Derivatives -- Will the future see more action?

Anup Menon

IT IS four months since index futures were introduced.

And many events have shaped the development of this product. The listing of the NSE contracts in Singapore; the early start of trading on the BSE for futures against spot; and the RBI allowing foreign funds to bring in margin money to trade in index futures are some of the major events.

Thus, the conditions were right for increased activity in the instrument. For all that, however, there is still no significant interest in it, with volumes around 500 contracts a week for the BSE one-month contract. Paradoxically, the period also saw a general decline in volatility.

Business Line analysed the trading trends in index futures over the past few months. The results show that there was no significant impact on the volatility of the underlying asset. Trading interest always centred on near-term contracts, specifically the one-month contract. The arbitrage potential is fairly limited, given such constraints as transaction and borrowing costs. Institutions have not yet entered the market fully. Given the paucity of data, a causal relationship between the spot and futures markets cannot be established.

Volatility trends

A significant indicator of the effect of index futures on the underlying market is volatility in the spot market. There was no significant impact on volatility in the spot market following the introduction of index futures. Index values hovered between 4964 and 3594 -- lower than the variation since January. A statistical measure of volatility too confirms this. The results of the test are more or less identical in the Nifty and the Sensex.

The volatility of the spot index and futures quotes since the introduction was identical. For instance, the daily volatility of returns, as measured by the standard deviation of the series, for the Sensex and the one-month Sensex futures contracts indicates a level of around 2 per cent. The volatility of the returns on the Sensex portfolio before the introduction of futures was around 0.3 per cent. However, the drop in the volatility can be attributed to the overall market sentiment. Generally, there is reduced volatility in a falling market. This was also reflected in the price trends prevailing on the NSE.

Theoretically, the discounted value of the `futures' price must correspond closely to the spot price. To the extent the discounted value is at variance with the spot price there is, technically, a `mispricing' in the futures market. Such mispricing is the potential source of arbitrage. The mispricing in the one-month futures market shows considerable variation from mid-September, indicating that the futures market has been more volatile since then. In fact, it increased to 3.71 per cent in this period. For the same time-frame, volatility in the spot market was around 2.17 per cent. Does mispricing mean there are arbitrage opportunities?

Arbitrage potential

The potential for arbitrage is not very high. One main indicator that an arbitrage opportunity exists is the carrying cost of the contract. Arbitrage opportunities between the spot and futures markets exist only if the trading opportunity is available after adjusting for liquidity and transaction costs.

The no-arbitrage range would be from 5 per cent to about 17 per cent. This is due to the huge difference in the rates for lending and borrowing for small investors. An investor can go long on index futures when the cost of carry is lower than 5 per cent, and short when it is over 17 per cent.

A good measure of the presence of arbitrage opportunities is the frequency distribution of carrying costs for the entire period. For this purpose, the one-month contract on the BSE was used. A look at the carrying costs associated with the BSE Sensex one-month contract indicates that arbitrage opportunities based on closing prices of the contract existed for close to 40 per cent of the period measured. Since September, arbitrage opportunities were present for around 62 per cent of the time.

This effectively indicates that higher volatility leads to greater arbitrage opportunities. However, the efficient use of arbitrage opportunities depends on market liquidity. The simplest way to gauge liquidity in the market is to study volume trends.

Volumes

Market interest is reflected in the trading volumes of the contracts. Unfortunately, as of now, trading interest is limited in the stock index futures market, and is confined to short-term contracts. The overall trading volumes average Rs 20-25 crore. Of this, the BSE leads, with average volumes hovering between Rs 10 crores and Rs 15 crores.

The volume trends indicate that investors are not enthused by the three-month contract, which was not traded for around 70 per cent of time since the start of futures trading. It indicates that investors are not willing to take long-term views on the market. The two-month contract, too, has few takers. However, as the contracts are structured on a rolling basis, in the week before maturity of the two-month contract, trading interest strengthens.

Consider the differences in the two-month and one-month contract on September 28 (one day before the September maturity date). The two-month contract closed on September 28, at 4170.10. This now moves into the one-month range from September 29. The closing value of the one-month contract on September 29 is around 4068.10. Hence, an investor taking a short position on the date of maturity and closing it the next day would have made a profit of around 100 points. How does this happen?

This could be due to the fact that, generally, the longer-end contracts have a problem of liquidity. Hence, the excess risk gets priced in, leading to skewed valuations. However, as trading interest increases when futures come into the one-month range, traders can look to make profits by entering into the two-month contracts a week before the maturity date. It also shows that arbitrage opportunities in the one-month contract can be exploited.

But why has the market not really kicked off?

Starting problems

One of the fundamental reasons for the subdued market activity is the lack of institutional participation. When activity is limited and there are only a few players, the process of price-discovery slows down and is hampered. Effective price-discovery happens only in a deep and liquid market.

The inability of international funds to bring in money from abroad to meet margin payments has been cited by market participants as one of the reasons, at least in the initial days of trading. However, that problem has been eliminated with the RBI permitting funds to bring in advance money for meeting margin requirements. The other factor is that funds and institutions need to take permission from their trustees to engage in derivatives trading. This process seems to take time.

Even if these factors are resolved, there is need for a risk-management cell to be put in place. Here, software plays a critical role. There is a lot of talk about the expensive nature of back-office software keeping many potential participants from participating in the market. The BSE introduced a system wherein it bears part of the cost for setting up the software. However, the impact of this on volumes is yet to be established.

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Relationship between markets

The relationship between the spot and the futures markets is in line with that of efficient markets. For instance, the spot and futures markets moved in the same direction on most occasions. However, given the lack of data, it is difficult to state whether the spot market lead the futures, or vice-versa. The causal effect between the spot and the futures markets has been extensively researched and documented in international markets.

An argument that the futures market leads the spot can be put forward in the light of the fact that the BSE opens trading in futures 25 minutes before the opening of the cash market. This means traders can set the price-discovery process in motion before the cash market opens.

However, the problem with the Indian market is that with just a few traders dealing in futures, it is hard to believe they can influence the market. Similarly, the NSE's products are also traded in Singapore, where the market opens a few hours earlier than in India. However, there has not been significant interest in those products either. Hence, a causal relationship between the spot and futures markets cannot be established.

Conclusion

The development of derivatives in India will take time. There is a need for structural reform and increased awareness of such products to increase participation. Overall, in the first four months, the market was shallow and, as it stands, it may be quite a while before there is full-fledged activity in the market.