Table of Contents
Introduction to Forward Contracts:
- Forward contracts are agreements between two parties to buy or sell an asset on a future date at predetermined terms.
- They are used in commodities, foreign exchange, equity, and interest rate markets.
- Forward contracts differ from cash market transactions, where the asset is bought or sold immediately at the spot price.
Example: Cash Market vs. Forward Contract:
- In the cash market, you buy gold at the spot price (e.g., Rs. 49,950 for 10 grams).
- In a forward contract, you agree with the goldsmith on a future price (e.g., Rs. 50,000) and settle the transaction after one month.
- Both parties are obligated to fulfill the contract, regardless of the value of the underlying asset (gold) at the time of delivery.
Essential Features of Forward Contracts:
- Forward contracts are bilateral contracts between two parties.
- All contract terms (price, quantity, quality, delivery terms, etc.) are fixed at the time of entering into the contract.
- Forwards are over-the-counter (OTC) transactions negotiated directly between the parties.
- Terms can be altered if both parties agree.
- They help fix the price to mitigate price risk associated with the underlying asset.
Limitations of Forward Contracts:
Liquidity Risk:
- Forward contracts are tailor-made and not easily accessible to other market participants.
- They are not listed or traded on exchanges, leading to illiquidity.
- Exiting a forward contract before maturity can be challenging.
Counterparty Risk:
- Counterparty risk refers to the risk of economic loss if the counterparty fails to fulfill its contractual obligations.
- There is a possibility of default or non-compliance with the contract terms.
Futures Contracts:
- Futures contracts are standardized forward contracts traded on an exchange.
- They are agreements to buy or sell a fixed amount of a commodity or financial asset at a predetermined price on a future date.
- The exchange and its clearing corporation guarantee the settlement of these contracts.
Features of Futures Contracts:
- The contract between two parties through an exchange.
- Centralized trading platform.
- Price discovery through the interaction of buyers and sellers.
- Margins are payable by both parties.
- Standardized quality and quantity.
Limitations of Futures Contracts:
- Limited maturities and underlying set.
- Lack of flexibility in contract design.
- Increased administrative costs due to mark-to-market settlement.
Contract Specifications of Futures Contracts:
- The exchange determines all terms and conditions except for the price.
- Contract specifications include:
- Underlying instrument and underlying price (spot price in cash market).
- Contract multiplier or contract size.
- Contract cycle (trading period).
- Expiration day (last trading day).
- Tick size (minimum price movement).
- Daily settlement price (calculated by the exchange).
- Final settlement price (closing price of underlying on expiration day).
- Trading hours and holidays.
Example: Nifty Futures Contract (as of September 21, 2021):
- Instrument type: Index futures.
- Underlying asset: Nifty 50.
- Expiry date: September 30, 2021.
- Contract specifications include open, high, low, and closing prices, number of contracts traded, turnover, and underlying value.
Open Interest and Volumes Traded
- Open interest represents the total number of outstanding contracts in the market.
- It indicates the depth of the market and is equal to the number of long futures or short futures.
- Volumes traded reflect the market activity for a specific contract over a given period.
- Traded volume measures the volume of contracts traded during a specific time period.
Price Band
- Price band is the permitted price range within which a contract can trade during a day.
- It is calculated based on the previous day’s closing price of the contract.
- For example, if the price band is 10%, a contract with a previous day closing price of Rs.100 can trade between Rs.90 and Rs.110.
- Price bands are defined in contract specifications and can be expanded by exchanges in certain situations.
Positions in Derivatives Market
- Long position: Outstanding buy position in a contract.
- Short position: Outstanding sell position in a contract.
- Open position: Outstanding long or short positions in various derivative contracts.
- Naked position: Long or short position in a futures contract without a position in the underlying asset.
- Calendar spread position: Combination of long and short positions in futures contracts on the same underlying asset but different maturities.
Opening a Position
- Opening a position refers to buying or selling a contract, which increases the client’s open position (long or short).
- For example, if a client buys 10 contracts of a futures contract, their open position increases by 10 contracts.
Closing a Position
- Closing a position refers to buying or selling a contract, which results in the reduction of the client’s open position (long or short).
- If a client sells a contract that they had previously bought or buys a contract that they had previously sold, their open position is considered closed.
- Closing a position allows the client to exit their position in the market.
Differences between Forwards and Futures:
| Feature | Forward contracts | Futures contracts |
|---|---|---|
| Operational mechanism | Not traded on exchanges | Exchange-traded contract |
| Contract specifications | Tailor-made contracts | Standardized contracts (except price) |
| Counter-party risk | Exists, reduced by guarantor | Clearing agency becomes counter-party, ensuring settlement guarantee |
| Liquidity profile | Low, contracts cater to specific parties | High, standardized and accessible to market participants |
| Price discovery | Not efficient, scattered markets | Efficient, centralized trading platform for price discovery |
| Quality of information and dissemination | Poor quality, weak dissemination speed | Nationwide trading, quick dissemination of relevant information |
Payoff Charts for Futures contract:
Payoff on a position represents the expected profit/loss with changes in the underlying asset’s price at expiry. The payoff diagram illustrates the underlying asset price on the X-axis and profits/losses on the Y-axis.
For futures contracts, both long and short positions have unlimited profit or loss potential, resulting in linear payoffs. The payoffs for futures contracts are as follows:
Payoff for the buyer of futures (Long futures):
Assuming a person goes long in a futures contract at Rs. 100, agreeing to buy the underlying at that price on expiry. If the price of the underlying at expiry is Rs. 150, the buyer can purchase at Rs. 100 and sell it immediately in the cash market at Rs. 150, resulting in a profit of Rs. 50. Conversely, if the price falls to Rs. 70, buying at Rs. 100 and selling at Rs. 70 leads to a loss of Rs. 30.
Futures Pricing
– Pricing of futures contracts depends on the characteristics of the underlying asset.
– Two popular models for futures pricing: Cost of Carry model and Expectations model.
Cost of Carry Model:
– Assumes no-arbitrage opportunities exist in an efficient market.
– The fair price of a futures contract is the sum of the spot price and the cost of carrying the asset from today to the future date.
– Cost of carrying includes transaction costs, financing costs, warehousing costs (for commodities), etc.
– “Cash and carry arbitrage” occurs when futures price exceeds the fair price, leading to buying in the cash market and selling in the futures market until prices align.
– “Reverse cash and carry arbitrage” occurs when futures price is less than the fair price, resulting in buying futures and selling in the cash market.
No-Arbitrage Bound and Transaction Costs:
– Transaction costs create a no-arbitrage bound, limiting arbitrage opportunities.
– Wider no-arbitrage bounds indicate markets are further from equilibrium.
– Lower costs lead to more efficient markets and narrower no-arbitrage bounds.
Extension to Assets Generating Returns:
– Inflows during the holding period (e.g., dividends, interest) are adjusted in the fair futures price calculation.
– Fair futures price formula: F = S(1+r-q)T, where F is the fair price, S is the spot price, r is the cost of carry, q is expected return, and T is the time to expiration.
Example:
– Index futures fair price calculation:
– Spot price: 17,500
– Cost of financing: 12%
– Holding period return: 4% per annum
– Fair price after 3 months: 17,835.26
– If the futures price is above the fair price, one can buy in the cash market and sell futures to lock in gains.
Note:
– Different market participants may have different fair values of futures contracts based on their borrowing costs, return expectations, etc.
– Continuous trading occurs due to variations in fair values and no-arbitrage bounds among participants.
Assumptions of the Cost of Carry Model:
– Underlying asset is available abundantly in the cash market.
– Demand and supply for the underlying asset are not seasonal.
– Holding and maintaining the underlying asset is easy.
– The underlying asset can be sold short.
– There are no transaction costs.
– There are no taxes.
– There are no margin requirements.
Limitations of the Cost of Carry Model:
– It doesn’t work well for assets with seasonal patterns of demand and supply.
– It is not applicable to underlying assets that are difficult to hold or maintain.
– It may not be suitable for pricing futures contracts if the underlying asset cannot be sold short.
– The model does not account for transaction costs, taxes, or margin requirements.
– Adjustments may be needed to fit the specific requirements of underlying assets.
Convenience Yield:
– Convenience yield refers to intangible benefits perceived by market participants from holding an asset.
– It can arise in situations where there is a scarcity of a commodity and its inventory is low.
– Convenience yield can be subjective and difficult to price.
– It may dominate the cost of carry and cause futures to trade at a discount to the cash market.
– The cash and carry model may not be applicable in such cases.
Expectations Model of Futures Pricing:
– The expectations hypothesis states that futures prices are based on the expected spot prices of the underlying assets.
– It suggests that it is the relationship between expected spot and futures prices that influences the market.
– Futures prices can trade at a premium or discount to the spot price.
– Futures prices provide an indication of the expected direction of movement of the spot price in the future.
– If futures price is higher than the spot price, it may indicate an expected rise in the spot price (Contango market).
– If futures price is lower than the spot price, it may indicate an expected decrease in the spot price (Backwardation market).
Uses of Index Futures:
Index futures are derivative instruments that are used to manage and mitigate the systematic risk associated with investing in the stock market. They provide a way for investors to hedge their portfolios and protect against unfavorable market movements. Here are some important points to understand about the uses of index futures:
1. Price Risk: Equity derivatives, including index futures, help in managing the component of price risk inherent in securities investment. Price risk can be divided into specific risk (unsystematic risk) and market risk (systematic risk).
2. Unsystematic Risk: Specific risk refers to the price risk that is unique to particular events of a company or industry. It includes risks like labor strikes, key personnel changes, or emerging competition. Specific risk can be reduced through diversification.
3. Systematic Risk: Market risk, or systematic risk, is the non-diversifiable portion of price risk associated with overall market or economic movements. Examples include policy changes, exchange rate fluctuations, or geopolitical events. Systematic risk is separable from the investment and can be traded using index-based derivatives.
4. Beta: Beta is a measure of a security’s systematic risk that cannot be eliminated through diversification. It quantifies the sensitivity of a stock or portfolio to movements in the overall market. A beta of more than 1 indicates an aggressive stock/portfolio, while a beta of less than 1 indicates a conservative stock/portfolio.
5. Portfolio Beta: The beta of a portfolio is calculated as the weighted average of the individual stocks’ betas based on their investment proportions. The formula for portfolio beta is: W1 β1 + W2 β2 + … + Wn βn = βp, where W is the weight and β is the beta of each stock.
6. Hedging with Single Stock Futures: Single stock futures can be used to hedge the specific risk of a stock investment. A hedge ratio of 1:1 is commonly used, where one futures contract is used to hedge one unit of the underlying stock.
7. Hedging with Index Futures: Index futures are used to manage the systematic risk of a portfolio. The hedge ratio for index futures is calculated based on the value of the portfolio, the beta of the portfolio, and the value of the index futures contract.
8. Long Hedge: A long hedge involves hedging a position in the cash market by going long in the futures market. It is used when expecting to receive funds in the future and wanting to invest them in the securities market.
9. Short Hedge: A short hedge involves hedging a position in the cash market by going short in the futures market. It is used when expecting prices to decrease in the future and wanting to protect the portfolio’s value.
10. Cross Hedge: Cross hedge refers to hedging with futures contracts on a closely associated asset when futures contracts on the desired asset are not available. It is done to protect the value of the actual asset.
11. Hedge Contract Month: The hedge contract month is the maturity month of the futures contract used for hedging. It is important to select a contract that expires just after the date when the exposure needs to be unwound.
Note: It is essential to consult financial newspapers, magazines, or information networks like Bloomberg or Reuters for information on individual stock betas and other relevant data.
Trading in Futures Market:
– Traders in the futures market take positions based on their expectations of price movements in the underlying asset.
– Naked positions involve taking a long or short position in futures contracts without having a position in the underlying cash market.
– Traders take a long position when they expect the market to go up and a short position when they expect it to go down.
– Profit is made by reversing the position at a higher or lower price in the future, depending on the position taken.
– Single stock futures can also be traded by taking long or short positions based on market expectations.
– Futures positions are exposed to both profit and loss, depending on the movement of the market or stock.
Spread Positions:
– Spread positions involve taking two opposite positions, either in different products with the same maturity or in the same product with different maturities.
– Inter-commodity spreads and calendar spreads are examples of spread positions.
– Spread positions are treated as conservatively speculative positions as they are hedged to a large extent.
Arbitrage Opportunities in Futures Market:
– Arbitrage involves simultaneous purchase and sale of assets in different markets to profit from price discrepancies.
– Arbitrage helps keep futures prices aligned with prices of the underlying assets.
– There are three types of arbitrage in the futures market: cash and carry arbitrage, reverse cash and carry arbitrage, and inter-exchange arbitrage.
– The fair futures price is determined based on the spot price and carrying costs.
– If the futures price deviates from the fair price, arbitrage opportunities may exist.
Inter-Market Arbitrage:
– Inter-market arbitrage involves exploiting price differences in the same underlying asset at different exchanges.
– Traders can buy contracts at one exchange where prices are lower and sell them at another exchange where prices are higher.
– The positions can be reversed when the price difference narrows, resulting in a profitable opportunity.
– Transaction costs and other incidental costs must be considered before entering into an inter-market arbitrage transaction.
Overall, futures provide market participants with a means to alter portfolio composition and manage risk effectively. They can be used to add or reduce risk in existing portfolios, making them valuable tools for risk management and portfolio restructuring.
