3A.

Forwards and Futures

1. Introduction to Derivatives
The Nature of Derivatives
• A derivative is a financial instrument whose value depends on
the value of an underlying variable.
• Interest rate or foreign exchange rate
• Index value such as a stock index value (NIFTY, SENSEX)
• Commodity price
• Common stock
• Other - weather, energy, insurance etc.

• Examples:
• A stock option’s value depends upon the value of a stock on
which the option is written.
• A gold futures contract’s value depends on gold’s spot price
(price for buying “now”)
The Nature of Derivatives..
• Thus, the value of a derivative is ‘derived’ from another
variable.
• The term "derivative" indicates that it has no independent
value, i.e. its value is entirely "derived" from the value of the
cash asset.
• Derivatives hedge the risk of owning things that are
subject to unexpected price fluctuations, e.g. foreign
currencies, crude oil, stocks and government bonds.
• A derivative contract or product, or simply "derivative", is
to be sharply distinguished from the underlying cash
asset, i.e. the asset bought/sold in the cash market on
normal delivery terms.
The Four Basic Derivatives
Forward
Contracts
Futures
Contracts
Call Option
Derivatives Options
Put Option

Interest
Rate Swap
Swaps
Currency
Swap
The Four Basic Derivatives
Forward
Contracts
Futures
Contracts Interest
Rate Swap
Derivatives Swaps
Currency
Swap

Call Option
Options
Put Option
 FORWARDS:
Agree on price now, trade later.
January July

I’ll buy your Thanks for Thanks for

You’ve got the Rs.35,00,000.
house in July a deal. the house.
For Rs.35,00,000.

Nothing is exchanged now. Trade occurs in the future.

 Payoffs From Forward/Futures Contracts
Payoff
LONG POSITION

K
0
Asset price at maturity

K: Delivery price
 Payoffs From Forward/Futures Contracts
Payoff
SHORT POSITION

K
0
Asset price at maturity

K: Delivery price
OPTIONS
• An Option is the right but not the obligation of the holder, to buy or
sell underlying asset by a certain date at a certain price.
• There are two types Options:
• A call option is a contract that gives the owner the right, but not obligation to
buy the underlying asset by a specified date at a specified price.
• A put option is a contract that gives the owner the right, but not obligation to
sell the underlying asset by a specified date at a specified price.
 CALLS: Agree on price now; if
option buyer wants, he buys asset later.
January July
If you pay ­Housing Prices Rise
I’ll buy your house in me
July for Rs.35,00,000, Rs.500,000 Thanks for
if I want to then. Thanks for
extra now, it’s the house. the Rs.35,00,000.
a deal.

¯ Housing Prices Fall

That’s OK. But

I’ve decided
I get to keep
not to buy.
the Rs.500,000.
 Net Results: “Zero-Sum Game”

¯ Housing Prices Fall

­Housing Prices Rise
to Rs.41,00,000 I’m glad I sold the
Too bad I bought
I’m glad I bought the call; I got paid for
that call; it didn’t
call because now I can Too bad I sold pay to exercise it. it and still kept
buy a Rs. 41,00,000 my house.
that call; I
house for only Rs. had to sell
35,00,000. my
house cheaply.

Rs- 41,00,000
Rs.41,00,000
35,00,000 Rs – 5,00,000 Rs. 5,00,000
- 35,00,000
5,00,000
- 5,00,000
Rs. – 1,00,000
Rs, 1,00,000
 PUTS: Agree on price now; if option
buyer wants, she sells asset later.
January July
I’ll sell you my house If you pay me ­Housing Prices Rise
in July for Rs.500,000 extra
Rs. 35,00,000 now, it’s a deal.
if I want to then. That’s OK. But
I’ve decided
I get to keep
not to sell.
the Rs.500,000.

¯ Housing Prices Fall

Thanks for Thanks for
the Rs.35,00,000. the house.
OPTIONS BUYERS & SELLERS

Buyers Sellers=Writers
Pay Premium
CALL PUT PUT CALL
Buy Sell Buy Sell
 SWAPS: Exchange assets now; return
them later; in meantime, pay differential rent.

January July
I’ll use your I’ll use your Here’s your house Thanks for returning
house until July boat until July back; thanks for my house; here’s
For Rs.4,000/mo. For Rs.3,000/mo. returning my boat. your boat back.

(Rs.4,000 – Rs.3,000)/mo = Rs.1,000/mo

2.Forwards and Futures
Forward Contract
• A forward is an agreement between a buyer (“long”) and a seller
(“short”) to trade
• a specified quantity of an asset
• at a specified price (forward/delivery price)
• at a specified time (maturity/delivery date) and place.
• For example, a foreign exchange forward contract requires party A to
buy (and party B to sell) 1 million Euros for U.S. dollars at $0.9275 per
euro say, a year from now.
Main features of forward contracts
• They are bilateral contracts and hence exposed to
counter-party risk.
• Each contract is custom designed, and hence is unique in
terms of contract size, expiration date and the asset type
and quality.
• The contract price is generally not available in public
domain.
• The contract has to be settled by delivery of the asset on
expiration date.
• In case, the party wishes to reverse the contract, it has to
compulsorily go to the same counter party, which being
in a monopoly situation can command the price it wants.
Futures Contract
• Futures were designed to solve the problems that existed in the
forward markets
• Counter Party risk
• Liquidity
• Futures contracts are standardized forward contracts that are traded
on an exchange
Futures Contract
• Forwards and futures are similar: they can be stated as “contract
now, transact later.”
• But unlike forwards, futures are
• standardized
• regulated
• exchange-traded
• settled through a clearing house
• post daily gains and losses (daily settlement).
Futures…
• They are liquid and transparent. Their market prices and trading
volumes are regularly reported.
• The futures trading system has effective safeguards against defaults in
the form of Clearing Corporation guarantees for trades and the daily
cash adjustment (mark-to-market) to the accounts of trading
members based on daily price change.
Clearing House Function

Clearing House

buys sells
sells buys

Ms. Long Mr. Short

 Futures …….exchange traded forwards

1. Exchange Traded (transparency)

2. Standardized contracts (reduce complexity)

3. Settlement Guarantee (Clearing Corporation)

4. Marked to Market settlement everyday (reduce risk

of final settlement)
Forward contract
Seller Buyer

Futures Contract

Seller Exchange Buyer

Initial Margins Daily Mark to Market Settlement Guarantee

Settlement
Margin and Settlement
• Settlement price (Price established at the end of
each trading day ) is used to mark-to-market a futures
contract.
• Margin account is opened to trade futures.
• Initial margin Amount that is deposited at the time of
contract
• is needed as a security deposit to open a futures position.
• Maintenance margin: To ensure that the balance never
becomes negative ( if balance falls below this level margin
call – investor required to top up the margin account to the
initial margin level)
Marked to Market
• Margin account is daily adjusted with losses/gains.
• Marked to market- adjusting each margin account by changes in
the settlement price each day
• If balance falls below maintenance margin, it must be
topped up.
• As soon as a futures contract is purchased or sold at
the stock exchange the daily marked to market
settlement commences.
• It is to take care of the losses owing to daily price
fluctuations in the futures contract.
Settlement Price
• During the day trades take place in Futures contracts
at different prices from 9:00 am to 3:30 pm.

• All these trades are settled at the end of the day at a

single price (closing price of the futures contract*)

• This price is also called as the Daily Settlement Price.

* Closing Price of Futures contract = last half an hour’s

weighted average price
Settlement Price

Last ½ hours (3:00 to 3:30) weighted average price

(1000 X Rs.100) + (2000 X Rs.101) + (3000 X Rs. 102)

6000

= Rs. 101.35 (Closing Price)

Example of a Futures Trade
• An investor takes a long position in two August
futures contracts on security XYZ on June 5
• contract size is 100 shares.
• futures price is Rs 400/share
• margin requirement is Rs 2,000/contract (Rs. 4,000 in total)
• maintenance margin is Rs. 1,500/contract (Rs. 3,000 in total)
Example of a Futures Trade
• Total margin requirement
= 2 x 2000 = Rs. 4000
• Maintenance margin requirement
= 2 x 1500 = Rs. 3000
Suppose the price goes down to Rs. 397 the next day
Loss = (397-400) x 2 x 100 = (600)
Day Futures Daily Cumulati Margin Margin
price gains ve gains account call
(Rs.) (Rs.) balance
Rs.
400.00 4000
5-Jun 397.00 (600) (600) 3400
6-Jun 396.10 (180) (780) 3220
9-Jun 398.20 420 (360) 3640
10-Jun 397.10 (220) (580) 3420
11-Jun 396.70 (80) (660) 3340
12-Jun 395.40 (260) (920) 3080
13-Jun 393.30 (420) (1340) 2660 1340
16-Jun 393.60 60 (1280) 4060
17-Jun 391.80 (360) (1640) 3700
18-Jun 392.70 180 (1460) 3880
19-Jun 387.00 (1140) (2600) 2740 1260
20-Jun 387.00 0 (2600) 4000
23-Jun 388.10 220 (2380) 4220
24-Jun 388.70 120 (2260) 4340
25-Jun 391.00 460 (1800) 4800
26-Jun 392.30 260 (1540) 5060
 Futures terminology
• Spot price : Price at which asset trades in the spot market

• Futures price : Price at which Futures contracts trade in the futures

market

• Delivery price : Price at which futures contract has been entered into
in the futures market

• Contract cycle : The period over which a contract trades

• Expiry Date : Last date of the contract

• Contract size : Amount or value of each contract

Convergence of Prices
Prices

Futures Price

Spot Price

Time
Determination of
Forward and Futures
Prices
Continuous Compounding

• In the limit as we compound more and more frequently we obtain

continuously compounded interest rates
• 100 grows to 100eRT when invested at a continuously compounded
rate R for time T
• 100 received at time T discounts to 100e-RT at time zero when the
continuously compounded discount rate is R
Short Selling
• Short selling involves selling securities you do not
own
• Your broker borrows the securities from another
client and sells them in the market in the usual way
• At some stage you must buy the securities back so
they can be replaced in the account of the client
• You must pay dividends and other benefits the
owner of the securities receives
Notation

S0: Spot price today

F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T
Cost of Carry Model
• Basic relationships
• Future price must equal spot price plus cost of carry
• Distant future price must equal nearby future price plus cost of carry
• Concept of full carry
• Forward price = Spot + Carry Cost
• If these basic relationship do not hold true, arbitrage opportunities
arise
• Assumes perfect markets
• By arbitrage arguments, the forward price for an
asset which provides no income is
F0 = S0erT

If the forward price is higher than this, buy the

asset now, short the forward contract, and deliver
the asset then.
If the forward price is less than this, short the
asset, go long on the forward contract, and return
the asset after taking delivery.
 Gold Example
For gold
(assuming no storage costs)
r is compounded continuously F0 = S0erT
• Spot Gold = $2035/oz
• Interest Rate= 10% per annum
• T= 6 months = 0.50 years
Therefore F0 = 2035 e0.1x 0.5 = $2139.34
Arbitrage

• Spot Gold $2035

• Futures Price (6 months) $2150
• Interest Rate =10% per annum
• At t = 0
• Borrow $2035 for 6 months @ 10% -$2035
• Buy 1 oz of gold $2035
• Short 1 futures contract $0
• At t = 6 months
• Deliver Gold $2150
• Repay Loan $2139.34
• Profit $ 10.66
 Arbitrage

• Spot Gold = $2035

• Futures Price (6 months)= $2100
• Interest Rate= 10% per annum
• At t = 0
• Short Sell 1 oz of gold $2035
• invest the proceeds for 6 months @ 10% -$2035
• Go long / Buy 1 futures contract $0
• At t = 6 months
Receive principal and interest $2139.34
Buy Gold and reverse the short sale $2100
• Profit $ 39.34
 Forwards’ Prices
Extension of the Gold Example

Consider a forward contract on a security that provides the

holder with no income (no dividends, etc). Examples are non-
dividend paying stocks.

We can use the no arbitrage argument to obtain the following

forward price:

F0 = S0erT
 Forwards’ Prices
Example: Consider a forward contract on a non-dividend paying
stock that matures in 3 months. Suppose that the stock price is
$40, and the 3-month risk free rate is 5% per annum.
Calculate the 3 month Forward Price
In this case, T = 0.25, r=0.05 and S=40

 
rT
F  Se  

0.05 0.25 

F  40e  40.50