By Sunil K. Parameswaran
All investors and traders have access to the standard valuation model for the valuation of securities, whether they are stocks, bonds or derivatives. Information about financial markets is also readily available. Agencies such as Thomson-Reuters and Bloomberg broadcast real-time information around the world. Thirty years ago, people who were privileged as far as information benefited because they could react in front of others. Today, given that everyone has access to computers and the Internet, people are getting information at the same time, and from an information standpoint, the playing field has been leveled.
The unique value of a trader or investor is the ability to locate his or her unnatural and overpriced assets. If an asset is of lesser value then it should be bought. Later when the price is correct, it can be sold at a higher price. Highly priced properties should be sold short. Again, when there is an improvement, the situation can be covered by acquiring the property at a lower price. The value of one trader, or some is paid in millions and the other only in thousands, is due to the undisclosed ability of the former to locate the wrong securities.
Risk-adjusted rate of return
Investment in a risk-less asset such as a Government of India bond should yield a risk-less rate. If we invest in risky assets then we should earn a risk-adjusted rate of return. The Capital Asset Pricing Model (CAPM) predicts that investing in a risky asset should earn a risk premium in addition to the risk-lower rate, where the risk premium is given by the risk of the asset’s beta and the product of the risk premium in the market portfolio.
Stock pickers are those who seek undervalued or overvalued securities. They believe that security will give either positive or negative returns as predicted by CAPM. This is called abnormal withdrawal or ‘alpha’. Low-value securities will have a positive abnormal return. Therefore stock pickers will buy and hold such securities. Highly priced securities will give a negative abnormal return. Thus, stock pickers will short-sell such securities.
Unpredictable market movements
The practical issue is that even if the trader is spot on regarding his estimate of abnormal return, unexpected movements in the market can spoil the party. For example, a trader feels abnormal returns are positive and buys a stock. However, the Nifty crashed by 200 points. The overall return is likely to be negative, despite the fact that he supported the right horse.
Hence stock pickers use stock index futures to overcome this market risk. In the finance system we refer to this as ‘removing the beta to occupy alpha’. Traders who buy stocks will sell stock index futures in anticipation of a positive abnormal return. If there were tanks in the market, there would be a negative return from the security, but a positive cash flow from the futures market would compensate.
On the other hand, traders who sell securities short in anticipation of a negative abnormal return will stay in index futures for a long time. If the market grows rapidly, the short position will cause a loss, but the long futures will have a compensatory gain. Thus, stock picking is a source of short and long position demand in stock index futures.
The author is CEO, Tarahel Consultancy Services.