Are We Ready For Turbulence?

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One of the most frightening aspects of modern business is the naiveté of regulators in grasping the fundamentals of the markets they try to regulate. This is particularly true of India, and quite well illustrated by the L C Gupta Committee report on Derivatives in India: A framework of economic purpose. As is well-known, this committee has opposed the old badla system and is in favour of a derivatives market, particularly for stock indices. Readers are no doubt familiar with a stock index. One should, therefore, carve their indulgence in giving simple definitions and explanations. However, it is absolutely necessary that the argument be set out from first principles.

A stock index is figure calculated for the purpose of representing a collection of individual stock prices. It is normally a weighted index. This means that each stock carries a different importance. Thus a typical index will consist, let us say, of 6 per cent Reliance, 4 per cent State Bank, 1 per cent Great Eastern etc. Another way of looking at the index is to assume that it has six shares of Reliance, four shares of State Bank and so on. The index is calculated continuously simply by multiplying each share by its price and adding them all together. In a well-constructed index, the shares chosen reflect their trading importance.

Institutions, unlike individuals, build up a portfolio of stocks so that their wealth depends on the movements in the stock index. This seldom applies to individuals. Thus a 10 per cent move in Reliance will have little effect on my wealth as I am not a shareholder in Reliance, but it would effect a fund like UTI which tries to mirror the index. In general, institutions like to invest as close to the index as possible with variations. The extent of their variance is called the Beta of the portfolio after the second letter in the Greek alphabet. Thus, if the Beta of your portfolio is described as 0.8, it means that a movement in the index of 1 per cent should move your portfolio in the same direction by 0.8 per cent.

In many stock markets in the world, you are allowed to place bets on the movement of the index. If you believe that the index will go up, you just buy the index futures, which means that you will be entitled to a point by point profit if the index moves up and a point by point loss if it goes down. It is called a futures index because the contract expires on a certain date in the future when the clearing-house has to settle. Thus if you buy, say, the December index futures at 4000 and it goes up to 4500, you will be entitled to a profit of 500 points at, say, Rs 100 a point, and if the index moves down to 3500 you will lose 500 points. In that event, you will need to pay Rs 100 a point. Buying and selling index futures is a convenient way of buying or selling the standard portfolio. It is, of course, a very useful instrument for those who have a portfolio of stocks because it tells them at a glance how the market is affecting their wealth. For individuals, it will have only limited value as their portfolio

often consists of non-index stocks. Nevertheless, movements in the index will effect even their wealth, because market makers tend to mark down prices of all stock when the index falls, and raise them when the index rises.

This happens sometimes very dramatically when major indices in world markets rise or fall. For example, even if an individual owns no US stocks, movements in the Dow Jones Index in New York affect the world. If the New York market falls, all market makers will reduce their prices for equity wherever they may be. This is known as the domino effect.

In the game of dominoes, the link is that they are all placed to join each other. In stock markets, the notion is one of arbitrage carried out through index futures. The story needs telling first because it explains the speed at which things happen in the stock markets of the world today. It spells out the essential inter-connectivity of stock markets. They are inter-connected because there are people always arbitraging between markets. But the second and separate reason for pointing this out is that it is a notion that has been entirely lost on the L C Gupta Committee.

In the report under paragraph 3.7 (I), the Committee claims that indices can be used by institutions to minimise risk in the following way:

Reducing the equity exposure in a mutual fund scheme: Suppose that the UTI decides to reduce its equity exposure in the US-64 Scheme from say, 40% to 30% of the corpus. Presently this can be achieved only by actually selling of equity prices to the disadvantage of UTI and the whole market. Second it cannot be achieved speedily. Thirdly it is a costly procedure because of brokerage etc. The same objective can be achieved through index futures at once at much less cost and without disturbing the cash market.

This analysis ignores the elementary rule of markets that for every seller there has to be a buyer and vice versa. UTI may wish to sell the index but it needs a counter-party, which will buy the index. You cannot sell index futures in vacuum. It is a basic flaw of the Gupta report that they have failed to follow a transaction to its logical end. If they had, they would have realised that a market maker will not buy index futures without hedging, and that can only be done if he sells the underlying equity in the cash markets. Such selling would entail the market maker with precisely the same problems, which UTI itself would face in selling equities.

The advantage of index futures is that traders can act fast. They can, for example, sell US futures and buy UK futures simultaneously. It can be done almost without thinking and that is how it often is done. But it can be a very dangerous game simply because it is so easy. It is an ideal instruments for speculators. It will make institutions gamblers, not hedgers. It is ironic that in India, the NSE, through that supposed champion of investors, Mr Gupta, should prefer these instruments. If one were to be irreverent, one might conclude that they are quite inexperienced.

If nothing else will warn our regulators let them at least reflect on the events that have taken place recently throughout the world. Such tremendous volatility as allowed the Hong Kong stock to plunge from $40 to $22 within a week could not possibly be achieved without the use of equity futures. The question is are we ready for such turbulence?

The L C Gupta Committee on derivatives may have missed the point, argues Sudhir Mulji