Index Futures: An Insight

Example: On 1st October 2009, Mr. X got a hot tip that the share market was going to go upwards. Based on this he decided to buy shares of ABC Ltd as it had the highest market capitalization then. Mr. X therefore bought 200 shares @ Rs.2,400/- per share, and to finance this he took a loan @ 18% p.a. pledging some of his lifelong savings. Mr. X was a happy man for his smart investment.

Three months later, on 1st January 2010 Mr. X’s prediction proved to be right. The BSE index did move upwards from 4270 to 5215. However Mr. X was neither happy, nor was he rich. He had suffered a loss of Rs.21,200/- (4.42% of his investment).

How can this happen? Mr. X was as surprised as all of us are. What actually happened was that though the Sensex rose by 22%, ABC Ltd’s share price did not rise in the same proportion. Mr. X suffered a loss even though his prediction was accurate.

Does the above scene ring a bell? How often have we found ourselves to be in Mr. X’s shoes? How often has it happened, that we bought some shares and then every other share except our shares touched the sky?

The above scenario can be explained with the help of CAPM (Capital Asset Pricing Model) theory given by William Sharpe in 1962. The author has bifurcated risk (i.e. chances that the price may deviate) involved in holding any share/asset into Market risk and Unique risk.

Market risk represents that part of risk which is common to all the companies/assets (from hereon we will use shares and assets interchangeably). Thus it is that part of the total risk which is attributable to the fluctuations of the market as a whole. An example would be that of a change in the interest rate, change in the tax structure etc. Unique risk is that risk which is unique to the company and is independent of the market. It arises from ‘firm-specific’ risk. To quote an example, changes in oil prices may affect the refinery business, but will not so affect a soft drink company.

Further, the theory tells us that an investor can do away with unique risk by holding a portfolio of shares (20 to 30 shares). This happens because rise in one stock is setoff by the fall in some other stock. An investor, thus, by holding number of shares can minimize, if not eliminate unique risk. As the number of shares increases, the unique risk reduces, thus reducing the total risk involved in the portfolio. However, market risk cannot be reduced even by diversification of the portfolio.

Market return compensates an investor for bearing the market risk. However as unique risk can be eliminated (though not completely) through diversification of the portfolio, market does not compensate for unique risk.

Now applying this concept to Mr. X’s case, if Mr. X had invested in 20 shares from different industries, he would have gained had the market gone up, as it did. He would have eliminated the unique risk by holding a diversified portfolio of shares.

So the next question that comes to our mind is why not everyone in the market holds a well diversified portfolio of shares. The main constraint is funds. Imagine buying a port-folio of 20 stocks. It will entail an investment of about Rs.25-30 lakhs. This is not possible for every investor. So is there some other means by which one would be able to do away with unique risk. Yes there is, and It is called index futures.

Let us first try and understand the concept of ‘futures’ before we get into the details of index futures. A futures contract is an agreement between two parties to buy or sell an asset at a certain specified time in future for certain specified price. Futures are a security in the family of derivatives, whose value is derived from an underlying asset. The underlying asset can vary from commodities, currencies and fixed income instruments to stock indices.

Let’s understand futures with the help of a commodity deal, say oilseeds. Suppose ABC Co. Ltd. purchases oilseeds, which is the major raw material in its production cycle. A slight upward change in the price of oilseeds may affect this company adversely, as the selling price of the final product is predetermined by way of a contract. Thus the company is running a risk occurring due to a change in the commodity’s price. The company would therefore prefer to buy the oilseeds at a fixed price. It would then be able to do away with the commodity price fluctuation risk. However it will not be willing to purchase the oilseeds today and stock them as this would involve a high carrying cost.

On the other hand, another company PQR Co. Ltd. which sells oilseeds faces the risk if the prices of oilseeds move downwards. It also would like a fixed price for its oilseeds. In a futures contract both ABC Co. Ltd. and PQR Co. Ltd. will deal with each other through an exchange to buy/sell oilseeds at a rate fixed on the day of contract (today) for a future date (maturity date) say three months hence. Now after three months what-ever be the price of oilseeds, ABC Co. Ltd. is obliged to buy and PQR Co. Ltd. is obliged to sell oilseeds at the rate agreed upon.

Extending the above logic to index futures, the two parties enter into an index futures contract to buy/sell indices at a future date. Assume that, in our example of Mr. X, the BSE index on 1st October 2009 is 4270. The 3 month index futures are available at 4500 and Mr. Mehta believes that the index will reach 5000 in three months; he will buy 50 indices at the rate of 4500. After three months the difference between the index on maturity rate (5215) and the contracted rate (4500) will be either paid to or received from Mr. Mehta.

Concepts which govern index futures are as follows: