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27 September 2020

Index Futures

Holding portfolio of securities is associated with the risk of the possibility that the investor may realize his returns, which would be much lesser than what he expected to get. There are various influences, which affect the returns, viz., price or dividend (interest). Some are internal to the company while others may be linked to the industries. Internal risks such strikes, management policies, etc. are to a large extent controllable and are termed as non-systematic risks. An investor can easily manage such non-systematic risks by having a well-diversified portfolio spread across the companies, industries and groups so that a loss in one may easily be compensated with a gain in other.

Risks that are external and beyond the control of the company are termed as Systematic risk such as economic, political and sociological changes. Their impact is on prices of all individual stocks and they move together in the same manner. Therefore quite often the stock prices may be falling despite good company performance and vice versa.

How to manage these systematic risks :

Derivatives are financial instruments, which are used to manage external risk or the risk. Futures contracts and Options contracts are two of the many derivatives instruments, which are widely being used throughout the world. Stock Index futures are the most popular financial futures, and have been used to hedge or manage the systematic risk by the investors of Stock Market.

Hedging is the act of taking a temporary position in the futures market that is equal to and opposite of one's cash market position to protect the cash position against loss due to price fluctuations.

The premise of hedging is that cash and futures market prices move upward and downward together. This parallel movement may not be perfect, but it is close enough to minimize the risk of cash market loss by taking an opposite position in the futures market.

The major participants in the Derivatives market are hedgers and speculators. The risk-avoiders are known as hedgers; the risk-takers are called speculators.

Hedgers and speculators are vital to futures markets. Speculators assume the risk that is transferred by hedgers. While the motive of the speculator is profit, speculators do provide an essential element to the marketplace--liquidity--that enables the hedger to buy or sell a large number of contracts without adversely disrupting the market.

Why are Index Futures the best alternative :

Stock Indices are true representative of the over all market movements

  • Every portfolio of stocks has certain amount of exposure to the index movements
  • The index movement risk could be hedged by using index futures, and
  • When the Index risk is hedged, only portfolio stocks specific risk remains.
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