INTRODUCTION TO FUTURE PRESENTATION BY Dr. Rana Singh Associate Professor.

INTRODUCTION TO FUTUREINTRODUCTION TO FUTUREPRESENTATION BYPRESENTATION BY

Dr. Rana SinghDr. Rana SinghAssociate ProfessorAssociate Professor

The Role of Forward The Role of Forward Market Market

A Forward is an obligation to buy or sell a A Forward is an obligation to buy or sell a financial instrument or physical commodity financial instrument or physical commodity at some date in the future at an agreed price. at some date in the future at an agreed price.

For our purposes, forwards include over-For our purposes, forwards include over-the-counter(OTC) forward contracts and the-counter(OTC) forward contracts and exchange-traded (ET) futures contracts.exchange-traded (ET) futures contracts.

Forward contracts represent a starting point Forward contracts represent a starting point for all derivative valuation.for all derivative valuation.

InstrumentsInstruments

The following instruments are included in these The following instruments are included in these two groups that make up Forwards:two groups that make up Forwards:

Foreign Exchange Forward contractsForeign Exchange Forward contracts Forward Rate AgreementsForward Rate Agreements Forward BondsForward Bonds Short-term interest rate futuresShort-term interest rate futures Bond FuturesBond Futures Stock index futuresStock index futures Commodity futures contractsCommodity futures contracts

Forward Vs Cash Forward Vs Cash TransactionsTransactions

We might expects any transaction that settles today to be a We might expects any transaction that settles today to be a cash transactioncash transaction and anything settling from tomorrow and anything settling from tomorrow onward to be a onward to be a Forward.Forward.

Unfortunately, this is not always the case and depending Unfortunately, this is not always the case and depending on the underlying financial asset, a cash transaction can on the underlying financial asset, a cash transaction can range from today for a money market transaction to range from today for a money market transaction to several weeks, or longer in some securities markets. several weeks, or longer in some securities markets.

A forward transaction does not commence until the A forward transaction does not commence until the settlement day passes the cash settlement date. settlement day passes the cash settlement date.

Eg.In foreign exchange market, a Forward is a transaction Eg.In foreign exchange market, a Forward is a transaction that settles after two business days. In the Indian Equity that settles after two business days. In the Indian Equity market minimum Forward we can have is 8 days. market minimum Forward we can have is 8 days.

Future Future

A future contract is an agreement A future contract is an agreement between two parties to buy or sell an between two parties to buy or sell an underlying asset at a certain time in underlying asset at a certain time in ffuture at a certain price.uture at a certain price.

FFuture uture IIndex is a type of derivative ndex is a type of derivative contracts which derive their value from contracts which derive their value from an underlying index. an underlying index.

Deriving the Forward PriceDeriving the Forward Price

Calculating the forward price is the same as asking the Calculating the forward price is the same as asking the question –question –How much should I pay to buy something How much should I pay to buy something in the Futurein the Future??

A forward transaction can be replicated by purchasing A forward transaction can be replicated by purchasing the asset today and borrowing the money to finance it.the asset today and borrowing the money to finance it.

The fair forward price indicates the price at which The fair forward price indicates the price at which buyers and sellers are indifferent to buying and selling buyers and sellers are indifferent to buying and selling the underlying asset today or in the future,based on the the underlying asset today or in the future,based on the current market cash price,cost of financing the asset current market cash price,cost of financing the asset and the expected return on the asset. and the expected return on the asset.


The “Fair” forward price is given by the The “Fair” forward price is given by the cash price plus the net cost of financing the cash price plus the net cost of financing the asset over the term of the Forward contract.asset over the term of the Forward contract.

The The interest costinterest cost tends to tends to increaseincrease the the forward price versus the cash price.forward price versus the cash price.

Any Any cash returncash return on the asset over the term on the asset over the term of the forward contract tends to of the forward contract tends to decreasedecrease the forward price versus the cash price.the forward price versus the cash price.


These general rules should apply to all forward prices These general rules should apply to all forward prices on financial assets, regardless of whether it is an on financial assets, regardless of whether it is an interest rate, foreign exchange or equity product, interest rate, foreign exchange or equity product, provided they operate in freely operating markets.provided they operate in freely operating markets.

It is worth noting that these relationships start to It is worth noting that these relationships start to break down when we move away from financial break down when we move away from financial assets,particularly to consumable commodities. This assets,particularly to consumable commodities. This is so because the decision to have the physical is so because the decision to have the physical commodity today or in the future also has to take into commodity today or in the future also has to take into consideration when the commodity is required for consideration when the commodity is required for consumption. consumption.

Price for Forward and Price for Forward and FuturesFutures The cost of CARRY model: Forward(or Futures)=(Spot Price+Carry Cost-

Carry Return)– F=S0+CC-CR

Spot Price = Current Price Carry Cost = Holding Cost, Interest Charges

on Borrowing.- Insurance,Storage Costs etc. Carry Return= Dividends

Forward Pricing FormulaeForward Pricing Formulae

We will develop three formulae for pricing We will develop three formulae for pricing forward transactions. These formulae vary forward transactions. These formulae vary depending on the nature of the income steam depending on the nature of the income steam generated by the underlying financial asset during generated by the underlying financial asset during the period of time to the forward expiry date.the period of time to the forward expiry date.

The three forms considered are assets that payThe three forms considered are assets that pay• No incomeNo income

• Constant incomeConstant income

• Lumpy IncomeLumpy Income

No IncomeNo Income

Financial Asset Pays No IncomeFinancial Asset Pays No Income F= S * {1+r * (f/D)}F= S * {1+r * (f/D)}

• F=Forward PriceF=Forward Price

• S=Cash or Spot price of the underlying instrument.S=Cash or Spot price of the underlying instrument.

• r= interest rate to forward rate (preferably zero-coupon r= interest rate to forward rate (preferably zero-coupon rate)rate)

• Accurate pricing requires Zero-coupon yields.Accurate pricing requires Zero-coupon yields.

• D= Day count basis (365 or 360)D= Day count basis (365 or 360)

• f= Number of days to the forward expiry date.f= Number of days to the forward expiry date.

Constant IncomeConstant Income

Financial Asset Pays Constant rate of incomeFinancial Asset Pays Constant rate of income F=S * {1+(r –q)* (f/D)}F=S * {1+(r –q)* (f/D)}

• F=Forward PriceF=Forward Price

• S=Cash or Spot price of the underlying instrument.S=Cash or Spot price of the underlying instrument.

• r= interest rate to forward rater= interest rate to forward rate

• q= Asset Income expressed as a % pa.q= Asset Income expressed as a % pa.

• D= Day count basis (365 or 360)D= Day count basis (365 or 360)

• f= Number of days to the forward expiry date.f= Number of days to the forward expiry date.

Lumpy IncomeLumpy Income Financial asset pays income only at certain points over its life.Financial asset pays income only at certain points over its life. F=S * {1+(rF=S * {1+(r11* (f* (f11/D))} – c* (1 +(r/D))} – c* (1 +(r22*(f*(f22/D))/D))

• F=Forward PriceF=Forward Price• S=Cash or Spot price of the underlying instrument.S=Cash or Spot price of the underlying instrument.• rr11 = interest rate to forward rate = interest rate to forward rate• rr22= interest rate between the income payment and forward expiry dates= interest rate between the income payment and forward expiry dates• c= Asset Income expressed in the same units as the cash price.c= Asset Income expressed in the same units as the cash price.• D= Day count basis (365 or 360)D= Day count basis (365 or 360)• ff11 = Number of days to the forward expiry date. = Number of days to the forward expiry date.• ff22= Number of days between the income payment and forward expiry = Number of days between the income payment and forward expiry

dates.dates.

Forward Price ExampleForward Price ExampleYou intend to buy a security 180 days forward. The current spot price is $90 and the 6 month interest rate is 6.7% pa (A/360). Calculate the forward price under the following three asset income scenarios.

No IncomeIncome paid at rate of 8% pa on a constatnt basisA lump sum of $.4.50 will be paid in 91 days- assume the 3 month interest rate inthree months is also 6.7% pa.

1) No income S=$90 r=0.067 f=180 D=360

F=S* (1 + (r*f/D)= 93.02

2) Income = 8% pa constant S=$90 r=0.067 f=180 D=360 q=0.08F=S* (1+((r-q)* f/D))= 89.42

3) Income = Lump sum payment of $4.50 S=$90 r1=0.067 r2=0.067 f1=180 f2=89 D=360 c=4.50F=S*(1+(r1*f1/D))-c*(1+(r2*f2/D)= 88.44

Valuation on the Forward Valuation on the Forward

Forward value= Forward bond value- Forward value= Forward bond value- Forward contract priceForward contract price

Forward bond value is the value of all of the Forward bond value is the value of all of the cash flows created by the bond after the cash flows created by the bond after the forward expiry date.(Forward Spot Value)forward expiry date.(Forward Spot Value)

Forward contract price is the price agreed Forward contract price is the price agreed under the forward contract.under the forward contract.

It is described as the “pay-off” of the forward It is described as the “pay-off” of the forward contract and the graphical representation as a contract and the graphical representation as a “pay-off diagram”.“pay-off diagram”.

Long futures positionLong futures position

Strike price 140

Spot Price Buy Future120 -20125 -15130 -10135 -5140 0145 5150 10155 15160 20165 25170 30175 35180 40185 45190 50195 55200 60205 65210 70

LONG FUTURES POSITION ON ACC

Long Futures PositionLong Futures Position

Long Future

-30

-20-10

010

2030

4050

6070

80

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

Long Future

FORWARD Vs FORWARD Vs FUTURE FUTURE

OTC in natureOTC in nature Customised contract Customised contract

terms henceterms hence• Less LiquidLess Liquid

• No Secondary marketNo Secondary market

No margin PaymentNo margin Payment Settlement happens at Settlement happens at

end of period end of period

Trade on an organised Trade on an organised exchangeexchange

Standardised contract Standardised contract terms henceterms hence

• More liquidMore liquid

• Secondary marketSecondary market Requires margin Requires margin

requirementrequirement Follows daily settlementFollows daily settlement

Valuation Differences Valuation Differences between Forward & between Forward & FuturesFutures

AnAn OTC and a Futures contract with the same OTC and a Futures contract with the same forward expiry date should have the same forward expiry date should have the same forward price.forward price.

The differences between OTC and ET futures The differences between OTC and ET futures contracts arise from the fact that futures contracts contracts arise from the fact that futures contracts are subject to daily mark-to-markets (the price is are subject to daily mark-to-markets (the price is calculated based on the daily market price) and calculated based on the daily market price) and upfront initial margins. upfront initial margins.

FOREX FORWARDSFOREX FORWARDS

Foreign ExchangeForeign Exchange (FX) transaction represents the (FX) transaction represents the largest OTC market with daily turnover in excess of largest OTC market with daily turnover in excess of one trillion dollars a day.one trillion dollars a day.

FX transaction represents an agreement to exchange FX transaction represents an agreement to exchange one currency for another. one currency for another.

Instruments;Instruments;• Short-term FX ForwardsShort-term FX Forwards• Long-term FX forwardsLong-term FX forwards• Par ForwardsPar Forwards• Currency FuturesCurrency Futures

FOREX QUOTATIONFOREX QUOTATION

In any FX quotation it is essential to know which In any FX quotation it is essential to know which currency is the currency is the basebase currency and which is currency and which is termterm currency.currency.

In a quote , the base currency is the unit or the In a quote , the base currency is the unit or the currency that is held constant and the terms currency that is held constant and the terms currency is the variable part of the quote.currency is the variable part of the quote.

To put it another way, the exchange rate quotation To put it another way, the exchange rate quotation is the price of the base currency in “terms” of the is the price of the base currency in “terms” of the term currency.term currency.

It represents the bulk of FX turnoverIt represents the bulk of FX turnover They are an agreement between two parties They are an agreement between two parties

on an exchange of currency cash flows at on an exchange of currency cash flows at some date after the cash,or spot, FX some date after the cash,or spot, FX transactions settle.transactions settle.

The market for forward FX is very liquid The market for forward FX is very liquid and has been in existence since the floating and has been in existence since the floating of the exchange rates in the 1970s.of the exchange rates in the 1970s.

Short-term Forward FX Short-term Forward FX TransactionsTransactions

Short-term Forward FX Short-term Forward FX TransactionsTransactions

Forward FX transaction are comprised of the Forward FX transaction are comprised of the simultaneously execution of a spot FX transaction and simultaneously execution of a spot FX transaction and a money market borrowing and lending.a money market borrowing and lending.

Synthetic Forward Purchase Example:A company will Synthetic Forward Purchase Example:A company will receive US$ in 6 months’ time that it wants to convert receive US$ in 6 months’ time that it wants to convert immediately into JPY. It is concerned that JPY will immediately into JPY. It is concerned that JPY will rise against the US$. It is not permitted to use rise against the US$. It is not permitted to use derivatives so it must create the forward using only derivatives so it must create the forward using only cash instruments. cash instruments.

To do this the Company buys JPY against the US$ at To do this the Company buys JPY against the US$ at a spot rate of 103. a spot rate of 103.

Short-term Forward FX TransactionsShort-term Forward FX Transactions

The settlement of this spot transaction in two days requires The settlement of this spot transaction in two days requires the company to pay its counter-party US$ and receive JPY.the company to pay its counter-party US$ and receive JPY.

To fund the US$ settlement, the company borrows in the To fund the US$ settlement, the company borrows in the US$ money market for 6 months and it invests the JPY US$ money market for 6 months and it invests the JPY received for six months.received for six months.

At the end of six months the US$ are received and use to At the end of six months the US$ are received and use to repay the money market borrowing and JPY money market repay the money market borrowing and JPY money market investment matures. investment matures.

The implied forward FX rate is then given by the respective The implied forward FX rate is then given by the respective currency balances at the end of six months.currency balances at the end of six months.

Since the interest rate in US is higher than the Japan the Since the interest rate in US is higher than the Japan the premia is at discount.premia is at discount.

Figure 6.4 - Synthetic forward purchase example

Current market rates : Spot JPY/USD: 103 6 month JPY rate - % pa A/365 2.50% 6 month USD rate - % pa A/360 6.50%

Cashflows JPY USDDay 0 Spot FX : Buy JPY at 103

Day 2 Settle Spot FX 500,000,000 (4,854,369) Invest JPY at 2.5%pa (500,000,000) Borrow USD at 6.5%pa 4,854,369

Day 182 Money market interest 6,164,384 (157,767)

Currency Balances 506,164,384 5,012,136

Effective Forward FX rate = 506,164,384 / 5,012,136= 100.99

Spot JPY/USD ForwardJPY/USD

JPYMoney Mkt

USDMoney Mkt

Buy JPY 500m, sell USD 4.85M

Invest JPY at 2.5% for 6 mths

Borrow USD at 6.5% for 6mths

JPY/USD 6mths Forward at 100.99

A model for Forward FX A model for Forward FX PricesPrices

Short –Term Forward Exchange Price:Short –Term Forward Exchange Price: F=(S*(1+rF=(S*(1+rTT)*f/D)*f/DTT)/((1+ r)/((1+ rBB)*f/D)*f/DBB))

• F=Forward Exchange RateF=Forward Exchange Rate• S=Spot Exchange Rate.S=Spot Exchange Rate.• rrTT = Terms Currency interest rate to forward rate = Terms Currency interest rate to forward rate• rrBB= Base currency interest rate to forward rate= Base currency interest rate to forward rate• DDTT = Term Currency Day count basis (365 or 360) = Term Currency Day count basis (365 or 360)• DDB B = Base Currency Day count basis (365 or 360)= Base Currency Day count basis (365 or 360)• ff11 = Number of days to the forward expiry date. = Number of days to the forward expiry date.• f= Number of days to the forward expiry date from the spot f= Number of days to the forward expiry date from the spot

settlement date.settlement date.

Forward pricing example

The current spot rate for USD/CAD is 1.3513. Calculate the rate ofa forward FX deal settling in 30days from the spot date. The 1month US$ interest rate is 6.25% p.a and the CAD rate is 8.2%p.a. Calculate the implied forward FX rate.

S = 1.3513 f = 30

rT = 8.20% DT = 365

rB = 6.25% DB = 360

F = S x ( 1 + rT ) x f / DT ( 1 + rB ) x f / DB

= 1.3513 x ( 1 + .082 ) x 30 / 365 ( 1 + .0625 ) x 30 / 360

= 1.3534

Forward Points = 0.0021 premium

AssumptionsAssumptions

Simple Interest:Simple Interest: There is assumed to be no There is assumed to be no compounding in the interest calculation.compounding in the interest calculation.

Zero-couponZero-coupon:The interest rate assumed to :The interest rate assumed to be zero coupon rates.This is generally an be zero coupon rates.This is generally an appropriate assumption for forward FX appropriate assumption for forward FX deals of up to six months; most interest deals of up to six months; most interest rates longer than that contain reinvestment rates longer than that contain reinvestment risk.risk.

Long –Term Forward FX Long –Term Forward FX Transactions(LTFX)Transactions(LTFX)

It is a longer term version of the Forward FX It is a longer term version of the Forward FX transaction.transaction.

Any Forward contract longer than six months are Any Forward contract longer than six months are LTFX.LTFX.

LTFX contracts are a relatively small proportion LTFX contracts are a relatively small proportion of total FX market volume.of total FX market volume.

Typically ,LTFX contracts are associated with Typically ,LTFX contracts are associated with hedging FX exposures created by long-term hedging FX exposures created by long-term borrowing.borrowing.

LTFX (Assumptions)LTFX (Assumptions) Zero-coupon yieldZero-coupon yield:The forward pricing and valuation :The forward pricing and valuation

models assume that there are no interest cash flow models assume that there are no interest cash flow during the forward period-hence the interest rates are during the forward period-hence the interest rates are zero-coupon rates.This is a reasonable assumption when zero-coupon rates.This is a reasonable assumption when using money market interest rates. However, the quoted using money market interest rates. However, the quoted yields in most currencies that have a term to maturity of yields in most currencies that have a term to maturity of more than one year are usually coupon-paying interest more than one year are usually coupon-paying interest rates. The difficulty with coupon-paying interest rates is rates. The difficulty with coupon-paying interest rates is that there is a reinvestment risk associated with each that there is a reinvestment risk associated with each coupon payment.To price LTFX, this risk has to be coupon payment.To price LTFX, this risk has to be removed by deriving zero coupon interest rates.removed by deriving zero coupon interest rates.

LTFX (Assumptions)LTFX (Assumptions)

Compounding:Compounding: Longer term interest rates Longer term interest rates are expressed typically as compound are expressed typically as compound interest rates; accordingly , compounding interest rates; accordingly , compounding also needs to be incorporated into the also needs to be incorporated into the model.model.

LTFX (Price)LTFX (Price) F=(S*(1+rF=(S*(1+rTT)*f/m)*f/mTT))nn

TT /((1+ r /((1+ rBB)*f/m)*f/mBB))nnBB

• F=Forward Exchange RateF=Forward Exchange Rate• S=Spot Exchange Rate.S=Spot Exchange Rate.• rrTT = Terms Currency zero-coupon interest rate to forward = Terms Currency zero-coupon interest rate to forward

raterate• rrBB= Base currency zero-coupon interest rate to forward rate= Base currency zero-coupon interest rate to forward rate• mmTT = Term Currency payment frequency (1,2,3,…) = Term Currency payment frequency (1,2,3,…)• mmB B = Base Currency payment frequency (1,2,3,…)= Base Currency payment frequency (1,2,3,…)• nnTT = Terms currency of payment periods to the forward date. = Terms currency of payment periods to the forward date.• nnB B = Basis currency of payment periods to the forward date.= Basis currency of payment periods to the forward date.

LTFX Pricing and Sensitivities

The tables below shows the sensitivity of a 5 year JPY/USD LTFX deal to changes inboth the interest differential and the spot exchange rate. A feature of LTFX transactionsis the increasing importance of the interest differential the longer the term to expiry. Inthis 5 year deal the impact of a move in the exchange rate of 1% is approximatelyequal to a change in the interest differential of 0.20%p.a

Market DataSpot FX rate 101.00USD 5 Year rate % p.a (sa) 6.20JPY 5 Year rate % p.a (sa) 2.50Interest Differential % p.a 3.70

LTFX Price = S x ( 1 + rT / mT ) n̂T ( 1 + rB / mB ) n̂B

= 101 x ( 1 + 0.025/2) 1̂0 ( 1 + 0.062/2) 1̂0

= 84.2723374

The sensitivities of this position in foreign exchange points are as follows

PVBP = -0.0368That is, a 1bp rise in the interest differential will decrease the present value of theposition by 0.0368 fx points.

PVFP = 0.0074That is, a 0.01 change in the spot FX rate will alter the presentvalue by 0.0074

PVD = 0.0075Each day that passes increases the present value by 0.0075 fx points.

89 9510

110

7

113

5.7

4.1

2.5

0.9

60

70

80

90

100

110

LTFX

Price

Spot FX rate

Interest Differential

LTFX Price Sensitivity

100-110

90-100

80-90

70-80

60-70

PAR FORWARDSPAR FORWARDS

Another form of LTFX is the Par-Forward.Another form of LTFX is the Par-Forward. It is a series of LTFX contracts.It is a series of LTFX contracts. In terms of the present value of these transactions , In terms of the present value of these transactions ,

the economics of a par –forward & series of the economics of a par –forward & series of LTFX are same. LTFX are same.

In terms of the FX transaction, there have little In terms of the FX transaction, there have little added value than LTFX. added value than LTFX.

The advantage is that they can very useful for cash The advantage is that they can very useful for cash flow management and tax planning. flow management and tax planning.

PAR FORWARDSPAR FORWARDS

AA Swiss based distribution company is Swiss based distribution company is about to commence importing equipment about to commence importing equipment from the US.from the US.

It has signed a 5-year contract that will It has signed a 5-year contract that will require it to buy US $ 10 million of require it to buy US $ 10 million of equipment every quarter. equipment every quarter.

Market Parameters LTFX Cashflows Par Forward Net CHF Net CHFZero Zero Forward USD CHF CHF Funding FundingUSD Rate CHF Rate FX rate Amount Amount Amount Difference NPV

1 5.7500 2.0000 1.1196 10,000,000 11,195,564 10,470,118 -725,446 (721,837) 2 5.7500 2.0000 1.1092 10,000,000 11,092,093 10,470,118 -621,975 (615,802) 3 5.7817 2.0628 1.0992 10,000,000 10,992,155 10,470,118 -522,037 (514,043) 4 5.8134 2.1257 1.0895 10,000,000 10,894,820 10,470,118 -424,702 (415,793) 5 5.8358 2.2508 1.0810 10,000,000 10,809,644 10,470,118 -339,526 (330,133) 6 5.8582 2.3759 1.0731 10,000,000 10,730,621 10,470,118 -260,504 (251,409) 7 6.6166 2.8575 1.0589 10,000,000 10,588,703 10,470,118 -118,585 (112,821) 8 7.3751 3.3391 1.0435 10,000,000 10,434,820 10,470,118 35,297 33,026 9 7.2463 3.4347 1.0383 10,000,000 10,383,014 10,470,118 87,104 80,653

10 7.1175 3.5304 1.0343 10,000,000 10,342,908 10,470,118 127,210 116,508 11 7.0405 3.6254 1.0300 10,000,000 10,299,796 10,470,118 170,322 154,230 12 6.9634 3.7205 1.0266 10,000,000 10,265,579 10,470,118 204,539 183,032 13 6.9159 3.8062 1.0227 10,000,000 10,227,428 10,470,118 242,690 214,577 14 6.8685 3.8920 1.0196 10,000,000 10,196,121 10,470,118 273,997 239,261 15 6.8380 3.9668 1.0161 10,000,000 10,161,093 10,470,118 309,025 266,506 16 6.8076 4.0416 1.0131 10,000,000 10,131,450 10,470,118 338,668 288,347 17 6.7881 4.1057 1.0098 10,000,000 10,097,918 10,470,118 372,200 312,883 18 6.7686 4.1697 1.0069 10,000,000 10,068,646 10,470,118 401,472 333,110 19 6.7534 4.2142 1.0032 10,000,000 10,032,394 10,470,118 437,724 358,691 20 6.7382 4.2587 0.9999 10,000,000 9,999,221 10,470,118 470,897 381,012

Net CHF NPV (Target) (0)

Summary of Results (0) Average LTFX rate = 1.0447Funding Cost = 0.0023Par Forward rate = 1.0470

How this Spreadsheet works

1. Generate the Zero Coupon interest rates (on a quarterly basis for columns B and C)2. Calculate the LTFX rates in Column C 3. Calculate the USD and CHF cashflows for each quarterly roll for column E and F.4. Enter a "guess" of the Par Forward Rate an enter into the cell labelled "Unrounded Par Forward"5. Calculate the Par Forward CHF amount in column H by multiplying the USD amount by the Unrounded Par Forward Amount.6. The Net CHF amount is simply the difference between columns F and G

How this Spreadsheet works

1. Generate the Zero Coupon interest rates (on a quarterly basis for columns B and C)2. Calculate the LTFX rates in Column C 3. Calculate the USD and CHF cashflows for each quarterly roll for column E and F.4. Enter a "guess" of the Par Forward Rate an enter into the cell labelled "Unrounded Par Forward"5. Calculate the Par Forward CHF amount in column H by multiplying the USD amount by the Unrounded Par Forward Amount.6. The Net CHF amount is simply the difference between columns F and G7. Calculate the NPV in column I by taking the present value of column H using the CHF zero interest rates and the compound interest present value formula.8. From the Tools menu invoke the "Goal Seek" or "Solver" function9. Make the Net NPV cell (column I ) the target by changing the cell with the Unrounded Par Forward rate so that the target becomes Zero and then press solve, this will iteratively solve for the Unrounded Par Forward Rate which makes the NPV zero.

Currency FuturesCurrency Futures

Currency Futures are an exchange-traded forward FX instrument.Currency Futures are an exchange-traded forward FX instrument. The volume in currency futures is low compared to interest rate The volume in currency futures is low compared to interest rate

futures .futures . The Pricing model underlying currency futures is the short-term The Pricing model underlying currency futures is the short-term

forward FX model. However like all exchange –traded contracts there forward FX model. However like all exchange –traded contracts there are funding cost associated with initial margin and mark-to market are funding cost associated with initial margin and mark-to market requirement, which is unknown when the futures contract is requirement, which is unknown when the futures contract is executed.As a result, the effective forward FX rate of a currency rate executed.As a result, the effective forward FX rate of a currency rate of a currency futures contract will not be known until the contract is of a currency futures contract will not be known until the contract is terminated. This can expressed as follows: terminated. This can expressed as follows: • Effective forward price=Future Price+Funding AdjustmentEffective forward price=Future Price+Funding Adjustment

EXCELEXCEL

INTEREST RATE INTEREST RATE FORWARDSFORWARDS

What is a Forward Rate Agreement (FRA)What is a Forward Rate Agreement (FRA) ??

FRA is an off-balance sheet contract between two counterparties to exchange FRA is an off-balance sheet contract between two counterparties to exchange interest payments for a interest payments for a specified periodspecified period starting in starting in future future – the interest payments are calculated on the notional principalthe interest payments are calculated on the notional principal– the specified period is from the start date to the maturity date the specified period is from the start date to the maturity date – the floating rate is the actual rate on the start date of the swap and available the floating rate is the actual rate on the start date of the swap and available

for the entire specified periodfor the entire specified period

Convention of FRA : 3 X 6 month FRA, at 9.35% against 91-day T-Bill rate on a Convention of FRA : 3 X 6 month FRA, at 9.35% against 91-day T-Bill rate on a notional principal of Rs. 25 croresnotional principal of Rs. 25 crores– 3 X 6 implies specified period : start dates and maturity dates3 X 6 implies specified period : start dates and maturity dates– Fixed rate payer pays 9.35% for 3 months from start date to the maturity dateFixed rate payer pays 9.35% for 3 months from start date to the maturity date– Floating Rate payer pays 91-day T-Bill rate which would be determined on Floating Rate payer pays 91-day T-Bill rate which would be determined on

the start date of the swapthe start date of the swap– the net amount would be settled on the the net amount would be settled on the start datestart date

Trade date Maturity dateStart Date

t=0 t+3m t+6mSpecified Period

INTEREST RATE INTEREST RATE FORWARDSFORWARDSFRAFRA

FRA are the predominant form of OTC forward on FRA are the predominant form of OTC forward on short-term interest rate securities.short-term interest rate securities.

The party that benefits from a fall in interest rate is The party that benefits from a fall in interest rate is defined as the lender or seller of the FRA. defined as the lender or seller of the FRA.

The party that benefits from a rise in interest rate The party that benefits from a rise in interest rate is defined as the borrower or buyer of the FRA.is defined as the borrower or buyer of the FRA.

FRA (PRICE)FRA (PRICE)

FRAs are instruments in which the FRAs are instruments in which the underlying asset is cash providing a constant underlying asset is cash providing a constant income in the form of interest payments.income in the form of interest payments.

The Future value of this cash flow is given The Future value of this cash flow is given byby

FV=S*(1+(q*d/D))FV=S*(1+(q*d/D)) S=Cash Flow q=YTM d=number of days S=Cash Flow q=YTM d=number of days

from today ,until maturity of the asset. from today ,until maturity of the asset.


From the basic formula we know that From the basic formula we know that F=S*(1+(r-q)*(f/D))F=S*(1+(r-q)*(f/D)) Our aim is to express this same concept in terms Our aim is to express this same concept in terms

of a forward interest rate calculation.of a forward interest rate calculation. The interest rate on the forward security will be The interest rate on the forward security will be

equivalent to the difference between the interest equivalent to the difference between the interest earned between today and the forward settlement earned between today and the forward settlement date and the interest earned between today and date and the interest earned between today and the maturity date of the underlying security.the maturity date of the underlying security.

Forward Interest= S*((q*d/D)-(r*f/D))Forward Interest= S*((q*d/D)-(r*f/D))


The forward interest rate can then be expressed as:The forward interest rate can then be expressed as: Forward rate=(Forward interest/Forward Price) x Forward rate=(Forward interest/Forward Price) x

(D/(d-f))(D/(d-f)) rrff= (((q x d/D) – (r x f/D))/(1+(r-q) x (f/D))) x = (((q x d/D) – (r x f/D))/(1+(r-q) x (f/D))) x

(D/(d-f))(D/(d-f)) We know that the future value of using a We know that the future value of using a

continuous rate is a followscontinuous rate is a follows FV=S x exp(q x d/D)FV=S x exp(q x d/D)


ThereforeTherefore S x exp(q *d/D)=S*exp(r x f/D+rS x exp(q *d/D)=S*exp(r x f/D+rff x(d-f)/D) x(d-f)/D) If we cancel S and take the natural logarithm of both sides of this If we cancel S and take the natural logarithm of both sides of this

equation, this simplifies to:equation, this simplifies to: rrff= (q x d/D – r x f/D)/(d/D-f/D)= (q x d/D – r x f/D)/(d/D-f/D) Where Where

• rrff= forward interest rate % pa= forward interest rate % pa• r= interest rate to the forward settlement date %par= interest rate to the forward settlement date %pa• q=interest raet to the maturity date % paq=interest raet to the maturity date % pa• D= day count basis (360 or 365)D= day count basis (360 or 365)• f= number of days to the forward expiry date.f= number of days to the forward expiry date.• d= number of days to the maturity date of the underlying security.d= number of days to the maturity date of the underlying security.

Forward rate agreement calculator

Field CellInputsTrade date 01-Nov-00Forward Settlement date 30-J an-01Underlying Maturity date 30-Apr-01Spot rate to Forward settlement date % 5.5000Frequency (1,2 or 4) 4Interest rate for maturity % 5.8050Frequency (1,2 or 4) 2OutputsTerm to Forward Settlement in days - f 90Term to Maturity in days - d 90Continuous rate to settlement date % - r 5.4625Continuous rate to maturity % - q 5.7224Forward rate % -continuous compounding 5.9822

-quarterly compounding 6.0271 -s.annual compounding 6.0725 -annual compounding 6.1647

FRA Settlement FRA Settlement

If rIf rss> r> rcc, then the settlement sum is, then the settlement sum is

Seller pays buyerSeller pays buyer If rIf rss< r< rcc, then the settlement sum is, then the settlement sum is

Buyer pays SellerBuyer pays Seller WhereWhere

• rrcc= contract rate % pa= contract rate % pa

• rrss= settlement rate % pa= settlement rate % pa

SHORT-TERM INTEREST SHORT-TERM INTEREST RATE FUTURESRATE FUTURES

Short-term interest rate futures represent Short-term interest rate futures represent standardized , exchange –traded forward contracts standardized , exchange –traded forward contracts on money market instruments.on money market instruments.

The pricing and valuation of these instruments is The pricing and valuation of these instruments is very similar to FRAs and the two markets can very similar to FRAs and the two markets can often be viewed as direct substitutes.often be viewed as direct substitutes.

The global volume in these instruments is The global volume in these instruments is enormous, representing the largest single category enormous, representing the largest single category of futures contract.of futures contract.

Eurodollars contract Eurodollars contract The Eurodollar contract was the first global short-term futures The Eurodollar contract was the first global short-term futures

contract listed in 1981 at Chicago Mercantile Exchange(CME).contract listed in 1981 at Chicago Mercantile Exchange(CME). The Eurodollar is a cash-settled contract on a 3-Month The Eurodollar is a cash-settled contract on a 3-Month

Eurodollar time deposit. The name “Eurodollar” derives from Eurodollar time deposit. The name “Eurodollar” derives from the fact it is a forward contract on a US dollar money market the fact it is a forward contract on a US dollar money market instrument traded in Europe.instrument traded in Europe.

The CME lists contracts to expire in quarterly resets in The CME lists contracts to expire in quarterly resets in March,June,September and December.Currently , there are 40 March,June,September and December.Currently , there are 40 consecutive quarters listed.consecutive quarters listed.

The Eurodollar is mainly traded by corporations,banks and fund The Eurodollar is mainly traded by corporations,banks and fund managers with short term interest rate exposures. It expires on managers with short term interest rate exposures. It expires on 33rdrd Monday of the month. Monday of the month.

Eurodollars contractEurodollars contract

TheThe price of a contract is expressed as:price of a contract is expressed as:• Futures Price=100-(Interest rate *100)+ Funding Futures Price=100-(Interest rate *100)+ Funding

AdjustmentAdjustment• Eg. If the current interest rate for a Eurodollar deposit Eg. If the current interest rate for a Eurodollar deposit

starting on the futures expiry date is 5% pa, then the futures starting on the futures expiry date is 5% pa, then the futures price is 95.price is 95.

• The aim of quoting in terms of price rather than yield is The aim of quoting in terms of price rather than yield is primarily to keep interest rate contracts in line with other primarily to keep interest rate contracts in line with other price-based contracts on bonds,shares and commodities.price-based contracts on bonds,shares and commodities.

• A buyer of a Eurodollar contract gains, if the futures price A buyer of a Eurodollar contract gains, if the futures price rises ( interest rate falls) above the price at which they rises ( interest rate falls) above the price at which they purchase it and the seller gains if price falls . purchase it and the seller gains if price falls .

Short-Term Interest Rate Short-Term Interest Rate ContractContract

Contract Exchange Face Value90-Day T.Bill CME 1,000,0003-month Euro-Swiss Franc LIFFE 1,000,0001 & 3 Month Euribor Futures EUREX 1,000,0003-month Euro LIFFE 1,000,0003-month sterling interest rate LIFFE 500,0003-month Euro-Yen TIFFE 100,000,000

Short-Term Interest Rate Short-Term Interest Rate Contract (PRICE)Contract (PRICE)

The short-term futures contract price is The short-term futures contract price is primarily determined by the prevailing primarily determined by the prevailing forward rate.forward rate.

There is, however an element of the There is, however an element of the interest rate that will not be known, until interest rate that will not be known, until expiry of the contract. expiry of the contract.

Futures Price = 100- (Forward Rate + Futures Price = 100- (Forward Rate + Funding adjustment) Funding adjustment)


Hedge Ratio and Convexity Adjustment:Hedge Ratio and Convexity Adjustment: Short Term Interest Rate Futures to Hedge Short Term Interest Rate Futures to Hedge

FRA.FRA. For a futures contract and an FRA with For a futures contract and an FRA with

same maturity , the forward interest rate is same maturity , the forward interest rate is very similar. very similar.

The difference arises only in the funding The difference arises only in the funding consequences of the futures contract.consequences of the futures contract.

Futures and FRAs : Dealing with different PVBP's

It is the 13th of June 2002. Calculate today's PVBP on bank bill futures ("BAB") contractand FRA listed below for face values of A$1 million. Using this information, if you hadbought $100 million face value of FRAs, how many futures contracts would you sell tohedge the price risk?

Current Market DataUnderlying Expiry Current PVBP

Instrument Tenor Days Date Yield Yield

1. FRA 15/18 90 13-Sep-02 7.58% 7.59%2. BAB Sep-02 90 13-Sep-02 7.58% 7.59%Note: Zero coupon rate to 13 Sep 2002 = 7.90%

CalculationsCurrent PVBP Future Present PVBP

Instrument Value Value Value Value

1. FRA 981,652.51 981,628.75 (23.76) (21.60) 21.60 2. BAB 981,652.51 981,628.75 (23.76) (23.76) 23.76

Difference (2.16)

Number of futures contract to hedge $100m FRA's.

We assume that the futures price and FRA are very closely correlated. And then apply thehedge ratio formula developed in section 3.5.3.

Hedge Ratio = PVBP(FRA) / PVBP= 21.60 / 23.76= 0.9092

So for every $1 face value of FRA we would sell 0.9099 BAB contracts.

Number of contracts = FRA face value x Hedge Ratio / BAB face value= $100,000,000 x 0.9093 / $1,000,000= 90.92 = 91 contracts ( rounded to nearest whole contract)

EXCELEXCEL


A complete Futures Pricing Model:A complete Futures Pricing Model:• Futures Price=100-(Forward rate + Funding adjustment Futures Price=100-(Forward rate + Funding adjustment

+ convexity adjustment)+ convexity adjustment)

• In Practice , the convexity adjustment is ignored for In Practice , the convexity adjustment is ignored for forward period of up to 1 year.forward period of up to 1 year.

• For longer forward terms the adjustment is in the order For longer forward terms the adjustment is in the order of one or two basis points, gradually rising as the of one or two basis points, gradually rising as the forward period increases.forward period increases.

FORWARD BONDSFORWARD BONDS

Forward Bonds are an OTC forward Forward Bonds are an OTC forward contract on fixed –interest rate security. contract on fixed –interest rate security.

In a forward bond agreement , two parties In a forward bond agreement , two parties agree to deliver a specified bond prices at at agree to deliver a specified bond prices at at future date.future date.

F=S x (1 + rF=S x (1 + r11 x f x f11/D)-c x (1x r/D)-c x (1x r22 x f x f22/D)/D)

FORWARD BONDSFORWARD BONDS

WhereWhere• F= forward price per face value including accrued interestF= forward price per face value including accrued interest• S=Cash bond price including accrued interestS=Cash bond price including accrued interest• rr11= interest rate to the forward expiry date= interest rate to the forward expiry date• rr22= interest rate between the coupon payment and forward = interest rate between the coupon payment and forward

expiry datesexpiry dates• D= Day count basis (360 or 365)D= Day count basis (360 or 365)• ff11= number of days to the forward expiry date= number of days to the forward expiry date• ff22= number of days between the coupon payment and = number of days between the coupon payment and

forward expiry datesforward expiry dates• c= periodic coupon paymentc= periodic coupon payment

FORWARD BONDSFORWARD BONDSForward Rate Calculations

Original cash cost = 100,000,000.00

Bond value at = 95,000,000.00 The bond value is reduced by thethree months coupon payment

Borrowing interest = 100m x (1+ 0.0575 x 90 / 360 ) at three months = 1,437,500.00

Asset cashflows = 5,000,000.00

Net Cash value at = 96,437,500.00 three months

Forward Price = 96.4375

BOND FUTURESBOND FUTURES

Bond futures represent a standardized, Bond futures represent a standardized, exchange-traded forward bond contract.exchange-traded forward bond contract.

Like short-term interest rate futures Like short-term interest rate futures contracts, they have become an integral part contracts, they have become an integral part of most financial markets , and they of most financial markets , and they typically represents a benchmark for long-typically represents a benchmark for long-term interest rate transaction.term interest rate transaction.

BOND FUTURESBOND FUTURES The price of most bond futures contracts is quoted as the The price of most bond futures contracts is quoted as the

current price per 100 units of face value.current price per 100 units of face value. The other alternative is the yield method. Futures prices The other alternative is the yield method. Futures prices

are quoted as 100 minus the YTM of the underlying asset.are quoted as 100 minus the YTM of the underlying asset. The futures quotation method is usually the local bond The futures quotation method is usually the local bond

market convention.market convention. There are two alternative methods with which bond There are two alternative methods with which bond

contracts are terminated: physical delivery and cash contracts are terminated: physical delivery and cash settlement.settlement.

Future Price= Forward Price+ Funding adjustment Future Price= Forward Price+ Funding adjustment +convexity adjustment.+convexity adjustment.

EQUITY FORWARDSEQUITY FORWARDS

Equity forwards have gained a reputation as Equity forwards have gained a reputation as being a highly risky instrument in their being a highly risky instrument in their relative short existence.relative short existence.

Despite the bad press, share price index Despite the bad press, share price index futures and all other equity derivatives futures and all other equity derivatives volume growth has been an outstanding volume growth has been an outstanding success since they were introduced in the success since they were introduced in the US in 1982.US in 1982.

Share Price Index Share Price Index Futures(SPI)Futures(SPI)

A share price index (SPI) future is an A share price index (SPI) future is an exchange-traded contract based on a broad-exchange-traded contract based on a broad-based share price index.based share price index.

A buyer benefits from a rise in the value of A buyer benefits from a rise in the value of the underlying index and loses from a fall in the underlying index and loses from a fall in the index.the index.

They are cash settled.They are cash settled.

Share Price Index Share Price Index Futures(SPI)Futures(SPI)

A Pricing Model for SPI FuturesA Pricing Model for SPI Futures• F= S x (1+(r-q) x f/D)F= S x (1+(r-q) x f/D)

• F= Forward SPI priceF= Forward SPI price

• S= cash price of the share price indexS= cash price of the share price index

• r= interest rate to the forward expiry dater= interest rate to the forward expiry date

• D= day count basisD= day count basis

• f= number of day to the forward expiry datef= number of day to the forward expiry date

• q= dividend yield expressed as a % pa on the same day q= dividend yield expressed as a % pa on the same day count basis as the interest rate.count basis as the interest rate.

Pricing of Future ContractPricing of Future ContractCase1- Securities Providing No Income

–F=S0ert

–S0=Spot Price–r=Risk Free Return–t=time to maturity–Example:–Spot Price of Non-payable dividend XYZ Share=Rs.70,–Contract matures after 3months.–Risk-free return=8% (For 3 months)–e=2.7183–F=70e(0.25)(0.08)

– =70x1.0202– = Rs71.41–Premium=2.014%

Pricing of Future Pricing of Future ContractContract

Case2- Securities Providing a known cash IncomeCase2- Securities Providing a known cash Income– F=(SF=(S00-I)e-I)ertrt

– SS00=Spot Price=Spot Price– r=Risk Free Returnr=Risk Free Return– t=time to maturityt=time to maturity– I=Present Value of the IncomeI=Present Value of the Income– ExampleExample::– Spot Price of dividend payable XYZ Share=Rs.38,Spot Price of dividend payable XYZ Share=Rs.38,– Contract matures after 6months.Contract matures after 6months.– Contract size=100 sharesContract size=100 shares– Risk-free return=10% (For 6 months)Risk-free return=10% (For 6 months)– Dividend=Rs.1.50 per share after 4 monthsDividend=Rs.1.50 per share after 4 months– Present Value of the Dividend I= (100x1.50)ePresent Value of the Dividend I= (100x1.50)e-(4/12)(0.10)=-(4/12)(0.10)=Rs.145.08Rs.145.08– F=(3800-145.08)eF=(3800-145.08)e(0.5)(0.10)(0.5)(0.10)

– =3654.92 x 1.05127=3654.92 x 1.05127– =Rs3842.31=Rs3842.31– Premium=1.113%Premium=1.113%

Pricing of Future Pricing of Future ContractContract

Case3- Stock Index FuturesCase3- Stock Index Futures– F=(SF=(S00-I)e-I)ertrt

– SS00=Spot Price=Spot Price– r=Risk Free Returnr=Risk Free Return– t=time to maturityt=time to maturity– I=Present Value of the IncomeI=Present Value of the Income– ExampleExample::– Two month futures contract on NIFTYTwo month futures contract on NIFTY– Let us assume that M&M will be declaring a dividend of Rs.10 per share Let us assume that M&M will be declaring a dividend of Rs.10 per share

after 15 days of purchasing the contract.after 15 days of purchasing the contract.– Current Value of NIFTY=1200 r=15%Current Value of NIFTY=1200 r=15%– Multiplier =200 200x1200=240,000Multiplier =200 200x1200=240,000– If M&M has a weight of 7% in NIFTY,its value in NIFTY is Rs.16,800 If M&M has a weight of 7% in NIFTY,its value in NIFTY is Rs.16,800

i.e(240,000 x 7/100).i.e(240,000 x 7/100).– If the market price of M&M is Rs.140, then a traded unit of NIFTY If the market price of M&M is Rs.140, then a traded unit of NIFTY

involves 120 shares of M&M.involves 120 shares of M&M.– Present Value of the Dividend I= (120x10)ePresent Value of the Dividend I= (120x10)e -(15/365)(0.1398)-(15/365)(0.1398)

– e=2.7183e=2.7183– F=Rs.1221.80F=Rs.1221.80– Premium=1.816%Premium=1.816%

Pricing of Financial Pricing of Financial ContractsContracts

Assumptions:Assumptions:

• The markets are perfect.The markets are perfect.

• All the assets are infinitely divisible.All the assets are infinitely divisible.

• Bid/Ask spreads do not exist so that it is Bid/Ask spreads do not exist so that it is assumed that only one price prevails.assumed that only one price prevails.

• There are no restrictions on short selling.There are no restrictions on short selling.

Future StrategiesFuture Strategies

HedgingHedging• LLong ong StockStock, , SShort Index hort Index FuturesFutures• SShort hort StockStock, , LLong Index ong Index FuturesFutures• HHave ave portfolioportfolio,,SShort Index hort Index FuturesFutures

SpeculationSpeculation• BBullish ullish IndexIndex,,LongLong Index Index FuturesFutures• BBearish earish IndexIndex, , SShort Index hort Index FuturesFutures

An Example of HedgingAn Example of Hedging

A buyer faces many A buyer faces many rrisks (price risk, liquidity risk, credit risk, operating isks (price risk, liquidity risk, credit risk, operating risk) in equity investment.risk) in equity investment.

Price risk is made of two parts: Price risk is made of two parts:

•Price movement due to market sentimentsPrice movement due to market sentiments

•Price movement due to company-specific factorsPrice movement due to company-specific factors Say beta of Infosys is 1.5Say beta of Infosys is 1.5 Assume that Infosys equity is selling at Rs.4000Assume that Infosys equity is selling at Rs.4000 Say over a day, Infosys equity price moves to Rs. 3900 when the index Say over a day, Infosys equity price moves to Rs. 3900 when the index

moves down by 1%moves down by 1% Of this price movement of 100, market sentiment causes Rs.60.Of this price movement of 100, market sentiment causes Rs.60. Remaining s.40 is due to company-specific factorsRemaining s.40 is due to company-specific factors

ContinuedContinued……

•LLong ong StockStock, , SShort Index hort Index FuturesFutures

Suppose that a buyer does not want to assumeSuppose that a buyer does not want to assume

the price risk of Rs.60 due to market sentimentsthe price risk of Rs.60 due to market sentiments

Assume that the equity index future is selling at 2000. He will sell “n” Assume that the equity index future is selling at 2000. He will sell “n” index futures where “n” is calculated as follows:index futures where “n” is calculated as follows:

n = (Price of the share*beta)/(value of the index)n = (Price of the share*beta)/(value of the index)

In this case, n = (4000*1.5)/(2000)=3In this case, n = (4000*1.5)/(2000)=3

If the index goes down by 1% to 1980 (that is, 20) as the seller he gains If the index goes down by 1% to 1980 (that is, 20) as the seller he gains Rs.20*3= Rs.60Rs.20*3= Rs.60

ContinuedContinued....

LLong ong StockStock, , SShort Index hort Index FuturesFutures

Gain/loss when Gain/loss when Index down by 1%, Infosys down by 1.5%Index down by 1%, Infosys down by 1.5%

Short on Index 3 units: + 60

Long on Share 1 unit: -60

ExampleExample

Stock=OrientbankStock=Orientbank Beta=0.8%Beta=0.8% Long Position of Rs.200,000Long Position of Rs.200,000 Which of the following is complete hedge?Which of the following is complete hedge? Sell 200,000 NiftySell 200,000 Nifty Buy 200,000 of NiftyBuy 200,000 of Nifty Buy 160,000 of NiftyBuy 160,000 of Nifty Sell 160,000 of NiftySell 160,000 of Nifty

Example Cont.Example Cont.

Answer:Answer: Long on Orientbank Rs200,000=Long on Long on Orientbank Rs200,000=Long on

Nifty Rs.160,000Nifty Rs.160,000 To completely To completely Sell Rs.160,000 of Nifty.Sell Rs.160,000 of Nifty.

Stock-picker Stock-picker OvervaluedOvervalued Short Infosys Position=Short Index PositionShort Infosys Position=Short Index Position Short Infosys +Short Index-Long IndexShort Infosys +Short Index-Long Index IF bearish on market short index onlyIF bearish on market short index only But bearish on Stock ;short stock and long But bearish on Stock ;short stock and long

index. index.

•ShortShort StockStock, , LongLong Index Index FuturesFutures

G=Index FallG=Index Fall

L=Index RiseL=Index Rise

An Example of HedgingAn Example of Hedging

A buyer faces many A buyer faces many rrisks (price risk, liquidity risk, credit isks (price risk, liquidity risk, credit risk, operating risk) in equity investment.risk, operating risk) in equity investment.

Price risk is made of two parts: Price risk is made of two parts: •Price movement due to market sentimentsPrice movement due to market sentiments•Price movement due to company-specific factorsPrice movement due to company-specific factors

Say beta of Infosys is 1.5Say beta of Infosys is 1.5 Assume that Infosys equity is selling at Rs.4000 and you Assume that Infosys equity is selling at Rs.4000 and you

have sold it.have sold it. Say over a day, Infosys equity price moves to Rs. 4100 Say over a day, Infosys equity price moves to Rs. 4100

when the index moves up by 1%when the index moves up by 1% Of this price movement of 100, market sentiment causes Of this price movement of 100, market sentiment causes

Rs.60.Rs.60. Remaining s.40 is due to company-specific factorsRemaining s.40 is due to company-specific factors

Continued…Continued…

•ShortShort StockStock, , LongLong Index Index FuturesFutures

Suppose that a buyer does not want to assumeSuppose that a buyer does not want to assume

the price risk of Rs.60 due to market sentimentsthe price risk of Rs.60 due to market sentiments

Assume that the equity index future is selling at 2000. He Assume that the equity index future is selling at 2000. He will sell “n” index futures where “n” is calculated as will sell “n” index futures where “n” is calculated as follows:follows:

n = (Price of the share*beta)/(value of the index)n = (Price of the share*beta)/(value of the index)

In this case, n = (4000*1.5)/(2000)=3In this case, n = (4000*1.5)/(2000)=3

If the index goes up by 1% to 2020 (that is, 20) as the If the index goes up by 1% to 2020 (that is, 20) as the seller he gains Rs.20*3= Rs.60seller he gains Rs.20*3= Rs.60

Continued..Continued..

ShortShort StockStock, , LongLong Index Index FuturesFutures

Gain/loss when Gain/loss when Index up by 1%, Infosys up by 1.5%Index up by 1%, Infosys up by 1.5%

Long on Index 3 units: + 60

Short on Share 1 unit: -60

Bullish Index, Long NIFTY Bullish Index, Long NIFTY FuturesFutures

On September 8 2001, XYZ feels Index will rise.On September 8 2001, XYZ feels Index will rise. He buys a Future Index with expiration date of He buys a Future Index with expiration date of

30th September 2001.30th September 2001. At this time NIFTY September cost was Rs.1071 At this time NIFTY September cost was Rs.1071

so his position is worth Rs.2,14,200.so his position is worth Rs.2,14,200. On 14th September NIFTY increase to 1075On 14th September NIFTY increase to 1075 The Nifty contract has risen to to Rs.1080The Nifty contract has risen to to Rs.1080 XYZ sells of f his position at Rs.1080XYZ sells of f his position at Rs.1080 His profit is Rs.1800.His profit is Rs.1800.

Bearish Index, Short NIFTY Bearish Index, Short NIFTY FuturesFutures

On October 8 2001, XYZ feels Index will fall.On October 8 2001, XYZ feels Index will fall. He sells a Future Index with expiration date of He sells a Future Index with expiration date of

30th October 2001.30th October 2001. At this time NIFTY September cost was Rs.1060 At this time NIFTY September cost was Rs.1060

so his position is worth Rs.2,12,000.so his position is worth Rs.2,12,000. On 20th October NIFTY decrease to 1050On 20th October NIFTY decrease to 1050 The Nifty contract has fallen to to Rs.1055The Nifty contract has fallen to to Rs.1055 XYZ buy t his position at Rs.1055XYZ buy t his position at Rs.1055 His profit is Rs.1000His profit is Rs.1000..

ExampleExample

STOCK =SBISTOCK =SBI SHORT on SBI of Rs.200,000SHORT on SBI of Rs.200,000 LONG on NIFTY of Rs.100,000LONG on NIFTY of Rs.100,000 Beta=0.8%Beta=0.8% Which of the following is true?Which of the following is true? Partial HedgePartial Hedge Complete HedgeComplete Hedge Overhedged Overhedged

Example Example

Short on SBI=Rs.200,000=Short on Nifty of Short on SBI=Rs.200,000=Short on Nifty of Rs160,000.Rs160,000.

Long on Nifty=Rs.100,000Long on Nifty=Rs.100,000 Hence is partial hedge.Hence is partial hedge.

Have Portfolio, Short Index FuturesHave Portfolio, Short Index Futures Have Fund, Long Index FutureHave Fund, Long Index Future

Have Funds, Lend them to Have Funds, Lend them to the Marketthe Market

On 1 August, Nifty is at 1200. A futures contract is On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. Ashish trading with 27 August expiration for 1230. Ashish wants to earn this return (30/1200 for 27 days.)wants to earn this return (30/1200 for 27 days.)

He buys Rs. 3 million of Nifty on the spot market. In He buys Rs. 3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up doing this, he places 50 market orders and ends up paying slightly more. His average cost of purchase is paying slightly more. His average cost of purchase is 0.3% higher, i.e. He has obtained the Nifty spot for 0.3% higher, i.e. He has obtained the Nifty spot for 1204.1204.

He sells Rs. 3 million of the futures at 1230. The He sells Rs. 3 million of the futures at 1230. The futures market is extremely liquid so the market order futures market is extremely liquid so the market order for Rs. 3 million goes through at near-zero impact cost.for Rs. 3 million goes through at near-zero impact cost.

Have Funds, Lend them to Have Funds, Lend them to the Market the Market (contd..)(contd..)

3.3. He takes delivery of the shares and waits.He takes delivery of the shares and waits.4.4. While waiting, a few dividends come into his While waiting, a few dividends come into his

hands. The dividends work out to Rs. hands. The dividends work out to Rs. 7,000.Simultaneously he lends security and earn 7,000.Simultaneously he lends security and earn fees on itfees on it

5.5. On 27 August, at 3.15, Ashish puts in market On 27 August, at 3.15, Ashish puts in market orders to sell off all the shares. Nifty happens to orders to sell off all the shares. Nifty happens to have closed at 1210 and his sell orders (which have closed at 1210 and his sell orders (which suffer impact cost) goes through at 1207suffer impact cost) goes through at 1207

6.6. The futures position spontaneously expires on 27 The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last August at 1210 (the value of the futures on the last day is always equal to the Nifty spot)day is always equal to the Nifty spot)

7.7. Ashish has gained Rs. 3 (0.25%) on the spot Nifty Ashish has gained Rs. 3 (0.25%) on the spot Nifty and Rs.20(1.63%) on the futures for the return of and Rs.20(1.63%) on the futures for the return of near 1.88%. In addition, he has gained Rs. 70,000 near 1.88%. In addition, he has gained Rs. 70,000 or 0.23% owing to the dividends plus (0.2% on or 0.23% owing to the dividends plus (0.2% on lending) for a total return of 2.31% for 27 days, lending) for a total return of 2.31% for 27 days, risk free.risk free.It is easier to make a rough calculation of return. It is easier to make a rough calculation of return. To do this, we ignore the gain from dividends and To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. we assume that transactions costs account for 0.4%. In the above case, the return is roughly 1230/1200 In the above case, the return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days. This is transactions costs giving 2.1% for 27 days. This is very close to the actual number.very close to the actual number.

Have Funds, Lend them to Have Funds, Lend them to the Market the Market (contd..)(contd..)

11stst Aug-NIFTY-1200 Aug-NIFTY-1200 2727thth Aug Future NIFTY on 1 Aug Future NIFTY on 1stst AUG-1230 AUG-1230 Expected Return-(1230/1200)=2.1%Expected Return-(1230/1200)=2.1% Long NIFTY on SPOT=Rs.3 Ml @1204Long NIFTY on SPOT=Rs.3 Ml @1204 Short NIFTY on FUTURE=Rs.3 Ml @ 1230Short NIFTY on FUTURE=Rs.3 Ml @ 1230 Ashish Takes Delivery and lends the securityAshish Takes Delivery and lends the security On 27On 27thth Aug at 3.15 pm Aug at 3.15 pm Ashish sells NIFTY spot at 1207 and NIFTY Close at 1210Ashish sells NIFTY spot at 1207 and NIFTY Close at 1210 Stock=1207-1204=3(0.25%)Stock=1207-1204=3(0.25%) Future=1230-1210=20(1.63%)Future=1230-1210=20(1.63%) Dividend=0.23% Dividend=0.23% Lending=0.2%Lending=0.2% Total Return=0.25+1.63+0.23+0.2=2.31%Total Return=0.25+1.63+0.23+0.2=2.31%

Have Funds, Lend them to the Market (contdHave Funds, Lend them to the Market (contd..)..)

Have Securities, Lend Have Securities, Lend them to the Marketthem to the Market

Suppose the Nifty spot is 1100 and the two-Suppose the Nifty spot is 1100 and the two-month futures are trading at 1110. Hence month futures are trading at 1110. Hence the spot futures basis (1110/1100) is 0.9%. the spot futures basis (1110/1100) is 0.9%. Suppose cash can be risklessly invested at Suppose cash can be risklessly invested at 1% per month. Over two months, funds 1% per month. Over two months, funds invested at 1% per month yield 2.01%. invested at 1% per month yield 2.01%. Hence the total return that can be obtained Hence the total return that can be obtained in stock lending is 2.01-0.9-0.4 or 0.71% in stock lending is 2.01-0.9-0.4 or 0.71% over the two-month period.over the two-month period.

Have Securities, Lend Have Securities, Lend themthemto the Marketto the Market

Let us make this concrete using a specific Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs. sequence of trades. Suppose Akash has Rs. 4 million of the Nifty portfolio which he 4 million of the Nifty portfolio which he would like to lend to the market.would like to lend to the market.

1.1. Akash puts in sell orders for Rs. 4 million Akash puts in sell orders for Rs. 4 million of Nifty using the future in NEAT to rapidly of Nifty using the future in NEAT to rapidly place 50 market orders in quick succession. place 50 market orders in quick succession. The seller always suffers impact cost; The seller always suffers impact cost; suppose he obtains an actual execution in suppose he obtains an actual execution in 1098.1098.

Have Securities, Lend Have Securities, Lend themthemto the Market to the Market (contd…)(contd…)

2.2. A moment later, Akash puts in a market A moment later, Akash puts in a market order to buy Rs. 4 million of the Nifty order to buy Rs. 4 million of the Nifty futures. The order executes at 1110. At futures. The order executes at 1110. At this point, he is completely hedged.this point, he is completely hedged.

3.3. A few days later, Akash makes delivery of A few days later, Akash makes delivery of shares and receives Rs. 3.99 million shares and receives Rs. 3.99 million (assuming an impact cost of 2/11/00).(assuming an impact cost of 2/11/00).

4.4. Suppose Akash lend this out at 1% per Suppose Akash lend this out at 1% per month for two months.month for two months.

5.5. At the end of two months, he gets back Rs. At the end of two months, he gets back Rs. 4,072,981. Translated in terms of Nifty, this 4,072,981. Translated in terms of Nifty, this is 1098*1.01is 1098*1.012 2 or 1120. or 1120.

6.6. On the expiration date of the futures, he puts On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market in 50 orders, using NEAT, placing market orders to buy back his Nifty portfolio. orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in time. This makes shares are costlier in buying back, but the difference is exactly buying back, but the difference is exactly offset by profits on the futures contractoffset by profits on the futures contract..



When the market order is placed, suppose he When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to ends up paying 1153 and not 1150, owing to impact cost. He has funds in hand of 1120, and impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150 – 1110) so he the futures contract pays 40 (1150 – 1110) so he ends up with a clean profit, on the entire ends up with a clean profit, on the entire transaction, of 1120 + 40 – 1153 or 7. On a transaction, of 1120 + 40 – 1153 or 7. On a base of Rs. 4 million, there is Rs. 25,400.base of Rs. 4 million, there is Rs. 25,400.


11stst Aug-NIFTY-1100 Aug-NIFTY-1100 2727thth Sep Future NIFTY on 1 Sep Future NIFTY on 1stst AUG-1110 AUG-1110 Expected Return-(1110/1100)=0.9%, RFR=1% for 2MonthsExpected Return-(1110/1100)=0.9%, RFR=1% for 2Months Short NIFTY on SPOT=Rs.4 Ml @1098Short NIFTY on SPOT=Rs.4 Ml @1098 Long NIFTY on FUTURE=Rs.4 Ml @ 1110Long NIFTY on FUTURE=Rs.4 Ml @ 1110 Akash gives Delivery Akash gives Delivery Receives RS.3.99 MlReceives RS.3.99 Ml and lend the money for 2 months @ 1% and and lend the money for 2 months @ 1% and

return=Rs.4,072,981=1098*1.01^2=1120 NIFTYreturn=Rs.4,072,981=1098*1.01^2=1120 NIFTY On 27On 27thth Sep at 3.15 pm Sep at 3.15 pm Akash buys NIFTY spot at 1153 and NIFTY close at 1150Akash buys NIFTY spot at 1153 and NIFTY close at 1150 Return =1120+40-1153=7Return =1120+40-1153=7 On a base of Rs. 4 million, there is Rs. 25,400.On a base of Rs. 4 million, there is Rs. 25,400.

SPOT THE MISPRICINGSPOT THE MISPRICING

If for instance F> S(1+r)If for instance F> S(1+r)TT, arbitrageurs will , arbitrageurs will borrow funds, buy the spot with these borrow funds, buy the spot with these borrowed funds, sell the futures contract borrowed funds, sell the futures contract and carry the asset forward to deliver and carry the asset forward to deliver against the future contract. This is called against the future contract. This is called cash-and-carry arbitragecash-and-carry arbitrage. .

If for instance F< S(1+r)If for instance F< S(1+r)TT: It is : It is reverse reverse cash-and-carry arbitrage.cash-and-carry arbitrage.


Month Quantity Bid Ask Fair Value QuantityNovember 1000 1009 1010.5 1009.5 1000December 200 1022 1025 1019 200January 400 1028 1032 1028.7 400

Fair-Value Vis-à-vis market prices for variuos future contracts


If the fair value of the contract is higher than the If the fair value of the contract is higher than the ask, the contract is underpriced and should be ask, the contract is underpriced and should be bought at the ask price.bought at the ask price.

If the fair value of the contract is lower than the If the fair value of the contract is lower than the bid, the contract is overpriced and should be sold bid, the contract is overpriced and should be sold at the bid price.at the bid price.

In the example December is overpriced. Hence the In the example December is overpriced. Hence the investor can sell 200 units and close the contract investor can sell 200 units and close the contract when it come back to its fair value.when it come back to its fair value.

SPREAD TRADINGSPREAD TRADING

The observe spread is 6. Since the spread is The observe spread is 6. Since the spread is narrowed we can profit by selling the near month narrowed we can profit by selling the near month contract and buying the far month .contract and buying the far month .

Sell F1(1012) and Buy F2 (1018)Sell F1(1012) and Buy F2 (1018) After some time market correct itself and weAfter some time market correct itself and we Buy F1(1010) and sell F2 1020.Buy F1(1010) and sell F2 1020. We end up making a profit of Rs.4 on the round trip.We end up making a profit of Rs.4 on the round trip.

Spot Contract Fair Price Fair Basis Fair Spread Mkt Price Obs Basis Obs Spread

1000 F1 1010 10 1012 12

F2 1020 10 10 1018 18 6

F3 1030 30 10 1032 32 4

NSE DataNSE Data

Futures (June 2000-March 2001)Futures (June 2000-March 2001)• 90580 contracts traded90580 contracts traded• Turnover: Rs. 2365 croresTurnover: Rs. 2365 crores• Average daily turnover: Rs.11.59 croresAverage daily turnover: Rs.11.59 crores

Equity (2000-01)Equity (2000-01)• Turnover:Rs. 1339,510 croresTurnover:Rs. 1339,510 crores• Average daily turnover: Rs. 5337 cr.Average daily turnover: Rs. 5337 cr.

UTI INSTITUTE OF CAPITAL UTI INSTITUTE OF CAPITAL MARKETMARKET

REGULATORY FRAMEWORKREGULATORY FRAMEWORK

UTI INSTITUTE OF CAPITAL MARKETUTI INSTITUTE OF CAPITAL MARKET

Contents of the Contents of the presentationpresentation

SCRA(1956)SCRA(1956) SEBI(1992)SEBI(1992) SEBI(Brokers and Sub-Brokers SEBI(Brokers and Sub-Brokers

Regulation),1992Regulation),1992 Regulation for Derivatives tradingRegulation for Derivatives trading Regulation for clearing and settlementRegulation for clearing and settlement Risk ManagementRisk Management Accounting IssuesAccounting Issues Taxation IssuesTaxation Issues

SSecurities ecurities CContracts(ontracts(RRegulation)egulation)AAct,1956ct,1956 SCRASCRA

Securities:Securities: Shares,Scrips,Stocks,Bonds,Debentures,Debentures Shares,Scrips,Stocks,Bonds,Debentures,Debentures stock,Government securities or any other Instruments as may stock,Government securities or any other Instruments as may be declared by the Central Government to be securities,Units be declared by the Central Government to be securities,Units or any other instrument issued by any collective investment or any other instrument issued by any collective investment scheme to the investors in such scheme, Rights or interest in scheme to the investors in such scheme, Rights or interest in

securities and Derivativessecurities and Derivatives. .

Derivative:Derivative:A security from a debt instrument, share, loan A security from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for whether secured or unsecured, risk instrument or contract for differences or any other form security.differences or any other form security.

SSecurities ecurities CContracts(ontracts(RRegulation)egulation)AAct,1956ct,1956 SCRA (Cont.)SCRA (Cont.)DerivativeDerivative::A contract which derives its value from the prices A contract which derives its value from the prices ,or index of prices, of underlying ,or index of prices, of underlying

securities.securities.According to According to SCRASCRA the contracts in derivative shall be legal the contracts in derivative shall be legal and and valid valid if such contracts are:if such contracts are: Traded on a recognized stock exchangeTraded on a recognized stock exchange Settled on the clearing house of the recognized stock Settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye-laws of such exchange, in accordance with the rules and bye-laws of such stock exchange.stock exchange.

SSecurities and ecurities and EExchange xchange BBoard of oard of IIndia Act, 1991 SEBIndia Act, 1991 SEBI According to SEBI Act ,the SEBI has powers forAccording to SEBI Act ,the SEBI has powers for

1)Regulating the business in stock exchange 1)Regulating the business in stock exchange

and any other securities markets.and any other securities markets.

2)Registering and regulating the working of2)Registering and regulating the working of

stock brokers,sub-brokers etc.stock brokers,sub-brokers etc.

3)Promoting and regulating self-regulatory 3)Promoting and regulating self-regulatory

organisation.organisation.

4)Prohibiting fraudulent and unfair trade4)Prohibiting fraudulent and unfair trade

practices.practices.

5)Conducting inquiries and audits of the5)Conducting inquiries and audits of the

stock exchanges,mutual funds ,….stock exchanges,mutual funds ,….

Regulation for Derivative Regulation for Derivative Trading Trading

1.1. Any Exchange fulfilling the eligibility criteria as prescribed in the LC Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta committee report may apply to SEBI for grant of recognition Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC®A, 1956 to start trading derivatives. The under Section 4 of the SC®A, 1956 to start trading derivatives. The derivatives exchange /segment should have a separate governing derivatives exchange /segment should have a separate governing council and representation of trading/clearing members shall be limited council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will exchange shall regulate the sales practices of its members and will obtain prior approval of SEBI before start of trading in any derivatives obtain prior approval of SEBI before start of trading in any derivatives contract.contract.

2.2. The Exchange shall have minimum 50 members.The Exchange shall have minimum 50 members.3.3. The members of an existing segment of the exchange will not The members of an existing segment of the exchange will not

automatically become the members of derivative segment. The automatically become the members of derivative segment. The members of the derivative segment need to fulfill the eligibility members of the derivative segment need to fulfill the eligibility conditions as laid down by the LC Gupta committee.conditions as laid down by the LC Gupta committee.

Regulation for Derivative Regulation for Derivative Trading Trading (cont’d)(cont’d)

4.4. The clearing and settlement of derivatives trades shall be The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/house. through a SEBI approved clearing corporation/house. Clearing corporation/houses complying with the Clearing corporation/houses complying with the eligibility conditions as laid down by the committee eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval.have to apply to SEBI for grant of approval.

5.5. Derivatives brokers/dealers and clearing members are Derivatives brokers/dealers and clearing members are required to seek registration from SEBI. This is an required to seek registration from SEBI. This is an addition to their registration as brokers of existing stock addition to their registration as brokers of existing stock exchanges. The minimum networth for clearing exchanges. The minimum networth for clearing members of the derivatives clearing corporation/house members of the derivatives clearing corporation/house shall be Rs.300 lakh. shall be Rs.300 lakh.


The networth of the member shall be computed as follows:The networth of the member shall be computed as follows: Capital + Free reservesCapital + Free reserves Less non-allowable assets viz.,Less non-allowable assets viz.,

a)a) Fixed assetsFixed assets

b)b) Pledged securitiesPledged securities

c)c) Member’s cardMember’s card

d)d) Non-allowable securities (unlisted securities)Non-allowable securities (unlisted securities)

e)e) Bad deliveriesBad deliveries

f)f) Doubtful debts and advancesDoubtful debts and advances

g)g) Prepaid expensesPrepaid expenses

h)h) Intangible assetsIntangible assets

i)i) 30% marketable securities30% marketable securities


6.6. The minimum contract value shall not be less than Rs.2 lakh. The minimum contract value shall not be less than Rs.2 lakh. Exchanges should also submit details of the futures contract they Exchanges should also submit details of the futures contract they propose to introduce.propose to introduce.

7.7. The initial margin requirement, exposure limits linked to capital The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the adequacy and margin demands related to the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time.position shall be prescribed by SEBI/Exchange from time to time.

8.8. The L.C. Gupta committee report strict enforcement of “Know your The L.C. Gupta committee report strict enforcement of “Know your customer” rule and requires that every client shall be registered with customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the clientDocument and obtain a copy of the same duly signed by the client

9.9. The trading members are required to have qualified approved user and The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by sales person who have passed a certification programme approved by SEBI.SEBI.

Regulation for Clearing Regulation for Clearing and Settlementand Settlement

1.1. The LC Gupta committee has recommended that The LC Gupta committee has recommended that the clearing corporation must perform full the clearing corporation must perform full novation, i.e. the clearing corporation should novation, i.e. the clearing corporation should interpose itself between both legs of every trade, interpose itself between both legs of every trade, becoming the legal counterparty to both or becoming the legal counterparty to both or alternatively should provide an unconditional alternatively should provide an unconditional guarantee for settlement of all trades.guarantee for settlement of all trades.

2.2. The clearing corporation should ensure that none The clearing corporation should ensure that none of the Board members had trading interests.of the Board members had trading interests.

Regulation for Clearing Regulation for Clearing and Settlement and Settlement (cont’d)(cont’d)

3.3. The definition of net-worth as prescribed by The definition of net-worth as prescribed by SEBI needs to be incorporated in the SEBI needs to be incorporated in the application/regulations of the clearing application/regulations of the clearing corporation.corporation.

4.4. The regulations relating to arbitration need to be The regulations relating to arbitration need to be incorporated in the clearing corporations incorporated in the clearing corporations regulations.regulations.

5.5. Specific provision/chapter relating to declaration Specific provision/chapter relating to declaration of default must be incorporated by the clearing of default must be incorporated by the clearing corporation in its regulations.corporation in its regulations.


6.6. The regulation relating to investor protection fund for The regulation relating to investor protection fund for the derivatives market must be included in the clearing the derivatives market must be included in the clearing corporation application/ regulations.corporation application/ regulations.

7.7. The clearing corporation should have the capabilities to The clearing corporation should have the capabilities to segregate upfront/initial margins deposited by clearing segregate upfront/initial margins deposited by clearing members for trades on their own account and on members for trades on their own account and on account of his clients. The clearing corporation shall account of his clients. The clearing corporation shall hold the client’s margin money in trust for the client’s hold the client’s margin money in trust for the client’s purpose only and should not allow its diversion for any purpose only and should not allow its diversion for any other purpose. This condition must be incorporated in other purpose. This condition must be incorporated in the clearing corporation regulations.the clearing corporation regulations.


8.8. The clearing member shall collect margins from his The clearing member shall collect margins from his constituents (clients/trading members). He shall clear constituents (clients/trading members). He shall clear and settle deals in derivatives contracts on behalf of and settle deals in derivatives contracts on behalf of the constituents only on the receipt of such minimum the constituents only on the receipt of such minimum margin.margin.

9.9. Exposure limits based on the value at risk concept will Exposure limits based on the value at risk concept will be used and the exposure limits will be continuously be used and the exposure limits will be continuously monitored. Clearing members will be subject to monitored. Clearing members will be subject to exposure limits not exceeding 20 times their base exposure limits not exceeding 20 times their base capital. The exposure limit shall be within the limits capital. The exposure limit shall be within the limits prescribed by SEBI from time to time.prescribed by SEBI from time to time.


10.10. The clearing corporation must lay down a procedure The clearing corporation must lay down a procedure for periodic review of the networth of its members.for periodic review of the networth of its members.

11.11. The clearing corporation must inform SEBI how it The clearing corporation must inform SEBI how it proposes to monitor the exposure of its members in proposes to monitor the exposure of its members in the underlying market.the underlying market.

12.12. Any changes in the bye-laws, rules or regulations Any changes in the bye-laws, rules or regulations which are covered under the “Suggestive bye-laws which are covered under the “Suggestive bye-laws for regulations and control of trading and settlement for regulations and control of trading and settlement of derivatives contracts” would require prior of derivatives contracts” would require prior approval of SEBI.approval of SEBI.

Eligibility criteria for Eligibility criteria for membership on F&O membership on F&O segmentsegment

ParticularsParticulars New membersNew members Existing membersExisting members

CM and F&O CM and F&O segmentsegment

CM, WDM and F&O CM, WDM and F&O segmentsegment

Net worth Net worth 11 Rs.100 lakhRs.100 lakh Rs.200 lakhRs.200 lakh Rs.100 lakhRs.100 lakh

Interest free security Interest free security deposit (IFSD)deposit (IFSD)22

Rs.125 lakhRs.125 lakh Rs.275 lakhRs.275 lakh Rs.8 lakhRs.8 lakh

Collateral security Collateral security deposit (CSD)deposit (CSD)

Rs.25 lakhRs.25 lakh Rs.25 lakhRs.25 lakh --

Annual subscriptionAnnual subscription Rs.1 lakhRs.1 lakh Rs.2 lakhRs.2 lakh Rs.1 lakhRs.1 lakh

1. Networth of Rs.300 lakh is required for clearing membership.1. Networth of Rs.300 lakh is required for clearing membership.

2. Additional Rs.25 lakh is required for clearing membership. In addition, the clearing 2. Additional Rs.25 lakh is required for clearing membership. In addition, the clearing member is required to bring in IFSD of Rs.2 lakh and CSD of Rs.8 lakh per trading member member is required to bring in IFSD of Rs.2 lakh and CSD of Rs.8 lakh per trading member in the F&O segment.in the F&O segment.

Requirement for Requirement for professional clearing professional clearing membershipmembership

ParticularsParticulars F&O segmentF&O segment CM segmentCM segment CM & F&O CM & F&O segmentsegment

EligibilityEligibility Trading members of NSE/SEBI Trading members of NSE/SEBI registered custodians/ recognised registered custodians/ recognised bkbk

NetworthNetworth Rs.300 lakhRs.300 lakh

Interest free security Interest free security deposit (IFSD)deposit (IFSD)

Rs.25 lakhRs.25 lakh Rs. 25 lakhRs. 25 lakh Rs. 34 lakhRs. 34 lakh

Collateral security Collateral security depositdeposit

Rs. 25 lakhRs. 25 lakh Rs. 25 lakhRs. 25 lakh Rs. 50 lakhRs. 50 lakh

Annual subscriptionAnnual subscription NilNil Rs. 2.5 lakhRs. 2.5 lakh Rs. 2.5 LakhRs. 2.5 Lakh

Note: The PCM is required to bring in IFSD of Rs. 2 lakh and CSD of Rs.8 lakh per trading Note: The PCM is required to bring in IFSD of Rs. 2 lakh and CSD of Rs.8 lakh per trading member in the F&O segment and IFSD of Rs.6 lakh and CSD of Rs. 17.5 lakh (Rs.9 lakh and member in the F&O segment and IFSD of Rs.6 lakh and CSD of Rs. 17.5 lakh (Rs.9 lakh and Rs. 25 lakh respectively for corporate members) per trading member in the CM segment.Rs. 25 lakh respectively for corporate members) per trading member in the CM segment.

Risk containment Risk containment measures for options on measures for options on indicesindices

1.1. The index option contracts to be traded on the derivative The index option contracts to be traded on the derivative exchange/segments shall have prior approval of SEBI. The exchange/segments shall have prior approval of SEBI. The contract should comply with the disclosure requirements, if contract should comply with the disclosure requirements, if any, laid down by SEBI.any, laid down by SEBI.

2.2. Initially, the exchange shall introduce European style index Initially, the exchange shall introduce European style index options which shall be settled in cash.options which shall be settled in cash.

3.3. The index option contract shall have a minimum contract The index option contract shall have a minimum contract size of Rs. 2 lakh at the time of its introduction in the size of Rs. 2 lakh at the time of its introduction in the market.market.

4.4. The index option contract shall have minimum of 3 strikes The index option contract shall have minimum of 3 strikes (in-the-money, near-the-money and out-of-the money).(in-the-money, near-the-money and out-of-the money).

Risk containment Risk containment measures for options on measures for options on indices indices (cont’d)(cont’d)

5.5. The initial margin requirements shall be based on worst The initial margin requirements shall be based on worst case loss of a portfolio of an individual client to cover a case loss of a portfolio of an individual client to cover a 99% VaR over a one day horizon. The initial margin 99% VaR over a one day horizon. The initial margin requirement shall be netted at the level of individual requirement shall be netted at the level of individual client and it shall be on gross basis at the level of client and it shall be on gross basis at the level of Trading/Clearing member. The initial margin Trading/Clearing member. The initial margin requirement for the proprietary position of requirement for the proprietary position of Trading/Clearing member shall also be on net basis.Trading/Clearing member shall also be on net basis.

6.6. A portfolio based margining approach shall be adopted A portfolio based margining approach shall be adopted which will take an integrated view of the risk involved in which will take an integrated view of the risk involved in the portfolio of each individual client comprising of his the portfolio of each individual client comprising of his positions in index futures and index options contractspositions in index futures and index options contracts. .

Risk containment Risk containment measures for options on measures for options on indices indices (cont’d)(cont’d)

The parameters for such a model should include:The parameters for such a model should include:

a)a) Worst scenario lossWorst scenario lossb)b) Short option minimum margin (3%)Short option minimum margin (3%)c)c) Net option value (NW-SO+LO)Net option value (NW-SO+LO)d)d) Cash settlement of premiumCash settlement of premiume)e) Unpaid premiumUnpaid premiumf)f) Cash settlement of futures mark to marketCash settlement of futures mark to marketg)g) Position limitsPosition limitsh)h) Real time computationReal time computation

Accounting Issues: Accounting Issues: A discussionA discussion

Accounting at the inception of a contractAccounting at the inception of a contract Accounting at the time of daily settlementAccounting at the time of daily settlement Accounting for open positionsAccounting for open positions Accounting at the time of final settlementAccounting at the time of final settlement Accounting in case of a defaultAccounting in case of a default Disclosure requirementsDisclosure requirements

Taxation issues: A Taxation issues: A discussiondiscussion The only provisions which have an indirect bearing on The only provisions which have an indirect bearing on

derivative transactions are sections 73(1) and 43(5). derivative transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the respect of a speculative business carried on by the assessee, shall not be set off except against profits and assessee, shall not be set off except against profits and gains, if any, of speculative business. Section 43(5) of gains, if any, of speculative business. Section 43(5) of the Act defines a speculative transaction as a the Act defines a speculative transaction as a transaction in which a contract for purchase or sale of transaction in which a contract for purchase or sale of any commodity, including stocks and shares, is any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scrips. actual delivery or transfer of the commodity or scrips.

Taxation issues: A Taxation issues: A discussion discussion (cont’d)(cont’d)

It excludes the following types of transactions from the ambit It excludes the following types of transactions from the ambit of speculative transactions:of speculative transactions:

1. A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holding of stocks and shares through price fluctuations;

2. A contract entered into by a members of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in ordinary course of business as such member.

From the above, it appears that a transaction is speculative, if it is settled otherwise than by actual delivery.

Major Recommendations Major Recommendations of LCGCof LCGC

Introduction of Financial DerivativesIntroduction of Financial Derivatives There is need of equity derivatives, interest rate derivatives and There is need of equity derivatives, interest rate derivatives and

currency derivatives.currency derivatives. Phased Introduction: Index Futures, followed by options on Phased Introduction: Index Futures, followed by options on

Index and then options on Stock.Index and then options on Stock. Two level regulatory framework,exchange level and SEBI level.Two level regulatory framework,exchange level and SEBI level. The derivative segment will have separate segment with separate The derivative segment will have separate segment with separate

governing council and it will have on-line trading with governing council and it will have on-line trading with surveillance.surveillance.

Creation of Derivative cell, a derivatives Advisory committee, Creation of Derivative cell, a derivatives Advisory committee, and Economic Research wing by SEBIand Economic Research wing by SEBI

JRVC RecommendationJRVC Recommendation

Open positionsOpen positions Calendar spreads and margins to be levied on Calendar spreads and margins to be levied on

themthem Non-spread positions and margins to be levied on Non-spread positions and margins to be levied on

themthem Clearing member initial marginClearing member initial margin Clearing member net worth and depositsClearing member net worth and deposits Intra-day monitoring limitsIntra-day monitoring limits End of day initial marginsEnd of day initial margins

TerminologyTerminology

Spot Price : The price at which an asset trades in the spot market. Future Price: The price at which the futures contract trades in the

futures market. Basis: Basis is usually defined as the spot price minus the future

price.. Contract Cycle: The period over which a contract trades. The index

futures contract on the exchange have 1,2,3 months expiry cycles which expires on the last Thursday of the month.

Expiry Date: It is the maturity date of the contract. Long= Buy Short=Sell

TerminologyTerminology

Initial Margin:The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Maintenance Margin:This is somewhat lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative.

Marking-to-Market:In the futures market, at the end of each trading day , the margin account is adjusted to reflect the investor’s gain/loss depending upon the future closing price. This is called marking-to-market..

Thank YouThank You

INTRODUCTION TO FUTURE PRESENTATION BY Dr. Rana Singh Associate Professor.

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Transcript of INTRODUCTION TO FUTURE PRESENTATION BY Dr. Rana Singh Associate Professor.