Chapter 9: Participants in the Futures Market

Whenever you play a game, you need to know who you are up against. There are new people like you in it as well as those who have played for years. Aisha knew that it was a matter of time. She could learn a lot from her experience in Futures trading.

After experimenting with Futures contract for a while, Aisha comes to know that there is more than one way to participate in the Futures market. A friend tells her that there are three major participants in the Futures market: Speculators, Hedgers and Arbitrageurs.

Understanding the participants

 

Speculators

Speculators are participants who take a position in derivatives based on their outlook of the market. For instance, if Aisha expects the market to move up, she would should take a long position in the Futures contract, by locking in a purchase price today. Similarly, if she feels the market may go down, she should take a short position. Speculators bet on the possibility of a market movement.  

Hedgers

Hedgers use Futures contracts to protect their investment portfolio value during volatile times. They usually would take opposite stands in different contracts on the same underlying to reduce risk.

In simple terms, hedging is used to reduce current business risk. Corporates, banks, financial institutions and individuals use derivatives to mitigate their risk to different variables like the value of shares and bonds, interest rates, currencies and commodity prices.

Let’s take an example of a farmer who shorts a Futures contract to deliver a certain quantity of wheat at a particular date at Rs. 17.50 per kg.  The farmer has hedged the risk of price going down by locking in the contract price. On the other side, a long position can be taken by a food processing company that requires wheat as a raw material for its production, thereby aiming to lock in the cost of acquisition at Rs. 17.50 per kg.

Did you know?

 

We got the word 'hedge from the Anglo Saxon word 'haeg,' which means enclosure.

Hedging a portfolio through a Futures contract

You can make efficient use of derivatives, Futures in particular, to hedge your current open position in any underlying asset.

Suppose you are an exporter and are expected to receive $1,000 after 3 months from one of your export orders. The current rate of $1 is equal to Rs. 70 and you are of the view that USD might depreciate which would reduce your receivable amount in rupee terms. If the rupee appreciates to Rs. 68 per USD, then you will receive fewer rupees Rs. 68,000 ($1000*68) instead of the amount of the current receivables of Rs. 70,000 ($1000 *70). To reduce this exchange rate risk, you can short a 3-month USD Futures contract at Rs. 69 which would lock the amount of receivables irrespective of what the spot price of the dollar would be at the end of 3 months.

Scenario 1:

Suppose, after 3 months, 1 USD is equivalent to Rs. 65.

  1. On dollar conversion, you will get Rs. 65,000
  2. Your short Futures position in the dollar will give you an additional Rs. 4,000 [(69 – 65)*1000 = 4,000]
  3. Your total receivable would be Rs. 69,000 (65,000+4,000)

Scenario 2:

On the contrary, if 1 USD becomes Rs. 75 after 3 months

  1. On dollar conversion, you will get Rs. 75,000
  2. But on your short Futures position, you will need to pay Rs. 6,000 [(69–75)*1000=  – 6,000]
  3. You will still receive only Rs. 69,000 (75,000 – 6,000)

Similarly, hedging can also be done for a stock portfolio. You will need to find the beta of a portfolio.

  • Beta is the sensitivity of a stock with respect to an index. The beta of an index is considered as 1. If the beta of a stock is 1.2, we can consider that the stock will move by 1.2 % if the index moves by 1%. Similarly, if the stock’s beta is 0.8, it will move by 0.8% if the index moves by 1%.

Let’s understand this with an example:

Suppose you have an equity portfolio of Rs. 10,00,000, consisting of three stocks A, B and C in the proportion of 50:30:20. The beta of these stocks is 0.8, 0.5 and 1.25 respectively. The portfolio’s beta is the weighted average of stock beta.

Portfolio beta = 50%*0.8 + 30%*0.5 + 20%*1.25 = 0.4 + 0.15 + 0.25 = 0.8

To hedge the portfolio, we need to take an opposite position on the Nifty index, equal to portfolio value, multiplied by portfolio beta. In this case, it is Rs. 10,00,000 * 0.8 = Rs. 8,00,000. This means we need to short Nifty Futures worth Rs. 8,00,000 to hedge our stock portfolio.

Note: Hedging is done for a short period only when the market is volatile and you will neither earn nor lose anything if the portfolio is fully hedged. The maturity of the Futures contract should be equal to the period for which you want to hedge your portfolio.

Let us understand how it works in various scenarios:

Scenario 1: Nifty closes 5% lower at the end of the hedging period

In this case, our stock portfolio will move down by 5%*0.8 i.e. 4%.

Loss from the portfolio = 10,00,000* 4% = Rs. 40,000

Profit from the short Nifty position = 8,00,000* 5% = Rs. 40,000

Net profit/loss = 0

 

Scenario 2: Nifty closes 5% higher at the end of the hedging period

In this case, our stock portfolio will move up by 5%*0.8 i.e. 4%.

Profit from the portfolio = 10,00,000* 4% = Rs. 40,000

Loss from the short Nifty position = 8,00,000* 5% = Rs. 40,000

Net profit/loss = 0

 

Scenario 3: Nifty remain stagnant and closes at the same value at the end of the hedging period

In this case, both the stock portfolio and Nifty short position will not give any profit or loss.

We can see that in all the three scenarios, there is no profit or loss and the portfolio is fully hedged. Please note that hedging also has a cost in terms of the margin required to take a short position in Nifty Futures and also requires enough liquidity to maintain MTM profit/loss.

One can also go for a partial or over hedge position based on the view on the underlying security and risk appetite. In case of partial hedging, you can short the Nifty Futures for a value lesser than Rs. 8,00,000 i.e. Rs. 4,00,000 if you want 50% hedging. If you want to take advantage of rising markets, you can over hedge by shorting Nifty for more than Rs. 8,00,000.

Arbitrageurs

Arbitrage is an investment strategy that aims at capturing the price differences of the same underlying in two different markets. Arbitrageurs sell overpriced Futures contracts in the market and buy the same quantity of the stock in the cash market to earn risk-free profit.

  • Arbitrage can be implemented between two different exchanges like BSE and NSE or between the spot markets and derivatives through Futures.
  • Arbitrage is based on the investment logic that if the underlying asset provides equal benefit, then the price of underlying should be the same across different markets. If not, then there exists an arbitrage opportunity.

Typically, the arbitrageur buys the underlying where it is cheaply available and simultaneously sells it in the market where it is highly valued.

For example, the price of Stock A is Rs. 130 on BSE and Rs. 131 on NSE, then an arbitrageur would buy the stock from BSE and sell on NSE and capture Rs. 1 (less trading costs). As adjustment between two markets is not allowed, he has to reverse his position in both the markets before the end of the day.

Also, most of the time, transaction costs will be more than the price difference between two markets, so arbitrage will not yield any profit.

The risk in arbitrage is the fluctuation in market prices of the underlying asset in both markets. The arbitrageur should make sure that the entire transaction gets completed before the price changes in either of the markets. One more risk to be considered is the liquidity of the underlying to square off positions separately in both markets.

How to earn profit from arbitrage through a Futures contract?

One of the ways of implementing an arbitrage strategy through a Futures contract is called cash and carry arbitrage.

  • In cash and carry arbitrage, the trader goes long in the cash/spot market and short in Futures. E.g.: Stock A is priced at Rs. 200 in the spot market and the 3-month Futures price of the stock is Rs. 204. The trader borrows money to undertake arbitrage at a rate of 5%.

The Futures price of an underlying has cost of carry as one of the key factors, so the arbitrageur will first calculate the intrinsic value or theoretical price of a Futures contract as below:

Futures price = Spot price* (1 + Risk free rate*t)

Futures price = 200*(1 + 0.05*3/12) = Rs. 202.5

So as per the arbitrageur, the price of the Futures contract should be Rs 202.5, but the market price is Rs. 204. This means that the Futures contract is overvalued. The right strategy now would be to go long in the cash market and short in the Futures market. As the Futures price will converge with the spot price on expiry, the captured difference of Rs. 1.5 will be the profit for the arbitrageur.

Summary

  • There are three major players in a Futures contract: Speculators, Hedgers and Arbitrageurs.
  • Speculators are participants who take a position in derivatives based on their outlook of the market.
  • Hedgers use Futures contracts to protect their investment portfolio value during volatile times. They usually would take opposite stands in the same underlying to reduce risk.
    • Corporates, banks, financial institutions and individuals use derivatives to mitigate their risk to different variables like the value of shares and bonds, interest rates, currencies and commodity prices.
    • Hedging is done for a short period only when the market is volatile and you will neither earn nor lose anything if the portfolio is fully hedged.
    • Arbitrageurs sell overpriced Futures contracts in the market and buy the same quantity of the stock in the cash market to earn risk-free profit.
      • Arbitrage is based on the investment logic that if the underlying asset provides equal benefit, then the price of underlying should be the same across different markets. If not, then there exists an arbitrage opportunity.
      • Typically, the arbitrageur buys the underlying where it is cheaply available and simultaneously sells it in the market where it is highly valued.

This brings us to the end of the Futures Trading module. You should know what a derivative means, the difference between Forwards and Futures and how to trade in Futures. You can refer to our module on Options Trading to learn about Options.

 

Disclaimer:

 

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