A wish list for the F&O segment in 2007

Updated: Dec 31 2006, 06:44am hrs
The first change that I look forward to in the equity derivatives market would be, permitting actual deliveries against derivatives position. Today, derivatives are necessarily settled only in cash. For example: a person holding a Reliance 1300 call option cannot effectively demand delivery of Reliance shares on the settlement day at the strike price.

Permitting deliveries against F&O positions will have two far-reaching implications on the derivative markets in India. Firstly, it will reduce the speculative excesses in the derivative market and make it more orderly and a safer place to trade. Secondly, today, most institutions prefer to hedge their positions using futures rather than options as the cost of hedging through options is prohibitively high. Permitting delivery against derivatives could make options more attractive as a hedging mechanism.

The second change I look forward to is with respect to the criteria adopted for stock selection and stock inclusion in F&O. Another concern is with respect to the floating stock of certain scrips that have been permitted to trade in F&O. Stocks like Shoba Developers and Parsvanath tend to very frequently cross the limit of 95% of MWPL (market wide position limit). As a result, the investors are left in the lurch. They are unable to hedge their positions, as fresh exposures are not permitted and existing positions may be forcibly closed at the brokers end. This creates a situation wherein the risk to the investor gets amplified. We believe that tighter entry norms for F&O can pre-empt this kind of a situation.

The third issue pertains to two aspects which may be outside the purview of the market regulator which are securities transaction tax (STT) and stamp duty. The rates of STT and stamp duty in certain states are so prohibitive that it actually makes derivatives trading impossible. It needs to be remembered that short-term traders play a very critical role of providing liquidity to the markets. Making their activity unprofitable through prohibitive rates of STT and stamp duty can be dangerous to the health of the markets in the long run.

The fourth issue pertains to the risk management aspect of derivatives. Today, the exchange imposes a variety of margins on an F&O position like initial margin, MTM, ad-hoc margin, etc. However, a major step forward in this direction will be permitting cross margining. Many a times an investor who is short in a call option ends up paying the entire margin for a short call as if it were naked position.

Cross margining will ensure that an individual's cash market and derivatives positions are aggregated and margins are imposed on the net open positions
Even though the investor may be holding a cash market long position, in the current margining system, he does not get the benefit of the hedge that he holds. Cross margining will ensure that an individual's cash market and derivatives positions are aggregated and margins are imposed on the net open positions. This will avoid over management of risk and thus free up resources for the client.

The fifth requirement would be with respect to introduction of long-term F&O contracts. Currently, the maximum tenure that we have for a derivative contract is 90 days. However, a 90-day contract is more theoretical in existence, as most of the F&O volumes are confined only to the near month contracts.

The introduction of long-term contracts of 6 months to 1 year would be a major value addition. Firstly, it would be instrumental in creating the equivalent of a yield curve for pricing option risk. Therefore, investors would be in a position to pay different rates of risk premium depending on time to maturity and the volatility quotient.

The second benefit of a long-term derivative market would be a reduction in the cost of hedging. Today, the cost of hedging a long position using put option can be as high as 1.5 - 2% per month which makes option hedging unviable. The moot point, however, is ensuring liquidity in such long-dated options to make them meaningful.

The last point is introduction of market-making in F&O. Market making is a process wherein the exchange authorises brokers, who meet certain basic criteria, to provide simultaneous bid-ask quotes in the market. This would provide the much needed liquidity on long-dated options and futures and in the process simplify hedging through options.

The author is head-derivatives research, Karvy Securities