Mechanics of Futures Markets - Chapter 3

By: Prof. N P Singh singhnp_26@yahoo.com

Futures Contracts

Available on a wide range of assets like stocks, Indices, Commodities, currencies, inte-rest rate etc. Exchange traded and standardised, Settled daily The standardized items in a futures contract are:
Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

Terminology
Spot Price Future Price Contract Cycle Expiry Date Contract Size Basis Cost of Carry (Storage + Interest Income) MTM Initial Margin Maintenance Margin

Futures Vs Forwards
Futures Trade on an organized exchange Standardized contract terms hence more liquid Requires margin payments Forwards OTC in nature Customised contract terms hence less liquid No margin payment

Follows daily settlement

Settlement happens at end of period

Margins
A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract

Example of a Futures Trade

An investor takes a long position in 2 December gold futures contracts on June 5

contract size is 100 oz. futures price is US$600 margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total)

A Possible Outcome
Futures Price (US$) 600.00 5-Jun 597.00 . . . . . . 13-Jun 593.30 . . . . . . 19-Jun 587.00 . . . . . . 26-Jun 592.30 (600) . . . (420) . . . (1,140) . . . 260 (600) . . . (1,340) . . . (2,600) . . . (1,540) Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 3,400 . . . 0 . . .

Day

2,660 + 1,340 = 4,000 . . . . . < 3,000 2,740 + 1,260 = 4,000 . . . . . . 5,060 0

Other Key Points About Futures

They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity

Collateralization in OTC Markets

It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)

Futures Prices for Gold on Jan 8, 2007: Prices Increase with Maturity: Normal Market

650

Futures Price ($ per oz)

640 630 620 610

Contract Maturity Month

600 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

10

Futures Prices for Orange Juice on January 8, 2007:Prices Decrease with Maturity:Inverted Mkt.

Futures Price (cents per lb)

210
205 200 195 190 185 180 175 170 Jan-07 Mar-07 May-07 Jul-07

Contract Maturity Month

Sep-07 Nov-07

11

Delivery
If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash

12

Some Terminology
Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of trades in 1 day

13

Convergence of Futures to Spot

Futures Price Spot Price Futures Price

Spot Price

Time

Time

(a)

(b)

14

Futures Payoffs

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited.

15

Payoff for buyer of futures: Long futures

16

Payoff for seller of futures: Short futures

17

Consumption vs Investment Assets

Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver) Consumption assets are assets held primarily for consumption (Examples: copper, oil)

18

Short Selling
Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way

19

Short Selling
(continued)

At some stage you must buy the securities back so they can be replaced in the account of the client You must pay dividends and other benefits the owner of the securities receives

20

Notation for Valuing Futures and Forward Contracts

S0: Spot price today F0: Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T

21

1. An Arbitrage Opportunity?
Suppose that: The spot price of a non-dividend paying stock is $40 The 3-month forward price is $43 The 3-month US$ interest rate is 5% per annum Is there an arbitrage opportunity?

22

2. Another Arbitrage Opportunity?

Suppose that: The spot price of nondividend-paying stock is $40 The 3-month forward price is US$39 The 3-month US$ interest rate is 5% per annum Is there an arbitrage opportunity?

23

The Forward Price

If the spot price of an investment asset is S0 and the futures price for a contract deliverable in T years is F0, then F0 = S0erT where r is the 1-year risk-free rate of interest. In our examples, S0 =40, T=0.25, and r=0.05 so that F0 = 40e0.050.25 = 40.50
24

If Short Sales Are Not Possible..

Formula still works for an investment asset because investors who hold the asset will sell it and buy forward contracts when the forward price is too low i) F0 > S0erT ii) F0 < S0erT

25

When an Investment Asset Provides a Known Dollar Income

F0 = (S0 I )erT
where I is the present value of the income during life of forward contract Example: Long Forward Contract to purchase a coupon-bearing bond

26

When an Investment Asset Provides a Known Yield

F0 = S0 e(rq )T
where q is the average yield during the life of the contract (expressed with continuous compounding) e.g. 6-month forward contract, S0 = 25, r = 10%, q = 3.96% and T = 0.5 We get F0 = 25.77
27

When an Investment Asset Provides a Known Yield

A two-month futures contract trades on the NSE. The cost of financing is 10% and the dividend yield on Nifty is 2% annualized. The spot value of Nifty 4000. What is the fair value of the futures contract? Fair value = 4000 x exp(0.10.02) (60 / 365) i.e. Fair value = Rs.4052.95
28

Forward vs Futures Prices

Forward and futures prices are usually assumed to be the same. When interest rates are uncertain they are, in theory, slightly different: A strong positive correlation between interest rates and the asset price implies the futures price is slightly higher than the forward price A strong negative correlation implies the reverse

29

Pricing equity index futures

The main differences between commodity and equity index futures are that: There are no costs of storage involved in holding equity. Equity comes with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are short the stock. Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with equity futures as opposed to commodity futures is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, the better is the estimate of the futures price.
30

Pricing equity index futures

Can be viewed as an investment asset paying a dividend yield The futures price and spot price relationship is therefore

F0 = S0 e(rq )T where q is the average dividend yield on the portfolio represented by the index during life of contract

31

Pricing equity index futures

For the formula to be true it is important that the index represent an investment asset In other words, changes in the index must correspond to changes in the value of a tradable portfolio

32

Pricing equity index futures

Nifty futures trade on NSE as one, two and three-month contracts. Money can be borrowed at a rate of 10% per annum. What will be the price of a new two-month futures contract on Nifty? Let us assume that ABC Ltd. will be declaring a dividend of Rs.20 per share after 15 days of purchasing the contract. Current value of Nifty is 4000 and Nifty trades with a multiplier of 100. Since Nifty is traded in multiples of 100, value of the contract is 100*4000 = Rs.400,000. If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is Rs.28,000 i.e.(400,000 * 0.07). If the market price of ABC Ltd. Is Rs.140, then a traded unit of Nifty involves 200 shares of ABC Ltd. i.e. (28,000/140).
33

Pricing equity index futures

To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.4000 i.e. (200*20). The dividend is received 15 days later and hence compounded only for the remainder of 45 days. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty. Hence we divide the compounded dividend figure by 100.
34

Pricing equity index futures: Future Price of Index is

35

Index Arbitrage
When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index

36

Index Arbitrage
(continued)

Index arbitrage involves simultaneous trades in futures and many different stocks Very often a computer is used to generate the trades Occasionally simultaneous trades are not possible

37

Pricing stock futures when no dividend expected

F0 = S0erT Example: XYZ futures trade on NSE as one, two and three-month contracts. Money can be borrowed at 10% per annum. What will be the price of a unit of new two-month futures contract on SBI if no dividends are expected during the two-month period? Assume that the spot price of XYZ is Rs.228. Thus, futures price F = 228 x e0.10 (60/365) = Rs.231.90

38

Pricing stock futures when dividends are expected

F0 = (S0 I )erT where I is the present value of the dividend during life of forward contract XYZ futures trade on NSE as one, two and three-month contracts. What will be the price of a unit of new two-month futures contract on XYZ if dividends are expected during the two-month period? Let us assume that XYZ will be declaring a dividend of Rs. 10 per share after 15 days of purchasing the contract. Assume that the market price of XYZ is Rs. 140. To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.10. The dividend is received 15 days later and hence compounded only for the remainder of 45 days. Thus, futures price F = 140xe 0.1 (60/365) 10xe0.1 (45/365)= Rs.132.20

39

Futures and Forwards on Currencies

A foreign currency is analogous to a security providing a dividend yield The continuous dividend yield is the foreign risk-free interest rate It follows that if rf is the foreign risk-free interest rate

F0 S0 e

( r rf ) T

40

Why the Relation Must Be True

1000 units of foreign currency at time zero

1000 e

rf T

units of foreign currency at time T

1000S0 dollars at time zero

1000 F0 e

rf T

dollars at time T

1000 S 0 e rT
dollars at time T

41

Futures on Consumption Assets

F0 S0 e(r+u )T where u is the storage cost per unit time as a percent of the asset value. Alternatively,

F0 (S0+U )erT where U is the present value of the storage costs.

42

The Cost of Carry

The cost of carry, c, is the storage cost plus the interest costs less the income earned For an investment asset F0 = S0ecT For a consumption asset F0 S0ecT The convenience yield on the consumption asset, y, is defined so that F0 = S0 e(cy )T

43

Futures Prices & Expected Future Spot Prices

Suppose k is the expected return required by investors on an asset We can invest F0er T at the risk-free rate and enter into a long futures contract so that there is a cash inflow of ST at maturity This shows that

F0 e or

rT

kT

E ( ST )

F0 E ( ST )e ( r k )T
44

Futures Prices & Future Spot Prices (continued)

If the asset has no systematic risk, then k = r and F0 is an unbiased estimate of ST positive systematic risk (asset is +vely correlated with the stock market e.g. Stock Index), then k > r and F0 < E (ST ) i.e. Normal Backwardation negative systematic risk (asset is -vely correlated with the stock market), then k < r and F0 > E (ST ) i.e. Contango
45

Long & Short Hedges

A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price A short futures hedge is appropriate when you know you will sell an asset in the future and want to lock in the price

46

Basis Risk
Basis is the difference between the spot and futures price Basis risk arises because of the uncertainty about the basis when the hedge is closed out

47

Long Hedge
We define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price If you hedge the future purchase of an asset by entering into a long futures contract then Cost of Asset=S2 (F2 F1) = F1 + Basis

48

Short Hedge
Again we define F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price If you hedge the future sale of an asset by entering into a short futures contract then Price Realized=S2+ (F1 F2) = F1 + Basis

49

Optimal Hedge Ratio

Proportion of the exposure that should optimally be hedged is sS r sF where sS is the standard deviation of DS, the change in the spot price during the hedging period, sF is the standard deviation of DF, the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF.
50

Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts that should be shorted is P
F where P is the value of the portfolio, b is its beta, and F is the value of one futures contract

51

Example
S&P 500 futures price is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5

What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?

52

Changing Beta
What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?

53

Rolling The Hedge Forward

We can use a series of futures contracts to increase the life of a hedge Each time we switch from one futures contract to another we incur a type of basis risk

54

CASH AND CARRY ARBITRAGE

ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs.1025 and seem overpriced. You can make riskless profit by entering into the following set of transactions.
On day one, borrow funds, buy the security on the cash/spot market at 1000. Simultaneously, sell the futures on the security at 1025. Take delivery of the security purchased and hold the security for a month. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Say the security closes at Rs.1015. Sell the security. Futures position expires with profit of Rs.10.
55

CASH AND CARRY ARBITRAGE

The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position If your cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is termed as cashand-carry arbitrage.

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

56

REVERSE CASH AND CARRY ARBITRAGE

ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions.
On day one, sell the security in the cash/spot market at 1000. Make delivery of the security. Simultaneously, buy the futures on the security at 965. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Say the security closes at Rs.975. Buy back the security. The futures position expires with a profit of Rs.10. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position.
57

REVERSE CASH AND CARRY ARBITRAGE

If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cashand-carry arbitrage.

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull 2008

58