Strategic uses of stock indexÎUse of stock index futures will help reduce volatility
Derivatives or a future or an options contract is relatively new having emerged only around 25 years back. It essentially facilitates temporary hedging of the price risk inventory or a financial/commercial transaction over a certain period. The predetermined duration of an option is linked to the value of financial assets or to the index of securities.Time and again the FIIs have stressed on introducing derivatives in the Indian stock exchanges, impressing on the Indian Government that derivatives would not be used for speculative purposes but only for portfolio hedging. "The low transaction costs, facility to take geared exposure, less volatility and difficulty in manipulating are the reasons why global investors prefer derivatives," adds Stock Holding Corporation research executive, Anant Katare. Finally, stock index futures have been ushered in now. Some of the ways in which these institutions would be using index futures are as follows:
Reducing the equity exposure in an MFS
In case a balanced mutual fund scheme (MFS) decides to reduce its equity exposure from say 40 to 30 per cent of the corpus, currently this can be done only by actual sale of equity holdings. But, such sales entail three problems: it is likely to depress the equity prices to the disadvantage of the entire market and the schemes’ NAVs; secondly, it is expensive because of brokerage, etc., lastly, it is a cumbersome procedure dragging into months on end. On the other hand, the concerned mutual fund could achieve the same objective using the index futures much faster, cheaper and with minimal impact on the cash markets. The index futures could be sold immediately. In fact, the actual sale of equity holdings can be done gradually -- depending on market conditions -- to realise the best possible prices. Even as such unloading progresses, the index futures transaction may be unwound by an opposite transaction to the same extent.Investing the funds raised by new schemes
When a new scheme is floated, the money raised does not get fully invested, as often the required quantities of suitable securities may not be immediately available at reasonable prices. And, indiscriminate buying would only help drive up the prices, pushing up the costs of further investments. As such, timing is an important factor in equity investments, especially if the purpose of the scheme is to take advantage of the low equity prices. The stock index futures precisely take care of this entire problem.
Partial liquidation of portfolio for open-ended funds
In case of open-ended schemes, redemption may sometimes necessitate liquidation of part of the portfolio. But such liquidation is wrought with problems. Selling each holding in proportion to its weight in the portfolio is often impracticable. And, rushing to the cash market to liquidate would only drive down the prices. The price realised may be different from the price used for NAV computation for repurchase. Some of the holdings may be relatively illiquid. It is also possible that timing of the liquidation may not be right because of a depression in the market. The stock index futures could deal with these problems to the advantage of the unit-holders.
Preserving the value of the portfolio during times of market stress
Sometimes, the main worry is that the value of the entire equity portfolio may fall substantially if, say, event "X" occurs. It could be anything right from a war to a no-confidence motion to a moderate bank rate change in the credit policy. In such situations, sale of stock index futures could be used to insure against the risk. Such insurance is especially important if the closing date of the account is nearby as the yearly results could get affected in the event of the risk actually materialising.
International investors
Buying and selling by FIIs is currently causing a disproportionate price-effect on the Indian equity market as all the transactions are through the cash market only. This is an important factor making the Indian equities market highly volatile. The FIIs' buying/selling is aimed at either increasing or reducing their exposure to the Indian equities market. In other words, what the FIIs buy/sell is a "piece" of the entire Indian equities market.
Here, if stock index futures were available it would facilitate greater speed, lower costs and a much smoother procedure. The FII flows show sudden changes from time to time. While trying to maximise the net inflow of FII portfolio investments, it’s disturbing effects on the cash market for the Indian equities could be minimised if the facility of stock index futures is available. Availability of such a hedging device could increase the international investors' appetite for Indian equities.