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Tarheel Consultancy ServicesBangalore, Karnataka

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Introduction to

Futures and Forwards

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Derivative Securities

Appropriate term “Derivative Contracts”

Represent a contract between 2 parties

Gives owner certain rights or obligations

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Derivatives…

“Contracts” due to an underlying

asset / portfolio of assets

“Underlying asset” Primary Asset

These contracts are derived from primary

securities hence the term “Derivatives”

Introduction (Cont…)

Underlying asset may be A stock A bond A foreign currency (USD) A commodity like wheat A precious metal like gold A portfolio of assets such as a stock index

(NIFTY, DJIA)

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Categories of derivative securities

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Cash transaction F & F

When the deal is struck the buyer pays for the asset & The seller transfers the rights to the asset

The transaction does not take place at the outset.The 2 parties merely agree on the terms The transaction is scheduled for a future date

Money changes hands when the 2 parties enter into the contract

No money changes hands. Both have an obligation to perform at the future date

Cash Transaction vs F&F

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Illustration

Mitoken Solutions enters a forward contract with ICICI Bank: To acquire $100,000 after 90 days at Rs.

50.50 90 days later:

Mitoken is obliged to pay Rupees 5.05 MM The bank is obliged to deliver $100,000

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Long and Short Positions

Every Forward/Futures contract has a Buyer and a Seller.

Long position Short position

The party agreeing to buy

the underlying asset is

called the LONG

The counterparty

agreeing to sell the

underlying asset is

called the SHORT

Said to assume a Long

position

Said to assume a

Short position.

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Options contracts F & F contracts

Options contracts give a

Right to the buyer

They impose an obligation

on the seller

Futures/Forwards

impose an obligation

on both parties

Option buyers are referred

to as Holders

Option sellers are referred

to as Writers

Options contracts vs F&F contracts

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Right Obligation

A right need be exercised

only if it is in the interest of

the holder

A right holder is under no

compulsion to transact

The short has a

contingent obligation.

If the long exercises,

the short has to

perform

Right vs Obligation

Options vs F&F

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Call option Put option

Gives the holder the right to buy the underlying asset

Gives the holder the right to sell the underlying asset

If a holder exercises the writer has to deliver

If a holder exercises the writer has to take delivery

Calls and Puts

When a person is given a right with respect to an asset, it can take on two forms Right to Buy Right to Sell

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European option American option

The right can be exercised only on a fixed date in the future

The right can be exercised at any time after it is acquired till the Expiration Date

The expiration date is the only point in time at which the option can be exercised

The expiration date is the last point in time at which the option can be exercised

European and American Options

European and American Options (Cont…)

Most exchange traded options worldwide are American On the NSE and BSE stock options are now

European Index options have always been European They are easier to value

Cash flows only at a single point of time

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Option Price

(option premium)Exercise Price

(strike price)

Price paid by the buyer to the writer for giving him the right

Price payable by the buyer if a call is exercisedPrice receivable by the buyer if a put is exercised

It is a sunk costNon-refundable

Enters the picture only if the holder exercises

Option Price vs Exercise Price

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Illustration

Komal goes long in a call on Reliance X = Rs 900 and 3 months to maturity Premium = Rs 8.75

She has to pay Rs 8.75 per share at the outset

The options have been written by Kiran If ST > 900 Komal will exercise and buy

Else she will forget the option and buy spot At a price which by assumption is lower.

Option Price vs Exercise Price

Example of a Put

Ross bought a European put on IBM with X = $85 The premium is $1.10

He has to pay $110 to the writer In the US each contract is for 100 shares

If ST < $85 It makes sense to exercise and deliver the

shares for $85 each Else it is better to let it expire The writer once again has a contingent

obligation.

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Options F & F

The buyer has to pay a premium to the writer

Because he is acquiring a right from the writer who is taking on an obligation

The futures price will be set such that the value for both parties is zero at inception

Rights are never free

Buyers have to pay for the right to transact

There are two equal and opposite obligations

Neither party has to pay

Premium for Futures?

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Swaps

Contract between 2 parties to exchange cash flows

calculated on the basis of pre-specified criteria

calculated at predefined points in time Cash flows represent interest

payments on a specified principal1. One payment may be based on a fixed

interest rate2. The other may be based on a variable rate

such as LIBOR

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Swaps…

All interest rate swaps need not be

‘fixed rate – floating rate’

Floating rate – floating rate swaps

where each rate is based on a different

benchmark

E.g. one leg could be based on Libor and the

other on the US T-bill rate “BASIS Swaps”

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Pure interest rate

swap

Currency swaps

The cash flows are

denominated in the

same currency

Swaps where the cash

flows are in two different

currencies

We cannot have a fixed

rate – fixed rate swap

We can have all

possibilities

Fixed to Fixed

Fixed to Floating

Floating to Floating

Swaps…

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Pure interest rate

swap

Currency swaps

There is no need to exchange the principal

The principal amount is actually exchanged

Both interest streams are in the same currency

The interest streams are in different currencies

However a principal is required

Purely to facilitate the computation of interest Hence it is called a “Notional principal”

PrincipalSwaps

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Forward vs Futures Contracts

Similarities Both require the long to acquire the asset

and the short to deliver Obligation for both parties

Difference Futures contracts are standardized while

Forward contracts are customized

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Customization vs Standardization

In such contracts certain terms and conditions need to be made explicit. 1. How many units of the underling asset is

the long required to acquire2. What are the acceptable grade(s)

allowable for delivery 3. What are the acceptable location(s) for

delivery 4. When can delivery be made

Is there a Delivery Day or is there a Window

Forward vs Futures

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Customized contract Standardized

contract

Terms and conditions

have to be bilaterally

negotiated

There is a third party

that specifies the

allowable terms and

conditions

The parties can

incorporate any mutually

agreed upon

features

This third party is the

futures exchange

Customization vs Standardization

Forward vs Futures

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Illustration – Futures Exchange

Rice futures are trading on the

Trivandrum futures exchange. Each contract is for 100 kg.

Allowable grades are IR-7 and IR-8.

Allowable locations are Trivandrum, Kollam,

and Nagarcoil.

Delivery can be made at any time during

the last week of the month.

Forward vs Futures

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Jacob wants to buy 5,000 kg of IR-7 in Trivandrum during the last week of the month

Vishant seeks to sell 5,000 kg of IR-7 in Trivandrum during the last week of the month

The futures contract is suitable for both parties

If they were to meet on the floor of the exchange at the same time a trade could be executed for 50 contractsAssume that the agreed upon price is Rs. 16 per kg.The price is not specified by the exchange and has to be set by bilateral negotiations

It is a function of supply and demand conditions

Illustration – Futures Exchange…

Forward vs Futures

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Jacob wants to buy 4,750

kg of BT rice in Kochi

during the last week of

the month

Vishant is looking to

deliver the same

quantity of BT rice in

Kochi during that

period.

The terms that are being sought are not within the

framework - A futures contract is unsuitable

Illustration

Forward vs Futures

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Illustration - Fwd contract

Nothing prevents them from negotiating a customized agreement This would be a “forward contract”.

Forward vs Futures

Futures contracts are exchange traded products like stocks and bonds

Forward contracts are private contracts.

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Multiple Grades/Locations

If the contract permits delivery of more

than one grade and/or at multiple

locations Who gets to choose what and where to

deliver?

Traditionally the right to choose the location

and the grade, as well as the right to initiate

the delivery process has been given to the

short Thus a long cannot demand delivery.

Forward vs Futures

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Multiple…

Thus longs who do not wish to take delivery will exit before delivery commences. How will they exit?

By offsetting or taking a counter position.

What is the risk if they do not offset? They can be called upon to take delivery

without having the right to refuse.

Forward vs Futures

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Clearinghouse

It may be a wing of the exchange or a

separate corporation

It guarantees the long & the short

against the possibility of default by the

other

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How it functions

Positions itself as the effective counterparty for each initial counter-party

it becomes the effective buyer for every seller

it becomes the effective seller for every buyer

A party needs to worry only about the financial strength & integrity of the clearinghouse.

Neither party actually trades with the clearinghouse.

Clearinghouse

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Why do we need a clearinghouse?

A futures contract imposes an obligation on both parties

On the expiration date: It will be in the interest of 1 party to

transact A price move in favor of one party would

translate into a loss for the other Given an opportunity, one party would like to

default

Clearinghouse

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Illustration

Consider two parties to a trade

Poonam has gone long in a futures contract

to buy an asset 5 days hence at Rs 400.

Kunal has taken the opposite side.

Clearinghouse

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Illustration

Assume that the spot price 5 days hence is Rs 425.

If Kunal already has

the asset

If Kunal does not have

the asset

He is obliged to deliver

at Rs. 400

Has to forego an

opportunity to sell it in

the spot market for Rs.

425

He is required to acquire

it for Rs. 425 and deliver

at Rs. 400

Quite obviously Kunal would like to default

Clearinghouse

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Illustration

Assume that the spot price 5 days hence is Rs 375

If Kunal already has the asset

If Kunal does not have the asset

He would be happy to deliver it for Rs 400

He would be more than happy to buy it for Rs 375 and then deliver it

The problem is that Poonam would like to default if possible

Clearinghouse

contd

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Illustration

If Poonam does not want the asset

If Poonam wants the asset

She would have to take delivery and then sell it for Rs 375

She would rather buy it in the spot market for Rs 375

Clearinghouse

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Why…?

The presence of a clearinghouse ensures that defaults do not occur.

It ensures protection for both parties by requiring them to post a performance bond / collateral – “Margin”

The collateral is adjusted daily to reflect any profit/loss compared to the previous day. By doing so the clearinghouse effectively

takes away the incentive to default.

Clearinghouse

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Margins

In a futures contract there is always the risk of default The price of the asset will either rise or fall Given an opportunity one party would like to

back out.

Compliance is ensured by requiring both parties to deposit collateral The deposit, referred to as the Initial Margin

is a performance guarantee.

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Margins - Collateral

The collateral represents the potential

loss for a party.

Once it is collected the incentive to

default is taken away. Even if the losing side were to default

The collateral would be adequate to take care

of the interests of the other party

Margin

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Clearing Margin

Since the clearinghouse gives a guarantee to both sides, it also collects “ Clearing margin”

In practice:

Both parties Brokers Clearinghouse

Margin Margin

Margin

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Offsetting

It means taking a counter-position

If a party has originally gone ‘long’ it should

subsequently go ‘short’ and vice versa.

The effect of offsetting is to cancel an

existing long or short position

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Offsetting

Forward contract Futures contract

It is a customized contract

The 2 parties effectively enter into a contract with the clearinghouse

A party who wants to cancel must seek out the counterparty.

Canceling is a lot easier.

Both contracts have been designed according to exchange specified features

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Illustration – Futures contract

A contract between any two parties will be identical to a contract between two other parties Jacob & Vishant Kripa & Priyanka

The moment Jacob & Vishant trade, they effectively enter into a contract with the clearinghouse And the link between them is broken.

Offsetting

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Illustration – Futures contract

Jacob (the long) wishes to get out of his position

He need not seek out Vishant (the short)

By entering into an initial long position followed by a short position, Jacob is effectively out of the market and has no further obligations

He simply goes back to the floor & offers to take

a short position

This time the opposite position may be taken

by, say Rahul

Offsetting

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Illustration…

For the clearinghouse: Jacob has bought a contract Jacob sold an identical contract Jacob’s net position is 0

Profit/Loss for a party who trades & subsequently offsets =

(the futures price prevailing at inception) – (the price at the time of cancellation)

Offsetting

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Marking to Market (MTM)

Why are margins collected? To protect both parties against default by

the other

Why does potential for default arise? Once a position is opened it will invariably

lead to a loss for one party if it were to

comply

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Loss from default

The loss will not arise all of a sudden at the time of expiration As the futures price fluctuates from trade to

trade: One party will experience a gain The other will experience a loss

Total loss from pt. of inception till expiration (or offsetting) = the sum of these small losses/profits

Marking to market

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Marking to Market (MTM)

It is the process of calculating the

gain/loss for a party… at a specified time…

with reference to the price prevailing when

the contract was previously marked to

market

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MTM – Futures contract

When a futures contract is entered it will be MTM EOD Subsequently it will be MTM EOD everyday

Till the contract expires Or an offsetting position is taken

The party with a profit will have his margin account credited The other party will have his margin

account debited.

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Illustration

Consider Poonam who has gone long in a futures contract with Kunal It expires 5 days hence It is at a price of Rs. 425

Assume that the prices EOD are as depicted in the following table. Each contract is for 100 units of the

underlying The initial collateral (Initial Margin) is

Rs.5,000

Marking to market

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Illustration…

Day t Futures Price

0 400

1 405

2 395

3 380

4 405

5 425

Marking to market

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Illustration – EOD 1st day The futures price EOD 1st day is Rs.405

Marking to market

• If Poonam were to offset she would be agreeing to sell at Rs. 405/unit

• She would have a profit of Rs. 5/unit or total Rs. 500

• While the contract is MTM the broker would behave as if she is offsetting

• He would credit Rs.500 to her margin account

But since she has not expressed a desire to offset, he would act as if she were re-establishing a long position at the new price i.e. at Rs. 405

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Illustration – EOD 2nd day

The futures price EOD next day is Rs. 395 When the contract is MTM Poonam would

have a loss of Rs. 1,000 Once again a new long position would be

established, this time at a price of Rs. 395

The process will continue:1. either until the delivery date

2. Or until the day that the position is offset, if that were to happen earlier.

Marking to market

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Illustration…

As can be seen

Rising futures prices

lead to profits for the

long

Declining futures prices

lead to losses for the

long

Marking to market

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Illustration…

Now look at it from Kunal’s perspective. EOD 1st day, MTM when the price is Rs. 405

would imply a loss of Rs. 500 By the same logic the next day his margin

account will be credited with Rs. 1000

Shorts lose when prices

rise

Shorts gain when prices

fall

Marking to market

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Zero Sum Games

Profit/loss for the long is identical to the loss/profit for the short Futures contracts are consequently referred

to as Zero Sum Games. One man’s gain is another man’s loss.

Rising futures prices Declining futures prices

Lead to profits for the long

Lead to losses for the long

Shorts lose when prices rise

Shorts gain when prices fall

Marking to market

Zero Sum (Cont…)

One participant’s gains are due to another’s equivalent losses

The net change in total wealth for all traders considered together is zero Wealth is merely transferred from one party

to another

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Illustration…

By the time the contract expires the loss

incurred by 1 party (here the short)

would have been totally recovered

In this case Poonam’s account would have

been credited with Rs. 2,500

Kunal’s account would have been debited

with Rs. 2,500

Marking to market

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Illustration…

Now if Kunal were to default Poonam

would not be at a disadvantage She already has a profit of Rs. 2,500

She can now take delivery at the spot price of

Rs. 425

The effective price paid by her would be Rs.

400 This is what was contracted for in the first

place

Marking to market

MTM – A Detailed Illustration

Typically a trader will trade more than once on a given day

The profit/loss from MTM is given by the difference between: The Trade Price and the Settlement Price for

Contracts executed during the day and not offset

The previous day’s settlement price and the current settlement price

For contracts brought forward and not offset

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Illustration (Cont…)

The previous day’s settlement price and the trade price

For contracts brought forward and offset The buy price and the sell price

For contracts executed during the day and offset on the same day

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Example-1

End of previous day Steven was long in 250 contracts Yesterday’s settlement price was $122 Each contract is for 50 units

Today: He went long in 125 more contracts at 125 75 of these were subsequently offset at

127.50 Today’s settlement price is $130

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Example-1 (Cont…)

Profit/loss for contracts carried over and not offset: 250 x 50 x (130 – 122) = $100,000

Profit/loss for contracts entered into during the day and offset on the same day: 75 x 50 x (127.50 – 125) = $9,375

Profit/loss for contracts entered into during the day and not offset: 50 x 50 x (130 – 125) = $12,500

Total inflow/outflow = $121,875 65

Example-2

Shelly had a long position in 200 contracts as of yesterday Yesterday’s settlement price was $114 Each contract is for 50 units of the

underlying Today she went long in100 contracts at

$118 125 contracts were subsequently offset at

$122.50 Today’s settlement price is $126

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Example-2 (Cont…)

Profit loss for contracts carried forward and not offset: 175 x 50 x (126 – 114) = $105,000

Profit/loss for contracts executed during the day and offset on the same day: 100 x 50 x (122.50 – 118) = $22,500

Profit/loss for contracts carried over from the previous day and offset today: 25 x 50 x (122.50 – 114) = $10,625

Total Inflow = $138,12567

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The Clearinghouse and MTM

The clearinghouse essentially plays the

role of a banker.

It will debit the margin account of the broker

whose client has incurred a loss

& credit the margin account of the broker

whose client has made a profit.

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Forward Contracts

Unlike futures contracts, forward contracts are not MTM. So both the parties are exposed to default

risk. Consequently parties to a forward contract

tend to be large and well known, such as Banks Financial institutions Corporate houses Brokerage firms

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Maintenance Margin & Variation Margin

In a futures contract Both longs and shorts have to deposit a

performance bond known as the Initial Margin

Margin account will be credited…

Margin account will be debited…

If a party makes a profit If a party makes a loss

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Maintenance…

The broker has to ensure that the client always has adequate funds

Otherwise the entire purpose of margining can be defeated

Consequently the broker will specify a threshold balance - Maintenance

Margin

This will obviously be less than the initial margin level

Maintenance Margin

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Maintenance…

A call for additional margin is referred to as a “Margin Call”. The additional funds deposited are referred to as “Variation Margin”

If the balance in the margin account declines below the maintenance

level

The client will be asked to deposit additional

funds to take the balance back to the

initial level

Maintenance Margin

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Illustration

Take the case of Poonam She went long:

Contract for 100 units Price of Rs 400 per kg, Deposited an initial margin of Rs 5,000. Assume the maintenance margin = 4,000

The contract lasts for 5 days and daily prices are as depicted earlier

Maintenance Margin

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Illustration…

Maintenance Margin

Initial Margins

Need not be in the form of cash Brokers will accept cash-like assets like

marketable securities

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Initial Margins

But the value assigned to the collateral will be less than its current market value. To protect the broker against a sharp price

decline E.g. a security worth $100 may be valued

at $90 The broker is said to have applied a Haircut of

10%

Maintenance Margin

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Value at Risk

If the collateral collected is high, the potential for default will be reduced.

Amount of collateral : Potential for default

Margins specified by the exchange would depend on the estimate of the potential loss.

“Value at Risk” (VaR) : Statistical technique for estimating loss

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Concept of VaR

We cannot be sure about the loss from one day to the next.

At best - with a given level of probability, the loss cannot exceed a specified amount

VaR : Summary statistical measure of the possible loss of a portfolio of assets over a pre-specified time horizon.

Value at Risk

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Example: Concept of VaR

99% VaR over a 1 day horizon = Rs

1,000

Interpretation: Only a 1% probability that

the loss over a 1 day holding period > Rs

1,000

Value at Risk

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Interpreting VaR

A VaR number is meaningless unless

these are specified: Probability level

E.g. the 99% VaR for a portfolio will differ

from the 95% VaR

Holding period E.g. the VaR for a 1 day holding period will be

different from the VaR for a 3 day holding

period.

Value at Risk

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Value at Risk…

Maximum possible loss that a portfolio

can suffer = VaR

In principle the value of a portfolio can

always go to zero

Maximum loss that a portfolio can suffer

entire current value.

Value at Risk

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Gross Margins vs. Net Margins

Some clearinghouses collect margins on

a Gross basis while others do so on a

Net basis.

We will illustrate the difference between

the two with the help of an example.

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Illustration

There are 2 brokers – Alpha and Beta Alpha has 2 clients

Alfred is long in 100 contracts Betty is short in 80 contracts

Beta has 2 clients Charlie is long in 80 contracts Debby is short in 100 contracts

Assume: The initial margin is $ 4 / contract

Gross vs Net margins

Illustration (Cont…)

Alpha will collect 4 x 180 = 720 from his two clients

Beta will collect 720 from his two clients We say that the brokers are collecting

margins on a Gross Basis Contracts are MTM daily

Variation margin is paid/withdrawn the following morning

There is a price limit of $4 in either direction

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Illustration

Gross margining Net margining

Each broker will have to

deposit the entire Rs

720 with the clearing

house

The clearinghouse

would calculate the

broker’s position as 20

long (100 long – 80

short) for Alpha and 20

short for Beta

Both brokers have to

deposit only $ 80 each

with the clearinghouse

Gross vs Net margins

Price Limits

Limits are measured with respect to the previous day’s settlement price Apply in both directions

Example: Settlement price for Soybeans is $6 There is a limit of 30 c on the daily price

change So tomorrow’s price limits will be $6.30 and

$5.70 Limit moves

If it moves to the lower limit – Limit Down If it moves to the upper limit – Limit Up

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Price Limits (Cont…)

Why have we assumed a $4 price limit? The Initial Margin is $4 There is no maintenance margin Limit moves should be such that balance in

the margin account cannot become negative

Negative account balances will defeat the purpose of margining

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Illustration (Cont…)

Of the total margin of 1,440 160 is with the clearinghouse 640 is with each broker

Assume the price rises by $4 Longs will have a profit of $4 Alpha will require 400 to pay Alfred Beta will require 320 to pay Charlie

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Illustration (Cont…)

If the clients want to hold on to their positions Betty will have to pay 320 to Alpha and Debby will have to pay 400 to Beta The margin balances of the shorts have

gone to Zero They must raise the balance to the initial

level

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Illustration (Cont…)

Beta will use 320 to pay Charlie It will pay 80 to the clearinghouse which will

pay Alpha Alpha would receive 320 from Betty It will have a total of 400 – adequate to pay

Alfred

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Illustration (Cont…)

The clearing members perform a banking function Transfer funds from one client to another

The clearinghouse too performs a banking function Transfers funds from one broker to another

As long as the magnitude of the price change does not exceed the IM The deposit held by the clearinghouse and

brokers will be adequate to protect buyers and sellers

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Illustration (Cont…)

Suppose the price rises by $4 The shorts are unable to pay Variation

Margin Alpha has 640 It requires 800 to pay Alfred

Sum of IM of 400 and profit of 400 from MTM It requires 160

Will be passed on by the clearinghouse Beta has 640

Adequate to pay Charlie 320 IM 320 profit from MTM

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Illustration (Cont…)

What if the price rises by $4 and Alpha goes bankrupt

Alfred has to be paid 800 He is assured of only the 160 that is

available with the clearinghouse

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Merits / Demerits: Illustration

Gross margining Net margining

Clearinghouse has resources to pay both longs & shorts since each broker has deposited 720 with it

Clearinghouse can guarantee payment for 40 contracts only

since each broker deposited only 80 with it

Clients may not pay adequate attention to the credit-worthiness of the brokersThe cost of operations of the clearinghouse will increase

as it has to provide guarantees on a much larger scale

Clients need to be more concerned with the financial strength and integrity of the broker.

They cannot bank on the clearinghouse to always bail them out

Gross vs Net margins