futures & forward contracts

Published on: **Mar 4, 2016**

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Education

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- 1. Pricing Forward Contract
- 2. THE FORWARD MARKET I. INTRODUCTION A. Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.
- 3. THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange rate risk.
- 4. THE FORWARD MARKET B. Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted to commercial customers. b. Swap Rate: quoted in the interbank market as a discount or premium.
- 5. THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract
- 6. THE FORWARD MARKET C. Forward Contract Maturities 1. Contract Terms a. 30-day b. 90-day c. 180-day d. 360-day 2. Longer-term Contracts
- 7. Interest Rate Parity
- 8. Meaning of Interest Rate Parity Uses nominal interest rates to analyze the relationship between spot rate and a corresponding forward rate Relates interest rate differentials between home country and foreign country to the forward premium/discount on the foreign currency The size of the forward premium or discount on a currency should be equal to the interest rate differential between the countries of concern If nominal interest rates are higher in country A than country B, the forward rate for country B’s currency should be at a premium sufficient to prevent arbitrage
- 9. INTEREST RATE PARITY THEORY 1. The Theory states: the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.
- 10. INTEREST RATE PARITY THEORY 2. The forward premium or discount equals the interest rate differential. (F - S)/S = (rh - rf) where rh = the home rate rf = the foreign rate
- 11. INTEREST RATE PARITY THEORY 3. In equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S
- 12. INTEREST RATE PARITY THEORY B.Covered Interest Arbitrage 1. Conditions required: interest rate differential does not equal the forward premium or discount. 2. Funds will move to a country with a more attractive rate.
- 13. INTEREST RATE PARITY THEORY 3. Market pressures develop: a. As one currency is more demanded spot and sold forward. b. Inflow of fund depresses interest rates. c. Parity eventually reached.
- 14. INTEREST RATE PARITY THEORY C. Summary: Interest Rate Parity states: 1. Higher interest rates on a currency offset by forward discounts. 2. Lower interest rates are offset by forward premiums.
- 15. Interest Rate Parity (IRP)
- 16. Covered Interest Arbitrage (CIA)
- 17. Uncovered Interest Arbitrage (UIA): The Yen Carry Trade In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts the proceeds to another currency such as the U.S. dollar where the funds are invested at a higher interest rate for a term. At the end of the period, the investor exchanges the dollars back to yen to repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor profits. If, however, the yen were to appreciate versus the dollar over the period, the investment may result in significant loss.
- 18. Implications of IRP If domestic interest rates are less than foreign interest rates, foreign currency must trade at a forward discount to offset any benefit of higher interest rates in foreign country to prevent arbitrage If foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset the interest rate advantage of foreign country, arbitrage opportunity exists for domestic investors. Domestic investors can benefit by investing in the foreign market
- 19. Implications of IRP If domestic interest rates are more than foreign interest rates, foreign currency must trade at a forward premium to offset any benefit of higher interest rates in domestic country to prevent arbitrage If foreign currency does not trade at a forward premium or if the forward premium is not large enough to offset the interest rate advantage of domestic country, arbitrage opportunity exists for foreign investors. Foreign investors can benefit by investing in the domestic market
- 20. Applications of Futures
- 21. Trading Underlying v/s Trading Single Stock Futures To trade securities ---- a customer must open a security trading account with a broker and a demat account with a depository. Buying security involves putting up all the money upfront. With the purchase of shares of a company, the holder becomes a part owner of the company. The shareholder typically receives the rights and privileges associated with the security --- dividends, invitation to the annual shareholders meeting and the power to vote. Selling securities involves buying the security before selling it
- 22. Trading Underlying v/s Trading Single Stock Futures To trade futures ---- a customer must open a futures trading account with a derivatives broker. Buying futures simply involves putting in the margin money. They enable the futures traders to take a position in the underlying security without having to open an account with a securities broker. With the purchase of futures on a security, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). Security futures do not represent ownership in a corporation and the holder is therefore not regarded as a shareholder.
- 23. Trading Underlying v/s Trading Single Stock Futures Selling security futures without previously owning them simply obligates the trader to selling a certain amount of the underlying security at some point in the future.
- 24. Futures Payoffs Futures contracts have linear or symmetrical payoffs. It means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited.
- 25. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
- 26. Payoff for buyer of futures: Long futures Take the case of a speculator who buys a two- month Nifty index futures contract when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses.
- 27. Payoff for a buyer of Nifty futures
- 28. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.
- 29. Payoff for seller of futures: Short futures Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 2220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.
- 30. Payoff for a seller of Nifty futures
- 31. Pricing Futures Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value.
- 32. Pricing Futures The cost of carry model used for pricing futures is given below: where: r Cost of financing (using continuously compounded interest rate) T Time till expiration in years e 2.71828
- 33. Pricing Futures Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows:
- 34. Pricing equity index futures A futures contract on the stock market index gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there is no delivery of the underlying stocks.
- 35. 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.
- 36. Pricing equity index futures 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.
- 37. Pricing index futures given expected dividend amount The pricing of index futures is also based on the cost-of-carry model, where the carrying cost is the cost of financing the purchase of the portfolio underlying the index, minus the present value of dividends obtained from the stocks in the index portfolio.
- 38. Pricing index futures given expected dividend amount 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? 1. Let us assume that ABC Ltd. will be declaring a dividend of Rs.20 per share after 15 days of purchasing the contract. 2. Current value of Nifty is 4000 and Nifty trades with a multiplier of 100.
- 39. Pricing index futures given expected dividend amount 3. Since Nifty is traded in multiples of 100, value of the contract is 100*4000 = Rs.400,000. 4. If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is Rs.28,000 i.e.(400,000 * 0.07). 5. 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).
- 40. Pricing index futures given expected dividend amount 6. 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.
- 41. Pricing index futures given expected dividend amount 7. Thus, futures price
- 42. Pricing index futures given expected dividend yield If the dividend flow throughout the year is generally uniform, i.e. if there are few historical cases of clustering of dividends in any particular month, it is useful to calculate the annual dividend yield. (r−q)T F = Se where: F--- futures price S--- spot index value r--- cost of financing q--- expected dividend yield T--- holding period
- 43. Pricing index futures given expected dividend 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? (0.1−0.02) × (60 / 365) Fair value = 4000e = Rs.4052.95
- 44. Pricing index futures given expected dividend yield The cost-of-carry model explicitly defines the relationship between the futures price and the related spot price. 1. As the date of expiration comes near, the basis reduces - there is a convergence of the futures price towards the spot price. On the date of expiration, the basis is zero. If it is not, then there is an arbitrage opportunity. 2. There is nothing but cost-of-carry related arbitrage that drives the behavior of the futures price. 3. Transactions costs are very important in the business of arbitrage.
- 45. Pricing index futures given expected dividend yield A futures contract on a stock gives its owner the right and obligation to buy or sell the stocks. Stock futures are also cash settled; there is no delivery of the underlying stocks. The main differences between commodity and stock futures are that: 1. There are no costs of storage involved in holding stock. 2. Stocks come 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 stock 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.
- 46. Pricing stock futures when no dividend expected The pricing of stock futures is also based on the cost-of-carry model, where the carrying cost is the cost of financing the purchase of the stock, minus the present value of dividends obtained from the stock. If no dividends are expected during the life of the contract, pricing futures on that stock is very simple.
- 47. Pricing stock futures when no dividend expected 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?
- 48. Pricing stock futures when no dividend expected Assume that the spot price of XYZ is Rs.228. 0.10× (60/365) Thus, futures price F = 228e = Rs.231.90
- 49. Pricing stock futures when dividends are expected When dividends are expected during the life of the futures contract, pricing involves reducing the cost of carry to the extent of the dividends. The net carrying cost is the cost of financing the purchase of the stock, minus the present value of dividends obtained from the stock.
- 50. Pricing stock futures when dividends are expected 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? 1. Let us assume that XYZ will be declaring a dividend of Rs. 10 per share after 15 days of purchasing the contract. 2. Assume that the market price of XYZ is Rs. 140.
- 51. Pricing stock futures when dividends are expected 3. 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.
- 52. Pricing stock futures when dividends are expected Thus, futures price = 0.1× (60/365) 0.1× (45/365) F = 140e − 10e = Rs.132.20
- 53. Application of Futures Understanding beta Beta of a stock measures the sensitivity of the stocks responsiveness to these market factors. Beta of a portfolio, measures the portfolios responsiveness to these market movements. Beta is a measure of the systematic risk or market risk of a portfolio. Using index futures contracts, it is possible to hedge the systematic risk.
- 54. Hedging- Long security, sell futures Futures can be used as an effective risk- management tool. Case of an investor who holds the shares of a company and gets uncomfortable with market movements in the short run. (Example) Index futures in particular can be very effectively used to get rid of the market risk of a portfolio.
- 55. Hedging- Long security, sell futures Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs. 1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.
- 56. Hedging- Long security, sell futures Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profits than the unhedged position, half the time.
- 57. Speculation- Bullish security, buy futures A trader buys a 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of Rs. 1,00,000 for a period of two months. This works out to an annual return of 6 percent.
- 58. Speculation- Bullish security, buy futures The same trader buys 100 security futures @1006 for which he pays a margin of Rs.20,000. Two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs.400 on an investment of Rs.20,000. This works out to an annual return of 12 percent.
- 59. Speculation- Bearish security, sell futures Stock futures can be used by a speculator who believes that a particular security is over- valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell stock futures.
- 60. Speculation- Bearish security, sell futures A trader who expects to see a fall in the price of ABC Ltd. He sells one two-month contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at 220. On the day of expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs.2000.
- 61. Arbitrage: Overpriced futures: buy spot, sell futures If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs.1025 and seem overpriced.
- 62. Arbitrage: Overpriced futures: buy spot, sell futures As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day one, borrow funds, buy the security on the cash/spot market at 1000. 2. Simultaneously, sell the futures on the security at 1025. 3. Take delivery of the security purchased and hold the security for a month. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.1015. Sell the security. 6. Futures position expires with profit of Rs.10. 7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position. 8. Return the borrowed funds. This is termed as cash-and-carry arbitrage. Remember however, that exploiting an arbitrage opportunity involves trading on the spot and futures market.
- 63. Arbitrage: Underpriced futures: buy futures, sell spot You notice the futures on a security you hold seem underpriced. How can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs. 965 and seem underpriced.
- 64. Arbitrage: Underpriced futures: buy futures, sell spot As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day one, sell the security in the cash/spot market at 1000. 2. Make delivery of the security. 3. Simultaneously, buy the futures on the security at 965. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.975. Buy back the security. 6. The futures position expires with a profit of Rs.10. 7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position. 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-cash-and-carry arbitrage.