Before you begin
First Step in Investing is to define ?Objectives of Investing? which involves return goals and your risk preferences. You already know that you cannot state your objectives only in terms of return because there is a relationship between risk and return. So you cannot wish to make substantial returns if you do not have the willingness to tolerate high levels of risk. Return objectives for different investors usually vary among the following: capital appreciation, current income, and total return. Capital appreciation is the goal for those investors who are willing to take risk for the sake of making large capital gains (increase of value of the stocks in the portfolio) over time. With current income, investors are interested in generating periodic income. This is usually for the purpose of providing extra money to assist with the living expenses. This usually involves little risk.
Finally, total return is a blend between capital appreciation and current income. Here the investor desires to generate income as well as accumulate capital gains. With total return, moderate risk is undertaken. As the return objective dictates the level of risk that needs to be taken, it also helps guide the construction of an investor's portfolio. For example, a portfolio aiming for capital appreciation will comprise mainly of common stocks since they have the potential for the highest gains (as well as carry the highest risk). A portfolio of a risk-averse person interested in preserving his/her capital and looking for income will contain mainly corporate and government bonds. So before you start investing it is essential that you assess your goals and objectives so that you can construct a portfolio that best meets your desires.
When to Invest?
The sooner the better. By investing into the market right away you allow your investments more time to grow, whereby the concept of compounding interest swells your income by accumulating your earnings and dividends. Considering the unpredictability of the markets, research and history indicates these three golden rules for all investors 1. Invest early 2. Invest regularly 3. Invest with long-term view. While it?s tempting to wait for the ?best time? to invest, especially in a rising market, remember that the risk of waiting may be much greater than the potential rewards of participating. Trust in the power of compounding. Compounding is growth via reinvestment of returns earned on your savings. Compounding has a snowballing effect because you earn income not only on the original investment but also on the reinvestment of dividend/interest accumulated over the years. The power of compounding is one of the most compelling reasons for investing as soon as possible. The earlier you start investing and continue to do so consistently the more money you will make. The longer you leave your money invested and the higher the interest rates, the faster your money will grow. That's why stocks are the best long-term investment tools. The general upward momentum of the economy mitigates the stock market volatility and the risk of losses. That?s the reasoning behind investing for long term rather than short term.
What can you invest in?
The investing options are many, to name a few:
* Bonds
* Mutual funds
* Fixed deposits
* Stocks
* Others
How much money you need to invest?
There is no standard way of calculating the amount that you need to invest in order to generate adequate returns from your savings. The amount that you invest will eventually depend on factors such as:
* Your risk profile
* Your Time horizon
* Savings made
All the above three factors will be discussed in brief in the latter part of the course
Working of a stock market
To learn more about how you can earn on the stock (share) market, one has to understand how it works. A person desirous of buying/selling shares in the market has to first place his order with a broker. When the buy order of the shares is communicated to the broker, he routes the order through his system to the exchange. The order stays in the queue exchange's systems and gets executed when the order logs on to the system within buy limit that has been specified. The shares purchased will be sent to the purchaser by the broker either in physical or demat format.
Index
An index is a simple barometer of the underlying scrips/shares in the market. It is statistical average, simple or weighted average, of a few leading shares in the market. The number so arrived at is called an index. BSE 30 or SENSEX is such an average of thirty leading shares traded in the BSE. Some indices may track a large number of shares average whereas some may track particular industries. This is called a sector specific index.
Rolling Settlement Cycle:
In a rolling settlement, each trading day is considered as a trading period and trades executed during the day are settled based on the net obligations for the day. At NSE and BSE, trades are settled on a T+2 basis i.e. on the 2nd working day. For arriving at the settlement day all intervening holidays, which include bank holidays, NSE/BSE holidays, Saturdays and Sundays are excluded. Typically trades taking place on Monday are settled on Wednesday, Tuesday's trades settled on Thursday and so on.
Types of Trades
Going Short:
If you do not have shares and you sell them it is known as going short on a stock. Generally a trader will go short if he expects the price to decline. In a rolling settlement cycle you will have to cover by end of the day on which you had gone short.
Circuit Filters And Trading Bands:
In order to check the volatility of shares, SEBI has come with a set of rules to determine the fixed price bands for different securities within which they can move in a day. As per SEBI directive, all securities traded at or above Rs.10/- and below Rs.20/- have a daily price band of ?25%. All securities traded below Rs. 10/- have a daily price band of ? 50%. Price band for all securities traded at or above Rs. 20/- has a daily price band of ? 8%. However, now the price bands have been relaxed to ? 8% for select 100 scrips after a cooling period of half an hour. The previous day's closing price is taken as the base price for calculating the price. As the closing price on BSE and NSE can be significantly different, this means that the circuit limit for a share on BSE and NSE can be different.
What is Trade to Trade?
Scrips that are not recognized by Exchanges for squaring off positions in purchase and sales within the same settlement are covered under Trade-to-Trade category. The trade-to-trade segment is continuously reviewed by the exchanges as a result of which scrips from the normal settlement are moved to the trade-to-trade segment and vice versa on a periodic basis.
Why is it necessary to trade on a stock exchange?
Stock exchange lists securities and provides you an opportunity to trade in the listed securities. It ensures certain compliances and disclosures from companies in your interest. It guarantees settlement of trades executed on your behalf and provides you protection if your broker becomes a defaulter.
Any trade in securities outside stock exchanges other than spot transactions are not backed by regulatory framework of exchanges or SEBI. Hence you do not get any protection if you trade outside an exchange. Besides, the stock exchange offers a ready market for your securities. If you are trading outside an exchange, you have to waste considerable time to find out the right person who is willing to undertake a corresponding transaction with you. Other benefits of trading on an exchange include: you do not take counter party risk, which is assumed by a clearing corporation, you have access to the investor grievance redressal mechanism of stock exchanges. The brokers/sub-brokers are your link to the stock exchange. They are intermediaries in the market subject to the regulatory discipline of SEBI/the concerned stock exchange. They enter into transactions in securities on your behalf. Your relation with them is governed by the terms set out in the client-broker/client-sub-broker agreement. If you are buying and selling securities actively, it is advisable that you open a depository account to receive and deliver demat securities. It is in your interest that you have depository account to get immediate credit for purchase of securities, and avoid all the ills of physical certificates.
Types of Traders
Market Maker /Jobber
Market maker is the one who gives two way quotes for a security at any point of time. He can do this if he has financial strength and the shares to deliver. He is the liquidity provider in the scrip. A market maker would offer to do transaction on either side as chosen by the counter party at the prices indicated by the market maker for the quantities offered. The market maker assumes the price risk, the liquidity risk and the time risk. Price risk means that he may not be able to cover his position at the same or better price than the price at which he did the original transaction. Liquidity risk means that he may not be able to liquidate his purchase position and may have to take deliveries and vice versa. Time risk means that the market maker may have to hold the inventory for an unknown period of time and lose the interest on his investments. E.g. Market maker will give quotes for Satyam as Buy 1000 shares at Rs. 500 and Sell 100 shares at Rs. 5010. To cover for the risk involved, he keeps difference between buy and sell quote.
Arbitrage
A simultaneous buy and sale of an asset to get the benefit of price difference is called arbitrage. Arbitrage is of different types: price differences between two exchanges, between spot and futures market etc. E.g. If on the BSE price of SBI is Rs.1250 and on NSE is Rs.1253 one can buy the shares on BSE if he has the money and sell simultaneously on NSE if he has the shares with him for delivery and make risk free profit of Rs.3 per share.
Arbitrageur
The person who do arbitrage as a business is called arbitrageur. Arbitrageur attempts to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.
Derivatives
What are derivatives?
In finance, a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
Who can trade in Derivatives?
Although it is true that complicated mathematical models are used for pricing some derivatives, the basic concepts and principles underpinning derivatives and their trading are quite easy to grasp and understand. Indeed, derivatives are used increasingly by market players ranging from governments, corporate treasurers, dealers and brokers and individual investors.
Why have derivatives?
Derivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset.
What are forward contracts?
A simple forward-based contract obligates one party to buy and the other party to sell a financial instrument, a currency, equity or a commodity at a future date. Examples of forward-based contracts include forward contracts, futures contracts, forward rate agreements and swap transactions.
What are futures contract?
Futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.
Option
The right to purchase the underlying futures contract if the option is a call or the right to sell the underlying futures contract if the option is a put.
Call Option?
A call option conveys to the option buyer the right to purchase a particular futures contract at a stated price at any time during the life of the option
Put Option?
A put option conveys to the option buyer the right to sell a particular futures contract at a stated price at any time during the life of the option.
Strike Price?
Strike Price also known as the ?exercise price,? this is the stated price at which the buyer of a call has the right to purchase a specific futures contract or at which the buyer of a put has the right to sell a specific futures contract.
Who is Option Buyer?
The option buyer is the person who acquires the rights conveyed by the option seller.
Who is Option Seller?
The option seller (also known as the option writer or option grantor) is the party that conveys the option rights to the option buyer.
What is a "Spot" transaction?
In a spot market, transactions are settled ''on the spot''. Once a trade is agreed upon, the settlement - i.e. the actual exchange of money for goods - takes place with the minimum possible delay. When a person selects a shirt in a shop and agrees on a price, the settlement (exchange of funds for goods) takes place immediately. That is a spot market.
What is a "Forward'' transaction?
In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands at the time the trade is agreed upon.
What are "Exchange-traded derivatives''?
Derivatives which trade on an exchange are called "exchange-traded derivatives''. Trades on an exchange generally take place with anonymity. Trades at an exchange generally go through the clearing corporation.
What are "OTC derivatives''?
A derivative contract which is privately negotiated is called an OTC derivative. OTC trades have no anonymity, and they generally do not go through a clearing corporation. Every derivative product can either trade OTC (i.e., through private negotiation), or on an exchange. In one specific case, the jargon demarcates this clearly: OTC futures contracts are called "forwards'' (or, exchange-traded forwards are called "futures''). In other cases, there is no such distinguishing notation. There are "exchange-traded options'' as opposed to "OTC options''; but they are both called options.
"badla'' trading and ?derivatives? trading??
No. Badla is a mechanism to avoid the discipline of a spot market; to do trades on the spot market but not actually do settlement. The "carryforward'' activities are mixed together with the spot market. A well functioning spot market has no possibility of carryforward. Derivatives trades take place distinctly from the spot market. The spot price is separately observed from the derivative price. A modern financial system consists of a spot market which is a genuine spot market, and a derivatives market which is separate from the spot market.
Why is forward contracting useful?
Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest, at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because
Why is forward contracting useful?
Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest, at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because
1) the costs of taking or making delivery of wheat is avoided, and 2) funds are not blocked for the purpose of speculation.
What is "leverage''?
Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a good-faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is ''leverage of 20 times''. This example involves a forward market. More generally, all derivatives involve leverage. Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling leverage is equivalent to understanding and controlling derivatives.
What are the problems of forward markets?
Forward markets tend to be afflicted by poor liquidity and from unreliability deriving from ''counterparty risk'' (also called ''credit risk'')
Why do forward markets have poor liquidity?
One basic problem of forward markets is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form custom-designed contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation; this can make the contracts non-tradeable since others might not find those specific terms useful. In addition, forward markets are like the real estate market in that buyers and sellers find each other using telephones. This is inefficient and time-consuming. Every user faces the risk of not trading at the best price available in the country. Forward markets often turn into small clubs of dealers who earn elevated intermediation fees. This elevates the fees paid by users, i.e. it makes the forward market illiquid from the user perspective.
Why are forward markets afflicted by counterparty risk?
OA forward contract is a bilateral relationship between two people. Each requires good behaviour on the part of the other for the contract to perform as promised. Suppose L agrees to buy gold from S at a future date T at a (forward) price of Rs.10,000/tola. If, on date T, the gold spot price is at Rs.9,000/tola, then L loses Rs.1,000/tola and S gains Rs.1,000/tola by living up to the terms of the contract. When L buys at Rs.10,000/tola by the terms of the contract, he is paying Rs.1,000 more than what could be obtained on the spot market at the same time. Hence, L is tempted to declare bankruptcy and avoid performing as per the contract. Conversely, if on date T the gold spot price is at Rs.11,000/tola, then L gains and S loses by living up to the terms of the contract. S stands to sell gold at Rs.10,000/tola by the terms of the contract, which is Rs.1,000/tola worse than what could be obtained by selling into the spot market at date T. In this case, S is tempted to declare bankruptcy and avoid performing as per the contract. In either case, this leads to counterparty risk. When one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counterparty risk
How does counterparty risk affect liquidity?
A market where counterparty risk is present generally collapses into a small club of participants, who have homogeneous credit risk, and who have formed social and cultural methods for handling bankruptcies. Club markets do not allow for free entry into intermediation. They support elevated intermediation fees for club members, have fewer market participants, and result in reduced liquidity. Sometimes, regulators who are afraid of payments crises forcibly shut out large numbers of participants from an OTC derivatives market. This automatically generates a club market, and yields a fraction of the liquidity which could come about if participation could be enlarged
What is "price-time priority''?
A market has price-time priority if it gives a guarantee that every order will be matched against the best available price in the country, and that if two orders are equal in price, the one which came first will be matched first. Forward markets, which involve dealers talking to each other on phone, do not have price-time priority. Floor-based trading with open-outcry does not have price-time priority. Electronic exchanges with order matching, or markets with a monopoly market maker, have price-time priority. On markets without price-time priority, users suffer greater search costs, and there is a greater risk of fraud.
How does the futures market solve the problems of forward markets?
Futures markets feature a series of innovations in how trading is organised:
1) Futures contracts trade at an exchange with price-time priority. All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. This harnesses the gains that are commonly obtained in going from a non-transparent club market (based on telephones) to an anonymous, electronic exchange which is open to participation. The anonymity of the exchange environment largely eliminates cartel formation.
2) Futures contracts are standardised - all buyers or sellers are constrained to only choose from a small list of tradeable contracts defined by the exchange. This avoids the illiquidity that goes along with the unlimited customisation of forward contracts. 3) A new credit enhancement institution, the clearing corporation, eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This is called novation. This insulates each from the credit risk of the other. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk. Novation at the clearing corporation makes it possible to have safe trading between strangers. This is what enables large-scale participation into the futures market - in contrast with small clubs which trade by telephone - and makes futures markets liquid.
What is cash settlement?
The forward or futures contracts discussed so far involved physical settlement. On 31 Dec 2007, the seller was supposed to come up with 100 tolas of gold and the buyer was supposed to pay for it. In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an inter-bank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use ''cash settlement''. Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement. Cash settlement was an important advance, which extended the reach of derivatives into many products where physical settlement was unviable.
What determines the price of a futures product?
Supply and demand on the secondary market determines the futures price. On dates prior to 31 Dec 2007, the ''Nifty futures expiring on 31 Dec 2007'' trade at a price that purely reflect supply and demand. There is a separate order book for each futures product which generates its own price. Economic arguments give us a clear idea about what the price of a futures should be. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market which forces the theoretical prices to come about.
Doesn't the clearing corporation adopt an enormous risk by giving out credit guarantees to all brokerage firms?
Yes, it does. If a brokerage firm goes bankrupt with net obligations of Rs.1 billion, the clearing corporation has a legal obligation of Rs.1 billion. The clearing corporation is legally obliged to either meet these obligations, or go bankrupt itself. There is no third alternative. There is no committee that meets to decide whether the settlement fund can be utilised; there are no escape clauses. It is important to emphasise that when L buys from S, at a legal level, L has bought from the clearing corporation and the clearing corporation has bought from S. Whether S lives up to his obligations or not, the clearing corporation is the counterparty to L. There is no escape clause which can be invoked by the clearing corporation if S defaults.
How does the clearing corporation assure it does not go bankrupt itself?
The futures clearing corporation has to build a sophisticated risk containment system in order to survive. Two key elements of the risk containment system are the ''mark to market margin'' and ''initial margin''. These involve taking collateral from traders in such a way as to greatly diminish the incentives for traders to default. Electronic trading has generated a need for online, realtime risk monitoring. In India, trading takes place swiftly and funds move through the banking system slowly. Hence the only meaningful notion of initial margin is one that is paid upfront. This leads to the notion of brokerage firms placing collateral, and obtaining limits upon the risk of their position as a function of the amount of collateral with the clearing corporation.
How would index options work?
As with index futures, index options are cash settled. Suppose Nifty is at 4500 on 1 July 2007. Suppose L buys an option which gives him the right to buy Nifty at 4600 from S on 31 Dec 2007. It turns out that this option is worth roughly Rs.90. So a payment of Rs.90 passes from L to S for having this option. When 31 Dec 2007 arrives, if Nifty is below 4600, the option is worthless and lapses without exercise. Suppose Nifty is at 4650. Then (in principle) L can exercise the option, buy Nifty using the option at 1600, and sell off this Nifty on the open market at 1650. So L has a profit of Rs.50 and S has a loss of Rs.50. In this case, ``cash settlement'' consists of NSCC imposing a charge of Rs.50 upon S and paying it to L
When would one use options instead of futures?
Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from a futures: which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating ``guaranteed return products''. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer ``nonlinear payoffs'' whereas futures only have ``linear payoffs''. By combining futures and options, a wide variety of innovative and useful payoff structures can be created.
What are the patterns found, internationally, in options versus futures products on a given underlying?
In general, both futures and options trade on all underlyings abroad. Indeed, the international practice is to launch futures and options on a new underlying on the same day.
What determines the price of an option?
Supply and demand on the secondary market drives the option price. On dates prior to 31 Dec 2007, the ``call option on Nifty expiring on 31 Dec 2007 with a strike of 4500'' will trade at a price that purely reflects supply and demand. There is a separate order book for each option which generates its own price.
What derivatives exist in India in the interest-rates area?
The RBI has permitted OTC trades in interest rate forwards and swaps. These markets have so far had very little liquidity.
What derivatives exist in India in the foreign exchange area?
India has a strong dollar-rupee forward market with contracts being traded for one, two, .. six month expiration. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets. Outside India, there is a small market for cash-settled forward contracts on the dollar-rupee exchange rate.
Worldwide, what kinds of derivatives are seen on the equity market?
Worldwide, the most successful equity derivatives contracts are index futures, followed by index options, followed by security options.
At the individual stock level, are futures or options better?
Internationally, options on individual stocks are commonplace; futures on individual stocks are rare. This is partly because regulators (e.g. in the US) frown upon the idea of doing futures trading on individual stocks.
Why have index derivatives proved to be more important than individual stock derivatives?
Security options are of limited interest because the pool of people who would be interested (say) in options on ACC is limited. In contrast, every single person with any involvement in the equity market is affected by index fluctuations. Hence risk-management using index derivatives is of far more importance than risk-management using individual security options. This goes back to a basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the composition of the portfolio. All portfolios of around ten stocks or more have a pattern of risk where 70% or more of their risk is index-related. Hence investors are more interested in using index-based derivative products. Index derivatives also present fewer regulatory headaches when compared to leveraged trading on individual stocks. Internationally, this has led to regulatory encouragement for index futures and discouragement against futures on individual stocks.
How do futures trade?
In the cash market, the basic dynamic is that the issuer puts out paper, and people trade this paper. In contrast, with futures (as with all derivatives), there is no issuer, and hence, there is no fixed issue size. The net supply of all derivatives contracts is 0. For each buyer, there is an equal and opposite seller. A contract is born when a buyer and a seller meet on the market. The total number of contracts that exist at a point is called open interest.
How would a seller "deliver'' a market index?
On futures markets, open positions as of the expiration date are normally supposed to turn into delivery by the seller and payment by the buyer. It is not feasible to deliver the market index. Hence open positions are squared off in cash on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date, the last mark to market margin is calculated with respect to the spot Nifty instead of the futures price.
Who are the users of index futures?
As with all derivatives, there are: speculators, hedgers and arbitrageurs Speculators would make forecasts about movements in Nifty or movements in futures prices. Hedgers would take buy or sell positions on Nifty futures in offsetting equity exposure that they have, which they consider undesirable. Arbitrageurs lend or borrow money from the market, depending on whether rates of return are attractive.
What is "basis risk''?
Basis risk is the risk that users of the futures market suffer, owing to unwanted fluctuations of the basis. In the ideal futures market, the basis should reflect interest rates, and interest rates alone. In reality, the basis fluctuates within a band. These fluctuations reduce the usefulness of the futures market for hedgers and speculators.
What determines the fair price of a derivative?
The fair price of a derivative is the price at which profitable arbitrage is infeasible. In this sense, arbitrage (and arbitrage alone) determines the fair price of a derivative: this is the price at which there are no profitable arbitrage opportunities.
What determines the fair price of an index futures product?
The pricing of index futures depends upon the spot index, the cost of carry, and expected dividends. For simplicity, suppose no dividends are expected, suppose the spot Nifty is at 1000 and suppose the one-month interest rate is 1.5%. Then the fair price of an index futures contract that expires in a month is 1015.
What is `basis'?
The difference between the spot and the futures price is called the basis. When a Nifty futures trades at 1015 and the spot Nifty is at 1000, ``the basis'' is said to be Rs.15 or 1.5%.
What is "basis risk''?
Basis risk is the risk that users of the futures market suffer, owing to unwanted fluctuations of the basis. In the ideal futures market, the basis should reflect interest rates, and interest rates alone. In reality, the basis fluctuates within a band. These fluctuations reduce the usefulness of the futures market for hedgers and speculators.
Who needs hedging using index futures?
The general principle is: you need hedging using index futures when your exposure to movements of Nifty is not what you would like it to be. If your index exposure is lower than what you like, you should buy index futures. If your index exposure is higher than what you like, you should sell index futures.
If one has an equity portfolio and is not comfortable about equity market fluctuations for the near future. What can he do?
You can sell Nifty futures. The Nifty futures earn a profit if Nifty drops, which offsets the losses you make on your core equity portfolio. Conversely, if Nifty rises, your core equity portfolio does well but the futures suffer a loss. When you have an equity portfolio and you sell Nifty futures, you are hedged: whether Nifty goes up or down, you become neutral to it. This is not a recipe for making money; it is a recipe for eliminating exposure (risk).
If one has an equity portfolio and is not comfortable about equity market fluctuations for the near future. What can he do?
You can sell Nifty futures. The Nifty futures earn a profit if Nifty drops, which offsets the losses you make on your core equity portfolio. Conversely, if Nifty rises, your core equity portfolio does well but the futures suffer a loss. When you have an equity portfolio and you sell Nifty futures, you are hedged: whether Nifty goes up or down, you become neutral to it. This is not a recipe for making money; it is a recipe for eliminating exposure (risk).
How can Nifty futures be used for interest rate trading?
The basis between the spot Nifty and the 1 month Nifty futures reflects the interest rate over the coming month. If interest rates go up, the basis will widen. A buy position on the futures and a sell on the spot Nifty stands to gain if interest rates go up, while being immune to movements in Nifty. Similar positions can be used against the two-month and three-month futures to take views on other spot interest rates on the yield curve. Similar strategies can be applied for trading in forward interest rates, using the basis between the one-month and two-month futures, the one-month and three-month futures, etc.
When does hedging go wrong?
Hedgers fear basis risk. Basis risk is about Nifty futures prices moving in a way which is not linked to the Nifty spot. An unhedged position suffers from price risk; the hedged position suffers from basis risk. Of course, basis risk is generally much smaller than price risk, so that it is better to hedge than not to hedge. However basis risk does detract from the usefulness of hedging using derivatives
What influences basis risk?
A well designed index, and a well-designed cash market for equities, serve to minimise basis risk.
What do we know about Nifty and the BSE Sensex in their usefulness on hedging?
Nifty has higher hedging effectiveness for typical portfolios of all sizes. Nifty also requires lower initial margin (since it is less volatile) and is likely to enjoy lower basis risk (owing to the ease of arbitrage).
How does one lend money into the futures market?
Buy a million rupees of Nifty on the spot market. Pay for them, and take delivery. When you make the payment, you are "giving a loan". Simultaneously, sell off a million rupees of Nifty futures. Hold these positions till the futures expiration date. On the futures expiration date, sell off the Nifty shares on the spot market. When you get paid for these, you are "getting your loan repaid".
When is this attractive?
This is worth doing when the interest rate obtained by lending into the futures market is higher than that which can be obtained through alternative riskless lending avenues.
Why are these borrowing/lending activities called '''arbitrage'''?
They involve a sequence of trades on the spot and on the index futures market. Yet, they are completely riskless. The trader is simultaneously buying at the present and selling off in the future, or vice versa. Regardless of what happens to Nifty, the returns on arbitrage are the same. Since there is no risk involved, it is called arbitrage.
What do we know about Nifty and the BSE Sensex on the question of arbitrage?
The market impact cost in trading the BSE Sensex is higher, for two reasons: index construction and trading venue. Even if BSE Sensex trades were done on NSE, the impact cost faced in trading the BSE Sensex is higher than that of Nifty. In addition, arbitrageurs working on the BSE Sensex would be forced to trade at the less liquid market, the BSE. The BSE lacks a credit enhancement institution of the credibility of NSCC. These problems imply that arbitrageurs working on the BSE Sensex will demand a higher credit risk premium, and require larger pricing errors in order to compensate for the larger transactions costs. Hence, the BSE Sensex futures are expected to show lower market efficiency and greater basis risk.
How does one speculate using index futures?
There are several kinds of speculation that are possible - forecasting movements of Nifty, forecasting movements in Nifty futures prices, and forecasting interest rates.
There are several index futures trading at the same time - which one should I use?
Sometimes, the forecast horizon generates constraints. If you have a two-month view, then a futures contract that has only a few weeks of life left might be inconvenient. Another major issue is liquidity. Other things being equal, it is always better to use the contract with the tightest bid-ask spread.
Auction of Stocks
Auction is a mechanism which is used when a member broker selling shares defaults on the delivery i.e. if he has delivered short (shares fewer than what they have sold) or their deliveries are bad or if they have not rectified the company's objections reported against them. The exchange resorts to Auction to fulfill its obligation towards the broker buying the shares.
Modus Operandi of Auction
Investors can ask their broker member to sell their securities in the Auction. However they should ensure that.
Shares are readily available for delivery (pay-in day of securities for auction is held within 1 or 2 days of auction) and
Shares delivered are good delivery (no opportunity provided for rectification of bad delivery)
Securities not delivered on auction pay-in day or bad delivery of securities delivered in auction are directly squared off at a price specified by the Exchange/Clearing Corporation.
How to select your stockbroker?
You should transact through that intermediary who is subject to regulatory discipline of SEBI. The intermediary must be registered with SEBI and you should verify this from the registration certificate displayed at the office of the intermediary. While selecting an intermediary, you should also take into account (a) the cost of services, (b) the quality of services, (c) track record of the intermediary, and (d) the location and your convenience. You can know the general reputation of an intermediary from its existing clients. Besides, SEBI issues a press release as and when it punishes an intermediary for violation of any regulation, including code of conduct. The exchanges also issue press releases when they suspend a broker. In case the intermediary does not act professionally, you should take up the matter with SEBI and with the self-regulatory organization / industry association with which the intermediary is associated. In addition, you can also file complaints in the court of law.
What is a Mutual Fund?
Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Each scheme of a mutual fund can have different character and objectives. Mutual funds issue units to the investors, which represent an equitable right in the assets of the mutual fund.
What is the difference between an open ended and close ended scheme?
Open ended funds can issue and redeem units any time during the life of the scheme while close ended funds can not issue new units except in case of bonus or rights issue. Hence, unit capital of open ended funds can fluctuate on daily basis while that is not the case for close ended schemes. Other way of explaining the difference is that new investors can join the scheme by directly applying to the mutual fund at applicable net asset value related prices in case of open ended schemes while that is not the case in case of close ended schemes. New investors can buy the units from secondary market only.
How are mutual funds different from portfolio management schemes?
In case of mutual funds, the investments of different investors are pooled to form a common investible corpus and gain/loss to all investors during a given period are same for all investors while in case of portfolio management scheme, the investments of a particular investor remains identifiable to him. Here the gain or loss of all the investors will be different from each other.
What does Net Asset Value (NAV) of a scheme signify and what is the basis of its calculation?
Net asset value on a particular date reflects the realisable value that the investor will get for each unit that he his holding if the scheme is liquidated on that date. It is calculated by deducting all liabilities (except unit capital) of the fund from the realisable value of all assets and dividing by number of units outstanding.
Can I get fixed monthly income by investing in mutual fund units?
Yes, there are a number of mutual fund schemes which give you fixed monthly income. Further, you can also get monthly income by making a single investment in an open ended scheme and redeeming fix value of units at regular intervals.
What are the tax benefits for investing in mutual fund units?
Dividend income from mutual fund units will be exempt from income tax with effect from July 1, 1999. Further, investors can get rebate from tax under section 88 of Income Tax Act, 1961 by investing in Equity Linked Saving Schemes of mutual funds. Further benefits are also available under section 54EA and 54EB with regard to relief from long term capital gains tax in certain specified schemes.
As my dividend receipts from mutual fund units were tax free under section 80 L, will I loose because of the new budget provision whereby my mutual fund will pay 10% tax on total dividend distributed and indirectly even I will end up paying the tax?
The above statement is partially true. 10% tax on dividend paid is not applicable for funds which have invested more than 50% in equity for next three years. Hence, if you have invested in an equity scheme, you will not loose out for the time being. However, in case of debt funds, your statement is true.
Are investments in mutual fund units safe?
No stock market related investments can be termed safe with certainty as they are inherently risky. However, different funds have different risk profile which is stated in its objective. Funds which categorize themselves as low risk, invest generally in debt which is less risky than equity. Anyway, as mutual funds have access to services of expert fund managers, they are always safer than direct investment in the stock markets.
As mutual fund schemes invest in stock markets only, are they suitable for a small investor?
Mutual funds are meant only for a small investor like you. The prime reason is that successful investments in stock markets require careful analysis of scrips which is not possible for a small investor. Mutual funds are usually fully equipped to carry out thorough analysis and can provide superior returns.
