Futures and Forwards

⦿ In most cases we acquire assets and pay for

it simultaneously. The price of the asset and
the settlement (exchange of asset and its
consideration) are done at the same point of
time.
⦿ Forward contract is an agreement to buy or
sell an asset at a price determined now but
is settled later at a predetermined date.
⦿ Forward contract enables elimination of
price risk faced by both buyer and seller of
asset.
⦿ Forward contract is an O TC product
tailored to meet specific needs but with
counterparty risk. Features are:
• Over-the-Counter (OTC) Product, where
• The price is determined now, with
• Mutual obligation to perform, assuming
• Counter-party risk, and
• Mutual consent required for cancellation,
involving
• No front-end payment
⦿ by delivery of asset and the consideration:
if an exporter sold Euro 10,000 to a bank 6-m
forward at Rs 66 then at maturity, the contract is
settled by delivery of Euro 10,000 and bank
would pay Rs 6,60,000; or
⦿ byentering into an offsetting contract opposite
to the original contract at maturity or prior, at a
price prevailing then:
For example the exporter having sold 6-m
forward Euro 10,000 at Rs 66.00 may after 3
months, decide to buy 3-m forward Euro 10,000
at Rs 67.00 per Euro.
⦿ Forward contracts are subject to high
default risk as the price scenario at maturity
can favour only one party and not both.
Futures being exchange traded do not have
any such risk.
⦿ Futures are similar to a forward contract but
are exchange traded.
⦿ Since futures are exchange traded do not
have counter-party risk with exchange
serving as counter-party to both buyer and
seller.
⦿ For trading at the exchange the contract
need to be standardized.
⦿ Standardization of the contract needs to
be done for
• Size of the contract
• Delivery of the contract obligations
• Quotations of the price
• Specification of the underlying asset
⦿ Futures
is a standardized forward
contract that is traded on an exchange.
 Futures Contract on Gold at National Multi-Commodity Exchange of
Asset Code GOLD
Unit of Trading 100 gms of Fineness .999
Delivery Unit Gold Bars of 100 grams serially numbered and of fineness . 999

Quotation/ Base Value 10 grams of fineness .999

Tick Size Re.1
Quality Specification The Gold delivered under the contract must be Gold Bars weighing
100
grams each and assaying not less than .999 fineness bearing a
serial number and identifying origin of the refiner/brander.
No. of delivery Contracts in a Maximum 12 monthly or minimum 2
year monthly contracts running concurrently
Delivery Centres CWC, Cochin
Opening of Contracts Trading in any contract month will open on the 16th day of the
month, 12 months prior to the contract month
Due Date 15th day of the delivery months if 15th happens to be holiday
then previous working day.
Closing of Contract Squaring up of positions will be permitted between 12th and 15th
of
delivery month. No fresh positions building will be allowed. From 12th to
15th of delivery month, seller can tender Warehouse Receipt for
settlement and Warehouse Receipt will be accepted for settlement at
closing price of the previous day.
Delivery Logic Compulsory Delivery

7
⦿ Major
advantages of the futures as
against the forward contract are
• the elimination of counter-party risk,
• flexibility of entry and exit anytime, and
• cash settlement.
⦿ Positionin futures is mostly settled not by
delivery but by entering into a contract,
at maturity or prior opposite to the initial
one with difference in the prices of the
initial and subsequent contracts settled.
⦿ Open interest and volumes are often
thought to be same. However they are
different.
• Open interest is the number of futures contracts
outstanding. It reduces to zero upon maturity of the
contract.
• Volume refers to the number of contracts traded in
a day.
⦿ O pen interest is the number of new
contracts opened. The contracts that offset
initial position do not add to the open
interest but they do add to the volume.
⦿ Fromcash flow perspective, there are 2
differences in futures and forward contracts:
1. Initial and Variation Margins
2. Marking-to-market (MTM)
• To cover the default risk the exchange requires
initial margin before futures position is opened.
• The position is also marked-to-market (MTM) on
daily basis; i.e. profit/loss settled on daily basis.
• The margin cannot fall below a minimum level due to
MTM and if it does, then margin call is made to
replenish the same.
 MARKING TO MARKET
Day Price (Rs) Cash Flow (Rs) Remarks
Day 1 410 None A long position opened for
Opening one contract (400
a shares) valued at Rs
contract 1,64,000
Close 420 (420 - 410) x 400 Investor receives Rs 4,000
Day = + 4,000
1
Close 400 (400 – 420) x 400 Investor pays Rs 8,000
Day = - 8,000
2
Close 390 (390 – 400) x 400 Investor pays Rs 4,000
Day = - 4,000
3
Day 4 440 (440 – 390) x 400 Position closed out with
Closing = + 20,000 contract value of Rs
the 1,76,000. Investor
contract gets Rs 20,000
Net Profit (440 – 410) x 400 It remains the difference of
= 12,000 11
opening and close prices.
Features Futures
Location Exchange Ov
Counter party Unknown to each other, Co
Exchange serves counter to
party
Counter party risk Minimal Exi
Initial Cash flow Initial margin required No
Explicit cost Brokerage required to be paid No
Settlement Implicitly daily by marking to No
the market
Final settlement By delivery or cash settled By
Exit prior to maturity Possible by entering an Ge
opposite contract to square up un
the position ag
Quantity specification Fixed standard size/lot An
Time of Delivery On fixed dates An
by
Cost of hedging Very nominal Hig
Period of hedging Contracts available for limited Un
period
12
⦿ From pricing perspective forward and
futures follow the same principle.
⦿ Futures price is based on spot price
andthe cost of carry for the period less
benefits of ownership.
• F1 = S0 x (1+r)
• F1 = S0 x ert for continuous compounding
Where F1 is forward/futures price with contract
expiring at t = 1, S0 is spot price at t = 0 and r is
the cost of carry for the period 0 to1.
⦿ C o st
of carry model eliminates arbitrag e.
If mispriced it offers arbitrage one way or
the other.
C a sh and C a rry Arbitrag e: When futures
is overpriced:
🞄Spot price of 10 gms g old at Rs 7,000
🞄Risk free rate of 10% per annum
🞄forward contract period of 1 year is Rs 8,000
⦿ Arbitrageur can take following actions at t
= 0:
🞄Borrow Rs 7,000,
🞄Buy g old spot, and
🞄Sell forward contract at Rs 8,000.
⦿ At the end of futures contract
Realise cash from forward contract + Rs 8,000
Pay back the borrowed money
and interest thereon - Rs 7,700
Profit Rs
300
⦿ Sincefutures was overpriced by Rs 300 the
arbitrageur can pocket this profit by selling
the futures first and buying gold by
borrowing.
 When futures is underpriced at Rs 7,300 the
arbitrageur can take following actions:
🞄Borrows g old
🞄Sells g old at Rs 7,000 and lends at 10% and
🞄Buys a forward contract at Rs 7,300.
⦿ One year later following cash
flow will result:
🞄 Realise cash from lending activity + Rs 7,700
🞄Pay for the forward contract & return
borrowed gold - Rs 7,300
Profi Rs
t 400
⦿ For investment assets both cash and carry
and reverse cash and carry arbitrage are
possible.
⦿ Consumption value associated with
commodities tests the arbitrage argument.
⦿ For consumption asset while strategy of
cash and carry can be implemented but
the reverse cash and carry is not be
possible.
⦿ One cannot sell a commodity required for
consumption purposes, and buy futures
contract instead.
⦿ IfF1 is the forward price and S 0 is the spot
price and T is the maturity then at inception,
value of the forward contract, f = S0 – F1 . e-rT
=0
⦿ Once entered forward contract would have
value.
For initial long position Cash flow at t = T
Under initial long contract; pay - F1
Under subsequent short contract; receive +
F2 Net cash flow F2 – F1
Value of the forward contract, f = (F2 – F1) . e -rT
The current price of Bharti’s share is Rs 800. An investor, A
goes long with the 6 months contract. After one month
another investor, B is prepared to buy Bharti Share at Rs 925
for delivery after 5 months. If the risk free interest rate is 9%
per annum what is the value of the forward contract?
Solution
As of now 5 months are left for the expiry with payment of
Rs 900 to get the delivery of share. If A goes short he would
receive Rs 925. Therefore the value of the forward contract, f
is PV of the difference of current price and original
contract price
= (925 – 900) x e-0.09 x 5/12 = Rs 24.08
⦿ Thedifference of futures price and spot price is
called basis. As time progresses basis declines and
becomes zero on the day of maturity i.e. spot and
futures price converge.
Convergence of Spot and Futures Price
Price
Futures
Net cost of carry Maturit
y

Spo
t

Tim
e
⦿ The price of futures and forward are
identical in perfect markets.
⦿ Futures price would be marginally different
from forward depending upon the
correlation of price with interest rates.
Correlation of Spot & Interest Relationship of
Price
• Positive Correlation Futures Price > Forward
Price
• Negative Correlation Futures Price < Forward
Price
• No Correlation Futures Price = Forward
⦿ Normal backwardation hypothesis states
that the current future price is a
downward biased indicator of the future
spot price.
⦿ When futures price is more than the
expected future spot price it is referred
as contango.
⦿ Expected hypothesis assumes that the
futures price is an unbiased indicator of
the expected spot price.
⦿ Futures are broadly of two types;
• Commodity futures, and
• Financial futures
⦿ Commodity futures are those where the
underlying asset is a commodity.
🞄 Contracts are available in India on agricultural
commodities like Wheat, Rice, Soya, Coffee, Sugar,
Tea, Jeera, Pepper, Edible oils, C otton, C oconut,
etc.
🞄 Contracts on metals Gold, Silver, are also available.
🞄 Futures contracts on oil are also commodity
futures.
⦿ Financial
futures are those where
underlying asset is a financial product.
These are:
🞄 Currency Futures are those where the underlying assets
are currencies.
🞄 Stocks/Index futures are those where the underlying are
stocks or indices. Stock futures were introduced in India on
June 12, 2000 for Indices and on November 9, 2001 on
select individual securities, at NSE.
🞄Interest Rate futures are those where underlying assets
are interest rates. In India interest rate futures were
launched on June 24, 2003 at NSE.