Index Derivatives

 INDEX DERIVATIVES

Index derivatives are derivative contracts which have the index as the underlying. The most popular index derivatives contracts the world over are index futures and index options. NSE’s market index, the S&P CNX NIFTY was scientifically designed to enable the launch of index based products like index derivatives and index funds. The first derivative contract to be traded on NSE’s market was the index futures contract with the Nifty as the underlying. This was followed by Nifty options and thereafter by sectorial indexes. CNX IT and’BANK NIFTY contracts.

 

INDEX FUNDS

An Index fund is a fund that tries to replicate the index returns. It does so by investing in index stocks in the proportions in which these stocks exist in the index. The goal of the index fund is to achieve the same performance as the index it tracks.

For instance, a Nifty index fund would seek to get the same return as the Nifty index. Since the Nifty has 50 stocks, the fund would buy al 50 stocks in the proportion in which they exist in the Nifty’. Once invested, the fund will track the index, i.e., if the Nifty goes up. the value of the fund will go up to the same extent as the Nifty. If the Nifty falls, the value of the index fund will fall to the same extent as the Nifty. The most useful kind of market index is one where the weight attached to a stock is proportional to its market capitalization, as in the case of Nifty. Index funds are easy to construct for this kind of index since the index fund does not need to trade in response to price fluctuations. Trading is only required in response to issuance of shares, mergers, etc..

 

EXCHANGETRADEDFUNDS

Exchange Traded Funds (ETF’s) are innovative products, which first came into existence in the USA in 1993. They have gained prominence over the last few years with over $300 Billion invested as of end 2001 in about 360 ETFs globally. About 60% of trading volume on the American Stock Exchange is from ETFs. Among the popular ones are SPDRs (Spiders) based on the S&P 500 Index. QQQs (Cubes) based on the Nasdaq-100 Index, iSHARES based on MSC1 Indices and TRAHK (Tracks) based on the Hand Seng Index.

ETFs provide exposure to an index or a basket of securities that trade on the exchange like a single stock. They have number of advantages over traditional open ended funds as they can be bought and sold on the exchange at prices that are usually close to the actual intra-day NAV of the scheme. They are an innovation to traditional mutual funds as they provide investors a fund that closely tracks the performance ot an index with the ability to buy/sell on an intra-day basis. Unlike listed closed-ended funds, which trade at substantial premia or more frequently at discounts to NAV, ETFs are structured in a manner which allows to create new units and redeem outstanding units directly with the fund, there by ensuring that ETFs trade close to their actual NAVs.

The first ETF in India. “Nifty BeEs” (Nifty Bench mark exchange Traded Scheme) based on S&P CNX NIFTY, was launched in December, 2001 by Benchmark Mutual Fund. It is bought and sold like any other stock on NSE and has all characteristics of an index fund. It would provide returns that closely correspond to the total return of stocks included in NIFTY.

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