Syllabus
Module 2 Forwards and Futures 13 Hours
Meaning of forward & future, Forwards Vs Futures. Mechanics of trading in futures. Futures
Contract Specification and Terminologies. Concept of Convergence Relationship between
Futures Price and Expected Spot Price, Basis and Basis Risk. Mark-to-Market process, contract
specifications, Pricing of Futures Contract, Cost of Carry Model. Speculation and Arbitrage using
Futures. Payoff Charts and diagrams for future contracts. Pricing, Hedging, Speculation and
Arbitrage. (Theory and Problems).
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Pricing the Futures
Cost of Carry Model
The fair price of a futures contract is determined by the Cost of Carry Model. It states that the
futures price should be equal to the spot price plus the net cost of holding (carrying) the asset
until the futures expiry date.
Ft – forward price at period t
S0 – Spot price of the asset at period 0
r – Risk-free rate of interest
t – Represents the life of the forward contract
Problem 1
Calculate forward price of a share which is selling today at Rs.500, if t = 3 months and r =
10%
Problem 2
Assume the spot price of an asset is Rs. 1,200 and the only carrying cost is borrowing money
at 11%. What is the fair price of one year forward contract?
Problem 3
Sivam Securities need to purchase a security in 75 days. It expects security prices to rise by
that time, it decided to hedge this risk by buying the security forward. The spot price of the
asset is Rs.5,000, if the interest rate is 7.5% p.a. calculate the price of the 75 day and 90 day
forward for the security. Which contract should it use for its purpose?
Problem 4
A one year long forward contract on a non-dividend paying stock is entered into when the
stock price is Rs.140 and risk free rate of interest is 7.5% p.a. Using arbitrage argument
establish forward price. What transaction is undertaken if the forward price is Rs.148?
Alternatively if the forward trading price is 165, what strategy would be adopted by the
trader?
Calculation of forward price when there is known income
Note: – this is the case when the underlying asset pays income at discrete points in time over the life
of the asset. Usually, the income is accrued over a specific period and is paid at the end of the period;
for example, coupon paying bonds. Here, interest accrues daily and is added to the clean/traded price
of the bond at settlement. If the holder sells the bond before coupon date, he will receive accrued
interest since the last payment date. In such case formula to calculate forward price of the asset is as
follows.
( )
I = known Income
Problem 5
Consider a long forward contract to purchase a coupon bearing bond whose current price is Rs.900.
Assume that forward contract matures in 9 months and coupon payment of Rs.40 after four months.
Risk free rate of return 3% . Calculate forward rate.
Practice problem
Consider a long forward contract to purchase a coupon bearing bond whose current price is Rs.540.
Assume that forward contract matures in 6 months and coupon payment of Rs.20 after two months.
Risk free rate of return 4% . Calculate forward rate.
Consider a long forward contract to purchase a coupon bearing bond whose current price is Rs.1200.
Assume that forward contract matures in 8 months and coupon payment of Rs.50 after two months.
Risk free rate of return 8% . Calculate forward rate.
Problem 6
You are considering an opportunity to buy a commercial space as an investment for Rs.10lakh today
or the same can be purchased at 11lakh after one year. If the commercial space can be leased out at
Rs. 1,25,000, would rather buy it today or after one year if the interest rate is 10%. Assume interest
and rent is paid at the end of the year.
Problem 7
Mr. X is considering a long forward contract to purchase a coupon bond whose current price is Rs.900
maturing in 5 years. The forward contract matures in one year. The coupon payment of Rs.40 are
expected after 6 months and 12 months and risk free interest rate are 9% and 10% respectively. What
strategy arbitrageur adopt if the forward rate is Rs. 930
Problem 8
You are contemplating to buy a futures (with a 3 month maturity) contract on a stock that is currently
trading at Rs.135. If the stock does not pay any dividends, how much will you pay if the T bill yield is
6%.
Problem 9
For the above data by the end of the day if the contract calls for delivery of 1,500 shares and
if the margin is Rs.42,000, what is the rate of return earned by the investor if (a) the share
price drops by 2% (b) the share price appreciates by 3%.
Problem 10
PTC ltd., futures trade on NSE as one, two and three-month contracts. The market price of
PTC ltd., is Rs.140 and it is giving dividend of Rs. 10 per share after 15 days of purchasing
the contract. If Money can be borrowed at 10% per annum compounded continuously, what
will be the price of a unit of new three-month futures contract on PTC ltd?
Problem 11
A six-month forward contract on security where 4% p.a. dividend is expected. The risk free
interest is 10% p.a. The assets current price is Rs.300
Problem 12
An Index quoting in the spot market at 16,128. If money can be invested at 11% p.a.
compounded continuously, what is the fair value of a one-month futures contract on this
Index?
Problem 13
Calculate the value of a futures contract using the following data:
Spot value of index = 16,128
Time to expiration = 76 days
Contract Multiplier = 25
Risk-free rate of return = 8% p.a compounded half yearly
Problem 14
Nifty futures trade on NSE as one, two and three-month contracts. With the following details
calculate what will be the price of a new two-month futures contract on Nifty?
a. HINDALCO will give a dividend of Rs.20 per share after 15 days from today, it has
8% weight in Nifty and currently trading at Rs.346.
b. Current value of Nifty is 16,128 and Nifty trades with a multiplier of 25.
c. Money can be borrowed at a rate of 10% p.a Compounded continuously.