Forwards and Futures

In this Unit
• Features of Forwards and Futures Contracts
• Types of Futures Contracts
• Futures Trading Process
• Margin: Types, Marking to Market
• Valuation of Forwards and Futures
• Arbitrage
• Hedging Strategies
• Hedge Ratio
 • A forward contract is an over-the-contract
derivative contract in which one party
commits to buy and the other party commits
to sell a specified quantity of an agreed upon
asset for a pre- determined price at a specific
Forward date in the future.
Contract • It is a customized contract, in the sense that
the terms of the contract are agreed upon by
the individual parties. So, it is traded OTC.
• Different types forward contracts: Equity
Forwards, Bond, Interest Rate Forward
Contract and Currency Forward Contract
Example of Forward Contract
•Suppose on April 01,2016 the treasurer of an export company in India
knows that it will receive USD 1 million in 6 months i.e. on October 1,
2016 and wants to become indifferent against exchange rate moves.
He can undertake currency forward contract with a bank now to sell
USD 1 million in 6 months at a particular INR/USD forward rate.
Iyengar Bakery enters into a forward contract with Sakthi Sugars, a sugar
manufacturer, on January 1 to buy sugar on March 31 at INR 30,000 per 1,000 kg.
There will be no cash exchange on January 1; however, on March 31, Iyengar
Bakery will pay INR 30,000, irrespective of the price of sugar in the market, and
Sakthi Sugars will deliver 1,000 kg of sugar to the bakery. This contract will be
binding on both parties, and both will have to honour their commitments.
 Future contracts are also agreements between two
parties in which the buyer agrees to buy an underlying
asset from the other party (the seller). The delivery of
the asset occurs at a later time, but the price is
determined at the time of purchase.
• A future is a standardized forward contract.
Futures • It is traded on an organized exchange.
Contract • Standardizations-
- quantity of underlying
- delivery dates and procedure
- price quotes
• Types of Futures Contracts: Stock Futures Contracts,
Commodity Futures Contracts, Currency Futures
Contracts
Difference between Forwards and Futures.
Category Forward Contract Futures Contract
A forward contract is a private A futures contract is a standardized
Meaning agreement between two parties to contract to buy and sell an asset on
buy or sell an underlying asset a future date at a fixed price.
Forward contracts are often Futures contracts have
Standardization customized to suit the parties’ standardized terms for consistency
needs and pre-defined lot sizes.
Forward contracts lack Futures contracts are highly liquid
Liquidity and Transparency transparency and liquidity, being and traded on exchanges, providing
private agreements. transparency.
Forward contracts are over-the- Futures contracts are strictly
Regulations counter contracts and therefore regulated by exchanges and
have minimum to no regulation. relevant authorities.
Forward contracts have higher Future contracts have lower
Risk
counterparty risk. counterparty risks
Forward contracts are settled at Future contracts are settled on a
Settlement the maturity date and are settled in daily basis and are settled in cash
cash or physical settlement or delivery.
Difference between Forwards and Futures.
Category Forward Contract Futures Contract
A futures contract has a collateral
A forward contract has no collateral requirement, as the parties have to
Margin requirement, as the parties trust deposit an initial margin and
each other to honour the contract. maintain a maintenance margin to
cover potential losses.
Futures contracts may involve
Forward contracts usually have
Costs brokerage, exchange fees,
lower transaction costs.
and margin requirements.
Forward contract prices are
Futures contract prices are
Price determination mutually agreed upon between the
determined by open market forces.
parties to the contract.
Futures terminology
Lot size
• The lot size is an important term to know when we’re
discussing futures trading basics. It is the minimum number of
shares or derivatives (in the case of an index) in a contract. It is a
standardised quantity that is specified by the exchange and cannot
be changed by the user. The lot size is not constant and varies
from one security to the other.
• For instance, the lot size of HDFC Bank is 550, while that of Tata
Motors is set at 1425. This effectively means that when you buy
a futures contract of HDFC Bank, you agree to buy 550 shares of
the company upon expiry of the contract.
• Contract value
The contract value is the current price of the futures contract
multiplied by the lot size of the contract. Since the current
price of the futures contract keeps changing, the contract value
also changes accordingly. Let’s take up the following example
to better understand contract value.
Contract expiry
• Contract expiry is also another fundamental concept that you need to be aware
of as a part of futures trading basics. Every future contract expires on the last
Thursday of every month. In the event of the last Thursday being a holiday, the
contract would expire on the previous trading day.
• Also, at any point in time, futures contracts would always have three different
expiries. For example, if you were to search for the futures contracts of HDFC
Bank on the 2nd of Jan, 2024, you would find the following.
HDFCBANK JAN FUT (also known as near month)
HDFCBANK FEB FUT (also known as next month)
HDFCBANK MAR FUT (also known as far month)
• Once the JAN futures contract expires, the FEB futures contract then gets
categorized as near month, the MAR contract becomes next month, and the
APR futures contract becomes the far month. This goes on month after month.
Open contract
• A futures contract that you’ve bought (or sold) is termed as an open contract if
it has not been squared off or if it has not yet expired. For instance, let’s say that
you’ve bought a HDFCBANK JAN FUT contract on the exchange. This
contract will continue to be termed as an open contract till the date of expiry or
till the time you decide to square it off by selling the contract.
• An increase in the open interest indicates an increase in the number of
contracts available for delivery, and a decrease in the open interest
indicates a decrease in the number of contracts available for delivery. This
is an indication of the liquidity of the contract. When the open interest is
high and if a trader wants to close the position, it will be comparatively
easier to do so as compared to the situation where the open interest is very
low.
Open interest
• The open interest is the total number of open contracts of a
particular financial asset in the market. This asset can be a stock,
an index, a commodity, or a currency, among others. For
instance, if the open interest for the HDFCBANK JAN FUT
contract is 92409350, it essentially means that there are
92409350 contracts currently open and unsettled in the market.
• Basis: In the context of financial futures, basis can be defined as
the futures price minus the spot price. There will be a different
basis for each delivery month for each contract. In a normal
market, basis will be positive. This reflects that futures prices
normally exceed spot prices
Margin
• To trade in futures, you are not required to pay the entire contract
value upfront. Instead, you’re only required to deposit a
percentage of the contract value with the exchange. This amount
that you deposit is known as the ‘margin.’ Consider the margin
as a sort of a security deposit that’s collected by the stock
exchange to ensure that you, as the trader, fulfil all the obligations
related to the futures contract.
 What is SPAN and exposure margin?
• Standard Portfolio Analysis of Risk (SPAN) is used by exchanges to calculate risk
and margins for F&O portfolios. SPAN uses the price and volatility of the
underlying security along with several other variables to determine the
maximum possible loss for a portfolio and determines an appropriate margin.
SPAN margin is monitored and collected at the time of placing an order and is
revised by the exchanges throughout the day.
• Exposure margin is charged over and above SPAN margin by the exchanges to
cover risks that the SPAN margin may not cover.
• Exposure margins for index futures and index option selling is 2% of
the contract value (Spot price * Lot size).
• For stock futures and option selling, it’s 3.5% of the contract value
(Spot price * Lot size) or 1.5 standard deviations of the logarithmic
returns of the underlying share over the past 6 months.
• SPAN + Exposure margin is called initial margin, which is collected
when entering a position.
• A very important margin that is collected from the second day of the trade
is the mark to market or MTM margin. That is applicable when price
movement is unfavorable to the trader. MTM losses are calculated by
marking each transaction in security to the closing price and are
mandatorily collected before the start of trading the next day.
• Last, but not least, there are delivery margins for physical settlement
in equity derivatives, which is a recent addition. Under the new system,
any outstanding position in equity futures and equity options require
additional margins to be blocked on the last 4 days before expiry. The
delivery margin would be released automatically once the physical
settlement process is completed.
What is Mark to Market Margin?
• Mark to Market margin or MTM margin is the collateral required by a
broker or an exchange to ensure that traders can cover their potential
losses. This may result in the changes of market value and their
positions.
• Mark to margin is calculated based on the current market price of the
financial instrument. And it is adjusted periodically to reflect changes
in the market value.
• For example, if a trader buys a futures contract for a specific price and
the market price of that contract drops. Thereafter, the trader will have
to deposit additional funds to cover the potential loss resulting from
the decline in the market price. This is known as a margin call.
Steps Involved in the MTM Process
• Determine the original purchase price of the financial instrument
The first step in the MTM process is to determine the original purchase price
of the financial instrument. This is typically the price that the investor has paid
to acquire the asset.
• Determine the current market price of the financial instrument
The second step in the mark-to-market process is to determine the current
market price of the financial instrument. This is typically the price at which the
asset can be sold in the market.
• Calculate the gain or loss
The final step in the market to market process is to calculate the gain or loss on
the asset. If the current market price is higher than the purchase price, the asset
has a gain. However, if the current market price is lower than the purchase
price, the asset has a loss.
 Importance of Mark to Market in Financial
Instruments
• Accurate Valuation: Mark to market ensures that financial instruments are accurately valued based on
their current market price. Which provides investors with an accurate understanding of their
investments’ worth.
• Transparency: MTM accounting provides transparency to investors. As it enables them to understand
the actual value of their investments. And also helps them to make informed decisions based on that
information.
• Risk Management: Mark to market manages risk by enabling investors to adjust their positions in
response to changing market conditions. This allows them to minimize potential MTM losses and
maximize potential gains.
• Compliance: MTM accounting standards are set by regulatory bodies such as the SEC in the United
States and the IASB. These standards ensure that financial instruments are accurately valued and
reported in financial statements. Which ensures compliance with accounting rules and regulations.
• Market Efficiency: Mark to market helps to promote market efficiency by reflecting current market
prices and conditions. That ultimately results in accurate pricing and better investment decisions.
How Does the Margin Call Occur?
• Understanding MTM in trading raises the question: What if you’re
required to pay a certain amount, and your margin falls short? This is
where Margin Call occurs. This happens when the initial margin drops
below the maintenance margin. At this point, the broker will ask you
to add more funds to your trading account to mitigate risk. If you
don’t, the broker can sell your position to cover losses.
• In simple words, you will have to provide the additional funds
required if the price of the futures contract drops before the daily
settlement. Once the balance margin is submitted to the stockbroker,
you can proceed with your positions and close them as per your
discretion.
What is Mark to Market Settlement?
• Mark to market settlement is the process of settling financial contracts
at their current market values. Traders use this process in mark to
market derivatives. MTM trading, where the value of the underlying
asset constantly changes.
• MTM settlement is important because it ensures that both parties in a
contract are able to account for changes in market value and are not
subject to excessive risk. It also ensures that the contract accurately
reflects the price of the underlying asset. This promotes transparency
and fairness in financial markets.
 How to calculate Mark to Market
• After the trading hours, the MTM calculations are performed daily based on
the day's closing price. On the same day, the P&L is settled to the trading
account and will not be reflected in the positions on the following day.
• The values of the futures contract position are calculated as follows:
1.The change in the value of a futures contract can be calculated as the difference
between the futures contract price of the current day and the closing price of the prior
day.
2.The P&L for the day can be calculated by multiplying the price change in the futures
contract value by the number of lots.
3.The total P&L can be obtained by summing up all the daily P&L until the futures
contract position is held.
Example
1.Buy price - ₹100.
2.Sell price - ₹102.
3.Lot Size - 9500.
4.Profit on the trade: ₹102 - ₹100 = ₹2.
5.Total Profit: 9500 * ₹2 = ₹19,000.
While the above gives the overall P&L, let’s apply MTM for the same position
as a table. Assume the closing prices of SAIL for the 4 days are 101, 100,
101.5, and 102
1.Buy price - ₹550.
2.Sell price - ₹565.
3.Lot Size - 5500.
Apply MTM for the same position as a table. Assume the closing prices
of Reliance for the 5 days are 555, 553, 557, 560 and 565
Did you know?
• MTM calculation is applicable only for future contracts and not for options or
equity stocks.
• MTM is updated on a live basis but will reflect in the ledger only at the end of
the day.
• If the position is in loss and there is insufficient balance in the account, the
position may be squared off, and a margin penalty will be levied.
• If the security is not traded on a particular day, the latest available closing price
is considered for MTM.
Swdeen Ltd. futures are available in multiple of 200 units. Initial margin is required
at 30% for seller. Current level of Swdeen Ltd. Futures is Rs. 2410. The variation
margin is Rs. 1,00,000. The settlement of Swdeen ltd next 6 days are
1 Rs. 2450
2 Rs. 2560
3 Rs. 2370
4 Rs. 2290
5 Rs. 2350
6 Rs. 2430
Find out the mark to margin and Closing balance of margin on daily basis and also
the net profit and loss if the investor square off his position.
Glaxo Ltd. futures are tradable in multiple of 50 units. Initial margin is
required at 20% for buyer and 25% for seller. Current level of Glaxo Ltd.
Futures is Rs. 4210. The settlement of Glaxo next 5 days are Rs. 4240,
Rs. 4260, Rs. 4200, Rs. 4190 and Rs. 4215 respectively. Variation Margin
is Rs. 41,000. Find out the mark to margin and Closing balance of
margin on daily basis and also the net profit and loss position in the
last, of an investor (i) who buys the futures contract, or (ii) who sells
the futures contract.
On 15th March 2017, Mr. Pratap has taken short position in five futures
contract at Rs. 170 per share of NTPC. Initial margin of the contract is
10% and maintenance margin is ¾ th of initial margin. The closing prices
of the share are given below.

Date (Mar 16 17 20 21 22 23 24
2017)
Price (Rs) 172 169 174 176 172 175 183

Prepare a margin account of the investor assuming that if a margin call is

made at any time the investor would deposit the amount called for.
Contract size of NTPC is 4,000.
Mr. Rajesh has shorted five copper futures at an exercise price of Rs. 325
per kg. The initial margin of the contract is 15% and the maintenance
margin is 80% of initial margin. The future prices for the first five days of
the contract are given below.
Day 1 2 3 4 5
Settlement 330.50 327.70 338.20 335.10 340.75
Price (Rs
1kg)
Prepare a margin account of the investor assuming all margins are
honored immediately and lot size of the contract is 1000 kg
Futures on stock indices and individual stocks
• Index futures are contracts that allow a trader to purchase or sell a
financial index today and have it resolved at a later date. Traders
speculate on the price direction of an index, such as the Nifty, using
index futures. Index futures are also used by investors and investment
managers to protect their stock investments from losses.
• Index futures, like all futures contracts, provide the trader or investor the
power and responsibility to deliver the contract's cash value based on an
underlying index at a future date. The trader is bound to provide the cash
value on expiry unless the contract is unwound before expiration by an
offsetting deal.
• NIFTY
• BANKNIFTY
• FINNIFTY
• MIDCPNIFTY
• SENSEX
• BANKEX
• SX50
Pricing of Futures
1. Expectation Hypothesis:
The Expectancy Model of futures pricing states that the futures price of an
asset is basically what the spot price of the asset is expected to be in the
future.
This means, if the overall market sentiment leans towards a higher price for
an asset in the future, the futures price of the asset will be positive. In the
exact same way, a rise in bearish sentiments in the market would lead to a
fall in the futures price of the asset. What matters is only what the future
spot price of the asset is expected to be. This is also why many stock market
participants look to the trends in futures prices to anticipate the price
fluctuation in the cash segment.
Pricing of Futures
2. Backwardation Principle:
Two patterns of future prices can be identified that are known as “Contango” and
“Backwardation”.
Backwardation is a market condition in which a futures contract that is far from
its delivery date trades at a lower price than a contract closer to its delivery date.
In a “normal” market, longer-dated futures contracts are generally priced higher
than current spot prices in the market, due to inflation and the risk of other
unknown market factors that may develop over time.
For example, if a particular commodity is in short supply, market participants
may be willing to pay a premium for immediate delivery of that commodity. In
cases like this, suppliers may demand a premium for immediate delivery of a
commodity that’s in short supply, which is why the near-term price (or spot price)
of a commodity might be higher than longer-dated futures contracts.
In this scenario, the one-month futures contract might be priced at $69
per barrel, while the six-month futures contract might be priced at $67 per
barrel.
Pricing of Futures
3. Cost Of Carry Model
Why should we go for the valuation for the futures?
Assumptions
1. The price of underlying share changes continuously.
2. Transaction cost and taxes do not exist. (adjust if exist)
3. No restriction on short selling
4. Funds can be borrowed at risk free return to create risk neutral
portfolio.
5. During the time period to maturity no dividend declared if it is
declared it should be adjusted.
Pricing of Futures
3. Cost Of Carry Model
• The Cost of Carry Model assumes that markets tend to be perfectly efficient.
This means there are no differences in the cash and futures price. This,
thereby, eliminates any opportunity for arbitrage – the phenomenon where
traders take advantage of price differences in two or more markets.
• When there is no opportunity for arbitrage, investors are indifferent to the spot
and futures market prices while they trade in the underlying asset. This is
because their final earnings are eventually the same.
• The model also assumes, for simplicity sake, that the contract is held till
maturity, so that a fair price can be arrived at.
• In short, the price of a futures contract (FP) will be equal to the spot price (SP)
plus the net cost incurred in carrying the asset till the maturity date of the
futures contract.
Three different scenario of cost of carry model of pricing of futures
(a) When assets provides no income:
(b) When assets provides known dividend
(c) Where the assets provides a known dividend yield

Price of future will be

F= S+C
F= Future price
S= Spot Price
C= Carrying Cost or holding cost
 Cost Of Carry Model
• FP = SP + (Carry Cost – Carry Return)
• Cost of Carry= Interest on loan + storage cost + insurance cost - dividend
income
• Net Holding Cost = cost of carry – carry return
Here Carry Cost refers to the cost of holding the asset till the futures contract
matures. This could include storage cost, interest paid to acquire and hold the
asset, financing costs etc. Carry Return refers to any income derived from the
asset while holding it like dividends, bonuses etc.
While calculating the futures price of an index, the Carry Return refers to the
average returns given by the index during the holding period in the cash market.
A net of these two is called the net cost of carry.
Cost Of Carry Model
• The bottom line of this pricing model is that keeping a position open
in the cash market can have benefits or costs. The price of a futures
contract basically reflects these costs or benefits to charge or reward
you accordingly.
• In case of financial future contracts, the cost of carry is primarily the
interest cost.
• Calculated future price is called Theoretical minimum price or
arbitrage free price.
Cost Of Carry Model
In the pricing of futures the interest is taken up on basis of continuous
compounding.
When assets provides no income:
F = S × ert
When assets provides known dividend
F = (S-I) × ert
Where the assets provides a known dividend yield
F = S × e(r-q)t
F= Future price
S= Spot Price of the underlying asstes
e = 2.71828 (base of natural log)
r = Rate of interest on borrowing/lending
t = Time duration of futures
I = Present value of expected dividend @ ‘r’
q = Dividend yield
Numerical 1
The price of equity shares of Onida Picture Ltd. (non-dividend paying)
company is Rs. 30. The risk free rate is 12% p.a. with continuous
compounding. An investor wants to enter into a 6-month future
contract. Find out the future price.
Numerical 2
The stock index is currently Rs. 350 and the risk-free rate is 8%. Find
out the future price for a 4 months contract if the dividend yield is 4%
Numerical 3
The debenture of ABC Ltd. Are currently selling at Rs. 930 per
debenture. The 4-months futures contract on this debenture is
available at Rs. 945. There is no interest due during this 4 months
period. Should the investor buy this future if the risk-free rate of
interest is 6%?
Numerical 4
The market price of equity share of ABC Ltd. Rs. 40. if has not been
paying dividend. The risk-free rate for the investor is 5%. The 3 months
future rate for the share is Rs. 42. Should the investor enter into the 3-
months future contract?
Numerical 5
The NIFTY index is 1800 at present. The stock underlying this index
provides a yield of 3% p.a. The continuously compounding rate of
interest is 8%. What should be the futures value of 3 months NIFTY
index.
Numerical 6
An investor buys a NIFTY futures at 5500 in market lot of 200 futures.
On the settlement date, the NIFTY is 5600. Find out his profit or loss for
one lot of futures, What would be his position, if NIFTY is 5450 on the
settle date?
Numerical 7
An investor buys a stock futures contract for Rs. 2,80,000 (lot size 200
futures). On the settlement date, the stock closes at 1,378. Find out his
profit or loss, if he pays Rs. 1000 as brokerage. What would be position,
if he has sold the futures contract?
Numerical 8
Currently, a share is trading at Rs. 1800 and minimum lot is 100. Risk
free rate is 8% and the futures period is 3 months. Calculate the fair
value of 3-months futures.
Numerical 9
A share is selling at Rs. 900. Dividend of Rs. 40 is expected after 6
months and 12 months. The risk free rate is 9%. What is the price of
the 12 months futures?
Numerical 10
Market price of a share at present is Rs. 930 with transaction cost of
2%. A dividend yield of 5% is expected. Risk free rate of return is 10%.
Find out 3 months futures price.
Numerical 11
The shares of Yellow Pages Ltd are being traded at Rs. 250 on BSE. Its
futures for 1 month, 2-months and 3-months are also available one the
BSE. If the risk-free rate is 12% p.a. and no dividend are expected
during this period, what should be equilibrium price of these futures?
Numerical 12
The current market price of XYZ ltd share is Rs. 140 and is expected to
declare dividend of Rs. 10 after 10 days. What should be the price of 2-
months futures, if the risk-free rate is 15%?
Numerical 13
An investors buys 500 shares of X ltd @ Rs 210 per share in the cash
market. In order to hedge, he sells 300 futures of X ltd @ Rs.195 each.
Next day, the share price and futures decline by 5% and 3%
respectively. He closes his positions next day by the counter
transactions. Find out his profit and loss.
Numerical 14
The current spot price of a share is Rs. 450. Annual storage cost is Rs 2
per share payable at the end of the year. Risk-free rate is 7% p.a. Find
out price of one year futures on the shares. Under what situation, an
investor should sell or buy futures contract?
Numerical 15
On 31-08-2023, the value of stock index was Rs.2,200. the risk free rate
of return has been 8% p.a. The dividend yield on this stock index is as
under:
Month Dividend Expected
September 3%
October 4%
November 3%
December 3%
Assuming that interest is continuously compounded daily, find out the
future price of contract deliverable on 31-12-2023
Strategies for Futures Trading:
• The Pullback Strategy
• Going Long
• Breakout Trading
• Spread Trading
 Convenience Yield
• This the additional value of holding the asset rather than having a long forward or futures contract on the asset.

• An example of a consumption asset that has a convenience yield is oil. If you hold oil, you will have the
convenience of selling it at a higher price during a shortage or using it to put it into your car. On the other hand, if
you only had forwards or futures contracts for oil, you wouldn’t have the convenience of putting it into your car!

• If a forward contract has a storage cost, expressed as a percentage of the underlying, as well as a convenience
yield

• The convenience yield is deducted from risk-free rate of interest while finding theoretical value of the future
contract. So, the convenience yield is calculated as

Convenience Yield: Yt = ln (Theoretical Price/Actual Future Price)/t

F = S × e(r-c)t
Numerical 16
Compute convenience yield on a six month contract on Chilli futures
which is currently trading at RS 7,000 per kg and current spot price is
quoted at Rs 6,750 per kg. Assume 8% annual, continuous
compounding interest rate and Rs 10 per kg as storage cost over six
months period paid in advance.
ARBITRAGE
• The theoretical value of forwards or futures calculated is used to know existence of any opportunities
for arbitrage.

• When actual forward/futures price is exactly equal to theoretical value, there will be no opportunity
for arbitrage. The opportunity for arbitrage exists only' when actual forward/futures price is either
greater or less than the theoretical value.

• When actual forward/futures price is greater than theoretical price, (which exists in contango market)
the contract is said to be overpriced and the arbitrage exists for cash and carry (i.e., shorting
forwards/futures contracts).

• If actual forward/futures price is lower than theoretical price (which exists in backwardation market)
the contract is said to be underpriced and arbitrage exists for reverse cash and carry (i.e., taking long
position in forwards/futures contracts).
ARBITRAGE
• Though the arbitrager makes gain in such situations, it has certain risks. For
instance, existence of potential tracking errors and mispricing of the futures
contracts do not stay for long. Hence, the investor needs to be very careful in
trading it. Both the cash and carry and reverse cash and carry arbitrages are
explained as shown below.
ARBITRAGE
Cash and Carry Arbitrage (During Contango Market)
On the date of contract:
1. Borrowing sum equivalent to the amount required for buying underlying asset in cash
market.
2. Buying the underlying asset at the spot rate in the cash market.
3. Shorting forward/futures contract.
On the date of maturity:
l. Selling the underlying asset at the forward/futures price.
2. Repayment of the borrowed money with interest.
The amount received on selling the underlying asset at forward/futures price will be higher
than the amount paid for repayment of borrowed money which is treated as arbitrage gain.
ARBITRAGE
Reverse Cash and Carry Arbitrage (During Backwardation Market)
On the date of contract:
l. Selling the asset at the spot rate in the cash market.
2. Investing the sales proceeds till maturity.
3. Taking long position in forwards/futures contract.
On the date maturity:
I. Realising the investment on the maturity.
2. Buying the asset at forwards/futures price.
The amount received on realizing the investment will be higher than the
amount paid for buying the asset which is treated as arbitrage gain.
Numerical 17
Find out the theoretical price of a stock maturing in six months from now,
which is currently trading at Rs. 220. The annual risk-free rate of return
continuously compounded is 8%
(i) What would an arbitrager do if the six months futures contract on this stock
is trading at Rs 240?
(ii) Does it make any difference if the six months future contract on this stock is
trading at Rs 200? Calculate the arbitrage gain/loss in both the situations.
Solution of Numerical 17
Theoretical Price of the stock: F = S × ert
=220 × 2.71828(0.08*6/12)
= Rs 228.98 per share

(i) Since actual futures price (i.e., 240) is greater than the theoretical price
(i.e., 228.98), the futures contract is overpriced and hence there exists an
opportunity for cash and carry arbitrage which is explained as follows.
Arbitrage process on the date of entering into contract:
l. Borrowing Rs 220 (amount required for buying a share in the spot
market) at annual interest rate of 8% for 6 months
2. Buying the share in the spot market at Rs 220
3. Shorting six month futures contract at Rs 240
Solution of Numerical 17
On Date of maturity of contract:
Selling the share and receiving Rs 240.00
Less: Repaying the borrowed money with interest
[220 + 220 x 8% x 6/12) = 228.80] Rs 228.80
Net gain (per share) Rs 11.20
Solution of Numerical 17
(ii) Since actual futures price (i.e., Rs 200) is lower than the theoretical price
(i.e., Rs 228.80) the futures contract is underpriced and hence there exists an
opportunity for reverse cash and carry arbitrage which is explained as follows.
Arbitrage process on the date of entering into contract:
1. Selling a share in the spot market at Rs 220
2. Investing the amount received from selling the share at 8% for six months
period
3. Taking a long position on the share at Rs 200 to be delivered on the maturity
Solution of Numerical 17
On Date of maturity of contract:
Receivables on realising the investment Rs 228.80
[220 + 220 x 8% x 6/12) = 228.80]
Less: Payment for buying the share
(by exercising the long position on maturity) Rs 200
Net gain (per share) Rs 28.80
Numerical 18
A three months futures contract on ITC is available at Rs. 327 which currently
trading at Rs. 320 in the spot market. Assume that the continuously
compounded, annual risk-free rate of return is 7% and no dividend is expected
from the share in the next three months. Is there any arbitrage opportunity? If
yes, explain the process of arbitrage and find the amount of profit to be made.
Numerical 19
Find out the theoretical price of a stock maturing in six months from now,
which is currently trading at Rs. 540. The annual risk-free rate of return
continuously compounded is 9%.
(i) What would an arbitrager do if the six months future contract on this stock
is trading at Rs. 600?
(ii) Does it make any difference if the six months future contract on this stock is
trading at Rs. 500?
(iii) What are the risks involved in the arbitrage transactions in futures
contracts?
HEDGING STRATEGIES
Hedging refers to an investment made to avoid or reduce the risk arising out of
adverse price fluctuations. In other words, it is an offsetting position in a
related underlying asset of an existing position. Hedging strategies are
classified as follows.
• Short and long hedging
• Cross hedging and Delta hedging
• Static and Dynamic Hedging
• Perfect hedge
Short and Long Hedge
Short hedge involves taking a short position (i.e., selling underlying asset)
through forward/ futures contract. It is used when the hedger (i.e., a person or
a firm) already owns an asset and wants to lock in the price now as the hedger
expects the price may fall in future.
Long hedge involves taking a long position (i.e., buying underlying asset) in
(forward/futures contracts. Long hedge is used when a hedger (i.e., a person or
a firm) knows that it will require a certain asset in the future and wants to lock
in the price now as the hedger expects the price may increase in future.
Cross Hedging
cross hedge occurs when the two assets are different. A mismatch between
the underlying asset to be hedged and underlying asset of futures contract
available, gives rise to cross hedging. For instance, an exporter expecting to
receive Bangla Taka cannot be hedged selling Taka futures because no futures
contracts are available on Taka. But it can be hedged by selling equivalent
futures.
Delta Hedging
A mismatch between maturity of the underlying cash flows and that of futures
contract necessitates for delta hedging. For instance, an Indian exporter
expecting to receive USD in the month of November cannot be hedged in CME
by selling November dollar futures. Because, the futures contracts available in
CME are March, June, September and December only. There is a mismatch
between the month of foreign currency receivables and the month of currency
futures available. Hence, the exporter has to necessarily sell December futures
only and use delta hedging to hedge foreign currency receivables which is
calculated as shown below.
Delta Hedging
N= B x (Cashflow to be hedged/ size of each contract)
N = Number of contracts required to be traded to hedge the investment or
cash flows
B= Regression co-efficient (it measures changes in futures price in relation to
changes in spot rate).
The combination of both delta and cross hedging is known as delta cross
hedging.
Delta Hedging
Assume that an Indian exporter has exported goods worth 1.1 million pound
on 20th April 2016 which is receivable after three months (i.e., on 20th July
2016. The investor is fearing Of depreciation of the Pound sterling in near
future and hence wants to hedge by selling Pound futures in CME. But no July
month contract is available. How many futures contracts are to be sold to
hedge the pound receivables assuming 1.40 as beta value and 62500 as
contract size of Pound futures?
Hedge Ratio
A ratio between the value of a position protected
through a hedge and the size of the entire position is
known as hedge ratio or minimum variance hedge
ratio. It is a ratio between the change in theoretical
futures value and the change in price of the underlying
asset at a given point in time.
Hedge Ratio
Say for instance, if the exporter is expected to receive €
1,25,000 (i.e., foreign currency) which is exposed to
currency risk is hedged to the extent of €62500 with a
currency position. The investor's hedge ratio is said to
be 0.50 (€62500/ € 1, 25,000 x 100). It means 50% of
the position is protected from the exchange rate risk.
The hedge ratio helps to minimize the basis risk and
hence is very important for the investors. Hedge ratio is
calculated as shown below.
Hedge Ratio
Numerical 20
Mrs. Ashwini has bought 3000 shares of MUL at Rs. 7,550 and wants
to keep the investment for another three months but the market is
expected to fall in the near future due to economic recession in the
country. Hence, she wants to hedge the position by shorting three
months Nifty futures which is currently available at 9500 with lot size
of 75 points. The standard deviation of change in the prices of MUL
and Nifty index futures over three months period is 30 and 45
respectively. The co-efficient correlation between the three months
change in the prices of MUL and Nifty futures is 0.90. Find out the
minimum variance hedge ratio.