Would you like to lend funds into the stock market, without suffering the slightest risk?
Traditional methods of loaning money into the stock market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party. What is new about the index futures market is that it supplies a technology to lend money into the market without suffering any exposure to Nifty, and without bearing any credit risk.
The basic idea is simple. The lender buys all 50 stocks of Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo.
There is no price risk since the position is perfectly hedged. There is no credit risk since the counterparty on both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle for entities which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries.
How do we actually do this?
1. Calculate a portfolio which buys all the 50 stocks in Nifty in correct proportion, i.e. where the money invested in each stock is proportional to its market capitalization.
2. Round off the number of shares in each stock.
3. Using the NEAT software, a single keystroke can fire off these 50 orders in rapid succession into the NSE trading system. This gives you the buy position.
4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do not affect you.
5. A few days later, you will have to take delivery of the 50 stocks and pay for them. This is the point at which you are “loaning money to the market”.
6. Some days later (anytime you want), you will unwind the entire transaction.
7. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 stocks.
8. A moment later, reverse the futures position. Now your position is down to 0.
9. A few days later, you will have to make delivery of the 50 stocks and receive money for them. This is the point at which “your money is repaid to you”.
What is the interest rate that you will receive? We will use one specific case, where you will unwind the transaction on the expiration date of the futures. In this case, the difference between the futures price and the cash Nifty is the return to the moneylender, with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them, and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades. On 1 July 1998, if the Nifty spot is 942.25, and the Nifty July 1998 futures are at 956.5 then the difference (1.5% for 30 days) is the return that the moneylender obtains.
Example
On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. Ashish wants to earn this return (30/1200 for 27 days).
1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 1204.
2. He sells Rs.3 million of the futures at 1230. The futures market is extremely liquid so the market order for Rs.3 million goes through at near–zero impact cost.
3. He takes delivery of the shares and waits.
4. While waiting, a few dividends come into his hands. The dividends work out to Rs.7,000.
5. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty portfolio, putting 50 market orders to sell off all the shares. Nifty happens to have closed at 1210 and his sell orders (which suffer impact cost) goes through at 1207.
6. The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last day is always equal to the Nifty spot).
7. Ashish has gained Rs.3 (0.25%) on the spot Nifty and Rs.20 (1.63%) on the futures for a return of near 1.88%. In addition, he has gained Rs.70,000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free.
It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days. This is very close to the actual number.
Traditional methods of loaning money into the stock market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party. What is new about the index futures market is that it supplies a technology to lend money into the market without suffering any exposure to Nifty, and without bearing any credit risk.
The basic idea is simple. The lender buys all 50 stocks of Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo.
There is no price risk since the position is perfectly hedged. There is no credit risk since the counterparty on both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle for entities which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries.
How do we actually do this?
1. Calculate a portfolio which buys all the 50 stocks in Nifty in correct proportion, i.e. where the money invested in each stock is proportional to its market capitalization.
2. Round off the number of shares in each stock.
3. Using the NEAT software, a single keystroke can fire off these 50 orders in rapid succession into the NSE trading system. This gives you the buy position.
4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do not affect you.
5. A few days later, you will have to take delivery of the 50 stocks and pay for them. This is the point at which you are “loaning money to the market”.
6. Some days later (anytime you want), you will unwind the entire transaction.
7. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 stocks.
8. A moment later, reverse the futures position. Now your position is down to 0.
9. A few days later, you will have to make delivery of the 50 stocks and receive money for them. This is the point at which “your money is repaid to you”.
What is the interest rate that you will receive? We will use one specific case, where you will unwind the transaction on the expiration date of the futures. In this case, the difference between the futures price and the cash Nifty is the return to the moneylender, with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them, and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades. On 1 July 1998, if the Nifty spot is 942.25, and the Nifty July 1998 futures are at 956.5 then the difference (1.5% for 30 days) is the return that the moneylender obtains.
Example
On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. Ashish wants to earn this return (30/1200 for 27 days).
1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 1204.
2. He sells Rs.3 million of the futures at 1230. The futures market is extremely liquid so the market order for Rs.3 million goes through at near–zero impact cost.
3. He takes delivery of the shares and waits.
4. While waiting, a few dividends come into his hands. The dividends work out to Rs.7,000.
5. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty portfolio, putting 50 market orders to sell off all the shares. Nifty happens to have closed at 1210 and his sell orders (which suffer impact cost) goes through at 1207.
6. The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last day is always equal to the Nifty spot).
7. Ashish has gained Rs.3 (0.25%) on the spot Nifty and Rs.20 (1.63%) on the futures for a return of near 1.88%. In addition, he has gained Rs.70,000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free.
It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days. This is very close to the actual number.