Using derivatives to advantage

 

The Indian regulators have shown intentions of slowly but surely relaxing the framework in favour of mutual funds. Proposals like allowing MFs to short-sell securities, trade in derivatives, allowing investment in gold and more recently relaxing rules regarding investment in foreign equity are all steps in the right direction.

 

The domestic mutual fund industry has in recent times emerged as a strong investment avenue, and for the momentum to continue, it is necessary that a more liberal regime be put in place.

 

Mutual funds were allowed to trade in derivatives by the regulators to only hedge against the risk in the portfolio. Of all the changes proposed, clearly, allowing unrestricted trading in derivatives is the most exciting, because of the flexibility it offers.

 

Derivatives are instruments whose value is derived from the value of one or more underlying assets. The most common underlying assets include stocks, commodities, precious metals and market indices other than exchange rate and interest rate derivatives.

 

Some of the common derivatives are forwards, futures, options and swap. Fundamentally, derivatives are instruments for hedging, but they can be used for speculation as well.

 

The Indian derivatives market has come a long way. In an indication of its maturity, the average daily turnover in the derivatives segment as on January 31, 2006 was Rs 24,379 crore, while the average daily turnover in the cash segment was only Rs 6814 crore.

 

The advantage of using derivatives as an investment strategy over cash markets is that the fund outlay in a derivative contract is lower. Typically, only a percentage is to be paid upfront in the shape of initial margin. Thus, for the same fund outlay, much larger exposure is possible through a derivative contract. Mutual Funds in India are permitted to invest in derivative for the purpose of hedging against risk and portfolio rebalancing. SEBI regulates both effectiveness of the hedge and its size.

 

MFs can hedge for potential losses from cash positions by trading in derivatives products.

 

A fund is not allowed to hedge a diversified portfolio using a sectoral index, because it is not an effective hedge. Similarly, a short position in other stocks, which do not form part of the portfolio, would not be allowed. MF are required to cover their positions in derivatives by holding underlying securities/ cash and cash equivalent/option and/or obligations for acquiring underlying securities to honour obligations contracted in derivatives market.

 

Why derivatives in mutual funds? A fund manager, depending on his view of the markets as well as any arbitrage opportunity, may choose to have a position in derivatives and/or underlying securities. SEBI view is that an MF has an onus to create its preferred position in the most cost-effective manner, through use of cash markets, derivatives markets or both.

 

Derivatives and short selling provide avenues to make money even when the markets fall or move sideways. Short selling is being contemplated and once allowed would give the fund managers a lot more flexibility.

 

With derivatives fast gaining popularity and retail participation increasing, we feel it is just a matter of time before derivatives investments go beyond just fulfilling the hedging needs of the fund, and are looked upon as separate investment options.

 

The potential and the advantages that this avenue gives to the fund manager are immense and some  players have already drawn up plans for a separate class of products that focuses entirely on investment in derivatives, with active positions in the cash segment, which will eventually help the industry branch out to other areas as well.

 

 

 

MFs trade in derivatives to hedge against risks in their portfolio

 

Funds can use smaller outlays for larger exposures

 

Derivatives provide avenues to make money even when the markets fall