Derivative management

Unit – 2

Forward and future contracts

INTRODUCTION

Financial derivatives like futures, forwards options and swaps are important tools
to manage assets, portfolios and financial risks. Thus, it is essential to know the
terminology and conceptual framework of all these financial derivatives in order to
analyze and manage the financial risks. The prices of these financial derivatives
contracts depend upon the spot prices of the underlying assets, costs of carrying
assets into the future and relationship with spot prices. For example, forward and
futures contracts are similar in nature, but their prices in future may differ.
Therefore, before using any financial derivative instruments for hedging,
speculating, or arbitraging purpose, the trader or investor must carefully examine
all the important aspects relating to them.

Forward Contracts-Concept

Forward contract is a simple form of financial derivative instruments. It is an

agreement to buy or sell a specified quantity of an asset at a certain future date for
a certain price agreed upon now. In a forward contract, two parties agree to do a
trade at some future date at a stated price and quantity. No money changes at the
time the deal is signed. However unlike futures contracts, they are not traded on an
exchange. They are private contracts between two parties which may be between
financial institutions, between a financial institution and one of its corporate client,
etc. Further, these contracts differ from 'cash' or 'spot' contracts where delivery is
made immediate within a short settlement period. Most of the forward contracts
are traded on the over-the-counter (OTC) market or by telephones. Honouring the
contract is made generally by taking and giving delivery and counter parties risk
depends on the counter party only.
At the time the forward contract is written, a specified price is fixed at which the
asset is purchased or sold. This specified price is referred to as the delivery price.
This delivery price is set such that the value of the forward contract is zero at the
time of its formation. This means that it costs nothing to take either a long (buyer)
or a short (seller) position. This is done by convention so that no cash is exchanged
between the parties entering into the contracts. In this way, the delivery price
yields a 'fair' price for the future delivery of the underlying asset. One of the parties
to a forward contract agrees to buy the underlying asset is said to have a 'long'
position. On the other hand, the party that agrees to sell the same underlying asset
is said to have a 'short' position.

Features of Forward Contract

 It is an agreement between the two counter parties in which one is buyer and
other is seller. All the terms are mutually agreed upon by the counterparties
at the time of the formation of the forward contracts .It specifies a quantity
and type of the asset (commodity or security) to be sold and purchased
 It specifies the future date at which the delivery and payment are to be
made.
 It specifies a price at which the payment is to be made by the seller to the
buyer. The price is determined presently to be paid in future. . It obligates
the seller to deliver the asset and also obligates the buyer to buy the asset.
 No money changes hands until the delivery date reaches, except for a small
service fee, if there is.

Classification of Forward Contracts

The forward contracts can be classified into different categories. Under

the Forward Contracts (Regula-tion) Act, 1952, forward contracts can be classified
in the following categories:

Hedge contracts:
 The basic features of such forward contracts are that they are
freely transfer-able and do not specify any particular lot, consignment or
variety of delivery of the underlying goods or assets. Delivery in such
contracts is necessary except in a residual or optional sense. These contracts
are governed under the provisions of the Forward Contracts (Regulation)
Act, 1952.

Transferable specific delivery (TSD) contracts:

These forward contracts are freely transferable from one party

to other party. These are concerned with a specific and predetermined
consignment or variety of the commodity. There must be delivery of the
underlying asset at the expiration time. It is mandatory. Such contracts are
subject to the regulatory provisions of the Forward Contracts (Regulation)
Act, 1952, but the Central Government has the power to exempt (in
specified cases) such forward contracts.

Non-transferable specific delivery (NTSD) contracts:

These contracts are of such nature which cannot be

transferred at all. These may concern with specific variety or consignment of
goods or their terms may be highly specific. The delivery in these contracts
is mandatory at the time of period .

Forward Trading Mechanism

Forward contracts are very much popular in foreign exchange markets

to hedge the foreign currency risks. Most of the large and international banks have
a separate 'Forward Desk within their foreign exchange trading room which are
devoted to the trading of forward contracts. Let us take an example to explain the
forward contract.
Suppose on April 10, 2002, the treasurer of an UK Multinational firm (MNC)
knows that the coгроration will receive one million US dollar after three months,
i.e., July 10, 2002 and wants to hedge aganist the exchange rate movements. In this
situation, the treasurer of the MNC will contact a bank and find out that the
exchange rate for a three-month forward contract on dollar against pound sterling,
1.c.. £/S = 0.6250 and agrees to sell one million dollar. It means that the
corporation has short forward contracts on US dollar. The MNC has agreed to sell
one million dollar on July 10, 2002 to the bank at the future dollar rate at 0.6250.
On the other hand, the bank has a long forward contract on dollar. Both sides have
made a binding contract/commitment.

Before discussing the forward trading mechanism, let us see some important
terminology frequently used in the forward trade.

Long position:

The party who agrees to buy in the future is said to hold long
position. For example, in the earlier case, the bank has taken a long position
agreeing to buy 3-month dollar in futures.

Short position:

The party who agrees to sell in the future holds a short position in
the contract In the previous example, UK MNC has taken a short position by
selling the dollar to the bank for a 3-month future.

The underlying asset:

It means any asset in the form of commodity, security or

currency that will be bought and sold when the contract expires, e.g., in the
earlier example US dollar is the underlying asset which is sold and
purchased in future.

Spot-price:
 This refers to the purchase of the underlying asset for immediate
delivery. In other words, it is the quoted price for buying and selling of an
asset at the spot or immediate delivery

Future spot price:

The spot price of the underlying asset when the contract expires
is called the future spot price, since it is market price that will prevail at
some futures date.

Delivery price:

The specified price in a forward contract will be referred to as the

delivery price. This is decided or chosen at the time of entering into forward
contract so that the value of the contract to both parties is zero. It means that
it costs nothing to take a long or a short position. In other words, at the day
on writing of a forward contract, the price which is determined to be paid or
received at the maturity or delivery period of the forward contract is called
delivery price. On the first day of the forward contract, the forward price
may be same as to delivery price. This is determined by considering each
aspect of forward trading including demand and supply position of the
underlying asset. However, a further detail regarding this will be presented
in forthcoming chapter.

The forward price:

It refers to the agreed upon price at which both the counter parties will
transact when the contract expires. In other words, the forward price for a
particular forward contract at a particular time is the delivery price that
would apply if the contract were entered into at that time. In the example
discussed earlier, on April 10, 2002, 0.6250 is the forward price for a
forward contract that involves the delivery of US dollar on July 10, 2002.

The determination of forward prices

 In Section 3.2, we have already discussed about the forward contracts
and market. Forward contracts are generally easier to analyze than futures
contracts because in forward contracts there are no daily settle-ment and only a
single payment is made at maturity. Though both futures prices and forward prices
are closely related, this will be described in the latter part of this chapter.

It is essential to know about certain terms before going to determine the forward
prices such as distinction between investment assets and consumption assets,
compounding, short selling, repo rate and so on because these will be frequently
used in such computation. We are not discussing these here in detail but the traders
must be aware about them thoroughly. A brief view of these terms is explained
here as under:

An investment asset is an asset that is held for investment purposes, such as

stocks, shares, bonds, treasury, securities, etc. Consumption assets are those
assets which are held primarily for consumption, and not usually for investment
purposes. There are commodities like copper, oil, food grains and live hogs.

Compounding is a quantitative tool which is used to know the lump-sum value of

the proceeds received in a particular period. Consider an amount A invested for n
years at an interest rate of R per annum. If the rate is compounded once per annum,
the terminal value of that investment will be

Terminal value = A (1+R)",

and if it is compounded m times per annum then the terminal value will be

Terminal value = A (1+R/m)

where A is amount for investment, R is rate of return, n is period for return and m
is period of compounding.

Suppose A = Rs 100, R = 10% per annum, n = 1 (one year), and if

we compound once per annum (m=1) then as per this formula, terminal value will
be

100 (1+10)=100 (1.10) = Rs 110,

If m = 2 then

100 * (1 + 0.05) ^ (2 * 1) = 100 * 1.05 * 1.05 =Rs 110.25

Short selling refers to selling securities which are not owned by the investor at the
time of sale. also called 'shorting', with the intention of buying later. Short selling
may not be possible for all investment assets. It yields a profit to the investor
when the price of the asset goes down and loss when it goes up. For example, an
investor might contract his broker to short 500 State Bank of India shares then the
broker will borrow the shares from another client and sell them in the open market.
So the investor can maintain the short position provided there are shares available
for the broker to borrow. However, if th contract is open, the broker has no shares
to borrow, then the investor has to close his position immediate, this is known as
short-squeezed.

The repo rate refers to the risk free rate of interest for many arbitrageurs operating
in the future markets. Further, the 'repo' or repurchase agreement refers to that
agreement where the owner of the securities agrees to sell them to a financial
institution, and buy the same back later (after a particular period). The repurchase
price is slightly higher than the price at which they are sold. This difference is
usually called interest earned on the loan. Repo rate is usually slightly higher than
the treasury bill rate

Assumptions and notations

Certain assumptions considered here for determination of forward or futures
prices are:

 There are no transaction costs.

 Same tax rate for all the trading profits.
 Borrowing and lending of money at the risk free interest rate.
 Traders are ready to take advantage of arbitrage opportunities as and when
arise. These assumptions are equally available for all the market
participants; large or small.

Further, some Notations which have been used here are:

T = Time remained up to delivery date in the contract

S = Price of the underlying asset at present, also called as spot or cash or current

K = Delivery price in the contract at time T

F = Forward or future price today

f = Value of a long forward contract today

r = Risk free rate of interest per annum today

t = Current or today or present period of entering the contract

Now, we will discuss the mechanism of determination of forward prices of

different types of assets.

The forward price for investment asset (Securities)

Here we will consider three situations in case of investment assets:

1. Investment assets providing no income

2. Investment assets providing a known income

3. Investment assets providing a known dividend income

Forward price for an asset that provides no income:

This is the easiest forward contract to value because such assets do not
give any income to the holder. These are usually non-dividend paying equity
shares and discount bonds. Let us consider the relationship between the forward
price and spot price

FUTURE CONTRACTS

INTRODUCTION

In the last two decades, the futures markets have experienced a

remarkable growth all over the world in size, trading volume and acceptance by
the business community. New contracts with new products along with entirely new
possibilities in the futures markets have become the reality now. Futures trading
was started in the mid-western part of the USA during 1970s, but today it is traded
throughout the world, and 24 hours a day. Most common underlying assets used in
futures markets today are commodities, agricultural products, metals, energy
products, weather, electricity, interest rates, foreign exchange, equities, stock
index, and so on. In fact, today the futures markets have become an integral part of
the financial markets all over the world.

Financial Futures Contracts

A futures contract is an agreement between a buyer and a seller where the seller
agrees to deliver a specified quantity and grade of a particular asset at a
predetermined time in futures at an agreed upon price through a designated market
(exchange) under stringent financial safeguards. A futures contract, in other words,
is an agreement to buy or sell a particular asset between the two parties in a
specified future period at an agreed price through specified exchange. For
example, the S&P CNX NIFTY futures are traded on National Stock Exchange
(NSE). This provides them transparency, liquidity, anonymity of trades, and also
eliminates the counter party risk a due to the guarantee provided by National
Securities Clearing Corporation Limited (NSCCL).

Bombay Stock Exchange (BSE) website defines futures contract: "Futures are
exchange traded contracts to sell or buy financial instruments or physical
commodities for future delivery at an agreed price. There is an agreement to buy or
sell a specified quantity of financial instrument/commodity in a designated future
month at a price agreed upon by the buyer and the seller. The contracts have
certain standardized specifications."

The standardized items in any futures contract are:

 Quantity of the underlying asset

 Quality of the underlying asset (not required in financial futures)
 The date and month of delivery
 The units of price quotation (not the price itself) and minimum change in
price (tick-size)

From the above, it is evident that a financial futures termed as a notional

commitment to buy or sell a standard quantity of a financial instrument at a
specified (predetermined) price on a specified future date. It means this market is
rarely used for the exchange of financial instruments. In fact, financial futures
markets are independent of the underlying assets. For example, currency futures
contracts are different from the currencies themselves. No doubt, currency futures
prices normally move in the direction of the related underlying currency prices
changes, but sometimes this relationship may not exist.

For example, contract traded on Chicago Mercantile Exchange of wheat for the
fine grade delivery months in March, May, July, September and December are
available for up to 18 months into the future. Each contract size is 5000 bushels.
Contracts traded on National Stock Exchange of equity share for delivery period of
one, two, six and twelve months named as NIFTY futures. Each contract size is of
50 shares comprising different companies from different sector of Economy.

In general, financial futures are not different from commodity futures except of the
underlying asset, for example, in commodity futures, a particular commodity like
food grains, metals, vegetables, etc. are traded whereas in financial futures, various
particular financial instruments like equity shares, deben-tures, bond, treasury
securities, currencies, etc. traded. There are now a large variety of financial futures
contracts available at the various markets (centres) like Chicago, London, Tokyo
and so on.

Types of Financial Futures Contracts

There are different types of contracts in financial futures which are traded in the
various futures financial markets of the world. These contracts can be classified
into various categories which are as under:

Interest rate futures

It is one of the important financial futures instruments in the world Futures trading
on interest bearing treasury belts, has been tremendous. Important bonds this
market, almost entire range of maturities bearing securities are traded. For
example, three-instruments at Chicago Mercantile Exchange (CME), British
Government Bonds at London International Financial Futures Exchange (LIFFE),
Japanese Government Bonds at CBOT, etc. are traded. This market is also further
categorized into short-term and long-term interest bearing instruments. A few
important interest rate futures traded on various exchanges are notional gilt-
contracts, short-term deposit futures, treasury bill futures, euro-dollar futures,
treasury bond futures and treasury notes futures.
Foreign currencies futures

These financial futures, as the name indicates, trade in the foreign currencies, thus,
also known as exchange rate futures. Active futures trading in certain foreign
currencies started in the early 1970s. Important currencies in which these futures
contracts are made such as US-dollar, Pound Sterling, Yen, French Franca, Marks,
Canadian dollar, etc. These contracts have a directly corresponding to spot market,
known as inter bank foreign exchange market, and also have a parallel inter bank
forward market. Normally futures currency contracts are used for hedging
purposes by the exporters, importers, bankers, financial institutions and large
companies.

Stock index futures

These are another major group of futures contracts all over the world. These
contracts are based on stock market indices. For example, in the US markets, there
exist various such futures contracts based on different indices like Dow Jones
Industrial Average, Standard and Poor's 500, New York Stock Exchange Index,
Value Line Indes, etc. Other important futures contracts in different countries are
like in London market, based on the Financial Times Stock Exchange 100 share
Index, Japanese Nikkei Index on the Tokyo Futures Exchange and on the
Singapore International Monetary Exchange (SIMEX) as well. Similarly, in
September, 1990, Chicago Mercantile Exchange began trading based on Nikkei
225 Stock Index and Chicago Board of Trade launched futures contracts based on
the TOPIX index of major firms traded on the Tokyo Stock Exchange.

One of the most striking features of these contracts is that they do not
insist upon the actual delivery, only trader's obligation must be fulfilled by a
reversing trade or settlement by cash payment at the end of trading. Stock Index
futures contracts are mainly used for hedging and speculation purposes. These are
commonly traded by mutual funds, pension funds, investment trusts, insurance
companies, speculators, arbitrageurs and hedgers.
Bond index futures

Like stock index futures, these futures contracts are also based on particular bond
indices, ie, indices of bond prices. As we know that prices of debt instruments are
inversely related to interest rates, so the bond index is also related inversely to
them. The important example of such futures contracts based on bond index is the
Municipal Bond Index futures based on US Municipal Bonds which is traded on
Chicago Board of (CBOT)

Cost of living index futures

This is also known as inflation futures. These futures contracts are based on a
specified cost of living index, for example, consumer price index, wholesale price
index, etc. At International Monetary Market (IMM) in Chicago, such futures
contracts based on American Consumer Price Index are traded. Since in USA, the
inflation rates in 1980s and 1990s were very low, hence, such contracts could not
be popular in the futures market. Cost of living index futures can be used to hedge
against unanticipated inflation which cannot be avoided. Hence, such futures
contracts can be very useful to certain investors like provident funds, pension
funds, mutual funds, large companies and governments.

Evolution of Futures Market in India

 Organized futures market evolved in India by the setting up of "Bombay

Cotton Trade Association Ltd." in 1875. In 1883, a separate association
called "The Bombay Cotton Exchange Lid." was constituted.
 Futures trading in oilseeds was started with the setting up of Gujarati
Vyapari Mandali in 1900. A second exchange, the Seeds Traders'
 Association Ltd., trading oilseeds such as castor and groundnuts, was set up
in 1926 in Mumbai. Then, many other exchanges trading in jute, pepper,
turmeric, potatoes, sugar, and silver, followed. Futures market in bullion
began at Mumbai, in 1920.
 In 1940s, trading in forwards and futures was made difficult through price
controls till 1952 when the government passed the Forward Contract
Regulation Act, which controls all transferable forward contracts and
futures.
 During the 1960s and 70s, the Central Government suspended trading in
several commodities like cotton, jute, edible oilseeds, etc, as it felt that these
markets helped increase prices for commodities
 Two committees that were appointed Datwala Committee in 1966, and
Khusro Committee in 1980, recommended the reintroduction of futures
trading in major commodities, but without much result.

One more committee on Forwards market, the Kabra Committee was appointed in
1993, which recom mended futures trading in wide range of commodities and also
upgradation of futures market. Accepting partially the recommendations,
Government permitted futures trading in many of the commodities.

Operators/Traders in Futures Market

Futures contracts are bought and sold by a large number of individuals, business
organizations, govern-ments and others for a variety of purposes. The traders in the
futures market can be categorized on the basis of the purposes for which they deal
in this market. Usually financial derivatives attract following types of traders
which are discussed here as under:

Hedgers:
 In simple term, a hedge is a position taken in futures or other markets for
the purpose of reducing exposure to one or more types of risk. A person who
undertakes such position is called as "hedger". In other words, a hedger uses
futures markets to reduce risk caused by the movements in prices of securities,
commodities, exchange rates, interest rates, indices, etc. As such, a hedger will
take a position in futures market that is opposite a risk to which he or she is
exposed. By taking an opposite position to a perceived risk is called "hedging
strategy in futures markets. The essence of hedging strategy is the adoption of a
futures position that, on average, generates profits when the market value of the
commitment is higher than the expected value. For example, a treasurer of a
company knows the foreign currency amounts to be received at certain futures
time may hedge the foreign exchange risk by taking a short position (selling the
foreign currency at a particular rate) in the futures markets. Similarly, he can take a
long position (buying the foreign currency at a particular rate) in case of futures
foreign exchange payments at a specified futures date.

The hedging strategy can be undertaken in all the markets like futures, forwards,
options, swap, etc. but their modus operandi will be different. Forward agreements
are designed to offset risk by fixing the price that the hedger will pay or receive for
the underlying asset. In case of option strategy, it provides insurance and protects
the investor against adverse price movements. Similarly, in the futures market, the
investors may be benefited from favourable price movements.

Speculators:

A speculator may be defined as an investor who is willing to take a risk by taking

futures position with the expectation to earn profits. The speculator forecasts the
future economic conditions and decides which position (long or short) to be taken
that will yield a profit if the forecast is realized. For example, suppose a speculator
has forecasted that price of gold would be Rs 5500 per 10 grams after one month.
If the current gold price is Rs 5400 per 10 grams, he can take a long position in
gold and expects to make a profit of Rs 100 per 10 grams. This expected profit is
associated with risk because the gold price after one month may decrease to Rs
5300 per 10 grams, and may lose Rs 100 per 10 grams Speculators usually trade in
the futures markets to earn profit on the basis of difference in spot and futures
prices of the underlying assets. Hedgers use the futures markets for avoiding
exposure to adverse movements in the price of an asset whereas the speculators
wish to take position in the market based upon such movements in the price of that
asset. It is pertinent to mention here that there is difference in speculating trading
between spot market and forward market. In spot market a speculator has to make
an initial cash payment equal to the total value of the asset purchased whereas no
initial cash payment except the margin money, if any, to enter into forward market.
Therefore, speculative trading provide the investor with a much higher level of
leverage than speculating using spot markets. That is why, futures markets being
highly leveraged market, minimums are set to ensure that the speculator can afford
any potential losses.

Speculators can be classified into different categories. For example, a speculator

who uses funda-mental analysis of economic conditions of the market is known as
fundamental analyst whereas the one who uses to predict futures prices on the
basis of past movements in the prices of the asset is known as technical analyst. A
speculator who owns a seat on a particular exchange and trades in his own name is
called a local speculator. These, local speculators can further be classified into
three categories, namely, scalpers, pit traders and floor traders. Scalpers usually try
to make profits from holding positions for short period of time. They bridge the
gap between outside orders by filling orders that come into the brokers in return
for slight price concessions. Pit speculators like scalpers take bigger positions and
hold them longer. They usually do not move quickly by changing positions
overnights. They most likely use outside news. Floor traders usually consider inter
commodity price relationship. They are full members and often watch outside
news carefully and can hold positions both short and long
Arbitrageurs:

Arbitrageurs are another important group of participants in futures markets. An

arbitrageur is a trader who attempts to make profits by locking in a riskless trading
by simultaneously entering into transactions in two or more markets. In other
words, an arbitrageur tries to earn riskless profits from discrepancies between
futures and spot prices and among different futures prices. For example, suppose
that at the expiration of the gold futures contract, the futures price is Rs 5500 per
10 grams, but the spot price is Rs 5480 per 10 grams. In this situation, an
arbitrageur could purchase the gold for Rs 5480 and go short a futures contract that
expires immediately, and in this way making a profit of Rs 20 per 10 grams by
delivering the gold for Rs 5500 in the absence of transaction costs.

The arbitrage opportunities available in the different markets usually do not last
long because of heavy transactions by the arbitrageurs where such opportunity
arises. Thus, arbitrage keeps the futures and cash prices in line with one another.

Spreaders:

Spreading is a specific trading activity in which offsetting futures position is

involved by creating almost net position. So the spreaders believe in lower
expected return but at the less risk. For a successful trading in spreading, the
spreaders must forecast the relevant factors which affect the changes in the
spreads. Interest rate behaviour is an important factor which causes changes in the
spreads. In a profitable spread position, normally, there is large gain on one side of
the spread comparison to the loss on the other side of the spread. In this way, a
spread reduces the risk even its Forecast is incorrect. On the other hand, the pure
speculators would make money by taking only the profitable side of the market but
at very high risk.

Comparison of forward and future contracts

Si Forward Future
no
1 Private contracts between the two Trade on organized
parties bilateral contracts exchanges
2 Not standardized ( customized) Standardized
contracts
3 Normally one specified delivery date Range of delivery
dates
4 Settled at the end of maturity . no Daily settled profit\
cash exchange prior to delivery date. loss are paid in
cash.
5 More than 90 percent of all forward Not more than
contracts are settled by actual 5percent of the
delivery of assets futures contracts
are settled by
delivery
6 Delivery or final cash settlement Contract normally
usually takes place. closed out prior to
the delivery
7 Usually no margin money required Margins are
required of all the
participants
8 Cost of forward contracts based on Entail brokerage
bid-ask spread fee for buy and sell
orders.
9 There is credit risk for each party. The exchanges
Hence credit limits must be set for clearing house
each customer becomes the
opposite, side to
each futures
contracts, thereby
 reducing credit risk
substantially.

Trading mechanism of future contracts ;

Futures contract, as stated in part, is an agreement between the two

parties to buy or sell an asset at a certain futures time for a certain price. Futures
contracts are traded on recognized stock exchanges. Since the value of a futures
contract is derived from the value of the underlying asset, hence, they are called
derivative instruments. If the underlying assets are financial instruments then these
will be called as financial derivatives or financial futures contracts.

Futures trading refers to entering into contracts to buy or sell financial asset or
commodities for futures delivery as settlement on standardized terms. In this
section, we will discuss the general mechanism in which the exchanges organize
the trading of futures contracts. The important issues relating to such trading
mechanism like specification of contracts, the operation of margin accounts,
delivery/settlement of the contract, the organization of exchanges, the regulation of
the markets, the way in which quotes are made, etc. will be discussed. We will be
following here the mechanism of futures trading in general and popular all over the
world rather of a particular exchange, because there can be some variations in the
terms of the futures contract on different exchanges. A list of the important
exchanges in USA which trade futures contracts both in financial assets and
commodities .

Prior to the discussion on the mechanism of futures trading, it is to be noted that

the vast majority of the futures contracts which are initiated do not lead to delivery
because most of the investors or traders choose to close out their positions prior to
the delivery period specified in the contract. The execution of the futures contracts
through delivery is often inconvenient and, in some instances even quite
expensive. This has been observed even in case of hedgers. However, a detail of
this will be discussed in the section of delivery arrangements of the futures
contracts.

Us Exchange That Trade Future

Chicago Board Of Trade Kansas City Board Of

( CBOT) Trade(KCBT)
Grains and oilseeds, metals, Grains ,financials
financials
Chicago Mercantile Exchange Mid America Commodity
(CME) Division; Exchange ( MIDAM)
International Monetary Market Grains and oilseeds, livestock,
(IMM) , Index And Option meat, metals, financials
Market( IOM)
Livestock , meat financials, wood
Coffee, Sugar, And Cocoa Minneapolis Grain Exchange
Exchange (CSCE) (MGE)
Food and fiber, financials Grains
Commodity Exchange, Inc. New York Cotton Exchange
(COMEX) (CIN) Division; Financials
Metals , financials Instruments Exchange (FINEX)
Food and fibre, financials
New York Futures Exchange Chicago Rice And Cotton
(NYFE) Exchange (CRCE)
Financials Food and fibre
New York Mercantile Exchange Philadelphia Board Of
(NYMEX) Trade(PBOT)
Metals, petroleum, food and fibre Financials

Margin Requirement:

Definition:

In derivatives management, a margin requirement is the minimum amount

of capital (cash or eligible securities) that a trader must deposit and maintain
with their broker or the clearing house/exchange to open and hold a
leveraged derivatives position .Margin requirements in derivatives
management are a crucial aspect of risk control and leverage.

Think of it as a performance bond or collateral that ensures the trader can

cover potential losses that might arise from adverse price movements in
their derivatives positions. Since derivatives allow for significant leverage
(controlling a large notional value with a small amount of capital), margin
requirements are crucial for managing the inherent risk.

Purpose of Margin in Derivatives Management:

  Risk Management: The primary purpose of margin is to mitigate credit risk for
the broker and the clearing house/exchange. It acts as a buffer to cover potential
losses that a trader might incur due to adverse price movements. If a trade goes
against the trader, the margin is used to cover those losses, ensuring that the trader
can fulfill their obligations.

 Leverage: Margin allows traders to control a larger notional value of a derivative

contract with a relatively small amount of capital. This amplification of potential
returns (and losses) is known as leverage.

 Market Integrity: By requiring margin, exchanges and clearing houses ensure that
participants have sufficient financial capacity to honor their commitments, thus
maintaining the stability and integrity of the derivatives market.

 Facilitates Trading: Without margin, traders would need to put up the full value
of the underlying asset, making derivatives trading inaccessible for many. Margin
makes it possible to trade these instruments with less upfront capital.

Types of Margins in Derivatives Trading:

1. Initial Margin:

o This is the upfront amount a trader must deposit with their broker to open a
new derivatives position (e.g., a futures contract or a short option position).

o It's calculated based on factors like the contract's notional value, volatility of
the underlying asset, and market conditions.

o Exchanges often use sophisticated systems like SPAN (Standardized

Portfolio Analysis of Risk) to calculate initial margins, which consider
 various price and volatility scenarios to determine the maximum potential
loss.

2. Maintenance Margin:

o This is the minimum amount of equity a trader must maintain in their margin
account after the initial position has been established.

o It is typically lower than the initial margin.

o If the market moves against the trader and the account's equity falls below
the maintenance margin level, a margin call is triggered.

3. Margin Call:

o A margin call is a demand from the broker for the trader to deposit
additional funds to bring their account balance back up to the initial margin
requirement.

o If the trader fails to meet the margin call, the broker may forcibly liquidate
(close out) some or all of their positions to cover the shortfall.

4. Exposure Margin (or Extreme Loss Margin - ELM):

o This is an additional margin collected over and above the initial margin
(SPAN margin in India) to cover potential losses from erratic market swings
that might exceed the usual risk estimates.

o It is often a fixed percentage of the notional value of the contract.

5. Mark-to-Market (MTM) Margin / Variation Margin:

o Derivatives positions (especially futures) are "marked-to-market" daily. This

means that at the end of each trading day, the profit or loss on open positions
is calculated based on the current market price (settlement price).
 o If a trader incurs a loss, the corresponding amount is debited from their
margin account. If they make a profit, it is credited.

o This daily settlement of profits and losses is facilitated by the variation

margin, ensuring that gains/losses are exchanged between counterparties on
a daily basis.

6. Premium Margin (for Option Buyers):

o For buyers of options, the premium they pay for the option itself acts as their
maximum potential loss and, therefore, often serves as their margin
requirement. No additional margin is typically required beyond the premium
for option buyers.

7. Ad-hoc Margins:

o Exchanges or brokers may impose additional, temporary margins during

periods of extreme market volatility or unusual events to manage heightened
risk.

8. Delivery Margin:

o For equity derivatives that may lead to physical settlement, additional

delivery margins might be required as the expiry date approaches to ensure
the trader can fulfill their delivery obligations.

Margin Requirements are Calculated:

The exact calculation of margin requirements varies by exchange, derivative

product, and market conditions. However, common methodologies include:

 SPAN (Standardized Portfolio Analysis of Risk): This is a widely used portfolio

margining system that calculates margin requirements by simulating a large
number of scenarios for price and volatility movements. It determines the
maximum potential loss for a portfolio and sets the margin accordingly.
 Value at Risk (VaR):VaR is a statistical measure used to estimate the potential
loss of an investment over a specific time horizon with a given confidence level.
Some margin calculations incorporate VaR to determine the required collateral.

 Notional Value Percentage: For some derivatives, margin might be a simple

percentage of the contract's notional value.

 Volatility-Based Calculations: Higher volatility in the underlying asset generally

leads to higher margin requirements, as the potential for large price swings
increases.

Recent SEBI Regulations and Changes (relevant to India as of early

2025):

SEBI (Securities and Exchange Board of India) has been actively refining
margin requirements to enhance market stability and discourage excessive
speculation, especially in the F&O segment. Some notable changes include:

 Increased Contract Value: SEBI has mandated an increase in the minimum

contract value for index derivatives to ₹15-20 lakhs (from ₹5-10 lakhs). This aims
to reduce participation from small retail traders who might be taking on excessive
risk.

 No Calendar Spread Benefits on Expiry Day: From February 10, 2025, margin
benefits for calendar spreads (a strategy involving options with different expiry
dates) will no longer be available on the expiry day. This aims to reduce last-
minute speculative activity.

 Additional ELM on Expiry Day: An additional 2% Extreme Loss Margin (ELM)

is being applied to short index options contracts on their expiry day (from
November 20, 2024, onwards for new contracts). This is a significant increase in
 margin requirement for option sellers on expiry day, especially for out-of-the-
money options.

 Upfront Premium Collection for Option Buying: SEBI has mandated that the
entire option premium must be collected upfront from option buyers. While many
brokers already followed this, it's now a formal regulation.

 Intraday Monitoring of Position Limits: From April 1, 2025, position limits

(maximum contracts a client or broker can hold) will be monitored multiple times
throughout the trading day, not just at the end of the day.

Margin Requirements Impact Traders:

 Capital Allocation: Traders need to ensure they have sufficient capital not just for
initial margin but also to cover potential MTM losses and maintain their positions.

 Risk Management: Understanding margin is crucial for effective risk

management. Traders must be aware of how much leverage they are employing
and the potential for margin calls.

 Trading Strategies: Margin requirements influence trading strategies. For

instance, higher margins might discourage highly leveraged, short-term speculative
trades.

 Liquidation Risk: Failure to meet margin calls can lead to forced liquidation of
positions by the broker, often at unfavorable prices, resulting in significant losses.

Marking to Market (MTM)

Definition:

Marking to Market is the daily process of adjusting the value of

financial instruments (like derivatives, especially futures) to reflect their
 current market price. This ensures that profits and losses are realized
daily, and margin accounts stay accurate and funded.

MTM Used:

 Futures contracts (most common)

 Options (partially – premiums are paid upfront)

 Swap contracts

 Mutual funds and balance sheets (for asset valuation)

Marking to Market Works (Futures Example)

Let’s say:

 You buy 1 Nifty Futures contract at ₹20,000

 Lot size = 75 units

 Margin deposited = ₹1,00,000

End of Day 1: Nifty Closes at ₹19,800

 Loss = ₹200 × 75 = ₹15,000

 Your account is debited ₹15,000

 Margin balance = ₹85,000

If this falls below maintenance margin, you receive a margin call.

End of Day 2: Nifty Closes at ₹20,100

 Gain = ₹300 × 75 = ₹22,500

 Your account is credited ₹22,500

 New margin balance = ₹1,07,500

Purpose of MTM

Objective Explanation

Real-time accounting Profits/losses realized daily

Prevents excessive accumulation of

Risk reduction
losses

Accurate valuation Reflects current market reality

Daily margin
Ensures counterparties remain solvent
settlement

Formula:

MTM Gain/Loss = (Today's Closing Price – Previous Day's Price) × Lot

Size

MTM Value = Current Market price – Original Purchase Price

Example :
 MT
D Cumul
Pri M
a ative
ce Gain/
y P&L
Loss

₹2
1 0,0 — ₹0
00

₹1 - -
2 9,8 ₹15,0 ₹15,00
00 00 0

₹2 +
+
3 0,1 ₹22,5
₹7,500
00 00

Purpose of Marking to Market

 Ensures real-time settlement of gains/losses

 Maintains financial integrity of derivative markets

 Reduces counterparty risk

 Keeps margin accounts accurate

HEDGING USING FUTURES

Introduction

Today, the corporate units operate in a complex business environment. Managers

often find that the profitability of their organizations heavily depends upon on
such factors which are beyond
theircontrol.Importantamongtheseareexternalinfluenceslikecommodityprices,stock
prices, interest rates, exchange rates, etc. As a result, modern business has become
more complex, uncertain and risky. So, it is essential for the executives of the
firms to control such uncertainty and risk so that the business can be run
successfully. An important function of futures market is to permit managers to
reduce or control risks by transferring it to others who are willing to bear the risk.
In other words, futures markets can provide the managers certain tools to reduce
and control their price risks. So the activity of trading futures with the objectives
of reducing or controlling risk is called hedging.

Hedging Concepts

Hedging, in its broadest sense, is the act of protecting oneself against futures loss.
More specifically in the context of futures trading, hedging is regarded as the use
of futures transactions to avoid or reduce price risk in the spot market. In other
words, a hedge is a position that is taken as a temporary substitute for a later
position in another asset (or liability) or to protect the value of an existing position
in an asset (or liability) until the position is liquidated.
According to this concept, the firm seeks hedging whether it is on the asset side or
on the liability side of the balance sheet.

Example:
In the month of March, 2003, a Jute mill anticipates a requirement of 10,000
candies of Jute in the month of July, 2003. Current price of jute is Rs 1000 per
candy. Based on this price, the company has entered in too the financial
arrangements. It is of great importance to the mill that, at the time of jute is
actually purchased, price is not changed substantially higher than Rs 1000 per
candy .To avoid this, it buys10,000candiesofjuteonthejute futures market ,where
current price of jute is Rs 1050 per candy. In the month of July, the price of jute
has risen sharply with the current spot price being Rs 1500 per candy. The
corresponding futures price for July jute is found to be Rs 1470 per candy.

At thispointoftimejutemillhastwooptions:

1. It can sell its futures contract on market at prevailing rate ofRs 1470, and

buys its requirement fromspot market.Profit/Lossprofile

ofthistransactionwillbeasfollows:

 Jutepurchased =Rs1000 percandy

 Saleproceeds= Rs1470percandy
 Profit fromsale=Rs1470percandyandcurrent
priceofjuteRs1500percandytobe paid and not Rs 1000 candy to mill is Rs
1030 per candy.
So,futurestransactionhasensured the minimizationofupwardpricerisk,a mere
forRs 30 percandy.
  The millcould take deliveryof jute directly from futures market. Inthis
case the mill wouldpayRs1000percandy, but fortakingdeliverythere
maybepossibilitiesofnot delivery of same variety of jute.
 Itisobserved fromtheaboveexamplethat bybuying futures,the
firmhashedgedagainst the upward price risk.

TheMulti-purposeConcept ofHedging

 Earlier hedging was taken to be onlyone kind (known as routine or naive

hedging), whereby the trader hedged all his transactions purely for covering
all the price risks. However,thisconcept wasimprovedbyHolbrookWorking,
inhisarticle “NewConcepts ConcerningFuturesMarketsandPrices”,and
hedevelopedthe multi-purposeconceptof hedging which iswidelyaccepted.
According tothisconcept,thehedging canbeused for many other purposes:
 Carryingchargehedging:
According to this approach, the stockist watchthe price spread between the
spot and futuresprices, and ifthespread
coversevencarryingcoststhenthestockist buyfutures. Itmeansthattheremaygo
for hedging ifthespreadisadequateto cover carryingcosts. Earlier view was
that hedges are used to protect against loss on stock held. Thus, according
to H. Working, “it is not primarily whether to hedge or not, but whether to
store or not”.
 Operationalhedging:
Accordingtothisview,hedgersusethe
futuresmarketsfortheiroperationsandusethe same assubstitute forcashor
forwardtransactions. Theythink that the futuresmarkets are more liquid
and have lower difference between ‘bid’ and ‘ask’ prices.
 Selectiveordiscretionary hedging:
As per this concept, thetraders do not always (in routine) hedge themselves
but onlydo soonselectedoccasionswhentheypredict adverse price
 movementsinfutures.Herethe objective is to cover the risk of adverse price
fluctuation rather to avoid price risk. So they use hedging technique
selectively at the time of adverse price movements.
 Anticipatory hedging:
This is done in anticipation of subsequent sales or purchases. For example,
a farmer might hedgebyselling inanticipationofhiscropwhilea miller might
hedgebybuying futures in anticipation of subsequent raw material needs.
 In brief, it is evident that now hedging is not used only for reducing or
controlling the
priceriskbutitalsoservesotherpurposesforthemarketparticipants.However,lar
gely, the hedging is used to eliminate or reduce the price risk in our further
discussion.
ThePerfectHedgingModel

 The perfect hedge is referred to that position which completelyeliminate the

risk. In
otherwords,theuseoffuturesorforwardpositiontoreducecompletelythebusines
srisk is called perfect hedge, for example:

Severalconditionsmust befulfilledbeforeaperfect
hedgeispossible.Inbrief,theseareas under:

1. Thebusinessfirmmust knowexactlytheeffect ofchange

inpriceontheprofit,and further this relationship must be linear.
2. Theremustbefuturesorforwardcontractsavailableinthe

marketwiththefollowing features:
o (a)Itiswrittenontheunderlyingassetwhichwill affectthefirm's profit.
o (b)Theexpirationdateofthecontractshould bethesameonwhichthe
firm's profits will be affected by the price of the said asset.
o (c)It specifiesaquantityequaltowhichwillaffectthefirm.

Howaperfecthedge works:
Let us assume today is todayperiod (present), T is date in June on which purchase
will be effected, Qrisquantityofsilverto bepurchased, PT ispriceatthetimeT,FTT
isfuturesprice at the time T and FtT is the futures price at present.

Thenetcosttothemanufactureristhepriceofthesilverlesstheprofitonthefuturesposition:

SilverCosts Time line

 SilverCos
Scenar FuturesProfits NetSilverCos
ts
io t
(QTPT)
PT
QT(FTT–
QTFtT
FtT)
QT(PTT–
FtT)

Here PT=FtTbecause deliverydate convergence,and

Net silvercost=Silvercosts– Futures profit

QTFtT=QTPT– QT(PT– FtT)

It is observed that the above hedge meets allthe requirements of a perfect hedge.
The manufacturer sees the silver cost at T (June) will be QTPT, which is a linear
function ofthe silver price becauseeverypricechange inthesilverpricewillchange
QTPTbyQT. Byentering into the long futures at time t, the manufacturer
establishes that his cost at time T will beQTFtT. He, thus, locks in today’s futures
price for his silver purchase. Note, that here the gains or losses have been
computed on the futures position as it were a forward position.
TheBasicLongandShort Hedges

Basically,thehedgingrefersto bytakingapositioninthe
futuresthatisoppositetoaposition taken inspot market orto afuture
cashobligationthat one hasor will incur. Thus,the hedges can be classified into
two categories: short hedges and long hedges.

Shorthedge

Ashorthedge(or asellinghedge) isahedgethat

involvesshortpositioninfuturescontract.In other words, it occurs whena
firm/trader plans to purchase or produce acashcommoditysells futuresto
hedgethecashposition.Ingeneralsense,it means “beingshort”—havinganet sold
position, or a commitment to sell.

Januarycontractsale @Rs9500perquintal. Januarycontract buy@10,500. Hence, net

lossof Rs 1000 per quintal.
Furtherhesellshisoutput @11,000inthespotmarket,afterdeductingthe lossonfutures
market position of Rs 1,000, net price obtained will be Rs 10,000 per quintal.

Hecandeliverinthefuturesmarket@Rs9500 perquintal.

Thissituation,wheresaleoffuturesbythosehedgingagainst price
falliscalledshorthedge i.e., taken guarding against downward price movements.

CrossHedging

Allthe hedgedpositionsdiscussedearlierused
futurescontractswhichareundertakenonthe asset whose price is to be hedged and
that expires exactly when the hedge is to be lifted.
Sometimes, it happens that the firms wish to hedge against a particular asset but
no futures contract available. This situation is called as asset mismatch. Further, in
many cases, same futuresperiod(maturity)onaparticularasset isnotavailable, it
iscalledamaturitymismatch.

Referringtothedifferent situationsreferredearlier,thereis stillpossibilityto

hedgeagainst price risk inrelatedassets(commoditiesorsecurities)orbyusing
futurescontractsthat expireondates different fromthose on which the hedges are
lifted. Such hedges are called cross hedges. In actualpractice and in the business
world, it will be rare for all factorsto match so well. Thus, across hedge is a hedge
in which the characteristics of the spot and futures positions do notmatch perfectly.

Mismatchsituationswhichmakethehedgeacrosshedge:

 Thehedginghorizon(maturity)maynotmatchthe futuresexpirationdate,
 Theasset tobehedgedmaynotmatchwiththequantityofthefuturescontractasset,
 Thephysicalfeaturesoftheassetto behedged maynot matchthe
featuresofthefutures contract asset.
Ingeneral, onecannot expect across-hedgeto beaseffective inreducingriskasadirect
hedge. However, crosshedgesare commonlyused to reduce the price risk. Now,the
question iswhich futures contracts are good candidates for a cross hedge. For
example, if we want to hedge a portfolio ofsilver coins then a silver futures
contract will be more effective cross-hedge rather thanagold futurescontract.Thus,
ifthepriceoftheunderlyingasset andthepriceofcorrelated asset, one can analyze the
nature of hedging. If perfectlycorrelated, it is perfect, in closely correlated, it is
cross hedge, and in negativelycorrelated, there willbe no hedging, rather more risk
will be added by taking a position in the future.

Long Hedge

Onthe other hand, a long hedge (ora buying hedge) involves where a long position
is taken in futures contract. The basic objective here is to protect itselfagainst a
price increase in the underlying asset prior to purchasing it in either the spot or
forward market. A long hedge is appropriatewhena firmplansto
purchaseacertainasset infuturesandwantstolock inaprice now. It is also called as
“being long”, having a net bought position or an actual holding ofthe asset.Itisalso
knownasinventoryhedge becausethe firmalreadyholdstheasset ininventory.

STOCKINDEXFUTURES

Introduction

Stockindexfuturestodayhave become most popularfinancialderivative

instrumentsandwidely traded all over the world. In the early 1980s, several futures
contracts written on various stock indices were introduced. The first of these was
introduced in 1982 bythe Kansas City Board of Trade in USA. These instruments
have become veryuseful to both individual and institutional investors due to their
low cost and efficient instrument for trading on expectations of futures general
movements in the stock market.

The investors who wanted to trade in stock market movements had to buyand sell
large proportion of the various stocks in which transaction costs were extremely
high and the executionwasveryslow.However,
nowthosewhoareinterestedtotradeinsuchmarketscan deal with one simple
transaction—choosing a particular stock index futures instrument.
Institutionalinvestorsarealsofindingtheseinstrumentsmostfavourablefortheirasset
allocations.

TheConceptofStock Index

Astockindexorstockmarket indexisaportfolio consistingofacollectionofdifferent

stocks.In other words, a stock index is just like a portfolio of different securities’
proportions tradedon stock exchanges like NIFTY S&P CNX traded on National
Stock Exchange of India, the S&P 500 in the USA composed of 500 common
stocks, etc. Table shows the major thirty eight different stock indexes.
These indices provide summary measure of changes in the value of particular
segments of the markets which is covered bythe specific index. This means that
achange ina particular index is achange intheaverage
valueofthestocksincludedinthat index. The numberofstocksincluded in a particular
index maydepend upon its objective, and thus, the size varies index to index. For
example, the number of stocks included in SENSEX is 30 whereas 500 stocks are
covered in Standard and Poor’s 500 index.

Commonfeatures

1. Astockindexcontainsaspecific numberofstocks, i.e.,

specificationofcertainsector must be made. The number of stocks like 30,
50, 100, 200, 500 and so on.
2. Selectionofabaseperiodonwhichindexisbased.

Startingvalueofbaseofindexis selected like 100, 1000, etc.

3. The methodorruleofselectionofastockforinclusioninthe indexto
determinethe index value must be there.
4. Thereareseveralmethodscommonlyusedtocombinethepricesofindividualstoc

klike arithmetic average, weighted average, etc.

5. Therearethreetypesofindexconstructionlikepriceweighted

index,returnequally weighted index and market capitalization weighted

index.
6. Astock indexrepresents the change inthe value of a set ofstocks

whichconstitutethe index.Hence, it
isarelativevalueexpressedasweightedaverageofpricesat aspecific date.
7. Theindexshouldrepresentthemarket

andbeabletorepresentthereturnsobtainedby any portfolio of that market.

8. Astockindexactsasabarometerformarket
 behaviour,abenchmarkforportfolio performance. Further, it also
reflects the changing expectations about the market.
9. The indexcomponents should be highly liquid, professionallymaintained and

accurately lated. Inthepresent section, wewillnot discussthe

mechanismofconstructionofastock index. However, it isbeneficialto
understand thoroughlythedetailsofconstructionofan stock index particularly
in which the investor is interested to trade. Because when the differences
and relationships among the indexes are understood, it will be easier to
understand the differences among the futures contracts that are based on
those indexes.

StockIndexFutures

Astockindexfuturescontract,insimpleterms, is afuturescontractto buyorsellthe face

value ofthe index. Table presentsthe summarydescriptionofthe contract
specifications ofthe major
stockindexfuturestradedbothinUnitedStatesandinothercountries. The most
activelytraded indexes are:
The Standard and Poor’s 500(S &P500) index is based ona portfolio of500
different stocks 400 industrials, 40 utilities, 20 transportation and 40 financials.
The weights of the stocks in portfolio
giventimereflectthestock’stotalmarketcapitalization.(Stockprice×No.ofshares
outstanding).Thisindexaccountsforabout 80percent ofmarket
capitalizationofallthestock listed on New York Stock Exchange.

Specification ofstockindexfutures contracts

Allthestockindexfuturescontractsaretradedonthespecifiedstock exchanges.
Forexample, the Standard and Poor’s 500 futures contract has the following
specifications:

StandardandPoor’s500futurescontract specifications:

Contract :StandardandPoor’s500 index

Exchange :Chicago MercantileExchange
Quantity :500 times the S&P 500 index
Delivery months
:March,June,September,Decem
ber
Delivery specifications :Cashsettlement accordingtothevalueofthe
indexattheopening onthe Friday after the last day
Minimumpricemovements:0.05indexpoints,or$25percontract

InIndia, boththeBSE andtheNSEhave introducedone

monthcontractsonthesensexand nifty respectively. At anypoint of time, index
futures of different maturities would trade simultaneouslyonthese exchanges.
BothBSE and NSE have introducedthree contractsonBSE sensitive index for one,
two and three months, maturities. Tick size on BSE has proposed of0.1 indexpoint
for trading in sensex. Everyindexpoint fortrading ofsensexcontract ispriced at Rs
50.0, 1 point would be equivalent to Rs 50. The salient features ofthese contracts
have been shown in Table 3.1 of Chapter 3 of this book being reproduced to
further elaborateon stock index futures.

Settlementproceduresordelivery

Stockindexfuturesarenearlyalwayssettled forcashdelivery, incontrasttomost futures

contracts
wherephysicaldeliveryofanunderlyingasset iscalled for.Thus,
inthestockindexfutures contracts, no
physicaldelivery(sharesorsecuritiescertificates)aredeliveredbytheseller(short).This
means that
thefuturespositionswhichareopenatthecloseofthe finaltrading
dayofthefuturescontract are settled bya cash transfer. This amount is determined
by reference to the cash price at the close of trading in the cash market in the last
trading day in the futures contract.

Probablythestockindexfutureswerethefirst toemploycashsettlement
asasubstitutefor physical
delivery. Thereasonbeingthat it isverydifficult
todeliver(forexamplethe500proportionsof the
stocks in S&P Index 500) all the stocks which is more cumbersome and costly
than the case of cash delivery. Further, if any investor is interested in actual
delivery of a stock, he can easily purchase the stock in the cash market. Hence, the
settlement in futures index contracts is convenient and
lesscostly.Furthereffectofthecashsettlement forcesthe futurespricesofstock index
futures to be identical to the cash stock index at the settlement.

TheStockIndexFutures Prices

Stockindexfutures,like mostotherfinancialfutures,arealsotradedina
fullcarrymarket.It means that
the cost-of-carry model providesa virtually complete understanding of the stock
index futures pricing. As per this, futures prices must be equalto the spot price plus
the cost ofcarrying charges, and if the conditions of this model are not fulfilled or
violated then arbitrage opportunities will arise. A trader (or investor) would buy
the stocks that underlie the futures contract and sellthe futures and willcarrythe
same untilthe futures expiration. Whenthe stocks arepriced
verylowrelativetothefutures,thecash-and-carrystrategyisattractive. thebasiccost- of-
carry model for a perfect market with
unrestrictedshortselling isas follows:

FtT=St(1+ C)

whereFtT is futurespriceat τfordeliveryat futurestimeT, Stisspot priceattimeτ(todayor

current) and C is the percentage cost of carrying the asset fromτ (current) to T
(futures).

Thecost-of-carry modelforstockindex
The cost-of-carry model as described in Eq. (8.1) can be easily applied to the
commodities and such assets where no futures cash income is available. In case
ofstock index futures, holding of
thestocksgivesdividendstotheowner,becausethecompaniesusuallydeclarethedividen
dsout of their usualprofits to the shareholders. However, each of the indexes is
simply a price index.
Thevalueofany indexat anytimedependssolelyonthepriceofthestocks,not
thedividends thattheunderlying stocksmight pay. Sincethe futurespricesaretied
or influenced directlyto the index values, the futures prices do not include
dividends.

Since Eq. (8.1)of futures price does not include dividends, thus, it must be
adjusted to include the dividends that would be received between the present and
the futures expiration dateofthe futurescontract.Thetrader willreceivedividends
fromthestockwhichwillreducethevalueof the stocks. Thus, the cost of carrying is
the financing costs for stocks, less the dividends to be received while the stock is
being carried.

Theoreticalvalue or fairvalueforstockindexfutures
A stock index futures price has its fair value when the entire cost ofbuying the
stock and carrying it to expiration is covered, i.e., the purchase price ofthe stocks
plus interest, less the futuresvalueofthedividends. Thus, inthecost-of-
carrymodelthe futuresprice must equalthis entire cost-of-carry.

Example:
Calculation of fair or theoretical (or no arbitrage) price. Assume on November 1,
2002 BSE sensitive indexis3200. What istheoreticalpriceonthat
datefortheDecember, 2002sensitive
indexfuturescontract,whichmaturesonDecember,2002?
Furtherassume,theborrowingcost for short period is 10 percent and expected
dividend (return) available annualized is 4 percent based on historical yield.

Carryingperiod=44daysfromNovember 1,2002toDecember 15,2002

Theexampleobservedhowto calculatethefuturestheoreticalvalueBSE
index(sensitive)using
actualcashindexactualandtheactualborrowinganddividendrates. Inthiscase, the
theoretical BSE index value is3223.14, isgreaterthanthecash indexvalueof3200
by23.14 points. Inthis case, the theoreticalBSE (financing cost) rate is higher than
the dividend yield. The theoretical value of the futures contract, therefore, is Rs
1,61,157 (Rs 50 × 3223.14).

Further if index futures for the above period from now are trading at a levelabove
3223.14, the investor canbuyindexandsimultaneouslysellindexfuturestolock
inthegainequivalenttothe futuresand fairprice.However,it shouldbe
notedthatthecostoftransportation,taxes,margins, etc. are not taken into
consideration while calculating the fair value. Similarly, if index is at a level
below the fair value, there is reverse arbitrage. This arbitrage between the cash
and the futures market will continue till the prices between both markets get
aligned.

It should also be further noted that the cost-and-carry model gives an approximate
indication about the true futures price (theoretical value). But in the market, the
observed price is an outcome of price discovery mechanismthrough the forces of
demand supplyand others. These forces maychange fromtime to time resulting in
difference between the fair price and actual priceofthe
indexfuturescontract.Thisleadsto arbitrageopportunitiesinthe market.However,
market forces of the index futures trading, when the variation becomes wide.
Earlier we have observed the calculation of the theoretical value of stock index
futures contract. In practice, the arbitrage opportunities available on such
contracts. Stock arbitrage, in reality, may not be as easyand cost-less as explained
earlier. There are severalreasons observed for the
differencebetweentheactualandtheoreticalfuturesprices.Afew
importantexplanations forthe observed differences are stated below in brief.

1. We

maymakeerrorinestimatingtheoreticalfuturesvaluesduetoassumedvariablesli
ke dividend yield, interest rate, etc. Further, the cash index value may have
been either wrong or not up-to-date.
2. Trading in the stock markets incurs transaction costs. This involves

commission to the brokers,executioncostsandothers.Thesecostsresult

inthedifferent valuationoffutures prices whereas cash prices do not usually
based on these.
3. The asset underlying a stock index futurescontract is inrealitymore

concept thanan asset.Inotherwords,it isdifficult to buythe

largenumberofsecuritiesneeded inthe proportions required to duplicate
exactly a stock index futures.
4. The reported value of the cash stock index mayalmost be correct dueto 'sale'

price quotations.Indexquotationsarebasedonthelast
salepricesofthesharesincluded inthat index, which sometimes may not be the
current quotes.
5. Allproceeds fromtheshortsalesareusuallynot
availabletopotentialarbitrageurs, as normally, observed in the case of
small or retail investors.
6. Sometimes, it isalso difficult
toborrowtherequiredstocktoshortanentirecash portfolio.
7. Finally, it is evident that the theoretical values are calculated on the
 assumption of constant dividend
yieldovertheholdingperiod,whichsometimesinrealitymaynotbe true. The
actual dividend yield usually vary, and further, there is a seasonality in
dividends too.

Fairfuturespricesandno-arbitragebands

As already observed, the fair futures price is based upon arbitrage, and in case
ofstock index futures is the would be cash-and-carryarbitrage. It means that the
futures price should be such that there is no arbitrage profit from buying stock
(with borrowed money) and simultaneously selling futures.
Howeveranarbitrageur'snet gainwilloccuronlyifit coversthetransactioncosts too.
The actual futures prices may deviate from the fair arbitrage pressure that tends to
prevent deviations of actual futures prices within range (the no-arbitrage band)
rather than equalitywith the theoreticalprices. In other words, transaction costs may
lead to fair prices to be in band and arbitrage occurs only when the actual futures
price is outside the no-arbitrage band.

StockIndexFuturesasaPortfolioManagementTool

Fundsmanagersormoneymanagersusestockindexfuturesbasicallyforthreepurposes:
hedging, asset allocation and yield enhancement.

Stockindexfuturesasahedgingtool
All such investors, specifically managing a huge pool of funds or public
funds like pension funds, mutual funds, life insurance companies,
investment and finance companies, banks, endowment funds, public
provident funds, etc. would like to reduce their fund’s exposure to a fallin
stock valuescaused dueto uncertaintiesabout futures market developments.
Thiscan be done by selling the shares and repurchasing themat a later time,
but this strategy is not so appropriate because it would incur substantial
transaction costs. As a result, funds managers
prefertohedgewithstockindexfuturesinsteadofalteringtheirportfolio
structure,directlyand repeatedly. Hedging is also done through stock index
options

Before proceeding to the discussion regarding hedging, one needs to

understand some backgroundonrisksrelatingtostockinvestmentsandportfolio
management.Therearetwo types of risks associated with holding a security:

1. Systematicrisk

2. Unsystematic risk

Allthe stocks are exposed to such factors which are not controlled by the
firm itself, these are called market risk factors like changes in the interest
rates, inflation rates, government trade
policies,economicactivities,politicalfactors,changesintaxlawsandso
on.Suchrisk istermed as market risk or systematicrisk. Ontheother hand,
unsystematicor firmspecificrisk isrelated to the particular firm or an
industry. This risk can be diversified by having diversified portfolio of
many shares. Market risk cannot be eliminated by diversification since each
of the stock moves with the market to some degree. Thus, stock index
futures can be used to hedge or manage this risk.
Currencies, commodities, delivery option

Currency hedging using futures is a technique to protect against losses due

to unfavorable movements in exchange rates. This is especially useful for
companies and investors involved in international trade or foreign currency
transactions. Currency futures allow businesses and investors to lock in an
exchange rate today for a future transaction, protecting them from
unfavorable movements in the forex market. Benefits of Hedging with
Currency Futures Currency futures are standardized contracts to buy or sell a
currency at a fixed exchange rate on a specific date in the future. Businesses
and investors use them to hedge against foreign exchange risk. Hedging with
currency futures offers multiple benefits in terms of financial protection,
cost-efficiency, and operational ease. Protection Against Exchange Rate
Fluctuations One of the most important benefits is protection from adverse
movements in exchange rates.
• Exchange rates are highly volatile and unpredictable.

• Sudden changes can lead to unexpected losses for exporters, importers,

and investors.

• Currency futures allow you to lock in an exchange rate today for a future
date.

• This reduces the impact of forex volatility on your financial results.

• Especially useful in global trade, outsourcing, and cross-border

investments. Cost-Effective Risk Management Currency futures are a low-
cost way to hedge currency exposure compared to other derivatives like
options or forwards. Why they are cost-effective

: • Only a margin deposit is required (usually 5–10% of contract value).

• There is no premium to pay (unlike currency options).

• Minimal transaction costs due to high liquidity

. • The margin can be adjusted daily, allowing efficient use of capital.

• Ideal for small and medium-sized businesses as well as large corporates.

Exchange-Traded Transparency and Standardization Currency futures are
traded on regulated exchanges (like CME, NSE, or BSE), which brings
transparency and confidence to hedgers.

• Prices are public and real-time.

• Contract terms (lot size, expiry, margin) are standardized.

• Trades are cleared by clearing houses, reducing counterparty risk.

• No need to negotiate terms like in forward contracts.

• Market supervision ensures fair practices and safety. Liquidity and Ease of
Entry/Exit Currency futures markets are highly liquid, especially in major
currency pairs like USD/INR, EUR/USD, and GBP/USD. Why liquidity
matters:

• Easier to buy or sell contracts quickly.

• Minimal price slippage or market impact.

• Better price discovery—you get the most competitive rates.

• You can exit early or roll over positions easily.

• Suitable for both short-term and long-term hedging needs. Flexibility in

Hedging Strategies Currency futures allow flexibility in how you hedge your
exposure. Flexible Features:

• Can hedge full or partial exposure depending on your risk appetite.

• You can choose contracts with different expiry dates to match your needs.

• Can combine with other tools (like forwards or options) for custom
strategies.

• Can be used by exporters, importers, investors, banks, and fund managers.

• Offers both directional and non-directional protection strategies. Hedging

Scenarios Using Currency Futures

There are two main types of currency exposure:

➤ A. Hedging Foreign Receivables (Exporters)

• If you are expecting to receive foreign currency in the future, and that
currency may depreciate, you are at risk.
• You hedge by selling currency futures today at a fixed rate.

➤ B. Hedging Foreign Payables (Importers)

• If you will pay foreign currency in the future, and that currency may
appreciate, you are at risk.

• You hedge by buying currency futures to lock in today’s exchange rate.

Hedging Using Futures – Commodities Commodity hedging using futures is
a strategy used by producers, consumers, and traders to protect against the
risk of price changes in physical goods like oil, gold, wheat, copper, sugar,
etc. Commodity prices are highly volatile, and futures help in stabilizing
financial outcomes. Commodity Risk Commodity risk refers to the
possibility of financial loss due to unfavorable price movements in physical
commodities.

Key Points:

• Affects both producers (e.g., farmers, miners) and consumers (e.g., food
companies, airlines). • Caused by weather conditions, geopolitics, supply
chain disruptions, or global demand/supply imbalance.

• Price volatility can affect revenue, costs, and profits.

• Creates uncertainty in budgeting and contracts. Hedging for Commodity

Sellers and Buyers – Detailed Explanation Hedging for Commodity Sellers
(Producers) Who are commodity sellers?

• Producers or suppliers of raw materials.

Examples: Farmers (wheat, corn), miners (gold, copper), oil producers.

What risk do sellers face?
• Price Risk: The risk that commodity prices will fall before they sell their
goods in the spot market.

• If prices drop after harvest or production but before sale, sellers earn less
revenue than expected. How does hedging help sellers use a short hedge by
selling futures contracts today to lock in the current price for a future sale.

Step-by-step example for a seller:

1. Situation:

A wheat farmer expects to harvest 1,000 quintals in 3 months. The current

spot price is ₹2,000/quintal.

2. Risk:

Prices might fall due to increased supply or lower demand.

3. Hedge Action:

The farmer sells wheat futures contracts today at ₹2,000/quintal for delivery
in 3 months.

4. Outcome:

o If the price falls to ₹1,800 at harvest:

▪ Farmer sells physical wheat at ₹1,800 → Loss of ₹200 per quintal

compared to ₹2,000.

▪ But futures position gains ₹200 per quintal (because futures price dropped,
seller benefits from short futures).
▪ Overall, losses in the spot market are offset by gains in the futures market
→ farmer effectively locks in ₹2,000 per quintal. o If the price rises to
₹2,200:

▪ Farmer sells physical wheat at ₹2,200 → Gains ₹200.

▪ Futures position loses ₹200 → offset by physical gains.

▪ Farmer misses out on higher price but avoids risk.

Benefits for Commodity Sellers:

• Price certainty: Know minimum guaranteed revenue.

• Risk reduction: Protects against sudden price drops.

• Financial planning: Easier to forecast income.

• Loan and credit access: Banks favor hedged producers.

• Business stability: Reduced income fluctuations. Hedging for Commodity

Buyers (Consumers) Who are commodity buyers

• Companies or individuals who need commodities as inputs.

Examples:

Food manufacturers, airlines, refineries, factories. What risk do buyers face

• Price Risk:

The risk that commodity prices will rise before they purchase.

• Rising prices increase costs and reduce profit margins. How does hedging
help buyers Buyers use a long hedge by buying futures contracts today to
lock in prices for future purchases.
Step-by-step example for a buyer:

1. Situation:

A bakery needs 500 quintals of wheat in 3 months. Current spot price is

₹2,000/quintal.

2. Risk:

Prices might rise due to poor harvests or increased demand.

3. Hedge Action:

The bakery buys wheat futures contracts today at ₹2,000/quintal for delivery
in 3 months.

4. Outcome:

o If the price rises to ₹2,200 at purchase:

▪ Bakery buys physical wheat at ₹2,200 → cost increases by ₹200 per

quintal.

▪ Futures contract gains ₹200 per quintal (long position gains as price rises).

▪ Overall, higher cost in spot market is offset by futures gains → bakery

effectively pays ₹2,000 per quintal. o If the price falls to ₹1,800:

▪ Bakery buys physical wheat at ₹1,800 → gains ₹200 compared to ₹2,000.

▪ Futures contract loses ₹200 → offset by physical purchase savings.

▪ Bakery misses out on cheaper price but gains price certainty. Benefits for
Commodity Buyers

: • Cost certainty:
Fix future purchase costs.

• Margin protection:

Safeguard profit margins against input cost spikes.

• Budgeting:

Easier to forecast expenses.

• Pricing stability:

Helps set product prices confidently.

• Competitive advantage:

Reduced exposure to commodity volatility.

Delivery Options

Delivery options refer to the choices available to the seller in how they
fulfill a commodity futures contract at the time of delivery. These options
give the seller some flexibility regarding quality, location, and timing of the
delivery.

Types of Delivery Options

Here are the main types of delivery options commonly found in physically
settled commodity futures:

Grade (Quality) Option

• The contract allows a range of acceptable grades or qualities of the

commodity.

• The seller can deliver any grade that meets the minimum specification.
• The buyer must accept it, even if it's the lowest acceptable grade.

Advantage for Seller:

Can deliver cheaper or more easily available grades (called Cheapest to

Deliver). Example: In a wheat futures contract, the exchange allows grades
between 11%–14% protein content. The seller may choose to deliver 11%
protein wheat if it meets contract rules.

Location (Delivery Point) Option

• Sellers are given a choice of multiple approved delivery points

(warehouses or ports).

• The seller chooses where to deliver the commodity.

• The buyer must arrange to take delivery at that location.

Advantage for Seller:

Can select the nearest or lowest-cost warehouse, reducing transport or

logistics costs. Example: A cotton futures contract may allow delivery at
Ahmedabad, Nagpur, or Coimbatore. The seller chooses the most convenient
city for them

Timing (Delivery Period) Option

• Futures contracts usually define a delivery month or period.

• Within this period, the seller can choose the exact day for delivery notice
and execution. • This helps sellers time delivery to their convenience.

Advantage for Seller:

Aligns delivery with inventory, harvest, or production schedules.

Example: If a gold contract expires in December, the seller may deliver any
day from Dec 1 to Dec 31, depending on their readiness.

Cheapest-to-Deliver (CTD) Option

• This is a combined effect of grade, location, and timing options.

• The seller evaluates all choices and selects the least expensive delivery
method that fulfills the contract terms.

Advantage:

Maximizes seller’s profit and reduces delivery costs.

Example: In crude oil delivery, the seller chooses a warehouse that’s closest
and delivers oil of acceptable quality that's cheaper to procure. Intention and
Notification Process

• The seller must notify the exchange of the delivery intention before a
deadline.

• Delivery details (grade, quantity, location) are submitted.

• The buyer is then assigned delivery obligations based on their futures

position.

FORWARD PRICE WHERE THE INCOME IS A KNOWN

DIVIDEND YIELD:

A known dividend yield means that when income expressed as a

percentage of the asset life is known let us assume that the dividend
yield is paid continuously as a constant annual rate at q then the
forward price for a asset would be

F=Se(-)T
VALUING FORWARD CONTRACTS :

On the basis of generalization in different situations, can find out the

value of a forward contract. As we know that the value of a forward
contract at the time it is first written(entered)into is zero. However, at
later stage,it may prove to have a positive or negative value.In
general,the value of a forward contract can be determined as follows:

f=(F-K)e-T

where f is value of a forward contract, F is forward price(current) of

the asset,K is delivery price of the asset in the contract,T is time to
maturity of contract and r is risk free rate of interest.

LET US EXAMINE THE EQUATION:

We compare a long forward contract that has a delivery price of F

with an otherwise identical long forward contract with a delivery
price of K.As we know that the forward price is changing with the
passage time, and that is why later on, F and K may not be equal
which were otherwise equal at the time of entrance of the contract.
The difference between the two is only in the amount that will be paid
for the security at time T. Under the first contract, this amount is F,
and under the second contract, it is K.A cash outflow difference of F-
K at time T translates to a difference of (F-K)e today. Therefore, the
contract with a delivery price Fis less valuable than the contract with
a delivery price K by an amount(F-k)e
The value of contract that has a delivery price of F is by
definition,zero

THEORETICAL RELATIONSHIP OF FORWARD AND

FUTURES PRICES :

Correlation of spot price and Price relationship

interest rates

POSITIVE FUTURES PRICE >

CORRELATION FORWARD PRICE

NEGATIVE FUTURES PRICE <

CORRELATION FORWARD PRICE

NO CORRELATION FUTURES PRICE =

FORWARD PRICE

FORWARD PRICES VERSUS FUTURES PRICES :

Whether the forward prices are equal to futures prices, this is very
important and debatable issue. It is argued that if risk free interest rate
is constant and the same for all maturities, in such market situations,
the forward price will be same as the futures price for the contract.
However, in actual practice, the interest rates do not remain constant
and usually vary unpredictably, then forward prices and futures prices
no longer remain the same. We can get a sense of the nature of the
relationship by considering the situation where the price of the
underlying asset is strongly positively correlated with interest rates.

GETTING OUT OF A FORWARD POSITION :

As observed earlier that having any position in forward contract like

long or short,the party bears the risk until the contract is
expired,because profit to be incurred will depend upon the future spot
price of the underlying asset.In other words,the major risk in a
forward contract arises due to the degree of volatility of future spot
price.So in this section we will see whether it is possible to limit this
risk be effectively getting out of the position before the expiration
date.As we know that one cannot unilaterally back out from the
obligation arisen in the forward contract,but he can certainly enter
into another forward position exactly opposite the original
position.This strategy is popularly known as 'offsetting the forward
contract.

CHARACTERISTICS OF FUTURES PRICES :

A few important characterstics of futures prices are as under:

RELATIONSHIP WITH FORWARD PRICE:

We have already seen in the past the differences between futures
contracts and forward contracts and also the determination of futures
as well as forward prices.

Now,we will visualize the relationship of futures prices with the

forward prices. Forward prices are It is already observed that futures

FUTURES PRICES AND EXPECTED FUTURE SPOT

PRICES:

It is already observed that futures prices and markets serve the society
by providing a mechanism for market traders to form expectation
about future spot prices.This is also called price discovery function.
Since the futures prices change continuously, so quite possible that
they may not be equal to the future or observed spot price. The futures
price could be an estimate of the expected future spot price.This
relationship has been discussed in detail in the section of normal
backwardation.
THE DISTRIBUTION OF FUTURES PRICES:

In this section, we will see how the futures prices are distributed in
the futures markets.In other words, the trend of these prices in the
market will be reviewed in actual practice. Most of the statistical tests
conducted on futures prices rely on the assumption that the underlying
price changes are normally distributed.It has been noticed from the
various studies conducted in this respect on different commodities
and with different time periods.
THE VOLATILITY OF FUTURES PRICES:

In this section. we will discuss two dimensions of futures price

volatility: First, relationship between futures trading and the volatility
of prices for the underlying asset. Here volatility is measured as the
variance of price changes. Second,patterns in the volatility of futures
prices themselves would be analyzed. Fuures trading and cash market
volatility. Some studies have observed that the futures trading makes
prices for the underlying asset more volatile, specifically, in equities.
Further, some studies had also been conducted to see the volatility in
cash market prices due to futures trading. However, in general, it is
observed that futures trading does increase the volatility of the cash
market.In other words, it does not de-stabilize the cash market. Time
to expiration and futures price volatility. Paul Samulson,a renowned
economist, argued that the volatility of futures prices should increase
as the contract approaches expiration .In other words, near
expiration ,there is more volatility than in the beginning. Virtually,all
the studies agree that futures prices exhibit seasonal volatility—they
are more volatile at some specific periods rather than at others.
Finally, there also seems to be a day-of-week effect in price
volatility,i.e.,volatility defers depending on the day of the week,as
seen higher on Monday than the other days.

Trading volume and futures price volatility. In addition to the

abovementioned observations, some studies have analyzed that there
appears to be a strong positive relationship between the volume of
futures trading volumes and the volatility of the futures prices. As
observed earlier that when more information are coming to the
market, the futures prices turn more volatile.Hence,traders who trade
based on information are also more likely to trade when information
are received more rapidly.So,the futures prices become more volatile
with the increase in the trading volume.

THE BASIS :

The basis is an important term in futures trading. The basis is the

difference between the current/cash/ spot price and the futures price
of a particular asset at a specified location.

BASIS: CURRENT CASH PRICE-FUTURES PRICE

Since the futures prices are different from places to places, hence,
usually people speaking on the basis are referring to the difference
between the cash price and the nearby futures price of a
contract.When the fuures contract is at expiration,the futures price
and spot price of an asset becomes the same.The basis must be zero,
but subject to the discrepancy due to transaction costs. This behaviour
of the basis over time is known as convergence.

It is observed that as the delivery month of a futures contract is

approached,the futures price converges to the spot price of the asset,
and at the delivery period, futures price equals or is very close to the
spot price. Thus,as time passes,the basis narrows near maturity of the
contract.

It is noted a significant behaviour pattern between cash prices and

futures prices that the fluctuation in the basis was much less than the
range of fluctuation in the futures price itself. This is noted almost in
all the cases. The basis is almost much more stable than the futures
prices or the cash Prices.