Unit-II

Future and Forward Market structure

of forward and Future Markets,
Mechanics of future markets, Hedging
Strategies by Using futures, Determination
of forward and future prices, Interest rate
futures, Currency futures and Forwards.
 Determination of
Forward and Future Prices
 The important difference between
forward and cash market, the
exchange of security and cash
happens immediately in a spot
transaction while in the forward
contract, this happens at a later
date, but in both transactions, the
terms and conditions of the deal are
laid down at the time of entering in
the contract.
 SPOT
TRANSACTIO
N

DAY 0 DAY 1 DAY 2 DAY 3

Price agreed and

paid + security
delivered
 FORWARD
TRANSACTIO
N

DAY 0 DAY 1 DAY 2 DAY 3

CASH paid +
Price agreed security
delivered
Theories of forward pricing
Forwards contract is a simple form of financial
derivative instruments. It is an agreement to buy (or)
sell a specified quantity of an asset at a certain future
date.
In this two persons agree to do a trade at some future
date at a stated price and quantity. No money
changes hands at the time of the deal is signed.
Forward contracts are generally easier to analyze
than futures contracts because in forward contracts
there are no daily settlement and only a single
payment is made at maturity.
Even both futures prices and forward prices are
closely related.
 Features of forward
contracts
1. It is an agreement between the two counter
parties in which one is buyer and other is
seller.
2. It specifies a quantity and type of asset to be
sold and purchased.
3. It specifies the future date at which the
delivery and payment are to be made.
4. It specifies a price at which the payment is to
be made by the seller to the buyer at
present, but the price has to be paid in future
5. It provides buyer the obligation to
buy the commodity in future and it
provides seller an obligation to sell
the commodity in future.
6. No money changes hands until the
delivery date is reached.
 Assumptions
Certain assumptions considered here for
determination of forward or futures prices
are:
1. There are no transaction costs.
2. Same tax rate for all the trading profits.
3. Borrowing and lending of money at the risk
free interest rate
4. Traders are ready to take advantage of
arbitrage opportunities as and when arise.
Note: These assumptions are equally
available for all the market
participants; large or small.
Forward price calculation situations
(For Securities)
2. Investment
1. Investment
assets
assets
providing a
providing no
known cash
income
income
3. Investment
assets
providing a
known
dividend
income
1. Investment assets
providing no income

This is the easiest forward contract

to value because such assets do not
give any income to the holder.
These are usually non-dividend
paying equity shares and discount
bonds.
 let us assume a forward contract on an investment
asset with price S0 that provides no income. The
following equation gives the price of a forward:

F0 = S0 erT
Where :
F0 is forward price.
S0- Price of an investment asset with no income.
e- Constant
r- Risk free rate of return.
T- Time to maturity
 If F0 > S0erT then the arbitrageurs will buy the asset and
short forward contracts on the assets.

If F0 < S0erT they can short the asset and buy forward
contracts.

Example 1:- Spot price of one year non dividend paying stock is
Rs.240/-Interest rate is 15%. Establish forward price using arbitrage
argument. What transactions will be undertaken if the forward price
is Rs.248/-.
F0 = 278.71 F 0 = S0 e rT

F0 = 240 e.15 X 1 F0 = 240 X 1.161

F0 = 240 e.15 F0 = 278.71

F0 = 240 X *2.71.15
*e = 2.71
 Example 2:- Suppose X enters into a
six-month forward contract on non
dividend paying stock when stock price
is Rs. 50 and risk free rate of interest is
14% p.a. Calculate forward price.

F0 = S 0 e rT
Where :
F0 is forward price.
S0- Price of an investment asset with no income Rs.50/-.
e- Constant = 2.71 (apprx.)
r- Risk free rate of return 14%
T- Time to maturity 6 months
Example 3:- Assume that an investor enters
into a six-month forward contract on a non-
dividend paying stock when the stock price is
Rs. 50 and risk free rate of interest is 10% p.a.
Compute forward price.

F0 = S 0 e rT
Where :
F0 is forward price.
S0- Price of an investment asset with no income Rs.50/-.
e- Constant = 2.71 (apprx.)
r- Risk free rate of return 10%
T- Time to maturity 6 months
Example 4:- Assume that an investor enters
into a four month forward contract on a non-
dividend paying stock when the stock price is
Rs. 930 and risk free rate of interest is 6% p.a.
Compute forward price.

F0 = S 0 e rT
Where :
F0 is forward price.
S0- Price of an investment asset with no income Rs.930/-.
e- Constant = 2.71 (apprx.)
r- Risk free rate of return 6%
T- Time to maturity 4 months
 Example 5:- A non income Current
stock price is Rs.100 and the three
months risk free rate of interest is
6% pa. find out the forward price.

F0 = S 0 e rT
 Example:- 6 Mr. Ramesh enters into a
six month forward contract on non-
dividend paying stock when stock
price is Rs. 30/- and risk free interest
rate is 12% per annum. Calculate
forward price.

F0 = S 0 e rT
 Spot price of stock is Rs.100; forward
price after 1 year of the stock is
Rs.120; Risk free rate of return (RFR)
10%. Calculate if there is any
arbitrage opportunity, and if yes,
what TODAY
will be profits to the trader.
AFTER 1 YEAR
STEP 1: BORROW Rs.100 STEP 1:DELIVER THE
@10% SHORT @ Rs.120.
STEP 2:PAY THE LOAN
STEP 2: BUY THE STOCK WITH INTEREST (100 +
10) Rs.110
STEP 3: SHORT THE
PROFIT = 120 110 = 10
FORWARD
CASH & CARRY ARBITRAGE
F0 = S0 erT
F0 = 100 e
.10 X 2 F0 = 122
F0 = 100 e.20 F0 = 122
F0 = 100 X 1.220
2. Investment assets
providing a known cash income
Forward contracts on such assets
which provides a known cash income,
for example a coupon bearing bond,
treasury securities, preference shares
etc.,
In general, that such assets which
provide known income ( I ) during the
life of a forward contract, then
forward price would be as follows:
F0 = (S I)e rT
 If F0 > (S0 I)erT then, the arbitrageurs can earn
the profit by buying the asset/stock/share and
shorting a forward contract on the asset.
If F0 < (S0 I)erT , an arbitrageur can earn the
profit by shorting the asset and taking a long
position in a forward contract.

Step 1:- find the value of I

Step 2:- put the values in the formula of F0
 10 month forward contract on a stock with
S0
Rs.50 return is 8% per annum, flat yield
curve Assume dividends of Rs.0.75 per
share. Which are expected at 3 months, 6
months, and 9 months.

STEP 1:- CALCULATION OF I by converting

in
to present value
STEP 2 :- USE THE FORMULA to calculate
the Forward value
F0 = (S I)erT
 F0 = (S I)e rT

Step 1:-
Present value of the dividend is :-
I = 0.75e (0.083/12) + 0.75e (0.086/12) + 0.75e(0.089/12)
I = 0.735 + 0.7205+ 0.7063 = 2.162
T is ten months, so that the forward
price is given by
F0T = (50 -2.162)e (0.08 X 10/12)

= 51.14
 F0 = (S I)erT
Example 1:-
If the S = Rs.900; r = 10%
I = Rs.40, (two times: r=9% for
6 months;
r = 10% for 12
months)
the T = 1.
*Calculate the forward price of the
scrip.
Step1:-
I = 40e (0.090.5) + 40e (0.101)
=
74.433
F0 = (S0 I) e rT

F0 = (900 74.433) e0.10 X 1

F0 = 825.567 X 2.7183 0.10
F0 = 825.567 X 1.10517

F0 = 912.39
 When S = Rs.500; r = 10% for 6
months ; T = 1 yr; (0.50) and I =
Rs.50/- calculate forward price.

F0 = (S0 I) erT
F0 = (500 - 50) 2.7183 0.10 x0.50

F0 = (450) 2.7183 0.05

F0 = (450) X 1.0512
F0 = 473.04
 Example No.1:- An investor to buy
one share (take a long position) of
TISCO after six months. Assume that
the current price (spot price) of
TISCO is Rs.500/- and expected
dividend payment, after three
months, on each share is Rs.10/-. The
three months risk-free return is 5%.
Let us look at arbitrage under two
different values of three months
forward TISCO.
 Situation No.1:- if the forward price is
Rs.530/-
Situation No.2:- if the forward price is
Rs.505/-
 F0 = (S I)e rT

Present value of the dividend is

I = 10e (0.053/12)
=?
T is ten months, so that the forward
price is given by
F0 = (500 - ?)e (0.08 X 6/12)
=?
3. Investment assets providing a
known dividend income
A known yield refers to income
expressed a percentage of the asset
life, and this yield is known for assets
like stock indices.
In this case the forward price is as
follows:

F0 = Se (r-q)T
 If F0 > Se
then
(r-q)T an investor can buy the

asset and enter into a short forward

contract to lock in a riskless profits.

If F0 < Se (r- then an investor can

enter q)T
into a long forward contract
and short the stock to earn a riskless
profit.
 A six month forward contract on a
security where 4% p.a continuous
dividend is expected. This risk free
rate of interest is 10% per annum.
The assets current price is Rs.25/-.
Then we can calculate the forward
price as: F 0 = Se (r-q)T

F0 = 25e (0.10-.04)0.5

F0 = 25.76
Ex:- A six month forward contract on a
security where 10% p.a. continuous
dividend is expected. The risk free
rate of interest is 15% p.a. the asset
current price is Rs.100. Then what is
forward price?
F = Se
0
(r-q)T

F0 = 100e (0.15-.10) x 0.5 (6/12)

F0 = 100e (0.025)

F0 = 100 X 1.0253 = 102.53

 BSE-SENSEX (stock index) give
annual yield of 4%. The current price
of Sensex is 11,500 and the three
month risk free rate is 6% per
annum. Find out the value of the
three-monthsFforward contract of
0 = Se
(r-q)T
SENSEX.

Price of the share Rs 11,500

Time to expiry 3 months
r = 0.06; q = 0.04; T = 3 months
Dividend expected
Time to dividend
4%
1 yr
Continuously
compounded risk 6 % p.a.
free rate of return
Example:- Calculate the price of a forward contract using the following data

Price of the share Rs 75

Time to expiration 9 months
Dividend expected Rs 2.20 per share
Time to dividend 4 months
Continuously compounded risk
12% p.a.
free rate of return
FEATURES OF FUTURES CONTRACTS

The Futures have the following salient features:

1. Exchange Traded:
futures contracts are organised /standardised
contracts, which are always traded on the
exchange. Trading in
commodity
futures
only
Facilitate for Trading in
A Futures
trading in Financial
Exchange
future contracts Futures
only
It is an
association of Trading in
certain members both
 2. Standardised
specifications
Futures contracts are exchange
traded contracts to sale or buy
financial of the asset. Underlying
Quantity

Assets
Quality

Date

Std.
specifications Delivery
Place
by exch., for terms
future trading

Processe

Price
Methods
Settlement
terms
Mode of
settlement
Theories of futures
pricing
SETTLEMENT OF FUTURES POSITION

PHYSICAL DELIVERY:- Futures contracts

are either cash settled or physically
delivered. Futures contracts that are
physically delivered require the holder to
either produce the commodity or take
delivery from the exchange.
Futures contracts that are cash settled
are not deliverable and a simple debit or
credit is issued when the contract expires.
 Physical Delivery:At the end of the
contract the holder of the position will either
have to deliver the physical commodity if
short or take delivery if long.
It is estimated that only 2% of all futures
contracts are actually delivered. All Physically
Delivered contracts have both aFirst Notice
Day and a Last Trading Day. Most brokers, if
not all, will notify traders if they are in a
contract and First Notice Day is approaching.
Cash Settlement: At the end of the contract the holder of
the position is simply debited or credited the difference
between their entry price and the final settlement.
 Offsetting Position: Parties to a futures contract may also
terminate the contract prior to expiration through an
offset. Offset is the transaction of a reversing trade on the
exchange. If you are long 20 March soybean futures traded on the
Chicago Board of Trade, you can close the position by taking an
offsetting short position in 20 March soybean contracts on the
same exchange.
There will be a final margining at the end of the day, and then the
position will be closed. In other words, if you buy (long) a futures
contract and subsequently sell (short) a comparable contract, you
have offset your position and the contract is extinguished.
Offset trades must match in respect to the underlying
asset, delivery dates, quantity, etc., or the original position will not
be effectively terminated. In such cases, price movements in the
original contract will continue to result in gains or losses.
 Basis: The basis reflects the
relationship between cash price and
futures price. (In futures trading, the
term "cash" refers to the underlying
product). The basis is obtained by
subtracting the futures price from the
cash price.
The basis can be a positive or negative
number. A positive basis is said to be
"over" as the cash price is higher than
the futures price. A negative basis is
said to be "under" as the cash price is
lower than the futures price.
 Basis Calculation Example
Spot (Cash) Price $42
August Futures Price $47
Basis -5
 FUTURE PRICE CALCULATION SYSTEM
PURPOSE:
http://thismatter.com/money/futures/
futures-prices.htm
http://www.investopedia.com/exam-guide/cfa-level-
1/derivatives/forward-markets-contracts-settlement-
procedures.asp
 Theories of futures pricing

There are several theories

which have made efforts to
explain the relationship
between spot and futures
prices. A few important of
them are as follows:
 Arbitrage
An Arbitrageur attempts to exploit
any discrepancies in price between
the futures and cash markets.
An arbitrage is a risk-free transaction
consisting of purchasing an asset at
one price and simultaneously selling
it that same asset at a higher price,
generating a profit on the difference.
 Assumptions
1.Perfect futures market
2.No taxes
3.No transactions costs
4.Commodity can be sold short
 Cost-of-Carry Model
The common way to value a futures contract
is by using the Cost-of-Carry Model. The
Cost-of-Carry Model says that the futures
price should depend upon two things:
The current spot price.
The cost of carrying or storing the underlying
good from now until the futures contract matures.
Assumptions:
There are no transaction costs
There are no restrictions on short selling.
Investors can borrow and lend at the same rate of
interest.
 Cash-and-Carry Arbitrage
A cash-and-carry arbitrage occurs
when a trader borrows money, buys
the goods today for cash and carries
the goods to the expiration of the
futures contract. Then, delivers the
commodity against a futures contract
and pays off the loan. Any profit
from this strategy would be an
arbitrage profit.
 0 1

1. Borrow money 4. Deliver the

2. Sell futures commodity
contract against the futures
3. Buy contract
commodity 5. Recover money &
payof
loan
 Futures on Commodities
(a)Some investors purchase gold and silver for investment
purposes. If the storage cost assume to be zero then these
can be considered asset paying no income, then in that
case the future price of gold/silver will be:-
F = S0ert
(b)If the storage costs are to be incurred, assuming U as
present value of all the storage costs, that will incurred
during the life of a futures contract, then the futures value
F will be:-

F = (S0 + U)ert
(c)Where U is a storage cost per annum as a proportion of
the spot price.
If the storage costs incurred at any time are proportional
to the price of the commodity, then it will treated as
negative dividend yield, and in this the futures price of a
commodity:

F =S0e(r+u)t

Where u denotes the storage costs per annum as

proportion of the spot price net of any yield earned on
the asset.
 Mr. Ramesh enteres into a six months
future contract on non-income
commodity, when stock price is Rs.
30 and RFR is 12% pa, calculate the
future price of the contract.

PG.no. 111 for examples.

 Example for 2 situation:- A one year
futures contract on gold with a
storage costs of Rs.20 per 10 grams
per year to store gold to be paid at
the end of the year. Assume that the
spot price of Rs.4,500 and RFR is 7%
pa for all maturities.
F = (S0 + U)e rt

S0 = Rs.4,500; r = 0.07; and t = 1

year.
 F = (S0 + U)ert
U = 20 ert
U = 20 e (-.o7 x 1)
U = 18.65

If F > 48.46, an arbitrageur can buy gold and short one

year gold futures contract and in this way can lock in a
profit. Similarly, if F < 48.46 then he is having own gold
can sell the gold and purchase the gold in futures
contract.
 What is Contango?
Contango means a situation, where futures
contract prices are higher than the spot
price .
What is convergence?
The difference between spot and futures
contract theoretically should have declining
trend over the life of a contract and tend to
become zero on the date on maturity. In
other words the futures and spot prices
should be the same at the time of the
maturity of the contract. This is known as
convergence of the spot and futures prices.
 Example:- Calculate the price of a forward contract using the following data

Price of the share Rs 75

Time to expiration 9 months
Dividend expected Rs 2.20 per share
Time to dividend 4 months
Continuously compounded risk free rate of return 12% p.a.

Example: - Determine the future price from the following data

Spot price = Rs 17,00,000
Cost of carry = 12% P.A
Carry period = 6 months
Use cost of carry model.
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