FUTURES

The Basics

FUTURES

FUTURES CONTRACT Financial

Derivative.
PRIMARY PURPOSE Hedge against
the risk of adverse price
movements.
Also useful to speculators as a
leveraging instrument.

FUTURES
TWO TYPES OF FUTURES TRADES:

COMMODITY FUTURES Agricultural

(grain, poultry, tea,..), Industrial
(fuel, oil, steel..).
FINANCIAL FUTURES Stock Index,
Interest rate futures, currency
exchange futures.

FUTURES CONTRACT?

A Contract to BUY or SELL a

specific amount of a commodity, at
a specific price, and at a specific
time in the future.
Like a FORWARD Contract.

EXAMPLE
Suppose that commodity XYZ is traded
on the Futures Exchange. Next
settlement date is 3 months from now.

Bobby Singh buys 1 unit of the futures

contract takes a long position.
Shirin Patel sells 1 unit of the futures
contract takes a short position.

FUTURES PRICE

Futures Price today = F0

Futures price is not determined by

Bobby and Shirin, but by the market.

Futures price today is governed by

Spot Price today (S0), and the risk free
rate (r).

FUTURES PRICE

F0 = S0*(1+r)T.

F0 = S0 * erT (continuous time

compounding).

S0 is random, hence F0 is random.

However, S0 and F0 move together.

FT = ST (price conversion at
delivery date).

FUTURES Clearinghouse

Unlike Forward trades, all Futures

trades are associated with a
clearinghouse.
Removes risk of default by either
party.
C.H.
Bobby

Shirin

FUTURES Clearinghouse

Margin requirements for Bobby and

Shirin at C.H.?

Initial Margin Rs. 500 (5-10% of

value).
Maintenance Margin Rs. 400.

Removes need for multiple delivery

prices (a bookkeeping nightmare).

Delivery Date Sept.

EXAMPLE
th
27 .
Date

June 27th, 2015

Futures
Rs. 10,000
Price

June 28th, 2015

Rs. 10,100

June 29th, 2015

Rs. 10,700

June 30th, 2015

Rs. 10,300

Bobbys Account
EXAMPLEContinued
Date
June 27th, 2015

Account
Position
Rs. 500

June 28th, 2015

Rs. 600

June 29th, 2015

Rs. 1200

June 30th, 2015

Rs. 900

Shirins Account?
EXAMPLEContinued
Date
June 27th, 2015

Account
Position
Rs. 500

June 28th, 2015

400

June 29th, 2015

put 700 500

?

June 30th, 2015

LEVERAGING WITH
FUTURES
Bobby closed his account on June 27th
by taking and equal and opposite
position.

What will be his rate of return?

What will be his rate of return without

the futures account?

HEDGING WITH
FUTURESThe asset XYZ in question is SUGAR!
EXAMPLE
Bobby Singh, a sugar mill owner, is ready to

deliver 10 tons of sugar on July 27th, 2015.

Shirin Patel, CFO, Malgudi Tiffin Room (MTR
Sweets) needs a delivery of 10 tons of
sugar on August 27th, 2015.
A Sugar Futures contract is available with
the terms:

Delivery date September 27th, 2015.

1 Ton delivered per contract.

HEDGING WITH
FUTURESOn June 27 , 2015
EXAMPLE
CONTINUED.
S = Rs. 9705.91/ton.
th

F = Rs. 10000/ton.

Bobby wishes to eliminate the risk of a

price decline on July 27th. He places a short
hedge of 10 contracts.
Shirin wishes to eliminate the risk of price
rise on August 27th. She places a long
hedge of 10 contracts.
Assume a risk-free rate of 12% per annum.

HEDGING WITH
FUTURES If the contractual obligations of
EXAMPLE CONTINUED.

Bobby and Shirin matched the

delivery dates of the Futures
contract, what is the price risk?
That is, Bobby and Shirin make and
take deliveries on Sept. 27th, as per
the Futures contract.

HEDGING WITH
FUTURES If on July 27th, 2015,
Bobbys Case.

S = Rs. 9500/ton, and

F = Rs. 9690.95/ton,
What must Bobby do on that day?
What is Bobbys effective price?

HEDGING WITH
FUTURES If on July 27th, 2015,
Bobbys Case.

S = Rs. 9900/ton, and

F = Rs. 10099/ton,
What must Bobby do?
What is Bobbys effective price?

HEDGING WITH
FUTURES If on August 27th, 2015,
Shirins Case.

S = Rs. 9500/ton, and

F = Rs. 9595.47/ton,
What must Shirin do?
What is Shirins effective price?

HEDGING WITH
FUTURES If on August 27th, 2015,
Shirins Case.

S = Rs. 9900/ton, and

F = Rs. 9999.50/ton,
What must Shirin do?
What is Shirins effective price?