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Are the domestic markets ready for futures trading?
Ramesh Gupta
Much of the written and public discourse in India tends to perpetuate comfortable myths that future trading is necessary for globalising Indian stock markets and that one should not worry much about its unintended and sometimes even harmful effects for domestic investors. The most charitable judgement one can make of these educational endeavours through the public media for their Indian audience is that they are exactly what they claim to be - oversimplified examples. Most articles merely define future trading and its obvious uses in portfolio management. Hardly anybody (including SEBI Committee on Derivatives) has cared to examine in depth the prerequisites for future trading to ensure a reasonably competitive market and its likely effect on the spot market and investment climate.
One singular truth about future trading which remains undisputed is that the justification for future markets depends on the need for risk hedging. The market simply does not come into existence solely to furnish a speculative arena, nor does it persist if hedgers, the genuine and long-term investors, do not find it rewarding to continue in those markets. The higher the level of hedging, the higher the level of future business. Therefore, it is very important that we understand fully the theory and practice of hedging and carry out an examination of the demand and supply forces that would determine its acceptability and viability in the Indian market place. There are many who regard `speculation' and `gambling' as synonymous terms. One generally hears of `investing in securities' and `gambling in futures'. However, the usual differentiation is based on the nature of the risk and the social good involved. Gambling involves the creation of a risk for the sole purpose of inducing someone to take it. The horse
race, poker game, and roulette wheel all create risks that would not be present without them. Gamblers are willing to accept these risks in return for the opportunity to win some money. On the other hand speculation deals in risks that are necessarily present in the system. These risks would be present whether future markets existed or not. If speculators are not there, somebody else would have to take them.
Any kind of future trading involves hedgers and speculators. For efficient functioning of future markets, speculators are necessary, because the volume of business done by genuine hedgers at any given time is frequently too small thus limiting the liquidity necessary for an efficient market. Moreover, a preponderance of hedgers frequently tends to want to buy at the same time or sell at the same time. Thus speculators along with professional traders and arbitrageurs are needed to take the other side of some of these trades. Speculators provide a continuous liquid market. Without the speculators future market would not function. Therefore if the future markets operate for the social good, the speculator who makes the operation possible also contribute to the social good. However, one must caution here that specially in stock markets which are secondary in nature, sometimes market practices and systems evolve in such a ways that excessive trading creates its own market risk without adding any economic value to
the society. For example, high volume turnover of securities in the secondary markets without new investment coming into the capital markets or reallocating the resources among different sectors, creates (and/or increases) market risks without any economic or social benefits. And then people who in the first place have created this economically unjustified risk begin pleading for instruments to hedge this risk. Thus, the hedging device itself becomes a new game to be played by sophisticated operators without adding much economic value and thus speculators and futures become gamblers.
There is a basic difference between commodity futures and equity index futures. In the former, hedging is done to protect manufacturers, traders and consumers of commodities from price variation in primary goods (i.e., agricultural and metallurgical commodities). Hedging through commodity future markets allow the risk of price changes to be shifted, and hence the costs of production, marketing and processing are reduced. If this is true, and if the cost savings are passed on to the consumers, future trading will benefit the consumers on whose behalf the economy is supposed to function. And if the speculators made this all possible, there could be little quarrel with the argument that their services had social value. Similarly, in the currency exchange markets if exchange risks for exporters and manufacturers can be reduced by the speculators, and benefits are passed on to the consumers, it would have social value.
In commodity and currency futures, speculation deals in risks that are necessarily present in the process of marketing of goods and services in a free capitalistic system. For example, as soybean grows and is harvested, concentrated, and disbursed, the obvious risks of price changes must be taken by those who own the soybeans or have commitments to buy them, either in original form or as oil or meal. These risks would be present whether future markets existed or not. If the speculator was unwilling to take them, someone else would have to do so. The speculator in commodity markets does not inject risk into the economy merely because of a desire to speculate. Investors in stock markets generally take two kinds of risk - stock specific risk and market risk. Two distinct types of strategies are implemented to manage these two types of risks. The first strategy is "stock selection" that is, trying to select stocks to buy that will outperform the market and, to a lesser extent, trying to select specific stocks to
short that will underperform the market. If one wants to take only market risk one does so by diversifying one's investments among various stocks which are not highly correlated. The strategy for managing market risk is "market timing", that is, switching to very volatile stocks during times of expected bull markets and to low volatility stocks or even money market instruments during times of expected bear markets. This strategy involves "asset allocation" that is, shifting among equities, money and bonds. Of course, market timing strategy may interfere with stock selection strategies and/or reduce the effectiveness of portfolio diversification. There may be problems in both stock selection and market timing strategies using only the cash stock market. With stock index future contracts the problem in implementing both types of strategies can be reduced or eliminated.
The most sophisticated new financial product in the world will go nowhere if it does not meet the basic need of a society. Perhaps less obviously, demand for a financial instrument is ineffective if no one will supply it in a convenient marketplace at a price consistent with the demand. Before introducing any future trading in India, a question one needs to ask here is: who and how many are these investors who have genuine needs to hedge their market risk; and who are the potential counterparties to such trade who are going to provide hedging. Only after assessing the demand and supply for hedging, one should introduce an instrument which would serve a social purpose.
If a future trading in index in India is advocated on the basis of hedging needs of investors, one must assess the market demand and supply source before introducing the product in the market. To determine demand, one would need to know:
How many investors (individual, institutional) in India hold and/or approximate the index portfolio?
What are the objectives in holding this portfolio?
What is size of their portfolio?
What are their hedging needs?
At what price would they be seeking hedging? (As we have discussed earlier, perfect hedging would result in earning only a risk-free rate of return minus administrative costs).
Would it be possible to have a reasonably continuous demand curve given the number of hedge seekers and their stated price preferences.
Similarly, on the supply side would there by a sufficient number of hedgers who would like to offset the opposite risks or liquidate another hedge as a result of a change in their positions in the cash markets. And if hedgers are few in number and if all hedger seekers are on the same side, which is most often the case, arbitrageurs and speculators would be needed to provide the other side of the transaction. For arbitrageurs to function properly, we would need to examine the working of the cash market, because arbitrage would be done in spot and future markets. Two major hurdles in perfect arbitrage are: tracking error - whether they would be able to trade in index portfolio or a mix of shares (particularly in the absence of short sale facilities) which would approximate the market risk inherent in their bought portfolio - minor error can wipe out their profits; and impact costs which are incurred to execute such large order in a brief time period. If the above is not possible in our existing cash markets,
then only speculators are going to dominate the future markets. Speculators needs to have large funds to operate and an appetite to take the risk. In India, one would need to assess the numbers of such players. If such numbers are small because of institutional and legal constraints which inhibit their operations (e.g.,mutual funds, government dominated financial institutions etc.), we would not be able to have a competitive market. Few speculators would be able to dictate the markets because there would not be many left to provide the opposite side of the transactions. This question become more crucial when settlements are done in cash only and not by actual delivery (which is the case in index future trading). One would have no choice but to enter the contract at dictated prices.
In the end, one can only ask what is the hurry in introducing derivative trading? First, regulators owe it to domestic investors to put in place a stable and reliable spot market for conducting genuine investment processes while avoiding the allure of sensuous hot money. Policy-makers would have to decide whether it is important to protect the interest of overwhelming number of domestic investors which provides more than 95 per cent of the savings for the country's development as opposed to satisfying the gambling instinct of providers of hot money. Genuine foreign investors which are willing to take risk in Indian markets are welcome, but not at domestic investors expense. If they are seeking hedges even from market risks, they should not expect to earn more than a risk-free return. They are gaining sufficiently by international diversification. They must learn to take some amount of risk to make extra gains. That's what the risk-return paradigm is all about.
It is a historically known fact that the contrast of `public interest' and `interest group' provides different conceptions of rationality in regulatory processes. It would be heartening if decision making of national importance involves wider investor participation than just the selected few who have vested interests, however, deep their pockets may be.
The author is on the faculty of the Indian Institute of Management, Ahmedabad
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