Have you ever been in a situation where you had funds which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity.
Some common occurrences of this include:
• A closed-end fund which just finished its initial public offering has cash which is not yet invested.
• Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to complete. It takes several weeks from the date that it becomes sure that the funds will come to the date that the funds actually are in hand.
• An open-ended fund has just sold fresh units and has received funds.
Getting invested in equity ought to be easy but there are three problems:
1. A person may need time to research stocks, and carefully pick stocks that are expected to do well. This process takes time. For that time, the investor is partly invested in cash and partly invested in stocks. During this time, he is exposed to the risk of missing out if the overall market index goes up.
2. A person may have made up his mind on what portfolio he seeks to buy, but going to the market and placing market orders would generate large ‘impact costs’.
The execution would be improved substantially if he could instead place limit orders and gradually accumulate the portfolio at favor-able prices. This takes time, and during this time, he is exposed to the risk of missing out if the Nifty goes up.
3. In some cases, such as the land sale above, the person may simply not have cash to immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises.
So far, in India, we have had exactly two alternative strategies which an investor can adopt: to buy liquid stocks in a hurry, or to suffer the risk of staying in cash. With Nifty futures, a third alternative becomes available:
• The investor would obtain the desired equity exposure by buying index futures, immediately. A person who expects to obtain Rs.5 million by selling land would immediately enter into a position LONG NIFTY worth Rs.5 million.
Similarly, a closed end fund which has just finished its initial public offering and has cash which is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity. The index futures market is likely to be more liquid than individual stocks so it is possible to take extremely large positions at a low impact cost.
• Later, the investor/closed-end fund can gradually acquire stocks (either based on detailed research and/or based on aggressive limit orders). As and when shares are obtained, one would scale down the LONG NIFTY position correspondingly.
No matter how slowly stocks are purchased, this strategy would fully capture a rise in Nifty, so there is no risk of missing out on a broad rise in the stock market while this process is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing stocks and placing aggressive limit orders.
Hedging is often thought of as a technique that is used in the context of equity exposure. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty.
Holding money in hand, when you want to be invested in shares, is a risk because Nifty may rise. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty!
Some common occurrences of this include:
• A closed-end fund which just finished its initial public offering has cash which is not yet invested.
• Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to complete. It takes several weeks from the date that it becomes sure that the funds will come to the date that the funds actually are in hand.
• An open-ended fund has just sold fresh units and has received funds.
Getting invested in equity ought to be easy but there are three problems:
1. A person may need time to research stocks, and carefully pick stocks that are expected to do well. This process takes time. For that time, the investor is partly invested in cash and partly invested in stocks. During this time, he is exposed to the risk of missing out if the overall market index goes up.
2. A person may have made up his mind on what portfolio he seeks to buy, but going to the market and placing market orders would generate large ‘impact costs’.
The execution would be improved substantially if he could instead place limit orders and gradually accumulate the portfolio at favor-able prices. This takes time, and during this time, he is exposed to the risk of missing out if the Nifty goes up.
3. In some cases, such as the land sale above, the person may simply not have cash to immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises.
So far, in India, we have had exactly two alternative strategies which an investor can adopt: to buy liquid stocks in a hurry, or to suffer the risk of staying in cash. With Nifty futures, a third alternative becomes available:
• The investor would obtain the desired equity exposure by buying index futures, immediately. A person who expects to obtain Rs.5 million by selling land would immediately enter into a position LONG NIFTY worth Rs.5 million.
Similarly, a closed end fund which has just finished its initial public offering and has cash which is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity. The index futures market is likely to be more liquid than individual stocks so it is possible to take extremely large positions at a low impact cost.
• Later, the investor/closed-end fund can gradually acquire stocks (either based on detailed research and/or based on aggressive limit orders). As and when shares are obtained, one would scale down the LONG NIFTY position correspondingly.
No matter how slowly stocks are purchased, this strategy would fully capture a rise in Nifty, so there is no risk of missing out on a broad rise in the stock market while this process is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing stocks and placing aggressive limit orders.
Hedging is often thought of as a technique that is used in the context of equity exposure. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty.
Holding money in hand, when you want to be invested in shares, is a risk because Nifty may rise. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nifty!