global equity investors in indian derivatives & cash market

Around a month back, I wrote (in the magazine I work for) on an interesting trend seen in foreign institutional investors' (FIIs') investments in Indian equity market through the cash and derivatives segment. The text of this write-up follows below and so does a chart that nicely brings out the trend (click on the image to see it enlarged & clear).

Here is my write-up:

One way, two paths

Bear rally or a new bull rally? Will it sustain or collapse? These are questions weighing heavily in the minds of not just the Indian retail and institutional investors but also of the foreign institutional investors (FII). Two weeks after the mid-May strong rise in stock prices and as intra-day and daily volatility shot up investors seem to have got confused not knowing what to do.

But at the same time, on the back of a surge in liquidity among global investment funds, new FIIs are trying to profit from the volatility through the use of equity derivatives on the National Stock Exchange (NSE).

Underscoring these uncertainties and volatility exploitation is the trading pattern in the Indian cash and derivatives markets of FIIs. The data (see graph below) in recent weeks seems to bring out a growing negative relation between the collective directional views of the FIIs in the cash market versus that in the index futures and stock futures segment of the derivatives market.

Other than Life Insurance Corporation of India, the FIIs, as a whole, influence prices the most in the Indian equities markets. While LIC never dabbles in the derivatives market, many FIIs do. An institutional investor would tend to use equity derivatives for a couple of reasons.

One, it would want to hedge its cash market position against a short-term loss in value. For instance, in May, when net collective FII inflow (purchases minus sales) on the NSE and the Bombay Stock Exchange was a total of Rs 13,886 crore as per data released by the two exchanges, their sales in futures (on S&P CNX Nifty index, other indices and stocks) on the NSE were more than their purchases (that is, a net outflow) by Rs 8,070 crore as per data released by the Securities and Exchange Board of India.

In July, till the 20th, the position was reversed with the FIIs registering a net outflow of Rs 3,516 crore in the cash market and a net inflow of Rs 3,267 crore in futures on stocks and indices.

Secondly, analysts believe beta games are being played out. A FII, strongly bullish on some stocks will buy their shares in the cash market. But simultaneously it will sell Nifty futures expecting the stocks to be more volatile than the index in either direction. If the market rises it will profits on its stocks but lose index futures, but since the stocks are high beta its profit from stocks will be more than the loss in the index futures position. The attraction however is to limit the loss when the market goes down – stocks lose in value but this is buffered by a profit from the index futures position.

Thirdly, global funds have to deploy inflows or outflows into their kitties immediately in the market to give same-day net asset value to their investors. If such flows are sudden and large the institutional investor dreads the high impact cost it incurs in executing it all in the cash market in a single day. For a sudden large inflow, therefore, it will first buy stock futures to lock in the current market price. Then, over a few days, it will sell the futures and buy the stock in the cash market. "Money is managed dynamically by global investors to retain their competitive edge," says a derivatives desk dealer at Enam Securities.

These strategies are implemented across cash and derivatives market simultaneously and the directional positions taken are opposite to each other. Uncertainty and volatility can make a heavy cocktail.