I am a speculator about an individual stock. What is my unwanted index exposure?

Suppose you have a forecast that the price of INFOSYSTCH will rise. As a speculator on an individual stock, you have purchased INFOSYSTCH. This position can go wrong for two reasons:

1. Core risk: You were wrong in your understanding of INFOSYSTCH, and the price fails to rise

2. Extraneous risk: Nifty falls owing to some macroeconomic development.

Every stock speculator suffers from the extraneous risk of movements in Nifty. A buy position on INFOSYSTCH tends to go wrong when Nifty drops. A sell position on INFOSYSTCH tends to go wrong when Nifty rises. This vulnerability to Nifty has nothing to do with the core interest of a stock speculator, which is valuation and forecasting of individual stocks. The position BUY INFOSYSTCH contains an unwanted index exposure embedded inside it. Every speculator who has purchased INFOSYSTCH is actually BUY INFOSYSTCH + BUY NIFTY whereas what he really wants is to only be BUY INFOSYSTCH

What does a speculator on an individual stock do?

A person who has forecasted INFOSYSTCH is not interested in being a speculator on Nifty. He should remove this risk. This is done by selling Nifty futures. The position BUY INFOSYSTCH + SELL NIFTY FUTURES is a focussed position which is only about INFOSYSTCH. This is easily done in practice. Every speculative buy position should be coupled with an equal sell position on Nifty. Every speculative sell position should be coupled with an equal buy position on Nifty.

Suppose you are long 100 shares of INFOSYSTCH and the share price is Rs.9,000, when the nearest Nifty futures is at Rs.1500. The position is worth Rs.900,000. Hedging away the Nifty exposure in this requires selling Rs.900,000 of Nifty. Translating this into a position on the index futures market, we have 900000/1500 = 600 nifties. So you would couple your position of “buy 100 shares of Infosys” with a hedging position: “sell 600 nifties”.

This hedging reduces the risk involved in stock speculation. It is good for the stock speculator (who faces less risk), for the brokerage firm (which faces a lesser risk of default by the client), for the clearing corporation (which faces less vulnerable brokerage firms) and for the economy (the systemic risk in the capital markets comes down, and level of resources deployed into analysing and forecasting stocks goes up).

Sometimes, the forecast horizon generates constraints. If you have a two–month view, then a futures contract that has only a few weeks of life left might be inconvenient. Another major issue is liquidity. Other things being equal, it is always better to use the contract with the tightest bid–ask spread

You can sell Nifty futures. The Nifty futures earn a profit if Nifty drops, which offsets the losses you make on your core equity portfolio. Conversely, if Nifty rises, your core equity portfolio does well but the futures suffer a loss. When you have a equity portfolio and you sell Nifty futures, you are hedged: whether Nifty goes up or down, you become neutral to it. This is not a recipe for making money; it is a recipe for eliminating exposure (risk).

You can buy Nifty futures today. This ensures that you get a lock–in on current share prices. When you get funds, and start getting invested in the equity market, you would closeout your futures position at the same time

You can sell Nifty to reduce your vulnerability to Nifty. Suppose your wealth normally drops by Rs.100,000 for each percentage point fall in Nifty. A sell position for Rs.10,000,000 in Nifty futures stands to gain Rs.100,000 for each percentage point fall in Nifty. This gives you a hedge against your core business exposure.

A similar strategy works for an IPO underwriter who stands to lose if Nifty crashes and the IPO devolves on him.

Every stock or portfolio or position has a number called “beta”. Beta measures the vulnerability to the index. ITC has a beta of 1.2. This means that, on average, when Nifty rises by 1%, ITC rises by 1.2%. In this case, a stock speculator with a position of Rs.1 million on ITC requires a hedge of Rs.1.2 million (not just Rs.1 million) of Nifty in order to eliminate his Nifty risk. Hindustan Lever has a beta of 0.8. This means that a stock speculator who has a sell on Rs.1 million on HLL requires to buy Rs.0.8 million of Nifty (not Rs.1 million). If you know nothing about a stock or a portfolio, it is safe to guess that the beta is 1. The average beta of all stocks or all portfolios is 1. If beta can be observed or measured, then this hedging becomes more accurate; however, this is not easy since accurate beta calculations are fairly difficult, especially for illiquid stocks. Tables of betas of all stocks in Nifty and Nifty Junior are available from NSE and from http://www.nseindia.com

The basis between the spot Nifty and the 1 month Nifty futures reflects the interest rate over the coming month. If interest rates go up, the basis will widen. A buy position on the futures and a sell on the spot Nifty stands to gain if interest rates go up, while being immune to movements in Nifty. Similar positions can be used against the two–month and three–month futures to take views on other spot interest rates on the yield curve. Similar strategies can be applied for trading in forward interest rates, using the basis between the one–month and two–month futures, the one–month and three–month futures,etc.

Hedgers fear basis risk. Basis risk is about Nifty futures prices moving in a way which is not linked to the Nifty spot. An unhedged position suffers from price risk; the hedged position suffers from basis risk. Of course, basis risk is generally much smaller than price risk, so that it is better to hedge than not to hedge. However basis risk does detract from the usefulness of hedging using derivatives.

A well designed index, and a well–designed cash market for equities, serve to minimise basis risk.

Nifty has higher hedging effectiveness for typical portfolios of all sizes. Nifty also requires lower initial margin (since it is less volatile) and is likely to enjoy lower basis risk (owing to the ease of arbitrage).

• Buy a million rupees of Nifty on the spot market. Pay for them, and take delivery. When you make the payment, you are “giving a loan”.

• Simultaneously, sell off a million rupees of Nifty futures.

• Hold these positions till the futures expiration date

• On the futures expiration date, sell off the Nifty shares on the spot market. When you get paid for these, you are “getting your loan repaid”.

This is worth doing when the interest rate obtained by lending into the futures market is higher than that which can be obtained through alternative riskless lending avenues.

• Sell a million rupees of Nifty on the spot market. Make delivery, and get paid. This is your “borrowed funds”.

• Simultaneously, buy a million rupees of Nifty futures.

• Hold these positions till the futures expiration date

• On the futures expiration date, buy back the Nifty shares on the spot market. When you pay for them, you are “repaying your loan”.

This is worth doing when the interest rate obtained by borrowing from the futures market is lower than that which can be obtained through alternative fully collateralised borrowing avenues.

Suppose Nifty is at 1500 and a futures product which expires within 30 days is trading at 1520. At first, this looks like a return of Rs.20 on a base of Rs.1500 for a one–month holding period. However, you should subtract out the transactions costs that you will suffer on doing two trades on the Nifty spot. Suppose we assume a transaction size of Rs.1 million. In this case, it’s safe to assume transactions costs of roughly 0.1% (or Rs.1.5) each. Hence, you will actually get only 20 - 1.5 - 1.5 or Rs.17 on a base of Rs.1500. This is a return of 1.13% for a one–month holding period, or 14.48% annualised. Thinking in terms of the actual transaction, you would lend Rs.1,000,000 into the market, and get back Rs.1,011,333 after a month. This thumb–rule ignores the dividends obtained on the shares you hold for the month. Dividend payments in India are highly bunched towards the year–end. At other times of the year, it’s safe to ignore dividends in a thumb–rule.

Suppose we are on 12 June 2000 (a Monday) and we have purchased the spot, and sold the near futures (which expires on 29 June 2000). We will only need to put up funds on Tuesday, 20 June 2000. The shares are sold on the spot market on 29 June 2000 (Thursday). These turn into funds on 11 July 2000 (Tuesday). Hence, the overall period for which funds are invested is from 20 June to 11 July, i.e. a holding period of 22 days. Hence, the cost of carry should be applied for a 22 day holding period.

Suppose the Nifty spot is the same as the price of the three month futures, i.e. that the basis is zero. This means that the futures market is willing to give you a loan (against a Nifty portfolio as collateral) for a three–month period at an interest rate of zero. If the Nifty futures is cheaper than the Nifty spot, it means that the futures market is willing to pay you if you borrow money. Many people in India would be very happy to borrow (against a Nifty portfolio as collateral) at a zero or negative interest rate. When they step into futures market to do so, they will buy the futures and sell the spot. That will push futures prices away from these weird states. Nothing forbids these weird states (negative or zero basis). It’s just that they are extremely attractive arbitrage opportunities and are unlikely to lie around for long

Index arbitrage is indeed an “index repo”, with one key difference. Repos normally involve counterparty risk. In index arbitrage, you face near–zero risk with NSCC as the counterparty.

They involve a sequence of trades on the spot and on the index futures market. Yet, they are completely riskless. The trader is simultaneously buying at the present and selling off in the future, or vice versa. Regardless of what happens to Nifty, the returns on arbitrage are the same. Since there is no risk involved, it is called arbitrage

These transactions are riskless insofar as the fluctuations of Nifty are concerned: no matter whether Nifty goes up or down, they will yield the identical and predictable rate of return. The rate of return you calculate at the outset is exactly what will come out at the end.

However, they involve the credit risk of the clearing corporation. When you do arbitrage on NSE, you are exposed to the risk that the National Securities Clearing Corporation (NSCC) – which is the legal counterparty to all your trades – might be unable to meet its obligations.

The required rate of return in lending to NSCC is the interest rate from the Government of India yield curve, with a credit risk premium for NSCC added into it. If the 90–day interest rate on the GOI yield curve is 7%, and if you believe that NSCC requires a credit risk premium of one percentage point, then the three–month futures should involve an interest rate of 8%