Single-stock futures -- Smart way to manage risk

Anup Menon

By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives...

These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it -- a process that has undoubtedly improved national productivity growth and standards of living. -- Fed Chairman Alan Greenspan

FOLLOWING the introduction of index futures, the Securities and Exchange Board of India (SEBI) permitted the BSE and the NSE to introduce more derivatives, such as options on indices and individual stocks. But an instrument that may be more in line with the domestic market structure -- single-stock futures -- is not under consideration.

Single-stock futures are a way to reap the benefits of a stock's performance without actually owning the stock. Theoretically, they offer the benefits of ownership, of leveraging the stock or its underlying asset. But a similar opportunity is not available to the speculator-investor to sell options in the underlying scrip. As delivery of futures contracts is on a future date, the investor has to put up only the margin money. Hence, he can leverage on the margins to buy more units of the underlying security.

One of the advantages enjoyed by single-stock futures is that they are cheaper to trade and easier to use for hedging strategies than options. Cheaper, because margins in futures trading are lower than in options. But the valuation of futures contracts are not as complicated as that of options. Hence, small investors find them relatively easy to understand and use.

Trading options: Trading options are riskier than futures. This is purely from the options-writer's perspective. Market-making in options depends to a great extent on institutions willing to write the contracts. Since the buyer of an option contract is not under any obligation to exercise his right, his risk is limited to the premium paid for purchasing the right.

However, the writer is under an obligation to deliver. This means the risk borne by the option-writer is enormous. Exchanges normally guarantee the writer's position. Hence, to limit default in the market, the margin requirements are quite high. For instance, in international markets, while the margin rate for index futures contracts is around 5 per cent, that for index options works out to the commission received plus around 15 per cent of the contract's notional value.

Thus, in this situation, there is excessive risk for the options-writer and transactions costs could be high. Currently, the regulations prevent funds from taking speculative positions in the spot market. So, they may not be allowed to write options. A market exists only if there is a writer and a buyer. But given that there are few takers for the futures market, it is difficult to foresee a lot of interest in the options market.

Structure of spot market: The structure of the spot market should be considered carefully before designing a derivative product. One of the major differences between the Indian market and international markets with efficient derivatives is the settlement system. In India, trading in the spot market is still on a weekly-settlement basis.

The non-availability of all stocks under rolling settlement is one of the key factors affecting the development of the derivatives market. Given the present settlement cycle, investors can trade in two different markets with different settlement cycles. For the moment, let us consider the two major markets -- the BSE and the NSE. An investor can enter a position on Wednesday at the start of the settlement on the NSE and close the position on Monday before the settlement date on the NSE.

At the time of closing the position on the NSE, the investor can open an identical position on the BSE on Monday (which happens to be the start of the settlement on the BSE) and close it on Wednesday. This dynamic allocation strategy can be used to ensure that a position is always maintained. Hence, the investor is actually holding a portfolio without ever having to close it.

Given that, on an average, the movements in the BSE and the NSE are near-perfectly correlated, the returns to the investor are not likely to fluctuate widely. However, this strategy has two main drawbacks. First, the transaction costs are higher in the spot market; and second, the strategy fails under a rolling settlement system, to which the Indian market is only slowly getting used. At present, 15 scrips are under rolling settlement, with a daily badla system. Soon, the entire market may move to a rolling-settlement basis.

At present, given the non-availability of other options, one could consider using the badla/ALBM markets to create strategies. When full rolling settlement comes in, investors cannot use the strategy mentioned in the previous paragraph and would have to depend on the rolling badla system for creating strategies. When rolling settlement is introduced in all stocks, there may be increased usage of the badla system, making the market more efficient and the valuation of premiums more objective. This may be a case in favour of the badla system. However, it has its disadvantages.

The badla market is normally associated with speculation. One of the primary disadvantages of the badla system on the BSE is that regulation prohibits big institutions from using it. Apart from this, most of the activity in both the badla and ALBM systems takes place on the money-lending side. This could be because more investors go long on the stocks than the number of short positions initiated. On an average, the total volumes on the badla market are 10-15 per cent of the total turnover in the spot market. Hence, the level of inter-settlement speculation is not very high.

The introduction of rolling badla in the 15 stocks is similar to stock futures trading. In this backdrop, it may be of greater use to introduce a formal exchange-traded product such as stock futures. Apart from helping increase volumes, traders may not much have trouble adjusting to the new market as they have been using the badla market.

Given the market structure and the regulatory framework, it may be a good move to introduce single-stock futures in India. If the market kicks off, it may go a long way in reducing volatility in the spot market and, hence, protect the interests of small investors. It also provides an efficient means of risk-management for the institutional investor.