Derivatives and Risk Management

F U T UR ES A N D F O RWA R D S
 Forwards
2

Compute funds outflow for a company X on 10 th July 2017 for

the transaction given the background as below:
 Company X is a regular importer of chemicals
 CFO of X is worried about falling INR vs USD
 On 11th June 2017, X buys 1 month forward USD 100mn @ 26 paise
premium over the spot rate of INR64.575 to be settled on 10 th July 2017
 The spot rate on 10th July 2017 was INR64.625

Ticket Size * Forward Price

USD 100mn * (64.5750 + 0.2600)
USD 100mn * (64.8350)
= INR 6483.5mn
 Forwards
3

In case of the example in the previous slide, would X have

been better off not buying the forward? What was the
motivation of X for entering into the contract?
 Forwards
4

 In case of the example in the previous slide, would X have been better off not
buying the forward? What was the motivation of X for entering into the
contract?

Yes, he would have been better off not buying the forward.
Motivation of X was to lock the price of USD so that there is no
uncertainty.

Forwards - USD 100mm * (64.5750 + 0.2600) = INR 6483.5mm

Spot – USD 100 mm * (64.625) = INR 6462.50 mm

In case he doesn’t buy Forwards, he would have saved = INR 6483.5 –

6462.50 = INR 21 mm
 Forwards
5

Did company X get possession of physical USD100mn? When?

Yes
On the settlement day.
 Forwards
6

Was this forwards contract transacted on an exchange? What

would be the most likely counter-party in this transaction?

No. It was OTC. Bank may be a counterparty.

 Forwards
7

Supposing the transaction in the earlier slide involving

Company X was in the form of futures contract and not
forwards contract, what would be the net funds flow for X on
10th July 2017?

USD 100mn * (64.625 - 64.835) => outflow of INR 21 mm

 Forwards vs Futures
8

Can a Forward contract be “customized”? Illustrate with

examples and compare with a standard Futures contract.

Yes, it can be customized along the following:

 Quantity
 Time
 Price
 Forwards
9

What would be the motivation of the bank which acted as

counterparty to X in the Forward transaction?

Bank runs a book (speculator) and makes spread on bid

vs ask (arbitrager)
 Forwards
10

Where would you get to see the USDINR forward rates?

 Find LTP for 3month forward USDINR
 Compute premium in terms of % p.a.

 https://in.investing.com/currencies/usd-inr-forward-rates
Forwards
11
 Valuation of Forward / Future contracts

Every financial instrument requires a method for valuation

Valuation process helps an investor to make purchase / sell

decision
 Eg. If price is less than value then buy

In case of forward / future contracts the concept of “cost of

carry” is typically used as method of valuation.

 Assumptions for Pricing Futures / Forward Contracts

1. The market participants are subject to no transactions costs when

they trade.
2. The market participants are subject to the same tax rate on all net

trading profits.
3. The market participants can borrow money at the same risk-free

rate of interest as they can lend money.

4. No restriction on short selling.
 Different Types of Interest Rates
Expected future price formulas

The future price Fe = (Principal) * e^(r*T) (using continuous

compounding)

The future price Fe = (P)*(1+r)^T ( using discrete compounding)

The future price Fe = (P)*(1+r *T) (using simple interest method)

 Derivation – Continuous Compounding
(Reference Only)

 Discreet Compounding Formula – F = P (1 + r/n)^nt

 n – number of time units (eg, quarterly – 4)

 If we substitute (n/r) = m. Thus, (r/n) = 1/m; n = mr

 F = P (1+ 1/m)^mrt
 F = P ((1+1/m)^m)^rt (just expanding the brackets in the power)
 If we take limit as m tends to infinity
 F = P (lim (1+1/m)^m)^rt

 We know, lim (1+1/n)^n = e

 Thus, F = P (e)^rt
 F = P * e^rt
 Derivation – Continuous Compounding
(Reference Only)

 In simple words,
 Discreet Compounding Formula – F = P (1 + r/n)^nt
 For example, if we invest INR 1 and earn 100% returns after 1 year

 In case of monthly compounding, my total investment value would be –

 F = 1 (1+100% / 12)^12 = 2.61304

 For Daily compounding –

 F = 1 (1+100%/365)^365 = 2.71457

 For compounding every Minute (525,600 minutes in a year)

 F = 1 (1+100%/ 525600)^525600 = 2.718279

 For compounding every Second (31,536,000 seconds in a year)

 F = 1 (1+100%/ 31536000)^31536000 = 2.718281
 Close enough to the value of “e”
 Equity Futures
Expected future price formulas

In case of equities with present value of dividend income I,

stock price S, risk-free interest rate r, time to maturity T->

The expected future price Fe = (S-I) * e^(r*T) (using continuous

compounding)

The expected future price Fe = (S-I)*(1+r)^T (using discrete

compounding)

The expected future price Fe = (S-I)*(1+r *T) (using simple

interest method)
 Cost of carry – numerical illustration

Spot price of a stock : 100

Transaction date : day 0
Settlement date : day 20
Interest rate : 8% p.a.
Dividend not expected in these 20 days
Expected price of the future contract on day 0 =
100 + cost of carry
Where cost of carry is due to interest cost on 100 for period of
20 days @ 8% p.a.
 3 ways to calculate expected price of the future contract

100 + 100 * 8% * 20/365 = 100.4384

(applicable in case of simple interest method)

 100 * (1 + 8%) ^ (20/365) = 100.4226

(applicable in case of discrete compounding method)

 100 * exp(8% * 20/365) = 100.4393

(applicable in case of continuous compounding method)

The method and the applicable interest rates would be specified for
appropriate calculation.
 Forwards / Futures on investment assets

Investment assets that pay no income (Zero-coupon bond,

gold, silver): Ignoring storage cost
 F0 = S0. er.T
 F0: Future price today
 S0: Price of underlying asset today
 r: annual risk free rate with continuous compounding
Investment asset with known cash income (stock, coupon
bond)
 F0 = (S0 – I). er.T
 I: PV of all income from underlying during life of future contract
Investment asset with known dividend yield (stock index)
 F = S . e(r-q).T
0 0
 q: Constant annual rate of dividend yield
 Principle of Convergence

Futures price on the day of expiry will be exactly equal to the

spot price prevalent at the time of expiry
E.g. 1 month futures contract (30 days) on an asset which has
a value Rs 200 today. Assuming an interest rate of 7%
Date Spot Futures = spot *ert

T=0 Rs 200 Rs 201.15= 200 *e(.07*(30/365))

T=5 Rs 210 Rs 211.01= 210 *e(.07*(25/365))

T=10 Rs 215 Rs 215.82= 215 *e(.07*(20/365))

T=15 Rs 220 Rs 220.63= 220 *e(.07*(15/365))

T=29 Rs 228 Rs 228.04= 228 *e(.07*(1/365))

T= 30 Rs 229 Rs 229= 229 *e(.07*(0/365))

Principle of Convergence
 Cost of Carry Model

Example:
Theoretical Correct price for a futures contract which has 3
months to go on a spot rate of Rs 40 and an interest rate of 5%
is
Futures = spot *ert
Where, e=2.718; r is risk free rate of interest; t is period of
contract reckoned as fraction of an year
 Cost of Carry Model

Example:
Theoretical Correct price for a futures contract which has 3
months to go on a spot rate of Rs 40 and an interest rate of 5%
is
Futures = spot *ert
Where, e=2.718; r is risk free rate of interest; t is period of
contract reckoned as fraction of an year

For the example above, F= 40*e(0.05* 3/12) = Rs 40.50

Therefore ideal price for the futures is Rs 40.50
 Calculating expected future price – adjusting for dividend

Example:
Spot price of a stock : INR 100

Transaction date : day 0

Settlement date : day 20

Interest rate : 8% p.a.

Dividend expected INR 2.5 in these 15 days

 Calculating expected future price – adjusting for dividend

Example:
 Spot price of a stock : 100
 Transaction date : day 0
 Settlement date : day 20
 Interest rate : 8% p.a.
 Dividend expected 2.5 in these 15 days

 Adjust spot price for the present value of dividend)dividend

 Adjusted spot price = 100 – 2.5* exp(-8%*15/365) = 100 – 2.5*0.996718 = 100 –

2.491794 = 97.50821 or 97.51

 Use adjusted spot price in the formula for the expected future price
 Expected future price = 97.51 * exp(8% * 20/365) = 97.94
 Examples

Consider a 10 month forward contract on a stock when the

stock price is INR 50. r=8% per annum. Dividends of INR 0.75
per share expected after 3,6,9 months. What is the theoretical
forward price for no arbitrage?
 Examples

Consider a 10 month forward contract on a stock when the stock

price is INR 50. r=8% per annum. Dividends of INR 0.75 per
share expected after 3,6,9 months. What is the theoretical
forward price for no arbitrage?

Solution:
PV of all dividends i.e I
I= 0.75e(-0.08*(3/12)) + 0.75e(-0.08*(6/12)) + 0.75e(-0.08*(9/12)) = INR 2.162

Forwards Price F for an asset providing a known income

F= (50 – 2.162) e(0.08*(10/12)) INR 51.14
 Equity Futures

Given
 Current date : 10th July
 Expiry : 27th July
 S = 1615.25
 Case 1:
 I = 0 (no dividend income expected between 10 th July and 27th July)
 Case 2:
 I = ___ (dividend of Rs 10 expected on 20th July)
 r = 5% p.a. compounded continuously
Compute in both cases
 Expected value of the future contract

Should it be bought or sold if the price of the future contract is

1628.1 in Case 1 ?
 Equity Futures

Given
 Current date : 10th July
 Expiry : 27th July
 Fa = 1628.1
 S = 1615.25
 Case 1:
 I = 0 (no dividend income expected between 10th July and 27th July)
 Case 2:
 I = ___ (dividend of Rs 10 expected on 20th July)
 r = 5% p.a.
Expected value of the future contract
 Continuous compounding
 Case 1 : 1615.25*exp(.05*17/365)=1619.02
 Case 2 : (1615.25-10*exp(-.05*10/365))*exp(.05*17/365)=1609.01
 Futures Price of Stock Index

 Stock index can be viewed as an investment asset paying a dividend yield

 It is usually assumed that the dividends provide a known yield rather

than a known income
 The futures price and spot price relationship is therefore

F0 = S0 e(r–q )T
where q is the average dividend yield on the portfolio represented by the
index during the life of the contract
 Futures

Show how this

number is
computed.

1628.1=1615.25*exp(r*t), where t = 17/365 ie 27 th

July – 10 th july expressed in years, r is the cost of
carry in % p.a. and is to be found.
r=365*ln(1628.1/1615.25)/17=17.01% p.a.
 Futures and Forwards on Currencies

 Interest Rate Parity – Exchange Rate moves in the direction of

the interest rates of their respective economies / countries

 Interest Rates in USA = 2%, India = 6%. You can borrow from US at 2%

and invest in India at 6%, thereby gaining 4% as arbitrage profit. This

phenomena does not happen because the USD would appreciate 4% vis-
à-vis INR, thereby negating any arbitrage.
 Refer “IRP-1” sheet from “Futures-Class” file to understand how

interest-rate arbitrage is prevented through this concept of interest-rate

parity.
 Futures and Forwards on Currencies

A foreign currency is analogous to a security providing a

dividend yield
The continuous dividend yield is the foreign risk-free interest
rate
It follows that if rf is the foreign
( r  r f ) Trisk-free interest rate
F0 S0e
Futures and Forwards on Currencies
Futures and Forwards on Currencies
COMMODITY FUTURES IN INDIAN
MARKETS
 Forward/Future Price for Investment Assets – A Generalization

F0 – Actual Futures Price stated on the exchange

S0erT – Price you found out using Valuation technique as per
Valuation

If F0 > S0erT, arbitrageurs can buy the asset and short futures
contracts on the asset.
If F0 < S0erT, arbitrageurs can short the asset and enter into
long futures contracts on the asset.
Hence if F0 = S0erT, no arbitrage opportunity arises
 This equation relates the future price and the spot price for any
investment asset that provides no income and has no storage costs.
 Futures on Investment Commodities

Example: Gold, Silver

If u is the storage cost per unit time as a percent of the asset
value, it can be treated as negative yield (regarded as
negative income). Then
F0 = S0 e(r+u)T

Similarly, if U is the present value of the storage costs, it can

be considered as negative income. Then
F0 = (S0+U)erT
Cash & Carry Arbitrage
Cash & Carry Arbitrage
Reverse Cash & Carry Arbitrage
Reverse Cash & Carry Arbitrage
 Futures on Consumption Commodities

 Consumption commodities usually provide no income, but can be subject to significant storage costs.

 Here arbitrage strategy can not be used in some cases.

 Individual and companies are reluctant to sell the commodity stored in inventory.

 Hence for consumption commodity the valid equations are

F0 ≤ (S0+U)erT

F0 ≤ S0 e(r+u)T
 Commodities are “consumption assets”, unlike equities which are “investment assets”

 Investment assets offer recurring income such as dividend

 Consumption assets do not offer any recurring income while holding those assets. Eg – holding

soyabean does not offer any recurring income

 Convenience Yield
45

 Convenience Yield is the benefit of holding the physical goods / underlying assets

rather than its derivative contract.

 Eg: you need sugarcane to process it into jaggery and derivative contract shall be of no use

 Individuals and companies engaged in the business of producing or processing or distributing

or selling consumption commodities benefit by holding physical commodity

 Eg: if 30 day actual forward price of a commodity is less than its expected forward price

 In that case, an investor SHOULD sell commodity and buy the forward contract

 However the processor of the commodity would not buy a forward contract; as the

manufacturing process requires the physical commodity. The processor has no use of the

forward contract as it can not be readily used to process the commodity.

 Convenience Yield
46

 Hence,

 Actual Forward Price would remain lower than Expected Forward Price
 Implied cost of carry would be less than Expected cost of carry
 Convenience Yield would be positive

 Implied Cost of Carry = Rf Rate + Storage Cost – Convenience Yield

 Expected Cost of Carry = Rf Rate + Storage Cost

 Commodity Futures - MCX
47

Gold 05Feb closed at 29390 (per 10 gms) on 12Jan. Spot gold at 29838

Compute implied cost of carry

LN (Actual Fut Price / Spot Price) * (365/t)
-23%

Compute convenience yield if risk free rate is 5% p.a. and storage cost is
3% p.a.
Implied Cost of Carry = Rf Rate + Storage Cost – Convenience Yield
-23% = risk free + storage – convenience
i.e. convenience yield = 31% p.a.
 Commodity Futures - MCX
48

Wheat 28Feb closed at 456.15 (per kg) on 12Jan. Spot Wheat

at454.30 Compute implied cost of carry

Compute convenience yield if risk free rate is 5% p.a. and

storage cost is 3% p.a.
 Commodity Futures - MCX
49

Wheat 28Feb closed at 456.15 (per kg) on 12Jan. Spot Wheat

at454.30 Compute implied cost of carry
3%

Compute convenience yield if risk free rate is 5% p.a. and

storage cost is 3% p.a.
3% = risk free + storage – convenience
ie convenience yield = 5% p.a.
 Contango vs Normal Backwardation
50

 Contango

 Expected future price < Actual future price, or

 Expected cost of carry < Implied cost of carry

 Normal backwardation

 Expected future price > Actual future price, or

 Expected cost of carry > Implied cost of carry

 In case of commodity futures/forward contracts

 Normal backwardation implies positive convenience yield

 Contango implies negative convenience yield
 Commodity vs Equity futures
Understanding normal backwardation
51

• Benefits leading to convenience yield are

Dividends are
not quantifiable and hence not known in
known in advance advance. They are deduced from the actual
and not market price of the forward contract and hence are
determined market determined

• In case of equities, spot price higher than

Hence futures price does not necessarily mean
backwardation
 Contango v/s Backwardation
52

Contango: Actual price of forward / future contract is higher

than the expected price

Backwardation: Actual price of forward /future contract is

lower than the expected price

 How does commodity futures market compare with equity
futures market
53

Underlying
 Equities – Underlying as well as futures get traded on the same exchanges
 Underlying stocks get traded on the NSE and the BSE
 Futures on these stocks also get traded on the NSE and the BSE
 Commodities get traded in various market places/ “mandis” across India.
Commodity futures get traded on the exchanges (which are NCDEX and MCX)
Trading process
 Both equity futures as well as commodity futures get traded on exchanges through

the process of electronic order matching

Settlement
 Equity futures get “cash / net” settled only
 In case of commodity futures, both modes of settlement (i.e. “net” and “physical”)
are applicable
What types of commodities are amenable for futures trading ?
54

Commodities
 having large market
 for which no single entity / group of entities can influence the market
price
 which are not perishable
 For which quality can be standardized and “graded”
 What are the categories of commodities for which future contracts
are traded?
55

Agricultural products

Bullion (i.e. gold and silver)

Metals

Energy products
 What are the types of the market participants?
56

Entities wishing to reduce future commodity price risk, Eg-

 Growers
 Millers/processors
 Jewelers

Speculators

Arbitragers
 How are spot prices determined?
57

Exchanges conduct polling of “mandis” twice a day , validate

those prices and publish the average price, which gets taken
as the benchmark spot price
 What are the types of contracts?
58

Compulsory delivery contract

 Both buyer and seller opt for compulsory physical settlement

Exchanges match buyers and sellers using the warehouse locations

indicated
 Warehouses can only be exchange-approved warehouses
 Receipts from the warehouses get dematerialized and electronically tracked and
transferred from seller to the buyer

For the unmatched quantities, buyer takes delivery wherever seller gives
 What are the types of contracts ?
59

Sellers right contract

 seller has the right to select warehouse

 buyer of such contract accepts the warehouse option offered by the
seller
 While matching, exchange meets buyer’s preferences to the extent
possible and thereafter buyer needs to accept delivery wherever the
“matched” seller offers the same
 What are the types of contracts ?
60

Intention matching contract

 Both buyer and seller give their warehouse preferences

 Matched preferences get settled through physical delivery
 Unmatched quantities get cash settled
 When are the delivery intentions required to be intimated to the
exchange ?
61

Within 3 days prior to the expiry

All open positions on the expiry day of the contract would

result in compulsory delivery
What happens if seller does not adhere to the delivery intentions
indicated ?
62

Exchange levies penalty on the seller

Part of the penalty goes to the buyer and the rest goes to the

investor protection fund (IEPF)

 How is quality verified before physical delivery ?
63

Exchange nominates “assayer” on behalf of every buyer

Assayer verifies the quality in the warehouse where the

commodity is stored
After verification, assayer either rejects the commodity or
accepts it and grades it
Appropriate grading discounts (as pre-specified by the exchange)

are applied to the purchase price at the time of settlement

 Regulation
64

Forward Market Commission (FMC) was the regulator for the

commodity futures market in India

FMC has merged with SEBI

Now, SEBI is the regulator for the commodity futures markets

 Global Perspective
65

CME group – the leading and most diverse market place, has 4

exchanges viz.
 CME (Chicago Mercantile Exchange)
 CBOT (Chicago Board of Trade)
 NYMEX (New York Metal Exchange)
 COMEX (Commodity and Metal Exchange)

London Metal Exchange

Shanghai Metal Exchange

 Product Range on the CME group
66

Agricultural commodities
Energy
Bullion
Metals
Equity indices
Currency pairs
Interest rates
Real estate
Weather
APPLICATION OF FORWARDS
AND FUTURES
 Selling vs shorting
Short vs long
Taking a Position
68

When a physical entity is sold without giving delivery of any

physical asset, it is “shorting”
Forwards and futures are sold but physical delivery of the
underlying is not required.
 Hence it is common to state that a person is short on Infosys future when
the person has sold Infosys futures
 Likewise a person who buys Infosys futures is “long” on Infosys futures
When a person either goes long or goes short on a future
contract, he/she assumes fresh risk
 the person is said to have taken a “position”
 Concept of margin
69

 Unlike delivery based transaction,

 Buyer of a future contract is not required to give funds

 Seller of a future contract is not required to give physical asset
 At the time of expiry, at least one of the two parties will make loss and the other party

will make profit

 If the loss making party reneges from its payment obligation at the time of expiry, this

would pose a risk to the system (i.e. the broker and the exchange and in turn the party
making profit)
 It is not possible to know in advance which party will make profit and which party will

make loss

 Margin Illustrated
70

27Jul Infosys is trading at 974

One new contract is created (lot size: 500)

 “notional value” = 974 * 1 * 500 = INR 487,000

A is on the “long” side and B is on the “short” side

Initial margin is 20%

Both A and B pay 20% of 487000 i.e. INR 97,400 to their

respective brokers prior to entering into their positions

 Initial Margin
71

How is initial margin of 20% in the previous slide determined?

 SPAN margin, plus
 CME GROUP proprietary methodology which is adopted by exchanges worldwide
 Exposure margin
 To cover extreme loss situations

 Computed client wise by broker and sent to exchange

 Broker debits individual client accounts
 Broker may add additional risk margin based on the prior knowledge about the client
 “Mark to Market”
72

Now, (say) Infosys future closes at 980 on the day this position is taken
 A has “mark to market” profit of 1 * 500 * (980 – 974) = INR 3000
 B has “mark to market” loss of INR 3000

A and B start with margin account credit balance of INR 97,400 on day

0
On day 1, A has margin account balance of INR 100,400 and B has

margin account balance of INR 94,400

 Maintenance Level
73

 If the margin credit balance drops to a certain level i.e. “maintenance level”; then
“margin call” is given
 Let us say broker and client agree on maintenance level of 12%
 If price of the Infosys future drops to INR 895 at any time before the expiry, the

balance in the margin account of A would be Balance Already Maintained +

Adjustment for MTM Loss
 97,400 + 500 * (895 – 974) = INR 57,900

 Maintenance level credit balance is 12% * 500 * 974 = INR 58,440

 In this A has two options

 Pay INR 39,500 (97400 – 57900), or

 Sell the future contract, book the loss and get out of the long position. A would
receive INR 57,900 from the broker and book the loss of INR 39,500

 Whenever your margin balance breaches Maintenance Level, top-up your margin
balance to the initial margin level; in this case to 97400
 Open Interest
74

Open interest is the total number of outstanding derivative

contracts that have not been settled for an asset. The
contract is considered "open" until the counterparty closes it

If a buyer and seller come together and initiate a new

position of one contract, then open interest will increase by
one contract. Should a buyer and seller both exit a one
contract position on a trade, then open interest decreases by
one contract. However, if a buyer or seller passes off their
current position to a new buyer or seller, then open interest
remains unchanged.
 Open Interest (OI)
75

Example –
When A and B enter into a new contract, open interest increases
by 1. A takes long position and B takes short position
A enters into 9 more contracts with B, making total open
interest = 10
A sells 6 contracts to C, open interest remains at 10
A sells 2 contracts to B, open interest reduces to 8
In case 0f Futures, Open interest is a better indicator of trading
activity and trader interest than the daily trading volumes
 Equity Futures
76
 Given
 On the current date : 10th July
 F = 1628.10
 S = 1615.25
 A buys underlying stock from B
 A sells future contract to C
 On the expiry date : 27th July
 S = 1650.20
 A sells underlying stock to D
 Future contracts of A and C expire
 r = 5% p.a.
 Transaction costs: delivery – 0.2%; futures – 0.01%, nil cost on expired
contracts
 Equity Futures
77
 Comment on
 Whether A,B,C and D are arbitragers, speculators or hedgers?
 How does the risk transfer among A,B,C and D?

 Illustrate the arbitrage involved in the previous transaction

 Explain using this example how the arbitrage actions would improve
market efficiency
 Explain using this example the “cost of carry” approach to calculating
the expected price of a future contract
 Compute net profit to C
 Equity Futures
78
 Comment on
 Whether A,B,C and D are arbitragers, speculators or hedgers?
 A : arbitrager, cannot say anything about B,C and D given the
information here
 How does the risk transfer among A,B,C and D?
 B sells the stock to A. Hence firstly , the market risk transferred from B
to A
 A sells future contract to C. Hence A , in turn; transfers the risk to C
 On the expiry day, A and C also get out of their positions. Risk is
assumed by D

 Illustrate the arbitrage involved in the previous transaction.

Irrespective of the stock price at the time of expiry, net gain to A would be
12.85 less transaction costs. Hence no market risk after the positions are
taken by A. Hence it is an arbitrage.
 Equity Futures
79

 Explain using this example how the arbitrage actions would improve market efficiency
As more market players go for arbitrage, there would be more buying of the stock
and more selling of the future. More buying would lift the stock price and more
selling would lead to dip in future’s price. Hence the difference between the two
prices would narrow. This would continue till equilibrium is achieved wherein the
difference between the future price and the stock price would be equivalent to risk
free interest rate. Hence arbitrage makes market more efficient.

 Explain using this example the “cost of carry” approach to calculating the expected price of a
future contract.
In the cost of carry formula, we used risk free interest rate to calculate expected
future price. This is based on the equilibrium situation described above.

 Compute net profit to C.

1650.2 – 1628.1 – 0.16 = 21.94. This is fairly high compared to the net profit to the
arbitrager. This is because speculator assumes much higher risk and expects higher
gain.
 HEDGERS PROBLEM
80

TO CREATE A LONG HEDGE

OR

A SHORT HEDGE?

There are two ways to determine whether to open a short or a long

hedge
 HEDGERS PROBLEM
81

LONG HEDGE
• Open a long futures position in order to hedge the purchase of the product
at a later date
• The hedger locks in the purchase price

SHORT HEDGE

• Open a short futures position in order to hedge the sale of the product at a
later date
• The hedger locks in the sale price

Whatever you are supposed to do at a Future date, do it right now in

the Futures market to ensure your price is locked-in
 Long Hedge – Example
82

 On May 15, a petroleum product producer has negotiated a contract

to buy 1 million barrels of crude oil. The price that will apply in the
contract is market price on Aug 31
 Spot price on May 15 is $100 per barrel

 Crude oil futures price expiring Aug 31 on the NYMEX is $105 per

barrel
 Each futures contract on NYMEX is for the delivery of 1,000 barrels
 The company can hedge its exposure by going long on 1,000 Aug futures contracts
 Long Hedge – Example
83

Case 1:
Let spot price of oil on Aug 31 be $110 > futures contract price

The company buys oil in spot by paying $110

Because Aug is the delivery month for futures contract, the futures price

on Aug 31 should be equal to spot (principle of convergence), say $110

On that date Co’s gain from futures position = $110 - $105 = $5 (by

closing the long futures contract)

Then, the net cost of buying oil = $110 - $5 = $105
 Long Hedge – Example
84

Case 2:
Let spot price of oil on Aug 31 be $103 < futures contract price

The company buys oil in spot by paying $103

Because Aug is the delivery month for futures contract, the futures

price on Aug 31 should be equal to spot (principle of convergence),

say $103.
On that date co’s loss from futures position = $103 - $105 = -$2

Then, the net cost of buying oil = $103 + $2 = $105

 Short Hedge – Example
85

On May 15, a petroleum product producer has negotiated a contract to

sell 1 million barrels of crude oil. The price that will apply in the
contract is market price on Aug 31
Spot price on May 15 is $100 per barrel

Crude oil futures price expiring Aug 31 on the NYMEX is $105 per barrel

Each futures contract on NYMEX is for the delivery of 1,000 barrels

 The company can hedge its exposure by going short on 1,000 Aug futures contracts
 Short Hedge – Example
86

Case 1:
Let spot price of oil on Aug 31 be $110 > futures contract price

The company sells oil in spot at $110

Because Aug is the delivery month for futures contract, the futures

price on Aug 31 should be equal to spot (principle of convergence),

say $110
On that date co’s loss from futures position = $105 - $110 = -$5

(by closing the short futures contract)

Then, the net price realized by selling oil = $110 - $5 = $105
 Short Hedge – Example
87

Case 2:
Let spot price of oil on Aug 31 be $103 < futures contract price

The company sells oil in spot at $103

Because Aug is the delivery month for futures contract, the futures

price on Aug 31 should be equal to spot (principle of convergence),

say $103
On that date co’s gain from futures position = $105 - $103 = $2

Then, the net price realized by selling oil = $103 + $2 = $105

 Basis Risk
88

 Basis refers to the difference between the spot price of the asset and the
futures price of the asset

 Basis = Actual Futures price of the contract used – Actual Spot price of
asset to be hedged

 Basis Risk arises because –

 The instrument used for hedging is different than underlying asset (Eg, Crude Oil Futures
used to hedge the price of Aviation Turbine Fuel as ATF futures contract is not available)
 The time period of the futures contract is different than the time period of holding the spot
asset (Eg, you are required to pay USD 100,000 to your supplier in the USA on 20-Oct-21
and you enter into October Futures to hedge the USDINR price. We know the Futures will
expire on the last Thursday of October i.e. 28-Oct-21. Future price will not converge to
Spot on 20-Oct-21 as it is not the expiry date, hence principle of convergence will not
work. This difference will lead to basis i.e. imperfect hedge)
 Basis: Example
89

Suppose the spot price of an asset at inception was Rs. 2.50 and the future
price at that time was Rs. 2.20
After 3 months, the spot price becomes Rs. 2 and the futures price Rs.
1.90

Basis at the beginning (b1)= Rs. 2.20 – 2.50 = Rs. -0.3

Basis at the end (b2)= Rs. 1.90 – 2.00 = Rs. -0.1 => basis has
strengthened

When the spot increases by more than the futures, basis weakens
&
When the futures increases by more than the spot, basis strengthens
 Basis Risk in Long Hedge: Illustration
90

A Long Hedge (Eg, buying crude at a future date – lock-in purchase

price by buying futures now) is described where spot price is Rs
1200, futures is Rs 1250 and we go long futures at Rs 1250
Scenario 1 Scenario 2
End Spot Price Rs 1300 Rs 1000
End Futures Price Rs 1400 Rs 1020
Gain from futures Rs 150 (1400-1250) Rs -230 (1020-1250)
Spot Payment paid Rs -1300 Rs -1000
Net cost paid Rs -1150 (-1300+150) Rs -1230 (-1000-230)
Basis at time 1 Rs 50 (1250-1200) Rs 50 (1250-1200)
Basis at time 2 Rs 100 (1400-1300) Rs 20 (1020-1000)
Basis strengthens Basis weakens

Long Hedger will gain (has to pay less) if the basis strengthens and lose if
the basis weakens
 Basis Risk in Short Hedge: Illustration
91

A Short Hedge (Eg, selling crude at a future date – lock-in sale

price by selling futures now) is described where spot price is
Rs 1200, futures is Rs 1250 and we short futures at Rs 1250
Scenario 1 Scenario 2
End Spot Price Rs 1300 Rs 1000
End Futures Price Rs 1400 Rs 1020
Gain from futures Rs -150 Rs 230
Spot Payment Rs 1300 Rs 1000
received
Net Gain Rs 1150 Rs 1230
Basis at time 1 Rs 50 Rs 50
Basis at time 2 Rs 100 Rs 20
Basis strengthens Basis weakens

Short Hedger will gain if the basis weakens and lose if the basis
strengthens
 Cross Hedging
92
 Cross hedging: when two assets in the spot and futures contracts are different
 Example: An airline wants to hedge against future price of jet fuel, which has
no futures contract. It may use heating oil futures contract.
 The common approach is to ascertain the beta (roughly the extent to which
asset will go up or down for a % increase in parent asset)
 Approximate number of contracts in the parent asset that are required for
effective hedging the risk in the asset of our interests is
Optimal hedge ratio= (Portfolio Value * Beta)/value of one futures
contract

Where, portfolio value= value of the asset that we wish to hedge in terms of
quantity* price we are interested to protect
Value of futures contract= value of the parent asset since the asset we interested
doesn’t have futures contract
 Equity Futures – Hedging
93

A diversified equity fund with corpus of INR 1000 cr has 5% exposure

to TCS. Fund manager expects short-term drag on the portfolio due to

expected TCS price performance (next 2 months) and wishes to
hedge against this risk without getting out of fund’s position in TCS.
Illustrate how the fund manager would carry out hedging if he uses
TCS Futures expiring 31-Aug
What are the pros and cons of selling July futures instead of August
futures?
 Equity Futures – Hedging
94

 A diversified equity fund with corpus of INR 1000 cr has 5% exposure to TCS. Fund
manager expects short-term drag on the portfolio due to expected TCS price
performance (next 2 months) and wishes to hedge against this risk without getting
out of fund’s position in TCS. Illustrate how the fund manager would carry out
hedging if he uses TCS Futures expiring 31-Aug

TCS31Aug : 2409
Market lot : 250 units
# of Contracts to be sold = 1000 * 1,00,00,000 * 5% / (2409*250)
= 830 contracts

What are the pros and cons of selling July futures instead of August futures?
August futures have low liquidity, but July Futures do not cover the full hedge
period.
 Equity Futures – Hedging
95

 Fund manager of a diversified equity fund with corpus of INR 8500

crores (Beta of 1.2) wishes to cover the short term risk on the portfolio
due to adverse announcement of monetary policy in the first week of
August.
Illustrate how the fund manager would carry out hedging if he uses Nifty
Futures contracts expiring 31-Aug
 Equity Futures – Cross Hedging
96

Fund manager of a diversified equity fund with corpus of INR 8500

crores (Beta of 1.2) wishes to cover the short term risk on the portfolio
due to adverse announcement of monetary policy in the first week of
August. Illustrate how the fund manager would carry out hedging if he
uses Nifty Futures contracts expiring 31-Aug

Notional value of Nifty : 1.2 * 8500 cr = INR 10200 cr

31Aug Nifty : 9967

Lot size : 75
# of Nifty contracts to be sold = 10200*1,00,00,000/ (9967*75)
= 136,450