Impact and Role of Mutual funds in Derivatives markets A Thematic Case study of Indian Capital Markets Dr.

Hiren M Maniar

AUTHOR PROFILE: NAME: Dr. Hiren M Maniar INSTITUTE: L&T Institute of Project Management, Vadodara, Gujarat PHONE NO: +919898008939

* Dr.HIREN M MANIAR is currently working as a Faculty in Finance at L&T Institute of Project Management , Vadodara, Gujarat, India. He may be contacted at hm_maniar@rediffmail.com

Paper Published in Journal

Management Today - Journal of Management Science, Vol-1, Paper No.4. Oct-Dec 2006

ABSTRACT:

India s experience with the launch of equity derivatives market has been extremely positive, by world standards. NSE (National Stock Exchange) is now one of the prominent exchanges, amongst all emerging markets, in terms of equity derivatives turnover. There is an increasing sense that the equity derivatives market is playing a major role in shaping a long lasting and healthy Indian capital markets. Indian equity market has added one more feather by starting a Equity Derivatives segment in year 2000, since than as on today Equity Derivatives markets has outperformed cash market by leap and frog manner. Derivatives markets world over are very volatile and India is not exceptional but in Capital markets it provide vital liquidity, which drives indices. The derivatives segment of NSE once again found favor in the media recently with SEBI (Securities and Exchange Board of India) permitting Mutual funds to participate in the Derivatives segment at par with other players like HNI (High Networth Investors) FII (Foreign Institutional Investors) and Retail Investors. The recent permission by SEBI for Mutual funds to participate will act much beyond the capacity of traditional hedgers. Main aim of this paper is to highlight impact and Role of Mutual funds trading in Derivatives markets and it s overall implication on Indian Indices with. Insights into what is going on with the equity derivatives market, and summarize broad empirical regularities about pricing and liquidity. With this one thing is sure that Derivatives segment is again set to witness a new round of evolution waiting for many surprises to be unveiled as the opportunity unfolds itself and as the mutual funds gear themselves for the exploitation of the same.

JEL Classification code: A11, D01, D40, D53, G24 Key words: Mutual funds, Derivatives, and FII etc

1. Introduction: Derivatives are a widely misunderstood term. This word often conjures up visions of speculative dealings, a big boom and a big crash. Bad news spreads fast and the Barings Bank collapse as well as the Orange County episodes has helped strengthen the idea that derivative trading is nothing but reckless speculation. But this notion is not true. Used carefully, a derivative transaction helps cover risks, which would arise on the trading of securities on which the derivative is based. A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities. A stock option, for example, is a derivative security whose value is contingent upon the price of a stock. However, derivative securities can be contingent upon the price of almost any variable. For this reason, another name accorded to derivative securities are contingent claims. 2. The need for a derivatives market:

The derivatives market performs a number of economic functions: 1. They help in transferring risks from risk averse people to risk oriented people 2. They help in the discovery of future as well as current prices 3. They catalyze entrepreneurial activity 4. They increase the volume traded in markets because of participation of risk averse people in greater numbers 5. They increase savings and investment in the long run 3. The participants in a derivatives market Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.

 Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. 4. Derivatives markets in India:

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE 30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official

gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent. 5. FII Investment and it s Impact on Indian Equity markets:

It is important to point out that even when foreigners are noisy and irrational, their activity does not necessarily have a destabilizing impact. Domestic investors may be powerful enough and the market as a whole succinctly liquid to accommodate selling or buying pressures from noisy foreigners. As long as domestic investors are not subject to the same

imperfections that give rise to noisy trading strategies, foreigners should have no impact on volatility. However, they find no permanent effects of net foreign order imbalances on prices and volatility. Domestic investors quickly accommodate large sales or purchases by foreign Investors. One is that the relationship between volume and volatility is driven by changes in fundamentals. If investors interpret information differently, new information will cause both price changes and trading. This gives rise to a contemporaneous relationship between volatility and trading. Trading is the process through which private information is incorporated into prices. In this case the causality runs from volatility to volume and markets are efficient. The other possibility is that trading itself generates volatility in prices. Foreign trading is part of the total trading volume. Given the positive relationship between total volume and volatility, one would expect that foreign trading is also associated with volatility. This relationship can mean two things. First, it can reflect the heterogeneity within the group of foreign investors. This heterogeneity causes information flow about fundamentals to be associated with trading. Second, it can mean that foreigners pursue noisy trading strategies and that their activity is not arbitraged away by domestic investors. If the degree of heterogeneity within groups of foreign and domestic investors is the same then the two groups should exhibit proportional amounts of trading based on heterogeneity and fundamentals. Hence, controlling for total trading volume, foreign trading should have no impact on volatility if foreign investors are as noisy as domestic. However, if foreign investors are especially noisy and irrational, then even controlling for total trading volume their activity may have an impact on volatility. The relationship between trading volume and volatility is of some importance. As on today total Investment of FII in India is apprx $b 40 and opposite to that Mutual funds investment is nearly $25 b, and in last three years thanks to rally on Indices Mutual funds market has increased by whooping 30-40% and so as FII inflow. But only critical issue is if FII press selling button to book profit and to pump out their money in that event will Domestic investors along with Mutual

funds will save the grace for Indian Equity markets? This is the question which is roaming in everyone s mind after Sensex and Nifty has corrected by whopping 12-13% in October itself, where net data shows FII were the sellers to the tune of $ 0.5 b and opposite to that Mutual funds where buyers by $ 0.75b. In this condition how Mutual funds role will be in coming months and time when market has become extremely volatile is very interesting to investigate especially after SEBI has given permission to Mutual funds to trade in Derivatives markets and how Mutual funds will save Indian Indices to not behave in the manner as per FII Inflow and Outflow. These are all the questions can be answered after studding Behavior of Mutual funds in days to come. 6. Role of Mutual funds in Indian Equity Markets:

Following the recommendations of the Secondary Market Advisory Committee, the SEBI decided to permit the Mutual funds to participate in the Derivatives market at par with Foreign Institutional Investors (FII). Accordingly the Mutual funds shall be treated at par with registered FII in respect of positions limits in Index futures, Index options, Stock options and Stock futures contracts. The Mutual funds will be considered as trading members like registered FIIs and the schemes of Mutual funds will be treated as clients like sub-accounts of FIIs.This revised policy will be applicable to all new schemes which are yet to be launched and for existing schemes, the Mutual funds are require to obtain positive consent from the majority unit holders for participation in the Derivatives segment while simultaneously allowing exit option to dissenting members without any load. 7. Impact Analysis of Mutual funds participation in Derivative segment: There are following possible impacts of Mutual funds participants will be on Derivatives and Cash segment.

1. Introduction of structured product regime. As on today the mutual funds had been offering the plain vanilla equity and debt products with add-ons. The new guidelines are likely to facilitate the way for new regime of structured products where the mutual funds will be able to offer hybrid of equity, debt and derivatives products with varied features in terms of risk Limited Loss Products: Hedged products Index based products Fixed Income products reward parameters.

Some of the new product structures could be:

2. Greater opportunity for Retail Investors to avail advantage in Derivatives: The retail investors will have even more options to choose between various options. It is expected to benefit the retail investors of Derivatives in the same way as the retail investor of equity. The investors will get a chance to diversify their derivatives portfolio with much lesser investment than otherwise in the form of margin money require in direct derivatives segment. Moreover portfolio will be in the hands of professionals, which will reduce the unsystematic risks. On the other hand the availability of leveraged products at leaser investment would attract and develop new investing community, which are as on today are not investing in Mutual funds due to less risk reward philosophy. In Debt segment also Mutual funds can have cannibalization advantage in which mixture of debt segment and derivatives can keep returns far more favorable and competitive compared to other investment avenues.

3. Greater liquidity and market depth: Mutual funds are now eligible to take positions in directional bets and not just hedging. By considering various position limits as specified by SEBI, it is likely to add liquidity of Rs. 75000Cr ore per month which will fuel Derivatives segment activity and Dependence of FII on Derivatives segment can be reduce by greater extend. Currently derivatives segment seems to be underutilized and the open positions are skewed towards the near month contracts. As a result the derivatives segment is yet to reap benefits of numerous strategies particularly the time spread strategies. The infusion of liquidity will encourage trading in lower maturities in both futures and options with relatively lesser impact cost. This will not only improve the market structure but will also open room for applications of more complex strategies, which generally fall within the purview of institutional trade.

4. Improved Pricing Efficiency As we know that higher liquidity and greater number of institutional players will improve the pricing efficiency as this will lead to enhanced market making which is currently not present in middle and far month contracts. After the permission to Mutual funds to trade in Derivatives segment options segment will be major beneficiary as market making institution will reduce the bid ask spreads in all the maturations. This will be a boon for retail investors who will get more opportunity for investment in options.

5. Decline in arbitrage opportunities Efficient market making will lead to greater pricing efficiency. This will shrink the spread between the spot and the derivatives segment, which will virtually eliminate the arbitrage opportunities between the two.

Hence this may prove tough for the arbitrageurs and the arbitrage mutual funds. However liquidity in options across the entire horizontal (price) and vertical (time) spectrum may give rise to synthetic and cross arbitrage opportunities.

6. Undue market volatility towards settlement With directional investments coming in from mutual funds after this permission, the derivatives settlement cycles are likely to be exceptionally volatile and choppy. Unwindining of large open positions towards the expiry will induce additional volatility in the markets. The stocks where the liquidity is currently limited will also come in the ambit of higher activity and trading interests due to large liquidity flowing into their derivatives instruments. This will give way to good trading opportunities in relatively smaller stocks too. Higher volatility is further expected to improve the pricing in the options segment.

Conclusion:

Thus it is to be conclude that by permitting Mutual funds to trade in Derivatives segment will not only benefit retail investors to hedge their positions without directly burning their fingers in highly volatile and risky Derivatives segment but other players like HNI and FII will also benefit due to much needed liquidity in Derivatives segment. Finally only time will tell the success and failures of Mutual funds trading in derivatives market till that period of time everyone will eagerly watch the whole drama which is about to unveil for a bright future of Derivatives from Mutual funds side.

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REFERNCES:

1. Bekaert, Geert, and Campbell R. Harvey, 1997, Emerging Equity Market Volatility, Journal of Financial Economics 43(1), 29-77. 2. Calvo, Guillermo A., and Enrique Mendoza, 1999, Rational Contagioan and Globalization of Securities Markets, Journal of International Economics, 3. Choe, Hyuk, Kho, Chan Bong, and Rene M. Stulz, 1999, 4. Do Foreign Investors Destabilize Stock Markets? The Korean Experience in 1997 Journal-of-Financial-Economics 54(2), 227-64. 5. Daigler, Robert T., and Marilyn K. Wiley, 1999, The Impact of Trader Type on the Futures Volatility-Volume Relation, Journal of Finance 54(6), 22972316. 6. DeLong, Bradford J., Andrei Shleifer, Lawrence H. Summers, and Rober J. Waldman, 1990a, Noise Trader Risk in Financial Markets, Journal of Political Economy 98(4), 703-738. 7. DeLong, Bradford J., Andrei Shleifer, Lawrence H. Summers, and Rober J. Waldman, 1990a, Positive Feedback Investment Strategies and Destabilizing Rational Speculation, Journal of Finance 45(2), 379-395.

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