Volatility indices, such as the India Vix of the National Stock Exchange (NSE), normally have an inverse relationship with the market. When the markets rise,
investors get more complacent, which is reflected in lower prices paid to buy protection using options. Another way to look at it is that the markets lower their expectations of volatility in an uptrend. When the market corrects, on the other hand, volatility expectations rise, or higher prices are paid to buy protection using options.
The chart alongside, with the India Vix on the one hand and NSE’s main Nifty index on the other shows that this relationship has largely been maintained this year. When the markets crashed in January, the India Vix shot up from the levels of 25 to over 50. (The chart readings are based on a seven-day moving average and the actual levels were even higher.) After the sharp fall in January, as the markets drifted gradually lower till May, the Vix fell back to the 25-level. Around the time of the crash in mid-July, volatility started increasing again, and has since drifted lower, in line with the recovery in the markets.
Still, most derivatives analysts aren’t impressed with the product NSE has designed. Hardly anyone uses it as an indicator. Sometimes, the Vix reading is far removed from the implied volatility of the most liquid options in the market. Also, unlike developed markets, there seems to be a lag with which the Vix moves vis-a-vis the market. Intra-day readings are far too volatile, says an analyst, alluding that there are flaws in the calculation methodology.
Although NSE doesn’t report intra-day numbers, it has revealed the way it calculates the index and one only needs access to option quotes to calculate the index on an intra-day basis. The problem lies in two areas — one, the exchange uses options that expire both in the immediate month as well as the next month for its calculation. In India, only near-month contracts are liquid enough to be used as reliable indicators. Secondly, as Yogesh Radke, quant analyst at Edelweiss Capital says, “The India Vix uses Nifty options contracts price with strike multiple of 50 points. Option strikes with 50 point multiple (for example 4,350, 4,450) lack liquidity compared with strikes with a multiple of 100. Vix does get influenced by these less-liquid contracts resulting in a skewed picture. Use of 100-multiple strikes may help in reducing the skew or volatility of Vix.”
To be sure, the Top 10 Nifty option contracts on Friday were all in multiples of 100, led by the 4,400 call option and the 4,200 put option.
The good thing is liquidity of Nifty options are improving, and hence the readings can only get better. If NSE makes necessary changes to the calculation methodology, the index can become much more useful. But in its current form, its use as an indicator itself is limited, leave alone launching futures and options on the index.
Why the yield on government securities is falling
Anoteworthy feature of the government securities market has been that of falling yields in spite of inflation remaining at high levels.
The yield on the benchmark 10-year bond was 9.07% on 28 July, a day before the Reserve Bank of India’s quarterly monetary policy review in which it raised repo rates by 50 basis points and cash reserve ratio by 25 basis points. Last Friday, the yield was 8.34%.
One hundred basis points make one percentage point.
The 10-year bond yield has been tumbling because banks have been scrambling to buy government securities to maintain their statutory liquidity ratio (SLR). In August, while scheduled commercial banks increased their deposits by Rs42,071 crore, they increased their investments by Rs15,991 crore, which means their incremental investment to deposit ratio during the month was as high as 38%. That shows banks have been buying the so called SLR securities hand over fist, sending yields plummeting.
On the other hand, the yields on bonds issued by state-run companies have gone up in the secondary market due to a lack of liquidity as buyers preferred the primary market. As a result, the spread between government bonds and corporate bonds of similar maturity have widened to around 230 basis points. Also, the fall in government bond yields hasn’t translated into lower borrowing costs for Indian companies. A recent offering by a government bank of Tier 2 bonds with a 15-year maturity, but with a call option at the end of the 10th year, was at a coupon rate of 11.5%.
The fall in SLR yields has led to a rally in banking stocks. The Bombay Stock Exchange’s Bankex index is up 4% from its close on 28 July, while the benchmark Sensex is down 2.4% in the same period.
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