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Introduction to Futures

Introduction to Futures

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Introduction
Overview

Derivatives have made the international and financial headlines in the past for mostly with their
association with spectacular losses or institutional collapses. But market players have traded
derivatives successfully for centuries and the daily international turnover in derivatives trading runs
into billions of dollars.
Are derivative instruments that can only be traded by experienced, specialist traders? Although it is
true that complicated mathematical models are used for pricing some derivatives, the basic
concepts and principles underpinning derivatives and their trading are quite easy to grasp and
understand. Indeed, derivatives are used increasingly by market players ranging from governments,
corporate treasurers, dealers and brokers and individual investors.

Indian scenario

While forward contracts and exchange traded in futures has grown by leaps and bound, Indian stock
markets have been largely slow to these global changes. However, in the last few years, there has
been substantial improvement in the functioning of the securities market. Requirements of adequate
capitalization for market intermediaries, margining and establishment of clearing corporations have
reduced market and credit risks. However, there were inadequate advanced risk management tools.
And after the ICE (Information, Communication, Entertainment) meltdown the market regulator felt
that in order to deepen and strengthen the cash market trading of derivatives like futures and
options was imperative.

Why have derivatives?

Derivatives have become very important in the field finance. They are very important financial
instruments for risk management as they allow risks to be separated and traded. Derivatives are
used to shift risk and act as a form of insurance. This shift of risk means that each party involved in
the contract should be able to identify all the risks involved before the contract is agreed. It is also
important to remember that derivatives are derived from an underlying asset. This means that risks
in trading derivatives may change depending on what happens to the underlying asset.
A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, forex, commodity or any other asset. For
example, if the settlement price of a derivative is based on the stock price of a stock for e.g.
Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a
daily basis. This means that derivative risks and positions must be monitored constantly.
The purpose of this Learning Centre is to introduce the basic concepts and principles of derivatives.
We will try and understand

\u2022
What are derivatives?
\u2022
Why have derivatives at all?
\u2022
How are derivatives traded and used?

In subsequent lessons we will try and understand how exactly will an underlying asset effect the
movement of a derivative instrument and how is it traded and how one can profit from these
instruments.

Back To Top
Forward Contracts, Indices, Index Futures
What are forward contracts?

Derivatives as a term conjures up visions of complex numeric calculations, speculative dealings and
comes across as an instrument which is the prerogative of a few 'smart finance professionals'. In
reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading
of securities on which the derivative is based and a small investor, can benefit immensely.
A derivative security can be defined as a security whose value depends on the values of other
underlying variables. Very often, the variables underlying the derivative securities are the prices of
traded securities.
Let us take an example of a simple derivative contract:

\u2022
Ram buys a futures contract.
\u2022
He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000.
\u2022
If the price is unchanged Ram will receive nothing.
\u2022
If the stock price of Infosys falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Infosys scrip, which is the
underlying security. Similarly, futures trading has already started in Sensex futures and Nifty
futures. The underlying security in this case is the BSE Sensex and NSE Nifty.
Derivatives and futures are basically of 3 types:

\u2022
Forwards and Futures
\u2022
Options
\u2022
Swaps
\u2022Forward contract

A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell
an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged
when the contract is entered into.

Illustration 1:

Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only
buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So
in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer
that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking
the current price of a TV for a forward contract. The forward contract is settled at maturity. The
dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash
equivalent to the TV price on delivery.

Illustration 2:

Ram is an importer who has to make a payment for his consignment in six months time. In order to
meet his payment obligation he has to buy dollars six months from today. However, he is not sure
what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract
with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract
on a future date it is afor ward contract and the underlying security is the foreign currency.
The difference between a share and derivative is that shares/securities is an asset while derivative
instrument is a contract

What is an Index?

To understand the use and functioning of the index derivatives markets, it is necessary to
understand the underlying index. A stock index represents the change in value of a set of stocks,
which constitute the index. A market index is very important for the market players as it acts as a
barometer for market behavior and as an underlying in derivative instruments such as index
futures.
The Sensex and Nifty
In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex
has 30 stocks comprising the index which are selected based on market capitalization, industry
representation, trading frequency etc. It represents 30 large well-established and financially sound
companies. The Sensex represents a broad spectrum of companies in a variety of industries. It
represents 14 major industry groups. Then there is a BSE national index and BSE 200. However,
trading in index futures has only commenced on the BSE Sensex.
While the BSE Sensex was the first stock market index in the country, Nifty was launched by the
National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index
consists of shares of 50 companies with each having a market capitalization of more than Rs 500
crore.

Futures and stock indices

For understanding of stock index futures a thorough knowledge of the composition of indexes is
essential. Choosing the right index is important in choosing the right contract for speculation or
hedging. Since for speculation, the volatility of the index is important whereas for hedging the
choice of index depends upon the relationship between the stocks being hedged and the
characteristics of the index.

Choosing and understanding the right index is important as the movement of stock index futures is
quite similar to that of the underlying stock index. Volatility of the futures indexes is generally
greater than spot stock indexes.
Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to
the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and
rise when the market as a whole is rising.
Retail investors will find the index derivatives useful due to the high correlation of the index with
their portfolio/stock and low cost associated with using index futures for hedging.

Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. Index futures are all futures contracts where the underlying is the
stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.
Index futures permits speculation and if a trader anticipates a major rally in the market he can
simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs.
We shall learn in subsequent lessons how one can leverage ones position by taking position in the
futures market.
In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3
months duration contracts are available at all times. Each contract expires on the last Thursday of
the expiry month and simultaneously a new contract is introduced for trading after expiry of a
contract.

Example:
Futures contracts in Nifty in July 2001
Contract month
Expiry/settlement
July 2001
July 26
August 2001
August 30
September 2001
September 27
On July 27
Contract month
Expiry/settlement
August 2001
August 30
September 2001
September 27
October 2001
October 25

The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract the
total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.
In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value
will be 50*4000 (Sensex value)= Rs 2,00,000.
The index futures symbols are represented as follows:

BSE
NSE
BSXJUN2001 (June contract)
FUTDXNIFTY28-JUN2001
BSXJUL2001 (July contract)
FUTDXNIFTY28-JUL2001
BSXAUG2001 (Aug contract)
FUTDXNIFTY28-AUG2001
In subsequent lessons we will learn about the pricing of index futures.
Back To Top
Application Of Index Future
Hedging

We have seen how one can take a view on the market with the help of index futures. The other
benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to
understand how one can protect his portfolio from value erosion let us take an example.

Illustration:

Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses
for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000
if the sale is completed.

Cost (Rs)
Selling price
Profit

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