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Futures Contract
A future contract is an agreement
between to parties to buy or sell an asset
at a certain time in future for a certain
price.
The buyer of the contract, who is said to be
long the contract has agreed to buy (take
delivery of) the goods in future.
The seller is said to be short the contract and
has obligation to sell (deliver) the goods in
the future.
Payoff for a buyer of Futures
60 55 65
0
Spot price
Profit/Loss
Payoff for a seller of Futures
60 55 65
0
Spot price
Profit/Loss
Futures Market in India
Stock index futures launched on 12
th
June, 2000
and stock futures in 9
th
Nov, 2001.
Futures on Stock Index and on individual stocks
NSE: S&P CNX Nifty Futures, CNXIT Futures, futures on
51 individual stocks
Commodity futures
Currency futures
Interest rate futures
NSE: Notional T Bills, Notional 10 year bonds (coupon
bearing and non-coupon bearing)
Futures Contract
Exchange traded products.
A standardized, transferable, exchange-
traded contract that requires delivery of a
commodity, bond, currency, or stock index,
at a specified price, on a specified future
date.
Forwards vs. Futures
A futures contract is like a forward contract:
Both specify that a certain commodity will be
exchanged for another at a specified time in the
future at prices specified today.
They represent zero net supply; for every buyer
there is a seller.
Profit-loss profile realized in forwards and
futures represent a zero sum game.
Forwards vs. Futures
A futures contract is different from a
forward:
Futures are standardized; only the price in
negotiated: e.g. all December 2004 gold futures
contracts are identical in that the amount of gold
(contract size), quality of gold, delivery date and
place of delivery are specified. Forwards are
customized and all the aspects can be
negotiated.
Forwards vs. Futures
Offesetting (prior to delivery date) a trade is
possible in futures market while it is non-existent
in most of the forward markets. For example, if
you are long Dec 2004 gold futures contract you
can close that position by later selling a Dec
2004 gold futures contract.
Default risk is least in case of futures. Since
forward contracts are agreements between the
two parties, each part face the counterparty
default risk.
Forwards vs. Futures
Most future positions are eventually offset
and in many cases they are cash settled. In
contrast, most forward contracts terminate
with delivery of the specified good.
Margins and daily marking to market in case
of futures.
Futures Contract: Standard Features
Contract specification
Asset type
Exchange stipulates the grade of the asset.
Contract size
Specifies the amount of the asset to be delivered
under one contract.
Delivery agreement
The place of delivery
Futures Contract: Standard Features
Delivery months
Futures are referred to by their delivery months.
Price quotes
Daily price movement limits
Daily price movement limits, termed as limit move
(limit up and limit down)
Position limits
Maximum number of contracts that a speculator may
hold
Futures Contract: Standard Features
Clearing house
Clearinghouse of the exchange becomes the
opposite party to both buyers and sellers - thus
guarantees the performance of the parties to
each transaction.
Margin requirement
When two parties trade a futures contract, the
futures exchange requires some good faith
money (security) from both, to act as a
guarantee.
Futures Contract: Standard Features
Initial Margin
Each exchange is responsible for setting the
minimum initial margin requirements. The initial
margin is the amount a trader must deposit into his
trading account (also called as margin account)
when establishing a position.
Exchanges use SPAN (Standard Portfolio Analysis of
Risk) to establish initial margin requirement.
Futures Contract: Standard Features
Beyond the initial margin, if the equity in the account
falls below a maintenance margin level, additional
funds must be deposited to bring the account back up
to the initial margin level. The process is known as
margin call. The amount that is to be deposited is
termed as variation margin.
Once a trader has received the margin call, he must
meet the call, even if the price has moved in his
favour.
Futures Contract: Standard Features
For example, if the initial margin required to
trade per gold futures contract is $1000, and the
maintenance margin level is $750, then an
adverse change of $2.60/oz. will result in a
margin call. Because one gold futures covers 100
oz. of gold a decline of $2.60/oz in the futures
price will deplete the long position by $260. The
trader with losses must deposit sufficient funds
to bring the margin to the initial level of $1000.
The margin that is deposited to meet margin call
is termed as variation margin.
Futures Contract: Standard Features
Types of orders
Market order
Trade to be carried out immediately at the best price
Limit order
Specifies a particular price. The order can be
executed only at this price or at one more favouarble
to the investor.
Stop order or stop-loss order
Also specifies a particular price. The order is executed
at the best available price once a bid or offer is made
at a particular price or a less favorable price.
Futures Contract: Standard Features
Stop-limit order
A combination of stop order and limit order.
Market-if-touched order
They are like limit orders, except that they become
market orders once a trade has occurred at the
specified price.
Discretionary order/Market-not-held order
Traded as a market order except that execution may
be delayed at the broker's discretion in an attempt to
get a better price.
Futures Contract: Standard Features
Time orders
Unless specified, an order is a day order and expires
at the end of the trading day. Good-till-cancelled
remains active till executed or cancelled by the
customer. Some other time orders are Good-this-
week, Good-this-month etc.
Spread order
Specifies two trades that must be filled together. The
order can specify a difference in the prices or it can
be a market order.
Futures Contract: Standard Features
Offsetting the positions (squaring up)
Most traders choose to close out their position
prior to delivery period specified in the contract
by entering into the opposite type of the trade.
Open Interest
Total number of contracts outstanding for a
particular delivery month.
Open interest is a good proxy for demand for a
contract.
Futures Contract: Standard Features
Settlement
Physical settlement vs. Cash settlement
Settlement month
Settlement price
Futures Contract: Standard Features
Marking to Market
All futures traders positions are marked to
market daily.
Also known as daily resettlement. It means
everyday, profits are added to, or losses are
deducted from the traders account.
Profits and losses are based on the changes in
the settlement prices or closing futures prices.
Contract specification: S&P CNX Nifty
Futures
Underlying index S&P CNX Nifty
Exchange of trading National Stock Exchange
Security descriptor N FUTIDX NIFTY
Contract size 200 and multiples thereof
Price steps Rs. 0.05
Trading cycle Maximum three month trading cycle
Expiry date Last Thursday of the expiry month or the previous
trading day if the last Thursday is a holiday
Settlement basis Mark to Market and final settlement is cash settled
on T+1 basis
Settlement price Daily settlement price will be the closing price of the
futures contracts for the trading day and the
final settlement price will be the closing value of
the underlying index on the last trading day
Futures Contract: Standard Features
Marked to Market: An example
In NSE all future contracts are marked to market to the
daily settlement price. The profit loss are computed as
thus:
The trade price and the days settlement price for contracts
executed during the day but not squared up
Previous days settlement price and the current days
settlement price for brought forward contracts
Buy price and the sell price for contracts executed during the
day and squared up
Futures Contract: Standard Features
Trade details Quantity
bought/sold
Settlement
price
MTM
Brought forward from
previous day
100@100 105 500
Traded during the day
Bought
Sold
200@100
100@102
102
200
Open position
(Not squared up)
100@100 105 500
TOTAL 1200
Source: NSE
Basis and Convergence
Basis and convergence explain the
relationship between futures price and cash
price.
Basis
Spot price (cash price) minus the futures price
In a normal market basis will be negative; since
future prices exceed spot prices and it is positive
in an inverted market.
Basis approaches zero as the delivery month is
approached.
Basis and Convergence
The process of basis moving towards zero
is termed as convergence. Why does it
happen?
It is due to arbitrage. For example, if future
price is above spot price during the delivery
period, the trader can
i. Short a futures contract
ii. Buy the asset
iii. Make delivery
Pricing Futures
Do the quoted prices reflect true value of the
underlying index?
Does there exist any opportunity for
arbitrage?
Why should the basis be negative in normal
markets?
The dynamics lies in the Cost-of-carry
model.
Cost of Carry Model
Cost of carry measures the storage cost,
plus the interest that is paid to finance the
asset less the income earned on the asset.
Cost of carry varies across the assets.
For a non-dividend paying stock, the cost of
carry is the risk free rate because there are no
storage costs and no income is earned.
For a commodity, storage cost is important.
Cost of Carry Model
The fair value of futures incorporates the
no-arbitrage limits on the prices. This is as
thus
F = S + CC - CR
F = Future prices
S = Spot price
CC = Holding costs or carry costs.
CR = Carry returns
Cost of Carry Model
For the stock index futures it can be mentioned
as
H(0,T) = rT/365, where r is the annual interest rate, T
is the number of days until delivery date and
E[FV(divs)] is the future value of all dividends paid by
the component of the stock index
| | | |
+ = FV(divs) - T) h(0, S S F
Cost of Carry Model
If
traders will engage in a cash-and-carry arbitrage which calls
for buying the spot index (it is relatively cheap) , carrying
it, and selling the futures (relatively expensive).
If
Traders will engage in a reverse cash-and-carry arbitrage which
calls for buying the futures and selling the spot, and investing the
proceeds.
| | | |
=
Computing the Conversion Factor
Assume it is the first day of the delivery month,
and calculate the time to maturity of the bond.
Round down this time to maturity to the nearest
three-month period. For example, 18 years and 5.5
months becomes 18 years and 3 months.
If after rounding off the life of the bond is an
integer multiple of semi-annual periods, then the
first coupon is assumed to be paid after 6 months,
otherwise assumed to be paid after 3 months.
Conversion Factor Example I
We are short in a June futures contract and that
today is June 1, 2001. Consider a 7% T-bond that
matures on 15 June, 2029 which is eligible for
delivery under the futures contract.
On June 1, this bond has 28 years and 1.5 months
to maturity. When rounded off to the nearest three
months, we get a figure of 28 years.
The first coupon is then assumed to be paid after
six months
Conversion Factor Example I
The conversion factor is calculated as below:
1348 . 1
100
1036 . 19 3791 . 94
100
) 56 , 3 ( 100 ) 56 , 3 (
2
7
=
+
=
+
=
PVIF PVIFA
CF
Conversion Factor Example II
Instead of the July 2029 bond, consider another
bond that is maturing on 15 September, 2029.
On June 1, 2001, this bond has 28 years and 3.5
months to maturity.
The life of the bond, when rounded off to the
nearest three months, is 28 yrs and 3 months.
First coupon is assumed to be paid after three
months.
Conversion Factor Example II
First the price of the
bond three months
from today, using a
yield 6% is calculated.
Discount the price for
another three months.
Subtract the accrued
interest for three
months, from the price
obtained above.
116.9827 19.1036 94.3791 3.5
) 56 . 3 ( 100 ) 56 , 3 (
2
7
2
7
= + + =
+ + = PVIF PVIFA P
2665 . 115
) 03 . 1 (
9827 . 116
5 . 0
=
1352 . 1
100
75 . 1 2665 . 115
75 . 1
2
1
2
7
=
=
= =
CF
AI
Invoice Price
Let us assume that on 15 June, 2001 the 7%
bond maturing on 15 September, 2029 will
be delivered under June contract.
The actual delivery will be made two days
later, that is, on 17 June.
How to calculate the invoice price?
Invoice Price
The last coupon would have been paid on 15
March, 2001 and the next will be due on 15
September, 2001.
Accrued interest for a T-bond with face value of
$100,000 is
The futures settlement price on 15 June is
assumed to be 95-12.
This corresponds to a decimal futures price per
dollar of the face value of
0435 . 1788 100000
184
94
2
07 . 0
= = AI
95375 . 0
100
32 / 12 95
=
+
Invoice Price
Invoice price
5 110057.743
0435 . 1788 100000 1352 . 1 95375 . 0 Price Invoice
=
+ =
T-Bond Futures Prices
Cost-of-Carry model determines the T-Bond futures
prices.
Because the short gets to choose which bond to
deliver, the futures price will reflect the spot price
(S) of the bond that the market expects the short
to select. This is called Cheapest-to-Deliver (CTD)
bond.
The carry cost (CC) is the interest rate changes
incurred when an trader borrows to buy the CTD.
Carry return (CR) is the accrued interest, actual
coupon payments and the interest on coupons, if
any.
Cheapest to Deliver T-Bond
During the delivery month the CTD is determined
by computing the cost and the invoice amount.
CTD is one that maximizes the inflows and
minimizes the outflows for the short.
CTD = max [invoice amount (spot price + accrued
interest)]
Before the delivery period, we can only estimate
which T-Bond will likely to be the CTD.
Cheapest to Deliver T-Bond
Implied repo rate (IRR)
IRR is the rate of return earned by buying the
deliverable spot asset and simultaneously selling a
futures contract. Thus
0
0 0
S
S CR F
IRR
+
=
Cheapest to Deliver T-Bond
Using duration
If yields are above 6%, the CTD bond will be the
eligible bond with highest duration.
If yields are below 6%, the CTD bond will be the
eligible bond with the lowest duration.
T-Bill Futures Contracts
Exchange
International Money Market (IMM) segment of
Chicago Mercantile Exchange (CME)
Underlying
3-month US T-bills having a face value at
maturity of $1 million.
Delivery dates
March, June, September and December
Eurodollar Futures
Underlying
3 month time deposits in dollars at banks
located outside the US mainly in Europe and in
particular, in London.
Cash settled