The Hindu Business Line : Derivatives: Contracting the contract size

THE size of the derivatives contract traded on the NSE has been revised with effect from April 1, 2005, as most contracts have exceeded the minimum value of Rs 2 lakh. The NSE should go a step further and halve the minimum value to Rs 1 lakh. That will enable traders and small investors take advantage of mispricing in assets beyond the no-arbitrage bounds. It will also deepen the futures market, leading to narrower bid-ask spreads. Then, there would be a compelling reason for the stock exchange to introduce long maturity futures contract. Besides, option-based hedging would become less costly for small investors.

No-arbitrage bounds: The cost-of-carry model suggests that futures price should be higher than the underlying, except when the latter carries dividends or other corporate actions such as bonus and rights. The premium over the underlying is essentially the interest cost. The actual carry cost is of course governed by the demand and supply for each contract.

Typically, arbitrage opportunity exists when futures trade beyond the no-arbitrage bounds. That is, futures trade at a significantly higher price to the underlying after adjusting for interest cost, brokerage and trading costs. Traders can then buy the underlying and sell futures.

If the differential does not narrow during the contract life, the position can be held till maturity, when futures price will converge with the underlying. Note that reverse arbitrage is not possible because shorting in the spot market is not permitted.

At present, small traders and investors cannot engage in arbitrage because the contract size is still large. For instance, a small investor has to buy 600 shares of satyam and sell one futures contract to capture the arbitrage profits. Setting up this position requires high initial outlay. Reducing the contract size would make such arbitrage deals more affordable to small investors.

Easier trade execution: At present, traders dominate the derivatives market because it offers only short maturity contracts. This has led to high basis volatility. For instance, the average daily basis volatility for one-month index futures is 7.5 per cent. Higher basis volatility leads to wider bid-ask spreads. Reducing the contract size will be beneficial as it will reduce the basis volatility through aggressive arbitrage. That will lower bid-ask spreads.

NSE will then have a compelling reason to introduce long maturity contracts- quarterly and half-yearly expiry. Such long maturity contract will benefit traders who prefer to take longer-than-normal view on the movement of the underlying.

At present, such traders are forced to take exposure in the near-month contract and resort to futures roll till the end of their trading horizon. This is because the farther month contracts are not actively traded because of wide bid-ask spreads. Resorting to futures roll increases cost, as traders are exposed to the term premium risk. Introducing long maturity contracts will be an efficient way to take such long term exposure.

Hedging: Importantly, reducing contract size has no implication on hedging. A professional money manager hedges her portfolio with index futures or options. It may not be optimal for small investors to hedge with index futures. The reason is that their portfolio is not constructed efficiently as to have a closer relationship with index futures. Shorting single-stock futures against the underlying will capture the arbitrage profits. It is not a hedge.

The primary objective for hedging is to protect the downside risk without capping the upside potential. That is possible only with options, not with single-stock futures. This essentially means buying puts as a portfolio insurance measure. Besides, small investors with long-term horizon can also use covered call-write as income-enhancing strategy.

This class of investors can benefit from such strategies only if the contract size is reduced. Otherwise, hedging and income-enhancing strategies become difficult because small investor portfolio typically contains small quantities in number of shares. There is, hence, a compelling reason for the NSE to reduce the contract size. And reducing it by half is a sure way to kick-start the process.

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

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