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The Futures (Derivatives) Market

The Indian market had an indigenous system called ‘badla’ that facilitated funding of speculation for the risk taker, while earning interest for the financier. The native badla also had a process for stock-lending. The Securities & Exchange Board of India (SEBI) banned badla effective March 1994 with the old financing product, ineffective for regular risk monitoring being replaced later by index derivatives, popularly referred to by the two common product streams, “Futures and Options”.

The stock market index futures introduced first were a good way of gradually exposing market participants to the big wide world of derivatives. Derivatives can be a crazy casino, or a sober and straight forward way to de-risk an investment portfolio. Volatility, or “vol” can be bought, or sold. Naked risk can be taken, or risk can be eliminated either entirely, or only up to the desired extent.

Interpreting and acting very quickly on news is vital in taking advantage of special opportunities from announcements or events. In the pre-index derivatives era was limited to individual securities, fraught with special risks in equities. The entire market could react positively, but the specific stock that I buy could behave contrarily (a salute to Murphy’s Law?) Providing index derivatives eliminated dear Mr. Murphy from the equation, with just my interpretation of the news left at stake. Instead of buying a particular security which could be the one that dropped in a positive market, through the index, the entire market could be bought. In our fixed-income market, the maturity basket approach has made the taking of calculated bets quite simple. The only real need now is the right interpretation of the news or event.

With the derivatives being better understood, practice following training and certification after testing by the National Stock Exchange through its education arm NCFM (subsequently all formal certification has by the NISM, branch of a premier capital market educational institution promoted by SEBI), futures and options on individual stocks, and later on commodities, fixed-income products (through ‘interest rate derivatives’) and currency derivatives were provided.

The pay-off on a futures contract is precisely the same as a cash, or spot market transaction. A futures contract buyer, gets a linear reward, or loss depending on the direction of the value of the value of the contract.

As the price of a contract rises, a long futures contract increases in value and results in a straight forward gain. As it drops, however, the losses are as linear. The buyer of a futures is a bull, expecting the security to move up. In the fixed-income market, the bull expects interest rates to go down. The inverse relationship between interest rates and bonds results in bond prices going up as interest rates fall (we have discussed this in the early posts).

The reverse is true for a bear, the pessimist who expects security values to go south.

The “directional call” taken by one who is either long, or short futures is a direct translation of her expectations of the future behaviour of the security, or market.

Take a punt, then, or protect your portfolio with a hedge, or arbitrage on the spot-futures differential (called ‘cost-of-carry’, explained earlier), the futures part of the futures and options market has much to offer.

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