Module 2 ( 10)(22%) nd Futures: Pricing and Trading Mechanism of forward ; Forward Contract concept ~ Features of Forward Contract — sification of Forward Contracts ~ Forward Trading Mechanism — ! Futures Contracts Forwards, contract and tures — Types of futures: Commodity Futures-Currency ock Futures: Index Futures-Interest rate Futures— Evolution of Futures Market in India — Prices and Risk Aversion — Settlement ~ ‘Theories of Future prices ~ Future ‘orward Contract Vs. Futures Contracts. FORWARDS Wis a contract between two Parties to buy or sell an underlying asset at today’s Pre-agreed price on a Specified date in the future. It is the most basic form of derivative contract. These cor ntracts are not standardized, the end users tracts to fit their ve ; co Fonward Rate Agreements (FRAS) Ke * Foreign Exchange Agreement (FXA) Forward Rate Agreements (FRAs) In FRAs, the two contracting parties (counter Parties) agree on some interest rate to be paid on a deposit to be teceived or made at a iter date, FRAs were originally introduced by banks in 1983, ‘They originated in London, and British banks remain the principal market makers (dealers). : The size of the deposit. Reference Rate: It is most often LIBOR, but it can just as easily be the prime rate, the T-bill rate, or any other well defined rate that is not easily manipulated, Notional Principal Contract Rate + The agreed upon rate of interest CHJebory kartedd OM aelorenee rfc): Foreign Exchange Agreement (FXA) A forward foreign exchange contract is an currency at a later date at a specified price. The s| agreement to buy or sell a exchange rate specified price is the forward The forward price paid must be expressed in terms of currency dil ferent from the one being bought or sold. As with most other ts, shere 0 payment made whes the contre s are Scanned with CamScannerOn the settlement date, two currencies are exchanged at the forward exchange rate that was agreed upon at origination. Program Trading —Jroor Arbibage , For indices involving many stocks, index arbitrage is sometimes accomplished by trading a relatively small representative sample of stocks whose movements closely mirror those of the index. Index arbitrage is implemented through program trading. Qu. nN Mr. A enters into a six month forward contract to sell wheat for Rs.5000, when the spot price is Rs.4500. The spot price in six months increased to be Rs.5700, calculate his profit or loss from this transaction? Ans.Rs.700 ( 1053) A trader enters into a one-year short forward contract to sell an asset for $60 when the spot price is $58. The spot price in one year proves to be $63. ~~ What is the trader's gain or loss? Ans.$3 ( loss) FUTURES Futures are financial contracts to eliminate the risk of change in price in the future date. Futures are highly standardized contracts for either deferred delivery of some underlying asset or a final cash settlement based on some clearly defined rules. These contracts are traded on organized futures exchanges. It is defined as “an agreement to buy or sell a standard quantity of a specific instrument at a predetermined future date and at a price agreed between the parties through open outcry on the floor of an organized futures exchange.” Going Short _: The act of selling. Going Long: The act of buying. Futures Price: The price agreed _by the two traders on the floor of exchange. Scanned with CamScannerAdvantages of Futures The futures are considered to be better than forwards because of the following reasons’ 1. Standard volume 2. Liquidity 3. Counterparty guarantee by exchange 4. Intermediate cash flows Types of Futures Basically there are two types of futures. They are: + Commodity futures - Wheat, Corn, Rubber, Cotton, etc. * Financial futures Financial futures include: — Foreign Currencies — Interest Rate — Market Index (Market index futures are directly related with the stock market) — Individual Stock, etc. Margin It is the initial deposit required to open a trading account in a futures trading exchange. The initial margin is fixed by the broker, but has to satisfy an exchange minimum. The variation margin i.e. the change in the amount of an account on a given day in response to a market —to- ket_process, is settled on daily basis. It is called margin transfers. + Initial Margin — The amount that must be deposited in the margin account when establishing a position, * Marking to Market ~ In the futures market at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss ee —— eer depending upon the futures closing account Scanned with CamScanneris set to ensure that the balance in the < ¢ balance in the margin 9 he investor is expected to < n the next day. + Maintenance Margin - Thi margin account never becomes negative. If th account falls below the maintenance margin, top up the initial level before trading commences o Trading Cycle The futures contract have a maximum of three months trading eycle i.e. — Near Month (ane), — Next Month (two) — Far month (three) New contract will be introduced on the next trading day following the expiry of near month contract. The expiry date is the last Thursday of every month. Fum In India - Nears different types of Index Futures and 206 Stock res are available for trading. + The Index Opn . FTSE 100 . INDIA VIX . Nifty CPSE . Nifty 50 Nifty IT . Nifty Bank |. Nifty Midcap 50 . Nifly PSE . Nifty Infrastructure List of Some Stock Futures PeENANawna + ACC LIMITED + ADANI ENTERPRISES LIMITED + ALLAHABAD BANK + ASHOK LEYLAND LIMITED + ASIAN PAINTS LIMITED * AUROBINDO PHARMA LIMITED * BAJAJ AUTO LIMITED + BHEL + CANARA BANK + SBI, etc. Scanned with CamScannerDERIVATIVES FUTURES TRADING AT NSE. Contracts Price (Rs.) FEBRUARY DLF MARCH DLF Open Interest Open 356 3 37710 APRIL, DLF Difference between Futures and Forwards 1. Vv Futures contracts are traded on futures exchanges while forward contracts are traded in over- the-counter dealer type markets. . Futures contracts are highly standardized, with all contract terms, except price, defined by the exchange on which they trade. But forward contracts are negotiated between the contracting parties with all contract terms subject to mutual agreement. A clearing association stands between the parties to a futures contract. As a result, counterparties’ identities are irrelevant. But in a forward contract each party is directly responsible to the other, and consequently, the identities of the counter parties are critically important. . Futures markets are usually regulated, while forward markets in general are not regulated. . The financial integrity of the futures markets is protected by requiring each party to a contract to post a performance bond called margin. Through a market-to-market process, with corresponding transfers of margin, each party to a contract is assured of the other party’s performance. No such market-wide systematic margining requirement Is employed in the forward markets. Consequently, market makers in the forward markets tend to limit their contracting to parties who are well- known to them Scanned with CamScanneracts makes them very easy to ‘ Forward contracts are much ion is often not possible. ie inst 8 f futures cont i ional structure of futures co! 6. The institutional stru ving soto fact, terminal! arket but in forward market credit terminate via simple 0 se more dificult to terminate =H ; = 7. Credit tisk is almost not in futures m depends on the counterparty. sehange ee issit i arges, C3 8. Transactions costs like commission, com a se See are high in the case of futures contracts on Senerally low in the ease of forward contracts. Aa -to- market every day, 9. Valuation jn futures are based on market —to- mi 7 fon i ract. there is no unique method of valuation in forward contra FUTUTERS EXCHANGES . The world leading exchanges were futures are traded are: » The Chicago Board of Trade (CBOT) » Chicago Mercantile Exchange (CME) }. London International Financial Futures Exchange (LIFFE) + Tokyo Intemational Financial Futures Exchange (TIFFE) ~ Singapore International Financial Futures (SIMEX) Swiss Options and Financial Futures Exchange (SOFFEX) ~ Sydney Futures Exchange (SFE) National Stock Exchange, Mumbai Qn. The settlement price (GO) Sy one a) Ves) of Nifty futures contract on a particular day was Rs.4600, The initialmargin is set at Rs.10000, while the maintenance margin is fixed at Rs,8000. ‘The lot size of The settlement Prices on the following days are as follows: Day_ each contract is 50, Settlement Price (Rs.) 4700 4500 4650 4750 4700 4700 Calculate the mark to market cash flows and the daily closing balances in the accounts of: bet |. Mr, Aravind, an investor who has gone long and “ 2 Mr. Praveen, an investor who has gone short at 4600 Scanned with CamScannerAlso calculate the net profit or loss on each of the contracts, Ans. a Status of Mr, Aravind ( ter) ee Day — J, Settlement Margin Account ———S—S—=id © Price Opening | Mark-to- | Margin | Closing T= | Balance | Market Call Balance P4700 tose 5000" 15000 2 4500 15000 =10000 5000 10000 3 4650 10000 7500 17500 4 4750 17500 5000 22500 5 4700 22500 =2500 20000 Net Profit on the contract =5000 — 10000 +7500 + 5000 - 2500 =Rs.5000 Status of Mr. Praveen (Who has gone short) Day Settlement »: Margin Account Price Opening | Mark-to- | Margin | Closing Balance_| Market | Call Balance 1 4700 10000 -5000 5000 10000 2 4500 10000 10000 20000 3 4650 20000 -7500 12500 4 4750 12500 -5000 2500 10000 5 4700 10000 2500 12500 Net loss on the contract =-5000+10000-7500-5000+2500 =Rs.5000 Qn, Mr. Mahesh has entered in to 125 long SBI stock futures contract on January 5, when the SBI share price was Rs.2000-The initial. and maintenance margin for the contract is set at Rs.50000 and Rs.40,000_respectively. The settlement prices of the futures contract on the following days dre as follows: Day Settlement Price (Rs.) January 6 2100 January 7 2150 January 8 1950 January 9 1900 [anny 0 eee 2050 Scanned with CamScannerfrom the contract if he has exercised it on Caleulate his profit or loss fh flows and th January 10. Also show the calculation of the mark to market cash flows and the daily closing balances in the account. Ans. Mark ~ to ~ Market Cash Flow of the Contract Day Settlement Margin Account - Price Opening | Mark-to- | Margin | Closing Balance_| Market Call Balance January 6 [2100 50000 12500 62500 January 7 2150 62500 6250 68750 January § 1950 68750 -25000 = 43750 | January 9 | 1900 43750 -6250 13000~ | 50000 January 10 | 2050 50000 18750 68750 Net Profit of the contract = 12500 + 6250 - 25000 — 6250 + 18750 = Rs. 6250 BASIS The basis is the relationship between the cash price and future price of a commodity. Basis represents the difference between the cash price and future price of a single commodity. Basis = Current Cash Price — Futures Price. The relationship between the cash price and the futures price of the Underlying asset is called basis, It is generally calculated by taking the difference between the cash price and the futures price of the underlying asset, PRICING OF FORWARD AND FUTURE CONTRACTS see The forward price of the asset would be equal to the Sh Price plus the carrying cost. F, = Poe” Where: Fy = Forward price of the asset at the beginning Py = Spot price of the asset at the beginning r = Risk free interest rate (Carrying cost) t = Life of the forward contract Scanned with CamScannerQn. The spot price of an asset i Rg Ly borrowing the money at 11 per cons yy ws forward contract? on What an and the only carryi s the fair price of a one year = Pyett F, = 1200 x e011 = 1339.53 Note: (e=2.71828) 1. IEF, > Poert, The forward price in the market is higher than the fair forward price of the asset. Therefore, e , arbitrageurs will get profit if they buy the asset in the spot market and sell in the forward market. IEF) < Pert, —~ ‘The forward price in the market is less than the fair forward price of the asset. Therefore, arbitrageurs will get profit if they sell the asset in the spot market and buy in the forward market. Qn. a _ A one year long forward contract on a non-dividend paying stock is entered in to when the stock price is Rs.140 and the risk free rate of interest is 7.5 per cent per annum. Using an arbitrage argument, establish the forward price. What transactions will be undertaken if the forward price is Rs.148? Ans. F, = Pye? Fy = 140 x e9975*1 = 150.90 Note: The forward is trading at Rs.148, which is less than the fair forward price. Therefore, the arbitrageur can make profit by selling in the spot market and buying in the forward market, CURRENCY DERIVATIVES Currency derivatives can be used as an effective tool for hed ing the unforeseen movements in exchange rates. Currency derivatives are contracts : eee ierween usa \ nose values a Scanned with CamScannerC7) In other words it is a contract to buy or juture specified date. Any the underlying assets, ic. the curr ; an agreed rate on 3 Para sell one currency for another at an agre' or pay certain amount in foreign rivatives to minimize the loss individual or corporate expecting to recei : ¢ currency der currencies at a future date can use currency sof a currency, Currency due to appreciation or depreciation in the value of a i ii ‘ions swaps. derivatives include forwards, futures, options and swap: Currency Futures A currency futures contract is a standardized contract to exchange one Surrency for another at a specified future date at an agreed rate of exchange. The wurrency Tuures wee fst inogaced in the Chicago Mereanie Exchange (CME) in the year 1972, immediately after the abandonment of the fixed Exchange rate system based on gold standard. National Stock Exchange is the first exchange which received the approval from SEBI for setting up currency derivatives segment. The NSE Started trading in currency futures on 29" August, 2008. Currency futures on U $ Dollar were fist introduced for trading and subsequently the Indian rupee was allowed to trade against other currencies such as Euro, British Pound Sterling and the Japanese yen. The currency futures available in India for trading are U $ Dollar — Indian Rupee (USD-INR), Euro — Indian Rupee (EUR-INR), Great Briton Pound ~ Indian Rupee (GBP-INR) and Japanese Yen - Indian Rupee (JPY- INR). Turnover of Currency Derivatives in India Year MSEI % NSE % BSE % Total 2016-17 _(2,97,928 4,28 48,57,076 [69.76 18,07,829 25.96 _|69,62,833 (2017-18 [1,15,733 {1.21 50,28,502 {52,49 44,36,430 46.31 _5,80,665| Scanned with CamScannerproduct-wise Market Share in Cu ‘eney Derivatives Segment at NSE ' ———_(percent) Near Cea EURO-INR|GBP-INR. ]PY-INR |USD-INR | | utures [Futures Futures: Futures: \Options 2016-17 44 2.0 3.8 1.4 48.7 017-18 43.4 3.2 3.9 0.9 48.4 COMMODITY DERIVATIVES In the current investment scenario, it is increasingly getting difficult for individuals and institutions to create a well-balanced investment_portfolio. Commodities today have become an attractive investment vehicle. With uncertainty in interest rate, it is tough for the investor to beat the ever rising inflation. Trading in commodities futures has a long history. Though the jodern trade in commodity futures could trace its origins back to the 17" century in Osaka, Japan, there is evidence to suggest that a form of futures trading in commodities existed in China 6000 years earlier. Organized trading on an exchange started in 1848 with the establishment of the Chicago Board of Trade (CBOT). The first milestone in the 125 years rich history of organized — in commodities in India was the constitution of the Bombay Cotton Trade Association in the year 1875. India had a vibrant futures market in commodities till it was discontinued in the mid 1960's, due to war, natural calamities and the consequent shortages. Commodities Traded in Commodity Exchanges Commodities futures contracts and the exchanges they trade in are wilatian) Act, 1952. The regulator is ission (FMC), a division of the Ministry of governed by the Forward the Forward Markets Commi sod and Public Distribution On 28 Septe Affairs # Scanned with CamScannerFMC was Merged with the Securities and Exchange Board of India (SEBI), In 2 1 > —— . 2002, the Government of India allowed the re-introduction of commodity futures in India, Together with this, three screen based, nation-wide multi- commodity exchanges were also permitted to be set up with the approval of the Forward Markets Commission, Some of the comn modities traded on various futures exchanges are as follows: Foodstuff, Coffee, Sugar, Cocoa, Maize, Roush tic, Soybean, Wheat, Sunflower Oil, Barley, Orange Juice, etc, The Multi Commodity Exchange of India Limited (MCX) The Multi Commodity Exchange of India Limited (MCX), Indi s first listed commodity derivatives exchange that facilitates online trading, and clearing _ nd settlement of commodit derivatives transactions, thereby Providing a platform for risk management. The Exchan Which started Operations in November 2003, operates under the regulatory framework of Securities and Exchange Board of India (SEB. MCX offers trading in commodity derivative contracts across v. aried segments including bullion, industrial metals, energy and agricultural commodities. It is India’s first exchange to offer commodity options contracts, The Exchange focuses on providing participants with secure and transparent trade mechanisms, and formulates quality parameters and trade regulations, in conformity with the regulatory framework. The Exchange has an extensive national reach, with 675 registered members and 53,015 Authorised Persons with its presence in around 1100 cities and towns across India as on 30 June, 2018. MCX is India’s leading commodity derivatives exchange with a market share of 92,25 per cent in terms of the value of commodity futures contracts traded in QI FY 2018-19, The Exchange's flagship index series, iCOMDEX, developed jointly with Thomson Reuters, is a series of real-time commodity futures price indices, which give information on market movements in key commodities traded on MCX. The iCOMDEX series consists of iCOMDEX Composite, apart from two sectoral indices: iCOMDEX Base Metals oo iCOMDEX Bullion, as also three single-commodity indices: eerie iCOMDEX Copper and iCOMDEX Crude Oil. Other indices developed by the exchange include MCXCOMDEX, MCXAgri, MCXEnergy, MCXMetal Rainfall Indices. iat Scanned with CamScannerfirst clearing corporation in the commodit fl mMakeE i 'Y derivatives market, will soon commence its operations. The Spo Undertake collateral management, risk management functions Settlement of trades executed on MCX. With state-of-the-art » MCXCCL will provide a settlement guarantee for all via the Settlement Guarantee Fund (SGF). With an aim to sean ecosyst exchan; Comm risk management system, trades executed on MCX mlessly integrate with the global commodities lem, MCX has forged strategic alliances with leading international 8S such as CME Group, London Metal Exchange (LME), Dalian ‘odity Exchange (DCE) and Taiwan Futures Exchange (TAIFEX). Commodity Futures in India Bullion: Gold, Silver Base Metals : Aluminium, Copper, Lead, Nickel, Zine Energy: Crude Oil, Natural Gas Agricultural Commodi Palm Oil, Rubber es: Black Pepper, Cardamom, Castor Seed, Cotton, Commodity Options: Copper, Crude Oil, Silver, Gold and Zine As per current regulatory norms, only European style commodity options are available in India at present. Normal Session Monday to Friday: 10:00 A.M. to 11:30 P.M. National Commodity and Derivative Exchange (NCDX) This exchange was originally promoted by ICICI Bank, National Stock Exchange (NSE), National Bank for Agriculture and Rural Development (NABARD) and Life Insurance Corporation of India (LIC). Subsequently other institutional shareholders have been added on, NCDEX is popular for trading in agricultural commodities. National Multi Commodity Exchange of India This exchange was originally promoted by Kailash Gupta, an Ahmedabad-based trader, and Central Warehousing Corporation (CWC). Subsequently other institutional shareholders have been added on. NMC popular for trading in spices and plantation crops, especially from Ké uthern state of Tred is Scanned with CamScanner