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September 22, 2000
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The thriving grey market of derivatives

In the warped lexicon of the command economy, speculation was a four-letter word. By extension, all derivatives were considered sinful since they aid speculation. Yet a decade after liberalisation, India is likely to see a derivative explosion in the near future.

Both badla and automated lending and borrowing mechanism -- ALBM -- will continue to be popular. Both systems will need extensive modification to deal with the rolling settlement system but this is a back office problem than a theoretical barrier. As IT systems improve, both instruments will evolve to tackle the rolling settlement. The only serious sticking point would be the circuit filters, which might lock traders out in rolling settlement mode.

The pure derivatives on offer will increase from just vanilla index derivatives to more complex instruments such as options. More markets such as forex and money markets will also be covered and commodity options will also become popular soon.

In both forex and money markets, there is a strong case for derivatives. The increased volatility of the underlying asset is the basic issue. Since the rupee is likely to gyrate and because short-term rates will gyrate along with the currency, every corporate treasury department needs hedges.

The easiest forex hedges could be quasi rather than rupee-dollar or cross-currency positions. If instruments such as Dollex and Defty futures, are traded both here and abroad, these would be hedges against rupee movements. There is a proposal to trade Indian index futures in Singapore. A combination of the Nifty-Defty could then hedge the dollar-rupee risk since the difference between the two index returns is precisely that currency risk.

Similarly derivatives could revolutionise the secondary money market. Assume availability of derivative instruments based on treasury bills of varying longevity. A yield-curve shift could be hedged or exploited with adequate leverage. If this sort of layoff is possible, money market liquidity will jump exponentially.

Equity options are likely to be available soon. The problem with an equity option on any given scrip is the prospect of non-delivery and hence default since the holder of a call option has the right to demand delivery. In stocks like Himachal and DSQ Software, the entire paid-up capital is often "traded" within a single settlement. So the defaults could be of truly extraordinary dimensions! Especially if the stock is in book closure-no delivery mode.

The Indian equity market already has a thriving if illegal cluster of options instruments available. These are carefully designed to afford short-term protection without excessive default risks. Since expertise already exists, they could be regularised without trouble. There isn't a legal or tax barrier anymore.

The traditional Indian options solve the major problem of duration mismatch in the current futures market. Most hedgers have problems trading instruments that are open for a month or longer, because the average equity position is settled within seven days.

The available derivatives are quite sophisticated and a short description of the market is in order. These instruments are available strictly on a trust and word-of-mouth basis in major financial centres like Bombay, Ahmedabad, Jaipur and Calcutta. It helps to know Gujarati and the Marwari dialect if you want to play this market. I'm not aware if South Indian versions exist, though I would be very surprised if they don't.

If the reader has moral qualms about such things, just assume that the following is a completely theoretical scenario. Assume the existence of call options (tejis), put options (mandis), and straddles (phataks and bhav-bhav) on specific A-Group shares. Only out-of-the-money options are offered, i e the strike price is always higher than the spot price for a teji and strike price is always lower than spot for a mandi.

In both cases of teji and mandi, the writer or khane-wallah accepts a premium to buy or sell underlying assets at a strike price. The premium is usually fixed at around Rs 25 per hundred shares and paid upfront. The strike price is negotiable. Obviously, circuit filters play a part.

The usual option expires at a designated time some 15 minutes or 30 minutes before the close of the next day's trading. Some options however are European-style to be exercised only on a specific day. These are on offer on the first post-Budget session, or the day after the given company's annual general meeting. These European options are usually double premium at Rs 50 per hundred shares.

A popular combination straddle is known as a phatak. A phatak consists of call and put options at prices respectively higher and lower than the closing price of the session. The spread of the phatak varies and is negotiable.

A simple example would be a phatak on a stock that closed at Rs 100. Let us say, the call is available at Rs 105 while the put is at Rs 95. The writer is thus hit only if the share moves out of that Rs 95 to Rs 105 range. The premium is usually double on a phatak, i e around Rs 50 per hundred shares.

Another combination is a bhav-bhav -- BB. Here the strike price is the closing price, let us say Rs 100. Within the next session, the holder of a BB can either buy or sell it from the option writer at that price.

Obviously if the stock is volatile, the BB carries a larger underwriting risk. The premium is thus negotiable and usually set at half of the phatak spread for the same stock. If the phatak spread is Rs 5 on either side as in our example, then the BB premium is usually charged at around Rs 2.50.

Oddly enough the risks-rewards are counter-intuitive because of this relationship between phatak spread and BB premium. Let us extend the above example. Closing price = BB = Rs 100. Phatak = Rs 95 (put/mandi) & Rs 105 (call/teji). Phatak spread on either side is Rs 5 and premium per share is Rs 0.50 and Premium for BB is Rs 2.50. The writer of a BB can also take a phatak to hedge, collecting premium at Rs 200 per hundred shares after hedging off some risks.

Let us assume the writer wants Rs 1,000 as premium. A phatak must go for 2,000 shares and an unhedged BB for only 400 shares. Then if the stock doesn't fluctuate a great deal, the phatak is the less risky instrument for the writer. For a highly volatile stock, the BB is the better instrument from the writer's point of view. Obviously this viewpoint is reversed for the option-holder.

It's fascinating. Assuming A-group stocks, short one-session durations, and circuit-filters, the risks and rewards are easy to calculate. Option-buyers should go with phataks for volatile ICE and BB for less staid stocks. There are lots of niggling imperfections, which the educated hedger could exploit.

But most importantly, a lot of local operators already know exactly what the risks are, and have worked out risk-management systems. So legitimising an extant grey market wouldn't cause too much upheaval.

Devangshu Datta


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