TYBMS SEM 5 : Finance: Commodity & Derivatives Market (Q.P. November 2019 with Solution)

 Paper/Subject Code: 46006/Finance: Commodity & Derivatives Market

TYBMS SEM 5 : 

Finance:

Commodity & Derivatives Market 

(Q.P. November 2019 with Solution)

Note: 1) All Questions are compulsory subject to internal choice.

2) All question carry 15 marks.

3) Use simple calculator

Q.1 (A) State weather the following statement are True or False.            (08)

1 A person buying a futures contract is said to hold a short position.

Ans: False

2 Long futures payoffs are directly related to underlying asset price.

Ans: True

3 Speculation in futures market involves higher risk as compared to holding same

Ans: True

4 position in spot market. A bearish speculator will enter into a long future contract.

Ans: False

5. Premium for an American option will generally be lower as compared to European option

Ans: False

6. Binomial model of option valuation is much more flexible as compared to Black & Scholes model.

Ans: True

7. Cash and carry arbitrage refers to a short position in the cash or underlying market and a short position in futures market.

Ans: False

8 The VAR obtained under the historical-simulation method should be the same as that under the delta normal method.

Ans: False

9 An option premium is the income received by an investor who holds the option contract.

Ans: False

10. Derivatives are mostly primary market instruments.

Ans: False

(B) Match the Column (Any 07):                        (07)

Column A	Column B
1 Hedgers	a measure of the risk of investment
2 Lot size	b Eliminates the risk
3 Time value of option	c. Public private partnership
4 VaR	d Call Option
5 Perfect hedge	e over the counter market
6 Right to Buy	f. Maturity date
7 Arbitrageurs	g. number of units of assets to be delivered
8 Option expires	h Risk Management
9. Forward Contract	i. Riskless profit
10 ICEX	j. Difference between option premium and intrinsic value

 Ans:

Column A	Column B
1 Hedgers	h Risk Management
2 Lot size	g. number of units of assets to be delivered
3 Time value of option	j. Difference between option premium and intrinsic value
4 VaR	a. measure of the risk of investment
5 Perfect hedge	b Eliminates the risk
6 Right to Buy	d Call Option
7 Arbitrageurs	i. Riskless profit
8 Option expires	f. Maturity date
9. Forward Contract	e over the counter market
10 ICEX	c. Public private partnership

 

Q.2 (A) What is derivative contract? What are its elements?

A derivative contract is a financial agreement whose value is derived from the price of an underlying asset, index, or rate. It is commonly used for hedging risks, speculation, or arbitrage.

Elements of a Derivative Contract:

1. Underlying Asset – The asset on which the derivative's value is based (e.g., stocks, commodities, currencies, interest rates, indices).

2. Contract Type – Different types include futures, options, forwards, and swaps.

3. Expiration Date – The date when the contract is settled or expires.

4. Strike Price (for options) – The predetermined price at which the holder can buy or sell the asset.

5. Contract Size – The quantity of the underlying asset covered by the contract.

6. Margin & Leverage – Many derivative contracts require a margin deposit, allowing traders to control larger positions with less capital.

7. Settlement Method – Either physical delivery (actual exchange of the asset) or cash settlement.

8. Market Type – Derivatives can be traded on organized exchanges (e.g., NSE, CME) or over-the-counter (OTC).

(B) What are the leading commodity exchanges in India & in abroad?

Commodity Exchanges in India:

1. Multi Commodity Exchange (MCX) – The largest commodity derivatives exchange in India, primarily dealing in metals, energy, and agricultural products.

2. National Commodity and Derivatives Exchange (NCDEX) – Focuses on agricultural commodities like wheat, soybeans, and pulses.

3. Indian Commodity Exchange (ICEX) – Known for trading in diamonds and other commodities.

4. National Multi-Commodity Exchange (NMCE) – Specializes in agricultural products and other commodities.

5. BSE & NSE Commodity Derivatives Segment – Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) have introduced commodity trading as well.

Major Commodity Exchanges Abroad:

1. Chicago Mercantile Exchange (CME), USA – One of the largest exchanges, dealing in agriculture, metals, and energy commodities.

2. New York Mercantile Exchange (NYMEX), USA – Specializes in crude oil, natural gas, and metals.

3. London Metal Exchange (LME), UK – A key market for trading industrial metals like aluminum, copper, and zinc.

4. Intercontinental Exchange (ICE), USA & Europe – Deals in energy, agricultural, and financial commodities.

5. Tokyo Commodity Exchange (TOCOM), Japan – Specializes in rubber, crude oil, and gold.

6. Shanghai Futures Exchange (SHFE), China – A leading exchange for metals and energy products.

7. Dalian Commodity Exchange (DCE), China – Major hub for trading agricultural commodities like soybeans and palm oil.

8. Euronext Commodities, Europe – European exchange offering trading in agricultural and industrial commodities.

OR

Q.2 (C) Explain the structure of commodities market in India.

The commodities market in India is well-structured and operates under the regulation of the Securities and Exchange Board of India (SEBI). It is broadly divided into two segments:

1. Spot Market (Physical Market)

   • Involves immediate buying and selling of commodities.

   • Transactions are settled in cash or by physical delivery.

   • Operates through mandis (APMCs), private markets, and online platforms like eNAM (Electronic National Agriculture Market).

2. Derivatives Market (Futures & Options Trading)

   • Involves trading standardized contracts for future delivery of commodities.

   • Helps in hedging, speculation, and price discovery.

   • Operates on recognized commodity exchanges.

Participants in the Indian Commodity Market

1. Hedgers – Farmers, manufacturers, and traders use commodity derivatives to protect against price volatility.

2. Speculators – Investors trade for profit by predicting price movements.

3. Arbitrageurs – Exploit price differences across markets to earn risk-free profits.

Commodity Exchanges in India

1. Multi Commodity Exchange (MCX) – Leading in energy, metals, and bullion trading.

2. National Commodity and Derivatives Exchange (NCDEX) – Majorly for agricultural commodities.

3. Indian Commodity Exchange (ICEX) – Specializes in commodities like diamonds.

4. National Multi Commodity Exchange (NMCE) – Focuses on smaller agricultural contracts.

5. BSE & NSE Commodity Derivatives Segment – Expanding commodity trading in India.

Regulatory Framework

• SEBI (Securities and Exchange Board of India) – Regulates commodity exchanges, ensuring transparency and fair trade.

• FMC (Forward Markets Commission) [Merged with SEBI in 2015] – Previously regulated the commodity derivatives market.

• APMC Act (Agricultural Produce Market Committee Act) – Governs the physical trading of agricultural commodities.

(D) Discuss the Participants in commodity market?

Participants in the derivative market can be categorized into four main groups based on their trading objectives and risk appetite:

1. Hedgers

• Objective: Reduce or eliminate price risk associated with their underlying assets.

• Participants: Businesses, farmers, exporters/importers, and financial institutions.

• Example: A wheat farmer hedges against price drops by selling wheat futures contracts.

2. Speculators

• Objective: Profit from price fluctuations in the derivative market by taking calculated risks.

• Participants: Traders, hedge funds, and high-net-worth individuals.

• Example: A trader buys call options on a stock expecting the price to rise before expiration.

3. Arbitrageurs

• Objective: Exploit price differences between markets to make risk-free profits.

• Participants: Institutional investors, hedge funds, and professional traders.

• Example: Buying a stock in one market at a lower price and simultaneously selling it in another market at a higher price.

4. Margin Traders (Market Makers)

• Objective: Provide liquidity to the market by constantly quoting buy and sell prices.

• Participants: Financial institutions, brokerage firms, and proprietary trading firms.

• Example: A market maker buys and sells options contracts to ensure continuous trading.

Q.3 (A) Explain the following Terminologies:

1. Call Option

A Call Option is a financial contract that gives the buyer the right, but not the obligation, to buy an underlying asset (such as stocks, commodities, or indices) at a specified strike price on or before the expiration date. The seller of the call option (option writer) is obligated to sell the asset if the buyer chooses to exercise the option.

Elements of a Call Option

1. Underlying Asset – The asset that the option contract is based on (e.g., stocks, commodities, currencies).

2. Strike Price – The price at which the buyer can purchase the asset.

3. Premium – The price paid by the buyer to the seller for acquiring the option contract.

4. Expiration Date – The last date on which the option can be exercised.

5. Intrinsic Value – The difference between the market price of the asset and the strike price (if the option is profitable).

6. Time Value – The extra value based on the time left until expiration.

Call Option Payoff

• In-the-Money (ITM): When the market price is higher than the strike price.

• At-the-Money (ATM): When the market price is equal to the strike price.

• Out-of-the-Money (OTM): When the market price is lower than the strike price.

Example of a Call Option

Suppose an investor buys a call option on Stock ABC with:

• Strike Price = ₹100

• Premium = ₹5

• Expiration Date = 1 month

If the stock price rises to ₹120 before expiration, the investor can buy at ₹100 and sell at ₹120, making a profit (minus the premium paid).

2 Expiry Date

The Expiry Date is the last date on which an options or futures contract is valid. After this date, the contract becomes worthless if not exercised or settled.

1. For Options (Call & Put):

   • The buyer must exercise the option before or on the expiry date.

   • If not exercised, the option may expire worthless or be automatically settled.

2. For Futures Contracts:

   • The expiry date is when the contract must be settled (either by cash or physical delivery).

   • Traders typically close positions before expiry to avoid settlement obligations.

3. Stock Options Expiry:

   • In India, stock options & futures expire on the last Thursday of every month.

   • If Thursday is a holiday, expiry shifts to the previous trading day.

4. Index Options Expiry:

   • Nifty & Bank Nifty weekly options expire every Thursday.

   • Monthly index options expire on the last Thursday of the month.

5. U.S. Market Expiry:

   • Stock options expire on the third Friday of the expiration month.

   • If Friday is a holiday, expiry moves to Thursday.

Example of Expiry Date in Options

Suppose you buy a Nifty 50 Call Option (Strike Price: 20,000) Expiring on April 25:

• If Nifty trades at 20,500 on expiry, you can exercise the option for profit.

• If Nifty trades below 20,000, the option expires worthless.

3 Market to Market

Mark-to-Market (MTM) is the process of valuing assets, liabilities, or financial contracts based on their current market price rather than historical cost. It ensures that financial statements reflect the realistic value of assets and liabilities as per market conditions.

1. MTM in Futures & Derivatives Trading

In futures contracts, MTM is used for daily settlement:

• Profits and losses are adjusted daily based on the closing market price.

• Traders must add more margin if they have losses (margin call).

• Gains are credited to traders' accounts.

Example of MTM in Futures

• You buy Nifty Futures at 20,000.

• At the end of the day, Nifty closes at 20,200.

• Your account is credited with ₹200 per unit.

• If Nifty drops to 19,800, your account is debited ₹200 per unit.

2. MTM in Accounting & Banking

• Used to value assets & liabilities (e.g., stocks, bonds, real estate).

• Banks & financial institutions use MTM for their loan portfolios & investments.

• During financial crises, MTM can increase volatility (e.g., 2008 crisis).

3. MTM in Stock Market Investments

• Stocks are marked to market daily based on closing prices.

• Mutual funds show Net Asset Value (NAV) based on MTM.

Advantages of MTM

Reflects real value of assets & liabilities.
Prevents hidden losses in financial reports.

Ensures fair settlement in derivative markets.

Disadvantages of MTM

High volatility in financial statements.
May lead to forced liquidation if margin calls occur.
Can cause panic selling in market crashes.

4 Basis

Basis refers to the difference between the spot price of a commodity and the futures price of the same commodity. It is an important concept in hedging and arbitrage.

Formula:

$$\text{Basis}=\text{Spot Price}-\text{Futures Price}$$

Types of Basis:

1. Positive Basis (Backwardation) – When the spot price is higher than the futures price.

   • Happens due to strong demand or supply shortages.

   • Common in perishable goods (e.g., agricultural products).

2. Negative Basis (Contango) – When the futures price is higher than the spot price.

   • Happens due to storage costs, interest rates, and carrying charges.

   • Common in non-perishable goods (e.g., gold, crude oil).

Example of Basis in Commodity Trading

• Spot price of Gold = ₹60,000 per 10g

• Futures price (1-month contract) = ₹60,500 per 10g

• Basis = ₹60,000 - ₹60,500 = -₹500 (Contango)

Importance of Basis in Trading & Hedging

Helps in risk management – Farmers & traders use basis to hedge against price fluctuations.
Indicates market trends – Positive or negative basis shows supply-demand conditions.

Affects arbitrage strategies – Traders profit from price differences between spot and futures.                                                                            

Q.3 (B) Explain Cash & Carry Arbitrage in detail?

Cash & Carry Arbitrage is a market-neutral trading strategy that takes advantage of the difference between the spot price and the futures price of an asset.

• It involves buying an asset in the spot market (cash market) and simultaneously selling a futures contract of the same asset.

• The strategy is risk-free when the futures contract is trading at a premium (higher than the spot price).

• The trader profits from the difference between the futures price and the total cost of holding the asset.

How Does Cash & Carry Arbitrage Work?

1. Identify Mispricing – Check if the futures price is significantly higher than the spot price.

2. Buy the Asset in the Spot Market – Purchase the asset at the lower spot price.

3. Sell (Short) a Futures Contract – Simultaneously sell a higher-priced futures contract for the same asset.

4. Hold the Asset Until Expiry – Keep the asset and bear the cost of carrying (storage, financing, and insurance).

5. Deliver the Asset at Expiry – At the expiration of the futures contract, deliver the asset and earn a risk-free profit.

Formula for Cash & Carry Arbitrage Profit

$$\text{Profit}=\text{Futures Price}-(\text{Spot Price }+\text{Cost of Carry})$$

Where:

• Futures Price = Agreed price in the futures contract.

• Spot Price = Current market price of the asset.

• Cost of Carry = Expenses like interest, storage, insurance, etc.

Example of Cash & Carry Arbitrage

Assume:

• Spot Price of Gold = ₹60,000 per 10g

• 3-Month Gold Futures Price = ₹61,500 per 10g

• Cost of Carry (interest & storage) = ₹500 per 10g

Steps:

1. Buy Gold in the spot market at ₹60,000 per 10g.

2. Sell Gold Futures contract at ₹61,500 per 10g.

3. Hold the gold for 3 months.

4. On expiry, deliver the gold and receive ₹61,500.

Profit Calculation:

$$\text{Profit}=(₹61,500-₹60,000-₹500)=₹1,000\text{ per 10g}$$

Since the market is efficient, such opportunities do not last long as arbitrageurs enter, bringing futures and spot prices closer.

When Does Cash & Carry Arbitrage Work?

✅ Contango Market – When futures prices are higher than spot prices.
✅ Low Holding Costs – When storage & financing costs are less than the futures premium.

Limitations of Cash & Carry Arbitrage

❌ High Carrying Costs – If storage and interest rates increase, arbitrage may not be profitable.
❌ Market Efficiency – Price gaps close quickly as more traders exploit the opportunity.
❌ Liquidity Issues – Arbitrage requires large capital, which may not be feasible for retail traders.

OR

Q.3 (C) The spot price of gold is Rs 39,000. The locker rent is Rs 500 and insurance charges are Rs 750. Interest rate on borrowed funds is 12% pa compounded on monthly basis. What will be the fair value of 3 months futures contracts?

Q.3 (D) Kattappa buys a PUT option of Bahubali Ltd at a strike price of Rs 30 for a price of premium of Rs 6. Calculate the profit or loss for Kattappa if the market the share is Rs. 14, Rs. 16, Rs. 18, Rs. 26, Rs. 28, Rs. 30, Rs. 31, Rs. 35, Rs. 39. Also draw the payoff diagram for the same.

Q.4 (A) Distinguish between Future & Option

	Forward Contract	Future Contract
Definition	A private agreement between two parties to buy or sell an asset at a future date for a predetermined price.	A standardized contract traded on an exchange to buy or sell an asset at a future date for a predetermined price.
Trading Venue	Over-the-Counter (OTC)	Exchange-traded
Standardization	Customized contract terms (quantity, price, expiration date, etc.)	Highly standardized with fixed contract sizes, expiration dates, and specifications.
Counterparty Risk	High, as the contract is private and not regulated by an exchange.	Low, as clearing houses act as intermediaries and guarantee the trade.
Liquidity	Low, as contracts are tailor-made and not easily tradable.	High, as contracts are standardized and actively traded on exchanges.
Margin Requirement	No margin requirement; settlement occurs at maturity.	Requires margin deposits and daily mark-to-market settlements.
Settlement	Settled at the contract’s expiration (physical or cash settlement).	Marked-to-market daily, meaning profits/losses are settled daily.
Flexibility	More flexible in terms of contract terms and conditions.	Less flexible due to standardization.
Example	A farmer agrees with a mill to sell 1000 bushels of wheat at $5 per bushel in 3 months.	A trader buys an oil futures contract on the Chicago Mercantile Exchange (CME) with set expiry and contract size.

(B) Explain what is meant by intrinsic value or moneyness of an option contract (07)

1. Intrinsic Value of an Option

Definition:

• Intrinsic value is the real value of an option if it were exercised immediately.

• It represents the difference between the spot price of the underlying asset and the strike price of the option.

Formula:

• Call Option:

  $$\text{Intrinsic Value}=\max (0,\text{Spot Price}-\text{Strike Price})$$

• Put Option:

  $$\text{Intrinsic Value}=\max (0,\text{Strike Price}-\text{Spot Price})$$

Example:

• Suppose a Nifty 50 Call Option has a strike price of ₹20,000 and Nifty is trading at ₹20,500.

  $$\text{Intrinsic Value}=20,500-20,000=₹500$$

• If the Nifty trades below ₹20,000, the intrinsic value is ₹0, as the option would expire worthless.

🔹 An option's premium consists of intrinsic value + time value.

2. Moneyness of an Option

Definition:

• Moneyness describes the financial state of an option—whether it has intrinsic value or not.

Types of Moneyness:

Type	Call Option Condition	Put Option Condition	Meaning
In the Money (ITM)	Spot Price > Strike Price	Spot Price < Strike Price	Option has positive intrinsic value.
At the Money (ATM)	Spot Price = Strike Price	Spot Price = Strike Price	No intrinsic value, only time value.
Out of the Money (OTM)	Spot Price < Strike Price	Spot Price > Strike Price	No intrinsic value, expires worthless.

Example: (Assume Nifty 50 is trading at ₹20,500)

• Call Option ₹20,000 (ITM) → Intrinsic Value = ₹500

• Call Option ₹20,500 (ATM) → Intrinsic Value = ₹0

• Call Option ₹21,000 (OTM) → Intrinsic Value = ₹0

• ITM options have intrinsic value.

• ATM & OTM options have only time value.

OR

Q.4 (C) The cost of 1kg of silver is Rs 65,000 and locker rent is Rs. 2,500, the insurance charges are Rs 500 for a month. Interest rate on borrowed funds is 12% pa which is compounded on monthly basis. What will be fair value of 1 month contract?                    (07)

(D) Mr Bhallaladeva takes the position in the futures market through the following transaction:    (08)

1. Sold HERO Motor Corp futures for Rs. 7,930. On the expiry the cash market price was Rs. 8,000, Find out the profit or loss for the lot size of 50 shares. 2. Took a long position on 10 contracts of RBL Bank at Rs. 960 and the settlement price was Rs. 1,050. Calculate the profit/ loss made if the contract size was 300.

Also draw pay off diagrams for the respective positions.

Q.5 (A) What are the various orders that can be placed in derivatives markets?

When trading in futures and options (F&O), traders use different types of orders to manage risk and execute trades efficiently. Below are the main order types used in derivatives trading:

1. Market Order

• Definition: An order to buy or sell a contract at the best available price.

• Usage: Used when immediate execution is required.

• Example: Buying an Nifty 50 futures contract at the current market price.

2. Limit Order

• Definition: An order to buy/sell a contract at a specific price or better.

• Usage: Ensures price control but may not get executed if the market doesn’t reach the limit price.

• Example: Placing a buy order for Bank Nifty at ₹44,500, even though the market price is ₹44,600.

3. Stop-Loss Order (SL Order)

• Definition: An order placed to limit losses by selling/buying at a predefined price when the market moves unfavorably.

• Types:

  • SL (Limit Order) – Executes at a specific price.

  • SL-M (Market Order) – Executes at the best available price once triggered.

• Example: If you buy Reliance futures at ₹2,500, you can set an SL order at ₹2,450 to limit losses.

4. Stop-Loss Trigger Price (SLTP)

• Definition: A price at which a stop-loss order gets activated.

• Usage: Helps traders avoid major losses in volatile markets.

• Example: If you set a trigger price at ₹2,480 and a sell limit at ₹2,475, your order activates when Reliance reaches ₹2,480 and tries to execute at ₹2,475.

5. Bracket Order (BO) (Available in Intraday Trading)

• Definition: A combination of a market/limit order, a stop-loss order, and a target order.

• Usage: Automates risk management by setting profit and stop-loss levels.

• Example:

  • Buy TCS futures at ₹3,500.

  • Set Target at ₹3,600 and Stop-loss at ₹3,450.

6. Cover Order (CO) (Available in Intraday Trading)

• Definition: A market/limit order with a compulsory stop-loss order attached.

• Usage: Reduces risk with a predefined stop-loss but allows higher leverage.

• Example:

  • Buy Infosys futures at ₹1,550.

  • Set mandatory stop-loss at ₹1,520.

7. Good Till Cancelled (GTC) Order

• Definition: The order remains active until executed or manually cancelled.

• Usage: Useful for traders waiting for specific price levels.

• Example: Placing a long-term buy limit order on Nifty at 21,500 while the current price is 22,000.

8. Immediate or Cancel (IOC) Order

• Definition: The order is executed immediately, and any unexecuted portion is automatically cancelled.

• Usage: Used in highly volatile markets to capture quick opportunities.

• Example: If you place an IOC order for 100 lots of crude oil futures, and only 60 get executed, the remaining 40 will be cancelled.

9. Day Order

• Definition: The order remains valid only for the trading day. If not executed, it is cancelled automatically.

• Usage: Common for intraday traders.

10. After Market Order (AMO)

• Definition: Orders placed after market hours, which execute when the market opens.

• Usage: Helps traders plan trades in advance.

• Example: Placing a buy order for SBI futures at ₹600 after market close, which executes in the morning session.

(B) Explain SPAN Margin

SPAN Margin (Standard Portfolio Analysis of Risk) is the minimum margin requirement set by exchanges for traders in futures & options (F&O) trading. It is calculated using a risk-based model to ensure traders have enough funds to cover potential losses under different market conditions.

🔹 Who Uses SPAN Margin?

• Exchanges like NSE, BSE, MCX use SPAN margin for risk management.

• Traders, brokers, and clearing members use it to determine margin requirements.

Components of SPAN Margin

SPAN Margin consists of two parts:

1️⃣ SPAN Margin (Initial Margin)

• Covers the maximum possible loss in 1 day due to price fluctuations.

• Based on factors like volatility, contract size, and risk exposure.

2️⃣ Exposure Margin (Extreme Loss Margin)

• An additional buffer to cover unexpected losses.

• Typically 3-5% of the total contract value.

✅ Total Margin Required = SPAN Margin + Exposure Margin

Example of SPAN Margin Calculation

Let’s assume:

• You buy 1 lot of Nifty Futures (50 units) at ₹22,000 per unit.

• Exchange sets:

  • SPAN Margin = 10% (₹1,10,000)

  • Exposure Margin = 3% (₹33,000)

🔹 Total Margin Required = ₹1,10,000 + ₹33,000 = ₹1,43,000

Why is SPAN Margin Important?

✅ Ensures risk control by exchanges.
✅ Helps traders avoid excessive leverage.
✅ Adjusts margin based on market volatility.
✅ Reduces chances of default & market instability.

OR

Q.5 (C) Write short notes on any three of the following:

1 Imperfect Hedge.

An imperfect hedge occurs when a hedging position does not fully eliminate risk due to a mismatch between the hedging instrument and the underlying asset. This results in partial risk protection rather than a perfect hedge.

Causes of an Imperfect Hedge

1️⃣ Basis Risk – The futures price and spot price may not move in perfect correlation.
2️⃣ Maturity Mismatch – The hedge and the underlying asset have different expiration dates.
3️⃣ Quantity Mismatch – The hedge does not cover the full exposure of the underlying asset.
4️⃣ Asset Mismatch – The hedge is placed on a similar but not identical asset (cross-hedging).
5️⃣ Market Imperfections – Price fluctuations due to liquidity, volatility, or external factors.

Example of an Imperfect Hedge

Scenario 1: Hedging with Futures (Basis Risk Example)

• A gold importer buys gold futures to hedge against rising gold prices.

• However, due to basis risk, the spot price and futures price do not move exactly in sync.

• If the spot price increases by ₹500, but the futures price only increases by ₹400, the hedge is not fully effective.

Risk is reduced, but not completely eliminated.

Scenario 2: Cross-Hedging (Asset Mismatch Example)

• A farmer grows soybeans but hedges using soybean oil futures.

• If soybean oil prices move differently from soybean prices, the hedge is imperfect.

2. Reverse Cash & Carry Arbitrage

Reverse Cash & Carry Arbitrage is a risk-free trading strategy where a trader sells (shorts) an asset in the spot market and buys a futures contract of the same asset when the futures price is lower than the spot price.

This strategy is applied when the market is in backwardation (futures price < spot price). The trader profits from the price convergence of spot and futures prices over time.

How Reverse Cash & Carry Arbitrage Works

1️⃣ Identify Mispricing – Check if the futures price is lower than the spot price.
2️⃣ Short the Asset in the Spot Market – Sell the asset at the higher spot price.
3️⃣ Buy the Cheaper Futures Contract – Enter a long position in futures at a lower price.
4️⃣ Wait Until Expiry – Hold the position until futures and spot prices converge.
5️⃣ Deliver the Asset – Buy the asset at the futures price and deliver it at the spot price.

Formula for Profit Calculation

$$\text{Profit}=(\text{Spot Price}-\text{Futures Price})-\text{Cost of Short Selling}$$

Where:

• Spot Price = The price at which the asset is sold.

• Futures Price = The price at which the asset is bought via a futures contract.

• Cost of Short Selling = Borrowing costs, dividend payments (if applicable), and transaction costs.

Example of Reverse Cash & Carry Arbitrage

Let’s assume:

• Spot Price of Gold = ₹62,000 per 10g

• 3-Month Gold Futures Price = ₹61,500 per 10g

• Cost of Short Selling = ₹200 per 10g

🔹 Steps:

1. Short sell gold in the spot market at ₹62,000.

2. Buy a futures contract at ₹61,500.

3. Hold the position until expiry (3 months).

4. At expiry, buy gold from the futures market at ₹61,500 and deliver it.

🔹 Profit Calculation:

$$\text{Profit}=(₹62,000-₹61,500)-₹200=₹300\text{ per 10g}$$

✅ Risk-Free Profit of ₹300 per 10g.

When is Reverse Cash & Carry Arbitrage Profitable?

✅ Backwardation Market – When futures prices are lower than spot prices.
✅ Low Short Selling Costs – The cost of borrowing and holding short positions is low.
✅ Strong Demand in Spot Market – Investors are willing to pay a higher price for immediate delivery.

Limitations of Reverse Cash & Carry Arbitrage

High Short Selling Costs – Borrowing charges can reduce profits.
Liquidity Issues – Some assets have low liquidity in the futures market.
Market Efficiency – Arbitrage opportunities close quickly as traders exploit them.

3 Contango

Contango is a market condition where futures prices are higher than the current spot price of an asset. This happens when traders expect prices to rise in the future due to factors like storage costs, interest rates, and inflation.

Characteristic:  Futures Price > Spot Price

Why Does Contango Occur?

Contango happens when:
Storage Costs Exist – Storing commodities (oil, gold, wheat) adds costs, making future prices higher.
Higher Demand for Future Delivery – Traders prefer buying later due to economic expectations.
Inflation Expectations – Prices are expected to increase over time.
Interest Rate Impact – Higher rates increase the cost of holding the asset today.

Common in Commodities Markets – Seen in oil, gold, and agricultural products.

Example of Contango

Let’s assume:

• Spot Price of Crude Oil = ₹6,000 per barrel

• 3-Month Futures Price = ₹6,300 per barrel

• 6-Month Futures Price = ₹6,600 per barrel

Since the futures prices are higher than the spot price, this is a contango market.

🔹 A trader may buy oil today at ₹6,000, expecting to sell it later at a higher futures price.

Impact of Contango on Traders & Investors

Profitable for Arbitrageurs – Traders use cash & carry arbitrage to profit from price differences.
Good for Long-Term Investors – Investors expect prices to rise in the future.
Bad for Short-Term Traders – Futures contracts may depreciate as they approach expiry.
Higher Costs for Hedgers – Hedging in a contango market can be expensive.

4 Arbitrage using Futures 

Futures arbitrage is a risk-free trading strategy where a trader profits from price differences between the spot market and futures market of an asset. Traders buy low and sell high simultaneously to exploit market inefficiencies.

Objective: Earn a risk-free profit by taking advantage of mispricing between futures and spot prices.

Types of Futures Arbitrage Strategies

1️⃣ Cash & Carry Arbitrage (Contango Market)

• Happens when Futures Price > Spot Price (Contango).

• Strategy:

  • Buy the asset in the spot market at a lower price.

  • Sell (short) the futures contract at a higher price.

  • Hold until expiry and deliver the asset at the higher futures price.

• Profit = Futures Price – Spot Price – Carrying Costs

Example:

• Spot Price of Gold = ₹60,000

• Futures Price (3-month) = ₹61,500

• Cost of Holding (Storage, Interest) = ₹500

• Profit = ₹61,500 - ₹60,000 - ₹500 = ₹1,000 per unit

2️⃣ Reverse Cash & Carry Arbitrage (Backwardation Market)

• Happens when Futures Price < Spot Price (Backwardation).

• Strategy:

  • Sell (short) the asset in the spot market at a higher price.

  • Buy a cheaper futures contract.

  • At expiry, buy back the asset at the lower futures price.

• Profit = Spot Price – Futures Price – Short Selling Costs

Example:

• Spot Price of Oil = ₹6,200 per barrel

• Futures Price (3-month) = ₹6,000

• Short Selling Costs = ₹100

• Profit = ₹6,200 - ₹6,000 - ₹100 = ₹100 per barrel

3️⃣ Intermarket Arbitrage (Exchange Arbitrage)

• Happens when the same asset has different prices in different exchanges.

• Strategy:

  • Buy in the exchange where the futures price is lower.

  • Sell in the exchange where the futures price is higher.

• Profit = Price Difference – Transaction Costs

Example:

• Nifty 50 Futures Price on NSE = ₹22,100

• Nifty 50 Futures Price on BSE = ₹22,150

• Profit per contract = ₹50 (before costs).

Factors Affecting Futures Arbitrage

🔹 Interest Rates – Higher rates increase carrying costs.
🔹 Storage & Holding Costs – Affects profit in commodities like gold, oil.
🔹 Market Liquidity – Arbitrage is easier in highly liquid markets.
🔹 Transaction Costs – Brokerage, taxes, and other fees reduce profit.
🔹 Market Efficiency – Arbitrage opportunities close quickly as traders exploit them.

5. Types of Margin

Margin is the collateral that traders must deposit to enter and maintain positions in the futures and options (F&O) market. It ensures that traders have sufficient funds to cover potential losses.

1️⃣ Initial Margin

🔹 The minimum amount required to enter a trade.
🔹 Includes SPAN Margin + Exposure Margin.
🔹 Ensures traders can handle market fluctuations.

Example:

• If the Initial Margin for Nifty Futures is ₹1,50,000, a trader must deposit at least this amount to open a position.

2️⃣ SPAN Margin (Standard Portfolio Analysis of Risk)

🔹 Risk-based margin calculated using worst-case loss scenarios.
🔹 Required for both long & short futures and options positions.
🔹 Higher for volatile assets & leveraged trades.

Example:

• If Nifty futures SPAN margin is ₹1,20,000, it covers extreme market movements.

3️⃣ Exposure Margin

🔹 An extra buffer collected over SPAN Margin.
🔹 Covers additional risks like sudden price movements.

Example:

• If the Exposure Margin for Nifty Futures is ₹30,000, the total Initial Margin = SPAN (₹1,20,000) + Exposure (₹30,000) = ₹1,50,000.

4️⃣ Maintenance Margin

🔹 The minimum balance required to keep a position open.
🔹 If the account falls below this level, traders get a margin call.

Example:

• If a trader’s margin falls below ₹1,20,000 (80% of initial margin), they must add funds or face liquidation.

5️⃣ Mark-to-Market (MTM) Margin

🔹 Daily profit/loss adjustment based on market price movements.
🔹 Traders must pay if their position loses value or receive funds if they gain.

Example:

• If a Nifty Futures position moves against a trader by ₹10,000, they must deposit ₹10,000 in their margin account.

6️⃣ Additional Margin

🔹 Extra margin imposed by exchanges during high volatility or major events.
🔹 Also known as Adhoc Margin.

Example:

• Before major events like elections or budget announcements, exchanges may increase margin requirements.

7️⃣ Delivery Margin (For Physical Settlement)

🔹 Imposed on traders holding positions near expiry in stock futures and options.
🔹 Ensures they have funds to take/give delivery of the asset.

Example:

• If a trader holds Reliance Futures near expiry, they need extra margin for delivery settlement.