A Note On Currency And Index Futures

TRADING USING INDEX FUTURES Contd..

Example:

On April 01, 2002, the spot price of Nifty is 1020 and a futures contract for April is trading at Rs. 1055. To earn this return of (35/1020 X 100) for 25 days, the investor buys Rs. 3.5 million of Nifty on the spot market. In order to do so he had to place 50 market orders and thus ends up paying 0.2% higher i.e. he obtains the Nifty at Rs. 1022. A moment later he sells Rs. 3.5 million of the futures at Rs. 1055, because of liquidity in the futures market the transaction takes place at zero impact cost. Few days later he takes delivery and it at this point he lends money to the market. He holds the securities for few days before unwinding the position and receives dividends during that period that work out to be Rs. 5650.

On April 25, 2002, investor unwinds the entire transaction by putting 50 market orders to sell off his Nifty portfolio at the price of Rs. 1034. The transaction goes through at Rs. 1032, the futures position simultaneously expires at Rs. 1034 (the futures price converges with the spot price on the expiration day). Thus the investor ends up gaining Rs. 12 (0.98%) in the cash market and Rs. 21 (1.99%) on the futures. In addition, investor also earned dividends of Rs. 5650 that works out to be return of (0.16%), thus culminating into a total risk free return of 3.13% for 25 days.

However, this strategy does not make sense when the return works out to be something really not worth putting in this much of money for, like 0.45 or 0.5%. Also it is essential to make a portfolio of Rs. 3 million or more as portfolios of less than Rs. 3 million do not replicate the Nifty Index.

• Lend to the market the securities you own

The index futures market provides an excellent opportunity for the owners of shares to earn positive returns by loaning out the shares. This trading method on index futures also does not involve any price risk and default risk.

The investor sells off all the securities that comprise an index (say Nifty), on the cash market. (The proportion of securities should be a representation of their market capitalization) A moment later, he buys a contract in the futures market. The investor receives the money after selling the securities and can invest that money at the risk-free rate of interest. A few days later the investor will unwind the position; the investor will send orders to buy all the securities of the portfolio and a moment later, will reverse the future position. The point the investor takes the delivery of the shares is when he pays the money back.

However, this method of trading is worth the effort only when the spot minus future basis is smaller than the risk-free interest rate available in the economy. For example, if the difference between the spot Nifty (1020) and the two-month futures nifty (1035) is 1.47% (15/1020) and the transaction cost is 0.4% (assumed). Further the cash can be invested at no risk at a rate of 1.3% per month. Over a two-month period, the yield works out to be 2.62% [(100 X 1.013 X 1.013) – 100]. The approximate return over a two-month period is 2.62 – 1.47 - 0.4 = 0.75%. On the other hand, if the difference between the spot and futures is say 2.2% over a period of two months and the riskless yield over the same period is 1.9%, then it is not profitable to loan out the money.

Example:

Suppose an investor holds Nifty worth Rs. 4.5 million, he puts in sell order for all the securities in Nifty at the spot price of Rs. 1200. The seller suffers the impact cost and thus ends up getting only 1197. A moment later he buys two-month Nifty futures worth Rs. 4.5 million at 1220. At the point of delivery of shares, the investor receives money 4.48 million from the sale (after taking into account the impact cost). The investor lends the money received at risk less rate, say 1.3% per month, so at the end of two months he gets back Rs. 45,97,237, in terms of Nifty it is 1197 X 1.0132 = 1228. On the date of expiration of the futures contract the investor unwinds his position, he puts in orders to buy back his Nifty portfolio at the spot price which has moved upto 1245 by this time. This makes the share buy-back costlier but the difference is offset by profits on the futures market.

The buy order placed by the investor goes through at Rs. 1248, because of the impact cost. The funds available with the investor is 1228, plus the profit made on the futures, that is, 25 (1245 – 1220). Thus, the investor ends up with a profit of Rs. 5 on the whole transaction (1228 + 25 – 1248). Speculation