INDEX FUTURES

ACKNOWLEDGEMENT

This formal piece of acknowledgement may be sufficient to express the feelings of gratitude

people who have helped me in successfully completing my Final Project Report.

We feel, we shall always remain indebted to without whom it is being impossible to complete

my project report. He gave his kind supervision, guidance, timely support and all other kind

of help required in each and every moment of need.

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S. No. Table of Contents Page No.

1 Acknowledgment

2 Table Of Contents

3 Chapter 1

1.1 Objectives of the study

1.2 Methodology for the study

4 Chapter 2: Introduction

2.1 Index Futures

2.2 History of Index Futures

2.3 Uses of Index Futures

2.4 Features and Specifications of Index Futures

5 Chapter 3: Pricing Of index Futures

6 Chapter 4: Applications of the Index Futures

7 Appendix A: References

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Chapter 1

1.1 Objectives of the Study:

To brief about index futures and practical aspects of pricing and risk hedging strategies using

index futures

1.2 Methodology for the Study:

Methodology is defined as system of methods used in a particular area of study or activity.

Once the objectives of the study are defined than this with various methods used to achieve

those objectives.

Study the concept of index futures

Analyzing the features and specifications of index futures

Pricing the index futures

Application of index futures to minimize risk.

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Chapter 2: Introduction

2.1 Index Futures:

Index futures are futures contracts with an index instead of a physical asset as its underlying

asset. Indeed, index futures are one of the most important financial futures in the world today

and opened up the way for futures traders to trade and profit from the performance of a

specific index directly instead of having to trade the entire basket of asset covered by the

index. 

The most important of index futures are index futures based on broad market indexes such as

the S&P500 Futures and theNikkei225 futures. These stock index futures allow futures

traders to "Buy the market" or "sell the market" for the first time without having to

simultaneously trade the hundreds of stocks that these indexes cover. In a way, trading index

futures is really trading all the stocks or assets covered by an index in the capital weightage

represented in the index. In fact, there are also mini index futures or simply known as "minis"

which allows retail traders to perform leveraged speculation on their underlying index using

very little money.

2.2History of index futures in India:

The first index futures started in February of 1982, known as the Value Line contract started

by the Kansas City Board of Trade, followed by the S&P500 index futures in April of the

same year. Since then, a new stock index futures is started in a new market almost every year

up to 1999. In 2010, one of the world's most important market, the Chinese market, also

started stock index futures trading on its hushen300 index.

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2.3 Uses of the Index Futures:

Stock index futures are used for hedging, trading, and investments.

Hedging using stock index futures could involve hedging against a portfolio of shares or

equity index options.

Trading using stock index futures could involve, for instance, volatility trading (The

greater the volatility, the greater the likelihood of profit taking – usually taking relatively

small but regular profits).

Investing via the use of stock index futures could involve exposure to a market or sector

without having to actually purchase shares directly.

Please note the following cases of equity hedging with index futures:

Where your portfolio 'exactly' reflects the index (this is unlikely). Here, your portfolio is

perfectly hedged via the index future.

Where your portfolio does not entirely reflect the index (this is more likely to be the

case). Here, the degree of correlation between the underlying asset and the hedge is not

high. So, your portfolio is unlikely to be 'fully hedged'.

Equity index futures and index options tend to be in liquid markets for close to delivery

contracts. They trade for cash delivery, usually based on a multiple of the underlying index

on which they are defined (for example £10 per index point).

OTC products are usually for longer maturities, and are usually a form of options product.

For example, the right but not the obligation to cash delivery based on the difference between

the designated strike price, and the value of the designated index at the expiration date. These

are traded in the wholesale market, but are often used as the basis of guaranteed equity

products, which offer retail buyers a participation if the equity index rises over time, but

which provides guaranteed return of capital if the index falls. Sometimes these products can

take the form of exotic options (for example Asian options or Quanto options).

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2.4 Features and Specifications:

Contract Size: The minimum contract size is set to be close to Rs 2 lakh at the time

of introduction. The minimum lot for BSE Sensex is 50 and for Nifty it is also 50.

Contract Value: Each Point is considered to be equivalent to Rs 1. .If NIFTY HAS A

VLUE OF 5050, THE CONTACT SIZE WOULD BE 5050 * 50* 1 = Rs 252500.

Tick Size: It indicates the minimum change that is allowed in price quotation. It is

fixed at .05 points for both Sensex and Nifty. Hence the minimum change in value of

a nifty contract would be 50*.05= Rs 2.50.

Margins: Futures have an elaborate margining system. Whether for a buy or sell

transaction, the margin (percentage of the contract value) determined by the exchange

needs to be compulsory deposited with the exchange before executing the trade. It is

called the initial margin.

Number of contracts: At any point of time three monthly contracts are available.

Therefore, the period of hedge or speculation is confined to the next 3 months. The

contact expiring first is referred to as near month contract, and the contact expiring

last is referred to as far month contract

Maturity/Expiry: Each contract expires on last thrusday of the delivery month. A

new series comes into the existence on the Friday

Settlement: As indices are non – deliverable, a future contract I cash settled.

However obligations under futures contract can be liquidated by entering into a

contract opposite to the original contract before expiry. If not closed by last day of

trading, the open position is automatically closed on that day aa price determined by

the exchange, called the final settlement price.

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Chapter 3: Pricing Index Futures

Pricing of futures on index follows the cost of carry model. The cost of carry is rather easy to

determine it in case of financial assets. The absence of convenience yield in financial assets

further simplifies the determination of price. In case of financial futures, the cost of carry

comprises only the interest cost adjusted for dividend yield on index. It represents the cost of

funds that would be incurred if similarposition would be taken in the cash market and carried

till maturity of futures contract, less any income, typically dividends incurring on this stocks

compromising the index. Thus,

Futures price = spot price + cost of carry – benefits of ownership (d)

Cost of carry = financing cost in case of stock index futures/financial asset

For discrete compounding:

F= S*(1+r/m)^mt

For continuous compounding:

F= S*e^(r-d)t

Where r = annual interst rate

m = number of compounding intervals in a year

d = dividend yield

t = time to maturity in years

Forward prices of equity indices are calculated by computing the cost of carry of holding a

long position in the constituent parts of the index. This will typically be:

The risk-free interest rate, since the cost of investing in the equity market is the loss of

interest

Minus the estimated dividend yield on the index, since an equity investor receives the

sum of the dividends on the component stocks. Since these occur at different times,

and are difficult to predict, estimation of the forward price can be difficult,

particularly if there are not many stocks in the chosen index.

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Indices for futures are the well-established ones, such as S&P 500, FTSE, DAX, CAC40 and

other G12 country indices. Indices for OTC products are broadly similar, but offer more

flexibility.

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Chapter 4: Applications of Index Futures

As you know, futures have an underlying stock or an index and derive the value from it. In case of NIFTY futures, the underlying is NIFTY index, which is comprised of 50 major companies’ stocks. As the value of the 50 stocks vary, the index moves accordingly. NIFTY future prices which derive value from NIFTY index also vary accordingly.We will take an example of NIFTY index futures and see how it works.

SpecificationLet’s look at the specification of NIFTY Index futures;Underlying index S&P CNX Nifty

Trading Exchange NSE

Contract Size Permitted lot size shall be 50 and multiples. Minimum value = 2 Lakh

Price steps 0.05

Contracts Available Near month, Mid-month, Far month

Expiry day The last Thursday of the expiry month or the previous trading day if the last Thursday is holiday

Settlement basis Mark to market and final settlement will be on cash, T+1 basis

Settlement price Daily mark to market settlement will consider closing price of the futures and final settlement will be the closing value of the index

The listing of index futures in a newspaper on a date (Let’s say 11-Nov-2009) at NSE is as follows. The near month is November, mid-month is December, and far month is January. You can always have 3 contracts in NSE.

November Contracts:

5080 5110 5075 5090 295200 95000

December Contracts:

5090 5120 5085 5100 10200 15300

January Contracts:

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The numbers indicate the following:

Opening price * Days High * Days Low * Closing price * Open position * Number of contracts traded

How it works?We will now see a practical example of futures in action.

Decide to Buy:Suppose I go long on the NIFTY contract on 11-Nov-2009. This means I buy the NIFTY futures contracts on 11-Nov-2009 at 1:00 PM when the price was 5085. Since each NIFTY futures contract contains 100 units and hence the value of 1 contract is 5085 * 1 * 100 = 5,08,500. I will not have to pay the full amount as I am buying the futures contract and not the index. I will have to pay initial margin.

Margin Payment:The initial margin depends on type of financial instruments you choose. Some brokers may ask you for more margins though. Let’s say that the initial margin for me is 10%. This means I will have to pay 10% of 5,08,500 = 50,850. This amount will go to my margin account.

Mark to Market Settlement:Suppose the day closed at 5090. In this case, you earned the profit of 5 per unit. Hence your account will increase by 100*5 = 500. Your margin account will now have 50,850 + 500 = 51,350

This new price of 5290 will be now the price on which next settlement will be done.

On 12-Nov-2009, the NIFTY index futures closes at 5100. In this case, I gain 100*(5100-5090) = 1000. Observe that we are taking the profit or loss on 5090 (last day’s closing price) and not the price at which the contract was bought. Your account will now have 51,350 + 1,000 = 52,350

On 13-Nov-2009, the closing price of NIFTY index futures is 5095. Now since the price went down, my account will be deducted by an amount of 100*(5100-5095) = 500. Your account will have 52,350 – 500 = 51,850.

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Suppose on the next day, the futures price went down to 4900. Your loss will be 100*(5095 – 4900) = 19500. Your account will have 51,850 – 19500 = 32,350. Your account now has 51,850 – 19,500 = 32,350. Since this is a big loss, the broker will look at my maintenance margin. Maintenance margin is typically 75% of the initial margin. This means you have to maintain at least 75% of initial margin (50,850) which is 38,137. Your account balance of 32,350 is less than 38,137 and hence the broker will give you a margin call and you have to deposit amount which brings the margin account to the level of initial margin. In this case, I have to deposit an amount of 50,850 – 32,350 = 18,500.

SettlementAt the end when the contract is has to be settled, similar transaction happens and the contract is closed. Most of the futures end up in cash settlement than delivery as it is more convenient. In fact, in India, all index and stock futures are cash-settled.

Example 2: Short hedge – hedging long position of portfolio of stocks

Consider a mutual fund having a huge portfolio of 100 Crore. Today is 2 February, and the expectation of a general budget this 28 February is not very realistic. The current value of BSE SENSEX is 6500. February and March futures are maturing on 25th Feb and 25th March, consisting of 50 SENSEX, are selling at 6525 and 6600 respectively. How can the fund be protected against the uncertainty of the budget?

Solution:

The Hedging Strategy:

The fund is long on assets and must go short on futures. It must sell futures contract for March, as uncertainty over budget will last till Feb 28th, and cannot be covered by selling Feb contracts expiring prior to that date. To cover the risk fully, the fund must sell March futures contracts. Alternatively, it can be protected by selling Feb futures contracts, which would leave the fund exposed for the period between the dates of expiration of the futures and the date of the budget.

No. of contracts to be traded

Value of BSE SENSEX contract = 50*6600 = 3.30 lakh

Value of the portfolio to be hedged = 10,000 lakh

No. of contracts to be sold = 10,000/3.30 = 3030 contracts(approx)

(assuming the fund is diversified enough, and that a 1% change in the market causes the same degree of change in the portfolio value)

The fund buys back the index at an appropriate time after 28th Feb.

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If the market goes down by 5% as anticipated:

The value of the portfolio stands reduced by 5 crore to 95 crore. The March futures falls from 6600 to 6260 when the fund squares up its position

Gain on futures = (6600-6270)*50*3030 = 499.95 lakh

Therefore, the fund more or less compensates itself for the loss incurred on the portfolio value. Remember that futures cannot provide permanent protection, and if market sentiments become bearish, the fund will have to resort to other methods, including rolling over of the hedge. A longer period of uncertainty can be covered by closing out the position in March futures and opening a new position by going short on, say, June futures.

If the market goes up by 5% against expectations:

The value of the portfolio stands increased by 5 crore to 105 crore. The price of March futures rises from 6600 to 6900 when the fund squares up its position.

Loss on futures = (6600-6930)*50*3030 = 499.95 lakh

Therefore, the increase in portfolio value is offset more or less by the loss incurred on the futures contracts, keeping the value of the portfolio almost constant. Note that hedging through futures does not mean protecting against loss while preserving gain. It only ensures a constant value of the portfolio.

Advantages of trading in Index Futures:-A. Add flexibility to your investment portfolio

Stock index futures add flexibility to your portfolio in anumber of ways.

First, futures are available on a wide variety of leading stock indexes such as the S&P 500® or DJIASM, on more technology-oriented indexes such as the Nasdaq-100®, on broad indexes such as the Russell 2000®, on international stock market indexes such as Japan’s Nikkei or the U.K.’s FTSE-100 and on many other stock market indexes. Virtually wherever there isstock market exposure, there is a stock index contract to cover or capitalize on it.

Second, there is now a stock index futures contract to fit almost any size account. While the S&P 500 futures margin may be $20,000 or more, you can trade the smaller E-mini S&P or DJIA futures for about one-fifth the amount. (These margin requirements can change asthe markets move, so please call Lind-Waldock for more specific details on current conditions.)

Third, many of the major stock index futures also offer options on the futures contract, increasing the strategies available to fit almost any market condition. You do need to remember that stock index futures and options are short-term trading vehicles with a time limitation and are not buy-and-hold investments.

B. Create the possibility of speculative gains using leverage.Because a relatively small amount of margin money controls a large amount of capital represented in a stock index contract, a small change in the index level might produce a profitable return on your investment if you’re right about the market’s direction.

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For example, with the S&P 500 Index at 1150, the value of an S&P futures contract ($250 times the index) is $287,500, but requires an initial margin of only approximately $20,000, or about 6.9% of the value of the contract. It is not unusual to have daily swings of 20 points (or $5,000) in S&P futures. If you happen to catch the whole move correctly, that’s about a 25% return on your margin in one day.

C. You can trade stock index futures electronically as easily as you trade stocks online.

The E-mini® — for “electronic” mini — S&P stock index contract was the futures industry’s first market to use a small-order electronic order-routing and execution system. Now, many stock index futures contracts use an electronic platform to execute trades quickly and easily. In addition, these platforms often offer trading virtually around the clock.

D. Provide hedging or insurance protection for a stock portfolio in a falling marketAlthough the stock market climbed steadily from the early 1980s to the late 1990s, it later became apparent that there is no guarantee that it will always do so. Even though you don’t expect a fire in your house or an accident with your automobile, you buy insurance incase that should happen. You can also get “insurance” for your stock portfolio by using stock index futures and options on futures to protect against the day a decline might come. And, unlike purchasing options as insurance, there is no time value erosion of the futuresposition.

E. Maintain your stock portfolio during stock market corrections

You may not need “insurance” all of the time, but there are certain times when you would like less exposure to stocks. Yet, you don’t want to sell off part of a stock portfolio that has taken you a long time to put together and looks like a sound, long-term investment program. Perhaps you are worried that the Federal Reserve or Congress might do something to give the stock market a jolt or that some national or international developments could cause a severe stock market correction. Every market goes through periods when it is more vulnerable to corrections, perhaps quite big ones. If you feel you need protection for only a few days to withstand a temporary weak period in the market, you can sell stock index futures instead of disturbing your stock market portfolio.

F. Sell as easily as you can buyOne of the major advantages of futures markets, in general, is that you can sell contracts as readily as you can buy them and the amount of margin required is the same. A few mutual funds specialize in bear market approaches by short selling stocks but, for the most part, it is very difficult for an individual to short stocks. And selling naked stock index options is even more prohibitive at many major brokerage firms unless you have an account of at least $50,000. In stock index futures, there is no “uptick rule” that requires traders to wait until the market moves up (trades on an uptick) to sell short. There are no special restrictions at all on being short. It is as simple to sell if you believe the market is going down as it is to buy if you think the market is going higher. If the initial margin is $20,000 to buy a contract, the margin is $20,000 to sell the same contract.

G. Substitute for a future stock or mutual fund transaction

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Futures generally are defined as a temporary agreement for a future transaction, and that concept can be applied to the investor who suddenly has a sum of money and wants to invest it in the stock market. You may have won the lottery or you may have just received an inheritance or your quarterly bonus. You expect the stock market to go up, but you don’t know which stocks to buy and you don’t want your money sitting idle in the meantime. Stock index futures can give you quick exposure to the stock market and give you time to decide what you want to do on a more permanent basis. If you are eager to get into what you consider a great buying opportunity, you can also use stock index futures as a proxy for purchasing a mutual fund while you are waiting for the fund company to process your request. Again, stock indexfutures are meant to be short-term positions, not a longterm holding strategy.

H. Transfer risk quickly and efficiently any time during the day — or even at night.Whether you are speculating, looking for insurance protection (hedging), or temporarily substituting futures for a later cash transaction, most stock index futures trades can be accomplished quickly and efficiently. Not every stock index futures market has sufficient liquidity to allow easy entry and exit with minimum slippage, but markets such as S&P 500 futures can handle almost any size order at any time during the trading session. With electronic trading in contracts such as the E-mini S&P 500, trading sessions are now stretching almost around the clock. Many mutual funds require investors to wait until the end of the day to see at what price they were able to purchase or sell shares. With today’s volatility, once-aday pricing may not give you the maneuverability to take positions at exactly the time you want. Stock index futures give you the opportunity to get into or out of a position whenever you want and often within seconds of receiving your order. At Lind-Waldock, you can trade many electronically traded stock index futures contracts directly from your own computer and know where you stand almost instantaneously.

I. Benefit from transaction costs that are lower than the costs of trading stocks.One thing to remember when you compare the commission costs of futures trading and stock trading is that futures trading usually lists commission rates as “roundturn,” meaning a “buy” and a “sell.” Commission rates for stock trading are normally quoted for only one side of a transaction — for a “buy” or a “sell.” So you need to double the quoted cost of a stock trade to make it comparable to the roundturn cost of a futures trade. Futures trading typically lets you capitalize on stock market movement for a lower commission rate. For example, if you were to trade one E-mini S&P 500® futures contract, your stock market exposure to large cap stocks would be $57,500 ($50 times the S&P 500 Index with the index at 1150.) Say the commission rate to buy and sell your E-mini S&P 500 Index futures contract is $19 roundturn online. On the other hand, to trade $57,500 worth of stocks, you might purchase 1,150 shares of a $50 stock. Your stock trading commissions, based on some widely advertise commission rates, could be around $20 for the buy sid of an online transaction, or $40 roundturn. The cost of attempting to buy each of the stocks represented in the index would be far higher. As you can see, stock trading commission fees can be 100% more than futures trading commissions. Large stock index futures contracts, like the S&P 500® with a $250 multiplier, are even more commission efficient.

J. Enjoy a potentially lower tax rate.Profits on futures are taxed differently from short-term profits you make trading stocks, and this difference can work to your advantage. Why? Because profits from stocks that you hold less than 12 months are taxed, if you’re in the top tax bracket, at 39.6%. But profits on futures gains — both realized and unrealized — are taxed at a blended rate

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of 27.8%. The blended rate is the result of an Internal Revenue Service policy that classifies 60% of futures gains as long-term gains and 40% as short-term gains — regardless of the holding period.For example, if you have a $10,000 short-term profit in the stock market, and you’re in the top tax bracket, you’re looking at taxes of $3,960. The same amount of profit in the futures market would generate a $2,784 tax bill —about 30% less than the taxes on the stocks.

Disadvantages of trading in Index Futures:-Futures trading can appear to be a quite attractive investment option. Many investors have made a fortune with futures trading, including John Henry, the principal owner of the Boston Red Sox baseball team. However, others have lost large sums of money, enduring the disadvantages of futures trading. The primary disadvantage is quite evident: The word "futures" says it all. You have limited or no control over many factors involved in futures investment contracts.

A. Popular Futures ChoicesCrops are popular choices. Corn, wheat and soybeans are common options for futures contracts. Oranges and orange juice are equally popular options. Natural resource futures, such as natural gas, oil, gasoline and coal, are also popular trading choices. Foreign currency trading, often shortened to Forex, has significantly grown in popularity during the new millennium. You could even invest in various interest rates, hoping that these rates will rise in the future.

B. Controlling Future EventsThe overriding disadvantage of futures trading is the lack of control over future events. For example, you've invested in orange juice futures. But Florida suffers a devastating freeze, killing off one-half of the orange crop. While supply and demand theory suggests the price will increase, the lack of supply can also result in massive losses. Weather disasters, over which you have no control, can wipe out all types of crops. You face similar risks with foreign currency futures, as various factors, all beyond your control, such as political issues or country borrowing defaults, could devalue a country's currency.

C. Complex Issues for Newer InvestorsAlong with the obvious risks, such as weather disasters, added risk comes with the complexity of futures contracts. Investors who do not fully understand these complexities can lose substantial money. You must decide if you have the time and inclination to follow national and international weather, political and financial conditions on a regular schedule. New investors must also find experienced professionals registered with the Commodity Futures Trading Commission, as typically licensed stock brokers cannot trade futures contracts.

D. Leverage IssuesThe leverage offered by futures contracts is both an advantage and a disadvantage. The advantage: You can buy futures contracts for only 5 percent or 10 percent of a contract's value. The disadvantage involves the sometimes fast movement of futures prices. Contract prices can tick up or down daily, sometimes within minutes. If lady luck is not smiling on you on a given day, you'll receive a margin call from your

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broker advising you that your margin account has dropped below minimum levels, meaning you must transfer more cash to your account immediately.

E. Timing IssuesFutures contracts come with definite expiration dates. Even if you have established fixed prices for the assets in the contract, as the expiration date approaches those prices can become much less attractive to others. At times, this condition can cause futures contracts to expire as worthless investments. Similar to banks that offer too many loans at fixed rates, changes in the market increase the risk that some of their loans will come with well-below market rates. Futures contract expiration dates, as they get closer, come with similar risks.

Appendix A: References

1. http://en.wikipedia.org/wiki/Stock_market_index_future

2. http://en.wikipedia.org/wiki/Derivative_(finance)

3. http://en.wikipedia.org/wiki/National_Stock_Exchange_of_India

4. http://www.investopedia.com/terms/i/indexfutures.asp

5. http://www.cmegroup.com/education/files/understanding-stock-index-futures.pdf

6. http://www.businessdictionary.com/definition/stock-index-futures.html

7. http://lastbull.com/nifty-index-futures-understand-with-live-example/

8. http://media.barchart.com/cm/pdfs/lind/LW_10reasons.pdf

9. http://finance.zacks.com/disadvantages-futures-trading-8394.html

10. Book – Derivatives and Risk Management by – Rajiv Srivastava

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