Signaling in CNX nifty futures: a perceptual approach.

Barik, Prasanna Kumar ; Supriya, M.V.

Introduction

The Indian futures trading system exists with passive day orders through the hierarchy of clearing members, branch managers, dealers, brokers and sub-brokers. Depending on the valid order entry in the market, clearing entities execute orders with clearing and settlement process. Here apart from the leveraging activities of derivatives instruments, one can benefit from both a downturn as well as an upturn market situation. Therefore, one can make money in both bull and bear market situations. However, the pathetic situation is that the above opportunity is not available to all of the market participants like investors, dealers, brokers, sub-brokers and market operators. This is also not easily and conveniently accessible to the retail investors. This leads to the autonomy, accountability, and transparency issues. In this context, the trading behaviour in asymmetric information situation is matter of concern. The market participants' trading behaviour affects the market making. Hence, it is pertinent to understand their strategies. These market strategies have a direct bearing on valuation. Moreover, the informational gap among the market participants is a cause of concern.

In this context, studies like, the job market signaling (Spence, 1973 and 1974), the financial incentive signaling approach (Ross, 1977), the signaling hypothesis test on Harris and Raviv (1985) by Acharya (1988), and signaling in insurance market by Rothschild and Stiglitz (1976), are relevant. The 'lemon' effect on market making (Akerlof, 1970), 'learning process through the signaling instruments' suggested by Miller (2002), and the market making analysis with order flow (Schultz, 2003) are significant other contributions in this context. Chung et al., (1999) have examined the role of the limit order traders' intraday competitiveness, in limit order placements and executions. Chow et al., (2002) have examined the various aspects of trading behaviour and found that both the institutional traders and individual traders supply liquidity in Taiwan stock exchange. The institutional traders do not trade on margin. Bondarenko and Sung (2003) have concluded in their paper that the market makers wish to trade against the market trend when the realized depth of the limit book is significantly lower than the critical value and vice versa. Naresh (2006) has found that in National Stock Exchange of India Ltd. (NSE), the market participants are not satisfied with the margining, cross-margining, minimum contract size, transaction tax, physical settlement, and eligibility requirement for the introduction of new derivatives. However, they are satisfied with the existing systems like the investors' protection, position limits, contract on the new indices, and use of derivatives by mutual funds.

Prasanna Kumar and Supriya (2005, 2007a, 2007b) have found that the signaling devices like efficient order entry system and efficient valuation are necessary to make a signaling equilibrium at NSE futures market. Through these informational norms, they have defined and measured the market activities like hedging, speculation, and arbitrage. It is observed that the market is not achieving the hedging, speculation and arbitrage positions efficiently. Therefore, futile trading and inconsistent profit maximization exist, suggesting the monopoly character of the market. At NSE F&O during the trading hours, it is observed that sub-brokers and individual investors trade in the derivatives. Sub brokers submit the limit orders through their subordinates. These are placed on behalf of their clients. These clients completely rely on the advice of sub-brokers for market information. This is usually disseminated through telephone. Investors on the other hand trade at the trading terminals on their own. They make decisions to invest on their own. It is observed that the market or limit orders are executed based on the tick value of the contract. Buy and sell orders are matched electronically. In effect, the particular passive limit order is used as the basis of trade. However, it appears that there is a gap in the information on market, its components, and characteristics available to the sub-brokers and investors. This may influence the trading in the market. Considering all these factors, the present study attempts to understand whether such an informational gap really exists among the market participants?

Methodology

This study relies on the responses to a field survey, which was conducted during the month of March 2008 to May 2008. The survey was carried out at Hubli-Dharwad city (Karnataka, India).This geographical area consists of twenty-one NSE traders. Of these, six are NSE futures and options (NSE F&O) sub-brokers and fifteen investors who are actively trading at NSE F&O. A questionnaire was prepared and administered for this purpose. This questionnaire has questions related to the demographic details of sub-brokers and investors, the nature and functioning of nifty trading, and its microstructure. The findings of prior studies like Naresh (2006), Prasanna Kumar and Supriya (2005), Prasanna Kumar and Supriya (2007a and 2007b), and studies like those of Miller (2002), Bloomfield et. al. (2003), Schultz (2003), Chow et. al. (2002), Werner (2003) etc. have influenced the choice of the questions. The purpose of the questionnaire is to conduct a comparative analysis, which is used to understand perceptual differences if any between the sub-brokers and the individual investors.

Results and Discussion

The demographic profile of the respondents has been shown in Table1. It can be seen that both sub-brokers and investors are educated enough for any kind of market trading. However, in the NSE F&O market, 67 per cent of sub-brokers have done professional courses related to the securities and derivatives market. About 83 per cent of sub-brokers have relevant training in these areas. About 67 per cent of investors have not done any professional courses on securities and derivatives market, and sadly, 73 per cent of them do not have any training in these areas. It suggests the need for emphasizing on appropriate education and training for investors to trade efficiently in this market. In addition, 33 per cent of sub-brokers have less than 100 clients and 67 per cent have over 100 clients. Also 83 per cent of sub-brokers have the expectation that participation of the total number of clients in both securities and derivatives markets will increase. As far as trading volume is concerned, 50 per cent of NSE F&O sub-brokers are trading with daily nifty trading volume worth of 50, 00, 000 INR. About 17 per cent of NSE F&O sub-brokers are trading with daily nifty trading volume worth of 80, 00, 000 INR.

The demographic profile suggests that the derivatives market consists of fairly well educated, rational, and informed market participants. The Indian derivatives market is about eight years old. There is a possibility that trading in derivatives may see a rise in the near future. Given the volatility reported in the securities market across the globe it is natural that derivatives would be used for hedging. Therefore, the derivatives market is likely to witness more trading and client participation. Majority of the sub-brokers (67 per cent) have opined that they have comfortable trading relations with other market participants like dealers, brokers, and investors. Questions on profitability yielded mixed responses (see Table 2).

About 33 per cent of sub brokers agreed that the daily nifty trading volume is enough for ensuring profit .The remaining respondents were non-committal on this issue. In addition, all sub-brokers have agreed that daily open interest for nifty trading is not enough for assuring the profit. However, 80 per cent of investors have opined that daily nifty trading volume is sufficient to assure profit .Where as 20 per cent of them have opined that daily open interest is not sufficient to assure profit. Considering these inconsistencies, the question that arises is 'what factors affect the trading volume'. From the responses, it is observed that 83 per cent of sub-brokers and 67 per cent of investors have agreed that the trading volume and open interest heavily depend on the geographically local market. It is observed that local trading is preferred to out of state and foreign trading. Here local trading indicates trading by investors and sub brokers on behalf of client investors within the Hubli-Dharwad region. Sub-brokers of this region are therefore able to influence the investments of their client investors and thereby influence market making. In addition, 50 per cent of sub brokers and 73 per cent of investors expressed that online trading is convenient. Since trading preference is localized, there is a need for local advertisements for nifty trading. This will provide necessary information and knowledge about financial instruments like futures and options and their underlying variables (FUTIDX, OPTIDX etc.). This will have a reach on grass-root traders.

About 50 per cent of sub-brokers and 33 per cent of investors have said that all the passive orders are executed. About 83 per cent of sub-brokers and 80 per cent of investors have said that all the passive orders are executed through the front end of Regular Book. Again, 83 per cent of sub-brokers have agreed that good-till-day orders are preferable than other types of orders like day, good-till-cancelled and fill-or-kill orders. Where as, 53 per cent of investors have not reported any such preference. The difference in preferences implies an information gap on the nature and functioning of orders in the market. In addition, 73 per cent of investors have opined that it is easy to trade with market orders than limit orders where as only 17 per cent of sub-brokers have agreed to the same. Therefore, according to investors, the limit price is seldom realized in the market. Where as, according to the majority of sub-brokers immediate best price is not available in the market. Therefore, they prefer limit orders. From this, we can conclude that the nifty price rarely reflects its true value. Therefore, asymmetric information exists in the market. In addition, 80 per cent of investors and 50 per cent of sub-brokers have agreed that order executions face basis risk with different costs. This is because of the marked difference between spot and futures price. This indicates the existence of inefficient order executions. Most of the respondents have responded that submission of both market and limit orders are high during the initial and in-between initial and last periods of nifty trading. In these trading periods, 68 per cent of respondents have said that there are large numbers of hedgers. Futile trading was reported (see Table 3) by respondents.

About 78 per cent of both groups have reported hedging experiences with futile trading. It is in this context, the question of 'hedging effectiveness' for nifty futures trading arises. In addition, all sub brokers and 67 per cent of investors have said that large number of speculators exists. Moreover, 84 per cent of sub brokers and 67 per cent of investors report speculation experiences with futile trading. Therefore, the question on 'rational speculation' for nifty futures trading arises. Almost all the respondents have said that 'arbitrage' does exist. The transaction cost is well adjusted with it. In other words, at the delivery of underlying asset the impact cost is well adjusted with the futures price, which converges to spot price through the settlement price. However, the issue of increasing or decreasing rate of transaction or impact cost in relation to the rate of market or limit order submission exists.

At NSE F&O market, the tick size is enough for trading activities. This is what 83 per cent and 73 per cent of both sub-brokers and investors have agreed. In addition, 67 per cent and 73 per cent of sub brokers and investors have agreed that the present tick size is enough to place market or limit orders. Most of the respondents have said that the tick size affects the submission of market and limit orders and vice versa. The tick size and hence the tick value for placing market and limit orders is high during the initial periods of the nifty trading than other periods of trading. Here, the tick value is equal to the product of tick size and the contract size. Most of the investors have responded that NSE has defined the tick size for nifty trading at Re. 0.05. The tick size and hence the tick value is one of the important variables which influences the nifty price formation, and hence determines the trading volume and return. Majority of the respondents have said that the tick size is very much related with the trading margin. Sub brokers observed that all types of margin are at the satisfactory level. In this study, 60 per cent of the investors are not ready to accept that all margins except initial margin are at the satisfactory level. Hassles in margin trading are experienced according to 53 per cent of investors. Here, hassles in margin trading arise on account of asymmetric information. In addition, despite the assurance of brokerage commission and availability of resources from call money market, traders experience difficulties that can impact trading. Market participants usually have access to the call money market. This is agreed to by 50 per cent and 60 per cent of sub-brokers and investors respectively. Most of the respondents have said that there is 100 per cent fund availability through call money markets to depository participants and clearing banks. They feel that the call money rate may be an alternative to the bank rate for borrowing and lending financial resources for investment purposes.

Conclusion

The survey result implies that the tick size, the tick value, trading margin, trading transaction cost, and scarcity of financial resources influence the trading return. In this context, studies like Bali and Hite (1998) and Frank and Jagannathan (1998) also observe that the tick size and the bid-ask bounce cause changes in premium and returns (cited in Graham et. al., 2003). Whereas other studies like Graham et. al. (2003) and Jakob and Ma (2004, as cited in Graham et. al., 2003) are inconsistent with these findings. The sub brokers are more experienced in trading in both the securities and derivatives markets. This may give them an edge over the investors while trading. Consequently, there is a need to provide appropriate training avenues to the individual investor. Current initiatives in investor education are a step in the right direction. However, there is a need to devote more attention on trading in the derivatives market. This is because trading in derivatives is of recent origin in India. Individual investors may be apprehensive of it. As trading is largely localized, there is a need for improving the reach of advertisements. More particularly, the advertisements need to be in the vernacular so that it is better understood. These advertisements will provide complete information and consequently draw investors to the derivative products. These twin measures will go a long way in reducing the differences in perceptions of sub brokers and investors. Thereby, the chances of market inequities arising out of asymmetric information can be reduced if not completely removed.

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Prasanna Kumar Barik, Centre for Multi-disciplinary Development Research, Lakamanahalli, Dharwad--580004, Karnataka, India. E-mail: barikpk@yahoo.com

M V Supriya, Department of Management Studies, Anna University, Chennai--600025, Tamil Nadu, India, E-mail: mvsupriya@hotmail.com

Table 1: The Demographic Profile of
the Respondents.

 Sub-broker Investor
Variables
 Percent Percent

Age

20-30 50.00 53.33
30-40 16.67 26.67
Above 40 33.34 20.00

Education

Graduate 50.00 67.00
Post Graduate 50.00 33.00

Knowledge in Trading (Professional Course)

Yes 67.00 33.00
No 33.00 67.00

Knowledge in Trading (Practical Training)

Yes 83.00 27.00
No 17.00 73.00

Securities Trading Experience

Above 15 years 16.67 6.67
5-15 years 50.00 --
Less than 5 years 33.33 93.34a

Derivatives Trading Experience

Above 5 years 50.00 6.67
3-5 years 33.33 40.00
Less than 3 years 16.67 46.67

Table 2: Assessment of Profitability of Trading

 Yes No Uncertain
Variables
 Percent Percent Percent

Trading Volume

Sub-brokers 33.00 -- 67.00
Investors 80.00 20.00 --

Daily Open Interest

Sub-brokers -- 100.00 --
Investors 80.00 20.00 --

Table 3: Futile Trading

Activity Sub-brokers Investors

Hedging 78% 78%
Speculation 84% 67%