UNIT 1

DERIVATIVES -
FUTURES
 DEFINITION OF
DERIVATIVES
“ A Derivatives is a financial
instrument whose value depends
on the values of other, more basic
underlying variables” - John C Hull

“ A Financial instrument which has

a value determined by the price of
something else” - Robert L
McDonald
 DEFINITION OF
DERIVATIVES

“A Security derived from a

debt instrument, share, loan
whether secured or
unsecured risk instrument
or contract for difference or
any other form of security”
 DEFINITION OF
DERIVATIVES

Types of underlying assets

• Stocks: Stock is another word for share. Stocks

are subject to market risk, balance sheet risk

and general economic risk factors as their price

is dependent on fundamentals as well as the

market forces of demand and supply

 DEFINITION OF
DERIVATIVES
• Indices: Indices refer to indexes like

Nifty50, Bank Nifty, Nifty Midcap50,

India VIX etc. These too are subject to

market risk and general economic risk.

Their prices too are dependent on the

market forces of demand and supply

 DEFINITION OF
DERIVATIVES
• Currencies: Currencies refer to the legal

tender used in various countries around

the world like Rupee (₹), Euro (€), etc.

These are subject to interest rate risk,

geo-political risk and sovereign debt risk.

E.g. USD/INR, GBP/INR, EUR/USD, etc.

 DEFINITION OF
DERIVATIVES
• Commodities: Commodities include
perishables like fresh fruits, non-
perishables like nuts and seeds,
(bullions) precious metals like gold,
silver etc. Commodities are also subject
to market risk and general economic risk
as their price is dependent on the
market forces of demand and supply.
 ELEMENTS OF DERIVATIVES
CONTRACT
A Derivatives contract need to
have a minimum of the following
five elements
A legally binding contract
Involvement of two or more parties
Existence of an ‘Underlying asset’
A determined future date
A determined future price
 EXAMPLE OF DERIVATIVES
CONTRACT
ABC, an airline company needs to
buy fuel for its planes
They are exposed to the risk of
changes in oil price
In case there is an huge increase
in the price, ABC faces huge loss
To overcome this risk, ABC
company can buy Oil Futures
Contract
 EXAMPLE OF DERIVATIVES
CONTRACT
With this, they are locking in
Oil prices
Thus, derivative helps them to
mitigate the risk
 EXAMPLE OF DERIVATIVES
CONTRACT
A local farmer harvests and sells
mango
There is a time lag between harvest
period and sale of mangoes, during
which the price of mangoes could fail
and in turn impact his earnings
Here the farmer can get into a
derivatives contract by locking in the
price of mangoes today to mitigate the
risk that may arise during the sale
 DERIVATIVES – NEED AND
IMPORTANCE
1. Enhances price discovery
process: Derivatives help in
price discovery by
predicating future prices
based on current prices
2. Risk Management:
Derivatives help in risk
management and mitigation
 DERIVATIVES – NEED AND
IMPORTANCE
3. Entrepreneurship: It increase the
entrepreneurial activities
amongst participants, it may
attract various investors who are
creative, educated and business
minded in nature
4. Trading volumes: It catalyzes
economic growth by increasing
trading volumes due to participation
of players from various sectors
 DERIVATIVES – NEED AND
IMPORTANCE
5. Saving and Investment: It
increase the savings
habit in the investors and
also enhances investment
opportunities in long run
6. Singles of market
movements: It Provides and
indicator of how the market
moves
 DERIVATIVES – NEED AND
IMPORTANCE
7. Low transaction: Derivatives
instruments are quite simple to
operate
Also all these instruments are low
cost product
8. Increased Liquidity: Participants
in the derivatives contract can get
in and come out of the deals very
easily and that too without high cost
 MAJOR PLAYERS IN
DERIVATIVES MARKET
1.Hedgers: The ‘Hedge’
means “to reduce the
risk’
Hedgers are the
participants who look at
reducing their risks in the
market
 MAJOR PLAYERS IN
DERIVATIVES MARKET
2. Speculators:
Speculators are the
participants who take a
view on the future price
movements in the market
and accordingly make
profits
 MAJOR PLAYERS IN
DERIVATIVES MARKET
2. Arbitrageurs: are the
participants who make
profits by taking benefit
of differences in prices of
the same asset in two
different markets
 FEATURES OF DERIVATIVES
CONTRACT
1.Forward: A forward contract
is a customized type of
contractual agreement
between two parties to buy
or sell an underlying asset
on a specific future date
at today’s pre agreed
price
 FORWARD CONTRACT
 Both buyers as well sellers are
bound to honor the deal
irrespective of the price of
underlying asset at the expiry date
of contract
 They are OTC contracts where both
the parties negotiate and customize
the terms and conditions of the
contract, without involvement of
stock markets
 FEATURES OF FORWARD
CONTRACT
 Features of Forward
Contract:
1. Bilateral: Forward contracts are bilateral
(two-sided) contracts
It is contract between two parties (without any
exchange between them)
Both the parties are expose to counter party risk
These two parties can be a. A bank and a
customer
b. Two banks of same country c. Two banks of
different countries
 FEATURES OF FORWARD
CONTRACT
 Features of Forward
Contract:
2. Counter Party risk: As these are OTC
contracts, there can be a risk of non
performance of obligations by either parties
These are a bit risky in nature
3. Customized Contract: Forward contracts
are quite flexible as they are custom
designed
Both the parties can negotiate the terms of
contract
 FEATURES OF FORWARD
CONTRACT
 Features of Forward
Contract:
4. Not traded on exchange:
Forward contract are not traded on
any exchange
They are entered by two parties to
meet their specific needs
Hence the prices of these contracts
are not available on public domain
 FEATURES OF FORWARD
CONTRACT
 Features of Forward
Contract:
5. No premium and margin required:
There is no premium and margin money
involved in forward contract
Premium amount is to paid in case of
option contracts
Whereas margin requirement is a feature
of futures contract
 FEATURES OF FORWARD
CONTRACT
 Features of Forward
Contract:
6. Physical Delivery: These contracts
have to be settled by delivery of the
underlying asset on expiration date
One party is bound to sell and the
other one to purchase at the pre
decided price
 FEATURES OF FORWARD
CONTRACT
 Features of Forward
Contract:
7. All the terms decided today:
All the terms of forward contract
are pre decided at the time of
contract
8. Widely used: As they are quite
simpler contracts, they are quite
popular and have been in use
 FUTURE CONTRACT
 Futures contract were
designed to solve the
problems with forward
contracts
 Futures contracts are exactly
like forward contract in
terms of basic economics
 FUTURE CONTRACT
 However futures are standardized
and trading in centralized
 Future market are highly liquid
 There is no counterparty risk
 Future contract is defined as a
standardized agreement with an
organized exchange to buy or
sell an underlying asset at a fixed
price at pre decided date in future
 FEATURES OF FUTURES
CONTRACT
 Bilateral
 No Counter party Risk
 Organized Exchange
 Standardized contracts
 Involvement of Clearing House
 Margin Money = 2.5% To 10%
 Mark to Market =
 Actual delivery may not happen
 Payoff in Futures Contract:
Long Futures
 On 1st Oct 2017 Mr. Ashok buys a
future’s contract at a price of Rs. 60.
Expiry date of the contract is 28th
Oct. 2017. If the spot price, at the
time of expiration of the contract is
Rs. 54,56,58,60,62,64,66,68 & 70.
What will be the maximum profits or
losses for Mr. Ashok? Also show
graphical representation.
Payoff in Futures Contract:
Long Futures
Spot Price Payoff
54 =54-60 = - 6
56 -4
58 -2
60 0
62 2
64 4
66 6
68 8
70 10
Payoff in Futures Contract:
Long Futures
 Payoff in Futures Contract:
Long Futures
 In this case Mr. Ashok is going
for long on future’s contract
 Pay offs of future’s contract is
linear
 If the spot price at expiration is
above Rs.60 he will earn profits
and if the spot price is below
Rs. 60, he will suffer losses
 Payoff in Futures Contract:
Short Futures
 On 1st Oct 2017 Mr. Ashok sells a
future’s contract at a price of Rs. 60.
Expiry date of the contract is 28th
Oct. 2017. If the spot price, at the
time of expiration of the contract is
Rs. 54,56,58,60,62,64,66,68 & 70.
What will be the maximum profits or
losses for Mr. Ashok? Also show
graphical representation.
Payoff in Futures Contract:
Short Futures
Spot Price Payoff
54 =60 – 54 = 6
56 =60 – 56 = 4
58 2
60 0
62 -2
64 -4
66 -6
68 -8
70 -10
 Payoff in Futures Contract:
Long Futures
 In this case Mr. Ashok is going
for short on future’s contract
 Pay offs of future’s contract is
linear
 If the spot price at expiration is
below Rs.60 he will earn profits
and if the spot price is above
Rs. 60, he will suffer losses
Payoff in Futures Contract:
Short Futures
 DIFFERNCE BETWEEN
FORWARD AND FUTURES
Heading Forward Futures
Nature OTC Exchange
Traded
Counter Exists Non Exists
party risk
Contract Customized Standardized
term
Guarantee Does not use Uses clearing
of Contract clearing houses to
fulfillment houses to guarantee
guarantee
Margin Not required Required
 DIFFERNCE BETWEEN
FORWARD AND FUTURES
Heading Forward Futures
Transparency No transparency Transparency in
in markets markets
MTM Not market to Marked to
market on a daily market on a
basis daily basis
Closed prior No Mostly
to delivery
Profit or No Yes
Losses
realized daily
Actual Actual Delivery of Actual delivery
Delivery Assets happens a of asset may or
the end of may not be
 DIFFERNCE BETWEEN
FORWARD AND FUTURES
Heading Forward Futures
Liquidity Less More
Settlement Settlement Follows daily
happens at the settlement
end of contract
Price Not efficient Efficient
discovery
Mechanism
Market Price On Phone or telex Electronic
exchange
THEORETICAL FUTURE PRICE

 Before understanding Theoretical

Futures price, let us understand
the meaning of the term BASIS
 Futures Prices and Spot Prices are
different they correspond at the
time of expiration of a contract
THEORETICAL FUTURE PRICE

 Before settlement futures and

spot prices need not be the same
 Different between the prices it
called BASIS
 It converges to zero as the
contract approaches maturity
 Basis is defined as the
difference between spot and
futures prices
THEORETICAL FUTURE PRICE

B=S–F

Where,
B is Basis Points
S is Spot Price
F Forward Price
THEORETICAL FUTURE PRICE

On October 12th a foreign exchange

currency is trading at Rs. 45.96 per
$ (Spot Price)
The November futures contract
is Rs. 45.99 then basis is -3 cents
B=S–F
= 45.96 – 45.99
= -3 cent
THEORETICAL FUTURE PRICE

If the sport price on

1 July 2017 is 72
st

cents, calculate the

basis for the following
futures contract
THEORETICAL FUTURE PRICE

Settleme Aug Sept Dec Feb

nt 2017 2017 2017 2018
Month
Future 75 70 78.5 69.5
Price
B= S – F 72- 72- 72- 72-
75= 70 = 78.5 69.5
-3 2 =- =
6.5 2.5
THEORETICAL FUTURE PRICE

Theoretical futures price (TFP)

also known as Fair Price, is the
mathematical calculations of price
of a future contract
It is a theoretical equilibrium price
of futures contract
Theoretical price is also known as a
Fair Value of a futures contract
THEORETICAL FUTURE PRICE

Simple put, TFP or Fair Futures Price

is Spot Price + Holding / Carrying
cost
Carrying Cost includes the cost of
holding the underlying till maturity
any dividend expected till expiry of
the contract
Cost of carry includes variables like
storage cost and interest rates
THEORETICAL FUTURE PRICE

F=S+C
Where,
F is Fair Price
S is Spot Price
C is Cost of Carry
THEORETICAL FUTURE PRICE

Spot price of 10 gm Gold is Rs.

32000, Locker storage cost is Rs.
400, insurance is Rs. 200 and
Interest is Rs. 250. Calculate the fair
price of 3 months Future Contract
Given: Spot Price (S) = 32, 000,
Storage Cost = 400, Insurance =
200, Interest = 250, Futures price (f)
=?
THEORETICAL FUTURE PRICE

Cost of Carry (C) = Storage

Cost + Insurance+ Interest
Cost
C = 400 + 200 +250 = 850
F=S+C
F = 32000 + 850
F = 32850
THEORETICAL FUTURE PRICE

Silver Current Market Price is

Rs. 40000 per kg. Storage cost
is Rs. 300 and Interest Cost is
Rs. 150. Calculate is the fair
price of 4 months Futures
contract.
THEORETICAL FUTURE PRICE

Spot price of 10 gm Gold is Rs.

32000, Locker storage cost is Rs.
400, insurance is Rs. 200 and
Interest is 10%. Calculate the fair
price of 3 months Future Contract
Given: Spot Price (S) = 32, 000,
Storage Cost = 400, Insurance =
200, Interest = 10%, Futures price
(f) = ?
THEORETICAL FUTURE PRICE

Future Price = Spot Price + Storage

Cost + Insurance + Interest Cost
Future Price = 32000 +400+ 200
[10% x (32000+400+200) x 3/12]
= 32600 X 3/12
F = 32600 + (10% of 8150)
F = 32600+ 815
F = 33145
THEORETICAL FUTURE PRICE

Note: In case of carry is given in %

terms, the problem can be solved
with the below formula
F = S (1+r)n
Where, F is Fair price, S is Spot
price
r is carrying cost (in%)
T is time to expiration (in
years)
THEORETICAL FUTURE PRICE

Formula of Theoretical Future

Pricing/Fair Pricing can be
Divided into Three parts
Future price of a contract is
dependent on the income to be
generated by the underlying
asset
THEORETICAL FUTURE PRICE

Future price of a stock paying

no dividend will be lesser than the
future price of stock paying
dividend before settlement of the
contract
Formula of Future pricing will be
different based on the income
yielding capacity of the underlying
assets
THEORETICAL FUTURE PRICE

There are three variants of such

contracts:
1. Where the underlying assets
pays no income till maturity
2. Where the underlying asset
pays fixed and continuous income
till maturity
3. Where the underlying asset pays
irregular income till maturity
 THEORETICAL FUTURE PRICE

Formula for calculations of

Futures – TFP
Sr. Underlying Examples Formula
No Assets
1 underlying Gold, F​=S​×
assets pays no Silver
income till
maturity
2 underlying Bonds, T- F​=S​×
asset pays fixed Bills
and continuous
 THEORETICAL FUTURE PRICE

Formula for calculations of

Futures – TFP
Sr. Underlying Examples Formula
No Assets
3 underlying Equity F​=(S​-
asset pays Shares
irregular income
Y)×
till maturity
THEORETICAL FUTURE PRICE

Where, F = Future fair price

S = Spot Price
e= Continuous
compounding factor
(2.71828)
r= risk free interest rate
y = % income yield pa
T = Time till maturity
THEORETICAL FUTURE PRICE

‘e’ stands for exponential x

function
It is continuous
compounding factor
i.e. number called as Napier
Number and its
approximate value is
2.718281828
THEORETICAL FUTURE PRICE

To solve the value of e raise to x by a

simple calculator following steps need to
be followed
Step 1: 2.7183
Step 2: Press square root (
button 12 times
Step 3: Subtract 1 from the answer at
step 2
Step 4: Multiply the answer at step 3
with power of ‘e’
THEORETICAL FUTURE PRICE

To solve the value of e raise to x by

a simple calculator following steps
need to be followed
Step 5: Add 1 to the answer at step
4
Step 6: Press multiply and equal to
button (Z and =) 12 times
THEORETICAL FUTURE PRICE

Example : find the value of

Step 1: Type 2.7183
button
Step 2: Step 2: Press square root
12 times (Answer is 1.00024417206)
Step 3: Subtract 1 from the above
answer (1 -1.00024417206 =
0.00024417206)
Step 4: Multiply this answer with the
power of ‘e’ (Answer is 0.00024417206.
* 2.2 = 0.00053717853)
THEORETICAL FUTURE PRICE

Step 5: Add 1 to this answer

(Answer is 1+ 0.00053717853 = 1.
00053717853)
Step 6: Press multiply and equals
to button (x and = ) 12 times
(Answer is 9.02223862126
Answer is = 9.02
 THEORETICAL FUTURE PRICE

Example
1. A one year long future contract on a
non dividend paying stock is entered
into when the stock price is Rs.60
and the risk free rate of interest is
10% p.a. with continuous
compounding. What is the theoretical
price of the future’s contract?
S=60, r=10% 0.1 T=1
 THEORETICAL FUTURE PRICE
Example
1.Step 1: Type 2.7183
Step 2: Step 2: Press square root button 12
times (Answer is 1.00024417206)
Step 3: Subtract 1 from the above answer
(1 -1.00024417206 = 0.00024417206)
Step 4: Multiply this answer with the power
of ‘e’ (Answer is 0.00024417206. * 0.1=
0.0000244172)
THEORETICAL FUTURE PRICE

Example
Step 5: Add 1 to this answer (Answer is
1+ 0.00053717853 = 1.0000244172)
Step 6: Press multiply and equals to
button (x and = ) 12 times (Answer is
1.10518374474
F = 60 * 1.1052
F = 66.312
THEORETICAL FUTURE PRICE

Example
2. If the spot price of gold
is Rs. 20000. Interest
rates are 5% and the
contract settles in one
year. Theoretical future
price would be?
THEORETICAL FUTURE PRICE

Example
3. Mr. Tushar enters into a futures
contract to buy bushels of corn at
spot price of Rs. 200000/-. The corn is
stored for use in 3 months time.
Storage and insurance charges of Rs.
200. Interest expenses are 10% per
year continuously compounded .
Calculate the fair price of the
contract
THEORETICAL FUTURE PRICE

Example
4. The share of X Ltd. Is Rs.
250 in spot market. No
dividend is expected. Risk
free interest rate is 8%. What
would be the theoretical
price of X Ltd.'s 3 months
futures?
THEORETICAL FUTURE PRICE

Example

5. Spot price of a 3 month

zero coupon bond is Rs.
970.87. Risk free interest
rate is 6%. Find the
Theoretical futures price.
 THEORETICAL FUTURE PRICE

Example
6.A T-Bill with a coupon rate of 8%
pa continuously compounded is
issued by Government and is
available in market at spot price
of Rs. 2080. Cost of financing is
12% pa. What is the fair price of
9 Months future contract?
THEORETICAL FUTURE PRICE

Example
F​=S​×
S = 150, r=7% 0.07 y 3.2% 0.032
t = 6 (6/12)
150 X e (0.07-0.032)
6/12
150 X e 0.019
152.88
THEORETICAL FUTURE PRICE

Example
7. A Futures contracts for 4 months
is entered into when a spot price is
at 1000. if the risk free interest
rate is 3% per year (with
continuous compounding) and the
dividend yield on the index is 2%
per year, What is the future price?
THEORETICAL FUTURE PRICE

Example
8. Current price of a stock listed on
NSE is Rs. 200. Risk free interest is
10%. Expected yield is Rs. 2.50.
Calculate the fair price of a three
month. Futures contract for an
investor.
PRICING INDEX FUTURES

Index future are a type of

futures contract on a particular
stock or financial Index
Just the way participants
buy/sell forward, futures and
options contracts, participants
also participate in buying/selling
contracts on a particular Index
PRICING INDEX FUTURES

Index future are a type of

futures contract on a particular
stock or financial Index
Just the way participants
buy/sell forward, futures and
options contracts, participants
also participate in buying/selling
contracts on a particular Index
PRICING INDEX FUTURES

A Stock index/stock market index is

a statistical tool used to measure
market value of a section of stock
market
Index future are considered a way
of determining market sentiment
Trading/Hedging with the help of
Index futures involves dealing into a
portfolio of shares or equity index
PRICING INDEX FUTURES

Some famous Stock Index

Futures around the world
are mentioned as below,
S&P Index Futures is the
most traded Index Futures
Contracts
 PRICING INDEX FUTURES
Country Index Futures
India Nifty 50 NSE, SENSEX, CNX NIFTY
US S&P500, DIJA, NYSE, NASDAQ, Dow
30
Canada TSE 35
Hong Kong Hang Sang
China China A50, Dj Shanghai
Malaysia Kualalumpur
South Kospi
Korea
Germany DAX
UK FTSE 100
PRICING INDEX FUTURES
Sr. Income Formula
No
.
1 When Income is F​=S​×
given in %
2 When Income is F​=S​×
given in Amount
 INITIAL MARGIN AND MAINTENANCE
MARGIN

To know the concept Margin we will

take on example
i.e. XYZ taking a flat on rent, before
getting the possession, XYZ has to
pay a security deposit to owner of
the flat
In case there are any damages to
the flat, the same is adjusted with
security deposit XYZ pay
INITIAL MARGIN AND MAINTENANCE
MARGIN

Similarly in Future Contract ,

a security deposit is paid
which is known as Margin
If there is any decrease in
value of the underlying
asset, the same is adjusted
from margin account
INITIAL MARGIN AND MAINTENANCE
MARGIN

Margin account allows investors to

make investments in future contract
It ensures that investors are
serious about he buying and
selling of stocks
Margin money ascertains the
buyers pays deal amount on time
and the seller also honours his
commitment
INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

1. Initial Margin: Initial Margin
means the minimum amount of capital
or equity provided by investors at time
of entering into a futures contact
It is required in order to avoid
overtrading and excessive trading in
futures contract
INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

x: If a person goes long on
futures contract for ABC stock
trading for 100 shares and if
the initial margin required is
20%. The initial margin will be
calculated as 100 X 100 X
20%= Rs. 2000
INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

2. Maintenance Margin:
Maintenance Margin is the
minimum balance that one
needs to keep in account in
order to keep the futures
position valid
INITIAL MARGIN AND MAINTENANCE
MARGIN

There are 2 types of Margins

2. Maintenance Margin: It
is the amount that an
investor is required to
maintain all the time in his
margin account
 MARKING TO MARKET AND
VARIATION MARGIN

Marking to Market: Also

known as “Daily Settlement”,
Marking-to-Market (MTM) is a
process of valuing underlying
assets in a futures contract at
the end of each trading day
The profit or loss is settled by
the exchange
 MARKING TO MARKET AND
VARIATION MARGIN

Marking to Market: At the end of

each trading session, all outstanding
contracts are calculated at settlement
price of that trading session
The exchange makes an adjustment
by debiting the margin accounts of
members who are at a loss and
crediting the accounts of members
who gain
 MARKING TO MARKET AND
VARIATION MARGIN

Variation Margin: As the name

suggest, variation margin is the
amount of money required to
bring the margin balance back up
to the initial margin level
In certain cases, there are some
losses that bring the margin below
the required Maintenance margin
level
MARKING TO MARKET AND
VARIATION MARGIN