News Column

Derivative instruments: Answer to an efficient shorting mechanism

August 19, 2014

In our previous article "Fundamental outlook for UAE markets is strong", we identified the need for efficient shorting mechanisms on local stocks to help protect the likelihood of formation of "bubble" conditions in the market.

(For the uninitiated, "short-selling a stock" is simply borrowing the item at a particular price on the basis that if the stock price reduces your obligation is simply to give back the stock and not the monetary value for which you borrowed it.) So given the increased focus of international fund managers on this market, such mechanisms are likely to become increasingly important for the UAE, especially given that the domestic market's fragility that was demonstrated by the recent broad selloff and spike, which was exacerbated by systematic margin covering.

When compared to competing global markets, the relative riskiness of the UAE market is demonstrated by its high standard deviation of 997 for Dubai and 741 for Abu Dhabi, based on five-year daily price data as of May 15, 2014. This is in contrast to the standard deviation range of 7.9 to 626 for the four Bric nations, 95.6 for Malaysia, 229 for Egypt (both relatively-mature emerging markets) and 214 for Singapore (a small but fully-developed market). Comparing standard deviation calculated on five-year month-end data also highlights a similar picture.

Although risk as defined by standard deviation is likely to decline once the local market matures, the development of a healthy derivatives market as an efficient shorting mechanism is an important fact that acts as catalyst to speed up the process.

Established in 2008, Nasdaq Dubai remains the only equity derivative exchange in the UAE. It currently offers only two products, both cash-settled: index futures based on the FTSE Nasdaq Dubai UAE 20 Index and single stock futures on 20 stocks. However, the market is still in its infancy stage as it is dominated by OTC trades between a limited number of major investment banks resulting in low liquidity. Ryan Mahoney, portfolio manager at Dalma Capital Management, was of the view that "[the] presence of dedicated market makers [brokers prepared to hold securities to facilitate trades] would provide on screen liquidity and boost overall trading volumes. Moreover, enhancement in product mix is also required to develop the market further: such as introduction of single-stock and index-based options."

The Abu Dhabi Securities Exchange also plans to add derivative products to its portfolio in the near term and, in June 2013, again raised discussions of establishing the GCC-wide Gulf Derivatives Exchange that was previously proposed nearly a decade ago

Separately, Elliot Carol, portfolio strategist at Dalma Capital Management, noted: "Should unique needs exist, alternative asset classes, such as hedge funds and managed futures, could participate in this market and represent a viable risk reducing instrument because combining with traditional asset classes offers exposure to special investment strategies."

Hedge funds by their very purpose generally both long and short the market in some cases even market neutral and most seek mitigated or even positive exposure to systematic risk. Many hedge funds exploit arbitrage (each way) opportunities and, as such, may be low-risk investments. In case of macro focus, rather than micro, managed futures could also prove to be an attractive alternative asset class because correlation with equities is low and often negative, and correlation with bonds is less than 0.5.

If used for purposes other than hedging, many alternative assets have potential for generating significantly higher returns. However, risk will be increased is leverage is utilised. In most cases, though, derivatives (contracted pricing) are utilised to limit riskiness and may be combined with traditional assets to increase risk-adjusted return. Increased hedge fund activity can be especially promising in a market dominated by traditional, long-only, market-oriented and largely-passive portfolios of stocks and bonds which may be susceptible to bubble formation. However, the situation as it pertains to local markets is the "chicken and egg" scene. In order to gain hedge fund participation, which could serve to increase volumes and liquidity whilst decreasing risk, the local market is unlikely to enjoy such presence unless short sale mechanisms are introduced.

The writer is a risk officer at Dalma Capital Management, a DIFC asset manager specialising in hedge fund management.

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Source: Khaleej Times (United Arab Emirates)

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