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Futures – Index Futures
 

  What are Index Futures?
  Why have index derivatives proved to be more important than individual stock derivatives?
  How can you use index futures for hedging?
  How can an investor benefit from a predicted rise or predicted fall in the price of a stock?
  There are several index futures trading at the same time. Which one should I use?
  How is the price of index futures determined?
  What happens to the profit or loss due to Daily Settlement?
  How does the Initial Margin affect the profit or loss?
 
What are Index Futures?

Index Futures are future contracts in which the underlying asset is an index (eg.BSE Sensex, S&P CNX Nifty). While trading on index futures, an investor is basically buying and selling the basket of securities comprising an index in their relative weights. Index Futures contracts have been standardized as far as market lot, minimum contract value etc are concerned for trading convenience.

Unlike commodity and other futures contracts, settlement in Index Future contracts is done in cash.

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Why have index derivatives proved to be more important than individual stock derivatives?

Every portfolio of stocks is subject to risk on account of volatility in benchmark indices such as Nifty and BSE Sensex. Since index movements reflect the overall direction of the market, risk on account of index movement can be hedged using Index Futures. Once the Index risk is hedged, an investment portfolio will be subject only to stock specific risk. On account of this hedging facility, a larger number of people are interested in Index Futures than in the futures of a specific stock.

Another convenience of using Index futures as opposed to individual stock futures, is that Index derivatives are subject to fewer regulatory restrictions.

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How can you use index futures for hedging?

If your exposure to a particular index is lower than what you would desire, you should buy the futures contract of that index. If the market moves upwards in the future, the futures contract will result in profit which can compensate losses on any short positions in individual stock futures (whose prices are moving upwards in the direction of the market). As you will have to pay only the margin (which forms a fraction of the notional value of the contract), your return on investment will be higher than on an equivalent purchase of shares.

If your index exposure is higher than what you like, you can limit the risk from a possible downward movement in the index value by selling the index futures. If the index value falls, the Futures contract will result in profit, which offsets losses on your core equity portfolio. Conversely, if the index rises, your core equity portfolio does well but the futures suffer a loss. Hence, your position is hedged and you are less susceptible to volatility in market movements.

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How can an investor benefit from a predicted rise or predicted fall in the price of a stock?

An investor can benefit from a predicted rise in the price of a stock by buying futures. As the price of the futures rises, the investor will make a positive return. As the investor will have to pay only the margin (which forms a fraction of the notional value of contract), his return on investment will be higher than on an equivalent purchase of shares.

Are your short-term investment giving you the desired rate of return or are you trapped

An investor can benefit from a predicted fall in the price of stock by selling futures. As the price of the future falls in line with the underlying stock, the investor will make a positive return.

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There are several index futures trading at the same time. Which one should I use?

Since contracts with different maturity dates are available for trading at the same time, one must consider certain points before selecting a contract. If you have a two-month view, then a futures contract that has only a few weeks of life left might be inconvenient. So, one must consider ones forecast horizon before selecting the contract. Another major issue is liquidity. Other things being equal, it is always better to use the contract with the tightest bid-ask spread.

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How is the price of index futures determined?

In simplest terms:
Futures Price = Spot Price + Cost of Carry where

Cost of carry is the sum of all costs incurred if a similar position is taken in the spot market and carried to maturity of the futures contract less any revenue which may result within that period. In case of stock index futures, the excess of the financing cost of holding the stock over the dividend receipts constitutes the net cost of carry.

In other words, the futures price of stock index futures should provide a guaranteed capital gain that exactly compensates the excess of interest payments over the dividend receipts.

The futures price should be such that there is no arbitrage profit from buying stock (with borrowed money) and simultaneously selling futures. If the secondary market prices deviate from the theoretical values, it would imply the presence of arbitrage opportunities, which would be swiftly exploited.

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What happens to the profit or loss due to Daily Settlement?

As long as the position is open, the same will be marked to market at the Daily Settlement Price, the difference will be credited or debited accordingly and the position shall be brought forward to the next day at the daily settlement price. Profit or loss would only depend upon the opening and closing price of the position, irrespective of how the rates have moved in the intervening days. Any position which remains open at the end of the final settlement day (i.e., last Thursday) shall be closed out by the exchange at the Final Settlement Price which will be the closing spot value of the underlying.

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How does the Initial Margin affect the profit or loss?

The initial margin is only a security provided by the client through the clearing member to the exchange. It can be withdrawn in full after the position is closed. Therefore it does not affect the calculation of profit or loss.

However there would be a funding cost / transaction cost in providing the security. This cost must be added to the total transaction costs to arrive at the true picture. Other items in transaction costs would include brokerage, stamp duty etc.

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