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FUTURES AND OPTIONS- 19COP27
II M.Com A
Google Classroom Code: fg7nbt5
Unit 1 – Lecture 3
Facilitator
Svetha G
Assistant Professor
Department of Commerce
Topics covered
1. FEATURES OF FUTURES
2. SPECIFICATIONS OF A FUTURES CONTRACT
3. TYPES OF FUTURES
4. CONVERGENCE OF FUTURE PRICES TO SPOT PRICE
5. UNDERSTANDING CONVERGENCE
6. ARBITRAGE
7. CONTANGO AND BACKWARDATION
Features of futures
Futures are traded on the floor of an organized exchange.
Futures contracts are standardized with respect to quality
and quantity of underlying asset, the expiry date and when
and where and how delivery is made.
It is not a bilateral agreement .
There is a clearing house for each futures exchange.
There is a margin system. The default risk is undertaken by
the clearing house.
The trader who promises to buy is said to be in ‘long
position’ and the one promises to sell is said to be in ‘short
position’. Both parties pay margin to the clearing house.
Futures contracts are mostly cash settled.
There is no counter party risk.
Specifications Of A Futures Contract
1. Underlying asset: The underlying asset may be a
commodity or financial asset. Futures contracts are
normally specified by the name of the underlying asset and
month and year of the expiry of the contract.
2. Contract period: This relates to the time when the
contract expires. The exchange specifies when the contracts
for delivery in a particular month will come into force and
when will it close for trading.
3. Contract size: Contract size or trading unit refers to the
standard contract size that will be traded on the exchange. It
is the amount of asset that has to be delivered under one
contract.
4. Price quotation: Quotation is the basis of price. It is not
the value of futures contract. Eg :- the price quotation for
futures contract on rice is rupees per quintal.
5. Tick size: This is the minimum change that will be
recognized in the price quotation. It is the minimum difference
between two quotes of a similar nature.
6. Price limit: These are the limits on the maximum price
variation permitted in a day’s trading.
7. Position limits: There are limits upon the maximum
number of contracts an individual client or a member broker
may hold. This is specified by futures exchange. The purpose
is to avoid any concentration of business in the market place.
8. Spot price: This is the price at which an asset trades in the
spot or current market. It is also called cash price or current
price.
9. Futures price: This is the price at which the futures
contracts trades in the futures market.
10. Expiry date: this is the date specified in the futures
contract. This is the last day on which the contract will be
traded. At the end of this, it will cease to exist.
11. Basis: this is the futures price minus the spot price. In
a normal market, basis will be positive. This means that
futures prices normally exceed spot prices.
12. Trading cycle: The futures contract will have a
maximum of 3 month trading cycle- The near month(one), The
next month(two), and the Far month(three). New contract will
be introduced on the next trading day following the expiry of
near month contract.
13. Cost of carry: This measures storage cost plus the
interest that is paid to finance the asset less income earned on
the asset.
14. Open interest: open interest is the number of futures
contracts outstanding. It is the number of open contracts or
contracts remaining to be settled(unsettled).
15. Long and Short positions: There are two parties to
every futures contract- A buyer and a seller. The act of buying a
futures contract is characterized as going long on the contract.
The act of selling a futures contract is similarly characterized as
going short on the contract. The buyer is said to have a long
position and the seller is said to have a short position.
Types Of Futures
1. Commodity futures:
• A commodity futures is an exchange traded contract
to buy or sell standardized physical commodities for
delivery on a specified future date at an agreed price.
• In the case of commodity futures, the underlying
asset is a commodity.
2. Financial futures:
• Financial futures are standardized, legally enforceable
forward contracts traded on exchanges called futures
exchanges.
• Here financial assets or instruments are underlying
assets.
Financial futures are further classified into
4:
1. Currency futures: Currency futures are those where the
underlying assets are currencies.
2. Stock futures: Stock futures are those where the
underlying assets are stocks.
3. Interest rate futures: These are the futures where the
underlying assets are interest rates.
4. Index futures: Index futures are those where the
underlying assets are stock indices such as BSE Sensex or
Nifty.
CONVERGENCE OF FUTURE PRICES TO
SPOT PRICE
Convergence is the movement of the price of a futures
contract toward the spot price of the underlying cash
commodity as the delivery date approaches.
It simply means that, on the last day that a futures contract
can be delivered to fulfill the terms of the contract, the price of
the futures and the price of the underlying commodity will be
nearly equal.
The two prices must converge. If not, an arbitrage
opportunity exists and the possibility for a risk-free profit.
Understanding Convergence
Convergence happens because the market will not allow
the same commodity to trade at two different prices at the
same place at the same time.
For example, you rarely see two gasoline stations on the
same block with two very different prices for gas at the pump.
Car owners will simply drive to the place with the lower price.
In the world of futures and commodities trading, big differences
between the futures contract (near the delivery date) and the price of
the actual commodity are illogical and contrary to the idea that the
market is efficient with intelligent buyers and sellers.
If significant price differences did exist on the delivery date, there
would be an arbitrage opportunity and the potential for profits with
zero risk.
Arbitrage
Arbitrage is the process of simultaneous purchase of securities
or derivatives in one market at a low price and sale of the same
in another market at a relatively higher price.
The traders who are engaged in arbitrage is known as
arbitrageurs.
These are done when the same securities are being quoted at
different prices in two markets.
The motive of arbitrageur is to make profit from difference in
prices of securities prevailing in the two markets.
They take advantage of the mismatch in the price levels in
two markets.
They are constantly monitoring the prices of different
assets to make profit that arise from mispricing of products.
The arbitrageurs aim is to make riskless profit by
simultaneously entering into transactions in two or more
market imperfections.
These imperfections cannot exist for long time.
These are extremely short – lived.
The arbitrageurs cashes upon these short-lived
opportunities.
Contango and Backwardation
If a futures contract's delivery date is several months or years in
the future, the contract will often trade at a premium to the
expected spot price of the underlying commodity on the delivery
date. This situation is known as contango or forwardation.
As the delivery date approaches, the futures contract will
depreciate in price (or the underlying commodity must increase in
price), and in theory, the two prices will be equal on the delivery
date. If not, then traders could make a risk-free profit by
exploiting the difference in prices.
The principle of convergence also applies when a
commodity futures market is in backwardation, which
happens when futures contracts are trading at a discount to
the expected spot price.
In this case, futures prices will appreciate (or the price of
the commodity falls) as expiration approaches, until the prices
are nearly equal on delivery date.
If not, traders could make a risk-free profit by exploiting any
price difference via arbitrage transactions
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