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
FUTURES TERMINOLOGY
Spot price: The price at which an asset trades
in the spot market.(delivery in t+2 basis)
Futures price: The price at which the futures
contract trades in the futures
market. (delivery in t+n basis)
Contract cycle: The period over which a
contract trades. The index futures contracts
FUTURES TERMINOLOGY
Expiry date: This is the last day on which the
future contract will be traded, at the end of
which it will cease to exist.
Contract size: The amount of asset that has
to be delivered under one contract. Also
called as lot size.
FUTURES CONTRACTS
Basis: The futures price minus the spot
price.
 

 Cost of carry: This measures the storage cost plus the

FUTURES CONTRACTS
 Marking-to-market: In the futures market, at the end of
each trading day, the margin account is adjusted to
reflect the investor's gain or loss depending upon the
futures closing price.
Margins
Margins

A margin is cash or marketable securities

deposited by an investor with his or her
broker.

Buyer or seller both have to deposit a

token payment to broker and broker will
deposit this money to exchange. This
Cash Market Margins

Margins in the cash market

segment comprise of the following
three types:
◦ Initial Margin
 Value at Risk (VaR) margin
 Extreme loss margin
◦ Mark to market Margin
Calculation of VaR margin.
 It
has two components
◦ Volatility
◦ Ln return
Formula to calculate volatility:
Calculation of VaR margin.
 Example: Share of ABC Ltd:
◦ Volatility on July 1, 2019 = 0.0214
◦ Closing price on June 30, 2019 = Rs. 100
◦ Closing price on July 1, 2019 = Rs. 108
 Log return = ln(108/100) = 0.076961

July 1, 2019 volatility

◦ This is
◦ = 0.028033 Volatility
not VaR
Margin
Value at Risk (VaR) margin
 These 3 categories are:
◦ Group 1
 Regularly traded (more than 80% of the trading days in the
previous six months)
 High liquidity (Impact cost less than 1%)
◦ Group 2
 Regularly traded (more than 80% of the trading days in the
previous six months)
 Moderate liquidity (Impact cost more than 1%)
◦ Group 3
 All other shares
Calculation of Extreme Loss Margin
 The extreme loss margin aims at covering the
losses that could occur outside the coverage of
VaR margins.

 The Extreme loss margin for any stock is higher

of 1.5 times the standard deviation of daily LN
returns of the stock price in the last six months
or 5% of the value of the position.
Calculation Mark-to-Market (MTM)
margin
 What is MtM Margin

◦ MTM is the P/L calculated at the end of the

day on all open positions. Amount require to
deposit w.r.t MTM is called as MTM margin.
MTM margin

Suppose,

◦ A buyer purchased 1000 shares @ Rs.100/-

on July 1, 2019.
 Initial Margin was 22% (VaR+ELM) =22000

◦ If Share close at Rs.75/-, then the buyer faces

a notional loss of Rs.75,000.
 In such case, chance that the buyer may not be able to
bring the required money by required date.

◦ Hence, MTM margin is required.

Example of a MTM Margin
An investor takes a long position in 2
December gold futures contracts on
June 5
◦ Contract size is 100 oz.
◦ Futures price is US$400/oz
◦ Margin requirement is US$2,000/contract
(US$4,000 in total)
◦ Maintenance margin is US$1,500/contract
(US$3,000 in total)
Example of a Futures Trade
Total margin requirement
= 2 x 2000 = $ 4000
Maintenance margin requirement
= 2 x 1000 = $ 3000
Suppose the price goes down to 397 the
next day
Loss = (397-400) x 2 x 100 = (600)
Day Futures Daily Cumulative Margin Margin
price gains ($) gains ($) account call
balance
400.00 4000
5-Jun 397.00 (600) (600) 3400
6-Jun 396.10 (180) (780) 3220
9-Jun 398.20 420 (360) 3640
10-Jun 397.10 (220) (580) 3420
11-Jun 396.70 (80) (660) 3340
12-Jun 395.40 (260) (920) 3080
13-Jun 393.30 (420) (1340) 2660 1340
16-Jun 393.60 60 (1280) 4060
17-Jun 391.80 (360) (1640) 3700
18-Jun 392.70 180 (1460) 3880
19-Jun 387.00 (1140) (2600) 2740 1260
20-Jun 387.00 0 (2600) 4000
23-Jun 388.10 220 (2380) 4220
24-Jun 388.70 120 (2260) 4340
25-Jun 391.00 460 (1800) 4800
26-Jun 392.30 260 (1540) 5060
Margins levied in
the Futures &
Options (F&O)
Segment
FUTURES CONTRACTS
Initial margin: The amount that must
be deposited in the margin account at
the time a futures contract is first
entered into is known as initial
margin.
Margins levied in the Futures &
Options (F&O) Segment
 Margins on both Futures and Options contracts
comprise of the following:

◦ Initial Margin

◦ Exposure margin
 In addition to these margins, in respect of
options contracts the following additional
margins are collected

◦ Premium Margin

◦ Assignment Margin
How to calculate Initial Margin?
 Initial margin for F&O segment is SPAN® (Standard
Portfolio Analysis of Risk).

◦ It is a product developed by Chicago Mercantile

Exchange (CME).
 SPAN® uses scenario based approach to arrive at
margins.

◦ SPAN® generates about 16 different loss scenarios by

assuming different values to the price and volatility.

◦ Investor require to pay highest among them.

How to calculate Initial Margin?
 Initial margin for F&O segment is SPAN® (Standard
Portfolio Analysis of Risk).

◦ It is calculated on a portfolio based approach.

◦ It is a product developed by Chicago Mercantile

Exchange (CME).
 SPAN® uses scenario based approach to arrive at
margins.

◦ SPAN® generates about 16 different loss scenarios by

assuming different values to the price and volatility.

◦ Investor require to pay highest among them.

SPAN® 16 scenarios
Underlying Price Change as % Volatility
Scenario
of Price Scan Range Move
1 UNCHANGED 0% UP
2 UNCHANGED 0% DOWN
3 UP 33% UP
4 UP 33% DOWN
5 DOWN 33% UP
6 DOWN 33% DOWN
7 UP 67% UP
8 UP 67% DOWN
9 DOWN 67% UP
10 DOWN 67% DOWN
11 UP 100% UP
12 UP 100% DOWN
13 DOWN 100% UP
14 DOWN 100% DOWN
15 UP 300% UP
16 Down 300% UP
The Specification of the gold futures contract

Standardizing Features:
◦ Contract Size
◦ Delivery Month
Daily resettlement
◦ Minimizes the chance of default
Initial Margin
◦ About 4% of contract value, cash or T-bills
held in a street name at your brokerage.

25
The Specification of the gold futures contract

Standardizing Features:
◦ Contract Size
◦ Delivery Month
Daily resettlement
◦ Minimizes the chance of default
Initial Margin
◦ About 4% of contract value, cash or T-bills
held in a street name at your brokerage.

26
NSE's DERIVATIVES MARKET

Nifty Index Options on individual

Index options June securities
futures on June 12, 4, 2001 July 2, 2001
2000

CNX IT Futures & Nifty Midcap 50

Single stock futures
Options Futures & Options
November 9, 2001
August 29, 2003 October 5, 2007

Mini Nifty Futures &

Options on S&P Long term Options Currency
CNX Nifty on S&P CNX Nifty Derivatives
January 1, 2008 March 3, 2008 August 2008
NSE's DERIVATIVES MARKET

Interest Rate Futures Currency Options

 31 August 2009 October 29, 2010
Participants and functions
• Self Clearing Member: A SCM clears and settles trades
executed by him only either on his own account or on
account of his clients.

• Trading Member Clearing Member: TM-CM is a CM

who is also a TM. TM-CM may clear and settle his own
proprietary trades and client's trades as well as clear and
settle for other TMs.
Participants and functions
• Professional Clearing Member PCM is a CM who is not
a TM. Typically, banks or custodians could become a PCM
and clear and settle for TMs.
Convergence of Futures Price to Spot Price
Convergence of Futures Price to Spot Price

As the delivery month of futures contract is

approached , the future price converges to
the spot price of the underlying asset.
When the delivery period is reached , the
future price equals – or is very close to - the
spot price.
Convergence of Prices
Prices

Futures Price

Spot Price

Time
Convergence of Futures to Spot

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
Convergence of Futures Price to Spot Price…
“spot price is higher than future price”
 Assume that the spot price is higher than the future
price during the delivery month.
 Arbitrage opportunity:

◦ Sell the asset

◦ Long a futures contract

◦ Get delivery
 Since spot price is greater than the future price the
investor makes a profit
Convergence of Futures Price to Spot Price…
“future price is higher than the spot price”

 Assume that the future price is higher than the spot

price during the delivery month.
 Arbitrage opportunity:

◦ Buy the asset

◦ Short a futures contract

◦ Make delivery
 Since future price is greater than the spot price the
investor makes a profit
Stock Futures Prices
PRICING FUTURES
 Pricing of futures contract is very simple. Using the cost-
of-carry logic, we calculate the fair value of a futures
contract.
 The cost of carry model used for pricing futures is given
below

◦ F = Sert
F = future price R = cost of financing
S = Spot price T = time to expiration
PRICING FUTURES
 Security XYZ Ltd trades in the spot market at Rs. 1150.
Money can be invested at 11% p.a. The fair value of a 1-
month futures contract on XYZ is calculated as follows.

F = Sert
F = 1150 * e 0.11* 1/12
F = 1160
Pricing - Index futures
 A futures contract on the stock market index gives its owner the right
and obligation to buy or sell the portfolio of stocks characterized by
the index
 Stock index futures are

◦ Cash settled

◦ There is no delivery of the underlying stocks

 The main differences between commodity and equity index futures are
that:

◦ There are no costs of storage involved in holding equity.

◦ Equity comes with a dividend stream.

Pricing index futures given expected
dividend amount
 Nifty futures trade on NSE as one, two and three-month contracts.
Money can be borrowed at a rate of 10% per annum. What will be the
price of a new two-month futures contract on Nifty?

◦ Let us assume that ABC Ltd. will be declaring a dividend of Rs.20

per share after 15 days of purchasing the contract

◦ Current value of Nifty is 4000 and with a multiplier of 100

◦ ABC Ltd. Has a weight of 7% in Nifty.

◦ Market price of ABC Ltd. Is Rs.140

Pricing index futures given expected
dividend amount
  
 Current value of Nifty is 4000 and with a multiplier of 100, value of
the contract is 100*4000 = Rs.400,000
 If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is
Rs.28,000 i.e.(400,000 * 0.07).
 If the market price of ABC Ltd. Is Rs.140, then a traded unit of Nifty
involves 200 shares of ABC Ltd. i.e. (28,000/140).
 F = Sert - ()
 F = 4000*e0.1*60/365 - () = 4025.8
If expected dividend given in yield
 F = Se(r – q)t
F futures price
 S spot index value
 r cost of financing
 q expected dividend yield
 T holding period
If expected dividend given in yield
A 2 -month futures contract trades on the NSE. The cost of
financing is 10% and the dividend yield on Nifty is 2%
annualized. The spot value of Nifty 4000. What is the fair
value of the futures contract
F = Se(r – q)t
F = 4000e(.1 – .02) 60/365
 Rs.4052.95
TYPES OF TRADERS
TYPES OF TRADERS
 Stock market attracts many different types of
traders and have a great deal of liquidity.
 Three broad categories of traders can be
identified:

◦ Hedgers

◦ Speculators

◦ Arbitrageurs.
TRADERS

TRADERS

Hedgers Speculators Arbitrageurs

Hedgers

These are investors with a present or anticipated

exposure to the underlying asset which is subject
to price risks.
 Hedgers use derivatives to reduce the risk that
they face from potential future movements in a
market variable.
How we can reduce the risk that we face
from potential future movements.
Hedging Using Forward Contracts

May 24, 2020, a Indian based company (XYZ

LTD.), knows that it will have to pay $10 million
on August 24, 2020.
Hedging Using Forward Contracts
 Without Hedge: XYZ will wait till August 24, 2020. On
this date, firm will buy $10 million from spot market.

 With Hedge: XYZ LTD. will hedge its foreign exchange

risk by buying USDINR from the financial institution in
the 3-month forward market at 70.9652. This would have
the effect of fixing the price to be paid to USA exporter at
i.e. 7,09,65,200.
Speculators
 These are individuals who take a view on the future
direction of the markets.
 They take a view whether prices would rise or fall in
future and accordingly buy or sell futures and options to
try and make a profit from the future price movements of
the underlying asset
Speculation Using Spot Prices
 Consider a speculator Mr. X, who in February thinks that
the SBI will strengthen over the next 2 months and is
prepared to back that hunch.

◦ Speculator will purchase SBI share in the spot market @

315 in the hope that he will able to sold later at a higher
price.

◦ If it reach to 350 then Mr. X will earn 35 rupees per

share and ROI will be 35/315 = 11.11% in two month or
66.66% annually.
Speculation Using Futures Prices
 Another possibility is to take a long position in SBI futures
contract of April month @ 325.

◦ If rate of SBI in April reach to 350 then inverter will

earn 25 per share.

◦ Investor will earn 25 rupees per share and ROI will be

25/31.5 (Assuming 10% Margin) = 79.36% in two
month or 476.19% annually.
Comparison

  Spot Futures

ROI Futures ROI

Investment Spot P/L
Spot P/L Futures

Profit if April closing price =

 35 11.11%  25  79.36% 
350

Profit if April closing price =

- 15  - 4.76% - 25  - 79.36%
300
Arbitrageurs

They take positions in financial markets to earn

riskless profits.
Arbitrage involves locking in a riskless profit by
simultaneously entering into transactions in two or
more markets.
Within country using futures contract
 Let us consider a stock that is traded on both
the BSE and the NSE.
◦ Suppose that the stock price of SBI is 315 in NSE and
320 in BSE at the same time. An arbitrageur could
simultaneously buy 100 shares of this stock in NSE
and sell them in BSE to obtain a risk-free profit 5
rupees per share.
Cross boarder using Futures/Spot market
 Let us consider a stock that is traded on both
the CME and the MCX.
◦ Suppose that the gold is $1200/troy ounces in CME
and 37000/10gm in MCX and USDINR is 70 at the
same time.

◦ An arbitrageur could simultaneously buy 100 troy

ounces of gold in CME and sell them in MCX to obtain
a risk-free profit.
Cross boarder using Futures/Spot market
 Pay out (INR) = 1200*70*100 = 84,00,000
 Excise duty = 13% of 8400000 = 1,09,2000
 Shipment, Insurance and other cost = 10,8000

 Total Pay out = 96,00,000

 Total Pay In (37000 * 100 *3.11035) = 1,15,08,295
 Profit = 19,08,295

Profit in % =19.87%
*37000 per 10 gram
*1 troy ounces = 31.1035 gm