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Chapter 19
FUTURES
Where the Hedgers and the
Speculators Meet
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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
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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.
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FUTURES TERMINOLOGY
SPOT PRICE
FUTURES PRICE
CONTRACT CYCLE
EXPIRY DATE
CONTRACT SIZETHE AMOUNT OF ASSET THAT HAS TO BE DELIVEREDUNDER ONE CONTRACT. FOR INSTANCE, THE CONTRACTSIZE ON NSES FUTURES IS 200 NIFTIES
BASIS
FUTURES PRICE - SPOT PRICE
INITIAL MARGIN
MARKING TO MARKET
MAINTENANCE MARGIN
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PAYOFFS TO THE FORWARD BUYER AND
FORWARD SELLER
A : Forward Buyer B : Forward SellerProfit Profit
Loss Loss
C
C
P
P
C = Contract price
P = Actual price
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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
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Longposition
Money
Clearinghouse
Shortposition
Asset
Money
Asset
THE ROLE OF THE CLEARING HOUSE
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MARGINS
When you execute a futures trade, you have to providethe 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.
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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.
Gold Forward Futures
Time Period Futures contract Buyers cash flow Sellers cash flow Buyers cashflow Sellers cash flow
1 465 $0 0 $5 $-52 455 0 0 -10 103 460 0 0 5 -54 465 5 -5 5 -5
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FUTURES CONTRACTS GLOBAL SCENE
Commodity Futures Exchange Financial Futures Exchange
Cocoa CSCE, FOX U.S Treasury bills IMM, MCECotton CTN Eurodollar deposits IMM, LIFFEAluminum COMEX,LME Standard & Poor'sGold LME (S&P) Index IMMCrude oil IPE, NYMEX Sterling IMM, LIFFE,MCESoyabean oil CBT Phil SE
CSCE Coffee , Sugar and Cocoa Exchange , New YorkFOX London Futures and Options ExchangeCTN New York Cotton ExchangeCOMEX Commodity Exchange , New YorkLME London Metal ExchangeIPE International Petroleum Exchange of London
NYMEX New York Mercantile ExchangeCBT Chicago Board of TradeIMM International Monetary Market(at the Chicago Mercantile Exchange)LIFFE London International Financial Futures ExchangeMCE Mid America Commodity ExchangePhil SE Philadelphia stock Exchange
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MAJOR TYPES OF FUTURES CONTRACTS
Type Example
Futures contracts on debt instruments US Treasury bond futures contract: Thisis a contract for delivery of US Treasurybonds with $100,000 face value andhaving a maturity of at least 15 yearfrom the delivery date
Futures contract on monetary metals Futures contract on gold: This is a
contract for delivery of 100 troy ouncesof gold of 0.995 fineness
Futures contract on foreign currencies Futures contract on British pound: Thisis a contract for delivery of 25,000 Britishpounds, on the appropriate future date
Futures contract on stock marketsindices Futures contract on S&P 500: The
underlying value of the contract is $500 times the S &P 500 index. Unlike other futures contracts, thesettlement of an index futures contract is by cashpayment
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FINANCIAL FUTURES
Equity Futures
Interest Rate Futures
Foreign Exchange Futures
j
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j
STOCK INDEX FUTURES
S & P CNX NIFTY FUTURES
TRADING CYCLE MAXIMUM OF 3 MONTHS
EXPIRY DAY LAST THURSDAY OF THE
EXPIRY MONTH
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INDIVIDUAL STOCK FUTURES
TRADING CYCLE MAXIMUM 3 MONTHS
EXPIRY LAST THURSDAY OF THEEXPIRY MONTH
SIZE SAME AS THE LOT SIZE OF
OPTIONS CONTRACT FOR AGIVEN UNDERLYING
BASE PRICE ON INTRODUCTION, THE
PREVIOUS DAYS CLOSING
PRICE OF THE UNDERLYINGSECURITY
SETTLEMENT CASH-SETTLED. DAILY MARK-
TO-MARKET
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PRICING OF EQUITY FUTURES
COST-OF-CARRY RELATIONSHIP
F0 = S0 (1 +rf)T
S0 = RS. 400 rf = 1% PER MONTH 3 MONTHS
FUTURES CONTRACT
F0 = S0 (1 +rf)T= 400 (1.01)3 = 412.12
SUPPOSE 3-MONTHS FUTURES RS. 412
ACTION INITIAL CASH FLOW CASH FLOW AT (3 MONTHS)
BORROW RS.400 + 400 - 400 (1.01)3 = - 412.12
NOW & REPAY
WITH INT. AT TIME T
BUY A SHARE - 400 ST
SELL A FUTURES 0 414 - ST
CONTRACT (F0 = RS. 414)0 RS. 1.88
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PRICING OF EQUITY FUTURES2
F0 = S0 erft
WHEN THE UNDERLYING ASSET PRODUCES
INCOME TO THE OWNER
F0 = S0 (1 +rf -d)T
SUPPOSE STOCK INDEX S0 = 1200
rf
= 1% P.M
d = 0.25% P.M
F0 = 1200 (1 + 0.0075)3 = 1227.2
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PRICING OF TREASURY BOND FUTURES
A TREASURY BOND FUTURES CONTRACT IS ACONTRACT FOR DELIVERY IN FUTURE OF
TREASURY BONDS HAVING CERTAIN FUTURES.
TREASURY BOND FEATURES ARE VALUED THEWAY STOCK INDEX FUTURES ARE VALUED, WITH
ONE DIFFERENCE.
F0 = (S0 -PVC) (1 +rf)T
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PRICING OF COMMODITY FUTURES
(STORABLE COMMODITIES)
FUTURES SPOT PV OF PV OF
PRICE PRICE STORAGE CONVENIENCE
= + COSTS - YIELD
(1 +rf)T
S A CO O S
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PERI SHABLE COMMODITIES
FUTURES PRICES VS. EXPECTED SPOT PRICES
SO FAR .. RELN FUTURES PRICES & CURRENT SPOT PRICE
A CONTROVERSY .. THEORY OF FUTURES PRICING CONCERNS .. RELN ..FUTURES PRICE & THE EXPECTED VALUE .. SPOT PRICE IN FUTURE
EXPECTNS
HYPOTHESIS : F = E (St)
NORMAL
BACKWARDN : F < E (St ) SUPPLIERS HEDGE
CONTANGO : F > E (St ) BUYERS HEDGE
FUTURES PRICES
CONTANGO
EXPECTNS HYPOTHES
NORMAL BACKWARDN
TIME
DELIVERY DATA
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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
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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 INVESTMENTCAPITAL DOWN AND TO THE RIGHT
DERIVATIVE MARKETS .. TRUE CHILD OF THE FINANCIAL &INFORMATION SERVICES REVOLN LEADING EDGE ..GLOBAL INTEGRATION OF FINANCE
RICHARD O BRIEN
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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 THECONSEQUENCE THEREOF
EMPIRICAL EVIDENCE DECLINE .. IN .. VOLATILITY OF ..
UNDERLYING .. CASH MARKET INTRN OF DERIVATIVES
SUMMING UP
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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 onindividual securities. Both the types of futures have beenintroduced in India.
A treasury bond futures contract is a contract for delivery infuture 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 futureson an individual stock, is:
F0 = S0 (1 +rfd)T
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