Page 116 - DCOM510_FINANCIAL_DERIVATIVES

Unit 7: Application of Futures Contracts

Notes

Task NSE Nifty is currently trading in spot market at 3200. The cost of financing is 12%
per annum. Calculate the fair value of 3-month futures of Nifty, when the dividend yield
is 3% per annum.

7.3.2 Speculation using Futures Contracts

Speculators can also benefit from trading in futures contracts. When the underlying asset is
expected to be bullish (rising prices), the speculator opts for buying futures; whereas when the
underlying asset is expected to be bearish (falling prices), the speculator opts for buying futures.
Both of these are described below using suitable illustrations.

Bullish Sentiment and Buying of Futures

Take the case of a speculator who has a view on the direction of the market. He would like to
trade based on this view. He believes that a particular security that trades at ` 1,000 is undervalued
and expects its price to go up in the next two–three months. How can he trade based on this
belief? In the absence of a deferral product, he would have to buy the security and hold on to it.

Assume he buys 100 shares which cost him one lakh rupees. His hunch proves correct and two
months later the security closes at ` 1,010. He makes a profit of ` 1,000 on an investment of
` 1,00,000 for a period of two months. This works out to an annual return of 6 %.
Today, a speculator can take exactly the same position on the security by using futures contracts.
Let us see how this works. The security trades at ` 1,000 and the two-month futures trades at 1006.
Just for the sake of comparison, assume that the minimum contract value is 1,00,000. He buys 100
security futures for which he pays a margin of ` 20,000. Two months later, the security closes at
1,010. On the day of expiration, the futures price converges to the spot price and he makes a
profit of ` 400 on an investment of ` 20,000. This works out to an annual return of 12%. Because
of the leverage they provide, security futures form an attractive option for speculators.

Bearish Sentiment and Buying of Futures

Stock futures can be used by a speculator who believes that a particular security is over–valued
and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a
deferral product, there wasn’t much he could do to profit from his opinion. Today all he needs
to do is sell stock futures.

Let us understand how this works. Simple arbitrage ensures that futures on an individual security
move correspondingly with the underlying security, as long as there is sufficient liquidity in the
market for the security.

Notes If the security price rises, so will the futures price. If the security price falls, so will
the futures price.

Now take the case of the trader who expects to see a fall in the price of SBI. He sells one two–
month contract of futures on SBI at ` 240 (each contract for 100 underlying shares). He pays a
small margin on the same. Two months later, when the futures contract expires, SBI closes at 220.
On the day of expiration, the spot and the futures price converge. He has made a clean profit of
` 20 per share. For the one contract that he bought, this works out to be ` 2,000.

LOVELY PROFESSIONAL UNIVERSITY 111