Derivatives: Some interesting trends - Views on News from Equitymaster

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Derivatives: Some interesting trends

Jul 6, 2002

The journey so far...
June' 00 Index Futures Introduced
June'01 Index Options Introduced
July' 01 Stock Options Introduced
Nov' 01 Stock Futures
Introduction of derivative products has been one of the most significant developments in the history of Indian capital markets. It's been almost 2 years since introduction of the first derivative product, index futures. The response to the same in such a short span has been encouraging, especially considering the complexity of the products. Let us take a look at some interesting trends in the derivative markets.

Stock futures, which entered the Indian scene last, as late as Nov 01, have caught the market fancy very fast. The product managed to divert market attention from other products that have been around for a longer period of time. Stock futures now account for more than half the total turnover in the derivatives segment on the NSE. The probable reasons for the popularity could be investors realizing the product, as a substitute for carry forward products. The stock futures are relatively easy to understand and since there is no need to deliver the underlying (stocks) i.e. it is not reversed at the end of the day, the speculative interest has shifted to this product. Further, since equity financing is still cumbersome for retail investors, stock futures are providing the easiest way of financing open positions.

Derivative instruments were introduced with a view to separate speculative interest from the cash markets. Again rolling settlement was introduced to discourage speculation in the cash markets. These moves seem to be working. The reason for dramatic rise in volumes for stock futures has been mirrored by the decline in intra-day speculative business in the cash markets.

The liquidity in the futures market is concentrated in futures of five stocks. The futures for the remaining 25 stocks have low liquidity. Further, institutional participation is low currently and it would require further depth and liquidity before institutional participation kicks in.

Stock Futures No. of Contracts in May % of Total
Satyam 154,523 26%
Reliance 69,298 11%
Digital 56,842 9%
Hind Petro 53,319 9%
Infosys 49,412 8%
Others-25 stock futures 221,890 37%
Total 605,284 100%
Having understood the trend in volumes and derivative products, let us take at the pricing trend in the futures market. One would wonder whether any trend is emerging in case of pricing of underlying (stocks in the cash market) based on the pricing of futures contract.

We conducted a study on the most active stock futures, Satyam. The objective of the exercise was to determine whether implied cost of carry on a day, influences the movement of the stock the next day. The chart below compares implied cost of carry to the percent change in stock the next day.

The relation between implied cost of carry and the movement of the stock is weak. Though, it does provide some indication an accurate prediction seems difficult. In the absence of liquidity and larger empirical evidence it is time before one can accurately predict future price movement on the underlying based on the stock futures movement.

Theoretically, the difference between the futures and spot price should reflect the cost of carrying the position to the future or essentially the interest. Therefore, it when futures are trading at a premium it is an indication that participants are bullish on the underlying and vice versa. Going forward, it would be interesting to watch the action in the derivatives segment and how that impacts the cash market.

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