Page 76 - DCOM510_FINANCIAL_DERIVATIVES

Unit 5: Introduction to Options

Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. Notes
Stock index is difficult to manipulate as compared to individual stock prices, more so in India,
and the possibility of cornering is reduced. This is partly because an individual stock has a
limited supply, which can be concerned. Stock index, being an average, is much less volatile
than individual stock prices. This implies much lower capital adequacy and margin requirements.
Index derivatives are cash settled, and hence do not suffer from settlement delays and problems
related to bad delivery, forged/fake certificates.

!
Caution Index derivatives are cash settled, and hence do not suffer from settlement
delays and problems related to bad delivery, forged/fake certificates.

5.5.1 Features of Index Derivatives

Following are the features of Index derivatives:
1. The index is hard to manipulate: Derivatives in individual securities are vulnerable to
market manipulation.

Example: A person might first buy all options on ACC and then try to manipulate
the price of ACC to make it go up.
This is, in principle, possible for the index also. However, the index is a large, well-
diversified portfolio, and manipulation of the index is much harder, and requires much
larger resources. The market capitalisation of the NSE-50 index today is around ` 200,000
crore. It is more difficult to manipulate it today as compared with any individual security
in the country.
2. Index derivatives go along with interesting investment strategies: Index funds have now
started appearing in India; internationally, it is common to see 30-40% of all professionally
managed funds being in index funds. Index futures are an invaluable tool for running
index funds: when index futures markets exist, it becomes easier to run index funds, which
yield returns that are highly close to the returns of the actual index.
Similarly, index options are useful for interesting new products like “guaranteed return
funds’’ (e.g. an index fund bundled with portfolio insurance in the form of a put option on
the index) or “equity-linked bonds’’ (e.g. an instrument which is 95% invested in a straight
bond, while 5% is invested in a call option which sharply benefits from the upside potential
of the market index).

3. Index derivatives support index forecasting: Today, a good deal of trading volume on the
market is composed of people who are taking a view on the index – this is implemented
using portfolios of two or three stocks. E.g. portfolios of Reliance, TISCO and SBI are often
used to be a proxy for the index. Index derivatives will directly give people a mechanism
through which a view on the index can be implemented on the market. This will be a spur
for research and analysis devoted to understanding and anticipating movements of the
market index.
4. Index derivatives are cash settled: Index derivatives are cash – settled, which means that
no delivery of securities is made. In an environment where the depository has not yet
come to dominate all settlement, this is a considerable advantage over any transactions
involving securities.

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