Turbulence on the equity market

The worldwide volatility on the equity market on 28 and 29 October was particularly remarkable from India's perspective. This was the first episode of spillovers of foreign volatility into the Indian equity market. In earlier days, India's markets were highly insulated from worldwide shocks. In October 1987 and 1989, months of high market volatility in the US, there was no impact upon the Indian equity market. The experience of last week would suggest that the correlation between Nifty and the S&P 500 is now greater than what it once used to be.

One immediate conclusion which is often heard is that this is a new source of volatility on India's equity market; that this makes India's equity more risky than it might otherwise have been. This conception is incomplete. While globalisation increases the correlations between equity markets worldwide, it also yields a reduced vulnerability in India's equity market to domestic fluctuations. Foreign investors are a stabilising factor in India's market in many ways, as is evidenced by the positive FII inflows into India in each of the last 50 months. In an increasingly integrated world economy, two opposing forces are at work: India's financial instruments have reduced vulnerability to domestic shocks and increased vulnerability to international shocks.

Fears of enhanced volatility on India's markets are hence somewhat off track. The most important consequence of an increased correlation between the NSE--50 and the S&P 500 is a reduced attraction of India as a destination for foreign investment. International investment has grown enormously over the last twenty years as investors have tried to obtain diversification, and a reduced exposure to the US equity market (the largest equity market in the world). International diversification yields superior risk--return tradeoffs for the investor.

However, spreading a portfolio over many assets yields the best reduction in risk when the assets are less correlated. If ITC and TISCO were highly correlated, then portfolios formed from ITC and TISCO would be no less risky than either stock in isolation. However, if ITC and TISCO fluctuate for different reasons, then investors obtain superior risk--return tradeoffs by forming portfolios which combine the two stocks.

This argument applies for all kinds of diversification: across stocks, industries, or nations. If India and Bangladesh are highly vulnerable to the same monsoon, then diversification between Indian and Bangladeshi stocks would yield small reductions in risk. The major attraction of investing in India, all the way upto two weeks ago, was the near--zero correlation between India's market index and the S&P 500. This near--zero correlation could not last indefinitely: India's globalisation on both product markets and financial markets was bound to yield higher correlations. We are now at the onset of this process.

Globalisation has a remarkable implication for the valuation of Indian securities: Indian stocks which are less correlated with world fluctuations require a lower cost of capital. This is in contrast with an isolated India, where the risk generated by a stock was measured solely using the correlation with Nifty. Analysts in India should now be increasingly concerned about the beta of Indian stocks against world market indexes.

Even if the correlation between the NSE--50 and the S&P 500 rises above 0, this does not mean that FII inflows will fall off sharply. As long as the correlation is below 1, diversification using investment in Indian equity will be useful to foreign investors. In addition, the correlation between India and the US is amongst the lowest seen among all emerging markets. What is new is that the early phase of a near--zero correlation seems to have ended.

What are the implications of this for India's economy, and what actions can India undertake in order to better cope with these challenges? Three major issues can be isolated:

I. Risk needs management

Where there is volatility, there is a need for financial instruments which help individuals in the economy control their exposure to price fluctuations. The development of markets for financial derivatives in India would enable such risk management in India, in contrast with the present situation where economic agents in India have no hedging mechanisms.

In the equity market, the pre--Diwali volatility has served as a textbook example of the importance of index derivatives: when Nifty moved by 8%, every equity portfolio in the country was affected. The risk that derives from individual stocks can be eliminated by diversification. However, diversification cannot eliminate exposure to the market index; it is only futures and options on the market index which enable risk management at the level of equity portfolios.

The pre--Diwali volatility was essentially index volatility: if index derivatives had existed in India during these volatile days, they would have been intensively used for both hedging and as a vehicle of price discovery.

II. India's investors should look beyond India alone in risk management

The focus of the institutional development of India's derivatives industry has been derivatives based on the equity index and the dollar--rupee. However, in a world where Indian firms and individuals are exposed to risks which are already addressed by financial derivatives available offshore, there is every reason to benefit from using these.

An important payoff from capital account convertibility is hence the risk reductions that Indians can get, using foreign derivatives markets. Obvious examples of these are futures on the S&P 500 index or on US treasury bills, but other examples abound. The most liquid wheat futures market in the world is found in Chicago. As liberalisation in agriculture comes about, equalising Indian wheat prices with world prices, this is one of the best risk management alternatives for India's wheat economy.

III. Trading hours in India should be extended

In a world where news of material significance to Indian stocks breaks outside Indian working hours, the price discovery on India's markets (which only function in daytime IST and are closed on Indian holidays) risks being disrupted. Positions adopted in trading time, which cannot be modified when news breaks offshore, increase the likelihood of payments crises.

One clear improvement which can be obtained is for India's stock markets to run an additional evening trading session. Markets in India should have the main trading session from 10 to 3:30, and then reopen for a second session from 6 to 8. The evening session presents some difficulties with clearing and settlement, but these can be readily overcome by merging all trades of the evening session with the main trading session of the next day.

The advantage of the evening session is that it better overlaps with trading hours on European and US markets. On days when significant news does not break on these markets, the evening session would be inactive. However, on days of turbulence on international markets, the evening session would be of vital importance to Indian users of the market.

The securities industry worldwide is increasingly moving towards `round the clock trading', with financial instruments being traded 24 hours a day in markets around the world. The Globex system of the Chicago Mercantile Exchange supplements the daytime (floor--based) trading of the CME with electronic trading in off hours. The evening session that is proposed here would be a step towards such round--the--clock price discovery.

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