Derivatives for CFP – 2

Relevance of futures market:

• Quick and low cost transactions
• Price discovery function (fair idea of future demand and supply)
• Advantage to informed individuals (Impart efficiency to the price)
• Hedging advantage

 Futures trading

Advantages	Disadvantages
1. Leverage : Smaller cash outlay i.e. Only margin amount	1. Risk : Trading loss more than initialinvestment
2. Ease of Short Selling: It is possible to sell futures without possessing the underlying	2. No stockholder privileges : No voting rights and no rights to dividends
3. Flexibility : Can use the instrument to speculate, hedge, spread or othersophisticated strategies	3. Required vigilance : Require investor to monitor their position because of marked to margin and margin call

Payoff for a buyer of Nifty futures:

The investor bought futures when the index was at 2220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses.

Example and Picture Source: NCFM Books, www.nseindia.com

Payoff for a seller of Nifty futures:

The investor sold futures when the index was at 2220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.

Example and Picture Source: NCFM Books, www.nseindia.com

Options:

For Options terminology and strategies, I will recommend the following book of NSE:

Click to download: option trading strategies module

 I will publish the relevent questions for the CFP exams on derivatives soon.

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Derivatives for CFP – 1

Forwards

A forward contract or simply a forward is a contract between two parties to buy or sell an asset at a certain future date for a certain price that is pre-decided on the date of the contract.

 

Features of Forwards:

1. The price fixed now for future exchange is the forward price.
2. The party with a “long position”(“Short position) will be the buyer(seller) of the underlying asset or commodity.
3. Custom tailored
4. Traded over the counter (not on exchanges)
5. No money changes hands until maturity
6. Counter-party risk

Settlement of Forward Contracts:

1. Physical Settlement
2. Cash Settlement

Futures

Like a forward contract, a futures contract is an agreement between two parties in which the buyer agrees to buy an underlying asset from the seller, at a future date at a price that is agreed upon today. However, unlike a forward contract, a futures contract is not a private transaction but gets traded on a recognized stock exchange. Futures contract is standardized by the exchange.

 

Features:

1. Standardized contracts in terms of:
• Underlying commodity or asset
• Quantity
• Maturity, delivery date and delivery terms
2. Exchange traded
3. Guaranteed by the clearing house — no counter-party risk
4. Gains/losses settled daily
5. Margin account required as collateral to cover losses

 Margins:

Initial Margin: The payment which investors have to pay to a broker to trade on margin, commonly used in trading futures and contracts for difference. Initial margin is usually set at a percentage of the value of the contracts being traded.

Maintenance Margin: The lowest balance of funds that a broker will allow a counterparty to maintain when trading on margin.

Variation Margin: Profits and losses on open futures contracts, which are revalued daily at the settlement price, which are subsequently paid to or received from the clearing house.

 

Basis:

The difference between the current cash price and future price is defined as basis.

Basis = Current cash price – Futures price

Negative basis refers to Contango market where futures prices are higher than cash prices. Positive basis refers to backwardation market where futures prices are lesser than cash prices.

 

References:

www.nseindia.com

NCFM Books of NSE.