Unit - II Future and Forward Market (Part - I)

FINANCIAL DERIVATIVES
UNIT II ( Part I)
FUTURE AND FORWARD MARKET
FORWARDS FUTURES
1. Concepts
2. Mechanics
3. Differences ----------- ---------------
4. Features
5. Pricing Estimation
6. Hedging Strategies ----------- ------------
WHO ARE THE TRADERS OF DERIVATIVE MARKET OPERATORS IN FUTURE

DERIVATIVE MARKET: -
Futures contracts are bought and sold buy a large number of individuals, business
organizations, governments and others for a variety of purposes. The traders in the futures
market can be categorized on the basis of the purposes for which they deal in this market.
1. Hedgers: -
In simple term a hedge is a position taken in futures or other markets for the purchase of
reducing exposure to one or more types of risk. A person who undertakes such position is called
as hedger. Hedgers are risk averse traders and are just opposite to speculators.
For reducing their risks they dont hesitate to pay a price also. Hence in simple terms
hedging can be understood as something asks in to insurance.
A hedger uses future markets to reduce risk caused by the movements in prices of
securities, commodities. Hedging by means of furtures contracts can also be used as a means to
look in an acceptable price margin between the cost of the raw materials and retails cost of final
product sold.
Farmers, manufactures, importers and exporters can all be hedgers.
Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 1

Assistant Professor and Training & Placement Officer,
Dept of MBA, VITS, PDTR,
E Mail Id: - bskmba06@gmail.com, Mobile No: - 09177873363, 09491641832.
2. Speculators: -
A speculator may be defined as an investor who is willing to take a risk by taking
futures position with the expectation to earn profits. They do not aim to minimize risk but
rather to benefit from the inherently risky nature of future market. Hedgers use the
futures markets for avoiding exposure to adverse movements in the price of an asset
where as the speculators wish to take position in the market based upon such movement
in the price of that asset.
In spot market a speculator has to make an initial cash payment equal to the total
value of the asset purchased whereas no initial cash payment except the margin money, if
any to enter into forward market. Therefore speculative trading provide the investor with
a much higher level of leverage than speculating using spot market. That is why, futures
markets being highly leveraged market, minimum are set to ensure that speculator can
afford any potential losses.
Unlike the hedger, the speculator does not actually seek to own the commodity in
questions. Rather he or she will enter the market seeking profits by offset rising and
declining prices through the buying and selling of contracts.
Positions of Hedgers and Speculators
Parameter Long Position Short Position
The hedger Secure a price now to Secure a price new to
protect against future rising protect against future
prices. declining price.
The speculator Secure a price now in Secure a price now in
anticipation of rising prices anticipation of declining
prices.
3. Arbitrageurs: -
Arbitrage is the process of simultaneous purchase of securities or derivatives in one
market at a lower price and sale thereof in another market at a relatively higher price. For,

Ex: - On maturity if the pepper futures contracts is Rs. 650 per KG and the price is Rs. 642, then
the arbitragers will buyer pepper in spot and short sell futures, there by gaining riskless profit of
650 642 i.e., Rs. 8 Per KG.
Here two markets are spot and futures market. Thus riskless profit making is the prime
goal of arbitragers. Arbitrage keeps the futures and cash prices in line with one another. This
relationship is also expressed by the simple cost of carrying pricing which shows that fair future
prices, is the set of buying the cash asset now and financing the same till delivery in future
market. It is generalized that the active trading of arbitragers will leave small arbitrage
opportunities in the financial market. In brief, arbitrage trading helps to make market liquid,
ensure accurate pricing and enhance price stability. It involves profits from relative miss -
pricing.
CLASSIFICATIONS OF FORWARD CONTRACTS: -
The forward contract can be classified into different categories. Under the forward
contracts (Regulation) Act, 1952, forward contracts can be classified in the following categories.
Hedge Contracts: -
These are freely transferable contracts which do not require specification of a particular
lot size, Quality or delivery standards for the underlying assets. Most of these are necessary to be
settled through delivery of underlying assets except in a residual or optional sense.
Transferable specific delivery (TSD) contracts:-
These forward contracts are freely transferable from one party to other party. These are
concerned with a specific and predetermined consignment or variety of the commodity. There
must be delivery of the underlying asset at the expiration. It is mandatory provision of the
forward contracts (Regulation) Act, 1952, but the central government has the power to exempt
(in specified cases) such forward contracts.
Non - Transferable specific delivery (TSD) contracts:-
These contracts are normally exempted from the provision of regulation under forward contract
act, 1952 but the central government the right to bring them back under the act when it feels
necessary. These are contracts which cannot be transferred to another party. The contracts, the
consignment lot size and quality of underlying asset are required to be settled at expiration
through delivery of the assets.

FORWARD CONTRACT MECHANISM: -

Forward contracts are very much popular in foreign exchange markets to hedge the
foreign currency risks. Most of the large and international banks have a separate Forward Desk
within their foreign exchange trading rooms which are devoted to the trading of forward
contracts.
Suppose on March 5 2011, the treasurer of an UK multinational firm (MNC) knows that
the corporation will receive one million US dollars after three months. i.e., July 5th 2011 and
wants to hedge against the exchange rate movements. In this situation the treasurer of the MNC
will contact a bank and find out that the exchange rate for a three month forward contract on
dollar against rupees $ / Rs. = 49 and agrees to sell one million dollar the MNC has agreed to sell
one million dollar on July 5th 2011 to the bank at the future rate at Rs. 49. On the other hand, the
bank has a long forward contract on dollar. Both sides have made a binding contract /
commitment.
Steps involved forward trading mechanism
1. The determination of forward prices,
2. Assumptions,
3. The forward price for,
i. Investment asset,
ii. Known cash income,
iii. Know income in form of dividend,
4. Valuing forward contracts.
1. The determination forward prices: -
Forward contracts are generally easier to analyze futures contracts because in forward
contracts there is no daily settlement and only a single payment is made at maturity.
Compounding is a quantitative tool which is used to know lump sum of the
proceeds received in a particular period. Consider an amount A invested for n years at an
interest rate of R per annum. If the rate is compounded per annum, the terminal value of
that investment,
Terminal value = A (1+R)n
If it is compounded m times per annum the terminal value will be

Terminal Value = A (1+R/m)mn

Where A is amount of investment,
R is rate of return,
n is period of return and
m is period of compounding.
2. Assumption: -
Certain assumptions considered here for determination of forward or futures
prices are,
There are no transaction costs,
Same tax rate for all the trading profits,
Borrowing and lending of money at the risk free interest rate,
Traders are ready to take advantage of arbitrage opportunities as and when arise.
These assumptions are equally available for all market participants large or small.
3. i. The forward price for investment asset (Securities): -
General equation of forward price F = ert (S+U I)
Investment asset that provides no income,
These are usually non dividend paying equity shares and discount bonds (No income and No
Storage cost),
Forward Price = S* ert
Where,
U = Storage Cost,
S = Spot price of stock,
T = Maturity period,
r = risk free interest rate or interest cost,
Conditions: -
1. if (F) > S* ert then the arbitrageur can buy the asset and will go for short forward
contract on the asset,
2. If (F) < S* ert then he can short the asset and go for long forward contract on it.
ii. Security that provides known cash income: -
F = (S I) * ert

Conditions: -
1. if (F) > (S I) * ert the investor can earn the profit by buying the asset and shorting a
forward contract on the asset,
2. If (F) < (S I) * ert an arbitrageur can earn the profit by shorting the asset and taking a
long position in a forward contract. Further if there is no short sale, the arbitrageur who
owns the asset will find it profitable to sell the asset and go long forward contract.
iii. Forward price where the income is a known dividend yield: -
A known dividend yield means that when income expressed as a percentage of the asset
life is known. Let us assume that the dividend yield is paid continuously as a constant annual rate
at q then the forward price of for a asset would be
F = S * e(r-q)t
Conditions: -
1. If (F) > S * e(r-q)t then an investor can buy the asset and enter into a short forward
contract to lock in a riskless profit.
2. If (F) < S * e(r-q)t then an investor can enter into a long forward contract and short the
stock to learn a riskless profit.
Further, if dividend yield varies during the life of a forward contract, the q should be set
equal to the average dividend yield during the life of the contract.
4. Value of a forward contract: -
There is a subtle difference the forward price and the value of a forward contract. The
forward price that has been determined so far is essentially the price that is equally acceptable to
the buyer and the seller and therefore is the price at which the forward contract has zero value at
its inception. If the forward contract had positive value at inception nobody would sell forward
and if a negative value had, nobody would buy forward at its inception; therefore the forward
contract has zero value.
But after some period of time the forward contract would have a non zero value. Suppose
for,
Ex: - An investor bought a three month forward contract two months ago, at a forward price of
113. Let this be the delivery price, as two month elapse, the forward contract now becomes a one

month forward contract. The delivery price specified in the contract of course remains fixed at
113. If the one month forward price is now 115 clear our investor is sitting on a profit.
If he were to enter into a forward contract, it would be at a price of 115, but his existing
contract allows him to buy at 113. The existing contract therefore reduces his cash outgo at
maturity by 2 from 115 to 113. The value of the forward contract is therefore, the present value
of this 2.
In general, the value of a forward contract can be determined as follows,
f = (F K) * e rt
Where,
F = Forward price (Current) of the asset,
K = Delivery price of the asset in the contract,
T = Time to maturity of contract,
r = risk free rate of interest.
Conditions: -
1. In the absence of any income, yield or storage costs, the forward price F = ert * S
f = (F K) * e rt
= (ert * S K) * e rt
f = S K * e rt
2. Asset with known income
f = S I K * e rt
3. Asset with known dividend yield at the rate q
qt
f=S*e K * e rt
Consider a six month long forward contract of a non income paying security. The risk free
rate of interest is 6% per annum. The stock price is Rs. 30 and the delivery price is Rs. 28. Compute the
value of forward contract
F = 30* e 0.06*0.5
= Rs. 30.90
Value of forward contract,
f = (F K) * e rt
= 30.90 28 * e 0.06*0.5 = 2.90 0.09 = 2.81

MECHANISM OF FUTURES TRADING: -
Futures contract is an agreement between the two parties to buy or sell an asset at a
certain futures time for a certain price. Futures contracts are traded on recognized stock
exchanges.
Futures trading refer to entering into contracts to buy or sell financial asset or
commodities for futures delivery as settlement on standardized terms.
The initial futures trading occurred through a system of open outcry where the parties
concerned used to gather in the pit of exchange and transaction were matched by parties
physically giving their consent at a prices and standard terms.
In India, the NSE popularized the electronic order matching system for derivative trading.
The futures and options trading system of NSE called NEATF and O (National Exchange for
Automated Trading for futures & options) trading system and DTSS (Derivatives Trading and
Settlement System) of BSE, provides a fully automated screen based trading for Nifty futures
and options and stock futures and options on a nationwide basis as well as an online monitoring
and surveillance mechanism. It supports an order driven market and provides complete
transparency of trading operations. It is similar to that of trading of equities in the cash market
segment.
An investor wishing to take position (Either Long or short) in futures contracts comes in
contact with a registered broker authorized to transact on the floor of exchange. The investor
opens an account with the broker member. Each recognized exchange usually has membership
facilities for brokers and this is limited to a few specified limited seats.
The broker collects initial margin money from investors (Clients), transacts on behalf of
client, records all transaction details and reports to the clearing house attached with the exchange
on regular basis. Usually two kinds of brokers are found commission brokers and local traders.
The important issues relating to future mechanism like specification of contracts the operation of
margin accounts, delivery or settlement of the contract, the organization of exchanges, the
regulation of the markets the way in which quotes are made etc are given in subsequent topics.
Specifications of the Futures contracts: -
1. Exchange,

2. Standardization,
3. The clearing house,
1. Exchange: -
All the futures contracts are initiated through a particular exchange when a new
futures contract is developed, an exchange must specify in some detail the exact nature of the
contract of the agreement between the parties. Further, it must specify the underlying asset,
size of the contract, how price will be quoted, where and when delivery will be made and
how the price will be determined.
Each exchange has usually membership organization whose members can be resident
Indians, NRIs, FIIs and Mutual funds. Based on nature of roles performed, futures
derivatives market, participants are
i. Trading member,
ii. Clearing member,
iii. Self clearing member,
iv. Professional clearing member.
Trading member who trades on his own behalf and on behalf of his clients, clearing
member who undertakes to settle his own trades as well as the trades of the other non
clearing members, self clearing member who clear and settle their own trades only,
professional clearing members who perform only clear functions and they do not trade on
their own or on behalf of their clients.
2. Standardization: -
Futures contracts have standardized term set by the exchanges on which these futures
contracts are to be traded. The benefit of the standardized specification is that the trading is
concentrated in just a few contracts resulting in more liquidity of these contracts. Further
standardization also makes it easier to compare future prices. A futures contract specifies
about every aspects of the deal regarding the asset, price limits, futures period, trading hours,
delivery settled etc.,
The Asset: - The first important term of the futures contract is the Underlying Asset. On
commodity futures market, the assets are commodities like food grains, metals, oils, gas and so
on where as on financial futures markets, financial assets like equities, debts, currencies etc., are

the specified assets. Exchange must stipulate the quality and grade of commodity. The issue does
not arise with financial assets, however, features of the assets must specify.
Daily price limits is to prevent large price moments from occurring because of speculative excess.
Positive limits are the maximum number of contacts that a speculator may hold. The purpose of
these limits is to prevent speculators from exercising under influence on the market.
3. The clearing houses:
Every exchange as an affiliated clearing house for the smooth functioning of the futures
trading in the future market. A clearing house is a separate body or a part of the future exchange and has a
number of members known as clearing brokers. Brokers who are not members of clearing houses have to
transact their futures through a member of the clearing house. Thus acting as an intermediary between
mediators and exchange, guarantees performance on futures and options contracts there by eliminating
counter party risk.
Obligation with a clearing House
Pay Money Pay Money
Party A Clearing House Party B
Receive Receive
Shares Shares
Goods
Buyer Seller Obligations without Clearing Houses
Funds
Clearing house does not assume any position the market; it is market in its exposure.
National securities clearing corporation limited (NSCCL) acts as clearing house for deal
globally provide clearing house, NSSCL permits meeting at the individual client level only.
Margins in future trading:
Before entering into a futures contract prospective trader (investor) must deposit some funds with his
broker which serves a good faith deposit. An investor who enters into futures contracts is required to
deposit funds with the broker called a margin.
The exchange set minimum margins but the brokers may require larger margins if they are
concerned about an investors financial situation because they are because ultimately responsible for their
client losses the amount of margins may vary from contract to contract and even broker to broker the
margin may be deposited in different forms like cash, banks better of credit, shares (50% of market
value). Some brokers may simply pay then money market interest rates on their margin account.
However, most of brokers usually do not pay interest on margin in money.

Types of margin:
(1). Initial margin:
It is the original amount that must be deposited into account to establish futures position.
To determine the initial margin, the exchange usually considers the degree of volatility of price
movements in the past of the underlying the asset. The initial margin approximately equals the maximum
daily price fluctuation permitted by the exchange for that underlying asset. For most of the futures
contracts, the initial margin may be5% or less of the underlying assets value. After proper completion of
all the obligations associated with an investors future position, the margin is returned to trader
(3) Maintenance margin:
The investor is entitled to withdraw any balance in the margin account in excess of the initial
margin. However minimum balance in the margin account must be maintained by the investor. This
minimum amount is called maintenance margin. This is normally about 75% of the initial margin.
(4). Variation margin:
It refers to that additional amount which has to be deposited by the traded with the broker to during
the balance of the margin account to the initial margin level.
(5). Margins and marking to Market (Daily Settlement):

It has been observed that the initial margin same times is even less than 5/0 which seems to be
very small consider the total values of contract. This smallness is reasonable because there is another
safeguard built in the system known as daily settlement marking - to Market. In the futures market all
the transactions are settled on daily basics thus, the system of daily settlement I the futures market is
called marking to Market.
The basic purpose of the marking to market is the futures contracts should be daily marked or
settled and not at the end of its life. Every day the traders gains (Loss) is added or subtracted, the margin

on the case may be this brings the value of the contract back to zero. In the other words, a futures contract
is closed but and re written at a new price every day.
SETTLEMENT OF FUTURES POSITION:
(Closing a futures position)
There are four ways to close the future position namely physical delivery, cash settlement
offsetting and exchange of future for physicals.
(1) Physical delivery :
One way of liquidating of futures position is by making or taking physical delivery of the
goods/asset. The exchange has provided alternatives as to when, where and what will be
delivered. It is the choice of the party with a short position. When the party is ready to deliver, it
will send a notice of intension to deliver to the exchange the price is settled which is normally
most recent with a possible adjustment for the Quality of the asset and chosen delivery location
after that, the exchange selects a party with an outstanding long position to accept delivery.
(2) Cash settlement / Delivery:
Cash payment is made based an the underlying reference rate such as a short term interest
rate such as a short term interest rate index such euro dollar, time deposits ,municipal bonds
indices futures, certain treasury securities on expiry of the settlement period, the exchange sets
the final settlement price equal to the spot price of the asset an that day. For example suppose an
investor takes long position in near month NSE Nifty futures with deliver price at 3100 on
maturity if the index it at 3200 with near month short at 3225, then the investor gains Rs 100
through cash settlement
3 offsetting position:
This type of settlement is evidenced in 90% of futures settlement worldwide, affecting
an offsetting futures transaction means of the initial position.
The initial buyer (long) liquidates his position by selling (going short) a similar future
contract and initial seller (short) goes for buying (long) an identical contract offsetting is a
process of carrying for word the transaction by changing sides.
HEDGING STRATEGIES WITH FUTURES: -
Risk is not loss rather it is uncertainty about the expectation of a future event (e.g. Fore cast of
tomorrows price) the uncertainty may turn out to be favorable(profit) or loss .Risk is thus a neutral
concept, profit or loss are merely two sides of the same coin called risk. Since hedging eliminates risk, it

follows, that hedging shuts the door closed to profit as well as loss investment is locked at a particular
value and it rather gains nor loss in value from subsequent price changes.
Hedging Vs Insurance:
Hedging is one of the three principal ways to manage risk, the others being diversification and
insurance.
Diversification minimizes risk for a given amount of return (or maximizes return for a given
amount of risk). Hedging elimates both sides of risk the potential profit and potential loss, insurance
resolves risk into profit and loss and eliminates the loss while retaining profit.
Hedging is implemented by adding a negatively and perfectly correlated asset to existing asset
insurance for investment is achieved by buying a put option on the investment.
Diversification and hedging do not have cost in cash but may have opportunity cost insurance on
the other hand, has explicit cost incurred in cash.
Features of Hedging:
The main features of hedging are
1. Hedging means buying and selling futures contracts to offset the risks of changing cash market prices.
2. Firms hedging because of tax advantages the firm managers may benefit from reducing the firm risk.
3. Hedging also is a tool used to offset the market (Systematic) risk of stock profiles.
4. Hedging is extremely important for the proper functioning long term liquidity and open interest of a
futures market. Thus viable futures contract are linked to commercial hedging activity.
TYPES OF HEDGING:
HEDGING
Position Nature
Short hedge Long Hedge Perfect hedge Gross hedger
Short hedge: A short hedge (or a selling hedge) is a hedge that involves short position in futures contract.
It means Being short a net sold position or a commitment to deliver etc. Thus the main objective is to
protect the value of the cash position against a decline in cash prices.
Long hedge: A long hedge (or a buying hedge) involves where a long position is taken in a futures
contract. The basic objective is to protect itself against increase in the underlying asset prior to purchasing
it in either the spot or forward market. A long hedge is appropriate when a firm has to purchase a certain
asset in futures and wants to lock in price now.
Long Vs Short Hedging

Position in spot market Short hedger Long hedger
Protection need against Price fall Price rise
Position in futures market Short Long
Perfect Hedging Vs Cross Hedging:

Perfect hedging refers to that position which completely eliminates the risk. Most of futures
contract may perfectly eliminate only price risk and not the quantity risk.
In a perfect hedge any gains or losses resulting from a change in the price of the item being
hedged are offset by an equal and opposite change in future prices. Perfect futures hedges are rarely
attainable in practice because futures contracts are not custom tailored agreements.
On the other hand, gross hedging is a situation of imperfect hedging because of following two
reasons.
(I)Asset mismatch: The arises when the forms wishes to hedge against in a particular underlying asset
but no futures contract of similar specification regarding that asset are available
Example: Gross hedging the future possible price fall of rare copper coins with short position in copper
futures.
(II) Maturity Mismatch: The hedging horizon (Maturity) May not match the futures expiration date.
Example A jute manufacturer needs jute during particular month of the year (say January, June and
December). But if jute futures trade for delivery in February, May and November, then the hedging
horizon and futures expiration do not perfectly match.
Why spot price and futures contract price is the same at times contract matures and expires.
Spot Price
Future Price
Future Price
Spot price
Expiry Date Expiry Date
Fig: - Future Spot Convergence

Generally basis is likely to be negative since most assets face a positive net carry as time elapses and
expires date approaches, future price will converge to the spot price since cost of carry will be approach
zero. Otherwise an arbitrage opportunity exists. If the futures price stays above the spot price, we can buy
the asset now and short futures contract (agree to sell the asset later at the future price. Then we deliver
and earn profit. If future price stays below the spot price, anyone who wants the asset should go long on a
future contract and accept delivery instead of paying the spot price.)
HEDGING USING FUTURES:
Futures contracts can be used to hedge a companys exposure to a price of a commodity. A
position in the futures markets is taken to offset the effect of the price of commodity on the rest of the
company business it is important to recognize that a future hedging does not necessarily improve the
overall financial outcome.
There are a number of reasons why hedging using future contracts works less than perfectly in
price.
(i) The asset whose price is to be hedged may not be exactly the same as the asset underlying the
future contract.
(ii) The hedger may be uncertain as to the exact date when the asset will be bought or sold.
(iii) The hedge may require the futures contracts to be closed out well before its expiration date.
Hence, the basic objective of a hedging strategy is to minimize risk or to maximize hedging
effectiveness. While deciding about futures
1. GOING LONG BUY FUTURES:
When an investor goes long that is enters a contract by agreeing to buy and receive
delivery of the underlying at a pre determined price. It means that he or she is trying to get
profit from an anticipated increase in future price. The pay off profile of going long is shown
in below figure
Profit Future price

Stock price
Loss
Pay off profile of going long

(i) Situation: Bullish outlook for the market price of the underlying expected to increase.
(ii) Risk: Unlimited as the price of the underlying and hence of futures increase, falls, until it
reaches zero.
(iii) Profit: Unlimited, depends on the upward price movement.
(iv) Break Even: The price of the underlying (on maturity) equal to the futures price
contracted.
2. GOING SHORT SELL FUTURES:
A speculator who goes short that is enters into a futures contract by agreeing to sell and
deliver the underlying at a set price is looking to make a profit from declining price levels. By selling high
now, the contract can be repurchased in the futures at a lower price, thus generating a profit for the
speculator. The pay off profile of going short is shown figure.
Figure:
Profit
Future Price
Stock Price
Loss
(i) Situation: Bearish outlook for the market price of the underlying expected to fall.
(ii) Risk: Unlimited as the price of the underlying and hence of futures increase.
(iii) Profit: Unlimited depends on the downward price movement until price of the underlying
reaches zero.
(iv) Break Even: The price of the underlying (at maturity) equal to the futures price contracted.
3. Long hedging Short spot and long futures:
Hedges where long position is taken in futures contract are known as long hedges a long hedge is
appropriate when a company knows it will have to purchases a certain asset in the future and wants to
lock in a price now. A company that knows that it is known as long hedge. A Long hedge is initiated
when a futures contract is purchased in order to reduce the price variability of an anticipated future long
position. Equivalently a long hedge locks in the interest rate of price of cash
Security that will be purchased in the futures subject to small adjustment due to the basis risk. A long
hedge is also known as an anticipatory hedge because it is effectively a substitute position for a futures
cash transaction. The pay off profile of long hedging is shown in fig:

Profit Long Futures
Stock Price
Loss
Short Spot
The salient features of long hedging strategy in futures.
(i) Situation: Bullish outlook: Prices expected to rise.
(ii) Risk: No upside risk strategy meant to protect against rising markets
(iii) Profit: No profit, no loss in case of price increase loss on the spot position offset by gain on
futures position. In case of price fall, gain on the spot position offset by loss on futures
position.
4. Short Hedging Long Spot and Short futures: -
A short hedge is one that involves a short position in futures contract. A short hedge is
appropriate when a hedger already own an asset and expects to sell it at some time in futures. It
can also used when a hedger does not own an asset right now, but knows that the asset will be
owned at some time in the future. A hedger who holds the commodity and is concerned about a
decrease in its price might consider hedging it with a short position in futures. If the spot price
and futures price move together, the hedge will reduce some of the risk. This is called short
hedge because the hedger has a short position. A company that knows it is due to sell an asset at
a particular time in the future can hedge by taking short futures position. This is known as a short
hedge. The pay off profile of short hedging is shown in figure,
Profit Long Spot Hedging
Stock Price
Loss Short Futures
Pay off profiles of short Hedging

The salient features of short hedging strategy in futures are,

i. Situation: - Bearch outlook, prices expected to fall, protection needed against risk of
falling prices.
ii. Risk: - No down side risk. Strategy meant to protect against falling markets.
iii. Profit: - No profits, no loss. In case of price increases, loss on the spot position in
offset by gain on futures position. In case of price increase, gain on the spot position
is offset by loss on futures position.
CONCEPT OF HEDGE RATIO: -
The next important decision in devising a hedging strategy is to determine the optional
futures position to follow, popularly known as optional hedge ratio. In other words, in order to
minimize the risk, the hedger must take a futures position i.e. the number of futures contracts
times the quantity represented by each contract, which will result in the maximum reduction in
the variability of the value of his total (hedged) position.
Hedge Ratio = Quantity of futures position (QF) / Quantity of cash position (QS)
HR = QF / QS
The hedge ratio which minimizes risk is defined as
HR* = Q*F / QS
QF = Quantity (Units) of futures that minimizes the risk,
QS = Quantity of the spot (Cash) that is being hedged.
If the change in the value of the hedge position is set equal to Zero (making variability equal to
Zero)
S / F = Q*F / QS
Q*F = QS * HR* -----------------1

But, Q*F = NFC * QFC ----------------2
Where NFC is number of futures contract which minimizes risk and
QFC is the quantity (or units) of the asset represented by each futures contract.
N*FC * QFC = QS * HR*
N*FC = QS / QFC * HR*

This is most common formula which is used frequently in the futures trading for hedge in order
to achieve the minimum variance hedge.
HR* = Hedge ratio that minimizes the variance of the hedgers position.
In case of perfect hedging (absence of asset miss match and maturity miss match) the hedge ratio
should be one because the future profit or loss matches the spot profit or loss.
If the objective of the hedger is to minimize risk, a hedger ratio is not necessarily optional. The
hedger should choose a value for the hedge ratio that minimizes the variance of the value of the
hedged position.
Optional Hedge ratio: -
HR* = S / F = S / F
If the coefficient of correlation between in spot price during a period of time equal to life
the hedge and change in futures price during a period of time equal to life of the hedge is equal to
1 and standard deviation of change in spot price during a period of time equal to life of the hedge
and standard deviation of change in futures price during a period of time equal to life the hedge
are equal the optimal hedge ratio, HR* is 1.0. This is to be expected because in this case the
futures price mirrors the spot price perfectly.
Variation of Position
HR*
Minimum variance of hedge ratio can be calculated by regression method. This method is
specifically designed to provide the best linear relationship between two prices i.e. future price
and the price to hedge.

St = + Ft and are estimates coefficients

St
Change in Spot Regression Line
Price
Change in future price

Management of the Hedge: -
After establishing a hedge it is essential to manage it effectively, so regular monitoring and
making adjustments are the key factors in managing of the hedge. There also needs to be a
systematic evaluation of the effectiveness of the hedge relative to its anticipated (or ex ante
measure). Further, if the desired results are not being achieved from the hedging then the reasons
should be identified and necessary steps be taken to improve hedge effectiveness in the futures.
To manage effectively the hedging following steps are taken.
Monitoring the Hedge: -
Continuous monitoring on the performance of a hedging is essential,
A miner, who is manufacturer of silver and having a mine, wants to take a decision whether to
open the mine or not. It is based upon the price of silver in futures because production of silver
takes two months. He wants to plan his profitability for his firm. If the silver prices fall, he may
suspend production of silver. Today is June 10. The price of silver in
Spot market on June 10 is = Rs. 1050 per kg and
August
Price per kg = Rs. 1060
He wants sells = 5000 kg
Spot market Futures market
June 10 June 10
Anticipate the sale of 50,000 kg silver in two Sell ten futures contract for August delivery at
months and expected to receive Rs. 1060 per Rs. 1060per kg.
kg or Rs. 53, 00,000 for total contract. August 10

August 10 Buys futures contract at Rs. 1070 amounting to

Spot price of silver is now Rs. 1070 per kg, the Rs. 5,35,00,000
miner sells 50,000 kg silver Rs. 5, 35, 00,000
for whole contract.
Profit = Rs. 5,00,000 Futures loss = Rs. 5,00,000
Long Hedge using Futures: -

On the other hand, a long hedge (or a buying hedge) involves where a long position is taken in a
futures contract. The basic objective here is to protect itself against a price increase in the
underlying asset prior to purchasing it in either the spot or forward market.
Ex: - A fund manager anticipates receipting of $1 million on January 10 and intends to use it to
buy a balanced portfolio of UK equities. He fears that one month later, stock prices will rise
before the money is received. He can go in futures market and buy today futures contract at
2200, current index (FTSE 100) is at 2200. He can close out his position by selling March 18,
FTSE contract.
Spot Market Futures Market
December 10 December 10
Will be received $1 million on January 10 Buys March 18 FTSE index futures contract at
expected price of 2200 and 2200 * 18*25 = 9,
Current FTSE 100 index is at 2200 fears a rise 90,000. Stock in futures date.
in the index.
January 10
The new FTSE index at 2300 Close out position by selling at a price of 2300.
Requires additional 45000 in order to buy the He notionally receipt of 10, 35,000 upon
stock that $1 million would have been bought maturity of contract profit from futures
on December 10 45,000.
Loss = 45,000 in spot market Profit = 45,000 in futures market.


Unit - II Future and Forward Market (Part - I)

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FINANCIAL DERIVATIVES

WHO ARE THE TRADERS OF DERIVATIVE MARKET OPERATORS IN FUTURE

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 1

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 2

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 3

FORWARD CONTRACT MECHANISM: -

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 4

Terminal Value = A (1+R/m)mn

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 5

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 6

3. Asset with known dividend yield at the rate q

= 30.90 28 * e 0.06*0.5 = 2.90 0.09 = 2.81

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 8

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 9

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 10

(5). Margins and marking to Market (Daily Settlement):

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 11

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 12

Short hedge Long Hedge Perfect hedge Gross hedger

Long Vs Short Hedging

Perfect Hedging Vs Cross Hedging:

Fig: - Future Spot Convergence

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 14

Profit Future price

Pay off profile of going long

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 15

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 16

Profit Long Futures

Profit Long Spot Hedging

Loss Short Futures

Pay off profiles of short Hedging

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 17

The salient features of short hedging strategy in futures are,

Q*F = QS * HR* -----------------1

N*FC = QS / QFC * HR*

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 18

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 19

St = + Ft and are estimates coefficients

Change in future price

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 20

August 10 Buys futures contract at Rs. 1070 amounting to

Long Hedge using Futures: -

Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), Ph.D Page 21

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QF = QS HR* -----------------1

NFC = QS / QFC HR*