The concept of Basis

The difference between spot price and Futures price is known as basis. Although the spot price and Futures prices generally move in line with each other, the basis is not constant. Generally basis will decrease with time. And on expiry, the basis is zero and Futures price equals spot price.

Under normal market conditions, Futures contracts are priced above the spot price. This is known as the Contango Market.

It is possible for the Futures price to prevail below the spot price. Such a situation is known as backwardation. This may happen when the cost of carry is negative, or when the underlying asset is in short supply in the cash market but there is an expectation of increased supply in future - example agricultural products.

This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity.

It is a process for performing a options/futures contract by payment of money difference rather than by physical delivery

t is a measurement of the variability rate (but not the direction) of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price.

It is the arrangement by which the Clearing Houses interpose between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer/or guarantor to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants.

It refers to the liquidation of a options/futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract.

A dealer is said to make a market when he quotes both bid and offer prices at which he stands ready to buy and sell the security. Thus, he is a person that brings buyers and sellers together. He lends liquidity in the system by making trading feasible.

They are specialist-dealers in particular instruments. In the case of single-stock futures, a market maker, for instance, may deal with only Satyam and Infosys futures. A market maker is similar to a jobber in the open-outcry system BSE had earlier. The market maker is obligated to give a buy-sell quote at all times during the trading session. The two-way quotes provide liquidity in the instrument concerned.

This is an arrangement whereby the profits or losses on the position are settled each day. This enables the exchange to keep appropriate margin so that it is not so low that it increases chances of defaults to an unacceptable level (by collecting MTM losses) and is not so high that it increases the cost of transactions to an unreasonable level (by giving MTM profits). The concept was earlier referred while dealing about margin requirements

Gearing (or leveraging) measures the value of your position as a ratio of the value of the risk capital actually invested. In case of index futures, if the margin requirement is 5%, the gearing possible is 20 times as on a given fund availability, an investor can take a position 20 times in size.

In respect of settlement systems for physical delivery in case it is impossible, or impractical, to effect physical delivery, open positions (open long positions always being equal to open short positions) are closed out on the last day of trading at a price determined by the spot "cash" market price of the underlying asset. This price is called "Exchange Delivery Settlement Price" or EDSP. In case of physical settlement short side delivers to the specified location while long side takes delivery from the specified location of the specified quantity / quality of underlying asset. The long side pays the EDSP to clearing house/ corporation which is received by the short side.

The Clearing House / Corporation matches the transactions, reconciles sales & purchases and does daily settlements. It is also responsible for risk management of its members and does inspection and surveillance, besides collection of margins, capital etc. It also monitors the net-worth requirements of the members.

The other role of the Clearing House / Corporation is to ensure performance of every contract. This can be done in two ways. One way is that Clearing house / Corporation imposes itself between the two counterparties thereby replacing the original contract (say between A & B) by two new contracts (between A and Clearing House /Corporation and between B and Clearing House / Corporation) thereby itself becoming counterparty to every trade. This is called full Novation. The other way is to guarantees performance of all the contracts done on the exchange.

Price Risk is defined as the standard deviation of returns generated by any asset. This indicates how much individual outcomes deviate from the mean. For example, an asset with possible returns of 5%, 10% and 15% is less risky than one with possible returns of -10%, 1% and 25%.

Diversifiable risk (also known as non market risk or unsystematic risk) of a security arises from the security specific factors like strike in factory, legal claims, non availability of raw material, etc. This component of risk can be reduced by diversification. Non-diversifiable risk (also known as systematic risk or market risk) is an outcome of economy related events like diesel price hike, budget announcements, etc that affect all the companies. As the name suggests, this risk cannot be diversified away using diversification or adding stocks in portfolio.

Price Risk can be controlled to an extent. The different types of price risk impacting any stock or company can be classified into two categories:

1. Company specific; and

2. Economy or market related.

As discussed earlier, the Company specific risks (also known as diversifiable risk or non market risk or unsystematic risk) can be reduced by proper diversification. Market risks to a certain extent can be minimised through hedging.

Hedging is a mechanism to reduce price risk inherent in open positions. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return.

The basic logic is "If long in cash underlying - Short Future and If short in cash underlying - Long Future". Let us understand this by a simple example. If you have bought 100 shares of Company A and want to Hedge against market movements, you should short an appropriate amount of Index Futures. This will reduce your overall exposure to events affecting the whole market (systematic risk). In case a war breaks out, the entire market will fall (most likely including Company A). So your loss in Company A would be offset by the gains in your short position in Index Futures.

Some examples of where hedging strategies are useful include:

• Reducing the equity exposure of a Mutual Fund by selling Index Futures;

• Investing funds raised by new schemes in Index Futures so that market exposure is immediately taken; and

• Partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higher.

• In general, the speculator takes a view on the market and plays accordingly. If one is bullish on the market, one can buy Futures, and vice versa for a bearish outlook.

• There is another strategy of playing the spreads, in which case the speculator trades the "basis". When a basis risk is taken, the speculator primarily bets on either the cost of carry (interest rate in case of index futures) going up (in which case he would pay the basis) or going down (receive the basis).

• Pay the basis implies going short on a future with near month maturity while at the same time going long on a future with longer term maturity.

• Receiving the basis implies going long on a future with near month maturity while at the same time going short on a future with longer term maturity.

Circuit Breaker means trading is halted for a specified period in stocks or / and stock index futures, if the market price moves out of a pre-specified band. Circuit filters do not result in trading halt but no order is permitted if it falls out of the specified price range.

1. Allows participants to gather new information and to assess the situation - controls panic.

2. Brokerages firms can check on customer funding and compliance.

3. Exchanges/ Clearing houses can monitor their members.

1. Only postpones the inevitable.

2. Limits the flow of market information - no one knows the real value of a stock.

3. They precipitate the matter during volatile moves as participants rush to execute their orders before anticipated trading halt.

Index Futures are Future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements. Suppose you feel that the markets are bullish and the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index Future. Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset allocation. Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have launched index futures in June 2000. These are the most popular products traded in the derivatives market. In fact major share oif trading in the market comprises of transactions in Sensex and Nifty futures

In the demutualised Exchange, unlike the Mutual form of Exchange, the owners do not automatically get the trading right by virtue ot their ownership. Though demutualisation per se does not bar an owner (equity holder) from acquiring trading rights, he has to comply with the admission criteria laid down by the Exchange. Also, it is a good corporate governance practice to have, in the organization of the equity holder, a Chinese wall between the trading division and the division dealing with the ownership of the Exchange, to avoid conflict of interest.

Derivatives in particular options and futures are to be traded compulsorily through a stock exchange approved by SEBI. The stock exchange through its regulated clearing system insulates the element of risk and provides safe trading environment to the buyers. Unlike spot trading, options and futures carry inherently several types of risks. Risk covering methods implemented the Stock exchanges are discussed in details separately in subsequent pages dealing with "options" and "futures" respectively.