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Futures and Forwards

Forward - an agreement calling for a future delivery of an asset at an agreed-upon price Futures - similar to forward but feature formalized and standardized characteristics Key difference in futures Secondary trading - liquidity Marked to market Standardized contract units Clearinghouse warrants performance

Forward contracts
They are bilateral contracts Each contract is custom designed The contract price is generally not available in public domain The contract has to be settled by delivery of asset on expiry In case, the party wishes to reverse the contract , it has to compulsorily go to same counter party, which ,being in monopoly situation, can command the price it wants

Futures contracts
The standardised items in any futures contract are: Quantity of the underlying Quality of underlying Date and month of delivery Units of price quotation Location of settlement

Underlying asset:NCDEX gold contract, quality is stated as not more than 999.9 fineness bearing a serial number and identifying the stamp of refiner approved by the exchange Contract size: cashew contract size is 50 cartons and net weight of each carton should be 22.68 kg Delivery arrangement: Location; price of contract adjusted according to location. Alternative delivery location choice given to seller Eg cashew delivery centre is Kollam and alternate is Mangalore.Gold contract - Mumbai and alternate is Ahemdabad

Specifications of a commodity future contract

Delivery arrangement: Alternative grade NCDEX gold contract specification is gold bars of 999.9/995 fineness Settlement price for fineness above 995 is (actual fineness/995)* Final settlement price. Delivery month: NCDEX- 20th day of each month Delivery notification: Tender period Daily Price Movement limits : Limit down and limit up Position limits- cornering the market Closing out the positions: speculators or hedgers

Specifications of a commodity future contract

Forwards Vs futures
Are not traded on an exchange Are private Involve no margin payments Physical delivery Terms of contract dependent on negotiated contract Not transparent Used for hedging Exchange traded Clearing house Requires margin payment 98% cash settled Terms of contract standardised Transparent

Used for hedging and speculation

Key Terms for Futures Contracts


Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot

Delivery of agricultural commodities is made by transfer of warehouse receipts issued by approved warehouses

Profits to Buyers and Sellers of Futures and Option Contracts

Unlike options , in case of futures there is no need to distinguish payoffs from net profits

Futures vs options contract


Both buyer and seller are under an obligation Unlimited risk of losing The buyer and seller have unlimited potential to gain One dimensional The buyer of the option has the right Seller is subject to unlimited risk The seller has limited potential to gain It is multidimensional as price depends on spot price ,strike price, time to maturity, risk free interest rate

Sample of Future Contracts

Trading Mechanics
Clearinghouse - acts as a party to all buyers and sellers
Obligated to deliver or supply delivery

Closing out positions


Reversing the trade Take or make delivery Most trades are reversed and do not involve actual delivery

Open Interest

Open interest
When contract begins to trade open interest is zero If a contract is approaching maturity ,open interest is small Again more distant the maturity little is the open interest If one party to trade is closing out the position , then there will be no change in the open interest If both parties closing their positions, the open interest will decrease.

Panel A, Trading without a Clearinghouse. Panel B, Trading with a Clearinghouse

Clearing house
Acts as a central counter party to all trades Clearing house has adequate resources to cover any losses, and to meet its own payment without any delay Financial and operational requirements for membership Margin requirements Close out positions in reaction to a default Practice by which exchange becomes counter party for all trades is Novation

The exchange platform


Demutualised Screen based trading Exchange membership Individuals Registered partnerships HUF Private and public limited company Co operative societies

Exchange membership
Min prescribed networth Annual subscription charges Following deposits to be maintained with the exchange Non refundable admission fees Contibution to TGF Initial base capital Additional base capital Annual subscription charges

Commodity brokerage
Day traders Floor traders Market markers Trading Systems on commodity Exchanges Open outcry system/Pit (NYME,CME,CBOT,LME) Specific dialect, hand signals, and clothing to communicate Chicago , Newyork ,London India and Singapore use almost identical hand signals to communicate trading transactions

Market order Market on opening Market on close Market if touched Spread Price condition Limit order Stop order Stop limit order

Order types

Order types
Time condition Good-till day , good- till- cancelled(open orders), Good-till-date orders Fill or kill order (Immediate or cancel orders)

Entities in a trading system


Trading cum clearing member Professional clearing member Trading member Strategic trading cum clearing member

Tick size for contracts and Ticker symbol


Smallest price change that can occur for trades on the exchange eg. Soy oil Rs.5 paise, Jeera Rs 1, wheat 20 paise) NCDEX uses a system of alphanumeric/alphabetic system to identify commodities. Indicates quantity, quality and base centre of the commodity SYOREFIDR TCMFGNZM Some commodities have 2 to 3 contracts available.Ticker helps in identifying them

Different approaches to enter into Derivative market


Self directed Full service Commodity fund Volume and open interest Low volume and high open interest- High business participation High volume and low open interest high speculative activity

Commodity Funds
Commodity funds help an investor participate in commodity-led inflation. India is a net importer of commodities, so in general, Indian assets are negatively correlated with inflation . "When the investor allocates a part of the portfolio to commodity funds, he partly hedges his portfolio. If commodity prices go up, inflation would increase . Increase in commodity prices would result in positive returns on commodity funds. Increase in inflation would result in fall in Indian equity and Indian fixed portfolio In the past one year, commodity funds have outperformed Indian equities and fixed income as an increase in commodity prices have resulted in 20%-plus returns from diversified commodity funds while Indian equities/fixed income have give single-digit returns.

Risk in the commodity market


Credit risk Market risk/ volatility risk Liquidity risk Legal risk operational risk

Other risk containment measures


SGF OR TGF Contributions is made by: Members of exchange cash and securities. All associates of the exchange are required to make initial contribution to TGF Most commodity exchanges rarely touch their guarantee fund Maximum allowable open positions or cornering the market(quantity freeze) eg GOLD (51kg)[Sumitomo corporation]

Other risk containment measures


Price limits Cooling period of 15minutes Price band is revised further ,no trade permitted beyond revised limit in case price reaches that revised level Eg Guar Seed- daily price fluctuation limit is (+-)4% (3%,1%)[% OF PREVIOUS DAY SETTLEMENT PRICE]

Base price
On introduction of new contract the base price is the previous days closing price of the underlying commodity in the prevailing spot markets. The base price of contracts on all subsequent trading days is the daily settlement price of the futures contract on previous trading day

Margins(futures)
A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract

Margin and Trading Arrangements


Initial Margin - funds deposited to provide capital to absorb losses Marking to Market - each day the profits or losses from the new futures price are reflected in the account. Maintenance or variation margin - an established value below which a traders margin may not fall.
The profits and losses are paid daily via the futures margining system, by a practice known as the Daily Mark-to- Market settlement

Margin and Trading Arrangements


Margin call - when the maintenance margin is reached, broker will ask for additional margin funds Variation Margin Clearing margins Gross margining or net margining Additional or volatility margin Tender period margin(pre expiry margin) Delivery period margin(Margins are paid the day following expiry of contract) Special Margin: Margin is levied more than 20% unidirectional movement from predetermined base Margin for Calendar Spread positions

Example of a Futures Trade


An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 futures price is US$600 margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total)

A Possible Outcome
Futures Price (US$) 600.00 5-Jun 597.00 . . .6-Jun .596.10 . . 12-Jun 595.40 13-Jun 593.30 . . . . 18- .Jun 592.70 19-Jun 587.00 . . . . . . 26-Jun 592.30 (600) . .(180) . (260) (420) . . . 180 (1,140) . . . 260 Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) Margin Account Margin Balance Call (US$) (US$) 4,000 (600) 3,400 0 . . . .(780) 3220. . . . . 3080 (920) (1,340) 2,660 + 1,340 = 4,000 . . . . . . . . < 3,000 (1460) 3880 (2,600) . . . (1,540) 2,740 + 1,260 = 4,000 . . . . . . 5,060 0

Day

Question
The settlement price of December Nifty futures contract on a particular day was 1310 The minimum trading lot on Nifty futures is 100. The initial Margin is 8% and maintenance Margin is 6% The Index closed at following levels on the next five days

Day

Closing price

1 2 3 4 5

1340 1360 1300 1280 1305

Calculate Mark to market cash flows and closing balances if an investor has gone long at 1310 and calculate the net profit or loss.

Warehousing and warehouse receipts


CWC,SWC and FCI WRs are title documents issued by warehouse to depositors against the commodities deposited in the warehouses.These documents are transferred by endorsement and delivery.Either the original depositors or transferee can claim commodities from warehouses. The Warehousing Development and regulation Act 2007 recommended NWRs

Charges
Transaction charge- Rs 4 per Rs 1,00,000 worth of trade done. Rate applicable upto Rs 20 crores. Reduced rate for increased turnover. Avg daily turnover = Total value traded by a member in month/No. of trading days including saturdays Due date Collection: Exchange dues account with clearing banks Adjustment against advance transaction charge Penalty for delayed payment

NWRs
NWRs can be traded and used to obtain finance This leads to increase in flow of credit to rural areas, reduces cost of credit and spurs activities like standardisation , grading , packaging and insurance to agriculture sector Dematerialization of warehouse receipts(risk of theft,mutilation,forgery,transferor and transferee are at two different locations) National level exchanges have empanelled DPs and demat account can be opened only with them.

The Delivery Process


The exchange enlist certain cities as delivery centres of specific commodities. Quality Assayer The role of deliverer and receiver is taken over by the clearing member (Eg In case of recently launched almond futures on MCX , almonds must be deposited at least three working days prior to expiry of respective contract in order to ensure timely completion of quality analysis and certification.MCX has appointed National Bulk Handling corporation as designated quality certification agency) Exchange is responsible for assuring proper grade , quantity , sanctioned delivery location and proper adherence by all the parties to the delivery procedure.

Contract can have any of the following options for delivery


Both option Seller option Compulsory delivery Delivery lot: The delivery can only be tendered in multiples of delivery lot.eg Gold(1kg) Delivery of the underlying commodity is made only when clearing house directs the seller( premium and discount is applicable to adjust for quality differences) Sampling and analysis at the time of delivery

The lifecycle of commodity futures contract


The trader enters buy/sell for a specific contract order executed through open outcry system or electronic trading CH collects required margin from the clearing member CM collects a higher margin as initial margin from trader The executed trade gives trader an open position Open interest is adjusted by the exchange

Two cases
Case I (Trader offsets his position before the delivery notice period starts) Reversing trade CH releases the CMs margin money deposit CM releases Traders margin Capital Gain are paid to customers while losses are deducted If losses exceed the margin fund deposited, CM collects the difference from trader in the form of margin call The exchange adjusts the open position

Case 2
a) Physical delivery Cash settlement When open contracts run into delivery period ,previously discussed delivery process is followed The period during which delivery can be made is decided by exchange. Exact delivery time is determined by party with short position Seller informs the broker of its intention which is further conveyed to Clearing House through a notice The notice states : Number of contracts , location and grade. Exchange randomly choses a party with a long position If the party with long position wants to take the delivery . The exchange randomly choses a party with short position. Seller will decide the place of delivery , quality to be delivered The exchange will then adjust the price of the contract

Case 2
b) When neither buyer or seller intends to give or take the delivery, open contracts are cash settled and due rates are notified by the exchange

Trading Strategies
Speculation short - believe price will fall long - believe price will rise

Hedging long hedge - protecting against a rise in price short hedge - protecting against a fall in price Cross hedging

Basis and Basis Risk


Basis - the difference between the futures price and the spot price over time the basis will likely change and will eventually converge Basis Risk - the variability in the basis that will affect profits and/or hedging performance Strengthening(narrowing)= Increase in spot price relative to futures price [A long spot and short futures] Weakening (widening)=Spot price is decreasing relative to future price Calendar spread

Other classifications of derivatives


By organization By trading system By settlement By complexity By graphical relationship with underlying By underlying

Speculating with oil futures


Suppose you believe that crude oil are going to increase, and therefore decide to purchase crude oil futures. Each contract calls for a delivery of 1000 barrels of oil. Suppose that the current futures price for delivery in Feb is $97.15 per barrel. For every dollar increase in futures price of crude, the long position gains $1000 and short position loses that amount. What happens if the crude oil selling at maturity date for $99.15?

Futures and leverage


Suppose initial margin requirement for oil contract is 10%.At a current futures price of $97.15, and contract size of 1000 barrels, margin requirement =$9715 A $2 ($2000 gain) represents 2.06% increase % gain in margin is 20.6% The 10:1 ratio of % change reflects leverage inherent in future position

Hedging with oil futures


Consider an oil distributor planning to sell 100,000 barrels of oil in Feb that wishes to hedge against a possible in oil prices. Because each contract calls for delivery of 1,000 barrels ,it would sell 100 contracts that mature in Feb. Any decrease in prices would then generate profits on contracts that would offset the lower sales revenue from oil

Hedging with oil futures


Oil prices in Feb,Pt

$95.15
Revenue $9,515,000 from oil sale (100000*Pt) Prices on 2,00,000 futures:1000 000*(F0-Pt) Total 9715,000 Proceeds

$97.15
9715,000

$99.15
9915,000

-2,00,000

9715000

9715000

Figure 22.4 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $97.15)

Concept check
Suppose in previous example that oil will be selling at $95.15, $97.15,$99.15 per barrel. Consider a firm such as an electric utility that plans to buy 1,00,000 barrels of oil in Feb. Show that if the firm buys 100 oil contracts today ,its net expenditures in Feb will be hedged and equal to $9715,000

Solution
Oil prices in Feb,Pt $95.15 $97.15 $99.15 -$9915,000

Cash flow to -$9,515,000 -$9715,000 purchase oil (100000*Pt) Prices on -2,00,000 0 futures:100,00 0*(Pt-F0) Total cashflows -$9715,000 -$9715000

2,00,000

-$9715000

Futures Pricing
Spot-futures parity theorem - two ways to acquire an asset for some date in the future Purchase it now and store it Take a long position in futures These two strategies must have the same market determined costs

Spot-Futures Parity Theorem


With a perfect hedge the futures payoff is certain -- there is no risk A perfect hedge should return the riskless rate of return This relationship can be used to develop futures pricing relationship

Hedge Example:
Investor owns an S&P 500 fund that has a current value equal to the index of $1,500 Assume dividends of $25 will be paid on the index at the end of the year Assume futures contract that calls for delivery in one year is available for $1,550 Assume the investor hedges by selling or shorting one contract

Hedge Example Outcomes


Value of ST
Payoff on Short (1,550 - ST) 40 0 -60

1,510

1,550

1,610

Dividend Income

25

25

25

Total (F0+D)

1,575

1,575

1,575

Rate of Return for the Hedge


( F0 D) S 0 S0 (1,550 25) 1,500 5% 1,500

General Spot-Futures Parity


( F0 D) S 0 rf S0
Rearranging terms

F0 S0 (1 rf ) D S0 (1 rf d ) dD S0

This equation applies to well functioning markets in which arbitrage opportunitie are competed away

Future Market Arbitrage


Suppose that parity were violated. Suppose that rf=4%. So acc to eqn Futures price $1500(1.04)-$25 =$ 1535 $15 higher than appropriate value=$1550 Arbitrage opportunity exists Shorting relatively overpriced future contract and buying relatively under priced stock by borrowing at 4% market interest rate Reverse strategy would apply if F0< $1535

Action
Action Initial cash flows Cash flows in 1 year

Borrow $1500 +1500 repay with interest in 1 year Buy stock for -1500 $1500
Enter short futures 0 position (F0= $1550) Total 0

-1500(1.04)=$1560
St+ $25 dividend $1550- St

$15

Arbitrage strategy
Action Initial cash flows Cash flows in 1 year -S0(1+rf) Borrow $1500 So repay with interest in 1 year Buy stock for -S0 $1500 Enter short futures 0 position (F0= $1550) Total 0

St+ D $F0- St

F- S0(1+rf)+D

Arbitrage Possibilities
If spot-futures parity is not observed, then arbitrage is possible If the futures price is too high, short the futures and acquire the stock by borrowing the money at the risk free rate If the futures price is too low, go long futures, short the stock and invest the proceeds at the risk free rate

Spread Pricing: Parity for Spreads


(1 rf d )T 1 F (T1 ) S0
T F (T2 ) S0 (1 rf d ) 2

F (T2 ) F (T1 )(1 rf d )

(T 2 T 1)

If the risk free rate is greater than dividend yield, then future price will be higher on longer maturity contracts. For future on assets like gold, which pay no dividend yield We can set d=0 and conclude that F must increase as time to maturity increases. The major difference is in the substitution of F(T1) for current spot price. Delaying delivery from T1 until T2 frees up F(T1 ) dollars ,which can earn risk free interest at rf.The delayed stock delivery also results in lost dividend yield between T1 and T2.Thus the net cost of carry rf - d

Spread pricing
Contract Maturity data Futures price

Jan 15
March 15

$105
$105.10

Suppose that the effective annual T bill rate is expected to persist at 5% and that the dividend yield is 4% per year. The correct futures price = 105(1+.05-.04)1/6 =105.174 The correct March future price is slightly Under priced compared to January futures and that aside from transaction costs , an arbitrage opportunity seems to be present

Figure 22.6 Gold Futures Prices

Pricing of commodity forward contracts


On Jan1 trader realises that he will need 20 MT of rice on July 1 Alternative 1: Not to do anything until July 1 and purchase on July 1 the prevailing market price at P1 Alt 2: enter into a forward contract to buy rice on July 1 at a forward price Alt 3:But 20 MT of rice on Jan 1 at price P0(spot price) and store it in a warehouse Alternative 2&3 do not result in risk , both of them must result in the same cost to buyer, f0= p0+c Cost of carry includes (cost of storage , freight and insurance and opportunity cost)

Example
Sun jewellers require 1000 grams of gold on July1 .On April 1, the price of gold is Rs 12000 per gram. It plans to enter into a forward contract to buy gold with delivery date of July. Storage cost =Rs 80,000 and it can invest its funds elsewhere at 8%. Calculate forward price of gold on April 1 for delivery on July 1. Opportunity cost for 3 months = 2% Interest lost = 12,000,000 *2%= Rs 2,40,000 Storage cost = Rs. 80,000 Total cost of carry= Rs. 3,20,000 Cost of carry per gram of gold = Rs 320 Forward price =Rs 12320

Carrying cost
Includes interest on capital , cost of storage , insurance etc Eg. Carrying charge for wheat is Rs 200 per tonne per month, and that mid April ,spot wheat is trading at Rs 12,000 per tonne The miller wishes to use wheat in mid May The total cost of procuring wheat works out to be Rs 12,200 per tonne. Assume that contract is trading at Rs 12180 per tonne (May) NCDEX Buying in the futures market rather than buy in spot market Buying in near future market will cause the prices to rise The twin effect of this balancing will continue until price difference equals carrying cost

Prices of future contract is made up of 4 components

Spot rate Risk free rate of return Storage costs Convenience yield (inventory level is low ,scarcity now greater than in future) eg. Wheat during scarcity can be sold at substantial premium. Carrying cost =interest on capital+cost of storage and insurance etc. Carrying cost of grain is expressed as cost per tonne per month while for gold it would be cost per 10 grams per month

Convenience yield
Benefit or premium derived from directly owning a particular good Based on actual possession and not owning a futures contract Depends on current market conditions

Commodity Futures Pricing


General principles that apply to stock apply to commodities Carrying costs are more for commodities Spoilage is a concern

F0 P0 (1 rf ) C
Where; F0 = futures price P0 = cash price of the asset C = Carrying cost c = C/P0

F0 P0 (1 rf c)
Two kinds of goods cannot be expected to be stored; Storage not technologically feasible Perishable goods that are available only in season

Arbitrage strategy
Action Initial cash flows Buy asset: pay the -Po carrying cost at T Borrow P0; repay with interest at time T Short future position P0 Cash flows in 1 year PT-C -P0(1+rf)

$F0- PT

Total

F0- P0(1+rf)-C

Typical Agricultural Price Pattern over the Season

Agricultural commodities and crop year


Wheat rice ,pulses, potatoes exhibit a crop year.The crop year for rabi runs from April 1 to March 31 The prices of the agricultural commodities at the lowest for the year at harvest time. However , if the outlook for new harvest is not good , the Feb futures price may well be lower than April price (inverse market). If the Harvest month is trading at a higher price than its preceding futures delivery month, this may be result of an expected shortage of commodity and even of an inverted market in the following crop year

Futures on Consumption Assets


F0 S0 e(r+u )T where u is the storage cost per unit time as a percent of the asset value. Alternatively,

F0 (S0+U )erT where U is the present value of the storage costs.

The Cost of Carry


The cost of carry, c, is the storage cost plus the interest costs less the income earned For an investment asset F0 = S0ecT For a consumption asset F0 S0ecT The convenience yield on the consumption asset, y, is defined so that F0 S0 e(r+u )T F0 eyT = S0 e(r+u )T F0 = S0 e(cy )T

Theories of Futures Prices


Expectations Normal Backwardation Contango

Futures Price Over Time, in the Special Case that the Expected Spot Price Remains Unchanged

Near futures

Deferred futures

Buying pressure severe /shortage of commodity in spot market (backwardation) Oversupply in cash market (contango)

Backwardation/contango
Contango: Hedgers are purchasers (millers and grain processors) of a commodity rather than suppliers. Long hedge Speculators would be induced for short position F0 > E(Pt) Backwardation: Farmers are hedgers Short hedge Speculators would take long position F0 < E(Pt)

Deriving forward prices: market in contango


A gold producer approaches a bank asking for a price for delivery of gold in, say 6 months.The cost of hedging will be driven by banks own exposure The bank sells the same amount of gold it intends to receive in future in spot market to say an investment bank. It borrows the gold to fulfill commitment in the spot market say from central bank. Having sold the gold the bank is holding sales proceeds which can be invested . The maximum amount bank will pay the producer =proceeds received from spot sale plus interest received from the dollar less interest paid to the lender of gold

Example
Assume producer asks for a 6 months forward price (182 day) Cash market gold is trading at USD 425.30 per ounce In order to complete the spot delivery he borrows the same amount from from Central bank for 6 months at a lease rate of .11570% p.a.The dollar received from spot sale are put on deposit for 6 months at a LIBOR to earn ,say 3.39% p.a Interest cost of borrowing the metal is USD .2488(spot* lease rate*182/360) Earned from cash deposit =USD 7.29(spot sale proceeds*6month LIBOR*182/360)

Example
Max amount he can afford to pay the producer is USD 432.4418 This is calculated as spot sale proceeds+interest on LIBOR deposit borrowing fee(USD 425.40+USD 7.29-USD .2488) The fair value is a breakeven price for the trader The shorter the time to maturity the smaller would be the differential between spot and forward price

If the fair value of gold for 6 month delivery was USD 432.44 Assume that market price of USD 425 was observed. Commodity would be described as cheap to fair value Arbitrager could: Buy the commodity forward ,paying USD 425 upon delivery Short the underlying in spot market to earn USD 425.40 Invest the cash proceeds at LIBOR ,earning 3.39% for 6 months to earn USD 7.29 Borrow gold in the lease market in order to fulfill the short spot sale paying a 6 month lease rate ,which equates to a cash amount of USD .2488

Example contd..

Example contd..
Repay the gold borrowing upon the receipt of metal under the terms of forward contract. Net profit USD 7.44

Markets in backwardation
If Forward price = spot price+LIBOR+warehousing/insurance costs Many commodities move in backwardation (eg. Base metals and crude oil) Forward price = spot price+LIBOR+warehousing/insurance costsconvenience yield If the commodity is in very short supply,its value will rise,moving towards zero in normal supply conditions

Markets in backwardation
Incase of backwardation futures price is lower than spot price Contract is mispriced Speculators should be able to buy the cheap future contract sell it for spot value and hold the combined position till maturity Since the availability of the commodity in the spot market is very scarce , these supplies simply cannot be obtained Hence ,this apparent mispricing will persist for prolonged periods,as there is no mechanism to exploit potential arbitrage

Price structure in inverted markets


price

spot

Near future

Deferred futures

If the future price increases with a decrease in time to maturity

Price structure in Normal market


price

spot

Near futures

Deferred futures

If the future price decreases with decrease in time to maturity

Example
Consider this arbitrage strategy to derive the parity relationships for spreads: Enter a long futures position with maturity date T1 and Futures price F(T1) Enter a short position with maturity T2 and futures price F(T2) At T1 when the first contract expires ,buy asset and borrow F(T1)dollars at rate rf Payback the loan with interest at time T2 What are the total cashflows to this strategy at times 0,T1 and T2

Naturally short position Buying hedge/long hedge/input hedge Eg. In Nov, a wheat miller has finalised a contract to supply flour to a bread maker in March.Amt needed to produce the flour is 5000 quintals (500 tonnes) At time of contracting wheat is selling for Rs 11,900 per tonne .March wheat futures trading at Rs 12,000 per tonne . Each future contract covers 10 tonne(100 quintals);he buys 50 future contracts In March spot price has risen to Rs 12200 and March future trading at Rs 12300 per tonne

Hedging for buyer

Buying hedge mechanism


Enter into contract to supply at a future date Buy futures contract corresponding to date of supply At the time of starting Buy input from spot production to supply as market per contract Close out futures contract by selling the same contract on the same exchange Now
No change in hedge basis

Buying hedge mechanism in example


Spot Market November Spot price of wheat Rs 11,900 per tonne Future Market Buy March Wheat Futures at Rs 12,000 per tonne

Feb

Buy wheat in spot market at Rs 12,200 per tonne


Rs 300 per tonne loss

Sell March Wheat Futures at Rs 12,300 per tonne


Rs 300 per tonne gain

Change

Buying hedge mechanism in example contd.


If wheat prices in the local market had declined by Rs 200 per tonne by Feb ,at Rs 11,700 per tonne,gain would have got offset by a loss in futures market
Spot Market November Spot price of wheat Rs 11,900 per tonne Future Market Buy March Wheat Futures at Rs 12,000 per tonne Sell March Wheat Futures at Rs 11,800 per tonne Rs 200 per tonne loss

Feb

Buy wheat in spot market at Rs 11,700 per tonne Rs 200 per tonne gain

Change

Hedging for seller


Naturally long position Selling hedge or short hedge or an output hedge In November ,a wheat farmer is planning to sow wheat ,which will be ready for harvest by late March and delivery in April.The farmer harvests 500 tonnes of wheat.Prevailing spot price is Rs 11800 per tonne.April future are trading at Rs 12,000 per tonne.

Selling hedge mechanics


Now Start production of product to sell at a future date Sell futures contract corresponding to date of sale Sell in spot market Close out futures contract by buying the same contract on same exchange

At the time of getting product ready to sell

Selling hedge mechanics


Spot Market November Spot price of wheat Rs 11,800 per tonne Sell wheat in spot market at Rs 11,500 per tonne Rs 300 per tonne loss Future Market Sell April Wheat Futures at Rs 12,000 per tonne buy April Wheat Futures at Rs 11,700 per tonne Rs 300 per tonne gain

Feb

Change

Selling hedge mechanics


Conversely, if wheat prices had increased by Rs 200 per tonne by March , at Rs 12,000 per tonne ,would have been offset by a loss in the futures market
Spot Market November Spot price of wheat Rs 11,800 per tonne Future Market Sell March Wheat Futures at Rs 12,000 per tonne buy March Wheat Futures at Rs 12,200 per tonne Rs 200 per tonne loss

Feb

Sell wheat in spot market at Rs 12,000 per tonne Rs 200 per tonne gain

Change

Payoff for a selling hedge


profit
Long physical payoff

Spot price 0

Short future payoff


losses

When spot /future prices are increasing

Payoff for a selling hedge


profit Short future pay off

0 Long physical payoff losses When spot /future prices are decreasing

Spot price

Logic: Do now what has to be done in future, so as to lock in the prices now. Assumption: constant basis

Mismatches in basis and basis risk


Difference between the asset whose price is to hedged and asset underlying the future contract Mismatch between the expiry date of futures and the actual selling date of the asset. When a person using futures to hedge an underlying cash position cannot obtain a perfect hedge. Quantative mismatch:overhedging and underhedging Over-hedged positions Naked risk Under hedged

Mismatches in basis and basis risk hedging(copper- based Commodity mismatch : proxy
electric cable cannot be hedged,since there is no future contract offered on such cable) Delivery date Mismatch(If the delivery date is not the same as the date on which the futures mature) Strengthening and weakening of basis Hedge basis The basis that concerns the hedger is the basis that will exist at the time the hedge is lifted. If there is no move, hedge is perfect. Second basis is established The difference between the original hedge basis and second basis will determine the outcome of hedges

Basis risk in long hedge


Spot Market November Spot prices of wheat Rs.11,900 per tonne Buy wheat in spot market at 12,200 per tonne Rs 300 per tonne loss Futures Market Basis Buy March -100 Wheat Futures at Rs 12,000 per tonne Sell March wheat futures at Rs 12,250 per tonne Rs 250 per tonne gain -50

Feb.

Change

50(strengthen ed or narrowed)

Basis risk in long hedge


Spot Market November Spot prices of wheat Rs.11,900 per tonne Buy wheat in spot market at 12,200 per tonne Rs 300 per tonne loss Futures Market Basis Buy March -100 Wheat Futures at Rs 12,000 per tonne Sell March -150 wheat futures at Rs 12,350 per tonne Rs 350 per tonne gain 50(weakened or widened)

Feb.

Change

Basis risk in short hedge


Spot Market Futures Market Basis

November

Spot prices of wheat Rs.11,800 per tonne


Sell wheat in spot market at 11,500 per tonne Rs 300 per tonne loss

Feb.

Change

Sell April Wheat Futures at Rs 12,000 per tonne Buy April wheat futures at Rs 11,650 per tonne Rs 350 per tonne gain

-200

-150

50(strengthen ed or narrowed)

Basis risk in short hedge


Spot Market November Spot prices of wheat Rs.11,800 per tonne Sell wheat in spot market at 11,500 per tonne Rs 300 per tonne loss Futures Basis Market Sell April -200 Wheat Futures at Rs 12,000 per tonne Buy April -250 wheat futures at Rs 11,750 per tonne Rs 250 per tonne gain 50(weakened or widened)

Feb.

Change

Important points to note


Hedging not necessarily improves the financial outcome Hedging is not perfect Underlying asset may be different Hedger might be uncertain about exact time of delivery Future contract expires after the delivery date

Optimal hedge ratio


h is also known as size of hedge Hedge ratio =(size of futures position)/size of exposure Optimal ratio need not always be 1 h (size of hedge or proportion of exposure that should be optimally hedged) = r * S/F

Optimal hedge ratio


A company will require 10,000 tonnes of wheat in 3 months.The SD of the change in price per tonne of wheat over the three month period is calculated as 0.040.The company chooses to hedge by buying future contracts on wheat. The SD of the change in wheat futures price over a three month period is .055 and coefficient of correlation between changes in wheat spot and future prices is 0.9.The unit of Trading is 10 tonnes. what is optimal hedge ratio How many wheat contracts should company buy?

Solution
Optimal hedge ratio (h) = .9* (.040/.050) =.9* .8 = .72 Number of wheat contracts the company should buy .72*10,000/10 = 720 contracts

Rolling the hedge


Choosing future contract with highest possible correlation with asset to be hedged Choosing the futures that expire as close as possible (but not earlier than the date when hedge matures) Assume a jeweler who owns gold which he will convert to jewellery and sell after one year.Only contracts upto 4 months are liquid,what does jeweller do to hedge the risk of fall in the price of gold? He does a short hedge.How does he hedge for 12 months later with contracts running only 4 months into future?

Achieving the hedge


Time (in months) Action

0
4

Short futures contract 1


Close out futures contract 1 Short futures contract 2 Close out futures contract 2 Short futures contract 3

12

Close out futures contract 3

The uncertainty about the difference of future price of contract that is closed and new contract that is opened when hedge is rolled forward is referred to as rollover basis. There will be n-1 rollover basis on any rolling over hedge Stack- rolling hedge Vs strip hedge

Cash and carry trades


Long the commodity and short the futures Strategy involves: Borrow money Buy the commodity for cash Sell the future contract of the commodity Carry the commodity to contract expiry Deliver the commodity against the futures contract Repay the borrowed money

Reverse cash- and carry arbitrage


Short sell a commodity Lend the money generated from short sale Buy the futures contract of the commodity Hold the contract to expiry Receive the commodity against the futures contract Cover short sale with commodity received

Spreads
Spread traders Less risky and less expensive way to participate in future market Margin requirements are low

Intra commodity spreads


Buying one month future in a particular commodity and selling a different month future in the same commodity Both contracts move in same direction but at different rates. Bull spread (buying the near month and selling the far month) Bear spread Known as calendar spreads/time spreads/intra market spreads/horizontal spreads The relationship between the nearby and distant months in the same commodity often tells about relative strength and weakness of the market itself.

If heavy rains in North India during April damages the wheat harvest.The May contract can trade at premium to the August contract In situation of perceived tightness of stocks , the nearby futures contract will rise faster than distant months This is a bull spread Conversely, in situation of over abundance. Nearby months will fall faster than distant months A bear spread would be created

Intra commodity spreads

Inter market spreads


Same market forces affect both Generally move in same direction but at a different rates Inter exchange spreads

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