## Tuesday, August 29, 2006

### Nifty rules (but why?)

I just looked at the July 2006 `Derivatives Update' from NSE. It shows an astonishing success with index derivatives trading. In the late 1990s, we used to think that the badla community would easily switch to stock futures and stock options, and that trading the index required new ways of thinking, which are always hard. But look at the data for July 2006:

• Of all futures traded at NSE, Nifty made up 47% of the turnover. The biggest stock futures (Reliance) was at 6%.
• The biggest traded product in July, unsurprisingly, was the July expiration Nifty (Rs.1531 billion). What was second? Nifty August expiration (Rs.330 billion). The July Reliance contract came in 3rd with Rs.232 billion.
• Turning to the options, Nifty was 80% of the turnover. Reliance was 2nd with 6%.
• The top 5 option products were all Nifty contracts with July expiration. The order was: 3100 call, 3100 put, 3000 put, 3000 call, 3200 call.

In a famous paper, Morck Yeung and Yu (JFE 2000) find that in emerging markets, market model R2 is bigger; the index plays a bigger role in the life of a stock. In the case of India, generally, market model R2 values are small by world standards - this suggests more price discovery about each stock in its own right. But when we look at the derivatives trading, it looks like there is a huge role for the index.

Another perspective is the distinction between macro underlyings and individual firms. The microstructure literature has argued that with macro underlyings -- indexes, currencies, interest rates -- there is intrinsically less asymmetric information, so bid-offer spreads are fine. But by that same yardstick, low asymmetric information ought to induce lower trading volume, since volume comes about when people disagree on a valuation. I don't understand this.

#### 1 comment:

1. Is this because of the proliferation of index linked funds. Also does the index derivative provide an easier mechanism to hedge portfolios than individual stocks. Does this explain the large index linked derivative trades?
(These are WILD guesses! :-P)

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