Forward Vs Future and it's indepth knowledge

Forward vs Future

1. Forward and Futures Dr .Tajinder Assistant Professor Mittal school of Business

2. Introduction Forward and futures contracts are derivative securities. Recall, a derivative security is a financial security that is a claim on another security or underlying asset. We will examine the specifics of forwards and futures and see how they differ Derivatives can be used to speculate on price changes in attempts to gain profit or they can be used to hedge against price changes in attempts to reduce risk. 2

3. Forward and Futures Contracts Both forward and futures contracts lock in a price today for the purchase or sale of something in a future time period E.g., for the sale or purchase of commodities like gold, canola, oil, pork bellies, or for the sale or purchase of financial instruments such as currencies, stock indices, bonds. Futures contracts are standardized and traded on formal exchange; forwards are negotiated between individual parties. 3

4. Example of using a forward or futures contract COP Ltd., a canola-oil producer, goes long in a contract with a price specified as $395 per metric tonne for 20 metric tonnes to be delivered in September. The long position means COP has a contract to buy the canola. The payment of $395/ tonne ● 20 tonnes will be made in September when the canola is delivered. 4

5. Futures and Forwards – Details Unlike option contracts, futures and forwards commit both parties to the contract to take a specified action The party who has a short position in the futures or forward contract has committed to sell the good at the specified price in the future. Having a long position means you are committed to buy the good at the specified price in the future. 5

6. More details on Forwards and Futures No money changes hands between the long and short parties at the initial time the contracts are made Only at the maturity of the forward or futures contract will the long party pay money to the short party and the short party will provide the good to the long party. 6

7. Institutional Factors of Futures Contracts Since futures contracts are traded on formal exchanges, margin requirements, marking to market, and margin calls are required; forward contracts do not have these requirements. The purpose of these requirements is to ensure neither party has an incentive to default on their contract. Thus futures contracts can safely be traded on the exchanges between parties that do not know each other. 7

8. The initial margin requirement Both the long and the short parties must deposit money in their brokerage accounts. Typically 10% of the total value of the contract Not a down payment, but instead a security deposit to ensure the contract will be honored SPAN + Exposure margin is called the initial margin and this is collected at the time of entering a position. 8

9. SPAN and Exposure Margin Standard Portfolio Analysis of Risk (SPAN) is used by exchanges to calculate risk and margins for F&O portfolios . SPAN uses the price and volatility of the underlying security along with several other variables to determine the maximum possible loss for a portfolio and determines an appropriate margin . SPAN margin is monitored and collected at the time of placing an order and is revised by the exchanges throughout the day. Exposure margin is charged over and above the SPAN margin by the exchanges to cover risks that may not be covered by the SPAN margin.

10. Remember, between the SPAN and Exposure margin; the most sacred one is the SPAN margin. Most brokers allow you to continue to hold your positions as long as you have the SPAN Margin (or maintenance margin). The moment the cash balance falls below the maintenance margin, they will call you asking you to pump in more money. In the absence of which, they will force close the positions themselves. This call that the broker makes requesting you to pump in the required margin money is also popularly called the “ Margin Call ”. If you are getting a margin call from your broker, it means your cash balance is dangerously low to continue the position.

11. Initial Margin Requirement – Example Manohar has just taken a long position in a futures contract for 100 ounces of gold to be delivered in January. Magda has just taken a short position in the same contract. The futures price is $380 per ounce. The initial margin requirement is 10% What is Manohar’s initial margin requirement? What is Magda’s initial margin requirement? 11

12. Marking to market At the end of each trading day, all futures contracts are rewritten to the new closing futures price. I.e., the price on the contract is changed. Included in this process, cash is added or subtracted from the parties’ brokerage accounts so as to offset the change in the futures price. The combination of the rewritten contract and the cash addition or subtraction allows for standardized contracts for delivery at the same time to trade at the same price. Example : http://surl.li/gfqwq https://faq-neo.kotaksecurities.com/support/solutions/articles/82000883733-what-is-mark-to-market-

13. Marking to market example Consider Manohar (who is long) and Magda (who is short) in the contract for 100 ounces of gold. At the beginning of the day, the contract specified a price of $380 per ounce At the end of the day, the futures price has risen to $385 so the contracts are rewritten accordingly. What is the effect of marking to market for Manohar (long)? What would be the effect on Magda (short)? Who makes the marking to market payments or withdrawals from Manohar’s and Magda’s brokerage accounts? How does marking to market affect the net amount Manohar will pay and Magda will receive for the gold? What would have happened if the futures price had dropped by $10 instead of rising by $5 as described above?

14. Recap on Marking to Market After marking to market, the futures contract holders essentially have new futures contracts with new futures prices They are compensated or penalized for the change in contract terms by the marking to market deposits/withdrawals to their accounts. 14

15. Why have marking to market? To reduce the incentive to default Discussion: 15

16. M argin call A margin call is  a “call” from your broker requiring you to top up cash into your account when your margin balance for your futures position drops below the maintenance margin level .

17. Example 10 th  Dec 2014 Sometime during the day, HDFC Bank futures contract was purchased at Rs.938.7/-. The lot size is 250. Calculate the contract value ? SPAN is 7.5%, and Exposure is 5% of CV, respectively. Calculate the % and amunt of CV blocked as margins (SPAN + Exposure);

18. Example 10 th  Dec 2014 Sometime during the day, HDFC Bank futures contract was purchased at Rs.938.7/-. The lot size is 250. Hence the contract value is Rs.234,675/-. SPAN is 7.5%, and Exposure is 5% of CV, respectively. Hence 12.5% of CV is blocked as margins (SPAN + Exposure); this works up to a total margin of Rs.29,334/-. The initial margin is also considered as the initial cash blocked by the broker

19. Going ahead, HDFC closes at 940 for the day. 1.Calculate the CV is now and the total margin requirement, increase in margin required at the time of the trade initiation. 2. The client required/not required to infuse this money into his account and why ? 3. Increase/Decrease marginal requirement ? Calculate t he total cash balance in the trading account 4. Cash balance is more/Less than the total margin requirement ? 5. Next day’s M2M is now ?

20. Going ahead, HDFC closes at 940 for the day. At 940, the CV is now Rs.235,000/- and therefore, the total margin requirement is Rs.29,375/- which is a marginal increase of Rs.41/- compared to the margin required at the time of the trade initiation. The client is not required to infuse this money into his account as he is sufficiently covered with an M2M profit of Rs.325/- which will be credited to his account. The total cash balance in the trading account = Cash Balance + M2M = Rs.29,334 + Rs.325 = Rs.29,659/- Clearly, the cash balance is more than the total margin requirement of Rs.29,375/- hence there is no problem. Further, the reference rate for the next day’s M2M is now set to Rs.940/-.

21. 11 th  Dec 2014 The next day, HDFC Bank drop by Rs.1/- to Rs.939/- per share, I mpacting on M2M ? This money is taken out/Deposited in/from the cash balance ? Hence the new cash balance will be ? The new margin requirement is ? Worry ? Next day’s M2M is reset

22. 11 th  Dec 2014 The next day, HDFC Bank drop by Rs.1/- to Rs.939/- per share, impacting the M2M by negative Rs.250/-. This money is taken out from the cash balance (and will be credited to the person making this money). Hence the new cash balance will be – = 29659 – 250 = Rs.29,409/- Also, the new margin requirement is calculated as Rs.29,344/-. Clearly, the cash balance is higher than the margin required; hence there is nothing to worry about. Also, the reference rate for the next day’s M2M is reset at Rs.939/-

23. 12 th  Dec 2014 This is an interesting day. The futures price fell by Rs.9/- taking the price to Rs.930/- per share. At Rs.930/- the margin requirement will be ? M2M loss? Cash balance? Worry

24. 12 th  Dec 2014 This is an interesting day. The futures price fell by Rs.9/- taking the price to Rs.930/- per share. At Rs.930/- the margin requirement also falls to Rs.29,063/-. However, because of an M2M loss of Rs.2250/- the cash balance drops to Rs.27,159/- (29409 – 2250), which is less than the total margin requirement. Since the cash balance is less than the total margin requirement, is the client required to pump in the additional money?

25. 19 th  Dec 2014 At 955, the trader decides to cash out and square off the trade. The reference rate for M2M is the previous day’s closing rate which is Rs.938. M2M profit/Loss ?. The final cash balance ?

26. 19 th  Dec 2014 At 955, the trader decides to cash out and square off the trade. The reference rate for M2M is the previous day’s closing rate which is Rs.938. So the M2M profit would Rs.4250/- which gets added to the previous day cash balance of Rs.29,159/-. The final cash balance of Rs.33,409/- (Rs.29,159 + Rs.4250) will be released by the broker as soon as the trader squares off the trade.

27. L et us assume HDFC Bank drops heavily on 20 th  December – maybe an 8% drop, dragging the price to 880 all the way from 955. What do you think will happen?  What is the M2M P&L? What is the impact on cash balance? What is the SPAN and Exposure margin required? What action does the broker take?

28. The M2M loss would be Rs.18,750/- = (955 – 880)*250.  The cash balance on 19 th  Dec was Rs. 33,409/- from which the M2M loss would be deducted, making the cash balance Rs.14,659/- (Rs.33,409 – Rs.18,750). Since the price has dropped, the new contract value would be Rs.220,000/- (250*880) SPAN = 7.5% * 220000 = Rs.16,500/- Exposure = Rs.11,000/- Total Margin = Rs.27,500/ Clearly, since the cash balance (Rs.14,659/-) is less than SPAN Margin (Rs.16,500/-), the broker will give a Margin Call to the client, or in fact, some brokers will even cut the position in real-time as and when the cash balance drops below the SPAN requirement.

29. Arbitrage live price chart of  Reliance Industries , the cash price on 25th Jan is Rs.960.50 while the Feb 22nd Futures price is Rs.965.15. So, the arbitrage spread is {(965.15-960.50)/960.50} which works out to  0.48% . That is the return for a period f 28 days. So, the annualized return in this case works out to (0.48% x (365/28) =  6.26% Normally arbitrageurs prefer an annualized return of around 12-14% as they also need to cover their cost of funding and the transaction and statutory costs of doing the arbitrage, apart from the tax implications. So how does arbitrage work with futures?

30. Hedging  Imagine you have bought 250 shares of Infosys at Rs.2,284/- per share. This works out to an investment of Rs.571,000/-. Clearly you are ‘ Long ’ on Infosys in the spot market. After you initiated this position, you realize the quarterly results are expected soon. You are worried Infosys may announce a not so favorable set of numbers, as a result of which the stock price may decline considerably. To avoid making a loss in the spot market you decide to hedge the position. In order to hedge the position in spot, we simply have to enter a position in the futures market. Future Price : 2285/- Price on Day-I , Day-II and D-III are 2200, 2290, 2500

31. Arbitrary Price Long Spot P&L Short Futures P&L Net P&L 2200 2200 – 2284 = – 84 2285 – 2200 = +85 -84 + 85 = [phone] – 2284 = +6 2285 – 2290 = -5 +6 – 5 = [phone] – 2284 = +216 2285 – 2500 = -215 +216 – 215 = +1

32. In order to hedge the position in spot, we simply have to enter a counter position in the futures market. Since the position in the spot is ‘ long ’, we have to ‘ short ’ in the futures market. Here are the short futures trade details – Short Futures @ 2285/- Lot size = 250 Contract Value = Rs.571,250/-

33. Intrinsic Value of option The intrinsic value of an option is the money the option buyer makes from an options contract provided he has the right to exercise that option on the given day. Intrinsic Value is always a positive value and can never go below 0.  How much money would you stand to make provided you exercised the contract today? Underlying CNX Nifty Spot Value 8070 Option strike 8050 Option Type Call Option (CE) Days to expiry 15 Position Long

34. Cont … Intrinsic Value of a Call option = Spot Price – Strike Price Let us plug in the values = 8070 – 8050 = 20 So, if you were to exercise this option today, you are entitled to make 20 points (ignoring the premium paid).

35. Option Type Strike Spot Formula Intrinsic Value Remarks Long Call 280 310 Spot Price – Strike Price 310 – 280 = 30 Long Put 1040 980 Strike Price – Spot Price 1040 -980 = 60 Long Call 920 918 Spot Price – Strike Price 918 – 920 = 0 Since IV cannot be - ve Long Put 80 88 Strike Price – Spot Price 80 – 88 = 0 Since IV cannot be - ve

36. important points – The intrinsic value of an option is the amount of money you would make if you were to exercise the option contract The intrinsic value of an options contract can never be negative. It can be either zero or a positive number Call option Intrinsic value = Spot Price – Strike Price Put option Intrinsic value = Strike Price – Spot price

37. Moneyness of a Call option Moneyness of an option is a classification method that classifies each option strike based on how much money a trader will make if he were to exercise his option contract today . There are three broad classifications – In the Money (ITM) At the Money (ATM) Out of the Money (OTM)

38. in the Money" (ITM) The phrase in the money (ITM) refers to  an option that possesses intrinsic value . An option that's in the money is an option that presents a profit opportunity due to the relationship between the strike price and the prevailing market price of the underlying asset.

39. Out of the Money (OTM) An OTM call option will have a  strike price  that is higher than the market price of the underlying asset. Alternatively, an OTM put option has a strike price that is lower than the market price of the underlying asset.

40. At the money (ATM) At the money (ATM) is a situation where an option's strike price is identical to the current market price of the underlying security. Both call and put options can be simultaneously ATM.