Forwards and Futures

Mechanism, Hedging,
and Pricing
DERIVATIVES
A product whose value is derived from the
value of another asset referred as
underlying asset.
Underlying Asset can be
COMMODITIES,
T-BILLS,
STOCKS,
CURRENCIES,
INDICES, etc.
Basic products are: Forwards, Futures,
Options and Swaps

2
Derivatives and Risk Management
Rajiv Srivastava
FORWARD CONTRACT
Spot transaction is characterised by simultaneous
negotiation of price and settlement by exchange of
consideration and delivery of asset.
Forward contract is a contract between two parties
to deliver the asset at a predetermined price at a
future date.
First phase is fixing of price, and
Second phase is settlement,
Both phases are at different times.
In the absence of forward market one can not
hedge, and the results will be sub-optimal because
of uncertainty.
It is an Over-the-Counter (OTC) product with
terms negotiated between buyer and seller.
3
Derivatives and Risk Management
Rajiv Srivastava
HEDGING WITH FORWARD
Farmer Rice Mill
Supplier of Rice User of Rice
Farmer sells harvest 3 m forward for delivery at price of say
Rs 20/Kg
Both supplier and user are assured of price and eliminate
price risk
Settlement: After 3 m farmer supplies and mill pays at Rs
20/Kg
4
Derivatives and Risk Management
Rajiv Srivastava
LIMITATIONS OF FORWARD
SIZE OF MARKET
OTC products have limited market size.
There will be few hedgers.
Finding counterparties with matching needs of timing, quality,
quantity and price is extremely difficult.
FAIR PRICE??
Price discovery is not likely to be true.
( Price of Rs 20/Kg would depend upon the negotiation power of
buyer and seller. It is likely to be an unequal market for buyer and
seller)
Exit Route:
Once entered it is difficult to make an early exit; requires consent of
the counterparty
COUNTERPARTY RISK
Settlement is by delivery
One of the parties would have strong incentive to default depending
upon the price at the time of harvest, the end of forward period.

5
Derivatives and Risk Management
Rajiv Srivastava
NEED FOR FUTURES
Need to increase the market size for discovery of fair price.
Speculators and Arbitrageurs (non-users) need to be
encouraged besides hedgers.
Delivery and price to be de-linked but not the process of
price determination.
Price must be governed by the physical market.
To eliminate counterparty risk a mediator (An Exchange) needs
to come in.




Buyer Exchange Seller
6
Derivatives and Risk Management
Rajiv Srivastava
FEATURES OF FUTURES
Organised Exchange: Forwards are OTC while
for Futures there exist an organised exchange.
Standardisation: Delivery and quantity of the
asset are not fixed in forward contract. They are
tailor made. Futures contracts are standardised
quantity, quality,
delivery time, delivery centres.
Price quotation vs. Contract size
Tick size: Minimum movement of price.

7
Derivatives and Risk Management
Rajiv Srivastava
FEATURES OF FUTURES
Clearing House: Futures are through a clearing
house, while forward contracts are done directly.
Margin Requirements: Margins have to be
deposited with clearing house. No margins are
required in a forward contract.
Commission: to be paid separately. In forward
contracts spread between Bid Ask exists.
Mark to the market: Futures contracts are marked
to the market. Forwards are settled only once upon
maturity.
Actual delivery is rare in futures while most
forward contracts are settled with delivery.

8
Derivatives and Risk Management
Rajiv Srivastava
NCDEX RICE FUTURES

9
Derivatives and Risk Management
Rajiv Srivastava
CBOT- WHEAT FUTURES

10
Derivatives and Risk Management
Rajiv Srivastava
FUTURES
Futures are forward contracts that are traded on
EXCHANGE.
It is a contract between two parties (not known to
each other as Exchange works as interface) to
deliver the asset at a predetermined price at a
future date.
Fundamentally, futures contract is same as forward
in terms of pricing, applications etc but
mechanisms of trading, and settlement are
substantially different.

11
Derivatives and Risk Management
Rajiv Srivastava
FUTURES Vs FORWARD
PARAMETER FUTURES FORWARD
Place Exchange OTC
Product Standardised Tailor-made
Initial Cash
flow
Margin required Nil
Settlement Daily by MTM Final
Closing out Offsetting, Easy,
Any time
Difficult
Delivery Rare Mostly
Liquidity Very high Very low
12
Derivatives and Risk Management
Rajiv Srivastava
TYPES OF FUTURES
Initially futures were used in merchandise business
only. Financial futures came in to being in 1972 on
the International Money Exchange at CME.
Commodity:
Where the underlying asset is a commodity
Agricultural commodities like Wheat, Rice, Soya,
Coffee, Sugar, Rubber, Coconut, or
Metals like Gold, Silver, Copper, Tin, Aluminum
Financial:
Where the underlying is a financial asset.
Stocks/Indices/Currencies/Interest Rate
13
Derivatives and Risk Management
Rajiv Srivastava
FINANCIAL FUTURES
Currency:
Where the underlying asset is a currency like $, Euro, , ,
Rs. etc.
Currency futures trading started in August 2008.
Stocks:
Where the underlying is a stock or index. Introduced in
India on J une 12, 2000 for Indices and on November 9,
2001 on select individual securities, at NSE.
Interest Rate:
Underlying is a Interest Rate (LIBOR, MIBOR). In India
launched on J une 24, 2003 at NSE. Failed. Re-introduced
with a notional GOI security as underlying.
Short term interest rate futures began trading on J uly 4,
2011 at NSE with 91-day T Bill as underlying.

14
Derivatives and Risk Management
Rajiv Srivastava
CONTROLLED PRICE AND
HEDGE
Hedging is essential feature of futures.
Price variability gives rise to the risk of dealing in
physical commodities.
To eliminate risk of prices one is required to have
substantial control either on supplies or on the
demand of the commodity.
Govt. providing minimum support price to grain
producers is an expensive way to provide price
protection.
15
Derivatives and Risk Management
Rajiv Srivastava
COMMODITY FUTURES
Commodity futures exist on vast range of
commodities Agriculture, Energy, Metals,




Exchanges in India commenced trading in Nov 2003
Multi Commodities Exchange (MCX), Mumbai
National Board of Trade (NBOT), Indore
National Multi Commodities Exchange (NMCE),
Ahmedabad
National Commodity and Derivatives Exchange
(NCDEX), Mumbai

16
Derivatives and Risk Management
Rajiv Srivastava
TRADING WITH FUTURES
One can buy/sell futures contract on the exchange.
Orders are matched in order of
Price - Time - Quantity.
Price conditions
Market order
Limit order
Stop loss order
Time conditions
Good for the Day, GTD
Good Till Cancelled, GTC
Immediate or Cancel, I/C (Partial match possible)
Quantity
Minimum Fill
All or None
17
Derivatives and Risk Management
Rajiv Srivastava
SETTLEMENT
Three ways to Settle
Physical Settlement Settlement by giving/
taking delivery
Prior intimation required.
Settlement is done on the basis of warehouse receipt.
Warehouses are designated.
Offsetting Before Maturity
Buy first and sell later.
Sell first and buy later.
Close out - Cash Settlement, On Maturity
Open positions on the expiry day considered closed with
offsetting contract at spot price.
Contracts are cash settled: Difference of price is
debited/credited
Closing price equals spot price
18
Derivatives and Risk Management
Rajiv Srivastava
SETTLEMENT BY DELIVERY
Delivery Notice Period
Some days prior to maturity of the contract (usually
2 weeks) buyers/sellers must declare intentions to
take/make delivery.
Delivery Notice Period required for delivery
preparation.
DELIVERY LOGIC: Who can force delivery
Specified in the contract and determined by the
exchange.
Option of the buyer
Option of the seller
Both
Compulsory
Normally at the option of seller.
19
Derivatives and Risk Management
Rajiv Srivastava
SETTLEMENT BY DELIVERY
MECHANISM/LOGISTICS
WAREHOUSE:
Warehouses and places of delivery are designated.
ASSAYERS
Suitable arrangement made for quality and quantity check,
(Assayers)
TRANSFER
Warehouse receipts are issued if quality/quantity found
acceptable.
Warehouse receipts would be given to intending buyer to
receive delivery.
Warehouse receipts are negotiable instruments.

20
Derivatives and Risk Management
Rajiv Srivastava
ASSIGNMENT
Mismatch between deliverable quantity among buyers and
sellers gives rise to problem of assignment.
Process of finding willing counterparty (buyer willing to take
delivery) is called ASSIGNMENT. Exchange has to find some
buyer /seller who accepts delivery against the futures contract.
Delivery notice to be assigned only to open positions.
METHODS OF ASSIGNMENT
1. Display Notice and call for bids from willing buyers
(CBOT, Brazil, CME)
2. Assign on some basis (COMEX, India)
Random
First in first out (FIFO)
Longest contract period
Method of assignment is known through the contract
specifications.
IMPLICATION: Assigned party loses opportunity to offset.
21
Derivatives and Risk Management
Rajiv Srivastava
SETTLEMENT BY DELIVERY
OPTIONS TO SELLER/BUYER
Those not needing delivery are expected to square up.
Both seller/buyer have option to square up even after
intention to deliver/assignment till the last day of Delivery
Notice Period. This is not the case in stocks futures.
After expiry of Delivery Notice Period, delivery is assigned to
open long positions.
DELIVERY RATE
Delivery rate depends upon the spot price.
Adjustment to the delivery price for quality, freight etc done.
These are already specified in the contract before-hand.
Warehouse receipt is given to assigned buyer, who pays to
the exchange.
Against receipt warehouse delivers.
Exchange makes payment to seller.
World over delivery is about 1% of the contracts
22
Derivatives and Risk Management
Rajiv Srivastava
SETTLEMENT BY
OFFSETTING
Normally settlement is done by offsetting contracts,
before expiry of the contract, permitting participants
to nullify positions.
Buy first sell later or sell first and buy later.
10 Dec Buy Gold Futures contract 12,680
15 Dec Sell Gold Futures contract 12,780
Net Profit = 100 x Size of the contract
(in terms of price quotation)
This profit is calculated on daily basis (Marking to
the market, MTM).
This helps an efficient discovery of price as all
participants monitor positions regularly and look for
opportunities to make profit/contain losses.
23
Derivatives and Risk Management
Rajiv Srivastava
CASH SETTLEMENT
Last day of trading all open positions are closed automatically
All long positions are nullified by selling
All short positions are nullified by buying
The closing price is the spot price, ensuring that futures price
is equal to the spot price in the physical market
The difference of price of the initial contract and closing
contract are settled in cash.
Spot price may be determined by polling and bootstrapping
Buy first sell later or sell first and buy later.
10 Dec Initial position
Buy Gold Futures contract 32,680 (Remains open till last day)
20 Dec Last trading day
Exchange Sells Gold Futures contract at spot price 32,880
Net Profit = 200 x Size of the contract (in terms of price
quotation)
This profit is calculated on daily basis (Marking To Market,
MTM)
24
Derivatives and Risk Management
Rajiv Srivastava
MARGIN
Initial margin is deposited to open trade to cover
the settlement risk, the onus for which lies of the
exchange. It is performance bond/good faith money
Payable upfront, refunded on closing out.
Margin is commodity specific, exchange specific
and depends upon the volatility of asset price.
Initial Margin:
Meant to cover the largest possible loss in a day.
Normally of the order of 5% 10%.
Maintenance Margin: Margin Call
Profit/loss on daily basis are credited/debited to the
margin account.
Cant fall below certain level: Maintenance Margin

25
Derivatives and Risk Management
Rajiv Srivastava
MARKING-TO-MARKET
(MTM MARGIN)
Exchange settles the contracts on daily basis.
Computation of profit/loss as if the positions were
closed out. Actually the open position remains.
Futures contracts are deemed settled and re-
written every day.
All positions are brought to the same price each
day.
Making good the loss or payment of profit on daily
basis.
Daily clearing price (different than closing price) is
used in calculating the daily profit/loss.
Final settlement price and daily settlement price
may be different. (Futures on currencies).
26
Derivatives and Risk Management
Rajiv Srivastava
MARKING-TO-MARKET
EXAMPLE
Gold Contract Size 1 Kg
Price quotation per 10 gms For Gold in India
Initial Margin 5%
DAY ACTION Price Profit /Loss (+/-) Margin
Day 1 Bought 1 Gold Contract 32,300 1,61,500
Day 1 Clearing Price 32,450 +150 +15,000 1,76,500
Day 2 Clearing Price 32,310 - 140 - 14,000 1,62,500
Day 3 Clearing Price 32,470 +160 +16,000 1,78,500
Day 4 Sold 1 Gold Contract 32,600 +130 +13,000 1,91,500
Amount in excess of 1,61,500 could be withdrawn at
any time.
Aggregate profit is 30,000: Remains same as
difference of closing and opening values.
This is split over series of daily cash flows over 4
days.
27
Derivatives and Risk Management
Rajiv Srivastava
OPEN INTEREST
Open Interest is the number of contracts
that are open on any given day.
It is an indicator of investors interest in the
contract.
It rises initially and has to become zero on
the last day.
New positions are added to open interest
Offsetting position (closing the open
position) reduces open interest
28
Derivatives and Risk Management
Rajiv Srivastava
OPEN INTEREST
Open Interest is different than Volume.
Day ACTIONS Open
Interest
Volume
1 A goes Long; B goes Short 50
C goes Long: D goes Short 100
150 150
2 E goes Long: F goes Short 100
(Two new contracts add to Open Interest)
250 100
3 B goes Long: H goes Short 50
(One party offsetting and second party
opening keeps Open Interest unchanged)
250 50
4 C goes Short: D goes Long 100
(Both parties closing reduces Open
Interest)
150 100
29
Derivatives and Risk Management
Rajiv Srivastava
PRICING AND
HEDGING

PRICING
FORWARDS & FUTURES
A derivative derives its price from the value of
another asset referred as underlying asset
Underlying assets can be commodities, T-bills,
stocks, currencies, indices, etc.
The spot price in the physical market must
determine the price of its futures contract
For pricing purpose there is no difference between
a forward contract and futures; both being
contracts for future delivery
31
Derivatives and Risk Management
Rajiv Srivastava
PRICING FORWARD
Cost of Carry
Suppose you needed 10 gms of Gold 3 months
later.
The current price (called spot price, S
0
) of gold is
Rs 18,000 per 10 gms.
If you were to buy and the goldsmith were to sell
today cash would be paid against delivery.
Instead you wish to firm up the price today for
delivery of gold 3 months later (entering a forward
contract) what price is appropriate?
32
Derivatives and Risk Management
Rajiv Srivastava
PRICING FORWARD
Cost of Carry
SELLER
Asset is committed to be
delivered 3 months later
If he sold spot he would realise
Rs 30,000
It would have grown to Rs
30,900 (assuming 1% return
per month) after 3 months, if
he invested the sum
He would also incur some
costs in holding the asset for
prospective buyer like
insurance, rent etc for 3
months, say % per month
Therefore he would charge a
minimum of Rs 31,350 (30,000
+ 900 + 450) to agree to enter
in the forward deal and be
indifferent
BUYER
Asset is assured for delivery 3
months later
If he bought spot he would part
away with Rs 30,000
If payment is deferred the
amount would grow to Rs
30,900 (assuming 1% return
per month) after 3 months, if
he invested
The buyer would also save
some costs like insurance, rent
etc for 3 months, say % per
month
Therefore buyer would be
indifferent to pay a maximum
of Rs 31,350 (30,000 + 900 +
450) to agree to enter in the
forward deal.

33
Derivatives and Risk Management
Rajiv Srivastava
PRICING FORWARD
Cost of Carry
COST OF CARRY
Cost interest, Insurance, Rent etc form the cost of
carrying, r (typically % per annum)
Seller incurs it and buyer saves it
For Buyer
Maximum payable forward price, F
= Spot price + Cost of carrying for the forward period, T
F S
0
+ S
0
x r x T
For Seller
Minimum acceptable forward price, F
= Spot Price + Cost of carrying for forward period
F S
0
+ S
0
x r x T
The only way both can agree is
F = S
0
+ S
0
x r x T = S
0
(1 + r x T)
= 18,000 (1 + .015 x 3) = 18,810


34
Derivatives and Risk Management
Rajiv Srivastava
ARBITRAGE
Cash and Carry
If forward price defied cost of carry model it offers arbitrage
Arbitrage refers to risk free profit with no investment
CASH AND CARRY
Actual price = 31,600 ( > Theoretical Forward Price 31,450)
ACTIONS Cash flow (Rs)
Today
Borrow at 1% pm for 3 months +30,000
Buy 10 gms Gold Spot -30,000
Sell Gold 3-m forward contract at 31,600 -
Initial cash flow Nil
After 3 months
Realise from forward contract against gold +31,600
Pay expenses % -450
Pay debt and Interest, 1% -30,900
Net cash flow 150
Earn profit of Rs 150 without investment and without risk

35
Derivatives and Risk Management
Rajiv Srivastava
ARBITRAGE
Reverse Cash and Carry
REVERSE CASH AND CARRY
(If actual price were 31,250 ( < Theoretical Forward Price 31,350)
ACTIONS Cash flow (Rs)
Today
Sell spot 10 gms Gold +30,000
Invest at 1% pm for 3 months -30,000
Buy Gold 3-m forward contract at 18,500 -
Initial cash flow 0
After 3 months
Realise gold from forward contract and pay cash -31,250
Saved expenses +450
Realise investment and Interest +30,900
Net cash flow +100

Earn profit of Rs 100 without investment and without risk

36
Derivatives and Risk Management
Rajiv Srivastava
PRICING FORWARD
Process of arbitrage will govern the price of the
forward contract for period t (With short selling
permitted)
F
t
= S
0
e
rt

If there is any dividend (benefit) accruing during the
period then
F
t
= (S
0
D) e
rt

where D = Present value of the benefit.
For securities providing known yield y (income
expressed as % of price),
F
t
= S
0
e
(r - y)t


37
Derivatives and Risk Management
Rajiv Srivastava
CONVERGENCE
Contango or backwardation, in either case the
futures price must converge to the spot price as
maturity approaches, as all cost of carry, benefits of
ownership, storage costs, convenience yields etc.
tend to become zero.

Convergence of price- Contango

Price


Futures



Spot



Maturity Time
Convergence of price- Backwardation

Price


Spot



Futures



Maturity Time
38
Derivatives and Risk Management
Rajiv Srivastava
LONG & SHORT
POSITIONS
ASSET
When you have the asset you are called LONG on
Asset
When you do not have the asset you are called
SHORT on Asset
FUTURES
When you buy futures it is called LONG on Futures
When you sell futures it is called SHORT on
Futures
39
Derivatives and Risk Management
Rajiv Srivastava
PAY OFF - ASSET
LONG & SHORT



PAY OFF - ASSET POSITION
Long on Asset Short on Asset
Bought at S
0,
Currently at S Sold at S
0
Currently at S
If S > S
0
Gain S S
0
If S > S
0
Loss S S
0

If S < S
0
Loss S
0
S If S < S
0
Gain S
0
S

Profit Profit





S
0
S S
0
S



Loss Loss


40
Derivatives and Risk Management
Rajiv Srivastava
PAY OFF - FUTURES
LONG & SHORT



PAY OFF - FUTURES POSITION
Long on Futures Short on Futures
Bought at F
0,
Currently at F Sold at F
0
Currently at F
If F > F
0
Gain F F
0
If F > F
0
Loss F F
0

If F < F
0
Loss F
0
F If F < F
0
Gain F
0
F

Profit Profit





F
0
F F
0
F



Loss Loss


41
Derivatives and Risk Management
Rajiv Srivastava
HEDGING PRINCIPLE
Futures offset the risk by taking of an opposite
position in the future contracts to that of in the
physical market.
SHORT HEDGE
LONG on asset Go SHORT on futures
LONG HEDGE
SHORT on asset Go LONG of futures
Loss in the physical market is expected to be
compensated in the futures position, and vice
versa,
This assures almost a steady and assured price.

42
Derivatives and Risk Management
Rajiv Srivastava
SHORT HEDGE
Asset and Futures



PAY OFF SHORT HEDGE
Long on Asset Short on Futures
Bought at S
0,
Sold at S

Sold at F
0
Bought at F
If S > S
0
Gain S S
0
If F > F
0
Loss F F
0

If S < S
0
Loss S
0
S If F < F
0
Gain F
0
F

Profit Profit





S
0
S F
0
F



Loss Loss


43
Derivatives and Risk Management
Rajiv Srivastava
SHORT HEDGE
EXAMPLE
SITUATION
Owned asset 1 Kg of Gold
Need to sell after 3 months
Risk falling price of asset, Need to cover risk and
protect value
MARKET SCENARIO
Spot price of Gold, S
0
= Rs 30,000
Futures price at Exchange F
0
= Rs 31,350
HEDGING STRATEGY
Long on Asset - Go Short of Futures
Sell 3-m futures contract on gold now (Size 1 Kg)
with intentions of buy the same futures contract at
the end of hedging period, after 3 months.
44
Derivatives and Risk Management
Rajiv Srivastava
SHORT HEDGE
OUTCOME
After 3 months
Sell gold in spot market and offset position in futures.
The price of the futures now would be same as spot due to
convergence.
ACTIONS Spot price decreases
to Rs 29,000
Spot price increases
to Rs 33,000
Sell gold in spot market
29,000 33,000
Buy futures back in
futures exchange
29,000 33,000
Initial futures contract
sold at
31,350 31,350
Cash flow from futures
exchange
2,350 -1,650
Effective Price
31,350 31,350
45
Derivatives and Risk Management
Rajiv Srivastava
LONG HEDGE
Asset and Futures



PAY OFF LONG HEDGE
Long on Futures Short on Asset
Bought at F
0,
Sold at F

Sold at S
0
Bought at S
If F > F
0
Gain F F
0
If S > S
0
Loss S S
0

If F < F
0
Loss F
0
F If S < S
0
Gain S
0
S

Profit Profit





F
0
F S
0
S



Loss Loss


46
Derivatives and Risk Management
Rajiv Srivastava
LONG HEDGE
EXAMPLE
SITUATION
Short on asset, To buy 1 Kg of Gold
Need to buy after 3 months
Risk rising price of asset, Need to cover risk and
protect value
MARKET SCENARIO
Spot price of Gold, S
0
= Rs 30,000
Futures price at Exchange F
0
= Rs 31,350
HEDGING STRATEGY
Short on Asset - Go Long of Futures
Buy 3-m futures contract on gold now (Size 1 Kg)
with intentions of sell the same futures contract at
the end of hedging period, after 3months.
47
Derivatives and Risk Management
Rajiv Srivastava
LONG HEDGE
OUTCOME
After 3 months
Buy gold in spot market and offset position in futures.
The price of the futures now would be same as spot due to
convergence.
ACTIONS Spot price decreases
to Rs 29,000
Spot price increases
to Rs 33,000
Buy gold in spot market
- 29,000 - 33,000
Sell futures back in
futures exchange
+ 29,000 + 33,000
Initial futures contract
bought at
- 31,350 - 31,350
Cash flow from futures
exchange
- 1,350 +1,650
Effective Price
31,350 31,350
48
Derivatives and Risk Management
Rajiv Srivastava
PAYOFF AND
EFFECTIVE PRICE
SHORT HEDGE
Value of asset owned S
0
Sell Asset S
Sold futures F
0
Bought back futures F
Pay off = (S S
0
) + (F
0
F) = (S F) - (S
0
F
0
)
Price realised = S + (F
0
F) = F
0


LONG HEDGE
Value of asset short S
0
Buy Asset S
Bought futures F
0
Sold futures F
Pay off = (S S
0
) + (F
0
F) = (S F) - (S
0
F
0
)
Price paid = S + (F
0
F) = F
0

(F = S due to convergence)

49
Derivatives and Risk Management
Rajiv Srivastava
PERFECT HEDGE
Profit/loss in position of asset is completely offset
loss/profit in position on futures.



PERFECT HEDGE
Long Hedge Short Hedge



Profit Long Future Profit Long Asset








F
0
Price F
0
Price

Short Asset Short Future

Loss Loss





50
Derivatives and Risk Management
Rajiv Srivastava
BASIS AND BASIS RISK
Basis is defined as difference between spot price
and futures price at any point of time.
As contract approaches maturity the basis
declines.
It becomes zero on the maturity.
Effective price is
Price paid/realised = S + (F
0
F) = F
0
Since S F when hedge is lifted price would be
S + (F
0
F) = F
0
+ (S F)
= F
0
+ Basis when hedge is lifted
The price risk gets replaced by basis risk

51
Derivatives and Risk Management
Rajiv Srivastava
HEDGE
FORWARD Vs FUTURES
Forward hedge is always a perfect hedge as it is a
customised contract. Price is fixed now.
Futures hedge is seldom perfect. Hedging through
the futures does not exactly and completely offsets
the gains/losses in the cash asset.
Perfect hedge is not possible due to
Difference in the asset: The underlying asset may not be
same as that of the futures. (Gold Ornaments vs. Gold)
Differences in timing: maturity of cash position and
futures contract may not coincide exactly. (Need to
buy/sell Gold at 2.5 m Contract available for 2 or 3 m)
Differences in quantity/amount: The amount of
exposure may not match with amount of futures contract.
(Need to buy/sell 2.50 Kg Gold Contract available in
multiples of 1 Kg.)

52
Derivatives and Risk Management
Rajiv Srivastava
OPTIMAL HEDGE RATIO
Futures price moves according to spot price
and principle of convergence applies.
Is the relationship of futures price and spot
price perfect.
Is co-efficient of correlation, = 1??
When cross hedge (Hedging through
related asset but not the same asset) is
used co-efficient of correlation would not
be 1 nor would be the changes in the price
of futures,
f
and spot,
s
.
Optimum Hedge Ratio h* =
s
/
f



53
Derivatives and Risk Management
Rajiv Srivastava



Rajiv Srivastava
rajiv@iift.ac.in
rajiv1234@hotmail.com
54
Derivatives and Risk Management
Rajiv Srivastava