Chapter 19

FUTURES

Where the Hedgers and the Speculators Meet

OUTLINE

• Features of a Futures Contract

• Mechanics of Trading

• Futures Contracts : The Global Scene

• Financial Futures

• Equity Futures in India

• Pricing of Futures Contracts

• Use of Futures Contracts

• Assessment

WHAT IS A FUTURES CONTRACT?

A forward contract is an agreement between two parties to

exchange an asset for cash at a predetermined future date

for a price that is specified today. A futures contract is a

standardised forward contract.

DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACTS

FORWARDS FUTURES

TRADED OVER THE COUNTER TRADED ON EXCHANGE

NO SECONDARY MARKET SECONDARY MARKET EXISTS

TERMS NEGOTIATED BETWEEN STANDARDIZED CONTRACT (QTY,BUYER AND SELLER DATE & DELIVERY CONDITIONS)

MOST CONTRACTS END WITH NORMALLY NO DELIVERY PHYSICAL DELIVERY OFFSETTING TRANSACTION

CREDIT RISK ASSUMED BY CREDIT RISK ASSUMED BY BUYER CLEARING CORPORATION AND

MEMBER FIRMS

NO COLLATERAL SECURITY COLLATERAL POSTED MARKET TO THE MARKET

PARTICIPATION LIMITED TO LARGE NUMBER OFSMALL NO. OF LARGE TRADERS PARTICIPANTS

FUTURES TERMINOLOGY

• SPOT PRICE

• FUTURES PRICE

• CONTRACT CYCLE

• EXPIRY DATE

• CONTRACT SIZETHE AMOUNT OF ASSET THAT HAS TO BE DELIVERED UNDER ONE CONTRACT. FOR INSTANCE, THE CONTRACT SIZE ON NSE’S FUTURES IS 200 NIFTIES

• BASISFUTURES PRICE - SPOT PRICE

• INITIAL MARGIN

• MARKING TO MARKET

• MAINTENANCE MARGIN

PAYOFFS TO THE FORWARD BUYER AND FORWARD SELLER

A : Forward Buyer B : Forward Seller

Profit Profit

Loss Loss

C

C

P

P

C = Contract priceP = Actual price

MECHANICS OF TRADING

Trading in futures is more complex than trading in stocks.

Inter alia it involves

• Intermediation by a clearing house

• Margins

• Marking - to - market

Longposition

Money

Clearinghouse

Shortposition

Asset

Money

Asset

THE ROLE OF THE CLEARING HOUSE

MARGINS

• When you execute a futures trade, you have to provide the initial margin.

• If you incur sustained losses from daily marking-to- market, and your margin amount falls below a critical level called the maintenance margin you have to replenish the margin amount.

MARKING-TO-MARKET

While forward contracts are settled on the maturity date, futures contracts are ‘marked to market’ on a periodic basis.

Assume that the spot price of gold is $450 and the four period futures contract in gold has a price of $460. In the wake of changes in the price of the gold futures contract, the cash flow to the buyer and seller of this contract will be as shown in the last two columns of the following table.

Gold Forward Futures Time Period Futures contract Buyer’s cash flow Seller’s cash flow Buyer’s cashflow Seller’s cash flow

1 465 $0 0 $5 $-5 2 455 0 0 -10 10 3 460 0 0 5 -5 4 465 5 -5 5 -5

FUTURES CONTRACTS GLOBAL SCENE

Commodity Futures Exchange Financial Futures Exchange Cocoa CSCE, FOX U.S Treasury bills IMM, MCE Cotton CTN Eurodollar deposits IMM, LIFFE Aluminum COMEX,LME Standard & Poor's Gold LME (S&P) Index IMM Crude oil IPE, NYMEX Sterling IMM, LIFFE,MCE Soyabean oil CBT Phil SE CSCE Coffee , Sugar and Cocoa Exchange , New York FOX London Futures and Options Exchange CTN New York Cotton Exchange COMEX Commodity Exchange , New York LME London Metal Exchange IPE International Petroleum Exchange of London NYMEX New York Mercantile Exchange CBT Chicago Board of Trade IMM International Monetary Market(at the Chicago Mercantile Exchange) LIFFE London International Financial Futures Exchange MCE Mid America Commodity Exchange Phil SE Philadelphia stock Exchange

MAJOR TYPES OF FUTURES CONTRACTS

Type Example

Futures contracts on debt instruments US Treasury bond futures contract: This is a contract for delivery of US Treasury

bonds with $100,000 face value and having a maturity of at least 15 year from the delivery date

Futures contract on monetary metals Futures contract on gold : This is a

contract for delivery of 100 troy ounces of gold of 0.995 fineness

Futures contract on foreign currencies Futures contract on British pound: This

is a contract for delivery of 25,000 British pounds, on the appropriate future date

Futures contract on stock markets indices Futures contract on S&P 500: The

underlying value of the contract is $500 times the S & P 500 index. Unlike other futures contracts, the

settlement of an index futures contract is by cash payment

FINANCIAL FUTURES

• Equity Futures

• Interest Rate Futures

• Foreign Exchange Futures

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STOCK INDEX FUTURES

S & P CNX NIFTY FUTURES

TRADING CYCLE … MAXIMUM OF 3 MONTHS

EXPIRY DAY LAST THURSDAY OF THE EXPIRY MONTH

INDIVIDUAL STOCK FUTURES

TRADING CYCLE MAXIMUM 3 MONTHS

EXPIRY LAST THURSDAY OF THE EXPIRY MONTH

SIZE SAME AS THE LOT SIZE OF OPTIONS CONTRACT FOR A GIVEN UNDERLYING

BASE PRICE ON INTRODUCTION, THE PREVIOUS DAY’S CLOSING PRICE OF THE UNDERLYING SECURITY

SETTLEMENT CASH-SETTLED. DAILY MARK-TO-MARKET

PRICING OF EQUITY FUTURES

COST-OF-CARRY RELATIONSHIP

F0 = S0 (1 + rf)T

S0 = RS. 400 … rf = 1% PER MONTH 3 MONTHS FUTURES CONTRACT

F0 = S0 (1 + rf)T = 400 (1.01)3 = 412.12

SUPPOSE 3-MONTHS FUTURES … RS. 412

ACTION INITIAL CASH FLOW CASH FLOW AT (3 MONTHS)

• BORROW RS.400 + 400 - 400 (1.01)3 = - 412.12 NOW & REPAY WITH INT. AT TIME T

• BUY A SHARE - 400 ST

• SELL A FUTURES 0 414 - ST

CONTRACT (F0 = RS. 414)

0 RS. 1.88

PRICING OF EQUITY FUTURES – 2

F0 = S0 erf t

WHEN THE UNDERLYING ASSET PRODUCES INCOME TO THE OWNER

F0 = S0 (1 + rf - d)T

SUPPOSE … STOCK INDEX … S0 = 1200

rf = 1% P.M

d = 0.25% P.M

F0 = 1200 (1 + 0.0075)3 = 1227.2

PRICING OF TREASURY BOND FUTURES

A TREASURY BOND FUTURES CONTRACT IS A CONTRACT FOR DELIVERY IN FUTURE OF TREASURY BONDS HAVING CERTAIN FUTURES.

TREASURY BOND FEATURES ARE VALUED THE WAY STOCK INDEX FUTURES ARE VALUED, WITH ONE DIFFERENCE.

F0 = (S0 - PVC) (1 + rf )T

PRICING OF COMMODITY FUTURES

(STORABLE COMMODITIES)

FUTURES SPOT PV OF PV OF PRICE PRICE STORAGE CONVENIENCE

= + COSTS - YIELD (1 + rf )T

PERI SHABLE COMMODITIESFUTURES PRICES VS. EXPECTED SPOT PRICES

• SO FAR .. REL’N … FUTURES PRICES & CURRENT SPOT PRICE

• A CONTROVERSY .. THEORY OF FUTURES PRICING CONCERNS .. REL’N .. FUTURES PRICE & THE EXPECTED VALUE .. SPOT PRICE IN FUTURE

EXPECT’NSHYPOTHESIS : F = E (St)

NORMALBACKWARD’N : F < E (St ) SUPPLIERS HEDGE

CONTANGO : F > E (St ) BUYERS HEDGEFUTURES PRICES

CONTANGO

EXPECT’NS HYPOTHES

NORMAL BACKWARD’N

TIMEDELIVERY DATA

WHO USES FUTURES CONTRACTS?

• Hedgers

• Short (sell) hedge

• Long (buy) hedge

• Speculators

• Arbitrageurs

• Futures-futures arbitrage

• Cash-futures arbitrage

WHAT ECONOMIC FUNCTIONS DO FUTURES AND OPTIONS PERFORM?

ECONOMIC FUNCTIONS • RISK TRANSFER • PRICE DISCOVERY • MARKET COMPLETION • LOWER VOLATILITY • HIGHER LIQUIDITY • LOWER TRANSACTION COSTS

EMPIRICAL EVIDENCE

CONCLUSION• DERIVATIVES .. SHIFT .. SUPPLY CURVE OF INVESTMENT CAPITAL DOWN AND TO THE RIGHT …

DERIVATIVE MARKETS .. TRUE ‘CHILD’ OF THE FINANCIAL & INFORMATION SERVICES REVOL’N … LEADING EDGE .. GLOBAL INTEGRATION OF FINANCE

RICHARD O’ BRIEN

CRITIQUE AND RESPONSE

NOTWITHSTANDING … ENDORSEMENT OF DERIVATIVES .. BY FINANCIAL ECONOMISTS AND BUSINESS PERSONS … WIDESPREAD CONCERN .. JOHN SHAD

“FUTURES AND OPTIONS ARE THE TAIL WAGGING THE DOG. THEY HAVE ESCALATED … THE LEVERAGE AND VOLATILITY OF THE MARKETS … TO PRECIPITOUS, UNACCEPTABLE LEVELS”

MANY IN THE PROFESSION DISAGREE

VOLATILITY IN THE UNDERLYING CASH MARKET IS THE IMPETUS FOR INTRODUCING DERIVATIVES AND NOT THE CONSEQUENCE THEREOF

EMPIRICAL EVIDENCE … DECLINE .. IN .. VOLATILITY OF .. UNDERLYING .. CASH MARKET … INTR’N OF DERIVATIVES

SUMMING UP

• A standardised forward contract is a futures contract.

• Broadly, there are two types of futures, commodity futures and financial futures.

• The three main types of financial futures are: equity futures, treasury bond (or interest rate) futures, and currency futures.

• Equity futures are of two types: stock index futures and futures on individual securities. Both the types of futures have been introduced in India.

• A treasury bond futures contract is a contract for delivery in future of treasury bonds having certain features.

• Futures contracts can be priced using the principle of arbitrage.

• The theoretical price of the stock index futures, as well as futures on an individual stock, is:

F0 = S0 (1 + rf – d)T

• The theoretical price of a Treasury bond futures contract isF0 = (S0 – PVC) (1 + rf)T

• The futures price of a perishable commodity is influenced by two factors mainly: (a) the expected spot price of the underlying commodity and (b) the risk premium associated with the futures position.

• Hedgers, speculators, and arbitrageurs are the participants in the futures market.

• Futures and options perform three very useful economic functions: risk transfer, price discovery, and market completion.

• There is a widespread popular belief that derivatives accentuate volatility. Many in the profession strongly disagree with this view.