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Wednesday, June 14, 2006

Trying to understand what happened on the stock market in May

I saw some fascinating data, from CMIE, on the behaviour of foreign investors in the recent days of enhanced market volatility. There are small difficulties in measurement in this data - it includes options notional values, which aren't that clearly interpreted. But options trading is small so it doesn't contaminate the results that much.

The data shows the net purchase by all foreign investors on the equity derivatives market, and on the equity spot market, both measured in rupees crore. I also show the official closing price of the Nifty spot, and of the May Nifty futures, in the table. A useful piece of background is that the last date in the table (25 May) was expiration date for the May contracts.

Buy on F&OBuy on spotNifty May Nifty
May 10 -156 322 3754 3745
May 11 -852 -1199 3701 3693
May 12-1124 18 3650 3633
May 15-1084 -728 3503 3462
May 16 537 -533 3523 3520
May 17 390 -423 3635 3641
May 18 430 -810 3389 3364
May 19 1877 -1361 3247 3224
May 22 1914 -929 3081 3021
May 23 1266 -1243 3199 3191
May 24 883 -1935 3116 3087
May 25 1017 -1632 3178 3180

As an example, if I may read out the last row in the table to you, on 25th May, FIIs purchased Rs.1,017 crore of equity derivatives in notional value, and sold Rs.1,632 crore on the equity spot market. The official Nifty close was 3177.7, and the May futures nicely converged to the spot with an expiration-date closing price of 3180.15.

The story that I think this data tells is like this.

  • I know, it seems like a long time ago, on 10 May, Nifty closed at 3754.25. On the three following days, foreigners appear to have been successful speculators, selling on both the spot and the derivatives market. Nifty dropped to 3502.95. By 15 May, a big negative basis (-1.17%) had opened up.
  • So from this point onwards, foreign investors were steadily buying on the derivatives while selling on the spot market. This sounds to me like reverse cash and carry arbitrage.
  • Particularly, from 19th to 25th, local speculators were selling the Nifty futures, while the FIIs were doing the work of buying on the futures and selling on the spot. The basis showed up values as large as -2% on 22nd may, when FII purchase on the derivatives peaked. I find it reassuring for my story that on the days with the largest FII purchases on derivatives (19-25), the basis was at it's biggest negative values (-0.7, -2, -0.3 and -0.9). Of course, this "basis" is computed by comparing the official closing price on the futures and the official closing price on the spot, so it surely misses out the intra-day story.

These are highly aggregated numbers summing up the behaviour of over 1000 distinct entities., and it's always dangerous to anthropomorphise across aggregation. So one should not interpret this as "the behaviour of all FIIs" - instead it is the behaviour of the aggregate FIIs, and I'm sure there is huge heterogeneity within that class of investors.

The other remarkable thing in this data is how small these values are. The equity market (NSE + BSE, spot + derivatives) typically does over Rs.45,000 crore of turnover a day. The values for FII turnover seen here are all small, much smaller than what you might think if you read the newspapers shouting about FII exit (here's an example) leading to a drop of Indian equities.

The numbers in this table sum up to: A sale of Rs.10,456 crore of equities on the spot market, coupled with a purchase of Rs.5,100 crore on the derivatives market. Once again, the average per-day net buy/sell is small change compared with the size of the equity market. And, this reasoning and evidence suggests that a full picture of what FIIs are doing on both spot and derivatives is important to understanding what is going on.

In an ideal world, near-infinite arbitrage capital should be in play through sophisticated IT systems, so that the fair value of the index futures is circumscribed between a very tight "no-arbitrage band" at all times. In India, there are two big problems holding this back. First, SEBI and NSE have banned the IT systems - they insist that arbitrage be done in a labour intensive way. Second, the big institutional investors who are the natural players in this fixed income game - banks, pension funds, insurance companies - are prohibited from doing it.

India is doing some pioneering stuff by world standards in overcoming this problem by selling arbitrage funds to retail customers through mutual funds. I disagree slightly with the sales pitch that some of these funds make - they should clearly say it's a fixed income investment, but they don't always say that. For the rest, it's a great way to make progress delivering risk/return profiles to customers that existing institutional investors are unable to, and helping the country achieve "near-infinite capital in play for arbitrage".

FIIs have found a niche in derivatives arbitrage, with a comparative advantage owing to their regulators being better than ours. They have near-infinite capital and could thus do a great job in bringing about market efficiency on the derivatives. What holds them back is (a) the ban on IT systems, and (b) limits on FII ownership of individual stocks.

1 comment:

  1. If you take the SEBI data for FII derivatives activity in May and leave out all the options trades, you’ll find that the activity (on a net buy basis) is pretty evenly distributed between index futures and stock futures. In fact the story from May 2nd to May 12th (when the Nifty hit 3700 odd) is, net buy in cash, net buy in index futures and net sell in stock futures. After this there is a complete reversal, esp. on days of large falls, with net sales in cash and huge buys in stock futures (much larger in magnitude compared to the buy/sell in index futures)…. which leads me to believe that most of the arbitrage activity is taking place between the stock and its corresponding futures contract. If this is indeed the case, we should expect that the basis for single stocks should be much closer to the fair value (thereby reflecting the cost of carry). We shouldn’t expect the kind of deviations in basis that we see in the Nifty futures (both on an intra day and end of day basis).

    Don’t you think that the problem of IT that u mentioned should apply more to index arbitrage rather than simple single stock-future arbitrage? When you long/short the index future (depending on whether it is trading rich/cheap) you need to sell/buy the “index”-which is essentially a basket of in other Asian markets like Japan/Korea, I have seen index arb traders using some complex algorithms to select an optimized basket of stocks when they want to buy/sell the index..These IT systems run the proper algorithms and automatically place orders almost on a minute by minute basis. In markets like India, I guess the trader has to use a lot more discretion because of which any deviations in Nifty basis may not be perfectly “arbed” away.

    FIIs and trading volume- Yeah, data does show that the volume that they trade in derivatives is quite small. In fact if you look at the proprietary positions file for NSE members (on the NSE site) you’ll find that for the month of May’06, the average (daily) of prop open positions across members as a percentage of total open positions (client + prop) is about 40%. It may not be possible to conclude about trading volume from this directly, but a significant portion of the trading volume should be as a result of prop positions. It could be almost 30-40% of the 30000-40000 odd crore of derivatives trade daily..I would therefore guess that it is the prop trading of these members/brokers that moves the market more than FIIs!!


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