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CA Final Strategic Financial Management, Paper 2, Chapter 5

CA Tarun Mahajan
Derivatives

Forwards

Futures basic

Speculation using futures

Hedging using futures

Arbitrage using futures


Derivative is something which does not have its
own existence and value.

Its value is dependent upon value of some


other item called underlying.

A non financial example of derivative is Curd.

Another example is mutual fund units.

Another example could be forward contract on


foreign exchange.
Forwards

Futures
Derivatives
Options

Swaps
It is a contract to buy/sell on a
specified future date, at a
predetermined rate.

Following things are fixed in


advance in a forward contract:
Underlying
Quantity
Quality
Settlement date
Rate
Buyer in a forward contract
is called long.
And his position is called
long position.
When price goes up
beyond the contracted
price, Long makes a gain.
Seller in a forward contract
is called short.
And his position is called
short.
When price goes down
below the contracted price,
Short makes a gain.
All derivatives are zero sum
games.
If long makes a gain, short loses
and vice versa.
Forwards are over the counter
contracts hence
These can be customized as per the
requirements of parties.
Counterparty risk exist.
Futures are exchange regulated forward contracts.

Following are points of differences:


Forward Future

Over the counter Exchange traded


Customized Standardized
Less liquid More liquid
No margin Margin is required
Counterparty risk exists No counterparty risk
Following things are standardized in a future contract:

Underlying Lot size Quality Expiry date Tick size


On 22nd April I agree to buy 125 shares (1 lot) of Infosys Ltd. for
30th May at a price of Rs. 2250 at NSE and you are the seller.

Here my position is long and your position is short.

NSE is the counterparty for both of us.

If on 30th May price rises to Rs.2300 you will pay me Rs.50 x


125 = Rs.6250.

But if it falls to Rs.2220, I will pay you Rs.30x125 =Rs.3750


Speculation: taking risk
in anticipation of gain.

Any derivative contract


Hedging: passing on
can be used for one of
risk to have a fixed
the following three
outcome.
purposes:

Arbitrage: making gain


from disequilibrium
between spot and
future price.
Bullish: Long future
Bearish: Short future
Example: say today it is 22nd April and spot gold
price is Rs.26,000 and I think that within a month
or two It will rise to 28,000 level.
Then I can long 1kg (1 lot) of gold future say at
Rs.26465 per 10 grams for expiry of 5th June.
If on 5th June gold price rises to 27,000 then I will
have a profit Rs.535 (27000-26465) per 10 grams,
totaling Rs.53,500.
Have Stock, Short stock future

If you have 500 shares of RIL and want to sell it in June


end, then you can short 2 lots (lot size 250) of RIL say at a price of
Rs.790. Now even if price falls you will realize Rs.790 per share.

Have Money, long stock future

If you want to buy 125 shares of SBI in May end, then you can long 1
lot (lot size 125) of SBI today at a price of 2290. Now even if price
rises, you will have to pay only Rs.2290 per share.
If stock futures are not available then
one can hedge through index futures also.
But it will hedge market related risk only, not
the total risk.
Index position = stock position x stock beta.
Example: if you have 10000 shares of
ONGC. Current price = Rs.330; Beta = 0.80.
Here you can short Nifty futures of 10000 x
330 x 0.80 = Rs.26,40,000.
Next month Nifty future is available at 5855 and lot
size is 50 hence one lot will be worth 2,92,750.

No. of lots = 26,40,000/2,92,750 = 9.02 lots, approx.


9 lots.

Now if market comes down by 10%:


Short Nifty will give you profit of 585.5x50x9 = 263475.
ONGC should fall only 8% (10% x 0.8) hence a loss of 330 x
8% =26.4, 26.4 x 10,000 = 2,64,000
A Mutual fund is holding the following assists in ` Crore :
Investment in diversified equity shares 90.00
Cash and bank Balances 10.00
100.00
The Beta of the portfolio is 1.1. The index future is selling at
4300 level. The Fund Manager apprehends that the index will
fall at the most by 10%. How many index futures he should
short for perfect hedging so that the portfolio beta is reduced
to 1.00? One index future consists of 50 units.
Substantiate your answer assuming the Fund Manager's
apprehension will materialize.
Short position required in index future = 100cr. (1.10-1) = 10cr.

Amount of one lot of index future = 4300 x50 = Rs.2,15,000

No. of futures = 10cr./215000 = 465 lots

Now if Index falls by 10% then there will be profit in index future of
Rs.430x50x465= 1cr.

Value of portfolio = 100cr -11% = 89 cr.

Total amount 90cr. Which is 10% hence beta of portfolio is 1.


Ideal Future Price = Spot Price + Cost of Carry
Cost of Carry includes mainly risk free interest
rate.
For stocks, dividend is a negative carrying cost.
For commodities it includes storage cost also.
rt
A simple formula is F = S x e
rt
With dividend F = S x e D x erm
rt
With Storage Cost, F = = S x e + C x erm
S=Spot price, r= risk free interest rate, t=no. of
year till expiry, m= no. of years from dividend to
expiry
Say spot price of TCS is Rs.1425, risk free rate is 6% p.a.
hence 6 months ideal future price = 1425 x e0.06 x 0.5 = 1425 x
1.0305 = 1468
Note that:
If actual future price is more say Rs.1490 then
one can make arbitrage profit as follows.

Particulars Today Expiry Date

Rs. 1000 Rs.2000

Short Future @1490 - 490 -510

Buy Spot -1425 1000 2000

Borrow Money 1425 -1468 -1468

Net 0 22 22
The share of X Ltd. is currently selling for
Rs.300. Risk free interest rate is 0.8% per
month. A three months futures contract is
selling for Rs. 312.

Develop an arbitrage strategy and show


what your riskless profit will be 3 month
hence assuming that X Ltd. will not pay any
dividend in the next three months. (4 Marks)
F = 300 (1.008)3 = 307.26.

Actual price is 312, means future is overvalued.

Particulars Today Expiry Date

Rs. 200 Rs.400

Short Future - 112 -88


@312
Buy Spot -300 200 400

Borrow Money 300 -307.26 -307.26

Net 0 4.74 4.74


Spot price of TCS is Rs.1425, risk free rate is 6% p.a.
and company is expected to give dividend of Rs.10 per
share after 2 months hence 6 months ideal future price

= 1425 x e0.06 x 6/12 - 10 x e0.06 x 4/12

= 1425 x 1.0305 10 x 1.0202 = 1458

In case of commodities we add storage cost similar to


we have deducted dividend in above formula.
Contracts deriving value from other items
are derivatives. Forwards are over the
counter derivative contracts

Futures are exchange traded forwards

Speculation with futures give leverage

Index can also be used to hedge stock


positions

Arbitrager not only makes profit but also


establishes equilibrium.
CA .Tarun Mahajan,
tarunmahajanca@gmail.com