UNIT-3

• Spot Market: A spot contract is one where the contract is performed immediately by both
the parties. Normally the payment by the buyer and the delivery of goods by the seller take
place instantly or within a short period of time.
• Forward Contract: A forward contract is an agreement between two parties to buy or sell
an asset at a future date at a price agreed today.
• Futures Contract: A future contract is to buy or sell a stated quantity of a commodity or
financial claim at a specified price at a future specified date. The contact is standardized by
the exchange with reference to quantity, price, date & quotation.
BASIS
• Basis = Futures 5000 – Spot 4950= 50
• = The term BASIS in a futures contract is the difference between the current cash ( Spot)
Price of an underlying asset and the futures price of the same asset

CONVERGENCE
• On Maturity the basis is Zero
• The basis decrease gradually and approaches to zero at expiration

• Basic mechanism of a futures contracts.

• Profit or payoff position in futures (Diagram)

 VALUATION OF LONG AND SHORT FORWARD
CONTRACT
• Both the Parties (Short or Long position ) are bound to bear risk until the expiry of the
contract (unless one defaults).
• The payoff is determined on expiration date.
• Gain position
• Any party can prematurely get out of the contract by entering into another forward
contract.
• Example:
Mr. R the wholesale dealer of sugar wishes to get out of his initial short forward position (of
delivering of 50 kg to Mr. K at Rs25 per kg on 1st July ,2021) before the maturity . Let us say,
on 1st may ,2021 , Mr. R decided to get out of his position and hence enter into forward
contract with Mr. W in which he agrees to buy ( offsetting position , since Mr. R initial
position was to sell).Wants to buy from Mr. W 50 kg of sugar at Rs.24 and this contract
expires on 1st July 2006.
So, what's Mr. R position

• Example:
Mr. Sam the wholesale dealer of sugar wishes to get out of his initial Long forward position
(of buying of 5 lot from Mr. Shallu at Rs240 for 10 kg on 1st July ,2022) before the maturity .
Let us say, on 1st may ,2022 Mr. Sam decided to get out of his position and hence enter into
forward contract with Mr. White in which he agrees to Sell ( offsetting position , since Mr.
Sam initial position was to buy). He wants to Sell to Mr. White 5 lot of sugar at Rs.250 for 10
kg and this contract expires on 1st July 2022. Note 10 kg = 1 lot. So, what's Mr. Sam position
net payoff
MECHANICS OF BUYING AND SELLING IN FUTURES
• Traders- Hedger, Speculators, Spreaders Arbitrageurs

• Participants – Traders, exchange, broker, clearing house

MECHANICS OF BUYING AND SELLING IN FUTURES

• Clearing House: A member of an exchange clearinghouse responsible for the financial
commitments of its customers. All trades of a non-clearing member must be registered and
eventually settled through a clearing member.
• A clearing house is an intermediary between buyers and sellers of financial instruments. It
is an agency or separate corporation of a futures exchange responsible for settling trading
accounts, clearing trades, collecting and maintaining margin money, regulating delivery, and
reporting trading data.
• Clearing house act as guarantee for both the buyer (long) and Seller (short)

• It is a non profit organisation

• It decides the margin
LIST CLEARING CORPORATION OF INDIA

MECHANICS OF BUYING AND SELLING IN FUTURES

• Margin:An amount of money deposited by both buyers and sellers of futures contracts and
by sellers of options contracts to ensure performance of the terms of the contract (the
making or taking delivery of the commodity or the cancellation of the position by a
subsequent offsetting trade). Margin in commodities is not a down payment, as in securities,
but rather a performance bond. See also Initial Margin, Maintenance Margin and Variation
Margin.
• Example: You (sell for 10,000) & me(Buy for 10,000). IM-Rs.1000. Wheat Rs. 10,000.
• 11,000 You SM or VM+1000,
• 12,000 You VM +1000.
• Your 12,000 • Me : I will receive IM1,000 + Profit 2,000.
• Initial Margin : The amount a futures market participant must deposit into a margin
account at the time an order is placed to buy or sell a futures contract.
• Maintenance Margin: A set minimum amount (per outstanding futures contract) that a
customer must maintain in his margin account to retain the futures position
• Variation margin :The variation margin is a variable margin payment made by clearing
members.
• Margin Call:A call from a clearinghouse to a clearing member, or from a broker or firm to a
customer, to bring margin deposits up to a required minimum level.
• Marking to Market: The unique features of futures contracts is that the positions of both
buyers and sellers of the contracts are adjusted every day for the change in the market price
that day. the profits or losses associated with price movements are credited or debited from
an investor’s account even if he or she does not trade.
• Benefit of leverage
MECHANICS OF BUYING AND SELLING IN FUTURES
• Settlement of Futures Contracts: When a futures trader takes a position (long or
short) in a futures contract, he can settle the contract in three different ways.

• Physical Delivery: If the futures trader does not closeout the position before expiry,
and keeps the position open and allows it to expire, then the futures contract will be settled
by physical delivery or cash settlement (discussed below). This will depend on the contract
specifications. In case of the physical delivery, the clearinghouse will select a counterparty
for physical settlement (accept delivery) of the futures contract. Typically the counterpart
selected will be the one with the oldest long position. So, at the expiry of the futures
contract,the short position holder will deliver the underlying asset to the long position
holder

• Cash Settlement: In case of cash settlement (in case the contract has expired), there is
no need for physical delivery of the contract. Instead the contract can be cash-settled. This
can be done only if the contract specifies so. If a contract can be cash settled, the trader
need not closeout the position before expiry, He can just leave the position open. When the
contract expires, his margin account will be marked-to market for P&L on the final day of
the contract. Cash settlement is a preferred option for most traders because of the savings
in transaction costs.

• Closeout/ offsetting position: In this method, the futures trader closes out the
futures contract even before the expiry. If he is long a futures contract, he can take a short
position in the same contract. The long and the short position will be off-set and his margin
account will be marked to marked and adjusted for P&L. Similarly, if he is short a futures
contract, he will take a long position in the same contract to closeout the position.
SPECIFICATIONS OF A FUTURES CONTRACT
• Expiration: Expiration (also known as maturity or expiry date) refers to the last trading day of the
futures contract. After the expiry of a futures contract, final settlement and delivery is made
according to the rules laid down by the exchange in the contract specifications document

• Contract Size: Contract size, or lot size, is the minimum tradable size of a contract. It is often one
unit of the defined contract.

• Initial Margin: Initial margin is the minimum collateral required by the exchange before a trader
is allowed to take a position. Initial margins can be paid in various forms as laid down by the
exchange and varies from commodity to commodity as well as from time to time.

• Price Quotation: Price Quotation is the units in which the traded price of a contract is displayed.
It can be different from the trading size of a contract and is often based on industry practices and
conventions.

• Tick Size: Tick Size is the minimum movement allowed by the exchange in Price Quotation. For
example, the tick size of PMEX 100gms gold futures contract is RS. 1000. SPECIFICATIONS OF A
FUTURES CONTRACT

• Tick Value: refers to the minimum profit or loss that can arise from holding a position of one
contract Tick value depends on the size of the contract and its tick size. (Tick Value = Contract Size x
Tick Size)

• Mark to Market: Mark to market refers to the process by which the exchange calculates and
values all open positions according to pre-defined rules and regulations. All profit and losses are
recognized by pricing them according to accurate market conditions.

• Delivery Date: Delivery date or delivery period refers to the time specified by the exchange
during or by which the seller has to make delivery according to contract specifications and
regulations.

• Daily Settlement: Daily settlement refers to the process whereby the exchange debits and credits
all accounts with daily profits and losses as calculated by the mark-to-market process

PRICING OF FUTURES & FORWARDS CONTRACTS

• Investment Product and Consumption products.

• Investment products: Stocks, Indices etc.

• Consumption products: Metals and agricultural products.

• Investment Product and Consumption products.

• Investment products: Stocks, Indices etc.

• Consumption products: Metals and agricultural products..

• Both the products are priced using cost of carry model, and in such a manner that no arbitrage
opportunities exist.
• Futures contracts can be priced on the basis of arbitrage, i.e., a price or range of prices can be
derived at which investors will not be able to create positions involving the futures contract and the
underlying asset that make riskless profits with no initial investment.

COST OF CARRY (COC) MODEL

• We use arbitrage arguments to arrive at the fair value of futures.

• the forward and the futures market as one and the same for pricing.

• Forwards and futures are priced using COC model, and in such a manner that

arbitrage opportunities exist. • The model is modified based the nature of asset and the cost
involved in it.

• Assumptions of COC model:

▪ Market are perfect i.e., information flow instantaneous and freely available.

▪ The underlying asset are infinitely divisible

▪ Absence of any market restriction like margin, short selling.

THE COST OF CARRY MODEL

• Forward Price = Spot Price + Carry Cost – Carry return

• The fair value of a futures contract can also be expressed as F = S(1 + r)T

• where: r =Percent cost of financing , T =Time till expiration.

• Whenever the futures price moves away from the fair value: ✓ There would be opportunities for
arbitrage ✓ If F < S(1+r)T ✓or F > S(1+r)T ✓ The components of holding cost vary with contracts on
different assets. ✓The holding cost may even be negative:

• In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and
insurance purchased.

• In the case of equity futures, the holding cost is the cost of financing minus the dividends returns.