A Note On Currency And Index Futures
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TRADING USING INDEX FUTURES Contd..
•Short on Security, Going Long on Index Futures
When trading, investors may be inclined to sell a security, which they
believe is overvalued. But while doing so, they face two kinds of risks:
a) The understanding of the company may be wrong.
b) The market moves in the direction opposite to their expectations and
generates losses even though their understanding of the company was correct.
The probability of the second outcome as explained before is high, because
every short position taken on a security is simultaneously a short position
on the index. For example, an investor may sell Infosys at Rs. 4000
expecting that during the period of economic slowdown in the US, Infosys
would not be able to maintain its profits. However, a few days later the
index may rise, resulting in losses for the investor even if his
understanding of the company was correct. Hence, in this case, every time an
investor takes a short position on a security, he should buy index futures.
Example:
The stock of Zee Telefilms has a beta of 1.2. An investor on March 03,
2003 takes a short position of Rs. 500,000 on the Zee's stock. The size
of the position an investor is required to take on Nifty futures to
hedge the index exposure is 1.2 X 500000 = Rs. 6,00,000.
The Nifty market lot is 200. On March 03, the Nifty is quoting at 960
and the nearest futures contract is trading at 1000. Thus to buy Nifty
worth 6,00,000 three lots will be bought since each market lot is worth
Rs. 200,000 (200 X 1000). Now the positions are:
Short Zee Telefilms = Rs. 500000
Long Nifty = Rs. 600000
On March 24, 2003, Nifty rises by 15%. The investor unwinds his position
with the following payoffs:
• His short position on Zee lost him Rs. (500000 X 0.15 X 1.2) = Rs.
90000
• His long position on Nifty earned him Rs. [(200 X 3 X 960 X 1.15) –
(200 X 3 X 1000)] = Rs. 62400.
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•Long on portfolio of securities,
Short on Index Futures
Investors who own a portfolio of securities often face the risk of adverse
market movements.
An investor having a portfolio of securities has the following alternatives:
a) Sell the portfolio of shares immediately.
b) Do nothing i.e. suffer the risk of adverse movement in the stock prices.
c) Use Index futures to overcome the risk related to the exposure of market
index fluctuations.
Every portfolio created by an investor is exposed to the index volatility
whether the portfolio consists of index securities or not. In a portfolio,
index fluctuations account for most of the risk. Hence, a position LONG
portfolio + SHORT Nifty is less risky than just the long position on
portfolio of securities.
Example:
On February 25, 2003, Ketan has a portfolio comprising five securities. The
securities include Grasim (100 shares, Market Price on Feb. 25, 2003 = Rs.
110), Andhra Bank (200 shares, Market Price Rs. 48.25), Pfizer (100 share,
Market Price Rs. 875.50), Infosys (200 shares, Market Price Rs. 150.5), and
BPL (200 shares, Market Price Rs. 245). The total portfolio value is Rs.
187,300. Ketan wants to remove the budget-related (Budget to be announced on
February 28) volatility from February 25 to March 10, 2003.
The beta of the portfolio is 0.90. For a complete hedge, Ketan will need to
sell futures worth 0.90 X 187,300 = Rs. 168,570. On Feb 25, 2003, Nifty is
at 1124.00. So he decides to sell 200 (market lot) Nifties. Hence, Ketan
takes a short position on one March Nifty Futures.
CONCLUSION
EXHIBIT I DIFFERENCE BETWEEN FUTURES AND FORWARDS CONTRACTS
EXHIBIT II A NOTE ON ANALYZING FUTURES PRICES
ADDITIONAL READINGS AND REFERENCES
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