Introduction

Overview
Derivatives have made the international and financial headlines in the past for mostly with their
association with spectacular losses or institutional collapses. But market players have traded
derivatives successfully for centuries and the daily international turnover in derivatives trading runs
into billions of dollars.
Are derivative instruments that can only be traded by experienced, specialist traders? 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.

Indian scenario
While forward contracts and exchange traded in futures has grown by leaps and bound, Indian stock
markets have been largely slow to these global changes. However, in the last few years, there has
been substantial improvement in the functioning of the securities market. Requirements of adequate
capitalization for market intermediaries, margining and establishment of clearing corporations have
reduced market and credit risks. However, there were inadequate advanced risk management tools.
And after the ICE (Information, Communication, Entertainment) meltdown the market regulator felt
that in order to deepen and strengthen the cash market trading of derivatives like futures and
options was imperative.

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.
A derivative is a product whose value is derived from the value of an underlying asset, index or
reference rate. The underlying asset can be equity, forex, commodity or any other asset. For
example, if the settlement price of a derivative is based on the stock price of a stock for e.g.
Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a
daily basis. This means that derivative risks and positions must be monitored constantly.
The purpose of this Learning Centre is to introduce the basic concepts and principles of derivatives.
We will try and understand

• What are derivatives?

• Why have derivatives at all?
• How are derivatives traded and used?

In subsequent lessons we will try and understand how exactly will an underlying asset effect the
movement of a derivative instrument and how is it traded and how one can profit from these
instruments.

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Forward Contracts, Indices, Index Futures

What are forward contracts?
Derivatives as a term conjures up visions of complex numeric calculations, speculative dealings and
comes across as an instrument which is the prerogative of a few 'smart finance professionals'. In
reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading
of securities on which the derivative is based and a small investor, can benefit immensely.
A derivative security can be defined as a security whose value depends on the values of other
underlying variables. Very often, the variables underlying the derivative securities are the prices of
traded securities.
Let us take an example of a simple derivative contract:

• Ram buys a futures contract.

• He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000.
• If the price is unchanged Ram will receive nothing.
• If the stock price of Infosys falls by Rs 800 he will lose Rs 800.

As we can see, the above contract depends upon the price of the Infosys scrip, which is the
underlying security. Similarly, futures trading has already started in Sensex futures and Nifty
futures. The underlying security in this case is the BSE Sensex and NSE Nifty.
Derivatives and futures are basically of 3 types:

• Forwards and Futures

• Options
• Swaps
•

Forward contract
A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell
an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged
when the contract is entered into.
Illustration 1:
Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only
buy it 3 months hence. He, however, fears that prices of televisions will rise 3 months from now. So
in order to protect himself from the rise in prices Shyam enters into a contract with the TV dealer
that 3 months from now he will buy the TV for Rs 10,000. What Shyam is doing is that he is locking
the current price of a TV for a forward contract. The forward contract is settled at maturity. The
dealer will deliver the asset to Shyam at the end of three months and Shyam in turn will pay cash
equivalent to the TV price on delivery.
Illustration 2:
Ram is an importer who has to make a payment for his consignment in six months time. In order to
meet his payment obligation he has to buy dollars six months from today. However, he is not sure
what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract
with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract
on a future date it is a forward contract and the underlying security is the foreign currency.
The difference between a share and derivative is that shares/securities is an asset while derivative
instrument is a contract

What is an Index?
To understand the use and functioning of the index derivatives markets, it is necessary to
understand the underlying index. A stock index represents the change in value of a set of stocks,
which constitute the index. A market index is very important for the market players as it acts as a
barometer for market behavior and as an underlying in derivative instruments such as index
futures.
The Sensex and Nifty
In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex
has 30 stocks comprising the index which are selected based on market capitalization, industry
representation, trading frequency etc. It represents 30 large well-established and financially sound
companies. The Sensex represents a broad spectrum of companies in a variety of industries. It
represents 14 major industry groups. Then there is a BSE national index and BSE 200. However,
trading in index futures has only commenced on the BSE Sensex.
While the BSE Sensex was the first stock market index in the country, Nifty was launched by the
National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index
consists of shares of 50 companies with each having a market capitalization of more than Rs 500
crore.

Futures and stock indices

For understanding of stock index futures a thorough knowledge of the composition of indexes is
essential. Choosing the right index is important in choosing the right contract for speculation or
hedging. Since for speculation, the volatility of the index is important whereas for hedging the
choice of index depends upon the relationship between the stocks being hedged and the
characteristics of the index.
Choosing and understanding the right index is important as the movement of stock index futures is
quite similar to that of the underlying stock index. Volatility of the futures indexes is generally
greater than spot stock indexes.
Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to
the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and
rise when the market as a whole is rising.
Retail investors will find the index derivatives useful due to the high correlation of the index with
their portfolio/stock and low cost associated with using index futures for hedging.

Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in
the future at a certain price. Index futures are all futures contracts where the underlying is the
stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.
Index futures permits speculation and if a trader anticipates a major rally in the market he can
simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs.
We shall learn in subsequent lessons how one can leverage ones position by taking position in the
futures market.
In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3
months duration contracts are available at all times. Each contract expires on the last Thursday of
the expiry month and simultaneously a new contract is introduced for trading after expiry of a
contract.
Example:
Futures contracts in Nifty in July 2001

Contract month Expiry/settlement

July 2001 July 26
August 2001 August 30
September 2001 September 27
On July 27
Contract month Expiry/settlement
August 2001 August 30
September 2001 September 27
October 2001 October 25
The permitted lot size is 200 or multiples thereof for the Nifty. That is you buy one Nifty contract the
total deal value will be 200*1100 (Nifty value)= Rs 2,20,000.
In the case of BSE Sensex the market lot is 50. That is you buy one Sensex futures the total value
will be 50*4000 (Sensex value)= Rs 2,00,000.
The index futures symbols are represented as follows:
BSE NSE
BSXJUN2001 (June contract) FUTDXNIFTY28-JUN2001
BSXJUL2001 (July contract) FUTDXNIFTY28-JUL2001
BSXAUG2001 (Aug contract) FUTDXNIFTY28-AUG2001
In subsequent lessons we will learn about the pricing of index futures.

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Application Of Index Future

Hedging
We have seen how one can take a view on the market with the help of index futures. The other
benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to
understand how one can protect his portfolio from value erosion let us take an example.

Illustration:
Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses
for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000
if the sale is completed.
Cost (Rs) Selling price Profit
 1000 4000 3000
However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a
new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of
Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as incentive.
Shyam defaults Shyam honours
1000 (Initial Investment) 3000 (Initial profit)
1000 (penalty from Shyam) (-1000) discount given to Shyam
- (No gain/loss) 2000 (Net gain)
As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial
investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has
hedged his risk against default and protected his initial investment.
The above example explains the concept of hedging. Let us try understanding how one can use
hedging in a real life scenario.
Stocks carry two types of risk - company specific and market risk. While company risk can be
minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So
how does one measure the market risk? Market risk can be known from Beta.
Beta measures the relationship between movement of the index to the movement of the stock. The
beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for
a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be
1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to
make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse price movements. In
order to hedge a position, a market player needs to take an equal and opposite position in the
futures market to the one held in the cash market. Every portfolio has a hidden exposure to the
index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta
of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to
assume that it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index would
offset the losses on the rest of his portfolio. This is achieved by multiplying the relative
volatility of the portfolio by the market value of his holdings. Therefore in the above
scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty.
Now let us study the impact on the overall gain/loss that accrues:
Index up 10% Index down 10%
Gain/(Loss) in Portfolio Rs 120,000 (Rs 120,000)
Gain/(Loss) in Futures (Rs 120,000) Rs 120,000
Net Effect Nil Nil
As we see, that portfolio is completely insulated from any losses arising out of a fall in market
sentiment. But as a cost, one has to forego any gains that arise out of improvement in the overall
sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures
market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of
whether the market goes up or not, his portfolio value would increase.
The same methodology can be applied to a single stock by deriving the beta of the scrip and taking
a reverse position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses in the cash
market.

Speculation
Speculators are those who do not have any position on which they enter in futures and options
market. They only have a particular view on the market, stock, commodity etc. In short, speculators
put their money at risk in the hope of profiting from an anticipated price change. They consider
various factors such as demand supply, market positions, open interests, economic fundamentals
and other data to take their positions.

Illustration:
Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in
predicting the market trend. So instead of buying different stocks he buys Sensex Futures.
On May 1, 2001, he buys 100 Sensex futures @ 3600 on expectations that the index will rise in
future. On June 1, 2001, the Sensex rises to 4000 and at that time he sells an equal number of
contracts to close out his position.
Selling Price : 4000*100 = Rs 4,00,000
Less: Purchase Cost: 3600*100 = Rs 3,60,000
Net gain Rs 40,000
Ram has made a profit of Rs 40,000 by taking a call on the future value of the Sensex. However, if
the Sensex had fallen he would have made a loss. Similarly, if would have been bearish he could
have sold Sensex futures and made a profit from a falling profit. In index futures players can have a
long-term view of the market up to atleast 3 months.

Arbitrage
An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless
profits. When markets are imperfect, buying in one market and simultaneously selling in other
market gives riskless profit. Arbitrageurs are always in the look out for such imperfections.
In the futures market one can take advantages of arbitrage opportunities by buying from lower
priced market and selling at the higher priced market. In index futures arbitrage is possible between
the spot market and the futures market (NSE has provided a special software for buying all 50 Nifty
stocks in the spot market.

• Take the case of the NSE Nifty.

• Assume that Nifty is at 1200 and 3 month's Nifty futures is at 1300.
• The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into
account.
• If there is a difference then arbitrage opportunity exists.

Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs
1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase ITC at Rs 1000
in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.
Sale = 1070
Cost= 1000+30 = 1030
Arbitrage profit = 40
These kind of imperfections continue to exist in the markets but one has to be alert to the
opportunities as they tend to get exhausted very fast.

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Pricing Of Index Futures

The index futures are the most popular futures contracts as they can be used in a variety of ways by
various participants in the market.
How many times have you felt of making risk-less profits by arbitraging between the underlying and
futures markets. If so, you need to know the cost-of-carry model to understand the dynamics of
pricing that constitute the estimation of fair value of futures.

The cost of carry model

The cost-of-carry model where the price of the contract is defined as:
F=S+C
where:
F Futures price
S Spot price
C Holding costs or carry costs
If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves
away from the fair value, there would be chances for arbitrage.
If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can
purchase Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures
for 3 months at Rs 1070.
Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of
arbitrage.
Sale = 1070
Cost= 1000+30 = 1030
Arbitrage profit 40
However, one has to remember that the components of holding cost vary with contracts on different
assets.

Futures pricing in case of dividend yield

We have seen how we have to consider the cost of finance to arrive at the futures index value.
However, the cost of finance has to be adjusted for benefits of dividends and interest income. In the
case of equity futures, the holding cost is the cost of financing minus the dividend returns.
Example:
Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is
earned throughout the year and finance rate=10% the fair value of the stock index portfolio after
one year will be F= Rs 100 + Rs 100 * (0.10 - 0.03)
Futures price = Rs 107
If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs
100, borrowing the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of
the year, the arbitrageur would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and
repay the loan of Rs 100 and interest of Rs 10.
The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.
Thus, we can arrive at the fair value in the case of dividend yield.

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Trading Strategies
Speculation
We have seen earlier that trading in index futures helps in taking a view of the market, hedging,
speculation and arbitrage. In this module we will see one can trade in index futures and use forward
contracts in each of these instances.
Taking a view of the market
Have you ever felt that the market would go down on a particular day and feared that your portfolio
value would erode?
There are two options available
Option 1: Sell liquid stocks such as Reliance
Option 2: Sell the entire index portfolio
The problem in both the above cases is that it would be very cumbersome and costly to sell all the
stocks in the index. And in the process one could be vulnerable to company specific risk. So what is
the option? The best thing to do is to sell index futures.

Illustration:
Scenario 1:
On July 13, 2001, 'X' feels that the market will rise so he buys 200 Nifties with an expiry date of
July 26 at an index price of 1442 costing Rs 2,88,400 (200*1442).
On July 21 the Nifty futures have risen to 1520 so he squares off his position at 1520.
'X' makes a profit of Rs 15,600 (200*78)
Scenario 2:
On July 20, 2001, 'X' feels that the market will fall so he sells 200 Nifties with an expiry date of July
26 at an index price of 1523 costing Rs 3,04,600 (200*1523).
On July 21 the Nifty futures falls to 1456 so he squares off his position at 1456.
'X' makes a profit of Rs 13,400 (200*67).
In the above cases 'X' has profited from speculation i.e. he has wagered in the hope of profiting
from an anticipated price change.

Hedging
Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to
control risk. The total risk is measured by the variance or standard deviation of its return
distribution. A common measure of a stock market risk is the stock's Beta. The Beta of stocks are
available on the www.nseindia.com.
While hedging the cash position one needs to determine the number of futures contracts to be
entered to reduce the risk to the minimum.
Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the
company made it worth a lot more as compared with what the market thinks?
Have you ever been a 'stockpicker' and carefully purchased a stock based on a sense that it was
worth more than the market price?

A person who feels like this takes a long position on the cash market. When doing this, he faces two
kinds of risks:
1. His understanding can be wrong, and the company is really not worth more than the market price
or
2. The entire market moves against him and generates losses even though the underlying idea was
correct.
Everyone has to remember that every buy position on a stock is simultaneously a buy position on
Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position
along with it, as incidental baggage i.e. a part long position of Nifty.

Let us see how one can hedge positions using index futures:
'X' holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL
is 1.13. How much Nifty futures does 'X' have to sell if the index futures is ruling at 1527?
To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty
futures.
On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. 'X' closes both positions earning Rs
13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940
(666*90).
Therefore, the net gain is 59940-46551 = Rs 13,389.
Let us take another example when one has a portfolio of stocks:
Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be
hedged by using Nifty futures contracts. To find out the number of contracts in futures market to
neutralise risk
If the index is at 1200 * 200 (market lot) = Rs 2,40,000
The number of contracts to be sold is:

1. 1.19*10 crore = 496 contracts

2,40,000
If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are
underhedged.
Thus, we have seen how one can hedge their portfolio against market risk.

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Margins & Settlement

Margins
The margining system is based on the JR Verma Committee recommendations. The actual
margining happens on a daily basis while online position monitoring is done on an intra-day basis.

Daily margining is of two types:

1. Initial margins
2. Mark-to-market profit/loss
The computation of initial margin on the futures market is done using the concept of Value-at-Risk
(VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered
on 99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may
stand to lose within a certain horizon time period (one day for the clearing corporation) due to
potential changes in the underlying asset market price. Initial margin amount computed using VaR
is collected up-front.
The daily settlement process called "mark-to-market" provides for collection of losses that have
already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses
on outstanding positions. The mark-to-market settlement is done in cash.
Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the
margins payments that would occur.

• A client purchases 200 units of FUTIDX NIFTY 29JUN2001 at Rs 1500.

• The initial margin payable as calculated by VaR is 15%.

Total long position = Rs 3,00,000 (200*1500)

Initial margin (15%) = Rs 45,000
Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:

Positions On Day 1
Close Price Loss Margin released Net cash outflow
1400*200 =2,80,000 20,000 (3,00,000- 3,000 (45,000- 17,000 (20,000-
2,80,000) 42,000) 3000)
Payment to be made (17,000)

New Positions On Day 2

Value of new position = 1,400*200= 2,80,000
Margin = 42,000
Close Price Gain Addn Margin Net cash inflow
1510*200 =3,02,000 22,000 (3,02,000- 3,300 (45,300- 18,700 (22,000-
2,80,000) 42,000) 3300)
Payment to be recd 18,700

Positions On Day 3
Value of new position = 1510*200 = Rs 3,02,000
Margin = Rs 3,300
Close Price Gain Net cash inflow
1600*200 =3,20,000 18,000 (3,20,000- 18,000 + 45,300* = 63,300
3,02,000)
Payment to be recd 63,300

Margin account*
Initial margin = Rs 45,000
Margin released (Day 1) = (-) Rs 3,000
Position on Day 2 Rs 42,000
Addn margin = (+) Rs 3,300
Total margin in a/c Rs 45,300*
Net gain/loss
Day 1 (loss) = (Rs 17,000)
Day 2 Gain = Rs 18,700
Day 3 Gain = Rs 18,000
Total Gain = Rs 19,700
The client has made a profit of Rs 19,700 at the end of Day 3 and the total cash inflow at the close
of trade is Rs 63,300.

Settlements
All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which
are not closed out will be marked-to-market. The closing price of the index futures will be the daily
settlement price and the position will be carried to the next day at the settlement price.
The most common way of liquidating an open position is to execute an offsetting futures transaction
by which the initial transaction is squared up. The initial buyer liquidates his long position by selling
identical futures contract.
In index futures the other way of settlement is cash settled at the final settlement. At the end of the
contract period the difference between the contract value and closing index value is paid.

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Miscellaneous
How to read the futures data sheet?
Understanding and deciphering the prices of futures trade is the first challenge for anyone planning
to venture in futures trading. Economic dailies and exchange websites www.nseindia.com and
www.bseindia.com are some of the sources where one can look for the daily quotes. Your website
has a daily market commentary, which carries end of day derivatives summary alongwith the
quotes.
The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open
Interest are the three primary data we carry with Index option quotes. The most important
parameter are the actual prices, the high, low, open, close, last traded prices and the intra-day
prices and to track them one has to have access to real time prices.
The following table shows how futures data will be generally displayed in the business papers daily.
Series First High Low Close Volume (No of Value No of trades Open interest (No
Trade contracts) (Rs in lakh) of contracts)
BSXJUN2000 4755 4820 4740 4783.1 146 348.70 104 51
BSXJUL2000 4900 4900 4800 4830.8 12 28.98 10 2
BSXAUG2000 4800 4870 4800 4835 2 4.84 2 1
Total 160 38252 116 54
Source: BSE
• The first column explains the series that is being traded. For e.g. BSXJUN2000 stands for the
June Sensex futures contract.
• The column on volume indicates that (in case of June series) 146 contracts have been traded in
104 trades.
• One contract is equivalent to 50 times the price of the futures, which are traded. For e.g. In case
of the June series above, the first trade at 4755 represents one contract valued at 4755 x 50 i.e.
Rs. 2,37,750/-.
Open interest indicates the total gross outstanding open positions in the market for that particular
series. For e.g. Open interest in the June series is 51 contracts.
The most useful measure of market activity is Open interest, which is also published by exchanges
and used for technical analysis. Open interest indicates the liquidity of a market and is the total
number of contracts, which are still outstanding in a futures market for a specified futures contract.
A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This
means that the buyer goes long and the seller goes short. Open interest is calculated by looking at
either the total number of outstanding long or short positions - not both.

Open interest is therefore a measure of contracts that have not been matched and closed out. The
number of open long contracts must equal exactly the number of open short contracts.
Action Resulting open interest
New buyer (long) and new seller (short) Rise
Trade to form a new contract.
Existing buyer sells and existing seller Fall
buys -The old contract is closed.
New buyer buys from existing buyer. The No change - there is no increase in long
Existing buyer closes his position by selling contracts being held
to new buyer.
Existing seller buys from new seller. The No change - there is no increase in short
Existing seller closes his position by buying contracts being held
from new seller.
Open interest is also used in conjunction with other technical analysis chart patterns and indicators
to gauge market signals. The following chart may help with these signals.
Price Open interest Market
 Up Up Strong
Up Down Warning signal
Up Weak
Up Warning signal
The warning sign indicates that the Open interest is not supporting the price direction.

Selecting the right index

In selecting the index and contract month one should consider the following points.
Expiration date: If the investor has a month or two's view about the market then he should choose
that index futures which has a similar time left for expiry.
Liquidity: The index and the contract month, which is the most liquid must be used. This will save
cost because of the low bid-ask spread. This also saves hedging costs.
Stock should be correlated to the index: The stock to be hedged should have a correlation with the
index selected.
Potential mispricing: One should sell index futures contract which is overpriced. In such an event
one can not only hedge but also earn some profit in selling high.
In a nutshell, one should hedge by using the most popular and fairly priced index and delivery
month should not be very far since liquidity and predictability of very few contracts are low.

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Glossary
Backwardation: A market where future prices of distant contract months are lower than the near
months.

Basis: The difference between the Index and the respective contract is the basis i.e. cash netted
for the Futures price. A negative basis means Futures are at a premium to cash and vice versa. It is
the strengthening and weakening of basis that is tracked by market players i.e. whether the basis
is widening or narrowing. A widening of basis is indicative of increasing longs and narrowing means
increasing short positions.

Basis Point: It is equal to one hundredth of a percentage point

Contango market: This is a market where futures prices are higher for distant contracts than for
nearby delivery months.

Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically
means the annualized interest cost players decide to pay (receive) for buying (selling) a respective
contract. A higher carry cost is indicative of buying pressure and vice versa. Carry Cost is a widely
used parameter not only because it is more interpretable being an annualized figure, as compared
to basis (Cash netted for Futures) but also because it works well with the trio of Price, Volume and
Open Interest in highlighting the market trend.

Delivery month: Is the month in which delivery of futures contracts need to be made.

Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are
invoiced. Also known as the expiry price or the settlement price.

Derivative: A financial instrument designed to replicate an underlying security for the purpose of
transferring risk.

Fair value: Theoretical value of a futures contract derived from a mathematical model of valuation.

Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell
so as to provide the maximum offset of risk. This depends on the

• Value of a Futures contract;

• Value of the portfolio to be Hedged; and
• Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).

The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be
hedged and underlying (index) from which Future is derived.

Initial margin: The money a customer needs to pay as deposit to establish a position in the
futures market. The basic aim of Initial margin is to cover the largest potential loss in one day.

Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on
closing market prices at the end of the trading day.
Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a
stated price and quantity. No money changes hands at the time the deal is signed.

Futures contract: A futures contract is similar to a forward contract in terms of its working. The
difference is that contracts are standardized and trading is centralized. Futures markets are highly
liquid and there is no counterparty risk due to the presence of a clearinghouse, which becomes the
counterparty to both sides of each transaction and guarantees the trade.

Far contract: The future that is furthest from its delivery month i. e. has the longest maturity.

Speculation: Trading on anticipated price changes, where the trader does not hold another position
which will offset any such price movements.

Spread ratio: The number of futures contracts bought, divided by the number of futures contracts
sold.

VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum
loss possible on a particular position, with a specified level of certainty or confidence.

Strike Price: The price at which an option holder may buy or sell the underlying asset, which is
specified in an option contract.