1. Futures Contract
A Futures contract is an agreement to buy (if you are long) or sell (if you are short)
something in the future, at an agreed upon price (the futures price).
Futures contract are standardized agreements that typically trade on an exchange.
One party to the contract agrees to buy a given quantity of securities or a
commodity & take delivery on a certain date. The other party agrees to provide it.
I have bought 1 lot (250 shares) of Reliance July Future @ Rs 700” mean in theory?
- It means that the person has agreed to buy 250 shares of Reliance Industries on
26th July 2012 (the expiration date) at Rs 700 per share. Here,
•The underlying is the shares of Reliance Industries
•The quantity is 1 lot, i.e. 250 shares
•The expiry date is 26th July 2012 (last Thursday of July), and
•The pre-determined price is Rs 700 (is called the Strike Price)
If the actual price of Reliance is Rs 800 on the settlement day (26th July), the person
buys 250 shares at the contracted price of Rs 700 and may sell it at the prevailing
market price of Rs 800 thereby gaining Rs 100 per share (Rs 25,000 in total). On the
other hand if the price falls to 650 he loses Rs 50 per share (Rs 12,500 in total) as he has
to buy at Rs 700 but the prevailing market price is Rs 650.
2. Key terms for Futures Contract:
1. The Underlying - The Product or Asset that is to be traded as agreed by the
Futures contract.
2. Type of Settlement - How the Product or Asset is to be delivered by cash
difference (Cash Settlement) or by actual Physical product (Physical Settlement).
3. Lot Size - Lot size refers to number of underlying securities in one contract.
For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum
contract size is Rs.2 lacs, then the lot size for that particular scrip stands to be
200000/1000 = 200 shares i.e. One contract in XYZ Ltd. covers 200 shares.
4. Spot price: Today's cash price.
5. Volume: The number of contracts traded today (or in any period of time)
6. Open interest: The number of contracts that are "open”, that exist right now, that
have a matched long and short position
7. Margin Requirement - Initial and maintenance margin established by the
exchange.
3. Margin Requirements
Margins are financial guarantees required of both buyers and sellers of futures
contracts to ensure that they fulfill their futures contract obligations.
Futures margin requirements are set by the exchanges and are typically only 2 to
10 percent of the full value of the futures contract.
• Maintenance Margin
The maintenance margin is the minimum amount a futures trader is required to
maintain in his margin account in order to hold a futures position. The maintenance
margin level is usually slightly below the initial margin.
If the balance in the futures trader's margin account falls below the maintenance
margin level, he or she will receive a margin call to top up his margin account so as
to meet the initial margin requirement.
• Initial Margin
Before a futures position can be opened, there must be enough available balance in
the futures trader's margin account to meet the initial margin requirement. Upon
opening the futures position, an amount equal to the initial margin requirement will
be deducted from the trader's margin account and transferred to the exchange's
clearing firm. This money is held by the exchange clearing house as long as the
futures position remains open.
4. An example of Margins:
• Let's assume we have Mr. X who has $10000 in his trading account. He decides to buy
August Crude Oil at $40 per barrel. Each Crude Oil Futures contract represents 1000
barrels (1 Lot) and requires an Initial margin of $9000 (2.25% of $40000) and has a
Maintenance margin level set at $6500.Since his account has $10000, which is more
than the initial margin requirement, he can therefore open up one August Crude Oil
futures position.
• One day later, the price of August Crude Oil drops to $38 a barrel. Mr. X has suffered an
open position loss of $2000 ($2 x 1000 barrels) and thus his account balance drops to
$8000. Although his balance is now lower than the initial margin requirement, he did
not get the margin call as it is still above the maintenance level of $6500.
• Unfortunately, on the very next day, the price of August Crude Oil crashed further to
$35, leading to an additional $3000 loss on his open Crude Oil position. With only
$5000 left in his trading account, which is below the maintenance level of $6500, he
received a call from his broker asking him to top up his trading account back to the
initial level of $9000 in order to maintain his open Crude Oil position. This means that
if the speculator wishes to stay in the position, he will need to deposit an additional
$4000 into his trading account. Otherwise, if he decides to quit the position, the
remaining $5000 in his account will be available to use for trading once again.
5. Mark to Market (MTM)
It refers to accounting for the Fair Value of an asset or liability based on the
current Market Price. Mark to market aims to provide a realistic appraisal of an
institution's or company's current financial situation. This is done most often in
futures accounts to make sure that margin requirements are being met. If the
current market value causes the margin account to fall below its required level, the
trader will be faced with a margin call. An example is shown below:
Day Futures Price
Price
Change
Margin Balance
(10% of Future Price)
0 1,100.00 0.00 110
1 1,027.99 -72.01 102.79
2 1,037.88 9.89 103.78
3 1,073.23 35.35 107.32
4 1,048.78 -24.45 104.87
5 1,090.32 41.54 109.03
6 1,106.94 16.62 110.69
6. A Ledger is a book where a complete record of monetary transactions
of a business are posted in the form of Debits and Credits. There will
be an Opening balance and Closing balance on each day for each A/c.
Sum of all
Debits
Sum of all
Credits
Cash Inflow (Money is
coming IN)
• Selling Stocks, Gold
• MTM margins (Profit)
• Receipt of Cash from
Client
Cash Outflow (Money
is going OUT)
• Buying Stocks, Gold
• MTM margins (Loss)
• Brokerage, VAT, Other
Charges
Ledger
7. Ledger of Gold
Date Particulars Credit Particulars Debit
15-Jan By Gold Purchase 12222700
By VAT 122227
By Brokerage 5493
By Cost & Freight charges 1373
To Closing balance
[carried forward] 12351793
16-Jan
By Opening balance
[brought forward] 12351793
To Closing balance 12351793
Balancing
Figure
As there are no transactions
on 16-Jan, hence the
Opening & Closing Balance
are the same
All these are Cash Outflows(money
is going out of the A/C) i.e. the
Client is paying money to Buy Gold
& Other Charges
15-Jan’s Closing Balance is being
carried forward & will be next day’s
(i.e. 16-Jan’s) Opening Balance
By Gold Purchase 12222700
By VAT 122227
By Brokerage 5493
By Cost & Freight charges 1373
To Closing balance
[carried forward] 12351793
8. Arbitrage
Arbitrage is the practice of taking advantage of a price
difference between two or more markets. The transactions
must occur simultaneously to avoid exposure to market risk.
The Two rules of Arbitrage:
• Buy in the spot market and sell
futures – if the futures price is
greater than the spot price.
Rule 1
• Buy futures and sell in the spot
market- If the futures price is
lower than the spot price.
Rule 2
9. Step1: An investor sells a Gold Futures contract listed
on Multi-Commodity Exchange (MCX). This contract is
supposed to mature in August 2013 and is available at
Rs 28924 per 10 grams.
Step2: At the same time, the investor buys physical
Gold in the market. The price, for a similar quantity,
of Gold is Rs 28860, which is lower that the amount
on the MCX.
Step 3: Now the Arbitrageur will deliver the physical
Gold he bought earlier to close the contract in
August 2013 and the investor will stand to gain Rs 64
from this transaction (assuming there are no other
costs).
An example of Arbitrage:
10. An exercise on Ledger:
Ledger exercise
Steps to be followed :
• Right Click on the Link & select Open Hyperlink.
• There are 3 Questions – each question in different sheets
mentioned as Q1, Q2, Q3.
• Fill the correct answers in Red spaces given there.
