Mumbai: Foreign portfolio investors (FPIs) are a far cry from turning bullish on Indian shares, with the recent buying in the cash market attributable to the closing out of reverse arbitrage (arb) positions rather than fresh cash market buying, per market experts.
Reverse arb, the opposite of arbitrage, involves purchasing stock futures and selling the underlying stock to lock in the spread. When the prices of the underlier and futures converge, the profit is realised by closing out the positions—i.e. buying back the underlier and selling the futures.
Normally, stock futures tend to trade at a premium to the cash or underlying stock due to the opportunity cost—i.e., the cost of holding the underlying stock over time.
But due to extreme bearishness or corporate actions like dividends, the market becomes inverted, in which futures trade at a discount to the cash or underlying share. The West Asia war and fears of a sub-normal monsoon created the conditions for reverse arb, with the benchmark Nifty plunging almost 5% from 25,179 on 27 February, a day before the war began, to 23,989 on 16 June, a day before the US and Iran signed a formal ceasefire.
This rise in bearishness prompted foreign investors to buy futures and sell the underlying shares, thereby locking in the spread, which narrows or disappears around contract expiry or as market fundamentals improve.
When the spread narrows or the cash and futures prices converge, the investor closes out the positions, which entails selling the stock futures and buying back the underlying stock.
This is precisely what FPIs have done since a minor improvement in sentiment after Iran and the US formally signed a ceasefire to end the war, according to experts.
A modest market recovery, not a turnaround
The so-called 60-day memorandum of understanding between the two sides has driven up the Nifty by 1.17% from 16 June, the day before it was signed, to 24,271 on 3 July, per financial portal Investing.com.
"The FPI activity must be disaggregated to infer their stance," said Nilesh Shah, managing director of Kotak Mahindra Asset Management Co.
"Before turning net buyers in cash, FPIs tend to close out their bearish index derivatives bets," said Shah, a view echoed by U.R. Bhat, director, Alphaniti Fintech.
"FPIs continue to remain cautious, attested to by the huge volume of index futures shorts they are still holding," said Bhat. "These will have to be closed out before they initiate significant cash market purchases."
Depository and exchange data support the expert views.
FPIs net purchased ₹6,623.03 crore in India's cash market between 16 June and 3 July, per the National Securities Depository Ltd (NSDL).
Over the same period, they net sold index futures—Nifty and Bank Nifty worth ₹5,118 crore and cut their net stock futures longs from 763,732 contracts to 547,349 contracts, per NSE data.
The reduction in longs in stock futures, along with net cash buying, aligns with market experts' view that this is due to the closure of reverse arb positions rather than fresh buying.
"While markets have priced in the positives from the Iran peace accord, the concerns around the monsoons predominate," according to D. K. Vijayakumar, chief investment strategist at Geojit Financial Services. "I would say the recent tapering of sales by FPIs indicates cautious optimism by the cohorts."
Monsoon deficit clouds the outlook
Kotak AMC's Shah added that the cumulative countrywide rainfall deficit of 21% was "a cause for concern" and that intensifying El Niño impacts around August-September could exacerbate inflationary pressures.
The FPI net cash sales for the year through 3 July stand at ₹2.97 trillion. The outstanding net shorts on index futures as of 3 July stand at 250,767 contracts, while net longs on stock futures stand at 547,349 contracts.
FPI net short in index futures remains elevated, with the record short at 279,467 contracts on 27 March, per analytics firm IndiaCharts. The buyers of the index futures sold by foreign portfolio investors are retail/HNI, domestic institutional investors, and proprietary traders, while the sellers of the stock futures are domestic institutional investors (DIIs).
- FPI cash buying reflects reverse arbitrage unwinding, not renewed bullishness on India.
- Nifty fell 5% on war fears, then recovered on ceasefire optimism.
- FPIs cut stock futures longs while simultaneously raising cash-market purchases.
- Index futures shorts remain heavy, signalling FPIs' continued underlying caution.
- A monsoon rainfall deficit threatens to further dampen investor sentiment.