The Hindu Business Line : P-note holders in a tight corner

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P-note holders in a tight corner

Since most P-note holders would prefer to unwind their positions as close to the peak as possible, a concerted unwinding of offshore derivative instruments can transform the next market correction into a more long-drawn one.

Lokeshwarri S. K.

October 25, 2007, was the last day on which offshore derivative instruments with derivatives as underlying were issued by FIIs in India. Data released by SEBI (Securities and Exchange Board of India) as part of the discussion paper revealed that one-third of the FII inflows through the participatory-note (P-note) route came through these instruments. That corroborates the view of those who have been issuing warnings about the dire consequences of ‘hot money’ p ropelling the dizzy spiral in India stock prices over the last three months.

Run-up to the ban

Though issue of fresh P-notes on derivatives has been banned with immediate effect, the existing instruments have been allowed eighteen months to unwind. That could account for the hectic activity witnessed in the FII transactions in the derivative segment in the run-up to the SEBI board meeting on October 25.

FII turnover in the futures and options segment reached a record high of around Rs 35,000 crore between October 23 and 25 . This flurry of activity suggests that some external investors might have initiated positions that they intend to hold on for some time.

When the unwinding?

That brings us to the sticky question, how long will these investors hold on to their P-notes? The ban on these instruments has pushed those holding them into a corner since they cannot re-enter the Indian market through this conduit once they sell their existing contracts.

Since most would prefer to unwind their positions as close to the peak as possible, a concerted unwinding of these instruments can transform the next market correction into a more long-drawn one because, unlike on previous occasions, the number of aggressive bargain hunters would be fewer.

Post P-note ban

FII activity in the derivative segment has been rather subdued since October 26. This segment has recorded a turnover of around Rs 6000 crore, which is near the lower end of the monthly range. The FII open interest too is static since the commencement of the November series.

“I think the market is still in a reactive phase as there are lot of strategic decisions being taken by both P-note holders and issuers. There are issues in terms of interpretation of the directive.

Once these minor clarifications are frozen then the market would get into application phase of the SEBI order and that would reflect more permanent and perpetual change in FII behaviour,” says Mr Sandeep Singal from Emkay Share and Stock Brokers.

Low PCR

The immediate effect of the ban on offshore derivative instruments on futures and options is visible in the low Nifty put call ratio (PCR). The number of put options (right to sell) always increases when the index nears a significant milestone, as market participants turn cautious and hedge their equity holdings by buying put options.

But this time around, though the Sensex crossed 20,000 last week, the Nifty PCR is abnormally low, below 1.2. Restricting FII activity in the derivatives segment appears to have reduced the short positions in the market. This is not good news since short positions help the markets to bounce back from a correction. With reduced short positions, the recovery can only get delayed.

Mr Singhal too is of the opinion that banning P-notes on derivatives takes away flexibility of going short on Nifty or any single stock. “This is detrimental to those funds that deploy long/short strategy to make absolute returns from the markets.

It also hurts all those players in the P-note circle that were playing on the volatility instead of direction of the market by using Nifty options.

Further, the long only funds also were using Nifty to hedge/rebalance their portfolio and that is restricted now. So it’s unfair on such players. In absence of P-notes with derivatives as an underlying, it would be difficult to hedge their position.” he adds.

Indian stocks on other Exchanges

Most analysts however concur that overseas money that wants to participate in the Indian stock market could do so through other exchanges. “Nifty futures traded on the Singapore Stock Exchange can be used by P-note holders to hedge their long positions in Indian stock markets,” says Mr Anand Kuchelan of PINC Research.

ADRs and GDRs of Indian companies can also witness a surge in interest. According to Mr Singhal, “In the long run, SEBI’s move would improve quality of the capital flowing into the country with somewhat restricted flows.”

FII activity in the derivative segment shows that they have withdrawn in to a shell since the ban on P-notes on derivatives.

The ban has also imposed limits on the kind of strategies that they can adopt in the Indian markets.

Only time will tell whether this diktat by SEBI will be in the interest of the investors or whether it will help in ushering in a deep correction in the market.

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