Financial Derivatives

Unit-II- Futures and Forward Market

Introduction:

Forwards:

A forward contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today’s pre-agreed price. For example, an Indian
car manufacturer buys auto parts from a Japanese car maker with payment of one million
yen due in 60 days. The importer in India is short of yen and supposes present price of yen
is Rs. 68. Over the next 60 days, the yen may rise to Rs. 70. The importer can hedge this
exchange risk by negotiating a 60-day forward contract with a bank at a price of Rs. 70.
According to forward contract, in 60 days the bank will give the importer one million yen
and importer will give the banks 70 million rupees to bank

Futures:

A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price. Futures contracts are special types of forward contracts
in the sense that the former are standardized exchange-traded contracts. A speculator
expects an increase in the price of gold from current future prices of Rs. 9000 per 10 gm.
The market lot is 1 kg and he buys one lot of future gold (9000 × 100) Rs.
9,00,000.Assuming that there is a 10% margin money requirement and 10% increase occur
in price of gold. the value of transaction will also increase. Rs. 9900per 10 gm and total
value will be Rs. 9,90,000. In other words, the speculator

Structure of Forward and Futures

The forward market is an unofficial market, it constitutes the buyer of forwards and the
seller of forwards. The future market constitutes the buyer of futures, the seller of forwards
and the financial intermediatory.

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Mechanics of Future markets

Futures contracts

Suppose a farmer produces rice and he expects to have an excellent yield on rice; but he is
worried about the future price fall of that commodity. How can he protect himself from the
falling price of rice in future? He may enter into a contract today with some party who
wants to buy rice at a specified future date on a price determined today itself. In the
complete process the Farmer will deliver rice to the party and receive the agreed price and
the other party will take delivery of rice and pay to the farmer. In this illustration there is
no exchange of money, and the contract is binding on both the parties.

Hence future contracts are forward contracts traded only on organized exchanges and are
in standardized contract size. The farmer has protected.

himself against the risk by selling rice futures and this action is called short hedge while
on the other hand, the other party also protects against-risk by buying rice futures is called
long hedge.

Features of financial futures contract

Financial futures, like commodity futures, are contracts to buy or sell financial aspects at a
future date at a specified price. The following features are there for future contracts:

• Future contracts are traded on organized future exchanges. These are forward contracts
traded on organized futures exchanges.

• Future contracts are standardized contracts in terms of quantity, quality, and amount.

• Margin money is required to be deposited by the buyer or seller in form of cash or

securities. This practice ensures honor of the deal.

• In case of future contracts, there is a dairy of opening and closing of position, known as
marked to market. The price differences every day are settled through the exchange
clearing house. The clearing house pays to the buyer if the price of a futures contract
increases on a particular day and similarly seller pays the money to the clearing house.
The reverse may happen in case of decrease in price.

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 Functions of futures markets
Initially futures were devised as instruments to fight against the risk of future price
movements and volatility. Apart from the various features of different futures
contracts and trading, futures markets play a significant role in managing the
financial risk of the corporate business world. The important functions of futures
market are described as follows:
Hedging function:
The primary function of the futures market is the hedging function which is also
known as price insurance, risk shifting or risk transference function. Futures markets
provide a vehicle through which the traders or participants can hedge their risks or
protect themselves from the adverse price movements in the underlying assets in
which they deal.

For example, a farmer bears the risk at the planting time associated with the uncertain
harvest price his crop will command. He may use the futures market to hedge this risk by
selling a futures contract. For instance, if he is expected to produce 500 tons of cotton in
next six months, he could set a price for that quantity (harvest) by selling 5 cotton futures
contracts, each being 100 tons. In this way, by selling these futures contracts, the farmer
tends to establish a price today that will be harvested in the futures. Further, the futures
transactions will protect the

farmer from the fluctuations of the cotton price, which might occur between present
and futures period. Here two prices come into picture: future price and spot price.
The difference between the two is the profit or loss for the farmer.
Price discovery function:
Another important function of the futures market is the price discovery which reveals
information about futures cash market prices through the futures market. Further, the
price discovery function of the futures market also leads to the inter temporal
inventory allocation function. According to this, the traders can compare the spot
and futures prices and will be able to decide the optimum allocation of their quantity
of underlying asset between the immediate sale and futures sale. The price discovery
function can be explained by an example. Supposing, a copper miner is trying to take

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a decision whether to reopen a marginally profitable copper mine or not.
Assuming that the copper ore in the mine is not of the best quality and so the yield
from the mine will be low. The decision will depend upon the cost incurred on
mining and refining of copper and the price of the copper to be obtained in futures.
Hence, the crucial element in this decision is the futures price of copper. The miner
can analyze the copper prices quoted in the futures market today for determining the
estimate of the futures price of copper at a specified futures period. In this
calculation, the miner has used the futures market as a vehicle of price discovery.
Financing function:
Another function of a futures market is to raise finance against the stock of assets or
commodities. Since futures contracts are standardized contracts, so, it is easier for
the lenders to ensure quantity, quality and liquidity of the underlying asset.
Liquidity function: It is obvious that the main function of the futures market deals
with such transactions which are matured on a future date. They are operated on the
basis of margins. Under this the buyer and the seller have to deposit only a fraction
of the contract value, say 5 percent or percent, known as margins.
This practice ensures honouring of the future deals and hence maintains liquidity.
When there is a futures contract between two parties, future exchanges require some
money to be deposited by these parties’ called margins. Each futures exchange is
responsible for setting minimum initial margin requirements for all futures contracts.
The trader has to deposit and maintain this initial margin into an account as trading.
Account.
Price stabilization function:
Another function of a futures market is to keep a stabilizing influence on spot prices
by reducing the amplitude of short-term fluctuations. In other words, futures market
reduces both the heights of the peaks and the depth of the troughs. There is less
default risk in case of future contract because the change in the value of a future
contract results in a cash flow every day. The daily change in the value of a futures
contract must be exchanged, so that if one party (the losing party) defaults, the
maximum loss that will be realized is just one day‟s change in value. The incentive
for default in futures is greater than in forwards.

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 Disseminating information:
Aside from the above mentioned functions of the futures markets like risk-
transference (hedging), price discovery, price stabilization, liquidity, and financing,
this market is very much useful to the economy too. Since in futures market, futures
traders‟ positions are marked to market on daily basis, which is known as daily
resettlements. It means that every day the trader’s account is added to if (profit
occurs) and deducted in case the losses occur. All the profits that increase the margin
account balance above the initial balance margin can be withdrawn and vice- versa.
If the future price falls, trader accounts equity rises and vice-versa

Hedging Strategies Using Futures

Concept and types of hedging

The beauty of derivative market lies in the fact that an investor can protect his risk by
entering into a contract. In broader sense, a hedging is enacted of protecting one from future
losses due to some reason. In a future market, the use of future contracts/instrument in such
a way that risk is either avoided or minimized is called hedging. The anticipated future
losses may occur due to fluctuations in the price, foreign exchange, or interest rate. In case
of unfavorable price movement, the hedgers enter into future at different time periods. This
concept considers that hedging activity is based on price risk. Why investors hedge?
According to Hollbook, hedging has following purposes:

Carrying charge hedging:

In this case, if the spread (Difference between futures and spot price) covers the carry cost
too, then stocks should be bought.

Operational hedging:

According to this approach, future markets are supposed to be more liquid and investors
(hedger) use futures as a substitute for cash market.

Selection or discretionary hedging:

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This hedging is done only on selected occasions or when there may be some adverse price
movements in future participatory hedging:

This is done in anticipation of the buying or selling price of an asset in future. If an investor
uses future contract in a fashion that it eliminates the risk completely is known as perfect
hedging model. The factors which may affect perfect hedging are:

• Profits are affected by change in commodity, security, interstate, or exchange rate.

• Knowledge of the firm gives the impact of these factors on profit.

• Quantity which affects the firm.

Types of hedges:

There are two categories of hedging- short hedge and long hedge.

Short hedge:

Having a short position (selling futures) in futures is known as a short hedge. It happens
when an investor plans to buy or produce cash commodity sells futures to hedge the cash
position. It is appropriate when a hedger owns an asset and expects to sell in future on a
particular date. Thus, selling some asset without having the same is known as short-selling.
For example suppose a US exporter expects to receive Euros in three months. He will gain
if the euro increases in value relative to the US dollar and will sustain loss if the euro
decreases in value relative to US dollar.

Long hedge:

A long hedge is taking long position in futures contract. A long hedge is done in anticipation
of future price increases and when the company knows that it will have to buy ascertain
asset in the future at anticipated higher price and wants to lock in a price now. The objective
of along hedge is to protect the company against a price increase in the underlying asset
prior to buy the same either in spot or future market. A net bought position is actually
holding an asset which is known as inventory hedge. Suppose an investment banker
anticipates receiving Rs. 1 million on June 20 and intends to buy a portfolio of Indian
equities. Assuming that he has a risk factor of increase in the Sensex before money is

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received. He can go in futures and buy today futures contract at 11000 (today’s Sensex
11000). He can close his position by selling 10 August stock futures.

Cross hedging:

A cross hedge is a hedge where characteristics of futures and spot prices do not match
perfectly which is known as mismatch, may occur due to following reasons to be hedged
may not be equal to the quantity of futures contract.

• Features of assets to be hedged are different from the future contract asset.

• Same futures period (maturity) on a particular asset is not available.

Suppose a wire manufacturer requires copper in the month of June but in exchange the
copper futures trade in long delivery in Jan, March, July , Sept. in this case hedging horizon
does not match with the futures delivery date. Suppose that the copper required by the
manufacturer is substandard quality but the available trading is of pure 100% copper and
in quantity aspect too, copper may be traded in different multiples than required actually.
These are examples of cross hedging.

Determination of Forward and Future Prices

Future price and the expected future spot prices:

Future prices keep on changing continuously. Thus future price can be an estimate
of the expected future spot price.
Theories of futures pricing
There are several theories which have made efforts to explain the relationship between spot
and futures prices. A few important of them are as follows:

The cost-of-carry approach

Some economists like Keynes and Hicks, have argued that futures prices essentially
reflect the carrying cost of the underlying assets. In other words, the inter-
relationship between spot and futures prices reflect the carrying costs, i.e., the
amount to be paid to store the asset from the present time to the futures maturity time
(date). For example, food grains on hand in June can be carried forward to, or stored
until, December. Cost of carry which includes storage cost plus the interest paid to

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 finance the asset less the income earned on assets. For more understanding of the
concept, let’s take

The expectation approach

The advocates of this approach J.M. Keynes, J.R. Hicks and N. Kalidor argued the
futures price as the market expectation of the price at the futures date. Many traders
and investors, especially those using futures market to hedge, will be interested to study
how todays futures prices are related to market expectations about futures prices. For
example, there is general expectation that the price of the gold next Oct 1, 2006 will be
Rs. 7000 per 10grams. The futures price today for Jan 1, 2007 must somewhat reflect
this expectation. If today‟s futures price is Rs. 6800 of gold, going long futures will
yield an expected profit of Expected futures profit = Expected futures price–Initial
futures prices. 200 = Rs. 7000 –Rs.6800.
Differences of the futures prices from the expected price will be corrected by
speculation. Profit seeking speculators will trade as long as the futures price is
sufficient far away from the expected futures spot price. This approach may be
expressed as follows: F0, t = E0 (St) Where F0,t is Futures price at time t = 0 and E0(St)
is the expectation at = 0 of the spot price to prevail at time t.
The above equation states that the futures price approximately equals the spot price
currently expected to prevail at the delivery date, and if, this relationship did not hold,
there would be attractive speculative opportunity. Future prices are influenced by
expectations prevailing currently.17This is also known as hypothesis of unbiased
futures pricing because it advocates that the futures price is an unbiased estimate of the
futures spot price, and on an average, the futures price will forecast the futures spot
price correctly.
The theory of normal backwardation
In general, backwardation is the market in which the futures price is less than the cash
(spot price). In other words, the basis is positive, i.e., difference between cash price and
future price is positive. This situation can occur only if futures prices are determined
by considerations other than, or in addition, to cost-of-carry factors. Further, if the
futures prices are higher than the cash prices, this condition is usually referred to as a

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contango market; and the basis is negative.
Normal backwardation
It is used to refer to a market where futures prices are below expected futures spot
prices. Second way of describing the can tango and backwardation market is that the
former (contango) is one in which futures prices are reasonably described most of time
by cost-of-carry pricing relationship, whereas later.
Backwardation
is one in which futures prices do not fit a full cost-of-carry pricing relationship.
Futures prices are lower than those predicted by the cost-of-carry pricing formula. It
has been observed in many futures markets that the trading volume of short hedging
(sales) exceeds the volume of long hedging (purchases), resulting in net short
position.
Types of Futures
Financial futures contracts can be categorized into following types:

Interest rate futures:

In this type the futures securities traded are interest bearing instruments like T-bills, bonds,
debentures, euro dollar deposits and municipal bonds, notional gilt-contracts, short term
deposit futures and Treasury note futures. Stock index futures: Here in this type contracts
are based on stock market indices. For example in US, Dow Jones Industrial Average,
Standard and poor's 500 New York Stock Exchange Index. Other futures of this type
include Japanese Nikkei index, TOPIX etc.

Foreign currency futures:

These future contracts trade in foreign currency generated by exporters, importers, bankers,
FIs and large companies.

Bond index futures: These contracts are based on particular bond indices i.e. indices of
bond prices. Municipal Bond Index futures based on Municipal Bonds are traded on CBOT
(Chicago Board of Trade).

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Cost of living index future:

These are based on inflation measured by CPI and WPI etc. These can be used to hedge
against unanticipated inflationary pressure.

Forward contract

A forward contract is a simple customized contract between two parties to buy or sell an
asset at a certain time in the future for a certain price. Unlike future contracts, they are not
traded on an exchange, rather traded in the over-the-counter market, usually between two
financial institutions or between a financial institution and one of its clients. In brief, a
forward contract is an agreement between the counter parties to buy or sell a specified
quantity of an asset at a specified price, with delivery at a specified time (future) and place.
These contracts are not standardized; each one is usually customized to its owner’s
specifications.

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