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Commentary/Harshad Mehta

The options of futures are win and win

My previous column blasted badla as anti-growth. It concluded that perhaps the time has come for the nation's capital markets to break with the past and fall in line with options and futures.

This should not only introduce global trading practices in the country, it should also go a long way in liberalising capital markets.

Before I begin counting the advantages of embracing options and futures, let me quickly recap its explanation which I discussed in my previous column: Say someone buys SBI at Rs 315. After the budget and the political developments that followed, he sees it go down to Rs 265 and sells out at that price. He loses Rs 50 per share. Options and futures, when introduced, would let him limit the loss.

The is how: The SBI buyer can enter into a contract with a second party wherein this second party undertakes to buy the stock from the investor at Rs 300 at the end of the tenure of the contract. In exchange, the investor would have to pay the second party a premium for honouring the contract. It could work on the upside as well.

The SBI buyer can enter into a contract with the second party to buy the stock at Rs 345 at the end of the tenure of the contract. And, as in the previous instance, the investor pays the second party a premium for honouring this contract.

The operative word is 'option'. If the stock drops to, say, Rs 265, then the investor can very well sell his stock out at Rs 300 which is the price agreed to in the contract. But let us assume that stock 'x' actually rebounds and rises to Rs 370. In this situation, the investor might not want to be sell at Rs 300. This is when he uses his option to say sorry. But he would not want to sell Rs 15 below his cost price and continues to hold the stock in the anticipation of selling at a stronger price.

This might appear to be loaded against the second party because the investor can always escape when the trading condition goes against him. But it is not so: For his assurance of picking up stock as per the agreement drawn out, the second party gets a fee or premium in return.

On the surface what might appear as a straightforwardly simple mechanism can actually unleash the latent potential of the Indian stock market. It creates the opportunity for a variety of players from bankers to brokers to investors. A financial institution can take over the role of the agency writing out the contract (referred to as the second party in the above instance).

The investor can sleep in comfort that the credible financial institution will not renege on the contract.

I find this arrangement to have a universal appeal. The badla system, for example, is generally initiated by those who are insiders on the capital market (of a sort) and are conversant with the intricate working of the exchanges.

Options and futures can be marketed by financial institutions in an open and transparent manner to big and small investors alike.

In the badla system, the risk is, in a sense, unlimited. Those who tie in funds for badla financing have to keep putting out incremental cash to take delivery when the stock starts rising as the entire system is linked to the fluctuation on the exchanges.

In options and futures, there is no question of putting out cash; the investor retains the option of not buying stock and therefore has an escape route.

In the current system of financing, bankers find it difficult to lend against shares because often they have differing opinions on the extent of safety buffer that should be built into the transaction.

This is particularly evident in a falling market. Those who are willing to finance against shares raise their safety buffer and eventually investor gets a pittance. But see how the system can work beautifully when options and futures are introduced. When the investor goes to the bank to finance his holding of stock 'y', all he now has to do is show the contract in which another financial institution (say, the UTI) has agreed to buy stock 'y' at the existing market price less 10 per cent.

In usual circumstance, the bank may have opted for a discount of 40 per cent below the existing market price of stock 'y'. But now with UTI's assurance of picking up stock 'y' from the investor at the existing market price less 10 per cent, the bank derives more confidence.

It ventures to finance the investor at existing market price less 13 per cent only. And here arises a win-win situation. UTI earns an attractive premium fee (which it can actually on its huge idle asset portfolio as well), the bank derives more confidence in lending since its downside has indirectly been protected by UTI's buyback agreement and the investor gets more ready finance against his stock position than usual.

I am extrapolating the scenario. If the UTI is willing to write out contracts then the bank can go one step further. The investor can go to the bank and ask for a loan of Rs 35,000 to buy 100 shares of SBI. The bank buys 100 shares on the investor's behalf, charges interest on the same and gets it underwritten immediately by the UTI through a put contract.

Since the loss per share can at the most be Rs 15, only (the UTI agrees to buy at Rs 300), the investor can hypothetically enter into contracts of 2,100 shares worth Rs 35,000, thereby creating two distinct possibilities. Making a huge killing should the stock rise, or losing all of his Rs 35,000 should the stock drop.

Gradually, a national competition for the put contracts of SBI could emerge with some foreign institutions offering better put rates to the investors based on their varying perception about the company/industry.

This could turn stocks into liquid lending and borrowing instruments. All the banker would need to see would be whether the put contract was written by a respectable institution or not and it would lend accordingly.

Gradually, writers of contracts would get themselves rated by CRISIL and the like.

Carry this extrapolation to a global level. Internationally, with funds available at LIBOR, agencies would be delighted to lend at LIBOR plus 300 basis points (say) to Indian investors, provided the put contract is written by someone like Jardine Fleming or Morgan Stanley.

Again, we have a win-win situation but this time with dynamic ramifications. The international lender makes more money financing Indian stock than he would in his own country, the Indian buyer of stock on credit has to pay a lower rate of interest than he would via the badla (rises up to 48 per cent at times), the Indian buyers are more inclined to buy not only on credit but now get the purchase protected with a put option, leading to a revolution at a time when the country's p/e ratio is at an all-time low.

We are sitting on a bomb of an opportunity. The actual volumes of buying and selling shares in the US is a sixth of the volume created by options and futures!

Where are we?

Earlier Coloumn: Badla is financial terrorism