What is Speculation/Hedging/Arbitrage?
In â€œKnowledge Center: Learning Derivatives - Session Iâ€, we gave a brief introduction of derivative contracts. What are forward and future contracts? What is the difference between the two? How they can be used for hedging and speculative purposes? What are Call and Put Options and how they permit non-linear payoffsâ€¦ and so on.
In “Knowledge Center: Learning Derivatives - Session I”, we gave a brief introduction of derivative contracts. What are forward and future contracts? What is the difference between the two? How they can be used for hedging and speculative purposes? What are Call and Put Options and how they permit non-linear payoffs… and so on. In this session, we will dwell further into the functioning of Future contracts.
A future contract is a standardized contract to buy or sell an underlying on a specified date for a pre-determined price and is traded on an exchange. The basic utility of the product is that it helps in managing the price risk of the underlying. Let us now understand the pay-off of future contracts.
Let us take an example of Reliance Industries, whose lot size is say 75 and the current market price is Rs 1200. Suppose Mr A is LONG 1 lot of Reliance Industries February Future at Rs 1220 (meaning that he has agreed to buy 75 shares of Reliance Industries on 26th Feb 2009 at a price of Rs 1220). On the other hand, Mr B is SHORT 1 lot of Reliance Industries February Future at Rs 1220 (meaning that he has agreed to sell 75 shares of Reliance Industries on the expiry date of 26th Feb 09 at a price of Rs 1220).
1. Payoff for Long position (Mr A): A has agreed to buy 75 shares of Reliance Industries on expiry at a rate of Rs 1220 per share. If on the expiry date, the actual price of Reliance Industries is Rs 1300, he can buy the shares at Rs 1220 and sell them at Rs 1300, thereby gaining Rs 80 per share (Total = 80 x 75 = Rs 6000). If however, the price on expiry is Rs 1150, he will have to bear a loss of Rs 70 (Rs 1220 - Rs 1150) per share (Total = 70 * 75 = Rs 5250)
2. Payoff for Short position (Mr B): B has agreed to sell 75 shares of Reliance Industries on expiry at a rate of Rs 1220 per share. If on the expiry date, the actual price of Reliance Industries is Rs 1300, he has to sell the shares at Rs 1220 but will have to buy the shares at Rs 1300, thereby making a loss of Rs 80 per share. If however, the price on expiry is Rs 1150, he will gain Rs 70 per share
An important thing to note here is that all the transactions in stock and index futures are currently cash settled in India and hence no actual buying/selling of the underlying has to be done on expiry. Had it not been the case, it would have been quite difficult to give actual delivery where the underlying is an index number (say Nifty), as all the stocks in Nifty had to be delivered physically in the same proportion.
1. Speculation: Future contracts are extremely attractive for speculators as they provide tremendous leverage. By paying a small margin amount, speculators can take higher exposure of the underlying, thereby increasing their reward potential as well as the risk. A person who is bullish on the price of the underlying can BUY a future contract while a person who is bearish would SELL the future contract.
The above images illustrate the use of leverage in normal life by which less effort is required to lift a weight. In Future contracts, leverage means that instead of paying the full amount to buy the underlying in the cash market, the same exposure can be taken by paying only a smaller margin amount. However, it must always be kept in mind that financial leverage also increases the risk significantly and must be used judiciously.
3. Hedging: Hedging is an act of protecting or guarding the investment against an undesired price movement. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lacs. Although he is optimistic about the stocks he has in the portfolio, he is not very comfortable with the overall movement of the market. The price movement of a stock is dependent both on the micro (profitability of the company, its growth potential, business model, management competency etc) and the macro factors (GDP growth of the country, interest rates, overall state of economy etc). Such an investor can hedge his portfolio by selling Index Futures (like Nifty future) and thereby removing the risk of macro variables from his portfolio.
Another way to hedge using future contracts is by buying the futures of an index/stock when the cash to buy the underlying would be available on a future date. Say a person is sure to receive cash inflows of Rs 5 lacs in 2 months’ time, which he wants to, invest in stocks. However, he is very bullish on the markets and wants to invest as early as possible. What can he do? He can simply pay the margin amount and take the relevant LONG exposure in future contracts. This will hedge him from the risk of losing out on the profits if market were to go up in the next 2 months. It must be noted here that hedging does not necessarily mean reduced possibility of losses. Like the long term investor we discussed above might lose on both cash and futures positions if market moved up while his stocks fell!
3. Arbitrage: An arbitrageur gains by buying the stock and going short in its future contract when the price of the future contract is higher than its theoretical price. When the price of the future contract is less than what it should be, the arbitrageur gains by going long in the future contract and selling the underlying in cash market. In the next section, we see what is the theoretical price of a futures contract?
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