Page 50 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 4: Future Contracts

Notes

Notes Hedging: Long Security, Sell Futures
Take the case of an investor who holds the shares of a company and gets uncomfortable
with market movements in the short run. He sees the value of his security falling from `
450 to ` 390. In the absence of stock futures, he would either suffer the discomfort of a price
fall or sell the security in anticipation of a market upheaval. With security futures he can
minimize his price risk. All he need do is enter into an offsetting stock futures position, in
this case, take on a short futures position. Assume that the spot price of the security he
holds is ` 390. Two-month futures cost him ` 402. For this he pays an initial margin. Now
if the price of the security falls any further, he will suffer losses on the security he holds.
However, the losses he suffers on the security will be offset by the profits he makes on his
short futures position. Take for instance that the price of his security falls to ` 350. The fall
in the price of the security will result in a fall in the price of futures. Futures will now trade
at a price lower than the price at which he entered into a short futures position. Hence his
short futures position will start making profits. The loss of ` 40 incurred on the security he
holds, will be made up by the profits on his short futures position.
Self Assessment

State the following are true or false:
12. When the index moves up, the long futures position starts making losses.
13. The payoff for a person who sells a futures contract is similar to the payoff for a person
who shorts an asset.

4.5 Cash Settlement vs Physical Settlement

Settlement is the act of consummating the contract, and can be done in the following ways:
1. Physical delivery: The amount specified of the underlying asset of the contract is delivered
by the seller of the contract to the exchange, and by the exchange to the buyers of the
contract. Physical delivery is common with commodities and bonds. In practice, it occurs
only on a minority of contracts. Most are cancelled out by purchasing a covering position-
that is, buying a contract to cancel out an earlier sale (covering a short), or selling a
contract to liquidate an earlier purchase (covering a long). This form of settlement involves
delivery of contract, and is most popular in commodity futures. The party with the short
position (seller) sends a notice of intention to the exchange who then selects a party with
outstanding long position to accept the delivery.

2. Cash settlement: Cash payment is made based on the underlying reference rate, such as a
short term interest rate index such as Euribor, or the closing value of a stock market index.
This is mostly used for settling stock indices futures. Stock indices cannot be delivered
physically. This is because that will involve transaction in constituent stocks (underlying
the index) in various proportions, which is not practically possible and involves higher
transaction cost. On expiry of the settlement period, the exchange sets the final settlement
price equal to the spot price of the asset on that day. For example, suppose an investor
takes long position in near month NSE Nifty Futures with delivery price at 3100. On
maturity, if the index is at 3200 with near month short futures at 3225, then the investor
gains ` 100 through cash settlement.

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