WORK SHEET – Financial Derivatives

Instruction: Write answers of the questions given in this word file & send the completed worksheet when done.

Q1) Enumerate the basic differences between Forward and Futures contracts.
Q2) What are stock futures? What are the opportunities offered by stock futures and how they are settled?

Stock Futures are financial contracts where the underlying asset is an individual stock. Stock Future
contract is an agreement to buy or sell a specified quantity of underlying equity share for a future date
at a price agreed upon between the buyer and seller. The contracts have standardized specifications
like market lot, expiry day, unit of price quotation, tick size and method of settlement.

The opportunities offered by Stock Futures

Stock futures offer a variety of usages to the investors. Some of the key usages are mentioned below:

 Investors can take long term view on the underlying stock using stock futures.

Stock futures offer high leverage. This means that one can take large position with less capital.
For example, paying 20% initial margin one can take position for 100 i.e. 5 times the cash outflow.

Futures may look overpriced or underpriced compared to the spot and can offer opportunities to
arbitrage or earn risk-less profit. Single stock futures offer arbitrage opportunity between stock
futures and the underlying cash market. It also provides arbitrage opportunity between synthetic
futures (created through options) and single stock futures.

When used efficiently, single-stock futures can be an effective risk management tool. For
instance, an investor with position in cash segment can minimize either market risk or price risk of
the underlying stock by taking reverse position in an appropriate futures contract.

Stock Futures settled

Presently, stock futures are settled in cash. The final settlement price is the closing price of the
underlying stock.
Q3) Write a short note on marking to market. What are the features of futures contract?

Marking to market refers to the daily settling of gains and losses due to changes in the
market value of the security. For financial derivative instruments, such as futures contracts, use
marking to market.

If the value of the security goes up on a given trading day, the trader who bought the security (the

long position) collects money – equal to the security’s change in value – from the trader who sold
the security (the short position). Conversely, if the value of the security goes down on a
given trading day, the trader who sold the security collects money from the trader who bought the
security. The money is equal to the security’s change in value.

The value of the security at maturity does not change as a result of these daily price fluctuations.

However, the parties involved in the contract pay losses and collect gains at the end of each trading
day.

Arrange futures contracts using borrowed money via a clearinghouse. At the end of each trading day,

the clearinghouse settles the difference in the value of the contract. They do this by adjusting
the margin posted by the trading counterparties. The margin is also the collateral.

Features of Futures Contracts

The features are:
1. Organised Exchanges
2. Standardisation
3. Clearing House
4. Margins
5. Marking to Market
6. Actual Delivery is Rare.

1. Organised Exchanges:

Unlike forward contracts which are traded in an over-the-counter market, futures are traded on
organised exchanges with a designated physical location where trading takes place. This provides a
ready, liquid market in which futures can be bought and sold at any time like in a stock market.

2. Standardisation:

In the case of forward currency contracts, the amount of commodity to be delivered and the maturity
date are negotiated between the buyer and seller and can be tailor-made to buyer’s requirements. In
a futures contract, both these are standardised by the exchange on which the contract is traded.

Thus, for instance, one futures contract in pound sterling on the International Monetary Market (IMM),
a financial futures exchange in the US, (part of the Chicago Board of Trade or CBT), calls for delivery
of 62,500 British Pounds and contracts are always traded in whole numbers, i.e., you cannot buy or
sell fractional contracts. A three-month sterling deposit on the London International Financial Futures
Exchange (LIFFE) has March, June, September, December delivery cycle.

The exchange also specifies the minimum size of price movement (called the “tick”) and, in some
cases, may also impose a ceiling on the maximum price change within a day. In the case of
commodity futures, the commodity in question is also standardised for quality in addition to quantity in
a single contract.

3. Clearing House:

The exchange acts as a clearing house to all contracts struck on the trading floor. For instance, a
contract is struck between A and B. Upon entering into the records of the exchange, this is
immediately replaced by two contracts, one between A and the clearing house and another between
B and the clearing house.

In other words, the exchange interposes itself in every contract and deal, where it is a buyer to every
seller and a seller to every buyer. The advantage of this is that A and B do not have to undertake any
exercise to investigate each other’s creditworthiness. It also guarantees the financial integrity of the
market.

The exchange enforces delivery for contracts held until maturity and protects itself from default risk by
imposing margin requirements on traders and enforcing this through a system called “marking to
market”.

4. Margins:

Like all exchanges, only members are allowed to trade in futures contracts on the exchange. Others
can use the services of the members as brokers to use this instrument. Thus, an exchange member
can trade on his own account as well as on behalf of a client. A subset of the members is the
“clearing members” or members of the clearing house and non- clearing members must clear all their
transactions through a clearing member.

The exchange requires that a margin must be deposited with the clearing house by a member who
enters into a futures contract. The amount of the margin is generally between 2.5% to 10% of the
value of the contract but can vary. A member acting on behalf of a client, in turn, requires a margin
from the client. The margin can be in the form of cash or securities like treasury bills or bank letters of
credit.

5. Marking to Market:

The exchange uses a system called marking to market where, at the end of each trading session, all
outstanding contracts are reprised at the settlement price of that trading session. This would mean
that some participants would make a loss while others would stand to gain. The exchange adjusts this
by debiting the margin accounts of those members who made a loss and crediting the accounts of
those members who have gained.

This feature of futures trading creates an important difference between forward contracts and futures.
In a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows.

Whereas, in a futures contract, even though the gains and losses are the same, the time profile of the
accruals is different. In other words, the total gains or loss over the entire period is broken up into a
daily series of gains and losses, which clearly has a different present value.

6. Actual Delivery is Rare:

In most forward contracts, the commodity is actually delivered by the seller and is accepted by the
buyer. Forward contracts are entered into for acquiring or disposing off a commodity in the future for a
gain at a price known today.

In contrast to this, in most futures markets, actual delivery takes place in less than one per cent of the
contracts traded. Futures are used as a device to hedge against price risk and as a way of betting
against price movements rather than a means of physical acquisition of the underlying asset. To
achieve this, most of the contracts entered into are nullified by a matching contract in the opposite
direction before maturity of the first.
Q4) What do you understand by hedging? Illustrate with the help of examples how it is used by investors?

Hedging

A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the
prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying
insurance policies.
Hedging employs various techniques but, basically, involves taking equal and opposite positions in
two different markets (such as cash and futures markets). Hedging is used also in protecting one's
capital against effects of inflation through investing in high-yield financial instruments (bonds, notes,
shares), real estate, or precious metals.

Understanding Hedging

Hedging techniques generally involve the use of financial instruments known as derivatives, the two
most common of which are options and futures. Keep in mind that with these instruments, you can
develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Say you own shares of Cory's Tequila Corporation (ticker: CTC). Although you believe in this
company for the long run, you are a little worried about some short-term losses in the tequila industry.
To protect yourself from a fall in CTC, you can buy a put option (a derivative) on the company, which
gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married
put. If your stock price tumbles below the strike price, these losses will be offset by gains in the  put
option.

The other classic hedging example involves a company that depends on a certain commodity. Let's
say Cory's Tequila Corporation is worried about the volatility in the price of agave, the plant used to
make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which
would severely eat into their profits.

To protect (hedge) against the uncertainty of agave prices, CTC can enter into a  futures contract (or
its less-regulated cousin, the forward contract), which allows the company to buy the agave at a
specific price at a set date in the future. Now, CTC can budget without worrying about the fluctuating
commodity.

If the agave skyrockets above the price specified by the futures contract, the hedge will have paid off
because CTC will save money by paying the lower price. However, if the price goes down, CTC is still
obligated to pay the price in the contract and would have been better off not hedging.

Because there are so many different types of options and futures contracts, an investor can hedge
against nearly anything, including a stock, commodity price, interest rate, or currency. Investors can
even hedge against the weather.

What Hedging Means for You

The majority of investors will never trade a derivative contract. In fact, most buy-and-hold investors
ignore short-term fluctuation altogether. For these investors, there is little point in engaging in hedging
because they let their investments grow with the overall market. So why learn about hedging?

Even if you never hedge for your own portfolio, you should understand how it works, because many
big companies and investment funds will hedge in some form. Oil companies, for example, might
hedge against the price of oil, while an international mutual fund might hedge against fluctuations in
foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these
investments.