NISM Series VIII: Equity Derivatives | Chapter 3: Introduction to Forwards & Futures | Detailed Notes

CHAPTER 3: INTRODUCTION TO FORWARDS & FUTURES

3.1 INTRODUCTION TO FORWARD CONTRACTS

A forward contract is a type of financial agreement between two parties to buy or sell an asset at a specific future date.

Essential features -

• It is a contract between two parties (a bilateral contract).

• All terms of the contract like price, quantity and quality of underlying, delivery terms like place, settlement procedure, etc. are fixed on the day of entering into the contract.

• Any changes to the contract terms can be made if both parties agree.

Difference Between Cash Market and Forward Market

FEATURE	CASH MARKET	FORWARD MARKET
DEFINITION	Immediate payment and delivery of the asset at the current market price.	Agreeing on a price today for payment and delivery of the asset at a future date.
EXAMPLE	On May 11, 2024, you buy 10 grams of gold from a goldsmith for Rs. 60,000 and take immediate delivery.	On May 11, 2024, you agree with a goldsmith to buy 10 grams of gold for Rs. 60,500, with the transaction and delivery to occur one month later, on June 11, 2024.

RISKS

Liquidity Risk:

• Forward contracts are customised and not traded on exchanges, making it hard for others to buy or sell these contracts easily.

• This lack of easy trading makes it difficult for parties to exit the contract before it matures.

Counterparty Risk:

• There's a risk that one party may not fulfil their obligation if the market price changes unfavourably for them.

• For example, if A agrees to buy 100 barrels of oil from B at Rs. 3,000 per barrel after 6 months, but the market price rises to Rs. 6,000 per barrel, B may refuse to sell at the agreed price.

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3.2 FUTURES CONTRACT

Futures contracts were created to overcome the limitations of forwards. They are standard agreements made through an exchange to buy or sell a set amount of a commodity or financial asset at a future date for an agreed price.

• When a trader buys a futures contract, said - "long" position.

• When a trader sells a futures contract, said - "short" position.

Essential features

• Involves 2 parties.

• The clearing corporation guarantees that all trades are settled.

• The contract is made through an exchange.

• Prices are determined by buyers and sellers interacting freely through the exchange.

• Both parties must pay margins (a type of security deposit).

• Standardised Quality & quantity is set by the exchange.

Limitations

• Contracts have fixed expiration dates.

• Only a specific set of assets can be traded.

• Contracts can't be customised.

• Daily mark-to-market (MTM) settlements increase costs.

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3.3 CONTRACT SPECIFICATION

It includes the various salient features of a derivatives contract:

• Underlying Instrument and Price: The asset (like Nifty 50 index) on which the futures contract is based and its current market price.

• Contract Multiplier/Size: The number of units per contract; for Nifty futures, it's 15 units.

• Contract Cycle: The period during which the contract is active; typically three months (near, next, far month).

• Expiration Day: The last trading day of the contract when it must be settled or rolled over.

• Tick Size: The smallest price movement allowed for the contract; for Nifty futures, it's 5 paisa.

• Daily Settlement Price: The price used for daily settlement of open positions, calculated from the last half-hour average price.

• Final Settlement Price: The price at which all open positions are settled on the expiration day, usually the closing spot price.

• Trading Hours: The time period during which futures can be traded, typically from 9:15 am to 3:30 pm, Monday to Friday.

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3.4 KEY TERMINOLOGIES

Basis:

• The difference between the spot price and the futures price.

• Positive if spot price > futures price, negative if spot price < futures price.

• The basis may change during the contract's life but becomes zero at maturity since the futures price matches the spot price on the expiry date.

Cost of Carry:

• The cost of holding an asset until the futures contract expires, including storage and interest costs minus any income earned.

Initial Margin:

• The upfront deposit required when entering a futures contract, to avoid counterparty risk (default).

Marking to Market (MTM):

• Daily settlement of profits and losses based on price changes.

• A trader buys a futures contract at Rs. 1,000. End of day price rises to Rs. 1,050, the trader gains Rs. 50. Next day price drops to Rs. 1,020, the trader loses Rs. 30.

Open Interest and Volume:

• Open Interest: Total number of outstanding futures contracts not yet settled.

• Volume: Number of contracts traded in a given period.

Price Band:

• The allowed range of price movements for a contract within a day.

Positions in the Derivatives Market:

• Long Position: Holding a buy (unsettled) position in a futures contract.

• Short Position: Holding a sell (unsettled) position in a futures contract.

• Open Position: Any unsettled long or short position.

• Naked Position: A long or short position without any offsetting position in the underlying asset.

• Calendar Spread: Holding a long position in one maturity contract and a short position in another maturity contract of the same underlying asset.

Opening and Closing a Position:

• Opening a Position: Entering into a new long or short futures contract.

• Closing a Position: Exiting a long or short futures contract by taking the opposite action (buying if short, selling if long).

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3.5 SUMMARY OF DIFFERENCES BETWEEN FORWARDS AND FUTURES

Features	Forward Contracts	Futures Contracts
Operational Mechanism	Not traded on exchanges	Exchange-traded
Contract Specifications	Tailor-made to participants' needs	Standardized terms (except price)
Counterparty Risk	Exists, reduced by a guarantor	Clearing agency guarantees settlement
Liquidity Profile	Low, not easily accessible	High, standardized and exchange-traded
Price Discovery	Inefficient, scattered markets	Efficient, centralized trading platform
Quality of Information	Poor quality, slow distribution	High quality, fast nationwide distribution

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3.6 PAYOFF CHARTS FOR FUTURES CONTRACT

Payoff chart - A graphical representation of potential profit or loss based on the underlying asset's price at expiry.

• Y-axis: Profit and loss

• X-axis: Price of the underlying asset

WHAT IS PAYOFF IN FUTURES?

Futures contracts, both long and short positions have unlimited profit or loss potential, resulting in linear payoffs.

1. PAYOFF FOR A LONG FUTURES

Calculated as: Payoff/profit&loss = Spot Price at Expiry - Future contract Price

Example -

A person goes long in a futures contract at Rs. 100.

• If the spot price at expiry is Rs. 70, Payoff = Rs. 70 - Rs. 100 = Rs. 30 (Loss)

• If the spot price at expiry is Rs. 150, Payoff = Rs. 150 - Rs. 100 = Rs. 50 (Profit)

2. PAYOFF FOR A SHORT FUTURES

Payoff (Profit/Loss) = Futures Contract Price - Spot Price at Expiry

Example:

A person goes short in a futures contract at Rs. 100.

• If the spot price at expiry is Rs. 60: Payoff = Rs. 100 - Rs. 60 = Rs. 40 (Profit)

• If the spot price at expiry is Rs. 120: Payoff = Rs. 100 - Rs. 120 = Rs. 20 (Loss)

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3.7 FUTURES PRICING

Prices vary based on the underlying asset's characteristics. Different assets have unique demand, supply patterns, and cash flow characteristics; there isn't a single method to price all futures contracts. Two common futures pricing models are the Cost of Carry model and the Expectations model.

Cost of carry model for futures pricing

It is also known as the no-arbitrage model. It assumes that in an efficient market, arbitrage opportunities (chances to make a risk-free profit) cannot exist. When mispricing occurs, arbitrageurs trade to profit from it, thus aligning the prices of the asset and its futures.

Workings of Cost of Carry Model:

• Direct Futures Contract: Enter into a futures contract to buy/sell the asset at a specific price on a future date.

• Synthetic Futures Position: Buy the asset in the cash market at the spot price. Hold the asset until the future date, incurring carrying costs. Total cost = Spot price + Carrying costs.

FORMULA: FUTURES PRICE = SPOT PRICE + COST OF CARRY

Example:

• Spot Price of Gold: Rs 62,130 per 10 grams

• Carrying Costs (financing, storage, insurance for three months): Rs 100 per 10 grams

• Expected Value After Three Months: Rs 62,230 per 10 grams (Spot price + Carrying costs)

Cash and Carry Arbitrage:

What if the futures price (Rs 62,280) is higher than the fair futures price calculated above (Rs 62,230). The arbitrage will happen:

1. Sell the Gold Futures @ 62,280

2. Buy the gold in cash (spot) market @ 62,130 hold for 3 months (@ 100)

3. Now post 3 months deliver the gold

4. Profit = Sell price (62,280) - Buy price (62,130 + 100) = Rs 50

   This Arbitrage will keep happening until FUTURES prices come down to 62,230.

Reverse Cash and Carry Arbitrage:

What if the futures price (Rs 62,180) is lower than the fair futures price (Rs 62,230). The arbitrage will happen:

1. Sell in the cash market @ 62,130 (earn interest @ 100)

2. Buy the gold futures (spot) market @ 62,180

3. Now post 3 months take the delivery of gold

4. Profit = Sell price (62,130 + 100 @ interest) - Buy price (62,180) = Rs 50

   This Arbitrage will keep happening until FUTURES prices goes up to 62,230.

Cost of transaction and no-arbitrage bounds:

In an actual market scenario, there are various costs like margins, transaction costs (commissions), taxes etc. associated with the transaction. Hence there is not always a fixed fair price, there is always a Fair price range beyond which only the cash & carry or reverse cash & carry arbitrage will get triggered.

• The larger the costs -> larger the bounds -> further the market is from the equilibrium price.

• Means for Markets to be efficient, Transaction cost should be low.

Extension of Cost of Carry model to the assets generating returns

Objective: Adjust the cost of carry model to include inflows such as dividends and interest during the holding period.

Modified Formula: $F = S(1 + r - q)^T$

Where:

• $F$ = Fair price of the futures contract

• $S$ = Spot price of the underlying asset

• $q$ = Expected return (dividends/interest)

• $r$ = Cost of carry

• $T$ = Holding period in years

Continuous Compounding Version: $F = S \cdot e^{(r - q) \cdot T}$

Assumptions of the Cost of Carry Model:

• Abundant Availability of the underlying asset.

• Non-Seasonal Demand and Supply.

• Ease of Maintenance.

• Short Selling Feasibility.

• No Transaction Costs, No Taxes, and No Margin Requirements.

Convenience Yield:

Refers to the intangible benefits or perceived values of holding an asset (e.g., stockpiling essentials during natural disasters).

• FAIR PRICE = SPOT PRICE + COST OF CARRY INFLOWS - CONVENIENCE YIELD.

• Convenience yield can cause futures prices to trade at a discount to spot prices if it is greater than the cost of carry.

Expectations model of futures pricing

States that futures prices are primarily determined by what traders expect the future spot prices to be.

• Contango Market: If the futures price is higher than the current spot price, it suggests the market expects the spot price to rise.

• Backwardation Market: If the futures price is lower than the current spot price, it indicates the market expects the spot price to decrease.

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3.8 PRICE DISCOVERY AND CONVERGENCE

• Price Discovery: Futures markets help determine where market participants collectively expect the spot price to be at a future date.

• Convergence at Expiry: As a futures contract nears its expiry, the futures and spot prices converge, ensuring that futures settle at the underlying cash market price on the last trading day.

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3.9 USES OF FUTURES

Hedgers:

Protect against price changes in assets. An investor with a diverse stock portfolio can sell futures to protect against a temporary market downturn.

Traders/Speculators:

Take advantage of price movements. It's easier to speculate using futures than trading the actual asset due to leverage. A trader expecting better results of a company can go long on its futures. They also provide liquidity to the market.

Arbitrageurs:

Earn risk-free profits by exploiting price differences. Buy cheaply in one market and sell higher in another. This increases market efficiency.

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RISKS IN FUTURES

Price Risk:

1. Unsystematic Risk: Unique to a specific company or industry. Can be minimized by diversifying. (Example: Factory workers strike).

2. Systematic Risks: Associated with overall market movements. Cannot be eliminated through diversification. (Examples: Changes in monetary policy, currency depreciation).

Role of Beta:

Beta is a measure of a security's systematic risk.

• Beta > 1: Security is more volatile than the market.

• Beta < 1: Security is less volatile than the market.

Hedging Systematic Risk:

• Single stock futures can hedge the specific risk of a stock (Hedge ratio 1:1).

• Index futures can hedge the systematic risk of a portfolio. A specific hedge ratio is calculated based on portfolio beta.

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IMPORTANT TERMS IN HEDGING

1. Long Hedge: Hedging by buying futures to protect against expected price increases.

2. Short Hedge: Hedging the current position in the cash market by selling futures to protect against expected price decreases.

3. Cross Hedge: Hedging using a related asset's futures when no direct futures are available (e.g., using crude oil futures to hedge jet fuel).

4. Hedge Contract Month: The month when the futures contract used for hedging expires.

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Dhaval Visariya

AMFI Registered Distributor (ARN-327925) | Software Developer & Finance Enthusiast

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