It’s well known why stock market indices have been falling lately. Policy paralysis, widening fiscal and current account deficits, slowing pace of export growth, contraction in industrial activity, inflation which has led to rising interest rates, a faltering capital expenditure cycle: All these factors have led to where the markets are now, down 23.5% since January, among the worst in Asia.

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The answer may very well lie in their activity in the equity derivatives market, where FIIs are active participants.

One theory that is doing the rounds in the markets is that there has been a spurt of short selling by foreign investors, exacerbating the pain and panic in equities. While short selling by FIIs is prohibited in the cash market, they can take short positions in the futures and options segment.

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Mint’s Ravi Krishnan says the steep fall in Indian markets in recent times could have been caused by FII activity in equity derivatives.

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To be sure, they took net short positions amounting to $860 million in the above-mentioned 10-day period. This could explain why Indian indices have fallen more than those of other emerging markets (see chart).

Also See | Performance of key emerging markets in recent times (PDF)

In the futures market, a foreign investor can take short positions without having an underlying position in the cash market. Of course, this is subject to position limits.

Overseas investors that are not registered with the Securities and Exchange Board of India (Sebi) can take indirect positions by buying participatory notes from Sebi-registered broker-members. Of late, there has been an increase in participatory note issuances that have equity derivatives as the underlying product, and it does appear that a fair bit of short selling is happening through this route as well.

Extend the numbers for a year and the relationship holds. In 2011, net FII sales in the cash market have been about $455 million compared with short positions worth $6.9 billion in futures. FIIs, therefore, have sold reasonably high amounts this year—it’s just that this isn’t captured in the widely tracked cash market data.

Graphics by Yogesh Kumar/Mint

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