Page 118 - DCOM510_FINANCIAL_DERIVATIVES

Unit 7: Application of Futures Contracts

6. The futures position expires with a profit of ` 10. Notes
7. The result is a riskless profit of ` 25 on the spot position and ` 10 on the futures position.
If the returns you get by investing in riskless instruments are lesser than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse–cash-and-carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost of carry. As we can see, exploiting arbitrage involves trading on the spot market. As
more and more players in the market develop the knowledge and skills to do cash-and-carry
and reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as
well as the derivatives market.

Task On Monday morning, an investor takes a long position in a pound futures contract
that matures on Wednesday afternoon. The agreed-upon price is $1.70 for £62,000. At the
close of trading on Monday, the futures price rises to $1.72. At Tuesday close, the price
rises further to $1.73. At Wednesday close, the price falls to $1.71 and the contract matures.
The investor takes delivery of the pounds at the prevailing price of $1.71. Detail the daily
settlement process. What will be the investor’s profit (loss)?

Self Assessment

Fill in the blanks:

10. There are three major categories of people who use futures: hedgers, ………………………
and ………………………
11. Applied to stock market, hedging means eliminating the risk in an ………………………

12. ……………………… minimizes risk for a given amount of return (or, alternatively,
maximizes return for a given amount of risk).
13. The ……………………… is the ratio of the size of the position taken in futures contracts to
the size of the exposure.
14. Simple arbitrage ensures that futures on an ……………………… security move
correspondingly with the underlying security.
15. ……………………… refers to riskless profit earned by taking positions in spot/futures
markets.

7.4 Futures Application

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade.
The main advantage of participating in a futures contract is that it removes the uncertainty about
the future price of an item. By locking in a price for which you are able to buy or sell a particular
item, companies are able to eliminate the ambiguity having to do with expected expenses and
profits. The focus of this section is on the basic application related to the future contracts.

7.4.1 Passive Management: Index Fund

Index Futures are futures contracts with indexes as their underlying asset. NSE trades Nifty
Futures with one month, two month, three month expiry cycles. All contracts expire on the last
Thursday of every month. On the Friday following the Thursday a new contract having
3 months expiry would be introduced for trading. Index futures are futures contracts with an

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