The Hindu Business Line : Equity derivatives: A case for product reforms

Impressive growth has been seen in equity derivatives in India in the last five years. But market efficiency can be improved by fine-tuning products, better information dissemination and investor education.

Derivatives have assumed a critical role as vehicles of speculation and hedging, not otherwise possible through the cash market.

T. B. Kapali

Derivatives on equities have, in the past few years, emerged a key segment of the broader securities market. The margin by which derivative trading volumes have consistently scored over those in the underlying cash rket over the last few years shows that the former have assumed a critical role as vehicles of speculation and hedging, not otherwise possible through the cash market.

Intermediaries such as securities houses and brokerages seem to be well aware of the immense business potential in these derived markets. The efforts they have been making to spread awareness about these markets/products to retail investors, even in Tier 2 and 3 cities (as derivatives are gradually permitted on a larger universe of underlying) is clear evidence of the opportunities they recognise.

Statistics from the NSE show that retail investors — not institutional — have been the largest participants in the derivatives markets in the past four-five years, accounting, on average, for around 60 per cent of all derivatives activity.

Solid foundation

Trading volumes, the level of retail participation so far and the fact that these markets have functioned in the past few years without causing any systemic crises (quite familiar in the global derivatives markets, particularly in the OTC segment) point to the solid foundation laid — in terms of systems and procedures for trading, clearing and settlement — for equity derivatives in India.

While quite encouraging, a study of the micro-structure of market activity shows many areas can still be improved upon to bring in greater market efficiency and enable these markets to function better as an arena for speculation, hedging and arbitraging.

Some of the characteristic features of activity in the NSE’s F&O segment are:

Retail investors account for a larger share of the overall market than institutional investors

Dominance of single-stock derivatives — particularly, single-stock futures, which on average account for 50-55 per cent of all activity

Very low level of activity in options as a product class — accounting for around 12-13 per cent of overall volumes

The availability of only American-style options in individual stocks and European-style options on the indices

Single stocks: Futures vs options

The dominance of single-stock futures and the negligible presence of stock options is one of the most prominent characteristics of the country’s derivatives market.

Looking at the level of retail participation alongside the preponderance of activity in single-stock futures, it is apparent that stock futures have well emerged (as an alternative to the erstwhile carry-forward system) as the most important speculative vehicle for retail investors.

The “ease” of trading futures and, more important, the “ease” of understanding it have probably played an important role in making the instrument the preferred derivative product. But should this be so?

Financial intermediaries can play an important role in enabling investors better understand the relative merits of futures and options.

For instance, an analysis of the level of margins to be put up for trading futures and the premium to be paid for purchasing options show that options could be a far more economical and efficient trading vehicle.

Quite simply, the cash outlay required as a margin deposit to trade futures could be higher than the cash premium to be put up for buying options on a stock, because the premium on the option would also be a function of the strike price chosen by the buyer.

The margin amount on the futures is worked out by direct application of the margin rate (based on the historical price variability of the underlying asset) on the contract value (a minimum Rs 2 lakh) fixed by the exchange. Another notable feature is the availability of only American-style options on individual stocks.

The ostensible reason for this is to provide investors an easier exit route by way of early exercise so that a profitable market position is optimally encashed.

While this may be true for put options, it is not always so in the case of call options. Indeed, with respect to calls on non-dividend paying stocks (as far as options go, unless the ex-dividend date is within the life of the option, the pricing is done as if the stock is non-dividend paying), the flexibility of early exercise (American style) is not optimal.

The option-holder would be better off selling the option rather than exercising it as he would get something higher than the option’s intrinsic value (the intrinsic value is the maximum that can be got by early exercise).

Even with respect to dividend-paying stocks, early exercise is optimal only under particular circumstances.

Permitting only American-style options on stocks, therefore, represents a less than optimal solution to the critical requirement of providing liquidity to investors. Overall, it is a kind of chicken and egg situation with respect to popularising options.

More retail participation is possible only if more efficient liquidity solutions are provided but better liquidity solutions are possible only if more investors trade options.

Index futures

Index futures account for a sizeable 30-35 per cent of overall market activity and it is possible that these instruments are being well used by institutional participants as a hedging platform. With more FII and mutual fund activity in the underlying cash market, the use of index futures as a portfolio hedge, even for short tenors of three months, is quite understandable. But speculative strategies can be employed through the index derivative too.

It is here that the regulators/exchange can think of something on the lines of the Commitment of Traders report put out every month by the CFTC in the US. Such a report could give a broad idea of the level of speculative positioning in the market (even as open interest for the overall market represents a certain level of longs counter-matched by an equal level of shorts) and be useful to retail investors also.

Overall prospects

Overall, the market for derivatives is set for considerable growth. A fine-tuning of the market micro-structure in terms of products, instruments, information generation and dissemination, better education and awareness could lead to higher levels of market efficiency and enable these derived markets to play their rightful roles in the capital market.

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