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Basis

Basis . Short hedge-Spot 1 : Rs 100 Spot 2: 85 Futures 1: Rs102 Futures 2:Rs87 When basis strengthens –Gain ? When basis weakens –Loss? Long hedge –Spot 1:Rs.200 Futures 1-Rs.203 Spot 2:Rs.240 Futures2:Rs243 Why spot price= future price @ expiry? Arbitrage opportunity .

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Basis

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  1. Basis • Short hedge-Spot 1 : Rs 100 Spot 2: 85 Futures 1: Rs102 Futures 2:Rs87 When basis strengthens –Gain ? When basis weakens –Loss? • Long hedge –Spot 1:Rs.200 Futures 1-Rs.203 Spot 2:Rs.240 Futures2:Rs243 • Why spot price= future price @ expiry? Arbitrage opportunity PSG Institute of Management -2010

  2. Contract specifications –stock futures • -Nov,2001 • Contract-underlying securities /S&P CNX Nifty • Exchange-NSE • Security descriptor –N FUTSTK • Contract size-as specified by exchange- Rs.2 lakh • Price steps-.05* respective lot size • Trading cycle-three month trading cycle PSG Institute of Management -2010

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  7. Contract specifications –stock futures • Near month(one); next month(two); far month(three)-New contract will be introduced on next trading day following the expiry of near month contract • Expiry day-last Thursday of the expiry month/previous trading day if the last Thursday is a trading holiday PSG Institute of Management -2010

  8. Open interest and Settlement price • Open interest:-Outstanding positions in the contract at that point of time and Liquidity of the contract . Next video Closing out position –easier at when open interest is high and vice versa Settlement price:-average of the prices at which the contract is traded-NSE: average price of Last half an hour and when trade is not taking place –theoretical price will be taken to consideration PSG Institute of Management -2010

  9. Open Interest PSG Institute of Management -2010

  10. key advantages &Major types • Key advantages • Highly liquid market-easy to open and close position • Gearing-buying large exposure with the help of 10% of the total exposure • Long futures –buying futures –Bullish • Short futures –selling futures –Bearish PSG Institute of Management -2010

  11. Features Geared instruments • Facilitates to buy the large exposure with small outlay is known gearing process • Futures to trade without owning stocks • Futures are used as hedging instruments • Futures for portfolio adjustments PSG Institute of Management -2010

  12. Gearing process –example • Share A is currently priced Rs.100 and the December future on that share is priced at Rs.102 • A few days later the share price has risen to Rs.110 and the future has risen to Rs.112 PSG Institute of Management -2010

  13. Futures-Features Futures to trade without stocks Futures-Pairs(Spread) trading To take position on relative performance of two shares –pairs trading Studying the movement of prices of two stocks –entering into the futures Determiining the net gains • Moving out of the existing futures by entering into counter positions PSG Institute of Management -2010

  14. Futures –Pairs Trading • Investor thinks that A will outperform the B stock over the next few months . He buys 2 futures of A and sells 3 futures of B (1000 shares) PSG Institute of Management -2010

  15. Port folio adjustments • Assume investor holds 10,000 shares of A . B is considered as outperforming stock over the A stock. (futures-1000) • He sells 10 futures of A and buys 13 futures B PSG Institute of Management -2010

  16. Maintenance margin • Maintenance Margin – to support the daily settlement process “mark to market”-losses already are collected • Initial margin- to safeguard against potential losses on outstanding positions. • Maintenance margin-75-80% of initial margin – adequate cash resources should be deposited –transactions will be with held- to maintain the margin shorting is done and profits are realised and set the balances in the margin deposit and the remaining are withdrawn by the investor PSG Institute of Management -2010

  17. Marking to market • - to evade credit risk – margin is maintained by the exchange- from the players- to overcome counterparty risk. • -Contract is marked to its present market value. • On every day- contract is marked to market • Trader vs Exchange • If trader earns profit- exchange is liable-profit will be credited • Unless otherwise vice versa PSG Institute of Management -2010

  18. Variation margin • To restore the initial margin- through margin call from the exchange Exercise On November 15, the spot price for Telco is Rs.473 per share , Mr. X buys 15 contracts of Jan Telco futures of Rs.491.Assume that initial margin is Rs.800 per contract and the maintenance margin is Rs.600 per contract .Given the each contract 50 shares .Daily settlement of prices are given Nove15 Rs.496;Nove16 Rs.503; Nove 17 Rs.488; Nove 18 Rs.485; Nov19 Rs.491 November16th Mr.X withdraws the profit from the maximum allowed on Nov16 and half the maximum amount allowed PSG Institute of Management -2010

  19. Arbitrage – Pricing of futures • Borrowing Rs 100 • Buying of shares Rs.100 Interest rate Rs.6 Dividends Rs.2 PSG Institute of Management -2010

  20. Arbitrage – Pricing of futures-cash and carry PSG Institute of Management -2010

  21. Pricing of futures • Cost of carry=????? • Fair value=????? • When will be the risk less profit –sell futures ? • Premium=? • Components of premium=? • Early future contract slides… PSG Institute of Management -2010

  22. Pricing of futures-Reverse cash and carry PSG Institute of Management -2010

  23. Currency futures –Introduction to currency market • Type of currencies –Base and counter currencies • USD-INR • GBP-INR • Japanese yen –USD • First currency – Base currency • Second currency – Counter /terms /qoute currency PSG Institute of Management -2010

  24. Exchange rate regimes PSG Institute of Management -2010

  25. Fixed and Floating exchange rates • Govt action towards buying and selling of domestic currency-in open market • Buying at value is coming down • Selling at value is going up • Self correcting mechanism • Demand and supply of the currency • Demand for currency is low-import is costlier and export is cheaper • When exports- payment leads to appreciation of domestic currency PSG Institute of Management -2010

  26. Factors –Exchange rates • Fundamental factors : inflation, BOP, unemployment , capacity utilisation , trends in import and exports-BOP surplus- Favourable exchange rate and vice versa • Technical factors : Interest rates ,Inflation rate and Exchange rate policy • Political factors • Speculation-over valuation PSG Institute of Management -2010

  27. Important reasons for Rupee Depreciation PSG Institute of Management -2010

  28. Quotes • Direct quote : in the expression of USD ;1USD =INR 45.000 • Indirect quote : in the expression of terms currency ; 1INR=.021 USD PSG Institute of Management -2010

  29. Tick size • NSE tick size :.0025 • Value of one on each contract =Rs 2.5 • Example 4 ticks improvement and 5 contracts • Bid price – willing of the buyer to pay • Ask price- willing of the price to sell • Spread PSG Institute of Management -2010

  30. Highlight –Forex Futures Contract PSG Institute of Management -2010

  31. Currency Future-Contract cycle PSG Institute of Management -2010

  32. Contract specification • Last trading day :Two working days prior to final settelment • Settlement :Cash settlement • Final settlement price: The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement . PSG Institute of Management -2010

  33. RBI Reference rate PSG Institute of Management -2010

  34. Currency futures contract trading process PSG Institute of Management -2010

  35. Pricing of futures contract-interest rate parity • A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.F/S= (1+Rh)/(1+Rf) • F=S *e(rh-rf)*r PSG Institute of Management -2010

  36. Example problems • Assume on March10,2002 annual interest rate was 10% p.a on indian rupees and US dollar was 7% per annum . The spot Re/$ exchange rate was 44 using the above futures ,calculate the theoretical futures price on one year forward exchange rate PSG Institute of Management -2010

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