The Hindu Business Line : Hedgers not daunted by cash-settled market

A RECENT article in a financial daily argued that derivatives cannot be used for hedging because they are cash settled. The article concluded that a delivery-based system would be a better market design for hedging purposes. Such a conclusion seems incorrect for two reasons. One, a delivery-based market design may also lead to imperfect hedge because of the high basis risk (basis is the difference between spot and futures price). And, two, the price risk is low for stocks in the derivatives segment.

Basis volatility: Hedge as a concept is typically used to protect near-term downside in a portfolio, and not for individual stocks. Typically, index futures are used for hedging a portfolio. Because all stocks constituting the index cannot be delivered, index futures world over have been traded in a cash-style market design.

But for the purpose of this article, we will assume that hedge is set up for individual stocks. Suppose an investor having 1,200 shares of Reliance hedges the position by shorting two futures contracts on that stock. Since each contract carries 600 units, the two contracts will fully hedge the spot position.

Assume Reliance trades at Rs 250 in the spot market and at Rs 255 in the futures market when the hedge is set up. After a while, Reliance declines to Rs 230 in the spot market and to Rs 235 in the futures market. The investor would have, hence, lost Rs 20 per share in the spot market, but gained Rs 20 per unit in the futures contract. The primary contention now is that if the investor chooses to sell the shares in the spot market, she may receive less than Rs 230 per share. The hedge is, hence, termed imperfect.

This argument is not, however, correct. Market players value assets after pricing-in all associated risks. If the short-sellers in the derivatives market are not required to deliver the underlying, the delivery risk is nil. This is likely to translate into lower basis risk; the basis risk will be primarily due to the presence of day-traders in the derivatives market.

The basis risk is, however, likely to be higher in a delivery-based marked design. Suppose there was number of naked short-sellers in the futures market on a certain trading day, the basis on that day may be high. This is because the short-sellers have to price-in the risk of having to buy from the spot market if futures are exercised against them.

By the same logic, basis may be lower on a trading day, when the delivery risk is perceived to be low. In other words, basis is likely to be highly volatile. This may lead to difficulty in setting up the hedge, for the correlation between the instrument to be hedged and the futures contract may be unstable.

This is not to suggest that a delivery-based market design is bad for hedging. The factors discussed above only go to show that that a cash-based market design does not discourage hedging.

Price risk: In this context, price risk primarily refers to the impact cost. This is the cost due to the adverse change in the stock price because of the change in the demand-supply conditions in the stock. Now, median quarter sigma rule is a primary criterion that SEBI applies to choose stocks for derivatives trading. This rule basically ensures that the stock price changes only if there is a large change in the buy-sell orders. The impact cost for these stocks are, hence, low.

Statistics show that Syndicate Bank has the highest average impact cost for stocks in the derivatives segment; its average impact cost is less than 0.50 per cent. That means that an order size of Rs 5 lakh will change the price of the stock by just 0.50 per cent. This is same cost that investors pay as brokerage for transacting in stocks. There is hardly any price risk for an investor wanting to offload the stocks in the spot market after unwinding the hedge. To conclude, a lower basis risk and price risk suggests that cash-style market design does not discourage hedgers.

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