Application of Futures
Chitra Potdar
The Future Payoffs
The payoff for a person who buys a futures contract
is similar to the payoff for a person who holds an
asset
He has a potentially unlimited upside as well as a
potentially unlimited downside
For e.g. a speculator who buys a two-month Nifty
index futures contract when the Nifty stands at 2220
The underlying asset in this case is the Nifty
portfolio. When the index moves up, the long futures
position starts making profits, and when the index
moves down it starts making losses
The Future Payoffs for the
Buyer
The Future Payoffs for the
Seller
Valuation of Stock Index
A stock index traces the changes in the value
of hypothetical stocks
The value of a futures contract on a stock
index may be obtained by using the cost of
carry model
The asset price today would simply be the
future price less the cost of storage and
interest
Valuation of Futures
Futures price = Spot price + Cost of Carry
Spot price is the price of the asset today (in
the cash market)
Cost of carry is the sum of all costs incurred if
a similar position is taken in cash and carried
to expiry of the futures contract LESS any
revenue that may arise out of holding the
asset. The cost is typically interest cost and
revenue is in the form of dividend
Valuation of Futures
Future price = Spot price + Cost of
carry - Inflows
Cost of carry = Financing cost, storage
cost and insurance cost
Inflows = Dividend or interest income
The difference between the Future price and
the Stock price is Basis
Valuation of Futures
Mathematical terms
Compounding F = S(1+r/m)mt
Continuous Compounding F = Sert
r = Cost of financing (using continuously
compounded interest rate)
T Time till expiration in epsilon 2.71828
Valuation of Futures
Securities Providing no income
F = Sert
Securities Providing an expected cash Income
/ Dividend
F = (S - I)ert , wherein I = de-rt’
Securities Providing a known yield
F = Se (r-y)t
Illustration 1
Securities providing no income
Security XYZ Ltd trades in the spot market at
Rs. 1150. Money can be invested at 11%
p.a. What is the fair value of a one-month
futures contract on XYZ?
Illustration 1 - Answer
Illustration 2
Pricing index futures given
expected dividend
An equity share of IPCL quoting at Rs.270/-
on 1.1.2007 in the cash market & the future
price with March 2007 expiration date,
quoting at Rs.275/- The borrowing rate is
10% & the expected dividend payable before
31.03.2007 is Rs.2.50. What is the 3 month
futures price of IPCL as on 1.1.2007?
Illustration 3
Pricing index futures given
expected dividend yield
A two-month futures contract trades on the
NSE. The cost of financing is 10% and the
dividend yield on Nifty is 2% annualized. The
spot value of Nifty 4000. What is the fair
value of the futures contract?
Illustration 3
Pricing of Futures
Consider a 3 month expiry futures contract
on a stock. The underlying stock is available
for Rs.70 (Face value Rs.10). With
continuously compounded risk free rate of
8% p.a. find out the price of a Future under
various circumstances
Pricing of Futures
When the stock does not pay dividend
Ans : 71.414
When the stock pays a dividend of 5%
Ans : 70.53
When the stock pays a dividend of Rs.1.50/-
Ans : 69.91
When the stock Pays a dividend of 1.50 in a
month’s time
Ans : 69.89
Pricing of Futures
4. When the stock pays a dividend of Rs.
2/- today
Ans : 69.37
5. When the stock pays a dividend of 10%
today
Ans : 70.39
Pricing of Index Futures
A futures contract on the stock market index
gives its owner the right and obligation to
buy or sell the portfolio of stocks
characterized by the index
Stock index futures are cash settled; there is
no delivery of the underlying stocks
Pricing of Index Futures
The main differences between commodity
and equity index futures are that
There are no costs of storage involved in
holding equity
Equity comes with a dividend stream,
which is a negative cost if you are long the
stock and a positive cost if you are short
the stock
Pricing of Index Futures
Cost of carry = Financing cost – Dividends
A crucial aspect of dealing with equity futures
as opposed to commodity futures is an
accurate forecasting of dividends
The better the forecast of dividend offered by
the better is the estimate of the futures price
Pricing of Index Futures
The pricing of stock futures is also based on
the cost-of-carry model, where the carrying
cost is the cost of financing the purchase of
the stock, minus the present value of
dividends obtained from the stock
If no dividends are expected during the life of
the contract, pricing futures on that stock is
very simple. It simply involves multiplying the
spot price by the cost of carry
Pricing of Index Futures
Ft = St [1+(rt) (T/365) – (dt) (T/365)]
where St = Spot price of Index
T = the no of days until expiration
Ft = Fair value of futures contract that
expires in T days
rt = risk free rate of return for T days
dt = dividend yield for the T days
Illustration - 1
If NSE spot index is 4000, the cost of
borrowing is 10.50% and the expected
dividend yield is 2%p.a. What is the fair value
of the Nifty futures contract with one month
expiration?
= 4000 [1+0.1050*30/365 – 0.02*(30/365)]
= 4027.95
Illustration -2
Consider a 3 month expiry futures contract on
an index. The underlying index is available for
4000. With continuously compounded Risk
free rate (CCRI) of 8% p.a. For each of the
scenario the price of the index is
Illustration -2
When the dividend yield is 5% and only 50%
of the stocks in the index distribute dividends
Ans : 4055 [4000* e(0.08-0.5*0.05)*0.25]
When the dividend yield is 5% and only 25%
of the stocks in the index distribute dividends
Ans : 4068
Effect of Corporate announcements
on stock future prices – Role of
Exchange
If announcements like dividends, bonus, stock split,
rights etc. are made by the company the exchange
adjusts the future position on cum-benefit and on ex-
benefit day is the same
As per the policy and the stock exchanges if the
dividend is more than 10% of the market price of the
stock on the day of the announcement, the future
price is adjusted
The exchanges rollover the positions from the last-
cum-dividend day to the ex-dividend day by reducing
the settlement price by dividend
Future Price Indicators
1. Volume and Open Interest
2. Market wide Open Interest
3. Cost of Carry and Basis
Volume and Open Interest
Is the total no of shares or contracts that
have changed hands in one day trading
session in the market
Open interest is the no of contracts that are
bought but not yet settled
Volume and open interest can be a barometer
of future activity and direction
Future Price Indicators
A price change on a “low” volume is a
correction – against the direction of the major
price trend
A price change on a “high” volume is a signal
in the direction of the major price trend
Futures is the zero sum game i.e. losers
provide the funds to the winners (those who
predicted the correct trend)
Future Price Indicators
The trend could be up or down
If the winners are bulls i.e. market is going
up, increasing open interest means upward
price move would continue
If the winners are bears i.e. market is going
down, increasing open interest means
downward price move would continue
Increasing open interest means the players
are betting on the prevailing price trend and
the trend is expected to continue and vice
versa
Future Price Indicators
Open
Price Volume Interest Change in market
Rising Up Up New money enetring market
Rising Down Down Money Leaving Market
Declining Up Up Aggressive New Short Selling
Liquidation by discouraged
Declining Down Down traders, market bottoms out,
a bullish signal
Cost of carry in the rising and
falling market
Incremental cost of carry + incremental long position
= Fresh Long position
Reducing cost of carry + Reducing open interest =
Long squaring
Reducing cost of carry + Increasing open interest =
Fresh Short position
Increasing cost of carry + Decreasing open interest
= Short covering
