Futures Markets and

the Use of Futures

for Hedging

1
Convergence of Futures to Spot

Contango Backwardation

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)

2
 Long & Short Hedges

A long futures hedge is appropriate when you

know you will purchase an asset in the
future and want to lock in the price
A short futures hedge is appropriate when you
know you will sell an asset in the future and
want to lock in the price

3
 Basis Risk

Basis is the difference between

spot & futures
Basis risk arises because of the
uncertainty about the basis when
the hedge is closed out

4
 Long Hedge
Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future purchase of an asset by
entering into a long futures contract
Cost of Asset=S2 -F2+F1 = F1 + Basis

5
 Short Hedge
Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S2 : Final Asset Price
You hedge the future sale of an asset by
entering into a short futures contract
Price Realized=S2 -F2+F1 = F1 + Basis

6
 Choice of Contract
Choose a delivery month that is as close as
possible to, but later than, the end of the life
of the hedge
When there is no futures contract on the asset
being hedged, choose the contract whose
futures price is most highly correlated with
the asset price. There are then 2 components
to basis

7
 Optimal Hedge Ratio
Proportion of the exposure that should optimally be
hedged is
S
h =  -------
F
where
S : spot price,
F : futures price,
S : standard deviation of DS ,
F : standard deviation of DF &
: coefficient of correlation between DS & DF
8
 Rolling The Hedge Forward

We can use a series of futures contracts to

increase the life of a hedge
Each time we switch from 1 futures contract
to another we incur a type of basis risk

9
Forward and Futures
Prices

10
 Introduction
Forwards and futures are similar contracts
except for some institutional features.
Futures are easier to use, but forwards are
easier to price.
A forward price can be easily determined
from the spot price. Arbitrage is the
adhesive that links the two together.

11
 Arbitrage
Arbitrage is any trading strategy requiring no cash
input that has some probability of making
profits, without any risk of a loss.
Example: Gold is selling for $2010/ounce in US but
$2025 in UK. Brokerage cost is $5/ounce. “Buy
cheap, sell dear,” and get arbitrage profit of $5.
Arbitrageurs correct such economic disequilibria
through profit taking.

12
 “No-Arbitrage” Pricing
NOW (time t) MATURITY (time T)

Portfolio A
Portfolios
Must equal, No intermediate have same
o/w arbitrage cash flows final value

Portfolio B

Or, Portfolio = 0 at time t  Portfolio = 0 at time T

13
 Cash-and Carry Arbitrage

Buying underlying asset in the Spot market

Selling Futures contract
Deliver at the end of the period
t T
Buy stock Deliver Stock
Go short Futures into futures

14
 Cash-and Carry Arbitrage
Example: Assume one year futures are available on
Reliance shares. The shares are selling at Rs.2500
and the futures price for delivery of one share
exactly one year from today is Rs.2700.
The arbitrageur can invest in the following Cash-and
Carry ;
1. Purchase 1,000 shares of Reliance at Rs.2500 per share
2. Go short, at Rs.2700 per share, 1,000 shares (4 futures
contract)
3. Hold the stock for one year and deliver
15
 Cash-and Carry Arbitrage
This strategy costs Rs.25 lakh today and will yield
Rs.27 lakh after one year. The rate of return
over the year is
Cash flow at T - Cash flow at t
Rate of Return =
Cash flow at t
Rs.27 lakh - Rs.25 lakh
Rate of Return =
Rs.25 lakh

= 8%
16
 Cash-and Carry Arbitrage
By doing this, the arbitrageur create an investment
that acts like a one year discount bond with a face
value of Rs.27 lakh which is trading at present at
Rs.25 lakh. This is a riskless discount bond like T-
bills, and hence we can call this cash-and-carry
investment a Synthetic T-bill. The arbitrageur has
made a Synthetic Loan, because he has lent out
money that will be received back with interest, just
as if a T-bill has been purchased outright. The rate
of return earned on the loan is the cash-and-carry
synthetic lending rate.

17
 Cash-and Carry Arbitrage
Pure Arbitrage
Assume that the arbitrageur can borrow the
Rs.25 lakh required for the cash-and-
carry trade at a rate of 7%. Since the
cash-and-carry rate of return is 8%, this
strategy of borrowing and synthetic
lending allows the investor to earn a
profit of 1% without any investment, and
hence it is a pure arbitrage profit.

18
 Cash-and Carry Arbitrage
A cash-and-carry pure arbitrage exists if
Cash-and-carry Synthetic lending rate > Borrowing rate.
As no investment is required, this arbitrageur can
continue to do this and make profits. This arbitrage
activity will have an immediate impact on market
prices :
The price of Reliance share will rise due to buying pressure
The futures price will fall due to selling pressure
The cost of borrowing will rise due to demand.
Arbitrageurs will continue to trade till there is a profit
possibility.
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 Reverse Cash-and Carry Arbitrage
It is possible to create a short, or borrowing
position in a T-bill, using futures and spot.
Short position = borrowing the instrument
A short position in a Rs.1 million one year T-bill
with a current price of Rs.930,000. Borrow the
T-bill today, sell in the market for Rs.930,000.
One year from now, we should buy the T-bill
from the market, and it will cost Rs.1 million.
The net effect is that we have a cash inflow of
Rs.930,000 today and a cash outflow of Rs.1
million after one year.

20
 Reverse Cash-and Carry Arbitrage
This is equivalent to borrowing Rs.930,000 for one year.
The interest rate is
Cash outflow at T - Cash inflow at t
Interest rate =
Cash inflow at t

Rs.1,000,000 - Rs.930,000
=
Rs.930,000

= 7.53 %

21
 Reverse Cash-and Carry Arbitrage
The reverse cash-and-carry strategy can create a
synthetic short position in T-bill by taking
opposite side of each step of the cash-and-carry
strategy.
1.Sell short 1,000 shares of Reliance at Rs.2500
per share. This will bring Rs.25 lakh today
2.Buy futures contract for 1,000 shares of
Reliance for Rs.2700 per share.
3.One year from now, take delivery of 1,000
shares from futures market at the locked-in price
of Rs.2700 per share and return the borrowed
shares.
22
 Reverse Cash-and Carry Arbitrage
In effect, we borrow Rs.25 lakh today and must
repay Rs.27 lakh in one year. Since we
know the amount to be paid in future, it is
equivalent to taking a short position in T-bill
maturing in one year. Thus this reverse cash-
and-carry strategy creates a synthetic
borrowing at the reverse cash-and carry
synthetic borrowing rate.

23
 Reverse Cash-and Carry Arbitrage
Like the cash-and-carry strategy, the reverse cash-
and-carry strategy can be used for pure
arbitrage. This is available if funds can be
obtained cheaply by borrowing through the
reverse cash-and-carry and then lent out at a
higher rate. That is, if

Reverse cash-and-carry synthetic borrowing rate

< Lending rate

24
 Reverse Cash-and Carry Arbitrage
In our example, the reverse cash and carry
synthetic borrowing rate is 8%, because we can
borrow Rs.25 lakh and pay back Rs.27 lakh. If
an arbitrageur can lend at a higher rate than 8%,
a reverse cash-and-carry pure arbitrage
opportunity exists.
As with the cash-and-carry pure arbitrage, the
market prices will respond to the profit taking.
• Selling pressure will drive the spot prices down
• Buying pressure will drive the futures prices up
• Lending rates will fall due to supply of more funds

25
Reverse Cash-and Carry Arbitrage
Implied Repo Rate : The rate of return earned
from cash-and-carry strategy (Synthetic
borrowing rate)

Implied Reverse Repo Rate : Reverse cash-

and-carry Synthetic lending rate.

No Arbitrage Equilibrium

26
No-Arbitrage Equation with no Payouts
The equilibrium relationship between futures and spot
market prices is equivalent to the relationship that
holds when no arbitrage opportunities exist. Assume
the following conditions,
1.The asset can be bought or sold in the spot market
without transaction costs
2.Except for opportunity cost of funds, the asset can be
held without cost (no warehousing, insurance, or
spoilage costs)
3.The asset can be sold short, with full use of proceeds
4.The asset has no payouts during the period
5.Arbitrager can borrow or lend at the same rate.

27
No-Arbitrage Equation with no Payouts
With a cash-and-carry synthetic lending, an
arbitrageur buys the underlying asset at time t
for Pt and locks in a sale price at time T for Ft,T.
The implied repo rate that an arbitrageur can
earn on a cash-and-carry is
Ft,T - Pt Cash inflow at T - Cash outflow at t
=
Pt Cash outflow at t
With a reverse cash-and-carry synthetic
borrowing, an arbitrageur borrows (goes short)
the underlying asset and sells it for Pt.

28
No-Arbitrage Equation with no Payouts
The futures contract is purchased to lock in a
price at T of Ft,T so as to return the underlying
asset to the lender at T. The implied reverse
repo rate is,
Ft,T - Pt Cash outflow at T - Cash inflow at t
=
Pt Cash inflow at t
These two equations show that synthetic
borrowing rate equals synthetic lending rate,
because we have assumed that the underlying
asset can be sold short without cost.

29
 No-Arbitrage Equation with no Payouts
i.e.,
Implied reverse repo rate = Implied repo rate
= Borrowing and lending rate.
If rt,T denotes the interest rate between time t
and T, then this implies
Ft,T - Pt
= rt,T
Pt
That is,
Ft,T = Pt (1 + rt,T )

30
No-Arbitrage Equation with no Payouts
i.e., Futures price = Spot price + Interest
This is called the fundamental no-arbitrage
relationship between spot and futures prices.
If the prices violates this condition then there is an
opportunity for arbitrageurs. If
Ft,T > Pt (1 + rt,T )
then pure arbitrage profits can be earned from the
cash-and-carry strategy. From our example, the
fundamental equation gives the futures price as,
Ft,T = 2700 > Pt (1 + rt,T ) = 2500*1.07 = 2675.

31
No-Arbitrage Equation with no Payouts

Thus you get a profit of Rs.25 per share (or Rs.

6,250 per contract).
If Ft,T < Pt (1 + rt,T )
then pure arbitrage profits can be earned from the
reverse cash-and-carry strategy.

32
More Realistic Models

33
 Arbitrage with Payouts
There can be different types of payouts for
different securities and commodities. Positive
payouts can be there for financial assets, such
as dividends, and negative payouts such as
storage costs, insurance, spoilage etc. for
commodities
t t1 T

Enter Futures Payout of C1 Futures Expires

34
 Arbitrage with Payouts
Then the fundamental no-arbitrage equation
becomes
Ft,T = Pt (1 + rt,T ) - C1 (1 + rt1,T )
where rt1,T is the interest earned between t1 and
T.

Cash-and-carry opportunities exists if

Ft,T > Pt (1 + rt,T ) - C1 (1 + rt1,T )

35
 Arbitrage with Payouts
Transaction t t1 T
Borrow Pt Pt - Pt (1 + rt,T )
Buy Spot - Pt C1 FT,T = Pt
Lend payout - C1 C1 (1 + rt1,T )
Go short futures Ft,T - FT,T
Net 0 0 Ft,T - Pt (1 + rt,T )
+ C1 (1 + rt1,T ) > 0

Reverse cash-and-carry opportunities exists if

Ft,T < Pt (1 + rt,T ) - C1 (1 + rt1,T )

36
 Arbitrage with Payouts
Transaction t t1 T
Short spot Pt - C1 - FT,T
Lend Pt - Pt Pt (1 + rt,T )
Borrow payout C1 - C1 (1 + rt1,T )
Go long futures FT,T - Ft,T
Net 0 0 Pt (1 + rt,T )
- C1 (1 + rt1,T ) - Ft,T > 0

37
 Arbitrage with dividends
In the earlier example, assume that Reliance share gives a
dividend of Rs.8, which is due six months from now. The
arbitrageur can borrow and lend at 7 % per annum. Is
there any arbitrage opportunity ?
The future value according to the fundamental no-arbitrage
equation is
= Spot price + interest - future value of payouts
= Rs.2500 + Rs.2500 * 0.07 - Rs.8 * (1+0.07*(6/12))
= Rs.2500 + Rs. 175 - Rs.8.28
= Rs.2666.72 < Rs.2700 = Futures price
Since futures price is higher than the no-arbitrage price, the
arbitrageur should perform a cash-and-carry arbitrage.

38
 Transaction Costs and Arbitrage
Bid-Ask Spreads
Margins and Short-Selling Costs
Differential Borrowing and Lending Rates
Transaction Fees

39
 Cash-and-Carry and Reverse
Cash-and-Carry Arbitrage
Transaction costs in the spot and futures markets affect
arbitrage trading through their inflence on implied repo
and reverse repo rates.
Ptb = bid price for spot security
Pta = ask price for spot security
Fbt,T= bid price for futures contract (price for going
short)
Fat,T= ask price for futures contract (price for going
long)
TF = total transaction fees
rbt,T = borrowing rate between t and T
rlt,T = lending rate between t and T
40
 Cash-and-Carry and Reverse
Cash-and-Carry Arbitrage
When transaction costs are included, the cash-and-carry
strategy is to buy the spot at the ask price and lock in
a sales price at the futures bid price. By
consolidating all transaction costs, the implied repo
rate is,
Cash inflow at T - Cash outflow at t
Implied repo rate =
Cash outflow at t
(Fbt,T - TF) - Pat
=
Pat
41
 Cash-and-Carry and Reverse
Cash-and-Carry Arbitrage
In the reverse cash-and-carry with transaction costs, the
arbitrageur sells the spot security short at the bid price
and covers the short position by locking in a futures ask
price. The implied reverse repo rate is

Implied Cash outflow at T - Cash inflow at t

reverse repo rate =
Cash infolw at t
(Fat,T + TF) - Pbt
=
Pbt
42
 Cash-and-Carry and Reverse
Cash-and-Carry Arbitrage
This implies that
Implied reverse repo rate > Implied repo rate
Synthetic borrowing rate > Synthetic lending rate
From this, we get
Fbt,T  Pat ( 1+ rbt,T ) + TF
and
Fat,T  Pbt ( 1+ rlt,T ) - TF
In most markets, the bid-ask spread in the futures
market is very small and hence we can assume it to
be zero.
43
 Cash-and-Carry and Reverse
Cash-and-Carry Arbitrage
Thus we get,
Pbt ( 1+ rlt,T ) - TF  Ft,T  Pat ( 1+ rbt,T ) + TF
Thus when transaction costs are taken into
account we get a no-arbitrage lower bound and
a no-arbitrage upper bound.
Reverse Cash- No arbitrage Cash-and-carry
and-carry arbitrage arbitrage
Ft,T < >
Lower bound Upper bound

44
 Example
Suppose the arbitrageur observes the following prices and rates;
Bid price on Reliance share Rs.2449.5
Ask price on Reliance share Rs.2500.5
Bid price on futures Rs.2699.5
Ask price on futures Rs.2700.5
Bid price on Rs.1 million face
value 1 year T-bill Rs.908,678.00
Ask price on Rs.1 million face
value 1 year T-bill Rs.909,504.00
Broker call rate 7.75 %
Arbitrager’s nominal borrowing rate 8.25 %
Transaction fees (per share basis) Rs.1.50
- Stocks Rs.0.90
- Futures Rs.0.20
- Borrowing or lending Rs.0.40
45
 Example
The arbitrageur wishes to determine if there is an
opportunity for pure arbitrage. From the cash-
and-carry strategy,
2699.5 - 1.50 - 2500.5
Implied repo rate = = 7.9 %
2500.5
Suppose margin requirements allow borrowing of
only 50 % of the cost of the stock at the broker
call rate. The arbitrageur should obtain the
remaining 50 % funds at nominal borrowing rate.
Thus the effective borrowing rate is

46
 Example
Borrowing rate = 0.50*7.75% + 0.50*8.25%
= 8.00 %
There appears to be no cash-and-carry arbitrage,
because the arbitrageur can borrow only at 8%,
and lend synthetically at 7.9 %.
The implied reverse repo rate from the reverse
cash-and-carry strategy is

47
 Example
2700.5 + 1.50 - 2499.5
Implied reverse repo rate =
2499.5
= 7.98 %
When the arbitrageur shorts Reliance share in this
reverse cash-and-carry, he must place the short sales
proceeds with the party who lent the stock. The rate
this party pays typically is about 80 per cent of the
broker call rate. The arbitrageur’s lending rate is,
therefore,

48
 Cash-and-Carry and Reverse
Cash-and-Carry Arbitrage
Lending rate = 0.80 * 7.75 % = 6.2 %
There appears to be no reverse cash-and-carry
arbitrage either.
We can also come to this conclusion of no arbitrage
by computing the price bounds.
Lower bound = Rs.2699.5 * 1.062 - Rs.1.50
= Rs.2784.38
Upper bound = Rs.2700.5 * 1.062 + Rs.1.50
= Rs.2788.42

49
 Value of a Forward Contract
That Began Earlier
At start, value of a forward, V0 = 0
At maturity, value of a forward to Long is
VT = [PT – F0,T] and opposite to Short. Long
gains, Short loses if spot soars.
At intermediate date t, value of a forward to
Long is Vt = present value of [P T – F 0,T]
= Pt – F0,T / (1+r t,T)

50
 Forward Contracts
on Commodities
Unlike investment assets, commodities can
have substantial storage costs. This cost
may be viewed as a negative dividend.
Many commodities like copper and crude oil
are chiefly held for use in production. This
productive usage benefit or implicit positive
dividend from holding such an asset is
called a convenience yield.
51
 Cost-of-Carry with Storage Costs
and Convenience Yields
When storage costs (G) and convenience
yields [Y 0,T ] are included (paid upfront in
our formula), then cash-and-carry is better
described as cost-of-carry relationship.

At time 0, cost-of-carry gives

F0,T = [P0+ G – Y 0,T ] (1 + i  T)

52
 Forward and Futures
Prices Compared
Forward |--------------------|--------------------|
Date 0 Date 1
Date 2
Forward price f 0,2 f 1,2 P2
Cash flow 0 0 P 2 - f 0,2

Futures |--------------------|--------------------|
Date 0 Date 1
Date 2
Futures price F 0,2 F 1,2 P2
Cash flow 0 F1,2 - F0,2 P 2 - F1,2
53
 Forward and Futures
Prices Compared (cont’d)
Long forward’s payoff = P2 - f 0,2
This should equal long futures net payoff
= P2 - F0,2. Otherwise, arbitrage
opportunity.
This holds even when interest rates are
constant. But in reality, interest rates are
random (stochastic). So futures and forward
prices often vary.

54
 Forward and Futures
Prices Compared (cont’d)
<--------- i1 --------->|<--------- i2 --------->
|------------------------|------------------------|
Date 0 Date 1 Date 2
<---------------------- j ----------------------->
Let i1 be the interest rate over 1st period, i2 over
2nd, and j be per period rate over 2 periods. Then
link between futures and forward is
f 0,2 = F0,2 - [1+j]2 PV0 ([F1,2 - F0,2 ] i2)

55
 Forward and Futures Prices

Forward and futures prices are equal if

interest rate remains constant till maturity.
In reality, marking-to-market and default risk
can make the forward and futures prices
different.
Empirical results are mixed.

56
 Forward and Futures Prices

Forward Versus Futures Prices

Forward and futures prices will be equal
One day prior to expiration
More than one day prior to expiration if
Interest rates are certain
Futures prices and interest rates are uncorrelated
Futures prices will exceed forward prices if futures
prices are positively correlated with interest rates.
Default risk can also affect the difference between
futures and forward prices.

57
 Conclusion
Forwards and futures are similar contracts
except for some institutional features.
A forward price can be easily determined
from the spot by cash-and-carry and cost-
of-carry relationships.
“No-arbitrage” principle also helped to value
a contract that began earlier and exploit an
arbitrage opportunity.

58