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Index Futures And Their Uses
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Futures are derivative products whose underlying is financial assets such as stocks and currency, commodities such as food grains, precious metals, oil and energy.
Futures are generally used to offset the risk in the spot markets, as a hedging mechanism though it is also used by speculators (who try to make profits by predicting the movement in asset prices) and arbitrageurs, who take advantage of the differentials in the prices of futures and the spot markets.
There are various types of futures available in the market. Let us deal with stock index futures first – that is futures, which have as their underlying the benchmark indices of scrips traded on stock exchanges.
As you must have realised, in index futures it is the index, which is bought and sold. In India, physical settlement of index futures is not done and the contract is cash settled. The difference between the sale and purchase price of the futures contracts are settled in cash and there is no actual delivery of the underlying shares in the index.
Why do you Need Stock Index Futures?
•Hedging Mechanism: As we have already explained, index futures are used as protection to lessen the risk of losses in your portfolio of stocks. Suppose you have a certain stock in your portfolio and you want to protect yourself from suffering capital losses due to price fluctuations. Then you take an offsetting position in index futures so that even if the price of your stock falls, the profit from the futures position will compensate for that loss.
•Flexibility: If you have stock index futures then you get the flexibility to either raise or lower your exposure to large cap stocks, with a single trade. If you anticipate that large cap stocks may see a spurt in prices then you can use index futures to participate in the rally with just a single trade.
•Lower risk: The advantage of exchange-traded futures is that it virtually eliminates counter-party risk (of default etc.). Those who participate in the futures segment are also subject to various types of margins, which protect the participants and the market.
•Leverage: When taking exposure in index futures you need to deposit as little as 10 percent of the contract value. You can take an exposure to the market, which is several times the value of what you actually invest. The investments are marked-to-market and the participants just have to maintain a margin, which is in line with the actual value of the portfolio at the end of the day.
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