Page 106 - DCOM510_FINANCIAL_DERIVATIVES

Unit 7: Application of Futures Contracts

models including Binomial options Pricing Model (BOPM) and Black-Scholes model for Call Notes
Options. This unit will help you to discuss the payoff for futures derivatives contracts. We will
also learn the difference between trading securities and trading futures on individual securities.
The various sections and subsections of this unit will also summarise the simple strategies of
hedging, speculation and arbitrage. To make the learning easier, we will take the help of globally
recognised best practices.
As we have seen in the earlier units, a futures contract is an agreement between two parties to
buy or sell an asset at certain time in the future at a certain price. Futures are instruments of
hedging. Since hedging is explained in terms of risk, let us explain what risk is. Risk is not loss;
rather, it is uncertainty about the expectation of a future event (e.g., forecast of tomorrow’s
price). The uncertainty may turn out to be favourable (i.e. profit) or unfavourable (i.e. loss). Risk
is, thus, a neutral concept: profit and loss are merely two sides of the same coin called risk. Since
hedging eliminates risk, it follows that hedging shuts the door closed to profit as well as loss:
the investment is locked at a particular value, and it neither gains nor loses in value from
subsequent price changes.

7.1 Payoff for Futures Derivatives Contracts

Futures contracts have linear payoffs. In simple words, it means that the losses as well as
profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are
fascinating as they can be combined with options ant he underlying to generate various
complex payoffs.
Essentially, futures contracts try to predict what the value of an index or commodity will be at
some date in the future. Speculators in the futures market can use different strategies to take
advantage of rising and declining prices.

Notes The most common are known as “going long,” and “going short”.

Did u know? Offsetting position type of settlement is evidenced in 90% of futures settlement
worldwide. Entering into an offsetting position of futures transaction implies entering
into a reverse trade of the initial position. The initial buyer (long) liquidates his position
by selling (going short) a similar future contract, and initial seller (short) goes for buying
(long) an identical contract. In our previous example, the long investor enters into a short
Nifty Futures at delivery price of ` 3225. This is because the investor does not wish to take
delivery (or rather cash settle) the futures. Offsetting is a process of carrying forward the
transaction by changing sides.

7.1.1 Going Long – Buy Futures

When an investor goes long — that is, enters a contract by agreeing to buy and receive delivery
of the underlying at a predetermined price — it means that he or she is trying to get profit
from an anticipated increase in future price. The pay-off profile of ‘going long’ is depicted in
figure 7.1.

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