Index futures are possibly the single most popular exchange traded derivatives products today. The S&P 500 futures products are the largest traded index futures product in the world.
In India both the BSE and NSE are due to launch their own index futures product on their benchmark indices the Sensex and the Nifty.
What is the trend abroad?
Although we have a whole host of popular exchange owned indices abroad including the DAX 30, the CAC 40 and the Hang Seng we see an increasing trend where global index providers are seen to have more influence among the foreign funds and investing community.
What do Global Index providers bring?
In the age of cross border capital flows and global funds, global index provider provide the uniformity and standardization in their index philosophy and methodologies that allows a global fund to compare performance across regions or sectors.
By following a common industry classification standard in all the countries that they operate in, index providers hope to wean away liquidity from the more popular and home grown indices.
Also global providers are currently, the only ones in a position to provide pan-continental or pan-global indices.
What does the future look like?
The future in India looks pretty exciting with Index futures being launched and Index options expected to follow. Hopefully with the growing popularity of ETF’s we might see SEBI allowing them in India too.
Globally while the debate between active and passive fund management still rages, we see standardised indices growing in popularity.
What are Index Futures?
- Index futures are the future contracts for which underlying is the cash market index.
- For example: BSE may launch a future contract on “BSE Sensitive Index” and NSE may launch a future contract on “S&P CNX NIFTY”.
Frequently used terms in Index Futures market
- Contract Size – is the value of the contract at a specific level of Index. It is Index level * Multiplier.
- Multiplier – It is a pre-determined value, used to arrive at the contract size. It is the price per index point.
- Tick Size – It is the minimum price difference between two quotes of similar nature.
- Contract Month – is the month in which the contract will expire.
- Expiry Day – is the last day on which the contract is available for trading.
- Open interest – it’s the total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted.
- Volume – Number of contracts traded during a specific period of time – During a day, during a week or during a month.
- Long position- Outstanding/unsettled purchase position at any point of time.
- Short position – Outstanding/ unsettled sales position at any point of time.
- Open position – is the outstanding/unsettled long or short position at any point of time.
- Physical delivery – Open position at the expiry of the contract is settled through delivery of the underlying. In futures market, delivery is low.
- Cash settlement – Open position at the expiry of the contract is settled in cash. These contracts are designated as cash settled contracts. Index Futures fall in this category.
- Alternative Delivery Procedure (ADP) – Open position at the expiry of the contract is settled by two parties – one buyer and one seller, at the terms other than defined by the exchange. World wide a significant portion of the energy and energy related contracts (crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.
a) Concept of basis in futures market
- Basis is defined as the difference between cash and futures prices:
Basis = Cash prices – Future prices.
- Basis can be either positive or negative (in Index futures, basis generally is negative).
- Basis may change its sign several times during the life of the contract.
- Basis turns to zero at maturity of the futures contract i.e. both cash and future prices converge at maturity
b) Life of the contract
Gearing or leverage results where initial cash outflow in taking a position is less than the value of the position. In case only 5% margin is paid for taking a futures position, the gearing factor is 20 i.e. on a given capital 20 times in value a position may be taken. Thus, higher the gearing higher the risk.
d) Pricing Futures
Cost and carry model of Futures pricing
- Fair price = Spot price + Cost of carry – Inflows
- FPtT = CPt + CPt * (RtT – DtT) * (T-t)/365 oFPtT – Fair price of the asset at time t for time T.
- CPt – Cash price of the asset.
- RtT – Interest rate at time t for the period up to T.
- DtT – Inflows in terms of dividend or interest between t and T.
- Cost of carry = Financing cost, Storage cost and insurance cost.
- If Futures price > Fair price; Buy in the cash market and simultaneously sell in the futures market.
- If Futures price <>
This arbitrage between Cash and Future markets will remain till prices in the Cash and Future markets get aligned.
Set of assumptions
- No seasonal demand and supply in the underlying asset.
- Storability of the underlying asset is not a problem.
- The underlying asset can be sold short.
- No transaction cost; No taxes.
- No margin requirements, and so the analysis relates to a forward contract, rather than a futures contract.
Index Futures and cost and carry model
In the normal market, relationship between cash and future indices is described by the cost and carry model of futures pricing.
Expectancy Model of Futures pricing
S – Spot prices.
F – Future prices.
E(S) – Expected Spot prices.
- Expectancy model says that many a times it is not the relationship between the fair price and future price but the expected spot and future price, which leads the market. This happens mainly when underlying is not storable or may not be sold short. For instance in the commodities market.
- E(S) can be above or below the current spot prices. (This reflects markets the expectations)
- Contango market- Market when Future prices are above cash prices.
- Backwardation market – Market when future prices are below cash prices.
e) Relationship between forward & future markets
- Analyze the different dimensions of Forward and Future Contracts:
(Risk; Liquidity; Leverage; Margining etc….)
- Assign value to each factor to arrive at the contract price.
(Perception plays a crucial role in price determination)
- Any substantial difference in the Forward and Future prices will trigger arbitrage.
f) What are stock specific futures?
There are very few countries that offer stock specific futures, since these instruments in general aren’t very popular. Price volatility in individual stocks is much higher than the index, which results in an increase in the risk of the Clearing Corporation and higher margin requirements. These instruments also suffer from lack of depth and liquidity in trading. In most cases, Futures based on individual stocks often have a physical settlement, which leads to more complex regulatory requirements.
Since it’s a lot more difficult to manipulate an index than individual stocks leading to price manipulations. The L.C.Gupta committee did not promote futures on individual stocks as a possible derivative contract.
g) What do you mean by closing out on contracts?
A long position in futures can be closed out by selling futures while buying futures can close out a short position. Once apposition is closed out, only the net difference needs to be settled in cash, without any delivery of the underlying. Most contracts are not held to expiry but are closed out before that. If held until expiry, some are settled for cash others for physical delivery.
What’s the difference between the settlement mechanism for cash and physical delivery?
In case it is not possible or practical to give physical delivery. Open positions, (open long positions always being equal to open short positions) are closed out on the last day of trading at a price determined by the spot “cash” market of the underlying asset. This price is called “Exchange Delivery Settlement Price” or EDSP. In case of physical settlement short side delivers to the specified location while long side takes delivery from the specified location of the specified quantity / quality of the underlying asset.
In case of physical settlement short side delivers to the specified location while long side takes delivery from the specified location of the specified quantity / quality of the underlying asset. The long side pays the EDSP to the clearing house/corporation which in turn is received by the short side.
h) Risk management through Futures?
Which risk are we going to manage through Futures ?
- Basic objective of introduction of futures is to manage the price risk.
- Index futures are used to manage the systemic risk, vested in the investment in securities.
i) Risk management through Futures?
- Long hedge- When you hedge by going long in futures market.
- Short hedge – When you hedge by going short in futures market.
- Cross hedge – When a futures contract is not available on an asset, you hedge your position in cash market on this asset by going long or short on the futures for another asset whose prices are closely associated with that of your underlying.
- Hedge Contract Month- Maturity month of the contract through which hedge is accomplished.
- Hedge Ratio – Number of future contracts required to hedge the position.
j) Some specific uses of Index Futures
- Portfolio Restructuring – An act of increasing or decreasing the equity exposure of a portfolio, quickly, with the help of Index Futures.
- Index Funds – These are the funds which imitate/replicate index with an objective to generate the return equivalent to the Index. This is called Passive Investment Strategy.
Speculation in the Futures market
- Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:
- Naked positions – Position in any future contract.
- Spread positions – Opposite positions in two future contracts. This is a conservative speculative strategy.
Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.
Arbitrageurs in Futures market
Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.
k) Margining in Futures market
The whole system dwells on margins:
o Daily Margins
o Initial Margins
o Special Margins
o Additional Margins
Please note: Compulsory collection of margins from clients including institutions. Also collection of margins on Portfolio basis is not allowed by L. C. Gupta committee.
- Daily margins are collected to cover the losses that have already taken place on open positions.
- Price for daily settlement – Closing price of futures index.
- Price for final settlement – Closing price of cash index.
- For daily margins, two legs of spread positions would be treated independently.
- Daily margins should be received by CC/CH and/or exchange from its members before the market opens for the trading on the very next day.
- Daily margins would be paid only in cash.
- Margins to cover the potential losses for one day.
- To be collected on the basis of value at risk at 99% of the days.
- Different initial margins on: oNaked long and short positions.
- Spread positions.
The concept of cross margining?
This is a method of calculating margins after taking into account combined positions in Futures, options, cash market, etc. Hence the total margin requirement reduces to cross Hedges, though this very unlikely to be introduced in India.
Short positions 100 [exp (3st ) – 1]
Long positions 100 [1 – exp (3st)]
Where (st)2 = l(st-1)2 + (1-l)(rt2)
- st is today’s volatility estimates.
- st-1 is the volatility estimates on the previous trading day.
- l is decay factor which determines how rapidly volatility estimates change and is taken as 0.94 by Prof. J. R. Varma.
- rt is the return on the trading day [log(It/It-1)]
- Because volatility estimate st changes everyday, Initial margin on open position will change every day. (for first 6 months of futures trading, minimum initial margin on naked positions shall be 5%)
- Flat rate of 0.5% per month of spread on the far month contract.
- margin of 1% and maximum margin of 3% on spread positions.
- A calendar spread would be treated as open position in the far month contract as the near month contract approaches maturity.
- Over the last five days of trading of the near month contract, following percentages of the spread shall be treated as naked position in the far month contract:
- 100% on the day of expiry
- 80% one day before the expiry
- 60% two days before the expiry
- 40% three days before the expiry
- 20% four days before the expiry
Margins on the calendar spread are to be reviewed after 6 months of futures trading.
In case of sudden higher than expected volatility, additional margin may be called for by the exchange. Its generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payment crisis, etc. this is a preemptive move by the exchange to prevent breakdown.
l) Liquid assets and Broker’s net worth
- Liquid assets
- Cash, fixed deposits, bank guarantee, government securities and other approved securities.
- 50% of Liquid assets must be cash or cash equivalents. Cash equivalents means cash, fixed deposits, bank guarantee and government securities.
- Liquid net-worth = Liquid asset – Initial margin
- Continuous requirement for a clearing member:
- Minimum liquid net-worth of Rs.50 Lacs.
- The mark to market value of gross open position shall not exceed 33.33 times of member’s liquid net worth.
m) Basis for calculation of Gross Exposure
- For the purpose of the exposure limit, a calendar spread shall be regarded as an open position of one third of the mark to market value of the far month contract. As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract in the same manner as defined in slide no. 49.
Margining in Futures market
Initial Margin (Value at risk at 99% of the days)
- Striking an intelligent balance between safety and liquidity while determining margins, is a million dollar point.
Position limits in Index Futures
No position limit. Disclosure to exchange, if position of people acting in concert is 15% or more of open interest.
Trading member level
- 15% of open interest or 100 crore whichever is higher.
- to be reviewed after 6 months of futures trading.
Clearing member level
- No separate position limit. However, C.M. should ensure that his own positions (if C.M. is a T.M. also) and the positions of the T.Ms. clearing through him are within the limits specified above for T.M.
- No limit. To be reviewed after 6 months of trading in futures.
Operators in the derivatives market
- Hedgers – Operators, who want to transfer a risk component of their portfolio.
- Speculators – Operators, who intentionally take the risk from hedgers in pursuit of profit.
- Arbitrageurs – Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mispricing.
Expected Advantages Of Derivatives To The Cash Market
- Higher liquidity
- Availability of risk management products attracts more investors to the cash market.
- Arbitrage between cash and futures markets fetches additional business to cash market.
- Improvement in delivery based business.
- Lesser volatility
- Improved price discovery.
What makes a contract click?
- Risk in the underlying market.
- Presence of both hedgers and speculators in the system.
- Right product specifications.
- Proper margining.
- Multiple indices trading on the same exchange even the same index with different contract designs
- Dedicated funds –
n) What are general hedging strategies?
The basic logic is ” If long in cash underlying: Short Future;
If short in cash underlying: Long Future”
Example: if you have bought 100 shares of company A and want to hedge against market movements, you should short an appropriate amount of Index Futures. This will reduce your overall exposure to events affecting the whole market (systematic risk). In case a war breaks out, the entire market will fall (most likely including Company A). so your loss in company a would be offset by the gains in your short position in Index Futures.
Some instances where hedging strategies are useful include:
- Reducing the equity exposure of a Mutual Fund by selling Index Futures;
- Investing funds raised by new schemes in Index Futures so that market exposure is immediately taken, and
- Partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higher.