Index Futures and cost and carry model

In the normal market, relationship between cash and future indices is described by the cost and carry model of futures pricing.

Expectancy Model of Futures pricing

S - Spot prices.
F - Future prices.
E(S) - Expected Spot prices.

• Expectancy model says that many a times it is not the relationship between the fair price and future price but the expected spot and future price which leads the market. This happens mainly when underlying is not storable or may not be sold short. For instance in commodities market.
• E(S) can be above or below the current spot prices. (This reflects market’s expectations)
• Contango market- Market when Future prices are above cash prices.
• Backwardation market - Market when future prices are below cash prices.

Relationship between forward & future markets

• Analyze the different dimensions of Forward and Future Contracts:
  (Risk; Liquidity; Leverage; Margining etc....)
• Assign value to each factor to arrive at the contract price.
  (Perception plays a crucial role in price determination)

• Any substantial difference in the Forward and Future prices will trigger arbitrage.

Risk management through Futures

Which risk are we going to manage through Futures ?

• Basic objective of introduction of futures is to manage the price risk.
• Index futures are used to manage the systemic risk, vested in the investment in securities.

Hedge terminology

• Long hedge- When you hedge by going long in futures market.
• Short hedge - When you hedge by going short in futures market.
• Cross hedge - When a futures contract is not available on an asset, you hedge your position in cash market on this asset by going long or short on the futures for another asset whose prices are closely associated with that of your underlying.
• Hedge Contract Month- Maturity month of the contract through which hedge is accomplished.
• Hedge Ratio - Number of future contracts required to hedge the position.

Some specific uses of Index Futures

• Portfolio Restructuring - An act of increasing or decreasing the equity exposure of a portfolio, quickly, with the help of Index Futures.
• Index Funds - These are the funds which imitate/replicate index with an objective to generate the return equivalent to the Index. This is called Passive Investment Strategy.

Speculation in the Futures market

• Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:

• Naked positions - Position in any future contract.
• Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.

Arbitrageurs in Futures market

Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.

    
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