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October 31, 2008
Quantos ....do they improve price discovery?
The Singapore Exchange(SGX) has a US$ denominated Nifty futures contract in Singapore. BSE's Dollex-30 is currently 'under review' by US' Commodity Futures Trading Commission and on getting a 'no action letter issued ' it may be introduced in America.
Would the introduction of overseas exchange traded derivatives based on Indian equity drive price discovery of Indian indices overseas? I shall attempt to answer this question. Please consider the following thought experiment:
Gold futures for current month's expiry are being traded at US$ 800 per ounce in London. Now, suppose a commodity exchange in India introduces an INR denominated contract which settles at the same numerical value and on the same date as the contract in London. However, the contract in Mumbai is necessarily cash settled. Thus, this contract in Mumbai is also being quoted at say INR 800 per ounce(I have just defined a QUANTO).
If on expiry date the London contract settles for US$ 840 per ounce then the contract in Mumbai will also settle at INR 840 per ounce.
Thus, for a trader in London for whom the base currency is US$, the gain/loss would be 5% in his currency.
Similarly, for a trader in Mumbai for whom the base currency is INR, the gain/loss would be 5% in his currency.
By using the contract in Mumbai, the trader in Mumbai can have a pure play on the movement of Gold prices without taking INR/US$ exchange rate risk.
Those of us who buy gold in India, will readily notice that this new contract in Mumbai is an artificial construct, as gold prices in jewelry stores in India are based upon the price of gold in US$ per ounce converted into INR per gram, to which an additional margin is added by the jeweler. The fact that INR denominated gold cannot currently exist in the spot market, only reinforces the assessment that INR denominated gold futures contract is an artificial construct.
Although we have an artificial construct, there is no risk-free arbitrage possible between the markets in London and Mumbai. Thus, there is no direct linkage between the two(the linkage may be called weak at best). Even if the turnover of this contract in Mumbai was many times that of the turnover in London, Mumbai would still be a price taker and London the price maker. Unless, traders in London were (irrationally) influenced by the traders in Mumbai.
A risk-free arbitrage would have been possible when the futures price in Mumbai and London are different, only if the INR/US$ exchange rate were fixed—which is clearly not the case.
On the other hand if a US$ denominated INR settled gold futures contract is introduced in Mumbai, then there would be a linkage between the market in Mumbai and London. This link would be created by arbitrageurs who would ensure that prices in the two markets are identical (but for transaction costs). Then, the market with larger volumes can reasonably expect to influence the price in the lower volume market. And if Mumbai were to one day have larger trading volumes than London, then it could influence the prices of gold (in US$) in London.
Similarly, the US$ denominated Nifty futures contract is an artificial construct since the Nifty is denominated in INR.
Considering that there is no real linkage between the SGX's US$ Nifty futures contract and the Nifty contract on the NSE, if the traders in Mumbai collectively believe that they should be taking the price of Nifty from Singapore--it shall be a damaging self-fulfilling prophecy for the Indian derivatives market!
In conclusion, we can say that we the SGX should perpetually be a price taker as long as its Nifty contract is not INR denominated, even if in future its turnover is many times the turnover at the NSE. Rationally, we can also say that the SGX is likely to become a price maker if its Nifty contract is INR denominated, and if its turnover is much larger than the turnover at the NSE---then India have truly exported the most important function of an exchange, namely price discovery.
Note-1: SGX has JPY denominated Nikkei futures contract since 1986 and a US$ denominated Nikkei futures contract was introduced two decades later. All Nikkei options on SGX are JPY denominated.USD denominated Nikkei futures are being traded in the US for decades.
Note-2: Dollex-30 is the BSE Sensex-30 adjusted for the change in INR/US$ exchange rate(in real time). US$ denominated Dollex-30 futures contract is equivalent to INR denominated BSE Sensex-30 futures contract.
So, can a quanto participate in the price discovery process?
Is a risk-free arbitrage between the two markets necessary?
And does the mere existance of the risk neutral valuation technique ensure a strong linkage between the two markets? Consider this : A group of friends play a game in which they play on the DJIA. There is a twist.The DJIA in this game is denominated in cattle! Thus if I am long DJIA @ 10,000 for current month's expiry and the settlement price is 9,000; I have to deliver 1,000 cows!
While the location where the price discovery occours may not necessarily be a cause of concern(except in the case of a few critical companies)........isn't punting on JPY denominated Nikkei and the USD/JPY exchange rate separately simpler?
WHAT DO YOU THINK?
Posted by amgodbole at October 31, 2008 02:42 PM
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