A Note On Currency And Index Futures

TRADING USING CURRENCY FUTURES Contd..

Example:

An investor has a long position on a portfolio of stocks worth $50 million with a beta of 1.2. To hedge this long position, the investor needs to take a short position on the futures contract (say S&P 500). The size of an S&P 500 futures contract is 250 times the value of S&P 500 index. The June 03, 2000, S&P 500 futures contract, was settled at 1427.35 on the last trading day. Therefore, the value of futures contract is 250 X 1427.35 = $356,837.5

Value of the portfolio
Hedge Ratio = X Beta
Value of the S&P 500 futures contract

$50, 000, 000
= X 1.2
$356,837.5

= 168 contracts

TRADING USING INDEX FUTURES

The following are the fundamental modes of trading on the index futures market:

Hedging

• Long on Security, Going short on Index Futures (say Nifty)^[8]

When investors'trade, they may be inclined to purchase a security, which they believe is undervalued. The investors may feel that the profits and the quality of management of a particular company make it seem worth more than the present market value. However, while purchasing the security the investor faces two kinds of risks:

a) His understanding of the company is wrong and the stock price goes down.
b) The market moves in the direction opposite to his expectations even though his understanding of the company was correct.

The probability of the second outcome is high. This is because assuming all other factors constant, a security constituting the market index gains if the market index rises and vice versa. To overcome this problem, every time an investor takes a long position on a particular security, he should sell some amount of index futures. This strategy offsets the index exposure when an investor takes purchases a security say Infosys. Thus a position Long Infosys + Short Index = Performance of Infosys.

To follow the above strategy, an investor needs to know the ‘beta of security^[9]'and the market lot on the futures market. An example to explain the concept is given below.

Example:

The stock of Carrier Aircon has a beta of 1.3 and an investor has taken a long position of Rs. 200,000 on the share. The size of the position to be taken on Index (Nifty) futures to hedge the index exposure is 1.3 X 200000 = Rs. 260,000.

The market lot on the futures market is 200 and Nifty is quoting at 1270 with the nearest futures contract trading at 1300. Hence, one market lot of Nifty is worth Rs. 260,000 (200 X 1300). So investor can take the following position.

Long Carrier Rs. 200,000
Short Nifty Rs. 260,000.

Assume that 10 days later, Nifty drops by 10% and the investor unwinds his position. His long position on Carrier led to a loss of Rs. 26000 (200,000 X 0.10 X 1.3). However, his short position earned him Rs. 31400. Overall he gained Rs. 5,400.

CONCLUSION

EXHIBIT I DIFFERENCE BETWEEN FUTURES AND FORWARDS CONTRACTS

EXHIBIT II A NOTE ON ANALYZING FUTURES PRICES

ADDITIONAL READINGS AND REFERENCES

^[8] Nifty is a well-diversified 50 stocks index accounting for 23 sectors of the Indian economy.

^[9] Beta is a statistical measurement of risk associated with an individual stock or a portfolio. It is the ratio of the covariance of the security returns and market returns to that of the variance of the market returns.