Module 2

Content: Risk Management using futures and forwards Differences between forwards and futures Valuation of futures, Valuation of long and short forward contract. Mechanics of buying &selling futures, Margins Hedging using futures -Specification of futures Commodity futures, Index futures interest rate futuresarbitrage opportunities

Marking to Market (MTM)

Marking to market means recording the value of a

contract at the day's settlement price to calculate the profits or losses. This is done on a daily basis and the gains or losses are netted against the initial margin. Types of Margins: Initial Margin ,maintence margin and variation margin.

Contract size or Lot size, Multiplier and Tick size

Contract size or Lot size refers to number of underlying

securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts. For eg, if shares of POR Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrip stands to be 200000/1000 = 200 shares i.e. one contract in POR Ltd. has 200 shares.

Contract Multiplier
It is the predetermined value used to arrive at the contract size.

In India this multiplier is guided by SEBIs directive and any derivative contract should have a minimum value of Rs.200,000.

In index futures it is the price per index point. For eg.contract multiplier for Sensex futures is Rs.50 and of Nifty contract the multiplier is Rs.200 (this means that each sensex point is worth Rs.50 or Rs 200)
Thus,when Nifty stands at1500 points , the notional value of

the Nifty futures contract is Rs.3,00,000 (1,500x200)

Tick Size
The gains or loses are computed in terms of ticks, where a risk

is defined as the monetary loss/ gain when the futures price changes by the minimum amount allowed by the exchange. In the case of Nifty futures contract the minimum price movement (tick size) is 0.05 index points and each index point is equal to Rs.200. therefore when the minimum allowable price movement occurs in the market, traders gain or loss per contract will be 0.05 x 200 = Rs.10.

 Therefore , for Nifty contracts ,one tick or tick value is

equal

Tick size
Tick size is the minimum price movement allowed in

the case of senses futures. or it is the minimum increment in which prices can change Tick size is also known as the minimum price change. Tick sizes and tick values are part of the contract specifications for all financial markets. eg.,the tick isze is 0.05 points or Rs.2.50 (.05xRs.50 per point)

Valuation of Forwards and Futures prices

The futures prices are same as the forward prices.

Differences in valuation is made only in assets held as investments (like Silver, gold)and those for consumption( like agricultural commodities) The financial forward and futures are priced using cost of carry model and agricultural commodities based on non-carry model.

Assumptions.
The pricing of financial contracts is based on certain

assumptions: The markets are perfect There are no transaction costs. All the assets are infinitely divisible. Bid-ask spreads (difference in price between the price that a buyer is willing to pay and the least price for which a seller is willing to sell .) do not exist, so it is assumed that only one price prevails. There is no restrictions on short selling.

Carry pricing model

cost-of-carry model is an arbitrage-free pricing model. Its

central theme is that futures contract is so priced as to prevent arbitrage profit. In other words, investors will be indifferent to spot and futures market to execute their buying and selling of underlying asset because the prices they obtain are effectively the same. Expectations do influence the price, but they influence the spot price and, through it, the futures price. They do not directly influence the futures price. According to the cost-of-carry model, the futures price is given by Futures price = Spot Price + Carry Cost - Carry Return

 Carry cost (CC) is the interest cost of holding the

underlying asset (purchased in spot market) until the maturity of futures contract. Carry return (CR) is the income (e.g., dividend) derived from underlying asset during holding period. Thus, the futures price (F) should be equal to spot price (S) plus carry cost minus carry return. If it is otherwise, there will be arbitrage opportunities as follows:-

 Wwhen F > (S + CC - CR): Sell the (overpriced)

futures contract, buy the underlying asset in spot market and carry it until the maturity of futures contract. This is called "cash-and-carry" arbitrage. when F < (S + CC - CR): Buy the (under priced) futures contract, short-sell the underlying asset in spot market and invest the proceeds of short-sale until the maturity of futures contract. This is called "reverse cash-and-carry" arbitrage

Valuation concepts
Annual Compounding - A=P(1+ r)n
Compounding can be quarterly, monthly ,weekly or on

a daily basis --

A=P(1+ r/m)mxn

r= rate of interest, m= N o . of compounding ie.,either quarterly - 4 ,monthly-12,0r daily 365 days.

Continuous compounding

A= P enxr e is the constant value=2.7183

Similarly, for discounting the formula is

A=P(1+ r)-n

and for continuous compounding discounted the

formula is

A= P. e -nxr

Converting Annual Compounding to continuous

A= (1+ r1/m)mxn

r n Ae 2
r n e 2

By canceling A we have (1+ r1/m)mxn = By canceling n we have (1+ r1/m)m =

r

e 2

Therefore , Applying log on both sides we get

r2= mln(1+ r1/m) Similarly, r1 = m (e. r2/m 1)

Notation for Valuing Futures and Forward Contracts

S0:Spot price today F0:Futures or forward price today

T:Time until delivery date

R:Risk-free interest rate for maturity T

Pricing of Forward Contracts

1)For securities providing no income F0 = S0erT
2)For securities providing a given amount of income

F0 = (S0 I )erT
where I is the present value of the income during life of forward contract

 3) For securities providing a known yield

F0 = S0 e(rq )T
where q is the average yield during the life of the contract (expressed with continuous compounding)

Divergence of futures and spot prices: The Basis

The difference between the futures price and the

current price is known as the basis Basis = P1 P0 P1 futures price, P0 =spot or market price The basis can be a positive or negative when futures price is greater than spot or market price, the basis is positive normal market. When the spot or market price is greater than the futures price the basis is negative inverted market.

Convergence of futures and spot prices

as the delivery month of a futures contract approaches, the future's

price will generally inch toward or even come to equal the spot price as time progresses.

For example, suppose the futures contract for corn is priced higher

than the spot price as time approaches the contract's month of delivery. In this situation, traders will have the arbitrage opportunity of shorting futures contracts, buying the underlying asset and then making delivery. In this situation, the trader locks in profit because the amount of money received by shorting the contracts already exceeds the amount spent buying the underlying asset to cover the position. Read more: http://www.investopedia.com/ask/answers/06/futuresconvergespot.as p#ixzz2N16VdzxR

 In terms of supply and demand, the effect of arbitrageurs

shorting futures contracts causes a drop in futures prices because it creates an increase in the supply of contracts available for trade. Subsequently, buying the underlying asset will causes an increase in the overall demand for the asset and the spot price of the underlying asset will increase as a result . As arbitragers continue to do this, the futures prices and spot prices will slowly converge until they are more or less equal. The same sort of effect occurs when spot prices are higher than futures except that arbitrageurs would short sell the underlying asset and long the futures contracts. Read more: