Forwards & Futures

Amit Kulkarni
"We view them as time bombs both for
the parties that deal in them and the
economic system .. In our view ...
derivatives are financial weapons of
mass destruction, carrying dangers
that, while now latent, are potentially
lethal."

- Warren Buffett, the Chairman of Berkshire Hathaway

and his critique of the derivatives market. (March 2003)
 "These increasingly complex financial
instruments have especially contributed,
particularly over the past couple of stressful
years, to the development of a far more
flexible, efficient and resilient financial
system than existed just a quarter-century
ago,"

- Alan Greenspan, Chairman of the Federal Reserve

and his summary of the derivatives market (2002)
• Evolution of Derivative products

• What is a Derivative ?

• OTC & Exchange traded derivatives

• Types of derivatives
 Futures
• Equity, Stock Index, Commodity,Currency &
Interest rate futures (non OTC products)
• Buyer, Seller & Clearing house
• Predetermined price & settlement date
• Physical settlement - Delivery based
• Cash settlement - Squaring off the deals
• Physical settlement not prevalent in India
• Margin system (M.T.M._SPAN)
 Issues in Futures pricing
• Discrete v/s Continuous compounding
• Cost of Carry model
• Mispricing of Futures
• Arbitrage mechanism
• Pricing of Stock Index futures
• Expected dividends / Known dividend
yields
 Expected Dividend OR Known
dividend yield
• Discount the dividends & deduct the
subsequent value from ‘S’

OR

• Subtract the known dividend yield from the

interest rate
 Interest Rate Parity
• Relationship between Interest Rates and
Forward exchange rate
• The return on a hedged (covered) foreign
investment will equal the return on a
domestic investment of identical risk
• Percentage forward premium or discount is
equal to the interest rate differential. That is,
currencies with higher interest rate are expected
to depreciate
 Interest Rate Parity contd...
• Identifying arbitrage opportunities
• Covered Interest Arbitrage
• Arbitrage principle: Borrow in undervalued
currency & invest in overvalued currency
• RBI permits banks to borrow 25% of their Tier I
capital or $ 10 million, whichever is higher.
(This excludes FC borrowings raised for funding export
credit since exporters have a ‘Natural Hedge’ through
export proceeds in same currency)
 Cash & Carry Arbitrage
• S: Rs.45/$ r$:6% rRs:10% F: Rs 47/$
• Hence, Firp : Rs 46.70/$
• Borrow Rs 45 & purchase $1
• Invest the dollar at 6% p.a.
• Sell $1.06 forward @ Rs 47/$ : Rs 49.82
• Repay the loan of Rs 49.50
• Profit = 49.82- 49.5 = Rs 0.32
Reverse Cash & Carry Arbitrage
• S: Rs.45/$ r$:6% rRs:10% F: Rs 46/$
• Hence, Firp : Rs 46.70/$
• Borrow $1,sell spot & receive Rs 45
• Invest Rs 45 at 10% p.a. : Rs 49.50
• Buy $1.06 forward @ Rs 46/$ : Rs 48.76
• Profit = 49.50- 48.76 = Rs 0.74