The Hindu Business Line : Using Futures/Options

The cost-of-carry model suggests that the price of futures should always be higher than the spot price; else it gives rise to arbitrage opportunities. I would be glad if you can explain why at times futures are at a discount to the spot price as has happened in the case of Ranbaxy, BHEL and ONGC, to name a few.

One can sell the stock and buy futures to have arbitrage profit. What are the factors that lead to the discount in the futures prices? Is it only because the short selling is not permitted? Are there any other factors that can explain the discount of the futures price over spot? — Anita Srivastava

From the early days of derivatives trading, futures prices of far-month index contracts and a few of the stock futures tend to trade at a discount to the spot price. This has nothing to do with the ban on short selling in the spot markets. This is because stocks can be borrowed and the arbitrage opportunity can be exploited. The prevalence of arbitrage opportunities is also not due to the lack of liquidity; there has been a substantial improvement in liquidity in index contracts over the past couple of years; yet the discount has persisted.

What is clear that it is not easy for retail investors to exploit the arbitrage opportunity. Retail investors can only get about 4 per cent for their short-term investments and can borrow funds at a rate in excess of 12 per cent. They also need to deal with the costs of the arbitrage trade. The impact cost too could be high as the prices at which they can put through these trades may be vastly different from the closing prices for the day. Thus, for retail investors, the futures prices mostly fall in the no-arbitrage zone.

Institutional investors such as FIIs, banks and insurance companies are, however, better placed to capitalise on such arbitrage opportunities. But price trends suggest that they are not taking advantage of such opportunities.

It is also possible that those who trade in the futures markets do so merely to take advantage of the potential for leverage possible with futures. They are not concerned about tapping into the arbitrage opportunities. They are looking for the higher returns that futures can offer as compared to the spot market for the same amount of money invested.

As volumes rise manifold over the next few years, these anomalies may be gradually eliminated.

Queries relating to futures/options may be mailed to

fno@thehindu.co.in

or to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002.

Suresh Krishnamurthy

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