FIIs try out reverse swing to beat the Street:
Santosh Nair MUMBAI


WITH futures of many key index stocks quoting at a significant discount to spot prices, some aggressive foreign fund houses are learnt to have been borrowing shares heavily in a bid to cash in on the situation. These overseas players borrow the shares for an interest charge, sell them in the market, and simultaneously buy an equivalent quantity of the futures of that stock, which are available at a discount. This entire transaction is known as ‘reverse arbitrage’ in market parlance. The difference between the sale price of the shares and the purchase price of the futures is the profit for the foreign fund house. This difference, also called spread, has to be wide enough to lock in a neat profit, after paying the interest charge on the borrowed shares. For the moment, reverse arbitrage is turning out to be a very profitable activity for investors who are able to borrow shares. During the current derivatives settlement cycle, stock futures have been quoting at discounts as high as Rs 20-30 to the spot on many days. Dealers say Wipro, Tata Steel, DLF and ICICI Bank are among the actively borrowed stocks for reverse arbitrage.

Reverse swing points to further slide .

How does it work?

FOR instance, on July 4, the ONGC scrip was quoting at Rs 876.50, while the July futures were quoting at Rs 844. If an investor owns ONGC shares, he can sell his holdings, and buy an equivalent amount of futures, thereby locking in a profit of Rs 28-30 (after adjusting for brokerage charges). Then depending on the spread, he can either carry forward those positions to the next derivative settlement cycle, or reverse them at expiry of the current cycle. Even if the investor were to borrow the ONGC shares, he would still make a profit of Rs 20-25 after adjusting for borrowing costs. Interestingly, none of the borrowing is happening through the securities lending borrowing scheme (SLBS) started by the Securities and Exchange Board of India (Sebi) in April this year. In fact, there has not been a single transaction through SLBS for more than two months. Dealers at foreign broking houses said the borrowings are taking place among foreign institutional investors. The lender is usually an FII who is authorised to issue participatory notes (PNs). Overseas investors not registered with Sebi — either out of choice or regulatory reasons — invest in Indian shares through the PN route. The FII authorised by Sebi to issue PNs has a separate account, in which it buys and sells shares for clients who wish to invest through the PN route. This FII has an assortment of stocks in its inventory and with — or sometimes even without — the permission of his PN clients, he lends the shares to investors willing to pay a charge for it. Since the lender and the borrower are global players, such agreements are entered into outside India. In the disclosures to the stock exchanges, it will appear as if the PN client is selling those shares. But as per the agreement signed in some other jurisdiction, the shares are being sold on behalf of the foreign fund, which has borrowed them for a fee.

Why not SLBS?

“The SLBS is too transparent,” said a dealer at a foreign broking house, on why foreign funds were avoiding this route to borrow shares. “If (market) operators get to know that institutions are heavily short on a certain stock, they will try to move the price in the opposite direction and force the institutions to cover up their positions,”( Is this planned hammering or WHAT?) he added. The other reasons are the high upfront margins in this segment and the rigidity in the contract tenure. In the PN route, margins are much lower and the terms far more flexible, since it is an over-the-counter (OTC) market.

Money for jam

As the name suggests, reverse arbitrage is the opposite of what most foreign funds were practising in a rising market till December last year. Then, futures were quoting at a premium to the spot price. So these foreign funds would sell the stock futures, and simultaneously buy an equivalent amount of the stock, the difference being their profit. Then depending on the spread, they would either carry forward those positions to the next settlement cycle, or reverse them at expiry of the prevailing cycle. ‘Money for jam’ is how one dealer at a foreign broking house had described the trade. There was no risk, since each leg of the trade was protected by the other, and the spread mostly remained constant.

Why reverse arbitrage?

Sources in foreign broking houses said even without reverse arbitrage, many foreign investors have been borrowing shares and selling them in the market in the past couple of months. When prices fall, these investors buy back the shares and return them to the lender. But should the stock price rise instead of falling, the borrower would face a loss, and he will have to buy the shares at a higher price to return them. In this form of borrowed transactions, gains as well as losses can be huge. In reverse arbitrage, the profits may be lower, but they are there for the taking. Profits are locked in the moment the trade is initiated. And if the spread starts narrowing, the position can be closed out with some sacrifice to the initial profit.

Bear hammering?

Market watchers are baffled by the steep discount which many stock futures are currently quoting at. Usually, the premium or discount between the futures and spot is not more than a rupee or two. One reason for such wide disparities in prices could be the reduced number of players in the derivatives segment. A good number of high net worth individuals and retail investors have permanently moved out, after suffering massive losses during the market meltdown in January. Lesser participants mean that arbitrage opportunities are available for longer. But there are conspiracy theories too. Some brokers allege that the steep fall in stock futures is being precipitated by basket selling of stock futures by some FIIs in a bid to pull down the index. “It can’t be a coincidence that the discounts are wider in stocks which are illiquid, but at the same time have a significant weightage in the index,” says a day trader, referring to stock futures of Wipro and ONGC. The disparity is much lower in the case of liquid index stocks like Reliance Industries. Reverse arbitrage, though perfectly legitimate, also tends to drag down prices in a scenario where there is not enough buying support. Stock futures quoting at a discount means investors are bearish in their outlook. So when shares are sold to capture the arbitrage opportunity, the prophecy becomes self-fulfilling. Incidentally, the same mechanism was in force, but in the opposite direction, when the market was rising. When investors were selling futures and buying shares, indices would rise as a result of the cash market purchases.

Payback time?

In the last couple of sessions, the price differential between the futures and cash market has narrowed down considerably. Dealers said the steep decline in crude prices has caught many of the arbitrage players on the wrong foot. With sentiment improving, the funds which had sold borrowed shares are frantically covering up their positions by buying back the shares(That is the catch). This was also reflected in the positive FII inflows on Thursday and Friday, even as the overall mood remains cautious ahead of the trust vote in Parliament on Tuesday. Should the differential reduce further, there could be further covering up of positions. The trade is profitable only as long as the difference between the futures and spot price can more than cover the borrowing costs.

nair.santosh@timesgroup.com


My comments:
Seems Bears(I have not named) has found out newer ways to break the market.I have been writing at my blog since long that the hammering in our market seen is unwarrented.Even if econmy is slowing a bit by couple of percentage ,market can't go on breaking the way it was/is breaking....
Hammering is overdone in our market.....and as it is a planned attack by through the Master Mind conspiracy of Indian Biggest Bear, Bears are going to caught on wrong foot like they did in last couple of days....
Freinds,All have been explained in a detailed manner in this post which I have copied and pasted from ET of Monday....(Yesterday)front page.....
The bear conspiracy is going on and it should get exposed in a state of a Scam....to break Nifty and thereby the market.....I am writing this since long about systamatic bear hammering but people were greedy not to believe that and thought Chart is working.........Lol.......

Rajeev