Introduction to forward contracts:
- Definition of Forward Contracts:
- Forward contracts are bilateral agreements to buy or sell an asset on a future date at terms agreed upon today. Common in commodities, forex, equity, and interest rate markets.
- Key Example:
- In a forward contract, a buyer and seller agree on a forward price, avoiding immediate payment or delivery. E.g., agreeing to buy gold at a fixed price for delivery in one month.
- Features of Forward Contracts:
- Tailor-made and negotiated over-the-counter (OTC) between two parties.
- Fixes price, quantity, quality, delivery terms, and settlement procedures upfront.
- Helps avoid price risk by securing future prices.
- Example of Profit/Loss:
- If the spot price at maturity exceeds the forward price, the buyer benefits and vice versa.
- Limitations of Forward Contracts:
- Liquidity Risk: Difficult to trade or exit due to the customized nature of contracts.
- Counterparty Risk: Risk of default by either party if market conditions favor non-fulfillment of obligations.
- Other issues include lack of transparency and settlement complications.
- Solution to Limitations:
- Futures contracts, traded on centralized platforms, address issues like illiquidity, counterparty risk, and lack of transparency.
Futures contracts :
- Definition of Futures Contracts:
- Agreements traded on an exchange to buy/sell a commodity or financial asset at a fixed future date and price.
- They are standardized forward contracts with guaranteed settlement by a clearing corporation.
- Key Features of Futures Contracts:
- Centralized trading platform with price discovery via buyer-seller interaction.
- Standardized terms for quality and quantity, excluding price.
- Both parties pay margins.
- Limitations of Futures Contracts:
- Restricted maturities and underlying assets.
- Limited flexibility in contract design and increased administrative costs due to mark-to-market (MTM) settlement.
Contract specifications of futures contracts :
- Contract Specifications: These are the terms and conditions of futures contracts, decided by exchanges, except for the price.
- Example: The Nifty futures contract traded on the NSE includes details like expiry date (Oct 31, 2024), open price (Rs. 25670.10), closing price (Rs. 25475.70), and turnover (Rs. 30,07,617.27 Lakhs).
- Underlying Asset & Price: The underlying asset refers to the index or stock, like the Nifty 50. The underlying price is its spot price in the market.
- Contract Size/Multiplier: The contract size (or lot size) is set by the exchange. For Nifty futures, the size is 25. For a Nifty contract, the value is Rs. 6,36,893.
- SEBI Guidelines: From Nov 2024, contract values should range between Rs. 15 Lakhs and Rs. 20 Lakhs. The lot size will adjust accordingly.
- Contract Cycle: Futures contracts on the NSE follow a 3-month cycle: near month, next month, and far month.
- Expiration Day: The contract expires on the last Thursday (Nifty futures) or Wednesday (Bank Nifty). Positions must be rolled over.
- Tick Size: Minimum price change allowed. For Nifty futures, it’s 5 paisa.
- Settlement Prices: Daily settlement price is based on the weighted average of the last half-hour. Final settlement is on the expiration day at the closing price.
- Trading Hours: Futures contracts trade from 9:15 am to 3:30 pm, Monday to Friday. Holidays affect trading and clearing.
- BSE Sensex Futures: These contracts differ in underlying asset, contract size (10), tick size (Rs. 0.05), and expiration day (last Friday for monthly, Friday for weekly).
- Trading Strategy: The correlation between Nifty and Sensex allows for pairs trading and better hedging opportunities.
Some important terminology associated with futures contracts :
- Basis: The difference between the spot price and futures price; a negative basis occurs when futures price is higher than spot price, and positive when the opposite is true. Basis can vary with the duration of the futures contract and becomes zero at maturity.
- Cost of Carry: The cost associated with holding an asset until delivery, including storage costs, interest, and less any income earned. In equity derivatives, it is the interest paid minus dividends received. Example: If the cost of carry is Rs. 4, the break-even futures price would be Rs. 104.
- Margin Account: Exchanges charge margins to protect against defaults. Brokers also charge clients these margins.
- Initial Margin: The deposit required when entering a futures contract. It is usually a percentage of the contract value. Example: 10% of Rs. 5,56,250 gives Rs. 55,625.
- Marking to Market (MTM): Daily settlement of profits and losses in the futures market. MTM adjustments are made based on daily price changes, with gains or losses transferred between participants.
- Open Interest and Volume: Open interest is the total number of outstanding contracts. Traded volume indicates market activity. These metrics help assess market depth and participation.
- Price Band: A range within which a contract can trade on a given day, set relative to the previous day’s closing price. Price bands may be adjusted by exchanges.
- Positions in Derivatives Market:
- Long Position: A buy position, where the trader expects prices to rise.
- Short Position: A sell position, where the trader expects prices to fall.
- Open Position: Any unsettled position, either long or short.
- Naked and Calendar Spread Positions:
- Naked Position: A position in futures without holding the underlying asset.
- Calendar Spread: A strategy involving long and short futures positions with different maturities.
- Opening and Closing Positions:
- Opening a Position: Buying or selling to create a new position.
- Closing a Position: Buying or selling to reduce an existing position.
Differences between Forwards and Futures :
- Operational Mechanism:
- Forwards: Not traded on exchanges.
- Futures: Traded on exchanges.
- Contract Specifications:
- Forwards: Terms vary per trade (customized).
- Futures: Standardized terms, only price varies.
- Counter-party Risk:
- Forwards: Exists but may be mitigated by a guarantor.
- Futures: Clearing agency guarantees settlement.
- Liquidity Profile:
- Forwards: Low liquidity, as contracts are custom-made and not easily accessible.
- Futures: High liquidity, as contracts are standardized and exchange-traded.
- Price Discovery:
- Forwards: Inefficient due to scattered markets.
- Futures: Efficient due to centralized trading platforms.
- Quality of Information:
- Forwards: Information quality and speed are poor.
- Futures: Nationwide trading ensures fast, reliable information dissemination.
Payoff Charts for Futures contracts :
- Payoff Definition: Payoff represents the likely profit or loss for a market participant based on changes in the price of the underlying asset at expiry.
- Payoff Charts: These charts graphically represent the price of the underlying asset (X-axis) and the profit/loss (Y-axis). They show potential outcomes based on the price changes at expiry.
- Futures Contract Payoff: Both long and short futures positions have unlimited profit or loss potential, leading to linear payoffs.
- Long Futures Position:
- If a person goes long at Rs.100, they buy the underlying at that price.
- If the price rises to Rs.150 at expiry, the person profits Rs.50 by selling at the market price.
- If the price drops to Rs.70 at expiry, the person incurs a loss of Rs.30.
- Payoff Chart for Long Futures: A table and chart illustrate various payoffs for different market prices at expiry, showing potential profits or losses.
- Short Futures Position: The short position’s payoff is the opposite of the long position.
- If a person shorts at Rs.100, they sell the asset at that price and buy back at expiry price.
- Profits occur if the market price falls; for example, if the price falls to Rs.60, the profit is Rs.40.
- Short Futures Payoff Chart: This chart shows how short futures result in profits when prices fall and losses when they rise.
Futures pricing :
- Futures Pricing Overview:
- Futures pricing varies based on underlying asset characteristics like supply, demand, and cash flow patterns.
- Two key models for futures pricing: Cost of Carry Model and Expectations Model.
- Cost of Carry Model:
- Assumes no-arbitrage conditions, meaning arbitrage opportunities eliminate pricing discrepancies.
- Synthetic futures position = Spot price + Carrying costs.
- Arbitrage arises if futures prices diverge from fair prices, causing alignment between cash and futures markets.
- Transaction costs widen no-arbitrage bounds.
- Modified formula for assets with returns (e.g., dividends, interest):
Fair futures price = Spot price + Cost of carry – Inflows. - Cost of Carry Model Assumptions:
- Works best when the asset is abundant, easily stored, and can be sold short.
- Assumes no transaction costs, taxes, or margin requirements.
- Not suitable for seasonal or non-storable assets.
- Convenience Yield:
- Describes the intangible benefit (e.g., mental comfort) from holding an asset, particularly during scarcity (e.g., commodity shortages).
- Convenience yield affects futures pricing, especially in markets like commodities, but not financial assets.
- Expectations Model:
- Futures price reflects expected future spot prices.
- Futures can trade at a premium (contango) or discount (backwardation) to the spot price.
- Contango: Futures price is higher than spot, indicating an expected price rise.
- Backwardation: Futures price is lower than spot, indicating an expected price decline.
Price discovery and convergence of cash and futures prices on the expiry :
- Expectations Hypothesis: The expectations model of futures pricing suggests that futures prices reflect the market’s expectation of the spot price at the contract’s expiry.
- Example: For example, if a May 2024 index futures contract is trading at 22308.70 on May 14, 2024, it indicates the market expects the spot index to settle at this value on the contract’s expiry date (May 30, 2024).
- Market Participants’ Objective: Every participant in the market is trying to predict the spot index at the expiry, leading to price discovery at a specific point (last trading day of the contract).
- Convergence of Prices: Futures and spot prices converge at the contract’s expiry, as there cannot be a difference between them at that point.
- Futures Settlement: All futures contracts settle at the underlying cash market price on expiry.
- General Principle: This price convergence principle applies to all underlying assets.
Uses of futures :
- Participants in Derivatives Markets:
- Hedgers: Entities (corporations, banks, governments) use derivatives to reduce exposure to market risks (e.g., interest rates, commodity prices). Example: A farmer uses futures to lock in a price for crops.
- Speculators/Traders: These participants use futures contracts to speculate on price movements of assets, leveraging positions for greater returns but also higher risk.
- Arbitrageurs: These traders exploit market price differences for risk-free profit, buying low in one market and selling high in another. They contribute to liquidity and efficient market pricing.
- Role of Traders and Hedgers:
- Traders provide liquidity, allowing hedgers to offload their risks. In a scenario, a farmer sells futures to lock in a price, while traders may buy those contracts betting on future price movements.
- Arbitrage Example:
- Arbitrageurs simultaneously buy and sell assets in different markets to lock in profit. Example: Buying in the cash market and selling in the futures market to exploit price discrepancies.
- Risks for Arbitrageurs:
- Arbitrageurs face risks like time lag between transactions and illiquid markets, which can lead to potential losses if one leg of a trade fails.
- Uses of Index Futures:
- Risk Management: Futures can mitigate specific risks related to equity investments by addressing both unsystematic risk (specific to a stock) and systematic risk (market-wide risk).
- Hedging Specific and Systematic Risk: Single stock futures hedge against specific risks, while index futures manage overall portfolio risk.
- Beta Calculation: Portfolio beta reflects its risk relative to the market, helping in the calculation of hedge ratios for systematic risk management using index futures.
- Hedge Ratio for Index Futures:
- The hedge ratio depends on the portfolio’s relationship with the index, requiring adjustments based on beta and portfolio size. It’s not a 1:1 ratio due to differing index compositions.
- Long Hedge: Involves going long in futures to hedge against potential price increases in the cash market. It compensates for price rises by profiting from futures positions.
- Short Hedge: Involves going short in futures to protect against potential price declines in the cash market, offsetting losses with profits from futures.
- Cross Hedge: Used when futures on a specific asset aren’t available. It involves hedging using futures of a closely related asset, e.g., using crude oil futures to hedge jet fuel risks.
- Hedge Contract Month: The futures contract expiration month should align with the desired time to unwind the exposure.
- Futures Trading: Traders take positions based on price expectations without holding underlying assets. They may go long or short in futures, aiming to profit from price movements.
- Naked vs. Spread Positions: A naked position involves a single long or short futures contract, while a spread position involves opposite positions in different contracts.
- Arbitrage in Futures: Involves taking advantage of price discrepancies between related assets or markets to make risk-free profits. Types include cash and carry arbitrage, reverse cash and carry arbitrage, and inter-exchange arbitrage.
- Arbitrage Pricing: Fair futures price = Spot price + Carrying cost. Arbitrage occurs when the futures price deviates from the theoretical price.
- Inter-Market Arbitrage: Occurs when price differences for the same asset exist across different exchanges, allowing arbitrageurs to profit by exploiting these discrepancies.
- Conclusion: Futures serve as efficient tools for portfolio restructuring and risk management, allowing participants to quickly adjust their exposure to market risks.