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Chapter 18 FUTURES Where the Hedgers and the Speculators Meet

Chapter 18 FUTURES Where the Hedgers and the Speculators Meet. OUTLINE Features of a Futures Contract Mechanics of Trading Futures Contracts : The Global Scene Financial Futures Equity Futures in India Commodity Futures in India

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Chapter 18 FUTURES Where the Hedgers and the Speculators Meet

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  1. Chapter 18 FUTURES Where the Hedgers and the Speculators Meet

  2. OUTLINE • Features of a Futures Contract • Mechanics of Trading • Futures Contracts : The Global Scene • Financial Futures • Equity Futures in India • Commodity Futures in India • Pricing of Futures Contracts • Use of Futures Contracts • Assessment

  3. What Is A Futures Contract? A forward contract is an agreement between two parties to exchange an asset for cash at a predetermined future date for a price that is specified today. A futures contract is a standardised forward contract.

  4. Differences Between Forward And Futures Contracts FORWARDSFUTURES TRADED OVER THE COUNTER TRADED ON EXCHANGE NO SECONDARY MARKET SECONDARY MARKET EXISTS TERMS NEGOTIATED BETWEEN STANDARDIZED CONTRACT (QTY,BUYER AND SELLER DATE & DELIVERY CONDITIONS) MOST CONTRACTS END WITH NORMALLY NO DELIVERY PHYSICAL DELIVERY OFFSETTING TRANSACTION CREDIT RISK ASSUMED BY CREDIT RISK ASSUMED BY BUYER CLEARING CORPORATION AND MEMBER FIRMS NO COLLATERAL SECURITY COLLATERAL POSTED MARKET TO THE MARKET PARTICIPATION LIMITED TO LARGE NUMBER OFSMALL NO. OF LARGE TRADERS PARTICIPANTS

  5. Futures Terminology • SPOT PRICE • FUTURES PRICE • CONTRACT CYCLE • EXPIRY DATE • CONTRACT SIZETHE AMOUNT OF ASSET THAT HAS TO BE DELIVERED UNDER ONE CONTRACT. FOR INSTANCE, THE CONTRACT SIZE ON NSE’S FUTURES IS 200 NIFTIES • BASISFUTURES PRICE - SPOT PRICE • INITIAL MARGIN • MARKING TO MARKET • MAINTENANCE MARGIN

  6. Payoffs To The Forward Buyer And Forward Seller A : Forward Buyer B : Forward Seller Profit Profit C P C P Loss Loss C = Contract price P = Actual price

  7. Mechanics Of Trading • Trading in futures is more complex than trading in stocks. Inter alia it involves • Intermediation by a clearing house • Margins • Marking - to - market

  8. The Role Of The Clearing House Money Money Long position Clearing house Short position Asset Asset

  9. Margins • When you execute a futures trade, you have to provide • the initial margin. • If you incur sustained losses from daily marking-to- • market, and your margin amount falls below a critical • level called the maintenance margin you have to • replenish the margin amount.

  10. Marking-To-Market While forward contracts are settled on the maturity date, futures contracts are ‘marked to market’ on a periodic basis. Assume that the spot price of gold is $450 and the four period futures contract in gold has a price of $460. In the wake of changes in the price of the gold futures contract, the cash flow to the buyer and seller of this contract will be as shown in the last two columns of the following table.

  11. Futures Contracts Global Scene

  12. Major Types Of Futures Contracts

  13. Financial Futures • Equity Futures • Interest Rate Futures • Foreign Exchange Futures

  14. j Stock Index FuturesS & P CNX NIFTY FUTURES TRADING CYCLE … MAXIMUM OF 3 MONTHS EXPIRY DAY LAST THURSDAY OF THE EXPIRY MONTH

  15. Individual Stock FuturesTRADING CYCLE MAXIMUM 3 MONTHS EXPIRY LAST THURSDAY OF THE EXPIRY MONTH SIZE SAME AS THE LOT SIZE OF OPTIONS CONTRACT FOR A GIVEN UNDERLYING BASE PRICE ON INTRODUCTION, THE PREVIOUS DAY’S CLOSING PRICE OF THE UNDERLYING SECURITY SETTLEMENT CASH-SETTLED. DAILY MARK- TO-MARKET

  16. Commodity Futures in India • The three national level multi-commodity exchanges offering on-line • futures trading in commodities are National commodity & Derivatives • Exchange Limited (NCDEX), Multi Commodities Exchange of India • Limited (MCX), and National Multi Commodity Exchange (NMCE). • Out of these NCDEX and MCX are the most popular ones. • NCDEX mainly attracts trading in agricultural commodities and MCX • in metals like gold and silver and crude oil. • Forward Markets Commission is the regulatory authority for futures • trading in commodities in India. • Almost all trades in the exchanges get reversed before the expiry date • with participants taking up offsetting positions and only a miniscule of • the trades result in actual delivery. • Unlike trading in securities futures market, trading in commodity • futures is somewhat complicated, particularly when it comes to giving • and taking of deliveries.

  17. Pricing Of Equity Futures COST-OF-CARRY RELATIONSHIP F0 = S0 (1 + rf)T S0 = RS. 400 … rf = 1% PER MONTH 3 MONTHS FUTURES CONTRACT F0 = S0 (1 + rf)T = 400 (1.01)3 = 412.12 SUPPOSE 3-MONTHS FUTURES … RS. 412 ACTIONINITIAL CASH FLOWCASH FLOW AT (3 MONTHS) • BORROW RS.400 + 400 - 400 (1.01)3 = - 412.12 NOW & REPAY WITH INT. AT TIME T • BUY A SHARE - 400 ST • SELL A FUTURES 0 414 - ST CONTRACT (F0 = RS. 414) 0 RS. 1.88

  18. Pricing Of Equity Futures - 2 F0 = S0erf t WHEN THE UNDERLYING ASSET PRODUCES INCOME TO THE OWNER F0 = S0 (1 + rf - d)T SUPPOSE … STOCK INDEX … S0 = 1200 rf = 1% P.M d = 0.25% P.M F0 = 1200 (1 + 0.0075)3 = 1227.2

  19. Pricing Of Treasury Bond Futures A TREASURY BOND FUTURES CONTRACT IS A CONTRACT FOR DELIVERY IN FUTURE OF TREASURY BONDS HAVING CERTAIN FUTURES.TREASURY BOND FEATURES ARE VALUED THE WAY STOCK INDEX FUTURES ARE VALUED, WITH ONE DIFFERENCE.F0 = (S0 - PVC) (1 + rf )T

  20. Pricing Of Commodity Futures (Storable Commodities) FUTURES SPOT PV OF PV OF PRICE PRICE STORAGE CONVENIENCE = + COSTS - YIELD(1 + rf )T

  21. Perishable Commodities Futures Prices vs. Expected Sport Prices • SO FAR .. REL’N … FUTURES PRICES & CURRENT SPOT PRICE • A CONTROVERSY .. THEORY OF FUTURES PRICING CONCERNS .. REL’N .. FUTURES PRICE & THE EXPECTED VALUE .. SPOT PRICE IN FUTURE • EXPECT’NSHYPOTHESIS : F = E (St) • NORMALBACKWARD’N : F < E (St ) SUPPLIERS HEDGE • CONTANGO : F > E (St ) BUYERS HEDGE • FUTURES PRICES • CONTANGO EXPECT’NS HYPOTHES NORMAL BACKWARD’N TIME DELIVERY DATA

  22. Who Uses Futures Contracts? • Hedgers • Short (sell) hedge • Long (buy) hedge • Speculators • Arbitrageurs • Futures-futures arbitrage • Cash-futures arbitrage

  23. What Economic Functions Do Futures And Options Perform? ECONOMIC FUNCTIONS • RISK TRANSFER • PRICE DISCOVERY • MARKET COMPLETION • LOWER VOLATILITY • HIGHER LIQUIDITY • LOWER TRANSACTION COSTS EMPIRICAL EVIDENCE CONCLUSION• DERIVATIVES .. SHIFT .. SUPPLY CURVE OF INVESTMENT CAPITAL DOWN AND TO THE RIGHT … DERIVATIVE MARKETS .. TRUE ‘CHILD’ OF THE FINANCIAL & INFORMATION SERVICES REVOL’N … LEADING EDGE .. GLOBAL INTEGRATION OF FINANCERICHARD O’ BRIEN

  24. Critique And Response NOTWITHSTANDING … ENDORSEMENT OF DERIVATIVES .. BY FINANCIAL ECONOMISTS AND BUSINESS PERSONS … WIDESPREAD CONCERN .. JOHN SHAD “FUTURES AND OPTIONS ARE THE TAIL WAGGING THE DOG. THEY HAVE ESCALATED … THE LEVERAGE AND VOLATILITY OF THE MARKETS … TO PRECIPITOUS, UNACCEPTABLE LEVELS” MANY IN THE PROFESSION DISAGREE VOLATILITY IN THE UNDERLYING CASH MARKET IS THE IMPETUS FOR INTRODUCING DERIVATIVES AND NOT THE CONSEQUENCE THEREOF EMPIRICAL EVIDENCE … DECLINE .. IN .. VOLATILITY OF .. UNDERLYING .. CASH MARKET … INTR’N OF DERIVATIVES

  25. SUMMING UP • A standardised forward contract is a futures contract. • Broadly, there are two types of futures, commodity futures and • financial futures. • The three main types of financial futures are: equity futures, • treasury bond (or interest rate) futures, and currency futures. • Equity futures are of two types: stock index futures and futures • on individual securities. Both the types of futures have been • introduced in India. • A treasury bond futures contract is a contract for delivery in • future of treasury bonds having certain features.

  26. Futures contracts can be priced using the principle of • arbitrage. • The theoretical price of the stock index futures, as well as • futures on an individual stock, is: • F0 = S0 (1 + rf– d)T • The theoretical price of a Treasury bond futures contract is • F0 = (S0 – PVC) (1 + rf)T • The future price of a perishable commodity is influenced by • two factors mainly: (a) the expected spot price of the under • lying commodity and (b) the risk premium associated with the • futures position.

  27. Hedgers, speculators, and arbitrageurs are the participants in • the futures market. • Futures and options perform three very useful economic • functions: risk transfer, price discovery, and market • completion. • There is a widespread popular belief that derivatives • accentuate volatility. Many in the profession strongly disagree • with this view.

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