Understanding Sensex and Index Derivatives: A Comprehensive Guide

Posted on Apr 30, 2024 in Economy

SENSEX

1 Sensex Index

The BSE Sensex, established in 1986, is a crucial indicator of the Indian stock market’s performance. It comprises 30 prominent and financially stable companies, reflecting their market capitalization. As a reliable barometer, the Sensex offers valuable historical data for investors to gauge market trends and make informed decisions.

2 Trading in Sensex Futures

Sensex futures are anticipated to be highly liquid contracts due to their lower costs and the widespread recognition of the Sensex. Institutional investors, money managers, and retail investors rely on the Sensex to assess the Indian stock market’s sentiment. The high liquidity translates to reduced trading costs, making Sensex futures an attractive investment option.

Several factors contribute to the expected significant retail participation in Sensex futures:

  1. Lower capital adequacy and margin requirements compared to individual stocks.
  2. Reduced brokerage costs.
  3. Cost savings through narrower bid-ask spreads.
  4. Lower impact cost compared to trading individual stocks.

Application of Index

1 Index Derivatives

Index derivatives are financial contracts based on an underlying index, such as the S&P CNX Nifty. The most common types are index futures and index options, providing investors with tools to manage risk and speculate on market movements.

2 Index Funds

Index funds aim to replicate the returns of a specific index by investing in the constituent stocks proportionally. They offer a convenient and diversified investment option for investors seeking to track the performance of a particular market segment.

Forward Contracts

A forward contract is a customized agreement between two parties to buy or sell an asset at a predetermined price on a future date. Unlike futures contracts, forwards are traded over-the-counter and are not standardized.

2 Features of a Forward Contract

Key characteristics of forward contracts include:

  1. Bilateral contracts with counterparty risk.
  2. Unique terms regarding contract size, expiration date, and asset specifications.
  3. One party takes a long position (agreeing to buy) while the other takes a short position (agreeing to sell).
  4. Potential for creating synthetic assets by combining underlying assets.
  5. Settlement by delivery of the asset on the expiration date.
  6. Covered parity or cost-of-carry relations between forward and underlying asset prices.

3 Classification of Forward Contracts

The Forward Contracts (Regulation) Act, 1952, categorizes forward contracts in India as follows:

  1. Hedge Contracts: Freely transferable contracts without specific lot size, quality, or delivery standards.
  2. Transferable Specific Delivery Forward Contracts: Freely transferable contracts with predetermined lot size and asset specifications.
  3. Non-transferable Specific Delivery Forward Contracts: Typically exempt from regulatory provisions.