Why Index Derivatives Matter

Financial derivatives -- such as futures or options -- are a powerful new technique through which hedging, speculation, investment and arbitrage takes place in a modern economy.

On the equity market, whenever derivatives are contemplated, the most natural and easily visualised kind of derivative product is options on individual securities. For example, the market could trade options on Reliance. These directly tap into the widespread interest in speculation in India. If a speculator thinks that the price of Reliance might go up, instead of buying the shares of Reliance, he can buy ``call options'' -- these ensure that he enjoys upside risk (i.e., profits if the price does go up) without downside loss (i.e., no further payouts in case the price does not go up). Conversely, a speculator who is bearish about Reliance could buy ``put options'' -- these would yield a profit if the price of Reliance drops, with no further payouts in case this fails to materialise.

Given the existing widespread interest in speculation at the security level in India, it is very easy to visualise derivatives on individual securities being quite successful. Indeed, given the widespread interest in security-level thinking in the country, the concept of index derivatives is often treated with puzzlement or incomprehension.

However, the major focus of the equity derivatives industry worldwide, is on index derivatives. Internationally, trading volume on index derivatives is often a hundred times larger than that seen on security--options. In India also, the major focus of NSE's upcoming Futures & Options market is on index derivatives. Why are index derivatives so important?

The Index is Pervasive

Index derivatives are a powerful tool for risk management for anyone who has portfolios composed of positions in equity. Using index futures and index options, investors and portfolio managers can hedge themselves against the risk of a downturn in the market when they should so desire.

For example, for many investors, the volatility associated with the budget might not be a ride that they wish to bear. Today, in the absence of index derivatives, the investor has only one alternative: to sell off equity, and move into cash or debentures, prior to the budget. Roughly a month after the budget, after the budget-related volatility has subsided, these transactions could be reversed, and the person would be back to the original equity exposure.

This is expensive in terms of the transactions costs faced in selling off a significant amount of equity. For retail investors, the total cost of this two-stage process could be around 5%, a high price to pay for the privilege of avoiding budget-related volatility.

Using index futures, the same objective would be accomplished at around one--tenth the cost, or less. Using index options, a very interesting kind of ``portfolio insurance'' could be obtained, whereby an investor gets paid only if the market index drops.

These are unique and new forms of risk management in the country. They are particularly appealing because the market index is highly correlated with every equity portfolio in the country. By the time a portfolio contains more than 15 stocks, it is very likely that the correlation between this portfolio and a market index like the NSE-50 would exceed 80%. This property holds, regardless of the identity of the securities which make up the portfolio: whether a person holds index stocks or not, the index is highly correlated with every portfolio in the country.

This fact is quite apparent when we look back at the experience of 1995 and 1996 -- every single equity investor in the country experienced poor returns in that period, regardless of the kind of portfolio owned. This widespread correlation of the risk exposure of investors with the index makes index derivatives very special in their risk management.

One example will help clarify matters. Suppose a person is long ITC. Unfortunately, by being long ITC on the cash market, he is simultaneously long ITC and long index (ITC and the index have a 65% correlation). I.e., if the index should drop, he will suffer, even though he may have no interest in the index when forming his position. In this situation, this person can match his ITC exposure with an opposing position using index futures (i.e. he would be simultaneously long ITC and short index futures) which effectively strips out his index exposure. Now, he is truly long ITC: whether the index goes up or down, he is unaffected, he is only taking a view on ITC. This is far closer to his real interests and objectives, and is much less risky than present market practice (i.e., a pure long ITC position).

The index is hard to manipulate

Derivatives in individual securities are vulnerable to market manipulation. For example, a person might first buy call options on ACC and then try to manipulate the price of ACC to make it go up.

This is, in principle, possible for the index also. However, the index is a large, well-diversified portfolio, and manipulation of the index is much harder, and requires much larger resources. The market capitalisation of the NSE-50 index today is around Rs.200,000 crore. It is more difficult to manipulate it today as compared with any individual security in the country.

Index derivatives go along with interesting investment strategies

Index funds have now started appearing in India; internationally, it is common to see 30--40% of all professionally managed funds being in index funds. Index futures are an invaluable tool for running index funds: when index futures markets exist, it becomes easier to run index funds, which yield returns that are highly close to the returns of the actual index. Similarly, index options are useful for interesting new products like ``guaranteed return funds'' (e.g. an index fund bundled with portfolio insurance in the form of a put option on the index) or ``equity-linked bonds'' (e.g. an instrument which is 95% invested in a straight bond, while 5% is invested in a call option which sharply benefits from the upside potential of the market index).

Index derivatives support index forecasting

Today, a good deal of trading volume on the market is composed of people who are taking a view on the index -- this is implemented using portfolios of two or three stocks. E.g. portfolios of Reliance, TISCO and SBI are often used to be a proxy for the index. Index derivatives will directly give people a mechanism through which a view on the index can be implemented on the market. This will be a spur for research and analysis devoted to understanding and anticipating movements of the market index.

Index derivatives are cash settled

Index derivatives are cash--settled, which means that no delivery of securities is made. In an environment where the depository has not yet come to dominate all settlement, this is a considerable advantage over any transactions involving securities.

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