Anyone who compares the numbers flashing on financial screens before the market opens may notice something puzzling. The futures price and the actual index level are rarely identical, even though they track the same underlying basket of stocks. Those who follow GIFT Nifty Live often see it quoted a few dozen points above or below where the domestic index closed the previous evening. Curious investors then wonder whether that difference tells them something meaningful about where the Nifty Share Price will open. The answer lies in a concept every serious market participant eventually learns: the relationship between futures prices and the underlying spot level, governed by cost of carry, expectations, and supply and demand.
The Idea of Fair Value
A futures contract is a contract to transact at a certain price on a future date. Because that date is in the future, its price should encompass whatever it would cost to hold the underlying asset until that date. In the case of an equity index, that comprises two costs: financing (interest) and expected dividends (the latter not being received by the futures buyer).
In short, fair value is spot plus the cost of financing minus the reinvested dividends. With interest rates being meaningful and dividends minor, futures typically trade at a premium to spot. That premium tends to narrow with the expiry date approaching and vanish on the day of expiry, as futures and spot converge.
In the Live Example
I mentioned at the beginning of this week, the closing price of the domestic benchmark was at 23,140.50, while the offshore futures contract was at 23,188.50, nearly a fifty-point spread. Someone looking at the futures might have assumed that the market was set to open flat to slightly positive. In truth, that premium represented almost normal fair value, in that the effective gap was minuscule. By the end of the session, the index had closed at 22,780.25, or 360.25 points lower. The lesson is that the premium or discount itself is largely meaningless, while the change in that premium and the change in the index versus the previous close after that change in fair value is the important factor.
Why the Premium Fluctuates
There are multiple factors that lead to the change in premium. Optimism is one, with buyers pushing futures up relative to spot, and a widening premium. The opposite, with a contraction of the premium or a discount, occurs when pessimism takes hold, with sellers pushing futures down relative to spot. A shift in interest rates will also change fair value, as higher rates increase the premium.
Arbitrageurs serve to keep prices in check, as they will sell futures and buy the underlying shares if futures become too expensive (versus fair value) and the reverse if they become too cheap, locking in a riskless short/long position as a result. That serves to narrow any premium or widen any discount, bringing the two prices into line, with the caveat that there is a period between trades when the price can stray, especially when arbitrageurs are unwilling to trade due to transaction costs or other factors.
The Number of Days to Expiry
The number of days to expiry will affect the premium, as a contract with a few weeks to expiry will have a higher financing cost component than one that only has a few days. Traders should be comparing the premium to the normal premium for a contract with that number of days to expiry, not some arbitrary number. Spot plus fifty points might be normal early on in the expiry cycle, but completely unexpected later on.
What a Discount Might Mean
Just as a premium reflects optimism or a need to hedge, a discount reflects pessimism or significant hedging needs. Institutional investors with large stock portfolios tend to sell futures to hedge against a potential decline in the market, which will push futures below spot. A widening or persistent discount can therefore be a signal that professional investors are becoming bearish.
There are other potential reasons for a discount, however, most notably technical factors. Month-end effects can cause discounts, as can rebalancing of indices or other factors. The reasons for a discount are important in isolation, but the fact that there is one should still be borne in mind. Part of interpreting it, however, is understanding what has happened in overseas markets and whether foreign institutional investors have been net sellers in the cash market.
Practical Takeaways
For ordinary investors, the main lessons are simple. First, the raw value of the futures versus the previous close is not interesting. Adjust it for the normal premium or look at the change overnight rather than the raw number. Second, futures should always be seen as where the market expects to be at a certain time. As such, they will always shift as new information comes out, and the picture on the domestic market opening will almost certainly not resemble the one when the offshore market closed.
Other data points should also be considered, not just the level of the futures. Institutional flows, sectors and technical levels are all worth considering. Most importantly, look at the bigger picture. If an investor is focussing on buying quality companies and sitting on their investments for years or decades, the fact that futures were up or down a small amount on any given day is largely irrelevant. Knowing the basis helps to make sense of what commentators are saying, but it is ultimately an academic exercise, designed to prevent investors from being unduly surprised or frightened by day-to-day changes. Armed with that knowledge, they can get on with the business of investing.