What is the level of institutional participation in Derivatives?

Institutional participation in Derivatives is limited in spite of a huge turnover level in this segment. This phenomenon is indeed surprising but true. The Finance Ministry and the Government were initially of the view that derivatives would be dominated by institutions. However, the reverse has happened. It is the retail crowd with the High Net Worth individuals and the broking proprietary positions that has dominated the Derivatives segment in India completely unlike the developed markets where institutional participation is the key driver of these markets.

While each of the institutional segment possibly have their reasons for not joining the band wagon, in recent months, Foreign Institutional Investors (FIIs) have become a important participating community. This is related to the fact that investments in the cash market by FIIs has increased considerably this year and to the rupee being stable and growing stronger against the dollar. It is also widely believed that FIIs have taken significant arbitrage positions in the cash and carry (buy cash, sell futures) trades.

Are Mutual Funds allowed to invest in Derivatives?

The first SEBI Committee on Derivatives headed by Chairman Shri L C Gupta recommended that Mutual Funds be allowed to enter into the derivative segment for the purposes of hedging and portfolio balancing. The report defined in detail the meaning of hedging and provided a fairly liberal scope for mutual funds in hedging. Subsequently, a SEBI circular on the subject reiterated the same scope for Mutual Funds. However, fund houses were not too keen to trade possibly because the definition was not very clear.

What is the position now?

Due to confusion about the scope of hedging and portfolio balancing, SEBI issued a Circular on 31st December 2002 which elaborated more on the understanding on the subject. Some confusion still prevails but the Circular does provide more light than before.

What is hedging as per the latest Circular?

Assume you are a Mutual Fund with a holding in Infosys and that you hold 10,000 shares. You are allowed to sell Infosys Futures to the extent of 10,000 units. You are also (alternatively) allowed to buy Infosys Puts to the extent of 10,000 units.

You can also use Index Futures or Index Puts (whether you hold index stocks or other than index stocks). The SEBI Circular provides that you can sell Index Futures or buy Index Puts to the extent of Portfolio Value multiplied by Portfolio Beta. For example, if you hold a portfolio of Rs 200 crores and a beta of 1.21, you can use Derivatives for a notional value to the tune of Rs 242 crores. It has been clarified you can use Index Futures or Index Puts to the same extent of Rs 242 crores of notional value. Any excess positions would obviously not be justified as that would amount to a speculative position.

It has been made clear that you cannot hedge Infosys long position by selling any other stock futures (e.g. Reliance), nor can you sell a diversified equity position by selling a sectoral index futures contract. For example, if you hold Infosys, Levers, Reliance and SBI, you cannot hedge this position by selling an IT Index Futures contract. These are logical limitations which make eminent sense.

It has further been stated that you can sell covered calls to the extent of notional value of stocks held. It is interesting to know that even covered calls are included under the definition of hedging. It is clarified that the notional value of covered calls sold cannot exceed the value of the underlying portfolio. This is a fairly liberal definition and fund managers should be happy to see this provision.

The L C Gupta Committee had considered the concept of hedging cash, which unfortunately has not been elaborated upon by this Circular. That Committee had stated that if a mutual fund has collected cash from its unit holders and is concerned that if it starts buying stocks immediately, it would involve a rather huge impact cost, the mutual fund could first buy futures. Slowly it could unwind its futures positions and buy cash positions instead. This kind of anticipatory hedging would also be allowed as per the Committee.

What is portfolio balancing?

The Circular defines portfolio balancing in a rather peculiar manner. It declares that if a mutual fund can create a position using derivatives which equates with a position similar to a cash position, then such a derivatives strategy should indeed be followed as a matter of good practice so long it creates a position at a lower cost for its unit holders. The Circular states that the mutual fund is working in a fiduciary capacity for its unit holders and is obligated to follow a strategy that lowers its cost of acquisition.

Thus, if the mutual fund desires to acquire shares of Infosys and finds that Infosys futures are quoting at a low cost of carry, it should buy Infosys futures, invest the surplus funds left in the money market and earn the cost of carry and convert the futures position into cash position at the expiry (or any time before the expiry) of the futures contract. This strategy would reduce the cost of acquisition of Infosys for its unit holders.

If a fund can improve upon a buy-and-hold strategy by selling a stock or an index portfolio today, investing the proceeds in the money market, and having a locked-in price to buy it back at a future date, then it would have a fiduciary obligation to do so.

What else can the mutual fund do?

It is surprising that the Circular provides for complex possibilities which appear to go beyond hedging and portfolio balancing. It provides that the mutual fund could buy calls, sell calls, buy puts and sell puts which literally opens the entire world of options to the mutual fund industry. It does provide for some limits on the maximum limits upto which such complex positions can be taken, but the limits are likely to be fairly liberal and hence should be a welcome signal for fund managers.

What limits have been defined for complex positions?

We are reproducing an example from the Circular which will enable you to appreciate the limits laid down for complex positions. Considering the following stock option strategy:

  1. Long call options on 5 million shares at a strike price of Rs 80.
  2. Long put options on 2 million shares at a strike price of Rs 90
  3. Short call options on 1 million shares at a strike price of Rs 110
  4. Long put options on 3 million shares at a strike price of Rs 120
  5. Long call options on 4 million shares at a strike price of Rs 130
  6. Short call options on 3 million shares at a strike price of Rs 140

Since the fund has a bullish position on 9 million shares (a plus e) and a bearish position on 9 million shares (b plus c plus d plus f), its option delta could be comparatively small especially when the stock price is not far from the weighted average strike price. However, depending on what the stock price turns out to be at expiry, only some of the options will end up in the money and will therefore get exercised by or against the fund. Consequently, the fund could end up with a long or short position in the stock at expiry depending on what the stock price turns out to be at that point of time. The worst case long and short exposures can be worked out as follows:

Price at expiry Options that end up in the money and therefore get exercised by or against the fund Net number of shares (short or long) the fund ends up holding as a result of the option exercises
Below 80 b and d 5 million shares short
80-90 a, b and d nil
90-110 a and d 2 million shares long
110-120 a, c and d 1 million shares long
120-130 a and c 4 million shares long
130-140 a, c and e 8 million shares long
above 140 a, c, e and f 5 million shares long

The worst case short exposure arises when the share price at expiry is below 80 and the fund ends up delivering 5 million shares to exercise the in-the-money puts. This would be an acceptable level of hedging only if the fund’s position in the underlying and the futures were at least 5 million shares.

Its worst case long position (8 million shares) is when the share price is above 130 and below 140. The fund receives 9 million shares from exercising its in-the-money calls (a and e) and delivers 1 million shares against its short calls (c) which are also in the money. This means that the fund can take up this option strategy only if this 8 million shares plus its position in the underlying shares and futures is together less than the maximum permissible limit for the fund’s holding in the stock.

The fund must therefore satisfy two conditions before it can take up this option strategy as part of “hedging and portfolio rebalancing”:

  • the fund’s position in the underlying and the futures must be at least 5 million shares so that the position does not become over-hedged
  • the fund’s existing position in the underlying shares and futures plus the 8 million shares worst case long exposure of the option strategy must together be less than the maximum permissible limit for the fund’s holding in the stock

Some fund managers may regard the worst case exposure analysis as an excessively harsh view of what they might consider a legitimate and relatively low risk derivative strategy. In particular, it might be objected that the worst case long exposure of 8 million shares should be treated more leniently since it applies only in a narrow range of share prices (130-140). The Committee is however of the view that even if strategies of this kind are attractive and low risk ways of creating and profiting from gamma and vega exposures to a stock, the creation of such exposures does not per se constitute “hedging and portfolio rebalancing”. To justify the strategy in a “hedging and portfolio rebalancing” framework, it is necessary to show that the worst case short position resulting from the strategy is an acceptable hedging activity and that the worst case long position resulting from it is an acceptable portfolio rebalancing activity.

Will mutual funds trade more in future?

It is widely accepted that with FIIs entering the derivatives market in a significant way, other institutions will also start coming forward. The systems for risk management followed in the derivatives industry have so far proved quite robust and will encourage larger players to trade. Mutual funds have been given a liberal scope by the above SEBI pronouncements and it can be expected that funds will trade more in the coming months.

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