Futures and Forwards
A future is a contract between two parties requiring deferred delivery of underlying asset (at a contracted price and date) or a final cash settlement.
Both parties are obligated to perform and fulfill the terms. A customized
futures contract is called a Forward
Contract.
Cash Flows on Forwards
Pay-off Diagram:
Spot price of underlying assets
Seller’s pay-offs Buyer’s pay-offs
Futures
Price
Why Forwards?
They are customized contracts unlike Futures and they are:
Tailor-made and more suited for certain purposes.
Useful when futures do not exist for
commodities and financials being considered.
Useful in cases futures’ standard may be
different from the actual.
Futures & Forwards Distinguished
FUTURES FORWARDS
They trade on exchanges Trade in OTC markets Are standardized Are customized
Identity of counterparties is
irrelevant Identity is relevant
Regulated Not regulated
Marked to market No marking to market Easy to terminate Difficult to terminate
Less costly More costly
Important Terms
Spot Markets: Where contracts for immediate delivery are traded.
Forward or Futures markets: Where contracts for later delivery are traded.
Both the above taken together constitute
cash markets.
Important Terms
Futures Series: All with same delivery month with same underlying asset.
Front month and Back month.
Soonest to deliver or the nearby contract
Commodity futures vs. financial futures.
Cheapest to deliver instruments.
Offering lags.
Important Terms
Variation Margin
Deliverables
Substitute for Future Cash Market Transactions
Settlement in Cash
Interest Rate Futures
Two factors have led to growth:
Enormous growth in the market for fixed income securities.
Increased volatility of interest rates.
Futures & Risk Hedging
Interest Rate Risk
Exchange Rate Risk
Commodity Price Risk
Equity Price Risk
Hedging Interest Rate Risk
A CFO needs to raise Rs.50 crores in February 20XX to fund a new investment in May 20XX, by selling 30-year bonds. Hedge instrument
available is a 20-year, 8% Treasury -bond based Future. Cash instrument has a PV01 of
0.096585, selling at par and yielding 9.75%. It
pays half-yearly coupons and has a yield beta of
0.45. Hedge instrument has a PV01 of 0.098891.
Hedging Interest Rate Risk
Hence, FVh= FVc [PV01c / PV01h] y
= 50 [0.096585 / 0.098891] 0.45
= Rs.21.98 Crores
If FV of a single T-Bond Future is Rs.10,00,000 then, Number of Futures (Nf) = 21.98/0.1
= 219.8 Futures
Hedging Interest Rate Risk
If corporate yield rises by 80bp by the time of actual offering, it has to pay 10.55% coupon
semi-annually to price it at par. Thus, it has to pay Rs.50,00,00,000 0.0080 0.5 = Rs.20,00,000 more every six months in terms of increased
coupons.
This additional amount will have a PV at 10.55%
= 20,00,000 PVIFA
5.275%, 60= Rs.3,61,79,720 Rs.3.618 Crores
Hedging Interest Rate Risk
Since corporate yield increases by 80bp, T-Bond yield will increase by 178bp resulting in an
increased profit on short position in T-bond futures
= 22,00,00,000 0.0178 0.5
= Rs.19,58,000 half yearly, which has a PV
= 19,58,000 PVIFA 4,89%,40
= Rs.3,41,09,729
= Rs.3.411 Crores
Why Not perfect Hedge?
PV01 provides accurate and effective hedge for small changes in yields.
PV01s of cash and hedge instruments change at different rates.
PV01s need to be recalculated frequently
(practice is every 5bps). This can change the residual risk profile.
Additional costs related to recalculations need to
be kept in mind.
A Transaction on the Futures Exchange
.
Buyer
Buyer’sBroker ExchangeFutures3
Buyer’s Broker’s Commission Broker
Futures Clearing
House
Buyer’s Broker’s
Clearing Firm Buyer’s Broker’s
Clearing Firm Seller’s Broker’s
Commission Broker Seller’s
Broker
Seller
1a 1b Buyer and seller instruct their respective brokers to conduct a futures transaction.
2a 2b Buyer’s and seller’s brokers request their firm’s commission brokers execute the transaction.
3 Both floor brokers meet in the pit on the floor of the futures exchange and agree on a price.
4 Information on the trade is reported to the clearinghouse.
5a 5b Both commission brokers report the price obtained to the buyer’s and seller’s brokers.
6a 6b Buyer’s and seller’s brokers report the price obtained to the buyer and seller.
1a 6a 7a
2a 5a
8a
4
8b9a 9b
2b 5b
1b 6b
7b
Note: Either buyer or seller (or both) could be a floor trader, eliminating
Exchange Rate Risk Hedging
Currency hedge is a direct hedge and not
a cross hedge as in case of interest rate
risk hedging. Hence, a hedge ratio of 1:1
works very well.
Forward Rate Agreements (FRAs)
FRAs are a type of forward contract wherein
contracting parties agree on some interest rate to be paid on a deposit to be received or made at a later date.
The single cash settlement amount is determined by the size of deposit (notional principal), agreed upon contract rate of interest and value of the
reference rate prevailing on the settlement date.
Determination of Settlement Amount
Step-1:Take the difference between contract rate and the reference rate on the date of contract settlement
Step-2: Discount the sum obtained using reference rate as rate of discount.
The resultant PV is the sum paid or received. The
reference rate could be LIBOR (most often used) or
any other well defined rate not easily manipulated .
Hedging with FRAs
Party seeking protection from possible
increase in rates would buy FRAs (party is called purchaser) and the one seeking
protection from decline would sell FRAs (party is called seller).
These positions are opposite of those
employed while hedging in futures.
Illustration
A bank in U.S. wants to lock-in an interest rate for
$5millions 6-month LIBOR-based lending that
commences in 3 months using a 39 FRA. At the time 6-month LIBOR (Spot Rate) is quoted at 8.25%. The
dealer offers 8.32% to commence in 3 months. U.S. bank
offers the client 8.82%. If at the end of 3 months, when
FRA is due to be settled, 6-month LIBOR is at 8.95%,
bank borrows at 8.95% in the Eurodollar market and
lends at 8.82%.
Illustration
Profit/Loss= (8.82-8.95) 5 millions 182/360
= - $3286.11
Hedge Profit/Loss = D(RR-CR)NP182/360
= 1 (8.95-8.32) 5 millions182/360
= $15925
Amount Received/Paid
= $15925/1.04525= $15235.59
Index Futures Contract
It is an obligation to deliver at
settlement an amount equal to ‘x’ times the difference between the stock index value on expiration date and the
contracted value
On the last day of trading session the
final settlement price is set equal to the
spot index price
Illustration (Margin and Settlement)
The settlement price of an index futures contract on a particular day was 1100. The multiple associated is 150.
The maximum realistic change that can be expected is 50 points per day. Therefore, the initial margin is 50×150 = Rs.7500. The maintenance margin is set at Rs.6000. The settlement prices on day 1,2,3 and 4 are 1125, 1095,
1100 and 1140 respectively. Calculate mark-to-market
cash flows and daily closing balance in the account of
Investor who has gone long and the one who has gone
Short at 1100. Also calculate net profit/(loss) on each
Illustration
Long Position:
Day Sett. Price Op. Bal. M-T-M CF Margin Call Cl. Bal
1 1125 7500 + 3750 - 11250
2 1095 11250 - 4500 - 6750
3 1100 6750 + 750 - 7500
4 1140 7500 + 6000 - 13500
Net Profit/(loss) = 3750-4500+750+6000 = Rs. 6000 Short Position: Day Sett. Price Op. Bal. M-T-M CF Margin Call Cl. Bal 1 1125 7500 - 3750 2250 6000
2 1095 6000 + 4500 - 10500
3 1100 10500 - 750 - 9750
4 1140 9750 - 6000 2250 6000
Pricing of Index Futures Contracts
Assuming that an investor buys a portfolio consisting of stocks in the index, rupee
returns are:
RI = (IE – IC) + D, where
RI = Rupee returns on portfolio IE = Index value on expiration IC = Current index value
D = Dividend received during the
Pricing of Index Futures Contracts If he invests in index futures and invests the money in risk free asset, then
RIF = (FE – FC) + RF, where
RIF = Rupee return on alternative investment FE = Futures value on expiry
FC = Current futures value
RF = Return on risk-free investment
Pricing of Index Futures Contracts
If investor is indifferent between the two options, then
RI = RIF
i.e. (IE-IC) + D = (FE-FC) + RF Since IE = FE
FC = IC + (RF – D)
(RF – D) is the ‘cost of carry’ or ‘basis’ and the
futures contract must be priced to reflect ‘cost
Stock Index Arbitrage
When index futures price is out of
sync with the theoretical price, the an investor can earn abnormal risk-less profits by trading simultaneously in
spot and futures market. This process is called stock index arbitrage or
basis trading or program trading.
Stock Index Arbitrage: Illustration
Current price of an index = 1150
Annualized dividend yield on index = 4%
6-month futures contract price = 1195 Risk-free rate of return = 10% p.a.
Assume that 50% of stocks in the index will pay dividends in next 6 months. Ignore
margin, transaction costs and taxes. Assume a
multiple of 100. Is there a possibility of stock
Stock Index Arbitrage: Illustration
Fair price of index future FC = IC + (RF – D)
= 1150 + [(1150×0.10×0.5)-(1150×0.04×0.5)]
= 1150 + 34.5 = 1184.5 (hence it is overpriced) Investor can buy a portfolio identical to index and short-sell futures on index.
If index closes at 850 on expiration date, then
A.
Profit on short sale of futures (1195 – 850) ×100 = Rs.34,500
B.
Cash Div recd on port. (1150 × 0.04 × 0.5 × 100 = Rs. 2,300
C.
Loss on sale of port. (1150 – 850) ×100 = ( - ) Rs.30,000
D.
Net Profit = 34,500 +2,300 – 30,000 = Rs.6,800
E.