The Hindu Business Line : A future for derivatives

THE SEBI decision to relax norms for introducing stocks in the derivatives segment is encouraging. Equally noteworthy is the measure to delink margin requirement from open interest position limits. But these norms are unlikely to change the structure of the derivatives market. This segment is likely to remain a traders' market unless SEBI introduces measures such as long-dated contracts and delivery-based market design to encourage hedging. Hedging is important because it aligns the derivatives market with the spot market, helping investors manage their portfolio risk better. That could lead to better asset price efficiency.

Why hedge?: At present, investment managers do not have products to control their portfolio risk. This leads to substantial erosion in portfolio value when the market tanks. Take mutual funds.

They build their portfolio from the same universe of stocks. Such a homogenous universe may have a telling effect on the net asset value (NAV) when asset prices decline. The reason is that all funds may want to offload a substantial proportion of their holding and move into cash. But such a move will lead to supply overhang in the market, causing asset values to decline further. The decision to move to cash will, hence, be counterproductive.

Importantly, the temporary supply overhang may cause discrete price jumps, forcing assets to trade far away from their perceived intrinsic value. Such distortions may cause problems in forecasting asset prices for technical analysts. Besides, such price jumps and resultant volatility may price away investors at the margin.

Hedging may help in this respect. If investment managers are able to control the portfolio risk through hedging, investors will be better served. Besides, the supply overhang in the market can be avoided. This can be lead to less discrete price jumps, helping in better forecasting decisions.

Current problems: At present, the derivatives segment caters just to traders who bet on the directional movement of the underlying. The primary reason is that the futures market is looked as a leveraged bet on the price movement. The options market hardly keeps pace with the futures market.

That is not surprising. Scalping trades constitute a substantial proportion of the trading in the derivatives market. Such trades are possible only with futures and not with options. The reason is that the payoff on scalping trades created from option positions is not attractive as the option delta is always less than one.

The broader issue is that the large directional bets on the price movements drives the derivatives market away from the underlying. This increases the risk for the hedgers. Take the Nifty futures. The change in basis during June-July between the July futures contract and the underlying spot index is very high. The standard deviation of the actual basis is 9.5 per cent, while the standard deviation of the change in basis is 32 per cent.

If an investment manager uses a hedge ratio based on the co-movements in the Nifty spot and futures prices, chances are that the high basis volatility could expose the hedged portfolio to higher risk. Another deterring factor is the non-availability of long maturity contracts. At present, contracts are available for three months. But the farthest month contract is never traded while the farther-month contract hardly attracts good volumes.

Suggestion: SEBI should permit stock exchanges to offer long-maturity contracts or, at the extreme, even `expiration-less' contracts. This will help portfolio managers buy or sell risk-control products to match their hedging horizon. These products should preferably be traded in a separate market with a delivery-based design. That would lead to a close relationship between the derivatives and the spot market, encouraging hedging activity.

Because hedgers will dominate this market, options may be a preferred product due to their convexity structure. There could some positive feedback in the short-term options market as well.

Suppose SEBI were to allow equity options with one-year maturity. By backing out time value and moderating the directional view and long-term volatility, traders can reasonably price two and three month options contracts that are currently available but hardly traded.

If volumes increase in the short-term options market, traders can use the prices to discern the likely future movement in the underlying. The derivatives market with the short-selling advantage may, perhaps, lead the spot market. All of this may, in turn, lead to better pricing of the underlying assets.

(Feedback can be sent to bvenky@thehindu.co.in)

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