A2: Have securities, lend them to the market
Do you have a portfolio of shares which is earning you nothing? Would you like to juice up your returns by earning revenues from stocklending?
Most owners of shares answer in the affirmative to these questions. Yet, stocklending schemes that are widely accessible do not exist in India.
The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. It is like a repo; you would sell off your certificates and con-tract to buy them back in the future at a fixed price. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the transaction is the NSCCL).
The basic idea is quite simple. You would sell off all 50 stocks in Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money as you like until the futures expiration. On this date, you would buy back your shares, and pay for them.
How do we actually do this?
Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalization).
1. Sell off all 50 shares on the cash market. This can be done using a single keystroke using the NEAT software.
2. Buy index futures of an equal value at a future date.
3. A few days later, you will receive money and have to make delivery of the 50 shares.
4. Invest this money at the riskless interest rate.
5. On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy the entire NSE-50 portfolio.
6. A few days later, you will need to pay in the money and get back your shares.
When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spot–futures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.2% per month, this stocklending could be profitable.
It is easy to approximate the return obtained in stock lending. To do this, we assume that transactions costs account for 0.4%. Suppose the spot–futures basis is x% and suppose the rate at which funds can be invested is y% Then the total return is y-x-0.4%, over the time that the position is held.
This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spot–futures basis is somewhat wider.
Example
Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. Hence the spot– futures basis (1110/1100) is 0.9%. Suppose cash can be risklessly invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over the two–month period.
Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs.4 million of the Nifty portfolio which he would like to lend to the market.
1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098.
2. A moment later, Akash puts in a market order to buy Rs.4 million of the Nifty futures. The order executes at 1110. At this point, he is completely hedged.
3. A few days later, Akash makes delivery of shares and receives Rs.3.99 million (assuming an impact cost of 2/1100).
4. Suppose Akash lends this out at 1% per month for two months.
5. At the end of two months, he get back Rs.4,072,981. Translated in terms of Nifty, this is 1098*1.012 or 1120.
6. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying back, but the difference is exactly offset by profits on the futures contract.
When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost.
He has funds in hand of 1120, and the futures contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25, 400.
Do you have a portfolio of shares which is earning you nothing? Would you like to juice up your returns by earning revenues from stocklending?
Most owners of shares answer in the affirmative to these questions. Yet, stocklending schemes that are widely accessible do not exist in India.
The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. It is like a repo; you would sell off your certificates and con-tract to buy them back in the future at a fixed price. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the transaction is the NSCCL).
The basic idea is quite simple. You would sell off all 50 stocks in Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money as you like until the futures expiration. On this date, you would buy back your shares, and pay for them.
How do we actually do this?
Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalization).
1. Sell off all 50 shares on the cash market. This can be done using a single keystroke using the NEAT software.
2. Buy index futures of an equal value at a future date.
3. A few days later, you will receive money and have to make delivery of the 50 shares.
4. Invest this money at the riskless interest rate.
5. On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy the entire NSE-50 portfolio.
6. A few days later, you will need to pay in the money and get back your shares.
When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spot–futures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.2% per month, this stocklending could be profitable.
It is easy to approximate the return obtained in stock lending. To do this, we assume that transactions costs account for 0.4%. Suppose the spot–futures basis is x% and suppose the rate at which funds can be invested is y% Then the total return is y-x-0.4%, over the time that the position is held.
This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spot–futures basis is somewhat wider.
Example
Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. Hence the spot– futures basis (1110/1100) is 0.9%. Suppose cash can be risklessly invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over the two–month period.
Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs.4 million of the Nifty portfolio which he would like to lend to the market.
1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098.
2. A moment later, Akash puts in a market order to buy Rs.4 million of the Nifty futures. The order executes at 1110. At this point, he is completely hedged.
3. A few days later, Akash makes delivery of shares and receives Rs.3.99 million (assuming an impact cost of 2/1100).
4. Suppose Akash lends this out at 1% per month for two months.
5. At the end of two months, he get back Rs.4,072,981. Translated in terms of Nifty, this is 1098*1.012 or 1120.
6. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying back, but the difference is exactly offset by profits on the futures contract.
When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost.
He has funds in hand of 1120, and the futures contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25, 400.