Equity Derivatives in India: An Interview

What is the status of futures and options on the equity market in India?

In April 1996, NSE was mostly ready to launch an index futures market. In November 1996, SEBI constituted the L. C. Gupta Committee in order to draft a policy towards these markets. This committee has made some progress towards creating its report. It is likely that by late October, the work of the committee will be complete. After this, SEBI will have to take this matter to the SEBI board. Once the SEBI board gives its approval, NSE seems to be ready to launch the market.

How will this market trade?

The market will trade in the index, on future dates. For example, an investor will be able to buy Nifty for delivery on 31 Dec 1997, or sell Nifty for delivery on 31 Dec 1997. Just as an investor goes up to the NSE screen and buys Reliance, he will be able to go up to the NSE screen and buy "31 December Nifty" which will be traded on the screen just like Reliance is.

What do you mean by "buying Nifty"? Does the seller have to deliver all fifty shares?

No, the index futures market settles by exchanging cash. For example, if someone buys 31 December Nifty for 1100, and on 31 December itself Nifty has gone up to 1200, then the buyer gets Rs.100 from the seller.

Once a person buys the 31 December Nifty, does he have to be a buyer in the market till 31 December?

No, squaring off transactions are perfectly possible. You can buy 31 December Nifty today, and sell it off anytime on or before 31 December, and obtain the profit or loss from the position. There is much more time available for squaring off transactions in the futures market than is seen with weekly settlement on the present cash market.

What about other delivery dates?

Multiple delivery months will all trade at the same time. So the user will have a choice of buying Nifty for delivery on 30 September, or 31 October, or 30 November, or 31 December. All four "Nifty futures" (as they are called) will trade separately with distinct prices. These prices will be determined solely by supply and demand -- so if there are many buyers for 31 December Nifty, then its price will rise.

So can anything happen to the prices? Can 31 December Nifty rise to a price of 2000?

Arbitrage is the key to holding prices in check. If you go to the screen and see 31 December Nifty trading for 2000, then you could (a) sell 31 Dec Nifty, and at the same time (b) buy the shares in Nifty on the cash market. This would earn you profits without any risk.

Such activities would produce fair prices on the futures market. Hence futures prices do depend solely on supply and demand, i.e. the exchange or SEBI have no role in setting the price, but effectively arbitrageurs will produce "sensible" prices.

Why is this so exciting for lots of people?

The index is the one pervasive influence on all equity portfolios. When the market index goes up, all equity portfolios in the country tend to do well, and vice versa. Recall in 1995, when the index had done poorly, every single mutual fund in the country also obtained poor returns: there was no investment strategy which could escape the downward movement of the index.

Many people in India like doing speculation on individual stocks. The commonest nightmare of a stock picker is to see stock picks go wrong because of index fluctuations: you may be right in being long ITC but your position may make losses because the index falls.

If the index is so pervasive, and if fluctuations of the index are unpleasant to so many people, then there has to be a way to protect oneself against these movements. Index futures are the answer. If you are long ITC, then you should simultaneously be short Nifty. Your position would then focus on the performance of ITC and be unaffected by Nifty. Conversely, if you are short ITC, then you should simultaneously be long Nifty.

The real importance of this reasoning is that it works at the level of an entire portfolio, and not just for individual stocks. If a budget announcement is coming up, and you are afraid of index volatility then you can neutralise your index exposure using index futures. This way, for the few weeks of high volatility, you are "out of the market". This is a far cheaper way to be out of the market as compared with distress selling of your portfolio, which is the only option available today.

Who are the users of the index futures and options market going to be? Will it interest individuals also?

Large institutions would obviously find index futures very interesting to hedge their exposures on the market (e.g. my budget example above). Individual investors can also use the market in the same fashion. If you have a portfolio and are afraid about what will happen on the market on the next three months, then sell the three month Nifty futures. The futures position will pay you money if Nifty drops in the coming three months.

All stock picking and stock speculation will face reduced risks once Nifty futures become available: this is like my ITC example earlier. Hence every stock picker or stock speculator in the country will be a user of this market.

Around times of political events or budget announcements, when the index is fluctuating, speculators can take positions on future index movements using the index futures. If you think the index will go up, buy the futures. If you think the index will go down, sell the futures.

What is rolling settlement, and why does it matter?

Under rolling settlement, the spot market becomes more like a true spot market. All open positions at the end of Monday turn into delivery or payment on Thursday. All open positions at the end of Tuesday turn into delivery or payment on Friday.

The concept of a settlement period is actually like a futures market. The "squaring off" trading that we see today within settlements would only be possible intraday with rolling settlement.

Rolling settlement would eliminate the glitches in price which we see today: on NSE the price jumps up on Wednesday and is lowest on Tuesday. These patterns deservedly belong on futures markets, not on the cash market. There is no reason why Reliance should be more valuable on Wednesday than on Tuesday. The spot market should reflect the true valuation of companies, without this kind of noise.

Rolling settlement is a very healthy form of organisation of the cash market. It is the international standard for operation on the cash market. Rolling settlement is desirable. The ideal long run scenario on India's capital markets should be one where the cash market uses rolling settlement, supplemented by borrowing and lending of shares and funds, and the derivatives markets exist in parallel.

Why does the L. C. Gupta Committee require transition into rolling settlement as a prerequisite for launching the index futures? Won't that greatly delay matters?

The committee has not said that the transition into rolling settlement is a precondition for launching the index futures market.

India's reforms of the capital market have made tremendous progress since 1992, with the introduction of screen based trading, strict weekly settlement, and superior methods in clearing and settlement. If these reforms had not already taken place, we would not be here, talking about derivatives today.

The next batch of reforms that are now needed is to move all settlement into the depository, to create facilities for borrowed shares or funds on the cash market, and to require that all cash market trading is done using rolling settlement. The draft report created by Dr. Gupta merely seeks to highlight this fact.

How do people working with squaring off trading or badla get ready for this world?

The line operators of today are well placed to be arbitrageurs of tomorrow. The people doing index speculation at times like budget announcements would obviously benefit when a tradeable index is given to them. The badla financiers of today will be able to lend funds or securities into the index futures market (by collaborating with the arbitrageurs).

Leveraged speculation, where a person puts in small funds to take large positions, is possible in a safe and convenient way using futures or options. These traders would do well to switch their activities into the futures market, which (they will find) is better suited to their needs than the cash market.

These new approaches will help people to better cope with the gradual phaseout of badla and of weekly settlement, which is quite likely to take place in the coming years.

What about options?

The committee feels that after the index futures market stabilises, other instruments would follow. Index options are obviously a very valuable financial instrument. You should come back and talk with me about them in a few months!

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