Buying by FII in the cash segment can send out a wrong signal of bullishness if such a move is hedged by selling in single-stock futures.
Buying by foreign institutional investors (FII) in the cash segment can send out a wrong signal of bullishness if such a move is hedged by selling in single-stock futures.
That’s because FIIs do this arbitrage for some other purpose — take exposure to the appreciating rupee.
Domestic investors usually follow FIIs in the cash market and are caught on the wrong foot when the FIIs reverse such arbitrage trades.
Welcome to the world of currency-related arbitrage flows. Such flows are an important factor that drive stock indices globally, and sustain extended bull runs.
Since April 2007, the Sensex has gained 24% or 3000 points from 12,500 levels. In the same period, the dollar has fallen 6.94% against the rupee.
This dollar-rupee rate and the Sensex have a very strong relationship, because a large part of FII flows are arbitrage-driven.
How do they arbitrage?
The FII converts dollars into rupees and buys shares in the cash market. Simultaneously, it also shorts — or sells without owning - the same in the futures market.
This phenomenon is well-known in the market, and has been going on for some time now.
What is not well-recognised, however, is that such arbitrage-shorts in single-stock futures are absorbed by domestic investors.
When they see that FIIs are buying in the cash market, they take a position in the same stock through derivatives.
The local investor believes that FIIs are bullish on stocks, while actually they are bullish on the currency - the rupee, in this case.
Such sustained arbitrage-flows also increase traded volumes in single-stock futures. So much so, they go well past the Nifty index trades.
The rise in the Sensex, the fall in the dollar, and the cash-futures arbitrage in single-stocks lead to single-stock futures gathering most of the trades in the derivatives segment.
For example, take F&O volumes from April 2007 to date. Single-stock futures, which contributed to only 33% of total derivatives volumes in the beginning of April, saw its contribution move up to a high 60% levels at the peak of the Sensex rise.
In periods of volatility such as on July 27, the contribution fell to 47% levels. This interlinking of the Sensex, rupee, FII flows and single-stock derivatives also contributes to large market falls.
Good examples of this are the May 2006 and February 2007 collapses. The Sensex attempted to fall on July 27th, but recovered in a short time.
But the elevated levels of the Sensex and the rupee have increased risk in the market. It is advisable to take risk off the table before another sharp fall.
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