The Hindu Business Line : Three years of equity derivatives: My money, my play

We may never modulate the "boom and bust" cycles of our capital markets... US investors have every right to expect that the system of SEC-registered, exchange-traded equities can weather such cycles without significant companies "melting down" due to failures of diligence, ethics and controls. Thus, the NYSE is committed to strengthening that system by drawing lessons from those failures and assuring that shareholders, directors, officers, employees and outside professionals are empowered and encouraged to discharge their responsibilities — and are held accountable if they do not.

— From the report of the NYSE Corporate Accountability and Listing Standards Committee, submitted to the NYSE's board of directors, June 6, 2002.

FINANCIAL economists have explained data availability as the result of the willingness of successful societies to discuss successes and the intense desire of other societies to hide failures.

Successful countries, companies, regulators and exchange-traded marketplaces willingly make available a large amount of data.

Financial economists hypothesise that others — the less successful and the unsuccessful — will prefer to indulge in the concealment of data.

If financial analysts have begun to discuss India's equity derivatives markets, it is because equity derivatives have succeeded stunningly in India.

Not `My money their play'

The reason for the splendid performance of stock derivatives: stock futures and stock options permit investors and market participants to regard financial events as `my money, my play' events.

Badla too vigorously promoted the `my money, my play' attitude towards stocks.

By contrast, stocks require investors to regard and accept financial events as `my money, their play' events. Why?

Shareholders invest in companies, but corporate managers will decide what the companies would do with other people's money.

When market participants choose to hold positions in equity derivatives, the flow of financial resources is from one market participant to another or to a clearinghouse, or both.

Margins, mark-to-market gains and option premiums constitute the financial resources. Companies and corporate managers do not gain access to these financial resources. Quite clearly, the `control' over other people's money stays outside companies.

Control does not get transferred to corporate managers. So, some thoughtful and influential market participants may have asked if it would not be more rewarding to choose `my money, my play' and be out of the reach of `my money, their play' situations.

They may have asked why they should make significant investments in companies and then worry if managers, directors, accountants and auditors of these companies would do a clean, professional job, 24x7 round the year.

Merit of detachment

Stock futures and stock options permit investors and market participants to detach themselves from the failures of corporate diligence, ethics and controls.

The success of stock futures in India and the swelling volumes show that some large, influential market participants are no longer keen to invest in some companies and then worry if these companies would stand by their shareholders.

These market participants have immunised themselves from the whims and preferences of corporate managers. The ever-rising open positions in stock derivatives, especially futures, show that some market participants have signalled their resolve to release themselves from the grip of companies and corporate managers that may choose to thrive in `their money, my play' situations.

Powerful features

The specific focus is on stock futures, but some or all of the arguments apply to stock options as well.

First, stock futures allow market participants to be in full play in the context of information pertaining to corporate performance, earnings and cash flows.

Second, market participants choose to be fully exposed to the business risks of the companies whose stocks are the underlying assets in stock futures.

Market participants are fully exposed to the `absolute price of risk', the `relative price of risk vis-à-vis the broad market' and the `payoffs from bearing risk'.

Third, stock futures allow participants to voluntarily choose the full play in the context of corporate performance, earnings and cash flows and the risks thereof without their having to transfer financial resources to acquire shares of companies. That is, longs in stock futures successfully avoid becoming shareholders. Therefore, they voluntarily forfeit the right to vote and the right to participate in the governance of companies.

Fourth, stock futures allow the whole market as well as individual participants to choose finite-period engagements with corporate performance, earnings and cash flows and the risks thereof.

Going à la carte

Stock futures empower market participants to selectively engage themselves in the pursuit of profits based on their expectations of corporate performance without having to make investments in stocks.

Thus, distant outsiders become intimate insiders in the context of corporate performance, earnings, cash flows and risk.

But they are not free riders and freeloaders. Why?

In order to become intimate insiders, they pay margins or option premiums.

And they gain when their expectations of corporate performance come true. They lose when their expectations do not come true.

But these intimate insiders have gone a la carte by dissecting through the full menu and leaving out some 'frills' that they have no use for, and for which they have no inclination to pay. The first frill is ownership of the financial claim.

The second frill is the voting right that could cause a change in the composition of management and the focus of corporate governance.

The third frill is the infinite life of the financial claim, and the right to cause a change in managerial composition and focus.

Pundits' predictions

The phenomenal success of stock futures has upset the traditional thinking among domestic opinion-makers.

They had asserted for long in convincing prose that index derivatives would be more suitable than stock derivatives.

They had argued that India had a reputation for stock price manipulation and irrational, suicidal speculation in particular stocks.

They said index derivatives would be apt. But stock derivatives have steamed ahead of index derivatives. The score: 85-15!

(The author is a financial analyst. Feedback may be sent to markets@prosyslab.com or indiagrow@sify.com)

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Three years of equity derivatives: My money, my play