What's going on with the index futures?

One of the serious occupational hazards of being an economist is being asked which way the stock market will go. This is something that is a pure mystery to almost everyone in finance, and economists are no exception. I have the good fortune of being routinely asked "What's going on with the index futures market?", a question where it is possible to come up with a good answer.

Index futures trading commenced in India in June 2000. The market has now been functioning for roughly eight months. In September 2000, Nifty futures started trading in Singapore.

Market activity. The market has now built up an outstanding position of roughly Rs.65 crore at NSE and Rs.40 crore at BSE. For the first 15 trading days of January, the trading volume averaged Rs.21.6 crore on NSE and Rs.10 crore on BSE. The highest trading volume at NSE, which was on 10 January, was Rs.42 crore. These are small numbers when compared with the immense trading which takes place on the equity spot market. Yet, if we sort individual companies by their trading volume on NSE, then the trading volume of Rs.42 crore would obtain rank 18.

The trading activity in Singapore has been erratic, but we often see larger trading volume and open interest for the Nifty futures trading in Singapore as compared with what we see on NSE. A note of caution: the contract size in Singapore is roughly five times larger than that on NSE, and the NSE contract is roughly 30% larger than that on BSE. Hence naive comparisons of the number of contracts (traded or outstanding) often give a misleading picture.

Initially, the activity on both NSE and BSE was concentrated in the near month. From November onwards, the liquidity at NSE has crept into the second month as well. If you watch an NSE F&O screen, you will see frequent refreshes of bid or offer for the near two months. The bid--offer spread on NSE is roughly 0.25% for the near two months and around 2% for the third month.

This choice between one--month or two--month Nifty futures is quite valuable for speculative and hedging users. In early February, users will have a choice of taking positions based on the level of Nifty on 22 February (the expiration date of the near month) or on 29 March (the expiration date of the second month). The fact that both contracts are liquid means that hedging and speculative users have a choice between adopting pre--budget or post--budget positions.

Patterns in pricing. The most remarkable thing about the index futures market so far is the lack of a clear relationship between the cost of carry on the index futures market and "normal" interest rates in the economy. This suggests that speculators and hedgers now dominate the ecosystem, and that the arbitrageurs have not yet understood how to engage in their trade on this new market. The commonest pricing error I have observed is futures prices which are too low. This suggests that the mutual funds have not yet figured out how to do "reverse cash and carry arbitrage".

A note of caution: the newspapers report the official closing prices of futures and of the index. The "arbitrage opportunities" present in these are somewhat illusory. In thinking about arbitrage, it is essential to look at the bid and offer prices prevalent on the futures market, and contemplate the riskless returns that could be obtained by placing limit orders on the futures market.

Intermediation. NSE has released some extremely interesting statistics about the firms which are participating in the market. Suppose we define an "active brokerage firm" as one which has done above Rs.1 crore of trading volume in a month. This number has risen from 21 firms in June to 36 firms in December. This tells us that when the index futures market started in June, just 21 brokerage firms were able to galvanise themselves to the extent of doing trading of atleast Rs.1 crore in the month. This number has risen by 71% to a point where there are 36 brokerage firms which did above Rs.1 crore of trading volume in December. (Data for January is not yet available).

Hence, for all practical purposes, knowledge about the index futures market is concentrated in just 36 pioneering brokerage firms. NSE's data also shows that the bulk of the trading volume originates from Bombay and Delhi.

These symptoms illustrate the biggest bottleneck faced for derivatives trading in any country: the gap in human capital. Until November 2000, most securities firms thought the index futures market was too small and ignored it. It is only after November that trading volumes have built up to a point where securities firms are now expending resources in building human capital, processes, etc.

The vagaries of pricing also link back to gaps in knowledge. There are embarassing arbitrage opportunities for mutual funds which understand "reverse cash and carry arbitrage". This is an extremely simple trading strategy where is like a "stock repo". The index is sold off today and bought back at a locked-in price at a future date. The funds are deployed into the fixed income market. On occasion, I have even seen negative interest rates on the futures market, which is like getting paid to borrow money! The fact that these opportunities have not been exploited for over a month suggest that this knowledge is not available in India's mutual fund industry.

Prognosis. All over the world, the establishment of liquidity in a young derivatives market is something that we only dimly understood. We do not quite understand why it was in November that NSE's second month went liquid: it was probably a combination of Nifty volatility and the steady increase in brokerage firms coming into the market. We do not know when NSE's third month will go liquid: this could probably happen when the number of active brokerage firms crosses 50, though a dose of index volatility would help.

The numbers seen today (mean daily volume of Rs.20 crore and open interest of Rs.65 crore) are large enough for numerous brokerage firms and investors to now start taking this market seriously. These numbers now justify investments in human capital and business processes which are absolutely essential for nontrival participation in derivatives trading. Hence I believe that we will now see a sharper growth rate of activity on the index derivatives market.

In India, we have seen only a handful of interesting market launches. OTCEI and NSE are two new markets where the experience of a market launch is now well understood. The index futures market is the first exchange-traded derivative in India, and the first interesting market launch after NSE got started (which was in 1994, a full seven years ago). Over the first eight months, this market has built up critical mass, and I now expect to see much sharper growth.

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