Page 231 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 2. Sell a future to agree to make delivery of a commodity to protect against a fall in price in
the spot market as it produces a gain if spot prices fall. Selling a future is said to be going
short.
Interest Rate Future
1. Selling short an interest rate futures contract protects against a rise in interest rates.
2. Purchasing long an interest rate futures contract protects against a fall in interest rates.

Future Rate Agreements (FRAs)
1. Selling short on FRA protects against a fall in interest rates.
2. Purchasing long on FRA Protects against a rise in interest rates.
Currency Futures

1. Buying long a currency future protects against a rise in currency value.
2. Selling short a currency future protects against a fall in currency value.

Notes Marking to Market: In futures contracts, a small payment known as ‘initial margin’
is required to be deposited with the organised futures exchange. Due to fluctuations in the
price of underlying asset, the balance in the margin account may fall below specified
minimum level or even become negative at the end of each trading session. All outstanding
contracts are appraised at the settlement price of that session, which is called ‘marking to
market.’ This means adjusting the margin accounts of both the parties. A member incurring
cost should make payment of profit to the counter party and the value of future contracts
is set to zero at the end of each trading session. The daily settlement payments are known
as ‘variation margin’ payments.
Closing Out of Futures Contract: A long position in futures, can be closed out by selling
futures while a short position in futures can be closed out by buying futures on the
exchange. Once position is closed out, only the net difference needs to be settled in cash,
without any delivery of underlying. Most contracts are not held to expiry but closed out
before that. If held until expiry, some are settled for cash and others for physical delivery.

Case Study ABC Ltd.

The following data relates to ABC Ltd.’s share prices:

Current price per share 180
Price per share in the futures market-6 months 195
It is possible to borrow money in the market for securities transactions at the rate of 12%
per annum.
1. Calculate the theoretical minimum price of a 6-month forward contract.

2. Explain if any arbitraging opportunities exist.

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