AIM COLLEGE-HISAR Financial Derivatives (FM-407) Contact: ,

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1 Ques-1 : Forward Contracts:-- A forward contract is a simple customize contract between 2 parties to buy or sell an asset at a certain time in future for a certain price. Unlike future contracts they are not traded on exchanges, rather traded in over the counter market, usually between 2 financial institutions or between a financial Institution and one of its is client. CONCEPT In a forward contract 2 parties agree to trade at some future date at a stated price and quantity. No money change at the time the deal is signed. Most of the forward contracts are traded on the over-the-counter (OTC) market or by telephones At the time the forward contract is written, a specified price is fixed at which the asset is purchased or sold which is referred to as delivery price. Eg-1: An Indian company buys automobile parts from USA with payment of 1 million dollar due in 90 days. The importer, thus, is short of dollar that is, it owes dollar for future delivery. Suppose present price of dollar is Rs 48. Over the next 90 days, however dollar might rise against Rs 48. The importer can hedge this exchange risk by negotiating a 90 days forward contract with a bank at a price Rs 50. According to forward contract in 90 days the bank will give importer 1 million dollar and importer will give the bank 50 million rupees hedging a future payment with forward contract. On the due date importer will make payment of Rs 50 million to the bank and bank will pay one million dollar to importer, whatever rate of dollar is after 90 day. Forward contract relating to foreign exchange market. A forward contract entered into a rate quoted in foreign exchange market at the time is normally zero-cost-contract, i.e., neither party pays anything to other party up-front. They simply exchange two promises to pay in the future just like exchange of 2 promissionary notes. Eg-2: A firm purchases say 1 million US dollar 6-month forward at a market rate of DEM when the spot rate is DEM from a bank say SBI. Thus in such contract, there are exchange of 2 promises i.e., SBI promises to pay 1 million US dollar to firm at the rate of DEM , whereas the other firm promises to pay DEM million to SBI. Both payments are to be made after 6 months. Thus both parties agree that the present value of US dollar 1 million to be paid 6 months later equals the present value of DEM to be paid after 6 months. FEATURES OF FORWARD CONTRACTS: 1) It is an agreement between 2 counter parties in which one is buyer and other is seller. 2) It specifies the quantity and type of asset to be negotiated. 3) It specifies future date at which the delivery and payment is to be made. 4) It specifies the price at which the payment is to be made by seller to buyer. The price is determined presently to be paid in future. 5) It obligates buyer and seller to exchange asset. Page : 1/ 25

2 6) No money changes hands until the delivery date reaches, except for small service fee, if there is. 7) Forward contracts are bilateral contracts and they are exposed to counter party risk. 8) Each contact is custom designed and hence unique in terms of contract size, expiration date, asset type, quality etc. 9) One of the parties takes long position by agreeing to buy the asset at a certain future date. The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price. A party with no obligation offsetting the forward contact is said to have an open position. A party with closed position is, sometimes, called a hedger. 10) The specified price in forward contract is referred to as delivery price. 11) In a forward market, the contact has to be settled by delivery of asset on expiration date Classification of forward contracts: Hedge contracts Transferable specific delivery (TSD) contract Non-Transferable specific delivery (NTSD) contract Forward rate agreements Range Forwards Ques-2 Future Contracts Types of Traders A future contract is an agreement between a buyer & seller, where seller agrees to deliver a specified quantity and grade of a particular asset at a predetermined time in futures at an agreed upon price through a designated market (exchange) under stringent financial safeguards. DIFFERECNE BETWEEN FORWARD AND FUTURES CONTRACT: Sno Basis Futures Forwards 1 Standardization Recognized stock exchange Private deal in 2 parties 2 Price, quantity, period Determined by exchange Decided by parties mutually 3 Registration Needed Self regulatory, no registration needed 4 Settlement Clearing house Default on terms of agreement 5 Margin money Required Depends on parties Page : 2/ 25

3 6 Delivery On specific dates On any date 7 Brokerage fee For purchase and sale orders Based on bid-ask spread Types of Financial Future Contracts :: Interest rate futures Foreign currency futures Stock index futures Bond index futures Cost of living index futures OPERATORS/TRADERS IN FUTURES MARKET: 1. HEDGER: Hedge is a position taken in markets for the purpose of reducing exposure to many types of risks. A person who undertakes such position is called as hedger. Hedger uses future markets to reduce risk caused by the movements in prices of securities, commodities, exchange rates, interest rates, indices etc.. By taking opposite position to perceived risk is called hedging strategy in future markets. Long Hedging Using Futures: Example-1:Silver is essential input in production of most types of photographic films and papers and the price of silver is quite volatile for a manufacturer XYZ Ltd, there is considerable risk. Suppose XYZ Ltd need 20,000 ounces of silver in 2 months and prices of silver on May 10 are::(spot:1050, July:1070, Sep:1080). One Contract of COMEX traded is of 5000 ounces. Fearing the price of silver may raise unexpectedly, XYZ Ltd. Enters into futures contract at Rs 1070 in July delivery. He therefore locked into futures price today and long hedge in silver will be as follows: Date Cash Market Futures Market May 10 Anticipates the trade for ounces of silver in 2-mont and pay Rs 1070 per ounce or total amount to Rs 21,400,000. Buys four 5000 ounce silver in July futures contract at Rs 1070 per ounce. July 10 Spot price of silver now is Rs 1080 and XYZ Ltd Because future contract at maturity, the futures have to pay Rs and spot prices are equal 21,600,000 and 4 contracts are sold at Rs 1080 per ounce. Profit/Loss Loss 2,00,000 Futures Profit 2,00,000 Page : 3/ 25

4 2. SPECULATORS: A speculator may be defined as an investor who is willing to take a risk by taking futures position with expectation to earn profit. The speculator forecasts the future economic conditions and decides which position (long or short) to be taken that will yield a profit if the forecast is realized. Example-2: Suppose a speculator has forecasted that the price of gold would be Rs 5500 per 10 Gms after one month. If current price is 5400 per 10 gms, he can take a long position in gold and expect to make a profit/loss of Rs 100 per 10 gms. Speculators usually trade in future markets to earn on basis of difference in spot and futures prices of underlying asset. Hedgers use future markets for avoiding exposures to adverse movements in the price of an asset whereas the speculators wish to take position in the market based upon such movements in the price of that asset. Speculators can be classified into different categories. 1) A speculator who uses fundamental analysis of economic conditions of the market is known as fundamental analyst 2) whereas the one who uses to predict futures prices on the basis of past movements in the prices of an asset is known as technical analyst. 3) A speculator who owns seat on a particular exchange and trades in his own name is called local speculator. Local speculators can be further classified in 3 category namely, scalpers, pit traders and floor traders. 3.1) Scalpers usually try to make profits from holding positions for short period of time. 3.2) Pit speculator take bigger position and hold them longer 3.3) Floor traders usually consider inter commodity price relationship. 3. ARBITRAGEURS: An arbitrageur is a trader who attempts to make profits by locking in risk less trading by simultaneously entering into transactions in two or more markets. He tries to earn risk less profits from discrepancies between futures and spot prices and among different futures prices. Example-3: Suppose that at expiration of gold futures contract, the futures price is Rs 5500 per 10 Gms, but the spot price is Rs 5480 per 10 Gms. In this situation the arbitrageur could purchase the gold for Rs 5480 and go short a futures contract that expires immediately, and in this way making a profit of Rs 20 per 10 Gms by delivering the gold for Rs 5500 in the absence of transaction costs. 4. SPREADERS: Spreads refers to the relationship of two different futures prices of an asset. Spreading is a specific trading activity in which offsetting futures position is involved by creating almost net position. So the spreaders believe in lower expected return but at the less risk. For a successful trading in spreading, the spreaders must forecast the relevant factors, which affect the changes in the spreads. Interest rate behavior is an important factor, which causes changes in spreads. Types of Spreads are: a. Intra-commodity time spreads: Difference in price between 2 futures contracts of different maturity dates on the same commodity. b. Intra-commodity spreads: Spread between the futures prices of two different but related commodities eg: Soyabean and its two products, soyabean oil and soyabean meal. Page : 4/ 25

5 c. Inter market spreads: It is related with different markets for inter related commodities. Eg: New York heating oil futures price against London Gasoil futures prices. FUNCTIONS OF FUTURES MARKET: 1. HEDGING: It is the primary function which is also known as price insurance, risk shifting or risk transfer function. Futures markets provide a vehicle through which the traders can hedge their risk or protect themselves from the adverse price movements. Example-4: A farmer bears the risk at the planting time associated with the uncertain harvest price his wheat will command. He may use futures market to hedge the risk by selling futures contact. For instance, if he is expected to produce 1000 tones of wheat in next 6 months, he could establish a price for that quantity (harvest) by selling 10 wheat futures contract, each being of 100 tones. In this way by selling the futures contracts, the farmer intends to establish a price today that will be harvested in the futures. Further the futures transactions will protect the farmer from fluctuations of wheat price, which might occur between present and future period. 2. PRICE DISCOVERY: It is revealing of information about futures cash market prices through the futures market. Price discovery function of futures market also leads to inter temporal inventory allocation function. According to this, the traders can compare the spot and futures prices and will be able to decide the optimum allocation of their quantity of underlying asset between immediate sale and future sale 3. FINANCING FUNCTION: It is to raise finance against the stock of assets or commodities. Since futures contracts are standardized contracts, so, they make it easier for the lenders about the assurance of quantity, quality and liquidity of underlying asset. 4. LIQUIDITY FUNCTION: Traders in futures markets can do business a much larger volume of contracts than in a spot market, and thus make markets more liquid. Volume of futures markets is much larger in comparison of spot market Example-5: A speculator estimates a price increase in the silver futures market from the current futures price of Rs 7500 per kg. The market lot being 10 kg, he buys one lot of futures silver for Rs (7500 x 10). Assuming the 10% margin, the speculator is to deposit only Rs Now supposing that a 10% increase occurs in the price of silver to Rs 8250 per kg. The value of t5ransction will also increase i.e., Rs 82500, and hence, incurring a profit of Rs 7500 ( ) on this transaction. In other words speculator earns in this transition Rs 7500 on the investment o Rs 7500, being 100% profit on investment, and viceversa. 5. PRICE STABILIZTION FUNCTION: It is to stabilizing influence on spot prices by reducing the amplitude of short term of fluctuations. Futures markets reduce Page : 5/ 25

6 both the heights of peaks and the depth of troughs. The major causative factors responsible for such price stabilizing influence are such as, speculation, price discovery, tendency to panic, etc. 6. DISSEMINATING FUNCTION: Futures markets disseminate (distribute/ broadcast/ circulate/ spread/ propagate/ publish) information quickly, effectively and inexpensively, and, as a result, reducing the monopolistic tendency in the market. THE SPECIFICATION OF THE FUTURES CONTRACT: 1. Exchange 2. Standardization a. The Asset b. Contract Size c. Delivery Months d. Delivery arrangement e. Daily price movement limits f. Position limits: (Maximum no. Of contracts that a speculator may hold.) 3. The Clearing House 4. The operation of margin a. The concept o margin b. Types of margin (initial, maintenance, variation) c. Initial margin (Initial amount that must be deposited into account to establish futures position) d. The maintenance margin (75% of initial margin) e. The variation margin (difference of initial margin and the balance in margin account. 5. Margin Cash flow 6. Closing a futures position a. Physical delivery b. Cash settlement c. Offsetting d. Excahange of futures for physicals (EFP) Example-6: Assume that the initial margin of futures contracts is Rs 5000 and maintenance margin is Rs 3750 (75% of 5000). Next day party sustains a loss of Rs 1000, reducing the balance in margin to Rs Further assume that on next day price decreased and sustained loss is Rs 500. Thus, the balance remained in margin account to Rs 3500, below maintenance margin. In this situation broker will make a call (margin call) to replenish the margin account to Rs 5000 the level of initial margin. Varition margin is Rs 1500 ( ) to be deposited by trader with the broker to bring the balance of margin account to initial margin level. Example-7: An investor enters into futures (short) contract to sell January cotton for Rs 50/kg on commodity exchange. Size of contract is 5000 kg. Initial margin is Rs and maintenance margin Rs Margin call to investor will occur when Rs lost from margin account. It will happen when price of cotton increase by Rs 2 per kg. Page : 6/ 25

7 So price of cotton must rise to Rs 52 per bundle for margin call. And in case investor does not make payment of margin call, broker will close the investor position. Que: Other Derivative Securities General approach to Derivative Securities DEFINATION OF FINANCIAL DERIVATIVES: The term derivative indicates that it has no independent value i.e. its value is entirely derived from the value of underlying asset. The underlying asset can be securities, commodities, currency, livestock or anything else. Derivative means any hybrid contract of predetermined fixed duration, linked for the purpose of contract fulfillment to the value of specified real or financial asset to indexes of securities. FEATURES OF FINANCIAL DERIVATIVES: i. A derivative instrument relates to future contract between two parties. ii. Value of derivative instrument is derived from other underlying assets. iii. Obligations of counter parties under different derivatives would be different. iv. Derivative contract can be undertaken directly between 2 parties or through particular exchange like financial future contracts. v. Financial Derivatives are carried off-balance sheet. vi. Taking or making of delivery of underlying asset is not involved vii. Derivatives also known as deferred delivery or deferred payment instrument. viii. Derivatives are mostly secondary market instrument and have little usefulness in mobilizing fresh capital by the corporate world, however warrants & convertibles are exception in this respect. ix. Financial Derivatives because of their off balance sheet nature, can be used to clear up the balance sheet. USES OF DERIVATIVES: 1) To control, avoid, shift and manage efficiently different types of risks through various strategies like hedging, arbitraging, spreading etc. 2) They serve as barometers of future trends in price, which result in discovery of new price both on the spot and future markets. 3) No immediate full amount of the transaction is required since most of them based on marginal trading. 4) Derivatives assist investors, traders and managers of large pools of funds to device such strategies to make proper asset allocation. 5) Derivatives have smoothened out price fluctuations, squeeze the price spread, integrate price structure at different po9ints of time and remove gluts and shortages in markets. 6) Derivative trading encourages competitive trading in market. Page : 7/ 25

8 7) Derivative trading develop the market toward complete markets CRITICS OF DERIVATIVES: 1) Speculative and gambling motives 2) Increase in risk 3) Instability of financial system 4) Price instability 5) Displacement effect 6) Increase regulatory burden. Types of financial derivatives DERIVATIVES Financial Commodities Basic Complex Forward, Future, Options, Warrants & Convertibles. Swaps Exotics WARRANTS AND CONVERTIBLES: Warrants and convertibles are important categories of Financial Derivatives, which are frequently traded in market. Warrant is just like option contract where the holder has the right to buy shares of a specified company at a certain price during the given time period. Holder of warrant has the right to purchase the specific number of shares at a fixed price in a fixed period from issuing company. If the holder exercises the right, it increases number of shares of the issuing company, and thus dilutes equities of shareholders. Warrants are usually issued as sweeteners attached to senior securities like bonds and debentures so that they are successful in their equity issues in terms of volume and price. Convertibles are hybrid securities, which combine basic attributes of fixed interest, and variable return securities. Eg: Convertible bonds, Convertible debentures, Convertible preference shares, which are also called equity derivative securities. EXOTICS: Page : 8/ 25

9 Forward, future, option and swaps are standard or plain vanilla derivatives. Some banks in 1980 s some new non-standard derivatives to meet the need of clients. The bases of the structure of these derivatives were not unique. Eg: Some non-standard derivatives were formed by combining two or more plain vanilla call & put options whereas some other was far more complex. In fact there is no boundary for designing the non standard financial derivatives and hence they are sometimes termed as exotic options or exotics. Ques-5 Future Markets and the use of futures for hedging HEDGING CONCEPTS: (continued from Ques 2) It is the primary function, which is also known as price insurance, risk shifting or risk transfer function. Futures markets provide a vehicle through which the traders can hedge their risk or protect themselves from the adverse price movements. THE MULTI-PURPOSE CONCPET OF HEDGING 1. Carrying charge hedging: According to this approach, the stockist watch the price spared between the spot and future price, and if the spread covers even carrying costs then the stockist buy the ready stocks. It means that the traders may go for hedging if the spread is adequate to cover carrying costs, whereas earlier view was that hedgers are used to protect against loss on stock held. 2. Operational Hedging: Hedgers use the futures markets for their operations and use the same as substitute for cash or forward transaction. 3. Selective or discretionary hedging: As pet this concept, traders do not always (in routine) hedge themselves but only do so on selected occasions when they predict adverse price movements in futures. 4. Anticipatory Hedging: This is done in anticipation of subsequent sale or purchase. Example-1: A farmer might hedge by selling in anticipation of his crop while a miller might hedge by buying futures in anticipation of subsequent raw material needs. THE PERFECT HEDGING MODEL The perfect hedge refereed to that position which completely eliminates the risk. The use of futures or forward position to reduce completely the business risk is called perfect hedge. Example-2: A jewelry manufacturer wants to lock in a price for purchasing silver for coming June. This he can do by going long June silver futures. If silver price rise, the risk of increased cost of silver will be offset by the profit earned on futures position. Page : 9/ 25

10 Similarly if silver price falls, the saving on silver purchase will be offset by futures losses. In either case, the net silver cost is locked in at the futures price. In above example-2, price risk is covered but nor the quantity risk. No doubt, availability of quantity of the asset at futures date may also influence the determination of futures prices. THE BASIC LONG AND SHORT HEDGE Hedgers can be classified in 2 categories Short hedgers and long hedgers SHORT HEDGE A short hedge or a selling hedge is a hedge that involves short position in futures contracts. It occurs when a firm/ trader plans to purchase or produce a cash commodity sells futures to hedge the cash position. It means, being short having a net sold position or a commitment to deliver, etc. The main objective is to protect the value of cash position against the decline in cash prices. A short hedge is appropriate when the hedger already owns an asset and expects to sell it at sometimes in the futures. Example-3: A US exporter who knows that he will receive German mark in 3 months from a German company. Exporter will realize gain if the mark increases, its value in relation to US dollar, and a loss if the mark decreases its value relative to US dollar. A short futures position leads to loss if mark increases in value, and a gain if decreases in value. It has the effect of offsetting exporter risk. LONG HEDGE Long hedge or buying hedge involves where a long position is taken in a futures contract. The basic objective here is to protect itself against a price increase in the underlying asset prior to purchasing it in either the spot or forward market. A long hedge is appropriate when a firm has to purchase a certain asset in futures and wants to lock in a price now. It is also called as being long. It is also known as inventory hedge because the firm already holds the asset in inventory The term long and short applies to both spot and futures markets and is widely used in futures trading. A person who hold stocks of an asset is obviously regarded as being long in spot market but is not necessary to actually hold stock. Similarly it is in the case of short, where one who has made a forward sale, regarded as being short on the spot market. LONG v/s SHORT HEDGING Short Hedger Position in Spot Market Long Short Long hedger Page : 10/ 25

11 Protection needs against Price Fall Price Rise Position in futures markets Short Long Example-4: A farmer anticipates a bumper crop amounting to 150 quintals, which he expects to harvest in month of January. It is October and current price of crop is Rs per quintal. The price is acceptable to farmer and gibe him a sufficient return. He is apprehensive of a fall in price by the time crop will be ready. He therefore, sells 150 quintals on the commodity futures market at a current price Rs 9500 per quintal. In the month of January, price of crop have in fact risen. Current spot spice is Rs per quintal. Now farmer has 2 alternatives a) He can buy back 200 quintals of January crop on futures market at a present futures price of Rs He can then deliver his actual crop of pepper in spot market at the ruling rate of Rs per quintal. Profit/Loss position is as follows: January contract Rs 9500 per quintal, January contract So net loss Rs 1000 per quintal. Further he sells his Rs in the spot market and by deducting the loss on futures market position of Rs 1000, net price obtained by farmer is Rs per quintal b) He can deliver in the future Rs 9500 per quintal CROSS HEDGING In all hedged positions, we use futures contracts, which are undertaken on the assets whose price is to be hedged, and that expires exactly when the hedge is to be lifted. Sometimes, it is seen that the firm s whish to hedge against in particular asset but no futures contracts available. This situation is called asset mismatch. Further in many cases, some futures period (maturity) on a particular asset is not available, it is called maturity mismatch. Reffering to these satiations, there is still possibility to hedge against price risk in related assets (commodities or securities) or by using futures contracts that expires on dates other than those on which hedgers are lifted. Such hedges are called cross hedges DEVISING A HEDGING STRATEGY Deciding of futures contract: to be undertaken (what kind of futures, which month to be used) Which Futures contract: (to select futures contracts of interrelated assets, with gold we can use gold coins, bullion, silver, silver coins etc.) Which contract month: Near month futures contracts will reduce basis risk. THE HEDGE RATIO CONCEPT It is to determine the optimal futures position to follow, popularly known as optimal hedge ratio. Hedge ratio HR is the ratio of size of the position taken in futures contracts to the size of the exposure. HR = Futures Position = Q f Cash Market Position Q s Page : 11/ 25

12 Where Q f is quantity (or units) of asset represented the futures position and Q s is quantity (or units) of the spot (cash) asset is being hedged. Example-5: If, a 3000 kg silver short futures position is taken to hedge a 4000 kg silver in spot position, the HR equals 3000/4000 = 0.75 MANAGEMETN OF THE HEDGE 1. Monitoring The Hedge: a. Cash position b. Futures Position c. Margins d. Basis movements e. New information 2. Adjustments to hedge: a. Changing in risk exposure b. Changes in hedge ratio c. New hedging goals d. Basis movement e. Rolling the hedge 3. Hedge Evaluation Ques-6 Forward & Futures Prices THE DETERMINATION OF FORWARD PRICE Forward contracts are generally easier to analyze than futures contracts because forward contracts there are no daily settlement and only a single payment is made at maturity. Few terms essential to know about forward contracts: An Investment Asset is an asset that is held for investment purpose, such as stocks shares bonds, treasury, securities, etc. Consumption Assets are those assets, which are held primarily for consumption, and not usually for investment purpose like cooper, oil, and food grains. Compounding is a quantitative too, which is used to know the lump-sum value of proceeds received in a particular period. Consider an amount A invested for n years at an interest rate of R percent per annum. If rate is compounded once per annum, the terminal value of investment will be Terminal Value = A(1+R) n And if it is compounded m times per annum then the terminal value will be Terminal value = A(1+R) mn Where A is amount for investment, R is rate of return, n is period for return and m is period for compounding. Example-1: Suppose A=Rs 100, R=10% per annum, n=1(one year), and if we compounded once per annum (m=1) then as per this formula, terminal value will be 100(1+10) 1 = 100(1.10) = Rs 110 Page : 12/ 25

13 if m=2 then 100(1+0.05) 1 = 100 x1.05 x 1.05) = Rs ASSUMPTIONS AND NOTATIONS FOR DETERMINATION OF FORWARD OR FUTURES PRICES There are no transaction costs. Same tax rate for all trading profits. Borrowing or lending of money at the risk free interest rate. Traders are ready to take advantage of arbitrage opportunities and when arise. THE FORWARD PRICE FOR INVESTMEN ASSET (SECURITIES) 1. Forward Price for an asset that provides no income: These are usually nondividend paying equity and discount bonds 2. Forward prices for the security that provides a known cash income: eg: coupon bearing bonds, treasury securities, known dividends etc. 3. Forward price where income is known as dividend yield: that when income expressed as a percentage of the asset lie is known. FORWARD PRICES VERSUS FUTURES PRICES In actual practice, the interest rate does not remain constant and usually vary unpredictably, then forward prices and futures prices no longer remains same. Since in futures contracts there is daily settlement, so if current price(s) increases, an investor who hold a long futures position, makes an immediate profit, which will be reinvested at a higher than average rate of interest. Similarly when current price(s) decreases, the investor will incur immediate loss, and this loss will be financed at a lower than average rate of interest. However this position does not arise in the forward contracts because there is no daily settlement and interest rate movements will not have any effect till maturity. When soot price are strongly positively correlated with the interest rates, futures prices will tend to higher than forward prices, if soot price are strongly negatively correlated with the interest rates then forward prices will tend to higher than the futures prices. GETTING OUT OF A FORWARD POSITION:: EXAMPLE-OFFSETTING THE FORWARD POSITION: Example-2: Suppose that on Jan 1,2002, a party X enters into a forward contract with another party Y, in which he agrees to buy 1 kg of gold on April 1, 2002 for Rs 5000 per 10 gms. On Feb 1, 2002, X decides to get out of his position, and hence enters into another forward contract with Z in which he agrees to sell 1 kg of gold on April , for Rs 5200 per 10 Gms. Page : 13/ 25

14 T T1 t2 Jan 1, 2002 Feb 1, 2002 April 1, 2002 Enters long forward contract expiring April Enters short forward contract expiring April 1, 2002 Long and short contracts expires X will take delivery from Y at Rs 5000 per 10 Gms of Gold (- 5 Lac for 1 kg), deliver to Z at Rs 5200 per 10 gms (+5,20,000 for 1 kg). Gain is 20,000. CHARACTERISTICS OF FUTURES PRICES 1. Relationship with forward contracts price X will Example-3: Consider a gold futures and a gold forward both expire after one year and we assume that current price of gold is Rs 5000/10 gms. Further we also assume that, futures spot price after one year is Rs 5000/10 gms. Thus, there will be no profit or loss on either contract. Also assume that when the contract will expire, the forward price, the futures price and the spot price must be equal. Further we assume 250 trading days in a year. Now let us consider 2 possible situations. First we assume that the futures price will rises by Rs 20/day for 125 days and then falls by 20 per day till maturity. Similarly the second situation where futures prices fall by Rs 20/day for 125 days and rises by Rs 20/day till maturity. At the end the price will be Rs 5000 and there is no profit and loss on either contract. 2. Futures Price and expected futures spot prices: 3. Distribution of futures prices: 4. The volatility of futures prices a. Futures trading and cash market volatility. b. Time to expiration and futures price volatility c. Trading volume and futures price volatility. THEORIES OF FUTURES PRICES 1. COST-OF-CARRY APPROACH. Futures price essentially reflect the carrying costs of the underlying asset. The interrelationship between spot and futures prices reflect the carrying costs i.e., the amount to be paid to store the asset from present time to the futures maturity time. Eg: Food grains on hand in June can be carried forward to, or stored until, December. Carrying costs are of several types i. Storage Costs: refers to those expenses, which are done on storing and maintaining the asset in safe custody, eg. Rent of warehouse and other expenses line deterioration, pilferage, normal wastage etc. In case of financial instruments, costs incurred on keeping the securities in a bank vault or with custodians. Page : 14/ 25

15 ii. iii. iv. Insurance costs: refers to amount incurred on safety of asset like fire, accidents and other. Transportation costs. Cost of financing a) Cost of Carry model in perfect market Futures price = Cash (spot) price + Carrying costs b) Cost of Carry model in imperfect market There are various imperfections in the real markets, which disturb some stages of perfect markets. Some of them are Direct transaction costs, Unequal differential borrowing and lending rates, Restrictions on short selling, Bid-ask spread, Storage problem. 2. THE EXPECTAION APPRAOCH Expected futures profits = Expected futures price initial futures price Example-4: There is general expectation that the price of gold next April 1 will Rs 5200 per 10 grams. The futures price today for July 1 must be somewhat reflects this expectation. If today s futures price is Rs 5180 of gold, going long futures will lead an expected profit of Rs 20 ( ). Ques- Ques- Interest Rate Futures Interest Rate Derivative Securities TYPES OF INTERESRT RATES 1. Treasury Rates is the rate of interest applicable to borrowing by a government in its own currency. 2. LIBOR rate London Inter Bank Offer rate at which large international banks are willing to lend money to another large international bank. 3. Repo rate Difference between selling price and repurchase price of security is called interest rate/ Repo rate. 4. Zero Rate / Spot Rate Rate of interest earned on an investment that starts today and lasts for n-years. 5. Forward rates rate of interest implied by current spot rate for periods of time in futures. THE UNDERLYING MARKETS 1. Inter bank market 2. Certificate of Deposit (CD) market. 3. The Commercial Paper (CP) market. 4. The local government securities market. RISK IN DEALING THE SECURITIES Page : 15/ 25

16 Default Risk losing principal amount due to bankruptcy of the borrower. Interest rate risk uncontrollable inflation rate, money supply growth rate THEORIES OF TERM STRUCTURE 1. Expectation theory 2. Market Segment Theory 3. Liquidity Preference Theory 4. Liquidity Premium Theory SHORT TERM INTEREST RATE FUTURES FORWARD INTEREST RATE It is rate of interest implied by current spot rate for periods of time in futures. Example-1 : Year (n) Spot rate for an n-year investment (% pa) Forward rate for an n-th year investment (% pa) Assuming 10% rate of interest for 1 year means that for an investment of Rs 100 the investor will receive Rs (100e 0.1 =110.52) and at the rate of 10.5 % pa, he will get Rs (100e 0.105x2 = ) in 2 years and so on. Forward rate of year-2 is 11% pa. The forward rate is implied to spot rate, it can be calculated from the 1-year spot interest rate of 10% pa and the 2-year spot interest rate of 10.5 % pa. To show the exact forward rate of interest of 11 % pa, let us assume that Rs 100 is invested. A rate of 10% for first year and 11 percent for second year yield will be 100e 0.1 e 0.11 = We have already seen that a rate of 10.5% pa for 2 years yields: 100e 0.105x2 = Similarly, the forward rate for the third year is the rate of interest that is implied by a 10.5% pa spot rate and a 10.8% pa three-year spot rate. It is 11.4 % pa. This is because an investment for two years at 10.5% pa averaged with the investment for 1 year at 11.4 % pa gives an overall return for three years at 10.8 % pa. TREASUREY BILL FUTURE Treasury Bill (TB) are major interest rate securities and normally issued for 90 days and 180 days respectively. They are issued on discount and have maturity less than one year. The difference between the purchase price of a treasury bill and its face value determines the interest earned by the buyer Page : 16/ 25

17 Purchase Price of T-Bill = Face Value Discount Or Face Value (Face Value) (Yield) (No. of days to maturity) / 360 THE TED SPREAD It is the difference between the prices of futures contracts between 3-months US treasury bills and the 3-month Eurodollar time deposit both with the same expiration month. The spread is quoted as T-Bill futures price minus Eurodollar futures price. HEDGING USING SHORT TERM INTEREST RATE FUTURES Short-term interest rate futures can be used to hedge against interest rate risk and to lock in future investment yield or futures cost of borrowing. Further, these can be used by banks and other corporations to structure their fixed income securities in accordance with changed economic conditions from time to time. LONG TERM INTEREST RATE FUTURES Long-term government bond futures contracts are,most actively traded contacts on derivative exchanges all over the world. First such trading was started in US market. TREASUREY BONDS AND TREASUREY NOTES Treasury bonds have maturity greater than 10 years and as long as 30 years. Treasury notes have original maturities of 10 years and less. COMMON FEATURES OF GOVERNMENT BONDS Pay a fixed rate of interest (coupon) per period (usually six months) They have definite redemption date like 5,10,20 and so on. They have a marked price expressed as a sum per $ 100 nominal. Ques-8 Barter, Badla & Swaps Barter the exchange of one commodity for another as per use. Badla whereby the buyer or seller of shares may be allowed to postpone payment of money, or delivery of the shares, as the case may be, in return for paying or receiving a certain amount of money. Swap are to barter or to give in exchange. It is private agreement in between 2 parties to exchange cash flows in future according to a prearranged formula. Page : 17/ 25

18 In financial market it has 2 meanings First it is a purchase and simultaneously sale or vice-versa. Secondly it is agreed exchange of future cash flows, possibly but not necessarily with a spot cash flow. FEATURES OF SWAPS 1. Counter parties at least 2 parties. 2. Facilitators intermidiatory usually a large financial institution / bank. 3. Cash Flows 4. Documentations - are generally less than loan deals. 5. Transaction costs 6. Benefits to parties 7. Termination 8. Default Risk. Major types of financial swaps are 1. Interest rate swaps 2. Currency swaps 3. Equity swaps I. INTEREST RATE SWAPS It is financial agreement between two parties who wish to change the interest payments or receipts in the same currency on assets or liabilities to a different basis. There is no exchange of principal amount in this swap. It is an exchange of interest payment or a specific maturity on an agreed upon notional amount. Features: 1. Notional principal 2. Fixed rate it is rate used to calculate size of fixed payment. 3. Floating rate it is one of the market indexes like LIBOR, SIBOR, MIBOR. 4. Trade date, Effective date, Reset date and Payment date Types of interest rate swaps: 1. Plain vanilla swap fixed for floating swap. 2. Zero coupon to floating 3. Alternative floating rates 4. Floating to floating 5. Forward swap 6. Rate-capped swap. 7. Swaptions. II. CURRENCY SWAP Swap deal across currencies. In this swap, two payment streams being exchanged are denominated in two different currencies. Eg: a firm which has borrowed Japanese yen at a fixed interest rate can swap away the exchange rate risk by setting up a contract Page : 18/ 25

19 whereby it receives yen at a fixed rate in return for dollars at either a fixed or floating interest rate. In this normally three steps are involved: Initial exchange of Principal amount. Ongoing exchange of interest. Re-Exchange of principal amount on maturity. Types of currency swaps are: Fixed-to-Fixed currency swap. Floating to Floating Swap. Fixed to-floating currency swap. III. DEBT-EQUITY SWAP In this a firm buy s country s debt on the secondary loan market at a discount and swaps it into local equity. In other words debts are exchanged for equity by one firm with the other. Ques-9 Options Market Option confers a right, rather than obligation, to buy or sell the underlying asset. It is type of contract between two parties where one person gives the other person, the right to buy or sell a specific asset at a specified price within a specified rime period. Option is a specific derivative under which one party gets the right, but no obligation, to buy or sell a specific quantity of an asset at an agreed price on or before a particular date. Option Terminology: Parties of the option contract Buyer is Holder and Writer is Seller. Exercise price Expiration date and exercise date Option premium Break-even price. Option In, Out and at the money Call option Put option In the money Futures > Strike Futures < Strike At the money Futures = Strike Futures = Strike Out of the money Futures < Strike Futures > Strike TYPES OF OPTIONS: 1. Call and Put options: When an option grants the buyer (holder) the right to purchase the underlying asset/stock from the writer (seller) a particular quantity at a specified price within a specified expiration date, it is called call option or simply a call. It is an option to purchase. A put option on the other hand, is an Page : 19/ 25

20 option contract where the option buyer has the right to sell the underlying asset to the writer, at a specified price at or prior to the option s maturity date. It is also called simply a put. 2. American and European option: European option can be exercised only at expiration date, whereas American option can be exercised at any time upto and including the expiration date. 3. Exchange-Traded and OTC-traded options OPTIONS POSITIONS 1. A Long position in a call. 2. A Long position in a Put. 3. A Short position in a call. 4. A Short position in a Put. Ques-10 Properties of Stock Options Prices DETERMINANTS OF OPTION PRICES 1. Current price of the underlying asset Option price will change as the stock price changes. 2. Strike Price of the option is fixed for the life of option. In case of call, lower the strike price higher will be the option price and vice-versa. The same is reverse in case of put option. 3. Time to expiration of the option longer the time to expiration higher will be the option price. 4. Expected stock price volatility greater the volatility of the price of the stock, the more an investor would be willing to pay for the option, and more premium an option writer would demand for it due to increased risk in option contract. 5. Risk free interest rate higher the short term risk free interest rate, the greater the price of a call option. 6. Anticipated cash payments on the stock Anticipated cash payments on the stock tend to decrease the price of a call option because the cash payments make it more attractive to hold stock than to hold the option. Ques-11 Strategies involving Options What happens when a position in a stock option is combined with a position created in a two or more different options on the same stock. The basic idea of opting trading is based on views as to whether or not the existing price of and option series is likely to change or not. STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK. SPREADS Vertical SPREADS Page : 20/ 25

21 Vertical Bull spread Bullish call option spread Bullish put vertical option spread Bearish vertical option spared Bearish vertiacal call option. Bearish vertiacal put option. Ques-12 Black Sholes (B-S) option Model The B-S option-pricing model is most commonly used option-pricing model in finance. IT was developed in 1973 by Fisher Black and Myron Scholes and was designed to price European options on non-dividend paying stocks. Later on it was applicable to American options also. In this model there is a formula in which certain values are input and from which option price is forthcoming. ASSUMPTIONS UNDERLYING B-S MODEL 1. Stock price behavior corresponds to log normal distribution. 2. There is no transaction costs or taxes. 3. All securities/ stocks are perfectly divisible. 4. No dividend payments on stock during the life of the option. 5. There are no risks less arbitrage opportunities. 6. Stock trading is continuous. 7. Investors can borrow or lend at the same risk free rate of interest. 8. The sort-term risk free interest rate r is constant. THE (B-S) PRICING FORMULA. Where C is call price, P is put option price, S is Stock price, K is strike price, e is exponential (which has the constant value of ), r is risk free interest rate (annualize), T is time to expiry (in years), mew is the annualized standard deviation of stock returns (volatility) as a decimal, e -rt is a discount term similar to I/(1+r) t and as such it determines the present value of a future sum of money and its discount on continuous compounding, I n (.) is the natural algorithm, N(.) is the cumulative probability distribution function for a standardized normal variable, N(d 1 ) is the area under the distribution to the left of d 1 and N(d 2 ) is the area under the distribution to the left of d 2. Page : 21/ 25

22 The model is based on 5 inputs (S,K,T, mew and r), four of them are easily available but only variable that is not directly observable is the expected volatility of stock return. Ques-13 Binomial Model It is pricing a stock option through constructing a binomial tree. This model line (B-S) model does not permit an analytical solution rather solves the problem numerically. There is no formula that can be programmed in computer, instead computer must be programmed to ascertain solution. ASSUMPTIONS UNDERLYING BINOMIAL MODEL 1. There are no market frictions. 2. Market participants entail no counter party risks. 3. Markets are competitive. 4. There are no arbitrage opportunities. 5. There is no interest rate uncertainty. A ONE-STEP BINOMIAL MODEL. Consider a very simple solution where a stock price is currently Rs 20, and it is known that after 3 months, it may be either Rs 22 or Rs 18. We further assume that we are considering in valuing a European Call option to buy the stock for Rs 21 in 3 months. In this option, we are estimating 2 values, i.e., Rs 22 and Rs 18, if the value turns up to Rs 22, the option value Re 1, and if Rs 18, the value will be zero. (Today) Stock ( S 0) Price Rs 20 After 3 months if stock price moves up After 3 months if stock price moves down Stock price Rs 22 (Option price 1) S1 = u 0(S 0) Stock price Rs 18 (Option price 0) S1 = D 0(S 0) Where S(1) = Stock price after the period. Page : 22/ 25

23 S(0) = Initial stock price. u 0 = Up factor. D 0 = Down factor. Exercise price = Rs 21 u 0 = (22-20 = 2/20, 1.10) and down factor D 0 are also called price relatives. with D 0 (20-18 = 2/20, 0.90). These Ques-14 Ques-15 Options on Stock Indices Currencies and futures contracts. The price pf one currency in terms of another currency is known as exchange rate. The foreign exchange spot market trades in different currencies for both spot and forward delivery. In a spot exchange market, the business is transacted throughout the world on a continual basis. The exchange rate, which is obtained by cross product of two exchange rates, is called cross rate. CURRENCY FUTURES A currency futures contracts provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified piece and a standard quantity. The different currencies are sold and purchased at specified future date, at predetermined price and specified quantity on a particular recognized stock exchange. FEATURES OF CURRENCY FUTURES 1. Organized exchangestandardization 2. Minimum variation (Tick size) 3. Clearing house 4. Marking to Market 5. Margins 6. Trading process 7. Settlement process and delivery Page : 23/ 25

24 Ques-18 Derivative Market in India ELIGIBILITY OF STOCKS DERIVATIVES Financial Derivative Markets Regulated by Commodities Futures Market Regulated by Forward Market Commission SEBI Stock Exchanges RBI Over-the-counter (OTC) Equity Carry Forward Currencies Interest Rates (Futures) (Forward) (Forward) Stock Index Stock Index Short-Term Long-Term Futures Futures Futures Futures Option Forward 1. Introduction 2. Need for derivatives 3. Evolution of derivatives in India 4. Major Recommendations of Dr. L.C. Gupta Committee. 5. Benefits of Derivatives in India 6. Categories of Derivatives in India 7. Emerging structure of Derivative market in India Page : 24/ 25

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