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The Pratip Kar Committee set up by the Securities & Exchange Board of India (Sebi), following the decision taken by the Reserve Bank of India (RBI) to permit mutual funds (MFs) to invest in overseas markets, has recommended that MFs should be allowed to invest through schemes either exclusively meant for overseas investments, or as a part of a scheme which includes domestic investment.
The committee has further recommended that funds may enter into index options or stock-index futures only for the purpose of hedging the risk of fluctuations of the securities within a portfolio, or for the purpose of efficient management of the portfolio. The committee has further suggested that MFs may be permitted to enter into forward-currency contracts or currency futures in foreign exchange, enter into interest-rate futures contracts, deal in options in interest rates or foray into interest- rate swap transactions only for the purposes of hedging and efficient portpolio management.
Accepting the recommendations, Sebihas issued guidelines permitting MFs to trade in derivatives, restricted to hedging and portfolio-balancing purposes. Funds are, however, required to fully cover their positions in the derivatives market by holding underlying securities/cash or cash equivalents/option, and/or obligation for acquiring underlying assets to honour the obligations contracted in the derivatives market. Sebi must be congratulated for its thoughtful action of issuing these guidelines well in advance of investment in overseas markets.
Hedging by Institutions: The LC Gupta committee on derivates has recommended that the present legal restrictions on the use of derivatives by investment institutions for hedging should be removed in the interest of the institutions themselves. Sebi is expected to issue guidelines permitting investment institutions to enter into transactions in derivatives for hedging, before commencement of trading in them.
In fact, these guidelines need to be issued well in advance to enable investmentinstitutions to equip themselves with the intricacies of entering into transactions in derivates even for hedging, and guard themselves against losses arising out of inadequate understanding of the techniques of hedging.
Badla - A Hedge Instrument: It needs to be noted in this connection that the modified carryforward system of trading, popularly known as badla trading, which is now in operation on the Bombay and Delhi Stock Exchanges, is basically a hedge instrument like options and futures. Anyone holding securities can hedge against a likely fall in prices by selling in the carryforward market. If the prices decline, the losses in the holdings would be offset by the gains in the carryforward market. Similarly, anyone anticipating a future cash flow can hedge against a likely rise in prices by buying in the carryforward market.
If the prices rise, the gains in the carryforward market would offset the additional costs that would have to be paid because of the rise in prices in the cash market. TheSebi (Mutual Funds) Regulations, 1996, requires mutual funds to buy and sell securities on the basis of deliveries only, and a mutual fund "shall in no case put itself in a position whereby it has to make short sale or carryforward transaction or engage in badla finance".
There is no reason why a mutual fund or any other investment institution for that matter should deny itself the benefit of hedging available under the modified carryforward system, which has today a host of checks and balances to prevent any aberration.
Relative merits of futures, options and badla as hedge instruments: It is worthwhile to examine the efficacy of futures, options and badla as bedge instruments.
Futures contracts are only on stock indices and not on individual stocks. A perfect hedge would require the prices of basket of shares held or proposed to be bought to move in unison with the stock index.
As such a movement normally does not take place. Beta factors measuring the variation beween the prices of concernedsharesand the stock-index values are worked out and purchase or sale of the number of futures contracts adjusted accordingly to provide for a perfect hedge. This assumes that the beta factor of the past will continue to operate in the future too - an assumption which may not always prove to be correct.
Besides, the investors inability to buy or sell the required number of shares (when it is not an integer number), transaction costs and lack of absolute correlation between the spot and futures values of the index, margin deposits, price limits, etc, detract the futures contract from acting as a perfect hedge.
Hedging through options is a relatively costlier proposition because of the premium the purchaser of the call or the put has to pay. In the case of a call, the premium is higher for lower strike prices, while the premium is higher for higher strike prices in respect of a put. The premium amount would be detracting the instrument from acting as a perfect hedge.
Badla is an almost perfect hedge instrument.The question of any lack of correlation between the futures and spot prices detracting the instrument from acting as a perfect hedge does not just exist, as the quotation in respect of all the three types of transactions, namely, for delivery, offsetting and carryforward, is one and the same.
There is also no question of payment of any premium amount, as the market is equally balanced between the buyer and the seller. Payment of contango by the buyer to the seller, short or otherwise, is only by way of interest for the amount of money the buyer would have to pay for the shares bought by him but has chosen out of his own volition not to pay, and instead, has carried forward the transaction to the next settlement.
It is also relevant to note that futures has its own limitations in discharging its function as a hedge instrument even with regard to index-based funds, not to speak of individual scrips.
The step-motherly treatment being given to the indigenously spun badla system of trading, being traded inits new avatar as a modified carryforward system, needs to be rectified.
While futures and options need to be introduced and the facility to take advantage of benefits of these instruments needs to be granted to all, not just the investment institutions, there is no accrue by trading in the modified carryforward system. That would establish a level-playing field for operators who can decide which instrument they need to resort to for getting the maximum benefit of hedging.
The author is a former director of the Bombay Stock Exchange
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
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