More liquidity, less volatility

MARKET INSIGHT

Introduction of new instruments will deepen the derivatives market.

There's been a huge amount of feel-good news in the past fortnight. Most will concentrate on excellent GDP numbers and try to make future projections.

Some will focus on improved liquidity flows in money markets. Yet some others will discuss the dynamics of the aviation industry, post-consolidation (Deccan-Kingfisher & Indian-Air India). There's also the various booze and water deals to contemplate.

Ignoring all these, I would prefer to philosophise about three new instruments, which could, between them, offer much more choice to traders in different markets. One is the rupee futures in dollar-denominated Rs 20-lakh market lots on Dubai. The other two are the NSE offerings of Nifty Junior and CNX100 indices in the futures and options segment.

Sometime in late March 2007, the RBI stopped religiously maintaining the rupee's range. That's when it started to move up from 43.50-44.5 versus $ and of 57-59 versus the €. By last week, it stood below 41 versus the $ and at around 54-55 against the €.

The trend may be temporary but the absence of an "enforcer" aka the central bank has led to enhanced volatility. The rupee is a thin market and liable to remain so until and unless capital account convertibility is available. There isn't much a trader can do to hedge the volatility without committing huge sums. Dubai lowers the entry barrier.

That's useful. Plenty of cash-rich treasury managers will be looking at it carefully. If liquidity is good in Dubai, it could have a "tail wagging the dog" effect and reduce volatility in the overall forex market. If the contract draws sufficient volumes, it could also lead to similar instruments being offered by other exchanges.

Anyhow, it's a start and it gives traders the chance to win or lose relatively small sums betting on rupee trend-perceptions. Speculative volumes should help deepen the market for those who actually have a fundamental reason to play it.

The other two instruments are less exotic. They don't involve direct currency risks and they are similar to extant index futures and options. The CNX100 and the Nifty Junior should slot right into the F&O traders' list. What's more, in combination with the Nifty, they offer a far more complete coverage of solutions for hedgers as well as speculators.

The Nifty incorporates the top 50 liquid stocks, the Nifty Junior is the next 50 liquid stocks. The CNX 100 involves the same universe "� all 100 of these stocks. In technical terms, the three indices have almost the same levels of average daily volatility of about 1.78 per cent in the last year. They have similar Value-At-Risk levels as well.

All these stocks generate huge futures volumes and very little options volume. That lack of stock option liquidity implies stock futures positions cannot be directly hedged. Until now, the only means of hedging individual stock exposure was through Nifty options. That only worked on the top 50 "� without recourse to complicated covariance calculations for other stocks. The new index instruments offer direct hedges on another 50 stocks.

Statistics indicate that the Nifty is the only underlying that consistently generates significant option volumes. The Junior generates almost as much futures activity as the Nifty underlyings. The index likely to start generating similar optionm volumes once hedgers get into the act.

The inclusion of the CNX 100 in F&O also creates an interesting possibility for cross hedges since this broad index incorporates both the Nifty and Nifty Junior universe. A simple example would be long Nifty plus long Junior versus short CNX 100. By combining appropriate quantities of futures and option and managing margins efficiently, many market-neutral methods could be applied. There may even be a market for pre-structured products.

Of course the CNX100 could also be traded as a standalone instrument. One interesting point is that the market lot of the CNX 100 is 50 units "� the same as the Nifty and twice that of the Junior (25). I'm not sure why this has been specified unless the NSE is trying to ensure that volumes in the Junior F&Os build up quick.

It will make calculations for cross-positions somewhat more complex. But that's detail. The derivatives picture has got bigger and it offers many more choices.