CHAPTER 2

Derivatives and Risk Management

By Rajiv Srivastava
(c) Oxford University Press, 2014. All rights reserved.
  In most cases we acquire assets and pay for it
simultaneously. The price of the asset and the
settlement (exchange of asset and its consideration)
are done at the same point of time.
 Forward contract is an agreement to buy or sell an
asset at a price determined now but is settled later at a
predetermined date.
 Forward contract enables elimination of price risk
faced by both buyer and seller of asset.

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  Forward contract is an OTC product tailored to meet
specific needs of counterparties. Features are:
 Price is determined now for settlement at future date
 Mutual obligations on both counterparties to perform
 Counterparty risk is assumed by both
 Cancellation can be done only by mutual consent
 No front-end payment
 No interim cash flows
 Cash flows only on settlement date

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  By delivery of asset and paying the consideration:
If an exporter sold € 10,000 to a bank 6-m forward at Rs 66
then at maturity, the contract is settled by delivery of €
10,000 by exporter and bank would pay Rs 6,60,000;

 By entering into an offsetting contract opposite to the

original at maturity or prior, at a price prevailing then:
For example the exporter having sold 6-m forward €
10,000 at Rs 66.00 may after 3 months, decide to buy 3-m
forward € 10,000 at Rs 67.00 per € and settle the
difference of Rs 10,000.
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  Forward contracts are subject to high default risk as
the price scenario at maturity can favour only one
party and not both.
 Futures are similar to a forward contract but are
exchange traded.
 Futures being exchange traded do not have any such
risk because exchange guarantees settlement.
Exchange serves as counterparty to both buyer and
seller.

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  For trading at the exchange the contract needs to be
standardized.
 Standardization of the futures contract is done for
 Size of the contract,
 Delivery of the contract obligations,
 Quotation and tick size,
 Specification of the underlying asset,
 Futures is a standardized forward contract that is
traded on an exchange.

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 Futures Contract on Gold at National Multi-Commodity Exchange of
Asset Code GOLD
Unit of Trading 100 gms of Fineness .999
Delivery Unit Gold Bars of 100 grams serially numbered and of fineness .999
Quotation/Base Value 10 grams of fineness .999
Tick Size Re.1
Quality Specification The Gold delivered under the contract must be Gold Bars weighing 100 grams
each and assaying not less than .999 fineness bearing a serial number and
identifying origin of the refiner/brander.
No. of delivery Contracts in a year Maximum 12 monthly or minimum 2 monthly contracts running concurrently
Delivery Centres CWC, Cochin
Opening of Contracts Trading in any contract month will open on the 16th day of the month, 12 months
prior to the contract month
Due Date 15th day of the delivery months if 15th happens to be holiday then previous
working day.
Closing of Contract Squaring up of positions will be permitted between 12th and 15th of delivery
month. No fresh positions building will be allowed. From 12th to 15th of delivery
month, seller can tender Warehouse Receipt for settlement and Warehouse
Receipt will be accepted for settlement at closing price of the previous day.
Delivery Logic Compulsory Delivery

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 Features Futures Forwards
Location Exchange Over the Counter
Counterparty Unknown to each other, Counter parties are known to
Exchange serves as counter parties each other
Counterparty risk Minimal Exists
Initial Cash flow Initial and Variation margins required None
Explicit cost Brokerage required to be paid No intermediary and no cost
Settlement Implicitly daily by marking to the market No marking to the market
Final settlement By delivery or cash settled By delivery
Exit prior to maturity Possible by entering an opposite Generally not possible unless
contract to square up the position both the parties agree.
Quantity specification Fixed standard size/lot Any quantity
Time of Delivery On fixed dates Any time mutually decided by
the parties concerned
Cost of hedging Very nominal High
Period of hedging Contracts available for limited period Unlimited
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  Major advantages of the futures as against the forward
contract are
 Elimination of counterparty risk,
 Flexibility of entry and exit at anytime, and
 Possibility of cash settlement.
 Position in futures is mostly settled not by delivery but by
entering into a contract, at maturity or prior, opposite to
the initial one. The difference in the prices of the initial and
subsequent contracts is settled. Alternatively one may also
opt for settlement by delivery.
(c) Oxford University Press, 2014. All rights reserved.
  Open interest and volumes are often thought to be
same. However they are different.
 Open interest is the number of futures contracts outstanding. It
has to be zero on opening and upon maturity of the contract.
 Volume refers to the number of contracts traded in a day.

 Open interest is the number of contracts not settled.

 The contract that offsets initial position does not add to the
open interest but they do add to the volume.

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  From cash flow perspective, there are 2 differences in
futures and forward contracts:
1. Initial and Variation Margins
2. Marking-to-market (MTM)
 To cover the default risk the exchange requires initial margin
when futures position is opened.
 The position is also marked-to-market (MTM) on daily basis; i.e.
profit/loss settled on daily basis.
 The margin cannot fall below a minimum level due to MTM
and if it does, then margin call is made to replenish margin at
the original level.

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 Day Price (Rs) Cash Flow (Rs) Remarks
Day 1 410 None on MTM A long position opened for one
Opening a But Initial Margin paid contract (400 shares) valued at Rs
contract 1,64,000
Close 420 (420 - 410) x 400 Investor receives Rs 4,000
Day 1 = + 4,000
Close 400 (400 – 420) x 400 Investor pays Rs 8,000
Day 2 = - 8,000
Close 390 (390 – 400) x 400 Investor pays Rs 4,000
Day 3 = - 4,000
Day 4 440 (440 – 390) x 400 Position closed out with contract
Closing the = + 20,000 value of Rs 1,76,000.
contract Investor gets Rs 20,000

Net Profit (440 – 410) x 400 It remains the difference of opening

= 12,000 and close prices.

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  From pricing perspective forward and futures follow
the same principle.
 Futures price is based on spot price and the cost of
carry for the period less benefits of ownership.
F1 = S0 x (1+r)
F1 = S0 x ert for continuous compounding
Where F1 is forward/futures price with contract expiring at
t = 1, S0 is spot price at t = 0 and r is the cost of carry for
the period 0 to1.

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  Cost of carry model eliminates arbitrage. If futures is
mispriced it offers arbitrage one way or the other.
Cash and Carry Arbitrage: When futures is overpriced:
 Spot price of 10 gms gold at Rs 27,000
 Risk free rate of 10% per annum
 Fair price of 1-year futures contract is 29,700 (spot + Cost of Carry)
 Futures contract for period of 1 year is trading at Rs 30,000 (overpriced)
 Arbitrageur can take following actions at t = 0:
 Borrow Rs 27,000,
 Buy gold spot, and
 Sell futures contract at Rs 30,000.

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  At the end of futures contract
Realize cash from futures contract + Rs 30,000
Pay back the borrowed money
and interest thereon - Rs 29,700
Profit Rs 300

 Since futures was overpriced by Rs 300 the arbitrageur

can pocket this profit by selling the futures first and
buying gold by borrowing.

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 When futures is underpriced at Rs 27,300 the
arbitrageur can take following actions:
 Borrows gold
 Sells gold at Rs 27,000 and lends at 10% and
 Buys a forward contract at Rs 27,300.

 One year later:

 Realize cash from lending activity + Rs 27,900
 Pay for the forward contract & return

borrowed gold - Rs 27,300

Profit Rs 600

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  For investment assets both types of arbitrages - cash
and carry and reverse cash and carry are possible.
 Consumption value associated with commodities tests
the arbitrage argument.
 For consumption assets while strategy of cash and
carry can be implemented, the reverse cash and
carry arbitrage may not be feasible because
 One cannot sell a commodity required for consumption
purposes, and buy futures contract instead.
 For example a refinery cannot go without oil and buy futures
contract instead.

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  If F1 is the forward price and S0 is the spot price and T is
the maturity then at inception, value of the forward
contract, f = S0 – F1 . e-rT = 0
 Once entered forward contract would have some
value at any time t.
For initial long position Cash flow at t
Under initial long contract; pay - F1 at T
Under subsequent short contract; receive + F2 at t
Net cash flow at T F2 – F1
Value of the forward contract at t, f = (F2 – F1) . e-r(T – t)
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  The current price of Bharti’s share is Rs 800. An investor, A goes
long with the 6 months contract at Rs 900. After one month
another investor, B is prepared to buy Bharti’s share at Rs 925 for
delivery after 5 months. If the risk free interest rate is 9% per
annum what is the value of the forward contract?
Solution
 As of now 5 months are left for the expiry with payment of Rs 900
to get the delivery of share. If A goes short he would receive Rs
925. Therefore the value of the forward contract, f is PV of the
difference of current price and original contract price
= (925 – 900) x e-0.09 x 5/12 = Rs 24.08

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  The difference of futures price and spot price is called basis. As
time progresses basis declines and becomes zero on the day of
maturity i.e. spot and futures prices must converge.
Convergence of Spot and Futures Price
Price
Futures
Net cost of carry Maturity

Spot

Time

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  The prices of futures and forward are identical in
perfect markets.
 Futures price would be marginally different from
forward price depending upon the correlation of price
with interest rates.
Correlation of Spot & Interest Relationship of Price
 Positive Correlation Futures Price > Forward Price
 Negative Correlation Futures Price < Forward Price
 No Correlation Futures Price = Forward Price

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  Normal backwardation hypothesis states that the
current future price is a downward biased indicator of
the future spot price.
 When futures price is more than the expected future
spot price it is referred as contango.
 Expected hypothesis assumes that the futures price is
an unbiased indicator of the expected spot price.

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  Futures are broadly of two types;
 Commodity futures, and
 Financial futures
 Commodity futures are those where the underlying
asset is a commodity.
 Contracts are available in India on agricultural commodities
like Wheat, Rice, Soya, Coffee, Sugar, Tea, Jeera, Pepper,
Edible oils, Cotton, Coconut, etc.
 Contracts on metals Gold, Silver, are also available.
 Futures contracts on Crude oil are also commodity futures.
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  Financial futures are those where underlying asset is a
financial product. These are:
 Currency Futures: where the underlying assets are currencies.
 Stocks/Index futures: where the underlying are stocks or
indices. Stock futures were introduced in India on June 12, 2000
for Indices and on November 9, 2001 on select individual
securities, at NSE.
 Interest Rate futures: where underlying assets are interest rates.
In India interest rate futures were launched on June 24, 2003 at
NSE.

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