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Module 2-1
Module 2-1
2. Forwards are widely used in commodities, foreign exchange, equity and interest
rate markets.
3. Let us understand with the help of an example. What is the basic difference
between cash market and forwards? Assume on March 9, 2009 you wanted to
purchase gold from a goldsmith. The market price for gold on March 9, 2009 was
Rs. 15,425 for 10 gram and goldsmith agrees to sell you gold at market price. You
paid him Rs. 18,510 for 12 gram of gold and took gold.
4. This is a cash market transaction at a price (in this case Rs.15, 425) referred to as
Spot Price.
Introduction to forwards
Contracts
1. Now suppose you do not want to buy gold on March 9, 2009, but only after 1
month. Goldsmith quotes you Rs.15, 450 for 10 grams of gold.
2. You agree to the forward price for 12 grams of gold and go away. Here, in this
example, you have bought forward or you are long forward, whereas the
4. After 1 month, you come back to the goldsmith pay him Rs. 18,540 and collect
your 12 grams of gold. This is a forward, where both the parties are obliged to go
through with the contract irrespective of the value of the underlying asset (in
this case gold) at the point of delivery.
Features of Forwards Contracts
1. It is a contract between two parties (Bilateral contract).
2. All terms of the contract like price, quantity and quality of underlying, delivery
terms like place, settlement procedure etc. are fixed on the day of entering
into the contract.
3. Forwards are bilateral over the counter (OTC) transactions where the terms of
the contract, such as price, quantity, quality, time and place are negotiated
between two parties to the contract.
4. Any alteration in the terms of the contract is possible if both parties agree to
it.
➢ Liquidity is nothing but the ability of the market participants to buy or sell the desired quantity
of an underlying asset. As forwards are tailor made contracts i.e. the terms of the contract are
according to the specific requirements of the parties, other market participants may not be
interested in these contracts
• Counterparty risk
➢ Counterparty risk is the risk of an economic loss from the failure of counterparty to fulfill its
contractual obligation.
• Lack of transparency
• Settlement complication
For equity derivatives, carrying cost is the interest paid to finance the purchase less
(minus) dividend earned.
For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A person
wishes to buy the share, but does not have money. In that case he would have to borrow Rs.
100 at the rate of, say, 6% per annum. Suppose that he holds this share for one year and in
that year he expects the company to give 200% dividend on its face value of Rs. 1 i.e.
dividend of Rs. 2. Thus his net cost of carry = Interest paid – dividend received = 6 – 2 = Rs.
4. Therefore, break even futures price for him should be Rs. 104
Forward Contract Pricing (Cost of
Carry – CoC Model)
• Forward / Futures price is based on spot price and the cost of carry for the period
less benefits of ownership.
• Simple interest
= 465.50 * 1.0023
= 466.57
PRICING FORWARD & FUTURE
• There are three possible cases for Future/Forward Pricing
1. For securities providing No income but storage cost (s)
2. For securities providing Known Cash Income (I) and storage cost (s)
3. For securities providing Known Yield (y) and storage cost in percentage
(%)
(Ex. Bonds)
Ft = S0 * e(r –y + s) t
Spot price of Reliance equity share is 2150.90 and Mr.
Shah wants to take long position in Reliance future to
be expired after 13 days. What price should he be ready
to pay, if risk-free interest rate is 7.5%?
Ft = Rs. 2156.70
Spot price of Reliance equity share is 2150.90 and Mr. Shah wants to take
long position in Reliance future to be expired after 13 days. What price should
he be ready to pay, if risk-free interest rate is 7.5%? Also, assume Reliance
will declare dividend of Rs. 12 per share on 8th day from now.
Ft = (S0 - Div) * ert
= (2150.90 – 11.98)*e(0.075*13/365)
= Rs. 2144.70
Time
F = P * ert ➔ P = F/ert = 12/e(0.075*8/365) = Rs. 11.98
Rs. 12
1 2 8
Spot price of Reliance equity share is 2150.90 and Mr.
Shah wants to take long position in Reliance future to
be expired after 13 days. What price should he be ready
to pay, if risk-free interest rate is 7.5%? Also, assume
Reliance will declare dividend of Rs. 12 per share on 8th
day from now. The per day Demat account charges is
Rs. 1.80. If Reliance future is available for Rs. 2170.50,
What should be strategy of Mr. Shah?
F = (So – I + s) * ert
= (2150.90 – 11.98 + 23.4) *e(0.075*13/365)
= Rs. 2168.16
Spot price of Reliance equity share is 2150.90 and Mr. Shah
wants to take long position in Reliance future to be expired
after 13 days. What price should he be ready to pay, if risk-
free interest rate is 7.5%? Also, assume Reliance pays 5.2%
Dividend yield. The per day Demat account charges are
0.025% of the price of the security.
2151.52, 2152.62
•A trader, who buys futures contract, takes a long position and the one, who
sells futures, takes a short position.
• The words buy and sell are figurative only because no money or underlying
asset changes hand, between buyer and seller, when the deal is signed.
Difference between Forward and Future
Specification Forward Future
Standardization No standardization in-terms Future contract are
of quantity, maturity date, standardize for quality,
quality place of delivery, etc quantity, price, maturity date
and place of delivery
Liquidity There is no liquidity or High liquidity with secondary
secondary market for this market in this
Conclusion of Generally forward contracts are Future contracts can be
Contract concluded with delivery of the concluded with either
asset delivery or cash
Margins Forward contracts does not Future contracts requires
require margins margins
Third party No existence Existence
• Spot Price: The price at which an asset trades in the cash market. This is the
underlying value of Nifty on 4th Febuary, 2015 which is 8912.50.
• Futures Price: The price of the futures contract in the futures market. The closing
price of Nifty in futures trading is Rs. 8930. Thus Rs. 8930 is the future price of Nifty,
on a closing basis.
• Contract Cycle: It is a period over which a contract trades. On 4th February, 2015
the maximum number of index futures contracts is of 3 months contract cycle- the
near month (Febuary, 2015), the next month (March, 2015) and the far month (April,
2015)
• Expiration Day: The day on which a derivative contract ceases to exist. It is last
trading day of the contract. The expiry date in the quotes given is February 26, 2015.
It is the last Thursday of the expiry month. If the last Thursday is a trading holiday,
the contracts expire on the previous trading day
Important terminologies of Future Contracts
• Tick Size (Price Step) : It is minimum move allowed in the price quotations.
Exchanges decide the tick sizes on traded contracts as part of contract specification.
Tick size for Nifty futures is 5 paisa. Bid price is the price buyer is willing to pay and
ask price is the price seller is willing to sell.
• Contract Size (Lot size) and contract value: Futures contracts are traded in lots and
to arrive at the contract value we have to multiply the price with contract multiplier
or lot size or contract size. For Ex. Lot size/Contract size for Reliance is 505 and at
price of Rs. 2130, Contract value is (2130 * 505 ) = Rs. 10.67 Lacs
Important terminologies of Future Contracts
• Basis: The difference between the spot price and the futures price is called basis.
• Basis = Sp - Ft
• If the futures price is greater than spot price, basis for the asset is negative. If basis
is negative it is known as “Premium” (Ft > Sp )
Similarly, if the spot price is greater than futures price, basis for the asset is
positive, it is known as “Discount” (Ft < Sp )
CONVERGENCE
Session –
16 & 17
Specifications of Future Contract
Important terminologies of Future Contracts
• Margin Account As exchange guarantees the settlement of all the trades, to protect
itself against default by either counterparty, it charges various margins from
brokers. Brokers in turn charge margins from their customers.
1.Initial Margin
• Initial margin, Mohan has to pay = Price * Lot Size * Margin percentage *
No. of lots = 8739.25 * 25 * 10% * 1 = 21848.12
• Both buyers and sellers pay initial margin, as there is an obligation on both
• The exchange collects these margins (MTM margins) from the loss
making participants and pays to the gainers on day-to-day basis
• Let us understand MTM with the help of the example. Suppose a person
bought a futures contract on February 7, 2015, when Nifty was 8739.25
while Nifty closes at 8759.75 on February 7, 2015
• This means that he benefits due to the 20.50 (8759.75 – 8739.25) points gain
on Nifty futures contract. Thus, his net gain is of Rs. 512.50(20.50 * 25)
• This money will be credited to his account and next day the position will
start from 8759.75
Important terminologies of Future Contracts
Example : Assume Mr. Mohan buys Nifty Future Contract on February 7th at
8739.25. Assuming Initial margin of 10%, and price movement of nifty is given
below. On 11th February, Mr. Mohan sells his contract at Rs. 8756.50.
Open Price / Close Price / Total Margin Account Margin Margin Margin Call
Buy Price Sell Price Profit/Loss (Open) Account Account (>21848.12)
(Plus/Minus) (Close)
Position (Buy), Lot size (2000), No. of lots (2), Opening Price per unit
(5.60), Closing price per unit (5.25)
Loss = 5.25 – 5.60 = 0.35 Per unit
Total MTM = Per unit profit/loss * Lot size * No. of lots
= -0.35 * 2000 * 2 = Rs. -1400
Loss = Per unit * Lot size * N
Few Examples = (11230.30-11289.90) * 75 * 4
= - 59.60 * 75 * 4
• Rekha Menon believes the market to crash = Rs. - 17880
and short 4 lot of Nifty at 11450.50 on 5th
August, 2020. Calculate her MTM, Total P/L
and Initial Margin, if each lot of nifty is of
75 and NSE charge 8.5% initial margin. Initial Margin = Open * L * N * M
= 11450.50 * 75 * 4 * 8.5 / 100
= Rs. 291987.75
• Open interest is the number of new contracts opened. The contracts that offset
initial position do not add to the open interest but they do add to the volume.
Open interest and volume (calculation)
Date Total Open Open Volume
Transaction / Trading (If lot size is 500 shares) Interest Interest
Change
12th Feb
14th Feb
15000 0 5000
+ 10 lots - 10 lots
150000
100000
50000
0
2000 2100 2200 2300 2400 2500
-50000
-100000
Short Chart
400000
300000
200000
100000
0
680 730 780 830 880 930 980 1030 1080 1130 1180
-100000
-200000
-300000
Chart Title
400000
300000
200000
100000
0
680 730 780 830 880 930 980 1030 1080 1130 1180
-100000
-200000
-300000
-400000
Series1 Series2
Hedging
•A party faces a loss when the price of some asset changes—they
want to reduce this loss by trading futures contracts
Since he needs to buy rice at a future time, he will enter into a long hedge
in rice futures for a total value of 50 MT today (on 3rd March, 2015) @
Rs. 50,000 per MTSurety of Payment
Even if the price of Rice on July 31, 2015 is Rs. 65,000/MT or Rs.
45,000/MT, he will require to pay for Rice @ Rs. 50,000/ MT only.
Since he must sell steel at a future time, he will enter into a short
hedge for a total Surety
value of 30of
MTReceipt
@ INR 45,000 / MT.
Even if the steel ingot price on March 31, 2015 will be INR
35,000/MT or INR 47,000/MT, he will need to provide 30 MT of steel
at Rs. 45,000/MT only and will receive INR 13,500,000 on March 31,
2015
Hedging : Example III
• On Jan 1, 2015, TRUST India - An importer of App Mobile buys App - 3 from
the USA for USD 1 million, on credit and to be paid on March 31, 2015
• Even if the futures price is USDINR 65.3000 or 59.4500, TRUST India needs
to pay INR 61.2450 million to receive USD 1 million from Indian Bank and
pay the same to App Mobile
Hedging : Example IV
Surety of Receipt
• Since he needs to sell EUR on March 31, 2015 (once received from
Germany), Co. would enter into a short hedge (Sell future) on EURO
futures @ 70.3000 on March 1, 2015.
The price that will be either paid or received will be the same as the
futures price contracted, irrespective of the price movement of the
underlying asset
Hedge Ratio
Size of exposure
Hedge ratio =
Size of position in futures
s
Optimal hedge ratio : h* = *
f
2*F2
Hedging effectiveness : h * 2
s
Example of Using Hedge Ratio
A company requires 20 tonnes of wheat on 31st March. On March