Tarheel Consultancy Services

Bangalore, Karnataka

Futures & Options

For PGP-II June-August 2013

Part-01
Introduction to Futures and Forwards

Derivative Securities

Appropriate term Derivative Contracts

Represent a contract between 2 parties

Gives owner certain rights or obligations

Derivatives

Contracts due to an underlying asset / portfolio of assets

Underlying asset Primary Asset

These contracts are derived from primary

securities hence the term Derivatives

Introduction (Cont)

Underlying asset may be

A stock A bond A foreign currency (USD) A commodity like wheat A precious metal like gold A portfolio of assets such as a stock index (NIFTY, DJIA)

Categories of derivative securities

Derivative Securities

Futures & Forward contracts

Options contracts

Swaps

Cash Transaction vs F&F

Cash transaction F&F When the deal is struck the The transaction does not buyer pays for the asset & take place at the outset. The seller transfers the rights to The 2 parties merely agree the asset on the terms The transaction is scheduled for a future date Money changes hands when the No money changes hands. 2 parties enter into the contract Both have an obligation to perform at the future date

Illustration

Mitoken Solutions enters a forward contract with ICICI Bank:

To acquire $100,000 after 90 days at Rs. 50.50

90 days later:

Mitoken is obliged to pay Rupees 5.05 MM The bank is obliged to deliver $100,000

Long and Short Positions

Every Forward/Futures contract has a Buyer and a Seller.

Long position Short position

The party agreeing to buy the

underlying asset is called the LONG Said to assume a Long position

The counterparty
agreeing to sell the underlying asset is called

the SHORT
Said to assume a Short position.
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Options contracts vs F&F contracts

Options contracts F & F contracts

Options contracts give a Right

to the buyer They impose an obligation on

Futures/Forwards impose
an obligation on both parties

the seller
Option buyers are referred to Option sellers are referred to
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as Holders

as Writers

Options vs F&F

Right vs Obligation
Right A right need be exercised only if Obligation

it is in the interest of the holder

A right holder is under no compulsion to transact The short has a contingent obligation. If the long exercises, the short has to perform

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Calls and Puts

When a person is given a right with respect to an asset, it can take on two forms

Right to Buy Right to Sell

Call option Put option Gives the holder the right to Gives the holder the right to buy the underlying asset sell the underlying asset
If a holder exercises the writer has to deliver If a holder exercises the writer has to take delivery
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European and American Options

European option American option

The right can be exercised

only on a fixed date in the future

The right can be exercised

at any time after it is acquired till the Expiration Date

The expiration date is the only The expiration date is the point in time at which the last point in time at which option can be exercised the option can be exercised
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European and American Options (Cont)

Most exchange traded options worldwide are American

On the NSE and BSE stock options are now European Index options have always been European They are easier to value

Cash flows only at a single point of time

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Option Price vs Exercise Price

Option Price (option premium) Price paid by the buyer to the writer for giving him the right Exercise Price (strike price) Price payable by the buyer if a call is exercised Price receivable by the buyer if a put is exercised Enters the picture only if the holder exercises

It is a sunk cost Non-refundable

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Option Price vs Exercise Price

Illustration

Komal goes long in a call on Reliance

X = Rs 900 and 3 months to maturity Premium = Rs 8.75

She has to pay Rs 8.75 per share at the outset

The options have been written by Kiran

Else she will forget the option and buy spot

If ST > 900 Komal will exercise and buy

At a price which by assumption is lower.

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Example of a Put

Ross bought a European put on IBM with X = $85

The premium is $1.10

He has to pay $110 to the writer In the US each contract is for 100 shares

If ST < $85

It makes sense to exercise and deliver the shares for $85 each Else it is better to let it expire The writer once again has a contingent obligation.

Premium for Futures?

Options The buyer has to pay a premium to the writer F&F The futures price will be set such that the value for Because he is acquiring a right both parties is zero at from the writer who is taking on inception an obligation Rights are never free There are two equal and Buyers have to pay for the right opposite obligations to transact Neither party has to pay
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Swaps

Contract between 2 parties to exchange cash flows

calculated on the basis of pre-specified criteria calculated at predefined points in time

Cash flows represent interest payments on a specified principal

1. 2.

One payment may be based on a fixed interest rate The other may be based on a variable rate such as LIBOR
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Swaps

LIBOR

LIBOR stands for the London Interbank Offer Rate

It is the rate at which a bank in London is willing to lend to another bank

The most widely used LIBOR is the value computed by the British Bankers Association (BBA) Benchmark Value

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Swaps

BBA LIBOR

BBA British Bankers Association

Most widely used benchmark for short term interest rates Rate is compiled by BBA and Reuters and released at around 11:45 a.m. London time BBA maintains a panel of min 8 banks per currency

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Swaps

BBA

The BBA currently computes the LIBOR for 10 international currencies

1. 2. 3. 4. 5. 6.

7.
8. 9. 10.

Australian Dollar Canadian Dollar Swiss Franc Danish Krone Swedish Krone Euro Sterling Pounds Japanese Yen New Zealand Dollar US Dollar

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BBA (Cont)

In 2013 the BBA will discontinue the process of disseminating the LIBOR for certain currencies and maturities The UK Government has

Recommended regulation of activities related to LIBOR A new set of institutions to administer and oversee LIBOR Set up the Hogg Committee for this purpose

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BBA (Cont)

For an interim period BBA has been asked to continue

To collect Calculate And Distribute LIBOR rates BBA LIBOR Limited will be authorized and regulated by the Financial Conduct Authority (UK)

From 2 April 2013

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Swaps

All interest rate swaps need not be fixed rate floating rate

Floating rate floating rate swaps where each rate is based on a different benchmark

E.g. one leg could be based on Libor and the other on the US T-bill rate BASIS Swaps

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Swaps
Pure interest rate swap The cash flows are denominated in the same currency We cannot have a fixed We can have all possibilities

Currency swaps Swaps where the cash flows are in two different currencies

rate fixed rate swap

Fixed to Fixed
Fixed to Floating Floating to Floating
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Swaps

Principal
Pure interest rate swap Currency swaps There is no need to exchange The principal amount is the principal actually exchanged Both interest streams are in the same currency However a principal is required
Purely to facilitate the computation of interest Hence it is called a Notional principal

The interest streams are in different currencies

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Forward vs Futures Contracts

Similarities

Both require the long to acquire the asset and the short to deliver

Obligation for both parties

Difference

Futures contracts are standardized while Forward contracts are customized

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Forward vs Futures

Customization vs Standardization

In such contracts certain terms and conditions need to be made explicit.

How many units of the underling asset is the long required to acquire 2. What are the acceptable grade(s) allowable for delivery 3. What are the acceptable location(s) for delivery 4. When can delivery be made Is there a Delivery Day or is there a Window
1.

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Forward vs Futures

Customization vs Standardization
Customized contract Standardized contract

Terms and conditions have to There is a third party that

be bilaterally negotiated specifies the allowable terms and conditions The parties can incorporate any mutually agreed upon This third party is the futures exchange

features
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Forward vs Futures

Illustration Futures Exchange

Rice futures are trading on the Trivandrum futures exchange.

Each contract is for 100 kg.

Allowable grades are IR-7 and IR-8.

Allowable locations are Trivandrum, Kollam, and Nagarcoil.

Delivery can be made at any time during the last

week of the month.
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Forward vs Futures

Illustration Futures Exchange

Jacob wants to buy 5,000 kg of IR-7 in Trivandrum during the last week of the month Vishant seeks to sell 5,000 kg of IR-7 in Trivandrum during the last week of the month

The futures contract is suitable for both parties If they were to meet on the floor of the exchange at the same time a trade could be executed for 50 contracts

Assume that the agreed upon price is Rs. 16 per kg. The price is not specified by the exchange and has to be set by bilateral negotiations

It is a function of supply and demand conditions

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Forward vs Futures

Illustration
Jacob wants to buy 4,750 kg Vishant is looking to deliver

of BT rice in Kochi during the the same quantity of BT last week of the month rice in Kochi during that period. The terms that are being sought are not within the framework - A futures contract is unsuitable

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Forward vs Futures

Illustration - Fwd contract

Nothing prevents them from negotiating a customized agreement

This would be a forward contract.

Futures contracts are Forward contracts are exchange traded products private contracts. like stocks and bonds

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Forward vs Futures

Multiple Grades/Locations

If the contract permits delivery of more than one grade and/or at multiple locations

Who gets to choose what and where to deliver?

Traditionally the right to choose the location and

the grade, as well as the right to initiate the delivery process has been given to the short

Thus a long cannot demand delivery.

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Forward vs Futures

Multiple

Thus longs who do not wish to take delivery will exit before delivery commences.

How will they exit?

By offsetting or taking a counter position.

They can be called upon to take delivery without having the right to refuse.

What is the risk if they do not offset?

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Clearinghouse

It may be a wing of the exchange or a separate corporation

It guarantees the long & the short against the possibility of default by the other

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Clearinghouse

How it functions

Positions itself as the effective counterparty for each initial counter-party

it becomes the effective buyer for every seller it becomes the effective seller for every buyer

A party needs to worry only about the financial strength & integrity of the clearinghouse.
Neither party actually trades with the clearinghouse.

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Clearinghouse

Why do we need a clearinghouse?

A futures contract imposes an obligation on both parties On the expiration date:

It will be in the interest of 1 party to transact A price move in favor of one party would translate into a loss for the other

Given an opportunity, one party would like to default

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Clearinghouse

Illustration

Consider two parties to a trade

Poonam has gone long in a futures contract to buy an asset 5 days hence at Rs 400.

Kunal has taken the opposite side.

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Clearinghouse

Illustration

Assume that the spot price 5 days hence is Rs 425. If Kunal does not have the asset asset

If Kunal already has the

He is obliged to deliver at
Rs. 400 Has to forego an

He is required to acquire it
for Rs. 425 and deliver at Rs. 400

opportunity to sell it in the

spot market for Rs. 425 Quite obviously Kunal would like to default
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Clearinghouse

Illustration

Assume that the spot price 5 days hence is Rs 375

If Kunal does not have the asset

If Kunal already has the asset

He would be happy to deliver it He would be more than happy for Rs 400 to buy it for Rs 375 and then deliver it The problem is that Poonam would like to default if possible
contd

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Clearinghouse

Illustration

If Poonam does not want the asset She would have to take delivery and then sell it for Rs 375

If Poonam wants the asset She would rather buy it in the spot market for Rs 375

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Clearinghouse

Why?

The presence of a clearinghouse ensures that defaults do not occur. It ensures protection for both parties by requiring them to post a performance bond / collateral Margin The collateral is adjusted daily to reflect any profit/loss compared to the previous day.

By doing so the clearinghouse effectively takes away the incentive to default.

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Margins

In a futures contract there is always the risk of default

The price of the asset will either rise or fall

Given an opportunity one party would like to back out.

Compliance is ensured by requiring both parties to deposit collateral

The deposit, referred to as the Initial Margin is a performance guarantee.

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Margin

Margins - Collateral

The collateral represents the potential loss for a party. Once it is collected the incentive to default is

taken away.

Even if the losing side were to default

The collateral would be adequate to take care of the interests of the other party

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Margin

Clearing Margin

Since the clearinghouse gives a guarantee to both sides, it also collects Clearing margin In practice:

Margin Both parties Brokers

Margin Clearinghouse

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Offsetting

It means taking a counter-position

If a party has originally gone long it should subsequently go short and vice versa.

The effect of offsetting is to cancel an existing long or short position

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Offsetting
Forward contract It is a customized contract Futures contract The 2 parties effectively enter into a contract with the clearinghouse Canceling is a lot easier. Both contracts have been designed according to exchange specified features
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A party who wants to cancel must seek out the counterparty.

Offsetting

Illustration Futures contract

A contract between any two parties will be identical to a contract between two other parties

Jacob & Vishant

Kripa & Priyanka

The moment Jacob & Vishant trade, they effectively enter into a contract with the clearinghouse

And the link between them is broken.

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Offsetting

Illustration Futures contract

Jacob (the long) wishes to get out of his position He need not seek out Vishant (the short)

He simply goes back to the floor & offers to take a short position
By entering into an initial long position followed by a short position, Jacob is effectively out of the market and has no further obligations 52

This time the opposite position may be taken by, say Rahul

Offsetting

Illustration

For the clearinghouse:

Jacob has bought a contract Jacob sold an identical contract Jacobs net position is 0

Profit/Loss for a party who trades & subsequently offsets = (the futures price prevailing at inception) (the price at the time of cancellation)
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Marking to Market (MTM)

Why are margins collected?

To protect both parties against default by the other

Why does potential for default arise?

Once a position is opened it will invariably lead to a loss for one party if it were to comply

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Marking to market

Loss from default

The loss will not arise all of a sudden at the time of expiration

As the futures price fluctuates from trade to trade:

One party will experience a gain The other will experience a loss

Total loss from pt. of inception till expiration (or offsetting)

= the sum of these small losses/profits

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Marking to Market (MTM)

It is the process of calculating the gain/loss for a party

at a specified time

with reference to the price prevailing when the

contract was previously marked to market

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MTM Futures contract

When a futures contract is entered it will be MTM EOD

Subsequently it will be MTM EOD everyday

Till the contract expires

Or an offsetting position is taken

The party with a profit will have his margin account credited

The other party will have his margin account debited.

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Marking to market

Illustration

Consider Poonam who has gone long in a futures contract with Kunal

It expires 5 days hence It is at a price of Rs. 425

Assume that the prices EOD are as depicted in the following table.

Each contract is for 100 units of the underlying The initial collateral (Initial Margin) is Rs.5,000

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Marking to market

Illustration
Day t 0 1 2 3 Futures Price 400 405 395 380

4
5

405
425
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Marking to market

Illustration EOD 1st day

The futures price EOD 1st day is Rs.405

While the contract is MTM the broker would behave as if she is offsetting He would credit Rs.500 to her margin account But since she has not expressed a desire to offset, he would act as if she were re-establishing a long position at the new price i.e. at Rs. 405 60

If Poonam were to offset she would be agreeing to sell at Rs. 405/unit

She would have a profit of Rs. 5/unit or total Rs. 500

Marking to market

Illustration EOD 2nd day

The futures price EOD next day is Rs. 395

When the contract is MTM Poonam would have a loss of Rs. 1,000 Once again a new long position would be established, this time at a price of Rs. 395

The process will continue:

1. 2.

either until the delivery date

Or until the day that the position is offset, if that were to happen earlier.
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Marking to market

Illustration

As can be seen

Rising futures prices lead

to profits for the long

Declining futures prices

lead to losses for the long

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Marking to market

Illustration

Now look at it from Kunals perspective.

EOD 1st day, MTM when the price is Rs. 405 would imply a loss of Rs. 500 By the same logic the next day his margin account will be credited with Rs. 1000

Shorts lose when prices

rise

Shorts gain when prices

fall
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Marking to market

Zero Sum Games

Profit/loss for the long is identical to the loss/profit for the short

Futures contracts are consequently referred to as Zero Sum Games.

One mans gain is another mans loss.

Rising futures prices Shorts lose when prices rise

Declining futures prices Shorts gain when prices fall

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Lead to profits for the long Lead to losses for the long

Zero Sum (Cont)

One participants gains are due to anothers equivalent losses The net change in total wealth for all traders considered together is zero

Wealth is merely transferred from one party to another

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Marking to market

Illustration

By the time the contract expires the loss incurred by 1 party (here the short) would have been totally recovered

In this case Poonams account would have been credited with Rs. 2,500

Kunals account would have been debited with Rs.

2,500
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Marking to market

Illustration

Now if Kunal were to default Poonam would not be at a disadvantage

She already has a profit of Rs. 2,500

She can now take delivery at the spot price of Rs.

425 The effective price paid by her would be Rs. 400

This is what was contracted for in the first place

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MTM A Detailed Illustration

Typically a trader will trade more than once on a given day The profit/loss from MTM is given by the difference between:

The Trade Price and the Settlement Price for

Contracts executed during the day and not offset

The previous days settlement price and the current settlement price

For contracts brought forward and not offset

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Illustration (Cont)

The previous days settlement price and the trade price

For contracts brought forward and offset

The buy price and the sell price

For contracts executed during the day and offset on the same day

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Example-1

End of previous day Steven was long in 250 contracts

Yesterdays settlement price was $122 Each contract is for 50 units He went long in 125 more contracts at 125 75 of these were subsequently offset at 127.50 Todays settlement price is $130

Today:

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Example-1 (Cont)

Profit/loss for contracts carried over and not offset:

250 x 50 x (130 122) = $100,000

Profit/loss for contracts entered into during the day and offset on the same day:

75 x 50 x (127.50 125) = $9,375

Profit/loss for contracts entered into during the day and not offset:

50 x 50 x (130 125) = $12,500

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Total inflow/outflow = $121,875

Example-2

Shelly had a long position in 200 contracts as of yesterday

Yesterdays settlement price was $114 Each contract is for 50 units of the underlying 125 contracts were subsequently offset at $122.50 Todays settlement price is $126

Today she went long in100 contracts at $118

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Example-2 (Cont)

Profit loss for contracts carried forward and not offset:

175 x 50 x (126 114) = $105,000

Profit/loss for contracts executed during the day and offset on the same day:

100 x 50 x (122.50 118) = $22,500

Profit/loss for contracts carried over from the previous day and offset today:

25 x 50 x (122.50 114) = $10,625

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Total Inflow = $138,125

The Clearinghouse and MTM

The clearinghouse essentially plays the role of a banker.

It will debit the margin account of the broker whose client has incurred a loss

& credit the margin account of the broker whose

client has made a profit.

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Forward Contracts

Unlike futures contracts, forward contracts are not MTM.

So both the parties are exposed to default risk.

Consequently parties to a forward contract tend to be large and well known, such as

Banks Financial institutions Corporate houses Brokerage firms

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Maintenance Margin & Variation Margin

In a futures contract

Both longs and shorts have to deposit a performance bond known as the Initial Margin

Margin account will be credited

Margin account will be debited

If a party makes a profit

If a party makes a loss

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Maintenance Margin

Maintenance
The broker has to ensure that the client always has adequate funds Otherwise the entire purpose of margining can be defeated

Consequently the broker will specify a threshold balance Maintenance Margin

This will obviously be less than the initial margin level

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Maintenance Margin

Maintenance

If the balance in the margin account declines below the maintenance level

The client will be asked to deposit additional funds to take the balance back to the initial level

A call for additional margin is referred to as a Margin Call. The additional funds deposited are referred to as Variation Margin

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Maintenance Margin

Illustration

Take the case of Poonam She went long:

Contract for 100 units Price of Rs 400 per kg, Deposited an initial margin of Rs 5,000. Assume the maintenance margin = 4,000

The contract lasts for 5 days and daily prices are as depicted earlier

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Maintenance Margin

Illustration

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Initial Margins

Need not be in the form of cash Brokers will accept cash-like assets like marketable securities

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Maintenance Margin

Initial Margins

But the value assigned to the collateral will be less than its current market value.

To protect the broker against a sharp price decline E.g. a security worth $100 may be valued at $90

The broker is said to have applied a Haircut of 10%

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Value at Risk

If the collateral collected is high, the potential for default will be reduced. : Potential for default

Amount of collateral

Margins specified by the exchange would depend on the estimate of the potential loss. Value at Risk (VaR) : Statistical technique for estimating loss
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Value at Risk

Concept of VaR

We cannot be sure about the loss from one day to the next. At best - with a given level of probability, the loss cannot exceed a specified amount VaR : Summary statistical measure of the possible loss of a portfolio of assets over a pre-specified time horizon.
84

Value at Risk

Example: Concept of VaR

99% VaR over a 1 day horizon = Rs 1,000

Interpretation: Only a 1% probability that the loss

over a 1 day holding period > Rs 1,000

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Value at Risk

Interpreting VaR

A VaR number is meaningless unless these are specified:

Probability level

E.g. the 99% VaR for a portfolio will differ from the
95% VaR

Holding period

E.g. the VaR for a 1 day holding period will be

different from the VaR for a 3 day holding period.
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Value at Risk

Value at Risk

Maximum possible loss that a portfolio can suffer = VaR

In principle the value of a portfolio can always go to zero

Maximum loss that a portfolio can suffer entire

current value.
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Gross Margins vs. Net Margins Some clearinghouses collect margins on a Gross basis while others do so on a Net basis.

We will illustrate the difference between the

two with the help of an example.

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Gross vs Net margins

Illustration

There are 2 brokers Alpha and Beta Alpha has 2 clients

Alfred is long in 100 contracts Betty is short in 80 contracts Charlie is long in 80 contracts Debby is short in 100 contracts

Beta has 2 clients

Assume: The initial margin is $ 4 / contract

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Illustration (Cont)

Alpha will collect 4 x 180 = 720 from his two clients Beta will collect 720 from his two clients

We say that the brokers are collecting margins on a Gross Basis Variation margin is paid/withdrawn the following morning

Contracts are MTM daily

There is a price limit of $4 in either direction

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Gross vs Net margins

Illustration
Gross margining Each broker will have to deposit the entire Rs 720

Net margining The clearinghouse would calculate the brokers

with the clearing house

position as 20 long (100

long 80 short) for Alpha and 20 short for Beta

Both brokers have to

deposit only $ 80 each with the clearinghouse

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Price Limits

Limits are measured with respect to the previous days settlement price

Apply in both directions There is a limit of 30 c on the daily price change So tomorrows price limits will be $6.30 and $5.70

Example: Settlement price for Soybeans is $6

Limit moves

If it moves to the lower limit Limit Down If it moves to the upper limit Limit Up
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Price Limits (Cont)

Why have we assumed a $4 price limit?

The Initial Margin is $4 There is no maintenance margin Limit moves should be such that balance in the margin account cannot become negative

Negative account balances will defeat the purpose of margining

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Illustration (Cont)

Of the total margin of 1,440

160 is with the clearinghouse 640 is with each broker Longs will have a profit of $4 Alpha will require 400 to pay Alfred Beta will require 320 to pay Charlie

Assume the price rises by $4

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Illustration (Cont)

If the clients want to hold on to their positions Betty will have to pay 320 to Alpha and Debby will have to pay 400 to Beta

The margin balances of the shorts have gone to Zero They must raise the balance to the initial level

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Illustration (Cont)

Beta will use 320 to pay Charlie

It will pay 80 to the clearinghouse which will pay Alpha Alpha would receive 320 from Betty It will have a total of 400 adequate to pay Alfred

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Illustration (Cont)

The clearing members perform a banking function

Transfer funds from one client to another

The clearinghouse too performs a banking function

Transfers funds from one broker to another

As long as the magnitude of the price change does not exceed the IM

The deposit held by the clearinghouse and brokers will be adequate to protect buyers and sellers
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Illustration (Cont)

Suppose the price rises by $4

The shorts are unable to pay Variation Margin

Alpha has 640 It requires 800 to pay Alfred

Sum of IM of 400 and profit of 400 from MTM

Will be passed on by the clearinghouse

It requires 160

Beta has 640

Adequate to pay Charlie 320 IM 320 profit from MTM

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Illustration (Cont)

What if the price rises by $4 and

Alpha goes bankrupt He is assured of only the 160 that is available with the clearinghouse

Alfred has to be paid 800

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Gross vs Net margins

Merits / Demerits: Illustration

Gross margining
Clearinghouse has resources to pay both longs & shorts since each broker has deposited 720 with it Clients may not pay adequate attention to the creditworthiness of the brokers The cost of operations of the clearinghouse will increase as it has to provide guarantees on a much larger scale

Net margining
Clearinghouse can guarantee payment for 40 contracts only since each broker deposited only 80 with it Clients need to be more concerned with the financial strength and integrity of the broker. They cannot bank on the clearinghouse to always bail them out 100