Pricing of futures contract is very simple. Using the cost of carry logic, we calculate fhe fair value of a futures contract. Every time the the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value.
APPLICATION OF FUTURES
We look here at some applications of futures contracts. We refer to single stock futures. However since the index is nothing but a security whose price or level is a weighted average of securities constituting an index, all strategies that can be implemented using stock futures can also be implemented using index futures.
HEDGING. LONG SECURITY, SELL FUTURES
Futures can be used as an effective risk management tool. Take the case of an investor who holds the shares of a company and gets uncomfortable with market movements in the short run. He sees the value of his security falling from Rs.450 to Rs.390 . In the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he need to do is to enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot prFce of the security he holds is Rs.390. Two month futures cost him Rs.402. For this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security, will be offset by the profits he makes on his short futures position. Take for instance that the price of his security falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position.
Index futures in particular can be very effectively used to get rid of the market risk of a portfolio. Every portfolio contains a hidden index exposure or a market exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In this case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 30 – 60 % of the securities risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become 1/10th risky as the LONG PORTFOLIO Position !
WARNING: Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e., unnecessary risk. The hedged position will make less profits than the unhedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk.
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