Understanding the futures

market

By. Prof. Samie A Sayed

What are futures?

A futures contract is an agreement between two
parties to buy or sell an asset at a certain time in the
future at a certain price.
It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the
underlying instrument that can be delivered, (or
which can be used for reference purposes in
settlement) and a standard timing of such settlement.
A futures contract may be offset prior to maturity by
entering into an equal and opposite transaction.
More than 99% of futures transactions in India are
offset this way.

The terms of a futures

contract
The standardized items in a futures
contract are:
Quantity of the underlying
Quality of the underlying
The date and the month of delivery
The units of price quotation and
minimum price change
Location of settlement

TERMINOLOGY FUTURES IN INDIA

Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the
futures market.
Contract cycle: The period over which a contract trades. The index
futures contracts on the NSE have one- month, two-months and three
months expiry cycles which expire on the last Thursday of the month.
Thus a January expiration contract expires on the last Thursday of
January and a February expiration contract ceases trading on the last
Thursday of February. On the Friday following the last Thursday, a
new contract having a three- month expiry is introduced for trading.
Expiry date: It is the date specified in the futures contract. This is
the last day on which the contract will be traded, at the end of which
it will cease to exist.
Contract size: The amount of asset that has to be delivered under
one contract. Also called as lot size.

Source : nseindia.com

Snapshot Index futures

Snapshot Stock futures

Terminology futures in India

Initial margin: The amount that must be deposited in
the margin account at the time a futures contract is
first entered into is known as initial margin.
Marking-to-market: In the futures market, at the
end of each trading day, the margin account is
adjusted to reflect the investor's gain or loss
depending upon the futures closing price. This is
called marking-to-market.
Maintenance margin: This is somewhat lower than
the initial margin. This is set to ensure that the
balance in the margin account never becomes
negative. If the balance in the margin account falls
below the maintenance margin, the investor receives
a margin call and is expected to top up the margin
Source : nseindia.com
account
to the initial margin level before trading

Futures trading India

Futures trading globally occurs primarily in interest rate
futures, currencies, equity indices and commodities.
In India, futures trading started with index futures
followed by single stock futures, then commodities and
currencies.
SEBI oversees equity market trading, FMC oversees
commodity trading, and RBI SEBI overview the
currency futures trading market.
Before we proceed, it is important to note that all
equity and currency derivatives in India are cash
settled while commodity contracts are settled on
physical delivery.

Stock futures India

Every stock futures contract consists of a fixed lot of the
underlying share; this lot is determined by SEBI /
Exchanges on which it is traded and differs from stock to
stock.
In stock futures, contracts are available in durations of 1
month, 2 months and 3 months (called near month,
middle month and far month, respectively).
The month in which a contract expires is called the
contract month for that contract. All three maturities are
traded simultaneously on the exchange and expire on
the last Thursday of their respective contract months.
If the last Thursday of the month is a holiday, they expire
on the previous business day. In this system, as near
month contracts expire, the middle month contracts
become near month contracts and the far month
contracts become middle month contracts. Fresh far

SEBI Lot size particulars

F&O
Until October 2015, the minimum contract size in
equity derivatives segment was Rs. 2 lakhs. The
requirement was recently reviewed and it has
been decided to increase the minimum contract
size in equity derivatives segment to Rs. 5 lakhs.
Maximum contract size is Rs. 10 lakhs.
For stock derivatives, the lot size (in units of
underlying) shall be fixed as a multiple of 25,
provided the lot size is not less than 50.
However, if the contract value of the stock derivatives
at the minimum lot size of 50 is greater than Rs. 10
lakhs , then lot size shall be fixed as a multiple of 5,
provided the lot size is not less than 10.
For index derivatives, the lot size (in units of
underlying) shall be fixed as a multiple of 5, provided

NSE Indices lot size Oct

2015

Pricing of futures Cost of

carry
Pricing of futures contract can be done using the costof-carry model.
To calculate the fair value of a futures contract, every
time the observed price deviates from the fair value,
arbitragers would enter into trades to capture the
arbitrage profit.
This in turn would push the futures price back to its fair
value.
The cost of carry is the cost of holding a position.
Conversely, if short, the cost of carry is the cost of
paying dividends, or rather the opportunity cost; the
cost of purchasing a particular security rather than an
alternative. In commodity markets, it is the cost of
storage and insurance.

Pricing of futures index

futures

This formula could be used to investment assets. If

dividend is received during the period, the remove
q(dividend %) from r in the above formula.

ource: NCFM Derivatives Module

Pricing of futures
Consumption
The cost of carry model expresses the futures price (or, as an
approximation, the futures price) as a function of the spot price
and the cost of carry.
F= Se^(r+s-c)t

F is the forward price,

S is the spot price,
e is the base of the natural logarithms, (e=2.71828)
r is the risk-free interest rate,
s is the storage cost,
c is the convenience yield, and
t is the time to delivery of the forward contract (expressed as a
fraction of 1 year).

Basis Risk
Basis risk is the market risk
mismatch between a position in the
spot asset and the corresponding
futures contract.
More broadly speaking, basis risk
(also called spread risk) is the market
risk related to differences in the
market performance of two similar
positions.
Basis = Futures Spot

Contango and
Backwardation
A positive cost of carry, meaning that
forward/futures prices F are higher
than spot prices S .
The basis F S is positive. Futures
markets are said to be in contango.
A negative cost of carry, implying a
negative basis. Futures markets are
said to be in backwardation.

Contango and
Backwardation

Black Monday UBS

In May 2005, SEBI put a ban on UBS for acting as a catalyst for one the
largest intraday drops in the history of Indian equity markets.
The market regulator, in its report, said it was suspected that the steep
market fall on May 17,2004, could have been triggered as a result of
UBS trading in the market which heightened selling pressure for no
reason linked to the fundamentals of scrips and their performance.
On that day, UBS at the gross level had sold stocks worth Rs 188
crore. UBS incurred a loss of Rs 17.54 crore on May 17, 2004 on account
of its sale in the cash segment, while it earned a profit of Rs 59.37 crore
on account of short positions in the futures market, thus making a net
gain of Rs 41.83 crore, the order pointed out.
In its order against UBS, the regulator has also accused it of not
providing adequate information about its clients to which it had issued
ODIs, namely participatory notes (PNs). PNs are instruments by which
an unregistered foreign fund can take exposure to Indian markets,
whereby the shares are held in the name of the entity which issues the
participatory notes to the unregistered foreign fund.

Margins and futures

Margins ensure that buyers bring money and sellers bring
shares to complete their obligations even though the
prices have moved down or up.
It is important to understand the meaning of volatility
before we proceed because it has a major bearing on how
margins are computed.
Volatility refers to the amount of uncertainty or risk about
the size of changes in a security's value.
A higher volatility means that a security's value can potentially
be spread out over a larger range of values. This means that the
price of the security can change dramatically over a short time
period in either direction, hence higher margins
A lower volatility means that a security's value does not
fluctuate dramatically, but changes in value at a steady pace
over a period of time, hence lower margins

Calculating volatility using

excel
Date

NIFTY

Daily Returns

Log Normal Returns

12-May-11

5499

13-May-11

5438.95

-1.1%

-0.01098023

16-May-11

5420.6

-0.3%

-0.003379517

17-May-11

5428.1

0.1%

0.001382654

18-May-11

5486.35

1.1%

0.010674024

19-May-11

5428.1

-1.1%

-0.010674024

20-May-11

5486.35

1.1%

0.010674024

23-May-11

5386.55

-1.8%

-0.018358083

24-May-11

5394.85

0.2%

0.001539689

25-May-11

5348.95

-0.9%

-0.008544515

Std Dev

1.00%

The daily volatility of NIFTY based on the period under consideration is 1.0%

Pay off futures

Margins for cash vs.

derivatives
Shares traded on cash market are settled in two days
whereas derivative contracts may have longer time to
expiry.
Derivative market margins have to address the
uncertainty over a longer period. Therefore, SEBI has
prescribed different way to margin cash and derivatives
trades taking into consideration unique features of
instruments traded on these segments.
Margins in the cash market segment comprise of the
following three types:
1) Value at Risk (VaR) margin
2) Extreme loss margin
3) Mark to market Margin
Source : bseindia.com

VALUE AT RISK Cash

segment
VaR is a technique used to estimate the probability of
loss of value of an asset or group of assets based on
the statistical analysis of historical price trends and
volatilities.
A VaR statistic has three components: a time period, a
confidence level and a loss amount (or loss
percentage). Keep these three parts in mind as we
give some examples of variations of the question that
VaR answers:
With 99% confidence, what is the maximum value
that an asset or portfolio may loose over the next
day?
In the stock exchange scenario, a VaR Margin is a
margin intended to cover the largest loss (in %) that
may be faced by an investor for his / her shares (both

Extreme loss margin

The extreme loss margin aims at covering the
losses that could occur outside the coverage
of VaR margins.
The Extreme loss margin for any stock is
higher of 1.5 times the standard deviation of
daily LN returns of the stock price in the last
six months or 5% of the value of the position.
This margin rate is fixed at the beginning of
every month, by taking the price data on a
rolling basis for the past six months.

The logic of open interest

Open Interest is the total number of outstanding
contracts that are held by market participants
while trading in derivatives.
Open interest measures the flow of money into
the futures market. For each buyer of a futures
contract there must be a seller of that contract.
Thus a buyer and seller combine to create only
one contract
is known
as open interest.
Price which
Open Interest
Interpretation
Rising

Rising

Market is Strong

Rising

Falling

Market is Weakening

Falling

Rising

Market is Weak

Falling

Falling

Market is Strengthening

Futures trading strategies

Futures trading strategies can be
understood from a perspective of the
major players in the derivatives
market the hedgers, the arbitragers
and the speculators.
Hedgers long portfolio, sell futures
Arbitrageurs Overpriced futures,
buy spot and sell futures
Speculation Bullish security, buy
futures

Conclusion
We have briefly touched upon the working of the
futures market in general with specific emphasis
on the working of the Indian markets.
Futures can be a great hedging tool for the
corporates who wish to hedge their risks
associated with their businesses.
Speculators can make tremendous amount of
money when they get the direction of their
futures bets correct.
Futures can be priced using the cost of carry
model.