The Hindu Business Line : Options are forever

SEBI’s proposal to introduce longer-maturity options makes economic sense, as it provides a risk management tool for hedgers. Market for such options will take off if SEBI introduces a lower uniform contract size of 100 on the underlying. This will attract more participation from traders and lead to better price discovery. The article also suggests introduction of infinite-life options.

B. Venkatesh

The Securities and Exchange Board of India (SEBI) proposes to introduce new products in the derivatives market. This article is a comment on one such product — longer-maturity options. SEBI proposes to issue options with maturity up to five years.

A longer-maturity option makes economic sense because it is a valuable risk management tool for hedgers. SEBI should, however, first introduce a lower uniform contract size on the underlying.

Only such a move will induce more participants to enter the longer-maturity options market. SEBI should also consider introducing infinite-life options, the advantages of which are also discussed below.

No entry for hedgers

In India, derivatives segment is primarily a traders’ market, with activity primarily concentrated in the near-month contract. This allows little scope for hedgers to enter the market.

Consider a closed-end mutual fund that needs to fold in March 2009. The money manager will have to move into cash in March to redeem the units then. But what if the asset prices decline in late 2008? The money manager may want to hedge the portfolio risk so that the fund can fold successfully.

The money manager will have to buy one or two-month index options and rollover till the hedging horizon in March 2009. Such a hedging process will be expensive and tedious.

An alternative could be to wait till December 2008 and then buy index puts and rollover till March 2009. The portfolio will then be exposed to decline in asset prices from now till the hedge is set up in December 2008. Hedging with Nifty futures may not be optimal because it caps the upside potential.

Longer-maturity options

Longer-maturity options are optimal tools to manage portfolio risk. But will there be enough demand-supply for such options? Longer-maturity puts will be demanded by hedgers wanting to protect their downside risk.

Their counterparties can be traders wanting to buy the underlying stock. Selling puts essentially amounts to buying the stock; the put premium helps the option seller subsidize the cost of buying the stock.

What about calls? Buying longer-maturity calls may not be the preferred choice for many traders because of the higher premium due to higher time value. Moreover, traders prefer to take short-term view and trade accordingly.

So, we need to bank on hedgers to drive demand for calls as well. Hedgers in this case may be money managers and institutions who expect to buy stocks or the constituents of the underlying index at a future date.

Suppose a money manager expects Rs 5,000 crore of cash inflow next July. What if asset prices move up by then? She will have to buy assets at a higher price in July. This exposes the portfolio to upside risk. The money manager can buy July 2008 calls now to hedge the risk. This is called an anticipatory hedge. If asset prices move up in July, the call option can be sold for a higher price. The profits on the calls will subsidise the cost of buying the assets in the spot market.

The counterparty to call-buyers can be traders who engage in covered call-writes. These can be institutional investors who hold shares for the long-term and want to enhance income in the short-term by selling out-of-the-money calls against the underlying.

The presence of institutional investors alone may not, however, provide liquidity in the longer-maturity options. We need participation from retail investors. SEBI should, hence, move to a lower uniform contract size.

Buying January 170 calls on Reliance Natural Resources on the contract size will entail a cash outlay of Rs 1 lakh per contract. The outlay will be higher for longer-maturity options.

SEBI should, hence, introduce a lower uniform contract size of 100 in the market. This will attract retail traders to the options market. More participation will lead to better price discovery and thin bid-ask spreads.

Infinite-life options

Longer-maturity options will command a higher premium because of higher time value. The risk of loss to option buyers is, hence, very high due to time decay.

SEBI should also consider introducing infinite-life options. These are options that do not expire. A version of infinite-life options have been patented in the US and are called XPOs (Expirationless Options).

A five-year 2900 strike call option on Reliance Industries will cost Rs 1,400. An infinite-life option could cost Rs 2,200. The addition premium minimises risk due to loss-aversion; holding on to loss-making positions will not hurt much as the options do not decay.

Such options will be meaningful for two reasons. First, dividend yields are no longer relevant. So, it will not be disadvantageous to hold infinite-life options instead of the underlying. And second, non-linear payoffs — unlimited gains but limited losses — to option buyers make it advantageous to hold infinite-life options instead of stocks.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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