The second coming

In 1969, Finance Minister Morarjee Desai introduced legislation to ban all derivative instruments. Ostensibly, this step was taken to prevent speculation and hoarding. It is rumoured however that Desai actually brought in this drastic measure to prevent Ramnath Goenka mounting a complicated takeover bid on the already ailing Indian Iron & Steel Co.

In retrospect, the late press baron could hardly have made a bigger mess of that unfortunate company, than the government eventually did. But IISCO wasn't the only, or even the largest sufferer from Desai's decision.

That decision to outlaw derivatives was repealed only recently. In the meantime, the textile and jute industries died. The ostensible reason in both cases was continuous labour problems. Aggressive unionism led first to unrealistic agreements between mill-owners and unions and then to a string of lock-outs.

The lack of a hedging mechanism was a contributory factor in the demise of both industries. Jute and cotton are commodities that fluctuate sharply in price and output. A futures market would have enabled the shrewder players to lay off risks and at least aided a ballpark estimate of next season's output and prices.

That would have meant more rational negotiations to the benefit of all concerned, not to mention prevented starvation and suicide in the cotton belts of Andhra Pradesh. In the absence of the futures market, there was no benchmark for negotiations.

By removing derivatives from the financial player's armoury, the government also drove an extremely sophisticated hedging system underground. As a result, every financial market suffered. Quasi-derivatives like badla and automated lending and borrowing mechanism (ALBM) were introduced through the backdoor in equity markets and futures in certain agri-commodities have been revived. But it was only a few months ago that the most basic form of index futures was introduced.

The second coming of equity derivatives might actually make the market a safer place. It may be argued that the default risk that always overhangs badla would be replaced with a hedging mechanism. A futures instrument carries certainties such as a known time-period and a fixed opportunity cost. An index future is non-deliverable by definition, so default risk doesn't arise. And the leverage available should attract the cowboys and gradually entice them away from the spot market making that a safer place as well.

In fact, the new futures market is still pretty small and the instruments are pretty restrictive. The Sensex futures market logged only Rs 80 million in August. But the market is doubling or tripling in size every month. And coupled to the earlier liberalisation in mutual funds, it allows some fascinating speculative plays as well as vanilla hedging strategies.

An Indian speculator now has the choice of implementing either market-neutral strategies or attempting what is called market timing. The first was completely impractical earlier and the second was difficult without prohibitive outlays in funding. It may be fun to take a look at both possibilities and some variations on them.

Sooner or later, the more enterprising players will be playing these games, and they won't be prohibitively expensive either. A market-neutral strategy is designed to generate returns after canceling out the market-specific risks as far as possible.

The market-neutral player picks a portfolio to sell short and also picks a balancing portfolio of long positions. Whichever way the market goes, he hopes to make money with the right mix. If the market drops, the short portfolio will outperform and if the market rises, the long portfolio will pull up returns. The gain or loss will come from stock-specific risks only since the market risk is being stripped off.

There are conflicting opinions on the success rates of market-neutral strategies. But there was a huge practical barrier to going market-neutral until the introduction of index futures. Funding long positions on Badla/ALBM was never a problem - at least in about 125-odd liquid counters. Long positions can always be settled one way or the other.

The difficulty lay in making naked shorts. There is always the danger of being squeezed while trying to cover. There is also the painful tendency for SEBI and exchange authorities to jack up margins for short sales or even ban them in falling markets when they are especially required.

The existence of an index future solves the problems for a market-neutral strategy. You can now trade the index with fixed leverages, known opportunity costs and no risk of being squeezed while playing the badla/ALBM game on the other side of the asset/liability divide. Nobody seems to be doing this on a large scale yet, given the tiny derivatives volumes. But it's bound to happen.

More complex strategies can be derived to exploit money market fluctuations and the linkages between interest rates and equity movements. If you expect falling rates, you can buy the index in anticipation of rising equity prices while selling debt instruments to hedge against the opposite possibility and vice versa if you expect interest rates to rise.

Again it's anybody's guess whether there are any players in this game. Since we can reasonably expect rising rates through the next few months, it must be tempting to sell three-month Sensex futures and buy debt securities to hedge the less likely possibility of rates falling.

It is when you add mutual funds to this mixture that the possibilities really ignite. A money market mutual fund is a liquid, cheap and broad option compared to a portfolio of thinly traded debt securities. Buying/selling a high-beta equity mutual may be a better option than going long in individual stocks to create the long side of a market-neutral portfolio.

Until the mutual fund sector was liberalised, this wouldn't have been possible because liquid no-load or low-load funds didn't exist. Nor did the concepts of portfolio transparency, regular net asset value (NAV) declarations and fast exit options.

Once the mutual fund market took off, other strategies became possible. Add index futures and you could just create a dynamite market-timing system. Big market-timers are amongst the most successful operators in the US. Their strategy is to ride market-specific risk after making the right call on market direction.

Timers trade a portfolio of mutual funds when they sense a market turn. The logic is that a diversified "fund of funds" will capture market-specific risks and even amplify them, while cancelling out stock-specific risks. If the call on market direction is correct, a market timer is saved the bother of actually picking stocks for his portfolio.

Market timing is a risky game and while it was possible before the introduction of futures, it could only be taken in one-sided trades. Constructing a portfolio of negative-beta funds to hedge a market-timing position is too cumbersome and the leverage is non-existent. Hedging with a highly leveraged futures instrument could cut market-timing risks down.

Of course, there is an implicit assumption in the above strategies. The operator is betting on his judgment. The market-neutral trader is backing himself to pick the right specific stocks for a high return after stripping off market risk. The market timer is stripping off stock-specific risks and backing his judgment on market directions. Derivatives seem to deliver both a possible upside as well as a cheaper hedging mechanism.

Devangshu Datta

Money

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