Futures contract Future is a legally binding agreement to buy or sell something in the future. Future contracts are promises - the person who initially sells the contract promises to deliver a quantity or a standardized commodity to a designated delivery point during a certain month called the delivery month. The other party promises to pay a predetermined price for the goods upon delivery Futures are special kind of forward contracts Forwards are different from futures in two principal aspects- they are not marketable and they are not marked to the market
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Futures contractFuture is a legally binding agreement to buy or
sell something in the future.Future contracts are promises - the person who
initially sells the contract promises to deliver a quantity or a standardized commodity to a designated delivery point during a certain month called the delivery month. The other party promises to pay a predetermined price for the goods upon delivery
Futures are special kind of forward contractsForwards are different from futures in two
principal aspects- they are not marketable and they are not marked to the market
Futures contractStandardized forward contract, traded on
an exchange where a seller agrees to deliver the specified quantity of an asset of defined quality at a predetermined date at a price fixed in advance with the buyer.
Each exchange lays own the specifications of the contract
Standardization of the contract pertains to the asset, size, time, place, and procedure of delivery, quality of underlying asset, price adjustments for variations in quality of the asset being delivered etc.
Specification terms used in futures contractUnderlying asset asset on which the futures contract is writtenFutures are usually specified by the name of the
underlying assetEg. Futures contract in rice at multi Commodity
Exchange(MCX) – denoted as RICEDEC09Contract periodTime when the contract expires, specifies when the
contract will come into force and when will it closeContract sizeStandard contract size that will be traded on the
exchangeEg. Futures contract for gold on NMCE is for 100gm.
Specification of a futures contractAssignment I – to be submitted on
25.01.2014Find out and submit the specifications of
futures contract on any two products in any derivative market in India
Futures regulationLegally, futures are not securities, they are
contracts, so they are not under the jurisdicion of SEBI
Governed by CFTC – Commodity Futures Trading Commission and NFA - National Futures Association
Forwards Vs FuturesForwards Futures
1. Private contract between two parties2. Not standardised3. Usually one specified delivery date4. Settled at the end of the contract5. Delivery or final cash settlement usually takes place6. Some credit risk is present7.Deals are done on OTC market
8.Price risk is eliminated9.Liquidity is low
1. Traded on an exchange2. Standardised contract3. Range of delivery dates4. Settled daily5. Contract is usually closed out prior to maturity6. Virtually no credit risk7. .Deals are done on organised exchanges8.Price risk is eliminated9.Liquidity is high
Future contractsObligations on the part of both buyer and
sellerTraded on organised exchanges like NSE
and BSEExchanges determine the standardised
specifications for traded contracts, set and enforce trading rules
Futures are always for a specified amount of a specified security for delivery on a specific date
The only item negotiated at the time of entering in to the transaction is price
OpeningAt close of day 0At close of day 1At close of day 2At close of day 3At close of day 4At close of day 5At close of day 6At close of day 7At close of day 8
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Initial marginA good faith deposit with Clearing House,
as soon as the investor enters into the contract
Initial margin should be such that it covers the worst day loss of the trader’s portfolio over one trading day
in other words, it is the portfolio’s one day VaR
trader is entitled to withdraw any surplus over the initial margin
If there is deficit, in margin account trader needs to replenish it – margin call
VALUE AT RISKWorst expected loss of a portolioVaR is a volatility based measure containing
information on losses during normal market conditions and the probability in a single number
Used for the first time by J.P MorganVaR = ∞√TσP∞ = critical value from standard normal distribution√T = square root of the number of time periodsσ = standard deviationP=estimate of initial value of portfolio
Convergence of future and spot priceAs the contract approaches expiry these two
prices (future and spot) will converge, or meet. Why does this happen? - Cost of carry. That is the futures price is equal to the cost of
holding the underlying to the period of expiry. The cost of carry would normally include interest less dividends (in the case of financial assets) or storage costs (in the case of a physical commodity like wool).
As the futures get closer to expiry, the prices will naturally converge .
Convergence of Futures to Spot
Time Time
(a) (b)
FuturesPrice
FuturesPrice
Spot Price
Spot Price
Futures PricingPricing is a result of convergence to the future - spot
price and arbitrage relations.
In general:
F0 = P0ert
F0 = Futures Price at time 0
P0 = Spot Price at time 0r = cost of carry (risk-free)t = Time to expiration
(Add Storage and Transportation for commodities)
Underlying asset can be Investment assets(carry type asset) – eg,
relationship between the futures price and the spot price. It is the cost of "carrying" or holding a position from the date of entering into the transaction up to the date of maturity. It measures the storage cost plus interest that is paid to finance the asset less the income earned on the asset.
As far as Equity Derivatives are concerned the Cost of Carry represents the "Interest Cost".
For example, if I buy $20,000 worth of futures and options contracts that $20,000 will not earn any interest. So, if I hold the contracts for six months and the risk free interest rate is 1%, I would make at least a $200 profit to break even. (I would have made $200 in interest if I had not bought the contracts.)
For contracts that require physical delivery, as opposed to cash-settled contracts, the cost of maintaining and delivering the product are also carrying costs.
For example, live cattle futures contracts require physical delivery. A farmer selling cattle with a futures contract has to make sure the cattle he is selling meet the contract specifications, are properly fed and maintained, and that they are delivered to the proper location at settlement. All of that is included as part of the cost of carry.
Cost of carry Model
The cost of carry model expresses the futures price as a function of the spot price and the cost of carry.
Forward price/future price = Spot price +Cost of carry
The same model in currency markets is known as interest rate parity.
Futures Pricing Example
Current Gold Price is Rs. 400 per ounce. Risk-free rate is 5%.Time to expiration of futures contract is 3 months.
F0 = P0ert
F0 = 400xe0.05x3/12
F0 = 404.91
Cash and Carry & Reverse Cash and CarryCash and Carry long underlying + short forwardReverse Cash and Carryshort underlying + long forward
Uses of futuresSpeculation – traders who have good
knowledge of the marketHedging – protection against adverse price
movements
Hedging with futuresHedging strategies for different spot
market position
Current status Concerned about hedge
Holding the assetAbout to buy the assetSold short the assetAbout to issue a liability
Have a floating rate liability
Have a floating rate asset
Asset price may fallAsset price may riseAsset price may riseAsset price(interest rate) may fall(rise)
Asset price(interest rate) may fall(rise)
Asset price(interest rate) may rise(fall)
ShortLongLongShort
Short
Long
Hedging with futuresTaking long and short positions in futures market, to
compensate the loss due to the position in the spot market and to lock in price
A party holds the asset – long on spotA party requires the asset – short on the spotSteps One who is long on asset, goes short in the futures
market, One who is short on asset, goes long in the futures market
Neutralise the position in the futures market at appropriate time
Buy/sell the underlying asset in the spot market at prevailing price
Short hedgeTaking short position in futuresUsed by those who are long on the underlying assetEg. A sugar mill, expected to produce 100MT sugar
in April. Current price (spot) of sugar(in feb) is Rs.22/kg , April futures price Rs 25 – how to hedge?
If April spot price is Rs.22Short on futures now – Rs.25Before futures contract expires, in April, long on the
futures market, to nullify the position in the futures market – Rs(22), gain in futures market – Rs.3
shot in the spot market – Rs.22Effective price realised – 3+22= Rs.25
If April spot price is Rs.26Short on futures now – Rs.25Prior to April, before futures contract
expires, long on the futures market, to nullify the position in the futures market – Rs(26), loss in futures market – Re.1
shot in the spot market – Rs.26Effective price realised – (1)+26= Rs.25
Long HedgeTaking long position in futures marketUsed by those who are short on the assetEg. A petrochemical plant needs to produce 10,000
barrels of oil in 3 months time. Spot price =1,950/barrel, 3months futures price Rs.2,200/barrel. How to hedge?
If spot price after 3 months is Rs.2,400Long futures now – 2,200Before expiry, shot futures – 2,400Gain – 200long in the spot market –(2,400)Effective price of oil= (2400)+200= 2,200
Long HedgeIf spot price after 3 months is Rs.1,800Long futures now – 2,200Before expiry, shot futures – 1,800loss – (400)long in the spot market –(1,800)Effective price of oil, barrel =
(1800)+(400)= 2,200
HedgingHedging involves assuming a position in the futures
Market, which will benefit if the price moves adversely against the spot market position
Hedge position will be opposite to a position in the spot market
If a trader already owns or plans to produce a commodity, and offer it for sale in the spot market, he will be concerned about price falls. So a short position in the futures will be beneficial when prices actually decline.
Hedge will be short position if spot position is long – short hedge
Hedge will be long position if spot position is short – Long hedge
HedgingHedge is to remove price riskIf the trader is able to completely remove
the price risk – perfect hedgePractically traders are exposed to basis riskBasis= cash price – future priceBasis can be positive or negativePositive basis – cash price is more than the
futures price, referred as over(over the futures)
Negative basis – cash price is less than the futures price, referred as under(under the future)
Hedge ratioHedge ratio is defined as the value of
futures contracts to the value of the underlying assets
when basis risk is present hedge is said to be imperfect
Optimal hedge ratio – ratio that eliminates or minimises the price risk
Number of futures contract to have minimum risk
It depends upon the risk in the spot prices, futures prices, and the coefficient of correlation between the two.
Minimum variance hedgeHedge that minimises the variance in the
position
Normal and Inverted marketsIf future prices are described by the cost of carry
model, then future prices will be more than cash prices and the basis will be negative – contago market
In contago market distant futures will be priced more than the near term futures
Most financial markets display contago conditions – Normal Market
If the basis is positive (cash prices more than futures prices), such market is called inverted market. Also known as in backwardation
An inverted market exist when the traders are unable to do reverse cash and carry due to regulatory constraints on short selling – ban on short selling , scarcity of asset in spot market
Widening and narrowing of basisIf basis becomes more positive or less
negative basis is said to be widenOccurs when cash price of the asset
increases relative to future pricesIf basis becomes more negative or less
positive basis is said to be narrowOccurs when cash price of the asset
