Forward view

Stock exchanges can expand the scope of derivatives by launching contracts on unfolding events

Much of the world’s woes over the past two years has been blamed on derivatives. Mortgage lenders in the US lured borrowers with teaser rates and disbursed credit to even those with spotty track record. These loans were spliced and bundled with other mortgages attracting different credit ratings into securities that were in demand from financial institutions to bolster their balance sheets. If derivatives caused grief to many, there was another group of investors who not only used these products to protect from downside risk but also to profit. As the fraud charges filed by the Securities and Exchange Commission against Goldman Sachs shows, the market is always efficient. Contrarians made money betting on crash in real estate. Though the US Congress has passed a bill to restrict the use of derivatives by banks for proprietary trading, the usage is not going dwindle. Financial transactions are becoming complex and contagious as markets are always open in some part of the globe. Tracking the DJIA late into night or the Nikkei early morning is the vanilla way to spot opportunities or eliminate risks. The other option is to use the futures market to take a view. The amazing properties of derivatives have resulted in their popularity extending to markets other than stocks. Forward trading in commodities is as old as that in stocks. Companies with exposure to foreign exchange have discovered the joy of hedging from currency volatility and those affected by monetary policy the comfort of interest-rate derivatives.

Even as investors, institutions and companies are embracing options, it is time to expand the scope to make gains and cushion risk. Why restrict forward view to company guidance, order wins, and industry outlook to predict the course of the stock over one, two or three months in the F&O market? The red herring prospectus contains risk factors to enable investors to take informed decision. If these are found to be inadequate in retrospect, Sebi can impose penalties and stock exchanges can even suspend trading. Commendable no doubt, these actions rarely are adequate to make up the erosion in market cap in the meanwhile. As government, market regulator and bourses wrestle to come up with solutions, the derivatives segment of stock exchange can launch contracts to take into account various out-of-the-box contingencies that may crop up to hurt investors. The freshest example is that of the RIL-RNRL row over gas pricing. If RIL had not backtracked from the agreement signed during the division of the Reliance group, the matter might have not reached the Supreme Court. There was, however, a possibility of intervention by government as natural gas from the same source would be supplied to RNRL and other customers at different pricing. How many investors who bought RNRL shares could have foreseen the reversal? If only the stock exchanges had quickly capitalized on this opportunity by launching contracts to take into account the possibility of the MoU turning junk as the case winded up from the high court to the apex court!

There have been instances of breaking up of partnerships even after commissioning of the joint venture, the most recent being the parting of ways of Renault and Mahindra & Mahindra. The division of assets between the Munjal family recently and the Bajaj family earlier are examples of how investors can shortlist groups that could see splits. What will be the shape of the RIL group and ADAG due to the scrapping of the non-compete agreement? Who will win RCom? MTN, AT&T or Etisalat of the UAE? Can Jeh and Ness Wadia manage the Bombay Dyeing group amicably? Will the Essar conglomerate remain intact between the two Ruai brothers? Mergers and acquisitions is another area. Bank stocks are active after ICICI Bank’s purchase of Bank of Rajasthan. Similarly, after the buyout of Primal Healthcare by Abbot Laboratories of the US, pharmaceutical stocks are in the limelight. Why not allow investors to bet on likely takeover or even bonus candidates? Or write options on the success rate of drug companies filing applications with overseas regulatory bodies? From the very accurate bets on the cricket team likely to win the World Cup to the composition of the government following national polls and listing price of IPOs, it is evident that there is vast market out there, filling a vacuum. It’s time to attract this money and talent into legitimate channels, creating a platform that will be expansive and exciting. As if endorsing this view, the Commodity Futures Trading Commission last fortnight approved trading in F&O contracts tied to the opening weekend box office revenue of the movie, ‘Takers’, a crime-thriller set for release in the US on 20 August 2010.

Off balance

Even careful calibration of issues such as gas pricing and regulating mutual funds can spin out of control

The current market turmoil has turned topsy-turvy rules of investing. Liquid companies with proven financial track record are supposed to be stable in a market downturn. Yet these stocks have not remained immune to recent volatility due to the sizeable presence of foreign institutional investors, who dumped them to meet redemption pressure at home. Dividend paying companies still lure but also invite scrutiny for lack of growth plans to effectively use cash. Sunrise industries are facing intensifying competition and regulatory attention from here and abroad. Market heavyweights are embroiled in their own problems, be it internal issues of control or debts taken for costly acquisitions. Frontline counters’ fortunes are getting linked to the dollar and the euro, whose movements are no longer linked solely to the health of the issuing region. High beta stocks capable of giving sizzling returns start discounting forward earning in a few sessions and become victims of their own success. Corporate governance issues stalk mid- and small-caps, making them unpredictable. Retail investors looking at mutual fund to anchor their savings are finding there is hardly any port to call after Sebi decided to give investors a say in deciding brokerage of distributors. Despite the economy posting strong growth numbers, prospects of fiscal deficit getting bridged due to the successful completion of the 3G auction, and forecast of normal monsoon, the market is stuck in a groove, pinning its hopes on recovery of the US economy and sorting out of the sovereign debt problems facing many euro zone countries for foreign funds to return and pull up the market.

For a brief period, it looked liked that the intervention of the Supreme Court in the dispute on pricing of natural gas from RIL’s Krishna-Godavari block to be supplied to RNRL’s power project in Uttar Pradesh would provide the much needed boost to the market as RIL, an index heavyweight, is now free from uncertainty. The market’s return to range-bound movement subsequently was because the verdict was not merely a judgment on a private memorandum of understanding between two companies. It was a reiteration of government’s role in deciding pricing. Foreign investors in Venezuela and Russia have had unpleasant experiences of the state’s arbitrary interference including expounding of assets. Besides administered pricing of a natural commodity is at odds when downstream products of another natural commodity are proposed to be deregulated. The rise and fall in the market cap of RIL and ADAG stocks following the SC’s say, thus, was as irrational as the bounce-back in ADAG companies after the terse announcement from the Ambani brothers of scrapping the non-compete agreement entered into while carving of group assets between them. The pivot of the ADAG is the power sector. The embargo on Big Brother from making a foray into natural gas-based power generation for another six years till 2022 is huge hedge for not getting natural gas at concession. On the other side, the entry of RIL in the money business — mutual funds, finance or insurance — will not mean much for the Anil Ambani group because it is already operating in a crowded field. Telecom is no longer a lucrative arena, and RCom’s fate is no different from that of other telcos.

Would our markets have fared better if Sebi had not chosen to discipline mutual funds at this juncture? The timing was indeed unfortunate: the market was once again displaying signs of nervousness after springing back into action. This is the period when investors either choose to stay on the sidelines or invest through SIP for the law of averages to work out. Suddenly, asset management companies stopped new launches as entry load, a lucrative avenue to make money, was banned. Following the shifting of onus of commission from AMCs to investors, distributors, too, stopped hawking mutual fund schemes. The diversion of flow to unit-linked insurance plans, which invest part of the corpus in equity markets, was not enough to compensate full-throated investment of equity schemes. The comatose state of the mutual fund industry following recent reforms is one more reminder that regulations that take care of only one section of the stakeholders do not succeed. A middle path could have been linking fees to performance over a period of time or a graded system of penalizing those who seek to redeem their investments before and after one year, making it fruitful for investors as well as AMCs to seek long-term association with the markets. There is a lesson here to be learnt by government, which is introducing the direct tax code, making investment subject to personal tax rate, irrespective of the holding period.