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Sunday, September 09, 2001













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Pricing of index futures

Anup Menon

M. S. Narasimhan

AN INVESTOR buying index futures is investing less than his counterpart who invests in the cash market.

The saving associated with such a transaction is the first factor that determines the price of the futures contract. Theoretically, the saving should be equal to the opportunity cost of funds for the investor.

A generalisation of the same would imply that the saving should be equal to at least the risk-free short-term interest rate for the period. Theoretically, this should actually increase the price of the futures contract and represent the time value of differences in the investment needs of two products.

The second factor that drives stock index futures is the expected dividend on stocks forming part of the index during the period. Since buyers of index futures do not get dividends, whereas investors of stocks do, the dividend is expected to have an impact on the future price.

This factor will have a negative impact on future prices. Since many Indian companies pay annual dividends and the average dividend yield of Nifty stocks for the last five years is around 2 per cent, which is less than risk free interest rate, the negative impact will be lower than the positive impact caused by the interest rate.

The third factor is transaction cost. Since the transaction cost of index futures is normally less than the transaction cost of buying or selling individual stocks, this, again, is expected to have a positive impact on the price of index future.

So, what is the key factor that drives the price of a stock index futures contract? For this we have to look at the product in its basic design. A stock index future is a derivative on a particular stock index which, in this case, happens to be either the Nifty and the Sensex. Therefore, a one-month Nifty contract would represent the investor's expectation on the value of the Nifty contract one month down the line.


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