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Sebi proposes to allow trading only in index futures. An index future can be used to reduce the volatility of the equity portion of the portfolio. For instance, assume that a mutual fund scheme has Rs 10 lakh cash earmarked for investment in equity, and after thorough research, it invests in a particular scrip, say ITC.
But the price of ITC is also sensitive to market movements. Suppose the degree of sensitivity of ITC to the movement in NSE 50 index (Nifty) is 1.22 times, which means that if Nifty rises 10 per cent, ITC rises by 12.2 per cent and if Nifty falls 10 per cent, price of ITC scrip also falls 12.2 per cent.
By investing Rs 10 lakh in ITC, the fund manager takes a risk that if the market (Nifty) falls by 10 per cent, it will suffer a loss of Rs 1.22 lakh. However, if the scheme sells an index future of an equivalent value, the value of the future goes down by 10 per cent (equal to the market movement), i.e., by Rs 1 lakh. Thus, the value of the future becomes Rs 9 lakh.
By selling the futureworth Rs 10 lakh and settling at Rs 9 lakh, the scheme makes a profit of Rs 1 lakh. Hence, by using an index future, the scheme has restricted the extent of possible loss from Rs 1.22 lakh to Rs 22,000 and reduced the volatility of portfolio value to movements in the index (see table).
Trading in derivatives also has the following risks: (a) An exposure to derivatives in excess of the hedging requirements can lead to losses; (b) An exposure to derivatives can also limit the profits from a genuine investment transaction. In the above example, if the market had moved up by 1 per cent instead of falling, the profit from the investment would have been limited to Rs 22,000 instead of Rs 1.22 lakh; (c) Efficiency of a derivatives market depends on the development of a liquid and efficient stock market.
In case of index futures, this pertains to the underlying index scrips. Any loss on derivative transaction is sought to be prevented by taking exposure to derivatives only for the purpose of hedging and not forspeculative purposes. Such an exposure will be backed by assets in order to meet cost of derivative trading and loss, if any, due to unfavourable movements in the market. The index futures selected will be based on an index which consists of sufficiently liquid scrips.
Any transaction in derivatives will be strictly in compliance with relevant Sebi guidelines for trading in derivatives.
Reproduced from SBI MF MMIS '99 draft prospectus
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
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