X

This is an entirely free service. No payments are to be made.

Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
Stock futures: Return of the lenders - Views on News from Equitymaster

 PRINT E-MAIL FEEDBACK A  A  A
 Home > Outlook Arena > Views On News > Dec 5, 2001 - Stock futures: Return of the lenders

# Stock futures: Return of the lenders

In the previous article we had introduced futures on individual stocks. In this article we try to understand the pricing of futures and how they can be used for arbitrage and leveraging.

If one wants trade in stock futures, understanding how these products are priced is a must. The concept is very simple and is based on the time value of money. One of the very first principles of finance is that ‘cash today is worth more than tomorrow’.

The future is a derivative contract. Therefore, the price of the future has to be derived from that of the underlying. Future contract is an agreement to buy/sell a stock at a future date. Theoretically, the price of the future contract has to be the current stock price plus the cost of capital required to buy the stock (to keep it for delivery at a future date).

Thus, if F=Future price of the stock
S= Current market price of the underlying stock/index
R= risk free rate of return
T = time in days

F= S* e^(r*t)

This is the fundamental basis (or formula) for pricing future contracts. Irrespective of what the underlying is, an index or an individual stock. A simple definition for futures is that they are an agreement to buy or sell a stock or an index at a particular price on a particular date in the future. And if on the future date if the instrument does not give returns that is equal to the risk free rate there is no point in investing in the instrument. Thus, the future price should always reflect this premium.

Please note: For simplicity, it is assumed that stocks and the index will not pay any dividends.

For determining the risk free rate (r), the overnight MIBOR rate or the actual returns, yield, (based on the market price) of a T-bill (Govt. paper) with corresponding duration could be used.

On the 28th of November, let us take the example of Satyam’s December futures that expire in 29 days from now. The stock closed at Rs 208 in the cash market (on November 28). The 30-day MIBOR rates are 7.89%. Using the data the fair value for the future could be arrived at.

The price for the future should be Rs 209, theoretically. However, the Satyam futures closed at Rs 215. This indicates that the players are willing to take delivery of the stock at Rs 215, a month from now. This is based on the optimism that the stock price will move higher than Rs 215. Therefore, players are willing to carry the contract at a cost of 40% (or at a premium of 40%). This is on expectations that returns will be higher than cost of carry.

 Stock Price (Rs) Days to expiry MIBOR rate 1 m Theoretical futures price (Fair value) (Rs) Futures price (Rs) Implied cost of carry 208 29 7.9% 209 215 39.6%

In the case of ACC, the players are not willing to pay Rs 167 (the fair value of the current market price in December end) to buy the stock one-month down the line. Infact, they are willing to buy the stock only at Rs 164 (ACC December futures price). Therefore, the stock price could be expected to go down.

 Stock Price (Rs) Days to expiry MIBOR rate 1 m Theoretical futures price (Fair value) (Rs) Futures price (Rs) Implied cost of carry 167 29 7.9% 168 164 -15.2%

Arbitrage opportunities
The arbitrage opportunities can replace the old badla system. The stock and money can be lent into the markets to make risk less gains. The mispricing in futures contracts gives rise to arbitrage opportunities. Since the future is quoting at such a significant premium or discount to its fair value arbitrage gains could be possible.

• Futures priced higher than theoretical value

In a situation where the future contract is highly priced the future could be sold and the stock could be bought in the cash markets. This presents an opportunity to lend money to the markets.

F> S*e^(r*t)
F= Futures price
S*e^r*t = Theoretical futures price

However, the premium has to be large enough to justify transactions costs. On November 28, the closing prices indicated that Satyam’s November futures were priced at Rs 215, significantly higher that the expected fair value of Rs 209, based on the stock price of Rs 208. Therefore, by shorting Satyam futures at Rs 215 and buying the stocks at Rs 208 arbitrage gains could be made.

 Market lot for Satyam is 1,200 Buy stocks @ Rs 208 249,600 Sell futures @ Rs 215 257,940 Brokerage (0.75%) 1,872 Brokerage 284 Service tax (5%) 94 Required IM @ 20% 51,588 Cost of borrowing (7.89% annualised) 1,641 Cost of borrowing 339 Total cost (a) 253,207 Total cost (b) 52,211 At expiry Satyam is Rs 220 Sell the stocks @ Rs 220 264,000 Buy the futures @ Rs 220 264,000 Brokerage 1,980 Brokerage 290 Service tax 99 Gain /(loss) on the contract (6,060) Total realisation 261,921 Total cost of transaction 913 Net gains/(loss) on the stock transaction 8,714 Net gain/(loss) from futures of transaction (6,973) Net gain/(loss) from both the transactions 1,741 Total funds utilised (a+b) 305,418 Returns on the transaction 0.6% Annual returns 7.4%

Please note: All figures in Rs, except those specified otherwise

The operation could be used to lend money. In this case there will be not be any need to borrow money and there will be no borrowing costs. Thus, if the cost of borrowing is removed the gains realized will be even higher.

• Futures priced lower than theoretical value

If the futures are quoting at a price much lower to the fair value, the future could be bought and the stock could be sold. This presents an opportunity to lend stocks to the markets.

F F= Futures price
S*e^r*t = Theoretical futures price

On November 28, ACC was quoting Rs 167 on close and the December futures were quoting at a discount at Rs 164. The theoretical fair value for the contract was expected to be Rs 168. In such a situation by selling the stock at Rs 167 and buying the futures for Rs 164 one could make arbitrage gains, provided the transaction costs are justified. Therefore, the kindly note the mispricing should be wide enough to lock in the gains. The transaction is equivalent to lending stocks in the Badla market.

 Market lot for ACC is 1,500 Sell stocks @ Rs 167 250,050 Buy futures @ Rs 164 246,000 Brokerage (0.75%) 1,875 Brokerage (0.11% incl stamp duty) 271 Service tax (5%) 94 Required IM @ 20% 49,200 Total realisation (b) 248,081 Total cost (c) 49,471

Please note: All figures in Rs, except those specified otherwise

Here we have assumed that of the total realisations of Rs 248,081 from selling the stocks, Rs 49,200 are utilized to pay for the initial margin requirements for buying the futures.

 At expiry ACC is Rs 175 Buy the stocks @ Rs 175 262,500 Sell the futures @ Rs 175 262,500 Brokerage 1,969 Brokerage 289 Service tax 98 Gain /(loss) on the contract 16,500 Gains from investing (7.89% annualised) (1,319) Total cost of transaction 559 Total cost (a) 263,248 Net gain/(loss) from futures of transaction 15,941 Net gains/(loss) on the stock transaction (15,168) Net gain/(loss) from both the transactions 773 Total funds utilized (a-b+c) 64,638 Returns on the transaction 1.2% Annual returns 15.4%

Please note: All figures in Rs, except those specified otherwise

The transaction is subject to the rules on short selling. However, if there are stocks available for delivery then the operation is possible.

Please note that the arbitrage opportunity arises in both the cases if the transaction costs are justified.

Leveraging
To buy 1,200 stocks of Satyam @ Rs 208 in the cash markets you will have to pay Rs 249,600. But you can take a similar position on the same stock by buying futures. The value of a future contract for Satyam comes to Rs 258,000 at Rs 215. However, to take this position you need to pay only the initial margin, which at 20% works out to be Rs 51,600. If the stock on the expiry day is at Rs 220, the return for selling the stock works out to be 3.4%, while the return on selling the futures works out to be 11.4%.

 Market lot for Satyam is 1,200 Buy stocks @ Rs 208 249,600 Buy futures @ Rs 215 258,000 Brokerage 1,872 Brokerage 284 Service tax 94 Required IM @ 20% 51,600 Cost of borrowing 1,641 Cost of borrowing 339 Total cost 253,207 Total cost 52,223 Sell Stocks at @ Rs 220 264,000 Sell futures @ Rs 220 264,000 Brokerage 1,980 Brokerage 290 Service tax 99 Total gains from the transaction 6,000 Total realisation from selling 261,921 Total funds utilised 52,513 Total gains from the transaction 8,714 Returns 11.4% Total funds utilised 253,207 Annualised returns 265.3% Returns 3.4% Annualised returns 49.4%

Please note: All figures in Rs, except those specified otherwise

However, there is a flip side. If you take delivery you will have to pay out only once. However, in a futures transaction you will be marked to market daily and but far more critical is to realize that the downside is unlimited. On the expiry day you will have to pay up for whatever losses have been made.

Therefore, before starting to use derivative instruments please thoroughly understand the mechanics and the risk profile.

## More Views on News

Sorry! There are no related views on news for this company/sector.

## Most Popular

### Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

Aug 7, 2017

The data tells us quite a different story from the one the government is trying to project.

### A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

Aug 10, 2017

Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

### Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

### Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

Aug 7, 2017

Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

More
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407

Become A Smarter Investor In
Just 5 Minutes

Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.