Demystifying index futures

Ajay Shah

Susan Thomas

A FUTURE is a forward contract traded on an exchange. Forward contracting is invaluable in hedging and speculation.

The classic hedging application is that of a wheat farmer forward-selling his harvest, at the time of sowing, to eliminate price risk. Conversely, a bread factory could forward-buy wheat to assist production planning without the risk of price fluctuations.

If a speculator has information or analysis which forecasts a price upturn, he could `buy' (go long) on the forward market instead of the cash market. He would wait for the price to rise and then close out the position on the forward market (by selling 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. A speculator prefers transactions involving a forward market because (a) the costs of taking or making delivery of wheat are avoided, and (b) funds are not blocked for the purpose of speculation.

How do futures trade?

In the cash market, the basic dynamic is that the issuer puts out paper, which is traded. In contrast, with futures (as with all derivatives), there is no issuer and, hence, no fixed issue size. The net supply of all derivatives contracts is zero. For each buyer, there is an equal and opposite seller. A contract is born when a buyer and a seller meet on the market. And the number of contracts that exist at a point in time is termed open interest.

What determines the price of a futures product?

Supply and demand on the secondary market determines the futures price. On dates before December 31, 2000, the Nifty futures expiring on December 31 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 of how futures are priced. If the secondary market prices deviate from the projected 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 can make the theoretical prices a reality.

What determines the fair price of an index futures product?

The fair price of a derivative is the price at which profitable arbitrage is not feasible. The pricing of index futures depends on the spot index, the cost of carry, and expected dividends. For simplicity, assuming no dividends are expected, and assuming that the spot Nifty is at 1,000, and the one-month interest rate at 1.5 per cent, the fair price of an index futures contract that expires in a month is 1015.

What is a `spot' transaction?

In a spot market, transactions are settled ``on the spot''. Once a trade is agreed upon, the settlement -- 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 the spot market.

That is okay for shirts, but does it ever happen in finance?

There are two real-world implementations of a spot market -- rolling settlement and real-time gross settlement (RTGS). With rolling settlement, trades are netted through one day, and settled `x' working days later; this is called T+x rolling settlement.

For example, with T+5 rolling settlement, trades are netted through Monday, and the net open position as of Monday evening is settled the next Monday. With RTGS, all trades settle in a few seconds, with no netting. Rolling settlement is a close approximation, and RTGS is a true spot market. The equity market in India today, for the major part, is not a spot market.

What is `basis'?

The difference between the spot and the futures price is called the basis. When a Nifty futures trades at 1015 and the spot Nifty at 1000, ``the basis'' is said to be Rs. 15, or 1.5 per cent.

What is `basis risk'?

Basis risk is the risk futures market players take owing to unwanted fluctuations of the basis. In the ideal futures market, the basis should reflect the interest rate, 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. A well-designed index, and a well-designed cash market for equities, serve to minimise basis risk.

What happens if the futures trade at Rs. 1,025 instead of Rs. 1,015 ?

This is an error in the futures price of Rs. 10. An arbitrageur can, in principle, capture the mispricing of Rs. 10 using a series of transactions. He would (a) buy the spot Nifty, (b) sell the futures, and (c) hold till expiration.

This strategy is equivalent to no-risk lending of money to the market at 2.5 per cent per month. As long as a person can borrow at 1.5 per cent month, he would be making a profit of 1 per cent per month by doing this arbitrage, without bearing any risk.

What happens if the futures trade at Rs. 1,005 instead of Rs. 1,015?

This is an error in the futures price of Rs. 10. An arbitrageur can, in principle, capture the mispricing of Rs. 10 using a series of transactions. He would (a) sell the spot Nifty, (b) buy the futures, and (c) hold till expiration. This is equivalent to borrowing money from the market, using (Nifty) shares as collateral, at 0.5 per cent per month. As long as a person can lend at 1.5 per cent month, he would make a profit of 1 per cent per month by doing this arbitrage, without bearing any risk.

Are these pricing errors really captured by arbitrageurs?

In practice, arbitrageurs suffer transactions costs in doing Nifty programme trades. The arbitrageur suffers one market impact cost in entering a position on the Nifty spot, and another when exiting. As a thumb rule, transactions of a million rupees suffer a one-way market impact cost of 0.1 per cent. So the arbitrageur suffers a cost of 0.2 per cent 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.

What is cash settlement?

Futures markets use `cash settlement'. Here, the terminal value of the product is deemed equal to the price 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 purchases 30 units of Nifty from S at a price of Rs. 1,500 on December 31, 2000. Suppose, on the expiration date, December 31, the Nifty spot is actually at 1,600. 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 profit/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 that extended the reach of derivatives into many products where physical settlement was not viable.

How would a seller `deliver' a market index?

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 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.

There are several (one-, two-, and three-month) index futures trading at the same time. Which is the best to use?

Sometimes, the forecast horizon generates constraints. If you have a two-month view, a futures contract with only a few weeks of life 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.

When does hedging go wrong?

Hedgers fear basis risk, which is about Nifty futures prices moving in a way 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. However, basis risk does detract from the usefulness of hedging using derivatives.

Can a Nifty futures be cheaper than the Nifty spot?

Suppose the Nifty spot is the same as the price of the three-month futures, that is, the basis is zero. This means the futures market is willing to give you a loan (against a Nifty portfolio as collateral) for a three-month period at zero interest. If the Nifty futures is cheaper than the Nifty spot, it means the futures market is willing to pay you if you borrow money.

Many people in India would be happy to borrow (against a Nifty portfolio as collateral) at zero or negative interest rate. When they step into the futures market to do so, they will buy futures and sell spot. That will push futures prices away from their unnatural levels. Nothing forbids these unnatural levels (negative or zero basis). It is just that they are extremely attractive arbitrage opportunities, and unlikely to lie around for long.

Comparison with stock futures

SECURITY options are of limited interest because the pool of people interested in, say, options on ACC, is small. In contrast, anyone with any involvement in the equity market is affected by index fluctuations. Hence, risk-management using index derivatives is far more important than risk-management using individual security options.

This goes back to the basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the portfolio composition. All portfolios of ten stocks or more have a pattern in which 70 per cent or more of the risk is index-related.

Hence, investors are more interested in using index-based derivative products. Index derivatives also present fewer regulatory headaches than leveraged trading on individual stocks. Internationally, this has led to regulatory encouragement for index futures, and discouraged futures on individual stocks.

(The authors are with the Indira Gandhi Institute for Development Research, Mumbai. A detailed version of `Derivatives in India: Frequently Asked Questions' can be accessed at www.igidr.ac.in/ajayshah)