A primary hedging instrument across the world is the futures contract. A highly leveraged zero-sum instrument, a futures contract makes it possible for traders to assess their risks exactly and employ minimax optimisations. It is possible to set-up market-neutral strategies and ensure nearly risk-free gains whichever way the market moves. However, any hedging instrument is better than none.
In theory there is no bar to trading in futures contracts on any underlying asset. But in practice, the risk of default in a deliverable asset complicates the issue enough for futures trading in individual equities to be unusual even in the most developed markets. But which is the ideal underlying asset?
The Nifty has caused dissatisfaction because it is not considered broad enough and it would be little use to somebody attempting to hedge a portfolio of B1/B2 stocks. We consider the merits and demerits of the Nifty versus several other popular stock indices.
Many practical problems can arise from trading any index as the underlying asset. It may not be broad enough, it may not be liquid enough, it may be too stable or it may be too volatile. Since indices are supposed to be market surrogates, it may be thought that the larger the market-cap covered, the better the index. But market-cap can mislead.
Companies also have huge disparities in size. The largest 100 listed companies collectively control over 90 per cent of market-cap and, on an average, generate 97 per cent of trading. But there are over 7,000 listed Indian companies. Indices which accurately reflects the small caps movements often march to different tunes from the Sensex and Nifty. There are yet more problems. Liquidity becomes an increasing hassle as market-cap drops. Barely 1,200-1,500 large companies are regularly traded and around 5,500-6,000 smaller companies often languish. Thus a very large population index may be deceptive since large subsets of members may be unquoted.
In addition, the question of volatility is crucial. If the underlying asset is very volatile, the high-leverages of a futures contract can induce huge meltdowns. If it is too stable, then the hedger cannot cover his other positions adequately.
Now let's look at it from the point of view of the user. If the buyer is a large FI concentrated on A group shares, it will probably prefer to hedge with a large cap index future. If the buyer is a small-cap specialist, it will prefer to play in something like the
S&P CNX 500. If the buyer is an FII, with a major forex risk it may prefer a dollar-index like the Defty or the Dollex. We have attempted to tackle an analysis of some popular indices from the above angles.
The Nifty has been taken as the general benchmark for this exercise and some general conclusions can be drawn. Daily correlation between indices as diverse as the S&P CNX-500 and the Dollex is very high. In general the Indian markets move in the same direction. Over a two-year period, the returns from the five indices considered suggests traders with forex risks took big hits and smaller scrips underperformed bigger scrips. But on a day to day basis they moved in the same direction mostly.
Thus the directional aspect of trading several different sets of indices is similar. However, the volatility of different indices is significantly different. We have used several measures of volatility. The first measure is the arithmetic mean of daily changes. This has been considered in modulus terms since the futures trader is equally interested in negative and positive moves.
The mean may be unduly influenced by the effect of large single day swings. So we have also calculated the median which may actually be a more representative average since it eliminates the effects of large occasional swings. Finally we have taken the standard deviation of the daily moves which is probably the most common means of judging volatility.
Higher volatility means higher risk and returns in general and it allows easier hedging in the sense that a position in stocks can be made market neutral for a smaller outlay. We have assumed that the minimum risk for a trader is at least the median value of the index's daily swings. But daily swings could easily reach the value of the modulus mean plus the standard deviation. If there is a ten per cent margin, daily gains/losses on a position could be ten times the daily swing.
Some indices and their characteristics S&P CNX Nifty: The default contender for the first NSE futures contract. This is a weighted index of 50 of the largest scrips in the market. All the stocks in the population covered are liquid. But, it is reported to be currently reworked to include a better representation of IT scrips among other industry groups. It has great relevance to large players who tend to have portfolios close to the index mix. It would be possible for a large player to create a portfolio which accurately reflects the Nifty by weight.
The Nifty has registered a gain of merely 2.67 per cent since January 1996. This is pathetic when one realises the average daily movement is 1.27 per cent and the highest /lowest daily moves recorded in that 32-months is 7.26 per cent and -8.46 per cent respectively. The median value of the Nifty moves is as much as 0.96 per cent which is probably closer to the actual daily risk for a trader. It has a standard deviation of 1.12 per cent which means the stock could easily move 2.39 per cent in a single given day. Assuming a 10 per cent margin on a future contract and a daily mark to market, the loss/gain could be around 23.9 per cent daily per contract.
BSE Sensex: A more concentrated variation of the Nifty this contains 30 of the same stocks and their market cap weighted trades on the BSE. It has the essential flaws and advantages of the Nifty plus the further serious problem that badla in the same scrips is rampant on the BSE. Default in Sensex component scrips is not unheard of _ nor are short squeezes.
Thus more complicated cross hedges are possible and may in fact be necessary. So the opportunity for gain/loss and speculation is more. Since it is narrower than the equally liquid Nifty, it is probably less suitable. The Sensex is almost back at the same levels as in January 1996. It has a higher diurnal average of 1.29 per cent and a similar standard deviation of 1.12 per cent. The median is also much higher at 1.04 per cent. The diurnal range is between +7.55 and -8.27 per cent.
The Sensex has seen daily moves ranging between 3-4 per cent in this period. A trader in Sensex futures could expect to face swings of 2.42 per cent regularly- which would be loss/gains of 24.2 per cent on a 10 per cent margin. The Sensex is obviously unsuitable also because of the badla option on the same exchange leading to additional complications in evaluating risks like rates and make-up prices. Interestingly the Sensex has a 0.90 correlation with the daily moves of the Nifty so it makes little sense to switch from the Nifty to the Sensex. Except for cowboys enamored of fast payoffs.
Dollex & BSE-200: The Dollex has high levels of correlation at 0.87 with the other market indices despite being dollar-denominated. Of course the correlation is lower than in the other indices. The additional exchange risk has meant negative returns. The Dollex has lost 12.37 per cent since January 1996. It has a lower volatility than the Sensex/Nifty but higher than the BSE-200. Given the standard deviation, the Dollex could see a daily swing of 2.31 per cent easily.
S&P CNX 500: This covers a much wider compass of scrips being unweighted it is also less liable to be affected by a large move in a single scrip. It would be the index of choice for someone hedging positions in smaller scrips. It has a high correlation with the Nifty, however, at 0.89 which suggests that even the small stock specialist can live with a large stock index as his hedge.
Over 32 months, the small scrip index has shown a slight loss at -2.16 per cent. The index is also less volatile carrying a daily swing of 2.17 per cent. its breadth and stability may make it attractive.
