Sebi has issued a draft report (they have called it a note) on new products to be launched in the derivatives’ segment. The idea is to make the segment more popular, something it has already become as seen by the vast difference in trading volumes in the cash and derivative markets.The note is based on the recommendations of the Committee on Derivatives Market Review led by Prof. M. Rammohan Rao.
Suggestions have been invited in four days, which is an unusually short time. A short period for comments was given when the participatory notes’ guidelines were proposed too, which had some justification one would imagine. The haste in this case seems unnecessary. One would expect that a note of this kind would give some details on the background that led to the suggestions for new products.
But the entire note is bereft of any data (on Indian markets) that would have been used to arrive at the need for new products. More instruments are welcome but little can be made of the recommendations, because it does not go into specifics. Perhaps, when the stock exchanges themselves come out with products in these categories, the impact may become clearer.
What is on the cards? Mini Contracts in Equity Indices These will be contracts at a fraction of an existing derivative contract, making it easier for a small investor to trade in these instruments. Call it the derivative version of a stock split, if you will. Initially, index futures and index options with the Sensex and Nifty as underlying will be introduced. No size has been prescribed.
Options contracts – longer tenure
Current contracts have a maximum life of 3 months. Long term options for both stocks and equity indexes will be made available for trading upto 5 years. That is a really long tenure, and it is not clear how they arrived at this tenure. Why would you want to buy stocks when you can buy options and hold for 5 years? Am not sure if this is a popular instrument in international markets either, probably aimed at spurring interest in stock options, which has not become popular in Indian markets.
A volatility index modeled on the lines of Chicago Board of Options’ VIX index will be designed. At a later date, derivatives based on this index too will be designed. Options on Futures These are derivatives, in which on exercise, the options position is converted to a futures’ position, instead of delivery. These products will be introduced on existing interest rate products. In any case, we do not have physical delivery in options, so this product has no relevance for equities, at this stage, it appears. If we shift to deliveries for derivatives, it may have more relevance at that point in time.
Bond Index derivative contracts
This is perhaps another attempt to inject some life into the corporate bond market segment, like the earlier one. They plan to create bond indexes (both government and corporate) and then issue derivatives with these indexes as the underlying.
Exchange Traded foreign exchange derivatives
This is a conceptual product where they want to make an enabling framework to allow small and medium enterprises to hedge their forex exposures. The RBI is not going to be too happy about this one. But the committee has hedged by saying that with capital account convertibility being allowed at some time in the future, this is possible. They seem to be suggesting that RBI could play a role here too: “Further, supervision of Forex F&O trading activities, prescription of risk containment and market integrity measures could be managed by appropriate authority.”
Exchange-traded Products Involving Different Strategies Not really clear on this. This is what the report said: “An individual investor may want to create a strategy using options on a broad based index. However, it may not be very convenient for an individual investor. This may be due to the fact that the cost of buying all components of the stock and margin requirement on individual options may turn out to be fairly large. Further, buying of all stocks in the index may have a tracking error and would require re-shuffling of portfolio for changes in the Index. In addition to this, selling of near the money option on expiry of existing option in the portfolio may also be time consuming and costly for the investor.
The following two illustrations are for ready reference. (A) Buy-write Index For example, an individual investor wants to write covered call options on a broad based index but does not have all the resources required to track the performance of this strategy. In this situation, a ‘buy-write index’ works like a benchmark for the performance of hypothetical covered call i.e. buying of the underlying index portfolio and selling of the call option on the same portfolio in same notional amounts.
It is proposed that a buy-write index tracking a hypothetical portfolio of long stocks and short call options on a broad based index may be created. Initially the Index values to be disseminated to the market, and as a further step, derivative contracts to be introduced on this index. (B) Put-Write Index Now, say, another individual investor wants to create a strategy through buying short-term treasury bills and selling put options on a broad based index. But this individual investor may not be able to do this, due to the fact the money-market in India is mostly Institutional in nature and an individual investor may not be able to have a small portfolio of investment in the treasury bills.
Further, selling of near the money option on expiry of existing option in the portfolio may also be time consuming and costly for the investor. In effect, it may not be feasible for the investor to track this portfolio in a cost-effective and efficient manner. It is proposed that an index tracking a hypothetical portfolio of investment in short term T-Bills and short put options on a broad based index to be created. Initially the Index values to be disseminated to the market, and as a further step, derivative contracts to be introduced on the index.”