Unregistered foreign investors raise exposure to equity derivatives

The sharp decline in stock prices in January that sent most investors scurrying for cover has, however, left unregistered foreign investors unfazed. They increased their investments in derivative instruments on Indian equity in this period.

According to data published by SEBI, outstanding P-notes or Participatory Notes (the instrument through which such investors route their money into the Indian market) drawn on derivatives spiked up from Rs 33,690 crore in December to Rs 39,647 crore towards January-end. This is 86 per cent higher compared with the same period a year ago.

P-notes are offshore derivative instruments issued by foreign institutional investors and their sub-accounts to investors in other countries. Entities that do not want to go through the rigmarole of registering with the Indian regulator such as hedge funds typically subscribe to these instruments.

Although P-notes drawn on derivative instruments registered an increase in January, those issued for taking a direct exposure to equity and debt instruments has declined in value by about Rs 8,000 crore. They have fallen from Rs 1,41,894 crore to Rs 1,33,531 crore. Assets under FII management also registered a similar trend, declining from around Rs 11,65,000 crore towards the end of last year to Rs 10, 57,000 crore in January.

The market decline in the first two months of this calendar has seen traders revving up their activity in the futures and options segment. The daily average derivative volume in January was about 32 per cent higher than December. Increase in outstanding P-notes drawn on derivatives implies that foreign investors that take an indirect route to Indian market could also have contributed to spurring the trading activity in that period.

It may be recalled that the Indian market was the worst performer in that month. It is possible that hedge funds and other foreign investors may have been lured by the pronounced down-trend and could have increased their exposure to Indian equities through the P-note route.

Increased participation of such foreign investors in derivative market is, on the face of it, a stark reminder to the days in the second half of 2007 that saw an overseas investor frenzy grip the Indian market. SEBI had then banned fresh issue of such instruments in October 2007 fearing heightened volatility caused by sudden movement in and out of the country by these short-term fund flows. The higher proportion of P-Notes on derivatives has been accompanied by higher volatility this time round too. Intra-day swings in stocks have risen sharply since January this year.

The difference this time, however, lies in the relative decline in importance of such investments to total overseas funds. The share of P-notes in FII assets is drastically down from the peak of 51 per cent in August 2007 to around 16 per cent currently. P-notes drawn on derivatives are similarly down from 17 per cent to around 3 per cent.

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