Speculation and Intermediation

Q13.1: How does one speculate using index futures?
A: There are several kinds of speculation that are possible – forecasting movements of
Nifty, forecasting movements in Nifty futures prices, and forecasting interest rates. ••
Q13.2: What is involved in forecasting Nifty?
A: Nifty is a well–diversified portfolio of companies that make up 54% of the market
capitalisation of India. The diversification inside Nifty serves to “cancel out” influences
of individual companies or industries.
Hence Nifty, as a whole, reflects the overall prospects of India’s corporate sector and
India’s economy. Nifty moves with events that impact India’s economy. These include
politics, macroeconomic policy announcements, interest rates, money supply and budgets,
shocks from overseas, etc. Thomas & Shah (1999) offer some time–series econometrics
applied to Nifty. ••

Q13.3: I have a forecast about Nifty. What can I do?
A: If you have a forecast that Nifty will go up, buy Nifty futures. If you have a forecast
that Nifty will go down, sell Nifty futures. ••
Q13.4: There are several index futures trading at the same
time – which one should I use?
A: 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. ••

Q13.5: I have a forecast that Nifty will rise, and I buy Nifty
futures. What can go wrong now?

SPECULATION
A: Two scenarios are unfriendly to the speculator. The obvious problem is where Nifty
fails to rise as forecasted. But sometimes, even if Nifty rises, the futures price may not
move in sympathy.
A speculator may make a loss, owing to a slight fall in the futures price, even though
there was a slight rise in Nifty. This problem is called basis risk.
Sometimes, the speculator may be right in essence – and good news about the macroeconomy
does appear – but may lose money in practice because the index is badly constructed
and does not reflect shocks to the macroeconomy. ••
Q13.6: How can these risks be minimised?
A: Basis risk is minimised by having a well–designed index where the index is highly
liquid and the underlying spot market is well thought out and highly liquid. The index
accurately tracks the macroeconomy when it is as large as possible while avoiding illiquid
stocks, it is regularly maintained, and accurate in terms of data reliability. See Question
10.1. ••

Q13.7: I have a forecast about a change in a Nifty futures
price. What can I do?
A: If you think the futures price will go up, buy the futures. If you think the futures price
will go down, sell the futures. ••

Q13.8: How does one forecast the Nifty futures price, as distinct
from forecasting Nifty?
A: The speculator who works on movements of the futures price makes calculations for
the fair value of the futures, after carefully accounting for interest rates, initial margin
requirements and transactions costs faced by arbitrageurs, and dividend forecasts.
If, based on this analysis, the speculator feels that arbitrageurs are going to lend money
to the market (i.e. buy the spot Nifty and sell the futures), then he has a forecast that the
futures price will drop.
Such a speculator is front–runing against the arbitrageurs by selling Nifty futures
before they do so. ••

Q13.9: I have a forecast that interest rates will rise. What can
I do with the Nifty futures market?
A: The basis between (say) 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 coupled with a sell on the spot Nifty represents a view that the
basis will widen.
The difference between the two month and three month futures reflects the forward
interest rate for 30 days, two months from now. Interest rate views can be expressed using
this also. ••

Intermediation
Q14.1: What kinds of intermediaries are found on the index
futures market?
A: There are two kinds of brokerage firms on the index futures market: trading members
(TMs) and clearing members (CMs). NSCC only deals with clearing members: NSCC
bears the full risk of default by a clearing members. Trading members obtain the right to
trade through a clearing member; the CM adopts the full credit risk of the TM. If a TM
fails, NSCC holds the relevant CM responsible.
CMs don’t need to be brokerage firms; entities such as banks or SHCIL are CMs. ••

Q14.2: How is derivatives intermediation different from that on
the equity spot market?
A: There are a few key differences between intermediation on the equity spot market as
compared with the derivatives market:
• Certification of employees is mandatory on the derivatives market from the outset.
In contrast, certification requirements on the equity spot market are only gradually
being phased in. Anyone who actually obtains a password from NSE and trades on
the futures market has to have obtained a score of above 60 on the “NCFM F&O”
certification examination.
• The equity spot market is primarily focused upon execution. Users of the market
generally know what shares they want to buy/sell, and they only look to the broker
to do the low–skill job of trade execution. In contrast, for the forseeable future,
users in the index futures and options market will turn to the brokerage firm for
advice and analytical support in the context of their derivatives trading. It will
be typical to see a user who has a buy on HINDLEVER hedging away his Nifty
exposure, upon the advice of the stock broker.
• On NSE’s equity market, the broker is both trading member and clearing member.
On the futures market, we will see a clear specialisation coming about, where firms
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with a focus upon customers will become “trading members”, and get their clearing
and settlement services from clearing members. Banks will be important in being
clearing members.
• On the equity market, the settlement process using physical shares and (to a much
lesser extent) using the depository implies that the typical brokerage firm has a
large staff which processes settlement activities. Index futures and options are cash
settled, so the staffing patterns in the brokerage firm will be quite different.
••

Q14.3: What’s the role for mutual funds in the index futures
and index options market?
A: There are numerous areas where mutual funds benefit from index futures and index
options:
• Index funds can directly use index futures in implementing index funds. When
funds come in, the index fund can just buy index futures, and gradually unwind the
futures position as the spot market trading is done.
• All mutual funds can excel in reverse-cash-and-carry arbitrage, where full Nifty
baskets are sold off on the spot market and bought back at future dates.
• Mutual funds can hedge when their index views are adverse. If a fund feels that
Nifty will fare poorly, it can sell Nifty futures and reduce its index exposure. Conversely,
it can increase its index exposure when it feels that Nifty will do well.
• Income funds and money market funds can invest money into the Nifty futures
market.
• Once index options come about, mutual funds can offer “guaranteed return products”,
by bundling a Nifty index fund with a Nifty put option. Conversely, funds
can be designed by bundling a core investment in government securities with an
investment in a Nifty call option: these funds would have a pure upside if equities
do well.