I saw some fascinating data, from CMIE, on the behaviour of foreign investors in the recent days of enhanced market volatility. There are small difficulties in measurement in this data - it includes options notional values, which aren't that clearly interpreted. But options trading is small so it doesn't contaminate the results that much.
The data shows the net purchase by all foreign investors on the equity derivatives market, and on the equity spot market, both measured in rupees crore. I also show the official closing price of the Nifty spot, and of the May Nifty futures, in the table. A useful piece of background is that the last date in the table (25 May) was expiration date for the May contracts.
|Buy on F&O||Buy on spot||Nifty||May Nifty|
As an example, if I may read out the last row in the table to you, on 25th May, FIIs purchased Rs.1,017 crore of equity derivatives in notional value, and sold Rs.1,632 crore on the equity spot market. The official Nifty close was 3177.7, and the May futures nicely converged to the spot with an expiration-date closing price of 3180.15.
The story that I think this data tells is like this.
- I know, it seems like a long time ago, on 10 May, Nifty closed at 3754.25. On the three following days, foreigners appear to have been successful speculators, selling on both the spot and the derivatives market. Nifty dropped to 3502.95. By 15 May, a big negative basis (-1.17%) had opened up.
- So from this point onwards, foreign investors were steadily buying on the derivatives while selling on the spot market. This sounds to me like reverse cash and carry arbitrage.
- Particularly, from 19th to 25th, local speculators were selling the Nifty futures, while the FIIs were doing the work of buying on the futures and selling on the spot. The basis showed up values as large as -2% on 22nd may, when FII purchase on the derivatives peaked. I find it reassuring for my story that on the days with the largest FII purchases on derivatives (19-25), the basis was at it's biggest negative values (-0.7, -2, -0.3 and -0.9). Of course, this "basis" is computed by comparing the official closing price on the futures and the official closing price on the spot, so it surely misses out the intra-day story.
These are highly aggregated numbers summing up the behaviour of over 1000 distinct entities., and it's always dangerous to anthropomorphise across aggregation. So one should not interpret this as "the behaviour of all FIIs" - instead it is the behaviour of the aggregate FIIs, and I'm sure there is huge heterogeneity within that class of investors.
The other remarkable thing in this data is how small these values are. The equity market (NSE + BSE, spot + derivatives) typically does over Rs.45,000 crore of turnover a day. The values for FII turnover seen here are all small, much smaller than what you might think if you read the newspapers shouting about FII exit (here's an example) leading to a drop of Indian equities.
The numbers in this table sum up to: A sale of Rs.10,456 crore of equities on the spot market, coupled with a purchase of Rs.5,100 crore on the derivatives market. Once again, the average per-day net buy/sell is small change compared with the size of the equity market. And, this reasoning and evidence suggests that a full picture of what FIIs are doing on both spot and derivatives is important to understanding what is going on.
In an ideal world, near-infinite arbitrage capital should be in play through sophisticated IT systems, so that the fair value of the index futures is circumscribed between a very tight "no-arbitrage band" at all times. In India, there are two big problems holding this back. First, SEBI and NSE have banned the IT systems - they insist that arbitrage be done in a labour intensive way. Second, the big institutional investors who are the natural players in this fixed income game - banks, pension funds, insurance companies - are prohibited from doing it.
India is doing some pioneering stuff by world standards in overcoming this problem by selling arbitrage funds to retail customers through mutual funds. I disagree slightly with the sales pitch that some of these funds make - they should clearly say it's a fixed income investment, but they don't always say that. For the rest, it's a great way to make progress delivering risk/return profiles to customers that existing institutional investors are unable to, and helping the country achieve "near-infinite capital in play for arbitrage".
FIIs have found a niche in derivatives arbitrage, with a comparative advantage owing to their regulators being better than ours. They have near-infinite capital and could thus do a great job in bringing about market efficiency on the derivatives. What holds them back is (a) the ban on IT systems, and (b) limits on FII ownership of individual stocks.