Unit Ii FD

NOIDA INSTITUTE OF ENGINEERING & TECHNOLOGY
GREATER NOIDA
MBA
Financial Derivatives and Risk
Management (AMBAFM0413)
Unit-2
By
Dr. Mohd Iftikhar Baig

Assistant professor
Department-MBA
NIET, GREATER NOIDA
Forward Contract
• A forward contract is an agreement between two counterparties - a buyer and seller. The
buyer agrees to buy an underlying asset from the other party (the seller).
• The delivery of the asset occurs at a later time, but the price is determined at the time of
purchase. Key features of forward contracts are:
. Subject: Financial Derivatives & Risk Management (AMBAFM0413) By: Mohd Iftikhar Baig
Forward Contract
• Highly customized - Counterparties can determine and define the terms and features to fit
their specific needs, including when delivery will take place and the exact identity of the
underlying asset.
• All parties are exposed to counterparty default risk - This is the risk that the other party may
not make the required delivery or payment.
Forward Contract
• Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.
Forward Contract
• Underlying assets can be a stocks, bonds, foreign currencies, commodities or some

combination thereof. The underlying asset could even be interest rates.
• They tend to be held to maturity and have little or no market liquidity.
• Any commitment between two parties to trade an underline asset in the future is a forward
contract.
Benefits of Forward Contract
• Forward contracts can be used to hedge or lock-in the price of purchase or sale of the asset
at a future date.
• In case of forward contracts, no initial margin or premium is payable, so these can be used
without any cash outflow.
• All, the forward contracts are bilateral and tailor-made.
• 100% of the price-risk exposer can be hedged.
Shortcomings of Forward Contract
• It requires tying up capital. There are no intermediate cash flows before settlement.
• It is subject to default risk.
• Contracts may be difficult to cancel.
• There may be difficult to find a counter-party.
Daily Quiz
1. An exchange traded futures contracts is an OTC (over the counter) derivate. Some
common features are :
(a) Both are tailored (e.g. non-standardized) instruments.
(b) Both require margin collection by a clearing house.
(d) None of the above.
2. Tick size is:
(a) The maximum daily movement permitted in the price of the contract.
(b) The maximum permitted price movement during the entire life of the contract.
(c) The minimum permitted price movement in two futures contract.
Daily Quiz
3. Each forward contract:

(a) Can be structured as required by the buyer and seller.
(b) Will have the same specifications.
(c) Specifications are decided by the SEBI.
4. Spot price is same as:

(a) Strike price. (b) Exercise price.
(c) Price of the underlying (d) None of the above
Daily Quiz
5. Selling short a stock can be used to donate that the seller:

(a) Does not own the stock he is supposed to deliver.
(b) Has to deliver the stock after a long time.
(c) Owns the stock he is supposed to deliver.
Daily Quiz
6.Define forward contract.
7. Discuss future contract.
8. What is option?
9. Define put option.
10. Discuss call option.
Summary
• We have covered the following topics in this lecture :
• Forward Contract
• Benefits of Forward Contract
• Shortcomings of Forward Contract
Prerequisite and Recap
• Forward Contract
• Benefits of Forward Contract
• Shortcomings of Forward Contract
Topic Mapping with Course Outcomes
Objectives of Topic/Session
• Students will be able to know the following concepts:
• Future Contract
• Features of Future Contract
Objectives of Topic/Session
• Future Contract
• Features of Future Contract
Future Contract
• A futures contract is an agreement to either buy or sell an asset on a publicly-traded

exchange. The asset is a commodity, stock, bond, or currency. The contract specifies when
the seller will deliver the asset. It also sets the price. Some contracts allow a cash settlement
instead of delivery.
Features of Future Contract
There are following features are given below:
1. Organised Exchanges: Unlike forward contracts which are traded in an over-the-counter

market, futures are traded on organised exchanges with a designated physical location
where trading takes place. This provides a ready, liquid market in which futures can be
bought and sold at any time like in a stock market.
2. Standardisation: In the case of forward currency contracts, the amount of commodity to

be delivered and the maturity date are negotiated between the buyer and seller and can be
tailor-made to buyer’s requirements. In a futures contract, both these are standardised by
the exchange on which the contract is traded.
3. Clearing House: The exchange acts as a clearing house to all contracts struck on the
trading floor. For instance, a contract is struck between A and B. Upon entering into the
records of the exchange, this is immediately replaced by two contracts, one between A
and the clearing house and another between B and the clearing house.
.
4 Margins: Like all exchanges, only members are allowed to trade in futures contracts on
the exchange. Others can use the services of the members as brokers to use this
instrument. Thus, an exchange member can trade on his own account as well as on
behalf of a client. A subset of the members is the “clearing members” or members of
the clearing house and non- clearing members must clear all their transactions through
a clearing member.
5. Marking to Market: The exchange uses a system called marking to market where, at the
end of each trading session, all outstanding contracts are reprised at the settlement price
of that trading session. This would mean that some participants would make a loss while
others would stand to gain.
• The exchange adjusts this by debiting the margin accounts of those members who made a
loss and crediting the accounts of those members who have gained.
6. Actual Delivery is Rare: In most forward contracts, the commodity is actually delivered
by the seller and is accepted by the buyer. Forward contracts are entered into for
acquiring or disposing off a commodity in the future for a gain at a price known today.
7. Futures contracts have very low margin.
8. Futures contracts are on exchange so somewhat reduce counter party risk
9. The cost for trading futures are very low compare to currency forwards.
Daily Quiz
1. The area within the exchange where training was conducted through open outcry, is
known as the Pit.
(a) True. (b) False.
(c) None of these. (d) Sometimes called.
2. An investor has an buy position in a scrip. He can make his position nil in the
settlement by selling.
(a) Any security of equal quantity.
(b) The same scrip and same quantity.
(c) Any index scrip of equal quantity.
(d) Any A-group scrip for equal quantity.
Daily Quiz

4. The selection criteria for a scrip to form part of the BSE Sensitive Index is :
(a) The scrip must have been traded every day in the last six month.
(b) The company must be a dividend paying company.
(c) Number of trades in the six month should be greater than a certain number specified by
the index Committee.
Daily Quiz
5. Which is the oldest index in India?

(a) S&P BSE SENSEX. (b) BSE 100.
(c) CNX NIFTY. (d) BSE 200.
6. What is commodity?
7. Define bond.
8. Discuss derivative market.
9. What is BSE?
10. Give full form of NSE.

Summary
• Future Contract
• Function of Future Contract
• Future Contract
• Function of Future Contract
Topic Mapping with Course Outcome
Objectives of topic/Session
• Shortcomings of Future Contract
• Differences Between Forward Contract and Future Contract
• Clearinghouses
• The Function of Clearing houses
• Major Futures Clearing Organizations
• Types of Margin
• Formulate Monetary Policy
Formulate Monetary Policy
• Maintain price stability and ensuring adequate flow of credit in the economy.
• It formulates implements and monitors the monetary policy.
• Instruments: qualitative & quantitative.
Tools of Monetary Policy
1. Interest rate adjustment
• A central bank can influence interest rates by changing the discount rate. The discount rate
(base rate) is an interest rate charged by a central bank to banks for short-term loans.
2. Change reserve requirements
• If monetary authorities increase the required reserve amount, commercial banks find less
money available to lend to their clients and thus, money supply decreases.
3. Open market operations
• The central bank can either purchase or sell securities issued by the government to affect the
money supply.
Shortcoming of Future Contract
• Some brokers may insist clients close positions before delivery
• Trade in lots of present amounts that are inflexible for exact accounting
• Mainly traded on US based exchanges
• Not as flexible for accounting purposes
• Mainly a speculative product
• They trade in large amounts that cannot be partially closed
• You need to be a professional trader to get the full benefits
Difference between forward contract & future contract
Difference between forward contract & future contract
Daily Quiz


(c) Price of the underlying (d) None of the
Daily Quiz

(d) Has to deliver the stock along with interest.

Daily Quiz
5. Derivatives are highly leveraged, which implies that:

(a) One can take a higher position with smaller investment using derivatives.
(b) One can take a lower position with higher investment using derivatives.
(c) One can take a higher position if the underlying assets instead of buying derivatives is
bought.
Daily Quiz
6. Define monetary policy.
7. What is clearinghouse?
8. Define margin.
9. Discuss default risk.
10.Define open market operations.
Summary
Unit II S.No. Topic CO Level

Unit II 1 Pricing of CO2 High
future
2 Currency CO2 High
futures and
Hedging
3 Arbitrage vs CO2 High
Speculation
4 Cost carry CO2 High
model
Objectives of the Topic/Session
Students will be able to know the following concepts:
• Pricing of futures
• Clearinghouses
• The Function of Clearinghouses in Futures Markets
Pricing of futures
The formula for futures pricing is given below:
Futures price = Spot price*(1+rf) – d
Where rf is the risk-free rate and d is the dividend
Here rf is the interest rate that one can earn throughout the year in normal circumstances.
However, traders can adjust it proportionately for one, two or three months depending on the
expiry of the contract. The adjusted formula looks like this:
Future price = Spot price*[1+rf(X/365)-d]
Here X denotes the number of days to expiry.
Link:https://www.youtube.com/watch?v=72tkiQffkDw
Currency futures
Currency futures contracts are a type of futures contract to exchange a currency for another
at a fixed exchange rate on a specific date in the future.
The contracts are standardized and are traded on centralized exchanges.
Currency futures can be used for hedging or speculative purposes.
Due to the high liquidity and ability to leverage the position, speculators will often use
currency futures over currency forwards.
Link: https://www.youtube.com/watch?v=SchyB3QLmeo
Hedging in currency futures
A currency hedge is a strategy used to reduce the risk of loss from fluctuations in currency
exchange rates. This is achieved by investing in financial instruments that protect against
unfavorable movements in a specific currency. It is used to mitigate the risk of currency
fluctuations and protect against potential losses in international transactions.
 Link: https://www.youtube.com/watch?v=SchyB3QLmeo
. Subject: Financial Derivatives & Risk Management (AMBAFM0413) By: Mohd Iftikhar Baig49
Arbitrage vs. Speculation
 Arbitrage and speculation are both investment strategies used in financial markets, but they differ in their
approach and objectives. Arbitrage involves taking advantage of price discrepancies between different markets
or assets to make risk-free profits. Traders engaging in arbitrage buy an asset at a lower price in one market
and simultaneously sell it at a higher price in another market, profiting from the price difference.
 On the other hand, speculation involves taking calculated risks to profit from anticipated price movements.
Speculators aim to predict future market trends and make profitable trades based on their expectations. While
arbitrage seeks to exploit existing price differences, speculation relies on forecasting and analysis to make
profitable trades.
Link: https://www.youtube.com/watch?v=_Fj4b9LWfWM&t=5s
Futures Cost of Carry Model
This model is used to understand how the cost of carrying is calculated in Futures contracts. This model works on two
assumptions:
 The Futures contracts are held till maturity and not squared off before expiry.
 The arbitrage spread between the spot and Futures prices effectively eliminates all pricing flaws. Thus ensuring that
the cost of carrying in futures refers to the difference between the futures and spot price.
 Cost of carrying = Futures price - Spot price
Formula: F =Se[(rf+s-c) x t]
Where,
F: future price of the underlying S: spot price of the underlying
e: natural log base (approximated as 2.718) rf: risk free rate
s: storage cost t: duration till expiry (expresse)
Link: https://www.youtube.com/watch?v=mqvM6KjpSzA
Daily Quiz

(d) Has to deliver the stock along with interest.
2. Forward contract is a good means of avoiding price risk, but it also entails element of
risk because:
(a) Contract is not standardized.
(b) A party may not honor.
(c) The contract value is fixed.
Daily Quiz

4. The bid at the price at which market maker is prepared:

(a) To buy. (b)To sell.
(c) To remain idle. (d)None of the above.
Daily Quiz
(a) Has to deliver the stock after a long time.

(b) Owns the stock he is supposed to deliver.
(c) Does not own the stock he is supposed to deliver.
Daily Quiz
6. Give full form of BSE.
7. Give full form of IEX.
8. Give full form of MSEX.
9.Give full form of NCDEX.
Daily Quiz
6. Give full form of BSE.
7. Give full form of IEX.
8. Give full form of MSEX.
9.Give full form of NCDEX.
Summary
• Clearinghouses
• The Function of Clearinghouses in Futures Markets
• Clearinghouses.
• The Function of Clearinghouses in Futures Markets.
• Major Futures Clearing Organizations.
• Types of Margin
• Futures Market Obligations
Types of Margins
There are three types of margin:
1. Initial Margin
Deposit that a trader must make before trading any futures.
2. Maintenance Margin
When margin reaches a minimum maintenance level, the trader is required to bring the
margin back to its initial level. The maintenance margin is generally about 75% of the
initial margin.
Types of Margins
There are three types of margin:
1. Initial Margin
Deposit that a trader must make before trading any futures.
2. Maintenance Margin
When margin reaches a minimum maintenance level, the trader is required to bring the
margin back to its initial level. The maintenance margin is generally about 75% of the
initial margin.
Types of Margins
3. Variation Margin
Additional margin required to bring an account up to the required
level.
. Subject: Financial
Subject:
Derivatives & Risk Management (AMBAFM0413)
by: By: MohdSlide
Iftikhar
no. Baig
#
Futures Market Obligations(Example)
• Based on Table 1.2, a trader purchases an oat Contract at 171 cents/ bushel at the close of
day 0. The initial margin is $1,400.
• Day 1
Contract closed @ 168 cents/bushel.
Loss: 3 cents/bushel or $150 .
Required maintenance margin: $1,100.
Initial Margin $1,400

(-) Daily Settlement 150
New Margin Balance $1,250
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
• Day 2
Loss: 4 cents/bushel or $200
Margin Balance $1,250
Trader’s margin is below the maintenance margin. Margin call occurs.
Variation Margin needed: $350
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
• Day 2
Loss: 4 cents/bushel or $200
Margin Balance $1,250
Trader’s margin is below the maintenance margin. Margin call occurs.
Variation Margin needed: $350
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
Daily Quiz
1. A forward contract is an agreement to buy a certain asset at a certain future date

for a price to be determined in the future.
(a) True (b) False
(c) Any one of the above. (d) Both of the above.
2. In which underlying asset, the future contract cannot be used as means of securing
the underlying assets.
(a) Foreign currency. (b)Gold.
(c) Stock-index.
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
Daily Quiz

4. Which of the following can be the underlying in a financial future?

(a) Sugar. (b)T-bills
(c) Coffee. (d)All of the above.
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
Daily Quiz
5. Hedgers and speculators strike a balance due to their needs because:

(a) Hedger has to take risk while speculators have to give up risk.
(b) Bothe hedger and speculators have to take risk.
(c) Hedger avoid risk while the speculators takes risk.
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
Daily Quiz
6. Define initial margin.
7.Define maintenance margin.
8. What is variation margin.
9.Give full form of MCX.
10.Discuss stock index.
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
Summary
• Types of Margin
• Futures Market Obligations(Example)
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
• Types of Margin
• Futures Market Obligations(Example)
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
Subject:
by: By: MohdSlide
Iftikhar
no. Baig
#
Objectives of the Topic/Session
• Closing a Futures Position
• Types of Futures Contracts
• Social Function of Futures Markets
• Market Regulators
Closing a Future Positions
• There are 3 ways to close a futures position:
1. Delivery or cash settlement
2. Offset or reversing trade
3. Exchange-for-physicals (EFP) or ex-pit transaction
• Delivery
Most commodity futures contracts are written for completion of the futures contract through
the physical delivery of a particular good.
• Cash settlement
Most financial futures contracts allow completion through cash settlement.
• In cash settlement, traders make payments at the expiration of the contract to settle any
gains or losses, instead of making physical delivery.
• Two traders agree to a simultaneous exchange of a cash commodity and futures contracts
based on that cash commodity. Table 1.5 illustrates a EFP transaction.
Types of Futures Contracts
• In this section, we will examine the following types of futures contracts:
• Physical Commodity
• Foreign Currency
• Interest-Earning Asset
• Index (Stock Index)
• Individual Stocks
Future Contracts: Physical Commodity
• Contracts on physical commodities include:

1. Agricultural contracts
2. Metallurgical contracts
3. Energy contracts
These commodities, excluding electricity, are physically settled and are highly storable.
Trading varies from commodity to commodity.
Future Contracts: Physical Commodity
Daily Quiz
1. Foreign Exchange future markets are………. And the foreign Exchange forward
markets are…….
(a) Informal; formal. (b) Formal; formal.
(c) Informal; informal. (d) organized; unorganized.
2. Which of the following is NOT an example of a forward contract?

(a) An agreement to buy a car in the future at a specified.
(b) An agreement to buy an airplane ticket at a future date for a certain price.
(c) An agreement to buy a refrigerator today at the posted price.
Daily Quiz
3. Which of the following derivatives product can be classified as American and

European?
(a) Forwards. (b)Futures.
(c) Option. (d)Swaps.

Daily Quiz
5. In future contracts, the contract maturity period is defined by:

(a) The Exchange. (b)The RBI.
(c) The parties to the contract.
Daily Quiz
6. Discuss future position.
7.What is cash settlement?
8. Define reversing trade.
9. What is ex-pit transaction?
10. Give full form of EFP.
Summary
Topic Mapping with course outcomes
Objectives Of the Topic/Session
Social Function of Futures Markets
• Futures markets meet the needs of three groups of users:
1. Those who wish to discover information about future prices of commodities
2. Those who wish to speculate
3. Those who wish to hedge
• There are two main social functions of futures markets:
1. Price discovery
2. Hedging
• Speculation is not regarded as a social function by itself, but it may have socially useful by-
products.
Topic Mapping with course outcomes
1. Price discovery
• Futures market information helps people make better estimates of future prices.
• Futures market information helps people with their production or consumption decisions.
• Example: silver Mine
2. Hedging
• Hedging is the prime social rationale for futures trading.
• Hedgers have a pre-existing risk exposure that leads them to use futures transactions
as a substitute for a cash market transaction. By doing so, they are able to reduce or
eliminate their risk.
• Example: wheat Farmer
Futures Markets Levels of Regulation (Market
Regulators)
1. Brokers
2. Exchanges and clearinghouses
3. National Futures Association (NFA), industry self-regulatory body
4. Commodity Futures Trading Commission (CFTC), federal governmental agency
Market Regulators: Brokers
• The Broker is responsible for:
1. Knowing the customer's position and intentions.
2. Ensuring that the customer does not disrupt the market or place the system in
jeopardy.
3. Keeping the customer's trading activity in line with industry regulations and legal
restrictions.
Market Regulators: Exchange & Clearinghouses
• Futures exchanges and clearinghouses formulate and enforce rules to:
1. Prohibit fraud
2. Prohibit dishonorable conduct
3. Prevent defaulting on contract obligations
Market Regulators: National Futures Association
(NFA)
• The NFA seeks to prevent fraudulent and manipulative acts by:
1. Screening and test applicants for registration.
2. Requiring members who handle customer funds to maintain adequate capital.
3. Requiring members to keep accurate trading records.
Market Regulators: Commodity Futures Trading
Commission (CFTC)
• CFTC protects market participants from manipulation, abusive trading practices, and
fraud by enforcing regulatory oversight of:
1. Futures exchanges
2. Futures clearinghouses
3. NFA
Market Regulators: Commodity Futures Trading
Commission (CFTC)
• The heart of the CFTC’s market surveillance is its large-trader electronic reporting
system. This reporting system helps identify potential concentrations of market power
within a market and to enforce speculative position limits.
Daily Quiz
1. An exchange traded futures contracts is an OTC (over the counter) derivate. Some
common features are :
2. Tick size is:
Daily Quiz


100
Daily Quiz


(c) One can take a higher position if the underlying assets instead of buying derivatives
is bought.
101
Weekly Assignment
Q.1 Briefly explain the basic principle underlying the pricing of forward contracts.
Q.2 What is tailing the hedge in the context of minimum-variance hedging? What does
one tail the hedge?
Q.3 Explain the basic principles of cost carry model for pricing of futures.
Q.4 Discuss the importance of convenience yield in pricing commodity futures.
102
MCQ s
1. An exchange traded futures contracts is an OTC (over the counter) derivate.

Some common features are :
2. Tick size is:
103
MCQ s


104
MCQ s


(c) One can take a higher position if the underlying assets instead of buying derivatives
is bought.
105
MCQ s
7. Forward contract is a good means of avoiding price risk, but it also entails element
of risk because:
(a) Contract is not standardized.
(b) A party may not honor.
(c) The contract value is fixed.
8. The bid at the price at which market maker is prepared:

(a) To buy.
(b) To sell.
(c) To remain idle.
106
MCQs
9. A forward contract is an agreement to enter into a contract at a prep-specified

future date:
(a) True.
(b) False.
(c) True only in Europe.
(d) True only in Africa.
10. A forward contract is an agreement to buy a certain asset at a certain future date
for a price to be determined in the future.
(a) True
(b) False
(c) Any one of the above.
(d) Both of the above.
107
MCQs
11. In which underlying asset, the future contract cannot be used as means of securing the
underlying assets.
(a) Foreign currency.
(b) Gold.
(c) Stock-index.
(d) Any of the above.
12. Which of the following can be the underlying in a financial future?

(a) Sugar.
(b) T-bills
(c) Coffee.
(d) All of the above.
108

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NOIDA INSTITUTE OF ENGINEERING & TECHNOLOGY

Dr. Mohd Iftikhar Baig

• Underlying assets can be a stocks, bonds, foreign currencies, commodities or some

• They tend to be held to maturity and have little or no market liquidity.

• All, the forward contracts are bilateral and tailor-made.

• 100% of the price-risk exposer can be hedged.

• It is subject to default risk.

• Contracts may be difficult to cancel.

• There may be difficult to find a counter-party.

3. Each forward contract:

4. Spot price is same as:

5. Selling short a stock can be used to donate that the seller:

6.Define forward contract.

7. Discuss future contract.

9. Define put option.

10. Discuss call option.

• We have covered the following topics in this lecture :

• Benefits of Forward Contract

• Shortcomings of Forward Contract

• Benefits of Forward Contract

• Shortcomings of Forward Contract

• Students will be able to know the following concepts:

• Features of Future Contract

• Students will be able to know the following concepts:

• Features of Future Contract

• A futures contract is an agreement to either buy or sell an asset on a publicly-traded

There are following features are given below:

1. Organised Exchanges: Unlike forward contracts which are traded in an over-the-counter

2. Standardisation: In the case of forward currency contracts, the amount of commodity to

7. Futures contracts have very low margin.

8. Futures contracts are on exchange so somewhat reduce counter party risk

3. Each forward contract:

5. Which is the oldest index in India?

8. Discuss derivative market.

10. Give full form of NSE.

• We have covered the following topics in this lecture :

• Function of Future Contract

• Function of Future Contract

• Students will be able to know the following concepts:

• Shortcomings of Future Contract

• Differences Between Forward Contract and Future Contract

• The Function of Clearing houses

• Major Futures Clearing Organizations

• Students will be able to know the following concepts:

• Formulate Monetary Policy

• Shortcomings of Future Contract

• Differences Between Forward Contract and Future Contract

• It formulates implements and monitors the monetary policy.

• Instruments: qualitative & quantitative.

Tools of Monetary Policy

1. Interest rate adjustment

2. Change reserve requirements

3. Open market operations

• Some brokers may insist clients close positions before delivery

• Mainly traded on US based exchanges

• Not as flexible for accounting purposes

• Mainly a speculative product

• They trade in large amounts that cannot be partially closed

• You need to be a professional trader to get the full benefits

1. Each forward contract:

2. Spot price is same as:

3. Selling short a stock can be used to donate that the seller:

4. Spot price is same as: