Why Index Derivatives Matter

Financial derivatives such as futures or options are powerful instruments through which hedging, speculation, investment and arbitrage take place in a modern economy.

Whenever derivatives are contemplated on the equity market, the most natural and easily visualised derivative product is options on individual securities. For example, the market could trade options on Reliance. These directly tap into the widespread interest in speculation in Indian markets. If a speculator thinks that the price of Reliance shares might go up, instead of buying the shares, he can buy call options these ensure that he enjoys upside risk (i.e profits if the price goes up) without downside loss (i.e no further payouts in case the price does not go up). Conversely, a speculator who is bearish about Reliance shares, could buy put options these would yield a profit if the price of Reliance shares drops, with no further payouts in case this fails to materialise.

Given the widespread interest in speculation at the security-level in India, it is very easy to visualise derivatives on individual securities as being quite successful. Indeed, given the widespread interest in security-level thinking in the country, the concept of index derivatives is often treated with puzzlement or incomprehension.

However, the major focus of the equity derivatives industry worldwide is on index derivatives. Internationally, trading volume on index derivatives is often hundred times more than that seen on security options. In India also, the major focus of the National Stock Exchanges upcoming futures and options market is on index derivatives. Why are index derivatives so important?

Index derivatives are a powerful tool for risk management for anyone who has portfolios composed of positions in equity. Using index futures and options, investors and portfolio managers can hedge themselves against the risk of a downturn in the market when they should so desire.

For example, for many investors, the volatility associated with the Budget might not be a ride that they wish to undertake. Today, in the absence of index derivatives, the investor has only one alternative: to sell off equity and move into cash or debentures prior to the announcement of the Budget. Roughly a month after the Budget has been announced, and after the budget-related volatility has subsided, these transactions can be reversed, and the person concerned will go back to the original equity exposure that he had.

This is expensive in terms of the transactions costs faced in selling off a significant amount of equity. For retail investors, the total cost of this two-stage process could be around 5 per cent, a high price to pay for the privilege of avoiding Budget-related volatility.

Using index futures, the same objective can be accomplished at around one-tenth the cost, or less. Using index options, a very interesting kind of portfolio insurance can be obtained, whereby an investor gets paid only if the market index drops.

Index derivatives are unique and new forms of risk management in the country. They are particularly appealing because the market index has a high degree of correlation with every equity portfolio in the country. By the time a portfolio ends up with more than 15 stocks in it, it is likely that the correlation between this portfolio and a market index like the NSE-50 will exceed by 80 per cent. This property holds, regardless of the identity of the securities which make up the portfolio: whether a person holds index stocks or not, the index has a high degree of correlation with every portfolio in the country.

This is quite clear if we look back at the experience of 1995 and 1996 every single equity investor in the country experienced poor returns during this period, regardless of the kind of portfolio owned by them. This widespread correlation between risk exposure of investors and the index is what makes index derivatives very special in their risk management ability.

One example will help clarify matters. Suppose a person is long ITC. Unfortunately, by being long ITC on the cash market, he is simultaneously long ITC and long index (ITC and the index have a 65 per cent correlation) i.e if the index should drop, he will suffer, even though he may have no interest in the index when forming his position. In this situation, this person can match his ITC exposure with an opposing position using index futures (i.e. he would be simultaneously long ITC and short index futures) which effectively strips away his index exposure. Now, he is truly long ITC: whether the index goes up or down, he is unaffected, he is only taking a view on ITC. This is far closer to his real interests and objectives, and is much less risky than present market practice (i.e a pure long ITC position).

Derivatives in individual securities are vulnerable to market manipulation. For example, a person might first buy call options on ACC and then try to manipulate the price of ACC to make it go up. This is, in principle, possible for the index also. However, the index is a large, well-diversified portfolio, and its manipulation is much harder and requires much larger resources. The market capitalisation of the NSE-50 index today is around Rs 200,000 crore. It is more difficult to manipulate it today as compared with any individual security in the country.

Index funds have now started appearing in India; internationally, it is common to see 30-40 per cent of all professionally managed funds being index funds. Index futures are an invaluable tool for running index funds: where the market for these futures exists, it becomes easier to run these funds, which yield returns that are quite close to the returns of the actual index. Similarly, index options are useful for interesting new products like guaranteed return funds (an index fund bundled with portfolio insurance in the form of a put option on the index) or equity-linked bonds ( an instrument which is 95 per cent invested in a straight bond, while 5 per cent is invested in a call option which sharply benefits from the upside potential of the market index).

Today, a good deal of trading volume on the market is composed of people who are taking a view on the index this is implemented using portfolios of two or three stocks. For instance, the portfolios of Reliance, Tisco and State Bank of India are often used as a proxy for the index. Index derivatives will directly give people the option of a mechanism through which a view on the index can be implemented on the market. This will be a boost for research and analysis devoted to understanding and anticipating movements of the market index.

Index derivatives are cash-settled, which means that no delivery of securities is made. In an environment where the depository has not yet come to dominate all settlement, these are a considerable advantage over any transactions involving securities.

(Ajay Shah is associate professor at the Indira Gandhi Institute of Development Research (IGIDR), Mumbai)