Part-17

Futures & Forwards

1
Comparisons & Contrasts
 We have said that forward and futures contracts
contain an essential similarity.
 Both call for the delivery of a specified quantity of the
underlying asset, on a pre-specified date, at a price
that is agreed upon at the outset.
 Besides, both types of contracts, impose an obligation
on the buyer as well as the seller.

2
Comparisons & Contrasts
(Cont…)
 While there are obvious similarities
between the two types of
contracts, there are certain vital
differences.

3
Comparisons & Contrasts
(Cont…)
 We have already discussed one
fundamental difference.
 Futures contracts are traded on an
organized exchange whereas forward
contracts are private or OTC
contracts.
 Now we will go on to look at other
differences.
4
Dissimilarities
 Since a forward contract is traded
OTC, it is customized in nature.
 That is, the core features of the
agreement to transact, are arrived at
by a process of consensus between
the two parties to the contract.

5
 Core Features
 What exactly are these core features?
 How many units of the underlying asset is
the short required to deliver to the long per
contract?
 What grade of the asset (this is applicable
mainly for commodities) is acceptable for
delivery?
Or can more than one grade be eligible
for delivery?

6
Core Features (Cont…)
 Where should delivery be made?
Or is there a choice of locations for
one of the parties?
 When can delivery be made?
Is it possible only on a fixed date,
or is there a specified time
interval during which it can
occur?
7
Core Features (Cont…)
 In the case of contracts where
multiple grade and/or locations are
allowed, who gets to choose as to
what and where to deliver?

8
Customized Contracts
 In the case of customized
contracts, all these issues have to
be resolved through bilateral
negotiations and incorporated into
the contract.
 This is therefore the case with
forward contracts.

9
Standardized Contracts
 In the case of a standardized contract, like a
futures contract, there is a third party, which will
spell out the permissible terms and conditions
that may be incorporated into the contract.
 This party is the exchange.
 Let us take each of the issues raised above from
the standpoint of a futures contract.

10
Contract Size
 The contract size or the number of units of
the underlying asset that is required to be
delivered by the short to the long, is fixed
by the exchange.
 While setting the size, two opposing forces
have to be judiciously balanced.
 While a smaller size will favour small traders,
larger sizes will reduce the average
transactions cost.

11
Allowable Grades &
Delivery Locations
 The grade or grades that are
eligible for delivery are specified
by the exchange.
 The place or places where delivery
is permitted, are specified by the
exchange.

12
Grades & Locations
(Cont…)
 In the case of multiple allowable
grades, one grade is designated as
the par grade.
 Other grades may be delivered at
a specified premium to or discount
from the par grade.

13
Grades & Locations
(Cont…)
 In the case of multiple deliverable
grades and/or delivery locations, one of
the parties to the contract has to be
given the right to choose in order to
avoid a conflict.
 Traditionally futures exchanges have given
this choice to the short.

14
Grades & Location
(Cont…)
 If multiple locations are specified
the short can choose the place of
delivery.
 If he decides to deliver at a location
other than the par location, he will
receive a premium or discount per
unit of the underlying asset that is
delivered.

15
Delivery Period
 The exchange will also specify a
delivery period by indicating the first
date on which delivery can be made,
and the last possible date on which it
can occur.
 The decision to deliver is made by the
short in practice.
 That is, the long cannot call for delivery.

16
Unit Price
 The last remaining issue is the price
at which the underlying asset is to
be delivered.
 In the case of both forward as well as
futures contracts, this is arrived at by
negotiations between traders on
opposite sides of the market, and is a
function of supply and demand forces.

17
Dissimilarities (Cont…)
 The second major difference between
the two types of contracts is that while
most of the forward contracts that are
entered into, result in eventual
delivery of the underlying asset, only a
very small percentage of the futures
contracts that are entered into,
actually result in delivery.

18
Offsetting
 What happens when a trader who
has entered into a futures
contract, desires to get out of his
position without having to deliver
or to accept delivery?
 He can simply offset by taking a
counter-position in the same contract,
on the floor of the futures exchange.

19
Counter-positions
 What is a counter-position?
 If a trader has taken a long position
initially, taking a counter-position
would entail going short subsequently
and vice versa.

20
The Advantage of
Standardized Contracts
 Forward contracts are customized.
 Thus each contract will typically have
features that are unique to it.
 Therefore to abrogate an existing
contract, it is essential to seek out the
party with whom the trade was
originally consummated, and have
the contract nullified.

21
Standardization (Cont…)
 A futures contract however is
standardized.
 Thus a contract to trade 100 kg of wheat of
type Indian Red in New Delhi on 31
October between two people Poonam and
Kunal, will be the same as a contract to
trade 100 kg of wheat of type Indian Red in
New Delhi on 31 October between two
others, Aditi and Shibani.

22
Standardization (Cont…)
 Let us assume that Poonam has
gone long to start with.
 If she wants to get out of her position,
she has to simply call her broker and
indicate her desire to go short in a
contract with the same features as
the one she had traded initially.

23
Standardization (Cont…)
 That is, she should seek to establish
a short position in an October
contract on Indian Red wheat.
 It will obviously have a contract size of
100 kg, because that would have been
fixed by the exchange.
 So too would be the place of delivery,
which in this case is New Delhi.

24
Offsetting (Cont…)
 When Poonam’s order goes to the
floor of the exchange, it will be
matched with an order to go long
that has been placed by another
trader.
 It is important to note that this trader
need not be Kunal, the person with
whom she had originally traded.

25
Offsetting (Cont…)
 Once this trade is put through, Poonam will
have a net position of zero.
 Of course, in the process she may have
made a profit or a loss, since the prevailing
futures price when she had initially gone
long, would in general be different from the
price prevailing at the time of offsetting.

26
Offsetting (Cont…)
 Is standardization the only reason
why offsetting is easy?
 The answer is no.
 In the case of a forward contract,
there is an element of credit risk,
because each party is exposed to
the risk of nonperformance on the
part of the other.
27
Credit Risk
 Consequently, each party must
verify the credit history and
antecedents of the other.
 It is for this reason that parties to a forward contract
tend to be large institutional players like

Commercial banks

Investment banks

Investment funds

insurance companies

And brokerage firms.

28
Futures & Credit Risk?
 What about futures contracts?
 These contracts are traded on
organized exchanges.
 Each exchange has an associated
entity known as a clearinghouse.
 The clearinghouse may be a wing of
the exchange or may be a separate
legal entity.

29
The Clearinghouse
 The clearinghouse takes the stand
that once a buyer and a seller
enter into a futures contract, it will
come in between and provide a
performance guarantee to both the
parties.

30
The Clearinghouse
(Cont…)
 That is, as far as the buyer is
concerned, the clearinghouse will
become the effective seller, and as
far as the seller is concerned, it will
become the effective buyer.

31
The Clearinghouse
(Cont…)
 Notice that neither party actually
trades with the clearinghouse.
 It therefore enters the picture only
after a deal has been struck between
a long and a short.

32
The Clearinghouse
(Cont…)
 How does the clearinghouse
guarantee the performance of both
the parties?
 It does so by insisting that both the
parties deposit a performance
guarantee called Margin with it.

33
Margins
 What is this concept of a Margin?
 Let us first see as to why a margin
is required.
 Since a futures contract imposes an
obligation on both the parties, it is
but logical that given a chance, one
of the two parties would like to
default on the expiration date.
34
Margins (Cont…)
 The question is, how can the
clearinghouse guard itself against
this eventuality?
 Remember it has provided a
performance guarantee to both the
parties, and unless it takes adequate
precautions, it could be saddled with
a loss.

35
Margins (Cont…)
 The protection technique is fairly
simple.
 Estimate the potential loss for either
party and collect it in advance.
 Since both the parties have an
obligation, both can lose in principle.
 Consequently it is necessary to collect
collateral from both the parties.

36
Margins (Cont…)
 Once the potential loss is collected from
a party, there is no incentive to default.
 And even if the party that ends up on the
losing side of the transaction were to fail to
perform its obligations, the clearinghouse is
in a position to take care of the interests of
the other party.
 This is the crux of margining.

37
Marking to Market
 Closely related to the system of
margining is the concept of
marking to market.

38
Marking to Market (Cont…)
 What is marking to market?
 Now, the reason for collecting
margins, is to protect both the
parties against default by the other
party.

39
Marking to Market (Cont…)
 The potential for default arises
because a position once opened,
can and invariably will lead to a
loss for one of the two parties.
 Now this loss will not simply arise
all of a sudden at the time of
expiration of the contract.

40
Marking to Market (Cont…)
 As the prices in the market
fluctuate from trade to trade, one
of the two parties to an existing
futures position will experience a
loss while the other will experience
a gain.

41
Marking to Market (Cont…)
 The total loss or gain from the time of
getting into a position, till the time the
contract expires or is offset by taking a
counter-position, whichever were to happen
first, will be the sum of the these small
losses/profits corresponding to each
observed futures price in the interim.

42
Marking to Market (Cont…)
 Marking to Market refers to the
process of calculating the loss for one
party, which implies a corresponding
gain for the other, at specified points
in time, with reference to the futures
price that was prevailing at the time
the contract was previously marked to
market.

43
Marking to Market (Cont…)
 When a futures contract is entered
into, it will be marked to market
for the first time at the end of that
day.
 Subsequently, it will be marked to
market everyday until either the
position is offset or else the
contract expires.
44
Marking to Market (Cont…)
 Remember that both the parties
have deposited a performance
guarantee or collateral in their
margin accounts.
 The amount of margin that is
deposited when the contract is first
entered into is called the Initial
Margin.
45
Margin Accounts
 If a profit is made subsequently, the margin
account will be credited, while if a loss is
made, it will be debited.
 An increase in the balance in the margin
account can be withdrawn by the investor.
 However the broker has to ensure that the
balance in the account does not dip below a
threshold level due to repeated losses.

46
Margin Accounts (Cont…)
 Otherwise the entire purpose of
depositing margins will be defeated.
 This threshold is known as the
Maintenance Margin.
 If the balance dips below this level,
the trader will get a Margin Call
asking for additional funds to be
deposited, to take the balance back
to the Initial Margin level.
47
VaR
 The whole purpose of margining is
to remove the incentive to default
by collecting an amount equal to
the potential loss in advance.
 The pertinent question is
therefore,
 `how do we calculate the potential
loss over a given time horizon?’
48
VaR (Cont…)
 This is where the concept of Value
at Risk or VaR comes in.
 The Value at Risk of a position is a
statistical measure of the possible
loss of value of a portfolio of assets
over a specified time horizon.

49
VaR (Cont…)
 For instance, assume that the 99%
VaR of a portfolio over a one day
horizon is Rs 5,000.
 It signifies that the portfolio is
expected to suffer a loss exceeding
Rs 5,000 only with a probability of 1%
over a one day horizon.

50
VaR (Cont…)
 This does not mean that the
maximum loss that a portfolio can
suffer from one day to the next, is
equal to the VaR.
 The maximum possible loss of value is
always equal to the initial value of the
portfolio, since, in principle, the value
of the assets constituting the portfolio
can go to a minimum of zero.
51
VaR (Cont…)
 A given measure of VaR is
meaningless unless the
corresponding probability level and
time horizon are specified.
 Obviously the 99% VaR will be different
from the 95% VaR
 And the VaR for a 1 day horizon will be
different from the VaR for a 3 day
horizon.
52
Spot-Futures Convergence
 Before we go on to look at
numerical illustrations of the
concept of margining, it is
essential to understand a
fundamental pricing relationship.

53
Convergence (Cont…)
 At the point in time, at which a
futures contract is about to expire,
the prevailing price for a futures
position should be equal to the
price of the underlying asset in the
cash or spot market.

54
Convergence (Cont…)
 Symbolically, if we are at T, where T
denotes the time of expiration of the
futures contract, we require that
FT = ST
 where FT is the price of a futures contract
per unit of the underlying asset, and ST is
the price of the asset in the spot market.

55
Convergence (Cont…)
 What is the rationale for this?
 A futures contract that is about to
expire is nothing but a contract that
calls for immediate delivery.
 Thus it is no different from a spot
transaction.
 Consequently the two prices must
be equal to preclude arbitrage.
56
Arbitrage
 Let us see the consequences if this
relationship were to be violated.
 Case A: FT > ST
 Let FT = $ 405 per unit and ST = $ 400
per unit.

57
Arbitrage (Cont…)
 Under such circumstances, an
arbitrageur will do the following.
 He will acquire the asset in the spot
market and simultaneously go short in
the futures market.
 Since by assumption the futures
contract is about to expire, he will have
to immediately deliver as per the
contract.
58
Arbitrage (Cont…)
 So the transaction entails a purchase
at $ 400 for an immediate
delivery at $ 405.
 The difference of $ 5 is obviously an
arbitrage profit.

59
Arbitrage (Cont…)
 Case B: FT < ST
 Let FT = 395 per unit and ST = 400 per
unit.
 An arbitrageur will now do the
following.
 He will short sell the asset in the spot
market and go long in a futures
contract.
60
Arbitrage (Cont…)
 Therefore he will receive $ 400 by
way of the short sale, which he will
immediately cover by paying $ 395 to
acquire the asset under the futures
contract.
 The difference of $ 5 is once again an
arbitrage profit.

61
Illustration of Credit Risk
 Assume that Poonam goes long in a futures
contract to buy the asset five days hence at
a price of $ 400, and that Kunal takes the
opposite side of the transaction.
 We will assume that no margin is collected,
and that neither party quits the market prior
to the expiration of the contract by
offsetting.

62
Illustration (Cont…)
 We will first assume that the spot price
of the asset five days hence is $ 425.
 If Kunal does not have the asset, he will
have to buy it by paying $ 425.
 It will then have to be delivered for $ 400.
 Else if he already owns it, he will have to
forego the opportunity to sell it for $ 425
since he is committed to selling at $ 400.

63
Illustration (Cont…)
 Quite obviously Kunal will default
unless he has an impeccable
conscience and character.

64
Illustration (Cont…)
 Now let us see if on the other hand, the spot
price at the end of five days were to be $
375.
 In this case, if Kunal already has the asset, he
would be delighted to deliver it for $ 400.
 For, the alternative is to sell it in the spot market
for $ 375.
 Else, he will be more than happy to acquire the
asset for $ 375 and deliver it at $ 400.

65
Illustration (Cont…)
 The problem now is that Poonam
will refuse to pay $ 400 for it.
 There are two ways of looking at it.
 If she does not want the asset, and
she buys it at $ 400, she will have to
liquidate it at $ 375.
 Even if she wants the asset, she
would rather buy it in the spot market
for $ 375.

66
Illustration (Cont…)
 So once again we have a situation
that is conducive for default.
 Margins are collected to get over
this problem.
 Let us assume that the prices at
the end of each day during the five
day period are as follows.

67
Price Sequence
DAY PRICE Daily
Gain/Loss
0 400 -
1 415 +15
2 405 -10
3 390 -15
4 360 -30
5 375 +15
TOTAL -25
68
Illustration (Cont…)
 Over a period of five days, Poonam
will have suffered a loss of $ 25 if
she were to be forced to go through
with the contract.
 This loss of $ 25 did not accrue
overnight.
 If we look at the last column, the overall
loss (it could have been a profit
instead), is nothing but the sum of daily
gains and losses.
69
Illustration (Cont…)
 At the end of the first day, Poonam
has gained $ 15.
 Who has lost $ 15?
 Obviously Kunal.

70
Illustration (Cont…)
 At the end of the second day, as
compared to the end of the first day,
Poonam has lost $10.
 Who has gained $ 10?
 Obviously Kunal.
 So Kunal’s gains/losses may be
depicted as follows.

71
Price Sequence
DAY PRICE Daily
Gain/Loss
0 400 -
1 415 -15
2 405 +10
3 390 +15
4 360 +30
5 375 -15
TOTAL +25
72
Illustration (Cont…)
 Kunal has thus gained $ 25 over the
five day period.
 As you can see, one person’s
gain/loss is exactly equal to the
other person’s loss/gain.
 This is why futures contracts are called
ZERO SUM GAMES.

73
Illustration (Cont…)
 Now the purpose of collecting the
margin is to take away the incentive
for default.
 In this case, if both the parties had been
forced to deposit an amount equal to or
exceeding $25 at the outset, there would
be no scope for default.
 But how do we know how much one
party will lose over five days?

74
Illustration (Cont…)
 In practice, it is always easier to
forecast the probable loss over a
shorter period such as one day
than over a longer period like five
days.
 And in real life, futures contracts
often have expiration dates that
are three months or more away.
75
Illustration (Cont…)
 Quite obviously, it is not easy to
estimate the collective loss over
such a long period.
 Besides most traders may not
remain in the market till the end.
 Remember that the vast majority of
contracts are offset prior to maturity.

76
Illustration (Cont…)
 There are two ways to address this
situation in practice.
 The probable loss over a one day
period can be calculated and
collected in the form of an Initial
Margin.

77
Illustration (Cont…)
 At the end of each day, the
profit/loss for a position will be
calculated with respect to the
futures price that was prevailing at
the end of the previous day.
 Gains if any are credited to the
margin account and can be
withdrawn by the investor.
78
Illustration (Cont…)
 The loss if any must be settled by
the losing party by paying the
other party before the
commencement of trading on the
following day.
 Thus the account will see either a
cash inflow or an outflow on a daily
basis.
79
Illustration (Cont…)
 If the trader fails to deposit the
loss, the broker will automatically
offset his position, thereby
ensuring that there are no further
liabilities.
 This is the essence of the
margining system that is prevalent
in India.
80
Illustration (Cont…)
 In India the initial margin is
calculated on a real-time basis
using the value at risk principle.

81
Illustration (Cont…)
 There is another approach to
margins that is followed in many
global exchanges.
 The initial margin is set at a high
enough level to cover more than
one day’s anticipated loss, and is
collected from both parties at the
outset.
82
Illustration (Cont…)
 As trades keep occurring and the
futures price fluctuates, both the
parties will keep makes gains and
losses.
 The broker will specify a threshold
level for the balance in the margin
account, which will be below the
initial margin level.
83
Illustration (Cont…)
 This threshold is called the
Maintenance Margin level.
 As long as the cumulative loss does
not cause the account balance to
breach the maintenance margin
level, the broker will take no action.

84
Illustration (Cont…)
 However if a party were to incur
losses which cause the account
balance to dip below the threshold
the broker will issue a Margin Call.
 A Margin Call is a call for more
margin.

85
Illustration (Cont…)
 The trader must respond by
putting additional collateral to take
the balance back up to the initial
margin level.
 The additional margin deposited in
response to a margin call is called
the Variation Margin.

86
Illustration (Cont…)
 Failure to respond to a margin call
will lead to the offsetting of the
position by the broker.

87