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DERIVATIVES AND RISK MANAGEMENT 2011

INTRODUCTION

What Does Forward Contract Mean


A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Most forward contracts don't have standards and aren't traded on exchanges. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest. Difference between a forward contract and future contract Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never. Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date. Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place. Fundamentally, forward and futures

DERIVATIVES AND RISK MANAGEMENT 2011


contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never. Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date. Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place.

Characteristics of Forward Contracts Forward A forward contract is an agreement in which the seller is obliged to deliver an underlying asset or to make a cash settlement at a future maturity (expiration) date at a forward price agreed at the start of the contract. The buyer agrees to pay for the underlying asset or to make settlement at a future date. Cash-settled forward contracts are called NDFs (nondelivery forwards). The future delivery date or settlement date is usually the same as the expiration date. The value of the forward contract is equal to zero at the initiation and no money changes

DERIVATIVES AND RISK MANAGEMENT 2011


hands. The global market for forward contracts is a network of financial institutions, mostly banks, that make market in these transactions. Forward contracts are not traded on exchanges. They are over-the-counter (OTC) contracts. Forward contracts are privately negotiated between two parties at least one of which is usually a financial intermediary (market maker, dealer), a commercial or an investment bank. The second party of a forward contract may be one of two types: end user or other dealer. An end user is typically a corporation, government or a private person. The dealer quotes a bid and ask price or rate. The bid is the price at which the dealer is willing to pay and the ask price is the price at which the dealer is willing to sell. The competition makes bid-ask spreads low. Dealers make a profit from the market making activity. They do not hold the exposure. They offset the exposure with other derivative or spot transactions. The terms of the contract, such as identity and amount of the underlying asset, expiration date, settlements) are directly negotiated between two parties. A forward contract can be either purchased or sold. The buyer is called the long and the seller is called the short. The negotiated forward price for future delivery of the asset is different from the current cash price (spot price). The forward price is fixed. It is possible to terminate the position prior to expiration by entering a new forward contract expiring at the same time as the original contract. To completely offset the original forward position the second transaction must be with the same counterparty. The termination of the original forward position with the other counterparty does not eliminate credit risk. With the sophisticated terms of forward contract it may be difficult or more costly to terminate the contract before it matures. Illiquidity is a buy-product of the contracts flexibility. Solution to the problems Given: We have bought LP shares in spot market of around 1000. Current Market Price is Rs. 100/-, Beta = 1.1, Sensex Contract size is 50. Sensex Futures is available at 4500. 1. The number of contracts to be Shorted : = Beta * Number of shares bought in spot market/lot size of Sensex futures = 1.1 * 1000/50

DERIVATIVES AND RISK MANAGEMENT 2011


= 22 contracts on Sensex Futures must be shorted. Because we want to hedge our risk. 2. If the spot price drops by 12% then: Here index will fall by: 12/1.1 = 10.90 Sensex falls to 4500 10.90 = 4489.09 Loss in Spot Market is = 1000 * (12% * 100) = Rs. 12,000/Therefore profit in futures will be 10.9090 * 22 * 50 = Rs. 12,000/-. Therefore net position will be zero. 3. If spot price jumps by 5%: Then the spot price will get to Rs. 105/-. The index will by 5/1.1 = 4.5454, therefore to 4504.54. The profit in Spot market will be Rs. 5* 1000 = Rs.5,000. The loss in Futures will be 5.5454*22*50 = Rs. 5000/Therefore net position will be Zero.

There are basically three categories pf people who tarde in the securities market. Each of them is described in detailed below: Hedging Hedging is a risk reduction strategy whereby investors and traders take offsetting positions in an instrument to reduce their risk profile. The practice usually involves taking both along and a short position in an instrument and so, usually, necessitates using financial derivatives with which it is possible to short sell. Hedging strategies are also employed by professional fund managers to control the risk exposure of large managed funds. In this context, hedging is a more complex process as it involves a whole portfolio of different investments each with its own unique risk/return profile. Futures contracts can be an extremely useful hedging tool. The principle of hedging is simple: as the value of your assets fall, the value of the hedge increases, therefore offsetting these losses.

DERIVATIVES AND RISK MANAGEMENT 2011

In a perfect hedge the profit on the hedge will exactly offset the loss on your underlying position. However, most hedges are unlikely to be perfect, as there will be slight differences between the price movements of the derivatives you have chosen and your cash market holdings, or the number of derivatives contracts you buy doesnt exactly match the exposure you have. Example You hold a diversified portfolio of shares, which broadly match movements in the Dow Jones Industrial Average (DJIA), and you anticipate a temporary fall in market value. You are unwilling to liquidate your portfolio as it is part of your long term strategy. To protect the portfolio you could use index futures, which are available on all the major world markets. The exposure an index future gives is found by multiplying the value of the index future (i.e. what it is quoted at) by the value per point of the futures contract. The Dow Jones Industrial Average futures trading on the CBOT are worth $10 per point, so if the futures were quoted at 10,600 then one contract gives an exposure of 10,600 x $10 = $106,000. Suppose your US portfolio is worth roughly $5m. In this case you would need $5,000,000 / $106,000 = 47 futures contracts to hedge your holdings. As you are long the market, you sell futures contracts in order to profit from any fall in price. Let's assume that when the hedge is set up in January, the Dow is at 10580. By March, when the March futures contracts you have bought stop trading, the index is at 10400, a fall of 1.7%.

DERIVATIVES AND RISK MANAGEMENT 2011

With the index now at 10400, profits and losses are:

In this case, the hedge has actually over compensated for the loss in value of your equity portfolio. Of course, if your expectations were wrong, and the index went up instead of down, then a profit would have been made on the portfolio, which would have been reduced by the loss on the hedge. Let's assume the market had gone up by 1.7%. What would the net position have been:

In this case upside gains have been sacrificed by the presence of a hedge. In reality, as we have already seen, the fact that you can close out whatever position you have adopted before expiry means you are unlikely to hold the hedge if your original view looks like it is going to be incorrect. Arbitrage Arbitrage, or true arbitrage, involves buying and selling a security and taking advantage of prices differences that may exists on different markets. While rare, this does happen from time to time. For example, suppose you find on eBay that someone is selling a brand new iPod for $150 while the local store is buying the same iPods for $170. In theory, you can buy all the iPods available on eBay and sell them all to the local store, pocketing $20 per music

DERIVATIVES AND RISK MANAGEMENT 2011


player. Taking advantage of this price inequality is the essence of true arbitrage. In the old days when computers werent as sophisticated, humans can spot these price inequalities in financial markets and take advantage of them. However, complex programs nowadays are able to spot these so quickly that it is extremely difficult to truly take advantage of this type of risk less arbitrage without developing complex trading programs yourself. Risk Arbitrage The good news is that with some added risk, everyone can still profit from whats known as risk arbitrage. The major difference between true and risk arbitrage is that you are trading a different security in the latter. The risk comes in because while the two securities in question might be related, they are different and the relationship can change at any point in time. Another less obvious difference between the two types of arbitrages is that while true (or pure as it is sometimes called) arbitrage takes place instantly (you buy and immediately sell it), risk arbitrage can take days (if not weeks or even months). This added time lapse is never good, because as time goes on, there are more risk for the dynamics of the relationship to change. Examples of Risk Arbitrage 1. Merger and Acquisition Arbitrage The most common type of risk abitrage is the price inequalities that is created when a merger or acquistion is announced. Typically when this happens, the acquiring companys stock price usually drops in case the deal doesnt go through, while the stock price of the company being acquired shoots up close to the offered price (usually at a siginificant premium to the current traded price). It is interesting to note (and the key to profiting from it) that while the stock price of the acquired company rises, it will never reach the full offered price because there is always a risk of the deal not happening. Therefore, we can take advantage of this by buying stock of the acquired company and as the deal becomes more likely, the stock will rise. 2. Interest Rate Arbitrage When you are able to borrow at a short term lower interest rate and invest with higher interest rates long term, you are practicing arbitrage. Most people arent able to take advantage of this because these types of arbitrate most exists in inter-country rates. For

DERIVATIVES AND RISK MANAGEMENT 2011


example, many people for years have been taking advantage of the low interest rates in Japan loans to invest in the stock market. 3. Futures Contracts and Derivatives Arbitrage Another common type of artibrage exists with options and all other derivatives related to the underlying stock price. While these should all be in sync with the actual stock price, they often do not due to the supply and demand nature of all these investments trading in the open market. Therefore, there are many opportunities for us to profit if we can spot the dynamics of the relationships. 4. Funds Arbitrage Since mutual funds and ETFs all buy and sell assetsand at the same time have a value, there are opportunities for arbitrages. For example, lets say that you were able to find a mutual fund and ETFwith the exact same portfolio. In theory, their price relationship should stay constant at all times. However, as ETFs are traded on the open market and mutual funds are not, there could be times that enough of a price inequality exists for you to profit. Of course, it is pretty much impossible to find a mutual fund and ETF that has the exact same portfolio, but people are able to profit when more complex models are used as long as the relationship of the two funds are correlated and predictable. As long as a pricing relationship exists and are correlated, it can be a form of risk arbitrage. Therefore, there are in theory unlimited number of arbitrages to profit from. The key is to be absolute certian that you understand the sometimes complex correlation. What Does Arbitrage Trading Mean for Us While it often seems like a great opportunity to profit without much risk, arbitrage is considered a more advanced form of investing and should only be considered if you understand exactly what the risks are. More often than not, investors underestimate the risks involved and is caught off guard when results dont happen the way it was intended. To be able to consistently profit from arbitrage, having a deep understanding of the securities and pricing relationships involved is key. Speculator In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum.[1] Speculation

DERIVATIVES AND RISK MANAGEMENT 2011


typically involves the lending of money for the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment. The term, "speculation," which is formally defined as above in Graham and Dodd's 1934 text, Security Analysis, contrasts with the term "investment," which is a financial operation that, upon thorough analysis, promises safety of principal and a satisfactory return.[1] In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is commonly used to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured moneyincluding funds placed in the world's stock marketsis technically not investment, but speculation. Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stocks security, economic factors associated with market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities. There are also some financial vehicles that are, by definition, speculation. For instance, trading commodity futures contracts, such as for oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative. Financial speculation can involve the trade (buying, holding, selling) and shortselling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to attempt to profit from fluctuations in its price irrespective of its underlying value. In architecture, speculation is used to determine works that show a strong conceptual and strategic focus.

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