Introduction to Futures And

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Introduction to Future and Option


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FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a

specified date for a specified price.

One of the parties to the contract assumes a long position and

agrees to buy the underlying asset on a certain specifiedfuture date for a certain specified price.

The other party assumes a short position and agrees to sell the

asset on the same date for the same price.

Other contract details like delivery date, price and quantity arenegotiated bilaterally by the parties to the contract. The

forward contracts are normally traded outside the exchanges.


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The salient features of forward

contracts are:

y They are bilateral contracts and hence exposed to counter-party

risk.

y Each contract is custom designed, and hence is unique in terms of

contract size, expiration date and the asset type and quality.

y The contract price is generally not available in public domain.

y On the expiration date, the contract has to be settled by delivery

of the asset.

y If the party wishes to reverse the contract, it has to compulsorily

go to the same counter-party, which often results in high prices

being charged.


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LIMITATIONS OF FORWARD MARKETS

y Lack of centralization of trading,

y Illiquidity, and

y Counterparty risk


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INTRODUCTION TO FUTURES

Futures markets were designed to solve the problems that exist

in forward markets. A futures contract is an agreement

between two parties to buy or sell an asset at a certain time

in the future at a certain price. But unlike forward contracts,

the futures contracts are standardized and exchange traded.


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The standardized items in a futures

contract are:

y Quantity of the underlying

y Quality of the underlying

y The date and the month of delivery

y The units of price quotation and minimum price changey Location of settlement


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DISTINCTION BETWEEN FUTURES AND

FORWARDS CONTRACTS


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FUTURES TERMINOLOGYy Spot price:The price at which an asset trades in the spot market.

y Futures price: The price at which the futures contract trades in thefutures market.

y Contract cycle: The period over which a contract trades. The indexfutures contracts on the NSE have one- month, two-months and three

months expiry cycles which expire on the last Thursday of the month.Thus a January expiration contract expires on the last Thursday of

January and a February expiration contract ceases trading on the lastThursday ofFebruary. On the Friday following the last Thursday, a newcontract having a three- month expiry is introduced for trading.

y Expiry date: It is the date specified in the futures contract. This is

the last day on which the contract will be traded, at the end of which itwill cease to exist.

y Contract size: The amount of asset that has to be delivered underone contract. Also called as lot size.


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y Basis: In the context of financial futures, basis can be defined as the

futures price minus the spot price. There will be a different basis for each

delivery month for each contract. In a normal market, basis will be positive.

This reflects that futures prices normally exceed spot prices.y Cost of carry: The relationship between futures prices and spot prices

can be summarized in terms of what is known as the cost of carry This

measures the storage cost plus the interest that is paid to finance the asset

less the income earned on the asset.

yInitial margin: The amount that must be deposited in the marginaccount at the time a futures contract is first entered into is known as initial

margin.

y Marking-to-market: In the futures market, at the end of each trading

day, the margin account is adjusted to reflect the investors gain or loss

depending upon the futures closing price. This is called marking-to-market.y Maintenance margin: This is somewhat lower than the initial margin.

This is set to ensure that the balance in the margin account never becomes

negative. If the balance in the margin account falls below the maintenance

margin, the investor receives a margin call and is expected to top up the

margin account to the initial margin level before trading commences on thenext da .


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INTRODUCTION TO OPTIONS

y Options are fundamentally different from forward and

futures contracts. An option gives the holder of the option

the right to do something. The holder does not have to

exercise this right.

y In contrast, in a forward or futures contract, the two parties

have committed themselves to doing something. Whereas it

costs nothing (except margin requirements) to enter into a

futures contract, the purchase of an option requires an up-

front payment.


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OPTION TERMINOLOGY

y Index options: These options have the index as the underlying. Someoptions are European while others are American. Like index futures contracts,

index options contracts are also cash settled.

y Stock options: Stock options are options on individual stoc ks. Options

currently trade on over 500 stocks in the United States. A contract gives theholder the right to buy or sell shares at the specified price.

y Buyer of an option: The buyer of an option is the one who by paying the

option premium buys the right but not the obligation to exercise his option on

the seller/writer.

y

Writer of an option: The writer of a call/put option is the one who receivesthe option premium and is thereby obliged to sell/buy the asset if the buyer

exercises on him.


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y Call option: A call option gives the holder the right but notthe obligation tobuy an asset by a certain date for a certain price.

y Put option: A put option gives the holder the right but notthe obligation to sell an asset by a certain date for a certain price.

y

Option price/premium: Option price is the price which theoption buyerpays to the option seller. It is also referred to as theoption premium.

y Expiration date: The date specified in the options contract isknown as the expiration date, the exercise date, the strike date orthe maturity.

y Strike price: The price specified in the options contract isknown as the strike price or the exercise price.


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y American options: American options are options that can beexercised at any time upto the expiration date. Most exchange-traded options are American.

y European options: European options are options that can beexercisedonly on the expiration date itself. European options areeasier to analyze than American options, and properties of anAmerican option are frequently deduced from those of its

European counterpart.y In-the-money option: An in-the-money (ITM) option is an

option that would lead to a positive cash flow to the holder if itwere exercised immediately. A call option on the index is said tobe in-the-money when the current index stands at a level higher

than the strike price (i.e. spot price > strike price). If the index ismuch higher than the strike price, the call is said to be deep ITM.In the case of a put, the put is ITM if the index is below the strikeprice.


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y At-the-money option: An at-the-money (ATM) option is an option that would leadto zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).

y Out-of-the-money option: An out-of-the-money (OTM) option is an option thatwould lead to a negative cash flow if it were exercised immediately. A call option on theindex is out-of-the-money when the current index stands at a level which is less than thestrike price (i.e. spot price < strike price). If the index is much lower than the strikeprice, the call is said to be deep OTM. In the case of a put, the put is OTM if the index isabove the strike price.

y Intrinsic value of an option: The option premium can be broken down into two

components - intrinsic value and time value. The intrinsic value of a call is the amountthe option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting itanother way, the intrinsic value of a call is Max[0, (St K)] which means the intrinsic valueof a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max[0, K St],i.e.the greater of 0 or (K St). K is the strike price and St is the spot price.

y Time value of an option: The time value of an option is the differencebetween itspremium and its intrinsic value. Both calls and puts have time value. An option that is

OTM or ATM has only time value. Usually, the maximum time value exists when theoption is ATM. The longer the time to expiration, the greater is an option's time value,all else equal. At expiration, an option should have no time value.


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Distinction between futures and

options


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INDEX DERIVATIVESy Institutional and large equity-holders need portfolio-hedging facility. Index-

derivatives are more suited to them and more cost-effective than derivatives

based on individual stocks. Pension funds in the US are known to use stock

index futures for risk hedging purposes.

y

Index derivatives offer ease of use for hedging any portfolio irrespective ofits composition.

y Stock index is difficult to manipulate as compared to individual stock

prices, more so in India, and the possibility of cornering is reduced. This is

partly because an individual stock has a limited supply, which can be

cornered.y Stock index, being an average, is much less volatile than individual stock

prices.This implies much lower capital adequacy and margin requirements.

y Index derivatives are cash settled, and hence do not suffer from settlement

delays and problems related to bad delivery, forged/fake certificates.


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Maturity of Future Contract

y presently, SEBI has permitted Exchanges to offer futures

products of 1 month, 2 months and 3 months maturity only

on a rolling basis- e.g. say for May, June and July months.

When the May contract expires there will be a fresh contract

month available for trading viz. the August contract. These

months are called the Near Month, Middle Month and Far

Month respectively.

On 9th June 2000, when Equity Derivatives were first

introduced in India at the Bombay Stock Exchange, westarted with the three monthly series for June, July and

August 2000.


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acted Price

Notional Value in

Rs.

of Futures

( based on

Market Lot of 15 )17800 267000

17850 267750

17900 268500

17950 269250

18000 270000

What is the contract multiplier ?

The contract multiplier is the minimum number of the underlying - index or stock that a

participant has to trade while taking a position in the Derivatives Segment. As of May 2008, the

contract multiplier for SENSEX is 15. This means that the Rupee notional value of a sensex

futures contract would be 15 times the contracted value. The following table gives a fewexamples of this notional value.


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y What is the ticker symbol and trading hours ?

The ticker symbol is the selected alphabets of the underlying for e.g. the ticker for BSE Sensex is BSX while that for

the Sensex 'mini' contract is MSX, for Reliance Industries Ltd., it is RIL, etc.

The trading timings for the Derivatives Segment of BSE are the same as that in the Equity Segment - from 9:55 a.m. to3:30 p.m. (except in cases of Sun Outage when the timings are extended on account of a halt in trading during the

day).Trading session's timings can be viewed at the

y What is the tick size ?

This means that the minimum price fluctuation in the value of a contract the tick size is presently "0.05" or 5 paisa. In

Rupee terms, this translates to a minimum price fluctuation of Rs. 0.75 for a single transaction of SENSEX

Futures Contract (Tick size X Contract Multiplier = 0.05 X Rs. 15).

y How is the final settlement price determined ?

The closing value of underlying Index of the cash market is taken as the final settlement price of the futures contract

on the last trading day of the contract for settlement purposes.

y What is margin money ?

The aim of collecting margin money from the client / broker is to minimize the risk of settlement default by either

counterparty. The payment of margin ensures that the risk is limited to the previous day's price movement on each

outstanding position. However, even this exposure is offset by the initial margin holdings.Margin money is like a security deposit or insurance against a possible Future loss of value. Once the transaction is

successfully settled, the margin money held by the exchange is released / adjusted against the settlement liability.

y Are there different types of Margin ?

Yes, there are different types of margin like Initial Margin, Variation margin(commonly called Mark to market or M -

T- M) Exposure Margin and Additional Margin, if any.


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y What is the objective of Initial margin ?

The basic aim of Initial margin is to cover the largest potential loss in

one day. Both buyer and seller have to deposit margins. The initialmargin is deposited before the opening of the position in the

futures transaction. This margin is calculated by SPAN by

considering the worst case scenario.

y What isVariation or Mark-to-Market Margin ?

Variation or mark to market Margin is the daily profit or loss

obtained by marking the member's outstanding position to the

market (closing price of the day) and receiving or paying the

difference from / to him in cash on the succeeding working day.

y What are long / short positions ?

In simple terms, long and short positions indicate whether you have

a buy position (long) or sell position (short).


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y Is there a theoretical way of pricing Index Future ?

The theoretical way of pricing any Future is to factor in the current price and holding costs or cost ofcarry. A Futures contract is normally by its very definition for a specified period of time, at the endof which it is settled. In order to compensate the seller for waiting till expiry for realizing the sale

proceeds the buyer has to pay some interest which is reflected in the form of cost of carry.In general, the Futures Price = Spot Price + Cost of Carry.

Theoretically, the Cost of carry is the sum of all costs incurred if a similar position is taken in cashmarket and carried to maturity of the futures contract less any revenue which may result in thisperiod. The costs typically include interest in case of financial futures (also insurance and storagecosts in case of commodity futures). The revenue may be dividends in case of index futures.

Apart from the theoretical value, the actual value may vary depending on demand and supply of the

underlying at present and expectations about the future. These factors play a much more importantrole in commodities, especially perishable commodities than in financial futures.

In general, the futures price is greater than the spot price (in case of a bullish sentiment in the market).In special cases, when cost of carry is negative (on account of a bearish view in the market), thefutures price may be lower than Spot prices.

y What is the concept of Basis?

The difference between Spot price and Futures price is known as Basis. Although the Spot price andFutures prices generally move in line with each other, the basis is not constant. Generally basis will

decrease with time and on expiry, the basis is zero as the Futures price equals Spot price.

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Introduction to Futures And