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Index futures : An instrument of future

Subject : Derivatives
Month-Year : Jul 2000
Author/s : Kiran Rotkar
Chartered Accountant
Topic : Index futures : An instrument of future
Article Details :

On 1st November 1999, Mr. Mehta got a hot tip that the share market was headed towards north. Based on this perception he decided to buy shares of HLL as it had the highest market capitalisation then. Mr. Mehta therefore bought 200 shares @ Rs.2,303/- per share, and to finance this he took a loan @ 18% p.a. pledging some of his lifelong savings. Mr. Mehta was a happy man for his smart investment.

Three months later, on 1st February 2000 Mr. Mehta's pre-diction proved to be right. The BSE index did move upwards from 4270 to 5215. However Mr. Mehta was neither happy, nor was he rich. He had suffered a loss of Rs.20,327/- (4% of his investment).

Interest paid @ 18% 20,727/-
Capital appreciation 400/-
  -------------
Loss 20327/-
  -------------

How did this happen ? Mr. Mehta was as surprised as you are. What actually happened was that though the Sensex rose by 22%, HLL's share price did not rise in the same proportion. Mr. Mehta suffered a loss even though his prediction was accurate.

Does the above scene ring a bell ? How often have you found yourself to be in Mr. Mehta's shoes ? How many times has it happened, that you bought some shares and then everything other than your share touched the sky ?

The above scenario can be explained with the help of CAPM (Capital Asset Pricing Model) theory given by William Sharpe in 1962. The author has bifurcated risk (i.e. chances that the price may deviate) involved in holding any share/asset into Market risk and Unique risk.

Market risk represents that part of risk which is common to all the companies/assets (from hereon we will use shares and assets interchangeably). Thus it is that part of the total risk which is attributable to the fluctuations of the market as a whole. An example would be that of a change in the interest rate, change in the tax structure etc. Unique risk is that risk which is unique to the company and is independent of the market. It arises from 'firm-specific' risk. To quote an example, changes in oil prices may affect the refinery business, but will not so affect a soft drink company.

Further, the theory tells us that an investor can do away with unique risk by holding a portfolio of shares (20 to 30 shares). This happens because rise in one stock is setoff by the fall in some other stock. An investor, thus, by holding number of shares can minimise, if not eliminate unique risk. As the number of shares increases, the unique risk reduces, thus reducing the total risk involved in the portfolio. However, market risk cannot be reduced even by diversification of the portfolio.

Market return compensates an investor for bearing the market risk. However as unique risk can be eliminated (though not completely) through diversification of the portfolio, market does not compensate for unique risk.

Now applying this concept to Mr. Mehta's case, if Mr. Mehta had invested in 20 shares from different industries, he would have gained had the market gone up, as it did. He would have eliminated the unique risk by holding a diversified portfolio of shares.

So the next question that comes to our mind is why does not everyone in the market hold a well diversified portfolio of shares. The main constraint is funds. Imagine buying a port-folio of 20 stocks. It will entail an investment of about Rs.25-30 lakhs. This is not possible for every investor. So is there some other means by which one would be able to do away with unique risk. Yes there is, and the good news is that it is now coming to India. It is called index futures.

Let us first try and understand the concept of 'futures' before we get into the details of index futures. A futures contract is an agreement between two parties to buy or sell an asset at a certain specified time in future for a certain specified price. Futures is a security in the family of derivatives, whose value is derived from an underlying asset. The underlying asset can vary from commodities, currencies, fixed income instruments to stock indices.

Let's understand futures with the help of a commodity deal, say oilseeds. Suppose ABC Co. Ltd. purchases oilseeds, which is the major raw material in its production cycle. A slight upward change in the price of oilseeds may affect this company adversely, as the selling price of the final product is predeter-mined by way of a contract. Thus the company is running a risk occurring due to a change in the commodity's price. The company would therefore prefer to buy the oilseeds at a fixed price. It would then be able to do away with the commodity price fluctuation risk. However it will not be willing to purchase the oilseeds today and stock them as this would involve a high carrying cost.

On the other hand, another company PQR Co. Ltd. which sells oilseeds, faces the risk if the prices of oilseeds move downwards. It also would like a fixed price for its oilseeds. In a futures contract both ABC Co. Ltd. and PQR Co. Ltd. will deal with each other through an exchange to buy/sell oilseeds at a rate fixed on the day of contract (today) for a future date (maturity date) say three months hence. Now after three months what-ever be the price of oilseeds, ABC Co. Ltd. is obliged to buy and PQR Co. Ltd. is obliged to sell oilseeds at the rate agreed upon.

Extending the above logic to index futures, the two parties enter into an index futures contract to buy/sell indices at a future date. Assume that, in our example of Mr. Mehta, the BSE index on 1st November 1999 is 4270. The 3 month index futures is available at 4500 and Mr. Mehta believes that the index will reach 5000 in three months, he will buy 50 indices at the rate of 4500. After three months the difference between the index on maturity rate (5215) and the contracted rate (4500) will be either paid to or received from Mr. Mehta.

Concepts which govern index futures are as follows :

1. Portfolio :
 

Index represents a number of shares from different industries. This helps in diversifying the portfolio without actually buying/selling all the shares which would cost a huge sum. Thus it helps doing away with the unique risk. What the investor is actually holding is the market risk for which he may be rewarded by way of capital appreciation.

2. Multiplier :
 

Multiplier is that factor which is applied to the index to deter-mine the minimum value of the contract. In case of BSE the multiplier is 50 whereas in case of NSE it is 100. What this implies is that one sensex futures would be equal to index multiplied by 50. Say the index is 6000 the minimum contract value would be 6000 x 50 = Rs.3 lakhs. This is done to keep small investors away as they tend to be the losers in case of high volatility in the market.

3. Standardisation :
 

Index is based on weighted average prices of certain specified shares where weights are their respective market capitalisation (shares issued * market price per share). These shares are generally a representative of the market as a whole. Thus it gives a standard portfolio which is the need for ease in marketability of any commodity which in this case is the index.

4. Duration of the contract :
 

The duration of futures is fixed. In the Indian context there will be three futures contracts at any particular time, 1 month, 2 month and 3 month. The expiry of the contract will be on the last Thursday of the month on the BSE and the last Friday of the month on the NSE. Thus at a given time 3 futures contracts will be available for trading at each exchange.

5. Exchange :
 

All the transactions will be routed through recognised stock exchanges, initially NSE and BSE. Thus the default risk involved in the transaction is eliminated. The exchange guarantees (though technically it is the clearing house/corporation that gives the guarantee) the payment of dues on the due dates to all the parties.

6. Margin :
 

Margin refers to that part of the transaction value which the member has to maintain with the exchange. This helps the exchange by giving security against default by its member, and it also prevents the member from taking high risk by keeping high open positions without financial support. Margins are of 3 types — initial margin, maintenance margin and variation margin. While initial margin can be cash or collateral like treasury bonds variation margin is always in cash.

7. Mark to market :
 

All the outstanding positions at the end of the day will be marked to the closing price of that day. Any difference in the contracted price and the marked price will be paid or received on a daily basis.

8. Liquidity :
 

The exchange provides high liquidity to the futures contracts. A person who has taken an open position in Futures market has 2 options. He can retain the position till the maturity of the contract or he can take an opposite position to square off the earlier transaction. This arrangement gives high liquidity to futures contracts.

Though in this article, we have seen the transactions where speculation was the main motive, index futures can be efficiently used to hedge against risk arising out of market movements. Further the pricing of futures is not covered in this article. This and such other issues also need to be understood to gain a complete understanding of index futures.

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