In Nifty futures, the risk was reduced by perfect hedging. Investors use hedging when they were unsure of the future price of Nifty. The highest risk that is faced by traders in Nifty is the price risk. Price risk is the risk that the seller will not be able to sell the assets at a price higher than acquisition cost. A person who wants to shift the price risk to others is called as hedger. Hedgers transfer risk by taking future position that is opposite to the current position in the underlying asset. When the price of assets falls then the value of assets is protected by taking a short position in the future contracts. By using this short position for hedging purposes, a short hedge is created.
NSE index futures can mitigate risks in the stock market when the market moves in the opposite direction from the prediction of the investors. The best step to put forward is by countering the original position with the opposite position in the index futures. Suppose the future contract traded on NSE has lot size of 200 and the index is quoting at 1657.65 (on December 1, 2003) with the first month contract (near month contract) trading at 1912.25 (on January 1, 2004) (Ranganatham, 2004)
1 market lot of the index future = Lot size x Trading price of near month contract
= 200 x 1912.25
1 market lot of the index future = Rs 382450
Number of contracts required to hedge portfolio of stocks = (0- Current beta of stock portfolio) x (Value of stock portfolio / Value of one stock index future contract)
Small traders in India can buy mini lot of Nifty contract which consists of 20 quantities of Nifty. 1 mini lot of Nifty contract cost Rs 19122 which is cheaper. Certain things should be kept in mind before trading Nifty future contracts and that is how to calculate profit and loss. First of all the direction of the market is determined and if the market goes up then it is call bullish market and if the market goes down then it is called bearish market. In bullish market Nifty futures are bought and in bearish market Nifty futures are sold. The profit and loss is very important in future trading and in this case it can be calculated with examples.
If current price of Nifty is Rs 1657.65 (on December 1, 2003) and last date of expiry is 1st January 2004, the profit and loss is calculated by the direction of the market and this is explained in figure2.2 and 2.3 below (Ranganatham, 2004)
In Bullish Market
Future trading in NSE is such that trading can be done at any time till the last date of expiry. If traders do not sell Nifty that they had bought till the last day then trading takes place in NSE at settled price of Nifty on the last day of expiry
Buy Nifty future at Rs 1657.65, size of the future is 200.
I) If Nifty price is Rs 1912.25 and sold before expiration, then Profit = (Rs 1912.25- Rs 1657.65) x 200= Rs 50920
II) If Nifty price is Rs 1600 and sold before expiration, then Loss = (Rs 1657.25 - Rs 1600) x 200 = Rs 11450
In Bearish Market
Sell Nifty futures January1, 2004 at Rs 1912.24, size of the future is 200
I) If Nifty price is Rs 1879.75 (closing price of Nifty on December 31, 2003) and bought before expiration, then Profit = (Rs 1912.25- Rs 1879.75) x 200 = Rs 6500
II) If Nifty price is Rs 2000 and bought before expiration, then Loss = (Rs 2000 - Rs 1912.24) x 200 = Rs 17550
Future trading in NSE is such that trading can be done at any time till the last date of expiry (till January 1, 2004). If traders do not buy what they had sold till the last day then trading takes place in NSE at settled price of Nifty on the last day of expiry (Ranagantham, 2004, p.46)
There are two parties in a future contract, the buyer and seller. The buyer of the futures contract is one who "LONG" on the futures contract and the seller of the futures contract is who is "SHORT" on the futures contract.
Traders make profit or suffer loss due to the fact that the future contract price is determined at the maturity of the contract. At maturity, if the spot price of the future contract is lower than the future price then the buyer suffers a loss because the buyer could have bought the security in the market at a lower price. The opposite applies when the spot price of the contract is above the future price. The buyer makes an immediate profit by buying the underlying instrument at lower price and selling them at higher market price (Deepak Gupta, 2003, p.45)
Figure 2.3 (Deepak Gupta, 2003, p.45)
The pay off for the buyer and the seller of the futures of the contracts are as follows:
Payoff for a Buyer of Nifty Futures
F
LOSS
PROFIT
E2
P
L
E1
F- Future Price of Nifty
E1,E2 - Settlement Price
CASE 1:- The above graph is used to explain the profit and loss in Nifty future contracts. This graph explains how profit and loss varies with settlement price when a future contract has been signed by buyer and seller. The term of the contract is 1 month. When the contract is signed then the future price is "F" and the settlement price of this contract is E1 and E2. Suppose if the settlement price is larger than the future price then the buyer will have a profit (P). The profit is calculated by:
Profit (P) = (Settlement price - Future price) x Lot size of contract.
CASE 2:- The buyer faces loss when the future price move above settlement price (E2)
If the market fluctuates and the future price becomes greater than the settlement price (E2), then at expiry the buyer will have to face a loss.
Loss = (Settlement price - Future price) x Lot size of contract
CASE 3:- When the seller sells the future contract at (F); if the future goes to E1.
The graph below shows the payoff diagram of seller of future contracts. The seller will have profit if the future price goes to E1. This means that the settlement price when the contract expires is less than the future price. So, seller will have profit if he or she sells the contract at expiry.
CASE 4: The seller has to face loss when the future price goes greater than settlement price (E2).
When the settlement price at expiry is lesser than the future price of the contract then the seller has to face loss and the buyer will have the profit.
Figure 2.4 (Prasanna Chandran, 2004, p 47)
Payoff for a Seller of Nifty Futures
E2
PROFIT
LOSS
E1
P
L
F- Future Price of Nifty
E1, E2 - Settlement Price
Risk minimization is always effect in Nifty future contracts as the contract is all about taking long and short positions. The future price of the contracts are not fixed, it changes with the market. The investors should know how to calculate profit and loss. If the investors feel that the future price of the contract can go down then they should take short position and use the equation mentioned in the bearish market above. If the investors feel that the future price of the contract can go up in the future then they can take the opposite position by going long. In bullish market the investor should follow the instructions mentioned in the bullish market above and calculate the profit and loss (Prasanna Chandran, 2004, p.50)
2) High Leverage
Trading in Nifty futures is very risk as investor can face heavy loss. Trading requires lot of experience in predicting market. 75% investors in India are small investors, which mean that they concentrate more on leverage. Traders must open an account with brokerage firm and then they can start trading on margin (leverage). Traders have to invest 5% to 10% of the total size of the contract as initial margin to purchase a contract and the rest will be delivered by the brokerage firm. When the market moves leverage can work against the investors and with the investors. If the market moves, then the margin levels are increased and the broker gives an indication to the investors to add additional funds into the account in order to maintain the future position. Nifty future trading expose traders to high leverage which means that they have to invest less and borrow large amount.
Leverage = Asset / Equity
If Nifty 50 futures trade at Rs 20,000
Then the value of one contract = Rs 20,000 x 25
= Rs 500,000
Initial margin of Nifty futures = 10% x value of the contract
= Rs 50,000
Leverage = Rs 500,000 / Rs 50,000
= 10
If the trader has Rs 500,000 in the account can trade one Nifty future contract. In this case the leverage will be 1. This is the case of high leverage trading. This means that there will be a 1% chance result in a loss equal to the margin. If the trader has Rs 100,000 in the account then the trader has the choice to trade the future contract with Rs 100,000 from the account and borrowing the rest of the amount from the broker. In this case leverage will be 0.5 (Ranganatham, 2004)
High leverage is effective in future contracts, because future contracts are basically carried out in leverage. When leverage increases then the value of the contract also increases as it is directly related to leverage. This point is proved from the equation of leverage. This shows that when there is high leverage then traders have to put less money in the account for purchasing the futures and if the market moves down in the future then the traders has to face less loss in the margin (less loss in the money they have put to purchase the future). (Jay Seth, 2007)
3) Minimizing Risk through Hedging Strategy
Index futures are the most important and useful medium for hedging in the Indian market. In commodity and currency markets this is not useful, as the commodity and currency markets are not substitutable with each other. Hedging in Nifty futures is effective only when there is a correlation between changes in prices of the underlying asset and the future contract. Hedging does not always improve the financial outcome, but it reduces the uncertainty. Hedging may be affected by basis risk, which arises because of the differences between the expiration date and the actual selling date of the future contracts. Basis risk arises due to two reasons and they are, asset that is hedged might be different from the one underlying Nifty future contract, and hedger does not know the exact time of the delivery of future contracts. In future contracts there are two types of hedge and they are:
1) Short Hedge
2) Long Hedge
Short Hedge
It is a process of adding short position to long position. It is a process that protects the traders against decline of price of Nifty future contracts in the underlying assets. The changes in the value of long position in the underlying asset are offset by equal and opposite change in the short position of the underlying asset. This is explained well with the help of an example. The following chart shows that an investor holds portfolio of different companies on December 12, 2003 (Deepak Gupta, 2003, p.10)
The investor predicts the market movement in the future and when the investor feels that the market will go down in the future the investor will go short in order to protect against the price risk. "Going short" means that the investor will sell Nifty futures.
Figure 2.4 (Rudhramurty, 2005)
The above chart shows that Global Tele has the highest risk (as the beta is high 2.06) as the amount of holding the stock of this company is Rs 200,000. It is important for any investors to calculate the number of future contracts for hedging purposes. The number of NIFTY future contracts for hedging purpose is calculated as follows:
Figure 2.5(Rudhramurty, 2005)
Date
Open
High
Low
Close
Volume
Adjusted Close
9 Dec' 03
1646.40
1677.90
1646.40
1675.85
345108500
1675.85
10 Dec'03
1675.75
1697.30
1672.65
1686.90
359809900
1686.90
11Dec' 03
1,688.35
1,701.70
1,701.70
1,695.40
304,345,700
1,695.40
12Dec' 03
1,695.80
1,705.95
1,686.45
1,698.90
299,741,400
1,698.90
The above chart shows the historical prices of Nifty future contracts.
Portfolio beta of all the companies mentioned in figure 2.3 is = P1 r1 + P2 r2 + P3 r3 + P 4 r4
Portfolio beta = (Rs 400,000 x 1.55) + (Rs 200,000 x 2.06) + (Rs 175,000 x 1.95) + (Rs 125,000 x 1.9)
= 1.61
Nifty futures on December 12, 2003 was 1698.90
Number of Nifty futures = (Total value of portfolio x Beta / Value of Nifty futures on December 12, 2003)
Number of Nifty futures = (Rs 1,000,000 x 1.61 / 1698.90)
= 947.67 = 948 contracts approximately
One Nifty future contract is 200 units.
Number of Nifty future contracts required for hedging purpose
=948 / 200
= 4.74 = 5 contracts (approximately)
Long Hedge
Long hedge is a process of adding long future position to short position in the underlying asset. Traders that use long hedge do not own the underlying asset, but they plan to acquire it in the future. It is beneficial to those traders who plan to purchase underlying asset and lock in the purchase price. Long hedge is used to hedge against a short position that has already been taken by the investor. This can be proved with the help of an example (Prasanna Chandra, 2004)
Assume that in bull market, an investor expects to earn Rs 2,000,000 in 1 month time. If the investor waits for two months to invest then it means that the investor can miss the bull market altogether. The best alternative for the investor in this scenario is to use NIFTY future market. The investor could buy NIFTY futures contract that has amount equal to Rs 2,000,000. This process is called long hedge (Rudhramurty, 2005)
The number of future contracts that investor should buy for long hedge is calculated as follows:
Assume that on December 12, 2003, the value of NIFTY futures was 1698.90. The investor expects to receive Rs 2,000,000 by the end of January 2004. The investor has to buy June Nifty futures in May and the number of contracts he/she should buy to reduce risk is calculated as follows:
Number of contracts = Amount expected by the investor / (1698.90 x 200)
= Rs 2,000,000 / (1698.90 x 200) = 5.88 contracts (approximately 6 contracts).
Optimal hedging ratios are used to find out the hedging effectiveness of S&P CNX Nifty future contracts over a period of December 1, 2003 and January 1, 2004. In this study, Error Correction Model (ECM) is used to estimate the optimal hedging ratios. This model is a linear regression changes on spot price and future price. CRM can be expressed as:
ΔSt = a + β . ΔFt + u (t) + є
Where St = Spot price of Nifty
Ft = Future price of Nifty
ut = Error term
Ñ” = Standard error
a= Constant (For Nifty a =0.001388)
Optimal hedging ratios are defined as the ratio of difference of variance of unhedged position and the variance of hedged position to the variance of unhedged position. The table below shows the results of ECM.
Table: 2.6 (Shivraj, 2004)
Putting the above value in the following equation, we have
ΔSt = a + β . ΔFt + u (t) + є
0.40 = 0.001838 + β x 0.492 + (-0.000483) + 0.001
β = Optimal hedge ratio = 0.8103
The slope coefficient β is greater than 0.5 and closer to 1, which means that the hedging is highly significant. As the standard error increases the optimal ratio β reduces and this shows that the hedging effectiveness reduces as the standard error increases. This answers the research question that hedging has a significant effect on Nifty future trading.(Shivraj, 2004)
Effects on Italian Stock Exchange
The effect of introducing stock index futures on the volatility of Italian stock exchange was examined through GARCH model. Bologna and Cavallo (2002) used GARCH model to capture the variation of volatility using daily closing price of Milano Italia Borsa stock index (MIB) between December 1, 2003 and January 1, 2004. GARCH model showed there was no destabilization of Italian spot market after the introduction of futures contract in Italy. GARCH model concluded that the volatility of Italian stock market reduced after the introduction of futures contract in Italy due to impact of increased new or recent news (Bologna and Cavallo, 2002)
Problems faced following the implementation of Nifty future contract
Before entering into a future contract, a trader has to open an account in the brokerage firm. The trader is required to deposit some funds in the account which is called as margin. National Stock Exchange in India has the right to increase or decrease the initial margin depending upon the anticipated changes in the future price. A trader should keep minimum amount in the account which is called as maintenance margin. The traders in India starts trading with 5% of the total future contract size in the initial margin. There are various problems following implementation of Nifty future contract and they are:
1) Margin Call
When the maintenance margin falls below its minimum level then traders receive margin call. The minimum balance in the margin account is normally 75% of the initial margin. If the future prices fluctuate against the investor then the margin account will fall below the maintenance margin and as a result the investor will receive a margin call. Suppose, the initial margin of Nifty future contract is Rs 10,000 and maintenance margin is Rs 7500 (75% of initial margin). On the following day of trading, the investor faces a loss of Rs 2000. Now the balance in the account of the trader or investor is Rs 8000. When the investor again faces loss of Rs 1000, then on preceding day the margin account further falls to Rs 7000 which is below maintenance margin. This is the period when the investor receives margin call. Buying contracts with borrowed or leveraged money is very risky because both gains and losses are amplified. When the money is borrowed by the investor, then he or she has to pay interest payments and if the investor holds future contracts in a margin account, then the investor have to maintain certain amount of margin depending upon the changes in the market value. If the market goes up then the margin requirement will go up and the investor has to borrow large amounts to maintain the initial margin. This is the major problem in Nifty future trading. Most traders in India are risk seeking investors but they often gets margin call during trading. Once they start trading it will be very difficult for them to maintain the account. If the traders get margin call then most of them fail to increase the balance in the account and as a result the brokerage firm becomes the legal owner of the contract (security). This shows that trading in futures is effective only when initial margin is maintained (Jordan, 2009, p.437)
