FIIs play arbitrage game in F&O segment to net gains

Foreign institutional investors (FIIs), who are big players in the futures and options (F&O) segment, are making a killing in the domestic market by using arbitrage as a weapon in the spot and derivatives trade as well as structured derivative deals.

The arbitrage game is on despite the curb on the issue of P-notes or participatory notes by the Securities and Exchange Board of India (Sebi) recently.

The NSE's F&O segment daily averages around Rs 1,00,000 crore. "Many FIIs are just doing arbitrage trading in the spot and derivatives segments. When the futures are higher than the spot prices, they buy in spot and simultaneously sell in futures," said Siddharth Bhamre, a derivatives analyst at Angel Broking.

If the futures fall, they can book profits. Even if the futures rise, spot prices rise in tandem, and FIIs cash in by selling shares in the spot and squaring off in the futures.

However, since they have sold in futures at a price higher than that of spot, they stand to gain. They also buy in spot and short the Nifty to cover their market risk.

If prices in futures are higher by 1 per cent, the annual return of FIIs is around 12 per cent. This is higher than the interest rates in the US and a safer bet. Returns from arbitrage are more than 8-9 per cent from liquid funds.

The rupee appreciation also adds to the returns. Currently, selling in spot and buying in futures is possible only when investors have shares. Short-selling can set right this discrepancy.

If buying in spot and selling in futures is possible, the reverse must also be allowed and that would be possible only if short-selling or stock lending and borrowing is allowed.

FIIs also enter into structured derivative deals such as assured returns and capped returns, where brokers assure returns in certain stocks to investors even if the stock prices don't rise or fall.

If the prices rise more than the returns assured, depending on the contract, additional returns are shared between buyers and sellers. In another type of deal, returns are capped for investors.

Some products are designed to give returns only if (for example) the Nifty crosses a certain level. Sellers of such products implement their hedging mechanism depending upon the product. These are not regular F&O transactions, but are called derivative products.

According to an FII broker, many products were sold through P-notes for three years and Sebi has given 18 months for unwinding. This may result in cancellation of some P-notes. The impact of the actual unwinding of these derivatives depends on what kind of hedging mechanism was applied for it.