Forward Contract

• A forward is an agreement between two parties in which one party, the

buyer, enters into an agreement with the other party, the seller that he

would buy from the seller an underlying asset on the expiry date at the

forward price.

• The future date is referred to as expiry date and the pre-decided price is

referred to as Forward Price.

• Therefore, it is a commitment by both the parties to engage in a transaction

at a later date with the price set in advance. This is different from a spot

market contract, which involves immediate payment and immediate transfer

of asset.
 Cont..

• It may be noted that Forwards are private contracts and

their terms are determined by the parties involved.

• Forward contracts are traded only in Over the Counter

(OTC) market and not in stock exchanges. OTC market is

a private market where individuals/institutions can

trade through negotiations on a one to one basis.

 Settlement of forward contracts
• When a forward contract expires, there are two alternate
arrangements possible to settle the obligation of the parties: physical
settlement and cash settlement.

• Both types of settlements happen on the expiry date

• Physical Settlement: A forward contract can be settled by the

physical delivery of the underlying asset by a short investor (i.e. the
seller) to the long investor (i.e. the buyer) and the payment of the
agreed forward price by the buyer to the seller on the agreed
settlement date.
• Consider two parties (A and B) enter into a forward contract on 1 August, 2018 where, A agrees

to deliver 1000 stocks of Unitech to B, at a price of Rs. 100 per share, on 29 th August, 2018 (the

expiry date).

• In this contract, A, who has committed to sell 1000 stocks of Unitech at Rs. 100 per share on

29th August, 2018 has a short position and B, who has committed to buy 1000 stocks at Rs.

100 per share is said to have a long position.

• In case of physical settlement, on 29th August, 2018 (expiry date), A has to actually deliver

1000 Unitech shares to B and B has to pay the price (1000 * Rs. 100 = Rs. 1,00,000) to A.

• In case A does not have 1000 shares to deliver on 29th August, 2018, he has to purchase it

from the spot market and then deliver the stocks to B.

• On the expiry date the profit/loss for each party depends on the settlement price, that is, the

closing price in the spot market on 29th August, 2018.

• The closing price on any given day is the weighted average price of the underlying during the

last half an hour of trading in that day.

 Cash Settlement
• The main disadvantage of physical settlement is that it results in huge

transaction costs in terms of actual purchase of securities by the

party holding a short position (in this case A) and transfer of the

security to the party in the long position (in this case B).

• Further, if the party in the long position is actually not interested in

holding the security, then she will have to incur further transaction

cost in disposing off the security.

• An alternative way of settlement, which helps in minimizing this cost,

is through cash settlement.

 Cont…
• Cash Settlement does not involve actual delivery or receipt of
the security.

• Each party either pays (receives) cash equal to the net loss
(profit) arising out of their respective position in the contract.

• If the spot price at the expiry date (ST) was greater than the
forward price (F T), the party with the short position will have
to pay an amount equivalent to the net loss to the party at
the long position.
 Depending on the closing price, three different scenarios of
profit/loss are possible for each party. They are as follows:

• Scenario 1 - Spot Price > Forward Price

(the party who has a long position would make a profit)

• Scenario 2 – Spot Price < Forward Price

(the party who has a short position would make a profit)

• Scenario 3 – Spot Price = Forward Price

(neither party will gain or lose anything)

 Default risk in forward contracts
• A drawback of forward contracts is that they are subject to default risk.

• Regardless of whether the contract is for physical or cash settlement, there

exists a potential for one party to default, i.e. not honour the contract. It could

be either the buyer or the seller. This results in the other party suffering a loss.

This risk of making losses due to any of the two parties defaulting is known as

counter party risk.

• The main reason behind such risk is the absence of any mediator between the

parties, who could have undertaken the task of ensuring that both the parties

fulfill their obligations arising out of the contract.

• Default risk is also referred to as counter party risk or credit risk.

• A futures contract is a forward contract, which is traded on an
Exchange that avoids counterparty risk
• So how does the exchange make sure this works seamlessly in
a future contract?
Well, they make this happen by means of:
• Collecting the margins
• Marking the daily profits or losses to market (also called MTM)

• Mark to market is an accounting practice that involves

adjusting the value of an asset to reflect its value as
determined by current market conditions.
 Basis of
Difference Forwards/OTC Futures
Organised
Traded On OTC
Stock/Commodity exchange
Liquidity No liquidity High
Default Risk High Almost No
Margin Not required Required
Regulation Self Regulated By stock exchange

As per the terms of Mark to market on daily

Maturity the contract basis and expires on last
Thursday of the month

Settlement dates can Fixed settlement dates as

Settlement be set by the parties declared by the
exchange
 A theoretical model for Future Pricing
•While
  Future Price in reality is determined by demand and supply,
one can obtain a theoretical future price using the below formula:
• -D
Where F = Future Price
S = Spot Price
r = Cost of financing (Usually continuous compounding interest rate)
t = Time to expiry in years
e = 2.71828
D = Dividend
 Problem
•  
• SBI is trading at Rs. 1800 in the cash (spot)
market. What would be the price of SBI futures
expiring three months from today. Risk free rate
= 8% p.a.

Future Price = 1836.3

 Quiz
•• The
  spot price of Wipro Ltd. is Rs.200 and the interest
rate is 12% Per annum. Which of the below price is
closest to the 3 months future maturity? - D
A. 203

B. 201

C. 206
D. 210
• A commodity's futures price is based on its current spot
price plus the cost of carry during the interim before
delivery.
• Cost of carry refers to the price of storage of the
commodity, which includes interest and insurance as well
as other incidental expenses.
• Add storage costs to the spot price of the commodity.
Multiply the resulting value by Euler's number
(2.718281828…) raised to the risk-free interest rate
multiplied by the time to maturity.
• This difference in price between the futures
price and the spot price is called the “basis or
spread”.
• Every time the market price for futures (which
is determined by demand and supply) deviates
from the fair value determined by using the
above formula, arbitragers enter into trades to
capture the arbitrage profit.
 Cont…
• For example, if the market price of the Future is
higher than the fair value, the arbitrageur would
sell in the futures market and buy in the spot
market simultaneously and hold both trades till
expiry and book riskless profit. As more and
more people do this, the Future price will come
down to its fair value level
• Futures can trade at a premium or discount to the spot price of
underlying asset.
• Futures price give market participants an indication of the
expected direction of movement of the spot price in the future.
• If futures price is higher than spot price of an underlying asset,
market participants may expect the spot price to go up in near
future. Expectedly rising market is called “Contango market”.
• Similarly, if futures price is lower than spot price of an asset,
market participants may expect the spot price to come down in
future. Expectedly falling market is called “Backwardation
market”.
 Points to remember

• The futures contract is a standardized contract wherein all the

variables of the agreement is predetermined

• Futures contracts are time bound and the contracts are available

over different timeframes

• Most of the futures contracts are cash settled

• The futures market is regulated by SEBI in India

• Lot size is the minimum quantity specified in the futures contract

• Contract value = Lot size * Futures price

 Cont.…

• To enter into a futures agreement one has to deposit a margin

amount, which is a certain % of the contract value.

• Every futures contract has an expiry date beyond which the

contact would seize to exist. Upon expiry old contracts cease

and new ones are created

• Unlike a forwards contract, the futures contract is tradable and

one need not wait till expiry and contract is settled on m2m
 Nifty50 Future contract Specifications
• Instrument Type : FUTIDX

• Underlying : NIFTY

• Expiry date : Date of contract expiry

• Trading cycle - Nifty 50 futures contracts have a maximum of 3-month trading

cycle - the near month (one), the next month (two) and the far month (three).

• Expiry day - Nifty 50 futures contracts expire on the last Thursday of the expiry
month. If the last Thursday is a trading holiday, the contracts expire on the
previous trading day.

• Contract value - The value of the futures contracts on Nifty 50 may not be less
than Rs. 5 lakhs at the time of introduction. (Nifty Future Price * Lot size (75))
 Initial Margin
• Broadly, there are 2 types of margins that are normally collected. At the time of

taking the position you are required to pay the Initial Margin on the position

(SPAN + Exposure margin).

• The SPAN margin is based on a statistical concept called VAR (Value at Risk).

• Initial margin is based on the potential maximum loss in a single day on the

portfolio. Greater the volatility of the stock, greater the risk and therefore

greater is the initial margin.

•  The minimum margins required for each specific position are defined by the

stock exchange. Brokers are free to collect more than this margin but they are

not permitted to collect less than this margin.

 SPAN Margin
• SPAN margin is measured by standardized portfolio analysis of risk (SPAN), a leading

system that has been endorsed by most options futures and exchanges around the

world.

• SPAN is based on a sophisticated set of algorithms, developed by the Chicago

Mercantile Exchange in 1988.

• The SPAN system, through its algorithms, sets the margin of each position in a

portfolio of derivatives and physical instruments to its calculated worst possible one-

day move.

• The main inputs to the models are strike prices, risk-free interest rates, changes in

prices of the underlying stocks. changes in volatility, and decreases in time to

expiration.
 VAR
• Value at risk (VaR) is a statistic that measures and quantifies the level

of financial risk within a firm, portfolio or position over a specific time

frame.

• This metric is most commonly used by investment and commercial

banks to determine the extent and occurrence ratio of potential

losses in their institutional portfolios.

• Investment banks commonly apply VaR modeling to firm-wide risk

due to the potential for independent trading desks to unintentionally

expose the firm to highly correlated assets.

 MTM (Mark To Market Margin)

• In futures contract, profits and losses are settled on day-to-day

basis – called mark to market (MTM) settlement.

• The exchange collects these notional margins (MTM margins)

from the loss making participants and pays to the gainers on

day-to-day basis.

• The settlement goes on till the expiry or till we close the

contract.
 Future Contract Pay-off
There are two positions that could be taken in a
futures contract:
– Long position
– Short position

• Long Pay-off = Spot price – Future Price

• Short Pay-off = Future Price – Spot Price

• Pay off on a position held by a market participant is the likely profit/loss that

would stem with the change in the price of the underlying asset at expiry.

Pay off for buyer of futures: Long futures

• Lets say a person goes long in a futures contract at Rs.100. This equates to him

agreeing to buy the underlying at Rs.100 on expiry.

• On expiry, if the price of the underlying is Rs.150, then the person will buy it at

Rs.100 as per the futures contract and can immediately sell the underlying in the

cash market at Rs.150, thereby making a profit of Rs.50.

• Similarly, if the price of underlying falls to Rs.70 at expiry, it would translate to a

loss of Rs.30.

• This potential profit/loss at expiry when expressed graphically is known as pay

off chart.
 Long Future at Rs.100
Market Price at Expiry (X) Long Future Pay-off (Y)
50 -50
60 -40
70 -30
80 -20
90 -10
100 0
110 10
120 20
130 30
140 40
150 50
 Long Future Pay-off Diagram
60
50
40
P 30
r
o 20
f 10
i
t 0
/ 40 50 60 70 80 90 100 110 120 130 140 150 160
-10
L
o -20
s
s -30
-40
-50
-60
Spot/Market Price on Expiry
 Short Futures at Rs.100
Market Price at Expiry (X) Long Future Pay-off (Y)
50 50
60 40
70 30
80 20
90 10
100 0
110 -10
120 -20
130 -30
140 -40
150 -50
 Short Futures Pay-off
60

50

40

P 30
r
o 20
f 10
i
t 0
40 50 60 70 80 90 100 110 120 130 140 150 160
/
-10
L
o -20
s
s -30

-40

-50

-60

Spot/ Market Price at Expiry

 Quiz
• Mr. Ram sold Apollo tyres future contract at Rs. 278 and
the lot size is 1,200. What will be his profit/loss, if the
spot price on expiry is Rs.265?
A. 16,600

B. -16,600

C. 15,600

D. -15,600
Ans: C. 15,600
• You have taken a short position of one contract in June Wipro
futures (contract multiplier or lot size 50) at the price of Rs.
3,400. When you closed this position after a few days, you
realised that you made a profit of Rs.10,000. which of the
following closing actions would have enabled you to generate
this profit?
A. Selling I June Wipro futures contract at 3600
B. Buying 1 June Wipro futures contract at 3600
C. Selling I June Wipro futures contract at 3200
D. Buying 1 June Wipro futures contract at 3200
• Which of the following is closest to the future price
of a share, if cash price is 750, time to maturity is 6
months from date and interest rate is 12%. F =
S*(e^r*t)

A. 772.5

B. 796

C. 840

D. 940.8
Ans: B. 796
• If you have sold Infosys future contract
(contract multiplier 50) at 3100 and bought it
back at 3300, what is your Gain/Loss?
A. -10,000
B. 10,000
C. -5,000

D. 5,000
Ans: A. -10,000
• An investor who is anticipating a broad stock
market fall, but is not willing to sell his entire
portfolio of stocks, can offset his potential
losses by shorting a number of index futures.

A. True
B. False
• Margins in future trading are to be paid by
_________
A. Only the buyer
B. Only the seller
C. Both Buyer and Seller
D. Clearing Corporation
• Cost of carry model states that, price of future =

A. Spot – Cost of carry

B. Spot Price
C. Spot + cost of carry
D. Cost of carry
• What role do speculators play in the future
market?

A. They transfer the risk to the hedgers

B. They produce the commodities traded at the

futures exchange

C. The take delivery of commodities at expiration

D. They add to the liquidity in the futures market

• Mark to market margins in future contract are
collected on __________
A. Weekly Basis

B. Every 2 days

C. Daily Basis

D. Every 3 days
• Initial margin collection is monitored
by_______
A. SEBI
B. RBI
C. Clearing corporation
D. Margin office
• If the price of the future contract decreases,
the margin account of the buyer of this future
contract is debited for the loss.

A. True
B. False
 Commodity, Equity and Index Futures

• The basic concept of derivatives contract remains the same for

all the underlying assets, whether the underlying happens to

be equity, index or commodity futures.

• The varying quality of assets does not really exist as far as

financial underlying is concerned, but in case of commodities,

the quality of asset underlying a contract can vary significantly.

• Financial assets are not bulky and do not need special facilities for storage.
• Whereas in commodity market, due to bulky nature of the underlying
assets, physical settlement in commodity derivatives creates the need for
warehousing.
• Stock index futures, also referred to as equity index futures or just index
futures, are futures contracts based on a stock index. In this case, the
underlying asset is tied to a stock index.
• A stock market index is made up of a basket of stocks that indicate the
general movement of stock prices. Stocks that make up an index have to
satisfy certain conditions like high market capitalisation, good liquidity,
and so on. Index futures allow traders to cash in on the general
movements in stock prices.
 Cont..
• Index futures, however, are not delivered at the
expiration date. They are settled in cash on a daily
basis.
• Index futures can be used often by traders speculating
on how the index or market will move, or by investors
looking to hedge their position against potential future
losses.
 Hedging through Index Futures

• Equity derivatives instruments facilitate hedging of price risk

• Price risk is nothing but change in the price movement of asset, held

by a market participant, in an unfavorable direction.

• This risk broadly divided into two components - specific risk or

unsystematic risk and market risk or systematic risk.

• Specific risk or unsystematic risk is the component of price risk that is

unique to particular events of the company and/or industry. This risk

could be reduced to a certain extent by diversifying the portfolio.

• what is left is the non-diversifiable portion or the market

risk-called systematic risk. Variability in a security’s total

returns that are directly associated with overall

movements in the general market or economy is called

systematic risk.

• Thus, every portfolio is exposed to market risk. This risk is

separable from investment and tradable in the market

with the help of index-based derivatives.

• Beta is the measure of systematic risk.

• Beta measures the sensitivity of a stock / portfolio compared
to the index movement over a period of time, on the basis of
historical prices.

• Suppose a stock has a beta equal to 2. This means that

historically a security has moved 20% when the index moved
10%, indicating that the stock is more volatile than the index.

• Stocks / portfolios having beta more than 1 are called

aggressive and having beta less than 1 are called conservative
stocks / portfolios.
 Beta of the portfolio
• In order to calculate beta of a portfolio, betas of individual stocks are used.

• It is calculated as weighted average of betas of individual stocks in the portfolio based

on their investment proportion.

• For example, if there are four stocks in a portfolio with betas 0.5, 1.1, 1.30 and 0.90

having weights 35%, 15%, 20% and 30% respectively, the beta of this portfolio would be

0.87 (0.5*0.35 +1.10*0.15 +1.30*0.20 +0.90*0.30).

• A generalized formula for portfolio beta can be written as W1 β1+W2 β2+…+ Wn βn= βp

• Where, W1 is weight of stock 1, β1 is the β of stock 1, W2 is weight of stock 2, β2 is the

β of stock 2, Wn is weight of stock n, βn is the β of stock n and βp is the β of portfolio.

Number of contracts for perfect hedge = Vp * βp / Vi
• Vp – Value of the portfolio
• βp– Beta of the portfolio
• Vi – Value of index futures contract
• Assuming Beta of the portfolio is 1.8, portfolio value is Rs
10,00,000 and benchmark index level is 11500, then hedge
ratio will be (10,00,000*1.8/11500) = 156.5 indices.
• Assume one Futures contract has a lot size of 75. You will
have to hedge using 156.5/75 = 2.08 contracts.
• Since you cannot hedge 2.08 contracts, you will have to
hedge by 2 futures contracts. You have to pay the broker
initial margin in order to take a position in futures.
 VIX
• Volatility Index is a measure of market’s expectation of volatility

over the near term. Volatility is often described as the “rate and

magnitude of changes in prices" and in finance often referred to

as risk.

• Volatility Index is a measure, of the amount by which an

underlying Index is expected to fluctuate, in the near term,

(calculated as annualised volatility, denoted in percentage e.g.

20%) based on the order book of the underlying index options.

 India VIX
• India VIX stands for the India Volatility Index.

• It is an index circulated by the NSE and calculates the degree of

fluctuation that can be expected in the Nifty50 by active traders
over the next 30 days.

• The term VIX was initially coined in 1993 by Chicago Board Options
Exchange. With their permission, NSE started the India VIX in
2008.

• The calculation of the volatility index is done based on the Black

Scholes Model. It is used for pricing options contracts.
• If India VIX has a high value, one can expect higher
volatility, which means that a noteworthy change in Nifty
can be expected. If the India VIX has a low cost, this
means that we can expect lower volatility, which
translates to minimal change.
• India VIX and Nifty show a massive negative correlation.
Whenever India VIX drops, there is a rise in Nifty.
Conversely, Nifty can be expected to fall whenever there
is a rise in India VIX. 
 Open Interest

• Open interest is the total number of outstanding contracts that are held by

market participants at the end of each day. Open interest measures the

total level of activity in the futures market.

• If both parties to the trade are initiating a new position (one new buyer and

one new seller), open interest will increase by one contract. If both traders

are closing an existing or old position (one old buyer and one old seller),

open interest will decline by one contract.

• If one old trader passes off his position to a new trader (one old buyer sells

to one new buyer), open interest will not change.