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Sunday, September 09, 2001













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Index futures -- Pricing glitches, flagging interest


Anup Menon

M. S. Narasimhan

THE Indian futures market, though some 14 months old, has a long way to go before it can have a bearing on price formation.

Only when volumes increase and pricing efficiency improves will the product serve the purpose of hedgers and speculators.

This process could take quite some time given the present state of the markets. Individual stock futures and options may be preferred due to their proximity, in some form, to such earlier products as badla and ALBM.

Just contrast the picture here (even allowing for a recent start) with the US markets. In the US markets, futures trading is as dominant as regular trading on the stock markets. This helps investors manage risks better, though sometimes things go wrong too.

Last year saw the New York Stock Exchange (NYSE) clock volumes of about $10 trillion. At the Chicago Mercantile Exchange (CME), the volumes recorded in the S&P 500 index futures contract were close to 50 per cent of the volumes on the spot market at the NYSE. This is the most actively traded index futures contract in the world.

Add the volume levels of other index futures contracts, such as the E-mini S&P and the Nasdaq futures, among others, which are gaining in popularity among US investors and fund managers. And the total volumes in index futures contracts would be close to those in the cash market. This means the liquidity levels in the futures market are as high as in the cash market.

Marginal volumes in India

In contrast, the total turnover of contracts traded on the Nifty and the Sensex hardly crossed 5 per cent of the turnover in the cash market. The statistic holds good even after the abolition of the badla system and the transition to the current market systems.

For instance, on August 31, trading volumes in the Nifty one-month contract, the most actively traded among the six listed contracts, represented around 4 per cent of the volumes on the NSE.

Though the introduction of index futures was a step in the right direction, lack of interest in the market, even after 14 months of trading, is worrying. We examine a few critical issues tending to act as impediments to the growth of index futures.

Little to enthuse speculators

First, take the position of investors interested in index futures as a hedging instrument. Since very few portfolios of consequence actually track the index, the use of index futures for hedging is not very effective. Hence, it is perfectly logical for investors to demand products on individual stocks.

This would help them manage their market risk more effectively without getting into such complexities as hedge ratio or other neutralising strategies. While this could be the reason from the hedgers' perspective, what prevents speculators from entering the futures market?

Speculators' interest normally lies in a product with high volatility. A comparison of the weekly changes of the indices during the last 31 weeks (since January 2001) shows that the Sensex and Nifty have shown an average high-low range of 6.50 per cent, whereas a few frontline stocks have shown nearly four times the price changes compared to index (see Table).

For example, over the same period, Zee Telefilms and NIIT showed price changes of 25 per cent, and Digital, Satyam and HCL Info 20 per cent. In fact, among the 50 Nifty stocks, only SmithKline Beecham and Asian Paints have shown lower price variations during the period. Since the intra-week and intra-day volatility of individual stocks is much higher than the indices, the natural choice for speculators is individual stocks.

Hedgers/speculators shun futures

Given the dominance of speculators in the Indian market, when the carry-forward system was banned, where could they have possibly moved? We believe the speculators have, possibly, become day traders instead of moving into the index futures market.

When badla was banned in 1994, the weekly volume of Group A declined from Rs 1,000 crore to Rs 250 crore. A similar action by SEBI in 2001, with the additional burden of rolling settlement, affected volumes only by 50 per cent. After this initial reaction, volumes have improved further over the last two months.

The presence of day trading, facilitated by the computerised trading system, ensured good volumes even after the ban of badla and the ALBM. Since the speculators have moved from weekly trading to day trading instead of the futures market, the absence of speculators has had a negative impact on trading interest in index futures.

In other words, index futures neither provide a role for hedging nor do they attract the speculators. Given this apparent inefficiency in the product design vis-a-vis its effect on speculator behaviour, we believe the pricing of index futures could also be inefficient.

Logical reason for inefficiency

Let us take the case of Nifty. Given that the underlying asset base is the 50 stocks constituting the Nifty, any information affecting the value of any one or more of the Nifty stocks should have the same impact on both the Nifty and the futures contract on the Nifty.

As the value of both assets is affected by the same fundamental factors, the technical differences in terms of investing in futures and the spot market leads to pricing inefficiency. The price difference can be attributed to opportunity income on lower investments, dividend and transaction costs (see `Pricing of Index Futures' for details).

This, assuming that the above factors determine the price of the futures contract, futures should normally be priced at a premium to the spot, with the values converging as the expiration date approaches. But the reality in the 14 months trading has been different.

Reality is different

Surprisingly, the price history of the indices and the index futures (both Nifty and Sensex) paints a different picture. Several anomalies have been noted, and are listed below (see also accompanying story `Why futures are at a discount'):

*We observed that of the 247 days of trading data available, the closing price of Sensex one-month future value is less than the spot value of Sensex in 135 days. Nifty one-month futures were less than Nifty spot on 132 out of 238 trading days. Strangely, value of the two-month index futures is also less than the spot in more than one-third of days.

*Of the 247 days in the sample data on which the Sensex one-month contract was traded, the annualised cost of carry is positive for only 112 days. (The cost of carry, in rough terms, factors in the opportunity cost for the investor by dividing the futures price by the spot.) On the remaining days, the cost of carry is negative. In the one-month futures contract on the Nifty, the cost of carry is positive for around 106 days out of the sample data for 238 days.

*This evidence suggests that there is a significant element of mispricing in index futures contracts. The one-month contracts were chosen as they are the most liquid. Hence, we feel that the result is applicable for the two-month contract also.

*The average cost of carry on the Sensex and the Nifty during this period works out to around 7 per cent and 4.2 per cent respectively. However, the series is highly volatile, as indicated by the standard deviations of 232 per cent and 233 per cent respectively.

*Cost-of-carry figures show abnormal values, as in call money rates, during the last few days of the month. One possible explanation is that the holders of index futures usually liquidate their positions on the last few days, and there is a lack of buyers of that month's future on those days. If this explanation is right, it is a major anomaly in the index futures, particularly when holders of futures can avoid such losses by allowing the open position to lapse and pay the difference between the spot and futures prices.

(M. S. Narasimhan is Associate Professor, Finance and Control, Indian Institute of Management, Bangalore.)


Section  : Opinion
Next     : Where `discounted' futures may go

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