HEDGING and Arbitrage

HEDGING
stocks in Nifty and Nifty Junior are available from NSE and from http://www.nseindia.
com ••
Q11.10: How can Nifty futures be used for interest rate trading?
A: The basis between 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 and a sell on the spot Nifty stands to gain if interest rates go up, while being
immune to movements in Nifty. Similar positions can be used against the two–month and
three–month futures to take views on other spot interest rates on the yield curve.
Similar strategies can be applied for trading in forward interest rates, using the basis
between the one–month and two–month futures, the one–month and three–month futures,
etc. ••

Q11.11: When does hedging go wrong?
A: Hedgers fear basis risk. Basis risk is about Nifty futures prices moving in a way which
is not linked to the Nifty spot.
An unhedged position suffers from price risk; the hedged position suffers from basis
risk. Of course, basis risk is generally much smaller than price risk, so that it is better to
hedge than not to hedge. However basis risk does detract from the usefulness of hedging
using derivatives. ••
Q11.12: What influences basis risk?
A: A well designed index, and a well–designed cash market for equities, serve to minimise
basis risk. See Question 10.1. ••
Q11.13: What do we know about Nifty and the BSE Sensex in
their usefulness on hedging?
A: Nifty has higher hedging effectiveness for typical portfolios of all sizes. Nifty also
requires lower initial margin (since it is less volatile) and is likely to enjoy lower basis
risk (owing to the ease of arbitrage). ••

Arbitrage

Q12.1: How do I lend money into the futures market?
A:
• Buy a million rupees of Nifty on the spot market. Pay for them, and take delivery.
When you make the payment, you are “giving a loan”.
• Simultaneously, sell off a million rupees of Nifty futures.
• Hold these positions till the futures expiration date.
• On the futures expiration date, sell off the Nifty shares on the spot market. When
you get paid for these, you are “getting your loan repaid”.
••

Q12.2: When is this attractive?
A: This is worth doing when the interest rate obtained by lending into the futures market
is higher than that which can be obtained through alternative riskless lending avenues.••

Q12.3: How do I borrow money from the futures market, using
shares as collateral?
A:
• Sell a million rupees of Nifty on the spot market. Make delivery, and get paid. This
is your “borrowed funds”.
• Simultaneously, buy a million rupees of Nifty futures.
• Hold these positions till the futures expiration date.
• On the futures expiration date, buy back the Nifty shares on the spot market. When
you pay for them, you are “repaying your loan”.

••
Q12.4: When is this attractive?
A: This is worth doing when the interest rate obtained by borrowing from the futures
market is lower than that which can be obtained through alternative fully collateralised
borrowing avenues. ••

Q12.5: Is there a compact thumb–rule through which I can
visualise the interest rates actually available in lending to the
index futures market?
A: Suppose Nifty is at 1500 and a futures product which expires within 30 days is trading
at 1520. At first, this looks like a return of Rs.20 on a base of Rs.1500 for a one–month
holding period. However, you should subtract out the transactions costs that you will
suffer on doing two trades on the Nifty spot. Suppose we assume a transaction size of
Rs.1 million. In this case, it’s safe to assume transactions costs of roughly 0.1% (or
Rs.1.5) each.
Hence, you will actually get only 20 - 1.5 - 1.5 or Rs.17 on a base of Rs.1500. This
is a return of 1.13% for a one–month holding period, or 14.48% annualised. Thinking
in terms of the actual transaction, you would lend Rs.1,000,000 into the market, and get
back Rs.1,011,333 after a month.
This thumb–rule ignores the dividends obtained on the shares you hold for the month.
Dividend payments in India are highly bunched towards the year–end. At other times of
the year, it’s safe to ignore dividends in a thumb–rule. ••
Q12.6: Exactly what is the time–period for which we calculate
the interest cost?
A: Suppose we are on 12 June 2000 (a Monday) and we have purchased the spot, and
sold the near futures (which expires on 29 June 2000). We will only need to put up funds
on Tuesday, 20 June 2000. The shares are sold on the spot market on 29 June 2000
(Thursday). These turn into funds on 11 July 2000 (Tuesday). Hence, the overall period
for which funds are invested is from 20 June to 11 July, i.e. a holding period of 22 days.
Hence, the cost of carry should be applied for a 22 day holding period. ••
Q12.7: Can it happen that a Nifty futures is cheaper than the
Nifty spot?
A: Suppose the Nifty spot is the same as the price of the three month futures, i.e. that the
basis is zero. This means that the futures market is willing to give you a loan (against a
Nifty portfolio as collateral) for a three–month period at an interest rate of zero.
If the Nifty futures is cheaper than the Nifty spot, it means that the futures market is
willing to pay you if you borrow money.
Many people in India would be very happy to borrow (against a Nifty portfolio as
collateral) at a zero or negative interest rate. When they step into futures market to do so,
they will buy the futures and sell the spot. That will push futures prices away from these
weird states.
Nothing forbids these weird states (negative or zero basis). It’s just that they are
extremely attractive arbitrage opportunities and are unlikely to lie around for long. ••
Q12.8: These transactions look exactly like a “stock repo” to
me.
A: Index arbitrage is indeed an “index repo”, with one key difference. Repos normally
involve counterparty risk. In index arbitrage, you face near–zero risk with NSCC as the
counterparty. ••
Q12.9: Why are these borrowing/lending activities called “arbitrage”?
A: They involve a sequence of trades on the spot and on the index futures market. Yet, they
are completely riskless. The trader is simultaneously buying at the present and selling off
in the future, or vice versa. Regardless of what happens to Nifty, the returns on arbitrage
are the same. Since there is no risk involved, it is called arbitrage. ••
Q12.10: Are these transactions really riskless?
A: These transactions are riskless insofar as the fluctuations of Nifty are concerned: no
matter whether Nifty goes up or down, they will yield the identical and predictable rate of
return. The rate of return you calculate at the outset is exactly what will come out at the
end.
However, they involve the credit risk of the clearing corporation. When you do arbitrage
on NSE, you are exposed to the risk that the National Securities Clearing Corporation
(NSCC) – which is the legal counterparty to all your trades – might be unable to meet
its obligations.
The required rate of return in lending to NSCC is the interest rate from the Government
of India yield curve, with a credit risk premium for NSCC added into it. If the
90–day interest rate on the GOI yield curve is 7%, and if you believe that NSCC requires a
credit risk premium of one percentage point, then the three–month futures should involve
an interest rate of 8%. ••
Q12.11: What’s the probability that NSCC will default?
A: Internationally, clearing corporations calibrate their risk containment system so that
failures are expected to take place roughly once or twice in each fifty years.
The track record of futures clearing corporations internationally is impressive. In the
20th century, we have seen just a handful of failures (e.g. Hong Kong in 1987).
NSCC has a short track record: it has been doing novation on the “equity spot market”
(which is actually a futures market) from 1996 onwards. In these five years, the
equity market has experienced high volatility, a high incidence of bankruptcies by NSE
brokerage firms, payments problems on other exchanges, etc. NSCC has successfully
shouldered the task of doing novation on India’s largest financial market (NSE). While
this suggests that NSCC may have fairly sound risk containment systems, we should be
cautious since it only has a track record of five years of doing novation. •• Also see: Gemmill (1994).

Q12.12: What do we know about the risks of BSE’s clearinghouse?
A: BSE has no experience with novation. Today, equity trading at BSE takes place without
novation. BSE has experienced payments problems fairly recently. ••

Q12.13: What do we know about Nifty and the BSE Sensex
on the question of arbitrage?
A: The market impact cost in trading the BSE Sensex is higher, for two reasons: index
construction and trading venue. Even if BSE Sensex trades were done on NSE, the impact
cost faced in trading the BSE Sensex is higher than that of Nifty. In addition, arbitrageurs
working on the BSE Sensex would be forced to trade at the less liquid market, the BSE.
The BSE lacks a credit enhancement institution of the credibility of NSCC.
These problems imply that arbitrageurs working on the BSE Sensex will demand a
higher credit risk premium, and require larger pricing errors in order to compensate for
the larger transactions costs. Hence, the BSE Sensex futures are expected to show lower
market efficiency and greater basis risk. ••