IIM, CALCUTTA

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IIM, CALCUTTA IIM, CALCUTTA Operation of Money Operation of Money Market, Capital Market, Market, Capital Market, Foreign Exchange Market Foreign Exchange Market and Derivative Market and Derivative Market A Broad Overview A Broad Overview July 2009 July 2009

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IIM, CALCUTTA. Operation of Money Market, Capital Market, Foreign Exchange Market and Derivative Market A Broad Overview July 2009. Financial Market. Financial Market is that market where any kind of financial deal or transaction can be put through. - PowerPoint PPT Presentation

Transcript of IIM, CALCUTTA

Page 1: IIM, CALCUTTA

IIM, CALCUTTAIIM, CALCUTTA

Operation of Money Market, Operation of Money Market, Capital Market, Foreign Capital Market, Foreign Exchange Market and Exchange Market and

Derivative Market Derivative Market A Broad Overview A Broad Overview

July 2009July 2009

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Financial MarketFinancial Market

Financial Market is that market where any kind ofFinancial Market is that market where any kind offinancial deal or transaction can be put through.financial deal or transaction can be put through.

All fund raising need not necessarily be through All fund raising need not necessarily be through thethe

market route. For instance, borrowing can be by market route. For instance, borrowing can be by way way

of some bilateral negotiations rather than by of some bilateral negotiations rather than by access toaccess to

the market. the market. Credit Rating necessary and Transparent Pricing Credit Rating necessary and Transparent Pricing achieved for Financial Markets. achieved for Financial Markets.

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Segments of Financial Segments of Financial MarketMarket

Financial MarketFinancial Market

Money Market Capital Market Foreign ExchangeMarket

Financial DerivativeMarket

Used for Raising

Short TermFinance

Used for Raising

Long Term Finance

Used forConverting

Existing FundFrom one Currency

to another

Used for Managing/Hedging

Market Risk

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Money MarketMoney Market

Money Market (Short Term Money Market (Short Term Finance) Finance)

Call MoneyMarket

Repo andReverse Repo

Treasury Bill

CommercialPaper

Certificate ofDeposit

Fixed Income Securities

CBLO

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Capital MarketCapital Market

Capital Market (Long Term Capital Market (Long Term Finance) Finance)

Debt Shares

EquityPreference

VariableIncomeSecurity

Fixed Income Security

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SecuritySecurityDefinition of SecurityDefinition of SecuritySecurity Contract Regulation Act (SCRA)Security Contract Regulation Act (SCRA)Stock Exchange and ListingStock Exchange and ListingFixed Income Security - Long Term (Bond,Fixed Income Security - Long Term (Bond,Preference Shares) & Short TermPreference Shares) & Short Term(Treasury Bill, Commercial Paper,(Treasury Bill, Commercial Paper,Certificate of Deposit) Certificate of Deposit) Variable Income Security – Long (Infinite)Variable Income Security – Long (Infinite)Term only ( Equity Shares) Term only ( Equity Shares)

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Commercial PaperCommercial Paper

Short Term – Tenure 7 to 365 days Short Term – Tenure 7 to 365 days Maximum Depth – 90 daysMaximum Depth – 90 daysIssuer – CorporatesIssuer – CorporatesSecurity – YesSecurity – YesTraded in – Money MarketTraded in – Money MarketNature – Usance Promissory Note issued Nature – Usance Promissory Note issued

at at a discount to the face value a discount to the face value Amount – Multiples of Rs 5 lacs Amount – Multiples of Rs 5 lacs

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Risk Management Risk Management

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Risk ManagementRisk Management Definition of Risk, Exposure and Market Definition of Risk, Exposure and Market

VolatilityVolatility Quantification of RiskQuantification of Risk Interest Rate Risk and Capital Market Interest Rate Risk and Capital Market

RiskRisk Systematic and Unsystematic RiskSystematic and Unsystematic Risk Need for Risk ManagementNeed for Risk Management Portfolio TheoryPortfolio Theory Risk Management and Financial Risk Management and Financial

DerivativesDerivatives Stock and Index Futures and OptionStock and Index Futures and Option Interest Rate SwapInterest Rate Swap FRAFRA

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RiskRisk FactorsFactors Diversification will reduce risk by Diversification will reduce risk by

eliminating unsystematic risk.eliminating unsystematic risk.

With an integrated market for With an integrated market for securities, the investor is able to securities, the investor is able to reduce risk more quickly and reduce risk more quickly and further by diversifying across further by diversifying across international stocks as opposed to international stocks as opposed to only domestic onesonly domestic ones

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Degrees of Exposure on Degrees of Exposure on Existing Assets and Existing Assets and

LiabilitiesLiabilities Hekman has derived a framework for Hekman has derived a framework for categorizing assets and liabilities as to categorizing assets and liabilities as to their degree of exposure their degree of exposure

Coefficient of 1.0 means the market value Coefficient of 1.0 means the market value of the balance sheet item is entirely of the balance sheet item is entirely exposedexposed

Coefficient of 0.0 means the market value is Coefficient of 0.0 means the market value is unexposedunexposed

Coefficients between 0 and 1 means the Coefficients between 0 and 1 means the item is partially exposeditem is partially exposed

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DerivativeDerivative SecuritiesSecurities Derive their value from primary Derive their value from primary

securitiessecurities Primary financial instrument Primary financial instrument

evidences a direct claim against evidences a direct claim against some other partysome other party

Traded in the spot market with Traded in the spot market with prices set by the forces of supply prices set by the forces of supply and demandand demand

Put and Call Options on stocksPut and Call Options on stocks Cascade of new derivativesCascade of new derivatives Insulate a corporation from Insulate a corporation from

different types of riskdifferent types of risk

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HedgingHedging RiskRisk

Use futures contracts, forward contracts, Use futures contracts, forward contracts, options, or swaps for hedging.options, or swaps for hedging.

Taking a derivative position opposite to Taking a derivative position opposite to your exposure.your exposure.

Value of the derivatives used to hedge do Value of the derivatives used to hedge do not move in concert with that of the not move in concert with that of the underlying assetsunderlying assets

Slight to moderate deviations create basis Slight to moderate deviations create basis riskrisk

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Hedging FundamentalsHedging Fundamentals Hedge ratio is the ratio of one position Hedge ratio is the ratio of one position

relative to the other where risk is neutralizedrelative to the other where risk is neutralized Must adjust the hedge ratio over time (known Must adjust the hedge ratio over time (known

as dynamic hedging) if risk is to be minimizedas dynamic hedging) if risk is to be minimized The lower the transaction cost, the more that The lower the transaction cost, the more that

adjustments can occur and the more that risk adjustments can occur and the more that risk is minimizedis minimized

Requires continual vigilance if risk is to be Requires continual vigilance if risk is to be controlledcontrolled

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Arguments for Corporate Arguments for Corporate HedgingHedging

In spite of imperfections, hedging In spite of imperfections, hedging may be a thing of value.may be a thing of value.

Stabilize accounting earnings and Stabilize accounting earnings and reduce the probability of falling reduce the probability of falling below some regulatory below some regulatory requirement.requirement.

Insulate operating managers from Insulate operating managers from the vagaries of interest-rate the vagaries of interest-rate changes and currency movements.changes and currency movements.

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Futures MarketFutures Market Futures contract is a standardized Futures contract is a standardized

agreement that calls for delivery of an agreement that calls for delivery of an asset at some specific future date (in some asset at some specific future date (in some cases only cash delivery is allowed.)cases only cash delivery is allowed.)

With financial futures the asset is a With financial futures the asset is a securitysecurity

Only a small percentage of contracts come Only a small percentage of contracts come to actual deliveryto actual delivery Buyers and sellers take offsetting positionsBuyers and sellers take offsetting positions

Open interest is the number of futures Open interest is the number of futures contracts outstanding that have not been contracts outstanding that have not been closedclosed

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Several Interest-Rate Several Interest-Rate Futures MarketsFutures Markets

EurodollarsEurodollars Treasury notesTreasury notes Indian ScenarioIndian Scenario

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Features of Futures Features of Futures MarketsMarkets

Margin requirementsMargin requirements Amount of money that must be pledged to Amount of money that must be pledged to

cover fluctuations in the market price of the cover fluctuations in the market price of the contract, and is subject to daily resetcontract, and is subject to daily reset

Initial and maintenance margin requirementsInitial and maintenance margin requirements Marked-to-market means daily valuation of a Marked-to-market means daily valuation of a

contract with the loser owing money to the contract with the loser owing money to the winnerwinner

Longer-term instrumentsLonger-term instruments Settlement price multiplied by a conversion Settlement price multiplied by a conversion

factorfactor Established for each coupon rate and time to Established for each coupon rate and time to

maturitymaturity

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Hedging and Hedging and SpeculationSpeculation Hedging represents taking a futures contract Hedging represents taking a futures contract

position opposite to a position taken in the spot position opposite to a position taken in the spot market to reduce risk exposuremarket to reduce risk exposure

Speculator takes position in futures markets in Speculator takes position in futures markets in the pursuit of profits and assumes price riskthe pursuit of profits and assumes price risk

Long hedges involves buying a futures contractLong hedges involves buying a futures contract Futures market provides a “two-sided” hedgeFutures market provides a “two-sided” hedge

Short hedges involves writing a contract Short hedges involves writing a contract Cross hedgeCross hedge

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Basis RiskBasis Risk

Is the random fluctuation in net Is the random fluctuation in net position that remains after hedgingposition that remains after hedging

Futures price Futures price (adjusted(adjusted

Basis = Spot market - by Basis = Spot market - by appropriateappropriate

price conversion price conversion factor)factor)

Spot price less the futures price should equal Spot price less the futures price should equal the cost of carry the cost of carry Positive carryPositive carry Negative carry Negative carry

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Option ContractOption Contract

One-sided HedgesOne-sided Hedges Put and CallPut and Call European/AmericanEuropean/American In the Money, At the Money, Out In the Money, At the Money, Out

of the Moneyof the Money Use of Hedge OptionsUse of Hedge Options

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Caps, Floors, and CollarsCaps, Floors, and Collars

Cap is a put option on a fixed-income Cap is a put option on a fixed-income security’s valuesecurity’s value

Floor is a call optionFloor is a call option Collar is a combination of a cap and Collar is a combination of a cap and

a floor, with variation only in the a floor, with variation only in the mid-rangemid-range

Developed as customized derivative Developed as customized derivative productsproducts

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Interest-Rate SwapsInterest-Rate Swaps Exchanges a floating-rate obligation Exchanges a floating-rate obligation

for a fixed-rate one, or vice versafor a fixed-rate one, or vice versa With an interest-rate swap, With an interest-rate swap,

interest-payment obligations are interest-payment obligations are exchanged between two parties exchanged between two parties denominated in the same currencydenominated in the same currency

Floating-/fixed-rate exchangeFloating-/fixed-rate exchange A fixed-rate interest payment is exchanged A fixed-rate interest payment is exchanged

for a floating ratefor a floating rate Basis swapBasis swap

Two floating-rate obligations are exchangedTwo floating-rate obligations are exchanged Swaps can be customizedSwaps can be customized

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Credit RiskCredit Risk Default risk with respect to differential in Default risk with respect to differential in

interest paymentsinterest payments Intermediaries increasingly interposed Intermediaries increasingly interposed

themselves between the parties in such a themselves between the parties in such a way as to assume the default riskway as to assume the default risk

Replacement risk is that of having to Replacement risk is that of having to replace a counterparty in case of defaultreplace a counterparty in case of default

Swap positions can be sold giving them a Swap positions can be sold giving them a degree of liquidity not found in many degree of liquidity not found in many loansloans

Standardized contract specifies how Standardized contract specifies how swaps are to be liquidated in event of swaps are to be liquidated in event of defaultdefault

Margin is not sufficient to compensate for Margin is not sufficient to compensate for the credit risk if default occursthe credit risk if default occurs

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CreditCredit DerivativesDerivatives

Unbundle default risk from the other Unbundle default risk from the other features of a loanfeatures of a loan Can be transferred to others for a priceCan be transferred to others for a price

Protection buyer transfers riskProtection buyer transfers risk Protection seller assumes the credit risk Protection seller assumes the credit risk

and receives a premium for providing the and receives a premium for providing the insuranceinsurance

Credit-swap spread is the periodic Credit-swap spread is the periodic premium paidpremium paid

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Total Return SwapTotal Return Swap

Protection

Seller

Protection

BuyerDebt instrument’s total return

Reference rate +/- spread

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Credit SwapCredit Swap

Protection

Seller

Protection

Buyer

Premium

No credit event: $0

Credit event: Face value-market value

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28

OptionsOptions

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OptionsOptions

A call option A call option is an option to is an option to buy a certain buy a certain asset by a asset by a certain date certain date for a certain for a certain price (the price (the strike price)strike price)

A put is an A put is an option to sell option to sell a certain a certain asset by a asset by a certain date certain date for a certain for a certain price (the price (the strike price)strike price)

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Long Call on MicrosoftLong Call on Microsoft Profit from buying a European call option on Profit from buying a European call option on

Microsoft: option price = $5, strike price = $60Microsoft: option price = $5, strike price = $60

30

20

10

0-5

30 40 50 60

70 80 90

Profit ($)

Terminalstock price ($)

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Short Call on MicrosoftShort Call on Microsoft Profit from writing a European call option on Profit from writing a European call option on

Microsoft: option price = $5, strike price = $60Microsoft: option price = $5, strike price = $60

-30

-20

-10

05

30 40 50 60

70 80 90

Profit ($)

Terminalstock price ($)

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Long Put on IBMLong Put on IBM

Profit from buying a European put option on Profit from buying a European put option on IBM: option price = $7, strike price = $90IBM: option price = $7, strike price = $90

30

20

10

0

-790807060 100 110 120

Profit ($)

Terminalstock price ($)

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Short Put on IBMShort Put on IBM Profit from writing a European put option on Profit from writing a European put option on

IBM: option price = $7, strike price = $90IBM: option price = $7, strike price = $90

-30

-20

-10

7

090

807060

100 110 120

Profit ($)Terminal

stock price ($)

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Payoffs from OptionsPayoffs from OptionsWhat is the Option Position in Each Case?What is the Option Position in Each Case?

KK = Strike price, = Strike price, SSTT = Price of asset at = Price of asset at maturitymaturityPayoff Payoff

ST STK

K

Payoff Payoff

ST STK

K

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Types of TradersTypes of Traders

• Hedgers

• Speculators

• Arbitrageurs

Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

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Types of OptionsTypes of Options

A call is an option to buyA call is an option to buy A put is an option to sellA put is an option to sell A European option can be exercised A European option can be exercised

only at the end of its lifeonly at the end of its life An American option can be exercised An American option can be exercised

at any timeat any time

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Assets UnderlyingAssets UnderlyingExchange-Traded Exchange-Traded

OptionsOptions

StocksStocks Stock Indices Stock Indices Foreign Foreign

CurrencyCurrency CommodityCommodity FuturesFutures

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Specification ofSpecification ofExchange-Traded Exchange-Traded

OptionsOptions Expiration dateExpiration date Strike priceStrike price European or AmericanEuropean or American Call or Put (option Call or Put (option

class)class)

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TerminologyTerminology

Moneyness :Moneyness :At-the-money optionAt-the-money option In-the-money optionIn-the-money optionOut-of-the-money optionOut-of-the-money option

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TerminologyTerminology(continued)(continued)

Option PremiumOption Premium Option seriesOption series Intrinsic valueIntrinsic value Time valueTime value

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Executive Stock OptionsExecutive Stock Options

Option issued by a company to Option issued by a company to executivesexecutives

When the option is exercised the When the option is exercised the company issues more stock company issues more stock

Usually at-the-money when issuedUsually at-the-money when issued

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Executive Stock Executive Stock Options continuedOptions continued

They become vested after a period ot They become vested after a period ot timetime

They cannot be soldThey cannot be sold They often last for as long as 10 or They often last for as long as 10 or

15 years15 years

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Types of OptionsTypes of Options

A call is an option to buyA call is an option to buy A put is an option to sellA put is an option to sell A European option can be exercised A European option can be exercised

only at the end of its lifeonly at the end of its life An American option can be exercised An American option can be exercised

at any timeat any time

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Assets UnderlyingAssets UnderlyingExchange-Traded Exchange-Traded

OptionsOptions

StocksStocks Foreign Foreign

CurrencyCurrency Stock IndicesStock Indices FuturesFutures

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Specification ofSpecification ofExchange-Traded Exchange-Traded

OptionsOptions Expiration dateExpiration date Strike priceStrike price European or AmericanEuropean or American Call or Put (option Call or Put (option

class)class)

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TerminologyTerminology

Moneyness :Moneyness :At-the-money optionAt-the-money option In-the-money optionIn-the-money optionOut-of-the-money optionOut-of-the-money option

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TerminologyTerminology(continued)(continued)

Option classOption class Option seriesOption series Intrinsic valueIntrinsic value Time valueTime value

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Market MakersMarket Makers

Most exchanges use market makers Most exchanges use market makers to facilitate options tradingto facilitate options trading

A market maker quotes both bid and A market maker quotes both bid and ask prices when requestedask prices when requested

The market maker does not know The market maker does not know whether the individual requesting whether the individual requesting the quotes wants to buy or sellthe quotes wants to buy or sell

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Trading Strategies Trading Strategies Involving OptionsInvolving Options

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Three Alternative Three Alternative StrategiesStrategies

Take a position in the option Take a position in the option and the underlyingand the underlying

Take a position in 2 or more Take a position in 2 or more options of the same type options of the same type (A spread) (A spread)

Combination: Take a position Combination: Take a position in a mixture of calls & puts in a mixture of calls & puts (A combination) (A combination)

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Positions in an Option Positions in an Option & the & the

UnderlyingUnderlying

Profit

STK

Profit

ST

K

Profit

ST

K

Profit

STK

(a) (b)

(c)

(d)

Long Stock

Short Call

Long Stock

Long Put

Short Stock

Long Call

Short Stock

Short Put

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Bull Spread Using CallsBull Spread Using Calls

K1 K2

Profit

ST

Long Call (K1)Short Call (K2)

K2> K1

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Bull Spread Using PutsBull Spread Using Puts

K1 K2

Profit

ST

Long Put (K1)Short Put (K2)

K2> K1

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Bear Spread Using CallsBear Spread Using Calls

K1 K2

Profit

ST

Short Call (K1)Long Call (K2)

K2> K1

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Bear Spread Using PutsBear Spread Using Puts

K1 K2

Profit

ST

Short Put (K1)Long Put (K2)

K2> K1

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Butterfly Spread Using Butterfly Spread Using CallsCalls

K1 K3

Profit

STK2

Long Call (K1)Long Call (K3)

Short 2 Calls (K2)K3>K2>K1

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Butterfly Spread Using Butterfly Spread Using PutsPuts

K1 K3

Profit

STK2

Long Put (K1)Long Put (K3)

Short 2 Puts (K2)K3>K2>K1

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OptionsOptions

A call option A call option is an option to is an option to buy a certain buy a certain asset by a asset by a certain date certain date for a certain for a certain price (the price (the strike price)strike price)

A put is an A put is an option to sell option to sell a certain a certain asset by a asset by a certain date certain date for a certain for a certain price (the price (the strike price)strike price)

Page 59: IIM, CALCUTTA

Long Call on MicrosoftLong Call on Microsoft Profit from buying a European call option on Profit from buying a European call option on

Microsoft: option price = $5, strike price = $60Microsoft: option price = $5, strike price = $60

30

20

10

0-5

30 40 50 60

70 80 90

Profit ($)

Terminalstock price ($)

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Short Call on MicrosoftShort Call on Microsoft Profit from writing a European call option on Profit from writing a European call option on

Microsoft: option price = $5, strike price = $60Microsoft: option price = $5, strike price = $60

-30

-20

-10

05

30 40 50 60

70 80 90

Profit ($)

Terminalstock price ($)

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Long Put on IBMLong Put on IBM

Profit from buying a European put option on Profit from buying a European put option on IBM: option price = $7, strike price = $90IBM: option price = $7, strike price = $90

30

20

10

0

-790807060 100 110 120

Profit ($)

Terminalstock price ($)

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Short Put on IBMShort Put on IBM Profit from writing a European put option on Profit from writing a European put option on

IBM: option price = $7, strike price = $90IBM: option price = $7, strike price = $90

-30

-20

-10

7

090

807060

100 110 120

Profit ($)Terminal

stock price ($)

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Payoffs from OptionsPayoffs from OptionsWhat is the Option Position in Each Case?What is the Option Position in Each Case?

KK = Strike price, = Strike price, SSTT = Price of asset at = Price of asset at maturitymaturityPayoff Payoff

ST STK

K

Payoff Payoff

ST STK

K

Page 64: IIM, CALCUTTA

Types of TradersTypes of Traders

• Hedgers

• Speculators

• Arbitrageurs

Some of the large trading losses in derivatives occurred because individuals who had a mandate to hedge risks switched to being speculators

Page 65: IIM, CALCUTTA

Types of OptionsTypes of Options

A call is an option to buyA call is an option to buy A put is an option to sellA put is an option to sell A European option can be exercised A European option can be exercised

only at the end of its lifeonly at the end of its life An American option can be exercised An American option can be exercised

at any timeat any time

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TerminologyTerminology(continued)(continued)

Option PremiumOption Premium Option seriesOption series Intrinsic valueIntrinsic value Time valueTime value

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Executive Stock OptionsExecutive Stock Options

Option issued by a company to Option issued by a company to executivesexecutives

When the option is exercised the When the option is exercised the company issues more stock company issues more stock

Usually at-the-money when issuedUsually at-the-money when issued

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Executive Stock Executive Stock Options continuedOptions continued

They become vested after a period ot They become vested after a period ot timetime

They cannot be soldThey cannot be sold They often last for as long as 10 or They often last for as long as 10 or

15 years15 years

Page 69: IIM, CALCUTTA

Types of OptionsTypes of Options

A call is an option to buyA call is an option to buy A put is an option to sellA put is an option to sell A European option can be exercised A European option can be exercised

only at the end of its lifeonly at the end of its life An American option can be exercised An American option can be exercised

at any timeat any time

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Assets UnderlyingAssets UnderlyingExchange-Traded Exchange-Traded

OptionsOptions

StocksStocks Foreign Foreign

CurrencyCurrency Stock IndicesStock Indices FuturesFutures

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Specification ofSpecification ofExchange-Traded Exchange-Traded

OptionsOptions Expiration dateExpiration date Strike priceStrike price European or AmericanEuropean or American Call or Put (option Call or Put (option

class)class)

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FINANCIAL FUTURESFINANCIAL FUTURES Futures is a SFutures is a Securityecurity trading in the trading in the

Futures ExchangeFutures Exchange.. Futures are securities (like Bonds) while Futures are securities (like Bonds) while

Forwards are agreements (like loans).Forwards are agreements (like loans). So, Futures have standardized (by Futures So, Futures have standardized (by Futures

Exchange) features. They have given face Exchange) features. They have given face values; given periods of maturity; values; given periods of maturity; transparant costing. transparant costing.

On the other hand, Forward contracts On the other hand, Forward contracts (being like loans) are negotiable and tailor-(being like loans) are negotiable and tailor-made, and their costing is not transparant.made, and their costing is not transparant.

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Price of Futures is related to the Price of Futures is related to the Price of the underlying Asset.Price of the underlying Asset.

If Price of underlying assets If Price of underlying assets increases Price of Futures increases Price of Futures increasesincreases

If Price of underlying assets If Price of underlying assets decreases Price of Futures decreases Price of Futures decreasesdecreases

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Underlying Asset –Stock Stock Futures

Underlying Asset -Stock Index Stock Index Futures Underlying Asset –Currency Currency Futures (£,¥,CHF,Euro) (₤,¥,CHF,Euro)

Underlying Asset Bond Bond/Interest rate Futures

Underlying Asset- Commodity Commodity Futures(Wheat,Brent Crude) ( Wheat, Brent Crude)

Note that there is NO US Dollar Currency Futures)

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FUTURES- ContdFUTURES- Contd While Forward contracts have While Forward contracts have

credit/default risk associated with them, credit/default risk associated with them, Futures do NOT have any such risk Futures do NOT have any such risk because of the following mechanisms:-because of the following mechanisms:-

Sellers and Buyers of Futures deal with Sellers and Buyers of Futures deal with the Futures Exchange (the Clearing the Futures Exchange (the Clearing Corporation) rather than among Corporation) rather than among themselves.themselves.

The system of Futures trading involves a The system of Futures trading involves a process of daily margining and marking process of daily margining and marking to market.to market.

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In India, there are Stock & Stock Index In India, there are Stock & Stock Index Futures and commodity Futures. The Futures and commodity Futures. The settlement dates for Stock and Stock settlement dates for Stock and Stock Index Futures are the last Thursday (or Index Futures are the last Thursday (or the previous business day if the relevant the previous business day if the relevant Thursday is a holiday for some reason) of Thursday is a holiday for some reason) of the current month (near month Futures the current month (near month Futures contract), of the next month (middle contract), of the next month (middle month Futures contract) and of the next month Futures contract) and of the next to next month (far month Futures to next month (far month Futures contract). contract).

After the last Thursday of the current After the last Thursday of the current month, a new contract is available (the month, a new contract is available (the far Month Contract) and the erstwhile far Month Contract) and the erstwhile middle month, and far month contracts middle month, and far month contracts now become the near month and middle now become the near month and middle month contracts respectively.month contracts respectively.

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Currency Futures, trading on IMM Currency Futures, trading on IMM (International Money Market), a part of the (International Money Market), a part of the CME (Chicago Mercantile Exchange) and CME (Chicago Mercantile Exchange) and LIFFE (London International Financial LIFFE (London International Financial Futures Exchange) have the following Futures Exchange) have the following standard sizes:-standard sizes:-

£ (Pound) Futures – Face value of each £ (Pound) Futures – Face value of each contract = £ 62,500/-contract = £ 62,500/-

¥ (Japanese Yen) Futures - Face value of ¥ (Japanese Yen) Futures - Face value of each contract = ¥ 12,500,000/-each contract = ¥ 12,500,000/-

CHF (Swiss Franc) Futures - Face value of CHF (Swiss Franc) Futures - Face value of each contract = CHF 125,000/-each contract = CHF 125,000/-

€ € (Euro) Futures - Face value of each (Euro) Futures - Face value of each contract = € 125,000/-contract = € 125,000/-

All these are quoted in terms of US Dollar All these are quoted in terms of US Dollar corresponding to one unit ( 100 units in case corresponding to one unit ( 100 units in case of Japanese Yen) of the relative currency.of Japanese Yen) of the relative currency.

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1.1. Convergence of Price of Futures Convergence of Price of Futures and Price of underlying asset on and Price of underlying asset on the date of settlement of Futures the date of settlement of Futures contracts must take place because contracts must take place because otherwise arbitrage opportunities otherwise arbitrage opportunities leading to riskless profits will arise. leading to riskless profits will arise. As a matter of fact, such As a matter of fact, such arbitrages between the spot market arbitrages between the spot market and the Futures market ensure the and the Futures market ensure the convergence at equilibrium.convergence at equilibrium.

Page 79: IIM, CALCUTTA

Hedging with Forward Hedging with Forward ContractContract

Spot Exchange Rate on

settlement date

Rate as per Forward Contract

Rate for purchase of Foreign ExchangeSettlement Date