What are Index Futures?
An index is a benchmark like the Nifty or the Sensex. Typically, indices can be generic benchmarks like Nifty and Sensex. Alternatively, indices can also be thematic benchmarks like the Bank Nifty, Nifty IT, etc. Currently, the NSE offers liquid index futures trading on 3 indices viz. Nifty-50, Bank Nifty, and Nifty Financial Services.
Having looked at the index, let us get to what are index futures? Stock index futures or share index futures as they are popularly called; represent a contract on the index for future data at a price fixed today. You can either buy index futures if you are confident of upward movement or you can sell index futures if you are confident of downward movement. Let us understand in detail what are index futures and the actual index futures meaning.
About Index Futures?
If you understand a forward contract, then you have understood the futures contract too. That is because a share index futures contract is a forward contract, which is traded on an Exchange. When a forward is traded on a stock exchange, it acquires some important characteristics. For example, stock index futures are standardized, they are exchange-traded and they are also free of counterparty risk as the clearing corporation gives a counter-guarantee on all trades. In India, index futures are available on the NSE on Nifty-50, Bank Nifty, and Nifty Financial Services.
When you say that the stock index futures are standardized, it means that the contract specification in terms of maturity, expiry, ticks, etc are standardized. Traders cannot decide or input their terms and conditions. That is only possible in OTC contracts and not in exchange-traded stock index futures contracts. Let us now look at the contract specifications of stock index futures contracts with specific reference to Bank Nifty.
The product is designated with the symbol FUTIDX while the underlying is designated as BANKNIFTY. The monthly contract will expire on the last Thursday of the month and there will be added weekly contracts expiring each week on Thursday. Let us now turn to the trading cycle of the Bank Nifty for illustrative purposes.
BANKNIFTY futures contracts will have a maximum of 3-monthly trading cycles viz. Near Month (last Thursday of current month), the Mid Month (last Thursday of next month), and far month (last Thursday of the third month). A new contract is introduced on the trading day following the expiry of the near month contract for a 3-month duration. Subsequently, the mid-month becomes the near month and the far month becomes the mid-month. The new contract introduced becomes the far month contract now. Let us quickly look at contract sizes permitted in Bank Nifty.
The only condition laid down by the exchange is that the notional value of the Bank Nifty contract at any point in time should not be less than Rs.5 lakhs. Notional value is the product of the futures price and the lot size. For example, currently, Bank Nifty June 2021 futures are quoting at Rs.35,050 and the minimum lot size is 25. Hence the notional value of one contract will be Rs.876,250. That sums up the gist of index futures and stock index futures. The very index futures meaning is that it is a derivative contract on an underlying index. Stock index futures are unique to stock market indexes while there are also derivative products available on bond indices, commodity indices, etc.
What are swap, interest rate swaps & currency swaps?
Broadly, swaps are derivative contracts between two parties that involve the exchange of cash flows. The very word swap means exchange. How does a swap work? One counterparty agrees to receive one set of cash flows while paying the other another set of cash flows. That sounds complicated, so let us take an example.
A is invested in a fixed rate bond and B is invested in a floating rate bond. Now suppose A prefers a floating rate bond and B prefers a fixed rate bond, then they both have to sell their existing bonds and buy new bonds. That is normally not only time-consuming but also entails costs, liquidity challenges, and tax implications. Instead, A and B can enter into an OTC (over-the-counter) contract to exchange their cash flows. There will be a cost for this exchange which is called the swap cost.
What exactly is an interest rate swap?
An interest rate swap is a financial derivative product used by companies and businesses to exchange interest rate payments with each other. These Swaps are very useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead. It does not matter whose view is correct or wrong because both have their priorities.
Typically, in an interest rate swap, the two parties trade fixed-rate and variable-interest rates. For example, a variable rate bond paying LIBOR + 50 bps can be exchanged for another fixed rate bond paying a fixed rate of say 5%. The primary investment is never traded, but the parties will agree privately to this swap, which makes it an OTC product. Since credit risk is huge, swaps are normally done among very reputed institutions only.
How do currency swaps work
If interest rate swaps entail exchanging fixed-rate flows for floating rate flows and vice versa, the currency swap entails exchange receivables in one currency with another currency. The concept of the swap remains the same. For example, if X borrows in US dollars and Y borrows in Euros and both want payables in the exact opposite currencies, they can enter into a swap with each other and exchange currency-based cash flows.
The currency swap market works exactly like collateralized borrowing or lending market to avoid exchange rate risk. Being an OTC product once again, the players in this market are large multinationals, institutions, and banks.
What is spread trading?
Spread trading is popularly referred to as “Relative value trading”. The idea of spread trading is to capitalize on spreads between two asset classes. The spread trader is agnostic to the movement of prices, but only bets on whether the spread will widen or narrow. You buy a spread hoping the spread will widen and sell the spread contract hoping the spread will narrow. Some of the popular spread traders in the market are calendar spreads (between different futures maturities), arbitrage spreads (between spot and futures), and vertical spreads (the spread between two strike prices).
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Frequently Asked Questions
The structure of the contract is the same. Index futures have stock indices as underlying while commodity futures have commodities like gold, silver, oil as the underlying.
Index futures attracts trading interest from speculators, arbitrageurs, hedgers looking to protect risk, scalpers who trade volumes on thin spreads etc.
Index futures have monthly expiry on the last Thursday. They also have weekly expiries.
Contract size or lot size is the minimum tradable lot. For example, the contract size or lot size of Nifty is 75 shares and you can only trade in multiples of this lot size.