Derivatives FAQ's
In finance, a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
Although it is true that complicated mathematical models are used for pricing some derivatives, the basic concepts and principles underpinning derivatives and their trading are quite easy to grasp and understand. Indeed, derivatives are used increasingly by market players ranging from governments, corporate treasurers, dealers and brokers and individual investors.
While forward contracts and exchange traded in futures has grown by leaps and bound, Indian stock markets have been largely slow to these global changes. However, in the last few years, there has been substantial improvement in the functioning of the securities market. Requirements of adequate capitalization for market intermediaries, margining and establishment of clearing corporations have reduced market and credit risks. However, there were inadequate advanced risk management tools. And after the ICE (Information, Communication, Entertainment) meltdown the market regulator felt that in order to deepen and strengthen the cash market trading of derivatives like futures and options was imperative.
Derivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset.
A simple forward-based contract obligates one party to buy and the other party to sell a financial instrument, a currency, equity or a commodity at a future date. Examples of forward-based contracts include forward contracts, futures contracts, forward rate agreements and swap transactions.
Futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.
The right to purchase the underlying futures contract if the option is a call or the right to sell the underlying futures contract if the option is a put.
A call option conveys to the option buyer the right to purchase a particular futures contract at a stated price at any time during the life of the option.
A put option conveys to the option buyer the right to sell a particular futures contract at a stated price at any time during the life of the option.
Strike Price also known as the “exercise price,” this is the stated price at which the buyer of a call has the right to purchase a specific futures contract or at which the buyer of a put has the right to sell a specific futures contract.
The option buyer is the person who acquires the rights conveyed by the option seller.
The option seller (also known as the option writer or option grantor) is the party that conveys the option rights to the option buyer.
In a spot market, transactions are settled ''on the spot''. Once a trade is agreed upon, the settlement - i.e. the actual exchange of money for goods - takes place with the minimum possible delay. When a person selects a shirt in a shop and agrees on a price, the settlement (exchange of funds for goods) takes place immediately. That is a spot market.
In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands at the time the trade is agreed upon. Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2001 at Rs.5,000/tola. Here, Rs.5,000/tola is the "forward price of 31 Dec 2001 Gold''. The buyer L is said to be long and the seller S is said to be short. Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec 2001, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to accept Rs.500,000 on 31 Dec 2001, and give 100 tolas of gold in exchange.
Mutual funds are meant only for a small investor like you. The prime reason is that successful investments in stock markets require careful analysis of scrips which is not possible for a small investor. Mutual funds are usually fully equipped to carry out thorough analysis and can provide superior returns.
A derivative contract which is privately negotiated is called an OTC derivative. OTC trades have no anonymity, and they generally do not go through a clearing corporation. Every derivative product can either trade OTC (i.e., through private negotiation), or on an exchange. In one specific case, the jargon demarcates this clearly: OTC futures contracts are called "forwards'' (or, exchange-traded forwards are called "futures''). In other cases, there is no such distinguishing notation. There are "exchange-traded options'' as opposed to "OTC options''; but they are both called options.
No. Badla is a mechanism to avoid the discipline of a spot market; to do trades on the spot market but not actually do settlement. The "carryforward'' activities are mixed together with the spot market. A well functioning spot market has no possibility of carryforward. Derivatives trades take place distinctly from the spot market. The spot price is separately observed from the derivative price. A modern financial system consists of a spot market which is a genuine spot market, and a derivatives market which is separate from the spot market.
Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest, at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because
Forward markets tend to be afflicted by poor liquidity and from unreliability deriving from ''counterparty risk'' (also called ''credit risk'').
One basic problem of forward markets is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form custom-designed contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation; this can make the contracts non-tradeable since others might not find those specific terms useful. In addition, forward markets are like the real estate market in that buyers and sellers find each other using telephones. This is inefficient and time-consuming. Every user faces the risk of not trading at the best price available in the country. Forward markets often turn into small clubs of dealers who earn elevated intermediation fees. This elevates the fees paid by users, i.e. it makes the forward market illiquid from the user perspective.
A forward contract is a bilateral relationship between two people. Each requires good behaviour on the part of the other for the contract to perform as promised. Suppose L agrees to buy gold from S at a future date T at a (forward) price of Rs.5,000/tola. If, on date T, the gold spot price is at Rs.4,000/tola, then L loses Rs.1,000/tola and S gains Rs.1,000/tola by living up to the terms of the contract. When L buys at Rs.5,000/tola by the terms of the contract, he is paying Rs.1,000 more than what could be obtained on the spot market at the same time. Hence, L is tempted to declare bankruptcy and avoid performing as per the contract. Conversely, if on date T the gold spot price is at Rs.6,000/tola, then L gains and S loses by living up to the terms of the contract. S stands to sell gold at Rs.5,000/tola by the terms of the contract, which is Rs.1,000/tola worse than what could be obtained by selling into the spot market at date T. In this case, S is tempted to declare bankruptcy and avoid performing as per the contract. In either case, this leads to counterparty risk. When one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counterparty risk.
A market has price-time priority if it gives a guarantee that every order will be matched against the best available price in the country, and that if two orders are equal in price, the one which came first will be matched first. Forward markets, which involve dealers talking to each other on phone, do not have price-time priority. Floor-based trading with open-outcry does not have price-time priority. Electronic exchanges with order matching, or markets with a monopoly market maker, have price-time priority. On markets without price-time priority, users suffer greater search costs, and there is a greater risk of fraud.
Futures markets feature a series of innovations in how trading is organised:
A market where counterparty risk is present generally collapses into a small club of participants, who have homogeneous credit risk, and who have formed social and cultural methods for handling bankruptcies. Club markets do not allow for free entry into intermediation. They support elevated intermediation fees for club members, have fewer market participants, and result in reduced liquidity. Sometimes, regulators who are afraid of payments crises forcibly shut out large numbers of participants from an OTC derivatives market. This automatically generates a club market, and yields a fraction of the liquidity which could come about if participation could be enlarged.
The forward or futures contracts discussed so far involved physical settlement. On 31 Dec 2001, the seller was supposed to come up with 100 tolas of gold and the buyer was supposed to pay for it. In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an inter-bank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use ''cash settlement''. Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement. Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Dec 2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a loss of Rs.100 per Nifty. A p rofit/loss of Rs.100 per nifty applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation organises a payment of Rs.3,000 from S and a payment of Rs.3,000 to L. This is called cash settlement. Cash settlement was an important advance, which extended the reach of derivatives into many products where physical settlement was unviable.
Supply and demand on the secondary market determines the futures price. On dates prior to 31 Dec 2000, the ''Nifty futures expiring on 31 Dec 2000'' trade at a price that purely reflect supply and demand. There is a separate order book for each futures product which generates its own price. Economic arguments give us a clear idea about what the price of a futures should be. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market which forces the theoretical prices to come about.
Yes, it does. If a brokerage firm goes bankrupt with net obligations of Rs.1 billion, the clearing corporation has a legal obligation of Rs.1 billion. The clearing corporation is legally obliged to either meet these obligations, or go bankrupt itself. There is no third alternative. There is no committee that meets to decide whether the settlement fund can be utilised; there are no escape clauses. It is important to emphasise that when L buys from S, at a legal level, L has bought from the clearing corporation and the clearing corporation has bought from S. Whether S lives up to his obligations or not, the clearing corporation is the counterparty to L. There is no escape clause which can be invoked by the clearing corporation if S defaults.
The futures clearing corporation has to build a sophisticated risk containment system in order to survive. Two key elements of the risk containment system are the ''mark to market margin'' and ''initial margin''. These involve taking collateral from traders in such a way as to greatly diminish the incentives for traders to default. Electronic trading has generated a need for online, realtime risk monitoring. In India, trading takes place swiftly and funds move through the banking system slowly. Hence the only meaningful notion of initial margin is one that is paid upfront. This leads to the notion of brokerage firms placing collateral, and obtaining limits upon the risk of their position as a function of the amount of collateral with the clearing corporation.
India's "Cash Market'' for equity is ostensibly a cash market, but it functions like a futures markets in every respect. NSE's ''EQ'' market is a weekly futures market with tuesday expiration. The trading modalities on NSE from Wednesday to tuesday, in trading ITC, are exactly those that would be seen if a futures market was running on ITC with tuesday expiration. On NSE, when a person buys on thursday, he is not obligated to do delivery and payment right away, and this buy position can be reversed on friday thus leaving no net obligations. Equity trading on NSE involves leverage of seven times. Like all futures markets, trading at the NSE is centralised and there is no counterparty risk owing to novation at the clearing corporation (NSCC). The only difference between ITC trading on NSE, and ITC trading on a true futures market, is that futures contracts with several different expiration dates would all trade at the same time on a true futures market; this is absent on India's ''cash mark et''.
As with index futures, index options are cash settled. Suppose Nifty is at 1500 on 1 July 2000. Suppose L buys an option which gives him the right to buy Nifty at 1600 from S on 31 Dec 2000. It turns out that this option is worth roughly Rs.90. So a payment of Rs.90 passes from L to S for having this option. When 31 Dec 2000 arrives, if Nifty is below 1600, the option is worthless and lapses without exercise. Suppose Nifty is at 1650. Then (in principle) L can exercise the option, buy Nifty using the option at 1600, and sell off this Nifty on the open market at 1650. So L has a profit of Rs.50 and S has a loss of Rs.50. In this case, ``cash settlement'' consists of NSCC imposing a charge of Rs.50 upon S and paying it to L.
The strike prices and expiration dates for traded options are selected by the exchange. For example, NSE may choose to have three expiration months, and five strike prices (1200,1300,1400,1500,1600). There would be two types of options: put and call. This gives a total of 30 distinct traded options ( 3 x 5 x 2), with 30 distinct order books and prices.
Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from a futures: which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating ``guaranteed return products''. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer ``nonlinear payoffs'' whereas futures only have ``linear payoffs''. By combining futures and options, a wide variety of innovative and useful payoff structures can be created.
In general, both futures and options trade on all underlyings abroad. Indeed, the international practice is to launch futures and options on a new underlying on the same day.
Supply and demand on the secondary market drives the option price. On dates prior to 31 Dec 2000, the ``call option on Nifty expiring on 31 Dec 2000 with a strike of 1500'' will trade at a price that purely reflects supply and demand. There is a separate order book for each option which generates its own price.
Trading on the ``spot market'' for equity has actually always been a futures market with weekly or fortnightly settlement. These futures markets feature the risks and difficulties of futures markets, without the gains in price discovery and hedging services that come with a separation of the spot market from the futures market. India's primary market has experience with derivatives of two kinds: convertible bonds and warrants (a slight variant of call options). Since these warrants are listed and traded, options markets of a limited sort already exist. However, the trading on these instruments is very limited. A variety of interesting derivatives markets exist in the informal sector. These markets trade contracts like bhav-bhav, teji-mandi, etc. For example, the bhav-bhav is a bundle of one in-the-money call option and one in-the-money put option. These informal markets stand outside the mainstream institutions of India's financial system and enjoy limited participation. In 1995, NSE asked SEBI whether it could trade index futures. In 2000, SEBI gave permissions to NSE and BSE to trade index futures. In addition, futures and options on Nifty will also trade at the Singapore Monetary Exchange (SIMEX) from end-August 2000.
The RBI has permitted OTC trades in interest rate forwards and swaps. These markets have so far had very little liquidity.
India has a strong dollar-rupee forward market with contracts being traded for one, two, .. six month expiration. Daily trading volume on this forward market is around $500 million a day. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets. Outside India, there is a small market for cash-settled forward contracts on the dollar-rupee exchange rate.
The RBI setup a committee, headed by R. V. Gupta, which has established guidelines through which Indian users can obtain hedging services using derivatives exchanges outside India.
It is useful to note here that there are no exchange-traded financial derivatives in India today. Neither the dollar-rupee forward contract nor the option-like contracts are exchange-traded. These markets hence lack centralisation of price discovery and can suffer from counterparty risk. We do have exchanges trading derivatives, in the form of commodity futures exchanges. However, they do not use financials as underlyings. In this sense, the index futures market will be the first exchange-traded derivatives market, which uses a financial underlying.
Worldwide, the most successful equity derivatives contracts are index futures, followed by index options, followed by security options.
Internationally, options on individual stocks are commonplace; futures on individual stocks are rare. This is partly because regulators (e.g. in the US) frown upon the idea of doing futures trading on individual stocks.
Security options are of limited interest because the pool of people who would be interested (say) in options on ACC is limited. In contrast, every single person with any involvement in the equity market is affected by index fluctuations. Hence risk-management using index derivatives is of far more importance than risk-management using individual security options. This goes back to a basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the composition of the portfolio. All portfolios of around ten stocks or more have a pattern of risk where 70% or more of their risk is index-related. Hence investors are more interested in using index-based derivative products. Index derivatives also present fewer regulatory headaches when compared to leveraged trading on individual stocks. Internationally, this has led to regulatory encouragement for index futures and discouragement against futures on individual stocks.
In the cash market, the basic dynamic is that the issuer puts out paper, and people trade this paper. In contrast, with futures (as with all derivatives), there is no issuer, and hence, there is no fixed issue size. The net supply of all derivatives contracts is 0. For each buyer, there is an equal and opposite seller. A contract is born when a buyer and a seller meet on the market. The total number of contracts that exist at a point is called open interest.
On futures markets, open positions as of the expiration date are normally supposed to turn into delivery by the seller and payment by the buyer. It is not feasible to deliver the market index. Hence open positions are squared off in cash on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date, the last mark to market margin is calculated with respect to the spot Nifty instead of the futures price.
Three Nifty futures contracts will trade at any point in time, expiring in three near months. The expiration date of each contract will be the last thursday of the month. For example, in January 1996 we will see three tradeable objects at the same time: a Nifty futures expiring on 25 January, a Nifty futures expiring on 29 February, and a Nifty futures expiring on 28 March. The three futures trade completely independently of each other. Each has a distinct price and a distinct limit order book. Hence, once this market trades, there would be four distinct prices that can be observed: the Nifty spot, and three Nifty futures prices.
The market lot is 200 nifties. A user will be able to buy 200 or 400 nifties, but not 300 nifties. If Nifty is at 1500, the smallest transaction will have a notional value of Rs.300,000.
The initial (upfront) margin on trading Nifty is likely to be around 7% to 8%. Thus, a position of Rs.300,000 (around 200 nifties) will require up-front collateral of Rs.21,000 to Rs.24,000. Nifty futures at SIMEX will probably involve a somewhat lower initial margin as compared with Nifty futures at NSE. Since the BSE Sensex is more volatile than Nifty, a higher initial margin will be required for trading it. The daily mark-to-market margin will be similar to that presently seen on the cash market, with two key differences: 7 As is presently the case, mark-to-market losses will have to be paid in by the trader to NSCC. However, mark-to-market profits will be paid out to traders by NSCC - this is not presently done on the cash market. 7 Hedged futures positions will attract lower margin - if a person has purchased 200 October nifties and sold 200 November nifties, he will attract much less than 7-8% margin. In the present cash market, all positions attract 15% initial (upfront) margin from NSCC, regardless of the extent to which they are hedged.
Individual stocks are more volatile, and more vulnerable to manipulative episodes such as short squeezes. Hence, highly leveraged trading on individual stocks is fraught with problems. In contrast, the index futures/options are cash settled, and are based on an underlying (the index) which is hard to manipulate.
As with all derivatives, there are:
Basis risk is the risk that users of the futures market suffer, owing to unwanted fluctuations of the basis. In the ideal futures market, the basis should reflect interest rates, and interest rates alone. In reality, the basis fluctuates within a band. These fluctuations reduce the usefulness of the futures market for hedgers and speculators.
The fair price of a derivative is the price at which profitable arbitrage is infeasible. In this sense, arbitrage (and arbitrage alone) determines the fair price of a derivative: this is the price at which there are no profitable arbitrage opportunities.
The pricing of index futures depends upon the spot index, the cost of carry, and expected dividends. For simplicity, suppose no dividends are expected, suppose the spot Nifty is at 1000 and suppose the one-month interest rate is 1.5%. Then the fair price of an index futures contract that expires in a month is 1015.
The difference between the spot and the futures price is called the basis. When a Nifty futures trades at 1015 and the spot Nifty is at 1000, ``the basis'' is said to be Rs.15 or 1.5%.
In practice, arbitrageurs will suffer transactions costs in doing Nifty program trades. The arbitrageur suffers one market impact cost in entering into a position on the Nifty spot, and another market impact cost when exiting. As a thumb rule, transactions of a million rupees suffer a one-way market impact cost of 0.1%, so the arbitrageur suffers a cost of 0.2% or so on the roundtrip. Hence, the actual return is lower than the apparent return by a factor of 0.2 percentage points or so.
The international experience is that in the first six months of a new index futures market, there are greater arbitrage opportunities that lie unexploited for relatively longer. After that, the increasing size and sophistication of the arbitrageurs ensures that arbitrage opportunities vanish very quickly. However, the international experience is that the glaring arbitrage opportunities only go away when extremely large amounts of capital are deployed into index arbitrage.
Arbitrage in the index futures market involves having the clearing corporation (NSCC) as the legal counterparty on both legs of the transaction. Hence the credit risk involved here will be equal to the credit risk of NSCC. This is in contrast with the risks of badla financing.
A market index is just a portfolio of all the stocks in index where weightage given to each stock proportional to its capitalisation. Hence ``buying Niftyequivalent buying 50 stocks their correct proportions. take one example suppose Reliance has 7.14% weight Nifty price Rs.108 and we are Rs.1 million Nifty. This means that need buy 661 shares Reliance.
These orders should not be placed ``by hand''. In the time that it would take to place 50 orders, market prices would move, generating execution risk. A rapid placement of a batch of orders is called program trading. NSE's NEAT software (which is used for trading on the cash market) supports this capability. However, even though NSE is a fully electronic market, the time taken in doing program trades is quite high (around two to three minutes to do a Nifty program trade). This compares poorly against stock exchanges elsewhere in the world.
Program trading replaces the tedium, errors, and delays of placing 50 orders ``by hand''. If program trading didn't exist, these orders would be placed manually. It's hard to see how this automation can be dangerous.
Several issues play a role in terms of the choice of index.
Diversification: A stock market index should be well-diversified, thus ensuring that hedgers or speculators are not vulnerable to individual company- or industry-risk. This di-versification is reflected in the Sharpe's Ratio of the index.
Liquidity of the index: The index should be easy to trade on the cash market. This is partly related to the choice of stocks in the index. High liquidity of index compo-nents implies that the information in the index is less noisy.
Liquidity of the market: Index traders have a strong incentive to trade on the market which supplies the prices used in index calculations. This market should feature high liquidity and be well designed in the sense of supplying operational conve-niences suited to the needs of index traders.
Operational issues: The index should be regularly maintained, with a steady evolution of securities in the index to keep pace with changes in the economy. The calculations involved in the index should be accurate and reliable. When a stock trades at mul-tiple venues, index computation should be done using prices from the most liquid market.
Nifty has a higher Sharpe's ratio. Nifty is a more liquid index. Nifty is calculated using prices from the most liquid market (NSE). NSE has designed features of the trading system to suit the needs of index traders. Nifty is better maintained. Nifty is used by three index funds while the BSE Sensex is used by one
At one level a market index is used as a pure economic time-series. Liquidity affects this application via the problem of non-trading. If some securities in an index fail to trade today, then the level of the market index obtained reflects the valuation of the macroeconomy today (via securities which traded today), but is contaminated with the valuation of the macroeconomy yesterday (via securities which traded yesterday). This is the problem of stale prices. By this reasoning, securities with a high trading intensity are best-suited for inclusion into a market index. As we go closer to applications of market indexes in the indexation industry (such as index funds, or sector-level active management, or index derivatives), the market index is not just an economic time-series, but a portfolio which is traded. The key difficulty faced here is again liquidity, or the transactions costs faced in buying or selling the entire index as a portfolio.
It turns out that it is efficient for arbitrageurs to trade Nifty in transaction sizes of Rs.1 million. At a transaction size of Rs.1 million, the one-way market impact cost in doing trades on Nifty is generally around 0.1%. This means that when Nifty is at 1000, the buyer ends up paying 1001 and the seller gets 999.
Dollar Nifty (Nifty re-expressed in dollars) is an interesting index, one that reflects the combination of movements of Nifty and fluctuations of the exchange rate. Nifty Junior is the second-tier of fifty large, liquid, stocks; they are the best stocks in terms of liquidity and market capitalisation which did not make it into Nifty. The construction of Nifty and Nifty junior is done in such a way that no stock will ever figure in both indexes.
The general principle is: you need hedging using index futures when your exposure to movements of Nifty is not what you would like it to be. If your index exposure is lower than what you like, you should buy index futures. If your index exposure is higher than what you like, you should sell index futures.
A person who has forecasted INFOSYSTCH is not interested in being a speculator on Nifty. He should remove this risk. This is done by selling Nifty futures. The position BUY INFOSYSTCH + SELL NIFTY FUTURES is a focussed position which is only about INFOSYSTCH. This is easily done in practice. Every speculative buy position should be coupled with an equal sell position on Nifty. Every speculative sell position should be coupled with an equal buy position on Nifty. Suppose you are long 100 shares of INFOSYSTCH and the share price is Rs.9,000, when the nearest Nifty futures is at Rs.1500. The position is worth Rs.900,000. Hedging away the Nifty exposure in this requires selling Rs.900,000 of Nifty. Translating this into a position on the index futures market, we have 900000/1500 = 600 nifties. So you would couple your position of ``buy 100 shares of Infosys'' with a hedging position: ``sell 600 nifties''. This hedging reduces the risk involved in stock speculation. It is good for the stock speculator (who faces less risk), for the brokerage firm (which faces a lesser risk of default by the client), for the clearing corporation (which faces less vulnerable brokerage firms) and for the economy (the systemic risk in the capital markets comes down, and level of resources deployed into analysing and forecasting stocks goes up).
Sometimes, the forecast horizon generates constraints. If you have a two-month view, then a futures contract that has only a few weeks of life left might be inconvenient. Another major issue is liquidity. Other things being equal, it is always better to use the contract with the tightest bid-ask spread.
You can sell Nifty futures. The Nifty futures earn a profit if Nifty drops, which offsets the losses you make on your core equity portfolio. Conversely, if Nifty rises, your core equity portfolio does well but the futures suffer a loss. When you have an equity portfolio and you sell Nifty futures, you are hedged: whether Nifty goes up or down, you become neutral to it. This is not a recipe for making money; it is a recipe for eliminating exposure (risk).
Every stock or portfolio or position has a number called ``beta''. Beta measures the vulnerability to the index. ITC has a beta of 1.2. This means that, on average, when Nifty rises by 1%, ITC rises by 1.2%. In this case, a stock speculator with a position of Rs.1 million on ITC requires a hedge of Rs.1.2 million (not just Rs.1 million) of Nifty in order to eliminate his Nifty risk. Hindustan Lever has a beta of 0.8. This means that a stock speculator who has a sell on Rs.1 million on HLL requires to buy Rs.0.8 million of Nifty (not Rs.1 million). If you know nothing about a stock or a portfolio, it is safe to guess that the beta is 1. The average beta of all stocks or all portfolios is 1. If beta can be observed or measured, then this hedging becomes more accurate; however, this is not easy since accurate beta calculations are fairly difficult, especially for illiquid stocks. Tables of betas of all stocks in Nifty and Nifty Junior are available from NSE and from http://www.nseindia.com
The basis between the spot Nifty and the 1 month Nifty futures reflects the interest rate over the coming month. If interest rates go up, the basis will widen. A buy position on the futures and a sell on the spot Nifty stands to gain if interest rates go up, while being immune to movements in Nifty. Similar positions can be used against the two-month and three-month futures to take views on other spot interest rates on the yield curve. Similar strategies can be applied for trading in forward interest rates, using the basis between the one-month and two-month futures, the one-month and three-month futures, etc.
Hedgers fear basis risk. Basis risk is about Nifty futures prices moving in a way which is not linked to the Nifty spot. An unhedged position suffers from price risk; the hedged position suffers from basis risk. Of course, basis risk is generally much smaller than price risk, so that it is better to hedge than not to hedge. However basis risk does detract from the usefulness of hedging using derivatives
A well designed index, and a well-designed cash market for equities, serve to minimise basis risk.
Nifty has higher hedging effectiveness for typical portfolios of all sizes. Nifty also requires lower initial margin (since it is less volatile) and is likely to enjoy lower basis risk (owing to the ease of arbitrage).
Buy a million rupees of Nifty on the spot market. Pay for them, and take delivery. When you make the payment, you are "giving a loan". Simultaneously, sell off a million rupees of Nifty futures. Hold these positions till the futures expiration date. On the futures expiration date, sell off the Nifty shares on the spot market. When you get paid for these, you are "getting your loan repaid".
This is worth doing when the interest rate obtained by lending into the futures market is higher than that which can be obtained through alternative riskless lending avenues.
Suppose we are on 12 June 2000 (a Monday) and we have purchased the spot, and sold the near futures (which expires on 29 June 2000). We will only need to put up funds on Tuesday, 20 June 2000. The shares are sold on the spot market on 29 June 2000 (Thursday). These turn into funds on 11 July 2000 (Tuesday). Hence, the overall period for which funds are invested is from 20 June to 11 July, i.e. a holding period of 22 days. Hence, the cost of carry should be applied for a 22 day holding period.
They involve a sequence of trades on the spot and on the index futures market. Yet, they are completely riskless. The trader is simultaneously buying at the present and selling off in the future, or vice versa. Regardless of what happens to Nifty, the returns on arbitrage are the same. Since there is no risk involved, it is called arbitrage.
BSE has no experience with novation. Today, equity trading at BSE takes place without novation. BSE has experienced payments problems fairly recently.
The market impact cost in trading the BSE Sensex is higher, for two reasons: index construction and trading venue. Even if BSE Sensex trades were done on NSE, the impact cost faced in trading the BSE Sensex is higher than that of Nifty. In addition, arbitrageurs working on the BSE Sensex would be forced to trade at the less liquid market, the BSE. The BSE lacks a credit enhancement institution of the credibility of NSCC. These problems imply that arbitrageurs working on the BSE Sensex will demand a higher credit risk premium, and require larger pricing errors in order to compensate for the larger transactions costs. Hence, the BSE Sensex futures are expected to show lower market efficiency and greater basis risk.
There are several kinds of speculation that are possible - forecasting movements of Nifty, forecasting movements in Nifty futures prices, and forecasting interest rates.
Sell a million rupees of Nifty on the spot market. Make delivery, and get paid. This is your "borrowed funds". Simultaneously, buy a million rupees of Nifty futures. Hold these positions till the futures expiration date. On the futures expiration date, buy back the Nifty shares on the spot market. When you pay for them, you are "repaying your loan".
Internationally, clearing corporations calibrate their risk containment system so that failures are expected to take place roughly once or twice in each fifty years. The track record of futures clearing corporations internationally is impressive. In the 20th century, we have seen just a handful of failures (e.g. Hong Kong in 1987). NSCC has a short track record: it has been doing novation on the "equity spot mar-ket" (which is actually a futures market) from 1996 onwards. In these five years, the equity market has experienced high volatility, a high incidence of bankruptcies by NSE brokerage firms, payments problems on other exchanges, etc. NSCC has successfully shouldered the task of doing novation on India's largest financial market (NSE). While this suggests that NSCC may have fairly sound risk containment systems, we should be cautious since it only has a track record of five years of doing novation.
Nifty is a well-diversified portfolio of companies that make up 54% of the market capitalisation of India. The diversification inside Nifty serves to "cancel out" influences of individual companies or industries. Hence Nifty, as a whole, reflects the overall prospects of India's corporate sector and India's economy. Nifty moves with events that impact India's economy. These include politics, macroeconomic policy announcements, interest rates, money supply and budgets, shocks from overseas, etc. Shah & Thomas (1999c) offer some time-series econometrics applied to Nifty.