By Sunil K Parameswaran
All investors and traders have access to the standard valuation models for valuing securities, stocks, bonds, or derivatives. Information about financial markets is also readily available. Agencies like Thomson-Reuters and Bloomberg broadcast news in real-time all over the globe. Thirty years ago, people who had privileged access to information stood to benefit since they could react before others. Today, considering that everyone has access to computers and the Internet, people are getting information simultaneously, and from an informational standpoint, the playing field has been leveled.
The unique value of a trader or investor is their ability to detect undervalued and over-valued assets. If a purchase is under-priced, it should be bought. Subsequently, when the price corrects, it can be sold at a higher price. Over-priced assets should be sold short. Again, when there is a correction, the position can be covered by acquiring the support at a lower price. The value of a trader, or why some are paid in millions and others only in thousands, is due to the uncanny ability of the former to detect mispriced securities.
Risk-adjusted rate of return
An investment in a risk-less asset such as a Government of India bond should earn the risk-less rate. If we invest in a risky asset, we should make a risk-adjusted rate of return. The Capital Asset Pricing Model (CAPM) predicts that an investment in a risky asset ought to earn a risk premium in addition to the risk-less rate, where the risk premium is given by the product of the asset’s beta and the risk premium of the market portfolio.
Stock pickers are people on the lookout for undervalued or overvalued securities. They believe that the deposit will yield either a positive or negative return over what is predicted by the CAPM. This is called the abnormal return or ‘Alpha’. Under-priced securities will yield a positive abnormal return. Hence stock pickers will buy and hold such securities. Over-priced securities will deliver a negative abnormal return. Thus, stock pickers will short-sell such securities.
Unexpected market movements
The practical issue is that even if the trader is spot on regarding their estimation of the abnormal return, unexpected movements in the market may spoil the party. For instance, a trader feels that the abnormal return is positive and buys a stock. However, the NIFTY crashes by 200 points. The overall return is likely to be negative, even though he backed the right horse.
Stock pickers, therefore, use stock index futures to hedge away this market risk. We refer to this as ‘hedging away the beta to capture the alpha’ in finance parlance. Traders who buy stocks in anticipation of a positive abnormal return will sell stock index futures. If the market were to tank, there would be a negative return from the security but a compensating positive cash flow from the futures market.
On the other hand, traders who short-sell securities in anticipation of a negative abnormal return will go long in index futures. If the market rallies sharply, there will be a loss from the short position but a compensatory gain from the long futures position. Thus, stock picking is a source of demand for short and long positions in stock index futures.