Forex and Risk Management in Derivatives

FUTURES AND FORWARDS

 Forwards
2

Compute funds outflow for a company X on 10 July for the transaction

given the background as below:
 Company X is a regular importer of chemicals
 CFO of X is worried about falling INR vs USD
 On 11 June, X buys 1 month forward USD 100mn @ 26 paise premium over the spot rate
of INR64.575 to be settled on 10 July
 The spot rate on 10 July was INR64.625

Ticket Size * Forward Price

USD 100mn * (64.5750 + 0.2600)
USD 100mn * (64.8350)
= INR 6483.5mn
 Forwards
3

In case of the example in the previous slide, would X have been

better off not buying the forward? What was the motivation of X for
entering into the contract?
 Forwards
4

 In case of the example in the previous slide, would X have been better off not buying
the forward? What was the motivation of X for entering into the contract?

Yes, he would have been better off not buying the forward.
Motivation of X was to lock the price of USD so that there is no uncertainty.

Forwards – USD 100mm * (64.5750 + 0.2600) = INR 6483.5mm

Spot – USD 100 mm * (64.625) = INR 6462.50 mm

In case he doesn’t buy Forwards, he would have saved

= INR 6483.5 – 6462.50 = INR 21 mm
 Forwards
5

Did company X get possession of physical USD100mn? When?

Yes
On the settlement day.
 Forwards
6

Was this forwards contract transacted on an exchange? What would be

the most likely counter-party in this transaction?

No. It was OTC. Bank may be a counterparty.

 Forwards
7

Supposing the transaction in the earlier slide involving Company X was

in the form of futures contract and not forwards contract, what

would be the net funds flow for X on 10th July 2017?

USD 100mn * (64.625 - 64.835) => outflow of INR 21 mm

 Forwards vs Futures
8

Can a Forward contract be “customized”? Illustrate with examples

and compare with a standard Futures contract.

Yes, it can be customized along the following:

 Quantity
 Time
 Price
 Forwards
9

What would be the motivation of the bank which acted as counterparty

to X in the Forward transaction?

Bank runs a book (speculator) and makes spread on bid vs ask

(arbitrager)
 Forwards
10

Where would you get to see the USDINR forward rates?

 Find LTP for 3month forward USDINR

 Compute premium in terms of % p.a.

 https://in.investing.com/currencies/usd-inr-forward-rates
Forwards
11
 Valuation of Forward / Future contracts

Every financial instrument requires a method for valuation

Valuation process helps an investor to make purchase / sell decision

 Eg. If price is less than value then buy

In case of forward / future contracts the concept of “cost of carry” is

typically used as method of valuation.

 Assumptions for Pricing Futures / Forward Contracts

1. The market participants are subject to no transactions costs when they

trade.
2. The market participants are subject to the same tax rate on all net trading

profits.
3. The market participants can borrow money at the same risk-free rate of

interest as they can lend money.

4. No restriction on short selling.
 Different Types of Interest Rates
Expected future price formulas

The future price Fe = (Principal) * e^(r*T) (using continuous compounding)

The future price Fe = (P)*(1+r)^T (using discrete compounding)

The future price Fe = (P)*(1+r *T) (using simple interest method)

 Derivation – Continuous Compounding
(Reference Only)

 Discreet Compounding Formula – F = P (1 + r/n)^nt

 n – number of time units (eg, quarterly – 4)

 If we substitute (n/r) = m. Thus, (r/n) = 1/m; n = mr

 F = P (1+ 1/m)^mrt
 F = P ((1+1/m)^m)^rt (just expanding the brackets in the power)
 If we take limit as m tends to infinity
 F = P (lim (1+1/m)^m)^rt

 We know, lim (1+1/n)^n = e

 Thus, F = P (e)^rt
 F = P * e^rt
 Derivation – Continuous Compounding
(Reference Only)

 In simple words,
 Discreet Compounding Formula – F = P (1 + r/n)^nt
 For example, if we invest INR 1 and earn 100% returns after 1 year

 In case of monthly compounding, my total investment value would be –

 F = 1 (1+100% / 12)^12 = 2.61304

 For Daily compounding –

 F = 1 (1+100%/365)^365 = 2.71457

 For compounding every Minute (525,600 minutes in a year)

 F = 1 (1+100%/ 525600)^525600 = 2.718279

 For compounding every Second (31,536,000 seconds in a year)

 F = 1 (1+100%/ 31536000)^31536000 = 2.718281
 Close enough to the value of “e”
 Equity Futures
Expected future price formulas

In case of equities with present value of dividend income I, stock price
S, risk-free interest rate r, time to maturity T->

The expected future price Fe = (S-I) * e^(r*T) (using continuous compounding)

The expected future price Fe = (S-I)*(1+r)^T (using discrete compounding)

The expected future price Fe = (S-I)*(1+r *T) (using simple interest method)
 Cost of carry – numerical illustration

Spot price of a stock : 100

Transaction date : day 0
Settlement date : day 20
Interest rate : 8% p.a.
Dividend not expected in these 20 days
Expected price of the future contract on day 0 =
100 + cost of carry
Where cost of carry is due to interest cost on 100 for period of 20 days @
8% p.a.
 3 ways to calculate expected price of the future contract

100 + 100 * 8% * 20/365 = 100.4384

(applicable in case of simple interest method)

 100 * (1 + 8%) ^ (20/365) = 100.4226

(applicable in case of discrete compounding method)

 100 * exp(8% * 20/365) = 100.4393

(applicable in case of continuous compounding method)

The method and the applicable interest rates would be specified for appropriate
calculation.
 Forwards / Futures on investment assets

Investment assets that pay no income (Zero-coupon bond,

gold, silver): Ignoring storage cost
 F0 = S0. er.T
 F0: Future price today
 S0: Price of underlying asset today
 r: annual risk free rate with continuous compounding
Investment asset with known cash income (stock, coupon
bond)
 F0 = (S0 – I). er.T
 I: PV of all income from underlying during life of future contract
Investment asset with known dividend yield (stock index)
 F = S . e(r-q).T
0 0
 q: Constant annual rate of dividend yield
 Principle of Convergence

Futures price on the day of expiry will be exactly equal to the spot price
prevalent at the time of expiry
E.g. 1 month futures contract (30 days) on an asset which has a value Rs
200 today. Assuming an interest rate of 7%
Date Spot Futures = spot *ert

T=0 Rs 200 Rs 201.15= 200 *e(.07*(30/365))

T=5 Rs 210 Rs 211.01= 210 *e(.07*(25/365))

T=10 Rs 215 Rs 215.82= 215 *e(.07*(20/365))

T=15 Rs 220 Rs 220.63= 220 *e(.07*(15/365))

T=29 Rs 228 Rs 228.04= 228 *e(.07*(1/365))

T= 30 Rs 229 Rs 229= 229 *e(.07*(0/365))

Principle of Convergence
 Cost of Carry Model

Example:
Theoretical Correct price for a futures contract which has 3 months to go
on a spot rate of Rs 40 and an interest rate of 5% p.a is
Futures = spot *ert
Where, e=2.718; r is risk free rate of interest; t is period of contract
reckoned as fraction of an year
 Cost of Carry Model

Example:
Theoretical Correct price for a futures contract which has 3 months to go
on a spot rate of Rs 40 and an interest rate of 5% p.a is
Futures = spot *ert
Where, e=2.718; r is risk free rate of interest; t is period of contract
reckoned as fraction of an year

For the example above, F= 40*e(0.05* 3/12) = Rs 40.50

Therefore ideal price for the futures is Rs 40.50
 Calculating expected future price – adjusting for dividend

Example:
Spot price of a stock : INR 100

Transaction date : day 0

Settlement date : day 20

Interest rate : 8% p.a.

Dividend expected INR 2.5 in these 15 days

 Calculating expected future price – adjusting for dividend

Example:
Spot price of a stock : 100
Transaction date : day 0
Settlement date : day 20
Interest rate : 8% p.a.
Dividend expected 2.5 in these 15 days

Adjust spot price for the present value of dividend)dividend

 Adjusted spot price = 100 – 2.5* exp(-8%*15/365) = 100 – 2.5*0.996718 = 100 – 2.491794 =
97.50821 or 97.51
Use adjusted spot price in the formula for the expected future price
 Expected future price = 97.51 * exp(8% * 20/365) = 97.94
 Examples

Consider a 10 month forward contract on a stock when the stock price is

INR 50. r=8% per annum. Dividends of INR 0.75 per share expected after
3,6,9 months. What is the theoretical forward price for no arbitrage?
 Examples

Consider a 10 month forward contract on a stock when the stock price is

INR 50. r=8% per annum. Dividends of INR 0.75 per share expected after
3,6,9 months. What is the theoretical forward price for no arbitrage?

Solution:
PV of all dividends i.e I
I= 0.75e(-0.08*(3/12)) + 0.75e(-0.08*(6/12)) + 0.75e(-0.08*(9/12)) = INR 2.162

Forwards Price F for an asset providing a known income

F= (50 – 2.162) e(0.08*(10/12)) INR 51.14
 Equity Futures

Given
 Current date : 10th July
 Expiry : 27th July
 S0 = 1615.25
 Case 1:
 I = 0 (no dividend income expected between 10 th July and 27th July)
 Case 2:
 I = ___ (dividend of Rs 10 expected on 20th July)
 r = 5% p.a. compounded continuously
Compute in both cases
 Expected value of the future contract
Should it be bought or sold if the price of the future contract is 1628.1 in Case 1 ?
 Equity Futures

Given
 Current date : 10th July
 Expiry : 27th July
 Fa = 1628.1
 S0 = 1615.25
 Case 1:
 I = 0 (no dividend income expected between 10 th July and 27th July)
 Case 2:
 I = ___ (dividend of Rs 10 expected on 20 th July)
 r = 5% p.a.
Expected value of the future contract
 Case 1 : 1615.25*exp(5%*17/365) = 1619.02
 Case 2 : (1615.25-10*exp(-5%*10/365))*exp(5%*17/365) = 1609.01
 Futures Price of Stock Index

 Stock index can be viewed as an investment asset paying a dividend yield

 It is usually assumed that the dividends provide a known yield rather than a known
income
 The futures price and spot price relationship is therefore

F0 = S0 e(r–q )T
where q is the average dividend yield on the portfolio represented by the index during
the life of the contract
 Futures

Show how this

number is
computed.

1628.1=1615.25*exp(r*t), where t = 17/365 ie 27 th July –

10 th july expressed in years, r is the cost of carry in % p.a.
and is to be found. r=365*ln(1628.1/1615.25)/17=17.01%
p.a.
 Futures and Forwards on Currencies

 Interest Rate Parity – Exchange Rate moves in the direction of the

interest rates of their respective economies / countries

 Interest Rates in USA = 2%, India = 6%. You can borrow from US at 2% and

invest in India at 6%, thereby gaining 4% as arbitrage profit. This phenomena

does not happen because the USD would appreciate 4% vis-à-vis INR, thereby
negating any arbitrage.
 Refer “IRP-1” sheet from “Futures-Class” file to understand how interest-

rate arbitrage is prevented through this concept of interest-rate parity.

 Futures and Forwards on Currencies

A foreign currency is analogous to a security providing a dividend yield

The continuous dividend yield is the foreign risk-free interest rate
It follows that if rf is the foreign risk-free interest rate

( r rf ) T
F0  S0e
Futures and Forwards on Currencies
Futures and Forwards on Currencies
COMMODITY FUTURES IN INDIAN MARKETS
 Forward/Future Price for Investment Assets – A Generalization

F0 – Actual Futures Price stated on the exchange

S0erT – Price you found out using Valuation technique as per Valuation

If F0 > S0erT, arbitrageurs can buy the asset and short futures contracts
on the asset.
If F0 < S0erT, arbitrageurs can short the asset and enter into long futures
contracts on the asset.
Hence if F0 = S0erT, no arbitrage opportunity arises
 This equation relates the future price and the spot price for any investment asset that
provides no income and has no storage costs.
 Futures on Investment Commodities

Example: Gold, Silver

If u is the storage cost per unit time as a percent of the asset value, it can
be treated as negative yield (regarded as negative income). Then
F0 = S0 e(r+u)T

Similarly, if U is the present value of the storage costs, it can be

considered as negative income. Then
F0 = (S0+U)erT
Cash & Carry Arbitrage
Cash & Carry Arbitrage
Reverse Cash & Carry Arbitrage
Reverse Cash & Carry Arbitrage
 Futures on Consumption Commodities

 Consumption commodities usually provide no income, but can be subject to significant storage costs.

 Here arbitrage strategy can not be used in some cases.

 Individual and companies are reluctant to sell the commodity stored in inventory.

 Hence for consumption commodity the valid equations are

F0 ≤ (S0+U)erT

F0 ≤ S0 e(r+u)T
 Commodities are “consumption assets”, unlike equities which are “investment assets”

 Investment assets offer recurring income such as dividend

 Consumption assets do not offer any recurring income while holding those assets. Eg – holding soyabean does

not offer any recurring income

 Convenience Yield
45

 Convenience Yield is the benefit of holding the physical goods / underlying assets rather than

its derivative contract.

 Eg: you need sugarcane to process it into jaggery and derivative contract shall be of no use

 Individuals and companies engaged in the business of producing or processing or distributing or selling

consumption commodities benefit by holding physical commodity

 Eg: if 30 day actual forward price of a commodity is less than its expected forward price

 In that case, an investor SHOULD sell commodity and buy the forward contract

 However the processor of the commodity would not buy a forward contract; as the manufacturing process

requires the physical commodity. The processor has no use of the forward contract as it can not be readily

used to process the commodity.

 Convenience Yield
46

 Hence,

 Actual Forward Price would remain lower than Expected Forward Price
 Implied cost of carry would be less than Expected cost of carry
 For Consumption Commodities, Convenience Yield can be positive

 Implied Cost of Carry = Rf Rate + Storage Cost – Convenience Yield

 Expected Cost of Carry = Rf Rate + Storage Cost

 Commodity Futures - MCX
47

Gold 05Feb closed at 29390 (per 10 gms) on 12Jan. Spot gold at 29838

Compute implied cost of carry

LN (Actual Fut Price / Spot Price) * (365/t)
-23%

Compute convenience yield if risk free rate is 5% p.a. and storage cost is 3% p.a.
Implied Cost of Carry = Rf Rate + Storage Cost – Convenience Yield
-23% = risk free + storage – convenience
i.e. convenience yield = 31% p.a.
 Commodity Futures - MCX
48

Wheat 28Feb closed at 456.15 (per kg) on 12Jan. Spot Wheat at 454.30
Compute implied cost of carry

Compute convenience yield if risk free rate is 5% p.a. and storage cost is
3% p.a.
 Commodity Futures - MCX
49

Wheat 28Feb closed at 456.15 (per kg) on 12Jan. Spot Wheat at454.30
Compute implied cost of carry
3.16%

Compute convenience yield if risk free rate is 5% p.a. and storage cost is
3% p.a.
3% = risk free + storage – convenience

i.e convenience yield = 4.84% p.a.

 Contango vs Normal Backwardation
50

 Contango

 Expected future price < Actual future price, or

 Expected cost of carry < Implied cost of carry

 Normal backwardation

 Expected future price > Actual future price, or

 Expected cost of carry > Implied cost of carry

 In case of commodity futures/forward contracts

 Normal backwardation implies positive convenience yield

 Contango implies negative convenience yield
 Commodity vs Equity futures
Understanding normal backwardation
51

• Benefits leading to convenience yield are not

Dividends are known quantifiable and hence not known in advance.
in advance and not They are deduced from the actual price of the
market determined forward contract and hence are market
determined

• In case of equities, spot price higher than futures

Hence price does not necessarily mean backwardation
 Contango v/s Backwardation
52

Contango: Actual price of forward / future contract is higher than the

expected price
Backwardation: Actual price of forward / future contract is lower than

the expected price

How does commodity futures market compare with equity futures market
53

Underlying
 Equities – Underlying as well as futures get traded on the same exchanges
 Underlying stocks get traded on the NSE and the BSE
 Futures on these stocks also get traded on the NSE and the BSE
 Commodities get traded in various market places/ “mandis” across India. Commodity futures
get traded on the exchanges (which are NCDEX and MCX)
Trading process
 Both equity futures as well as commodity futures get traded on exchanges through the
process of electronic order matching
Settlement
 Equity futures get “cash / net” settled only
 In case of commodity futures, both modes of settlement (i.e. “net” and “physical”) are
applicable
 What types of commodities are amenable for futures trading ?
54

Commodities

 having large market

 for which no single entity / group of entities can influence the market price
 which are not perishable
 For which quality can be standardized and “graded”
 What are the categories of commodities for which future contracts are traded?
55

Agricultural products

Bullion (i.e. gold and silver)

Metals

Energy products
 What are the types of the market participants?
56

Entities wishing to reduce future commodity price risk, Eg-

 Growers
 Millers/processors
 Jewelers

Speculators

Arbitragers
 How are spot prices determined?
57

Exchanges conduct polling of “mandis” twice a day, validate those

prices and publish the average price, which gets taken as the
benchmark spot price
 What are the types of contracts?
58

Compulsory delivery contract

 Both buyer and seller opt for compulsory physical settlement

Exchanges match buyers and sellers using the warehouse locations

indicated
 Warehouses can only be exchange-approved warehouses
 Receipts from the warehouses get dematerialized and electronically tracked and
transferred from seller to the buyer

For the unmatched quantities, buyer takes delivery wherever seller gives
 What are the types of contracts ?
59

Sellers right contract

 seller has the right to select warehouse

 buyer of such contract accepts the warehouse option offered by the seller
 While matching, exchange meets buyer’s preferences to the extent possible
and thereafter buyer needs to accept delivery wherever the “matched” seller
offers the same
 What are the types of contracts ?
60

Intention matching contract

 Both buyer and seller give their warehouse preferences

 Matched preferences get settled through physical delivery
 Unmatched quantities get cash settled
When are the delivery intentions required to be intimated to the exchange ?
61

Within 3 days prior to the expiry

All open positions on the expiry day of the contract would result in
compulsory delivery
What happens if seller does not adhere to the delivery intentions indicated ?
62

Exchange levies penalty on the seller

Part of the penalty goes to the buyer and the rest goes to the investor

protection fund (IEPF)

 How is quality verified before physical delivery ?
63

Exchange nominates “assayer” on behalf of every buyer

Assayer verifies the quality in the warehouse where the commodity is

stored
After verification, assayer either rejects the commodity or accepts it and

grades it
Appropriate grading discounts (as pre-specified by the exchange) are

applied to the purchase price at the time of settlement

 Regulation
64

Forward Market Commission (FMC) was the regulator for the

commodity futures market in India

FMC has merged with SEBI

Now, SEBI is the regulator for the commodity futures markets

 Global Perspective
65

CME group – the leading and most diverse market place, has 4 exchanges

viz.
 CME (Chicago Mercantile Exchange)
 CBOT (Chicago Board of Trade)
 NYMEX (New York Metal Exchange)
 COMEX (Commodity and Metal Exchange)

London Metal Exchange

Shanghai Metal Exchange

 Product Range on the CME group
66

Agricultural commodities
Energy
Bullion
Metals
Equity indices
Currency pairs
Interest rates
Real estate
Weather
APPLICATION OF FORWARDS
AND FUTURES
 Selling vs shorting
Short vs long
Taking a Position
68

When a physical entity is sold without giving delivery of any physical

asset, it is “shorting”
Forwards and futures are sold but physical delivery of the underlying is
not required.
 Hence it is common to state that a person is short on Infosys future when the person
has sold Infosys futures
 Likewise a person who buys Infosys futures is “long” on Infosys futures
When a person either goes long or goes short on a future contract,
he/she assumes fresh risk
 the person is said to have taken a “position”
 Concept of margin
69

 Unlike delivery based transaction,

 Buyer of a future contract is not required to give funds

 Seller of a future contract is not required to give physical asset
 At the time of expiry, at least one of the two parties will make loss and the other party will make profit

 If the loss making party reneges from its payment obligation at the time of expiry, this would pose a

risk to the system (i.e. the broker and the exchange and in turn the party making profit)
 It is not possible to know in advance which party will make profit and which party will make loss

 PRACTICE IS TO COLLECT MARGINS FROM BOTH BUYER AND SELLER, AT THE TIME OF
THEIR ENTERING INTO THE POSITION
 Margin Illustrated
70

27Jul Infosys is trading at 974

One new contract is created (lot size: 500)

 “notional value” = 974 * 1 * 500 = INR 487,000

A is on the “long” side and B is on the “short” side

Initial margin is 20%

Both A and B pay 20% of 487000 i.e. INR 97,400 to their respective

brokers prior to entering into their positions

 Initial Margin
71

How is initial margin of 20% in the previous slide determined?

 SPAN margin, plus

 CME GROUP proprietary methodology which is adopted by exchanges worldwide

 Exposure margin
 To cover extreme loss situations

 Computed client wise by broker and sent to exchange

 Broker debits individual client accounts
 Broker may add additional risk margin based on the prior knowledge about the client
 “Mark to Market”
72

Now, (say) Infosys future closes at 980 on the day this position is taken

 A has “mark to market” profit of 1 * 500 * (980 – 974) = INR 3000

 B has “mark to market” loss of INR 3000

A and B start with margin account credit balance of INR 97,400 on day 0

On day 1, A has margin account balance of INR 100,400 and B has

margin account balance of INR 94,400

 Maintenance Level
73

 If the margin credit balance drops to a certain level i.e. “maintenance level”; then “margin call” is
given
 Let us say broker and client agree on maintenance level of 12%
 If price of the Infosys future drops to INR 895 at any time before the expiry, the balance in the
margin account of A would be Balance Already Maintained + Adjustment for MTM Loss
 97,400 + 500 * (895 – 974) = INR 57,900

 Maintenance level credit balance is 12% * 500 * 974 = INR 58,440

 In this A has two options

 Pay INR 39,500 (97400 – 57900), or
 Sell the future contract, book the loss and get out of the long position. A would receive INR
57,900 from the broker and book the loss of INR 39,500

 Whenever your margin balance breaches Maintenance Level, top-up your margin balance to the
initial margin level; in this case to 97400
 Open Interest
74

Open interest is the total number of outstanding derivative

contracts that have not been settled for an asset. The contract is
considered "open" until the counterparty closes it

If a buyer and seller come together and initiate a new position of one
contract, then open interest will increase by one contract. Should a
buyer and seller both exit a one contract position on a trade, then open
interest decreases by one contract. However, if a buyer or seller passes
off their current position to a new buyer or seller, then open interest
remains unchanged.
 Open Interest (OI)
75

Example –
When A and B enter into a new contract, open interest increases by 1. A
takes long position and B takes short position
A enters into 9 more contracts with B, making total open interest = 10
A sells 6 contracts to C, open interest remains at 10
A sells 2 contracts to B, open interest reduces to 8
In case 0f Futures, Open interest is a better indicator of trading activity
and trader interest than the daily trading volumes
 Equity Futures
76
 Given
 On the current date : 10th July
 F = 1628.10
 S = 1615.25
 A buys underlying stock from B
 A sells future contract to C
 On the expiry date : 27th July
 S = 1650.20
 A sells underlying stock to D
 Future contracts of A and C expire
 r = 5% p.a.
 Transaction costs: delivery – 0.2%; futures – 0.01%, nil cost on expired contracts
 Equity Futures
77
 Comment on
 Whether A,B,C and D are arbitragers, speculators or hedgers?
 How does the risk transfer among A,B,C and D?

 Illustrate the arbitrage involved in the previous transaction

 Explain using this example how the arbitrage actions would improve market
efficiency
 Explain using this example the “cost of carry” approach to calculating the expected
price of a future contract
 Compute net profit to C
 Equity Futures
78
 Comment on
 Whether A,B,C and D are arbitragers, speculators or hedgers?
 A : arbitrager, cannot say anything about B,C and D given the information here
 How does the risk transfer among A,B,C and D?
 B sells the stock to A. Hence firstly , the market risk transferred from B to A
 A sells future contract to C. Hence A , in turn; transfers the risk to C
 On the expiry day, A and C also get out of their positions. Risk is assumed by D

 Illustrate the arbitrage involved in the previous transaction.

Irrespective of the stock price at the time of expiry, net gain to A would be 12.85 less
transaction costs. Hence no market risk after the positions are taken by A. Hence it
is an arbitrage.
 Equity Futures
79

 Explain using this example how the arbitrage actions would improve market efficiency
As more market players go for arbitrage, there would be more buying of the stock and more
selling of the future. More buying would lift the stock price and more selling would lead to dip
in future’s price. Hence the difference between the two prices would narrow. This would
continue till equilibrium is achieved wherein the difference between the future price and the
stock price would be equivalent to risk free interest rate. Hence arbitrage makes market more
efficient.

 Explain using this example the “cost of carry” approach to calculating the expected price of a future contract.
In the cost of carry formula, we used risk free interest rate to calculate expected future price.
This is based on the equilibrium situation described above.

 Compute net profit to C.

1650.2 – 1628.1 – 0.16 = 21.94. This is fairly high compared to the net profit to the arbitrager.
This is because speculator assumes much higher risk and expects higher gain.
 HEDGERS PROBLEM
80

TO CREATE A LONG HEDGE

OR

A SHORT HEDGE?

There are two ways to determine whether to open a short or a long hedge
 HEDGERS PROBLEM
81

LONG HEDGE
• Open a long futures position in order to hedge the purchase of the product at a later date
• The hedger locks in the purchase price

SHORT HEDGE

• Open a short futures position in order to hedge the sale of the product at a later date
• The hedger locks in the sale price

Whatever you are supposed to do at a Future date, do it right now in the

Futures market to ensure your price is locked-in
 Long Hedge – Example
82

On May 15, a petroleum product producer has negotiated a contract to buy

1 million barrels of crude oil. The price that will apply in the contract is
market price on Aug 31
Spot price on May 15 is $100 per barrel

Crude oil futures price expiring Aug 31 on the NYMEX is $105 per barrel

Each futures contract on NYMEX is for the delivery of 1,000 barrels

 The company can hedge its exposure by going long on 1,000 Aug futures contracts
 Long Hedge – Example
83

Case 1:
Let spot price of oil on Aug 31 be $110 > futures contract price

The company buys oil in spot by paying $110

Because Aug is the delivery month for futures contract, the futures price on

Aug 31 should be equal to spot (principle of convergence), say $110

On that date Co’s gain from futures position = $110 - $105 = $5 (by closing

the long futures contract)

Then, the net cost of buying oil = $110 - $5 = $105
 Long Hedge – Example
84

Case 2:
Let spot price of oil on Aug 31 be $103 < futures contract price

The company buys oil in spot by paying $103

Because Aug is the delivery month for futures contract, the futures price

on Aug 31 should be equal to spot (principle of convergence), say $103.

On that date co’s loss from futures position = $103 - $105 = -$2

Then, the net cost of buying oil = $103 + $2 = $105

 Short Hedge – Example
85

On May 15, a petroleum product producer has negotiated a contract to

sell 1 million barrels of crude oil. The price that will apply in the
contract is market price on Aug 31
Spot price on May 15 is $100 per barrel

Crude oil futures price expiring Aug 31 on the NYMEX is $105 per barrel

Each futures contract on NYMEX is for the delivery of 1,000 barrels

 The company can hedge its exposure by going short on 1,000 Aug futures contracts
 Short Hedge – Example
86

Case 1:
Let spot price of oil on Aug 31 be $110 > futures contract price

The company sells oil in spot at $110

Because Aug is the delivery month for futures contract, the futures price on

Aug 31 should be equal to spot (principle of convergence), say $110

On that date co’s loss from futures position = $105 - $110 = -$5 (by closing

the short futures contract)

Then, the net price realized by selling oil = $110 - $5 = $105
 Short Hedge – Example
87

Case 2:
Let spot price of oil on Aug 31 be $103 < futures contract price

The company sells oil in spot at $103

Because Aug is the delivery month for futures contract, the futures price

on Aug 31 should be equal to spot (principle of convergence), say $103

On that date co’s gain from futures position = $105 - $103 = $2

Then, the net price realized by selling oil = $103 + $2 = $105

 Basis Risk
88

 Basis refers to the difference between the spot price of the asset and the futures
price of the asset

 Basis = Actual Futures price of the contract used – Actual Spot price of asset to
be hedged

 Basis Risk arises because –

 The instrument used for hedging is different than underlying asset (Eg, Crude Oil Futures used to hedge
the price of Aviation Turbine Fuel as ATF futures contract is not available)
 The time period of the futures contract is different than the time period of holding the spot asset (Eg, you
are required to pay USD 100,000 to your supplier in the USA on 20-Oct and you enter into October
Futures to hedge the USDINR price. We know the Futures will expire on the last Thursday of October i.e.
29-Oct. Future price will not converge to Spot on 20-Oct as it is not the expiry date, hence principle of
convergence will not work. This difference will lead to basis i.e. imperfect hedge)
 Basis: Example
89

Suppose the spot price of an asset at inception was Rs. 2.50 and the future price at
that time was Rs. 2.20
After 3 months, the spot price becomes Rs. 2 and the futures price Rs. 1.90

Basis at the beginning (b1)= Rs. 2.20 – 2.50 = Rs. -0.3

Basis at the end (b2)= Rs. 1.90 – 2.00 = Rs. -0.1 => basis has strengthened

When the spot increases by more than the futures, basis weakens
&
When the futures increases by more than the spot, basis strengthens
 Basis Risk in Long Hedge: Illustration
90

A Long Hedge (Eg, buying crude at a future date – lock-in purchase price by
buying futures now) is described where spot price is Rs 1200, futures is Rs 1250
and we go long futures at Rs 1250
Scenario 1 Scenario 2
End Spot Price Rs 1300 Rs 1000
End Futures Price Rs 1400 Rs 1020
Gain from futures Rs 150 (1400-1250) Rs -230 (1020-1250)
Spot Payment paid Rs -1300 Rs -1000
Net cost paid Rs -1150 (-1300+150) Rs -1230 (-1000-230)
Basis at time 1 Rs 50 (1250-1200) Rs 50 (1250-1200)
Basis at time 2 Rs 100 (1400-1300) Rs 20 (1020-1000)
Basis strengthens Basis weakens

Long Hedger will gain (has to pay less) if the basis strengthens and lose if the basis
weakens
 Basis Risk in Short Hedge: Illustration
91

A Short Hedge (Eg, selling crude at a future date – lock-in sale price by
selling futures now) is described where spot price is Rs 1200, futures is Rs
1250 and we short futures at Rs 1250
Scenario 1 Scenario 2
End Spot Price Rs 1300 Rs 1000
End Futures Price Rs 1400 Rs 1020
Gain from futures Rs -150 Rs 230
Spot Payment received Rs 1300 Rs 1000
Net Gain Rs 1150 Rs 1230
Basis at time 1 Rs 50 Rs 50
Basis at time 2 Rs 100 Rs 20
Basis strengthens Basis weakens

Short Hedger will gain if the basis weakens and lose if the basis strengthens
 Cross Hedging
92

 Cross hedging: when two assets in the spot and futures contracts are different
 Example: An airline wants to hedge against future price of jet fuel, which has no futures
contract. It may use heating oil futures contract.
 The common approach is to ascertain the beta (roughly the extent to which asset will
go up or down for a % increase in parent asset)
 Approximate number of contracts in the parent asset that are required for effective
hedging the risk in the asset of our interests is
Optimal hedge ratio= (Portfolio Value * Beta)/value of one futures contract

Where, portfolio value= value of the asset that we wish to hedge in terms of quantity* price
we are interested to protect
Value of futures contract= value of the parent asset since the asset we interested doesn’t
have futures contract
 Equity Futures – Hedging
93

A diversified equity fund with corpus of INR 1000 cr has 5% exposure to

TCS. Fund manager expects short-term drag on the portfolio due to

expected TCS price performance (next 2 months) and wishes to hedge
against this risk without getting out of fund’s position in TCS.
Illustrate how the fund manager would carry out hedging if he uses TCS
Futures expiring 31-Aug
What are the pros and cons of selling July futures instead of August futures?
 Equity Futures – Hedging
94

 A diversified equity fund with corpus of INR 1000 cr has 5% exposure to TCS. Fund manager
expects short-term drag on the portfolio due to expected TCS price performance (next 2 months)
and wishes to hedge against this risk without getting out of fund’s position in TCS. Illustrate how
the fund manager would carry out hedging if he uses TCS Futures expiring 31-Aug

TCS31Aug : 2409
Market lot : 250 units
# of Contracts to be sold = 1000 * 1,00,00,000 * 5% / (2409*250)
= 830 contracts

What are the pros and cons of selling July futures instead of August futures?
August futures have low liquidity, but July Futures do not cover the full hedge period.
 Equity Futures – Hedging
95

 Fund manager of a diversified equity fund with corpus of INR 8500 crores (Beta of 1.2)

wishes to cover the short term risk on the portfolio due to adverse announcement of
monetary policy in the first week of August.
Illustrate how the fund manager would carry out hedging if he uses Nifty Futures contracts
expiring 31-Aug
 Equity Futures – Cross Hedging
96

Fund manager of a diversified equity fund with corpus of INR 8500 crores (Beta
of 1.2) wishes to cover the short term risk on the portfolio due to adverse
announcement of monetary policy in the first week of August. Illustrate how the
fund manager would carry out hedging if he uses Nifty Futures contracts expiring
31-Aug

Notional value of Nifty : 1.2 * 8500 cr = INR 10200 cr

31Aug Nifty : 9967

Lot size : 75
# of Nifty contracts to be sold = 10200*1,00,00,000/ (9967*75)
= 136,450