CA Final Strategic Financial Management, Paper 2, Chapter 5 CA Tarun Mahajan
Derivatives Forwards Futures basic Speculation using futures Hedging using futures Arbitrage using futures
Derivative is something which does not have its own existence and value. Its value is dependent upon value of some other item called underlying. A non financial example of derivative is Curd. Another example is mutual fund units. Another example could be forward contract on foreign exchange.
Forwards Derivatives Futures Options Swaps
It is a contract to buy/sell on a specified future date, at a predetermined rate. Following things are fixed in advance in a forward contract: Underlying Quantity Quality Settlement date Rate
Buyer in a forward contract is called long. And his position is called long position. When price goes up beyond the contracted price, Long makes a gain. Seller in a forward contract is called short. And his position is called short. When price goes down below the contracted price, Short makes a gain.
All derivatives are zero sum games. If long makes a gain, short loses and vice versa. Forwards are over the counter contracts hence These can be customized as per the requirements of parties. Counterparty risk exist.
Futures are exchange regulated forward contracts. Following are points of differences: Forward Over the counter Customized Less liquid No margin Counterparty risk exists Future Exchange traded Standardized More liquid Margin is required No counterparty risk
Following things are standardized in a future contract: Underlying Lot size Quality Expiry date Tick size
On 22nd April I agree to buy 125 shares (1 lot) of Infosys Ltd. for 30th May at a price of Rs. 2250 at NSE and you are the seller. Here my position is long and your position is short. NSE is the counterparty for both of us. If on 30th May price rises to Rs.2300 you will pay me Rs.50 x 125 = Rs.6250. But if it falls to Rs.2220, I will pay you Rs.30x125 =Rs.3750
Speculation: taking risk in anticipation of gain. Any derivative contract can be used for one of the following three purposes: Hedging: passing on risk to have a fixed outcome. Arbitrage: making gain from disequilibrium between spot and future price.
Bullish: Long future Bearish: Short future Example: say today it is 22nd April and spot gold price is Rs.26,000 and I think that within a month or two It will rise to 28,000 level. Then I can long 1kg (1 lot) of gold future say at Rs.26465 per 10 grams for expiry of 5th June. If on 5th June gold price rises to 27,000 then I will have a profit Rs.535 (27000-26465) per 10 grams, totaling Rs.53,500.
Have Stock, Short stock future If you have 500 shares of RIL and want to sell it in June end, then you can short 2 lots (lot size 250) of RIL say at a price of Rs.790. Now even if price falls you will realize Rs.790 per share. Have Money, long stock future If you want to buy 125 shares of SBI in May end, then you can long 1 lot (lot size 125) of SBI today at a price of 2290. Now even if price rises, you will have to pay only Rs.2290 per share.
If stock futures are not available then one can hedge through index futures also. But it will hedge market related risk only, not the total risk. Index position = stock position x stock beta. Example: if you have 10000 shares of ONGC. Current price = Rs.330; Beta = 0.80. Here you can short Nifty futures of 10000 x 330 x 0.80 = Rs.26,40,000.
Next month Nifty future is available at 5855 and lot size is 50 hence one lot will be worth 2,92,750. No. of lots = 26,40,000/2,92,750 = 9.02 lots, approx. 9 lots. Now if market comes down by 10%: Short Nifty will give you profit of 585.5x50x9 = 263475. ONGC should fall only 8% (10% x 0.8) hence a loss of 330 x 8% =26.4, 26.4 x 10,000 = 2,64,000
A Mutual fund is holding the following assists in ` Crore : Investment in diversified equity shares 90.00 Cash and bank Balances 10.00 100.00 The Beta of the portfolio is 1.1. The index future is selling at 4300 level. The Fund Manager apprehends that the index will fall at the most by 10%. How many index futures he should short for perfect hedging so that the portfolio beta is reduced to 1.00? One index future consists of 50 units. Substantiate your answer assuming the Fund Manager's apprehension will materialize.
Short position required in index future = 100cr. (1.10-1) = 10cr. Amount of one lot of index future = 4300 x50 = Rs.2,15,000 No. of futures = 10cr./215000 = 465 lots Now if Index falls by 10% then there will be profit in index future of Rs.430x50x465= 1cr. Value of portfolio = 100cr -11% = 89 cr. Total amount 90cr. Which is 10% hence beta of portfolio is 1.
Ideal Future Price = Spot Price + Cost of Carry Cost of Carry includes mainly risk free interest rate. For stocks, dividend is a negative carrying cost. For commodities it includes storage cost also. A simple formula is F = S x e rt With dividend F = S x e rt D x e rm With Storage Cost, F = = S x e rt + C x e rm
S=Spot price, r= risk free interest rate, t=no. of year till expiry, m= no. of years from dividend to expiry Say spot price of TCS is Rs.1425, risk free rate is 6% p.a. hence 6 months ideal future price = 1425 x e 0.06 x 0.5 = 1425 x 1.0305 = 1468 Note that:
If actual future price is more say Rs.1490 then one can make arbitrage profit as follows. Particulars Today Expiry Date Rs. 1000 Rs.2000 Short Future @1490-490 -510 Buy Spot -1425 1000 2000 Borrow Money 1425-1468 -1468 Net 0 22 22
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. 312. 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. (4 Marks)
F = 300 (1.008) 3 = 307.26. Actual price is 312, means future is overvalued. Particulars Today Expiry Date Rs. 200 Rs.400 Short Future - 112-88 @312 Buy Spot -300 200 400 Borrow Money 300-307.26-307.26 Net 0 4.74 4.74
Spot price of TCS is Rs.1425, risk free rate is 6% p.a. and company is expected to give dividend of Rs.10 per share after 2 months hence 6 months ideal future price = 1425 x e 0.06 x 6/12 0.06 x 4/12-10 x e = 1425 x 1.0305 10 x 1.0202 = 1458 In case of commodities we add storage cost similar to we have deducted dividend in above formula.
Contracts deriving value from other items are derivatives. Forwards are over the counter derivative contracts Futures are exchange traded forwards Speculation with futures give leverage Index can also be used to hedge stock positions Arbitrager not only makes profit but also establishes equilibrium.
CA.Tarun Mahajan, tarunmahajanca@gmail.com