Excitement in equity derivatives

When does a new financial market take off? This is always hard to predict. Initially, it takes time for infrastructure to fall into place - distribution, knowledge in the minds of market participants, backoffice capacity, etc. Through this period, we have slow growth. Then, sometimes, we get a trigger which is a sharply defined event where the new market is the right answer to the needs of a lot of people. At this point, the market grows dramatically. Once the market comes into prominence, many new economic agents come into intermediation, trading, etc. and this fuels further growth.

The attack on 11 September in the US will be remembered as the trigger where the Indian equity derivatives market took off.

The index futures market had begun in June 2000, and one year later index options and stock options trading had also commenced. These markets had small absolute numbers and high growth rates of 20% per month or so.

When the WTC attacks took place, the most important central question was the impact on overall Indian equity valuation, i.e. the impact on Nifty. For many, speculation and hedging using Nifty proved to be the right tool which they could utilise at the time. This led to a large spike in activity on the equity derivatives market.

Liquidity. On a typical day now, the near index futures contract has a bid/offer spread of 10 paisa or 0.01%. That is, the market impact cost for small transactions works out to 0.005%. This is the highest liquidity seen for any traded product on the Indian equity market.

A derivatives market is said to have succeeded when the liquidity on the derivatives market is superior to that of the spot market. For small transactions of Rs.200,000 to Rs.600,000, this condition now appears to be met by the index futures market.

As of today, options are enormously inferior in liquidity when compared with the index futures. Bid/offer spreads on the options range from 3% to 25%. This seems to reflect poor knowledge and IT systems on the part of market participants.

Turnover. While market liquidity is important to the Indian economy, which cares about transactions costs, turnover is supremely important for market intermediaries, who derive revenues off turnover. NSE's derivatives turnover rose from Rs.785 crore in June, to Rs.2031 crore in July, to Rs.2697 crore in August, to above Rs.6,000 crore in September. On many days, Nifty was the most-traded underlying in the country.

There are three competing markets in the index futures game: NSE, BSE and SGX (in Singapore). In November and December 2000, SGX was the largest market. However, in 2001, NSE has decisively pulled ahead.

Turning to the options, the typical values seem to be around Rs.30 crore a day for Nifty options, and Rs.120 crore a day for all the stock options put together. Options are traded on 31 stocks, so the turnover on stock options is diffused over a larger number of underlyings. However, the most-traded stock tends to have turnover and spreads which are comparable to Nifty.

If we count trades, NSE is now at roughly 6000 to 9000 trades a day. This corresponds to a remarkable trading intensity of one derivatives trade every two to three seconds on average. The mean transaction size seems to be around Rs.350,000.

Pricing. When we discuss pricing of index futures, we talk about the implied interest rate in the futures prices. Similarly, when we discuss pricing of options, we talk about the implied volatility that is embedded in the observed option prices.

Interest rates on the index futures market have fluctuated significantly. However, there is a broad regularity that when the interest rates are "too high", they tend to get plucked off by arbitrageurs, since the arbitrageur has to deploy funds, which are easily obtained. When the interest rates are "too low", arbitrage is harder since the arbitrageur has to have a basket of the Nifty stocks. Every mutual fund and every FII has these baskets, however they have clearly not been in the market performing this arbitrage function.

On the options market, implied volatilities have moved around dramatically. Before the WTC bombings, the typical implied volatility on Nifty that was visible on the market was 10% to 13%. On 12 September, there were options being traded at volatilities above 40%.

We are now starting to see a new breed of speculators who work on forecasting and taking positions on volatility. The options market makes it possible to express views on volatility without having any view on the underlying. For example, a person who believes that WTC is behind us, and that volatility will now revert to normal levels, will sell the call option at 900 and the put option at 900. This position is a bet that volatility will go down while being agnostic about whether Nifty will go up or down.

Implied volatilites on individual stocks are obviously enormously higher than those seen on the index. Broadly speaking, this makes stock options costlier than index options, and serves to increase margin requirements for sellers of stock options as compared with sellers of index options. For example, on 7 September, when implied volatility on Nifty options was between 10% to 13%, the implied volatility on Satyam options was 45% to 65%.

Intermediaries. NSE's data shows that roughly 100 brokerage firms were active in August, in the sense of having derivatives turnover of above Rs.2 crore in futures and options. This number has probably gone up to above 200 in September, given the enormous increase in turnover and levels of interest in the market.

Some important brokerage firms have reached a point where over half their aggregate revenue is now coming from derivatives brokerage. This is a very important turning point for the broker. At this point, the brokerage firm sees derivatives as it's main business, and spot market brokerage as a side activity.

Looking forward.

In summary, the equity derivatives market has shaped up as one more success story where an open market design has harnessed Indian retail order flow from all around the country. It is a reminder of the enormous vitality and innovation that is found with the retail segment of the market, in contrast with the south Bombay institutional community.

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