One of the big lessons of 2007 is that new financial products and the strategies to trade in them can sometimes be bewilderingly complex. And that troubles in financial markets that have gorged on complexity can quickly ripple out into the rest of the economy. Credit markets in the US and Europe are still trying to make sense of the smorgasbord of derivatives and other securities that lie in bank balance sheets. That is why they seize up with fright every now and then.
Regulators have two options: to demand more clarity on what is going on or to clamp down on financial innovation. The former is quite clearly the more sensible option. Bans never help, although there are the inevitable calls for them whenever there are problems in the financial markets. Usually, crises in the real economy bring with them calls for further deregulation while crises in the financial economy come with calls for tighter regulation: That’s a big paradox in the annals of contemporary policy debate.
All this is of relevance to India. The domestic financial markets are still repressed. Local investors have access to a limited range of securities to buy and sell. But the same cannot be said of offshore investors who are taking positions on the Indian economy—either directly or indirectly. Many of them are hedge funds who use a range of trading strategies. They buy into the India story through participatory notes (PNs), which are offshore instruments backed by Indian equities and derivatives and whose proliferation has kept troubling the Reserve Bank of India and the Securities And Exchange Board of India (Sebi).
This column has argued earlier that a lot of the Indian debate on hedge funds does not take into account the fact that their India strategies could be far more complex than just buying certain shares. It is safe to assume that many hedge funds trade across various Indian assets—individual stocks, indexes, currency and offshore debt. Thus, for example, a violent sell-off in the stock market may unsettle the rupee and interest rates as they are all linked through hedge funds’ trading strategies. No wonder regulators want to know what’s going on in the PN market. It’s systemic risk they are worried about.
A new International Monetary Fund (IMF) working paper by Manmohan Singh, an economist in the Fund’s monetary and capital markets department, throws some light on the types of positions that hedge funds could be taking in India. The main intent of this paper is to assess the probable impact of Sebi’s new regulations on the PN market. But right through the research paper, Singh mentions various investment strategies that PN investors could be using.
Here are some examples.
The most common one is to go long on select shares and hedge by shorting the Nifty index in the futures and options market. Sebi has said that of the $90 billion of money that has come in through PNs, $60 billion has come into the cash market and $30 billion in the derivatives market. Much of the latter could be to take short positions on the Nifty.
These short positions will lose money in a bull market such as ours. Singh then presents an interesting possibility. “Market sources in Hong Kong, Singapore and London suggest that margins (i.e., down payments on futures positions) are roughly 25-30%. Although counter-intuitive, $7.5-$9 billion…has come into India from such margin accounts due to losses on futures positions, without the initial transaction being closed, yet. These inflows have placed an additional upward pressure on the rupee, over and above the pressures from onshore FII (foreign institutional investors) accounts.” This means that even short positions push up the rupee.
In fact, stock prices and the rupee have been positively correlated in recent years. Both move in tandem. So every FII buying stocks is also buying the rupee. In fact, says Singh, it is possible for offshore to take a bet on the rupee through the stock market: go long on Security A in the cash market and short the same security using a PN. Going long in the cash market means that rupees are paid upfront. The short position using a PN derivative means that the investor receives dollars when his trade is closed. In effect, this investor has no net exposure to equity but has taken a bet on the dollar-rupee exchange rate.
I am sure there will be many, many more mixed strategies out there—and why not? That’s the whole point of being hedged.
Hedge funds take simultaneous positions in various markets, be it cash stocks, stock options, the rupee or even offshore rupee bonds. Their actions in one will affect prices in the other. There is nothing wrong in all this. It’s just that the public debate should take into account that hedge funds could be doing far more than buying individual stocks and pushing up the market to new highs—and accept that regulators have good reason to worry.
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