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Thursday, May 31, 2007

Derivatives on Nifty Junior and CNX-100

When Nifty was done a long time ago [link], the key insight was that for an efficient futures market, it should be easy for arbitrageurs to force the futures towards fair price. This requires low impact cost (IC) when doing basket trades for the index. Low impact cost for doing basket trades for the index also helps other applications of an index, such as index funds.

Nifty futures were launched in mid-2000 and from 2001 onwards, the Nifty derivatives market did pretty well. The 9/11 attacks were of decisive importance in getting many stock market participants to shift their gaze away from individual stocks to the overall index.

Nifty Junior is the second tier: of stocks which don't make it into Nifty. For the rest, it's the identical methodology as that in Nifty. The methodology ensures that Nifty and Nifty junior have no common members. CNX-100 is the not-so-nifty name that's been given to the merged index of all 100 stocks. It's the index of the top 100 liquid stocks of India.

How Nifty Junior is different

The most interesting feature of Nifty Junior has been the remarkable returns over the last 10.57 years (the data starts from 4 November 1996). While Nifty returned 4.82 times (16.04% per year) over this period, Nifty Junior returned 8.1 times (21.89% per year) over the identical period. When many actively managed mutual funds talk about outperforming Nifty, it has to do with their loading up on Nifty Junior risk.

Over the last 10.57 years, you could have got a 21.89% return per year (not counting dividends) while paying 25 basis points to an index fund manager. Imagine that. If you use ETFs, you can replace the (big) cost of the mutual fund agent / distributor with the (small) brokerage fee.

Where did these wonderful returns come from? The CNX-100 (total return) index went from 1000 on 1-1-2003 to 4576.6 today, while the P/E went from 14.04 to 19.75. So there was a 1.4x gain owing to improved P/E, and a 3.25x gain in net profit, multiplying up to the overall 4.5766 times return. The bulk of the story was in the growth of net profit.

Current valuations for the three indexes are:

Feature NiftyJuniorCNX-100
P/E 20.1117.7819.75
P/B 5.594.025.30
Dividend yield (%) 1.1 1.06 1.1

Today, the market capitalisation of Nifty Junior is 3.52 trillion while Nifty is at 22.05 trillion. Put together, the CNX-100 has a market capitalisation of Rs.25.57 trillion or $630 billion. Out of this, Nifty Junior has a weight of 13.8%.

Nifty Junior is a bit more volatile than Nifty. Looking at the recent period, from 1-1-2003 onwards, Nifty had a daily volatility of 1.47% while Junior had 1.66%.

All three indexes have high correlations. The correlation between Nifty and Junior is 0.85 while that between Nifty and CNX-100 is 0.995%. The correlation between Junior and CNX-100 is 0.893.

Liquidity of the new indexes

NSE has been calculating the IC, off three or four snapshots of the limit order book every day, for both indexes for a while. The transaction sizes they are using for analysis are Rs.5 million for Nifty and Rs.2.5 million for Nifty Junior. These are plausible transaction sizes for index funds and generous sized transactions for arbitrageurs who are able to do smaller baskets.

How have these numbers been faring?

Year Nifty Junior
2001 0.20
2002 0.12
2003 0.10 0.24
2004 0.09 0.24
2005 0.08 0.16
2006 0.08 0.16
Jan-Apr 2007 0.08 0.14

In the case of Nifty, the IC at a Rs.5 million transaction, which used to be roughly 0.25% in 1996, had dropped to 0.2% in 2001 and has since dropped nicely to 0.08%. The IC for the Rs.2.5 million basket of Nifty Junior has dropped nicely from 0.24% in 2003 to 0.14% today.

The liquidity of Nifty Junior is thus roughly where Nifty was in 2001-2002. If Nifty futures succeeded in 2001-2002, then one precondition (adequate liquidity) is met by Nifty Junior today. These IC numbers appear to non-comparable because they pertain to different transaction sizes. While that's true, a Rs.2.5 million transaction size is ample from the viewpoint of an index arbitrageur seeking to achieve an accurate Nifty Junior program trade.

The bulk of the weight in CNX-100 is in Nifty stocks. So the IC of CNX-100 transactions will be a bit worse than that of Nifty : we might see an IC of 10 basis points for a basket of Rs.7.5 million. NSE says that a program trade for the 100-stock CNX-100 basket gets executed in under a second, so there is no practical impediment on doing direct spot-futures arbitrage for the CNX-100, if you wanted to.


Many interesting applications can be conjured for the new products:

  • At the simplest, if you are an index fund investor, you can go beyond the front-line bluechip stocks and buy Nifty Junior index funds, so as to delve into less liquid and smaller stocks.
  • CNX-100 is a more-diversified broad-Indian-index than Nifty. It would make a better proxy for broad market movements; it is likely to correlate better for most well-diversified portfolios. CNX-100 index funds would be better than Nifty index funds at catching the broad Indian market movements.
  • Mid-cap stocks (Junior) have differing fluctuations when compared with the front-line stocks. Some people have an interest in that price discovery and would be able to trade on it. A position that's long Nifty Junior and short Nifty would be focused on the difference between the movements of Nifty and the movements of this second tier of stocks.
  • Many stock speculators buy a stock and short the index in order to hedge against broad market movements. For many stocks, the correlations with Nifty Junior or CNX-100 are superior, so this application would work better by shifting away from Nifty. Sometimes, it may make sense to hedge a long position for a stock using positions on both Nifty and Nifty Junior futures. Here's a spreadsheet where, for many firms, we calculate the market model R2 for three cases: (a) Using Nifty alone, (b) using Nifty Junior alone and (c) using both. Here's an example from that file: Reliance Petroleum. Using Nifty alone, you have a beta of 0.58 and a market model R2 of 0.39. Using Junior only, you get to an R2 of 0.48 (with a beta of 0.52). You can do both: with a beta of 0.04 on Nifty and a beta of 0.49 on Nifty Junior, you get to a market model R2 of 0.48.
  • 37 of the 50 stocks in Nifty Junior, which make up 87.3% of the market capitalisation, have stock futures trading. So it'd be possible to do futures-futures arbitrage between Nifty Junior futures and stock futures, for the bulk of Nifty Junior. For the remaining 13%, it would be necessary to use the spot market.
  • With some cleverness, it should be possible to use a portfolio of Nifty futures, coupled with only a few stocks, in order to approximate Nifty Junior.
  • It is, of course, easy to construct arbitrage positions between Nifty, Junior and CNX-100 because the latter is just a weighted average of the other two. I would imagine that the bulk of CNX-100 futures pricing would be done by arbitrage which combines Nifty futures and Nifty Junior futures.
  • Index funds on both Nifty and Nifty Junior are available (JUNIORBEES, from Benchmark, is the ETF on the latter). They can be used for writing covered calls on both indexes. It is possible to put together a portfolio of the two, with a 13% weight on JUNIORBEES, and approximate CNX-100.

Candles of liquidity

Introducing a new product, and building liquidity in it, is like lighting a candle. We span new states, we obtain new information. But my intuition is that we jump from liquidity in one product to getting liquidity in a correlated product. It is difficult to light uncorrelated candles.

What we have in hand today is: Nifty futures plus 37 stock futures, and it is hoped that this will give liquidity in Nifty Junior. And if Nifty Junior becomes liquid, then CNX-100 will be just an easy arbitrage away. So these developments are a very interesting case of standing on the shoulders of some liquid products and pushing further into spanning new (yet not completely new) states. I had written something in 1997 about such a spiral of innovation which may interest you.

Today, in India, the indexation industry consists of:

  1. BSE Sensex and it's index funds
  2. Nifty and it's index funds
  3. Nifty Junior and it's index funds
  4. A bunch of ETFs on the above
  5. Exchange-traded futures and options on the above
  6. An OTC derivatives market on primarily Nifty outside the country.

If things go right, we will be able to add derivatives on Nifty Junior and on CNX-100 to this list.

While this will be a good situation in terms of the information produced through speculative price discovery, these markets are as yet inadequately liquid for the needs of the big portfolio hedgers. In an equity market with a market capitalisation of $1 trillion, a modest sized equity portfolio is $1 billion (such a portfolio manager owns 10 basis points of the broad market). Such a manager needs to be able to easily buy or sell $500 million (Rs. 2025 crore) of index futures, and occasionally be able to buy or sell $1 billion (Rs.4050 crore) of index futures. We're just not there yet. To get to this, index derivatives turnover would have to exceed a notional value of Rs.100,000 crore per day, at which point a person putting in a trade of Rs.2025 crore would account for 2% of the day's turnover.


  1. Nice write up Ajay...I believe nifty would still continue to dominate as far as volumes are concerned. Nifty Junior would take some time to get popular

  2. awsome site and awsome research ! first time visitor here but u will see more of me !

    Congrats for being blessed with such gr8 insight gujjubhai!


  3. Dear Ajay Shah,

    I am planning to invest only in Futures market. I am planning to do a SIP of 25% of contract value and buy Nifty-50 features every month for next 2-8 years. I am guessing the value might not below 25% than a one year average value, if I manage to the SIP with discipline I may not have any problem. I need to roll-over the features to far months every time, in such a way that I will have (long positions on) N contracts after N months.
    Do you expect any flaw in the idea?
    what is that?. Do you think one might end up paying more premium during roll-over of contracts than necessary? If you think this is a bad idea, please advice me of the consequences. I am putting all my savings into it.

  4. As an investment strategy, won't it be better to buy index funds regularly? The only case for buying Nifty futures (or nifty junior futures) is when (a) the basis is very low or negative and (b) the mispricing of the basis pays for all the transactions costs.

  5. To buy index funds, I will have to put 300% more than what I planned and the profit is likely to remain same. but what I couldnt control is my desire to get out in a falling market and the desire to book profit in raising market. Where as in stock positions i do keep a cool head as I forget the money invested. IN futures the fear of unknown is much more as I might loose more than what I can imagine as well as earn more.

  6. I am looking for a software which can calculate the correleation coefficient between any two stocks of the nifty. Can you helpme find one?



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