Chapter 19 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 Pricing of Futures Contracts Use of Futures Contracts Assessment

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.

DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACTS FORWARDS FUTURES TRADED OVER THE COUNTERTRADED ON EXCHANGE NO SECONDARY MARKETSECONDARY MARKET EXISTS TERMS NEGOTIATED BETWEENSTANDARDIZED CONTRACT (QTY, BUYER AND SELLERDATE & DELIVERY CONDITIONS) MOST CONTRACTS END WITHNORMALLY NO DELIVERY PHYSICAL DELIVERYOFFSETTING TRANSACTION CREDIT RISK ASSUMED BY CREDIT RISK ASSUMED BY BUYER CLEARING CORPORATION AND MEMBER FIRMS NO COLLATERAL SECURITYCOLLATERAL POSTED MARKET TO THE MARKET PARTICIPATION LIMITED TO LARGE NUMBER OF SMALL NO. OF LARGE TRADERS PARTICIPANTS

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

PAYOFFS TO THE FORWARD BUYER AND FORWARD SELLER A : Forward BuyerB : Forward Seller Profit Loss C C P P C = Contract price P = Actual price

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

Long position Money Clearing house Short position Asset Money Asset THE ROLE OF THE CLEARING HOUSE

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.

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.

FUTURES CONTRACTS GLOBAL SCENE

MAJOR TYPES OF FUTURES CONTRACTS

FINANCIAL FUTURES Equity Futures Interest Rate Futures Foreign Exchange Futures

j STOCK INDEX FUTURES S & P CNX NIFTY FUTURES TRADING CYCLE … MAXIMUM OF 3 MONTHS EXPIRY DAY LAST THURSDAY OF THE EXPIRY MONTH

INDIVIDUAL STOCK FUTURES TRADING 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

PRICING OF EQUITY FUTURES COST-OF-CARRY RELATIONSHIP F 0 = S 0 (1 + r f ) T S 0 = RS. 400 … r f = 1% PER MONTH 3 MONTHS FUTURES CONTRACT F 0 = S 0 (1 + r f ) T = 400 (1.01) 3 = SUPPOSE 3-MONTHS FUTURES … RS. 412 ACTION INITIAL CASH FLOW CASH FLOW AT (3 MONTHS) BORROW RS (1.01) 3 = NOW & REPAY WITH INT. AT TIME T BUY A SHARE S T SELL A FUTURES S T CONTRACT ( F 0 = RS. 414) 0 RS. 1.88

PRICING OF EQUITY FUTURES – 2 F 0 = S 0 e r f t WHEN THE UNDERLYING ASSET PRODUCES INCOME TO THE OWNER F 0 = S 0 (1 + r f - d) T SUPPOSE … STOCK INDEX … S 0 = 1200 r f = 1% P.M d = 0.25% P.M F 0 = 1200 ( ) 3 =

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. F 0 = (S 0 - PVC) (1 + r f ) T

PRICING OF COMMODITY FUTURES (STORABLE COMMODITIES) FUTURES SPOT PV OF PV OF PRICE PRICE STORAGE CONVENIENCE = + COSTS - YIELD (1 + r f ) T

PERI SHABLE COMMODITIES FUTURES PRICES VS. EXPECTED SPOT 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’NS HYPOTHESIS: F = E (S t ) NORMAL BACKWARD’N: F < E (S t ) SUPPLIERS HEDGE CONTANGO: F > E (S t ) BUYERS HEDGE FUTURES PRICES CONTANGO EXPECT’NS HYPOTHES NORMAL BACKWARD’N TIME DELIVERY DATA

WHO USES FUTURES CONTRACTS? Hedgers Short (sell) hedge Long (buy) hedge Speculators Arbitrageurs Futures-futures arbitrage Cash-futures arbitrage

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 FINANCE RICHARD O’ BRIEN

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

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. 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: F 0 = S 0 (1 + r f – d) T

The theoretical price of a Treasury bond futures contract is F 0 = (S 0 – PVC) (1 + r f ) T The futures price of a perishable commodity is influenced by two factors mainly: (a) the expected spot price of the underlying commodity and (b) the risk premium associated with the futures position. 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.