Nonetheless, the market regulator will have to seriously consider removing circuit filters at least for the scrips constituting the Sensex and Nifty (as the first derivative products will be based on these two indices). Sebi's view is that while circuit filters will make index arbitrage more difficult, it is not a sufficient reason to tinker with systems in the cash market. Hence, in this scenario, it would be better if the introduction of derivatives is put off till Sebi deems it fit to abolish circuit filters.

This is because the very pricing model of the futures contracts will be faulty if it is based on a cash market that has restrictions on price movement.

Like most financial futures, stock index futures essentially trade in a full carry market. Therefore, the cost-of-carry model provides the foundation for futures pricing. When the conditions of the cost-of-carry model are violated, arbitrage opportunities arise and the strategies for exploiting these opportunities are called index arbitrage.

The cost of carrying stocks is nothing but the cost of financing the purchase price of the stocks underlying the index from the present until the futures expiration, adjusted for the future value of dividends expected to be received during the period, ie, the dividend plus interest from the time of receipt till the expiration of the contract.

A fair futures price model should be consistent with the above cost-of-carry model in the sense that the futures price should be the spot price plus the cost of carrying the stocks that underlie the index.

Index arbitrage opportunities arise whenever the futures price deviates from the fair price according to the cost-of-carry model. When the futures price is too high relative to the prices of the underlying stocks, a cash-and-carry strategy is adopted. In this, the trader would buy the stocks that underlie the futures contract and sell the futures. He would then carry the stocks until the futures expiration. Since the futures price converges with the spot price on the day of the expiration (no cost of carrying), the trader is guaranteed a return that is equal to the difference between the errant futures price and the fair value according to the cost-of-carry model.

Similarly, a trader would adopt the reverse cash-and-carry strategy in case the futures price is too low relative to the stock prices on the cash market. In this, he would sell the stocks underlying the futures contract and buy the futures contract.

Hence, it can be seen that the futures price is purely derived from that on the cash market. Also, any discrepancy in the pricing model is corrected by arbitrageurs by either the cash-and-carry or reverse cash-and-carry strategies.

However, traders will face the problem of executing programme trades of either buying or selling the set of stocks that underlie the index if any of these scrips is stuck at the circuit filter. Hence, the futures price will continue to deviate from it's fair value. This will be a very unusual situation considering that no other country with derivatives markets have circuit filters on individual stocks.

Loopholes in takeover code
Two recent and simultaneous events have once again highlighted the loopholes in Sebi (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (the Code). Zee Telefilms is acquiring 26 per cent stake in Aplab through the preferential allotment route. In another unrelated development, Jatias, the original promoters of Wimco are divesting their stake to Swedish Match Company (SMC). As a result, SMC's stake in Wimco will go up from 52 per cent to 74 per cent. Earlier, SMC had hiked its stake from 38 per cent to 52 per cent through the preferential allotment route. In both cases, there is no requirement of an open offer.

Under regulation 3(1)(c) of the code, no open offer is required to be made for a preferential allotment, if the disclosures prescribed are complied with. This rules out any open offer from Zee. Regulation 3(1)(e)(iii) provides an exemption for inter-se transfer among promoters if the transferor as well as transferee is individually holding at least 5 per cent shares in the target company for a period of at least three years prior to the proposed acquisition. This will mean that no open offer will be made to the shareholders of Wimco either.

The oft-given excuse for granting exemption to the preferential allotment route is that because of the pricing formula prescribed by SEBI, price advantage is done away with. However, this route is normally used by companies with a low equity base - Paper Products being an example. It is logical that the exit option through the open offer route is needed most for companies which are not very liquid. However, exactly the opposite has happened far too frequently. It is high time Sebi amends the code.

The anamoly in inter-se transfer route is that the price at which the stake of the promoter is being bought need not be disclosed. This is what has happened in Wimco's case. Effectively, this route allows one group of promoters to exit at a price that could be higher than the market price and leaves other shareholders high and dry. Regulation 12 provides that where there are two or more persons in control, the cessation of one of them from such control shall not be deemed to be change in the control of management nor shall any change in the nature and quantum of control amongst them constitute change in control of the management. Hence, no open offer needs to be made as was the case in the GACL-ACC deal.

The simplest option is to make a preferential allotment and then use Regulation 12 to acquire control of the company without making an open offer.It is clear that the code provides enough exit opportunities to the promoters but very few to the shareholders. The preferential allotment route coupled with Reg 12 makes an open offer absolutely voluntary and makes the rest of the code completely irrelevant.

It is time either the preferential allotment route is done away with or the equity dilution through this route is restricted to 5 per cent. Getting a special resolution is not as difficult as it seems as it is one person-one vote for those present and voting. Exemption for inter-se transfer among promoter needs to be done away with, as "sensible" companies will always use Regulation 12 and not make the mistake which Philips made to hike its stake from less than 5 per cent in Punjab Anand Lamp. If promoter(s) can exercise the option of buying out other promoter(s), thereby providing exit opportunity to other promoters, there is no reason why a non-management shareholder should not have the exit option. At least an open offer should be mandatory as a result of inter-se transfer among either group companies or promoters.

KSESH (with contributions from Mobis Philipose and Prashant Kothari)