business analytics_forwards and futures

8/7/2019 Business Analytics_Forwards and Futures

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Forwards and Futures


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Introduction

The emergence of the market for derivative products can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in assetprices. Thus, derivative products initially emerged as hedging devices against fluctuations incommodity prices. Commodity linked derivatives remained the sole form of such products for almostthree hundred years.

Financial products commonly traded in the derivatives market are themselves not primary loans orsecurities. But can be used to change the risk characteristics of underlying asset or liability position,they are referred to as 'derivative financial instruments' or simply 'derivatives.'

These financial instruments are so called because they derive their value from some underlyinginstrument and have no intrinsic value of their own. The world over, derivatives are a key part of thefinancial system.

Figure 1 displays the classification of derivatives.

Figure 1. Classification of Derivatives

In this unit, we will discuss in detail about different types of derivatives.

Forward Contracts

With a forward market, the transfer of ownership occurs on the spot, but delivery of the commodity orinstrument does not occur until some future date. In a forward contract, two parties agree to do a trade

According to the Securities Contracts (Regulation) Act, 1956, derivatives are thoseassets whose value is determined from the value of some underlying assets. Theunderlying asset may beequity, commodity or currency. A common place where suchtransactions take place is called the derivative market.

A forward contract is an agreement made today between a buyer and a seller toexchange the commodity or instrument for cash at a predetermined future date at aprice agreed upon today. The agreed upon price is called the forward price.

Types

of

Derivatives

ForwardContracts Future

Contracts

Options

Swaps

Swaptions

Baskets

LeapsWarrants


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at some future date, at a stated price and quantity. No money changes hands at the time the deal issigned.

A wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of achange in prices by that date. Such transaction would take place through a forward market.

Forward contracts are not traded on an exchange, they are said to trade Over the Counter (OTC). Thequantities of the underlying asset and terms of contract are fully negotiable. The secondary marketdoes not exist for the forward contracts and faces the problems of liquidity and negotiability.

Features of Forward Contracts

The following are the features of forward contracts.

1. Custom tailored2. Traded over the counter (not on exchanges)3. No money changes hands until maturity4. Non-trivial counter-party risk

Consider a 5-month forward contract for 1,000 tons of castors at a forward price ofRs. 255 per ton. The long side is committed to buy 1,000 tons of castors from the short side in fivemonths at the price of Rs. 255 per ton.

Futures Contracts

The futures contract relates to a given quantity of the underlying asset and only whole contracts canbe traded. The trading of fractional contracts is not allowed in futures contracting. The terms of thefutures contracts are not negotiable.

A futures contract is a financial security, issued by an organised exchange to buy or sell a commodity,security or currency at a predetermined future date at a price agreed upon today. The agreed uponprice is called the futures price.

Features of Futures Contracts

The following are the features of futures contracts.

1. Standardised contracts:

(a) underlying commodity or asset(b) quantity(c) maturity

The futures contract is traded on a futures exchange as a standardised contract, subjectto the rules and regulations of the exchange. It is the standardisation of the futurescontract that facilitates the secondary market trading.


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2. Exchange traded3. Guaranteed by the clearing house no counter-party risk4. Gains or losses settled daily5. Margin account required as collateral to cover losses

Yesterday, Jammy bought ten December live-cattle contracts at CME, at a price of Rs. 0.7455 per pound.The following are the details related to contract.

Contract size 40,000 lb

Agreed to buy 400,000 pounds of live cattle in December

The value of position yesterday: (0.7455)(10)(40, 000) = Rs. 298, 200.

Assuming, no money changed hands and the initial margin required (5%-20% of contract value), today, the

futures price closes at Rs. 0.7435/lb.

The value of position today (at the future price of Rs. 0.7435/lb) is calculated as:

(0.7435)(10)(40, 000) = Rs. 297, 400 (that is, a loss of Rs. 800)

We can infer that:

Standardisation makes futures liquid Margin and marking to market reduce default risk Clearing-house guarantee reduces counter-party risk

Futures vs. Forward

Forward contracts are private bilateral contracts and have well-established commercial usage. Futurescontracts are standardised tradable contracts fixed in terms of size, contract date and all other features.Table 6.1 lists the differences between forward and futures contracts.

Table 1. Forward Contracts vs. Futures Contracts

Forward contracts Future contracts

1. The contract price is notpublicly disclosed and hence not

transparent.

1. The contract price is transparent.

2. The contract is exposed to defaultrisk by counterparty.

2. The contract has effectivesafeguards against defaults in theform of clearing corporationguarantees for trades and daily markto market adjustments to theaccounts of trading members basedon daily price change.

3. Each contract is unique interms of size, expiration date

3. The contracts are standardised interms of size, expiration date and all


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and asset type/quality. other features.

4. The contract is exposed tothe problem of liquidity.

4. There is no liquidity problem inthe contract.

5. Settlement of the contract is done bydelivery of the asset on theexpiration date.

5. Settlement of the contract is doneon cash basis.

Types of Futures

Futures contracts can be classified into four categories. They are:

Interest Rate Futures

Index Futures

Currency Futures

Commodity Futures

Interest Rate Futures

Interest rate futures are based on an underlying security which is a debt obligation. An interest rate

future moves in value according to the changes in the interest rates.

In a market condition in which the interest rates are moving higher, the futures contract buyer has topay the seller an amount equal to that of the profit accrued by investing at a higher rate in comparisonto that of the rate specified in the futures contract.

On the contrary, when interest rates move lower, the futures contract seller compensates the buyer forthe lower interest rate at the time of expiration.

An interest rate futures price index was created in order to accurately determine the gain or loss of aninterest rate futures contract. In the condition of buying, the index is calculated by subtracting the

futures interest rate from 100 (which can be mathematically written as 100 Futures Interest Rate).This price index fluctuates in accordance with the interest rates.

In other words, when the interest rates increase, the index will move lower and vice versa. Examplesinclude Treasury-bill futures, Treasury-bond futures and Eurodollar futures.

By now, it is quite clear that the interest rate futures are used to hedge against the risk of the interestrates that will move in an adverse direction, causing a cost to the company. Typically, the interest ratefutures contract has 1 basis point or base price move (tick) of 0.01. Nevertheless, certain contractshave a tick value of 0.005 or half of 1 basis point.

Solved Problem - 1

A T-bond with an annual coupon rate of 7% (with semi-annual coupon payments) is selling at par.


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If the current short rate is 5%, what would be the 6-month forward price of the T-bond?

Solution:

Table 6.2 displays the cash flow particulars of T-bond.

Table 6.2. Cash flow Particulars of T-bond

Time 0 1 2 3

Buy T-bond 100.0 3.5 3.5 3.5Sell T-bill 100.0 102.5 0 0

Net 0 99.0 3.5 3.5

This strategy allows one to lock in a purchase of the 7% T-bond 6-month later for $ 99. Noarbitrage requires the current forward price to be $ 99.

In general, a bonds forward price is calculated as shown in equation 6.1.

)yr1(SF += -------- Eq. 6.1

where,

S = T-bonds spot price

r = Spot interest rate

y = C/S = T-bonds coupon yield

Index Futures

Index or Stock index futures are one of the varieties of futures contracts. The first stock index futurescontract based on value line index were introduced by Kansas City Board of Trade (KCBT) on 24thFebruary, 1982. Two months later, the Standard and Poor (S&P) 500 Index futures contract was

introduced by the Chicago Mercantile Exchange (CME).

At present, S&P 500 Index Futures is the most actively traded futures contract. Table 6.3 displays thestock index futures that are the most actively traded financial derivatives in the world.

Table 6.3. Stock Index Futures

S. No. Country Stock Name

1. India BSE SENSEX, NSE, CNX, NIFTY

2. US DJIA, S&P 500, NYSE, RUSSELL 2000,NASDAQ 100

3. Japan NIKKEI

4. Germany DAX5. UK PTSE 100

6. France CAC 40

7. Switzerland SMI

8. Spain IBEX 35

9. Canada TSE 35

10. Hong Kong HANGSENG

11. Malaysia KUALALUMPUR

12. South Korea KOSPI 2000


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Trading in Stock Index Futures

Trading in Sensex or Nifty futures is just like trading in any other security. An investor is able to buyor sell futures on the BSE Bolt terminal or the NSE NEAT screen with his broker. In the trading,the order will have to be punched in the system. The confirmation from the system will be immediatelike the existing system. Since the tick size and market lot size in futures are similar to individualstock, the feel of trading in stock index futures is the same as trading on stocks.

Separate bids and ask quotations are available like shares. Simply, the investor has to punch in theorder of the required quantity at a price he wishes to buy, sell or execute the same at the market price.Upon execution of the order he would receive a confirmation of the same. A trader can carry the stockindex futures contract till maturity or square it off at any time before expiry.

Pricing of Stock Index Futures

Contract theoretical or fair price of a stock index futures contract is derived from the well-celebratedcost of carry model.

Accordingly, the stock index futures price depends upon:

i. Spot index valueii. Cost of carry or interest rateiii. Carry return, that is, dividends expected on securities comprising the index

Speculation in Stock Index Futures Trading

An investor can speculate by trading in stock index futures based on his expectations of market rise ormarket fall. Suppose an investor expects the market to rise then he can buy stock index futures.

Hedging with Stock Index Futures

Hedging technique is very useful in the case of high net worth entities such as mutual funds having aportfolio of securities. For instance, if the investor wants to reduce the loss on his holding of securitiesdue to uncertain price movements in the market, he can sell futures contracts.

Reasons for Popularity of Stock Index Futures

Stock index futures are the most preferred derivatives in India owing to the undernoted reasons:

1. The portfolio hedging is given priority by the institutional and other enormous equity-holders.2. The most cost-efficient hedging is the stock index futures.3. Stock index is almost beyond the scope of manipulation, whereas it is very easy tomanipulate the individual stock price (Instances such as, manipulation of individual stock

prices of Reliance Industries Ltd. and the State Bank of India by some interested parties,are recorded in history).4. The most liquidity featured stock index futures are most popular in India and abroad.5. The remote possibility of bankruptcy in stock index futures has been guaranteed by theclearinghouse effects.6. The individual stock futures are always used for manipulating their prices in cashmarket.7. The less volatility featured stock index futures have lowered the requirement of capitaladequacy and margin in comparison to individual stock futures.


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8. The regulatory framework for stock index futures ensures less complexity and hence,the popularity for equity derivatives is growing.

Stock index futures offer implementation advantages and incremental returns to portfolios onlybecause of the fact that some useful strategies are available for institutions using stock index futures.

There are a number of useful strategies available for institutions using stock index futures.

1. The benefit of the lowest possible transaction costs is attractive.2. The actual disposing of equity holdings may be made gradually subject to the market conditions.3. The low commission rate on stock index futures trading and the high level of liquidity in stock indexfutures market offer the potential for significant savings.4. Stock index futures offer an attractive strategy for maintaining the desired stock market exposure ofthe portfolio at all points of time.5. Stock index futures are strategically used for insuring against market risks.6. Stock index futures offer an effective beta control to the portfolio manager for having the followingadvantages:

i. Optimal stock mixii. Considerable lower transaction costs

iii. Achieving the portfolio target beta through buying targeted futures

7. Stock index futures offer the most productive as well as effective asset allocation strategy to theportfolio manager in order to maximise the investors wealth by minimising the market risks.8. The market volatility can be effectively managed by stock index futures by making transactions withgreater speed with lower implementation cost.9. The market disruptions caused by the external investment managers can effectively be reduced withthe strategic use of stock index futures.10. The most important advantage of stock index futures is that less money needs to be involved to alterthe asset-mix due to the leveraged impact of contracts.

Solved Problem - 2

The following data relates to ABC Ltd.s share prices.

Current price per share = Rs. 180 Price per share in the futures market-6 months = Rs. 195

It is possible to borrow money in the market for securities transactions at the rate of 12% perannum.

i. Calculate the theoretical minimum price of a 6-month forward contract.

ii. Explain if any arbitraging opportunities exist.

Solution:

i. Calculation of theoretical minimum price of a 6-month forward contract:

Current share price Rs. 180Interest rate prevailing in money market for securities transactions 12%


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Then,

Theoretical Minimum Price = Rs.180 + (Rs.180 12/100 6/12) Rs.190.80

ii. Arbitraging opportunities

The current price per share in the futures market for 6 months is Rs. 195 and thetheoretical minimum price of 6-month forward is Rs. 190.80.

The arbitrage opportunities exist for ABC Ltd.s share. An arbitrageur can invest inABC Ltd.s shares at Rs. 180 by borrowing at 12% p.a. for 6 months and at the sametime he can sell the shares in the futures market at Rs. 195.

On the expiry date, that is, after 6 months period, the arbitrageur can collect Rs. 195 andpay off Rs. 190.80 and can record a profit of Rs. 4.20 (that is, Rs. 195 Rs. 190.80).

Currency Futures

More popularly, currency future is called as foreign exchange future or FX future. Usually, one of thecurrencies of exchange in such contracts is US dollar. The price of the futures contract of this type ishence measured in terms of US dollars per unit of other currency.

The trading unit of each contract is a particular amount of the other currency, for example, Rs.290,000. Most of the currency futures contracts have a physical delivery, so as to make the actualpayments of each currency for those held at the end of the last trading day.

Nevertheless, most contracts get closed even before the end of the last trading day. This means thatthe investors can close out the contract at any time before the contract's delivery date.

Currency futures contracts are similar to the currency markets, but there are certain significantdifferences between them. One such difference is that the currency futures are traded throughexchanges, such as the Chicago Mercantile Exchange (CME), but the currency markets are tradedthrough currency brokers. Thus, the currency markets are not as controlled as the currency futures.

While the traders prefer the currency markets on certain days, the currency futures become theirfavourites on the other. The currency futures are recommended as they do not suffer from some of theproblems that currency markets suffer from. For example, the problems may be from the currencybrokers trading against their clients, and may be due to non centralised pricing.

Settlement and Delivery of Currency Futures

Since currency futures are based upon the exchange rates of two different currencies, they are settledin the underlying currency in the form of cash.

The EUR futures market has the Euro as its underlying currency and is based upon the Euro to USDollar exchange rate. When an EUR futures contract expires, the holder thus receives the deliveryworth Euros in cash. This happens only when the contract expires.

Currency future, is a futures contract to exchange one currency for another at a

specified future date at a price (exchange rate) fixed on the purchase date.


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The day traders do not usually hold futures contracts until they expire. The day traders are generallynot involved in the settlement. Therefore, they do not receive delivery of the underlying currency.

Popular Currency Futures

Table 4 displays the most popular currency futures markets.

Table 4. Popular Currency Futures Markets

Name DescriptionEUR The Euro to US Dollar currency future

GBP The British Pound to US Dollar currency future

CHF The Swiss Franc to US Dollar currency future

AUD The Australian Dollar to US Dollar currency future

CAD The Canadian Dollar to US Dollar currency future

RP The Euro to British Pound currency future

RF The Euro to Swiss Franc currency future

Commodity Futures

The underlying commodity can be wheat, cotton, butter, eggs and so on. Such contracts began tradingon Chicago Board of Trade (CBOT) in 1860s. In India too, futures on soya bean, black pepper andspices have been trading for long.

For commodity futures:

Contango means the spot prices are lower than futures prices and/or the prices for near

maturities are lower than for distant.

Backwardation means the spot prices are higher than the futures prices and/or the pricesfor near maturities are higher than for distant.

Standardisation of Contracts

Since futures are traded on exchange, so future contracts are always standardised, that is, they mustspecify the asset. This standardisation includes:

How much asset is to be delivered under one contract

Where delivery will be made When delivery will be made

In principle, the parameters to define a contract are endless (see for instance in futures contract).There are only a limited number of standardised contracts to make sure that the liquidity is high.

The standardised items in any futures contract are:

i. Quantity of the underlying

Commodity futures can be defined as those futures where the underlying is acommodity or physical asset.


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ii. Quality of the underlying (not required in financial futures)iii. The date and month of deliveryiv. The units of price quotation (not the price itself) and minimum change in price (tick-size)v. Location of settlement

Thus, it becomes imperative that standardisation enhances liquidity, and makes it possible to trade thesame instrument for large numbers of participants in the market. This liquidity consequently makesthe contract more useful for hedging.

Minimum Price Fluctuation

Futures markets often have specific tick sizes, unlike the stock markets that have a tick size of 0.01,which is the equivalent of $ 0.01 for US stock markets. Tick sizes and tick values are part of thecontract specifications for all financial markets.

Tick Size

The minimum price fluctuation in the value of a contract, that is, the tick size, is presently "0.05" or5 paisa. In Rupee terms, this translates to a minimum price fluctuation of Rs. 0.75 for a singletransaction of SENSEX Futures Contract

(Tick size X Contract Multiplier = 0.05 X Rs. 15);

The EUR futures market has a tick size of 0.0001, which means that the smallest increment that theprice can move from 1.2902, would be up to 1.2903, or down to 1.2901.

Tick Value

The EUR futures market has a tick value of $ 12.50, which means that for every 0.0001 that theprice moves up or down, the profit or loss of a trade would increase or decrease by $ 12.50.

Remember that the standardisation also reduces the usefulness of a futurescontract as a merchandising vehicle.

Financial markets move in different sizes of price increments, and the minimum pricefluctuation is known as a tick.

A market's tick size is the minimum amount that the price of the market can change.

A market's tick value is the cash value of one tick (one minimum price movement).


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Profit and Loss Potential

Each day, the trading market has a different tick size (the smallest increment that the price can move),

and tick value (the amount of money per tick size). The higher the tick value, the more money is madeor lost with each price movement. So at the beginning of the day, traders need to trade markets thathave low to medium tick values.

Table 5 displays some popular day trading markets that have tick sizes and tick values low enough forbeginning day traders.

Table 5. Tick Sizes and Tick Values of Popular Day Trading Markets

Currency Futures EUR: The Euro futures market has a tickvalue of $ 12.50

GBP: The British Pound futures market has a

tick value of $ 6.25Stock Index Futures YM: The Dow Jones futures market has a tick

value of $5.00 ES: The S&P 500 futures market has a tick

value of $12.50 ER2: The Russell 2000 futures market has a

tick value of $10.00 CAC40: The CAC40 futures market has a tick

value of 5.00 EUR HSI: The Hang Seng futures market has a tick

value of 50.00 HKD

Commodity Futures ZG: The Gold 100 troy ounce futures markethas a tick value of $10.00

ZI: The Silver 5000 ounce futures market hasa tick value of $5.00

Agricultural Futures ZC: The corn futures market has a tick valueof $12.50

ZW: The wheat futures market has a tickvalue of $12.5

One popular futures market that is missing from the table 6.5 is the DAX (The DAX futures market).This is because the DAX has a tick value of EUR 12.50, so it is one of the highest tick value markets.

Therefore, it is not suitable for beginning day traders.

Future Price Quotations

Future price quotations can be explained as that price which has been stated or offered by the buyer tothe seller of the futures contracts. In most of the developed countries, future price quotations can bereached by the following two methods.

1. Cost of Carry Model

The tick size is also known as the minimum price movement. The tick value is alsoknown as the minimum price value.


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2. Expectancy Model

Let us discuss each model of futures pricing in detail.

Cost of Carry Model of Futures Pricing

Equation 2 represents the formula to calculate the fair price of the commodity.

InflowsCarryofCosticePrSpoticePrFair += ........ Eq. 2

where, Cost of carry is the financing cost, storage cost and insurance cost

Equation 2 can also be represented symbolically as shown in equation 3.

365/)tT()DR(CPCPFP tTtTtttT += ........ Eq. 3

where,

FPtT = Fair price of the asset at time t for the period up to time T CPt= Cash price of the asset RtT = Interest rate at time t for the period up to T DtT = Inflows in terms of dividend or interest between t and T

Assumptions of Cost of Carry Model

The following are the set of assumptions of cost of carry model.

No seasonal demand and supply in the underlying asset Storability of the underlying asset is not a problem The underlying asset can be sold short No transaction cost; no taxes

No margin requirements, and so the analysis relates to a forward contract, rather than afutures contract

Index Futures and Cost of Carry Model

In the normal market, relationship between cash and future indices is described by the cost and carrymodel of futures pricing.

Expectancy Model of Futures Pricing

If Futures price is greater than the Fair price, it is better to buy in the cash market andsimultaneously sell in the futures market.

If Futures price is less than the Fair price, then it is better to sell in the cash market andsimultaneously buy in the futures market.

This arbitrage between cash and future markets will remain till prices in the cash and futuremarkets get aligned.


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Expectancy model says that many-a-time it is not the relationship between the fair price and futureprice but the expected spot price and future price which leads the market. This happens mainly whenunderlying asset or instrument is not storable or may not be sold short, for instance, in thecommodities market.

E(S) can be above or below the current spot prices. This reflects markets expectations. Figure 2displays the relationship between expected spot price and Future price.

Figure 2. Relationship between Expected Spot Price and Future Price

where,

S = Spot prices

F = Future prices E(S) = Expected spot prices

In India, the way of pricing any Future is to factor in the current price and holding costs or cost of

carry. As we already know, the futures contract is usually for a specified period of time, at the end ofwhich, it is settled. The buyer has to pay some interest in order to compensate the seller for waiting tillexpiry for realising the sale proceeds which is reflected in the form of cost of carry.

In general the futures prices are calculated by the formula represented in equation 4.

CarryofCosticePrSpoticePrFutures += ........ Eq. 4

In equation 4, the cost of carry is the sum total of all the costs incurred in case a similar position istaken in cash market and carried to maturity of the futures contract minus any revenue which may

result in this period. The costs typically include interest in case of financial futures (also insurance andstorage costs in case of commodity futures). The revenue may comprise of dividends in case of indexfutures.

Apart from the theoretical value as calculated using the formula represented by equation 6.4, theactual value of the future price may vary depending on demand and supply of the underlying atpresent and expectations about the future. These factors play a much more important role incommodities, especially perishable commodities than in financial futures.

Contango market: Market when future prices are above cash pricesBackwardation market: Market when future prices are below cash prices


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Usually, in case of a bullish sentiment in the market, the futures price is greater than the spot price. Onaccount of a bearish view in the market which makes it a special case, when cost of carry is negative,the futures price may be lower than spot prices.

Trading Mechanism of Futures

For future markets, one must understand that they work on the principle of convergence of futureprices to the spot prices at the time of delivery.

Suppose the future prices go above or below to expected spot prices then obviously traders wouldhave a clear arbitrage opportunity and would exploit it either by going short or long. Keynes andHicks have argued that in case hedger tends to shorten his position and speculator tends to lengthenhis position then future price will fall below the expected future spot price. This is because thespeculator would require compensation for the risk he is bearing.

Hence, one can trade only if there is an expectation that the future price will rise again. Converse willhappen in case hedger tends to lengthen his position and speculator tends to shorten his position. Themechanism of futures contracts can be understood by going through the following explanation:

Buy a future to agree to take delivery of a commodity. This will protect against a rise inprice in the spot market as it produces a gain if spot prices rise. Buying a future is said to begoing long.

Sell a future to agree to make delivery of a commodity. This will protect against a fall inprice in the spot market as it produces a gain if spot prices fall. Selling a future is said to begoing short.

Futures Contract

Certain futures contracts, such as on stocks or currency, settled in cash on the price differentials,because clearly, delivery of this particular commodity would be difficult.

As already discussed, the futures price is the sum of spot price and costs of carrying, where spot priceis the current price of a commodity and the costs of carrying of a commodity is the aggregate of thefollowing.

(a) Storage

(b) Insurance(c) Transport costs involved in delivery of commodity at an agreed place(d) Finance costs, that is, interest forgone on funds used for purchase of the commodity

Although the spot price and futures price generally move in line with each other, the basis is notconstant. Equation 5 represents the formula to calculate basis.

icePrSpoticePrFuturesBasis = ........ Eq. 5

A futures contract is a contract for delivery of a standard package of a standard commodity orfinancial instrument at a specific date and place in the future but at a price that is agreed when the

contract is taken out


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Generally, the basis will decrease with time. And on expiry, the basis is zero and futures price equalsspot price.If the futures price is greater than the spot price, it is called contango. Under normal market conditionsfutures contracts are priced above the spot price. This is known as the contango market. In this case,the futures price tends to fall over time towards the spot, equalling the spot price on delivery day.

If the spot price is greater than the futures price it is called backwardation. Then the futures pricetends to rise over time to equal the spot price on the delivery day. So in either case, the basis is zero atdelivery. This may happen when the cost of carry is negative, or when the underlying asset is in shortsupply in the cash market, but there is an expectation of increased supply in future, for exampleagricultural products.

The direction of the change in price tends to hold for cycles of contracts with different delivery dates.If the spot price is expected to be stable over the life of the contract, a contract with a positive basiswill lead to a continued positive basis although this will be lower in nearby delivery dates than in far-off delivery dates. This is a normal contango.

Conversely, normal backwardation is the result of a negative basis where nearer maturing contractshas higher futures prices than far-off maturing contract.

Figure 3 illustrates the concepts of contango and backwardation in case of Futures contracts.

FuturesPrice

Contango

SpotPrice

Backwardation

Delivery Time Time

Figure 3. Futures Contracts Contago and Backwardation

Simple Pay-off Positions in Futures

The buyer of a futures contract is said to go long the future, whereas the seller is said to go short.With a long position, the value of the position rises as the asset price rises and falls as the asset pricefalls. With a short position, a loss ensues if the asset price rises but profits are generated if the assetprice falls.

Buyers Pay-off

The buyer of futures contract has an obligation to purchase the underlying instrument at a price whenthe spot price is above the contract price. The buyer will buy the instrument for the price C and cansell the instrument for higher spot price thus making a profit. When the contract price is above spotprice, a loss is made by the buyer of the contract.


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Sellers Pay-off

The seller of the contract makes a profit when the contract price is above the spot price. The seller willpurchase the instrument at the spot price and will sell at the contract price. The seller makes a losswhen the spot price is above the contract price.

Figure 4 represents the Pay-off in Long and Short Futures Position.

L o n g p o s i t i o n S h o r t p o s i t i o n

P

ro

fi

t

0

L

o

s

s

P a y o f f

C

P

ro

fi

t

0

L

o

s

s

F u t u r e p

Pa

y o

ff

C

P a y o f f

C = C o n t r a c t p r i c e C = C o n t r a c t p

Figure 4. Pay-off in Long and Short Futures Position

Suppose a trader has bagged an order for which he has to supply 2,000 tonnes of aluminium sheetto the buyer within next two months.

After obtaining the order, the trader is observing a rise of price of aluminium sheet in the openmarket. If such a rise continues, the profit margin of the trader may get shrunk; he may even landon a huge loss just because of rise in the procurement price of the aluminium sheet.

But if the trader under the circumstances purchases aluminium sheet futures, then any loss for therise of price of aluminium to be bought by the trader for the supply order could be then off-set

against profit on the future contract.

However, if there is a fall of price, extra profit on fall of price of aluminium sheet can also be offsetagainst cost or loss of futures contract. So hedging technique is the equivalent of insurance facilityagainst market risk where price is always volatile.

Marking to Market

In futures contracts, a small payment known as initial margin is required to be deposited with theorganised futures exchange. Due to fluctuations in the price of underlying asset, the balance in the

margin account may fall below specified minimum level or even become negative at the end of eachtrading session.

All outstanding contracts are appraised at the settlement price of that session, which is called markingto market. This means adjusting the margin accounts of both the parties. A member incurring costshould make payment of profit to the counter party and the value of future contracts is set to zero atthe end of each trading session. The daily settlement payments are known as variation marginpayments.


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Closing Out of Futures Contract

A long position in futures can be closed out by selling futures while a short position in futures can beclosed out by buying futures on the exchange. Once position is closed out, only the net differenceneeds to be settled in cash, without any delivery of underlying. Most contracts are not held to expirybut closed out before that. If held until expiry, some are settled for cash and others for physicaldelivery.

Simple Strategies in Futures Market

Table 6 displays the simple strategies that are popular in the futures market.

Table.6. Popular Strategies in Futures Market

Strategy Explanation

CommoditiesFutures Market

Buy a Future to agree to take delivery of a commodity to protectagainst a rise in price in the spot market as it produces a gain ifspot prices rise. Buying a Future is said to be going long

Sell a Future to agree to make delivery of a commodity to

protect against a fall in price in the spot market as it produces again if spot prices fall. Selling a Future is said to be going short

Interest RateFuture

Selling short an interest rate futures contract protects against arise in interest rates

Purchasing long an interest rate futures contract protects againsta fall in interest rates. Future Rate Agreements (FRAs)

Selling short on FRA protects against a fall in interest rates

Purchasing long on FRA Protects against a rise in interest rates

CurrencyFutures

Buying long a currency Future protects against a rise incurrency value

Selling short a currency Future protects against a fall incurrency value

Clearing and Settlement of Futures

Clearing and settlement of futures is done by the clearing houses. Clearing houses serve as the agencyor a separate corporation of a futures exchange. These clearing houses are responsible for settlingtrading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery andreporting trading data. They act as third parties to all futures contracts and play the role of a buyer toevery clearing member seller and a seller to every clearing member buyer.


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Suppose a member broker reports to the clearing house at the end of a trading day that he had atotal purchase of 100,000 tonnes of steel and total sales of 50,000 tonnes of steel, implying that hewould be net long 50,000 tonnes of steel.

Assuming that it is the broker's only position in futures and that the clearing house margin is 6paisa/ton. Then, the broker would be required to have Rs. 3,000 on deposit with the clearing house.

Settlement may be of two types, namely, cash settlement and physical settlement.

Let us assume that the price of gold is Rs. 6000 on the date of expiration. So if the contract saysthat you have to give someone a tula (1 tula = 100 gms) at Rs.5500, you lose Rs. 500. In case, bothyou and your trading partner decide to settle this contract forever on the ground that he pays youRs. 500, it will be known as cash settlement.

National Securities Clearing Corporation Limited (NSCCL) was established in August 1995, which isthe first clearing corporation in India. It is a wholly owned subsidiary of NSE and acts as the bodyresponsible for carrying out the entire clearing and settlement process.

The primary functions of NSCCL are:

To operate tight risk containment system

To carry out the Novation (It is a process of replacement of one obligation by anotherby mutual agreement of both the parties)

To act as the counter party to all the trades

To guarantee the final settlement

Model of Clearing and Settlement Process

Clearing members and clearing banks are the entities that help NSCCL in carrying out the activities ofclearing and settlement.

There are two types of clearing members. They are:

Trading and Clearing Members (TCM): TCM clear and settle their own trades as wellas the trades of other trading members (TM)

Professional Clearing Members (PCM): PCM clear the trades executed by tradingmembers

Each futures exchange has its own clearing house. It is mandatory for all members of an exchange toclear their trades through the clearing house at the end of each trading session.

It is also mandatory to deposit with the clearing house a sum of money sufficient to cover themember's debit balance. This sum is based on clearing house margin requirements.


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TCM and PCM have to pay deposit to undertake clearing and settlement of trades of every TM. TCMand PCM have to open a separate bank account with NSCCL designated bank for settlement of trades.

Figure 5 represents the three components of the model of clearing and settlement process.

Figure 5. Model of Clearing and Settlement Process.

Clearing Mechanism:

The clearing mechanism involves the following steps.

NSCCL works out open positions and obligations of clearing members (TCM andPCM) at the end of every business day.

Daily exposure limits and margin obligations are derived based on net open positions.Net open contracts (Buy Sell) multiplied by 1000 gives the net open positions in USDterms.

Settlement Mechanism:

The settlement mechanism involves the following steps.

1. Settlement is done in cash mode payable in Indian Rupees (INR).

2. Daily Marking to Market (MTM) settlement takes place based on Daily SettlementPrice (DSP).3. NSE daily disseminates DSP on its website.4. If a client has carried forward the position from previous day, then MTM is calculatedas the difference between previous days DSP and current days DSP.5. Clearing members with net loss in daily MTM have to pay the amount in cash. Clearingmembers with net profit will receive the amount in cash. Payment and receipts are to besettled on the basis of T+1 day.6. Clearing members are responsible for collection/payment of daily MTM from/to thetrading members, who in turn are responsible for the clients liabilities.7. At the end of the day, all the net positions are carried forward to next day after resetting

with respect to the current days DSP.8. Final settlement is also done in cash mode in terms of INR.9. Final settlement price is the RBI reference rate on the last trading day of the expirycontract.10. Final profit and loss or MTM of all the net open positions of the clearing members willbe on the basis of final settlement price. Final settlement takes place on the basis of T+2days.

Risk Management


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National Securities Clearing Corporation Limited (NSCCL) has a comprehensive risk managementsystem, which is constantly upgraded to pre-empt market failures. The Purpose is to make the tradingmember obligations commensurate with their networth.

The following tasks are performed in the risk management process.

Additional areas of perceived risk are identified

Members are required to stick to capital adequacy requirements

Unusually high pay-in liability members are required to make advance pay-in of funds

Continuous monitoring of member performance and track record

Intensive monitoring of members' position having concentration in certain high-risksecurities that attract high volumes and volatility is done

Margin requirements are quite stringent

Online monitoring of member positions

An automatic disablement from trading is done when limits are breached

Motives for using FuturesFigure 6 displays the three motives for using futures contracting.

Figure 6. Motives for using Futures

1. Hedging:The classic hedging application would be that of wheat farmer forward/futures selling hisharvest at a known price in order to eliminate price risk. Conversely, a bread factory may wantto buy wheat forward/futures in order to assist production planning without the risk of pricefluctuations.

2. Price Discovery:

Price discovery is the use of forward/futures prices to predict spot price that will prevail in thefuture. These predictions are useful for production decisions involving the variouscommodities.3. Speculation:

If a speculator has information or analysis which forecasts an upturn in a price, then he can golong on the forward/futures market instead of the cash market, wait for the price rise, and thentake a reversing transaction. The use of forward/futures market here gives leverage to thespeculator.

On the basis of the above motives, there exist various types of participants in futures market.

Figure 7 represents the major players in the futures markets.

Motives

for using

Futures

Hedging

Price Discovery

Speculation


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Figure 7. Major Participants in the Futures Markets

Hedging Strategies using Futures

It may appear that companies in which individual investors place money do not have exposures tofinancial prices. The predictability of future results shows a strong correlation with the volatility ofeach strategy.

Future performance of strategies with high volatility is far less predictable than future performance

from strategies experiencing low or moderate volatility.

The following are the various hedging strategies using futures.

1. Aggressive Growth:

Under the aggressive growth strategy, hedge fund investors invest in equities expected toexperience acceleration in growth of earnings per share. These are generally high P/Eratios, low or no dividends; often smaller and micro cap stocks, which are expected toexperience rapid growth.

The stocks that need aggressive growth strategy include sector specialist funds such as

technology, banking, or biotechnology. The strategy comprises of hedges by shortingequities where earnings disappointment is expected or by shorting stock indexes. This typeof strategy tends to be long-biased.

The expected volatility of aggressive growth hedging strategy is high.

2. Distressed Securities:

Under the strategy of distressed securities, the investors buy equity, debt, or trade claims atdeep discounts of companies in or facing bankruptcy or reorganisation. Hence, theinvestors will be profited from the markets lack of understanding about the true value of


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the deeply discounted securities. This is also because the majority of institutional investorscannot own below investment grade securities.

This selling pressure creates the deep discount. The results of the strategy generally do notdepend on the direction of the markets.

The expected volatility of distressed securities type of hedging strategy is low to moderate.

3. Emerging Markets:

The strategy of emerging markets make the hedge funders invest in equity or debt ofemerging (less mature) markets, which tend to have higher inflation and volatile growth.

Short selling is not permitted in many emerging markets, and, therefore, effective hedgingis often not available, although bad debt can be partially hedged through Indian Treasuryfutures and currency markets.

The expected volatility of emerging markets type of hedging strategy is very high.

4. Fund of Funds:

Fund of funds is a strategy which mixes and matches hedge funds and other pooledinvestment vehicles. This blending of different strategies and asset classes aims to providea more stable long-term investment return than any of the individual funds.

The mix of underlying strategies and funds can control returns, risk and volatility. Capitalpreservation is generally an important consideration. Volatility depends on the mix andratio of strategies employed.

The expected volatility of fund of funds type of hedging strategy is low to moderate.

5. Income:

The strategy based on income will have the primary focus on yield or current income ratherthan solely on capital gains. Under this strategy, the investors may utilise leverage to buybonds and sometimes fixed income derivatives in order to profit from principalappreciation and interest income.

The expected volatility of hedging strategy based on income is low.

6. Macro:

The macro strategy aims to profit from changes in global economies typically broughtabout by shifts in government policy. The shifts in government policy impact interest rates,in turn affecting currency, stock, and bond markets. Investor utilises hedging, but leverageddirectional bets tend to make the largest impact on performance.

The expected volatility of macro strategy is very high.

7. Market Neutral Arbitrage:

The market neutral arbitrage strategy attempts to hedge out most market risk by takingoffsetting positions, often in different securities of the same issuer.

Investors may also use futures to hedge out interest rate risk. It focuses on obtaining returnswith low or no correlation to both the equity and bond markets. These relative value


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strategies include fixed income arbitrage, mortgage backed securities, capital structurearbitrage, and closed-end fund arbitrage.

The expected volatility of the market neutral arbitrage strategy is low.

8. Market Neutral Securities Hedging:

The strategist under this category invests equally in long and short equity portfoliosgenerally in the same sectors of the market. Market risk is greatly reduced, but effectivestock analysis and stock picking is essential to obtain meaningful results. Leverage may beused to enhance returns.

The strategy has usually low or no correlation to the market. Sometimes market indexfutures are used to hedge out systematic (market) risk. Relative benchmark indexes, usuallyT-bills, are used in market neutral securities hedging.

The expected volatility of the market neutral securities hedging strategy is low.9. Market Timing:

The market timing strategy allocates assets among different asset classes depending on themanagers view of the economic or market outlook. Portfolio emphasis may swing widelybetween asset classes.

Unpredictability of market movements and the difficulty of timing entry and exit frommarkets add to the volatility of this strategy.

The expected volatility of the market timing strategy is high.

10. Opportunistic:

Investment theme changes from strategy to strategy as opportunities arise to profit fromevents such as Initial Public Offerings (IPOs), sudden price changes often caused by aninterim earnings disappointment, hostile bids, and other event-driven opportunities.

Investors may utilise several of these investing styles at a given time and is not restricted toany particular investment approach or asset class.

The expected volatility of the opportunistic type of hedging strategy is variable.

11. Multi-Strategy:

Investment approach is diversified by employing various strategies simultaneously torealise short and long-term gains. Other strategies may include systems trading such astrend following and various diversified technical strategies.

Multi-strategy style of investing allows the manager to overweight or underweight different

strategies to best capitalise on current investment opportunities.

The expected volatility of the multi-strategy is variable.

12. Short Selling:

The strategy includes selling securities short in anticipation of being able to re-buy them ata future date at a lower price. This is due to the managers assessment of the overvaluationof the securities, or the market, or in anticipation of earnings disappointments often due toaccounting irregularities, new competition, change of management, and so on.


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Often the short selling type of strategy is used as a hedge to offset long-only portfolios.This strategy is also used by those who feel the market is approaching a bearish cycle.

The expected volatility of short selling strategy is very high.

13. Special Situations:

There are certain special situations in which the hedge funder invests in event-drivensituations such as mergers, hostile takeovers, reorganisations, or leveraged buy-outs.Investors may simultaneously purchase stocks in companies being acquired, and sell stocksin its acquirer, hoping to profit from the spread between the current market price and theultimate purchase price of the company. Investors may also utilise derivatives to leveragereturns and to hedge out interest rate and/or market risk. Results in such cases generally arenot dependent on direction of market.

The expected volatility of event-driven hedging strategy is moderate.

14. Value:

The value based strategies make the hedge funders invest in securities perceived to beselling at deep discounts to their intrinsic or potential worth. Such securities may be out offavour or underfollowed by analysts.

Long-term holding, patience, and strong discipline are often required until the marketrecognises the ultimate value of the hedge funds.

The expected volatility of value based strategy is low to moderate.

Hedging Process

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels willbe countered by changes in the value of a futures position. In this type of transaction, the hedger triesto fix the price at a certain level with the objective of ensuring certainty in the cost of production orrevenue of sale.

The futures market also has substantial participation by speculators who take positions based on theprice movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profitswhenever there are inefficiencies in the prices. However, they ensure that the prices of spot andfutures remain correlated.

Let us discuss the hedging process with an example Case of Cloth.

Case of Cloth

A garment manufacturer purchases huge quantities of cloth as raw material for garment production.The garment manufacturer enters into a contractual agreement to export garments three monthsafterwards to dealers in the European market. This presupposes that the contractual obligation hasbeen fixed at the time of signing the contractual agreement for exports.

The garment manufacturer is now exposed to risk in the form of increasing cloth prices. In order tohedge against price risk, the garment manufacturer can buy cloth futures contracts, which wouldmature in three months. Hence, in case of increasing or decreasing cloth prices, the garment


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manufacturer is protected.

Let us analyse the different scenarios such as the case of increasing or decreasing cloth prices.

Increasing Cloth Prices

If the cloth prices increase, this would result in increase in the value of the futures contracts, whichthe garment manufacturer has bought. Hence, he makes profit in the futures transaction. But thegarment manufacturer needs to buy cloth in the physical market to meet his export obligation. Thismeans that he faces a corresponding loss in the physical market. But this loss is offset by his gainsin the futures market.

Finally, at the time of purchasing cloth in the physical market, the garment manufacturer can squareoff his position in the futures market by selling the cloth futures contract, for which he has an openposition.

Decreasing Cloth Prices

If cloth prices decrease, this would result in a decrease in the value of the futures contracts, whichthe garment manufacturer has bought. Thus, he makes losses in the futures transaction. But thegarment manufacturer needs to buy cloth in the physical market to meet his export obligation. Thismeans that he faces a corresponding gain in the physical market. The loss in the futures market isoffset by his gains in the physical market.

Finally, at the time of purchasing cloth in the physical market, the garment manufacturer can squareoff his position in the futures market by selling the cloth futures contract, for which he has an openposition.

This results in a perfect hedge to lock the profits and protect from increase or decrease in rawmaterial prices. It also provides the added advantage of just-in time inventory management for thegarment manufacturer.

Buying Hedge or Long Hedge

A buying hedge is also known as a long hedge, means buying a futures contract to hedge a cashposition. Dealers, consumers, fabricators, and others, who have taken or who intend to take anexposure in the physical market and want to lock-in prices, use the buying hedge strategy.

The benefits of buying hedge strategy are that:

It replaces inventory at a lower prevailing cost It protects uncovered forward sale of finished products

The purpose of entering into a buying hedge is to protect the buyer against price increase of acommodity in the spot market that has already been sold at a specific price but not purchased as yet. Itis very common among exporters and importers to sell commodities at an agreed-upon price forforward delivery. If the commodity is not yet in possession, the forward delivery is considereduncovered.

Long hedgers are traders who have made formal commitments to deliver a specified quantity of rawmaterial or processed goods at a later date, at a price currently agreed upon and who do not have thestocks of the raw material necessary to fulfill their forward commitment.


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Selling Hedge or Short Hedge

A selling hedge is also known as a short hedge, means selling a futures contract to hedge.

The following are the benefits of selling hedge strategy.

It covers the price of finished products It protects inventory not covered by forward sales

It covers the prices of estimated production of finished products

Short hedgers are traders who acquire inventories of the commodity in the spot market and whosimultaneously sell an equivalent amount or less in the futures market. The hedgers in this case aresaid to be long in their spot transactions and short in the futures transactions.

The Basis

In the business of buying or selling a commodity, the spot price is different from the price quoted inthe futures market. The futures price is the spot price adjusted for costs such as freight, handling,storage and quality, along with the impact of supply and demand factors. The price differencebetween the spot and futures keeps on changing regularly.

In a market characterised by the situation when:

Hedger is benefited as follows when the futures price is higher than spot price.

A narrowing of the basis will benefit the short hedger A widening of the basis will benefit the long hedger

Hedger is benefited as follows when the futures quote at a discount to spot price.

A narrowing of the basis will benefit the long hedger A widening of the basis will benefit the short hedger

However, the impact of widening of the basis is opposite to that as in the case of narrowing.

Futures Markets in India

Organised futures market evolved in India by the setting up of "Bombay Cotton Trade AssociationLtd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners andmerchants over the functioning of the Bombay Cotton Trade Association, a separate association bythe name "Bombay Cotton Exchange Ltd." was constituted.

The futures trading in oilseeds was organised in India for the first time with the setting up of GujaratiVyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and cotton.Before the Second World War broke out in 1939, several futures markets in oilseeds were functioningin Gujarat and Punjab.

The price difference between spot price and futures price is known as the basis. The risk arising

out of the difference is defined as basis risk.A situation in which the difference between spot and futures prices reduces (either negative orpositive) is known as narrowing of the basis.If the difference between spot and futures prices increases (either on negative or positive side) itis defined as widening of the basis.


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Futures trading in raw jute and jute goods began in Calcutta with the establishment of the CalcuttaHessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd. was set up in 1927 fororganising futures trading in Raw Jute. These two associations amalgamated in 1945 to form thepresent East India Jute & Hessian Ltd., to conduct organised trading in both raw jute and jute goods.

In case of wheat, futures markets were in existence at several centers at Punjab and Uttar Pradesh(UP). The most notable amongst them was the Chamber of Commerce at Hapur, which wasestablished in 1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka,Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras,Gaziabad, Sikenderabad and Barielly in U.P.

Futures market in bullion began at Mumbai in 1920 and later similar markets came up at Rajkot,Jaipur, Jamnagar, Kanpur, Delhi and Kolkata. In due course several other exchanges were also createdin the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur(jaggory).

Commodity Futures Market in India

After independence, the Constitution of India brought the subject of "Stock Exchanges and FuturesMarkets" in the Union list. As a result, the responsibility for regulation of commodity futures marketsdevolved on Government of India (GoI).

A Bill on forward contracts was referred to an expert committee headed by Professor A.D. Shroff andSelect Committees of two successive Parliaments. Finally, in December 1952 Forward Contracts(Regulation) Act, 1952, was enacted.

The Forward Contracts (Regulation) Act provided for 3-tier regulatory system, that is:

An association recognised by the GoI on the recommendation of Forward MarketsCommission

The Forward Markets Commission was set up in September 1953. Forward Contracts(Regulation)

Central Government

The rules of Forward Contracts (Regulation) Act were notified by the Central Government in July,1954.

The Forward Contracts (Regulation) Act divides the commodities into 3 categories with reference toextent of regulation, namely:

i. The commodities in which futures trading can be organised under the auspices of recognisedassociation

ii. The commodities in which futures trading is prohibitediii. The commodities which have neither been regulated for being traded under the recognised association

nor prohibited are referred as Free Commodities. The association organised in such trading of freecommodities is required to obtain the Certificate of Registration from the Forward Markets Commission.

In the seventies, most of the registered associations became inactive, as futures as well as forwardtrading in the commodities for which they were registered came to be either suspended or prohibitedaltogether.


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The Khusro Committee (June 1980) had recommended reintroduction of futures trading in most of themajor commodities, including cotton, kapas, raw jute and jute goods and suggested that steps may betaken for introducing futures trading in commodities, such as, potatoes, onions, and so on, atappropriate time.

The government, accordingly initiated futures trading in potato during the latter half of 1980 in quite afew markets in Punjab and Uttar Pradesh. After the introduction of economic reforms since June 1991and the consequent gradual trade and industry liberalisation in both the domestic and external sectors,the GOI appointed in June 1993 one more committee on Forward Markets under Chairmanship ofProfessor K.N. Kabra.

The committee on Forward Markets under Chairmanship of Professor K.N. Kabra submitted its reportin September 1994.The majority report of the Committee recommended that futures trading be introduced in thefollowing commodities.

1. Basmati Rice2. Cotton and Kapas3. Raw Jute and Jute Goods4. Groundnut, Rapeseed/Mustard Seed, Cotton Seed, Sesame Seed, Sunflower Seed, Safflower Seed,Copra And Soybean, and oils and oilcakes of all of them5. Rice Bran Oil6. Castor Oil and its Oilcake7. Linseed8. Silver9. Onions

The committee also recommended that some of the existing commodity exchanges particularly theones in pepper and castor seed, may be upgraded to the level of international futures markets.

The liberalised policy being followed by the GOI and the gradual withdrawal of the procurement anddistribution channel necessitated setting in place a market mechanism to perform the economicfunctions of price discovery and risk management.

The National Agriculture Policy announced in July 2000 and the announcements of HonourableFinance Minister in the Budget Speech for 2002-2003 were indicative of the Governments resolve toput in place a mechanism of futures trade/market.

As a follow up, the Government issued notifications on April 1st, 2003 permitting futures trading inthe commodities, with the issue of these notifications futures trading is not prohibited in anycommodity.

At present, the concept of futures trading is permitted in 103 commodities. Apart from the threenational level exchanges, there are 21 other regional exchanges recognised for commodity futurestrading. The trading volume and value in the past two years have increased manifold.

In India, futures trading proved itself to be extremely beneficial in performing two importantfunctions of price discovery and price risk management with reference to the given commodity. Thisin turn proved to be beneficial to all segments of the economy.


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To the producer it was useful because he can now get an idea of the price likely to prevail at a futurepoint of time and therefore can decide between various competing commodities, the best that suitshim. It enables the consumer in that he gets an idea of the price at which the commodity would beavailable at a future point of time. The producer can do proper costing and also cover his purchases bymaking forward contracts.

The concept of futures trading is very useful to the exporters. Because, futures trading conceptprovides an advance indication of the price likely to prevail. Thus, helps the exporter in quoting arealistic price and thereby secure export contract in a competitive market. Having entered into anexport contract, it enables him to hedge his risk by operating in futures market.

Since, the concept of futures trading involves a passage of time between entering into a contract andits performance making, the contracts are susceptible to risks, uncertainties, and so on. Therefore, thethere was an immense need of the regulatory functions that are to be exercised on the futures market.

Unfortunately till 2008, Forward Markets Commission (FMC) did not have regulatory powers andauthority like Securities and Exchange Board of India (SEBI). It also did not have the financialautonomy as it depended on budgetary allocation and its administrative autonomy was also restrictedas it was subject to rules and regulations of the Government in all matters including recruitment ofstaff.

But with the promulgation of the Forward Contracts (Regulation) Amendment Ordinance, 2008, therole of FMC changed from enforcing prohibition to properly managing and regulating such explosivegrowth.

Forward Markets Commission has so far managed to discharge this role through the instruments ofmargin, limit on open interest, price limits and others. However, a need is felt to further strengthenand enhance the capabilities of FMC as well as to give it the necessary autonomy by makingcomprehensive amendments to the FCR Act.

During 2007-08 (till January, 2008), the volumes traded on the commodity exchanges have beenRs. 31.60 lakh crores. As per the estimates projected by Associated Chambers of Commerce andIndustry of India (ASSOCHAM), the trade value would increase to Rs. 74 lakh crores by 2010.

By April, 2009, the share of agriculture commodities including essential commodities in the totalcommodity futures trade turnover was about 25%. The share of essential commodities in the overallfutures trading was about 8%.

The volume of trade in bullion (gold and silver) had about 38% share, energy products had a share of12% and other metals and commodities, such as, alluminium, zinc, tin, copper, lead, sponge iron,steel, polymer and so on, had a share of about of 25 % in the total turnover.

Currency Futures Market in India

In the year 2008 only, the Reserve Bank of India (RBI) issued a set of directions and guidelines forthe launch of currency futures trading in India.The following are the main highlights of currency.

Currency futures are permitted in US Dollar, Indian Rupee or any other currency pairs, asmay be approved by the Reserve Bank from time to time.


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Only persons residing in India may purchase or sell currency futures to hedge an exposureto foreign exchange rate risk or otherwise.

The following are the features of the standardised currency futures.

Only USD-INR contracts are allowed to be traded

The size of each contract will be USD 1000 The contracts shall be quoted and settled in Indian Rupees

The maturity of the contracts shall not exceed 12 months The settlement price will be the Reserve Banks Reference Rate on the last trading day

The following are the guidelines regarding the participants.

No person other than 'a person residing in India' as defined in section 2(v) of the ForeignExchange Management Act, 1999 (Act 42 of 1999) will participate in the currency futuresmarket.

Notwithstanding sub-paragraph (i), no scheduled bank or such other agency falling underthe regulatory purview of the Reserve Bank under the Reserve Bank of India Act, 1934, theBanking Regulation Act, 1949 or any other Act or instrument having the force of law willparticipate in the currency futures market without the permission from the respectiveregulatory Departments of the Reserve Bank.

Similarly, for participation by other regulated entities, concurrence from their respectiveregulators should be obtained.

The following are regarding the membership of the currency futures.

The membership of the currency futures market of a recognised stock exchange will beseparate from the membership of the equity derivative segment or the cash segment.

Membership for both trading and clearing, in the currency futures market will be subject tothe guidelines issued by the SEBI.

Banks authorised by the Reserve Bank of India under section 10 of the Foreign ExchangeManagement Act, 1999 as AD Category-I bank are permitted to become Trading andClearing Members of the currency futures market of the recognised stock exchanges, ontheir own account and on behalf of their clients. The respective banks are subject tofulfilling the following minimum prudential requirements.

(a) Minimum net worth of Rs. 500 crores(b) Minimum CRAR of 10 per cent(c) Net NPA should not exceed 3 per cent(d) Made net profit for last 3 years

The AD Category-I banks which fulfill the prudential requirements should lay down detailedguidelines with the approval of their Boards for trading and clearing of currency futures contracts andmanagement of risks. AD Category-I banks which do not meet the above minimum prudentialrequirements.


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AD Category-I banks which are Urban Co-operative banks or State Co-operative banks can participatein the currency futures market only as clients, subject to approval therefore, from the respectiveregulatory Departments of the Reserve Bank.

Position Limits:

The position limits for various classes of participants in the currency futures market will be subject tothe guidelines issued by the SEBI.

The AD Category-I banks, will operate within prudential limits, such as Net Open Position (NOP) andAggregate Gap (AG) limits. The exposure of the banks, on their own account, in the currency futuresmarket shall form part of their NOP and AG limits.

Risk Management Measures in Currency Future Markets

The trading of currency futures will be subject to maintaining initial, extreme loss and calendar spreadmargins. The Clearing Corporations/Clearing Houses of the exchanges should ensure maintenance ofsuch margins by the participants on the basis of the guidelines issued by the SEBI from time to time.

Surveillance and Disclosures in Currency Futures Market

The surveillance and disclosures of transactions in the currency futures market shall be carried out inaccordance with the guidelines issued by the SEBI.

Authorisation to Currency Futures Exchanges/Clearing Corporations

Recognised stock exchanges and their respective Clearing Corporations/Clearing Houses shall notdeal in or otherwise undertake the business relating to currency futures unless they hold anauthorisation issued by the Reserve Bank under section 10 (1) of the Foreign Exchange ManagementAct, 1999.

Powers of Reserve Bank

The Reserve Bank may from time to time modify the eligibility criteria for the participants, modifyparticipant-wise position limits, prescribe margins and/or impose specific margins for identifiedparticipants, fix or modify any other prudential limits, or take such other actions as deemed necessaryin public interest, in the interest of financial stability and orderly development and maintenance offoreign exchange market in India.

Robust trading volumes in currency derivatives have drawn nine public-sector banks led by:

Bank of India

Federal Bank

Minerals and Metals Trading Corporation (MMTC)

TCS

Jaypee Capital

Robust trading volumes in currency derivatives have drawn nine public-sector banks to jointly floatIndias fourth currency futures exchange the United Stock Exchange of India Ltd (USEIL).

Other Stakeholders

With an authorised capital of Rs 150 crore and paid-up capital of Rs 120 crore, the new

exchange has received in-principle approval from the Securities and Exchange Board of India

(SEBI). It will commence operations in two months, said Mr. P.H. Ravikumar, Director,

Federal Bank.


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Besides Bank of India, the other public-sector banks with stake in USEIL are Andhra Bank,Allahabad Bank, Bank of Baroda, Canara Bank, Indian Overseas Bank, Oriental Bank of Commerce,Union Bank of India and United Bank of India. The nine public-sector banks and MMTC togetherwill hold minimum 49 per cent stake in the exchange.

The background of the promoters places the exchange in an ideal position to build liquidity

quickly. We will partner industry associations and reach out to the farthest geographies in the

country to enable the smallest enterprise which runs a currency risk to understand the

exchange platform mechanism and then use the same for mitigating risks, said Mr T.S.

Narayanasami, Chairman and Managing Director, Bank of India.

USEIL expects to ride on the strength of the promoter-banks in different geographies to offer itsexchange-traded currency futures product to the latters customers.

The promoters shareholding in USEIL will vary from 2.5 to 15 per cent. Bank of India,

Federal Bank, MMTC, and Jaypee will be the majority shareholders, said Mr M.

Venugopalan, Managing Director and CEO, Federal Bank.

As per regulatory prescription, an entity cannot hold more than 5 per cent stake in a currency futuresexchange. However, SEBI allows time for dilution of the stake exceeding this threshold. Currently,three entities offer trading in currency futures in dollar-rupee contracts. The three entities are NSE,MCX-SX and BSE.

Source: 9 PSBs on board new currency futures exchange,http://www.thehindubusinessline.com/2009/02/08/stories/2009020850960300.htm

Interest Rate Futures Market in India

Ever since the global financial crisis hit the economies world over in the year 2008, more and moreregulators and markets across the world are drifting away from the over-the-counter forward marketto embrace exchange-traded market. The main reason for this change is that the experts waste the

centrally counter-party guaranteed exchange-traded market.

The exchange where the currency futures are traded is perhaps the one institution to have come outunscathed in this economic meltdown. In India, the trading in the newly launched interest rate futuresbegan on August 31, 2009 clocking trading volumes of Rs. 276 crore in their first day of trade.

The underlying for interest rate futures trading is the Government of India's securitised 10-yearnotional coupon bond. The qualification of GoI securities to be used as underlying assets is that itshould have a maturity status between seven-and-a-half years and 15 years from the first day of thedelivery month. Apart from this, the outstanding should be for a minimum value of Rs. 10,000 crore(Rs 100 billion).

There will be a regular publishing of the list of deliverable-grade securities at the exchanges. To beeligible to trade in interest rate futures market then, one has to be a company, or a bank, or a foreigninstitutional investor, or a non-resident Indian or a retail investor.

Investors can trade live in interest rate futures on the currency derivatives segmentof the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).


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Contract size and quotation:

Globally, the interest rate futures are almost 25-30 per cent of all derivatives. In India the trading onthe NSE will see a minimum contract size of Rs. 200,000. As far as the quotation is concerned, it

would be the same as the quoted price of GoI securities and with a count convention of 30/360-day.

Maximum tenor of contracts:

While the maximum tenure of the futures contract is one year or 12 months. Usually, it will have to berolled over in three months making the contract cycle span over four fixed quarterly contracts.

Daily settlement calculation and procedure for final settlement:

Under normal circumstances, the weighted average price of the futures contract for the final 30minutes would be taken as the daily settlement price. However, at times when this trading is notcarried out, the exchange would fix the theoretical price as the daily settlement rate.

Usually, the daily settlement is done on a daily marked-to-market procedural basis while the finalsettlement would be through physical delivery of securities.

Index Futures Market in India

The National Stock Exchange (NSE) introduced stock index futures and options on the NSEs indexof 50 stocks (S&P CNX NIFTY) in June 12, 2000. The index futures contracts are based on thepopular market benchmark S&P CNX Nifty index.NSE defines the characteristics of the futures contract such as the underlying index, market lot, andthe maturity date of the contract.

The futures contracts are available for trading from introduction to the expiry date. Contracts have amaximum of 3-month trading cycle; they are the near month (one), the next month (two) and the farmonth (three). A new 3 month contract is introduced on the trading day following the expiry of thenear month contract. This way, at any point in time, there will be 3 contracts available for trading inthe market.

Index futures contracts expire on the last Thursday of the expiry month. If the last Thursday is atrading holiday, then the contracts expire on the previous trading day.

Bibliography

Chance, D.M., An Introduction to Options and Futures, Dryden Press, Orlando, FL., 1989 Childs, John F., Earnings per share and Management Decisions, Englewood Cliffs. NJ,Prentice Hall

Chitale, Rajendra P., 2003, Use of Derivatives by Indias Institutional Investors: Issues andImpediments, in Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill PublishingCompany Limited, New Delhi, India


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Fitch Ratings, 2004, Fixed Income Derivatives A Survey of the Indian Market, Gambhir,Neeraj and Manoj Goel, 2003, Foreign Exchange Derivatives Market in India Status andProspects, Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill PublishingCompany Limited, New Delhi, India Clendenin, John C and Christy, George A., Introduction to Investment, New York, McGrawHill, 1969 Dicksler, James L. and Samuelson, Paul A., Investment Portfolio Decision-making, London,Lexington Books, 1974 Donaldson, Gordon, Corporate Debt Capacity, Boston, Harvard University Press, 1966 Doodhan, Kersi D., Stock Exchange in a Developing Economy, University of Bombay,Bombay, 1962

Granger, Clive W. and Morgenstern Oskar, Predictability of Stock Market Prices, Lexington,Health Lexington, 1970

www.thebederivatives.co.za www.fitchratings.com www.bseindia.com www.helium.com www.rbi.org.inwww.sebi.gov.in www.fmc.gov.in
http://www.thebederivatives.co.za/http://www.thebederivatives.co.za/http://www.fitchratings.com/http://www.fitchratings.com/http://www.helium.com/http://www.helium.com/http://www.rbi.org.in/http://www.sebi.gov.in/http://www.thebederivatives.co.za/http://www.fitchratings.com/http://www.helium.com/http://www.rbi.org.in/http://www.sebi.gov.in/

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