The equity derivatives market: The state of the art

Susan Thomas susant@igidr.ac.in February 17, 2002

Liquidity Turnover Pricing Intermediaries Looking forward

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Goals
Liquidity Turnover Pricing Index futures Index options Stock options

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Liquidity Turnover Pricing Intermediaries Looking forward

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1.

Liquidity

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Measuring liquidity
Market impact cost is the best way to measure liquidity (i.e. the cost of transacting). Owing to SEBI regulations, the market lot for all the derivative products is roughly Rs.200,000. Hence, the bidoer spread we see on the screen is directly comparable across all these products.

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Index futures
Status as of 11 AM, 7 September 2001 Product Spread Rupees Basis Pts September 0.10 0.96 October 1.10 10.56 November 0.35 3.36 When Nifty is at 1000, a basis point is 10 paisa. This is a more liquid index proxy as compared with the spot Nifty! What does a spread of 1 basis point for a transaction of Rs.2 lakh mean on the spot market? Example: for Infosys (Rs.3250), it is a spread of Rs.0.33 for a transaction of 62 shares. Actually the Infosys spread was Rs.1.

Liquidity Turnover Pricing Intermediaries Looking forward

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Liquidity Turnover

Index options
Data from 11 AM, 7 September 2001 Product Spread (%) More liquid options 1020 September call 19.1 1040 September call 16.9 1020 September put 13.0 1040 September put 8.5 An OTM option 1080 September put 66.7 1080 September call 4.2

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Stock options
Index speculation is safer than stock options: with stock options you could always be trading against an informed speculator. With index, information is symmetric. Data from 11 AM, 7 September 2001 Product Satyam 150 Satyam 160 Satyam 150 Satyam 160 September September September September call call put put Spread (%) 5.2 3.5 11.4 5.0

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Turnover
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Recent evidence in 2001

(Rs. Crore)

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Products September October November December Nifty futures 2857 2485 2484 2339 Nifty options 412 559 455 405 Stock options 2012 2433 3010 2660 Stock Futures 2811 7515 Total 5281 5477 8760 12919

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Index futures
Data from Friday, 14 September 2001. Nifty close = 920.
(Rs. crore)

Liquidity Turnover Pricing Intermediaries Looking forward

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Product NSE BSE September 197.6 19.3 October 49.4 1.4 November 15.6 0.1 Total 262.6 20.9 Comparison with (NSE) spot market: Rank 1 (Ranbaxy) was Rs.283 crore, and Rank 2 (Wipro) was Rs.260 crore. Nifty is not yet decisively the underlying with the #1 turnover in India, but it soon will be.

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Growth in index futures turnover

1000 NSE SGX BSE

Liquidity Turnover Pricing Intermediaries Looking forward

Trading volume (Rs. crore)

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100

10

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1
Jun 00Jul 00Aug 00 00Oct 00 Sep Nov 00 Dec 00Jan 01Feb 01 Mar 01 Apr 01 May 01 01Jul 01Aug 01 01Oct 01 Jun Sep Nov 01 Dec 01

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Comparing stock and index futures

Underlying Turnover (crore) Nifty 2339 Satyam 2488 Infosys 1350 Digital 987 Relpetro 274 Sterlite Optical 208

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Comparing stock and index options (for December, 2001)

Top 5 index options Product Turnover (crore) December 1100 call 49 December 1120 call 46 January 1100 call 36 December 1140 call 32 December 1060 put 30 Total for all Nifty options 405 Top 5 stocks trading options Product Turnover (crore) Satyam 912 Relpetro 252 Digital 218 Sterlite Optical 105 ACC 173 The aggregate turnover of stock options is much higher than that of index options, but its diused over 31 stocks.
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Number of trades
NSE does roughly 6000 trades a day, i.e. roughly one trade each three seconds (on average). This implies a mean transaction size of a shade below two market lots (Rs.3.5 lakh or so).

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Pricing

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What we look for to talk about pricing

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Futures: the cost of carry. Options: implied volatility.

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Index futures
Broadly speaking, the interest rates are too low. Very often, all the rates from the three futures prices imply a negative basis. This suggests rampant opportunities for reverse cash and carry arbitrage. Every time there is index volatility, we see interest rates that are too low or too high not enough attentive arbitrageurs.

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Index options and stock options implied volatilities

Data as of 7 September 2001. Product Implied volatility More liquid index options 1020 September call 12.22 1040 September call 12.08 1020 September put 10.22 1040 September put 9.43 One less liquid index option 1080 September put 13.34 1080 September call 8.80 Stock options Satyam 150 September call 46.72 Satyam 160 September call 50.50 Satyam 150 September put 58.01 Satyam 160 September put 61.54

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Intermediaries
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Members who are active

Denitions Active in futures = futures turnover above Rs.1 crore / mth. Active in options = options turnover above Rs.1 crore / mth.
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Futures Options June 73 72 July 113 113 August 118 148 September 164 190 October 170 197 November 242 209 December 271 209 One major brokerage rm - on 14 September 2001, it got 50% of its turnover on derivatives.

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Brokerage revenue stream

Mean turnover of Rs.1000 crore /day If we assume 10 basis points of brokerage on each side, this is a brokerage revenue stream of Rs.500 crore per year. At a mean turnover of Rs.2000 crore/day Rs.1000 crore per year of brokerage revenue.

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Liquidity

Human capital: Individuals who have passed NCFM

Period Number passed 1998-1999 1408 1999-2000 240 2000-2001 1067 Apr-Aug 2001 1765 Three year validity: People who passed in 1998-1999 will need to take it again now. They should take it again now! Need for NCFM F&O certication across the organisation, not just for one person.

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Distribution of score of NCFM test-takers

Range of marks Number of candidates Below 0 4 0-9.75 22 10-19.75 66 20-29.75 189 30-39.75 357 40-49.75 679 50-59.75 1166 60-69.75 1701 70-79.75 1611 80-89.75 1196 90-99.75 379 100 18 Total 7388

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Stock futures?
Long call + Short put = Long futures. So once you have stock options, you already have stock futures. Hence the formal introduction of stock futures are unlikely to achieve much.

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The ideas used in trading

Index speculation - everyone cares about the index. Index hedging - every portfolio can be protected. Put options = portfolio insurance. Stock views - a pure play on a stock is buy stock + sell nifty.

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Conclusion
Remarkable pace of change on the equity market NSE became the # stock market in roughly 1 year; Nifty became the #1 underlying in roughly 1 year. The new world of the equity market is working out very well: no badla, no weekly settlement, rolling settlement, futures, options. The dynamism of the equity derivatives market 6000 trades/day, retail participation from all over India is a sharp contrast with the xed income and currency markets, which are south Bombay clubs.

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Finding out more

http://www.mayin.org/~ajayshah http://www.igidr.ac.in/~susant Ajay Shah and Susan Thomas. Derivatives in India: Frequently asked questions. (June 2000) NSEs monthly nse-india.com derivatives update from http://www.

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