Mutual Funds Propose Fair-Value Pricing For Equity Futures

The mutual fund industry has proposed a change in the way equity futures are valued at market close. This proposal aims to reduce sharp and unpredictable swings in the net asset values (NAVs) of arbitrage funds.

Arbitrage funds manage around ₹3.5 lakh crore and typically buy shares in the cash market while selling futures contracts. The introduction of the Closing Auction Session (CAS) has created a timing and pricing mismatch between the cash and derivatives markets.

The CAS establishes cash-market prices, while equity futures continue trading beyond that period and use a separate methodology to determine their closing value. This can result in the cash and futures legs of an arbitrage position being marked at prices that do not accurately reflect their economic relationship.

Consequently, funds may report sizeable daily NAV gains or losses despite little change in the underlying arbitrage position. The industry has suggested calculating the futures closing price using a formula based on the CAS cash closing price and a predetermined cash-futures spread.

The spread could be calculated from the relationship between the cash-market VWAP and the corresponding futures price over a specified period before the close. The regulator and exchanges would need to decide the exact calculation method and time window.

Such a system could provide more stable NAVs and make entry and exit pricing fairer for arbitrage-fund investors. The proposal could also have wider implications for the derivatives market.

A mathematically linked closing price could potentially reduce the need for futures markets to remain open after the cash-market close. However, any changes would affect clearing, settlement, margining, and mark-to-market calculations, meaning exchanges and clearing corporations may need to revise existing frameworks.

The proposed changes are intended to align the closing mechanisms of the cash and derivatives markets. This would help to reduce the volatility in arbitrage fund NAVs and provide a more stable investment environment for investors.

The mutual fund industry's proposal is a significant step towards addressing the issues faced by arbitrage funds. It is expected that the regulator and exchanges will consider the proposal and work towards implementing the necessary changes.

In the long run, the proposed changes could have a positive impact on the mutual fund industry and the derivatives market as a whole. It could lead to more stable and predictable NAVs, which would be beneficial for investors.

The proposal is also expected to promote fairness and transparency in the market, which is essential for maintaining investor confidence. Overall, the mutual fund industry's proposal is a welcome move, and its implementation could lead to a more stable and efficient market.