. 3 million from the sale of a house would take a long
position on index futures worth Rs. 3 million. The market for index futures is more liquid than
individual securities; hence it involves lower impact cost, at the same time allowing large
positions.
Later, the investor can select securities after detailed research, and as and when the shares are
purchased, the long position on index futures can be scaled down correspondingly. This strategy
provides the investor with the time to pick the securities carefully after research and analysis.
Speculation
 Expecting Bull Phase, Go Long on Index Futures
At times investors feel that market is expected to rise (in a bull phase). To benefit from such a
scenario, investors have two alternatives:
a) To buy securities which move in tandem with the index and offload at a time when investor
feels he has realized the profit.
b) To buy the index portfolio and sell at a later date.
The first alternative uses certain securities as a proxy for the index. However, it is subject to
company specific risks and may generate losses, as it is only a proxy for the index and not the
index itself. The second alternative involves large transaction costs and is therefore expensive.
A way out to this is to take a position on the index. It is effortless and is not costly as the entire
index can be bought or sold as a single security. If a person is long on the index, he gains if the
index rises, and vice versa.
To adopt this strategy, an investor can take a long position on the index by buying market lots.
Suppose, the market lot is 200 Nifties and Nifty is trading at 1860, it will involve an outlay of Rs.
372,000. But he is only taking a position and will therefore be required to pay only the initial
margin, say, Rs. 25000.
Example:
On January 01, 2003, an investor feels that the budget to be presented on February 28, 2003, will
be investor-friendly and expects the index to rise thereafter. He therefore buys a three-month index
futures contract expiring on March 27, 2003, currently trading at Rs. 1020. So his initial position is
long Index futures worth Rs. 204000 (200 X 1020). On March 12, 2003, the index rises to 1335
and the March futures contract rises to Rs. 1352. The investor unwinds his position by selling at
Rs. 1352. His total profit = 66400 (200 X (1352 – 1020)).
 Expecting Bearish Phase, Go Short on Index Futures
At times, investors feel that market is in for a bear phase for several reasons such as a series of bad
corporate results, a minority government and a forecast of a bad weather. To benefit from such a
scenario, investors have the following alternatives:
a) To sell securities which move in tandem with the index and buy at a time when investor feels
he has realized the profit.
b) To sell the index portfolio and buy at a later date.
c) To take a short position on index futures.
The third alternative is effortless and involves initial outlay only in terms of margin money.
Example:
On April 01, 2002, an investor feels that the year’s monsoon will be bad and expects the index to
fall thereafter. He therefore sells a three-month index futures contract expiring on June 27, 2002,

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 A Note on Currency and Index Futures

currently trading at Rs. 920. So his initial position is short in index futures worth Rs. 1,84,000 (200
X 920). On June 09, 2002, the index falls to Rs.835 and the June futures contract falls to Rs. 852.
Investor unwinds his position by buying at Rs. 852. His total profit = 13600 (200 X (920 – 852)).

ARBITRAGE

 Arbitraging when lending money to the market

Index futures market provides an opportunity to investors to lend money into the market without
being exposed to the (a) price risk and (b) default risk of the counter party. The investor creates a
portfolio, which buys all the securities that comprise an index (say Nifty). The proportion of
securities should be a representation of their market capitalization. A moment later, the investor
sells the contracts in the futures market. Now the investor is completely hedged against
fluctuations in the index and the credit risk is also eliminated since the counterparty is the clearing
house. The investor loans the money to the market at the point of delivery of securities. A few days
later the investor will unwind the position; the investor will send sell orders to sell off all the
securities of the portfolio, and a moment later will reverse the future position. The point when the
investor makes the delivery of the shares is when he receives his money back.
The return that investor earns when he unwinds the transaction at the expiration date of the futures
is equal to the futures price minus cash market price of the Index. There are two other intricacies,
which affect the return earned (1) dividends earned on shares during the period of holding and, (2)
brokerage and other transaction costs. Suppose on 1 January 2003, the spot price of the index is
Rs. 954.52, and the index January futures are at Rs. 965.3, then the return earned by the lender is
[(965.3 – 954.52)/954.52 X 100] 1.13% for 30 days.
Example:
On April 01, 2002, the spot price of Nifty is 1020 and a futures contract for April is trading at Rs.
1055. To earn this return of (35/1020 X 100) for 25 days, the investor buys Rs. 3.5 million of Nifty
on the spot market. In order to do so he had to place 50 market orders and thus ends up paying
0.2% higher i.e. he obtains the Nifty at Rs. 1022. A moment later he sells Rs. 3.5 million of the
futures at Rs. 1055, because of liquidity in the futures market the transaction takes place at zero
impact cost. Few days later he takes delivery and it at this point he lends money to the market. He
holds the securities for few days before unwinding the position and receives dividends during that
period that work out to be Rs. 5650.
On April 25, 2002, investor unwinds the entire transaction by putting 50 market orders to sell off
his Nifty portfolio at the price of Rs. 1034. The transaction goes through at Rs. 1032, the futures
position simultaneously expires at Rs. 1034 (the futures price converges with the spot price on the
expiration day). Thus the investor ends up gaining Rs. 12 (0.98%) in the cash market and Rs. 21
(1.99%) on the futures. In addition, investor also earned dividends of Rs. 5650 that works out to be
return of (0.16%), thus culminating into a total risk free return of 3.13% for 25 days.
However, this strategy does not make sense when the return works out to be something really not
worth putting in this much of money for, like 0.45 or 0.5%. Also it is essential to make a portfolio
of Rs. 3 million or more as portfolios of less than Rs. 3 million do not replicate the Nifty Index.
 Lend to the market the securities you own
The index futures market provides an excellent opportunity for the owners of shares to earn
positive returns by loaning out the shares. This trading method on index futures also does not
involve any price risk and default risk. The investor sells off all the securities that comprise an
index (say Nifty), on the cash market. (The proportion of securities should be a representation of
their market capitalization) A moment later, he buys a contract in the futures market. The investor
receives the money after selling the securities and can invest that money at the risk-free rate of

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 A Note on Currency and Index Futures

interest. A few days later the investor will unwind the position; the investor will send orders to buy
all the securities of the portfolio and a moment later, will reverse the future position. The point the
investor takes the delivery of the shares is when he pays the money back.
However, this method of trading is worth the effort only when the spot minus future basis is
smaller than the risk-free interest rate available in the economy. For example, if the difference
between the spot Nifty (1020) and the two-month futures nifty (1035) is 1.47% (15/1020) and the
transaction cost is 0.4% (assumed). Further the cash can be invested at no risk at a rate of 1.3% per
month. Over a two-month period, the yield works out to be 2.62% [(100 X 1.013 X 1.013) – 100].
The approximate return over a two-month period is 2.62 – 1.47 - 0.4 = 0.75%. On the other hand,
if the difference between the spot and futures is say 2.2% over a period of two months and the
riskless yield over the same period is 1.9%, then it is not profitable to loan out the money.
Example:
Suppose an investor holds Nifty worth Rs. 4.5 million, he puts in sell order for all the securities in
Nifty at the spot price of Rs. 1200. The seller suffers the impact cost and thus ends up getting only
1197. A moment later he buys two-month Nifty futures worth Rs. 4.5 million at 1220. At the point
of delivery of shares, the investor receives money 4.48 million from the sale (after taking into
account the impact cost). The investor lends the money received at risk less rate, say 1.3% per
month, so at the end of two months he gets back Rs. 45,97,237, in terms of Nifty it is 1197 X
1.0132 = 1228. On the date of expiration of the futures contract the investor unwinds his position,
he puts in orders to buy back his Nifty portfolio at the spot price which has moved upto 1245 by
this time. This makes the share buy-back costlier but the difference is offset by profits on the
futures market.
The buy order placed by the investor goes through at Rs. 1248, because of the impact cost. The
funds available with the investor is 1228, plus the profit made on the futures, that is, 25 (1245 –
1220). Thus, the investor ends up with a profit of Rs. 5 on the whole transaction (1228 + 25 –
1248).

CONCLUSION:

Futures can result in serious losses, if used without proper knowledge. Hence, the prerequisite for
trading in futures is a thorough knowledge of the futures market. This concept note is an attempt to
make the readers understand the futures market better and how it can be used to benefit market
participants. If used properly, futures can help to reduce price risk significantly.

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 A Note on Currency and Index Futures

Exhibit I
Difference between Futures and Forwards Contracts

Particulars Futures Forwards

Location Futures exchange No fixed location

Size of contract Standard (fixed) Varies from contract to contract
Valuation Market to market everyday No unique method of valuation
Maturity/payme Standard (fixed) Varies from contract to contract
nt date
Settlement Settled through closing out the Settled by delivery or through cash
position prior to maturity
Counterparty Clearing house Bank or client
Regulations Regulated by the exchange Self-regulated
concerned
Trading Exchange traded Over the counter i.e. private contract
between two parties
Source: Financial Risk Management, IBS Center for Management Research Textbook and Hull John. C, Options,
Futures and other derivatives.

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 A Note on Currency and Index Futures

Exhibit II
A Note on Analyzing Futures Prices

The pricing conventions in futures contracts differ from one commodity to another. Grains and
oilseed are quoted in terms of cents per bushel, heating oil in terms of dollar per gallon, copper
in cents per pound, livestock in cents per pound.
Live Cattle Futures
SESSION PRIOR DAY
Month/ OPEN HIGH LOW SETTLE PT EST SETTLE VOL INT
CHNG. VOL
Strike
APR 03 75.400 75.850 75.300 75.800 +200 5206 75.600 5357 28952
MAY0 72.350 73.200 72.300 73.200 +375 79 72.825 325 1999
3
JUN03 69.950 70.450 69.850 70.375 +350 3215 70.025 4292 40838

Feeder Cattle Futures

SESSION PRIOR DAY
Month/ OPEN HIGH LOW SETTLE PT EST SETTLE VOL INT
CHNG. VOL
Strike
APR03 77.450 78.200 77.300 78.150 +425 467 77.725 528 2744
MAY0 77.500 78.000 77.400 78.000 +325 602 77.675 835 5589
3
AUG03 80.950 81.600 80.900 81.500 +150 326 81.350 256 3190

The number in the open column shows the opening price of the contract for that day’s trading,
followed by the highest price in the second column achieved during the day, and the lowest
price achieved during the day of trading for a particular contract in the third column, say April
03, May 03. The fourth number in the row is the settlement price. This is the average of the
prices at which the contract traded immediately before the bell, signaling the end of the trading
for the day. The fifth number in the row is the change in the settlement price in comparison to
the settlement price the preceding day. The three columns under the prior day heading, show the
settlement price the preceding day, the volume of trading a day prior and the open interest for
each contract. Open interest is the total number of the contracts outstanding. It is the sum of all
the long positions, or equivalently, it is the sum of all the short positions.
Source: [Link], Financial Risk Management, IBS Center for Management Research Textbook and Hull John. C,
Options, Futures and other derivatives.

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 A Note on Currency and Index Futures

Additional Readings and References:

1. John C. Hull., Options, Futures and Other Derivatives.

2. Robert A. Strong, Derivatives An Introduction
3. Financial Risk Management, IBS Center for Management Research Textbook.
4. [Link]
5. [Link]
6. [Link]

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