Page 172 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 12: Risk Management with Derivatives I

and expects its price to go up in the next two-three months. How can he trade based on this Notes
belief? In the absence of a deferral product, he would have to buy the security and hold on to it.
Assume he buys a 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.
Case 2: 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. 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 contact 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.
12.4.2 Arbitrage using Futures

Arbitrage refers to riskless profit earned by taking positions in spot/futures markets. Following
are two of the primary benefits that an arbitrageur can obtain using futures contracts.

1. Arbitrage: Overpriced futures: Buy spot, Sell futures: As we discussed earlier in pricing of
futures, the cost-of-carry ensures that the futures price stay in tune with the spot price.
Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise.
If you notice that futures on a security that you have been observing seem overpriced, we
would illustrate as to how to obtain riskless arbitrage profits.

Example: Say for instance, SBI trades at ` 1,000. One-month SBI futures trade at ` 1,025
and seem overpriced. As an arbitrageur, you can make riskless profit by entering into the
following set of transactions:
1. On day one, borrow funds; buy the security on the cash/spot market at 1,000.
2. Simultaneously, sell the futures on the security at ` 1,025.
3. Take delivery of the security purchased and hold the security for a month.

4. On the futures expiration date, the spot and the futures price converge. Now unwind the
position.

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