Policy issues

Policy issues

Q15.1: Are many developing countries developing derivatives
exchanges?
A: There are many attempts at starting derivatives exchanges. As with spot exchanges,
there have been relatively few successes in terms of obtaining highly liquid markets. See
Tsetsekos & Varangis (1997) and van der Bijl (1996). ••

Q15.2: Does derivatives trading throw up new threats to the
financial system?
A: Derivatives trading does bring a whole new class of leveraged positions in the economy.
From a systemic risk standpoint, however, there are no externalities or contagion
when we consider exchange–traded derivatives with novation at the clearing corporation.
In fact, to the extent that equity derivatives make it easier for policy makers to eliminate
leverage on India’s equity spot market, it will help reduce the vulnerability of India’s
equity market.
It is with OTC derivatives that there are more serious policy concerns, about the extent
to which a few large failures can destabilise the financial system. This is because OTC
derivatives innately involve credit risk, and there is a clear channel for contagion – where
the failure of one firm impacts upon its counterparties. ••
Also see: Steinherr (1998).

Q15.3: What about market manipulation on derivatives markets?
A: Futures or options based on physical delivery (as opposed to cash settlement) are vulnerable
to “short squeezes” and other manipulative schemes. For example, there was a
famous effort to corner the world market for silver, partly using the silver futures market
(Houthakker & Williamson 1996b). These dangers require a strong supervisory mecha-
nism to deal with market manipulation. •• Q15.4: What is the direction for policy in regard of the equity
derivatives and spot markets?
A: We can expect the equity spot market to move towards rolling settlement (i.e. to
become closer to a spot market). We can expect a regulatory prohibition of badla, as part
of the migration into a genuine spot market. In the area of exchange–traded derivatives,
index options are the logical next stepping stone for India’s markets. •• Also see: Shah & Thomas
(1999a).

Q15.5: What is the progress in terms of exchange–traded currency
and interest–rate derivatives?
A: None. ••

Q15.6: Are derivatives on Indian assets traded outside India?
A: In Hong Kong and Singapore, there are cash–settled forwards on the dollar–rupee
exchange rate, called “non–deliverable forwards”.
The Singapore Monetary Exchange (SIMEX) has chosen Nifty in order to trade products
based on an Indian index. This is a significant development, considering the success
at SIMEX in competing against the home–country index futures market in Japan and Taiwan.
••

Q15.7: What is the implication of Nifty futures and options
trading at SIMEX for India?
A: From an Indian perspective, it helps FDI and FII inflows into India, since investors
would have an additional avenue through which “India risk” can be hedged. Trades on
SIMEX would be convenient and hassle–free for the international investor, when compared
with the operational frictions involved in doing trades in India.
From an NSE perspective, SIMEX represents competition. If SIMEX offers a superior
market design, more efficient transacting, and a less onerous regulatory structure, it will
take order flow away from NSE.
SIMEX will also impose stress upon India’s regulatory apparatus. For example,
SIMEX will trade Nifty futures and options from the outset, while India’s regulators have
not yet permitted options trading. Similarly, if India’s regulators are confused on questions
such as margin setting, then many users will have the choice of walking away from
NSE to SIMEX. ••

Q15.8: How will the two markets interact?
A: There be arbitrage opportunities between the two markets. A large buy order going
to SIMEX will push up the price of Nifty futures at SIMEX. Then arbitrageurs will step
in, selling Nifty futures at SIMEX and buying Nifty futures at NSE. This could, in turn,
propagate back to the NSE cash market through normal spot–futures arbitrage in India.
Arbitrage involving options at SIMEX be done in two ways. An arbitrageur could
choose to do trades between Nifty options (SIMEX) and Nifty futures (SIMEX). Alternatively,
if Nifty futures are much more liquid, then the arbitrageur could choose to do
trades between Nifty options (SIMEX) directly to Nifty futures (NSE). •• Also see: Stoll & Whaley (1990).

Q15.9: Is SIMEX a serious threat to NSE?
A: If we consider the pure merits of the market, then the great mass of retail traders in
India is likely to generate liquidity at NSE in a way that SIMEX cannot access. The
international experience is that in countries which have a strong tradition of retail trading
on financial markets, offshore trading does not present a major threat to the local market,
which dominates price discovery. NSE is dominated by retail trading, and has had peak
stock market trading of $2 billion, which is enormous by world standards.
The major question mark is about margins and regulation. It took NSE five years to
get permissions to do index futures trading. The delay in obtaining permissions for index
options has yet to be seen; SIMEX will have a head start on Nifty options. The regulatory
posture in India could turn off users, and drive them off to Singapore. This is not just
an idle possibility; it was the case with the Japanese Nikkei 225 futures, where stifling
regulation in Japan led to a flowering of futures liquidity in Singapore.
In summary, as with the Nikkei 225, the success of SIMEX will depend upon a combination
of Indian retail dynamism, and the ability of regulators in India to comprehend
derivatives and come up with a fair regulatory structure. ••

Speculation and Intermediation

Q13.1: How does one speculate using index futures?
A: There are several kinds of speculation that are possible – forecasting movements of
Nifty, forecasting movements in Nifty futures prices, and forecasting interest rates. ••
Q13.2: What is involved in forecasting Nifty?
A: Nifty is a well–diversified portfolio of companies that make up 54% of the market
capitalisation of India. The diversification inside Nifty serves to “cancel out” influences
of individual companies or industries.
Hence Nifty, as a whole, reflects the overall prospects of India’s corporate sector and
India’s economy. Nifty moves with events that impact India’s economy. These include
politics, macroeconomic policy announcements, interest rates, money supply and budgets,
shocks from overseas, etc. Thomas & Shah (1999) offer some time–series econometrics
applied to Nifty. ••

Q13.3: I have a forecast about Nifty. What can I do?
A: If you have a forecast that Nifty will go up, buy Nifty futures. If you have a forecast
that Nifty will go down, sell Nifty futures. ••
Q13.4: There are several index futures trading at the same
time – which one should I use?
A: Sometimes, the forecast horizon generates constraints. If you have a two–month view,
then a futures contract that has only a few weeks of life left might be inconvenient.
Another major issue is liquidity. Other things being equal, it is always better to use
the contract with the tightest bid–ask spread. ••

Q13.5: I have a forecast that Nifty will rise, and I buy Nifty
futures. What can go wrong now?

SPECULATION
A: Two scenarios are unfriendly to the speculator. The obvious problem is where Nifty
fails to rise as forecasted. But sometimes, even if Nifty rises, the futures price may not
move in sympathy.
A speculator may make a loss, owing to a slight fall in the futures price, even though
there was a slight rise in Nifty. This problem is called basis risk.
Sometimes, the speculator may be right in essence – and good news about the macroeconomy
does appear – but may lose money in practice because the index is badly constructed
and does not reflect shocks to the macroeconomy. ••
Q13.6: How can these risks be minimised?
A: Basis risk is minimised by having a well–designed index where the index is highly
liquid and the underlying spot market is well thought out and highly liquid. The index
accurately tracks the macroeconomy when it is as large as possible while avoiding illiquid
stocks, it is regularly maintained, and accurate in terms of data reliability. See Question
10.1. ••

Q13.7: I have a forecast about a change in a Nifty futures
price. What can I do?
A: If you think the futures price will go up, buy the futures. If you think the futures price
will go down, sell the futures. ••

Q13.8: How does one forecast the Nifty futures price, as distinct
from forecasting Nifty?
A: The speculator who works on movements of the futures price makes calculations for
the fair value of the futures, after carefully accounting for interest rates, initial margin
requirements and transactions costs faced by arbitrageurs, and dividend forecasts.
If, based on this analysis, the speculator feels that arbitrageurs are going to lend money
to the market (i.e. buy the spot Nifty and sell the futures), then he has a forecast that the
futures price will drop.
Such a speculator is front–runing against the arbitrageurs by selling Nifty futures
before they do so. ••

Q13.9: I have a forecast that interest rates will rise. What can
I do with the Nifty futures market?
A: The basis between (say) the spot Nifty and the 1 month Nifty futures reflects the
interest rate over the coming month. If interest rates go up, the basis will widen. A buy
position on the futures coupled with a sell on the spot Nifty represents a view that the
basis will widen.
The difference between the two month and three month futures reflects the forward
interest rate for 30 days, two months from now. Interest rate views can be expressed using
this also. ••

Intermediation
Q14.1: What kinds of intermediaries are found on the index
futures market?
A: There are two kinds of brokerage firms on the index futures market: trading members
(TMs) and clearing members (CMs). NSCC only deals with clearing members: NSCC
bears the full risk of default by a clearing members. Trading members obtain the right to
trade through a clearing member; the CM adopts the full credit risk of the TM. If a TM
fails, NSCC holds the relevant CM responsible.
CMs don’t need to be brokerage firms; entities such as banks or SHCIL are CMs. ••

Q14.2: How is derivatives intermediation different from that on
the equity spot market?
A: There are a few key differences between intermediation on the equity spot market as
compared with the derivatives market:
• Certification of employees is mandatory on the derivatives market from the outset.
In contrast, certification requirements on the equity spot market are only gradually
being phased in. Anyone who actually obtains a password from NSE and trades on
the futures market has to have obtained a score of above 60 on the “NCFM F&O”
certification examination.
• The equity spot market is primarily focused upon execution. Users of the market
generally know what shares they want to buy/sell, and they only look to the broker
to do the low–skill job of trade execution. In contrast, for the forseeable future,
users in the index futures and options market will turn to the brokerage firm for
advice and analytical support in the context of their derivatives trading. It will
be typical to see a user who has a buy on HINDLEVER hedging away his Nifty
exposure, upon the advice of the stock broker.
• On NSE’s equity market, the broker is both trading member and clearing member.
On the futures market, we will see a clear specialisation coming about, where firms
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with a focus upon customers will become “trading members”, and get their clearing
and settlement services from clearing members. Banks will be important in being
clearing members.
• On the equity market, the settlement process using physical shares and (to a much
lesser extent) using the depository implies that the typical brokerage firm has a
large staff which processes settlement activities. Index futures and options are cash
settled, so the staffing patterns in the brokerage firm will be quite different.
••

Q14.3: What’s the role for mutual funds in the index futures
and index options market?
A: There are numerous areas where mutual funds benefit from index futures and index
options:
• Index funds can directly use index futures in implementing index funds. When
funds come in, the index fund can just buy index futures, and gradually unwind the
futures position as the spot market trading is done.
• All mutual funds can excel in reverse-cash-and-carry arbitrage, where full Nifty
baskets are sold off on the spot market and bought back at future dates.
• Mutual funds can hedge when their index views are adverse. If a fund feels that
Nifty will fare poorly, it can sell Nifty futures and reduce its index exposure. Conversely,
it can increase its index exposure when it feels that Nifty will do well.
• Income funds and money market funds can invest money into the Nifty futures
market.
• Once index options come about, mutual funds can offer “guaranteed return products”,
by bundling a Nifty index fund with a Nifty put option. Conversely, funds
can be designed by bundling a core investment in government securities with an
investment in a Nifty call option: these funds would have a pure upside if equities
do well.