Introduction to Futures
Introduction to Futures
• A futures contract is an
agreement between two
parties to buy or sell an
asset at a certain time in
future at a certain price.
• But unlike forward
contracts, the futures
contracts are standardized
and exchange traded.
Standardized items in a futures contract
• Quantity of the underlying
• Quality of the underlying
• The date and the month of delivery
• Location of settlement
Distinction between Futures and Forwards
Futures Forwards
Trade on an organized OTC in nature
exchange
Standardized contract Customized contract terms
terms
More liquid Less liquid
Requires margin payment No margin payment
Follows daily settlement Settlement happens at end
of period
Almost no counter party High counter party risk
risk
Fixed settlement dates as Settlement dates can be
declared by the exchange set by the parties
Futures Terminology
• Spot price: The price at which an underlying asset trades
in the spot market.
• Futures price: The price that is agreed upon at the time of
the contract for the delivery of an asset at a specific future
date.
• Contract cycle: It is the period over which a contract
trades. The futures contracts on the NSE have one-month,
two-month and three-month expiry cycles which expire on
the last Thursday of the month. If the last Thursday is a
holiday, Futures and Options will expire on the previous
working day.
• At any point in time, there will be 3 contracts available for
trading in the market for each security i.e., one near
month, one mid month and one far month duration
respectively.
Futures Terminology
• Expiry date: is the date on which the final settlement of
the contract takes place.
• Contract size: The amount of asset that has to be
delivered under one contract. This is also called as the
lot size. Lot size for futures contracts differs from stock
to stock and index to index.
• Basis: Basis is defined as the futures price minus the
spot price.
• Settlement price: Closing price for a futures contract
shall be calculated on the basis of the last half an hour
weighted average price on NSE of such contract
Futures Terminology
• Base Prices
Base price of futures contracts on the first day of
trading (i.e. on introduction) would be the theoretical
futures price. The base price of the contracts on
subsequent trading days would be the daily
settlement price of the futures contracts as computed
by Clearing Corporation.
Trading of future
•Buy Futures when you are Bullish
•Sell Futures when you are Bearish
KINDS OF TRANSACTIONS IN FUTURES
• Opening Buy means creating a Long Position
• Opening Sell means creating a Short Position
• Closing Buy means offsetting (fully or partly) an earlier
Short Position
• Closing Sell means offsetting (fully or partly) an earlier
Long Position
• Equal and Opposite Transaction means Square Up
• If you do not square up till the day of expiry, it will be
automatically squared up by the exchange.
• In practice, most Futures contracts are squared up
before expiry date and hence never result in delivery.
Futures Payoffs
• Pay-off for a long futures position-
The long investor makes profits if the spot price (ST) at
expiry exceeds the futures contract price F, and makes
losses if the opposite happens.
• Pay-off for a short position-
The short investor makes profits if the spot price (ST) at
expiry is below the futures contract price F, and makes
losses if the opposite happens.
Futures Payoffs
• The pay-off for a long position in a futures contract on
one unit of an asset is:
• Long Pay-off = S p – F
• The pay-off from a short position in a futures contract
on one unit of asset is:
• Short Pay-off = F – Sp
Pay-off diagram for a long & Short futures position
Pricing Futures
Cost of Carry
Buys from Future Market Buys from Spot Market
Interest earned Dividend earned
Dividend Foregone Interest Foregone
Pricing of Futures
• While futures prices in reality are determined by
demand and supply, one can obtain a theoretical
Futures price (fair value), using the following model:
• F = Futures price
• S = Spot price of the underlying asset
• r = Cost of financing (using continuously compounded
interest rate)
• T = Time till expiration in years
• e = 2.71828
Pricing Stock Futures
• Pricing stock futures when no dividend expected
The pricing of stock futures is also based on the cost-
of-carry model, where the carrying cost is the cost of
financing the purchase of the stock, minus the
present value of dividends obtained from the stock.
If no dividends are expected during the life of the
contract, pricing futures on that stock involves
multiplying the spot price by the cost of carry.
• SBI futures trade on NSE as one, two and three-
month contracts. Money can be borrowed at 10%
per annum. What will be the price of a unit of new
two-month futures contract on SBI if no dividends
are expected during the two-month period? Assume
that the spot price of SBI is Rs.228.
• Thus, futures price F = 228 x e ^0.10× (60/365)
= Rs.231.90
One Example…
• Security XYZ trades in the spot market at Rs. 1150.
Money can be invested @11% pa. Calculate the fair
value of a One-Month Contract on XYZ
• F= 1150 x e^ (0.11x 1/12) = Rs. 1160.59
Pricing Stock Futures (with dividend)
• Pricing stock futures when dividends are expected
• When dividends are expected during the life of the futures
contract, pricing involves reducing the cost of carry to the
extent of the dividends. The net carrying cost is the cost of
financing the purchase of the stock, minus the present
value of dividends obtained from the stock.
• F = SerT- DerT
One More Example
• XYZ Ltd. futures trade on NSE as one, two and
three-month contracts. What will be the price of a
unit of new two-month futures contract on XYZ
Ltd. if dividends of Rs. 10 per share are expected
after 15 days of purchasing the contract during the
two-month period? The market price of XYZ Ltd.
is Rs. 140 and cost of fund is 10%.
• F = 140 * e^(0.1 * 60/365) – 10 * e^ (0.1*45/365)
= Rs.132.20
Index future (Nifty)
• NIFTY future is most widely traded future
instrument in Indian capital market
• Top 10 index future contract traded worldwide.
• Lot size = 50 shares
• Highly liquid contract
• Let us consider a value-weighted index of three stocks X, Y, Z.
• Assume, today, October 19, 2015, at time 0; their prices, share outstanding, and market
value are as follows:
No. of shares Market Composition of
Stock Price (₹)
(outstanding) Value (₹) Market Share
X 80 2,500 2,00,000 0.20
Y 60 5,000 3,00,000 0.30
Z 50 10,000 5,00,000 0.50
Further assume that the present price of the spot index is 1,000 and the multiplier of the
index is 200.
In addition, suppose that stock X is trading ex-dividend in the market and the rate of dividend
is ₹ 10 per share 30 days from today. Stock Y will trade ex-dividend in the amount of ₹ 8 per
share 30 days from today. Assume that stock Z pays no dividend and the risk-free return is 6
percent per year. Calculate the theoretical futures value of the contract expiring on
December 31, 2015.
One problem
• Nifty futures trade on NSE as one, two and three-month
contracts. Money can be borrowed at a rate of 10% per annum.
• ABC Ltd. has a weight of 7% in Nifty. It will be declaring a
dividend of Rs.20 per share after 15 days of purchasing the
contract. The market price of ABC Ltd. is Rs.140
• What will be the price of a new two-month futures contract on
Nifty Current value of Nifty is 6000?
Solution:
ABC has 7% weight- 6000*7% = 420
No. of shares of ABC in Nifty- 420/140= 3 shares
F= 6000* 2.72^0.1*60/365 – 3*20*2.72^0.1*45/365 = 6038.5
MARGIN
• The exchange sets two margins
• SPAN Margin and Exposure Margin.
• Standard Portfolio Analysis of risk (SPAN)/ VaR
margin/Initial margin/Maintenance margin
• Lower the volatility, lower the SPAN & vice-versa
• Strictly need to maintain as long as trader wishes to
carry his position
• Not static in nature
MARGIN
• Exposure margin
• Additional margin over & above SPAN
• Aimed to protect broker’s liability in case of wild
swings
• Usually remains same
• Total Margin= SPAN + Exposure margin
Types of settlement-continued
•Mark to market settlement is the
process of adjusting the margin balance
in a futures account each day for the
change in the value of the contract from
the previous day, based on the daily
settlement price of the futures contracts.
Margin A/C of buyer
A margin call is issued if it is below variation margin.
Gain from future trading- Cumulative loss/gain= 6250
Peak Margin
• The minimum margin is VAR+ELM (Extreme Loss Margin) for
stocks and SPAN +Exposure for F&O
• This minimum margin inherently has leverage
• Since margin reporting was happening only on an end of the
day basis until now, brokerage firms were allowing customers
to take intraday positions with margins far lesser than
VAR+ELM or SPAN+ Exposure.
Peak Margin
• If Nifty futures require SPAN+ Exposure of Rs 1.5L,
brokers would allow customers to trade intraday with
say just 30% of this amount or Rs 50,000.
• From Sept 2021 — penalty if margin blocked less than
100% of the minimum margin required.
Leverage financing • Investment- Rs. 1 lakh
• Spot Price- Rs. 2362.
• Sell after 5 days
• Price after 5 days- Rs.2519
• ROI??
Leverage financing
Leverage financing
Leverage financing
Arbitrage: Overpriced futures: buy spot, sell futures
• ABC Ltd. trades at Rs.1000. One-month ABC futures
trade at Rs.1025 and seem overpriced.
• An investor borrows fund, buy the security on the
cash/spot market at Rs. 1000
• Simultaneously, sell the futures on the security at Rs.
1025
• Take delivery of the security purchased and hold the
security for a month.
• Say the security closes at Rs.1015.
• The result is a riskless profit of Rs.15 on the spot
position and Rs.10 on the futures position.
• Return the borrowed funds
Hedging: Better vs. certain outcome
• Hedging does not necessarily improve the financial
outcome; What it does however is, that it makes the
outcome more certain
• There may be a situation where at the lifting of the
hedge you may realize that had you not hedged the
exposure, you would have made a higher profit
Short hedge and a long hedge
• A short hedge entails creation of a hedge by taking
a short position in the futures market
• You like to take a short hedge when you
are adversely affected by a fall in prices in the spot
market.
• A long hedge entails taking a long position in the
futures market to create the hedge.
Hedging Strategies
Futures Hedging
• The life of the futures contract need not coincide
with the hedge period.
• In other words, the futures position can be
liquidated at the end of the hedge period, which
may be earlier than the maturity of the futures
contract
Hedging using stock future
• Maruti shares are selling for INR 991.55 on January 1.
February futures contracts on the Maruti shares are
available at INR 1,004.45 with expiry on February 28.
The contract size for Maruti futures is 200 shares.
• You want to buy 200 shares of Maruti, and you are not
sure whether the Maruti share price will increase or
decrease in the future.
• You want to ensure that the value of your investment in
Maruti is of a particular value, irrespective of what the
market price of Maruti is. The risk-free rate is 8%.
• How can you accomplish this? Show the position on
expiry at Rs. 830, 860, 920, 980, 1010, 1040
Perfect vs Imperfect hedge
• Forward is a perfect hedge
• You decide to buy US Dollars in three months at a
certain forward price, let us say Rs. 75 per $. That
means as of now you have ensured the price at
which you are going to get dollars at the end of
three months.
• Future is an imperfect hedge
Cross Hedging in an Airline Company
• Hedging by closest alternative asset
available.
• An airline might be forced to cross hedge
its exposure to jet fuel by buying crude oil
futures instead
• Crude oil and jet fuel are highly correlated
and will therefore likely function adequately
as a hedge
• Risk remains that if the price of these
commodities diverges significantly
Why future is not a perfect hedge?
• Different
underlying assets
• Non- identical
maturity
• Lot size issue
• MTM
• Basis risks
Why future is not a perfect hedge?
• You have got admission in a US University and you
have to pay a fee in US dollars at the end of three
months from now and you want to hedge yourself
against a rise in the price of US dollars
• At the end of three months from now you are
going to buy dollars from the market and remit
them to the US University.
• But what happens if you require Mexican pesos
and your pesos futures are not traded in India
Open Interest (OI)
• In simple language, it helps a trader to understand
the market scenario by only showing a number of
futures contracts that have been changed hand
during the market hours.
• Open interest mostly used by the Future and
options contract traders.
Open Interest (OI)
• When a new entrant trades with a new entrant in
F&O market Open Interest goes up
• When an existing position holder squares off with
entry of a new entrant, open interest remain
unchanged
• When two existing position holders square off their
positions we see open interest go down
Open Interest (OI)
• There are 5 participants in the market A, B, C, D, and E.
• On 1st July, A buys 10 contracts from B
• => OI 10
• 2nd July C buys 20 contracts from D
• => OI 30
• 3rd July A sells his 10 contracts to D
• => OI 20
• 4th July E buys 20 contracts from C
• => OI 20
Price Volume OI Matrix
Price
OI Delivery Effect
Rising Rising Rising Strongly bullish
Rising Falling Falling Weak (short sellers covering their
positions are causing the rally)
Falling Rising Rising Strongly bearish (aggressive new short
selling)
Falling Falling Falling Possibly Market bottom (long
position holders being forced
to liquidate their positions)
• Any Question?
