Derivatives health-check

Mobis Philipose

Year 2002 has been a landmark year for the equity derivatives market in India.

Volumes in the derivatives market have jumped almost four-fold this year - from an average daily volume of around Rs 674 crore (Rs 6.74 billion) in December 2001, volumes have risen to around Rs 2,660 crore (Rs 26.60 billion) this month on the NSE.

Importantly, volumes on NSE's derivatives market now amount to around 85 per cent of the cash market volumes on the NSE, compared to less than 25 per cent a year ago.

With the regulator having cleared the way for exchanges to expand the list of stocks for derivatives trading, volumes will expand further and soon the equity derivatives market will be much larger than the cash segment in India.

But amidst all this excitement, one needs to keep in mind that the jump in volumes this year has been restricted to the individual stock derivatives market.

Incremental volumes on the index options and index futures markets have accounted for just two per cent and eight per cent respectively of the year-on-year increase in derivatives volumes.

And even within the individual stock derivatives segment, it's the stock futures market that has caught the fancy of market players.

While the stock options market has accounted for around 25 per cent of the growth, incremental volumes on the stock futures market accounted for over 65 per cent of the total increase.

Collectively, the stock futures and stock options markets now account for around 90 per cent of total derivatives volumes.

Furthermore, within this segment (stock-based derivatives, i.e.), around 75 per cent of the trading happens in the top five traded securities, and the top 10 traded securities account for around 90 per cent of the traded value.

Needless to say, these top few stocks are all stock market darlings such as Satyam, Infosys, Reliance and Digital.

These stocks are already very liquid in the cash segment, and it's not that the derivatives segment is imparting much needed liquidity.

In fact, the popularity of the individual stock futures market (65 per cent of total volumes) shows that the Indian derivatives market is primarily a punter's den.

Under the new eligibility criteria, the volatility and free-float requirements would be done away with, and hence there would be a large number of stocks that meet the new criteria.

What is unfortunate is that highly speculative counters would easily meet the new criteria. If one goes by the trend in the past, where derivatives trading has been restricted primarily to the Satyams and Digitals of the world, it wouldn't be surprising to see that among the new additions to the derivatives list, trading will be restricted to stocks like Zee and Wipro.

The regulator is also looking at doing away with the minimum contract size requirements. This would make the Indian derivatives market one of the most liberal in the world.

The sad part is that the average Indian trader is hardly as sophisticated as his counterpart in the rest of the world, especially in countries like Australia which also allows trading in single stock futures. The minimum contract size requirement at least ensured that only serious players were active.

As one market analyst puts it, "Such a move would only give small investors more avenues to lose money." Under the new regulations, the derivatives market is bound to grow at a fast pace, but it is not clear whether this will be in the long-term interests of the market.

Mispricing Interestingly, despite the high amount of liquidity in the futures market, the market is still inefficient in terms of pricing derivatives contracts. In glaring cases of mispricing, futures contracts trade at a discount to the cash market, and option premiums drop below their intrinsic value.

Taking advantage of such mispricings involve simple arbitrage strategies that can be executed in one-shot.

But it's often found that such arbitrage opportunities persist for extended periods of time, with no market player showing any interest in doing a simple and riskless arbitrage trade despite the possibility of large rates of return.

The primary reason why not much arbitrage activity takes place in the futures market, for instance, is because there are constraints on short sales.

If a trader shorts a stock, he has to have his shares ready for delivery on the settlement date. If he doesn't, there at least has to be a strong stock lending mechanism which can be used to deliver the shares.

But we don't have a strong stock lending mechanism, which means that the players who have a large pool of stocks in their portfolio (such as mutual funds) are best placed to take advantage of this opportunity.

But mutual funds hardly participate in the derivatives market currently because of the lack of clarity on what kind of positions they can take.

With new guidelines for mutual funds' participation in the derivatives market set to be announced, it makes sense for the regulator to clear the way for them to indulge in arbitrage activity.

Besides, arbitrage activity can require huge amounts of capital for a short period of time. Even as the arbitrageur waits for either the contract to expire or for the market to correct its pricing anomaly, it may so happen that the mispricing may worsen further.

This will require additional capital in terms of margin calls. With regulations that hinder loans by banks to arbitrageurs, funding is another problem area.

There are a whole lot more regulatory constraints like restrictions for brokers to do arbitrage transactions on behalf of their clients, and RBI regulations that hinder arbitrage by banks.

The lack of cross-margining between the cash and derivatives markets means that most times arbitrageurs are over-margined.

Considering that arbitrage positions are mainly riskless positions, paying a high amount on account of margins is meaningless.

Clearly, there are many things the regulator needs to sort out so that pricing on the derivatives market becomes more efficient.

In summary, even though volumes have grown manifold on the derivatives market, the way the market is currently pricing contracts suggest that the market is still in its nascent stage.

Much of the increase in volumes is speculative in nature and is restricted to stocks that are already among the top traded ones. It's issues such as mispricing and safety that the regulator should be more bothered about and not providing more avenues for traders to lose money in the derivatives market.

2002: The Year That Was

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