future and forward

contracts
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
Margins

 Two types of margins are set by the futures

exchanges:
1. Initial Margin

2. Maintenance Margin

 Purpose:
 To minimize counterparty default
Margins contd…

 The initial margin is only a security provided by

the client through the clearing member to the
exchange. It can be withdrawn in full after the
position is closed
 Both buyer and seller have to deposit margins
 Margins are set by CHs
Margins contd...

 All daily losses must be met by depositing of

further collateral - known as variation
margin/MTM, which is required by the close
of business, the following day.
 Any profits on the contract are credited to the
client’s margin account.
 When a contract is entered into ,both the
buyer and seller are required to deposit a
margin on the contract called as initial
deposit,which is typically 5 to 10 % of the
value of the contract
 The exact amount is determined by the
exchange and the clearing house ,primarily in
keeping with the expected fluctuations which
are estimated from the past data
 After the initial margin is deposited ,a change
in the price of the futures contract would
change the percentage relationship between
the margin and contract value
 At the end of each trading day,the margin
account is adjusted to reflect the investors
gain or loss
 The gains or losses are netted against the
initial margin ,this is called marking to market
 Suppose a contract size is 100 quintals and the
futures price is rs 600 per quintal
 Assume the initial depost at rs 6000
 At the end of the day the futures price declines from
600 to 598, the investor loses rs 200
 The balance in the margin account will be reduced
by rs 200 to rs 5800
 In a similar manner the margin account would
increase to rs 6200 if the futures price had instead
been 602 at the end of the day
Problem 1
 An investor long on Infosys @ Rs.1000. The
initial margin is 60% and maintenance margin
is 98%.
 Calculate the margin.

Day 6 940
Closing Price

Day 1 1040 Day 7 950

Day 2 1060
Day 8 960
Day 3 1020
Day 9 930
Day 4 988

Day 5 978 Day 10 920

 Valuation of Future and Forward
 Assumptions for Pricing of Financial Contracts
The pricing of financial contracts is based on certain assumptions:
1. The markets are perfect.
2. There are no transaction costs.
3. All the assets are infinitely divisible.
4. Bid-ask spreads do not exist so that it is assumed that only one price
prevails.
5. There are no restrictions on short selling. Also, short sellers get to use full
proceeds of the sales.
6.
Valuation of Future and
Forward
Case 1: Securities Providing No
Income
 Consider a forward contract on a non-
dividend paying share which is
available at Rs 70, to mature in 3-months’
time. If the riskfree rate of
interest be 8% per annum compounded
continuously, the contract should be priced ?
S0 ert = 70e(3/12 = 0.25)(0.08)

= 70 X 1.0202 = 71.41
 Case 2: Securities Providing a Known Cash
Income
 Let us consider a 6-month forward contract on 100 shares with a price of
Rs 38 each. The riskfree rate of interest (continuously compounded) is
10% per annum. The share in question is expected to yield a dividend
of Rs 1.50 in 4 months from now.

Dividend receivable after 4 months = 100 x 1.50 = Rs 150

Present value of the Dividend, I = 150e-rt = 150e-(4/12)(0.10)

= 150 X 0.9672 = 145.08
Value of Forward contract = (S0-I) ert = (3800 – 145.08) e(6/12)(0.10)
= 3654.92 X 1.05127
= Rs. 3842.31
 Case 3: Securities Providing a Known Yield
 Assume that the stocks underlying an index
provide a dividend yield of 4% per annum, the
current value of the index is 520 and that the
continuously compounded riskfree rate of
interest is 10% per annum. Find the value of a
3-month forward contract.

 527.85
Value of Forward contract = S0e (r-y)t
= 520 e (0.10-0.04)0.25
 Problem 1

Assume that a market-capitalization weighted index contains only three

stocks A, B and C as shown below. The current value of the index is
1056.

Market
Share Price
Company Capitalization (Rs
(Rs)
A crores)
120
12
B 50 30
C 80 24

Calculate the price of a futures contract with expiration in 60 days

on this index if it is known that 25 days from today, Company A would
pay a dividend of Rs 8 per share. Take the risk-free rate of interest to be 15% per
annum. Assume the lot size to be 200 units.

Total MC = 12+30+24 = 66 cr
= 12/66 X 1056 = 192 192/120 = 1.6 shares held in the index
Dividend = 1.6 shares X 8rs = 12.8
 Continuously compounded risk-free rate of
return, r = ln (1 + 0.15)
= 0.1398 = 13.98%
Company A constitutes 12/66 X 1056 = 192.
With a price of Rs.120 per share, 192/120 =
1.60 shares of A held for every unit of the
Index.
 Dividend receivables 1.60 shares x 8 =
12.80. The PV of dividend
 Dividend Rs 12.80
 F = (S0 –I)ert = (1056 – 12.67)e(0.1397 X 60/365)

1.0232
 = 1043.33 X

 =
1067.53 X 200 = 2,13,507

 I = De-rt
 = 12.80e-(0.1397 X 25/365) = 12.80e-0.009568
 = 12.67
 Problem 2
 Assume that a market-capitalisation weighted index consists of five
stocks only. Currently, the index stands at 970. Obtain the price of a
futures contract, with expiration in 115 days, on this index having
reference to the following additional information:
(a) Dividend of Rs 6 per share expected on share B, 20 days from now.
(b) Dividend of Rs 3 per share expected on share E, 28 days
from now.
(c) Continuously compounded risk-free rate of return = 8% p.a.
(d) Lot size: 300

(e) Other information:

Share Price Market Capitalization

Company (Rs) (crores of Rs)

A 22 110

B 85 170
C 124 372
D 54 216
E 25 200
 A one Year long forward contract on a non
dividend paying stock is entered into when the
stock price is $40 and the risk free rate of interest
is 10% per annum with continuous compounding.
 A) What are the forward price and the initial value
of the forward contract?
 B) Six months later, the price of the stock is $45
and the risk-free interest rate is still 10%. What are
the forward price and the value of the forward
contract?
 A) The Forward price, F0, = S0ert
 40e(0.10 X 1)
 = 44.21
 The initial value of the forward contract is
zero
 B) The delivery price K in the contract is
44.21

 F = 45-44.21e(rXt)
 = 2.95
 Forward Price is F = S0ert = 45e(0.1 X 0.5)
 = 47.31
 Consider a long forward contract to purchase
a non-dividend paying stock in 3 months.
Assume the current stock price is $40 and the
3 month risk-free interest rate is 5% pa.
 Suppose the forward price is relatively high at
$43 and relatively low at $39. Is there is any
arbitrage opportunity?

 F = S0ert = 40e0.05 * 3/12 = $40.50

 Forward Price $43  Forward Price $39
Borrow $40 at 5% for 3 months Short 1 Unit of asset to realize
$40
Buy one unit of asset
Invest $40 at 5% for 3 months
Enter into forward contract to
Enter into forward contract to buy
sell asset in 3 months for
the asset in 3 months for $39
$43
Action in 3 Months:
Action in 3 Months:
Buy asset at $39
Sell asset at $43
Close the short position
Use $40.50 to repay loan with Receive $40.50 from investment
Interest
Profit: 40.50 - 39 = $1.5 Profit
Profit: 43 – 40.50 = $2.5 Profit
Cost of Carry Model
 The relationship between futures prices and spot
prices can be summarized in terms of
the cost of carry.
 This measures the storage cost plus the interest
that is paid to finance
the asset less the income earned on the asset.
 Let us consider a 6-month gold futures contract of 100
gm. Assume that the spot price is Rs 480 per gram and
that it costs Rs 3 per gram for the 6-monthly period to
store gold and that the cost is incurred at the end of
the period. If the riskfree rate of interest is 12% per
annum compounded continuously. What is the future
price?
F = (S0 + S)ert
 r = 0.12, S0 = 480 X 100 = Rs 48,000,
 t = 6/12 or 0.5 and S = 3 X100 e–(0.12 X 0.5)
= Rs 282.53,
 the futures price, F, is given by
F = (48,000 + 282.53)e0.12 X 0.5
 = Rs 51,268.15.
Hedging an Equity Portfolio
Current Value of the portfolio
X Beta of Portfolio
Current value of future contract
 Suppose that a futures contract with 4 months to
maturity is used to hedge the value of a portfolio over the
next 3 months in the following situations.

 Value of S&P 500 index = 1,000

 S&P 500 futures price = 1,010
 Value of Portfolio = $5,050,000
 Risk free interest rate = 4% pa
 Dividend yield on Index = 1% pa
 Beta of portfolio = 1.5
 Lot size 250
 5,050,000
X 1.5 Beta = 30 Contracts
1,010 X 250 = 252500
 Suppose the index turns to be 900 in 3 months and the
futures price is 902.

 30 X (1010 – 902) X 250 = $810,000 (Hedged)

 Loss on the Index ? 10%

 After Adjustment of dividend, an investor in index would
earn? 1%pa = 3months?
 0.25% for 3 months
 10% - 0.25% = -9.75%
 Loss on the Index 10%
 After Adjustment of dividend, an investor in
index would earn = 10% - 0.25% = 9.75%
Apply CAPM
 E(r ) = Rf + [Beta X (Rm – Rf)

 Rf = 4% pa = 4% X 3/12 = 1%
 Beta 1.5
 Rm = -9.75


 E(r ) = 1 + [1.5 X (-9.75 - 1)
= - 15.125

So the expected portfolio value at end of 3

months is
$50,50,000 x (1-15.125%) = $42,86,187
Hedger’s position = $42,86,187 + $8,10,000 =
$50,96,187
 Calculate the number of units of S&P 500 that
investor would have to sell if he desires to hedge
until 3 months
 (1) 90% of his portfolio
 (2) 120% of his portfolio

 50,50,000 X 90% = 45,45,000 / 252500

X 1.5 = 27 contracts
120% = 36 contracts
 Determine the number of futures contracts
the investor should trade if he desires to
reduce the beta of his portfolio to 0.9.
 No of Contract to sell= Value (Bo – Bn
F
 50,50,000 (1.5 – 0.9)/ 252500
 = 12.02