final futures and forwards1

8/7/2019 Final Futures and Forwards1

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Introduction to DerivativesIntroduction to Derivatives

Futures And ForwardsFutures And Forwards

Institute of public EnterpriseInstitute of public Enterprise

March,2011March,2011


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Introduction to Derivatives

A derivative is a contract whose value is dependent onvalue of an underlying asset.

Broadly derivatives are classified in to two groups (i)Financial Derivatives and (ii) Commodity Derivatives

Based on the nature of contract Derivatives are classified as(i) Over The Counter (OTC) Derivatives and (ii) ExchangeTraded Derivatives.

Financial Derivatives are further classified as (i) Forwards

(ii) Futures (iii) Options (iv) Swaps and (v) Exotics

Forwards and Swaps are OTC contracts

Futures are exchange traded contracts. Options are alsotraded in exchanges but OTC options are also possible.

Derivatives are used by hedgers, speculators andarbitrageurs for hedging. Speculation and arbitration.


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FuturesFutures -- BasicsBasics

A futures contract is an agreementA futures contract is an agreementbetweenbetween two parties totwo parties tobuy or sell an asset at a certain time in future for a certainbuy or sell an asset at a certain time in future for a certainprice.price.

Future contracts are normally traded on an exchange. ToFuture contracts are normally traded on an exchange. To

make trading possible, the exchange specifies certainmake trading possible, the exchange specifies certainstandardized features of the contract.standardized features of the contract.

As the two parties to the contract do not necessarily knowAs the two parties to the contract do not necessarily knoweach other, the exchange also provided a mechanismeach other, the exchange also provided a mechanism

( through a clearing association) that gives the two parties( through a clearing association) that gives the two partiesa guarantee that the contract will be honored.a guarantee that the contract will be honored.

The contract seller is called short and the contract buyer isThe contract seller is called short and the contract buyer iscalled the longcalled the long


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FuturesFutures-- BasicsBasics

Both the parties post a performance bond, called margin, thatBoth the parties post a performance bond, called margin, thatis held by the clearing association.is held by the clearing association.

Margin transfers, called variation margin, are made daily inMargin transfers, called variation margin, are made daily inresponse to a markresponse to a mark--toto--market process based on dailymarket process based on dailysettlement prices. Margin requirements vary between 2% to 7%settlement prices. Margin requirements vary between 2% to 7%

by the nature of position held (Hedging, Speculation etc)by the nature of position held (Hedging, Speculation etc)

The contract is referred to by its delivery month, and theThe contract is referred to by its delivery month, and theexchange specifies the period during the month when deliveryexchange specifies the period during the month when deliverymust be made. For commodities, the delivery period is oftenmust be made. For commodities, the delivery period is oftenthe entire month. The holder of the short position has thethe entire month. The holder of the short position has the

right to choose the time during the delivery period when itright to choose the time during the delivery period when itwill make delivery. Usually , contracts with several deliverywill make delivery. Usually , contracts with several deliverymonths are traded at one time.months are traded at one time.

The exchange specifies the amount of the asset to beThe exchange specifies the amount of the asset to bedelivered and how the future price to be quoted.delivered and how the future price to be quoted.


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FuturesFutures -- BasicsBasics

In the case of commodities futures, the exchange alsoIn the case of commodities futures, the exchange alsospecifies the product quality and the delivery location.specifies the product quality and the delivery location.

Future prices are regularly reported in the financial press.Future prices are regularly reported in the financial press.

The oldest future exchange in the US is Chicago Board ofThe oldest future exchange in the US is Chicago Board of

Trade (CBOT). During initial years, trades in CBOT wasTrade (CBOT). During initial years, trades in CBOT wasrestricted to agricultural futuresrestricted to agricultural futures-- mostly grains and soybean.mostly grains and soybean.Later financial futures such as interest rate futures, currencyLater financial futures such as interest rate futures, currencyfutures and stockfutures and stock--index futures were traded.index futures were traded.

Unlike commodity futures, financial futures are notUnlike commodity futures, financial futures are not

deliverable in the traditional sense. These futures are settleddeliverable in the traditional sense. These futures are settledin cash on a specific final settlement date.in cash on a specific final settlement date.

Futures are used both for hedging and speculation purposes.Futures are used both for hedging and speculation purposes.

Future positions are offFuture positions are off--balance sheet positions.balance sheet positions.


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FutureFuture-- BasicsBasics

Margin requirements are small percentage of contract valueMargin requirements are small percentage of contract valueand this gives the speculators considerable leverage toand this gives the speculators considerable leverage tooperate.operate.

Margin is usually required to be deposited in cash. However,Margin is usually required to be deposited in cash. However,larger market players in CBOT deposit their marginlarger market players in CBOT deposit their marginrequirements with Trequirements with T-- Bills or other forms of nearBills or other forms of near--cashcashsecurities.securities.

The role of clearing association in future contracts is veryThe role of clearing association in future contracts is veryimportant as neither party may know the identity of theimportant as neither party may know the identity of thecounterparty.counterparty.

The clearing association, on the other hand, is protected fromThe clearing association, on the other hand, is protected fromprice risk by the fact that it is always long and short for anprice risk by the fact that it is always long and short for anidentical number of contracts; and is protected from creditidentical number of contracts; and is protected from creditrisk through the margining system.risk through the margining system.


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Salient Features of FutureSalient Features of Future

ContactsContacts Futures are nothing but Futures are nothing but Exchange Traded ForwardsExchange Traded Forwards

Standardization (Standardization (Quantity , Quality, Month of DeliveryQuantity , Quality, Month of Delivery ))

Clearing House (Acts as anClearing House (Acts as an intermediary between buyer and theintermediary between buyer and theseller)seller)

Settlement Price ( contract isSettlement Price ( contract is marked to marketmarked to market)) DailyDaily Settlement andSettlement and MarginMargin

Tick SizeTick Size (Minimum Price variation which is recognizable)(Minimum Price variation which is recognizable)

Cash SettlementCash Settlement ( mostly underlying assets not delivered)( mostly underlying assets not delivered)

Delivery periodDelivery period varies from contract to contractvaries from contract to contract

Future Contracts areFuture Contracts are regulatedregulated through the exchangethrough the exchange


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FuturesFutures -- PayoffsPayoffs

PayoffPayoff

Short Position Long PositionShort Position Long Position

Price of asset atPrice of asset at

maturitymaturity

Delivery PriceDelivery Price


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ForwardsForwards -- BasicsBasics

A forward contract is an agreement between two parties, aA forward contract is an agreement between two parties, abuyer and a seller for delivery of a good or service at a futurebuyer and a seller for delivery of a good or service at a futuredate at a price agreed upon today .date at a price agreed upon today .

Forward contracts are very common in everyday life. AnForward contracts are very common in everyday life. An

apartment lease is a series of forward contract. Asking for aapartment lease is a series of forward contract. Asking for aPizza over phone is a forward contract. Customer would buyPizza over phone is a forward contract. Customer would buythe pizza upon delivery at a specific price at a future point ofthe pizza upon delivery at a specific price at a future point oftime ( 30 minutes or less).time ( 30 minutes or less).

Forward contracts are private OTC contracts between twoForward contracts are private OTC contracts between two

parties. The terms and conditions are tailored to the specificparties. The terms and conditions are tailored to the specificneeds of the two parties. Neither party can legally get out ofneeds of the two parties. Neither party can legally get out ofthe commitments.the commitments.

Being private contracts, forward contracts are not regulated.Being private contracts, forward contracts are not regulated.


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ForwardsForwards-- BasicsBasics

Future contracts do not exist forFuture contracts do not exist for all commodities and for allall commodities and for allfinancial instruments. Even where they exist, the futurefinancial instruments. Even where they exist, the futurestandards and actual requirement of parties may differ.standards and actual requirement of parties may differ.Future contracts are usually traded with fixed deliveryFuture contracts are usually traded with fixed delivery

months such as March , June, September and December.. Onmonths such as March , June, September and December.. Onthe contrary, forward contracts are tailor made contractsthe contrary, forward contracts are tailor made contractswhich can be structured to meet the exact requirement of thewhich can be structured to meet the exact requirement of the

beneficiaries / parties.beneficiaries / parties.

Futures usually have short lives, not exceeding 2 years.Futures usually have short lives, not exceeding 2 years.Wherever futures are available with distant delivery dates,Wherever futures are available with distant delivery dates,

these tend to be very illiquid and the consequent cost ofthese tend to be very illiquid and the consequent cost oftransacting them is high. However, long dated forwards aretransacting them is high. However, long dated forwards arepossible even for commodities.possible even for commodities.

Forward contracts suffer from counterparty risks.Forward contracts suffer from counterparty risks.


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Features of Forward Contracts

Two Parties

Over-the-counter Contract

No Standardization

The settlement price is determined at the time ofentering the contract

Mutual Obligation to perform

Counterparty Risks

Mutual Consent for cancellation No Front-end Payments


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Comparison of Forward and Future Contacts

SerialNo.

Forwards Futures

1 Private contract between twoparties- OTC contractsTraded on organized exchanges

2 Not Standardized(Customized) Standardized Contracts

3 Normally one specified deliverydateRange of delivery dates

(delivery month)

4 Settled at the end of maturity.No cash exchange prior todelivery date

Daily settled. Profit & loss arepaid in cash

5More than 90% of all forwardcontracts are settled by actual

Not more than 5% of futurecontracts are settled by delivery


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Comparison of Forward and Future Contacts

SerialNo.

Forwards Futures

6 Delivery or final cash settlementusually takes place

Contracts normally close outprior to the delivery

7 No margin required Margins are required from allparticipants

8 Cost of forward contacts based on

bid-ask spread

Entails brokerage fee for buy

and sell orders

9 Counter party credit risk may betaken care of by fixing customer-wise limits

Exchange Clearing housereduces counter party risks


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Key Terms

Backwardation: Backwardation means that future price is lessthan the expected future spot price. Commonly it refers to thesituation where future price is less than the current spot price.

Basis: It is the difference between the future price and the spotprice.

Contago: Contago means that future price is more than theexpected future spot price. Commonly it refers to the situationwhere future price is more than the current spot price.

Convergence: Convergence means that on the day of maturity ofthe future contract the price of future converges to the spot price.

Cost ofCarry: Cost of carry is the cost that one would incur if

physical asset is possessed and carried for a period of time, I e.till the time of maturity of the future / forward contract.

Margin: Margin is the amount of money required to be depositedwith the exchange for taking a long, short or combination offuture contacts for covering the potential loss.


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Key Terms

Marking to Market : It refers to the daily settlement of profitand loss incurred on position of derivatives, as if the position ofderivatives is closed out.

OTCContract : It is a direct contract between two partiesmeeting their specific needs to be settled on maturity.

Tick Size: It is the minimum change in price that would berecognized

Hedgers: Hedgers are those who enter into a derivative contractwith an objective of covering risks arising out of their openposition

Speculators: Speculators are financial market players who enter

into a contract simply to make profit by assuming risk. Theyusually do not have any open position to hedge.

Arbitrageur : Arbitrageurs assume positions with no netinvestment in different markets and instruments to make profitdue to mis-pricing.


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Institute of Public EnterpriseInstitute of Public Enterprise

January,2009January,2009


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Forward Rate AgreementForward Rate Agreement A FRA is a forward contract in which one party pays a fixedA FRA is a forward contract in which one party pays a fixed

interest rate and receives a floating interest rate equal to ainterest rate and receives a floating interest rate equal to areference rate (the underlying rate). The payments arereference rate (the underlying rate). The payments arecalculated over a notional amount over a certain period, andcalculated over a notional amount over a certain period, and

the net, i.e., the only the differential is paid on the effectivethe net, i.e., the only the differential is paid on the effectivedate. The reference rate is decided, one or two days beforedate. The reference rate is decided, one or two days beforethe effective date, dependent on the market convention forthe effective date, dependent on the market convention forthe particular currency. FRAs are over the counter derivatives.the particular currency. FRAs are over the counter derivatives.A swap is a combination of FRAs. The payer of the fixedA swap is a combination of FRAs. The payer of the fixedinterest rate is also known as the borrower or the buyer,interest rate is also known as the borrower or the buyer,

whilst the receiver of the fixed interest rate is the lender orwhilst the receiver of the fixed interest rate is the lender orthe seller.the seller.


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FRAFRA-- ContinuedContinued The net payment made on the effective date is :The net payment made on the effective date is :

Payment = Notional Amount *(Reference RatePayment = Notional Amount *(Reference Rate Fixed Rate) *A) /(1+ReferenceFixed Rate) *A) /(1+ReferenceRate*A)Rate*A)

The Fixed Rate is the rate at which the contract is agreed.The Fixed Rate is the rate at which the contract is agreed.

The Reference Rate is typically LIBORThe Reference Rate is typically LIBOR

A is the day count fraction, i.e. the portion of year over which the rate isA is the day count fraction, i.e. the portion of year over which the rate iscalculated, using the day count convention used in the money markets in thecalculated, using the day count convention used in the money markets in theunderlying currency. For USD this is generally the number of days divided byunderlying currency. For USD this is generally the number of days divided by360, for GBP it is the number of days divided by 365 days.360, for GBP it is the number of days divided by 365 days.

The fixed rate and reference rate are rates that should accrue over a periodThe fixed rate and reference rate are rates that should accrue over a periodstarting on the effective date, and then paid at the end of the periodstarting on the effective date, and then paid at the end of the period

( termination date). However, as the payment is already known at the( termination date). However, as the payment is already known at thebeginning of the period, it is also paid at the beginning . This is why thebeginning of the period, it is also paid at the beginning . This is why thediscount factor is used in the denominator.discount factor is used in the denominator.


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FRAFRA-- ContinuedContinued

FRAs NotationFRAs Notation

NotationNotation EffectiveEffective

Date fromDate fromnownow

TerminationTermination

Date fromDate fromnownow

UnderlyingUnderlying

RateRate

11 33 1 month1 month 3 months3 months 2 months2 monthsLIBORLIBOR

33 66 3 months3 months 6 months6 months 3 months3 monthsLIBORLIBOR

3399 3 months3 months 9 months9 months 6 months6 monthsLIBORLIBOR

661212 6months6months 12 months12 months 6months6monthsLIBORLIBOR

12121818 12 months12 months 18 months18 months 6 months6 monthsLIBORLIBOR


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Stock Index FuturesStock Index Futures

Trading in Stock index futures was started in 1982 in USA.Trading in Stock index futures was started in 1982 in USA.

Stock index futures are traded in terms of number ofStock index futures are traded in terms of number ofcontracts. Each contract is to buy or sell a fixed value of thecontracts. Each contract is to buy or sell a fixed value of theindex. The value of the index is defined as the value of indexindex. The value of the index is defined as the value of indexmultiplied by the specified monetary amount. In the S&P 500multiplied by the specified monetary amount. In the S&P 500futures contract traded at the Chicago Mercantile Exchangefutures contract traded at the Chicago Mercantile Exchange(CME), the contract specification states:(CME), the contract specification states:

1 Contract = $ 250 * Value of the S&P 500. If we assume that1 Contract = $ 250 * Value of the S&P 500. If we assume thatthe S&P500 is quoting at 1000, the value of one contract willthe S&P500 is quoting at 1000, the value of one contract will

be equal to $250000.be equal to $250000.

InIndex futures, the portfolio is adjusted to the market value

InIndex futures, the portfolio is adjusted to the market valueon a daily basis and margins are charged accordingly.on a daily basis and margins are charged accordingly.

Index futures are settled on cash basis as it is impossible toIndex futures are settled on cash basis as it is impossible tomake actual deliverymake actual delivery


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Stock Index FuturesStock Index Futures

It is widely claimed thatIt is widely claimed that the trading in stock index futuresthe trading in stock index futures

reduces volatility in the underlying index.reduces volatility in the underlying index.

Mutual Funds and other institutional investors use stockMutual Funds and other institutional investors use stockindex futures for hedging purposes.index futures for hedging purposes.

Stock index futures have supplemented the secondary stockStock index futures have supplemented the secondary stockmarket as a stock price discovery mechanism.market as a stock price discovery mechanism.


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Exchange Traded FundsExchange Traded Funds

An exchange traded fund (ETF) is an investment vehicleAn exchange traded fund (ETF) is an investment vehicletraded in stock exchanges, much like stocks.traded in stock exchanges, much like stocks.

An ETF holds assets such as stocks or bonds and trades atAn ETF holds assets such as stocks or bonds and trades atapproximately the same price as the net asset value of itsapproximately the same price as the net asset value of its

underlying assets over the course of the trading day.underlying assets over the course of the trading day. Most ETFs track an index like S&P 500.Most ETFs track an index like S&P 500.

ETFs are attractive investment vehicles because of their lowETFs are attractive investment vehicles because of their lowcost, tax efficiency and stock like features.cost, tax efficiency and stock like features.

Only authorized agents ( large institutional investors) holdOnly authorized agents ( large institutional investors) hold

ETF shares and work as market makers for ETF shares.ETF shares and work as market makers for ETF shares. ETFs can be bought and sold exactly like a stock during theETFs can be bought and sold exactly like a stock during the

entire trading day.entire trading day.


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Types ofETFsTypes ofETFs

Index ETFsIndex ETFs : These are index funds that hold securities and: These are index funds that hold securities andattempt to replicate the performance of a stock market index.attempt to replicate the performance of a stock market index.

Commodity ETFsCommodity ETFs: Commodity ETFs invest in commodities,: Commodity ETFs invest in commodities,such as precious metals and futures on commodities.such as precious metals and futures on commodities.

Currency ETFsCurrency ETFs : These funds track all major currencies under: These funds track all major currencies undertheir brand currency shares.their brand currency shares.

Actively Managed ETFsActively Managed ETFs : These ETFs are of recent origin,: These ETFs are of recent origin,which were offered on 25which were offered on 25thth March, 2008 in US. These are fullyMarch, 2008 in US. These are fullytransparent funds , which publish their current securitiestransparent funds , which publish their current securities

portfolio on their website daily.portfolio on their website daily. Leveraged ETFsLeveraged ETFs : These funds try to achieve returns that are: These funds try to achieve returns that are

more sensitive to market movements than nonmore sensitive to market movements than non--leveragedleveragedETFs.ETFs.


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Comparison with Index Mutual Funds &Comparison with Index Mutual Funds &

StocksStocks

AttributeAttribute ETFETF Index MutualIndex MutualFundFund

Individual StockIndividual Stock

DiversificationDiversification YesYes YesYes NoNo

Traded Through outTraded Through outthe daythe day

yesyes NoNo YesYes

Can be bought onCan be bought onmarginmargin

YesYes NoNo YesYes

Can be sold shortCan be sold short yesyes NoNo YesYes

Tracks an index orTracks an index orsectorsector

YesYes YesYes NoNo

Tax efficient asTax efficient asturnover is lowturnover is low

YesYes PossiblyPossibly NoNo

Low expense ratioLow expense ratio YesYes SometimesSometimes Not a factorNot a factor

Trade at anyTrade at anybrokerage firmbrokerage firm

YesYes NoNo YesYes

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