The average investor has always been confused by badla. Its a peculiar system designed to allow forward trading and arrange financing for it. It solves both problems but it isnt an ideal solution. Harshad Mehta, who should know, says, Badla is a form of financial terrorism.
It isnt transparent and guessing badla rates and likely margins is near impossible. One cant create a simple model for badla trading since there are at least two unknown variables which are refixed from settlement to settlement.
Some of badlas provisions are so strange that it is perfectly possible to time your trades right, pay moderate badla and still lose money. Badla is usually skewed in favour of the short-seller who takes his interest income home. It adds huge undefined loads onto the forward players calculations he has to outperform both the badla rate and the risk-free interest rate to make a profit. The leveraging isnt always good 100 per cent return on a badla trade is unusual whereas it is common on a futures transaction.
Sebi acceptance of the Gupta Committees recommendations on Futures trading represents a quantum jump in trading systems. Futures are transparent, the leverage is awesome and financing costs arent a black box for the investor. So as both hedging mechanism as well as a speculative tool, futures are likely to revolutionise Indian markets.
Heres how futures work. Futures are contracts to buy or sell something by a future date for a certain price predetermined now. This is called the strike price. The central bank, ie the futures exchange or the NSE in this instance, matches out all the contracts to stay net zero.
It charges a small fixed transaction fee per trade this is a processing charge and does not depend on the size of the trade. It also fixes a predetermined small margin to be deposited by each buyer of a future contract. This margin is usually between 1-10 per cent of the strike price and it doesnt vary from settlement to settlement. So the investor know exactly what his costs are.
The buyer of a futures contract can settle by paying or accepting the difference between contract strike price and actual spot price. Most futures contracts are settled someone who actually wants delivery would use an option type derivative or go into the normal forward market. Indian futures will be offered only on market indices such as the Nifty so all deals must be settled.
The futures contract is a zero-sum game since the gain on one contract will be exactly equal to the loss on the opposite contract. The banker stays busy and generates income flow by matching trades. And it helps investors on spot markets to lock-in profits and limit losses on their trades.
The leverages are what makes futures such an ideal hedge. Since 100 per cent returns are possible, hedging via futures contracts requires smaller margins. But since the flip-side implies 100 per cent losses, speculators can easily go bust.This is what gets futures a bad name and demands brilliant regulation.
But wisely used, even an indirect hedge is effective. The investor can go long in a heavyweight index and short in the index future, or short in a stock and long in the index future. An index-fund should take precisely the first action, since its portfolio is mirrored by the composite future. By paying a small premium it can put an upper limit on its losses if the market falls. Similarly a seller can cushion a bear-hug. Futures players call one-way bets such as going long in both futures and underlying instrument a Texas Hedge. A Texas Hedge on the Yen and the Tokyo Nikkei Index contributed to the Barings Collapse.
