INDEX DERIVATIVES

H.R.COLLEGE OF COMMERCE AND ECONOMICS

T.Y.B.F.M

PRESENTED BY:

DIVYA CHHABRA
MONISHA BHATIA
PRIYA KUKREJA
YASH GANDHI
DHAVAL .M.SANGHVI
ADITYA GARG
Contents
INTRODUCTION..........................................................3
1 UNDERSTANDING THE INDEX NUMBER..................4
2 ECONOMIC SIGNIFICANCE OF INDEX MOVEMENTS.......5
3 INDEX CONSTRUCTION ISSUES................................6
4 TYPES OF INDEXES...................................................7
5 DESIRABLE ATTRIBUTES OF AN INDEX.....................9
6 THE S&P CNX NIFTY...............................................11
7 APPLICATIONS OF INDEX.......................................14
8 PRICING ................................................................17
9 CONTRACT SPECIFICATIONS..................................19

2
MARKET INDEX

Traditionally, indexes have been used as information sources.

By looking at an index, we know how the market is faring. In recent

years, indexes have come to the forefront owing to direct applications in finance

in the form of index funds and index derivatives. Index derivatives allow people

to cheaply alter their risk exposure to an index (hedging) and to implement

forecasts about index movements (speculation). Hedging using index derivatives has

become a central part of risk management in the modern economy.

INDEX DERIVATIVES
Index derivatives are derivative contracts which derive their value from an

underlying index. The two most popular index derivatives are index futures and

index options. Index derivatives have become very popular worldwide. Index

derivatives offer various advantages and hence have become very popular.

Institutional and large equity-holders need portfolio-hedging facility. Index derivatives

are more suited to them and more cost-effective than derivatives based

on individual stocks. Pension funds in the US are known to use stock index futures

for risk hedging purposes. Index derivatives offer ease irrespective of its

composition. of use for hedging any portfolio 3

1 UNDERSTANDING THE INDEX NUMBER
An index is a number which measures the change in a set of values over a period of

time. A stock index represents the change in value of a set of stocks which

constitute the index. More specifically, a stock index number is the current

relative value of a weighted average of the prices of a pre-defined group of

equities. It is a relative value because it is expressed relative to the weighted

average of prices at some arbitrarily chosen starting date or base period. The

starting value or base of the index is usually set to a number such as 100 or

1000. For example, the base value of the Nifty was set to 1000 on the start date

of November 3, 1995. A good stock market index is one which captures the behavior

of the overall equity market. It should represent the market, it should be well

diversified and yet highly liquid. Movements of the index should represent the

returns obtained by "typical" portfolios in the country. A market index is very

important for its use 1. as a barometer for market behavior, 2. as a benchmark

portfolio performance, 3. as an underlying in derivative instruments like index

futures, and 4. in passive fund management by index funds

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2 ECONOMIC SIGNIFICANCE OF INDEX MOVEMENTS
How do we interpret index movements? What do these movements mean? They
reflect

the changing expectations of the stock market about future dividends of the

corporate sector. The index goes up if the stock market thinks that the

prospective dividends in the future will be better than previously thought. When

the prospects of dividends in the future becomes pessimistic, the index drops. The

ideal index gives us instant readings about how the stock market perceives the

future of corporate sector. Every stock price moves for two possible reasons: 1.

News about the company (e.g. a product launch, or the closure of a factory) 2.

News about the country (e.g. budget announcements) The job of an index is to

purely capture the second part, the movements of the stock market as a whole

(i.e. news about the country). This is achieved by averaging. Each stock contains

a mixture of two elements - stock news and index news. When we take an average of

returns on many stocks, the individual stock news tends to cancel out and the only

thing left is news that is common to all stocks. The news that is common to all

stocks is news about the economy. That is what a good index captures. The correct

method of averaging is that of taking a weighted average, giving each stock a

weight proportional to its market capitalization. Example: Suppose an index

contains two stocks, A and B. A has a market capitalization of Rs.1000 crore and B

has a market capitalization of Rs.3000 crore. Then we attach a weight of 1/4 to

movements in A and 3/4 to movements in B.

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3 INDEX CONSTRUCTION ISSUES
A good index is a trade-off between diversification and liquidity. A well

diversified index is more representative of the market/economy. However there are

diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a

sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little

reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk.

Hence, there is little to gain by diversifying beyond a point. The more serious

problem lies in the stocks that we take into an index when it is broadened. If the

stock is illiquid, the observed prices yield contaminated information and actually

worsen an index.

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4 TYPES OF INDEXES
Most of the commonly followed stock market indexes are of the following two types:

Market capitalization weighted index or price weighted index. In a market

capitalization weighted index, each stock in the index affects the index value in

proportion to the market value of all shares outstanding. A price weighted index

is one that gives a weight to each stock that is proportional to its stock price.

Indexes can also be equally weighted. Recently, major indices in the world like

the S&P 500 and the FTSE-100 have shifted to a new method of index calculation

called the "Free float" method. We take a look at a few methods of index

calculation. Table 2.1 Market capitalization weighted index calculation In the

example below we can see that each stock affects the index value in proportion to

the market value of all the outstanding shares. In the present example, the base

index = 1000 and the index value works out to be 1002.60

Company Grasim Inds Telco SBI Wipro Bajaj Total

Current Market capitalization (Rs.Lakh) 1,668,791.10 872,686.30 1,452,587.65

2,675,613.30 660,887.85 7,330,566.20

Base Market capitalization (Rs.Lakh) 1,654,247.50 860,018.25 1,465,218.80

2,669,339.55 662,559.30 7,311,383.40

1. 2.

Price weighted index: In a price weighted index each stock is given a weight

proportional to its stock price. Market capitalization weighted index: In this

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type of index, the equity price is weighted by the market capitalization of the
company (share price * number of outstanding shares). Hence each constituent stock

in the index affects the index value in proportion to the market value of all the

outstanding shares. This index forms the underlying for a lot of index based

products like index funds and index futures. Table 2.1 gives an example of how

market capitalization weighted index is calculated.

In the market capitalization weighted method,

where: Current market capitalization = Sum of (current market price * outstanding

shares) of all securities in the index. Base market capitalization = Sum of

(market price * issue size) of all securities as on base date.

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5 DESIRABLE ATTRIBUTES OF AN INDEX
A good market index should have three attributes: 1. It should capture the

behavior of a large variety of different portfolios in the market. 2. The stocks

included in the index should be highly liquid. 3. It should be professionally

maintained.

5.1 Capturing behavior of portfolios

A good market index should accurately reflect the behavior of the overall market

as well as of different portfolios. This is achieved by diversification in such a

manner that a portfolio is not vulnerable to any individual stock or industry

risk. A well-diversified index is more representative of the market. However there

are diminishing returns from diversification. There is very little gain by

diversifying beyond a point. The more serious problem lies in the stocks that are

included in the index when it is diversified. We end up including illiquid stocks,

which actually worsens the index. Since an illiquid stock does not reflect the

current price behavior of the market, its inclusion in index results in an index,

which reflects, delayed or stale price behavior rather than current price behavior

of the market.

5.2 Including liquid stocks

Liquidity is much more than trading frequency. It is about ability to transact at

a price, which is very close to the current market price. For example, a stock is

considered liquid if one can buy some shares at around Rs.320.05 and sell at

around Rs. 319.95, when the market price is ruling at Rs.320. A liquid stock has
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very tight bid-ask spread.
5.3 Maintaining professionally
It is now clear that an index should contain as many stocks with as little impact

cost as possible. This necessarily means that the same set of stocks would not

satisfy these criteria at all times. A good index methodology must therefore

incorporate a steady pace of change in the index set. It is crucial that such

changes are made at a steady pace. It is very healthy to make a few changes every

year, each of which is small and does not dramatically alter the character of the

index. On a regular basis, the index set should be reviewed, and brought in line

with the current state of market. To meet the application needs of users, a time

series of the index should be available.

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6 THE S&P CNX NIFTY
What makes a good stock market index for use in an index futures and index options

market? Several issues play a role in terms of the choice of index. We will

discuss how the S&P CNX Nifty addresses some of these issues. Diversification: As

mentioned earlier, a stock market index should be well diversified, thus ensuring

that hedgers or speculators are not vulnerable to individual-company or industry

risk. Liquidity of the index: The index should be easy to trade on the cash

market. This is partly related to the choice of stocks in the index. High

liquidity of index components implies that the information in the index is less

noisy. Operational issues: The index should be professionally maintained, with a

steady evolution of securities in the index to keep pace with changes in the

economy. The calculations involved in the index should be accurate and reliable.

When a stock trades at multiple venues, index computation should be done using

prices from the most liquid market.

The S&P CNX Nifty is an market capitalisation index based upon solid economic

research. It was designed not only as a barometer of market movement but also to

be a foundation of the new world of financial products based on the index like

index futures, index options and index funds. A trillion calculations were

expended to evolve the rules inside the S&P CNX Nifty index. The results of this

work are remarkably simple: (a) the correct size to use is 50, (b) stocks
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considered for the S&P CNX Nifty must be liquid by the 'impact cost' criterion,
(c) the largest 50 stocks that meet the criterion go into the index. S&P CNX Nifty

is a contrast to the adhoc methods that have gone into index construction in the

preceding years, where indexes were made out of intuition and lacked a scientific

basis. The research that led up to S&P CNX Nifty is well-respected internationally

as a pioneering effort in better understanding how to make a stock market index.

The Nifty is uniquely equipped as an index for the index derivatives market owing

to its (a) low market impact cost and (b) high hedging effectiveness. The good

diversification of Nifty generates low initial margin requirement. Finally, Nifty

is calculated using NSE prices, the most liquid exchange in India, thus making it

easier to do arbitrage for index derivatives. Box 2.3: The S&P CNX Nifty

6.1 Impact cost

Market impact cost is a measure of the liquidity of the market. It reflects the

costs faced when actually trading an index. For a stock to qualify for possible

inclusion into the Nifty, it has to have market impact cost of below 0.75% when

doing Nifty trades of half a crore rupees. The market impact cost on a trade of

Rs.3 million of the full Nifty works out to be about 0.05%. This means that if

Nifty is at 2000, a buy order goes through at 2001, i.e.2000+(2000*0.0005) and a

sell order gets 1999, i.e. 2000(2000*0.0005).

6.2 Hedging effectiveness

Hedging effectiveness is a measure of the extent to which an index correlates with

a portfolio, whatever the portfolio may be. Nifty correlates better with all kinds
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of portfolios in India as compared to other indexes. This holds good for all kinds

of portfolios, not just those that contain index stocks. Similarly, the CNX IT and
BANK Nifty contracts which NSE trades in, correlate well with information

technology and banking sector portfolios. Nifty, CNX IT, BANK Nifty, CNX Nifty

Junior, CNX 100, Nifty Midcap 50 and 20

Mini Nifty 50 indices are owned, computed and maintained by India Index Services &

Products Limited (IISL), a company setup by NSE and CRISIL with technical

assistance from Standard & Poor's.

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7 APPLICATIONS OF INDEX
Besides serving as a barometer of the economy/market, the index also has other

applications in finance.

7.1 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, derivative contracts on sectoral indexes like CNX IT and BANK Nifty

contracts. Trading on index derivatives were further introduced on CNX Nifty

Junior, CNX 100, Nifty Midcap 50 and Mini Nifty 50.

7.2 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 all 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
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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 const ruct 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.

7.3 Exchange Traded Funds

Exchange Traded Funds (ETFs) 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 21

(Cubes) based on the Nasdaq-100 Index, iSHARES based on MSCI Indices and
TRAHK

(Tracks) based on the Hang Seng Index. ETFs provide exposure to an index or a

basket of securities that trade on the exchange like a single stock. They have a

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 of 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

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with the fund, thereby ensuring that ETFs trade close to their actual NAVs. The

first ETF in India, "Nifty BeEs" (Nifty Benchmark 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. Futures markets can be used for creating synthetic

index funds. Synthetic index funds created using futures contracts have advantages

of simplicity and low costs. The simplicity stems from the fact that index futures

automatically track the index. The cost advantages stem from the fact that the

costs of establishing and re-balancing the fund are substantially reduced because

commissions and bid-ask spreads are lower in the futures markets than in the

equity markets. The methodology for creating a synthetic index fund is to combine

index futures contracts with bank deposits or treasury bills. The index fund uses

part of its money as margin on the futures market and the rest is invested at the

risk-free rate of return. This methodology however does require frequent roll-over

as futures contracts expire. Index funds can also use the futures market for the

purpose of spreading index sales or purchases over a period of time. Take the case

of an index fund which has raised Rs.100 crore from the market. To reduce the

tracking error, this money must be invested in the index immediately. However

large trades face large impact costs. What the fund can do is, the moment it

receives the subscriptions it can buy index futures. Then gradually over a period

of say a month, it can keep acquiring the underlying index stocks. As it acquires

the index stocks, it should unwind its position on the futures market by selling

futures to the extent of stock acquired. This should continue till the fund is
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fully invested in the index.
8 Pricing Equity Index Futures
A futures contract on the stock market index gives its owner the right and

obligation to buy or sell the portfolio of stocks characterized by the index.

Stock index futures are cash settled; there is no delivery of the underlying

stocks. In their short history of trading, index futures have had a great impact

on the world's securities markets. Its existence has revolutionized the art and

science of institutional equity portfolio management. The main differences between

commodity and equity index futures are that: • There are no costs of storage

involved in holding equity. • Equity comes with a dividend stream, which is a

negative cost if you are long the stock and a positive cost if you are short the

stock. Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial

aspect of dealing with equity futures as opposed to commodity futures is an

accurate forecasting of dividends. The better the forecast of dividend offered by

a security, the better is the estimate of the futures price.

8.1 Pricing index futures given expected dividend amount

The pricing of index futures is also based on the cost-of-carry model, where the

carrying cost is the cost of financing the purchase of the portfolio underlying

the index, minus the present value of dividends obtained from the stocks in the

index portfolio.

8.2 Pricing index futures given expected dividend yield

If the dividend flow throughout the year is generally uniform, i.e. if there are 17
few historical cases of clustering of dividends in any particular month, it is
useful to calculate the annual dividend yield. (r- q)T

F = Se

where: F futures price S spot index value r cost of financing q expected dividend

yield T holding period Example A two-month futures contract trades on the NSE. The

cost of financing is 10% and the dividend yield on Nifty is 2% annualized. The

spot value of Nifty 4000. What is the fair value of the futures contract?

(0.1- 0.02) × (60 / 365)

Fair value = 4000e = Rs.4052.95 The cost-of-carry model explicitly defines the
relationship between the futures price and the related spot price. As we know, the
difference between the spot price and the futures price is called the basis.
Nuances • As the date of expiration comes near, the basis reduces - there is a
convergence of the futures price towards the spot price. On the date of
expiration, the basis is zero. If it is not, then there is an arbitrage
opportunity. Arbitrage opportunities can also arise when the basis (difference
between spot and futures price) or the spreads (difference between prices of two
futures contracts) during the life of a contract are incorrect. At a later stage
we shall look at how these arbitrage opportunities can be exploited. There is
nothing but cost-of-carry related arbitrage that drives the behavior of the
futures price. Transactions costs are very important in the business of arbitrage.
Figure 4.3 Variation of basis over time
The figure shows how basis changes over time. As the time to expiration of a
contract reduces, the basis reduces. Towards the close of trading on the day of
18
settlement, the futures price and the spot price converge. The closing price for
the June 28 futures contract is the closing value of Nifty on that day.
9 Contract specifications for index futures
NSE trades Nifty, CNX IT, BANK Nifty, CNX Nifty Junior, CNX 100, Nifty Midcap 50

and Mini Nifty 50 futures contracts having one-month, two-month and three- month

expiry cycles. All contracts expire on the last Thursday of every month. Thus a

January expiration contract would expire on the last Thursday of January and a

February expiry contract would cease trading on the last Thursday of February. On

the Friday following the last Thursday, a new contract having a three-month expiry

would be introduced for trading. Thus, as shown in Figure 5.5 at any point in

time, three contracts would be available for trading with the first contract

expiring on the last Thursday of that month. Depending on the time period for

which you want to take an exposure in index futures contracts, you can place buy

and sell orders in the respective contracts. The Instrument type refers to

"Futures contract on index" and Contract symbol - NIFTY denotes a "Futures

contract on Nifty index" and the Expiry date represents the last date on which the

contract will be available for trading. Each futures contract has a separate limit

order book. All passive orders are stacked in the system in terms of price-time

priority and trades take place at the passive order price (similar to the existing

capital market trading system). The best buy order for a given futures contract

will be the order to buy the index at the highest index level whereas the best

sell order will be the order to sell the index at the lowest index level. Example:

If trading is for a minimum lot size of 100 units. If the index level is around

2000, then the appropriate value of a single index futures contract would be
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Rs.200,000. The minimum tick size for an index future contract is 0.05 units. Thus
a single move in the index value would imply a resultant gain or loss of Rs.5.00

(i.e. 0.05*100 units) on an open position of 100 units. Table 5.1 gives the

contract specifications for index futures trading on the NSE. Figure 5.5 Contract

cycle

The figure shows the contract cycle for futures contracts on NSE's derivatives

market. As can be seen, at any given point of time, three contracts are available

for trading - a near-month, a middle-month and a far-month. As the January

contract expires on the last Thursday of the month, a new three-month contract

starts trading from the following day, once more making available three index

futures contracts for trading.

9.1 Contract specification for index options

On NSE's index options market, there are one- month, two- month and three month

expiry contracts with minimum nine different strikes available for trading. Hence,

if there are three serial month contracts available and the scheme of strikes is

4-1-4, then there are minimum 3 x 9 x 2 (call and put 82

options) i.e. 54 options contracts available on an index. Option contracts are

specified as follows: DATE-EXPIRYMONTH-YEAR-CALL/PUT -AMERICAN/

EUROPEAN-STRIKE.

For example the European style call option contract on the Nifty index with a

strike price of 2040 expiring on the 30th June 2005 is specified as '30 JUN 2005

2040 CE'. Just as in the case of futures contracts, each option product (for

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instance, the 28 JUN 2005 2040 CE) has it's own order book and it's own prices.

All index options contracts are cash settled and expire on the last Thursday of
the month. The clearing corporation does the novation. The minimum tick for an

index options contrac t is 0.05 paise. Table 5.2 gives the contract specifications

for index options trading on the NSE.

Table 5.1 Contract specification: S&P CNX Nifty Futures Underlying index S&P CNX

Nifty Exchange of trading National Stock Exchange of India Limited Security

descriptor NFUTIDX NIFTY Contract size Permitted lot size shall be 50 (minimum

value Rs.2 lakh) Price steps Re. 0.05 Price bands Not applicable Trading cycle The

futures contracts will have a maximum of three month trading cycle - the near

month (one), the next month (two) and the far month (three). New contract will be

introduced on the next trading day following the expiry of near month contract.

Expiry day The last Thursday of the expiry month or the previous trading day if

the last Thursday is a trading holiday. Settlement basis Mark to market and final

settlement will be cash settled on T+1 basis. Settlement price Daily settlement

price will be the closing price of the futures contracts for the trading day and

the final settlement price shall be the closing value of the underlying index on

the last trading day.

Table 5.2 Contract specification: S&P CNX Nifty Options Underlying index S&P CNX

Nifty Exchange of trading National Stock Exchange of India Limited Security

descriptor NOPTIDX NIFTY Contract size Permitted lot size shall be 50 (minimum

value Rs.2 lakh) Price steps Re. 0.05 Price bands Not applicable Trading cycle The

options contracts will have a maximum of three month trading cycle - the near
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month (one), the next mo nth (two) and the far month (three). New contract will be

introduced on the next trading day following the expiry of near month contract.
Expiry day The last Thursday of the expiry month or the previous trading day if

the last Thursday is a trading holiday. Settlement basis Cash settlement on T+1

basis. Style of option European. Strike price interval Rs.10 Daily settlement Not

applicable price Final settlement Closing value of the index on the last trading

price day.

Generation of strikes The exchange has a policy for introducing strike prices and

determining the strike price intervals. Table 5.3 and Table 5.4 summarizes the

policy for introducing strike prices and determining the strike price interval for

stocks and index. Let us look at an example of how the various option strikes are

generated by the exchange. • Suppose the Nifty has closed at 2000 and options with

strikes 2040, 2030, 2020, 2010, 2000, 1990, 1980, 1970, 1960 are already

available. It is further assumed when the Nifty index level is upto 4000, t he

exchange commits itself to an inter-strike distance of say 10 and the scheme of

strikes of 4-1-4. If the Nifty closes at around 2020 to ensure strike scheme of 4-

1-4, two new further contracts would be required at 2050 and 2060. 84

Conversely, if Nifty closes at around 1980 to ensure strike scheme of 4 -1-4, two

new further contracts would be required at 1940 and 1950.

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THANK YOU

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