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FAQ's on Index Futures

1    What are Index Futures ?

2    What are uses of Index Futures ?

3    When did the Index Futures start in India ?

4    What is margin money ?

5    Are there different types of Margin ?

6    What is the objective of Initial margin ?

7    What is Variation or Mark-to-Market Margin ?

8    What is the concept of Maintenance Margin ?

9    What is the concept of Additional Margin ?

10   What is the concept of Cross Margining ?

11   What are long/ short positions ?

12   Who is a market maker ?

13   What is marked-to-market ?

14   What is Gearing ?

15   What is the role of the clearing house/ Corporation ?

16   What is Price Risk ?

17   What are the different types of Price Risk ?

18   Can Price Risk be controlled ?

19   What is hedging ?

19.1What are general hedging strategies ?

20   What is the Hedge Ratio ?

21   What will one do if the period of Hedge is longer than available Futures ?

22   Who are Hedgers, Speculators and Arbitrageurs ?

23   What are the general strategies for speculating ?

24   What are Circuit Breakers or Circuit Filters ?

25   What are Hedge Funds ?

26   What is the difference between a hedge fund and a mutual fund ?

1 What are Index Futures ?

Index Futures are Future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements. Suppose you feel that the markets are bullish and the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index Future.

2 What are uses of Index Futures ?

Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset allocation.

3 When did the Index Futures start in India ?

Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have launched index futures in June 2000.

4 What is margin money ?

The aim of margin money is to minimize the risk of default by either counter-party. The payment of margin ensures that the risk is limited to the previous day's price movement on each outstanding position. However, even this exposure is offset by the initial margin holdings.

Margin money is like a security deposit or insurance against a possible Future loss of value.

5 Are there different types of Margin ?

Yes, there are different types of margin like Initial Margin, Variation margin and Additional margin.

6 What is the objective of Initial margin ?

The basic aim of Initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The initial margin is deposited before the opening of the position in the Futures transaction. This margin is calculated by SPAN by considering the worst case scenario.

7 What is Variation or Mark-to-Market Margin ?

All daily losses must be met by depositing of further collateral - known as variation margin, which is required by the close of business, the following day. Any profits on the contract are credited to the client's variation margin account.

8 What is the concept of Maintenance Margin ?

Some exchanges work on the system of maintenance margin, which is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the maintenance margin limit. For e.g.. If Initial Margin is fixed at 100 and Maintenance margin is at 80, then the broker is permitted to trade till such time that the balance in this initial margin account is 80 or more. If it drops below 80, say it drops to 70, then a margin of 30 (and not 10) is to be paid to replenish the levels of initial margin. This concept is not being used in India.

9 What is the concept of Additional Margin ?

In case of sudden higher than expected volatility, additional margin may be called for by the exchange. This is generally imposed when the exchange fears that the markets have become too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive move by exchange to prevent breakdown.

10 What is the concept of Cross Margining ?

This is a method of calculating margin after taking into account combined positions in Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-Hedges.

11 What are long/ short positions ?

In simple terms, long and short positions indicate whether you have a net over-bought position (long) or over-sold position (short).

12 Who is a market maker ?

A dealer is said to make a market when he quotes both bid and offer prices at which he stands ready to buy and sell the security. Thus, he is a person that brings buyers and sellers together. He lends liquidity in the system by making trading feasible.

13 What is marked-to-market ?

This is an arrangement whereby the profits or losses on the position are settled each day. This enables the exchange to keep appropriate margin so that it is not so low that it increases chances of defaults to an unacceptable level (by collecting MTM losses) and is not so high that it increases the cost of transactions to an unreasonable level (by giving MTM profits).

14 What is Gearing ?

Gearing (or leveraging) measures the value of your position as a ratio of the value of the risk capital actually invested. In case of index futures, if the margin requirement is 5%, the gearing possible is 20 times as on a given fund availability, an investor can take a position 20 times in size.

  

15 What is the role of the clearing house/ Corporation ?

The Clearing House / Corporation matches the transactions, reconciles sales & purchases and does daily settlements. It is also responsible for risk management of its members and does inspection and surveillance, besides collection of margins, capital etc. It also monitors the net-worth requirements of the members. The other role of the Clearing House / Corporation is to ensure performance of every contract. This can be done in two ways. One way is that Clearing house / Corporation imposes itself between the two counterparties thereby replacing the original contract (say between A & B) by two new contracts (between A and Clearing House /Corporation and between B and Clearing House / Corporation) thereby itself becoming counterparty to every trade. This is called full Novation. The other way is to guarantees performance of all the contracts done on the exchange.

16 What is Price Risk ?

Price Risk is defined as the standard deviation of returns generated by any asset. This indicates how much individual outcomes deviate from the mean. For example, an asset with possible returns of 5%, 10% and 15% is less risky than one with possible returns of -10%, 1% and 25%.  

17 What are the different types of Price Risk ?

Diversifiable risk (also known as non market risk or unsystematic risk) of a security arises from the security specific factors like strike in factory, legal claims, non availability of raw material, etc. This component of risk can be reduced by diversification.

Non-diversifiable risk (also known as systematic risk or market risk) is an outcome of economy related events like diesel price hike, budget announcements, etc that affect all the companies. As the name suggests, this risk cannot be diversified away using diversification or adding stocks in portfolio.

18 Can Price Risk be controlled ?

Yes, but to an extent. As mentioned earlier, the different types of price risk impacting any stock or company can be classified into two categories:

1.      Company specific; and

2.      Economy or market related.

As discussed earlier, the Company specific risks (also known as diversifiable risk or non market risk or unsystematic risk) can be reduced by proper diversification.

19 What is hedging ?

Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk.

Please note that hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return.

19.1 What are general hedging strategies ?

The basic logic is "If long in cash underlying - Short Future and If short in cash underlying - Long Future". Let us understand this by a simple example. If you have bought 100 shares of Company A and want to Hedge against market movements, you should short an appropriate amount of Index Futures. This will reduce your overall exposure to events affecting the whole market (systematic risk). In case a war breaks out, the entire market will fall (most likely including Company A). So your loss in Company A would be offset by the gains in your short position in Index Futures.

Some examples of where hedging strategies are useful include:

         Reducing the equity exposure of a Mutual Fund by selling Index Futures;

         Investing funds raised by new schemes in Index Futures so that market exposure is immediately taken; and

         Partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higher

20 What is the Hedge Ratio ?

The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to provide the maximum offset of risk. This depends on the

         Value of a Futures contract;

         Value of the portfolio to be Hedged; and

         Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and underlying (index) from which Future is derived.

21 What will one do if the period of Hedge is longer than available Futures ?

In such an event one can Roll forward a Hedge. This implies closing one Future position and taking the same position on another Future with the same specifications but having a later delivery date. However, this leaves the basis-risk open for uncovered period at the initial stage.

22 Who are Hedgers, Speculators and Arbitrageurs ?

Hedgers wish to eliminate or reduce the price risk to which they are already exposed. Speculators are those class of investors who willingly take price risks to profit from price changes in the underlying. Arbitrageurs profit from price differential existing in two markets by simultaneously operating in two different markets. All class of investors are required for a healthy functioning of the market.

Hedgers and investors provide the economic substance to any financial market. Without them the markets would lose their purpose and become mere tools of gambling. Speculators provide liquidity and depth to the market. Arbitrageurs bring price uniformity and help price discovery.

The market provides a mechanism by which diverse and scattered opinions are reflected in one single price of the underlying. Markets help in efficient transfer of risk from Hedgers to speculators. Hedging only makes an outcome more certain. It does not necessarily lead to a better outcome.

23 What are the general strategies for Speculating ?

In general, the speculator takes a view on the market and plays accordingly. If one is bullish on the market, one can buy Futures, and vice versa for a bearish outlook.There is another strategy of playing the spreads, in which case the speculator trades the "basis". When a basis risk is taken, the speculator primarily bets on either the cost of carry (interest rate in case of index futures) going up (in which case he would pay the basis) or going down (receive the basis). Pay the basis implies going short on a future with near month maturity while at the same time going long on a future with longer term maturity. Receiving the basis implies going long on a future with near month maturity while at the same time going short on a future with longer term maturity.

24 What are Circuit Breakers or Circuit Filters ?

Circuit Breaker means trading is halted for a specified period in stocks or / and stock index futures, if the market price moves out of a pre-specified band. Circuit filters do not result in trading halt but no order is permitted if it falls out of the specified price range.

Advantages

1.      Allows participants to gather new information and to assess the situation - controls panic.

2.      Brokerages firms can check on customer funding and compliance.

3.      Exchanges/ Clearing houses can monitor their members.

Disadvantages

1.      Only postpones the inevitable.

2.      Limits the flow of market information Ė no one knows the real value of a stock.

They precipitate the matter during volatile moves as participants rush to execute their orders before anticipated trading halt.

25 What are Hedge Funds ?

A hedge fund is a term commonly used to describe any fund that isnít a conventional investment fund, i.e. it uses strategies other than investing long. For example

         Short selling

         Using arbitrage

         Trading derivatives

         Leveraging or borrowing

         Investing in out-of-favour or unrecognized undervalued securities

The name hedge fund is a misnomer as the funds may not actually hedge against risk. The returns can be high, but so can be losses. These investments require expertise in particular investment strategies. The hedge funds tend to be specialized, operating within a given niche, specialty or industry that requires the particular expertise.

 

26 What is the difference between a hedge fund and a mutual fund ?

1.      Mutual funds are measured on relative performance - compared to a benchmark index. Hedge funds are expected to deliver absolute returns - under all circumstances, even if the indices are down. Mutual funds are not able to effectively protect portfolios against declining markets other than by going into cash or by shorting a limited amount of stock index futures. Hedge funds, on the other hand, are able to not only protect against declining markets, but also produce positive results, by using a variety of hedging and trading strategies.

2.      Mutual funds are highly regulated, restricting the use of short selling and derivatives. Hedge funds on the other hand are unregulated and unrestricted. Informal restrictions are placed on all hedge fund managers by investors who invest in a particular fund because of the manager's expertise in a particular investment strategy. These investors require and expect the hedge funds to stay within its area of specialization and expertise.

Mutual funds generally remunerate management based on a percent of assets under management. Hedge funds always remunerate managers with performance related incentive fees as well as a fixed fee.

Cochin Stock Exchange, Kochi, India