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Saturday, January 14, 2006

What's the Indian investor to do about global macroeconomic imbalances?

It is the best of times, it is the worst of times. On one hand, the Indian stock market is doing very well. The CMIE Cospi (2540 companies) is at a market capitalisation of Rs.24.7 trillion or roughly $550 billion. What is more, the Cospi P/E is up at 18.

At the same time, the world economy is plagued by important doubts - particularly about the US and the Chinese economies. Business Standard had an excellent editorial, a few days ago, exploring these themes.

What is doubly odd is that while many economists are truly worried about these `global macroeconomic imbalances' (e.g. Ken Rogoff, Martin Feldstein), the financial markets seem to be completely comfortable with what is going on! I use the implied volatility on the S&P 500 as a measure of expectations about future equity volatility. It is down to remarkably low levels like 11%. I can't help thinking it's a good idea to be long volatility.

What is someone invested in India to do? I think that India's exposure to a global business cycle downturn is greater than meets the eye. A lot of the Nifty stocks will take a beating if things go wrong between China and the US. Some Indian companies (e.g. Infosys) will suffer because they export a lot. Others (e.g. Tata Steel) will suffer because distressed Chinese companies will crash product prices.

And given how low the VIX is, it seems like a great idea to buy protection against the global business cycle by: Purchasing out-of-the-money put options on the S&P 500!

There is the small matter of RBI's capital controls, which prevent you or I from doing so. As Jayanth Varma says, the Indian capital account is open to all except the Honest Resident Indian (HRI). Can one use the limit of $20,000 per person per year of outbond capital in order to buy protection using the S&P 500 puts? Has anyone used this limit to do global diversification?


  1. Hi Sir,

    How about selling out_of_the_money calls on the Nifty index or even buying out_of_the_money puts ? Wont these enable domestic investors hedge their portfolios ?

    With the Union Budget around the corner, i think one really misses having instruments such as VIX options/futures, here in India ? If only financial innovation can take pace in India ?

    Best Regards.

  2. The implied vol we see with Nifty is much higher than that associated with the S&P 500. And, the interest rate in the US is lower. So put together, the S&P 500 put options are much cheaper than Nifty options.

    The S&P 500 options are also much more liquid. Lacking `Direct Market Access' (DMA), the Indian options market is rather clunky. You can easily do a $100 million transaction using the S&P 500 options. You can't do a $100 million buy of put options (notional value, of course) of Nifty puts without much trouble. In the case of Nifty options, you really only have one-month expiration, but with the S&P 500 puts, you have fair liquidity all the way out to 6 months.

    Another aspect is that your trade should flow from your view. My blog posting argued that the global macro imbalances pose a substantial threat to long positions on Indian equity. If that is the view, then the most
    effective ways to express that view are those that directly tap into the global business cycle.

    Can we do things like VIX here in
    India? Yes, but the first and more
    basic problem is to get the options
    market to work properly. In my mind,
    the #1 bottleneck is the lack of
    `Direct Market Access' (DMA).

  3. Sir,

    What is 'Direct Market Access' and how does it improve liquidity in options market ?


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