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Monday, Nov 03, 2003

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Columns - Mark To Market

Shift volumes from futures to options

B. Venkatesh

THAT the Indian derivatives market has improved in volumes is indeed commendable. But a cause for concern is the discernible shift in the market structure — volumes in the options segment have fallen even as trading in the futures segment has improved. For instance, equity options as a percentage of total turnover in the derivatives segment fell from 23 per cent in April 2003 to 11 per cent in September. The problem is that futures are useful for price-betters while options aid hedgers. If price-betters move from options to futures, there may not be enough counter parties for hedgers in the options market. If this trend persists, the options market may well become dormant after a while.

Hedging: Options are typically suitable for portfolio hedging. The reason is that options cap the downside without limiting the upside potential. Suppose the Nifty spot index is 1500. A portfolio may be effectively hedged with, say, the November 1480 Nifty puts. The hedged portfolio is protected if the spot index declines below 1480. But this downside protection does not come at the expense of limited upside; of course, the portfolio will have to bear the option premium cost for enjoying a convex strategy.

Note that this strategy is sub-optimal only if the spot index remains at 1480 levels when the hedge is lifted. The problem with futures is that the payoffs are symmetrical. Hedging with futures essentially means that the upside is sacrificed. Of course, a portfolio can be partially hedged with futures to allow for some upside, but that would also mean higher downside.

Market shift: When volumes shift from options to futures segment, hedgers may not have enough counter parties. The consequences may be severe. When volumes decline, the bid-ask spread widens. Sometime back, the Reliance November 510 puts had a bid-ask spread of Rs 10. High bid-ask spreads not only distort price efficiency, but also dissuade hedgers.

Agreed, our derivatives market primarily consists of price-betters and not hedgers. But this discernible shift in volumes from options to futures will permanently prevent hedgers from entering the derivatives market. And that may not be good for the market as a whole. Why?

There is a two-way information flow between the derivatives and the spot market. Of course, it is moot as to which market is the price-setter. But it is safe to presume that the derivatives market is important for the spot market. And if the derivatives market primarily has price-betters, spot prices may be pushed away from the underlying fundamentals.

Suggestion: The primary reason for the dwindling volumes is the high bid-ask spread. This is because of the highly negative convex payoffs for option writers. The maximum gain for the option writer is the option premium; the maximum loss is unlimited. The negative convexity increases, higher the underlying volatility. Clearly, there is incentive for option writers to switch to futures in a highly volatile market such as now.

The workable solution is to have sub-segment market-wide limit. At present, the NSE provides a market-wide limit for each stock at the beginning of the month. This is the maximum number of contracts that can be traded during that month in each stock. If the open interest position crosses 80 per cent of this limit, margins double to prevent any systemic risk due to position defaults. Because price-betters favour the futures market, 70-85 per cent of the open interest position is in the futures segment.

The NSE should provide sub-segment market-wide limit. This suggestion no doubt goes against the grain of free market. The point is that option sellers cannot be given incentives to trade in the market. The concept of market makers may not work because such specialists may demand high bid-ask spreads to lower their inventory risk. A sub-segment market-wide limit will shift volumes from futures to options market. The higher demand for contracts will reduce the bid-ask spread. And that may, in turn, create more volumes, leading to a self-generating demand for options. That is when portfolio managers can cost-effectively hedge in the market.

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