The Indian markets may have bounced back sharply from their early morning lows on Thursday, but record turnover in Nifty futures and options and a jump in implied volatility based on the prices of these options suggest that investors and traders are still hedging their bets.

With Western central banks infusing fresh liquidity into the system, markets across the world rallied, on hopes that things may not get worse. But, Indian traders don’t seem convinced yet. Turnover of Nifty options jumped to Rs32,000 crore, 62% higher than the average in the rest of September, while turnover of Nifty futures rose by 48% to Rs16,400 crore.

Sandeep Singal, co-head, institutional derivatives, Emkay Share and Stock Brokers Ltd, says the record turnover in index derivatives points to a high amount of hedging against market risk. According to him, the majority of such trades were done by foreign institutional investors (FIIs) and mutual funds.

Moreover, the India Vix index, the National Stock Exchange’s volatility index derived from Nifty options prices, jumped to nearly 40% on Thursday, from 34% the previous day. The increase in the implied volatility is a result of higher option prices paid by traders, which essentially means the price for buying protection in the market has risen.

Also See: Covering risk (Graphic)

All this points to increased caution.

Most market analysts also mentioned that the sharp bounce-back in shares was on account of a covering of short positions created earlier. It would hence be premature to construe that genuine buying reversed the downtrend in the market.

Provisional data of cash market trading on the Bombay Stock Exchange and the National Stock Exchange show that purchases by domestic institutional investors were fully offset by sales of FIIs.

This supports the theory that short-covering was responsible for the rise in the markets from its early morning lows. Besides, Nifty futures were traded at a substantially higher premium to the spot price compared with the previous two trading sessions, again pointing towards short-covering in the derivatives segment.

The trend in the derivatives market is not very different from that seen during previous crashes in March and July. On all occasions, traders have increased their use of Nifty products to hedge market risk, and the price of buying protection has soared.

The good thing is leveraged positions, especially in single-stock futures, have been progressively cut, and there’s little froth left in the market.

Disconnect between global and local views

Two research reports hit our desk on Thursday — both from Citi Investment Research.

One of them, on global equity strategy, says the process of deleveraging both bank and consumer balance sheets in the US, the UK and several other markets that enjoyed a leveraged housing boom has just begun. In the US, the note says, the household debt service obligation (the ratio of household debt payments to disposable income) remains close to the peak levels we saw in 2006. More important, from the point of view of the market, is what it says about corporate earnings: “We believe we are in the early stages of a significant corporate earnings recession (which we define as a fall in global earnings greater than 10%). We have had five of these since 1970. They last on average two years and see global earnings fall by 25%. We are about eight months into this current downturn and earnings have fallen by around 5%. This suggests that, in timing and magnitude terms, we are about a quarter of the way towards the bottom — so still early days."

The other report, on India equity strategy, sets a six-month target for the Sensex at 14,400-15,800 points. It assumes earnings growth will be 18.21% for 2008-09 and 17.09% for 2009-10.

It’s true that the composition of the index has changed, but note that their earnings growth forecast for 2009-10 was as low as 10.74% on 31 March. The report’s view is that “earnings growth…has stepped off 20%... but appears relatively hedged across its cyclical and commodity components… downside risks are now probably a little lower…." That’s because of the usual macro factors — lower oil prices, an improved fiscal position, peaking inflation and lower government bond yields — have improved. In fact the piece is called “Market’s missing the macro"?

And more importantly, it points out that its target Sensex range would translate into a price earnings multiple of 13.7-15.1 on 2008-09 earnings, which is below the 18-year average of 15.6.

The divergence in views is a reflection of the fact that the Indian markets have been more resilient in recent months. But isn’t this what decoupling was all about?

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