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How the volatility index will help markets
December 26, 2007
The Rammohan Rao committee's proposed V-I, among other things, signifies the financial sector's coming of age.
India's futures and options market has seen a boom in the past five years. While a total of only 176,000 index put/call options worth Rs 3,800 crore (Rs 38 billion) were traded on the NSE in 2001-02, those numbers have skyrocketed to 25 million and Rs 7,92,000 crore (Rs 7920 billion) respectively, in 2006-07.
The V-I will measure the market's expectation of Nifty/Sensex volatility over the coming month (30-day period). Since 1993, VIX, the first volatility index introduced by the Chicago Board Options Exchange (CBOE), has been a huge hit.
The V-I will help Indian markets in more ways than one. First, it will be the most direct measure of the increasing market volatility and will thus be helpful in the pricing of options.
But even beyond these uses, it sends a very important signal worldwide, that India is ready to move to the next level of financial maturity. While our capital markets are very well-developed (the BSE is the world's largest in terms of the number of scrips listed, while the NSE is the world's largest by stock futures trading volume), there is a dearth of modern financial products. Sebi's wish to introduce seven new products including V-I is a well-thought out decision to break out of the shackles.
According to recent news reports, India Index Services & Products Ltd (IISL), a joint venture between CRISIL and NSE, has expressed a desire to be a leading player for devising the index. It is likely to do so because of its experience in this space.
However, it's not that the rollover will be smooth. There are certain unique issues that will have to be tackled. The single biggest problem in devising the index will be liquidity concerns.
According to my preliminary research, in all likelihood, we'll follow the old VIX methodology for calculating V-I. The new VIX methodology might be unsuitable for calculating the Indian volatility index because options on Nifty, though aplenty at at-the-money strike, show an erratic behaviour for out-of-money and in-the-money strikes.
The first to cash in on opportunities in new derivative products in India are large institutional players who have already tried their hands at similar products in other markets, like the CBOE, NYSE or LME.
One of the problems cited in Mumbai's way to becoming an IFC is the lack of innovative financial products. While the V-I is not the panacea for all financial problems, it certainly is a very good indicator of Sebi's long-term reforms to align India with global best practices and vision.
The writer, a student at New Delhi's Indian Institute of Foreign Trade, can be reached at email@example.com
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