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Futures Contracts
Available on a wide range of assets like stocks, Indices, Commodities, currencies, inte-rest rate etc. Exchange traded and standardised, Settled daily The standardized items in a futures contract are:
Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement
Terminology
Spot Price Future Price Contract Cycle Expiry Date Contract Size Basis Cost of Carry (Storage + Interest Income) MTM Initial Margin Maintenance Margin
Futures Vs Forwards
Futures Trade on an organized exchange Standardized contract terms hence more liquid Requires margin payments Forwards OTC in nature Customised contract terms hence less liquid No margin payment
Margins
A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract
A Possible Outcome
Futures Price (US$) 600.00 5-Jun 597.00 . . . . . . 13-Jun 593.30 . . . . . . 19-Jun 587.00 . . . . . . 26-Jun 592.30 (600) . . . (420) . . . (1,140) . . . 260 (600) . . . (1,340) . . . (2,600) . . . (1,540) Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 3,400 . . . 0 . . .
Day
Futures Prices for Gold on Jan 8, 2007: Prices Increase with Maturity: Normal Market
650
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Futures Prices for Orange Juice on January 8, 2007:Prices Decrease with Maturity:Inverted Mkt.
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205 200 195 190 185 180 175 170 Jan-07 Mar-07 May-07 Jul-07
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Delivery
If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash
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Some Terminology
Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of trades in 1 day
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Spot Price
Time
Time
(a)
(b)
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Futures Payoffs
Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited.
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Short Selling
Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way
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Short Selling
(continued)
At some stage you must buy the securities back so they can be replaced in the account of the client You must pay dividends and other benefits the owner of the securities receives
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1. An Arbitrage Opportunity?
Suppose that: The spot price of a non-dividend paying stock is $40 The 3-month forward price is $43 The 3-month US$ interest rate is 5% per annum Is there an arbitrage opportunity?
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F0 = (S0 I )erT
where I is the present value of the income during life of forward contract Example: Long Forward Contract to purchase a coupon-bearing bond
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F0 = S0 e(rq )T
where q is the average yield during the life of the contract (expressed with continuous compounding) e.g. 6-month forward contract, S0 = 25, r = 10%, q = 3.96% and T = 0.5 We get F0 = 25.77
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A two-month futures contract trades on the NSE. The cost of financing is 10% and the dividend yield on Nifty is 2% annualized. The spot value of Nifty 4000. What is the fair value of the futures contract? Fair value = 4000 x exp(0.10.02) (60 / 365) i.e. Fair value = Rs.4052.95
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F0 = S0 e(rq )T where q is the average dividend yield on the portfolio represented by the index during life of contract
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Nifty futures trade on NSE as one, two and three-month contracts. Money can be borrowed at a rate of 10% per annum. What will be the price of a new two-month futures contract on Nifty? Let us assume that ABC Ltd. will be declaring a dividend of Rs.20 per share after 15 days of purchasing the contract. Current value of Nifty is 4000 and Nifty trades with a multiplier of 100. Since Nifty is traded in multiples of 100, value of the contract is 100*4000 = Rs.400,000. If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is Rs.28,000 i.e.(400,000 * 0.07). If the market price of ABC Ltd. Is Rs.140, then a traded unit of Nifty involves 200 shares of ABC Ltd. i.e. (28,000/140).
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To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.4000 i.e. (200*20). The dividend is received 15 days later and hence compounded only for the remainder of 45 days. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty. Hence we divide the compounded dividend figure by 100.
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Index Arbitrage
When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index
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Index Arbitrage
(continued)
Index arbitrage involves simultaneous trades in futures and many different stocks Very often a computer is used to generate the trades Occasionally simultaneous trades are not possible
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F0 S0 e
( r rf ) T
40
1000 e
rf T
1000 F0 e
rf T
dollars at time T
1000 S 0 e rT
dollars at time T
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F0 e or
rT
kT
E ( ST )
F0 E ( ST )e ( r k )T
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If the asset has no systematic risk, then k = r and F0 is an unbiased estimate of ST positive systematic risk (asset is +vely correlated with the stock market e.g. Stock Index), then k > r and F0 < E (ST ) i.e. Normal Backwardation negative systematic risk (asset is -vely correlated with the stock market), then k < r and F0 > E (ST ) i.e. Contango
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Basis Risk
Basis is the difference between the spot and futures price Basis risk arises because of the uncertainty about the basis when the hedge is closed out
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Long Hedge
We define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price If you hedge the future purchase of an asset by entering into a long futures contract then Cost of Asset=S2 (F2 F1) = F1 + Basis
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Short Hedge
Again we define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price If you hedge the future sale of an asset by entering into a short futures contract then Price Realized=S2+ (F1 F2) = F1 + Basis
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Example
S&P 500 futures price is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5
What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
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Changing Beta
What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?
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ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs.1025 and seem overpriced. You can make riskless profit by entering into the following set of transactions.
On day one, borrow funds, buy the security on the cash/spot market at 1000. Simultaneously, sell the futures on the security at 1025. Take delivery of the security purchased and hold the security for a month. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Say the security closes at Rs.1015. Sell the security. Futures position expires with profit of Rs.10.
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The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cashand-carry arbitrage.
Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008
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ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions.
On day one, sell the security in the cash/spot market at 1000. Make delivery of the security. Simultaneously, buy the futures on the security at 965. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Say the security closes at Rs.975. Buy back the security. The futures position expires with a profit of Rs.10. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.
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If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cashand-carry arbitrage.
Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008
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