From THE HINDU group of publications
Sunday, September 09, 2001


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Where `discounted' futures may go

Anup Menon

M. S. Narasimhan

THE use of badla and index futures would have provided a drastic contrast had both products been available till July 2, 2001.

Had an investor or trader consistently bought index futures at the beginning of every month for 10 months starting July 2000, instead of carrying over his position using the badla route, the cost of carry under the futures is a negative 5.68 per cent, whereas the average badla rate was 11.6 per cent.

This indicates that carrying forward using the futures contract was more profitable as the spread between the costs of the two products (badla and index futures) would be around 17.28 per cent. The negative cost of carry could indicate the lack of interest in buying index futures unless it is offered at a discount.

Behind the discount

The question is why index futures should trade at a discount to the spot for such a long period. Arbitrage pricing theory is the theoretical framework under which derivative instruments are priced. According to arbitrage theory, in a frictionless market, and after accounting for transaction costs and taxes, if an investor is able to find underpriced/overpriced securities, he can make a riskless profit by selling the overpriced security and buying the underpriced one.

If this is the case, the persistent underpricing of futures cannot be explained. Theoretically, the underpricing would have been exploited by arbitrageurs selling the stocks that form the index and buying into the futures contracts. The absence of arbitrage to set right the price inefficiency requires further analysis.

There is limited scope to use the reverse cash-and-carry arbitrage strategy as there are restrictions on short sales in the spot market. Before the ban on ALBM/BLISS, the cost of borrowing stocks was high through ALBM/BLISS and, hence, it was mainly used by speculators who focussed on price direction and were willing to pay a higher cost for such a strategy.

There were also restrictions on institutional investors short-selling using the facilities of ALBM/BLISS. Thus, an investor with a bearish view on the market can take a short position in futures market. When the index futures market gets sellers, who are the buyers or counter-party to the sellers? Here, the broad market trends play a role.

The buyers would have, again, to be another set of speculators, but they are in a minority when scam after scam is hitting the market, leading to negative sentiment and wariness among the bulls. As discussed earlier, hedgers would find little use in index products for hedging and even if they want to use it, the prevailing bearish condition since the introduction of stock index futures would have prompted them to take short positions in the market.

When the sellers outnumber the buyers, the index futures price declines and, often, it goes below the spot value. Bears are willing to bet on their side of the market, particularly when they are prevented from going short in the spot market.

Regulatory restrictions must go

This difference can be set right by the arbitrage process but the existing regulation rules out such arbitrage opportunity. In other words, the negative price difference between the index futures and index value can be attributed to regulatory restrictions, or the cost of banning short-selling.

Where do we go now?

In sum, the futures market has really not been successful so far. The following are the key findings and the likely trends:

*Volumes have shown some signs of improvement but they have not really been significant.

*Given the relative composition of the index vis-a-vis the composition of some of the portfolios, index futures per se are not the solution insofar as hedging is concerned.

*Rather, futures/options on individual stocks would be a better option. Substantially good volumes in the individual stock options segment, which started trading in July 2001, evidence this.

*Since SEBI is moving towards individual stock futures while relaxing the constraints on short-selling, it is to be seen how the index futures market will behave in future.

*While removal of ban on short-selling would attract some interest on index futures, the introduction of individual stock index futures would attract speculators and, hence, have a negative impact on the volume of index futures.

*Given the dominance of speculators and their familiarity with speculating in individual stocks, index futures may die over a period of time.

*Stock exchanges may look into innovative ways for restructuring their index futures products by drawing lessons from the experience of Chicago Mercantile Exchange, at least to keep the interest of those who want to use index futures for hedging.

Section  : Opinion
Previous : Index futures -- Pricing glitches, flagging
Next     : Nifty, Sensex futures: Weak footing

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