3.1 futures

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Presented by A.K.Tiwari

Assistant Professor-DSPSR

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` Spot Price : Spot price of an underlying asset is the price that isquoted for immediate delivery of the asset

` Futures price : The price at which the futures contract trades in the

futures market.` Contract cycle : The period over which a contract trades. The index

futures contracts on the NSE have one- month, two-months andthree months expiry cycles which expire on the last Thursday of themonth.

` Expiry date : It is the date specified in the futures contract. This isthe last day on which the contract will be traded, at the end of whichit will cease to exist.

A.K.Tiwari - Assistt. Professor 2

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` Tick SizeA market's tick size is the minimum amount that the price of themarket can change. For example, the EUR futures market has a tick size of 0.0001, which means that the smallest increment that theprice can move from 1.2902, would be up to 1.2903, or down to1.2901. The tick size is also known as the minimum price change.

` Tick ValueA market's tick value is the cash value of one tick (one minimumprice movement). For example, the EUR futures market has a tick value of $12.50, which means that for every 0.0001 that the pricemoves up or down, the profit or loss of a trade would increase or decrease by $12.50. The tick value is also known as the minimumprice value.


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` Clearing House/Corporation : Both buyer and seller of the futurescontracts are protected against the counter party risk by an entitycalled the Clearing Corporation. The Clearing Corporation providesthis guarantee to ensure that the buyer or the seller of a futures

contract does not suffer as a result of the counter party defaulting onits obligation. In case one of the parties defaults, the ClearingCorporation steps in to fulfill the obligation of this party, so that theother party does not suffer due to non-fulfillment of the contract.

` Standardization: The standardized items in a futures contract are:

Quantity of the underlying, Quality of the underlying, The dateand the month of delivery, The units of price quotation andminimum price change and Location of settlement


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` M argin : In finance, a margin is collateral that the holder of afinancial instrument has to deposit to cover some or all of the creditrisk of his counterparty (most often his broker or an exchange). Thecollateral can be in the form of cash or securities.

` M argin M oney: To be able to guarantee the fulfilment of theobligations under the contract, the Clearing Corporation/Exchangeholds an amount as a security from both the parties. This amount iscalled the M argin money and can be in the form of cash or other financial assets.

` M argin Account : An account with the broker/exchange in whichM argin money is deposited. The margin account may or may notearn account.


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` Initial margin : The amount that must be deposited in the marginaccount at the time a futures contract is first entered into is knownas initial margin. It may be 5% or less of the underlying assetsvalue and determined on the basis of the degree of volatility of price

movements in the past of the underlying assets.` M aintenance margin : This is somewhat lower than the initial

margin. This is set to ensure that the balance in the margin accountnever becomes negative. If the balance in the margin account fallsbelow the maintenance margin, the investor receives a margin call

and is expected to top up the margin account to the initial marginlevel before trading commences on the next day. This is normallyabout 75% of the initial margin.


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` The Variation margin : It refers to that amount which has to bedeposited by the trader with the broker to bring the balance of themargin account to the initial margin level.

` M arking-to-market : In the futures market, at the end of each trading

day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is calledmarking-to-market.

The basic purpose of the M arking to market is that the futurescontracts should be daily marked or settled and not at the end of itslife. Everyday the traders gain (loss) is added to or (subtracted)from margin account. In the other words, a futures contract is closedout and re written at a new price everyday.


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In fina nc e, short selling (also k nown as shorting or goingshort ) is the pra c tice of selli ng assets, usually se curities , thathave bee n borrowed from a third party (usually a broker ) with thein te n tion of buyi ng ide n tical assets ba ck at a later date to retur nto the le nder. The short seller hopes to profit from a de c line i n theprice of the assets betwee n the sale a nd the repur chase, as theseller will pay less to buy the assets tha n the seller re ceived o nselli ng them. Co nversely, the short seller will i nc ur a loss if theprice of the assets rises. Other costs of shorti ng may i nc lude afee for borrowi ng the assets a nd payme n t of a ny divide nds paidon the borrowed assets. "Shorti ng " a nd "going short" also refer toe n teri ng in to a ny derivative or other con tra c t u nder whi ch theinvestor profits from a fall i n the value of a n asset.


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Pay-Off is the likely profit and loss that should accrue to a marketparticipant with change in the price of the underlying assets. It maybe of two types.

1. Linear Pay-Off: It is applicable in both forward and futurecontract. It means profit and loss for both buyer/seller of future/forward are unlimited.

2. Non-Linear Pay-Off: It is applicable only in case of OptionContract. It means loss is limited but profit is unlimited for theoption buyer but profit to option writer is limited to the optionpremium but loss is unlimited.

` Gain = No. of Units ( Future Spot Price - Delivery/Forward Price)` Loss = No. of Units (Delivery/Forward Price - Future Spot Price)


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` Interest Rate Futures

` Foreign Currency Futures/Exchange Rate Futures

` Stock Index Futures

` Bond Index Futures

`

Cost of Living Index Futures


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` H ed gers

` Spe culators

` Arbitra geurs

` Spreaders


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In hedging, the trader holds two positions of equal amounts but

opposite directions, one in the underlying markets, and the other

in the derivatives markets, simultaneously. This risk management

strategy is based on the following reasoning: it is believed thatunder normal circumstances, prices of underlying assets and their

derivatives change roughly in the same direction with basically

the same magnitude; hence losses in the underlying assets

(derivatives) markets can be offset by gains in the derivatives(underlying assets) markets; therefore losses can be prevented or

reduced by combining the risks due to the price changes.


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H ed g ing in futures market ca n be do ne throu gh twopositio ns, viz. short hed ge a nd lo ng hed ge.

`

Short HedgeA short hed ge i nvolves taki ng a short positio n inthe futures market. Short hed ge positio n is take nby someo ne who already ow ns the u nderlyi ng

asset or is expe c ting a future re ceipt of theunderlyi ng asset.


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L ong Hedge

A long hed ge i nvolves holdi ng a lo ng positio n in the

futures market. A Lo ng positio n holder a grees to buy the

underlyi ng asset at the expiry date by payi ng the a greed

futures/ forward pri ce. This strate gy is used by those

who will need to a cq uire the u nderlyi ng asset i n the

future.


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A Spe culator is o ne who bets o n the derivatives market basedon his views o n the pote n tial moveme n t of the u nderlyi ngsto ck pri ce. They are willi ng to take a risk by taki ng futurespositio n with the expe c tatio n to ear n profit. Spe culators take

lar ge, calculated risks as they trade based o n a n tic ipatedfuture pri ce moveme n ts. They hope to make quick, lar gegains; but may not always be su cc essful. They normally haveshorter holdi ng time for their positio ns as compared tohed gers. If the pri ce of the u nderlyi ng moves as per their expe c tatio n they ca n make lar ge profits. H owever, if the pri cemoves i n the opposite dire c tion of their assessme n t, thelosses ca n also be e normous.


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Arbitrageurs attempt to profit from pricinginefficiencies in the market by makingsimultaneous trades that offset each other and capture a risk-free profit. Anarbitrageur may also seek to make profit incase there is price discrepancy between the

stock price in the cash and the derivativesmarkets.


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1. Hedging

2. Price Discovery

3. Financing Function

4. Liquidity Function

5. Price Stabilization Function6. Disseminating information


3.1 futures

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