Who Will Be No. 1?

We have found that the BSE National Index (Natex), and not the Nifty, is the best index for introducing index futures in India, declares M T Raju, dean at the UTI Institute of Capital Markets (henceforth Institute). Coming at a time when UTI has decided to use Nifty, it's easy to see why this statement has thrown up a strong debate in the concerned circles.

But before we move into the debate, we need to find out why Raju feels that Natex is a better choice, and under what circumstances? Two studies, done by the Institute to analyse the suitability of an index to introduce index futures, say that with index futures, the most important aspect is the risk hedging function, that is, when one only tries to minimise the risk of a hedged portfolio.

If that is the objective, the most important feature in an index should be a high hedging effectiveness (one which minimises risk). And seen from this context, it is obvious that the index which is least volatile, will have the minimum risk. We know that the standard deviation of an index measures its risk. For the period between 1993 and 1996, the standard deviation of Natex was approximately 0.1277, while that for Sensex and Nifty was about 0.15 each. But Crisil 500 had a smaller figure of only 0.1268. So why did the studies conclude that the Natex is the best bet?

That's because low standard deviation only means that the index is not volatile, and that by itself, it is not risky. But for index futures, the main consideration is the hedging effectiveness, that is minimising the risk of the hedged portfolio also. Seen from this angle, the Natex is the best bet because it has a higher hedging effectiveness than all other indices.

To understand how, we'll have to quickly go through the tests run by the Institute. First, the Institute used data of five growth funds