Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stock's Beta. The Beta of stocks are available on the www.nseindia.com.
While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum.
Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks?
Have you ever been a ‘stockpicker’ and carefully purchased a stock based on a sense that it was worth more than the market price?
A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:
1. His understanding can be wrong, and the company is really not worth more than the market price or
2. The entire market moves against him and generates losses even though the underlying idea was correct.
Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty.
Let us see how one can hedge positions using index futures:
‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is ruling at 1527?
To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures.
On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90).
Therefore, the net gain is 59940-46551 = Rs 13,389.
Let us take another example when one has a portfolio of stocks:
Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk
If the index is at 1200 * 200 (market lot) = Rs 2,40,000
The number of contracts to be sold is:
a. 1.19*10 crore = 496 contracts
2,40,000
If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged.
Thus, we have seen how one can hedge their portfolio against market risk.
MarginsThe margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis.
Daily margining is of two types:
1. Initial margins
2. Mark-to-market profit/loss
The computation of initial margin on the futures market is done using the concept of Value-at-Risk(VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon time period (one day for the clearing corporation) due to potential changes in the underlying asset market price. Initial margin amount computed using VaR is collected up-front.
The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash.
Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins payments that would occur.
- A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.
- The initial margin payable as calculated by VaR is 15%.
Position on Day 1
New position on Day 2
Value of new position = 1,400*200= 2,80,000
Margin = 42,000
Position on Day 3
Value of new position = 1510*200 = Rs 3,02,000
Margin = Rs 3,300
Margin account*
Initial margin = Rs 45,000
Margin released (Day 1) = (-) Rs 3,000
Position on Day 2 Rs 42,000
Addn margin = (+) Rs 3,300
Total margin in a/c Rs 45,300*
Net gain/loss
Day 1 (loss) = (Rs 17,000)
Day 2 Gain = Rs 18,700
Day 3 Gain = Rs 18,000
Total Gain = Rs 19,700
The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close of trade is Rs 63,300.
Settlements
All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market. The closing price of the index futures will be the daily settlement price and the position will be carried to the next day at the settlement price.
The most common way of liquidating an open position is to execute an offsetting futures transaction by which the initial transaction is squared up. The initial buyer liquidates his long position by selling identical futures contract.
In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract period the difference between the contract value and closing index value is paid.