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DERIVATIVES –

FUTURES

A. Compounding –
a. Annual Compounding

A = P (1 + r) n

b. Other Compounding

A = P (1 + r/m) mxn

c.Continuous Compounding

A=Pxe rxt
(e = 2.71828)

B. Discounting –
a. Annual Discounting

P= A
(1 + r) n

b. Other Discounting

P= A
(1 + r / m) nxm

c.Continuous Discounting

A=Pxe –r x t

C. Equivalent Rates
a. Normal Compounding to Continuous
Compounding –

r2 = m x loge 1+ r1
m
r2 = continuous compounding rate;
r1 = normal compounding rate;
m = frequency of compounding;

b. Continuous Compounding to
Normal Compounding rates

r1 = m [e m
– 1]
Futures –
a. Basis = Futures price less Spot price
b. Pricing of Forwards and Futures
Contract

Principle:
AFP v/s Valuatio Spot Borrow / Forward
FFP n Invest
AFP < FFP Under Sell Invest Buy
AFP > FFP Over Buy Borrow Sell
Situation 1: Securities providing no
income

F = S0 × e rt

Situation 2: Securities providing known


cash income

F = (S0 – I) × e rt

I=Y×e –rt

Situation 3: Securities providing known


yield

F = S0 × e (r-y) × t

Situation 4: Carry Type Commodity

F = (S0 + S) × e r×t

e.g. gold, silver, etc. i.e. investable commodity.


Situation 5: Non - Carry Type
Commodity

F = (S0 + S) × e (r-c) × t

e.g. wheat, rice etc. i.e. consumable commodity.

c.Hedging existing portfolio by Index


Futures
a. Under Bullish market
i. Object –to increase beta value of
portfolio.
ii. Action – Buy index futures
iii. Logic – in a bullish market, when
prices are rising, futures contract
will freeze the purchase price. This
will ensure that inspite of the
increasing price, the purchase
price is fixed.
iv. No. of Contracts to be purchased –
= Portfolio Value x [Desired Value
of –
of the Portfolio] ÷ Value of a
Futures Contract

This formula can also be used to


reduce the Beta and find the no. of
contacts on that reduced no. of
beta.

Vp = Value of the portfolio


Vf = Value of a future contract
βn = Desired or Required Beta.
(Higher the beta more the
reaction)
βe = Beta of Portfolio.

v. Illustration –
Vp = 1,00,000; β of Portfolio =
1.20; Market is bullish and
expected to grow @ 10%; with
market respect, portfolio will grow
@ 12%
[ market growth x β]. If the
investor wants the portfolio to
grow twice faster than the
market.]
To hedge a person should buy =
1,00,000 x [2.00 – 1.20]
= 80,000 should be invested in
futures.

b. Under Bearish market


i. Object – To decrease β value of the
portfolio.
ii. Action – Sell Index Futures
iii. Logic – In a bearish market, when
prices are dropping, Futures are
entered into to freeze the selling
prices.

c.Hedge Ratio –
It is a ratio allows the hedger to
determine the no. of contracts that
must be employed in order to
minimize the risk combined in cash
and future position. It is the β of the
stock in the cash market, with
reference to the Future Price.
Hedge Ratio =

= SD of change in spot price


= SD of change in futures price
= Co-relation between change in spot
and futures.

d. Relevance of β value
i. β value is the sensitivity of the stock to
be hedge to the change in the value of
index.
ii. It is also equal to the number of units
of Index Futures required to hedge one
unit of the stock.
iii. High beta or low beta value is not
the sole factor determining the
choice of a cross hedge. If
however, transaction costs are
high, and low beta index may be
preferred.

e. Correlation
Choice of the perfect cross hedge should
be based on the correlation between the
prices of the stock to be hedged and the
index used as cross-hedge. Higher the
correlation with the index, better the index
for cross hedging.

Related Nifty Infra Iron & Steel Bank


Index Index Index Index
Beta of X 0.8 1.1 1.3 1.0
Correlation of 0.6 0.9 0.6 0.3
X
No. of units X 1000 500 1000 1250
underlying
every future
contract of
index
Ranking / 2 1 3 4
Preference

f. Logarithms and Exponentional


A logarithm often called a log is an
exponent representing the power to which
one number: The two most commonly used
base number are 10 and e is a special
number such as 25. Its log are as follows –

Log10 25 = 1.3979 (the log of the base 10


of 25)
Loge 25 = 3.2189 (the log of the base e of
25)

We can verify the results as follows –


101.3979 = 25
2.718283.2189 = 25

Logs using 10 as a base is called common


logs;
Logs using e as a base is called natural
logs;

The log of a positive no. is a positive.


The log of a negative number is undefined.
The log of zero is undefined.
The log of I is zero.
The log of a no. between zero and 1 is
negative.
Laws of Logarithms –
i) log (m x n) = log m + log n
ii) log (m ÷ n ) = log m – log n
iii) log (m n) = n x log m
iv) log a m = log x m
log x a
log 10 100 = log e 100
log e 10

How to determine logarithms of a given


number?
If X is a positive real number then log x can be
written as
log x = characteristic of x + mantissa of x.
Characteristic is an integer that can be
positive or negative depending on whether x >
1 or 0 < x <1.
Mantissa of x has to be read from the log table.
How to determine the characteristics of a
number?
If x > 1, then count the number of digits
from left hand side. If the no. of digits is y, then
characteristics = (y-1).
If x<1, then count the number of zeros
appearing in the right side of the decimal point,
if the no. of zeros is z then the characteristics
is ñ (z+1). This is also written as (z + 1) read
as (z +1) bar.

How to determine the mantissa of a


number?
Log table consist of rows that go from 10 to 99.
The columns have values from 0 to 9. Beyond
the ten columns, there are additional columns
named as mean difference. For determining
the mantissa, a particular row has to be read
off and the mean difference needs to be
added. The following has to be remembered –
• Mantissa is usually a 4 digit no., and it
comes after the decimal point.
• While considering mantissa, the decimal
point has to be ignored.
• Most of the log tables give value of
mantissa up to 4 digits only. For more than
a 4 digit number, we have to round off the
last digit.
Number Characteri Mantis Logarithm
stic sa
9887 3 0.9951 3.9951
988.7 2 0.9951 2.9951
98.87 1 0.9951 1.9951
9.887 0 0.9951 0.9951
0.9887 -1 0.9951 -1+0.9951 =
0.0049
0.09887 -2 0.9951 -2+0.9951 =
-1.0049
0.00988 -3 0.9951 -3+0.9951=-
7 2.0049
0.00098 -4 0.9951 -4+0.9951=-
87 3.0049

Anti- Logarithms
Anti-Log is exactly opposite of Logarithms of
a number.
If x = log b, then antilog (x) = b.
Anti-log table for base 10 table is readily
available. Anti-log tables are used for
determining the inverse value of the
mantissa. From the characteristics, the
position of the decimal point can be
determined.
Anti-log table consist of rows that go from .
00 to .99. The columns have values 0 to 9.
Beyond the 10 columns, there is another
column which is mean difference. For
determining the antilog of the numbers after
the decimal point, a particular row has to be
read off and the mean difference is to be
added.

Rules –
• You find the anti-log of mantissa only.
• The characteristic is used to place the
decimal to left or right of the number you
get from the antilog table.
• If the characteristic is x, x ≥ 0, then
place decimal x + 1th place to the right.
Treating the first digit as the zero
position.
• If the characteristic is x, and x < 0, the
place the decimal x + 1th place to the
left. Treating the first digit as the zero
position.