Page 63 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 5.5 Summary

 This unit begins with a short review of the basics of futures contracts for clear understanding
of futures pricing.

 Futures contracts are like forward contracts, except that price movements are marked-to-
market each day rather than receiving a single, once-and-for-all settlement on the contract's
expiration day.
 The relationship between the futures market price and the cash price is called basis.
 The unit makes a clear distinction in pricing method used for whether the underlying
asset is held for investment or for consumption.
 The basic principle of futures pricing involve the requirement of 'no arbitrage
opportunities'.
 Cost-of-carry model is an arbitrage-free pricing model.
 Its central theme is that futures contract is so priced as to preclude arbitrage profit.
 This model stipulates that future prices are equal to sum of spot price and carrying costs
involved in buying and holding the underlying asset, and less the carry return (if any).

5.6 Keywords

Beta: Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification.
Carry Cost (CC): Carry cost is the interest cost of holding the underlying asset (purchased in spot
market) until the maturity of futures contract.

Carry Return (CR): Carry return is the income (e.g, dividend) derived from underlying asset
during the holding period.
Hedge Ratio (HR): The Hedge Ratio (HR) is the number of futures contacts one should use to
hedge a particular exposure in the spot market.
Leverage: The ratio of the value of the underlying contract to the equity invested in the money
market fund is known as the leverage.

Perfect Hedge: A perfect hedge is when the loss on your cash position is exactly offset by the gain
in the futures position.

5.7 Review Questions

1. Define the term 'Basis'. How is basis relevant in futures pricing?

2. 'Pricing of futures is based on no-arbitrage principle'. Explain this statement.
3. Explain the basic principles of cost of carry model for pricing of futures.
4. How is valuation of financial futures different from pricing of commodity futures?

5. Illustrate the valuation of stock index futures by citing an example.
6. What are the three case situations under which index futures valuation is made?
7. Discuss the importance of convenience yield in pricing commodity futures.

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