Index Futures

The economy is driven by the markets, which are constantly evolving and generating new instruments of commerce and trade to get around the challenges in the existing market ecosystem. Trade in commodity futures trade, which was born out of necessity several centuries ago, is one such innovation that has stood the test of time in spite of several hiccups on the way. However, this market sector is challenged with questions such as its role in the movement of prices in the real world, but traders have accepted futures trade because, with the least investment, they can narrow their risk and even multiply profits.

However, the beginning of stock index futures in the 1980s and commodity index futures later took futures trade to the next plane, where a trader could take a position on the commodity or stock index, and not on individual stocks or commodities. But once again “Mr Doubt” still drives the debate: Do we need commodity index futures? Do commodity index futures really help the investor? Does this new financial mechanism help the stock/commodity market grow quickly, or does it contribute to a meltdown as inferred in the U.S soon after index futures were introduced? And last, in the Indian context, is the derivative market mature enough to accept commodity index futures?

Although there are several fundamental points of departure between stock exchanges and commodity exchanges, there seems to be close likeness in the growth of instruments of trade in either arena. However, it is for sure that trade in derivatives helps hedgers safeguard themselves against the risks associated with the ebb and flow in the value of the underlying asset or index, and speculators to multiply earnings if the value of the basic asset or index moves in a positive direction.

In course of the self-discovery of formal trade instruments, the stock market seems to have been always ahead of the commodity market. Frequently, introduction of an instrument in the stock market leads to a demand for the same in commodity exchanges. The most significant such example is trade in index futures.

What are Index Futures?

Joseph is a new entrant in the market and finds himself overwhelmed by the range of opportunities available. It is a problem of plenty, where the critical decision needs to be made for holding on to the right stock or commodity. He wants to build a small portfolio, but he is simultaneously beset with the worries of a volatile market. Risks abound.

Let us bring in index futures to aid Joseph in his dilemma. Joseph’s basic quandary is to choose stocks that are likely to yield excellent returns, or commodities that provide the right signals couple of months down the line. Besides these factors, however, his success or failure is also related to the movement of the index; this is because every buy position on a specific stock is a buy position on the stock index. A downward slip in the index will have an impact on his position in the individual stock as well. In short, the outcome can go awry in spite of a correct assessment. But what if Joseph could take a position on the index itself by trading in an index futures contract?

While it is not realistic to hold positions in all stocks that figure in an exchange, trading in stock index futures has already arrived worldwide. A trade in index futures basically means that the trader is taking a posture against the movement of the index. If the market sentiment is that the index will move upward, a buy position is rational, and vice versa.

Moving to trade in commodity index futures, the commodity index shows the price movement of a basket of commodities, and the futures contract is an agreement on the expected value of that index at some specific time in the future.

Index Futures: The Global Scenario

Both stock index futures and commodity index futures are already deep-rooted in many U.S., European, and Asian markets. The Kansas City Board of Trade was the first to introduce stock index futures in February 1982, and within a short time the Chicago Mercantile Exchange initiated index futures based on the S&P 500 index. From then on, stock index futures have been doing reasonably well and have attracted investors as they showcase an opportunity to “buy into the components of the index.”

In the context of commodity index futures, the two leading indices represented in futures contracts are the Commodity Research Bureau (CRB) Futures Price Index and the S&P Goldman Sachs Commodity Index (GSCI).

Index futures in India started at the National Stock Exchange in June 2000. Here, futures contracts are founded on the S&P CNX Nifty index, which is a well-accepted market benchmark with good hedging efficiency and scope for arbitrage.  The next significant step for futures trading in India would be commodity index futures.

While we wait for such an eventuality, it is important to emphasize that the requirement is for an index that can act as a barometer of the price of the commodity basket. If such an index emerges and remains relatively unfettered in regulatory restrictions, it will provide the trader opportunity to mitigate risk. On the downside, irrevocable damage can be caused to the market ecosystem and sentiment if the trading gates are thrown open to an ill-computed index.  It is prudent to be cautious, rather than be in a mad rush to emulate stock index futures without allowing for problems that are exclusive to the commodity market.