Page 34 - DCOM510_FINANCIAL_DERIVATIVES

Unit 2: Derivatives Market in India

2.6.1 Index Derivatives Notes
Index derivatives are derivative contracts which have the index as the underlying. The most
popular index derivatives contract the world over is 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.

Did u know? 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 and
thereafter by sectoral indexes, CNX IT and BANK Nifty contracts.

2.6.2 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.

Example: 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
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 capitalisation, as in the case of Nifty. Index funds are easy to construct 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.

Caselet Use of Futures Market by Index Funds

utures market can be used for creating sympathetic index funds. Synthetic index
funds created using futures contracts have advantage of simplicity and low costs.
FThe 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 spread’s 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 be treasury bills. The index fund uses part 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 risen ` 100 crore
from the market. To reduce the tracking error, this money must be invested in the index
immediately. However large trades large impact costs. What they found 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, it should unwind
its position on the futures market by selling futures to the extent of stock period acquired.
This should continue till the fund is fully invested in the index.

Source: Derivative Products and Valuation, by Subba Rao.

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