Derivative: This is a financial product whose value is derived from some underlying asset.

This
underlying asset can be index, stock, commodity, currency, etc.

Index derivatives: Index derivatives are derivative contracts which have the index as the underlying.

Sock derivatives: Stock derivatives are derivative contracts which have the stock as the underlying.

Forward: A forward contract is a customized contract between two parties to buy or sell an asset on a
specified date for a specified price.

Future: A futures contract is a standardized contract between two parties to buy or sell an asset at a
certain time in future at a certain price.

These are basically exchange traded, standardized contracts.

Participants in a Derivative Market

The derivatives market is similar to any other financial market and has following three broad categories
of participants:

Hedgers: These are investors with a present or anticipated exposure to the underlying asset which is
subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets
and portfolios.

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.

Arbitrageurs: They take positions in financial markets to earn riskless profits. The arbitrageurs take short
and long positions in the same or different contracts at the same time to create a position which can
generate a riskless profit.

Distinction between Futures and Forwards

Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customised contract terms
More liquid Less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period
Futures Terminology

Spot price: The price at which an underlying asset trades in the spot market.

Futures price: The price that is agreed upon at the time of the contract for the delivery of an asset at a
specific future date.
Contract cycle: It is the period over which a contract trades. The index futures contracts on the NSE have
one-month, two-month and three-month expiry cycles which expire on the last Thursday of the month.
Thus a January expiration contract expires on the last Thursday of January and a February expiration
contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a
new contract having a three-month expiry is introduced for trading.

Expiry date: is the date on which the final settlement of the contract takes place.

Contract size: The amount of asset that has to be delivered under one contract. This is also called as the
lot size.

Basis: Basis is defined as the futures price minus the spot price. There will be a different basis for each
delivery month for each contract. In a normal market, basis will be positive. This reflects that futures
prices normally exceed spot prices.

Cost of carry: Measures the storage cost plus the interest that is paid to finance the asset less the
income earned on the asset.

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.

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. This is called
marking-to-market.

Maintenance margin: Investors are required to place margins with their trading members before they
are allowed to trade. If the balance in the margin account falls below the maintenance margin, the
investor receives a margin call and is expected to top up the margin account to the initial margin level
before trading commences on the next day.

Calculation of future price-

F = SerT

Where:

r = Cost of financing (using continuously compounded interest rate)

T = Time till expiration in years
e = 2.71828

Applications of Stock Futures

Long security, sell futures

Suppose you are already holding 1500 stock of Reliance. Now you have fear that market may fall then to
reduce the risk we short future of Reliance.

Reliance Future price is 1005/-

Reliance Spot price is 1000/-

Future lot size = 500

We sell Reliance future at 1005/-

Case1:

Now suppose Reliance price goes down and become 950/-

We are going to lose on reliance share-

Reliance Share Loss = (950-1000)*500

= 50*500

= 25000/-

We are going to gain on future-

Reliance future profit = (1005 – 950)*500

= 55*500

= 27500

Net Profit = 27500-25000

= 2500/-

Speculation: Bullish security, buy futures

Reliance Future price is 1005/-

Reliance Spot price is 1000/-

Future lot size = 500

We buy Reliance future at 1005/-

Now suppose when market goes up and price becomes 1050/-

Profit = Selling Price – Buying price

= (1050 – 1005)*500

= 22500/-

Speculation: Bearish security, sell futures

Reliance Future price is 1005/-

Reliance Spot price is 1000/-

Future lot size = 500

We sell Reliance future at 1005/-

Now suppose when market goes down and price becomes 950/-

Profit = Selling Price – Buying price

= (1005 - 950)*500

= 27500/-

Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the
spot price. Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise.

If you notice that futures on a security that you have been observing seem overpriced, how can you cash
in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. Trades at Rs.1000. One-month
ABC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit by
entering into the following set of transactions.

1. On day one, borrow funds, buy the security on the cash/spot market at 1000.

2. Simultaneously, sell the futures on the security at 1025.

3. Take delivery of the security purchased and hold the security for a month.

4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.

5. Say the security closes at Rs.1015. Sell the security.

6. Futures position expires with profit of Rs. 10.

7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position.

8. Return the borrowed funds.

If the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense
for you to arbitrage. In the real world, one has to build in the transactions costs into the arbitrage
strategy.

Arbitrage: Underpriced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It
could be the case that you notice the futures on a security you hold seem underpriced. How can you
cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One-
month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless
profit by entering into the following set of transactions.

1. On day one, sell the security in the cash/spot market at 1000.

2. Make delivery of the security.

3. Simultaneously, buy the futures on the security at 965.

4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.

Say the security closes at Rs.975. Buy back the security.

6. The futures position expires with a profit of Rs.10.

7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.

If the returns you get by investing in riskless instruments is more than the return from the arbitrage
trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and carry arbitrage. It is this
arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. As we
can see, exploiting arbitrage involves trading on the spot market. As more and more players in the
market develop the knowledge and skills to do cash and- carry and reverse cash-and-carry, we will s see
increased volumes and lower spreads in both the cash as well as the derivatives market.