Index futures

Q7.1: How do futures trade?
A: 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. ••

Q7.2: How would a seller “deliver” a market index?
A: 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. ••

Q7.3: What products will be traded on NSE’s market?
A: Three Nifty futures contracts will trade at any point in time, expiring in three near
months. The expiration date of each contract will be the last thursday of the month.
For example, in January 1996 we will see three tradeable objects at the same time: a
Nifty futures expiring on 25 January, a Nifty futures expiring on 29 February, and a Nifty
futures expiring on 28 March.
The three futures trade completely independently of each other. Each has a distinct
price and a distinct limit order book.
Hence, once this market trades, there would be four distinct prices that can be observed:
the Nifty spot, and three Nifty futures prices. ••

INDEX FUTURES
Q7.4: What is the market lot?
A: The market lot is 200 nifties. A user will be able to buy 200 or 400 nifties, but not
300 nifties. If Nifty is at 1500, the smallest transaction will have a notional value of
Rs.300,000. ••

Q7.5: What kind of margins do we expect to see?
A: The initial (upfront) margin on trading Nifty is likely to be around 7% to 8%. Thus, a
position of Rs.300,000 (around 200 nifties) will require up–front collateral of Rs.21,000
to Rs.24,000.
Nifty futures at SIMEX will probably involve a somewhat lower initial margin as
compared with Nifty futures at NSE. Since the BSE Sensex is more volatile than Nifty, a
higher initial margin will be required for trading it.
The daily mark–to–market margin will be similar to that presently seen on the cash
market, with two key differences:
• As is presently the case, mark-to-market losses will have to be paid in by the trader
to NSCC. However, mark-to-market profits will be paid out to traders by NSCC –
this is not presently done on the cash market.
• Hedged futures positions will attract lower margin – if a person has purchased 200
October nifties and sold 200 November nifties, he will attract much less than 7–
8% margin. In the present cash market, all positions attract 15% initial (upfront)
margin from NSCC, regardless of the extent to which they are hedged.
••

Q7.6: Isn’t this level of leverage much more dangerous than
what we presently see on NSE?
A: Individual stocks are more volatile, and more vulnerable to manipulative episodes such
as short squeezes. Hence, highly leveraged trading on individual stocks is fraught with
problems. In contrast, the index futures/options are cash settled, and are based on an
underlying (the index) which is hard to manipulate. ••

Q7.7: Who are the users of index futures?
A: As with all derivatives, there are (a) speculators, (b) hedgers and (c) 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. ••

Q7.8: What kind of liquidity is expected on index derivatives
markets?
A: Impact cost on index derivatives markets is likely to be much smaller than that seen
on the spot index. One thumb rule which is commonly used internationally is that transactions
costs on trading index futures are around one–tenth the cost of trading the spot
index. When this level of liquidity is attained, we will be able to trade Rs.1 million of
Nifty futures in a market impact cost of 0.01%.
High liquidity is the essential appeal of index derivatives. If trading on the spot market
were cheap, then many portfolio modifications would get done there itself. However,
because transactions costs on the cash market are high, using derivatives is an appealing
alternative. ••