Chapter 2 Forwards Futures

Derivatives and Risk ManagementBy Rajiv Srivastava

Copyright © Oxford University Press

In most cases we acquire assets and pay for it simultaneously. The price of the asset and the settlement (exchange of asset and its consideration) are done at the same point of time.

Forward contract is an agreement to buy or sell an asset at a price determined now but is settled later at a predetermined date.

Forward contract enables elimination of price risk faced by both buyer and seller of asset.


Forward contract is an OTC product tailored to meet specific needs but with counterparty risk. Features are:• Over-the-Counter (OTC) Product, where • The price is determined now, with• Mutual obligation to perform, assuming • Counter-party risk, and • Mutual consent required for cancellation,

involving • No front-end payment


by delivery of asset and the consideration:if an exporter sold Euro 10,000 to a bank 6-m forward at Rs 66 then at maturity, the contract is settled by delivery of Euro 10,000 and bank would pay Rs 6,60,000; or

by entering into an offsetting contract opposite to the original contract at maturity or prior, at a price prevailing then: For example the exporter having sold 6-m forward Euro 10,000 at Rs 66.00 may after 3 months, decide to buy 3-m forward Euro 10,000 at Rs 67.00 per Euro.


Forward contracts are subject to high default risk as the price scenario at maturity can favour only one party and not both. Futures being exchange traded do not have any such risk.

Futures are similar to a forward contract but are exchange traded.

Since futures are exchange traded do not have counter-party risk with exchange serving as counter-party to both buyer and seller.


For trading at the exchange the contract need to be standardized.

Standardization of the contract needs to be done for • Size of the contract• Delivery of the contract obligations• Quotations of the price• Specification of the underlying asset

Futures is a standardized forward contract that is traded on an exchange.


Chapter 2 Forwards and Futures

Derivatives and Risk ManagementBy Rajiv Srivastava 7

Futures Contract on Gold at National Multi-Commodity Exchange of Asset Code GOLDUnit of Trading 100 gms of Fineness .999Delivery Unit Gold Bars of 100 grams serially numbered and of fineness .999

Quotation/Base Value 10 grams of fineness .999Tick Size Re.1Quality Specification The Gold delivered under the contract must be Gold Bars weighing 100

grams each and assaying not less than .999 fineness bearing a serialnumber and identifying origin of the refiner/brander.

No. of delivery Contracts in a year

Maximum 12 monthly or minimum 2 monthly contracts runningconcurrently

Delivery Centres CWC, CochinOpening of Contracts Trading in any contract month will open on the 16th day of the month,

12 months prior to the contract month

Due Date 15th day of the delivery months if 15th happens to be holiday thenprevious working day.

Closing of Contract Squaring up of positions will be permitted between 12th and 15th ofdelivery month. No fresh positions building will be allowed. From 12th to15th of delivery month, seller can tender Warehouse Receipt forsettlement and Warehouse Receipt will be accepted for settlement atclosing price of the previous day.

Delivery Logic Compulsory Delivery


Major advantages of the futures as against the forward contract are • the elimination of counter-party risk, • flexibility of entry and exit anytime, and • cash settlement.

Position in futures is mostly settled not by delivery but by entering into a contract, at maturity or prior opposite to the initial one with difference in the prices of the initial and subsequent contracts settled.


Open interest and volumes are often thought to be same. However they are different. • Open interest is the number of futures contracts

outstanding. It reduces to zero upon maturity of the contract.

• Volume refers to the number of contracts traded in a day.

Open interest is the number of new contracts opened. The contracts that offset initial position do not add to the open interest but they do add to the volume.


From cash flow perspective, there are 2 differences in futures and forward contracts:1. Initial and Variation Margins2. Marking-to-market (MTM)• To cover the default risk the exchange requires

initial margin before futures position is opened.• The position is also marked-to-market (MTM) on

daily basis; i.e. profit/loss settled on daily basis. • The margin cannot fall below a minimum level due to

MTM and if it does, then margin call is made to replenish the same.




MARKING TO MARKETDay Price (Rs) Cash Flow (Rs) RemarksDay 1Opening a contract

410 None A long position opened for one contract (400 shares) valued at Rs 1,64,000

Close Day 1

420 (420 - 410) x 400 = + 4,000

Investor receives Rs 4,000

Close Day 2

400 (400 – 420) x 400 = - 8,000

Investor pays Rs 8,000

Close Day 3

390 (390 – 400) x 400 = - 4,000

Investor pays Rs 4,000

Day 4Closing the contract

440 (440 – 390) x 400 = + 20,000

Position closed out with contract value of Rs 1,76,000. Investor gets Rs 20,000

Net Profit (440 – 410) x 400 = 12,000

It remains the difference of opening and close prices.




Features Futures ForwardsLocation Exchange Over the CounterCounter party Unknown to each other,

Exchange serves counter partyCounter parties are known to each other

Counter party risk Minimal ExistsInitial Cash flow Initial margin required NoneExplicit cost Brokerage required to be paid No intermediary and no costSettlement Implicitly daily by marking to the

market No marking to the market

Final settlement By delivery or cash settled By deliveryExit prior to maturity Possible by entering an opposite

contract to square up the positionGenerally not possible unless both the parties agree.

Quantity specification Fixed standard size/lot Any quantityTime of Delivery On fixed dates Any time mutually decided by

the parties concerned

Cost of hedging Very nominal HighPeriod of hedging Contracts available for limited

periodUnlimited


From pricing perspective forward and futures follow the same principle.

Futures price is based on spot price and the cost of carry for the period less benefits of ownership.• F1 = S0 x (1+r) • F1 = S0 x ert for continuous compounding

Where F1 is forward/futures price with contract expiring at t = 1, S0 is spot price at t = 0 and r is the cost of carry for the period 0 to1.


Cost of carry model eliminates arbitrage. If mispriced it offers arbitrage one way or the other.

Cash and Carry Arbitrage: When futures is overpriced: Spot price of 10 gms gold at Rs 7,000 Risk free rate of 10% per annum forward contract period of 1 year is Rs 8,000

Arbitrageur can take following actions at t = 0: Borrow Rs 7,000, Buy gold spot, and Sell forward contract at Rs 8,000.


At the end of futures contractRealise cash from forward contract + Rs 8,000Pay back the borrowed money

and interest thereon - Rs 7,700Profit Rs 300

Since futures was overpriced by Rs 300 the arbitrageur can pocket this profit by selling the futures first and buying gold by borrowing.


When futures is underpriced at Rs 7,300 the arbitrageur can take following actions: Borrows gold Sells gold at Rs 7,000 and lends at 10% and Buys a forward contract at Rs 7,300.

One year later following cash flow will result: Realise cash from lending activity + Rs 7,700 Pay for the forward contract & return

borrowed gold - Rs 7,300Profit Rs 400


For investment assets both cash and carry and reverse cash and carry arbitrage are possible.

Consumption value associated with commodities tests the arbitrage argument.

For consumption asset while strategy of cash and carry can be implemented but the reverse cash and carry is not be possible.

One cannot sell a commodity required for consumption purposes, and buy futures contract instead.


If F1 is the forward price and S0 is the spot price and T is the maturity then at inception, value of the forward contract, f = S0 – F1 . e-rT

= 0Once entered forward contract would have

value.For initial long position Cash flow at t = T

Under initial long contract; pay - F1

Under subsequent short contract; receive + F2

Net cash flow F2 – F1

Value of the forward contract, f = (F2 – F1) . e-rT


The current price of Bharti’s share is Rs 800. An investor, A goes long with the 6 months contract. After one month another investor, B is prepared to buy Bharti Share at Rs 925 for delivery after 5 months. If the risk free interest rate is 9% per annum what is the value of the forward contract?SolutionAs of now 5 months are left for the expiry with payment of Rs 900 to get the delivery of share. If A goes short he would receive Rs 925. Therefore the value of the forward contract, f is PV of the difference of current price and original contract price

= (925 – 900) x e-0.09 x 5/12 = Rs 24.08


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 Spot and Futures PricePrice

Futures

Net cost of carry Maturity

Spot

Time


The price of futures and forward are identical in perfect markets.

Futures price would be marginally different from forward depending upon the correlation of price with interest rates.Correlation of Spot & Interest Relationship of

Price• Positive Correlation Futures Price > Forward Price• Negative Correlation Futures Price < Forward Price• No Correlation Futures Price = Forward Price


Normal backwardation hypothesis states that the current future price is a downward biased indicator of the future spot price.

When futures price is more than the expected future spot price it is referred as contango.

Expected hypothesis assumes that the futures price is an unbiased indicator of the expected spot price.


Futures are broadly of two types; • Commodity futures, and • Financial futures

Commodity futures are those where the underlying asset is a commodity. Contracts are available in India on agricultural

commodities like Wheat, Rice, Soya, Coffee, Sugar, Tea, Jeera, Pepper, Edible oils, Cotton, Coconut, etc. Contracts on metals Gold, Silver, are also available. Futures contracts on oil are also commodity futures.


Financial futures are those where underlying asset is a financial product. These are: Currency Futures are those where the underlying assets

are currencies. Stocks/Index futures are those where the underlying are

stocks or indices. Stock futures were introduced in India on June 12, 2000 for Indices and on November 9, 2001 on select individual securities, at NSE.

Interest Rate futures are those where underlying assets are interest rates. In India interest rate futures were launched on June 24, 2003 at NSE.


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Chapter 2 Forwards Futures