RISK MANAGEMENT,
FORWARDS AND FUTURES
2
CONTENTS
Introduction – Risk Management
BUSINESS RISKS: Price, Exchange Rate, Interest Rate
DERIVATIVES: Products, Participants, Functions, and Classification
FORWARD CONTRACTS: Hedging, Speculation and Arbitrage
FUTURES: Hedging, Speculation and Arbitrage
CURRENCY FUTURES: Specifications, Pricing and Applications
STOCK FUTURES: Hedging, Speculation and Arbitrage
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RISK & IT’S
MANAGEMENT
Each one of us in everyday life faces
variety of risks. Different ways to handle
risk include: a) control the potential
damage, b) diffuse the risk, c) transferring.
Business risks are characterised by small
losses but with high probability; relate to
changes in a) prices, b) exchange rates,
and c) interest rates.
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DERIVATIVES
Derivatives are product that derive
their value from some other asset
called underlying asset.
Forwards, Futures, Options and Swaps
are commonly used basic derivative
products.
Combinations of basis derivatives
products are also evolving.
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DERIVATIVE MARKETS
5 FUNCTIONS AND
PARTICIPANTS
Participants in derivative markets are
Hedgers,
Speculators, and
Arbitrageurs
Each of them is essential for proper and
efficient functioning of the markets.
Derivatives perform functions of price
discovery, transfer of risk and leveraging.
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PARTICIPANTS
Hedgers are those who enter into a
derivative contract with the objective of
covering risk.
Speculators are those who take positions
in derivative contracts to make profit by
assuming risk.
Arbitrageurs take risk less position and yet
earn profit.
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DERIVATIVE
INSTRUMENTS
Four types of derivative instruments are
Forwards,
Futures,
Options, and
Swaps
Forwards: are contracts which are settled at
a later date but at a price determined now.
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DERIVATIVE
INSTRUMENTS
Futures: Futures are exchange traded
forward contracts.
Options: Options are contracts where one
party holds a right buy or sell an asset at
predetermined price. The other party is
obligated to perform at the option of the
first party.
Swaps: Swaps are contracts to exchange a
series of cash flows according to a pre-
determined method.
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Hedging
Foreign Currency Risk
Exporters can book a forward contract
to sell the foreign currency asset at a
price determined today eliminating risk
of fall in the value of the asset due to
decline in exchange rate.
Similarly, importer can book forward
contract to buy the required foreign
currency to eliminate risk due to its
rising value.
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EXPORTER’S HEDGE
GRAPHICAL VIEW
Pay off of a Forward Hedge
Unhedged Position
Forward Price F1
Spot Price S1
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SPECULATION AND
ARBITRAGE
Speculation in the currency exchange rate
markets is made by holding a view contrary to the
market and taking a position.
Sell foreign currency when it is overpriced in the
forward market and buy when it is under priced.
Different currency exchange rates by different
banks for a currency also may provide
opportunities for arbitrage.
Buy from the bank that is under pricing the foreign
currency while selling to another that overprices the
currency.
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FUTURES
Futures are standardised forward contracts
that are exchange traded. The
standardisation is in terms of
Size,
Delivery, and
Price.
Futures contracts de-link the delivery and
price and yet provide efficient and effective
way of hedging.
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HOW FUTURES
WORKS
Futures provide hedge against the price
by taking an opposite position in the
futures market to that of the spot.
The expected loss in the spot position is
compensated by the equivalent gain in
the futures markets.
If one gains in the spot markets the
futures position would show equivalent
loss.
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FORWARD VS.
FUTURES
Major advantages of the futures as
compared to the forward contract
are
1. the elimination of counter-party
risk,
2. flexibility of exiting anytime, and
3. de-linking of delivery and price.
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FUTURES AND
FORWARD
Comparison between forward and futures contracts
Features Futures Forwards
Location Exchange Over the Counter
Counter party Unknown to each other, Counter parties are known to
Exchange serves as counter each other
parties
Counter party risk Minimal Exists
Initial Cash flow Initial and Variation margins None
required
Explicit cost Brokerage required to be paid No intermediary and no cost
Settlement Implicitly daily by marking to No marking to the market
the market
Final settlement By delivery or cash settled By delivery
Exit prior to maturity Possible by entering an Generally not possible unless
opposite contract to square up both the parties agree.
the position
Quantity specification Fixed standard size/lot Any quantity
Time of Delivery On fixed dates Any time mutually decided by
the parties concerned
Cost of hedging Very nominal High
Period of hedging Contracts available for limited Unlimited
period
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16 Pricing Forward/Futures
Futures price is equal to spot price plus
cost of carry for the period.
Upper and lower bounds on the price of
the forward contract, F1 are:
S0 < F1/(1+r), or F1 > S0 x (1+r)
F1 < S0 x (1+r)
Both inequalities are satisfied if
F1 = S0 x (1+r)
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17 Pricing Forward/Futures
With continuous compounding:
F1 = S0 x ert
With benefits and storage cost
F1 = (S0 – D + s) x ert
D and s are PVs of benefits and storage cost.
For continuously compounded, cost and
benefits :
F1 = S0 x e(r-D+s)t
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BASIS AND
CONVERGENCE
The difference of futures price and spot price is
called basis.
As time progresses basis declines and becomes
zero on the day of maturity i.e. spot and futures
price converge.
Convergence of price
Price
Futures
Maturity
Spot
Time
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TYPES OF FUTURES
Commodity futures: Underlying asset is
commodity.
Financial futures: Underlying asset is a
financial asset. They can be
Currency : Foreign exchange rate
Stocks/Index : Stock price/Index value
Interest Rate : Interest rate sensitive
instruments
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COMMODITY &
FINANCIAL FUTURES
Financial futures are easier to understand
as
Cost of carry model applies.
Arbitrage is possible due to absence of
convenience yield in financial futures.
The consumption value of commodities
makes valuation of futures contracts
difficult.
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Commodity & Financial
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Futures
Delivery and Settlement
Quality of underlying asset is immaterial in
case of financial products.
If the underlying is non-deliverable and
futures contracts are cash settled.
Contract features and Life:
Commodity futures are governed by seasons
and perishable nature of the underlying asset
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APPLICATIONS OF
FUTURES
All futures have three major
applications of
Hedging,
Speculation, and
Arbitrage.
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HEDGING WITH
FUTURES
To execute a hedge following steps are
taken:
1. If long on the asset, go short on the
futures market, and vice versa,
2. At a later date neutralise the position
in the futures market, and
3. Sell or buy the underlying asset in the
physical market at prevailing price.
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PERFECT HEDGE
The objective of hedging is to compensate the gain
or loss in the physical market with the loss or gain
in the futures market. When these are exactly
equal the hedge is perfect and the price realized is
firm. The Perfect Hedge
Short on
Underlying
Gain Long on Futures
Price
Loss
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REASONS FOR
IMPERFECT HEDGE
Realization of exact price is difficult to achieve
because of the following reasons:
Mismatch of asset and quality: Futures
contract may not be available on the same
underlying that is intended for hedging.
Mismatch of quantities: The exposure in
futures and underlying asset may not be
equal.
Mismatch of period of hedging: Maturity of
futures and underlying asset may not match.
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BASIS & BASIS RISK
Hedging with futures involves taking
futures position opposite to that of in
the physical asset hoping to
compensate for the likely losses in the
physical market with the gain in futures.
The total gain/loss on the combined
position in spot and futures markets is
= S1 – S 0 + F0 – F 1
= (F0 – S0) – (F1 – S1)
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BASIS & BASIS RISK
Basis is defined as difference of futures
price and spot price.
B0 = F0 – S0
With futures hedge the gain/loss is equal to
the difference of basis at start and end of
hedge.
Hedging price risk with futures is not
perfect. Price risk gets replaced by much
smaller risk called basis risk.
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HEDGE RATIO
Hedge ratio is the number of futures
contract that must be booked to have
minimum risk.
It depends upon the risks in the spot
prices, futures prices and the co-
efficient of correlation between the
two. σs
h* = ρ
σf
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Currency Futures
Currency forwards and futures are used
by importers/exporter to cover the
exchange rate risks in respect of their
receivables/payables .
Currency futures are the derivatives
based on the exchange rate and are
used for hedging against fluctuation in
the exchange rate.
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Currency Futures
Currency futures at NSE are traded in
standard lots of different currencies quoted
in terms of number of Rupees per unit of
foreign currency, with
Tick size of Rs 0.0025
12 monthly contracts available, and delivery
date is standardised for every month.
Standard Lot is 1,000 units of foreign currency
with Japanese Yen as JY 100,000.
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31 Pricing Currency Futures
Price of currency futures depends upon
the spot price and the interest rate
differential of the interest rates in two
currencies.
Forward/Futures price
F (direct) = S x (1 + rd)/(1 + rf)
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HEDGING THROUGH
CURRENCY FUTURES
An importer is short on foreign
currency. To hedge against
appreciating foreign currency he goes
long on the futures contract.
An exporter is long on foreign
currency. To hedge against
depreciating foreign currency he goes
short on the futures contract.
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STOCK INDEX
FUTURES
Stock index futures is a derivative with
stock index as underlying asset.
Stock index futures can be defined as
a commitment to buy or sell a
portfolio of stocks comprising the
index
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SPECIFICATIONS OF
STOCK INDEX FUTURES
Contract Size: 50 Nifty
Contract Value: Each point is equal to
one rupee. If NIFTY is at 4,500 the
contract value is 50 x 4,500 = Rs 2.25
lacs.
Tick Size: is 0.05; hence minimum
change in value of NIFTY contract will
be 50 x 0.05 = Rs 2.50
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SPECIFICATIONS OF
STOCK INDEX FUTURES
Margins: Initial Margin to cover the
largest potential loss in a day, and MTM
Margin are required.
Time of Expiry/Delivery: Contracts for 1,
2 and 3 months are available expiring on
Last Thursday of each month.
Settlement: Cash settled
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PRICING STOCK &
INDEX FUTURES
Futures Price
= Spot Price + Cost of Carry ‘r’ – Benefits
of ownership ‘d’
Cost of Carry = Interest Cost in case of
Stock index futures/financial asset.
F =S(1+ r m)mn
F =Se(r-d)t
RISK MANAGEMENT, FORWARDS & FUTURES CHAPTER 28
