CA FINAL - SFM - NOTES ON DERIVATIVES WITH EXAMPLE - MUST READ

What are derivatives?



Derivatives, such as options or futures, are financial contracts which derive their value off a spot price time-series, which is called “the underlying". For examples, wheat farmers may wish to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction would take place through a forward or futures market. This market is the “derivative market", and the prices on this market would be driven by the spot market price of wheat which is the “underlying". The terms “contracts" or “products" are often applied to denote the specific traded instrument.The world over, derivatives are a key part of the financial system. The most important contract types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange and real estate.

 

 

What is a forward contract?

 

In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.

 

 

Why is forward contracting useful?



Forward contracting is very valuable in hedging and speculation.The classic hedging application would be that of a wheat farmer forward-selling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist production planning without the risk of price fluctuations.

 

If a speculator has information or analysis which forecasts an upturn in a price, then she can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction. The use of forward markets here supplies leverage to the speculator.

 

 

What are the problems of forward markets?



Forward markets worldwide are afflicted by several problems: 

 

  (a) lack of centralisation of trading,

  (b) illiquidity, and 

  (c) counterparty risk.

 

In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation for the specific parties, but makes the contracts non-tradeable if non-participants are involved. Also the “phone market" here is unlike the centralisation of price discovery that is obtained on an exchange. Counterparty risk in forward markets is a simple idea: when one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counter- party risk.

 

Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, the counterparty risk remains a very real problem. 

 

 

What is a futures contract?



Futures markets were designed to solve all the three problems listed above of forward markets. Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardised and trading is centralised, so that futures markets are highly liquid. There is no counterparty risk (thanks to the institution of a clearinghouse which becomes counterparty to both sides of each transaction and guarantees the trade). In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counter party risk.

 

 

What is the difference between Forward and futures contract?

 

 

What are various types of derivatives traded at NSE ?

 

There are two types of derivatives products traded on NSE namely Futures and Options 



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. All the futures contracts are settled in cash.



Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.

 

Options are of two types - Calls and Puts options :

 

"Calls" give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. 

 

"Puts" give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. All the options contracts are settled in cash.



Further, the Options are classified based on type of exercise. At present the Exercise style can be European or American.

 

American Option - American options are options contracts that can be exercised at any time upto the expiration date. Options on individual securities available at NSE are American type of options.

 

European Options - European options are options that can be exercised only on the expiration date. All index options traded at NSE are European Options.

 

 

What are “exotic" derivatives?

 

Options and futures are the mainstream workhorses of derivatives markets worldwide. However, more complex contracts, often called exotics, are used in more custom situations. For example, a computer hardware company may want a contract that pays them when the rupee has depreciated or when computer memory chip prices have risen. Such contracts are “custom-built" for a client by a large financial house in what is known as the “over the counter" derivatives market. These contracts are not exchange-traded. This area is also called the “OTC Derivatives Industry".

 

An essential feature of derivatives exchanges is contract standardisation. All kinds of wheat are not tradeable through a futures market, only certain defined grades are. This is a constraint for a farmer who grows a somewhat different grade of wheat. The OTC derivatives industry is an intermediary which sells the farmer insurance which is customised to his needs; the intermediary would in turn use exchange-traded derivatives to strip off as much of his risk as possible.

 

 

Why are derivatives useful?

 

The key motivation for such instruments is that they are useful in reallocating risk either across time or among individuals with different risk-bearing preferences.

 

One kind of passing-on of risk is mutual insurance between two parties who face the opposite kind of risk. For example, in the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This sort of thing also takes place in speculative position taking, the person who thinks the price will go up is long a futures and the person who thinks the price will go down is short the futures.

 

Another style of functioning works by a risk-averse person buying insurance, and a risk-tolerant person selling insurance. An example of this may be found on the options market : an investor who tries to protect himself against a drop in the index buys put options on the index, and a risk-taker sells him these options. Obviously, people would be very suspicious about entering into such trades without the institution of the clearinghouse which is a legal counterparty to both sides of the trade.

 

In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, it is a considerable gain.

 

The ultimate importance of a derivatives market hence hinges upon the extent to which it helps investors to reduce the risks that they face. Some of the largest derivatives markets in the world are on treasury bills (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk).

 

 

What are various instruments available for trading in Futures and Options?

• Index Futures
  
   
• Index Options
  
   
• Stock Futures
  
   
• Stock Options
  
   
• Currency Futures and 
  
   
• Interest Rate Futures

 

When were Index Futures and Index options made available for trading at NSE?

 

Index Futures were made available for trading at NSE on June 12, 2000 and Index Options were made available for trading at NSE on June 4, 2001. S&P CNX Nifty Futures was the first index on which index futures and options was introduced. 

 

 

When were Stock Futures and stock options made available for trading at NSE?

 

Stock Futures were made available for trading at NSE on July 2, 2001 and stock options were made available for trading at NSE on November 9, 2001. 

 

 

When was currency futures made available for trading at NSE ?

 

Currency futures on the USD-INR pair exchange rate was made available for trading on August 29, 2008.

 

 

When was interest rate futures made available for trading at NSE?

 

Interest Rate futures were made available for trading on August 31, 2009.

 

 

Are there different trading segments at NSE which offer futures and options instruments with different types of underlying?

 

Yes, two different trading segments at NSE offer different kind of instruments in futures and options. The futures and options with the underlying as index and stock are traded on the Futures and Options segment while the futures and options with the underlying as exchange rate of currencies or the coupon of a notional bond (in case of interest rate derivatives) are traded on the Currency derivatives segment.

 

 

Why Should I trade in derivatives?



Futures trading will be of interest to those who wish to:

How will retail investors benefit from index derivatives?

 

The answer to this fits under “People who find Index fluctuations painful". Every retail investor in the economy who is in pain owing to a downturn in the market index is potentially a happy user of index derivatives.

 

 

If a contract is just a relationship between long and short, how do we ensure “contract performance"?

 

The key innovation of derivatives markets is the notion of the clearinghouse that guarantees the trade. Here, when A buys from B, (at a legal level) the clearinghouse buys from B and sells to A. This way, if either A or B fail on their obligations, the clearinghouse fills in the gap and ensures that payments go through without a hitch. The clearinghouse, in turn, cannot create such a guarantee out of thin air. It uses a system of initial margin and daily mark-to-market margins, coupled with sophisticated risk containment, to ensure that it is not bankrupted in the process of supplying this guarantee.

 

 

What is the role of arbitrage in the derivatives area?

 

All pricing of derivatives is done by arbitrage, and by arbitrage alone.

 

In other words, basic economics dictates a relationship between the price of the spot and the price of a futures. If this relationship is violated, then an arbitrage opportunity is available, and when people exploit this opportunity, the price reverts back to its economic value.

 

In this sense, arbitrage is basic to pricing of derivatives. Without arbitrage, there would be no market efficiency in the derivatives market: prices would stray away from fair value all the time. Indeed, a basic fact about derivatives is that the market efficiency of the derivatives market is inversely proportional to the transactions costs faced by arbitrageurs in that market. When arbitrage is fluent and effective, market efficiency is obtained, which improves the attractiveness of the derivatives from the viewpoint of users such as hedgers or speculators. 

 

 

What happens if there are only a few arbitrageurs ready to function in the early days of the market?

 

In most countries, there are bigger arbitrage opportunities in the early days of the futures market. As larger resources and greater skills get brought into the arbitrage business, these opportunities tend to vanish.

 

India is better placed in terms of skills in arbitrage, as compared with many other countries, thanks to years of experience with “line operators" who are used to doing arbitrage between exchanges. These kinds of traders would be easily able to redirect their skills into this new market. These “line operators" are fluent with a host of real-world difficulties, such as different expiration dates on different exchanges, bad paper, etc. Their skills are well-suited to index arbitrage.

 

 

What is the role of liquidity in enabling good derivatives markets?

 

The role of liquidity (which is defined as low transactions costs) is in making arbitrage cheap and convenient. If transactions costs are low, then the smallest mispricings on the derivatives market will be removed by arbitrageurs, which will make the derivatives market more efficient.

 

 

What should a market index be?

 

A market index is a large, well-diversified portfolio which is an approximation to returns obtained in owning \the overall economy". Portfolio diversification is a powerful means of stripping out firm- and industry-effects, so that the returns on the well-diversified portfolio reflect only economy-wide effects, and are relatively insensitive to the specific companies or industries in the index portfolio. Market index returns time-series are central to modern financial economics, and have enormous value for a variety of real-world applications. A good market index should be highly liquid to support products in the real world, it should have a high hedging effectiveness against a huge variety of real-world portfolios, and it should be hard to manipulate. 

 

 

What is special about Nifty for use in index derivatives?

 

The methodology created for the NSE-50 index explicitly isolates a set of securities for which the market impact cost is minimised when buying or selling the entire index portfolio. This makes Nifty well-suited to applications such as index funds, index derivatives, etc. Nifty has a explicit methodology for regular maintenance of the index set. It is successful at expressing the market risk inherent in a wide variety of portfolios in the country.

 

 

How does this low impact cost matter?

 

As is the case in all areas of finance, in the context of index derivatives, there is a direct mapping between transactions costs and market efficiency. Index futures and options based on Nifty will benefit from a high degree of market efficiency because arbitrageurs will face low transactions costs when they eliminate mispricings. This high degree of market efficiency on the index derivatives market will make it more attractive to pure users of the derivatives, such as hedgers, speculators and investors. High liquidity also immediately implies that the index is hard to manipulate, which helps engender public confidence.

 

 

At the operational level, how do security contracts compare versus index-based contracts?

 

The basic fact is that index-based contracts attract a much more substantial order-flow, which helps them have tighter spreads (i.e. greater liquidity). At a more basic economic level, we say that there is less asymmetric information in the index (as opposed to securities, where insiders typically know more than others), which helps index-based trading have better liquidity.

 

At settlement, in the case of security-options, there is the possibility of delivery, and in that case arises the question of depository vs. physical delivery. Both alternatives are quite feasible. However, in index-based contracts, that question does not arise since all index-based contracts are cash-settled.

 

The index has much less volatility than individual securities. That helps index options have lower prices, and index futures can work with lower margins.

 

The most important difference between the index and individual securities concerns manipulation. Given that an index is carefully built with liquidity considerations in mind, it is much harder to manipulate the index as compared with the difficulty of manipulating individual securities. 

 

 

How do I start trading in the index and stock derivatives (futures and options) market?

 

Futures/ Options contracts in both index as well as stocks can be bought and sold through the trading members of National Stock Exchange. Some of the trading members also provide the internet facility to trade in the futures and options market. You are required to open an account with one of the trading members and complete the related formalities which include signing of member-constituent agreement, constituent registration form and risk disclosure document. The trading member will allot to you an unique client identification number. To begin trading, you must deposit cash and/or other collaterals with your trading member as may be stipulated by him.

 

 

What is the Expiration Day for Stocks or Index futures and options?

 

It is the last day on which the contracts expire. Index / Stock Futures and Options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 

 

 

What is the contract cycle for Equity based products in NSE ?

 

Futures and Options contracts have a maximum of 3-month trading cycle -the near month (one), the next month (two) and the far month (three). New contracts are introduced on the trading day following the expiry of the near month contracts. The new contracts are introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market (for each security) i.e., one near month, one mid month and one far month duration respectively. For example on January 26,2008 there would be three month contracts i.e. Contracts expiring on January 31,2008, February 28, 2008 and March 27, 2008. On expiration date i.e January 31, 2008, new contracts having maturity of April 24,2008 would be introduced for trading.

 

 

What are mini- derivative contract and what are the uses of it?

 

The minimum contract size for the mini derivative contract on Nifty Index is1 lakh. The contract of Nifty index with this contract size is known as the mini derivative contract. The lower minimum contract size enables smaller investors / retail investors to participate and hedge their portfolio using these contracts.

 

 

What is meant by longer dated derivatives products? Why longer dated index options are required?

 

Longer dated derivatives products are useful for those investors who want to have a long term hedge or long term exposure in derivative market. The premiums for longer term derivatives products are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit. Currently, longer dated options on Nifty with tenure of upto 3 years are available for the investors.

 

 

What is meant by a volatility Index and how is it computed?

 

Volatility Index is a measure of expected stock market volatility, over a specified time period, conveyed by the prices of stock / index options. 

 

 

What is the concept of In the money, At the money and Out of the money in respect of Options?

 

In- the- money options (ITM) - An in-the-money option is an option that would lead to positive cash flow to the holder if it were exercised immediately. A Call option is said to be in-the-money when the current price stands at a level higher than the strike price. If the Spot price is much higher than the strike price, a Call is said to be deep in-the-money option. In the case of a Put, the put is in-the-money if the Spot price is below the strike price.

 

At-the-money-option (ATM) – An at-the money option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is said to be "at-the-money" when the current price equals the strike price.

 

Out-of-the-money-option (OTM) - An out-of- the-money Option is an option that would lead to negative cash flow if it were exercised immediately. A Call option is out-of-the-money when the current price stands at a level which is less than the strike price. If the current price is much lower than the strike price the call is said to be deep out-of-the money. In case of a Put, the Put is said to be out-of-money if current price is above the strike price.

 

 

What is the meant by lot size of contract in the equity derivatives market? 

 

Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at 1000 each and the minimum contract size is 2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

 

 

Is there any Margin payable?

 

Yes. Margins are computed and collected on-line, real time on a portfolio basis at the client level. Members are required to collect the margin upfront from the client & report the same to the Exchange.

 

 

How are the contracts settled in case of Index / Stock Futures and Options?

 

All the Index / Equity futures and options contracts are settled in cash on a daily basis and at the expiry or exercise of the respective contracts as the case may be. Clients/Trading Members are not required to hold any stock of the underlying for dealing in the Futures / Options market. All out of the money and at the money option contracts of the near month maturity expire worthless on the expiration date.

 

 

What are the Contract Specifications of Index / Stocks based derivatives traded in NSE?

What are the risks associated with trading in Derivatives?

 

Investors must understand that investment in derivatives has an element of risk and is generally not an appropriate avenue for someone with limited resources/ limited investment and / or trading experience and low risk tolerance. An investor should therefore carefully consider whether such trading is suitable for him or her in the light of his or her financial condition. An investor must accept that there can be no guarantee of profits or no exception from losses while executing orders for purchase and / or sale of derivative contracts, Investors who trade in derivatives at the Exchange are advised to carefully read the Model Risk Disclosure Document and the details contained therein. This document is given by the broker to his clients and must be read, the implications understood and signed by the investor. The document clearly states the risks associated with trading in derivatives and advises investors to bear utmost caution before entering into the markets.

 

 

What is meant by currency futures?

 

Currency futures can be described as contracts between the sellers and buyers whose values are derived from the underlying Exchange Rate. Currency derivatives are mostly designed for hedging purposes, although they are also used as instruments for speculation.

 

 

Currency futures trading is allowed in which currency pairs?

 

Currency future trading is allowed in the US dollar – Indian Rupee (USD – INR); Great Britain Pound – Indian Rupee (GBP – INR), Euro – Indian Rupee (EURO-INR) and Japanese Yen – Indian Rupee (JPY-INR). 

 

 

Who can trade in the Currency Futures Market?

 

Except FIIs and NRIs, every individual/corporate/institution/bank etc. is allowed to trade in the Currency Futures market.

 

 

What is the permitted lot size in case of Currency futures?

 

Permitted lot size for USDINR future contracts is 1000 US dollars. Members place orders in terms of number of lots. Therefore, if a member wants to take a position for 10000 USD, then the number of contracts required is 10000/1000 = 10 contracts.

 

 

How do I start trading Currency futures at NSE?

 

Currency futures can be bought and sold through the trading members of NSE. To open an account with a NSE trading member, you will be required to complete the formalities which include signing of member constituent agreement, constituent registration form and a risk disclosure document. The trading member will allot you a unique client identification number. To begin trading, you will be required to deposit cash or collateral with your trading member as may be stipulated by them.

 

 

What are the contract specifications for Currency futures traded at NSE?

What is the Settlement price for currency futures ?

 

The settlement price is the Reserve Bank of India Reference Rate on the last trading day. 

 

 

How is Settlement mechanism done in Currency futures?

 

The currency futures contracts are settled in cash in Indian Rupee.

 

 

What is the final settlement day in case of currency futures ?

 

Final settlement day is the last working day (subject to holiday calendars) of the month. The last working day is taken to be the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ are those laid down by FEDAI (Foreign Exchange Dealers Association of India). In keeping with the modalities of the OTC markets, the value date / final settlement date for the each contract is the last working day of each month and the reference rate fixed by RBI two days prior to the final settlement date is used for final settlement. The last trading day of the contract is therefore 2 days prior to the final settlement date. On the last trading day, since the settlement price gets fixed around 12:00 noon, the near month contract ceases trading at that time (exceptions: sun outage days, etc.) and the new far month contract is introduced.

 

 

What is meant by Interest Rate Futures? 

 

An interest rate futures contract is "an agreement to buy or sell a debt instrument at a specified future date at a price that is fixed today." 

 

 

What is the underlying for Interest Rate Futures?

 

Currently, exchange traded Interest rate futures are based on the notional coupon bearing GOI security. 

 

While the name ‘interest rate futures’ suggests that the underlying is interest rate, it is actually bonds that form the underlying instruments. An important point to note is that the underlying bond in India is a “notional” government bond which may not exist in reality. The underlying for bond futures in India is a notional 10 year government bond with a coupon payment of 7% p.a. In India, the RBI and the SEBI have defined the characteristics of this bond: maturity period of 10 years and coupon rate of 7% p.a.

 

 

Why a Notional Bond is being used as Underlying?

 

Currently, the underlying for bond futures in India is a notional 10 year government bond with a coupon payment of 7% p.a. Such a bond may not actually exist. So, let us understand why such a notional underlying has been selected.

 

If futures were to be introduced on each of the government bonds, then there would be a large number of interest rate futures contracts trading on each bond and as a result, the liquidity would be poor for many of these futures. So a single bond futures has been identified which pays 7% p.a. as coupon rate and has maturity of 10 years. All bonds have been assigned a multiplier called ‘conversion factor’ which brings that bond on par with the theoretical bond available for trading. We will learn more about the conversion factor in subsequent sections.

 

If the bond future were to be based on an actual bond issue, it could potentially raise the activity in the futures market to such a large extent as to cause severe shortages of this actual bond for delivery at expiry. To avoid this danger of shortages to meet the delivery requirement, the Exchange allows a specific set of bonds--rather than a single bond--with different coupons and expiry dates to be used for satisfying the obligations of short position holders in a contract. Thus, while the purpose of a notional underlying bond is to ensure liquidity, the purpose of having a basket of bonds is to ensure that there delivery is not affected by short supply, which would have arisen in case of a single bond. 

 

 

Why has the bond with a 7% coupon rate been chosen? 

 

The coupon rate of 7 % has been chosen for the hypothetical bond because the yields on government bonds are generally close to 7 % and hence there would not be much difference in yield between the delivered bond and the hypothetical underlying.

 

 

How is the settlement done in case of Interest Rate futures?

 

The interest rate futures have to be physically settled unlike the equity derivatives which are cash settled in India. Physical settlement entails actual delivery of a bond by the seller to the buyer. But because the underlying notional bond may not exist, the seller is allowed to deliver any bond from a basket of deliverable bonds identified by the authorities.

 

 

What are the uses of Interest Rate futures?

 

It is not just the financial sector, but also the corporate and household sectors that are exposed to interest rate risk. Banks, insurance companies, primary dealers and provident funds bear significant interest rate risk on account of the mismatch in the tenure of their assets (such as loans and Govt. securities) and liabilities. These entities therefore need a credible institutional hedging mechanism. Interest rate risk is becoming increasingly important for the household sector as well, since the interest rate exposure of several households are rising on account of increase in their savings and investments as well as loans (such as housing loans, vehicle loans etc.). Moreover, interest rate products are the primary instruments available to hedge inflation risk, which is typically the single most important macroeconomic risk faced by the household sector. It is therefore important that the financial system provides different agents of the economy a greater access to interest rate risk management tools such as exchange-traded interest rate derivatives.

 

 

Who can participate in the Interest Rate Futures market

• Banks and Primary Dealers
• Mutual Funds and Insurance Companies
• Corporate houses and Financial Institutions
• FIIs and NRIs
• Member Brokers and Retail Investors
  
   

How to participate in Interest Rate Futures trading at NSE ?

 

Interest rate futures can be bought and sold through the trading members of the National Stock Exchange. To open an account with a NSE trading member you will be required to complete the formalities which include signing of member constituent agreement, constituent registration form and a risk disclosure document. The trading member will allot you a unique client identification number. To begin trading you will be required to deposit cash or collateral with your trading member as may be stipulated by them. 

 

 

What are the contract specifications for Interest Rate futures traded at NSE?

Use Put as a portfolio Hedge?

 

Assumption: You are concerned about a downturn in the short term in the market and its effect on your portfolio. The portfolio has performed well and you expect it to continue to appreciate over the long term but would like to protect existing profits or prevent further losses.

 

Possible Action: Buy Nifty puts.

 

Example:

 

You held a portfolio with say, a single stock, HLL valued at10 Lakhs ( @ 200 each share). Beta of HLL is 1.13. Current Nifty is at 1880. Nifty near month puts of strike price 1870 is trading at15. To hedge, you bought 3 puts 600{Nifties, equivalent to 10 lakhs*1.13 (Beta of HLL) or1130000}. The premium paid by you is 9000, (i.e.600 * 15). If at expiration Nifty declines to 1800, and Hindustan Lever falls to 195, then

• Trade Date- 1st July 09 
• Futures Delivery date – 1st Sep 2009
• Current Futures Price- 97.50
• Futures Bond Yield- 7.21%
• Trader sell 250 contracts of the Sep 09 10 Year futures contract on NSE on 1st July 2009 at 97.50

Daily MTM due to change in futures price is as tabulated below

• 7th July 2009- Futures market Price – 96.60
• Trader buys 250 contracts of Sep 09 at 96.60 and squares off its position
• Therefore total profit for trader 250*2000*(97.25-96.60) is 3,25,000 (II)
• Total Profit on the trade = INR 4,50,000 (I & II)

Case 2: Hedging 

 

A bank has a large portfolio of GOI securities worth INR 25 crores. Bank’s portfolio consists of bonds with different coupons and different maturities. 

 

In view of rising interest rates in the near term. The treasury head has concern that rise in interest rate shall negatively affect the value of his portfolio in GOI securities. The treasury head wants to hold his entire portfolio and at the same time doesn’t want to suffer losses on account of fall in bond prices. 

 

Should the bank go short or long on the futures contracts to establish the correct hedge?

 

The treasury head decides to hedge the interest rate risk by taking a short position in the interest rate futures on NSE. 

 

 

Case 3: Calendar Spread Trading

 

A long & short position in different futures contracts on the same underlying is called as a calendar spread.

 

If a long position in a Sep 09 IRF contract versus a short position in the Dec 09 IRF contract on NSE is considered a calendar spread.

 

Since a calendar spread entails only the basis risk, the bank runs little risk on the positions. 

 

Example:

 

The difference between the Sep 09 & Dec 09 contracts is currently0.25 (after considering bid- ask). If the trader believes that this spread is very high, he would execute a calendar spread by

 

Buying the Dec09 futures at 99.95

 

Selling the Sep09 futures at 100.20

 

10 days later

Note: For simplicity accrued interest is not considered for calculation

 

Against its funding cost of 4.25% (borrowing rate), thereby earning risk free arbitrage

 

The bond with the highest implied repo rate would be the cheapest to deliver (CTD) bond

 

The arbitrager would identify the bond with the highest implied repo rate or the CTD bond and execute the strategy with the same bond, depending on its availability in the secondary market