SECTION II: REVIEW OF THE LITERATURE
India's financial market began its transformation path in the early 1990s. The banking sector witnessed sweeping changes, including the elimination of interest rate controls, reductions in reserve and liquidity requirements and an overhaul in priority sector lending. Persistent efforts by the Reserve Bank of India (RBI) to put in place effective supervision and prudential norms since then have lifted the country closer to global standards (Ranganatham, 2004, p.20)
Around the same time, India's capital markets also began to stage extensive changes. The Securities and Exchange Board of India (SEBI) was established in 1992 with a mandate to protect investors and improvements into the microstructure of capital markets, while the repeal of the Controller of Capital Issues (CCI) in the same year removed the administrative controls over the pricing of new equity issues. India's financial markets also began to embrace technology. Competition in the markets increased with the establishment of the National Stock Exchange (NSE) in 1994, leading to a significant rise in the volume of transactions and to the emergence of new important instruments in financial intermediation (Kailash Pradhan, 2005, p.21)
For over a century, India's capital markets, which primarily consists of debt and equity markets, have increasingly played a significant role in mobilizing funds to meet public and private entities financing requirements. The advent of exchange-traded derivative instruments in 2000, such as future contracts, had enabled investors to hedge their positions and reduce risks (Jordan Miller, 2007, p.21)
At the end of year 2003, the debt and equity markets of India were equivalent to 130% of GDP (Gross Domestic Product). However, the size of the country's capital markets relative to the United States, Malaysia's and South Korea's remains low, implying a strong catch-up process for India.
Future contract is the simplest of all financial assets. A future contract is just an agreement between two parties to buy and sell an asset at a fixed price in the future. Futures markets were originally designed to solve the problems of forward markets. Nifty 50 was introduced by NSE in April 22, 1996. NSE Nifty 50 consists of 50 companies that represents 20 industries with market capitalization of Rs 1,70,000 Crores. All companies included in the index should have traded for 85 percent of trading days at an impact cost of 1.5%. Future contracts are managed through an organized future exchange (National Stock Exchange). Future contract is a type of derivative security because the price of the future contract is derived from the price of underlying security, or index. The net value of a future contract is zero because future contract represents a zero sum game between a buyer and a seller. Future contracts are standardized to facilitate convenience in trading and price reporting. A futures contract may be offset before maturity by taking opposite position which means that future trading can be closed by entering into equal into an equal and opposite transaction. Future contract must specify at least five terms of the contract and they are:
1). The size of future contracts.
2) The identity of the financial instruments
3) The maturity date of future contracts.
4) The delivery procedure.
5) The future price (Jordan, 2009, p 438)
What Does NIFTY Future Trading Apply to Indian Stocks?
Future trading is a type of investment which involves speculating on the prices of securities in the future. Securities traded in future contract can be a stock (Reliance India Limited, TISCO, etc), Stock Index (NSE Nifty Index), commodity ( Agricultural Products, Silver, Gold etc)
Unlike stocks and bonds, when traders involve in future trading then they do not buy or own anything but speculate the direction of the price in the security they trade. Suppose traders speculate on Stock Index (NSE Nifty index) that the future price of stock index can go up in the future then they would buy a future contract. If traders speculate that the future price of the stock index can go down then they would sell a future contract (Edwin, 2003, p 24)
How to Trade in S&P CNX NIFTY Futures?
Trading on CNX Nifty futures is just like trading in other security. Before buying or selling traders use to predict the direction of the market and based on that prediction they buy or sell the index. A profit is made when the closing price on the expiration day is higher than the value at which they had bought the index (Ranagantham, 2004, p. 40)
Trading time on NSE (national Stock Exchange) of India is from 9.55 A.M to 3.30 P.M. The daily settlement price on NSE is reported at 3.30 P.M and it is the weighted average price of the last 30 minutes of trade, whereas future price is not affected by weighted average price and the settlement price is same as the trading price on the last traded price on future (Edwin, 2003, p 24)
Popularity of Stock Index Futures in India
Nifty futures are traded on NSE (National Stock Exchange) and it faces competitive pressure from BSE (Bombay Stock Exchange). The basic role of stock market of India is to provide a base or platform for the people of the country to invest their savings. All Indian stock markets are now computerized and trading on internet. Indian stock market has a dynamic nature and it can change from bullish to bearish slide. A small piece of information can affect the market and people from across the country and world get in extreme touch with minute wise readings on Indian stock market. Traders can gain lot of trading talent after daily seeing NSE stock gainers and losers list.
Nifty future trading in NSE has been accepted by most of the traders throughout the country due to many advantages. The acceptance of Nifty futures is mainly due to the following advantages of stock index futures:
1. Large institution such as Ambuja Cements, Reliance India Limited and large equity holders need the facility of portfolio hedging.
2. Stock index is very difficult to manipulate as compared to individual stock prices because stock markets are unpredictable and it can change at any time. The manipulation of stock index is done by influencing cash prices of its component securities.
3. Stock index is less volatile than the prices of individual stocks. This implies that index futures have much lower capital adequacy and margin requirements than many other securities.
The above advantages shows that trading in Nifty future contracts are effective as it brings liquidity to the Indian market (Ranganatham, 2004)
Introduction of Nifty Futures on Indian Stock Market
Nifty Index futures were introduced on June 12, 2000. In India, future trading is a form of investment involving speculating and hedging on the price of a security that fluctuates in the future market. Investor's uses futures to hedge the price risk, so if an investor buys future contracts then there are two types of risk involved. First, the understanding of the trader about future contracts can be wrong and the company is not worth more than the market price. Second, there are fair chances that the entire market can move against the investor and generate losses
Impact of Nifty Future Trading on the Volatility Derivative Markets
In derivative segments, NSE had accounted about 99.5% of the total trading volume. This was the main reason behind the study of the volatility behavior of derivative markets after the introduction of Nifty future contracts. This research clearly investigates the impact of Nifty index futures on the volatility of derivative markets. The effective tool used to measure the volatility of S&P CNX Nifty futures is GARCH (1,1) model (Generalized Autoregressive Conditional Heteroskedasticity). GARCH model captures the time varying nature of the volatility using daily closing price of CNX Nifty. GARCH model was developed by Bollerslev in 1986. GARCH model relates variance of CNX Nifty returns as a linear function of lagged variance and past squared error. GARCH (1,1) model can be expressed as:
Rt = 945; 0 + 945; 1 Rt-1 + &et
€ 968;t-1~ N(0, ht)
Where Rt is the spot price returns and it depends on past lagged returns, €t is GARCH error, and € 968;t-1 is the set of information available at time t-1. The error term mentioned above is the varying variance.
Variance (€) = 945; 0 (1- 945; 1 - 946;1)
Where 945; 1 = Coefficient that measures the impact of recent news on current volatility.
946;1 = Coefficient that measures the impact of old news on current volatility
Since the focus is on the impact of the introduction of index futures on the volatility of Nifty, a dummy variable (Dt) is introduced to the following equation:
Rt = 945; 0 + 945; 1 Rt-1 + €t + Dt
Dt is the dummy variable having a value of 0 before the introduction of future contracts and 1 after the introduction of futures. If the coefficient of dummy is negative, it indicates that there is a decrease in the volatility and if it is positive then it indicates an increase in the volatility due to futures introduction. The magnitudes of the dummy variable coefficients are used to check whether the introduction of index futures changes the volatility of derivative market. Further investigation on the effects on the volatility is conducted by dividing the sample period into two parts, the pre index period and post index period using the cutoff date of January 1, 2004. The coefficient of the GARCH model is estimated separately for the pre-index and post-index future period to know the changes in the values of the coefficients and its impact on the volatility of CNX Nifty (Sakthivel, 2005)
Table: 2.1(Sakthivel, 2005)
Changes in the Volatility of Derivative Market after the Introduction of Nifty Index Futures
The above table shows the coefficient of GARCH for BSE and NSE when compared. This part of research concentrated on the effect of futures trading on volatility of derivative market. There had been a reduction in the spot market volatility in the post future period when the market movement was controlled through surrogate index. It was not confirmed that whether the decline of the volatility was due to the market movements or the introduction of futures trading. The above chart cleared all the questions.
To reduce the future effects on volatility, BSE-200 was used and the result of this attempt is shown in the above chart. There has been a reduction in the spot market volatility after June 2000 which might be due to macroeconomic changes. The reduction in BSE-200 dummy coefficient indicated that the reduction in the volatility of the market was due to market movements. The results showed that after adjusting the market factors the dummy coefficient of BSE-200 had a negative sign of -0.01, which indicates that the futures trading, has a negative impact on Nifty futures. These finding shows that the change in BSE-200 market volatility is due to the market changes and not due to futures effect. The reading of S&P CNX Nifty shows different results. Even after controlling the market movements, the dummy coefficient showed a negative sign in the period 7 (Dt7) which clearly indicated that the decline in the volatility of S&P Nifty was due to the introduction of futures effect and not due to the market movements. Unlike BSE Sensex, the introduction of futures trading had a major role in reducing the volatility of S&P CNX Nifty (Sakthivel, 2005)
This clearly answered the research questions that the introduction of futures trading affected the volatility of Indian markets (S&P CNX Nifty). The declining of volatility can be reduced by controlling the movements of the market. The introduction of futures trading has affected stock market volatility. Futures trading have reduced stock market volatility, contributing to increase in market efficiency. Futures trading has a major role in reducing volatility of the SEP CNX Nifty (Sakthivel, 2005)
Mallikarjunappa and Afsal had opposed this study and according to them the introduction of Nifty future contracts had no effect on the volatility of derivative market, but the volatility had been reduced in the major markets. Mallikarjunappa and Afsal used the following GARCH (1,1) conditional variance:
= Future Dummy
ht = Stock Market Returns
At 1% significant level, the coefficients the GARCH coefficient 945; 0, 945; 1, and 946;1 were different from zero and within parametric restrictions, thus implying a greater effect of shocks on volatility. Coefficient " 945; 1" indicated a large shock on day "t-1" which is 29 days (in this research, 30 days Nifty future trading is taken from NSE) that led to large variance on day "t" which is 30th day. 945; 1 mentioned here is the recent news that had a greater impact on the price changes and the coefficient 946;1 measures the effect of old news on the price changes. The sum of 945; 1 and 946;1 was near to unity, which indicated that there was a large degree of persistence. The result of GARCH estimation that employed the use of dummy variable is shown below. The dummy variable assumed a value of zero before January 1, 2004 and one for the rest of the period. The table below showed that the coefficient of dummy variable was insignificant at 0.0582 with a t- value of 1.0633. The dummy variable was positive during pre future period and this indicated that the volatility of derivative markets were unaffected by the introduction of future trading (T. Mallikarjunappa, 2004)
Table: 2.2 (T. Mallikarjunappa, 2004)
Effectiveness of Trading NIFTY Future Contracts in NSE
The success of trading depends on the movement of index. Investing in future contracts takes place by predicting future price in relative to spot price. But when the index moves in downward direction then everything goes wrong for traders (Investors). Trading in Nifty index futures means that the participants are taking a stance against the movement of the index. Trading in Nifty future contracts has some advantages as compared to other successful future contracts:
1) Risk Minimization and Profit Maximization
In Nifty futures, the risk was reduced by perfect hedging. Investors use hedging when they were unsure of the future price of Nifty. The highest risk that is faced by traders in Nifty is the price risk. Price risk is the risk that the seller will not be able to sell the assets at a price higher than acquisition cost. A person who wants to shift the price risk to others is called as hedger. Hedgers transfer risk by taking future position that is opposite to the current position in the underlying asset. When the price of assets falls then the value of assets is protected by taking a short position in the future contracts. By using this short position for hedging purposes, a short hedge is created.
NSE index futures can mitigate risks in the stock market when the market moves in the opposite direction from the prediction of the investors. The best step to put forward is by countering the original position with the opposite position in the index futures. Suppose the future contract traded on NSE has lot size of 200 and the index is quoting at 1657.65 (on December 1, 2003) with the first month contract (near month contract) trading at 1912.25 (on January 1, 2004) (Ranganatham, 2004)
1 market lot of the index future = Lot size x Trading price of near month contract
= 200 x 1912.25
1 market lot of the index future = Rs 382450
Number of contracts required to hedge portfolio of stocks = (0- Current beta of stock portfolio) x (Value of stock portfolio / Value of one stock index future contract)
Small traders in India can buy mini lot of Nifty contract which consists of 20 quantities of Nifty. 1 mini lot of Nifty contract cost Rs 19122 which is cheaper. Certain things should be kept in mind before trading Nifty future contracts and that is how to calculate profit and loss. First of all the direction of the market is determined and if the market goes up then it is call bullish market and if the market goes down then it is called bearish market. In bullish market Nifty futures are bought and in bearish market Nifty futures are sold. The profit and loss is very important in future trading and in this case it can be calculated with examples.
If current price of Nifty is Rs 1657.65 (on December 1, 2003) and last date of expiry is 1st January 2004, the profit and loss is calculated by the direction of the market and this is explained in figure2.2 and 2.3 below (Ranganatham, 2004)
In Bullish Market
Future trading in NSE is such that trading can be done at any time till the last date of expiry. If traders do not sell Nifty that they had bought till the last day then trading takes place in NSE at settled price of Nifty on the last day of expiry
Buy Nifty future at Rs 1657.65, size of the future is 200.
I) If Nifty price is Rs 1912.25 and sold before expiration, then Profit = (Rs 1912.25- Rs 1657.65) x 200= Rs 50920
II) If Nifty price is Rs 1600 and sold before expiration, then Loss = (Rs 1657.25 - Rs 1600) x 200 = Rs 11450
In Bearish Market
Sell Nifty futures January1, 2004 at Rs 1912.24, size of the future is 200
I) If Nifty price is Rs 1879.75 (closing price of Nifty on December 31, 2003) and bought before expiration, then Profit = (Rs 1912.25- Rs 1879.75) x 200 = Rs 6500
II) If Nifty price is Rs 2000 and bought before expiration, then Loss = (Rs 2000 - Rs 1912.24) x 200 = Rs 17550
Future trading in NSE is such that trading can be done at any time till the last date of expiry (till January 1, 2004). If traders do not buy what they had sold till the last day then trading takes place in NSE at settled price of Nifty on the last day of expiry (Ranagantham, 2004, p.46)
There are two parties in a future contract, the buyer and seller. The buyer of the futures contract is one who "LONG" on the futures contract and the seller of the futures contract is who is "SHORT" on the futures contract.
Traders make profit or suffer loss due to the fact that the future contract price is determined at the maturity of the contract. At maturity, if the spot price of the future contract is lower than the future price then the buyer suffers a loss because the buyer could have bought the security in the market at a lower price. The opposite applies when the spot price of the contract is above the future price. The buyer makes an immediate profit by buying the underlying instrument at lower price and selling them at higher market price (Deepak Gupta, 2003, p.45)
Figure 2.3 (Deepak Gupta, 2003, p.45)
The pay off for the buyer and the seller of the futures of the contracts are as follows:
Payoff for a Buyer of Nifty Futures
F- Future Price of Nifty
E1,E2 - Settlement Price
CASE 1:- The above graph is used to explain the profit and loss in Nifty future contracts. This graph explains how profit and loss varies with settlement price when a future contract has been signed by buyer and seller. The term of the contract is 1 month. When the contract is signed then the future price is "F" and the settlement price of this contract is E1 and E2. Suppose if the settlement price is larger than the future price then the buyer will have a profit (P). The profit is calculated by:
Profit (P) = (Settlement price - Future price) x Lot size of contract.
CASE 2:- The buyer faces loss when the future price move above settlement price (E2)
If the market fluctuates and the future price becomes greater than the settlement price (E2), then at expiry the buyer will have to face a loss.
Loss = (Settlement price - Future price) x Lot size of contract
CASE 3:- When the seller sells the future contract at (F); if the future goes to E1.
The graph below shows the payoff diagram of seller of future contracts. The seller will have profit if the future price goes to E1. This means that the settlement price when the contract expires is less than the future price. So, seller will have profit if he or she sells the contract at expiry.
CASE 4: The seller has to face loss when the future price goes greater than settlement price (E2).
When the settlement price at expiry is lesser than the future price of the contract then the seller has to face loss and the buyer will have the profit.
Figure 2.4 (Prasanna Chandran, 2004, p 47)
Payoff for a Seller of Nifty Futures
F- Future Price of Nifty
E1, E2 - Settlement Price
Risk minimization is always effect in Nifty future contracts as the contract is all about taking long and short positions. The future price of the contracts are not fixed, it changes with the market. The investors should know how to calculate profit and loss. If the investors feel that the future price of the contract can go down then they should take short position and use the equation mentioned in the bearish market above. If the investors feel that the future price of the contract can go up in the future then they can take the opposite position by going long. In bullish market the investor should follow the instructions mentioned in the bullish market above and calculate the profit and loss (Prasanna Chandran, 2004, p.50)
2) High Leverage
Trading in Nifty futures is very risk as investor can face heavy loss. Trading requires lot of experience in predicting market. 75% investors in India are small investors, which mean that they concentrate more on leverage. Traders must open an account with brokerage firm and then they can start trading on margin (leverage). Traders have to invest 5% to 10% of the total size of the contract as initial margin to purchase a contract and the rest will be delivered by the brokerage firm. When the market moves leverage can work against the investors and with the investors. If the market moves, then the margin levels are increased and the broker gives an indication to the investors to add additional funds into the account in order to maintain the future position. Nifty future trading expose traders to high leverage which means that they have to invest less and borrow large amount.
Leverage = Asset / Equity
If Nifty 50 futures trade at Rs 20,000
Then the value of one contract = Rs 20,000 x 25
= Rs 500,000
Initial margin of Nifty futures = 10% x value of the contract
= Rs 50,000
Leverage = Rs 500,000 / Rs 50,000
If the trader has Rs 500,000 in the account can trade one Nifty future contract. In this case the leverage will be 1. This is the case of high leverage trading. This means that there will be a 1% chance result in a loss equal to the margin. If the trader has Rs 100,000 in the account then the trader has the choice to trade the future contract with Rs 100,000 from the account and borrowing the rest of the amount from the broker. In this case leverage will be 0.5 (Ranganatham, 2004)
High leverage is effective in future contracts, because future contracts are basically carried out in leverage. When leverage increases then the value of the contract also increases as it is directly related to leverage. This point is proved from the equation of leverage. This shows that when there is high leverage then traders have to put less money in the account for purchasing the futures and if the market moves down in the future then the traders has to face less loss in the margin (less loss in the money they have put to purchase the future). (Ranganatham, 2004, p.52)
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