Derivatives and Risk Management By Rajiv Srivastava

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 In

most cases we acquire assets and pay for it simultaneously. The price of the asset and the settlement (exchange of asset and its consideration) are done at the same point of time. Forward contract is an agreement to buy or sell an asset at a price determined now but is settled later at a predetermined date. Forward contract enables elimination of price risk faced by both buyer and seller of asset.
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 Forward

contract is an OTC product tailored to meet specific needs but with counterparty risk. Features are:
Over-the-Counter (OTC) Product, where The price is determined now, with Mutual obligation to perform, assuming Counter-party risk, and Mutual consent required for cancellation, involving No front-end payment

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by delivery of asset and the consideration: if an exporter sold Euro 10,000 to a bank 6-m forward at Rs 66 then at maturity, the contract is settled by delivery of Euro 10,000 and bank would pay Rs 6,60,000; or by entering into an offsetting contract opposite to the original contract at maturity or prior, at a price prevailing then: For example the exporter having sold 6-m forward Euro 10,000 at Rs 66.00 may after 3 months, decide to buy 3-m forward Euro 10,000 at Rs 67.00 per Euro.
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 Forward

contracts are subject to high default risk as the price scenario at maturity can favour only one party and not both. Futures being exchange traded do not have any such risk. Futures are similar to a forward contract but are exchange traded. Since futures are exchange traded do not have counter-party risk with exchange serving as counter-party to both buyer and seller.
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 For

trading at the exchange the contract need to be standardized. Standardization of the contract needs to be done for

Futures

is a standardized forward contract that is traded on an exchange.

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Size of the contract Delivery of the contract obligations Quotations of the price Specification of the underlying asset

Asset Code Unit of Trading Delivery Unit

Futures Contract on Gold at National Multi-Commodity Exchange of GOLD 100 gms of Fineness .999 Gold Bars of 100 grams serially numbered and of fineness .999 10 grams of fineness .999 Re.1 The Gold delivered under the contract must be Gold Bars weighing 100 grams each and assaying not less than .999 fineness bearing a serial number and identifying origin of the refiner/brander. Maximum 12 monthly or minimum 2 monthly contracts running concurrently CWC, Cochin Trading in any contract month will open on the 16th day of the month, 12 months prior to the contract month 15th day of the delivery months if 15th happens to be holiday then previous working day. Squaring up of positions will be permitted between 12th and 15th of delivery month. No fresh positions building will be allowed. From 12th to 15th of delivery month, seller can tender Warehouse Receipt for settlement and Warehouse Receipt will be accepted for settlement at closing price of the previous day. Compulsory Delivery

Quotation/Base Value Tick Size Quality Specification

No. of delivery Contracts in a year Delivery Centres Opening of Contracts Due Date Closing of Contract

Delivery Logic

Derivatives and Risk Management By Rajiv Srivastava

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Chapter 2 Forwards and Futures

 Major

advantages of the futures as against the forward contract are

the elimination of counter-party risk, flexibility of entry and exit anytime, and cash settlement.

Position

in futures is mostly settled not by delivery but by entering into a contract, at maturity or prior opposite to the initial one with difference in the prices of the initial and subsequent contracts settled.
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 Open

interest and volumes are often thought to be same. However they are different.

Open interest is the number of futures contracts

Open

interest is the number of new contracts opened. The contracts that offset initial position do not add to the open interest but they do add to the volume.
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outstanding. It reduces to zero upon maturity of the contract. Volume refers to the number of contracts traded in a day.

 From
1. 2.

cash flow perspective, there are 2 differences in futures and forward contracts:
Initial and Variation Margins Marking-to-market (MTM)
To cover the default risk the exchange requires

initial margin before futures position is opened. The position is also marked-to-market (MTM) on daily basis; i.e. profit/loss settled on daily basis. The margin cannot fall below a minimum level due to MTM and if it does, then margin call is made to replenish the same.
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Day Day 1 Opening a contract Close Day 1 Close Day 2 Close Day 3 Day 4 Closing the contract Net Profit

MARKING TO MARKET Price (Rs) Cash Flow (Rs) Remarks 410 None A long position opened for one contract (400 shares) valued at Rs 1,64,000 420 (420 - 410) x 400 Investor receives Rs 4,000 = + 4,000 400 (400 420) x 400 Investor pays Rs 8,000 = - 8,000 390 (390 400) x 400 Investor pays Rs 4,000 = - 4,000 440 (440 390) x 400 Position closed out with = + 20,000 contract value of Rs 1,76,000. Investor gets Rs 20,000 (440 410) x 400 = 12,000 It remains the difference of opening and close prices.
Chapter 2 Forwards and Futures

Derivatives and Risk Management By Rajiv Srivastava

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11

Features Location Counter party Counter party risk Initial Cash flow Explicit cost Settlement Final settlement Exit prior to maturity Quantity specification Time of Delivery Cost of hedging Period of hedging

Futures Exchange Unknown to each other, Exchange serves counter party Minimal Initial margin required Brokerage required to be paid Implicitly daily by marking to the market By delivery or cash settled Possible by entering an opposite contract to square up the position Fixed standard size/lot On fixed dates Very nominal Contracts available for limited period
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Forwards Over the Counter Counter parties are known to each other Exists None No intermediary and no cost No marking to the market By delivery Generally not possible unless both the parties agree. Any quantity Any time mutually decided by the parties concerned High Unlimited
Chapter 2 Forwards and Futures

Derivatives and Risk Management By Rajiv Srivastava

12

 From

pricing perspective forward and futures follow the same principle. Futures price is based on spot price and the cost of carry for the period less benefits of ownership.
F1 = S0 x (1+r) F1 = S0 x ert for continuous compounding

Where F1 is forward/futures price with contract expiring at t = 1, S0 is spot price at t = 0 and r is the cost of carry for the period 0 to1.
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 Cost

of carry model eliminates arbitrage. If mispriced it offers arbitrage one way or the other. Cash and Carry Arbitrage: When futures is overpriced:
Arbitrageur Spot price of 10 gms gold at Rs 7,000 Risk free rate of 10% per annum forward contract period of 1 year is Rs 8,000

= 0:

can take following actions at t

Borrow Rs 7,000, Buy gold spot, and Sell forward contract at Rs 8,000.
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 At

the end of futures contract

+ Rs 8,000 - Rs 7,700 Rs 300

Realise cash from forward contract Pay back the borrowed money and interest thereon Profit
Since

futures was overpriced by Rs 300 the arbitrageur can pocket this profit by selling the futures first and buying gold by borrowing.
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When futures is underpriced at Rs 7,300 the arbitrageur can take following actions:
Borrows gold Sells gold at Rs 7,000 and lends at 10% and Buys a forward contract at Rs 7,300.

One year later following cash flow will result:

Realise cash from lending activity Pay for the forward contract & return borrowed gold Profit
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+ Rs 7,700 - Rs 7,300 Rs 400

For investment assets both cash and carry and reverse cash and carry arbitrage are possible. Consumption value associated with commodities tests the arbitrage argument. For consumption asset while strategy of cash and carry can be implemented but the reverse cash and carry is not be possible. One cannot sell a commodity required for consumption purposes, and buy futures contract instead.
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 If

F1 is the forward price and S0 is the spot price and T is the maturity then at inception, value of the forward contract, f = S0 F1 . e-rT =0 Once entered forward contract would have value.
For initial long position Cash flow at t = T Under initial long contract; pay - F1 Under subsequent short contract; receive + F2 Net cash flow F2 F1 Value of the forward contract, f = (F2 F1) . e-rT
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The current price of Bhartis share is Rs 800. An investor, A goes long with the 6 months contract. After one month another investor, B is prepared to buy Bharti Share at Rs 925 for delivery after 5 months. If the risk free interest rate is 9% per annum what is the value of the forward contract? Solution As of now 5 months are left for the expiry with payment of Rs 900 to get the delivery of share. If A goes short he would receive Rs 925. Therefore the value of the forward contract, f is PV of the difference of current price and original contract price = (925 900) x e-0.09 x 5/12 = Rs 24.08
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The difference of futures price and spot price is called basis. As time progresses basis declines and becomes zero on the day of maturity i.e. spot and futures price converge.
Convergence of Spot and Futures Price Price Futures Net cost of carry Spot Time Maturity

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 The

price of futures and forward are identical in perfect markets. Futures price would be marginally different from forward depending upon the correlation of price with interest rates.
Correlation of Spot & Interest Relationship of Price Positive Correlation Futures Price > Forward Price Negative Correlation Futures Price < Forward Price No Correlation Futures Price = Forward Price
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 Normal

backwardation hypothesis states that the current future price is a downward biased indicator of the future spot price. When futures price is more than the expected future spot price it is referred as contango. Expected hypothesis assumes that the futures price is an unbiased indicator of the expected spot price.
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 Futures

are broadly of two types;

Commodity futures, and

Commodity

futures are those where the underlying asset is a commodity.

Contracts are available in India on agricultural commodities like Wheat, Rice, Soya, Coffee, Sugar, Tea, Jeera, Pepper, Edible oils, Cotton, Coconut, etc. Contracts on metals Gold, Silver, are also available. Futures contracts on oil are also commodity futures.
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Financial futures

 Financial

futures are those where underlying asset is a financial product. These are:
Currency Futures are those where the underlying assets are currencies. Stocks/Index futures are those where the underlying are stocks or indices. Stock futures were introduced in India on June 12, 2000 for Indices and on November 9, 2001 on select individual securities, at NSE. Interest Rate futures are those where underlying assets are interest rates. In India interest rate futures were launched on June 24, 2003 at NSE.
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