Forward vs Future

1. FORWARD AND
FUTURES
DR .TAJINDER
ASSISTANT PROFESSOR
MITTAL SCHOOL OF BUSINESS

2. INTRODUCTION
• Forward and futures contracts are derivative securities.
• Recall, a derivative security is a financial security that
is a claim on another security or underlying asset.
• We will examine the specifics of forwards and futures
and see how they differ
• Derivatives can be used to speculate on price changes
in attempts to gain profit or they can be used to hedge
against price changes in attempts to reduce risk.
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3. FORWARD AND FUTURES CONTRACTS
• Both forward and futures contracts lock in a price today
for the purchase or sale of something in a future time
period
• E.g., for the sale or purchase of commodities like gold,
canola, oil, pork bellies, or for the sale or purchase of
financial instruments such as currencies, stock indices,
bonds.
• Futures contracts are standardized and traded on formal
exchange; forwards are negotiated between individual
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4. EXAMPLE OF USING A FORWARD OR FUTURES
CONTRACT
• COP Ltd., a canola-oil producer, goes long in a contract with a
price specified as $395 per metric tonne for 20 metric tonnes to
be delivered in September.
• The long position means COP has a contract to buy the canola.
The payment of $395/tonne ● 20 tonnes will be made in
September when the canola is delivered.
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5. FUTURES AND FORWARDS – DETAILS
• Unlike option contracts, futures and forwards commit both
parties to the contract to take a specified action
• The party who has a short position in the futures or forward
contract has committed to sell the good at the specified price
in the future.
• Having a long position means you are committed to buy the
good at the specified price in the future.
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6. MORE DETAILS ON FORWARDS AND FUTURES
• No money changes hands between the long and short parties at
the initial time the contracts are made
• Only at the maturity of the forward or futures contract will the
long party pay money to the short party and the short party will
provide the good to the long party.
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7. INSTITUTIONAL FACTORS OF FUTURES CONTRACTS
• Since futures contracts are traded on formal exchanges, margin
requirements, marking to market, and margin calls are required;
forward contracts do not have these requirements.
• The purpose of these requirements is to ensure neither party has
an incentive to default on their contract.
• Thus futures contracts can safely be traded on the exchanges
between parties that do not know each other.
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8. THE INITIAL MARGIN REQUIREMENT
• Both the long and the short parties must deposit money in their
brokerage accounts.
• Typically 10% of the total value of the contract
• Not a down payment, but instead a security deposit to ensure
the contract will be honored
SPAN + Exposure margin is called the initial margin and this is
collected at the time of entering a position.
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9. SPAN AND EXPOSURE MARGIN
• Standard Portfolio Analysis of Risk (SPAN) is used by exchanges to calculate
risk and margins for F&O portfolios. SPAN uses the price and volatility of
the underlying security along with several other variables to determine the
maximum possible loss for a portfolio and determines an appropriate margin.
SPAN margin is monitored and collected at the time of placing an order and is
revised by the exchanges throughout the day.
• Exposure margin is charged over and above the SPAN margin by the
exchanges to cover risks that may not be covered by the SPAN margin.

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

11. INITIAL MARGIN REQUIREMENT – EXAMPLE
• Manohar has just taken a long position in a futures contract for 100
ounces of gold to be delivered in January. Magda has just taken a
short position in the same contract. The futures price is $380 per
ounce.
• The initial margin requirement is 10%
• What is Manohar’s initial margin requirement?
• What is Magda’s initial margin requirement?
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12. MARKING TO MARKET
• At the end of each trading day, all futures contracts are rewritten to
the new closing futures price.
• I.e., the price on the contract is changed.
• Included in this process, cash is added or subtracted from the
parties’ brokerage accounts so as to offset the change in the futures
price.
• The combination of the rewritten contract and the cash addition
or subtraction allows for standardized contracts for delivery at the
same time to trade at the same price.
Example : http://surl.li/gfqwq
https://faq-
neo.kotaksecurities.com/support/solutions/articles/82000883733-
what-is-mark-to-market-

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

14. RECAP ON MARKING TO MARKET
• After marking to market, the futures contract holders essentially
have new futures contracts with new futures prices
• They are compensated or penalized for the change in contract
terms by the marking to market deposits/withdrawals to their
accounts.
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15. WHY HAVE MARKING TO MARKET?
• To reduce the incentive to default
• Discussion:
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16. MARGIN CALL
• A margin call is a “call” from your broker requiring you
to top up cash into your account when your margin
balance for your futures position drops below the
maintenance margin level.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

32. IN ORDER TO HEDGE THE POSITION IN SPOT, WE SIMPLY
HAVE TO ENTER A COUNTER POSITION IN THE FUTURES
MARKET. SINCE THE POSITION IN THE SPOT IS ‘LONG’, WE
HAVE TO ‘SHORT’ IN THE FUTURES MARKET.
• Here are the short futures trade details –
• Short Futures @ 2285/-
• Lot size = 250
• Contract Value = Rs.571,250/-

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

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

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

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

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

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

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

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