MBA Forwards Futures Long Question Answer Sample Paper

MBA Forwards Futures Long Question Answer Sample Paper

MBA Forwards Futures Long Question Answer Sample Paper

MBA Forwards Futures Long Question Answer Sample Paper
MBA Forwards Futures Long Question Answer Sample Paper

MBA Forwards Futures Long Question Answer Sample Paper

Forwards and futures: forward contract, Features of forward contracts, Futures contract, Types ,Functions, Distinction between futures and forward, Pricing of futures contract, currency futures, Hedging in of futures, Cost of carry model, Application of market index, Index futures in the stick market, Indian derivatives market.

Section C

LONG ANSWER QUESTIONS

Q.1. Write a detailed note on Interest Rate Futures.

 Ans. Interest Rate Futures (IRF): An interest rate future (IRF) is a financial derivative with an interest-bearing instrument as the underlying asset. Interest rate futures means a standardized interest rate derivative contract traded on a recognized stock exchange to buy or sell a notional security of any other interest bearing instrument or an index of such instruments or interest rates at a specified future date, at a price determined at the time of contract. Interest rate futures are relatively new financial statements. It is one of the most successful financial futures instruments in the world. Interest rate futures trade in several maturities, currencies and different markets such as mortgages, federal issuance and short-term commercial paper. Interest rate futures tend to be highly liquid and are valued by the changing price of the security. Future trading on interest-bearing securities started only in 1975, but the growth in this market has been tremendous. Examples of interest rate futures are Treasury-bill futures, Treasury-bond futures and Euro-dollar futures.

Features of Interest Rate Futures

Salient features of exchange-traded interest rate futures are as follows:

  1. Greater transparency due to automated anonymous order matching system and settlement. 2. Delivery of underlying asset is possible on exchange platform.
  2. Exchange platform ensures protection against counterparty default risk, due to notation by clearing house of the exchange.
  3. Increased market reach enables higher liquidity.
  4. Large number of informed participants can traded using online electronic trading systems, leading to efficient price discovery.
  5. Futures contract available on notional 7% coupon 10 year Government of India Security as the underlying asset.
  6. Uniform standards and well-established procedures in IRF market allow symmetry of treatment to various participants.
  7. Exchange-traded IRF provides credit guarantee by the Clearing Corporation and hence

eliminates counterparty risk, thereby increasing the capital efficiency of the market participants.

  1. IRF are standardized products that allow for gauging the utility and effectiveness of different positions and strategies,
  2. Simple derivative instrument and easy to understand due to its linear pay-offs.
  3. IRF expands the set of hedging tools available to financial as well as non-financial entities to manage interest rate risk.
  4. Allows hedgers of efficiently transfer risk to speculators and arbitragers.
  5. Exchange-traded IRF ensure robust systems for risk management and surveillance, thereby, capable of eliminating any kind of market manipulation.
  6. Online real-time dissemination of prices.

 Types of Interest Rate Futures

Interest rate futures can be classified into two broad categories:

  1. Short-term Interest Rate Futures: Short-term interest rate futures are similar to forward rate contracts, but the terms of the contract are standardized and are traded on a recognized exchange. The Treasure bill and Euro-dollar futures traded on IMM are examples of short-term interest rate futures

(a) Treasury Bill Futures Contacts: Treasury bill (T-bill) futures contracts require the holder the short position to deliver $10,00,000 face value (the contract size) of three-month treasury bills (the deliverable item). The buyer must accept delivery and pay for the treasury bills: The delivery can actually be made anytime during the three business days following the last day of trading for the contract. The price quote for the T-bill contract is based on the IMM index (International Monetary Market), which is based on the discount yield on a 90-day treasury bill.

(b) Euro-dollar Futures Contracts: In all important regards, the Euro-dollar contract functions

just like the T-bill contract.

(I) It is based on a $10,00,000, 90-day instrument.

(ii) The contract price is 100 minus the expected yield on the 90-day instrument at contract expiration

(iii) Gains or losses are equal to 2,500 times the change in price per contract.

The differences are that the underlying asset is a euro-dollar deposit (a dollar denominated deposit held in a commercial bank outside the US). The yield is an interest-bearing yield rather than a discount yield,

The yield on euro-dollar deposits is commonly called LIBOR (London Interbank Offered Rate) because London is historically the most active market where international banks trade deposits between themselves. Similar to treasury bills, there is an IMM index based on LIBOR. Euro-dollar contract prices are based on this index.

  1. Long-term Interest Rate Future: Long-term interest rate futures are based on treasury bond, futures. The maturity of these futures can vary between 2-30 years.
  2. Treasury Bond Futures Contracts: The treasury bond futures contract is based on a generic $1,00,000 par value 6% coupon, 20-year bond and the price of the contract is the price of this underlying instrument. However, this creates a complication because it is unlikely that any such bond (6% coupon, due in exactly 20 years) will exist on contract expiration. To solve this problem, the seller of the contract (the short position) can deliver $1,00,000 par value of any treasury bond with a remaining term to maturity (or to call date) of 15 years or longer.

Q.2. Describe the uses and applications of stock index futures.

Ans. Stock Index Futures: Stock index futures is an index derivative that draws its value from an underlying stock index like Nifty or Sense. They were first pioneered by Kansas City Board of Trade on 24th February, 1982 and the contract is based on value line composite index.

Uses of Stock Index Futures

Some specific uses of stock index futures are as follows:

  1. Index Funds: These are the funds which imitate/replicate index with an objective to generate the return equivalent to the index. This is called passive investment strategy.
  2. Portfolio Restructuring: An act of increasing or decreasing the equity exposure of a portfolio quickly, with the help of index futures.
  3. Investing: Investing via the use of stock index futures could involve exposure to a market or sector without having to actually purchase shares directly.
  4. Hedging: Hedging is a phenomenon through which one can ensure that the losses from stock market investments are low when the market declines.
  5. Trading: Trading using stock index futures could involve, e.g. volatility trading (the greater the volatility, the greater the likelihood of profit taking-usually taking relatively small but regular profits).

Applications of Market Index or Stock Index Futures

The use of stock futures specifically arises out of the principle of convergence. The spot prices and the futures prices have a relationship based on the cost of carry. The prices converge on expiry. This and other aspects of stock index futures, as distinguished from regular futures, are as follows:

  1. As maturity draws near, the cost of carry keeps coming down until, on the date of expiration of the futures, the price converges with the spot price. Here, there will be no cost of carry and hence the spot price and the futures price will be equal.
  2. If the investor is planning an index portfolio (portfolio of stocks in proportion to those in the index), he/she will be able to hedge the portfolio by buying or selling the appropriate number of futures contracts. Generally, the regulatory authorities fix a minimum amount of futures that needs to be bought as one lot. This figure changes from time to time and from exchange to exchange. The current rules followed in the NSE can be seen from their website (www.nse. coin for the details of settlement and margin positions for futures).
  3. Further, if the holding period matches with the horizon of the futures, a perfect hedge is possible.
  4. Additionally, index futures offer cross-hedges and rolling the  hedge forward in a more structured manner.
  5. There are three futures going in the market at a given point of time. Theoretically, these three futures must be all following the cost-of-carry principle and hence the

longest futures (three-month futures) must have a price  proportionately higher than the two-month futures and the one-month futures.

 Q.3. What is the cost-of-carry model? Explain it.

Ans. Cost-of-carry Model: Cost-of-carry model is an arbitrage-free pricing model. Its central them is that a futures contract is so priced as to preclude arbitrage profit. In other words, investors will indifferent to spot and futures market to execute their buying and selling of underlying asset because the prices they obtain are effectively the same. Expectations do influence the price, but they influence the spot price and, through it, the futures price. They do not directly influence the futures price. If the investor does not book a futures contract, the alternative form to him is to buy at the spot market and hold the underlying asset. In such a contingency, he would incur a cost equal to the spot price plus the cost-of-carry, The theoretical price of a futures contract is spot price of the underlying plus the cost of carry. The futures are not about predicting future prices of the underlying assets.

This model stipulates that future prices are equal to sum of spot prices and carrying costs involved in buying and holding the underlying asset and less the carry return (if any). We use fair value calculation of futures to decide the no-arbitrage limits on the price of a futures contract. According to the cost-of-carry model, the futures price is determined by:

Futures price = Spot price + Carry cost – Carry return

This can also be expressed as

F=S(1+r)t

where’re=Cost of financing,

t= Time till expiration.

Carry Cost (CC) is the interest cost of holding the underlying asset (purchased in spot market) until the maturity of futures contract. Carry Return (CR) is the income (e.g. dividend) derived from underlying asset during the holding period.

The cost of carry for a physical asset equals interest cost plus storage costs less convenience yield, i.e.:

Carry costs = Cost of funds + Storage cost – Convenience yield

For a financial asset such as a stock or a bond, storage costs are negligible. Moreover, income (yield) accrues in the form of quarterly cash dividends or semi-annual coupon payments. The cost of carry for a financial asset is:

Carry costs = Cost of funds – Income Carry

costs and benefits are modeled either as continuous rates or as discrete flows. Some costs/ benefits such as the cost of funds (i.e., the risk-free interest rate) are best modeled continuously.

The futures pricing equation in computable terms are as follows:

F = Futures price.

S =Spot price,

r = Risk-free interest rate (p.a.).

D =Cash dividend from underlying stock.

t = Period (in years) after which cash dividend will be paid.

T = Maturity of futures contract (in years).

The futures price will thus be:

F=S+ (SrT) – (D-Drt)

It is customary to apply the compounding principle in financial calculations. With compounding, the above equation will change to:

F=S(1+rT).-D (1-rt)

Alternately, using the continuous compounding or discounting,

F=sert – De-rt

Cost-of-carry Model in Perfect Market

The following formula describes a general cost-of-carry price relationship between the cash (spot) price and futures price of any asset:

Futures Price = Cash (Spot) Price + Carrying Cost

Assumptions to the perfect market of cost-of-carry model are:

  1. There are no information or transaction costs associated with the buying and selling of the asset.
  2. There is unlimited capacity to borrow and lend.
  3. Borrowing and lending rates are the same.
  4. There is no credit risk. No margin is required on buying and selling the asset.
  5. Goods can be stored indefinitely without loss to their quality.
  6. There are no taxes.

Cost-of-carry Model in Imperfect Market

There are various imperfections in real markets which disturb the relationship of Rule 3 and Rule 4. Among the various imperfections, five are important which have been discussed here:

  1. Unequal or Differential Borrowing and Lending Rates: It refers to that market situation where the rates of interest on borrowing and lending are different and they are not equal. Normally, in real market, borrowing rates are higher than the lending rate. These differentials of borrowing and lending rates serve to widen the no-arbitrage boundaries.
  2. Direct Transaction Cost: In actual practice, when a trader makes the spot of futures transactions he has to pay a fee known as brokerage fee or commission. In other words, transaction costs refer to all such costs which have to be borne by the trader to buy or sell a particular asset for spot or futures. These costs are transaction fees, exchange charges and fee, fee for arranging funds, etc. It is also called as the round-trip fee.
  3. Bid-ask Spread: It is another market imperfection because we see in actual practice that the trader tries to sell the asset at higher price than to purchase the same. The difference between bid price and ask price is called bid-ask spread.
  4. Restriction on Short-selling: This is another market imperfection. Earlier, we have assumed that traders can sell assets short and use the proceeds from the short sale without any restrictions. Due to inherent risks in short sales, there are restrictions on short-selling virtually in all markets.
  5. Storage Problem: It is another market imperfection because except gold, most of the commodities cannot be stored very well at all. The storability of a commodity is very important in futures market trading. If a commodity cannot be stored, then full arbitrage opportunity will not be available in the market.

 

Q.4. What is hedging? What are the features and objectives of hedging? Also give the types of hedging.

Ans. Hedging: Hedge means making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Thus, in future contract risk can be managed by hedging in the market.

Hedging, in its broadest sense, is the act of protecting oneself against futures loss. More specifically in the context of futures trading, hedging is regarded as the use of futures transactions to avoid or reduce price risk in the spot market. In other words, a hedge is a position that is taken as a temporary substitute for a later position in another asset for liability or to protect the value of an existing position in an asset (or liability) until the position is liquidated. According  to this concept the firm seeks hedging whether it is on the asset side or on the liability side of the balance sheet.

Features of Hedging: The main features of hedging are explained below:

  1. Firms hedge because of tax advantages. Low income firms, e.g. those that are below the highest corporate tax rate, can particularly benefit from the interaction being also reduce the probability of bankruptcy. This is not necessarily valuable to the shareholders expected costs that are incurred if the firms does go bankrupt
  2. Hedging means buying and selling futures contracts to offset the risks of changing cash market prices. In order to hedge a position, a derivatives player needs to take an equal and opposite position in the futures market to the one held in the cash market.
  3. Hedging is extremely important for the proper functioning, long-term liquidity and open interest of a futures market. Thus, viable futures contracts are linked to commercial hedging activity.
  4. Hedging also is a tool used to offset the market (systematic) risk of stock portfolios.

Objectives of Hedging: Hedging is a method of reducing the risk ofloss caused by price fluctuation. It consists of the purchase or sale of equal quantities of the same or very similar commodities, approximately simultaneously, in two different markets with the expectation that a future change in price in one market will be offset by an opposite change in the other market.

There are two aspects or objectives of hedging:

  1. Isolating Stock Selection: A fund manager may want to isolate the firm or sector specific exposure. In order to isolate the stock selection dimension, the investor might remove market exposure by use of a short position in stock index futures. The investor can reduce his risk in the portfolio by taking short positions in the index (equivalent amount of the portfolio).
  2. Isolating Market Exposure: One would wish to avoid exposure to non-systematic risk (risk unique to an individual stock/selection). In other words, the intention may be to gain market exposure while avoiding the risk that the stocks bought’may under-perform the market. Such an investor could obtain market exposure by buying stock index future while keeping the investment fund on deposit.

Types of Hedges

The various types of hedging are as follows:

  1. Short Hedge: An investment strategy that is focused on mitigating a risk that has already been taken. The ‘short portion of the term refers to the act of shorting a security, usually a derivatives contract, that hedges against potential losses in an investment that is held long (ie the risk that was already taken) If a short hedge is executed well, gains from the long position will be offset by losses in the derivatives position and vice versa.
  2. Long Hedge: A situation where an investor has to take a long position in futures contracts in order to hedge against future price volatility. A long hedge is beneficial for a company which knows that it has to purchase an asset in the future and wants to lock in the purchase price.
  3. Cross Hedge: The act of hedging one’s position by taking an offsetting position in another good with similar price movements. Although the two goods are not identical, they are correlated enough to create a hedged position as long as the prices move in the same direction
  4. Anticipatory Hedge: It is a long hedging position taken to provide participation in a market! before an investor is ready to take a position in the related cash instruments or actuals, or a short equivalent position taken to protect against a decline when tax or other considerations force a delay in the sale of the related long position
  5. Rio Hedge: When a trader who is facing financial or legal troubles hedges his or her position in an investment with a ticket to a tropical location (such as Rio de Janeiro). The idea behind th hedge is that if the investment goes bad.(either legally or through financial loss), the investor will use the ticket to escape.

6.Legacy Hedge: Ahedge position that a company holds for an extended period of time, Commodity companies, such as gold and oil producers, will often have legacy hedges on their reserves. This gives them a more stable stream of revenue as the hedge provides price guarantees,

  1. Rolling Hedge: A strategy for reducing risk that involves using the high levels of liquidity typically present with exchange-traded futures and options in order to achieve a continual riske offsetting position.
  2. Chinese Hedge: A hedge involving a short position in a convertible security and a long position in its underlying asset. The Chinese hedge looks to capitalise on mis-pricod conversion factors. The trader will profit when the underlying asset depreciates, diminishing the premium on the convertible security. It is also known as a ‘Reverse Hedge
  3. Stack Hedge and Strip Hedge: Stack hedge is a hedge position using a sequence of short-term risk offsetting contracts, while strip hedge is a risk offsetting position that uses non-coinciding option contracts expiring on dates appropriate to the risk being hedged.
  4. Perfect Hedge: A position undertaken by an investor that would eliminate the risk of an existing position, or a position that eliminates all market risk from a portfolio, In order to be a perfect hedge, a position would need to have a 100% inverse correlation to the initial position. As such, the perfect hedge is rarely found.

Q.5. Describe the Indian derivatives market of future.

Ans. Indian Derivatives Market of Future: A futures contract is a forward contract, which is traded on an exchange. NSE commenced trading in futures on individual securities on November, 9, 2001. The futures contracts are available on 175 securities stipulated by th Board of India (SEBI).

NSE defines the characteristics of the futures contract such as the underlying security, market lot and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.

Futures trading is a form of investment which involves speculating on the price of a security going up or down in the future.

A security could be a stock (RIL, TISCO, etc), stock index (NSE Nifty Index), commodity (Gold, Silver, etc), currency, etc.

Unlike other kinds of investments, such as stocks and bonds, when we trade futures, we do not actually buy anything or own anything. We are speculating on the future direction of the price in the security we are trading. This is like a bet on future price direction. The terms ‘buy’ and ‘sell’ merely indicate the direction that we expect future prices will take.

As per the list presented on Forward Market Commission (FMC), there are more than 25 exchanges that are in operation carrying out futures trading activities in a wide variety of commodity items under eight major categories:

  1. Pulses,
  2. Vegetable oilseeds, oils and meals,
  3. Spices,
  4. Cereals,
  5. Energy products,
  6. Fibers,
  7. Metals, and
  8. Others.

The financial year 2016-17 witnessed an increase in currency derivatives (Currency Futures and Interest Rate Futures) volumes.

  1. Currency Futures: Average daily turnover in currency futures for the financial year 2016-17 decreased by 9.44% and stood at H10,288.34 cores as compared to H11,360.88 cores seen in 2015-16. Futures trading constituted 51.26% of the total turnover in the segment. USD INR currency pair was the most traded futures contracts. The average market share of NSE in currency futures stood at 54.33% in 2016-17.
  2. Interest Rate Futures: Average daily turnover in Interest Rate Futures for the financial year 2016-17 decreased by 41.53% and stood at H1,271.94 cores as compared to H2,175.31 cores in 2015-16. The daily average open interest decreased by 29.17% and stood at 1,69,313 contracts as compared to 2,39,044 contracts in the previous year.

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