Share Market School

Futures : Understanding basis risk

BASIS.

By creating a long or short hedge using futures, if you thought your cash position is safe, you are wrong. As we saw in the previous post’s examples, hedging eliminates price risk. But it opens up a second risk called ‘Basis risk’. To understand that, first you should understand the term ‘Basis’.

The difference between spot price and futures price at any point of time is called ‘Basis’.

BACK TO EXAMPLES.

Let’s go back to the HDFC’s example from our previous post. The basis at the beginning was Rs 5 per share. (How’s that? Cash price- futures price, Rs 500 – Rs 505).

In situation 1, the stock price moves up to Rs 525 and the futures were at Rs 530. Hence, the basis works out to Rs 5. In situation2, the stock price crashed to Rs 475 and the futures were at Rs 480. Again, the basis remains unchanged at Rs 5. The effect – in either situation, the loss was offset by the profit made.

2 Comments

Futures: Hedging & it’s importance

HEDGING.

Imagine this situation- you just bought a fundamentally good stock at a bargain. You know that you’ve done your home work and have bought the share at the right price and time. But still, in a surprise move, the market may think other wise and would send the stock price crashing. You may not even understand why the stock price tumbled. Such pitfalls are common in stock markets.What a weird place to be. isn’t it?

Now, is there a way to protect your money in such cases?

Yes ! There are many methods. One such method is to use futures to hedge your position. Before we explain that, let’s understand the meaning of hedging. Hedging is any act that trys to protect an investment from price risk to the maximum extend possible.So, it’s just like insurance. We insure our life - against death , against serious health problems, don’t we? But, we don’t take insurance for cold & cough. Similarly, hedging is not a strategy to employ for small investors because of the cost and effort involved. Hedging is effective when your investment involves a substantial amount.

4 Comments

Expected market outlook

SENSEX (16,292.9), NIFTY (4,928.9) – 14^th -18^th May 2012

Last week, the Sensex recorded the lowest weekly close in the last four months. Low Industrial production data, weak rupee, fears over euro-zone crisis and the RBI’s declaration that no more interest cut is possible all contributed to the highly volatile session that ended with benchmark indices losing over 3%. Although the GAAR has been deferred by a year, that did not give enough boost to FIIs to return to markets. Foreign institutional investors have sold Rs 376 Crore worth of equities on May 9, as per provisional data available on NSE. So far in May, they have been net sellers of Rs 557 Crore worth of shares.

7 Comments

Futures: Risk levels of participants.

Future contracts, as we have already seen, are instruments used for ‘transferring risk’. In other words, future contracts are basically used for Financial risk management.

That brings us to one basic question. When and for whom is risk management necessary? Risk management is necessary only for those who have a risky asset position. I.e., when you have assets (shares / gold / currency / commodity etc) which fluctuates heavily in value. The uncertainty of price movements that surrounds such investments necessitates the use of derivatives. Many examples were discussed in our early posts on how derivatives help investors in reducing the risk they face.

The point i would like to bring here is that you should be very clear about why you are using derivatives.

5 Comments