Unit 2

Financial Forward Contracts

A forward contract is a private agreement between two parties giving the buyer
an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at
a future point in time.

The assets often traded in forward contracts include commodities like grain, precious metals,
electricity, oil, beef, orange juice, and natural gas, but foreign currencies and financial
instruments are also part of today’s forward markets.

How it works (Example):

If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever
the price is when you harvest it, or you could lock in a price now by selling a forward
contract that obligates you to sell 500 bushels of wheat to, say, Kellogg after the harvest for a
fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the
other hand, if prices rise later, you will get only what your contract entitles you to.

If you are Kellogg, you might want to purchase a forward contract to lock in prices and
control your costs. However, you might end up overpaying or (hopefully) underpaying for the
wheat depending on the market price when you take delivery of the wheat.

Forward Contracts Are Not the Same as Futures Contracts

Futures and forwards both allow people to buy or sell an asset at a specific time at a given
price, but forward contracts are not standardized or traded on an exchange. They are private
agreements with terms that may vary from contract to contract.

Also, settlement occurs at the end of a forward contract. Futures contracts settle every day,
meaning that both parties must have the money to ride the fluctuations in price over the life
of the contract.

The parties to a forward contract tend to bear more credit risk than the parties to futures
contracts because there is no clearinghouse involved that guarantees performance. Thus, there
is always a chance that a party to a forward contract will default, and the harmed party’s only
recourse may be to sue. As a result, forward-contract prices often include premiums for the
added credit risk.

Valuing Forward Contracts

The value of a forward contract usually changes when the value of the underlying asset
changes. So if the contract requires the buyer to pay $1,000 for 500 bushels of wheat but
the market price drops to $600 for 500 bushels of wheat, the contract is worth $400 to the
seller (because he or she would get $400 more than the market price for his or her wheat).
Forward contracts are a zero-sum game; that is, if one side makes a million dollars, the other
side loses a million dollars.
Forward contracts may be “cash settled,” meaning that they settle with a single payment for
the value of the forward contract. For example, if the price of 500 bushels of wheat is $1,000
in the spot market (the current market price) when the forward contract expires, but the
forward contract requires the buyer to pay only $800, then the seller can just settle the
contract by paying the buyer $200 instead of actually delivering 500 bushels of wheat and
collecting a below-market price. The buyer might appreciate this; the only other way he
would see his $200 profit is if he purchased the wheat for $800 and then turned around and
sold it at the market price ($1,000). On a side note, when the spot price is higher than the
forward-contract price, this is called backwardation; the opposite condition is
called contango.

It is important to note that forward contracts also present a risk of price manipulation,
because a small transaction completed at an above- or below-market price could affect the
value of a much larger forward contract

Why it Matters:

There are two kinds of forward-contract participants: hedgers and speculators. Hedgers do
not usually seek a profit but rather seek to stabilize the revenues or costs of their business
operations. Their gains or losses are usually offset to some degree by a corresponding loss
or gain in the market for the underlying asset. Speculators are usually not interested in taking
possession of the underlying assets. They essentially place bets on which way prices will go.
Forward contracts tend to attract more hedgers than speculators.

Concepts and Characteristics Financial

Forward Contracts

In forward contract, two parties (two companies, individual or government nodal agencies)
agree to do a trade at some future date, at a stated price and quantity. No security deposit is
required as no money changes hands when the deal is signed.

Forward contracting is very valuable in hedging and speculation. The classic scenario of
hedging application through forward contract is that of a wheat farmer forward; selling his
harvest at a known fixed price in order to eliminate price risk. Similarly, a bread factory want
to buy bread forward in order to assist production planning without the risk of price
fluctuations. There are speculators, who based on their knowledge or information forecast an
increase in price. They then go long (buy) on the forward market instead of the cash market.
Now this speculator would go long on the forward market, wait for the price to rise and then
sell it at higher prices; thereby, making a profit.

Disadvantages of forward markets

The forward markets come with a few disadvantages. The disadvantages are described below
in brief −

 Lack of centralization of trading

  Illiquid (because only two parties are involved)
 Counterparty risk (risk of default is always there)

In the first two issues, the basic problem is that there is a lot of flexibility and generality. The
forward market is like two persons dealing with a real estate contract (two parties involved –
the buyer and the seller) against each other. Now the contract terms of the deal is as per the
convenience of the two persons involved in the deal, but the contracts may be non-tradeable
if more participants are involved. Counterparty risk is always involved in forward market;
when one of the two parties of the transaction chooses to declare bankruptcy, the other
suffers.

Another common problem in forward market is – 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 involved.

Even in case of trade in forward markets, trade have standardized contracts, and hence avoid
the problem of illiquidity but the counterparty risk always remains.

In finance, a forward contract or simply a forward is a non-standardized contract between two

parties to buy or to sell an asset at a specified future time at a price agreed upon today,
making it a type of derivative instrument. The party agreeing to buy the underlying asset in
the future assumes a long position, and the party agreeing to sell the asset in the future
assumes a short position. The price agreed upon is called the delivery price, which is equal to
the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the
instrument changes. This is one of the many forms of buy/sell orders where the time and date
of trade is not the same as the value date where the securities themselves are exchanged.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to take advantage of a
quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward
contracts are very similar to futures contracts, except they are not exchange-traded, or defined
on standardized assets. Forwards also typically have no interim partial settlements or “true-
ups” in margin requirements like futures – such that the parties do not exchange additional
property securing the party at gain and the entire unrealized gain or loss builds up while the
contract is open.

However, being traded over the counter (OTC), forward contracts specification can be
customized and may include mark-to-market and daily margin calls. Hence, a forward
contract arrangement might call for the loss party to pledge collateral or additional collateral
to better secure the party at gain.clarification needed] In other words, the terms of the forward
contract will determine the collateral calls based upon certain “trigger” events relevant to a
particular counterparty such as among other things, credit ratings, value of assets under
management or redemptions over a specific time frame, e.g., quarterly, annually, etc.
Futures Contract: Types, Functions

A futures contract is an agreement to either buy or sell an asset on a publicly-traded

exchange. The asset is a commodity, stock, bond, or currency. The contract specifies when
the seller will deliver the asset. It also sets the price. Some contracts allow a cash settlement
instead of delivery.

The role of the exchange is important in providing a safer trade. The contracts go through the
exchange’s clearing house. Technically, the clearinghouse buys and sells all contracts.

The exchanges make contracts easier to buy and sell by making them fungible. That means
they are interchangeable. But they must be for the same commodity, quantity, and quality.
They must also be for the same delivery month and location. Fungibility allows the buyers to
“offset” contracts. That’s when they buy and then subsequently sell the contracts. It allows
them to pay off or extinguish the contract before the agreed-upon date. For that reason,
futures contracts are derivatives.

How Futures Contracts Affect the Economy

Companies use futures contracts to lock in a guaranteed price for raw materials such as oil.
Farmers use them to lock in a sales price for their livestock or grain. Futures contracts
guarantee they can buy or sell the good at a fixed price. They plan to transfer possession of
the goods under contract. The agreement also allows them to know the revenue or costs
involved. For them, the contracts reduce a significant amount of risk.

Hedge funds use futures contracts to gain more leverage in the commodities market. They
have no intention of transferring any commodity. Instead, they plan to buy an offsetting
contract at a price that will make them money. In a way, they are betting on the future price
of that commodity. Price assessment and price forecasts for raw materials are how
commodities futures affect the economy. Traders and analysts determine these values.

Commodities

The most important is the oil futures contract. That’s because they set current and future oil
prices. Those are the basis for all gasoline prices. Other energy-related futures contracts are
written on natural gas, heating oil, and RBOB gasoline. Crude oil prices affect gasoline
prices directly because 71 percent of the gasoline price is dependent on the price of crude. A
rise in crude oil prices will raise the pump price as well.

Commodities contracts are also written on metals, agricultural products, and livestock. They
are also written on financials such as currencies, interest rates, and stock indices. Investing
in commodities futures is risky because prices are volatile and fraudulence is prevalent.
Investors have to know the market very well or they risk losing their investment, quickly.

Forward Contract
The forward contract is a more personalized form of a futures contract. That’s because the
delivery time and amount are customized to address the particular needs of the buyer and
seller. In some forward contracts, the two may agree to wait and settle the price when the
good is delivered. A forward contract is a cash transaction. It is common in many industries,
especially commodities.

Futures Option

A futures option gives the purchaser the right, or option, to buy or sell a futures contract. It
specifies both the date and the price. Contracts on options are commonly set for a month or
more. Weekly contracts are becoming popular for those who like to wager on short-term
events.

Forward Rate Agreement

A forward rate agreement is an over-the-counter forward contract. It is written on a short-

term interest rate. The buyer of an FRA is a notional borrower. That means the buyer
commits to pay a fixed rate of interest on some amount that is never actually exchanged. The
seller of an FRA agrees notionally to lend a sum of money to a borrower. Investors use FRAs
to hedge interest rate risk or to speculate on future changes in interest rates.

Depending on the type of underlying asset, there are different types of futures contract
available for trading. They are:

 Individual stock futures.

 Stock index futures.
 Commodity futures.
 Currency futures.
 Interest rate futures.

INDIVIDUAL STOCK FUTURES

Individual stock futures are the simplest of all derivative instruments. Stock futures were
officially introduced in India on 9th November 2001. Before that, the local version of stock
futures called ‘badla’ were traded which was eventually banned by the Securities Exchange
Board of India in July 2001.

The Badla system: the ‘badla system’ was almost similar to the futures contracts we
discussed. In simple terms- A badla trader can delay the settlement of a trade by one week for
payment of a small fee. So if you bought a particular share for Rs 100 and if you are bullish
on that stock, you can delay the settlement by one week if you pay a fee. This carry over can
be done for any number of times. Later on, unlimited carry over facility was restricted to 90
days at a time.

Badla system had its downsides – lack of transparency, data regarding volume, rates of badla
charges, open positions etc were not available. There was no margin requirement and badla
charges varied from seller to seller. So, chances of manipulation were more. Badla was pure
Indian version of futures but did not provide the advantages of price discovery or risk
management that organized futures market provide.
STOCK INDEX FUTURES

Understanding stock index futures is quite simple if you have understood individual stock
futures. Here the underlying asset is the stock index. For example – the S&P CNX Nifty
popularly called the ‘nifty futures’. Stock index futures are more useful when speculating on
the general direction of the market rather than the direction of a particular stock. It can also
be used to hedge and protect a portfolio of shares. So here, the price movement of an index is
tracked and speculated. One more point to note here is that, although stock index is traded as
an asset, it cannot be delivered to a buyer. Hence, it is always cash settled.

Both individual stock futures and index futures are traded in the NSE.

COMMODITY FUTURES

It’s the same as individual stock futures. The underlying asset however would be a
commodity like gold or silver. In India, Commodity futures are mainly traded in two
exchanges – 1. MCX (Multi commodity exchange) and NCDEX (National commodities and
derivatives exchange). Unlike stock market futures where a lot of parameters are measured,
the commodity market is predominantly driven by demand and supply.

The term ‘commodity’ is a very broad term and it includes –

 Bullion – gold and silver

 Metals – Aluminum , copper, lead, iron, steel, nickel, tin, zinc
 Energy-crude oil, gasoline, heating oil, electricity, natural gas
 Weather- carbon
 Oil and oil seeds – crude palm oil, kapsica khali,refined Soya oil, Soya bean
 Cereals- barley, wheat, maize
 Fiber- cotton, kapas
 Species-cardamom, coriander, termuric etc
 Pluses – chana
 Others- like potatoes, sugar, almonds, gaur

CURRENCY FUTURES

The MCX-SX exchange trades the following currency futures:

 Euro-Indian Rupee (EURINR),

 Us dollar-Indian rupee (USDINR),
 Pound Sterling-Indian Rupee (GBPINR) and
 Japanese Yen-Indian Rupee (JPYINR).

INTEREST RATE FUTURES

Interest rate futures are traded on the NSC. These are futures based on interest rates. In India,
interest rates futures were introduced on August 31, 2009.The logic of underlying asset is the
same as we saw in commodity or stock futures – in this case , the underlying asset would be a
debt obligation – debts that move in value according to changes in interest rates
(generally government bonds). Companies, banks, foreign institutional investors, non-
resident Indian and retail investors can trade in interest rate futures. Buying an interest rate
futures contract will allow the buyer to lock in a future investment rate.

Distinction between Futures and Forward

A forward contract is a contract whose terms are tailor-made i.e. negotiated between buyer
and seller. It is a contract in which two parties trade in the underlying asset at an agreed price
at a certain time in future. It is not exactly same as a futures contract, which is a standardized
form of the forward contract. A futures contract is an agreement between parties to buy or
sell the underlying financial asset at a specified rate and time in future.

While a futures contract is traded in an exchange, the forward contract is traded in OTC, i.e.
over the counter between two financial institutions or between a financial institution or client.

As in both the two types of contract the delivery of the asset takes place at a predetermined
time in future, these are commonly misconstrued by the people. But if you dig a bit deeper,
you will find that these two contracts differ in many grounds. So, here in this article, we are
providing you all the necessary differences between forward and futures contract so that you
can have a better understanding about these two.

Comparison Chart
BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON

Forward Contract is an agreement A contract in which the parties agree to

between parties to buy and sell the exchange the asset for cash at a fixed price
Meaning
underlying asset at a specified date and at a future specified date, is known as
and agreed rate in future. future contract.

What is it? It is a tailor made contract. It is a standardized contract.

Over the counter, i.e. there is no

Traded on Organized stock exchange.
secondary market.

Settlement On maturity date. On a daily basis.

Risk High Low

As they are private agreement, the

Default No such probability.
chances of default are relatively high.

Size of contract Depends on the contract terms. Fixed

Collateral Not required Initial margin required.

Maturity As per the terms of contract. Predetermined date

Regulation Self regulated By stock exchange

Liquidity Low High

Pricing of Futures Contract, Currency

Futures, Hedging In Currency Futures

Pricing Of Futures Contract

The value of a futures contract is derived from the cash value of the underlying asset. While a
futures contract may have a very high value, a trader can buy or sell the contract with a much
smaller amount, which is known as the initial margin.

The initial margin is essentially a down payment on the value of the futures contract and the
obligations associated with the contract. Trading futures contracts is different than trading
stocks due to the high degree of leverage involved. This leverage can amplify profits and
losses.

Initial Margin

The initial margin is the initial amount of money a trader must place in an account to open a
futures position. The amount is established by the exchange and is a percentage of the value
of the futures contract.

For example, a crude oil contract futures contract is 1,000 barrels of oil. At $75 per barrel, the
notional value of the contract is $75,000. A trader is not required to place this amount into an
account. Rather, the initial margin for a crude oil contract could be around $5,000 per
contract as determined by the exchange. This is the initial amount the trader must place in the
account to open a position.

Maintenance Margin

The maintenance margin amount is less than the initial margin. This is the amount the trader
must keep in the account due to changes in the price of the contract.

In the oil example, assume the maintenance margin is $4,000. If a trader buys an oil contract
and then the price drops $2, the value of the contract has fallen $2,000. If the balance in the
account is less than the maintenance margin, the trader must place additional funds to meet
the maintenance margin. If the trader does not meet the margin call, the broker or exchange
could unilaterally liquidate the position.
Currency Futures

The global forex market is the largest market in the world with over $4 trillion traded daily,
according to Bank for International Settlements (BIS) data. The forex market, however, is not
the only way for investors and traders to participate in foreign exchange. While not nearly as
large as the forex market, the currency futures market has a respectable daily average closer
to $100 billion.

Currency futures – futures contracts where the underlying commodity is a currency exchange
rate – provide access to the foreign exchange market in an environment that is similar to other
futures contracts.

Currency futures, also called forex futures or foreign exchange futures, are exchange-traded
futures contracts to buy or sell a specified amount of a particular currency at a set price and
date in the future. Currency futures were introduced at the Chicago Mercantile Exchange
(now the CME Group) in 1972 soon after the fixed exchange rate system and gold standard
were discarded. Similar to other futures products, they are traded in terms of contract months
with standard maturity dates typically falling on the third Wednesday of March, June,
September and December.

Hedging In Currency Futures

Currency Hedging is an act of entering into a financial contract in order to protect against
anticipated or unexpected changes in currency exchange rates. Currency hedging is used by
businesses to eliminate risks they encounter when conducting business internationally.

The concept of Currency hedging is the use of various financial instruments, like Forward
Contract and other Derivative contracts, to manage financial risk. It involves the designation
of one or more financial instruments (usually a Bank or an Exchange) as a buffer for potential
loss.

Suppose a firm receives an export order today with the delivery date being in 3 months time.
The contract is worth, say, US$100,000. At the time the contract is placed, the INR is say Rs.
65 per US$. Hence the value of the order, when placed, is Rs. 65,00,000. But suppose that the
exchange rate changes significantly between the date when the order is received and the date
the order is paid for (which we will assume is one month after the delivery date). The
exchange rate of the INR & US$ is at Rs. 62 on payment date. Which means that the firm
receives only Rs. 62,00,000 rather than Rs. 65,00,000. This will result in loss of Rs. 3,00,000
for the exporter. To insure against this happening, the firm can, at the time it receives the
order, hedge the currency risk.

So any business that has dealing in overseas market is open to such Currency or more
popularly known as Forex exposure. There may be other kinds of exposure including
commodity risk, Interest rate risk, wage inflation etc. Un-hedged exposure of FX can affect
the balance sheet or profitability, which can create cash flow and operational issues. Hedging
reduces a firm’s exposure to unwanted risk. This helps in sustaining profits, reducing
volatility and ensuring smoother operations.
Different type of Exposure
Revenue Exposure (in Foreign Currency) Expense Exposure (in Foreign Currency)

Value of Exports (FOB value) Value of Imports, Purchase of products and services

Revenue from Services and other consultancy Salaries and other administrative overheads

Other Income (Interest/ Dividend) Business establishment expenses

Purchase of Fixed Assets

Speculation and Arbitrage in Currency

Futures

Speculation:

Future contracts are extremely attractive for speculators as they provide tremendous leverage.
By paying a small margin amount, speculators can take higher exposure of the underlying,
thereby increasing their reward potential as well as the risk. A person who is bullish on the
price of the underlying can BUY a future contract while a person who is bearish would SELL
the future contract.

Hedging:

Hedging is an act of protecting or guarding the investment against an undesired price

movement. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lacs.
Although he is optimistic about the stocks he has in the portfolio, he is not very comfortable
with the overall movement of the market. The price movement of a stock is dependent both
on the micro (profitability of the company, its growth potential, business model, management
competency etc) and the macro factors (GDP growth of the country, interest rates, overall
state of economy etc). Such an investor can hedge his portfolio by selling Index Futures (like
Nifty future) and thereby removing the risk of macro variables from his portfolio.

Another way to hedge using future contracts is by buying the futures of an index/stock when
the cash to buy the underlying would be available on a future date. Say a person is sure to
receive cash inflows of Rs 5 lacs in 2 months’ time, which he wants to, invest in stocks.
However, he is very bullish on the markets and wants to invest as early as possible. What can
he do? He can simply pay the margin amount and take the relevant LONG exposure in future
contracts. This will hedge him from the risk of losing out on the profits if market were to go
up in the next 2 months. It must be noted here that hedging does not necessarily mean
reduced possibility of losses. Like the long term investor we discussed above might lose on
both cash and futures positions if market moved up while his stocks fell.
Arbitrage:

An arbitrageur gains by buying the stock and going short in its future contract when the price
of the future contract is higher than its theoretical price. When the price of the future contract
is less than what it should be, the arbitrageur gains by going long in the future contract and
selling the underlying in cash market.

Cost of Carry Model

This model assumes that arbitrage between the cash market and the futures market eliminates
all imperfections in pricing, i.e., unaccounted for differences between the cash price and
futures price. The difference that remains is due to a factor called ‘the cost of carry’. The
model also assumes, for simplicity sake, that the contract is held till maturity, so that a fair
price can be arrived at.

To put it briefly, once all distortions in the futures price have been erased by arbitrage, a fair
futures price = the spot price + the net cost of carry of the asset from today to the date on
which the contract expires.

The net cost of carry involves all costs that you may have had to incur in order to hold a
similar position open in the cash market, less the returns that you would have received from
this position. The costs typically include financing charges, at the prevailing rate of interest.
This is because you may have borrowed to finance a similar position in the cash market, and
if not, you may have lost interest on the capital that you invested to keep your position open.
In contrast in the futures market, you merely have to deposit a fraction of the value of your
position in the form of a margin. The returns that you receive could consist of dividends or
bonuses that you may have received in case you had held stocks in the cash market. In the
case of an index future, your returns may be gauged by the average return that an index
delivers.

As this theory is modified to become more realistic, by discarding assumptions or including

variables, it becomes more complex. However, what you must absorb from this theory is the
fact that there are costs and benefits involved in keeping a position open in a cash market and
the price of a futures contract charges you or compensates you to reflect these.

Cost of Carry or CoC is the cost to be incurred by the investor for holding certain positions in
the underlying market till the futures contract expires. The risk-free interest rate is included in
this cost. Dividend payouts from the underlying are excluded from the CoC.

CoC is the difference between the futures and spot price of a stock or index. The Cost of
Carry is important because higher the value of CoC, higher is the willingness of the traders to
pay more money for holding futures.

CoC calculated

Theoretically, Future price fair value=Spot Price+Cost of Carry-Dividend Payout Cost of

Carry = Difference between the futures and spot price at any time
CoC is calculated as an annual rate and expressed in percentage values. The real-time CoC
values are available on stock exchange websites.

The value of CoC is used as an indicator to understand the market sentiment i.e. Low CoC
means there is a fall in the value of the underlying and vice versa.

Traders often refer to CoC to guage market sentiment. Analysts interpret a significant fall
inCoC as an indicator of an impending fall in the underlying. For example, CoC of
benchmark index Nifty futures dropped by nearly half a fortnight ago,and served as an
indicator of the consequent correction in the index.Conversely, when the CoC for a stock
future rises, it means that traders are willing to incur higher costs for holding the position
and,thus,expect a rise in the underlying. CoC is expressed as an annualized figure in
percentage.

CAN COST OF CARRY BE NEGATIVE?

Yes. When futures trade at a discount to the underlying, the resultant cost of carry is negative.
This usually happens for two reasons: when the stock is expected to pay a dividend,or when
traders are aggressively executing a “reverse arbitrage” strategy, which involves buying spot
and selling futures. Negative cost of carry points to bearish sentiment

HOW DOES COST OF CARRY REPRESENT BULLISHNESS OR BEARISHNESS?

Change in CoC seen along with open interest shape a clear picture of broader sentiment for
the stock or index. Open interest is the total number of open positions in a contract. For a
rising OI,an increase in CoC indicates accumulation of long(or bullish) positions, while an
accompanied fall in the CoC indicates addition of short positions and bearishness. Likewise,
a fall in OI,accompanied with a rise in CoC, indicates closure of short positions. A falling
both OI and CoC indicates that traders are closing long positions. Analysts also observe
changes in CoC at the expiry of derivatives contract. If a significant number of positions are
rolled over with a higher cost of carry,it implies bullishness.

Application of Market Index

People from many walks of life use and are affected by market indexes. Economists and
statisticians use stock-market indexes to study long-term growth patterns in the economy, to
analyze and forecast business-cycle patterns, and to relate stock indexes to other time- series
measures of economic activity.

Investors, both individual and institutional, use the market index as a benchmark against
which to evaluate the performance of their own or institutional portfolios. The answer to the
question, “Did you beat the market?” has important ramifications for all types of investors.

Market technicians in many cases base their decisions to buy and sell on the patterns that
appear in the time series of the market indexes. The final use of the market index is in
portfolio analysis.
In discussions of the market model and systematic it will be evident that the relevant riskiness
of a security is determined by the relationship between that security’s return and the return on
the market.

Among economists and statisticians one of the major uses of stock-market indexes is to use
them as a leading economic indicator. Judging by how long they have been employed,
leading indicators of economic activity must be considered in a forecasting success.

Unlike econometric modeling, the leading economic indicator approach to forecasting does
not require assumptions about what causes economic behaviour. Instead, it relies on
statistically detecting patterns among economic variables that can be used to forecast turning
points in economic activity.

Index Futures in The Stock Market

A contract for stock index futures is based on the level of a particular stock index such as the
S&P 500 or the Dow Jones Industrial Average. The agreement calls for the contract to be
bought or sold at a designated time in the future. Just as hedgers and speculators buy and
sell futures contracts and options based on a future price of corn, foreign currency, or
lumber, they may—for mostly the same reasons—buy and sell contracts based on the level
of a number of stock indexes.

Stock index futures may be used to either speculate on the equity market’s general
performance or to hedge a stock portfolio against a decline in value. It is not unheard of for
the expiration dates of these contracts to be as much as two or more years in the future, but
like commodity futures contracts most expire within one year. Unlike commodity
futures, however, stock index futures are not based on tangible goods, thus all settlements
are in cash. Because settlements are in cash, investors usually have to meet liquidity or
income requirements to show that they have money to cover their potential losses.

All stock index futures contracts have a value equal to their price multiplied by a specified
dollar amount. To illustrate, the price of a stock index futures contract based on the New
York Stock Exchange (NYSE) Composite Index is derived by multiplying the index level
value by $500. This value results because each futures contract is equal to $500 times the
quoted futures price. So, if the index level is determined to be 200, the corresponding stock
index future would cost $100,000. The index level is marked-to-market, meaning that at the
end of each day its value is adjusted to reflect changes in the day’s share prices.

In stock index futures contracts, there are two parties directly involved. One party (the short
position) must deliver to a second party (the long position) an amount of cash equaling the
contract’s dollar multiplier multiplied by the difference between the spot price of a stock
market index underlying the contract on the day of settlement ( IP spot ) and the contract
price on the date that the contract was entered ( CP 0 ).

If an investor sells a six-month NYSE Composite futures contract (with a multiplier of $500
per index point) at 444 and, six, months later, the NYSE Composite Index closes at 445, the
short party will receive $500 in cash from the long party.
Similarly, if an investor shorts a one-year futures contract at 442 and the index is 447 on the
settlement day one year later (assuming that the multiplier is at $500), the short seller has to
pay the long holder $2,500.

Thus, positive differences are paid by the seller and received by the buyer. Negative
differences are paid by the buyer and received by the seller.

Investors can use stock index futures to perform myriad tasks. Some common uses are: to
speculate on changes in specific markets (see above examples); to change the weightings of
portfolios; to separate market timing from market selection decisions; and to take part in
index arbitrage, whereby the investors seek to gain profits whenever a futures contract is
trading out of line with the fair price of the securities underlying it.

Investors commonly use stock index futures to change the weightings or risk exposures of
their investment portfolios. A good example of this are investors who hold equities from two
or more countries. Suppose these investors have portfolios invested in 60 percent U.S.
equities and 40 percent Japanese equities and want to increase their systematic risk to the
U.S. market and reduce these risks to the Japanese market. They can do this by buying U.S.
stock index futures contracts in the indexes underlying their holdings and selling Japanese
contracts (in the Nikkei Index).

Stock index futures also allow investors to separate market timing from market selection
decisions. For instance, investors may want to take advantage of perceived immediate
increases in an equity market but are not certain which securities to buy; they can do this by
purchasing stock index futures. If the futures contracts are bought and the present value of the
money used to buy them is invested in risk-free securities, investors will have a risk exposure
equal to that of the market. Similarly, investors can adjust their portfolio holdings at a more
leisurely pace. For example, assume the investors see that they have several undesirable
stocks but do not know what holdings to buy to replace them. They can sell the unwanted
stocks and, at the same time, buy stock index futures to keep their exposure to the market.
They can later sell the futures contracts when they have decided which specific stocks they
want to purchase.

Investors can also make money from stock index futures through index arbitrage, also
referred to as program trading. Basically, arbitrage is the purchase of a security or commodity
in one market and the simultaneous sale of an equal product in another market to profit from
pricing differences. Investors taking part in stock index arbitrage seek to gain profits
whenever a futures contract is trading out of line with the fair price of the securities
underlying it. Thus, if a stock index futures contract is trading above its fair value, investors
could buy a basket of about 100 stocks composing the index in the correct proportion—such
as a mutual fund comprised of stocks represented in the index—and then sell the expensively
priced futures contract. Once the contract expires, the equities could then be sold and a net
profit would result. While the investors can keep their arbitrage position until the futures
contract expires, they are not required to. If the futures contract seems to be returning to fair
market value before the expiration date, it may be prudent for the investors to sell early.
Evolution and features of Derivatives

Nature of Financial Derivatives:

Financial derivatives refer to those financial products or instruments which derive their prices
from the prices of their underlying assets. The underlying assets could include stocks, bonds,
foreign currency, or interest rates.

The primitive and simplest form of derivative is forward contract. It goes on to take complex
forms like swaps, futures, options, share ratios and their different variations. Derivative
securities are also called contingent claims. There are certain distinguishing features of
financial derivatives.

In the first instance, value of a financial derivative is derived from some other asset.

Secondly, derivatives are used as vehicle for transferring risk from risk adverse investors to
risk bearing investors.

Thirdly, financial derivatives provide commitments to prices or rates for the future dates or
given protection against adverse movements of prices or exchange rates and thereby reduce
the magnitude of financial risk.

Finally, financial derivatives are highly levered.

Evolution and Growth of Financial Derivatives:

According to some financial scholars, future trading dates back in India to around 200 B. C.
Evolution of trading methods of futures can be traced in the medieval fairs of France and
England as early as the 12th century. The first futures contracts were reportedly done in
respect of rice in Japan in the 17th century when forward agreements were entered into for
the trading of commodities in Japan.

As per the records, rice was traded for future delivery in Osaka in the 1730s. Wheat and corn
futures were reportedly traded in the UK and the USA in the 19th century. The Chicago
Board of Trade (CBOT), established in 1848, was an active exchange for handling
commodities, especially corn and wheat.

The history of derivatives has two important milestones. The first was the establishment of
stock options trade in Chicago — initially OTC and subsequently on the CBOT market in
equity derivatives in 1987. The CBOT was set up in 1848 as a meeting place for farmers and
merchants. It standardized the quantities and qualities of the grains that were to be traded.
The first future type contract was known as ‘to arrive’ contract.

The CBOT now offers futures contract on various assets like corn, soya bean meal, soya bean
oil, wheat, silver, bonds, treasury notes, stock index, etc.
In 1874, the Chicago Produce Exchange was established to provide a market for poultry
products, butter and other perishable agricultural products. In 1898, the butter and egg dealers
detached themselves from this exchange and formed Chicago Butter and Egg Board.

In 1919, this was renamed as Chicago Mercantile Exchange and was reorganized for future
trading. In 1972, the International Monetary Market (IMM) was constituted as a division of
the Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies.

The first traded financial futures were foreign currency contracts which began trading on the
International Commercial Exchange (ICE) in 1970. However, it did not succeed and had to
go out of business. Additional foreign currency contracts commenced trading on the Chicago
Mercantile Exchange in 1974.

In 1975, the commodity futures trading commission (CFTC) officially designated nine
currencies as contract markets on these exchanges, these included British pound, Canadian
dollar, Deutschemarks, Dutch guilders, Japanese Yen, Swiss traces, Italian Lira and Mexican
Pesos. Global futures market currently include metals, grains, petroleum products financial
instruments and a whole lot of other products.

Other futures that trade in futures world over include the Chicago Rice and Cotton Exchange,
the New York Future Exchange, the London International Finance Futures Exchange
(LIFFE), the Toronto Futures Exchange (TFE) and the Singapore International Monetary
Exchange (SIMEX), MATIF (France), EOE (Holland), SOFFEX (Switzerland) and DTB
(Germany).

In India, there is no derivative based on interest rate currently. But there is a future market on
selected commodities (Castor seed, hessian, gur, potatoes, turmeric and pepper). The Forward
Markets Commission (FMC) is the controlling body for these markets.

India also has a strong currency forward market. Daily volume in this market is reportedly
over US $ 500 million per day. The forward cover is currently available for a maximum of 6
months. Indian users can also buy derivatives based on foreign currencies on foreign markets
for hedging.

Ever since the “Badla” was banned, there has been a crying need for other risk-hedging
devices. The Bombay Stock Exchange has been glamorizing for the return of the “Badla” in
its old form. But the National Stock Exchange has set into motion the process of introducing
futures and options.

The L. C. Gupta Committee on derivatives was of the view that there was need for equity-
based derivatives, interest rate derivatives and currency derivatives. But it recommended
introduction of equity-based derivatives in the first instance based on futures only, rather than
options or futures/options on individual stocks which are considered more risky.

The Committee suggested that the other complex type of derivatives should be introduced at
a later stage after the market participants have acquired some degree of comfort and
familiarity with the simpler types. The Securities and Exchange Board of India (SEBI) has, of
late, accepted the recommendation of the Gupta Committee and allowed phased introduction
of derivative trading in the country beginning with a stock index futures.
Amendments to the Securities Contract Act (SCRA) are on the anvil. This will facilitate
inclusion of derivative contracts based on index of prices of securities and other derivative
contracts in securities trading. The SEBI also approved suggestive by-laws proposed by the
Committee covering operational aspects for regulation and control on derivative contracts.

The RBI introduced recently, rupee derivative trading in the country. It formally allowed
banks and corporates from July 6, 1999 to hedge against interest rate risks through the use of
interest rate swaps (IRS) and forward rate agreements (FRA). According to the guidelines,
there would be no restriction on the tenure and size of the IRS and FRA entered into by
banks.

The IRS would allow corporates to hedge their interest rate risks and also provide an
opportunity to swap their old high cost loans with cheaper ones. However, the RBI has
warned that while dealing with corporates, the participants should ensure that they are
undertaking FRAs/IRS only for hedging their own balance sheet exposures and not for
speculative purposes.

Thus, commercial banks, primary dealers, and corporates can now undertake IRS and FRA as
a product for their own balance sheet management and market making purposes.

Derivatives Market:

The derivatives market is the financial market for derivatives, financial instruments like
futures contracts or options, which are derived from other forms of assets.

Derivative markets are investment markets that are geared toward the buying and selling of
derivatives. Derivatives are securities, or financial instruments, that get their value, or at least
part of then- value, from the value of another security, which is called the underlier.

The underlier can come in many forms including, commodities, mortgages, stocks, bonds, or
currency. The reason investors may invest in a derivative security is to hedge their bet. By
investing in something based on a more stable underlier, the investor is assuming less risk
than if she invested in a risky security without an underlier.

Derivatives are usually broadly categorized by the:

1. Relationship between the underlying and the derivative (e.g. forward, option, swap)
2. Type of underlying (e.g. equity derivatives, foreign exchange derivatives, interest rate
derivatives, commodity derivatives or credit derivatives)
3. Market in which they trade (e.g., exchange traded or over-the-counter)
4. Pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded
optionality)

Types of derivatives:

OTC and exchange-traded:

Broadly speaking there are two distinct groups of derivative contracts, which are
distinguished by the way they are traded in the market:
 1. Over-the-Counter (OTC) Derivatives are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or .other intermediary.
Products such as swaps, forward rate agreements, and exotic options are almost always
traded in this way.

The OTC derivative market is the largest market for derivatives, and is largely unregulated
with respect to disclosure of information between the parties, since the OTC market is made
up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC
amounts are difficult because trades can occur in private, without activity being visible on
any exchange.

2. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are
traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts
as an intermediary to all related transactions, and takes Initial margin from both sides of the
trade to act as a guarantee.

The world’s largest derivatives exchanges (by number of transactions) are the Korea
Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of
European products such as interest rate & index products), and CME Group.
 UNIT -3

Introduction to Options, Hedging with

Currency Options

An option is a financial contract that gives an investor the right, but not the obligation, to
either buy or sell an asset at a pre-determined price (known as the strike price) by a specified
date (known as the expiration date).

Options are derivative instruments, meaning that their prices are derived from the price of
their underlying security, which could be almost anything: stocks, bonds, currencies, indexes,
commodities, etc. Many options are created in a standardized form and traded on an options
exchange like the Chicago Board Options Exchange (CBOE), although it is possible for the
two parties to an options contract to agree to create options with completely customized
terms.

There are two types of options: call options and put options. A buyer of a call option has the
right to buy the underlying asset for a certain price. The buyer of a put option has the right to
sell the underlying asset for a certain price.

Here’s a brief look at a few of the most common types of options:

Every option represents a contract between the options writer and the options buyer.

The options writer is the party that “writes,” or creates, the options contract, and then sells it.
If the investor who buys the contract chooses to exercise the option, the writer is obligated to
fulfill the transaction by buying or selling the underlying asset, depending on the type of
option he wrote. If the buyer chooses to not exercise the option, the writer does nothing and
gets to keep the premium (the price the option was originally sold for).

The options buyer has a lot of power in this relationship. He chooses whether or not they will
complete the transaction. When the option expires, if the buyer doesn’t want to exercise the
option, he doesn’t have to. The buyer has purchased the option to carry out a certain
transaction in the future — hence the name.
Why it Matters:

Investors use options for two primary reasons: to speculate and to hedge risk. Rational
investors realize there is no “sure thing,” as every investment incurs at least some risk. This
risk is what the investor is compensated for when he or she purchases an asset.

Hedging is like buying insurance. It is protection against unforeseen events, but you hope you
never have to use it. Should a stock take an unforeseen turn, holding an option opposite of
your position will help to limit your losses.

If you’d like to read more in-depth information about options, check out these definitions:

Call Option: Option to purchase the underlying asset.

Put Option: Option to sell the underlying asset.

Options Contract: The agreement between the writer and the buyer.

Expiration Date: The last day an options contract can be exercised.

Strike Price: The pre-determined price the underlying asset can be bought/sold for.

Intrinsic Value: The current value of the option’s underlying asset.

Time Value: The additional amount that traders are willing to pay for an option.

Vanilla Option: A normal option with no special features, terms or conditions.

American Option: Option that can be exercised any time before the expiration date.

European Option: Option that can be exercised only on the expiration date.

Exotic Option: Any option with a complex structure or payoff calculation.

Hedging with Currency Options

Currency options are useful for all those who are the players or the users of the foreign
currency. This is particularly useful for those who want to gain if the exchange rate improves
but simultaneously want a protection it the exchange rate deteriorate. The most the holder of
an option can lose is the premium he paid for it. Naturally, the option writer faces the mirror
image of the holder’s picture: if you sell an option, the most you can get is the premium if the
option dies for lack of exercise. The writer of a call option can face a substantial loss if the
option is exercised: he is forced to deliver a currency-futures contract at a below-market
price. If he wrote a put option and the put is exercised, then he is obliged to buy the currency
at an above-market price.

Foreign exchange options present an asymmetrical risk profile unlike futures, forwards and
currency options. This lopsidedness works in favor of the holder and to the disadvantage of
the writer. This is why because the holder pays for it i.e he takes the risk. When two parties
enter into a symmetrical contract ;ole a forward, both can gain or lose equally and neither
party feels obliged to charge the other for the privilege. Forwards, futures, and swaps are
mutual obligations; options are one-sided. The holder of a call has a downside risk limited to
the premium paid up front; beyond that he gains one-for –one as the price of the underlying
security.

One who has brought p put option gains one-for-one as the price of the underlying instrument
falls below the strike price. Traders who have written or sold options face the upside down
mirror image profit profile of those who have bought the same options.

From the asymmetrical risk profile of options, it follows that options are ideally suited to
offsetting exchange risks that are themselves asymmetrical. The risk of a forward-rate
agreement is symmetrical; hence, matching it worth a currency option will not be a perfect
hedge. Because doing so would leave you with an open, or speculative, position. Forward
contracts, futures or currency swaps are suitable hedges for symmetrical risks. Currency
options are suitable in which currency risk is already lopsided, and for those who choose to
speculate on the direction and volatility of rates.

Options are not only for hedgers, but also for those who wish to take a “view”. However, for
one who is, say, bearish on the deutschemark, a DM put is not necessarily the best choice.
One can easily bet on the direction of a currency by suing futures or forwards. A DM bear
would simply sell DM futures, limiting his loss, if wants to do so, via a stop loss order.

For an investor who has a view on direction and on volatility, the option is the right choice. If
you think the DM is likely to fall below the forward rate, and you believe that the market has
underestimated the mark’s volatility, then buying a put on German marks is the right strategy.

Who needs American option? Because if offers an additional right- the privilege of exercise
on any date up to the expiration date- it gives the buyer greater flexibility and the writer
greater risk. American options will therefore tend to be priced slightly higher than European
options. Even so, the American option is almost always worth more ‘alive’ than “dead”,
meaning that it pays to sell rather than exercise early. The reason for this statement lies in the
fact that most option trade at a price higher than the gain that would be made from exercising
the option.

Speculation and Arbitrage with Options,

Pricing Options

Arbitrage and speculation are two very different financial strategies, with differing degrees of
risk.

Arbitrage involves the simultaneous buying and selling of an asset in order to profit from
small differences in price. Often, arbitrageurs buy stock on one market (for example, a
financial market in the United States like the New York Stock Exchange) while
simultaneously selling the same stock on a different market (such as the London Stock
Exchange). In the United States, the stock would be traded in U.S. dollars, while in London,
the stock would be traded in pounds.

As each market for the same stock moves, market inefficiencies, pricing mismatches, and
even dollar/pound exchange rates can affect the prices temporarily. Arbitrage is not limited to
identical instruments; arbitrageurs can also take advantage of predictable relationships
between similar financial instruments, such as gold futures and the underlying price of
physical gold.

Since arbitrage involves the simultaneous buying and selling of an asset, it is essentially a
type of hedge and involves limited risk when executed properly. Arbitrageurs typically enter
large positions since they are attempting to profit from very small differences in price.

Speculation, on the other hand, is a type of financial strategy that involves a significant
amount of risk. Financial speculation can involve the trading of instruments such as bonds,
commodities, currencies, and derivatives. Speculators attempt to profit from rising and falling
prices. A trader, for example, may open a long (buy) position in a stock index futures contract
with the expectation of profiting from rising prices. If the value of the index rises, the trader
may close the trade for a profit. Conversely, if the value of the index falls, the trade might be
closed for a loss.

Speculators may also attempt to profit from a falling market by shorting (selling short or
simply “selling”) the instrument. If prices drop, the position will be profitable. If prices rise,
however, the trade may be closed at a loss.

Pricing Options

Option pricing refers to the amount per share at which an option is traded. Options are
derivative contracts that give the holder (the “buyer”) the right, but not the obligation, to buy
or sell the underlying instrument at an agreed-upon price on or before a specified future date.
Although the holder of the option is not obligated to exercise the option, the option writer
(the “seller”) has an obligation to buy or sell the underlying instrument if the option is
exercised.

Depending on the strategy, options trading can provide a variety of benefits, including the
security of limited risk and the advantage of leverage. Another benefit is that options can
protect or enhance your portfolio in rising, falling and neutral markets. Regardless of why
you trade options – or the strategy you use – it’s important to understand how options are
priced. In this tutorial, we’ll take a look at various factors that influence options pricing, as
well as several popular options-pricing models that are used to determine the theoretical
value of options.

The value of equity options is derived from the value of their underlying securities, and the
market price for options will rise or decline based on the related securities’ performance.
There are a number of elements to consider with options.

 In-the-money: An in-the-money Call option strike price is below the actual stock price.
Example: An investor purchases a Call option at the $95 strike price for WXYZ that is
currently trading at $100. The investor’s position is in the money by $5. The Call option gives
the investor the right to buy the equity at $95. An in-the-money Put option strike price is
above the actual stock price. Example: An investor purchases a Put option at the $110 strike
price for WXYZ that is currently trading at $100. This investor position is In-the-money by
$10. The Put option gives the investor the right to sell the equity at $110
 At the money: For both Put and Call options, the strike and the actual stock prices are the
same.
 Out-of-the-money: An out-of-the-money Call option strike price is above the actual stock
price. Example: An investor purchases an out-of-the-money Call option at the strike price of
$120 of ABCD that is currently trading at $105. This investor’s position is out-of-the-money
by $15. An out-of-the-money Put option strike price is below the actual stock price. Example:
An investor purchases an out-of-the-money Put option at the strike price of $90 of ABCD
that is currently trading at $105. This investor’s position is out of the money by $15.

The Premium

The premium is the price a buyer pays the seller for an option. The premium is paid up front
at purchase and is not refundable – even if the option is not exercised. Premiums are quoted
on a per-share basis. Thus, a premium of $0.21 represents a premium payment of $21.00 per
option contract ($0.21 x 100 shares). The amount of the premium is determined by several
factors – the underlying stock price in relation to the strike price (intrinsic value), the length
of time until the option expires (time value) and how much the price fluctuates (volatility
value).

Intrinsic value + Time value + Volatility value = Price of Option

For example: An investor purchases a three-month Call option at a strike price of $80 for a
volatile security that is trading at $90.

Intrinsic value = $10

Time value = since the Call is 90 days out, the premium would add moderately for time
value.
Volatility value = since the underlying security appears volatile, there would be value added
to the premium for volatility.

Top three influencing factors affecting options prices:

1. the underlying equity price in relation to the strike price (intrinsic value)
2. the length of time until the option expires (time value)
3. and how much the price fluctuates (volatility value)

Other factors that influence option prices (premiums) including:

 the quality of the underlying equity

 the dividend rate of the underlying equity
 prevailing market conditions
 supply and demand for options involving the underlying equity
 prevailing interest rates

Black Scholes option pricing Model, Index

Options

The Black Scholes Model is one of the most important concepts in modern financial theory.
The Black Scholes Model is considered the standard model for valuing options. A model of
price variation over time of financial instruments such as stocks that can, among other things,
be used to determine the price of a European call option. The model assumes that the price of
heavily traded assets follow a geometric Brownian motion with constant drift and volatility.
When applied to a stock option, the model incorporates the constant price variation of the
stock, the time value of money, the option’s strike price and the time to the option’s expiry.
Fortunately one does not have to know calculus to use the Black Scholes model.

Black-Scholes Model Assumptions

There are several assumptions underlying the Black-Scholes model of calculating options
pricing..

The exact 6 assumptions of the Black-Scholes Model are :

1. Stock pays no dividends.

2. Option can only be exercised upon expiration.
3. Market direction cannot be predicted, hence “Random Walk.”
4. No commissions are charged in the transaction.
5. Interest rates remain constant.
6. Stock returns are normally distributed, thus volatility is constant over time.

These assumptions are combined with the principle that options pricing should provide no
immediate gain to either seller or buyer.
As you can see, many assumptions of the Black-Scholes Model are invalid, resulting in
theoretical values which are not always accurate. Therefore, theoretical values derived from
the Black-Scholes Model are only good as a guide for relative comparison and is not an exact
indication to the over- or underpriced nature of a stock option.

Limitations of the Black Scholes Model

The Black–Scholes model disagrees with reality in a number of ways, some significant. It is
widely used as a useful approximation, but proper use requires understanding its limitations –
blindly following the model exposes the user to unexpected risk.

Among the most significant limitations are:

1. The Black-Scholes Model assumes that the risk-free rate and the stock’s volatility are
constant.
2. The Black-Scholes Model assumes that stock prices are continuous and that large changes
(such as those seen after a merger announcement) don’t occur.
3. The Black-Scholes Model assumes a stock pays no dividends until after expiration.
4. Analysts can only estimate a stock’s volatility instead of directly observing it, as they can for
the other inputs.
5. The Black-Scholes Model tends to overvalue deep out-of-the-money calls and undervalue
deep in-the-money calls.
6. The Black-Scholes Model tends to misprice options that involve high-dividend stocks.

To deal with these limitations, a Black-Scholes variant known as ARCH, Autoregressive

Conditional Heteroskedasticity, was developed. This variant replaces constant volatility with
stochastic (random) volatility. A number of different models have been developed all
incorporating ever more complex models of volatility. However, despite these known
limitations, the classic Black-Scholes model is still the most popular with options traders
today due to its simplicity.
Variants of the Black Scholes Model

There are a number of variants of the original Black-Scholes model. As the Black-Scholes
Model does not take into consideration dividend payments as well as the possibilities of early
exercising, it frequently under-values Amercian style options.

As the Black-Scholes model was initially invented for the purpose of pricing European style
options a new options pricing model called the Cox-Rubinstein binomial model is also used.
It is commonly known as the Binomial Option Pricing Model or more simply, the Binomial
Model, which was invented in 1979. This options pricing model was more appropriate for
American Style options as it allows for the possibility of early exercise.

The Binomial Option Pricing Model (BOPM), invented by Cox-Rubinstein, was originally
invented as a tool to explain the Black-Scholes Model to Cox’s students. However, it soon
became apparent that the binomial model is a more accurate pricing model for American
Style Options.

Index Options

An index option is a financial derivative that gives the holder the right, but not the obligation,
to buy or sell the value of an underlying index, such as the Standard and Poor’s (S&P) 500, at
the stated exercise price on or before the expiration date of the option. No actual stocks are
bought or sold; index options are always cash-settled, and are typically European-style
options.

Index call and put options are simple and popular tools used by investors, traders and
speculators to profit on the general direction of an underlying index while putting very little
capital at risk. The profit potential for long index call options is unlimited, while the risk is
limited to the premium amount paid for the option, regardless of the index level at expiration.
For long index put options, the risk is also limited to the premium paid, and the potential
profit is capped at the index level, less the premium paid, as the index can never go below
zero.

Beyond potentially profiting from general index level movements, index options can be used
to diversify a portfolio when an investor is unwilling to invest directly in the index’s
underlying stocks. Index options can also be used in multiple ways to hedge specific risks in
a portfolio. American-style index options can be exercised at any time before the expiration
date, while European-style index options can only be exercised on the expiration date.

Index Option Examples

Imagine a hypothetical index called Index X, which has a level of 500. Assume an investor
decides to purchase a call option on Index X with a strike price of 505. With index options,
the contract has a multiplier that determines the overall price. Usually the multiplier is 100.
If, for example, this 505 call option is priced at $11, the entire contract costs $1,100, or $11 x
100. It is important to note the underlying asset in this contract is not any individual stock or
set of stocks but rather the cash level of the index adjusted by the multiplier. In this example,
it is $50,000, or 500 x $100. Instead of investing $50,000 in the stocks of the index, an
investor can buy the option at $1,100 and utilize the remaining $48,900 elsewhere.
The risk associated with this trade is limited to $1,100. The break-even point of an index call
option trade is the strike price plus the premium paid. In this example, that is 516, or 505 plus
11. At any level above 516, this particular trade becomes profitable. If the index level was
530 at expiration, the owner of this call option would exercise it and receive $2,500 in cash
from the other side of the trade, or (530 – 505) x $100. Less the initial premium paid, this
trade results in a profit of $1,400.

Hedging with Index Options

An alternative to selling index futures to hedge a portfolio is to sell index calls while
simultaneously buying an equal number of index puts. Doing so will lock in the value of the
portfolio to guard against any adverse market movements. This strategy is also known as a
protective index collar.

The idea behind the index collar is to finance the purchase of the protective index puts using
the premium collected from selling the index calls. However, as a result of selling the index
calls, in the event that the fund manager’s expectation of a falling market is wrong, his
portfolio will not benefit from the rising market.

Implementation

To hedge a portfolio with index options, we need to first select an index with a high
correlation to the portfolio we wish to protect. For instance, if the portfolio consist of mainly
technology stocks, the Nasdaq Composite Index might be a good fit and if the portfolio is
made up of mainly blue chip companies, then the Dow Jones Industrial Index could be used.

After determining the index to use, we calculate how many put and call contracts to buy and
sell to fully hedge the portfolio using the following formula.

No. Index Options Required = Value of Holding / (Index Level x Contract Multiplier)
Speculation and Arbitrage in Currency
Futures

Speculation:

Future contracts are extremely attractive for speculators as they provide tremendous leverage.
By paying a small margin amount, speculators can take higher exposure of the underlying,
thereby increasing their reward potential as well as the risk. A person who is bullish on the
price of the underlying can BUY a future contract while a person who is bearish would SELL
the future contract.

Hedging:

Hedging is an act of protecting or guarding the investment against an undesired price

movement. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lacs.
Although he is optimistic about the stocks he has in the portfolio, he is not very comfortable
with the overall movement of the market. The price movement of a stock is dependent both
on the micro (profitability of the company, its growth potential, business model, management
competency etc) and the macro factors (GDP growth of the country, interest rates, overall
state of economy etc). Such an investor can hedge his portfolio by selling Index Futures (like
Nifty future) and thereby removing the risk of macro variables from his portfolio.

Another way to hedge using future contracts is by buying the futures of an index/stock when
the cash to buy the underlying would be available on a future date. Say a person is sure to
receive cash inflows of Rs 5 lacs in 2 months’ time, which he wants to, invest in stocks.
However, he is very bullish on the markets and wants to invest as early as possible. What can
he do? He can simply pay the margin amount and take the relevant LONG exposure in future
contracts. This will hedge him from the risk of losing out on the profits if market were to go
up in the next 2 months. It must be noted here that hedging does not necessarily mean
reduced possibility of losses. Like the long term investor we discussed above might lose on
both cash and futures positions if market moved up while his stocks fell.

Arbitrage:

An arbitrageur gains by buying the stock and going short in its future contract when the price
of the future contract is higher than its theoretical price. When the price of the future contract
is less than what it should be, the arbitrageur gains by going long in the future contract and
selling the underlying in cash market.

Index Options Market in Indian Stock

Market

Futures contract based on an index i.e. the underlying asset is the index, are known as Index
Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These
contracts derive their value from the value of the underlying index.

Similarly, the options contracts, which are based on some index, are known as Index options
contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the
right but not the obligation to buy / sell the underlying index on expiry. Index Option
Contracts are generally European Style options i.e. they can be exercised / assigned only on
the expiry date.

An index, in turn derives its value from the prices of securities that constitute the index and is
created to represent the sentiments of the market as a whole or of a particular sector of the
economy. Indices that represent the whole market are broad based indices and those that
represent a particular sector are sectoral indices. In the beginning futures and options were
permitted only on S&P Nifty and BSE Sensex. Subsequently, sectoral indices were also
permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative
contracts may be permitted on an index if 80% of the index constituents are individually
eligible for derivatives trading. However, no single ineligible stock in the index shall have a
weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria
even after derivatives trading on the index has begun. If the index does not fulfill the criteria
for 3 consecutive months, then derivative contracts on such index would be discontinued.

By its very nature, index cannot be delivered on maturity of the Index futures or Index option
contracts therefore, these contracts are essentially cash settled on Expiry.
Index Options Market in Indian Stock
Market

Futures contract based on an index i.e. the underlying asset is the index, are known as Index
Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These
contracts derive their value from the value of the underlying index.

Similarly, the options contracts, which are based on some index, are known as Index options
contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the
right but not the obligation to buy / sell the underlying index on expiry. Index Option
Contracts are generally European Style options i.e. they can be exercised / assigned only on
the expiry date.

An index, in turn derives its value from the prices of securities that constitute the index and is
created to represent the sentiments of the market as a whole or of a particular sector of the
economy. Indices that represent the whole market are broad based indices and those that
represent a particular sector are sectoral indices. In the beginning futures and options were
permitted only on S&P Nifty and BSE Sensex. Subsequently, sectoral indices were also
permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative
contracts may be permitted on an index if 80% of the index constituents are individually
eligible for derivatives trading. However, no single ineligible stock in the index shall have a
weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria
even after derivatives trading on the index has begun. If the index does not fulfill the criteria
for 3 consecutive months, then derivative contracts on such index would be discontinued.

By its very nature, index cannot be delivered on maturity of the Index futures or Index option
contracts therefore, these contracts are essentially cash settled on Expiry.

Use of different option strategies to mitigate

the risk

Many investors mistakenly believe that options are always riskier investments than stocks
because they may not fully understand the concept of leverage. However, if used properly,
options may carry less risk than an equivalent stock position. Read on to learn how to
calculate the potential risk of options positions and how the power of leverage can work in
your favor.

Leverage has two basic definitions applicable to options trading. The first defines leverage as
the use of the same amount of money to capture a larger position. This is the definition that
gets investors into the most trouble. A dollar invested in a stock and the same dollar invested
in an option do not equate to the same risk.
The second definition characterizes leverage as maintaining the same sized position, but
spending less money doing so. This is the definition of leverage that a consistently successful
trader or investor incorporates into his or her frame of reference.

Interpreting the Numbers

Consider the following example. You’re planning to invest $10,000 in a $50 stock but are
tempted to buy $10 options contracts as an alternative. After all, investing $10,000 in a $10
option allows you to buy 10 contracts (one contract is worth one hundred shares of stock) and
control 1,000 shares. Meanwhile, $10,000 in a $50 stock will only buy 200 shares.

In this example, the options trade has more risk than the stock trade. With the stock trade,
your entire investment can be lost but only with an improbable price movement from $50 to
$0. However, you stand to lose your entire investment in the options trade if the stock simply
drops to the strike price. So, if the option strike price is $40 (an in-the-money option), the
stock only needs to drop below $40 by expiration for the investment to be lost, even though
its just a 20% decline.

Clearly, there is a huge risk disparity between owning the same dollar amount of stocks and
options. This risk disparity exists because the proper definition of leverage was applied
incorrectly. To correct this misunderstanding, let’s examine two ways to balance risk
disparity while keeping the positions equally profitable.

Conventional Risk Calculation

The first method to balance risk disparity is the standard and most popular way. Let’s go back
to our example to see how this works:

If you were going to invest $10,000 in a $50 stock, you would receive 200 shares. Instead of
purchasing the 200 shares, you could also buy two call option contracts. By purchasing the
options, you spend less money but still control the same number of shares. In other words, the
number of options is determined by the number of shares that could have been bought with
the investment capital.

Say you decide to buy 1,000 shares of XYZ at $41.75 for a cost of $41,750. However, instead
of purchasing the stock at $41.75, you can buy 10 call option contracts whose strike price is
$30 (in-the-money) for $1,630 per contract. The options purchase will incur a total capital
outlay of $16,300 for the 10 calls. This represents a total savings of $25,450, or about a 60%
of what you would have paid buying the shares.

This $25,450 savings can be used in several ways. First, it can take advantage of other
opportunities, providing you with greater diversification. Second, it can simply sit in a trading
account and earn money market rates. The collection of interest can create what is known as a
synthetic dividend. For example, if the $25,450 savings gains 2% interest annually in a
money market account.during the option’s life span, the account will gain $509 interest per
year, equivalent to about $42 a month.

You are now, in a sense, collecting a dividend on a stock that may not pay one while also
benefiting from the options position. Best of all, this can be accomplished using about one-
third of the funds needed to purchase the stock outright.
Alternative Risk Calculation

The other alternative for balancing cost and size disparity is based on risk.

As we’ve learned, buying $10,000 in stock is not the same as buying $10,000 in options in
terms of overall risk. In fact, the options exposure carries much greater risk due to greatly
increased potential for loss. In order to level the playing field, you must have a risk-
equivalent options position in relation to the stock position.

Let’s start with the stock position: buying 1,000 shares at $41.75 for a total investment of
$41,750. Being a risk-conscious investor, you also enter a stop-loss order, a prudent strategy
that is advised by market experts.

You set a stop order at a price that will limit your loss to 20% of the investment, which
calculates to $8,350. Assuming this is the amount you are willing to lose, it should also be the
amount you are willing to spend on an options position. In other words, you should only
spend $8,350 buying options for risk equivalency. With this strategy, you have the same
dollar amount at risk in the options position as you were willing to lose in the stock position.

If you own stock, stop orders will not protect you from gap openings. With an options
position, once the stock opens below the strike price, you have already lost all that you can
lose, which is the total amount of money you spent purchasing the calls. If you own the stock,
you can suffer much greater loss so the options position becomes less risky than the stock
position.

Say you purchase a biotech stock for $60 and it gaps down at $20 when the company’s drug
kills a test patient. Your stop order will be executed at $20, locking in a catastrophic $40 loss.
Clearly, your stop order didn’t afford much protection in this case.

However, say you pass on stock ownership and instead buy the call options for $11.50. Your
risk scenario now changes dramatically because you are only risking the amount of money
you paid for the option. Therefore, if the stock opens at $20, your friends who bought the
stock will be out $40, while you will have lost $11.50. Options become less risky than stocks
when used in this manner.

Determining the appropriate amount of money to invest in an options position allows the
investor to unlock the power of leverage. The key is maintaining balance in the total risk is to
run a series of “what if” scenarios, using risk tolerance as your guide.
 UNIT -4

Introduction to Commodity Markets,

History

Commodity market facilitates an exchange of physical goods among residents in a country.

Individuals aiming to diversify their portfolio can undertake investments in both perishable
and non-perishable products, thereby not only mitigating the risk factor, but also providing a
hedge against inflation rates in an economy.

Types of Commodities in the market

Available for trading are categorised into the following classes, based on their inherent
nature:

1. Hard commodities

 Precious metals: Gold, platinum, copper, silver, etc.

 Energy: Crude oil, Natural gas, gasoline, etc.

2. Soft commodities:

 Agriculture: Soybeans, wheat, rice, coffee, corn, salt, etc.

 Livestock and meat: Live cattle, pork, feeder cattle, etc.

As of 2019, some examples of commodities in the market that were most commonly traded in
major commodity exchanges in India included crude oil and silver. While crude oil acts as
one of the most important energy sources required for virtually every industry, silver is one of
the most precious metals other than gold with a steady demand.

As crude oil is not domestically available in abundance, almost 82% of it is imported from
OPEC and Middle Eastern countries. Similarly, silver is traded in extensive quantities from
countries such as Mexico, Peru, etc.

History and Origin of Commodity market

The world’s first commodities arose from agriculture practices (crop production and raising
livestock). Archaeological discoveries indicate that agriculture developed around 10,000 BC,
as humans began settlements and farming. An agricultural revolution started around 8,500
BC, which led to trading commodities between settlements. As trading developed, producers
and dealers looked for ways to preserve the price of their products. Factors such as weather,
conflict, and supply and demand wreaked havoc on pricing. In addition, as supplies became
more plentiful, storage was necessary; merchants sought ways to raise money while their
product sat until being sold. This is how futures agreements began. According to Bruce
Babcock, a noted commodity authority, the first recorded commodity futures trades occurred
in 17th century Japan, though there is some evidence that rice may have been traded as far
back as 6,000 years ago in China. (Babcock, 2009)

In the US during the early 1800s, agricultural commodities – notably grains – were brought
from Midwest farmlands to Chicago for storage until being shipped out to the east coast.
Because agricultural products are perishable, the quality of the stored items would usually
deteriorate over time. While stored, the purchase prices would occasionally change so the
first contract for a future price was created. This forward contract allowed a buyer to pay for
the commodity prior to taking delivery of it.

As more farmers and merchants began delivering their wares to Chicago, the first American
exchange was set up in 1848. It was called the Chicago Board of Trade (CBOT). This group
of brokers established a more efficient, standardized method of exchanging goods and
payment by creating futures contracts. Instead of managing numerous customized contracts
between interested parties, they streamlined the process of buying and selling future delivery
for a present price by generating contracts that were identical in terms of quality of the asset,
delivery time and terms.

For over 100 years, agricultural products remained the primary class of futures trading. The
CBOT added soybeans in 1936. In the 1940s, exchanges included trading for cotton and lard.
Livestock was added to the trading “block” during the 1950s. Contracts for precious metals
like silver started trading during the 1960s. By the 1970s, when global currencies were no
longer tied to gold prices, currency values fluctuated based on supply and demand, and
financial futures became a tradable “commodity”. Suddenly you could trade prices instead of
goods. This opened up a new era – one where a cash settlement is used instead of the
traditional “delivery” of goods. Throughout the 80s and 90s, stock market index benchmarks
like the S&P 500 and government debt instruments were added to the list of tradable futures.

During the 20th century, exchanges opened up all over the United States. Cities such as
Milwaukee, New York, St. Louis, Kansas City, Minneapolis, San Francisco, Memphis, New
Orleans and others hosted trading, but Chicago remained the most influential location for
commodities futures trading.

In the early 21st century the advent of the online trading systems led to heightened interest in
commodities and futures. From the comfort of home or office, buyers and sellers can place
orders through electronic trading systems and online brokerage houses. Easier access and
increased information sharing led many to pursue careers in futures trading.

These new steps brought thousands of more participants into the trading arena. Commodities
and futures trading became a hedge to protect their financial interests against losses in other
investment areas, such as stocks and bonds. Individuals and investment companies poured
millions of dollars into the commodities and futures markets. This influx of new third-party
traders now has a significant impact on the prices of commodity-based goods. Their interest
is not necessarily securing the price of goods they will take control of; rather they use
speculation about buying and selling behaviors to predict a futures contract’s value. These
new players seek to make profit through price movement.

Prices Determined in Commodities Exchange

The prices of commodity markets are heavily dependent on the market demand and supply of
commodities, both domestically and from foreign sources. Speculative news also affects the
commodity prices heavily, as socio-economic conditions deeply influence the productive
capacity of respective companies.

The factors affecting commodity prices in an economy are discussed below:

Market demand and supply

Market demand and consequent supply of goods traded on a commodity exchange heavily
influence the market price. A rising demand (for any reason) can cause prices to rise in the
short run, as supply cannot be increased immediately to compensate for the higher demand in
the market. Generally, such a rise in demand can be attributed to a pessimistic performance
outlook towards the stock market, thereby causing investors to shift towards relatively safer
investment avenues.

Global scenario

Global indicators play a crucial role in determining the prices of commodities available
internally in a country. For example, any turmoil in the Middle Eastern countries can affect
the prices at which crude oil is exported, thereby affecting the prices at which it is traded
domestically.

A significant example can be cited in this respect when a supply shock was experienced by
all major countries in the world triggered by Iraq-Kuwait tensions in the 1990s.

External factors

Any condition affecting the total production of stipulated goods traded in an exchange can
cause price changes accordingly. For example, a rise in the cost of production can drive up
the prices at which a product is sold in the market, consequently affecting the equilibrium
rate.

Also, the performance of the stock and bond market has an effect on the prices of
commodities, as a negative viewpoint regarding their performances tends to divert investors
towards commodity market securities. Individuals often trade in commodity derivatives to
compensate for stock market risks, or to safeguard their portfolio from stock market
downturns.

Speculative demand

Demand for derivative investing in commodities online can arise from speculative investors,
who aim to realise profits through market price fluctuations. Speculators often make
predictions regarding the direction of movement of prices and aim to close the contract before
the expiration date to realise capital gains on total gains.

Individuals unwilling to take physical delivery of the goods can opt for cash settlement
contracts, whereby upon completion of the tenure of the futures contract, the difference
between the price in spot trading and price stated in the futures contract has to be paid.
Depending upon the market assumptions, individuals can assume either a short or a long
position in a futures contract. Investors expecting the price to drop in the future can undertake
a short position (sell the security at a fixed price on a stipulated date) to realise profits
through a fall in the market price. On the other hand, if individuals expect the price of a
commodity future contract to rise in the future, they can opt to go long (buy the security at a
fixed price on a stipulated date) so as to sell the same at higher prices in the future.

Nonetheless, a futures contract tends to merge with the spot price at which a commodity is
trading at a future date, as prices adjust automatically at the expected level.

Market outlook

Any unforeseen fluctuations in the stock market can cause investors to shift towards
commodity trade, as chances of severe fluctuations in prices of certain commodities such as
precious metals are low. Hence, commodity market investments are secure in nature and act
as a hedge against inflation for risk-averse individuals.

Major commodities traded in derivatives

exchange in India

Commodity market facilitates an exchange of physical goods among residents in a country.

Individuals aiming to diversify their portfolio can undertake investments in both perishable
and non-perishable products, thereby not only mitigating the risk factor, but also providing a
hedge against inflation rates in an economy.

Types of Commodities in the market

Available for trading are categorised into the following classes, based on their inherent
nature:

1. Hard commodities

 Precious metals: Gold, platinum, copper, silver, etc.

 Energy: Crude oil, Natural gas, gasoline, etc.

2. Soft commodities

 Agriculture: Soybeans, wheat, rice, coffee, corn, salt, etc.

 Livestock and meat: Live cattle, pork, feeder cattle, etc.

As of 2019, some examples of commodities in the market that were most commonly traded in
major commodity exchanges in India included crude oil and silver. While crude oil acts as
one of the most important energy sources required for virtually every industry, silver is one of
the most precious metals other than gold with a steady demand.
As crude oil is not domestically available in abundance, almost 82% of it is imported from
OPEC and Middle Eastern countries. Similarly, silver is traded in extensive quantities from
countries such as Mexico, Peru, etc.

Major Commodity Exchanges in India:

 Multi Commodity Exchange of India

 National Multi Commodity Exchange of India
 Indian Commodity Exchange
 National Commodity and Derivatives Exchange

Types of Commodity Market:

 Spot markets are also known as “cash markets” or “physical markets” where traders
exchange physical commodities, and that too for immediate delivery.
 Derivatives markets involve two types of commodity derivatives: futures and forwards;
these derivatives contracts use the spot market as the underlying asset and give the owner
control of the same at a point in the future for a price that is agreed upon in the present.
When the contracts expire, the commodity or asset is delivered physically. The main
difference between forwards and futures is that forwards can be customized and traded
over the counter, whereas futures are traded on exchanges and are standardized.

Participant in Commodity Derivative

markets

Derivatives are financial securities whose values are derived from an underlying asset or
group of assets. Derivatives are contracts between two or more than two parties. Whenever
there is a fluctuation in the price of the underlying asset, it affects the price of the derivative
contract as well. These underlying assets can be stocks, indices, bonds, currencies or even
commodities like silver, gold, crude oil etc.

Derivatives are traded on the stock exchanges and are also used by institutional investors for
hedging risks and also to speculate the price changes in the value of the underlying asset. The
derivatives which are traded on the exchanges are standardized and have lower risks
compared to over the counter derivatives. Derivative instruments are leveraged instruments
and thus have a high risk to reward ratio.

The participants in the derivatives market can be broadly categorized into the following four
groups:

1. Hedgers

Hedging is when a person invests in financial markets to reduce the risk of price volatility in
exchange markets, i.e., eliminate the risk of future price movements. Derivatives are the most
popular instruments in the sphere of hedging. It is because derivatives are effective in
offsetting risk with their respective underlying assets.

2. Speculators

Speculation is the most common market activity that participants of a financial market take
part in. It is a risky activity that investors engage in. It involves the purchase of any financial
instrument or an asset that an investor speculates to become significantly valuable in the
future. Speculation is driven by the motive of potentially earning lucrative profits in the
future.

3. Arbitrageurs

Arbitrage is a very common profit-making activity in financial markets that comes into effect
by taking advantage of or profiting from the price volatility of the market. Arbitrageurs make
a profit from the price difference arising in an investment of a financial instrument such as
bonds, stocks, derivatives, etc.

4. Margin traders

In the finance industry, margin is the collateral deposited by an investor investing in a

financial instrument to the counterparty to cover the credit risk associated with the
investment.

Commodity Market Indices

A commodity index is an investment vehicle that tracks the price and the return on
investment of a basket of commodities. These indexes are often traded on exchanges. Many
investors who want access to the commodities market without entering the futures market
decide to invest in commodities indexes. The value of these indexes fluctuates based on their
underlying commodities; similar to stock index futures, this value can be traded on an
exchange.

commodity indices like MCX iCOMDEX are composed of instruments traded on the
exchange platform. However, unlike the former where the constituents are cash equity scrips,
the latter are constituted of commodity futures contracts. Thus, the MCX iCOMDEX are
indices created from the futures contracts traded on MCX. The index family consists of:

 Two sectoral indices (Bullion Index and Base Metal Index) constituted of the bullion and base
metals futures traded on MCX.
 A Composite Index, which is constituted from eleven commodity futures across different
segments traded on MCX.
 Being composed of futures contracts, commodity indices have some unique characteristics
not found in equity indices.
 Four single-commodity indices (Gold Index, Silver Index, Copper Index and Crude Oil Index),
which are constituted of futures of the respective commodity futures traded on MCX.
Every commodity index on the market has a different makeup in terms of what goods it is
comprised of. The Thomson Reuters/CoreCommodity CRB Index is traded on the New York
Board of Trade (NYBOT). This index consists of 28 different types of commodities,
including barley, cocoa, soybeans, zinc, and wheat.

Commodity indexes also vary in the way they are weighted; some indexes are equally
weighted, which means that each commodity makes up the same percentage of the index.
Other indexes have a predetermined, fixed weighting scheme that may invest a higher
percentage in a specific commodity. For example, some commodity indexes are heavily
weighted for energy-related commodities like coal and oil.

The Dow Jones futures index was the first index to track commodity prices in 1933.1
Goldman Sachs launched its commodity index in 1991, called the Goldman Sachs
Commodity Index (GSCI). Goldman Sachs’s index was renamed the S&P GSCI when it was
purchased by Standard and Poor’s in 2007.23 The Bloomberg Commodity Index (BCOM)
family and the Rogers International Commodity Index (RICI) are two other popular
commodity indexes.

Investing in commodity indexes gained in popularity in the early 2000s as the price of oil
began to move out of the historic $20 to $30 per barrel range that it had occupied for over a
decade, and Chinese industrial production started to grow rapidly.4 The rise in demand for
commodities as a result of China’s growing economy, combined with a limited global supply
of commodities, caused commodity prices to rise and many investors became more interested
in finding a way to invest in the raw materials of industrial production.

Commodity Futures

A commodity futures contract is an agreement to buy or sell a predetermined amount of a

commodity at a specific price on a specific date in the future. Commodity futures can be used
to hedge or protect an investment position or to bet on the directional move of the underlying
asset.

Many investors confuse futures contracts with options contracts. With futures contracts, the
holder has an obligation to act. Unless the holder unwinds the futures contract before
expiration, they must either buy or sell the underlying asset at the stated price. Commodity
futures can be contrasted with the spot commodities market.

Commodities futures contracts are agreements to buy or sell a raw material at a specific date
in the future at a particular price. The contract is for a set amount. It specifies when the seller
will deliver the asset. It also sets the price. Some contracts allow a cash settlement instead of
delivery.

The three main areas of commodities are food, energy, and metals. The most popular food
futures are meat, wheat, and sugar. Most energy futures are oil and gasoline. Metals using
futures include gold, silver, and copper.
Buyers of food, energy, and metal use futures contracts to fix the price of the commodity they
are purchasing. That reduces their risk that prices will go up. Sellers of these commodities
use futures to guarantee they will receive the agreed-upon price. They remove the risk of a
price drop.

Most commodity futures contracts are closed out or netted at their expiration date. The price
difference between the original trade and the closing trade is cash-settled. Commodity futures
are typically used to take a position in an underlying asset. Typical assets include:

 Wheat
 Crude oil
 Corn
 Silver
 Gold
 Natural gas

Commodity futures contracts are called by the name of their expiration month, meaning a
contract ending in September is a September futures contract. Some commodities can have a
significant amount of price volatility or price fluctuations. As a result, there’s the potential for
large gains but large losses as well.

Advantages:

 In a price drop, the producer does not lose money. He gets the agreed-upon price.
 These contracts ensure that the commodity producer receives a fixed sales price, come
harvest or selling time.
 Producers or companies can make better production plans.
 Producers can limit their risk, in case of a price drop.

Disadvantages:

 Trading in these contracts is very risky. World commodity prices are highly volatile.
 In the event of a price increase, producers can miss out on considerable gains. Contract
prices are fixed.
 Commodity prices are influenced by world events, traders’ emotions, and market
speculations, even when demand and supply remain at the same level
 This investment type is best left to experts.

Commodity Options

Commodity trade options contracts are rights to buy (call option) or sell (put option)
underlying commodity futures at predetermined prices on the date of contract expiry. It is
important to note that, unlike in equity options where options involve rights to sell or buy
shares of companies at pre-set prices, it works a bit differently for the commodity trading
space.
Options trading in commodities is widespread globally with major exchanges like CME,
NYMEX, LME and ICE offering options on commodities ranging from gold to oil to
industrial metals. After a 13 year long gestation, Indian commodity markets launched options
in Gold, opening new avenues for trading and hedging. However it is important for
traders/speculators and investors to understand options trading in commodity markets as the
expiry process is different from that of equities and Forex.

Broadly, there are two types of commodity options, a call option and a put option, similar
to what we have in equities and Forex. There are two sides to every option trade, a buyer and
a seller. Each of these sides experiences the opposite outcome; if the option buyer is making
money the option seller is losing money in the identical increment, and vice versa.

Gold options: A refiner/ Jeweler can sell out of the money options against their inventory, if
they are willing to accept considerable amounts of risk with the prospects of limited reward,
can write (or sell) options, collecting the premium. The premiums might be small on an
absolute basis but your inventory can pay you returns and generate additional income. On the
other hand, an option buyer is exposed to limited risk and unlimited profit potential, but faces
inherent risk like with any form of speculation.

In India, market regulators mostly exclusively allow options trading in the commodity futures
market and not the commodity spot market because in India the spot or cash market in
commodities is regulated by state governments while the SEBI only regulates the commodity
derivatives market.

A call option gives the owner a right to buy the underlying commodity futures at a fixed price
or the strike price on the date of the expiry of the contract. The buyer of an option is said to
go long on an option. If the buyer chooses to exercise his right to buy, then on the date of
expiry, the options contract devolves into the futures contract.

A buyer of a call option will only execute his right when there is intrinsic value; that is, the
strike price is lower than the prevailing price of the commodity futures contract.

Advantages:

 Cost is lesser than taking a futures contract, returns are relatively higher and maximum loss
is limited to the premium or price of option, unlike in futures where returns are high and
losses can be unlimited.
 There is no mark to market margin calls for option buyers since they pay premium upfront to
the option seller.
 Options are also more flexible and an option holder can participate fully in any price
movement
 Options represent a form of price insurance, the cost of which is the option premium
determined.
Uses of commodity derivatives: Hedging,
Speculation and Arbitrage

Commodity derivatives are investment tools that allow investors to profit from certain
commodities without possessing them. The buyer of a derivatives contract buys the right to
exchange a commodity for a certain price at a future date. The buyer may be buying or selling
the commodity. The buyer does not have to pay the full value of the amount of the
commodity in which investment is made. He only needs to pay a small percentage, known as
the margin price. On agreement, the seller gives the owner the ownership of the commodity
at the agreed future date along with the physical delivery. Based on the spot price of the
commodity the buyer makes profit or loss. Exchanges facilitate the contract settlements and
clearing.

Hedging

An understanding of hedging requires an understanding of the elements of the theory of asset

holding. Individuals will hold inventories of assets only in the expectation of increases in the
value of those assets by at least enough to cover the costs of carrying the assets. In the case of
financial assets, these carrying costs are largely the costs of the money tied up. In the case of
physical inventories, there will also be costs of storage and spoilage or deterioration. Set
against these costs will be certain benefits from the inventory: for merchants, for example, the
inventory may be the means to increased sales or commissions.

The net costs of carrying inventory may be positive or negative, but in economic equilibrium
the marginal cost of a unit of inventory must be equal to the expected price appreciation of
that unit of inventory (Working 1933; Brennan 1958). This introduces an asymmetry into the
behavior of expected changes in prices of storable assets. At no time can the expected price
one period from now be greater than the current price by more than the marginal cost of
storage for that period. Once the difference becomes equal to the costs of storage, an increase
in expected future price will increase today’s price as well. On the other hand, there is no
similar lower limit on the extent of expected price decreases: if prices are expected to fall,
current prices will be depressed by a reduction in the amount of inventories held until the
marginal value of those inventories is equal to the expected price decline. But while
inventories can be accumulated indefinitely, they can be reduced only to zero.

When inventories are increased, the holder exposes himself to increased capital risk from
fluctuations in the price of the goods being held. If the merchant is a risk averter, increasing
his inventory increases his subjective costs of storage. To reduce that risk, he may hedge by
selling for future delivery at some fixed price some or all of the inventory he owns. By doing
so, he passes the risk to the speculator who buys the futures contracts.

Speculation

Every trade is based on the expectation of the investor. The markets function only because
someone is willing to buy and someone on the other end is willing to buy. The seller
generally expects the price to fall and sells to monetise his profit, while the buyer expects the
price to rise and hence enters the counter to generate returns. Speculation is the broad term
for trading based on expectation, assumption or hunch. The speculation involves considerable
risk of loss. The primary driver of speculation is the probability of earning significant profits.
Speculation is not limited to financial instruments; it is common in other assets also. For
instance, speculation is common in the real estate market. Extreme speculation leads to the
formation of asset bubbles like the dot com bubble in the early 2000s and tulip bubble in
medieval times. The profit margin can be high in speculative trades, so even small traders can
trade based on speculation.

Arbitrage

Arbitrage is the act of buying and selling an asset simultaneously in different markets to
profit from a mismatch in prices. Arbitrage opportunities arise due to the inefficiency of the
markets. Arbitrage is a common practice in currency trade and stocks listed on multiple
exchanges. For instance, suppose the shares of company XYZ are listed on the National
Stock Exchange in India as well as the New York Stock Exchange in the US. On certain
occasions, there will be a mismatch in the share price of XYZ on the NSE and NYSE due to
currency fluctuations. Ideally, after considering the exchange rate, the share price of XYZ on
both the exchanges should be the same. However, stock movements, the difference in time
zones and exchange rate fluctuations create a temporary mismatch in prices. Seizing the
opportunity, arbitrage traders buy on the exchange where the share price is lower and sell the
same quantity on the exchange with the higher share price.

Arbitrage opportunities are very short-lived as markets have been designed to be highly
efficient. Once an arbitrage opportunity is used, it quickly disappears as the mismatch is
corrected. While arbitrage is more common in identical instruments, many traders also take
advantage of a predictable relationship between instruments. Generally, the price of a
mismatch is exceedingly small. To profit from a small price differential, traders must place
large orders to generate adequate profits. If executed properly, arbitrage trades are relatively
less risky, however, a sudden change in the exchange rate or high trading commission can
make arbitrage opportunities unfeasible.

Arbitrage vs Speculation

Arbitrage and speculation are two different financial strategies. The major differences
between arbitrage vs speculation are the size of the trade, time duration, risk and structure.
Only large traders can take advantage of arbitrage opportunities as they are short-lived, and
the profit margin is small which requires scale. Speculation doesn’t have any such
limitations; even small traders can place bets based on speculation. Speculative trades can last
anywhere from a few minutes to several months, but the same cannot be said about arbitrage
trades. Arbitrage opportunities arise due to market inefficiencies and disappear as soon as
someone utilises it. Arbitrageurs buy and sell the same asset simultaneously. The
simultaneous nature of arbitrage trade limits the risk for the trader. On the other hand, the risk
of loss remains high in the case of speculative trade as speculative price movements are based
on the assumption of many people.