Derivatives

Derivatives
Prescribed Text Books:
• Options, Futures and Other Derivatives by John C. Hull Pearson,
2015.
• An Introduction to Derivatives and Risk Management by Don M.
Chance and Robert Brooks, South-Western, Cengage Learning,
2010.
Other Reference/Suggested Books:
• Options, Futures and Other Derivatives by Hull, J.C. and Basu, S.,
Pearson, 2013.
• Derivatives-Valuation and Risk Management by Dubofsky, D. A.
and Miller, T. W., Oxford University Press, 2015.
• Derivatives and Risk Management Basics by Chance, D. M. and
Brooks, R., South Western Cengage Learning, 2011.
• Financial Derivatives by Robert W. Kolb, R.W. and Overdahl, J.A.,
John Wiley & Sons, 2003.
INTRODUCTION

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 Meaning of Derivative
The term ‘Derivative’ stands for a contract whose
price or value is derived from or is dependent upon an
underlying asset.
Or
A derivative is a financial instrument whose value
depends on (or derives from) the value (price) of basic
underlying variables.

Derivatives generally involve an agreement between

two parties (known as counterparties) to exchange a
standard quantity of an asset or cash flow at a
predetermined price at a specified date in future.
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 Meaning of Derivative (contd…)
The underlying asset could be a financial asset such
as currency, stock and market index, an interest
bearing security (bond, T-bills, notes) or a physical
commodity.
Derivative contracts are even traded on electricity,
weather, temperature, and volatility.
Derivatives derive their names from their respective
underlying asset.
If a derivative’s underlying asset is equity, it is called
equity derivative and so on.

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 Types of Derivative Contracts
• Forwards (OTC)
• Futures (Exchange Traded)
• Options (OTC and Exchange Traded)
• Swaps (OTC)
• Credit Derivatives (OTC)

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 Over-the-Counter (OTC) v/s Regulated Exchange
• Derivatives that trade on an exchange are called exchange traded derivatives,
whereas privately negotiated derivative contracts are called OTC contracts.
• Exchange Traded:
– Contracts are standardized.
– Once two traders have agreed on a trade, it is handled by the exchange
CLEARINGHOUSE and there is virtually no credit risk.
– Traditionally derivatives exchanges have used the open-outcry system, but
exchanges have largely replaced the open outcry system by electronic
trading
• Over-the-Counter (OTC):
– Traditionally, participants in the OTC derivatives markets have contacted
each other directly by phone and email, or have found counterparties for
their trades using an interdealer broker.
– Banks often act as market makers for the more commonly traded
instruments.
– Contracts are non-standardized (customized) and there used to exist small
amount of credit risk.
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 OTC Market: Some New Regulations

– Prior to the credit crisis, which started in 2007 OTC

derivatives markets were largely unregulated. Following
the credit crisis and the failure of Lehman Brothers OTC
derivatives markets saw development of many new
regulations affecting the operation of OTC markets.
– Particularly, introducing Central Counterparties (CCPs)
and Collateralization in OTC Markets.
– The purpose of the regulations is to improve the
transparency of OTC markets, improve market efficiency,
and reduce systemic risk.

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 OTC Market: Central Counterparty (CCP)/Central Clearing
Party (CCP) and Bilateral Trades
– Once an OTC trade has been agreed, the two parties can either
present it to a central counterparty (CCP) or clear the trade
bilaterally.

CCP Trades: A CCP is like an exchange clearing house. It stands

between the two parties to the derivatives transaction (through margin
requirements) so that one party does not have to bear the risk that the
other party will default.

Bilateral Trades: When trades are cleared bilaterally, the two parties
have usually signed an agreement (known as master agreement)
covering all their transactions with each other. This agreement often
includes an annex, referred to as the credit support annex (CSA),
requiring the counterparties to provide collateral (similar to the margin
required by exchange clearing houses or CCPs)

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 OTC Market and Central Counterparty/ Central Clearing
Party (CCP)
Example
If the transaction is a forward contract where A has agreed to
buy an asset from B in one year for a certain price, the clearing
house agrees to:
1. Buy the asset from B in one year for the agreed price;
2. Sell the asset to A in one year for the agreed price.
It takes on the credit risk of both A and B. All members of the
CCP are required to provide initial margin to the CCP.
Transactions are valued daily and there are daily variation
margin payments to or from the member.

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 OTC Markets: Collateralization in OTC Markets
Example:
Consider two companies, A and B. The collateralization
agreement applying to the transactions might involve the
transaction being valued each day. If from one day to the
next, the value of the transaction to company A increases by a
positive amount say X, company B is required to pay X to
company A and vice-versa.
Note: The contract is not settled daily. The payments are a
security deposit designed to ensure that obligations will be
honored.

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(a) The traditional way in which OTC markets have operated: a series of
bilateral agreements between market participants; b) how OTC markets would
operate with a single central counterparty (CCP) acting as a clearing house.

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 Participants in the Derivatives Market
1. Hedgers: Market participants who seek to reduce or
minimize their risk are called hedgers. Hedgers participate in the
derivatives market to lock the prices at which they will be able
to transact in the future..
Hedging in derivatives market can be done through two
positions, viz. SHORT HEDGE and LONG HEDGE:
• Short Hedge: A short hedge involves taking a short position in
the derivatives market. Short hedge position is taken by
someone who already owns or may own the underlying asset
and is BEARISH about the price of the underlying asset in the
market.
• A Short position holder agrees to SELL the underlying asset at
the expiry date by receiving the agreed upon or predetermined
price.
• Long Hedge: A long hedge involves holding a long position in
the derivatives market. This strategy is used by those who will
need to acquire the underlying asset in the future.
• Long hedge position is taken by someone who will need to
acquire/buy the underlying asset in the future and is BULLISH
about the price of the underlying asset in the market.
• A Long position holder agrees to BUY the underlying asset at the
expiry date by paying the agreed upon or predetermined price.

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 EXAMPLE
Strategy: Long Hedge and Short Hedge
Counterparties: A chocolate manufacturer and a Sugar
manufacturer.
Price Risk: Chocolate manufacturer needs sugar in future and
is BULLISH about the prices of sugar. Sugar manufacturer
wants to sell sugar in future and is BEARISH about the prices
of the sugar.
Hedging: To hedge against this price risk, the chocolate
manufacturer can hold a long position in sugar where as the
sugar manufacturer can hold a short position in sugar.
Gain: Long Hedge = Spot Price > Predetermined Price
Gain: Short Hedge = Spot Price < Predetermined Price

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WHY HEDGING?

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 WHY HEDGING?: TO MITIGIATE FINANCIAL RISK
(PRICE RISK and CREDIT RISK)
 Multinational Corporations (MNCs) operate in more than one
country and their operations involve multiple foreign
currencies, interest rates and different levels of prices.
 MNCs lend and borrow foreign currencies at different interest
rates on a short-term and long-term basis.
 MNCs also invest in foreign financial instruments whose cash
flows are denominated in foreign currency.
 MNCs import and export to different countries and their cash
flows are denominated in different foreign currencies.

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 Participants in the Derivatives Market
2. Speculators: Market participants who seek to increase their
risk are called speculators. Speculators generally bet on the
derivatives market based on their perception on the potential
movement of the price of the underlying.
A speculator will take a long position if he is BULLISH about
the market and takes a short position if he is BEARISH about
the market for a given underlying.
 Participants in the Derivatives Market
3. Arbitrageurs: Arbitrageurs attempt to profit from pricing
inefficiencies in the market by making simultaneous trades
that offset each other and capture a risk-free profit.
In derivatives market, an arbitrageur seek to make profit in
case there is price discrepancy between the spot market and
the derivatives markets.

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 Forward Contracts
• A forward contract is an agreement to buy or sell an
asset at a certain time/period/date in the future for a
certain price (the delivery/forward price).
• One of the parties to the contract assumes a long
position and agrees to buy the underlying asset on a
certain specified future date for a certain specified
price.
• The other party assumes a short position and agrees
to sell the asset on the same date for the same price.

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Important Features of Forward
Contracts

• It is traded only in the OTC market.

• Each contract is custom designed, and
hence is unique in terms of contract
size, delivery date and the asset type
and quality.

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 Hedging through Forwards
Suppose that on August 12, 2016, the treasurer of US
Corporation knows that the corporation will pay
£1million in six-months on February 12, 2017 and
believes that the US$ will depreciate at the time of
payment. What should the treasurer of US company do?

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Table 1: Foreign Exchange Quotes for GBP on
Aug 12, 2016 (No. of US$ per GBP)

Bid Offer
Spot 1.5541 1.5545
1-month forward 1.5538 1.5543
3-month forward 1.5533 1.5538
6-month forward 1.5526 1.5532
12-month forward 1.5528 1.5530
 Hedging through Forwards
Using the quotes given in Table by the dealer, the US
Treasurer can agree to BUY £1million six-months
forward at a forward exchange rate of $1.5532/1£.

US CORPORATION
Long Position (£): BUY £1million
from bank @ $1.5532/1£ for (SELL)
$15,53,200 ($1.5532 million) on Feb,
12, 2017.
BANK
Short Position (£): SELL £1million to
US CO @ $1.5532/1£ for (BUY)
$15,53,200 ($1.5532 million) on Feb,
12, 2017.

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 Hedging through Forwards
An Indian Company has ordered machinery from USA. The
price of $5,00,000 is payable after six months. The current
exchange rate is Rs.67.75/1US$. The CEO of the company
anticipates that the Indian rupee will depreciate in the next
six months. To hedge its currency risk the company enters
into a 6-month currency forwards contract a per the quotes
given in Table 2. Calculate the payoff of the company if the
spot rate is (a) Rs.69.95/1US$ and (b) Rs.65.95/1US$ on
delivery date.

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 Table 2: Foreign Exchange Quotes for US$
(No. of rupees per US$)

Bid Offer
Spot 67.72 67.75
1-month forward 67.69 67.71
3-month forward 67.67 67.70
6-month forward 67.91 67.95
12-month forward 67.97 67.99

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 Hedging through Forwards
Using the quotes given in Table, the CEO can lock
in the exchange rate by entering into a six-month
forward contract at a forward exchange rate of
Rs.67.95/$ and forget about any fluctuations in the
exchange rate.
INDIAN CORPORATION BANK
Long Position ($): BUY $5,00,000 from Short Position ($): SELL $5,00,000 to
bank @ Rs.67.95/$ for (SELL) INDIAN CO @ Rs.67.95/$ for (BUY)
Rs.33,975,000 on maturity or delivery Rs.33,975,000 on maturity or delivery
date. date.

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 Payoffs from Forward Contract
Case I: ST = 69.95/$; K= 67.95/$

INDIAN CORPORATION BANK

Long Position ($): ST -K Short Position ($): K-ST
= (69.95-67.95) =(67.95-69.95)
= Rs. 2 (500000) = Rs. -2 (500000)
= Rs.10,000,00 = Rs. -10,000,00

Case II: ST = 65.95/$; K= 67.95/$

INDIAN CORPORATION BANK
Long Position ($): ST -K Short Position ($):K-ST
= (65.95-67.95) =(67.95-65.95)
= Rs. -2 (500000) = Rs. 2 (500000)
= Rs. -10,000,00 = Rs.10,000,00
 Settlement of Contracts:
Physical Settlement and Cash Settlement
Physical Settlement
A forward contract can be settled by the physical
delivery of the underlying asset by a short investor (i.e.
the seller) to the long investor (i.e. the buyer) and the
payment of the agreed forward price by the buyer to the
seller on the agreed settlement date.
Cash Settlement
Cash settlement does not involve actual delivery or
receipt of the security. Each party either pays (receives)
cash equal to the net loss (profit) arising out of their
respective position in the contract.
 Futures Contracts
• Agreement to buy or sell an asset for a certain
price at a certain future time.
• Similar to forward contract.
• Whereas a forward contract is traded on OTC,
a futures contract is traded on an exchange
where the contract terms are standardized by
that exchange.
• The number of futures contracts outstanding at
any one time is called the open interest.

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 Forwards v/s Futures
Forwards
OTC in nature.
Customized contract terms.
Mostly was self-regulatory but swiftly
shifting to regulation.
Some element of counterparty risk or
default risk if CCP is not involved.
Can be delivered on any date as agreed
by the parties.
Futures
Traded on organized exchanges.
Standardized contract terms.
Regulated through the respective
exchanges.
No counterparty risk or default risk.
Available for delivery only on a few
specified dates in year.
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 Forwards v/s Futures
Forwards Futures
More than 90 percent of forward Most of the futures contracts (about
contracts are settled by actual delivery 95% to 99%) are settled without
of the assets. delivery.

The cost of forward contracts is based The cost of futures contracts is based
on bid-ask spread. on brokerage fee which is charged
based on purchase and sale orders.

Forward Contracts are usually quoted Futures Contracts are usually quoted in
in European Terms (Units of local American Terms (US$ per Unit of local
currency per US$) currency)

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A Transaction on the Futures Exchange: Under a Pit Trading System

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 Role: Futures Clearinghouse or Clearing Exchange
• Each futures exchange operates its own independent
clearinghouse or clearing exchange which is an independent
corporation that has a number of members who are known (act)
as clearing firms.
• The clearinghouse acts as an intermediary and guarantor to
ensure that the buyer and the seller of a futures contract does not
suffer as a result of the counterparty defaulting on its obligation.
• One of the main task of the clearinghouse is to keep track of all
the transactions that take place during a day so that it can
calculate the net position of each of its members.
• It guarantees the performance of the parties to each transaction
by collecting some amount known as Clearing Margin.

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 Futures: Closing Out Positions
• The vast majority of futures contracts do not lead to delivery.
The reason is that most traders choose to close out their
positions prior to the delivery period specified in the contract.
Closing out a position means entering into the opposite trade to
the original one.
• For example, the New York trader who bought a September corn
futures contract on June 5 can close out the position by selling
(i.e., shorting) one September corn futures contract on, say, July
20. The Kansas trader who sold (i.e., shorted) a September
contract on June 5 can close out the position by buying one
September contract on, say, August 25.
• In each case, the trader’s total gain or loss is determined by the
change in the futures price between June 5 and the day when the
contract is closed out.

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Mechanism of Reversing Trades

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 SPECIFICATION OF A FUTURES CONTRACT
• When developing a new contract, the exchange must
specify in some detail the exact nature of the
agreement between the two parties.
• In particular, it must specify the asset, the contract
size (exactly how much of the asset will be delivered
under one contract), where delivery can be made,
and when delivery can be made.

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 TYPES OF TRADERS
TRADERS: There are mainly two types of traders executing trades:
• Futures Commission Merchants (FCMs): FCMs follow the
instructions of their clients and charge a commission for doing so.
• Locals: Locals are trading on their own account.
Note: Individuals taking positions, whether locals or the clients of FCMs,
can be categorized as hedgers, speculators, or arbitrageurs.
Speculators can be classified:
Scalpers: Scalpers are watching for very short-term trends and attempt to
profit from small changes in the contract price. They usually hold their
positions for only a few minutes.
Day Traders: Day traders hold their positions for less than one trading
day. They are unwilling to take the risk that adverse news will occur
overnight.
Position Traders: Position traders hold their positions for much longer
periods of time. They hope to make significant profits from major
movements in the markets.
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 TYPES OF ORDERS
1. Market Order: It is a request that a trade be carried out immediately at the
best price available in the market.
2. Limit Order: A limit order specifies a particular price. The order can be
executed only at this price or at one more favourable price to the investor.
For example, if the limit price is $30 for an investor wanting to buy, the
order will be executed only at a price of $30 or less. Similarly, if the limit
price is $30 for an investor wanting to sell, the order will be executed only
at a price of $30 or above.
3. A Stop order or stop-loss order: A stop order or stop-loss order also
specifies a particular price. The order is executed at the best available price
(buy) or a less favourable price (sell). For example, suppose a stop order to
sell at $30 is issued when the market price is $35. It becomes an order to
sell when and if the price falls to $30. The purpose of a stop order is
usually to close out a position if unfavorable price movements take place.
It limits the loss that can be incurred.
4. A Stop–Limit Order: It is a combination of a stop order and a limit order.
Two prices must be specified in a stop–limit order: the stop price and the
limit price.
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 Delivery
The period during which delivery can be made is defined by the exchange and varies
from contract to contract. The decision on when to deliver is made by the party with the
short position, whom we shall refer to as investor A.
Delivery Process: 1. Issuance of Notice of Intention: When investor A decides to
deliver, investor A’s broker issues a notice of intention to deliver to the exchange
clearing house. This notice states how many contracts will be delivered and, in the case
of commodities, also specifies where delivery will be made and what grade will be
delivered.
2. Counterparty with long position chosen: The exchange then chooses a party with a
long position to accept delivery. Suppose that the party on the other side of investor A’s
futures contract when it was entered into was investor B. It is important to realize that
there is no reason to expect that it will be investor B who takes delivery. Investor B may
well have closed out his or her position by trading with investor C, investor C may have
closed out his or her position by trading with investor D, and so on. The usual rule
chosen by the exchange is to pass the notice of intention to deliver on to the party with
the oldest outstanding long position. Parties with long positions must accept delivery
notices. However, if the notices are transferable, long investors have a short period of
time, usually half an hour, to find another party with a long position that is prepared to
take delivery in place of them. In the case of a commodity, taking delivery usually means
accepting a warehouse receipt in return for immediate payment. The party taking delivery
is then responsible for all warehousing costs.
 Delivery
For all contracts, the price paid is usually the most recent settlement price. If
specified by the exchange, this price is adjusted for grade, location of delivery, and
so on. The whole delivery procedure from the issuance of the notice of intention to
deliver to the delivery itself generally takes about two to three days.

Three critical days for a contract: These are the first notice day, the last notice
day, and the last trading day.
The first notice day is the first day on which a notice of intention to make delivery
can be submitted to the exchange.
The last notice day is the last such day.
The last trading day is generally a few days before the last notice day. To avoid the
risk of having to take delivery, an investor with a long position should close out his
or her contracts prior to the first notice day.
48
 Mechanics of Futures Trading
(The Marking-to-Market Practice)
• The futures contract requires certain margins called Margin
Requirements (now called as Performance Bonds by CME).
• Before placing an order to trade futures contracts, an investor must
open an account known as Margin Account with his broker.
• The amount that must be deposited at the time the contract is
entered into is known as the Initial Margin (now called as Initial
Performance Bond by CME) and is usually about 2% of contract
value.
• To ensure that the balance in the margin account never becomes
negative a Maintenance Margin (now called as Maintenance
Performance Bond by CME) which is somewhat lower (about
75% of IPB) than the initial margin is set.

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 Mechanics of Futures Trading
(The Marking-to-Market Practice)
• If the balance in the margin account falls below the maintenance
margin, the investor receives a Margin Call (now called as Performance
Bond Call by CME) and is expected to top up the margin account to the
initial margin level the next day.
• The extra funds deposited is known as Variation Margin.
• At the end of each trading day, the margin account is adjusted to reflect
the investor’s gain or loss (Marking- to-Market or Mark-to-Market).

Note: A forward contract is settled at the end of its life, a futures contract is
settled daily. At the end of each day, the investor’s gain (loss) is added to
(subtracted from) the margin account, bringing the value of the contract
back to zero. A futures contract is in effect closed out and rewritten at a
new price each day.

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 The Clearinghouse and Clearing Margins
Just as an investor is required to maintain a margin account
with a broker, the broker is required to maintain a margin
account with a clearinghouse member (known as clearing
firms) and the clearinghouse member is required to maintain a
margin account with clearinghouse (which is sometimes
referred to as clearing margin).
The margin accounts for clearinghouse members are adjusted
for gains and losses at the end of each trading day in the same
way as are the margin accounts of investors. For clearinghouse
members, there is an original margin but no maintenance.
 The Clearinghouse and Clearing Margins
Every day the account balance for each contract must be
maintained at an amount equal to the original margin times the
number of contracts outstanding.
In determining initial margin, the number of contracts outstanding
is usually calculated on a net basis. This means that short
positions the clearing house member is handling for clients are
offset against long positions.
Suppose, for example, that the clearing house member has two
clients: one with a long position in 20 contracts, the other with a
short position in 15 contracts. The initial margin would be
calculated on the basis of 5 contracts.

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 Example of Futures Trading
(The Marking-to-Market Practice)
1. Consider an investor who contacts his broker on Thursday,
June 5 to buy two December Gold futures contracts on the
CME and closes out on June 26. The current futures price is
$600 per ounce and the contract size is 100 ounces. The broker
requires the investor to deposit $2000 per contract as initial
margin and the maintenance margin is $1500 per contract. The
settlement prices (futures prices) at the close of everyday
trading for June 5 through June 26 are given below:

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Settlement Prices (futures price) at the close of everyday
trading for June 5 through June 26
Day Close Futures Price ($)
5-Jun $600.00
5-Jun $597.00
6-Jun $596.10
9-Jun $598.20
10-Jun $597.10
11-Jun $596.70
12-Jun $595.40
13-Jun $593.30
16-Jun $593.60
17-Jun $591.80
18-Jun $592.70
19-Jun $587.00
20-Jun $587.00
23-Jun $588.10
24-Jun $588.70
25-Jun $591.00
26-Jun $592.30

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The daily cash flows and performance bond calls on Long investor’s account

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 Example of Futures Trading
(The Marking-to-Market Practice)
2. Consider an investor who contacts his or her broker to buy
two December gold futures contracts on the New York
Mercantile Exchange (NYMEX), which is part of the CME
Group. Suppose that the current futures price is $1,450 per
ounce. One contract size is 100 ounces. The initial margin is
$6,000 per contract and the maintenance margin is $4500 per
contract. The contract is entered into on Day 1 at $1,450 and
closed out on Day 16 at $1,426.90. The settlement prices
(futures prices) at the close of everyday trading for day 1
through day 16 are given below:

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Settlement Prices (futures price) at the close of everyday
trading for day 1 through day 16
Day Close Futures Price ($)
1 1,450.00
1 1,441.00
2 1,438.30
3 1,444.60
4 1,441.30
5 1,440.10
6 1,436.20
7 1,429.90
8 1,430.80
9 1,425.40
10 1,428.10
11 1,411.00
12 1,411.00
13 1,414.30
14 1,416.10
15 1,423.00
16 1,426.90

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The daily cash flows and performance bond calls on Long investor’s account

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 Currency Futures
On Tuesday morning, an investor takes a long position in a
Swiss franc currency futures contract containing SFr1,25,000
at a price of $0.75 that matures on Thursday afternoon. The
broker requires a performance bond of $1,890 and a
maintenance performance bond of $1,400. The settlement
prices for Tuesday through Thursday are $0.755, $0.743,
$0.74 respectively.
Calculate the daily cash flows on investor’s account and show
the performance bond calls on investor’s account.

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The daily cash flows and performance bond calls on long investor’s account
(Contract Size= SFr1,25,000, IM=$1,890 & MM=$1,400)
Futures Daily gains Cumulative Margin account Margin
Price (loss) ($) gain balance ($) call ($)
($) (Mark-to- (loss) ($)
Day market)
TUE $0.750 1890
TUE $0.755 625 625 2515
WED $0.743 (1500) (875) 1015 +875
THU $0.740 (375) (1250) 1515 Trade Closes

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 The Daily Cash Flows on long investor’s account:
TIME ACTION CASH FLOWS ON SFr
Futures

TUE Investor buys SFr futures contract NONE

(MORNING) that matures on Thursday @
Futures price =$0.750 $0.750/1SFr

TUE (CLOSE) Futures price rises to $0.755/1SFr (1) Investor Receives

Futures price =$0.755 ($-Depreciated, SFr-Appreciated) 125000Χ(0.755-0.750)
(1) Position mark-to-market =+$625 (profit)

WED (CLOSE) Futures price drops to $0.743/1SFr (1) Investor Pays

Futures price =$0.743 ($-Appreciated, SFr-Depreciated) 125000Χ(0.743-0.755)
(1) Position mark-to-market = -$1500 (loss)

THU (CLOSE) Futures price drops to $0.740/1SFr (1) Investor Pays

Futures price =$0.740 ($-Appreciated, SFr-Depreciated) 125000Χ(0.740-0.743)
(1) Position mark-to-market = -$375 (loss)
(2) Investor takes the delivery of (2) Investor pays
SFr 125000 125000Χ0.740 =$92,500

Net Profit/Loss to the Long Investor = +$625-($1500+$375) = -$1250 Loss

 Currency Futures
On Monday morning, you short one CME yen futures contract
containing ¥12,500,000 at a price of $0.009433. Suppose the
broker requires an initial performance bond of $4,000 and a
maintenance performance bond of $3,400. The settlement
prices for Monday through Thursday are $0.009542,
$0.009581, $0.009375, and $0.009369, respectively. On
Friday, you close out the contract at a price of $0.009394.
Calculate the daily cash flows on your account. Describe any
performance bond calls on your account. What is your cash
balance with your broker as of the close of business on Friday?
Assume that you begin with an initial balance of $4,590 and
that your round-trip commission was $27.

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The daily cash flows and performance bond calls on short investor’s account
(Contract Size= ¥12,500,000 , IM=$4000 & MM=$3400)
Investor begins with an initial balance of $4,590
Futures Daily gains Cumulative Margin account Margin
Price (loss) ($) gain balance ($) call ($)
($) (Mark-to- (loss) ($)
Day market)
MON $0.009433 $4590.00
MON $0.009542 ($1,362.50) ($1,362.50) $3227.50 +$772.50
TUE $0.009581 ($487.50) ($1850.00) $3512.50
WED $0.009375 + $2575.00 $725.00 $6087.50
THU $0.009369 +$75.00 $800.00 $6162.50
FRI $0.009394 −$312.50 487.50 $5850.00 Trade Closes
You pay out
FRI a round-trip $460.50 $5823.00
commission
$-27

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 The Daily Cash Flows on short investor’s account:
TIME
MON (MORNING)
Futures price =$0.009433
MON (CLOSE)
Futures price = $0.009542
TUE (CLOSE)
Futures price = $0.009581
WED (CLOSE)
Futures price = $0.009375
THU (CLOSE)
Futures price = $0.009369
FRI (CLOSE)
Futures price = $0.009394
Investor closes out the contract at a
futures price of $0.009394
ACTION
Investor sells one CME yen futures @
$0.009433/1¥
Futures price rises to $0.009542/1¥
($-Depreciated, ¥-Appreciated)
(1) Position mark-to-market
Futures price rises to $0.009581/1¥
($-Depreciated, ¥-Appreciated)
(1) Position mark-to-market
Futures price drops to $0.009375/1¥
($-Appreciated, ¥-Depreciated)
(1) Position mark-to-market
Futures price drops to $0.009369/1¥
($-Appreciated, ¥-Depreciated)
(1) Position mark-to-market
Futures price rises to $0.009394/1¥
($-Depreciated, ¥-Appreciated)
(1) Position mark-to-market
CASH FLOWS ON
FUTURES CONTRACT
NONE
(1) Investor Pays
12500000X(0.009433 − 0.009542)=
-$1,362.50 (Loss)
(1) Investor Pays
12500000Χ(0.009542 − 0.009581)
= -$487.500 (Loss)
(1) Investor Receives
12500000Χ($0.009581-$0.009375)
= + $2575 (Profit)
(1) Investor Receives
12,500,000 × (0.009375 −
0.009369)= +$75.00 (Profit)
(1) Investor Pays
12500000 × (0.009369 −
0.009394)= −$312.50 (Loss)
You pay out a round-trip
commission= −$27.00
Net gain on the futures contract
$460.50
 Speculation using Futures
Consider a US speculator who in February thinks that the British
pound will strengthen relative to the US dollar over the next 2
months and is prepared to back that hunch to the tune of
£250,000. The current exchange rate in February is $1.5470/1£
and the April futures price is $1.5410/1£.
Two alternate investment opportunities are available:
1. Speculation in the Spot Market: Purchase £250,000 in the
spot market at the spot rate of $1.5470/1£ in the hope that the
sterling can be sold later at a higher price. (The sterling once
purchased would be kept in an interest-bearing account.)
2. Speculation in the Futures Market: Take a long position in
four CME April futures contracts on sterling at a futures price is
$1.5410/1£. (One futures contract is for the purchase of
£62,500).
 Payoff: Speculation using Spot and Futures Contracts
Speculation using spot and futures contracts. One futures
contract is on £62,500. Initial margin on four futures contracts
= $20,000 @ $5000 per contract:

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HEDGING STRATEGIES USING FUTURES

67
 Hedging Strategies using Futures

General Issues: When is a short futures position appropriate?

When is a long futures position appropriate? Which futures
contract should be used? What is the optimal size of the futures
position for reducing risk?

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 Hedging Strategies using Futures

1. Long Hedge and

2. Short Hedge

Long Hedges: The purchase of a futures contract to protect

against the possibility of rise in the price of assets/securities or
commodities that will be bought in the near future.
Short Hedges: The sale of a futures contract to protect against
the possibility of decline/fall in the price of assets/securities or
commodities that will be sold in the near future.
Perfect Hedge: A perfect hedge is one that completely
eliminates the risk involved.

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• Hedging
– Long Hedges: When you need to buy a product (asset) in the future and
are concerned about an increase in price and would like to protect against
a rise in price. E.g, An oil company try to secure oil in the future. An
importer needs to secure home currency to make a foreign payment in
the future. (Importer makes payment in foreign currency and is
concerned about the depreciation of home currency).
– Short Hedges: When you need to sell a product (asset) and are worried
about a decrease in price and would like to protect against a fall in price.
E.g, A farmer would like to fix the future selling price of his crop today.
An exporter would like to fix today the selling price of foreign currency
he expects to receive in the future (Exporter receives payment in foreign
currency and is concerned about the depreciation of foreign currency).
• Speculation
– Go Long if you believe price will rise (Bullish) …
– Go Short if you believe price will fall (Bearish)…
 Summary of Futures Hedging Strategies
Situation Today Risk Appropriate Hedge
Hold Asset/
May Hold Asset Asset Price May Fall Short Hedge (Short (sell) Futures)
Plan/Need to Buy
Asset Asset Price May Rise Long Hedge (Long (buy) Futures)
Closing out positions on Maturity:
1. Short Hedge: Short Hedge means Short Futures and Long Spot
2. Long Hedge: Long Hedge means Long Futures and Short Spot
(Because futures price and spot price are expected to converge on maturity)