Hedging, Speculation and Arbitrage using Futures.ppt

Hedging, Speculation and Arbitrage using Futures

Introduction
Futures contracts have linear or symmetrical payoffs.
In simple words it means that the losses as well as profits for the buyer and the
seller of a futures contract are unlimited.
These linear payoffs can be combined with options and the underlying asset to
generate various complex payoffs.

Payoff for a long future contract
The payoff for a person who buys a futures contract can be compared
to the payoff for a person who holds an asset.
There is unlimited upside as well as downside risk.
Take the case of a speculator who buys a three (far) month A Ltd. futures contract at
₹ 750. The underlying asset in this case is the share of A Ltd. When the share price
moves up, the long futures position starts making profits, and when the share price
moves down it starts making losses.

Figure below shows the payoff diagram for the buyer of a futures contract.
The figure shows the profits/losses for a long futures position.
The investor bought futures when the share of A Ltd was at
₹ 750.
If the share price goes up, his futures position starts making
profit. If the share price falls, his futures position starts showing
losses.

Payoff for a short future contract
The payoff for a person who sells a futures contract is similar to the payoff for
person who shorts an asset. Here also, there is unlimited upside and downside risk.
Take the case of a speculator who sells a three-month A Ltd. futures contract when the
share price is ₹ 750. The underlying asset in this case is the share of A Ltd.
When the share price moves down, the short futures position starts making profits,
and when the share price moves up, it starts making losses.

Figure below shows the payoff diagram for the seller of the futures contract.
The figure shows the profits/losses for a Short futures position.
The investor sold futures when the share of A Ltd was at ₹ 750.
If the share price goes up, his futures position starts making
losses. If the share price falls, his futures position starts showing
profits.

As can be seen from above diagrams, payoff for long future is completely opposite of short future,
therefore we can conclude that whatever is the profit of an investor holding long future is loss of an investor
holding short future for the same underlying asset and vice versa.
Therefore, we also call futures to be a zero sum game.

Long Hedge using futures
A long hedge is a situation where investor enter into a buying contract for a
particular share/commodity/currency to protect yourself against future price
volatility or fluctuation.

To understand this take example of an Indian importer
who needs to make payment in US Dollar ($) three
months from today, he would like to eliminate the risk
of US Dollar ($) fluctuating against Indian Rupee (₹)
by entering into a long future for US Dollar ($), thus a
long hedge is beneficial for a person who knows he has
to purchase an asset in the future and wants to lock in the
purchase price today itself.
A long hedge can also
be used to hedge
against a short position
that has already been
taken by the investor.

Short Hedge using futures
A short hedge is completely opposite to long hedge. It is an investment
strategy that is focused on mitigating a risk that has already been taken.
Here “short hedge” is the term used for an act of shorting a security in
futures market; it is usually a derivatives contract that hedges against
potential losses in an investment that is held long.

Short hedging is often used in the agriculture
business, for example, a farmer would like to enter
into a short futures contract for his produce to lock
in the price he will get for the same and hence
eliminate his risk against any price fluctuation.

Institutional money managers often use short hedges on
interest rates when they have a lot of fixed-income
investments and worry about the risk of reinvesting at lower
rates in the future.
This helps protect their portfolio from potential losses due to
interest rate changes.

Short hedges are also used by exporters in currency derivative markets, here a
exporter enters into a short futures contract for the foreign currency that he is
going to receive some time in future for the goods exported by him today.
By doing so, the exporter will be able to lock in his profit irrespective of
exchange rate fluctuation in future.
If a short hedge is executed well, gains from the long position will be offset by losses in the derivatives position, and vice versa.

PERFECT & IMPERFECT HEDGE USING FUTURES
Perfect hedge using futures
A perfect hedge is the one that completely eliminates the future price
fluctuation risk, here an investor enters into exactly opposite contract in
future market as compared to his position in the cash market.
But in real life achieving a perfect hedge is nearly impossible.
To understand why it is impossible to achieve a perfect hedge we need to recall the fact that futures contract are very
standardized in nature in terms of underlying asset, contract size, trading cycles,
settlement date, settlement basis, settlement price, etc.

PERFECT & IMPERFECT HEDGE USING FUTURES
Imperfect hedge using futures
An imperfect hedge is the one that is not able to completely eliminate the future price fluctuation risk.
As discussed in the above slide, this happens in futures market mainly because future contracts are
standardized in nature in terms of various aspects like underlying asset, contract size, trading cycles,
settlement date, settlement basis, etc.

Reasons for Imperfect Hedge
1. Underlying asset
2. Contract size
3. Trading cycles
4. Settlement date

1. Underlying asset
Sometimes a future contract may not be available for a particular
underlying asset in which an investor holds a position in the cash market, in
such a case the investor may be forced to enter into a cross hedge*.
Cross hedge refers to hedging ones position by taking an opposite position in some other underlying
with similar price movements.

 A cross hedge is performed when an investor who holds a long or short position in an
underlying asset takes an opposite (may or may not be equal) position in some other
underlying asset, in order to limit both up- and down-side exposure related to the holdings in
initial underlying asset.
 Although the two underlying (cash and future) assets may not be identical, they are
correlated enough to create a hedged position as long as the prices move in the same
direction. An example of cross hedging would be an investor entering into a short crude oil
futures to hedge his short position in natural gas. Here, the prices of natural gas and crude oil
may not be identical, but may be similar enough for using the same for hedging purpose.
 As the prices of two different underlying assets are not identical, they don’t fully converge
on the settlement date leading to basis risk hence leading to an imperfect hedge.

2. Contract size
This happens when current position in an underlying asset does not perfectly
match with the futures contract in terms of quantity of the underlying asset.
For example, an exporter may be due to receive US Dollar ($) 1,05,600 three
months in future, but a future contract for US Dollar ($) may be available with a
contract size of US Dollar ($) 10,000.
In such a case the exporter will either be required to enter into a short position for
10 or 11 future contract both of them being not a perfect match with the position
in cash market leading to imperfect hedge.

3. Trading cycles
Futures on most of the stock exchanges are available for a cycle of one, two
or three months. If an investor wants futures contract a longer or a shorter
duration he may again end up having an imperfect hedge.

4. Settlement Date
This happens when futures contract settlement date does not perfectly match with the settlement date of underlying asset.
For example, an importer may be required to pay US Dollar ($) 1,10,000 on 18th August 2023 but a future contract
is available with a settlement date of month end and a contract size of US Dollar ($) 10,000. Here contract size may
perfectly match with the requirement in the form of going long for 11 future contracts, but the settlement date may
not match with the requirement leading to imperfect hedge.
As the prices of the underlying asset may not match on two different dates, they don’t fully converge leading
to basis risk hence leading to an imperfect hedge.

SPECULATION USING FUTURES CONTRACT
Speculators are the people who take a view of the market or an asset and would like to make profits using the same.
They don’t have any holdings in the cash market for the said asset and therefore they assume a lot of risk while entering into the futures market.
Revision before going to Start Case Study

Case Study A [Bullish Security, Buy Futures]

Let us further assume that contract size for Bosch Ltd is 25 shares in the futures market.
And a margin of 20% is required to trade in futures. Finally let us assume that Mr. M’s (Speculator) speculation proves correct
at the end of three months, in such a case Mr. M will be able to make profit in futures market as follows:
S.No. Particulars ₹
1. Value per share of Bosch Ltd. for a three
months future contract
22,600
2. Enter into a long future for Bosch Ltd.
[ ₹ 22,600 X 25]
5,65,000
3. Pay the margin [₹ 5,65,000 x 20%] 1,13,000
4. Spot price per share at end of three months 24,000
5. Profit per share [4 — 1] 1,400
6. Profit for one futures contract [1,400 x 25
shares]
35,000
7. Profit Percentage [35,000 / 1,13,000 X 100] 30.97%

Alternate Strategy,
As against this if Mr. M would have wanted to make profit through cash market operations his profit would have been as follows:
1. Value per share today in cash market 21,970
2. Purchase 25 shares in cash market 5,49,250
4. Profit per share [3 - 1] 24,000 – 21,970 2,030
5. Profit for 25 shares [2,030 x 25 shares] 50,750
6. Profit percentage [50,750/5,49,250 x 100] 9.24%

1. Value per share of Bosch Ltd. for a three months future contract 22,600
2. Enter into a long future for Bosch Ltd. [22,600 x 25] 5,65,000
3. Pay the margin 15,65,000 x 20%] 1,13,000
5. Loss per share [4 — 1] 1,600
6. Loss for one futures contract [1,600 x 25 shares] 40,000
7. Loss Percentage [40,000/ 1,13,000 X 100] 35.39%

1. Value per share today in cash market 21,970
2. Purchase 25 shares in cash market 5,49,250
4. Loss per share [3 — 1] 970
5. Loss for 25 shares [970 x 25 shares] 24,250
6. Loss percentage [24,250/5,49,250 x 100] 4.42%

Therefore, one should understand the fact that speculation in futures market is highly levered leading to huge up side and down side
risk making them a very risky venture.

Case Study B [Bearish Security, Sell Futures]

Let us further assume that contract size for Bosch Ltd is 25 shares in the futures market.
And a margin of 20% is required to trade in futures.
Finally let us assume that Mr. X’s speculation proves correct at the end of three months, in such a case Mr. X will be able to make
profit in futures market as follows:
1. Value per share of Bosch Ltd. for a three months future contract 22,600
2. Enter into a SHORT future for Bosch Ltd. [22,600 x 25] 5,65,000
3. Pay the margin [5,65,000 x 20%] 1,13,000
5. Profit per share [1 — 4] 2,600
6. Profit for one futures contract [2,600 x 25 shares] 65,000
7. Profit percentage [65,000/1,13,000 x 100] 57.52%

In the above table, the profit depends on the closing price of the security in
the spot market on the settlement date, therefore the profit shown above is
not certain or assured, but is totally speculative and can be more or less
than the amount.

Question on Long Hedge – Case Study of INFOSYS
The Infosys Ltd.’s shares currently on 1st July 2023 is trading on NSE @ Rs. 950 per share.
Mr Shubham, an investor is of the view that price of shares of Infosys Ltd is likely to fall to
Rs. 800 by 30th September 2023. September Futures Contract on shares of Infosys Ltd. is
available today @ Rs. 850 per share. The bank’s prevailing lending interest rate is 12% p.a.
and deposit interest rate is 10% P.A. Brokerage & Other Transaction costs on Futures and
Spot transaction is 1%. Mr Shubham sees an opportunity to make risk less profit.
Show cash flows of the hedge strategy that Mr. Shubham can adopt to make riskless profit
and also show the cash flows, if Mr Shubham does not adopt hedge strategy.

Mr. Shubham will adopt Long Hedge strategy in futures riskless profit.
The Mr Shubham will carry out following steps to make riskless profit.
STEP NO. 1:
Mr. Shubham will borrow shares of Infosys Ltd for a period of three months and
Sell them today i.e., 1st July 2023 in Spot Market @ Rs. 950 per share.
Since Mr Shubham has borrowed shares, he has liability of returning those share
to the lender of shares by 30th September 2023, thus M. Shubham is said to be
having ‘Short Position’ in shares of Infosys Ltd.

Step No. 2: Mr. Shubham will Long Hedge’ futures on Infosys Ltd.
That is, Mr Shubham shall buy September Futures on Infosys Ltd shares @ Rs.
850 per share, so as to cover the liability of returning the shares borrowed in
Step No. 1

The cash flows of Mr Shubham’s Hedge Strategy in different price scenario will be as under.
PARTICULARS
SPOT PRICE SCENARIO ON 30th SEPTEMBER 2023
Rs. 800 Rs. 950 Rs. 1,100
(A) Cash Flows on 1st July 2023
1 Borrow Shares @ lending rate of 12% p.a. on
Spot Price on 1st July 2023 & Sell
immediately in Spot Market
950 950 950
2. Brokerage and Other Transaction Cost on
Spot Sell @ 1%
(9.50) (9.50) (9.50)
3. Buy September Future Contract on 1st July
2023 @850 by paying initial margin of say
10%
(85.00) (85.00) (85.00)
4. Brokerage and Other Cost on Futures @ 1%
on 850
(8.50) (8.50) (8.50)
5 Cash Balance
847 847 847
6. Deposit Cash Balance in Bank, say @10%
p.a.
(847) (847) (847)
Net Cash Balance on 1st July 2023
0 0 0

PARTICULARS SPOT PRICE SCENARIO ON 30th SEPTEMBER 2023
Rs. 800 Rs. 950 Rs. 1,100
(A) Cash Flows on 30th September 2023
1 Deposit Matured – Principal 847 847 847
2. Interest on Deposit @ 10% for 3 Months i.e.,
[847 X (1 + 0.10)¼]
20.42 20.42 20.42
3. Maturity Value 867.42 867.42 867.42
4. Settlement of Futures = Future Price Rs. 850
– Initial Margin Rs. 85 (10% of 850) = 765
(765) (765) (765)
5 Cash Balance 102.42 102.42 102.42
6. Pay Interest on Borrowed Shares @ 12% p.a.
on 950 [950 X (1 + 0.12)¼]
(27.30) (27.30) (27.30)
7. Net Cash Balance on 30th September 2023 75.12 75.12 75.12
Net Cash Flows on 30th September 2023

Interpretation
Thus, by adopting Long Hedge Strategy Mr. Shubham will
earn riskless Profit of Rs. 75.12 per share irrespective of Spot
Price increasing or decreasing or remaining unchanged.

Cash Flows of Mr. Shubham in different Spot Price Scenario when he does not
adopt Long Hedge Strategy
PARTICULARS
Rs. 800 Rs. 950 Rs. 1,100
(A) Cash Flows on 1st July 2023
1 Borrow Shares @ lending rate of 12% p.a. on
Spot Price on 1st July 2023 & Sell
immediately in Spot Market
950 950 950
2. Brokerage and Other Transaction Cost on
Spot Sell @ 1%
(9.50) (9.50) (9.50)
3. Cash Balance
940.50 940.50 940.50
4. Deposit Cash Balance in Bank, say @10%
p.a.
(940.50) (940.50) (940.50)
Net Cash Balance on 1st July 2023
0 0 0

Cash Flows of Mr. Shubham in different Spot Price Scenario when he does not
adopt Long Hedge Strategy (Continue)
PARTICULARS
Rs. 800 Rs. 950 Rs. 1,100
(A) Cash Flows on 30th September 2023
1. Deposit Matured – Principal
Rs. 940. 50 Rs. 940. 50 Rs. 940. 50
2. Interest on Deposit @ 10% p.a. for 3 Months
[940.50 X (1 + 0.10)¼]
Rs. 22.67 Rs. 22.67 Rs. 22.67
3. Maturity Value
963.17 963.17 963.17
4. Buy Shares in Spot Market to return Borrowed Shares
(800) (950) (1,100)
5. Cash Balance
163.17 13.17 (136.83)
6. Pay Interest on Borrowed Shares @ 12% p.a. on 950 [950 X
(1 + 0.12)¼]
(27.30) (27.30) (27.30)
7. Net Cash Balance on 30th September 2023
Profit / (Loss)
135.87 (14.13) (164.13)

Thus, Mr Shubham if does not adopt long hedge strategy, he will
incur loss if spot price increases on maturity and when there is no
change in spot price on maturity.
He shall make profit only if price decrease by more than the
brokerage amount plus the net interest amount i.e. Rs. 9.50 + (27.30
- 22.67) = Rs. 9.50 + 4.63 = Rs. 14.13

Short Hedge
An entity having long position or likely to have long position in underlying would need to take
short position in futures market so as to manage the price risk. Therefore, when one hedges
with short position in futures it is referred to as Short Hedge.
Thus, Short Hedge means means a short position in futures.
By futures market an entity can freeze the price risk of underlying hedging
which it is long.
The basic objective behind short hedge is to retain value of underlying and
not to make any gains from fluctuation in the value.

Investment Portfolio of AMFI consists of 1,000 shares of Tata Steel Ltd.
Today, 1st July 2023, the spot market price is Rs. 500 per share.
Thus, the portfolio value of AMFI as on 1st July 2023 is Rs. 5,00,000.
AMFI is of the view that the share price of Tata Steel will decrease by 15% by
the end September 2023.
AMFI intend maintain the portfolio value at minimum Rs. 4,75,000.
The September Futures on Tata Steel is available for Rs. 480. The brokerage
and other transaction cost on futures contract is 1%. Explain how AMFI can
maintain the portfolio value of minimum Rs. 4,75,000.

PARTICULARS
LIKELY SEPTEMEBER PRICE SCENARIO
July Rs. 450 Rs. 500 Rs. 550
1. Short 1000 Shares in Future Contract @ Rs.
480
4,80,000 4,80,000 4,80,000
1. Brokerage on Futures @ 1% (4,800) (4,800) (4,800)
Septemb
er
30th Settlement of Future Contract at Spot Price (4,50,000) (5,00,000) (5,50,000)
30th Profit/ (Loss) in Future Contract = Cash
Inflow / Outflow
25,200 (24,800) (74,800)
30th Value of Shares held in the Portfolio 4,50,000 5,00,000 5,50,000
30th Value of Portfolio in September 4,75,200 4,75,200 4,75,200

ARBITRAGE USING FUTURES
Arbitrageurs in futures market are the people who take advantage of price
difference between cash market and futures market. Arbitrageurs take two
positions, one in cash market and other in futures market depending on the
price differences to make risk free profits.

Earlier, we studied that pricing of futures is based on cost-of-carry model and if the pricing
does not match with cost of carry arbitrageurs can make risk free profits by taking
advantages of price differences. Now, as per cost-of-carry model futures price of a non-
dividend paying security should be,
Whereas.
S = Spot price
r = Cost of financing (using continuously compounded interest rate)
t = Time till expiration in years
e = 2.71828 (Euler’s number or in simple words, a mathematical constant)

For Example: Security ABC Ltd trades in the spot market at ₹ 1170. Money can be invested at 11% p.a.
The Theoretical value of a one-month futures contract on ABC is calculated as follows:

CASH AND CARRY ARBITRAGE STRATEGY
In other words, Cash and carry arbitrage is an arbitrage strategy wherein an arbitrageur
creates a portfolio of a long position in an asset such as a stock or commodity, and a short
position in the same underlying futures.
Important Note: This strategy seeks to exploit pricing inefficiencies for the same asset in
the cash (or spot) and futures markets, in order to make risk free profits. The arbitrageur
typically ‘carries’ the asset until the expiration date of the futures contract and the same is
delivered against the futures contract on such expiration date.

Therefore, for example mentioned above we will use cash and carry
arbitrage if share of ABC Ltd. today is 1,170 and is being traded
theoretically above 1180.53 in one month’s future market.
Say the share of ABC Ltd. in the exchange is being traded at 1,200/-
for one month future, an arbitrageur can make risk free profit.

1. Borrow cash today + ₹ 1,170
2. Purchase one share of ABC Ltd. from cash market [i.e. take a
long position in cash market]
- ₹ 1,170
3. Enter into a one month futures contract to sell the share of
ABC Ltd. at 1,200/- per share [i.e. take short position in futures
market]
4. Sell the share after one month as per the futures contract [See
Point No. 3]
+ ₹ 1,200
5. Re-pay the money borrowed in point 1 above with interest - ₹ 1,180.53
6. Risk free profit [4— 5] + ₹ 19.47

Reverse Cash & Carry Arbitrage
As the name suggests, this strategy is opposite of cash and carry arbitrage.

In other words, reverse cash and carry arbitrage is an arbitrage strategy wherein
an arbitrageur creates a portfolio of a short position in an asset such as a stock or
commodity, and a long position in the same underlying futures.
This strategy seeks to exploit pricing inefficiencies for the same asset in the
cash (or spot) and futures markets, in order to make risk free profits.
The arbitrageur typically ‘sells” the asset today to invest the funds and get a
higher inflow on future settlement date as compared to the price he is required
to pay to purchase the same share in the futures market making risk free profit
while doing so.

Therefore, for example mentioned above we will use reverse cash and carry
arbitrage if share of ABC Ltd. is being traded below ₹ 1180.53 in one month’s
future market.
Say the share of ABC Ltd. is being traded at ₹ 1,175/- for one month future, an
arbitrageur can make risk free profit as follows.

1. Borrow Shares under SLBS Scheme at a price of 1,170
2. Sell the share in cash market today. + ₹ 1,170
3. Invest the funds received above (2) at cost of carry rate. -
₹1,170
4. Enter into a one month futures contract to buy the share of ABC Ltd.
at ₹ 1,175/- per share [i.e. take long position in futures market]
5. Redeem the funds invested in above (3) after one month to receive
funds with interest
+ ₹
1180.53
6. Purchase the share at prefixed future price. - ₹ 1,175
7. Risk free profit (5 – 6) + 5.53
8. Return Share to the Holder as per SLBS Scheme.

Securities Lending and Borrowing (SLB) is a mechanism through which
clients can lend or borrow securities at a specified price and time. Lenders and
borrowers can quote a lending fee and quantity at which they want to lend or
borrow, and the order will be executed if the quotes match at the exchange.
Why borrow securities?
 Borrow and sell the stock immediately or short sell if the view is that the
price of stock will go down over a period of time.
 Take advantage of arbitrage opportunities when futures or options are
mispriced.
 To fulfil physical delivery obligations for F&O trades.

Hedging, Speculation and Arbitrage using Futures.ppt

Hedging, Speculation and Arbitrage using Futures.ppt

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