CA-FINAL FUTURE, INDEX

Transcription

1 CA-FINAL SFM FUTURE, INDEX RAJESH RITOLIA, FCA HELPING HAND INSTITUTE G-80, 2 ND FLOOR, GUPTA COMPLEX, LAXMI NAGAR, DELHI-92 PH: , rritolia@correctingmyself.in; Web: correctingmyself.in Note: (a) (b) (c) (d) Video CD of missing classes will be provided free of cost Updated notes can be downloaded free of cost from our website: correctingmyself.in Updated classes can be covered in future at free of cost Notes also cover Suggested, RTP Positive Thoughts Just be yourself, utterly yourself. And don t be bothered about what kind of flower you turn out to be. It does not matter whether you are a rose or a lotus or a marigold, what matters is flowering. Earth provides enough to satisfy every man s needs, but not every man s greed. Nature does not hurry, yet everything is accomplished. Whenever you find me wrong, bad or rude at any point of time, at least tell me once before telling the whole world We can save many relations, If we understand as simple fact that people are not wrong. They are different. Judging a person does not define who they are. It defines who you are When you come to a point, where you have no need to impress anybody, your freedom will begin.

2 Future and Index Analysis THEORY T M11 N11 M12 N12 M13 N13 M14 N14 M15 N15 PRACTICAL P M11 N11 M12 N12 M13 N13 M14 N14 M15 N15

3 Chap 11B SUMMARY OF FUTURE 11BA.1 Index Particulars Summary of Topics Q No Exam RTP 11B.0 Future Futures: It is a contract to buy or sell a stated quantity of a commodity or a financial claim at a specified price at a future specified date. Obligation to Both Party Underlying Assets Settlement of Futures Features of Future The parties to the futures have to buy or sell the assets regardless of what happens to its value during the intervening period or what shall be the price on the date for which contract is finalized. Future can be of commodities such as agricultural products, oil, gold etc. or of financial claims such as shares, debentures, treasury bonds etc. The futures contract provide for the physical delivery of the assets, however in practice, all futures are settled by offsetting futures contract. Stock futures are cash settled. No delivery is made. Profits/losses of futures contracts are paid/ recovered over everyday at the end of trading day, a practice called marking to market. These profits and loss are calculated on the future price at close of trading day. No mark to market is done on the settlement day. The settlement is done on the basis of futures closing price on previous trading day and the closing spot price on the day of settlement. Standardization: Each Future contract is for a standard specified quantity, grade, coupon rate, maturity. Clearing House: An organization called future exchange will act as a clearing house. The exchange provides the counter party guarantee through its clearing house and different types of margins system. Margins: Clearing house requires the participants to keep margin money. Time Spreads: There is relationship between the spot price and the future price of contract. The difference between spot price and future price is known as time spread. Uses of Future a) Hedging: Futures are used for hedging the risk arising out of the investment b) Speculation gains (by taking the risk of speculative loss) can be made. c) Arbitrage gain can be made by comparing TFV with actual price of future 11B.1 Settlement of Future and Option on every day [Speculative Transaction] Future and options are settled every day on the basis of closing price of underlying assets Gain/Loss on every day settlement, are transferred to margin money account. On every day settlement, closing price becomes contract price for next day settlement. 1-4 M-13 Settlement of Future before maturity Settlement of Future on maturity Settlement of Long Position on Future [Purchased] Gain/Loss = Sale Purchase Purchase Price of future = Fixed at beginning Sale Price of future = Price of Future on Settlement Date Settlement of Long Position on Future [Purchased] Settlement of Short Position on Future [Sold] Gain/Loss = Sale Purchase Sale Price of future = Fixed at beginning Purchase Price of future = Price of Future on Settlement Date Settlement of Short Position on Future [Sold]

4 Chap 11B SUMMARY OF FUTURE 11BA.2 Gain/Loss = Sale Purchase Purchase Price of future = Fixed at beginning Sale Price of future = Price of UA on Maturity Date Gain/Loss = Sale Purchase Sale Price of future = Fixed at beginning Purchase Price of future = Price of UA on Maturity Date 11B.2 Settlement of Future or Option before maturity date 5 11B.3 Calculation of Theoretical Price of Future/Forward If there is no Income from UA If there is Income from UA Basis Contango Backwardation TFV of future = CMP of UA*(1+PIR) or CMP of UA*e rt OR TFV of future = CMP of UA + Cost to Carry(Intt Amt) TFV of future = CMP of UA*(1+PIR 1) Income from UA*(1+PIR 2) TFV of Future = (CMP of UA PV of Income from UA)*(1+PIR) In general future price is greater than the CMP of UA. In special cases, when the cost of carry is negative the future price may be lower than spot price. = Future Price CMP of UA Generally basis will decrease with time and on expiry, the basis is zero and future price equals spot price. If the future price is greater than spot price it is called contango. If the Spot price is greater than Future price it is called backwardation N-12 11B.4 Arbitrage Opportunity If CMP of Future is not equal to TFV of Future, then Arbitrage Profit is possible as follows 10 N-09-O If CMP of Future > TFV of Future If CMP of Future < TFV of Future M-04 Today Sell Future at CMP [Creating Risk] Buy UA at CMP [Reducing Risk of(a)] Borrow required amt at interest rate given Maturity Date Gain/Loss on settlement of Future [Short Position] Sell Shares at Market Price Repayment of Borrowing with interest This is called cash and carry arbitrage Today Buy Future at CMP [Creating Risk] Sell UA at CMP [Reducing Risk of(a)] Deposit required amt at interest rate given Maturity Date Gain/Loss on settlement of Future [Long Position] Buy Shares at Market Price Realisation of Deposit with interest This is called reverse cash and carry arbitrage

5 Chap 11B SUMMARY OF FUTURE 11BA.3 11B.4.1 If Interest rate is compounded periodically If Interest rate is compounded periodically, then we will calculate TFV of future with compounding interest If Monthly interest = X p.m., Period of Future = 6 months TFV of 6 months Future = CMP of UA(1+PIR) n TFV of 6 months Future = CMP of UA(1+X) 6 11 M-09 11B.4.2 Calculation of arbitrage profit if dividend is paid If Dividend amt and its payment date is given 12 If CMP of Future > TFV of Future Same Process as above If CMP of Future < TFV of Future Same Process as above Additional Steps Add: FV of Income received from UA Less: Loss FV of Income Lost from UA 11B.4.3 If Dividend rate and its payment date is given Dividend Amt = Face Value*Dividend Rate 13 N-08-O 11B.4.4 If Dividend yield is given but its payment date is not given Dividend yield is return on market price of share, hence we will calculate net interest rate Net Interest = Interest Rate Dividend Yield 14 11B.4.5 Arbitrage Profit in case of Commodity Future TFV of Commodity Future = CMP of UA(1+PIR 1) + Storage Cost(1+PIR 2) 15 If CMP of Future > TFV of Future Today Sell Future at CMP [Creating Risk] Buy UA at CMP [Reducing Risk of(a)] Borrow required amt at interest rate given Maturity Date Gain/Loss on settlement of Future [Short Position] Sell Shares at Market Price Repayment of Borrowing with interest less: FV of Storage Cost If CMP of Future < TFV of Future Today Buy Future at CMP [Creating Risk] Sell UA at CMP [Reducing Risk of(a)] Deposit required amt at interest rate given Maturity Date Gain/Loss on settlement of Future [Long Position] Buy Shares at Market Price Realisation of Deposit with interest Add: FV of Storage Cost 11B.5 Hedging through Future In Forex, hedging is done in following ways: If LHC is to be sold in future, then we should sell future. If LHC is to be purchased in future, then we should buy future M-15 N-11 N-06 N-15 M-14

6 Chap 11B SUMMARY OF FUTURE 11BA.4 11B.6 Calculation of Spot price of Underlying Assets if fair value of Future is given TFV of Future = CMP of UA*(1+PIR) or CMP of UA*e rt CMP of UA = TFV of Future/(1+PIR) or TFV of Future/ e rt 20 N-11 N-06 11B.7 Convenience yield In case of some products the supply of the commodity is quite uncertain. In this case, holding the commodity in store is more convenient than buying on future basis. The convenience yield reflects the market s expectation regarding the future availability of the commodity. The greater the possibility that storages will occur, the higher the value of convenience yield and vice versa. Convenience yield is nil for the items which can not be stored. For example electricity. Future Price = (Spot Price + Storage Cost PV of Convenience yield)*(1+r) 21 11B.8 Hedge Ratio in case of hedging through It says about how much quantity of Commodity Future to be contracted for 100% hedging 22 M-12 N-14 Hedge ratio = r SD SP/SD FP N-13 11B.9 Theory What are the features of Futures Contract? 1 N-10 M-07 Distinguish between Forward and Futures contract 2 N-08 M-06 Write short notes on stock lending scheme 3 M-08 M-05

7 Chap 11B FUTURE 11BB.1 11B.0 Future [Nov b-4] What are the features of Futures Contract? [May c-4] (i) What are Stock futures? (ii) What are the opportunities offered by stock futures? (iii) How are stock futures settled? a) Futures: It is a contract to buy or sell a stated quantity of a commodity or a financial claim at a specified price at a future specified date. (i) (ii) (iii) (b) (i) (ii) (iii) (iv) (c) (i) (ii) Obligation to Both Party The parties to the futures have to buy or sell the assets regardless of what happens to its value during the intervening period or what shall be the price on the date for which contract is finalized. Underlying Assets Future can be of commodities such as agricultural products, oil, gold etc. or of financial claims such as shares, debentures, treasury bonds etc. Settlement of Futures The futures contract provide for the physical delivery of the assets, however in practice, all futures are settled by offsetting futures contract. Stock futures are cash settled. No delivery is made. Profits/losses of futures contracts are paid/ recovered over everyday at the end of trading day, a practice called marking to market. These profits and loss are calculated on the future price at close of trading day. No mark to market is done on the settlement day. The settlement is done on the basis of futures closing price on previous trading day and the closing spot price on the day of settlement. Features of Future Standardization: Each Future contract is for a standard specified quantity, grade, coupon rate, maturity. Clearing House: An organization called future exchange will act as a clearing house. The exchange provides the counter party guarantee through its clearing house and different types of margins system. Margins: Clearing house requires the participants to keep margin money. Time Spreads: There is relationship between the spot price and the future price of contract. The difference between spot price and future price is known as time spread. Opportunities offered by Stock futures Stock futures offer high leverage. This means that one can take large position with less capital. For example, paying 20% initial margin one can take position for 100%, i.e., 5 times the cash outflow. Futures may look over-priced or under-priced compared to the spot price and can offer opportunities to arbitrage and earn riskless profit. Ex of Future or Forward Contract Today date = 01/01/2012 CMP of Share of Reliance = Rs 1000 = known as spot price Mr A wants to purchase share of Reliance on 31/03/2012, but he has fear that price of share may go up, then how he can hedge himself from rising of prices. For hedging, he may enter into (i) Call Option (ii) Forward Contract (iii) Future (iv) Index Future Understanding of Forward Contract Mr A has entered into Contract for purchase of 100 shares of Reliance directly from Mr B with following terms & Conditions Contract price of Share = Rs.1050 [known as Forward Price, Specified Price]

8 Chap 11B FUTURE 11BB.2 Maturity Date = 25/03/2012 Under Standing of above Contract (a) The above contract is known as Forward Contract (b) Risk of above contract lies with each party in case of default by other party. (c) Maturity Date can by any date as decided between Mr A and Mr B. (d) Quantity of Underlying Assets can be decided between A and B (e) CMP of share is Rs.1000 while Price of Forward Contract is Rs.1050 as decided between Mr A and Mr B. (f) Both the party has an obligation to fulfill the contract. (g) The above contact can be interpreted as Mr A has purchase Forward due on 25/03/2012 for 100 shares Understanding of Future Contract Mr A has entered into Contract for purchase of 100 shares of Reliance though Stock Exchange from Mr B with following terms & Conditions Maturity Date = Last Thursday of March [Fixed] Contract price of Share = Rs.1050 [known as March Future Price] Under Standing of above Contract (a) The above contract is known as Future. Future is recognized by Month (Like Jan Future, Feb Future, March Future) (b) Risk of above contract lies with Stock Exchange in case of default by each party. (c) Maturity Date for March Future will be last Thursday of Month (d) Quantity of Underlying Assets is fixed by stock exchange in lot for each future. (e) CMP of share is Rs.1000 while CMP of March Future is Rs (f) Both the party has an obligation to fulfill the contract. (g) The above contact can be interpreted as Mr A has purchase March due on last Thursday of March for 100 shares (h) Share is known as underlying assets for future. (i) (j) By purchasing future, Mr A has fixed its purchased price. By selling Mr B has fixed its selling price. [Known as hedging] Mr A is known as in Long position and Mr B is known as in Short Position (k) Mr A and Mr B both enter into contract with Stock Exchange but not with each other. (l) Both the parties have to deposit margin money with the stock exchange, say Rs (m) Future is settled every day and any surplus and deficit is added to or deducted from margin money account. (n) Every day there will be two prices. [First one is price of Underlying Assets and Second one is price of Future of each month] Now suppose, Actual price of share and March future increase or decrease as follows Date Actual price of Share Actual price of March Future Future is settled every day on the basis of Future price Gain/(Loss) to Mr A Balance in Margin Money Gain/(L oss) to Mr B Balance in Margin Money 05/01/2012 Rs.1020 Rs.1060 ( )*100 = /01/2012 Rs.1030 Rs.1070 ( )*100 = /02/2012 Rs.1050 Rs.1120 ( )*100 = /02/2012 Rs.1010 Rs.1055 ( )*100 = /03/2012 Rs.980 Rs.1010 ( )*100 = /03/2012 Rs.1010 Rs.1015 ( )*100 = /03/2012 Rs.1040 Rs.1045 ( )*100 = /03/2012 [Settlement Day] Rs.1030 Rs.1030 ( )*100 = Case-1 Final Settlement as on 31/03/2013 [Speculative Profit/Loss] Gain/(Loss) to Mr A = Sale Price (In Market) Purchase Price (Contracted Price) = Rs.1030 Rs.1050 = - Rs.2000 [Loss]

9 Chap 11B FUTURE 11BB.3 Gain/(Loss) to Mr B = Sale Price (Contracted Price) Purchase Price (From Market) = Rs.1050 Rs.1030 = + Rs.2000 [Gain] Case-2 Final Settlement as on 31/03/2013 [Hedging] Purchase Price of Share to Mr A = Rs.1050 Sale Price of Share for Mr A = Rs.1050 Case-3 Suppose Mr A wants to Settle March Future on 05/02/2012. Originally Mr A has purchased Future of Now to cancel original purchase future on 05/02/2012, Mr A will have to sale March for 100 shares Gain or Loss to Mr A on early settlement = Sale Price (New Contract) Purchase Price (Old Contract) = Rs = Rs.70*100 = Rs.7000 Profit Other Concepts of Future Contract (a) Any person can purchase/sale March Future before (b) At a time three future are being traded in the market. Say in the month of Jan, Jan Future, Feb Future and March Future are being traded in the market. (c) In case of Long Position, gain will arise if price of share increases and vice versa. (d) In case of Short Position, gain will arise if price of share decreases and vice versa. (c) Uses of Future Hedging: Futures are used for hedging the risk arising out of the investment Speculation gains (by taking the risk of speculative loss) can be made. Arbitrage gain can be made by comparing TFV with actual price of future 11B.1 Settlement of Future and Option on every day [Speculative Transaction] [Q-1 to 4] ICAI RTP ICWA M-13 1 (a) (b) (c) Future and options are settled every day on the basis of closing price of underlying assets Gain/Loss on every day settlement, are transferred to margin money account. On every day settlement, closing price becomes contract price for next day settlement. (d) (e) Settlement of Future before maturity Settlement of Long Position on Future [Purchased] Gain/Loss = Sale Purchase Purchase Price of future = Fixed at beginning Sale Price of future = Price of Future on Settlement Date Settlement of Future on maturity Settlement of Long Position on Future [Purchased] Gain/Loss = Sale Purchase Purchase Price of future = Fixed at beginning Sale Price of future = Price of UA on Maturity Date Settlement of Short Position on Future [Sold] Gain/Loss = Sale Purchase Sale Price of future = Fixed at beginning Purchase Price of future = Price of Future on Settlement Date Settlement of Short Position on Future [Sold] Gain/Loss = Sale Purchase Sale Price of future = Fixed at beginning Purchase Price of future = Price of UA on Maturity Date Question-1 On 27 th Nov, 2006 (Monday), Duryodhan bought four November Nifty futures contract which cost him Rs.7,40,000. At the close of trading on Mon, Tue and Wed, the future prices were Rs.3690, Rs.3710 and Rs At the close of trading on Thursday, spot rate was Rs What is his payoff of the transaction? No of Nifty in One future is 50. Question-1A [SP] Patelbhai sold four November Nifty futures contracts on 13 th November, 2006 for Rs.7,50,000. At the close trading on the last Thursday of November 2006, spot rate was Rs What is his pay-off the transaction?

10 Chap 11B FUTURE 11BB.4 Question-1B [SP] Manubhai purchased four November Nifty futures contracts on 13 th November,2006 for Rs.7,50,000. At the close of trading on the last Thursday of November 2006, spot rate was Rs.3,700. What is his pay off of the transaction? Question-2 Nifty stands at 3800 currently. Investor purchases a call option of 100 Nifty units maturity last Thursday of next month. Strike price Call premium Rs.15 per Nifty unit. Assume that at the close of trading on maturity, the Nifty stands at What is his pay-off the transaction? (f) Settlement of Commodity Future Question-3 Unit of trading for soya bean futures is 10 Quintals and delivery unit is 100 quintals. A trader buys future on 10 units of soya bean at Rs.1600/Quintals on 4 th Jan, On 18 th Jan, 2010 soya bean futures trade at Rs.1670/Quintal or Rs.1570/Quintals. How much profit / loss has he made on his position. Question-3A Unit of trading for Soya Bean futures is 10 Quintals and delivery unit is 100 quintals. A trader sells future on 10 units of soya bean at Rs.1600/Quintals on 4 th Jan, On 18 th Jan, 2010 soya bean futures trade at Rs.1670/Quintal or Rs.1570/Quintals. How much profit / loss has he made on his position Question-4 [RTP-May ] A wheat trader has planned to sell kgs of wheat after 6 months from now. The spot price of wheat is Rs.19 per kg and 6 months future on same is trading at Rs per kg (Contract Size =2000 kg). The price is expected to fall to as low as Rs per kg 6 months hence. What trader can do to mitigate its risk of reduces profit? If he decides to make use of future market what would be effective realized price for its sale when after 6 months is spot price is Rs per kg and future contract price for 6 months is Rs B.2 Settlement of Future or Option before maturity date [Q-5] ICAI RTP ICWA Question-5 [ICWA-Dec-2004] An investor purchased Reliance November Future (600 shares Tick size) at Rs.542 and write at Rs.580 November call option at a premium of Rs.6 (600 shares Tick size). As on November 20 spot price rises and so the future price and the call premium. Future price rises to Rs.575 and call premium rises to Rs.12. Find out profit/loss of the investor. If he/she settles the transaction on that date and at stated prices. Brokerage is 0.05% for the transaction value of futures and strike price net of call premium for option. 11B.3 Calculation of Theoretical Price of Future/Forward [Q-6 to 9] ICAI RTP ICWA N-12 7 (a) If there is no Income from UA TFV of future = CMP of UA*(1+PIR) or CMP of UA*e rt OR TFV of future = CMP of UA + Cost to Carry(Intt Amt) (b) If there is Income from UA TFV of future = CMP of UA*(1+PIR 1 ) Income from UA*(1+PIR 2 ) (c) (d) (e) (f) OR TFV of Future = (CMP of UA PV of Income from UA)*(1+PIR) In general future price is greater than the CMP of UA. In special cases, when the cost of carry is negative the future price may be lower than spot price. Basis = Future Price CMP of UA Generally basis will decrease with time and on expiry, the basis is zero and future price equals spot price. Contango: If the future price is greater than spot price it is called contango. Backwardation: If the Spot price is greater than Future price it is called backwardation.

11 Chap 11B FUTURE 11BB.5 Question-6 Following data relates to XYZ Ltd.'s share prices: Current price per share Rs.170 Price per share in the future market- 6 months Rs.185 It is possible to borrow money in the market for securities transactions 12% p. a. Calculate the theoretical minimum price of a 6 month-future contract. Question-7 [ICWA-CH-7-5] Compute the theoretical forward price of the following securities for 1 month, 3 months and 6 months CMP of Share of DD Ltd = Rs.160 You may assume a risk free interest rate of 9% p.a and 12% p.a. [CC] Question-8 Following data relates to XYZ Ltd.'s share prices: Current price per share Rs.140 It is possible to borrow money in the market for securities transactions 12% p. a. Calculate the theoretical minimum price of a 3 month-future contract if dividend of Rs.5 is received after 1 month. Question-9 [RTP-Nov ] Suppose that there is a future contract on a share presently trading at Rs The life of future contract is 90 days and during this time the company will pay dividends of Rs.7.50 in 30 days Rs.8.50 in 60 days and Rs.9.00 in days. Assuming that the compounded continuously Risk free Rate of Interest (CCRRI) is 12% p.a. you are required to find out (a) Fair value of the contract if no arbitrage opportunity exists. (b) Value of cost to carry. [Given e =0.9905, e = , e = and e 0.03 = ] 11B.4 Arbitrage Opportunity [Q-10 to 15] ICAI RTP ICWA M-04 M-08 N-08 M-05 M-09 M-04 N-09 M-06 (a) If CMP of Future is not equal to TFV of Future, then Arbitrage Profit is possible as follows If CMP of Future > TFV of Future Today If CMP of Future < TFV of Future Today (i) Sell Future at CMP [Creating Risk] Buy Future at CMP [Creating Risk] (ii) Buy UA at CMP [Reducing Risk of(a)] Sell UA at CMP [Reducing Risk of(a)] (iii) Borrow required amt at interest rate given Deposit required amt at interest rate given Maturity Date Maturity Date (i) Gain/Loss on settlement of Future [Short Position] Gain/Loss on settlement of Future [Long Position] (ii) Sell Shares at Market Price Buy Shares at Market Price (iii) Repayment of Borrowing with interest Realisation of Deposit with interest (iv) This is called cash and carry arbitrage This is called reverse cash and carry arbitrage

12 Chap 11B FUTURE 11BB.6 Question-10 [May a-8] The following data relates to ABC Ltd.'s share prices Current price per share Rs.180 Price per share in the future market- 6 months Rs.195 It is possible to borrow money in the market for securities transactions 12% p. a. Required: (a) Calculate the theoretical minimum price of a 6 month-future contract. [Ans: Rs ] (b) Explain if any arbitraging opportunities exist.[ans: 4.20] (c) If price of future is Rs.185 in place of Rs.195, then explain arbitrage profit. Question-10A [Nov-2009-O-2b-6] [SP] The following data relate to Anand Ltd.'s share price: Current price per share Rs months future's price Rs Assuming it is possible to borrow money in the market for transactions in securities at 12% per annum, you are required: To calculate the theoretical minimum price of a 6-months future purchase; To explain arbitrating opportunity. 11B.4.1 If Interest rate is compounded periodically If Interest rate is compounded periodically, then we will calculate TFV of future with compounding interest (a) If Monthly interest = X p.m., Period of Future = 6 months TFV of 6 months Future = CMP of UA(1+PIR) n TFV of 6 months Future = CMP of UA(1+X) 6 Question-11 [May c-4] The share of X Ltd. is currently selling for Rs.300. Risk free interest rate is 0.8% per month. A three months futures contract is selling for Rs Develop an arbitrage strategy and show what your riskless profit will be 3 month hence assuming that X Ltd. will not pay any dividend in the next three months. 11B.4.2 Calculation of arbitrage profit if dividend is paid (i) If Dividend amt and its payment date is given If CMP of Future > TFV of Future Same steps as above Additional Steps If CMP of Future < TFV of Future Same steps as above Additional Steps (d) Add: FV of Income received from UA Less: Loss FV of Income Lost from UA Question-12 [ICWA-CH-7-7] Compute the theoretical forward price of the following securities for 6 months Securities of A Ltd. B Ltd. D Ltd. Spot Price [So] Rs.4,550 Rs.360 Rs.900 Dividend Expected Rs.50 Rs.20 Rs.50 Dividend Receivable in 2 Months 3 Months 4 Months 6 Month s Futures Contract Rate Rs.4600 Rs.390 Rs.920 You may assume a risk free interest rate of 9% p.a. What action should follow to benefit from futures contract? Question-12A [SP] ABC Ltd. is quoted in the market at Rs.40. A 6-month futures contract on 100 shares of ABC Ltd. can be bought. The risk free rate of interest is 12% per annum continuously compounded. ABC Ltd is certain to pay a dividend of Rs. 2.5 per share 3 months from now. What should be value of the futures

13 Chap 11B FUTURE 11BB.7 contract? If the futures contract is priced at Rs.4100 what action would follow? If it is priced at Rs what would you do? 11B.4.3 If Dividend rate and its payment date is given (a) (b) We will calculate Dividend amt Dividend Amt = Face Value*Dividend Rate Question-13 [Nov-2008-O-6a-5] [SP] Calculate the price of 3 months PQR futures, if PQR (FV Rs.10) quotes Rs.220 on NSE and the three months future price quotes at Rs.230 and the borrowing rate is given as 15% and the expected annual dividend is 25% p.a. payable before expiry. Also examine arbitrage opportunities. Question-13A [ICWA-CH-7-11] The price of Compact Stock of a face value of Rs.10 on 31st December, 2012 was Rs.414 and the futures price on the same stock on the same date i.e., 31st December, 2012 for March, 2013 was Rs.444. Other features of the contract and the related information are as follows: Time to expiration 3 months (0.25 year) Annual dividend on the stock of 30% payable before Borrowing Rate is 20 % p.a. Based on the above information, calculate future price for compact stock on 31st December, Please also explain whether any arbitrage opportunity exists. 11B.4.4 If Dividend yield is given but its payment date is not given Dividend yield is return on market price of share, hence we will calculate net interest rate Net Interest = Interest Rate Dividend Yield Question-14 [ICWA-CH-7-8] Compute the theoretical forward price of the following securities Securities of R Ltd. S Ltd. Current Market Price i.e. Spot Price [So] Rs.1,300 Rs.600 Dividend Expected 2% 16% 3-Month s Futures Contract Rate Rs.1,360 Rs.580 You may assume a risk free interest rate of 10% p.a. What action should follow to benefit from futures contract? 11B.4.5 Arbitrage Profit in case of Commodity Future (i) TFV of Commodity Future = CMP of UA(1+PIR 1 ) + Storage Cost(1+PIR 2 ) If CMP of Future > TFV of Future Today If CMP of Future < TFV of Future Today (a) Sell Future at CMP [Creating Risk] Buy Future at CMP [Creating Risk] (b) Buy UA at CMP [Reducing Risk of(a)] Sell UA at CMP [Reducing Risk of(a)] (c) Borrow required amt at interest rate given Deposit required amt at interest rate given Maturity Date Maturity Date (a) Gain/Loss on settlement of Future [Short Position] Gain/Loss on settlement of Future [Long Position] (b) Sell Shares at Market Price Buy Shares at Market Price (c) Repayment of Borrowing with interest Realisation of Deposit with interest (d) less: FV of Storage Cost Add: FV of Storage Cost

14 Chap 11B FUTURE 11BB.8 Question-15 Consider a 6-month gold futures contract of 100 gm. If the spot price is Rs.600 per gram and that it costs Rs. 3 per gram for the 6-month period to store gold and that the cost is incurred at the end of 2 month. If the risk free rate of interest is 12% per annum, compute the futures rate? If the futures were available at Rs. 620, what action would follow? Would the position change if the futures were available at Rs. 660? 11B.5 Hedging through Future [Q-16 to 19] ICAI RTP ICWA N-06 M-10 M N-11 M-08 N M-15 M-06 (a) In Forex, hedging is done in following ways: (i) If LHC is to be sold in future, then we should sell future. (ii) If LHC is to be purchased in future, then we should buy future. Question-16 Today 05/06/2014 Ram is to purchase 100 Share of X Ltd on Sep, 2014 CMP of Share of X Ltd = Rs.100 CMP of Sep Future = Rs.115 Mr Ram has fear that Price of Share may increase, hence he wants to hedge its purchase through Sep Future. Case 1 Ram wants to Purchase on 30/09/2014 MP of Share as on 30/09/2014 = 110 Case 2 Ram wants to Purchase on 18/09/2014 MP of Share as on 18/09/2014 = 108 MP of Sep Future as on 18/09/2014 = Rs.117 How he can hedge its purchase through Sep Future Question 17 A Singapore based firm exported goods to an Australian Firm, invoicing Australian dollars(ad) 5,00,000 on 02/04/2007. The payment is due on 25/06/2007. On 18/04/2007, the finance manger of Singapore firm got an indication that the SGD will appreciate against AD. The following foreign exchange rates are quoted on 18/04/2007; Spot Rate SGD/AD = June 2007 future contract SGD/AD = The standard size of the futures contract is AD 1,00,000. Suggest the hedging strategy? Assuming that the finance manager follows your suggestion, find net cash inflow on 25/06/2007 assuming that on that day the following rates were prevailed in the market. Spot Rate SGD/AD = June 2007 future contract SGD/AD = Question-18 [Nov a-10] [RTP-May ] XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in customers' currency. Its receipt of US $ 1,00,000 is due on September 1, Market information as at June 1, Exchange rates Us $ /Rs Currency futures Us $/ Rs. Contract Size Rs. 4,72,000 Spot June month forward September month forward Initial Margin Interest rates in India

15 Chap 11B FUTURE 11BB.9 June Rs.10, % September Rs.15, % On September 1, 2005 the spot rate US $Re. is and currency future rate is Comment which of the following methods would be most advantageous for XYZ Ltd. (a) Using forward contract (b) Using currency futures (c) Not hedging currency risks. It may be assumed that variation in margin would be settled on the maturity of the futures contract. Question-18A [May a-6] EFD Ltd. is an export oriented business house. The Company invoices in customers' currency. Its receipt of US $ 10,000,000 is due on April 1, Market information as at Jan 1, Exchange rates Us $ /Rs Currency futures Us $/ Rs. Contract Size Rs Spot Month month forward Month month forward Initial Margin Interest rates in India 1-Month Rs.17, % 3-Months Rs.22, % On April 1, 2015 the spot rate US $Re. is and currency future rate is Comment which of the following methods would be most advantageous for EFD Ltd. (a) Using forward contract (b) Using currency futures (c) Not hedging currency risks. Question-19 [Nov b-8] [RTP-NOV ] Nitrogen Ltd, a UK company is in the process of negotiating an order amounting to 4 million with a large German retailer on 6 months credit. If successful, this will be the first time that Nitrogen Ltd. has exporter goods into the highly competitive German market. The following three alternatives are being considered for managing the transaction risk before the order is finalized. Invoice the German firm in Sterling using the current exchange rate to calculate the invoice amount. Alternative of invoicing the German firm in and using a forward foreign exchange contract to hedge the transaction risk. Invoice the German first in and use sufficient 6 months sterling future contracts (to the nearly whole number to hedge the transaction risk. Following data is available: Spot Rate / 6 months forward premium Euro Cents 6 months further contract is currently trading at / 6 months future contract size is Spot rate and 6 months future rate / Required Calculation to the nearest the receipt for Nitrogen Ltd. Under each of the three proposals. In your opinion, which alternative would you consider to be the most appropriate and the reason therefore. 11B.6 Calculation of Spot price of Underlying Assets if fair value of Future is given [Q-20] ICAI RTP ICWA N-06 M-04 N-11 M-05

16 Chap 11B FUTURE 11BB.10 In some cases, TFV of Future is given, then we are required to calculate CMP of UA as follows (a) (c) TFV of Future = CMP of UA*(1+PIR) or CMP of UA*e rt CMP of UA = TFV of Future/(1+PIR) or TFV of Future/ e rt Qustion-20 [Nov b-4] [Nov d-5] The 6-month forward price of a security is Rs The borrowing rate is 8% per annum payable with monthly rests. What should be the spot price of Underlying Share? 11B.7 Convenience yield [Q-21] ICAI RTP ICWA (a) (b) In case of some products the supply of the commodity is quite uncertain. In this case, holding the commodity in store is more convenient than buying on future basis. The convenience yield reflects the market s expectation regarding the future availability of the commodity. The greater the possibility that storages will occur, the higher the value of convenience yield and vice versa. Convenience yield is nil for the items which can not be stored. For example electricity. Future Price = (Spot Price + Storage Cost PV of Convenience yield)*(1+r) Question-21 3 months futures contract of an industrial input, having irregular supply, is being traded at Rs.1000 per ton. Spot price is Rs.990 and interest is 10% p.a. Storage cost is Rs.10 per ton for 3 months. Find the PV of convenience yield. 11B.8 Hedge Ratio in case of hedging through future [Q-22] ICAI RTP ICWA M-12 M-05 N N (a) (b) It says about how much quantity of Commodity Future to be contracted for 100% hedging Hedge ratio = r SD SP /SD FP Question-22 SD of the monthly spot prices of gold is SD of the monthly futures prices of gold is Coefficient of Correlation between these two prices is 0.60 Today is An exporter jeweler has to purchase 100 Kgs of gold after one month. Gold futures contracts mature on 20 th of every month. How it can be hedged against rise in gold prices. Question-22A [May d-5] [M-5] [RTP-Nov ] [RTP-Nov ] A company is long on 10 MT of (Spot) and intends to remain so for the ensuing quarter. SD of changes of its spot and future price are 4% and 6% respectively, having Coefficient of correlation 0.75 What is its hedge ratio? What is the amount of the copper future it should short to achieve a perfect hedge. 11B.9 Theory Question-1 [Nov b-4] What are the features of Futures Contract? [May c-4] (i) What are Stock futures? (ii) What are the opportunities offered by stock futures? (iii) How are stock futures settled?

17 Chap 11B FUTURE 11BB.11 (a) (i) (ii) (iii) (b) (i) (ii) (iii) (iv) (c) (i) (ii) Futures: It is a contract to buy or sell a stated quantity of a commodity or a financial claim at a specified price at a future specified date. Obligation to Both Party The parties to the futures have to buy or sell the assets regardless of what happens to its value during the intervening period or what shall be the price on the date for which contract is finalized. Underlying Assets Future can be of commodities such as agricultural products, oil, gold etc. or of financial claims such as shares, debentures, treasury bonds etc. Settlement of Futures The futures contract provide for the physical delivery of the assets, however in practice, all futures are settled by offsetting futures contract. Stock futures are cash settled. No delivery is made. Profits/losses of futures contracts are paid/ recovered over everyday at the end of trading day, a practice called marking to market. These profits and loss are calculated on the future price at close of trading day. No mark to market is done on the settlement day. The settlement is done on the basis of futures closing price on previous trading day and the closing spot price on the day of settlement. Features of Future Standardization: Each Future contract is for a standard specified quantity, grade, coupon rate, maturity. Clearing House: An organization called future exchange will act as a clearing house. The exchange provides the counter party guarantee through its clearing house and different types of margins system. Margins: Clearing house requires the participants to keep margin money. Time Spreads: There is relationship between the spot price and the future price of contract. The difference between spot price and future price is known as time spread. Opportunities offered by Stock futures Stock futures offer high leverage. This means that one can take large position with less capital. For example, paying 20% initial margin one can take position for 100%, i.e., 5 times the cash outflow. Futures may look over-priced or under-priced compared to the spot price and can offer opportunities to arbitrage and earn riskless profit. Question-2 [May bi-4] [Nov-2008-O-6d-5] Distinguish between Forward and Futures contract. There major differences between the traditional forward contract and a futures contract. Feature Forward Contract Futures Contract Amount Flexible Standard amount Maturity Any valid business date agreed to by the two parties Standard date. Usually one delivery date such as the second Tuesday of every month Furthest maturity Date Open 12 months forward Currencies traded All currencies Majors Cross rates Available in one contract; Multiple contracts avoided Usually requires two contracts Market-place Global network Regular markets futures market and exchanges Price fluctuations No daily limit in many Currencies Daily price limit set by exchange Risk Depends on counter Party Minimal due to margin Requirements Honouring of Contract By taking and giving Delive Mostly by a reverse transaction Cash flow None until maturity date Initial margin plus ongoing variation margin

18 Chap 11B FUTURE 11BB.12 because of market to market rate and final payment on maturity date Trading hours 24 hours a day 4 8 hours trading sessions Question-3 [May e-4] [May c-2] Write short notes on stock lending scheme Solution In stock lending, the title of a securities is temporarily transferred from a lender to a borrower. The lender retains all the incident of ownership other than the voting rights. The borrower is entitled to use the securities /shares as required but is liable to the lender for all benefits such as dividend interest rights etc. The basic purpose of stock borrower is to cover the short sales i.e. selling the shares without possessing them. SEBI has introduced scheme for securities lending and borrowing in Advantages (a) Lenders to get return (as lending charges) from it, instead of keeping it idle. (b) Borrower uses it to avoid settlement failure and loss due to auction. (c) From the view-point of market this facilitates timely settlement, increase in settlement, reduce market volatility and improves liquidity. (d) This prohibits fictitious bull run. The borrower has to deposit the collateral securities, which could be cash, bank guarantees, government securities or certificates of deposits or other securities, with the approved intermediary. In case, the borrower fails to return the securities, he will be declared a defaulter and the approved intermediary will liquidate the collateral deposited with it. In the event of default, the approved intermediary is liable for making good the loss caused to the lender. The borrower cannot discharge his liabilities of returning the equivalent securities through payment in cash or kind. National Securities Clearing Corporation Ltd. (NSCCL), Stock Holding Corporation of India (SHCIL), Deutsche Bank, Reliance Capital etc. are the registered and approved intermediaries for the purpose of stock lending scheme. NSCCL proposes to offer a number of schemes, including the Automated Lending and Borrowing Mechanism (ALBM), automatic borrowing for settlement failures and case by case borrowing.

19 Chap 11B FUTURE-SOLUTION 11BC.1 Solution-1 One Nov future Nifty No. of units of four contracts of Nifty Purchase price of 4 Nov Future Purchase price per unit of Nov Future purchase price is fixed at Rs.3700] Date of purchase of Nov Future = 27/11/2006 Settlement Date for Nov Future = 30/11/2006 Date Actual price of Nov Future Gain/(Loss) to Mr A 27/11/2006 Rs.3690 ( )*200 = /11/2006 Rs.3710 ( )*200 = /11/2006 Rs.3740 ( )*200 = /11/2006 Rs.3800 ( )*200 = = 50 Units = 4*50 =200 Units = Rs = Rs /4 = Rs.3700 [Duryodhan has long position on Nov Future and Net Gain of Loss on Final Settlement = = OR Net Gain of Loss on Final Settlement = Sale Price (From Market) Purchase Price (CMP of Future) = ( )*200 = Rs Solution-1A One Nov future Nifty = 50 Units No. of units of four contracts of Nifty = 4*50 =200 Units Sale Price of 4 Nov Future = Rs Sale price per unit of Nov Future = Rs /200 = Rs.3750 [Patelbhai has Short position on Nov Future] Date of Sale of Nov Future = 13/11/2006 Settlement Date for Nov Future = 30/11/2006 Closing price of Nifty on 30/11/2006 = Rs.3700 Net Gain/ Loss on Final Settlement = Sale Price (CMP of Future) Purchase Price (Market) = ( )*200 = Rs Solution-1B One Nov future Nifty = 50 Units No. of units of four contracts of Nifty = 4*50 =200 Units Purchase price of 4 Nov Future = Rs Purchase price per unit of Nov Future = Rs /200 = Rs.3750 [Manubhai has long position on Nov Future] Date of Purchase of Nov Future = 13/11/2006 Settlement Date for Nov Future = 30/11/2006 Closing price of Nifty on 30/11/2006 = Rs.3700 Net Gain of Loss on Settlement = Sale Price (In Market) Purchase Price (CMP of Future) = ( )*200= -Rs Solution-2 CMP of Nifty = Rs.3800 [Underlying Assets] Strike price of Call Option on Nifty = Rs.3900 Call Premium = Rs.15 No of Units in Call Option = 100 Nifty Price of Nifty on Maturity Date = Rs.3910 [Underlying Assets] Since Spot price of Nifty on maturity is more than strike price, hence investor would exercise the call option. Gain on Exercise of Call option = Rs = Rs.10 Net Gain/(Loss) = Rs = -5*100 = -500 Solution-3 One future of Soya Bean = 10 Quintals No. of units of 10 contracts of Soya Bean Future = 10*10 =100 Quintals Purchase price of Soya Bean Future on 04/01/2010 = Rs.1600 per Quintals On 18/01/2010, Price of Soya Bean Future = Rs.1670 or 1570 per Quintal On settlement on 18/01/2010, Trader has to sale future of Soya Bin Case 1 Gain or Loss on Settlement = Sale Price Purchase Price = 1670* *100 = Rs.7000 Profit Case 2 Gain or Loss on Settlement = Sale Price Purchase Price = 1570* *100 = -Rs.3000 Loss

20 Chap 11B FUTURE-SOLUTION 11BC.2 Solution-3A One future of Soya Bean = 10 Quintal No. of units of 10 contracts of Soya Bean Future = 10*10 =100 Quintals Sale price of Soya Bean Future on 04/01/2010 = Rs.1600 per Quintals On 18/01/2010, Price of Soya Bean Future = Rs.1670 or 1570 per Quintal On settlement on 18/01/2010, Trader has to buy new future of Soya Bin Gain or Loss on Settlement = Sale Price Purchase Price = 1600* *100 = - Rs.7000 Loss Gain or Loss on Settlement = Sale Price Purchase Price = 1600* *100 = +Rs.3000 Profit Solution-4 In order to hedge its position trader would go short on future at current future price of Rs per kgs. This will help the trader to realize sure Rs after 6 months. Quantity of wheat to be hedge Contract size kgs 2000 kgs No. of Contracts to be sold 220 Future Price Exposure in Future Market (Rs.18.50*220*2000) 81,40,000 After 6 months the traders would cancel its position in future market by buying a future contract of same quantity and will wheat in spot market and position shall be as follows. Price of Future Contract Amount bought = 17.55*220* ,22,000 Gain/Loss on Future position = Sale Purchase 4,18,000 Spot Price Amount realized by selling in spot market 77,00,000 Effective selling in spot market = Sale in Spot Rate + Profit on Future 81,18,000 Effective selling Price (Per Kg) = / Solution-5 An investor buys Nov future on 600 Reliance He writes Nov call option for 600 reliance shares at exercise price 580 by receiving premium of Rs.6 per share On Nov-20 Share Price of Reliance rises Market Price of Nov Future = Rs.575 Call Premium of Nov Call comes to Rs.12 of Strike price Rs580 Now Investor wants to settle both the transaction on 20 Nov (a) To cancel long position on Nov future, he has to sell Nov (b) To cancel Short Position on Call option, he has to buy Nov call option of Strike price of Rs.580 by paying premium of Rs.12 Gain or Loss on the Settlement Future Contract Brokerage fees = 0.05% Purchase Price of Nov Future = Rs.542*600 = Rs Brokerage fees on Purchase = Rs *0.05% = Rs Purchase Cost of Nov Future = = Sale Price of Nov Future = Rs.575*600 = Rs Brokerage fees on Sale = Rs *0.05% = Rs Sale Value of Nov Future = = Gain/(Loss) on Settlement of Future = Sale Value Purchase Cost = = Rs Alternative Answer Purchase Cost = 542*600* = Rs Sell Price = 575*600*( ) = Rs Gain/ (Loss) on settlement of Nov future = Sale price Purchase price = = Call Option Contract Brokerage is 0.05% for the transaction value of strike price net of call premium for option Premium Received on writing of Nov Call Option at strike price of Rs.580 = 600*6 = Rs.3600

21 Chap 11B FUTURE-SOLUTION 11BC.3 Brokerage fees paid on writing call option = (580-6)*600*0.05% = Rs Net Premium received on writing call option = Rs.3600 Rs = Rs Premium Paid on buying of Nov Call Option at strike price of Rs.580 = 600*12 = Rs.7200 Brokerage fees paid on buying call option = (580-12)*600*0.05% = Rs Total Premium paid on buying call option = Rs Rs = Rs Gain/ (Loss) on settlement of Nov Call = Premium Received Premium Paid = = Rs Alternative Answer Writing of Nov Call Option at strike price of Rs.580 = Premium Received = 600*6 (580-6)*600* = Purchase of Nov Call Option of strike price of Rs.580 = Premium Paid = 600*12 + (580-12)*600* = Gain/ (Loss) on settlement of Nov Call = Premium Received Premium Paid = = Rs Overall Gain = = Rs Solution-6 CMP of Share of XYZ Ltd = Rs.170 Interest rate p.a. = 12% Period of Future = 6 months Interest rate for 6 months = 6% TFV of a 6 months Future = CMP of Share*(1+PIR) = 170*1.06 = Rs Solution-7 CMP of Share of DD Ltd = Rs.160 Case 1 Period = 1 month Interest Rate = 9% Interest Rate = 12% TFV of a 1 month Future = CMP of Share*e rt 160*e 0.09*1/12 160*e 0.12*1/12 160*e *e * * = Rs = Rs Case 2 Period = 3 months Interest Rate = 9% Interest Rate = 12% TFV of a 3 months Future = CMP of Share*e rt 160*e 0.09*3/12 160*e 0.12*3/12 160*e *e * * = Rs = Rs Case 3 Period = 6 months Interest Rate = 9% Interest Rate = 12% TFV of a 3 months Future = CMP of Share*e rt 160*e 0.09*6/12 160*e 0.12*6/12 160*e *e * * = Rs = Rs Solution-8 CMP of Share of XYZ Ltd = 140 Interest rate p.a. = 12% Period of Future = 3 months Interest rate for 3 months = 3% Dividend is received after 1 month = Rs.5 TFV of a 3 months Future = CMP of Share*(1+PIR) FV of Dividend = 140*1.03 5*1.02 = Rs Alternative TFV of a 3 months Future = (CMP of Share-PV of Dividend)*(1+PIR) = (140-5/1.02)*1.3 = ( )*1.03 = Rs

22 Chap 11B FUTURE-SOLUTION 11BC.4 Solution-9 CMP of Share = Rs.1000 Interest rate p.a. = 12% [CC] Period of Future = 90 days PV of Dividend at t 0 =7.50e -0.12x30/360 + Rs.8.50e -0.12x60/360 + Rs.9.00e -0.12x90/360 = Rs.7.50e Rs.8.50e Rs.9.00e = Rs.7.50* * * = Rs Rs Rs.8.73 =Rs TFV of 90 days Future contract = (CMP of Share PV of Dividend)*e rt = ( )*e 0.12x90/360 = ( )* =Rs (b) TFV of future contract = CMP of Share + Cost to Carry Rs = Rs Cost to Carry Cost to Carry =Rs.5.21 Solution-10 (a) CMP of Share of ABC Ltd = 180 Interest rate p.a. = 12% Period of Future = 6 months Interest rate for 6 months = 6% TFV of a 6 months Future = CMP of Share*(1+PIR) = 180*1.06 = Rs (b) CMP of Future = Rs.195 and TFV = Rs , Therefore arbitrage is possible as follows: Today (a) Sell (b) Buy one share at (c) Borrow for six month After 6 months Actual Price of Share Rs.187 Rs.195 Rs.202 Contracted price of Future Sold Rs.195 Rs.195 Rs.195 (a) Gain/(Loss) on Settlement of future [Short] (b) Sale of Share in Market (c) Repayment of Loan with interest = 180* Arbitrage Profit (c) CMP of Future = Rs.185 and TFV = Rs , Therefore arbitrage is possible as follows Today (a) Buy (b) Suppose we have one share and sell that share at (c) Deposit for six month After 6 months Actual Price of Share Rs.180 Rs.185 Rs.195 Contracted price of Future Purchased [Long] Rs.185 Rs.185 Rs.185 (a) Gain/(Loss) on settlement of Future (b) Purchase of Share from Market (c) Amt Receivable from Deposit Arbitrage Profit