Foreign institutional investors (FIIs) took greater exposure to equity derivatives and debt market through

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participatory notes in November to offset their weakening portfolio in the cash market.

With equity markets reeling under global uncertainty and worsening domestic growth outlook, total value of participatory notes on equity and debt including those on derivatives as a proportion of total assets under the custody of FIIs rose to a six-month high of 19.1 per cent in November, according to data available on the Sebi website. The value of participatory notes on equity and debt, excluding those on derivatives, was 12.5 per cent in November.

FIIs issue participatory notes to investors, generally hedge funds, who do not take a long-term view of the market and exit any time creating short-term volatility in the market. There are a number of FIIs which do not wish to sell their cash market holding given that the valuation are low at this point. These FII's, therefore, sell similar or less quantity of the same stock which is held in their portfolio in the derivative market so that in case of any further fall, some of the losses of the cash market can be offset by gains in derivative market.

This sort of the strategy leads to increase in volatility in specific stocks. When FIIs which have sold the stock in derivative market come and cover their short positions it leads to a sharp rise in individual stocks.

Previously, FII participation through participatory notes on equity and debt including derivatives was the highest in May at 19.5 per cent while it was the lowest at 14 per cent in July in this calendar year. However, data show value of participatory notes on equity and debt including those on derivatives has been higher than the value excluding derivatives throughout the year.

Before the sudden fall in the rupee value against dollar, there was a good amount of debt paper which was getting subscribed by hedge funds through PN route, though these flow have seen minor tempering after the decline of rupee. Once rupee is stabilised the demand for Indian debt by hedge funds may see a rise as interest rates are seen to have been peaked and hedge funds would be keen to have short-term debt papers.

Kishor Ostwal, chairman and managing director of CNI Research said,“This shows that FIIs are increasing their bearish bets in the cash market by going short in the equity derivatives market. With rupee depreciating sharply in the last 3-4 months, their dollar returns has suffered in the cash market and hence they are hedging their positions in the derivatives market to offset losses.” As rupee started to sharply depreciate against dollar since August, domestic equity markets have been under severe bear hammering owing to offloading of shares by overseas investors.

In November, the benchmark Sensex slumped nearly 8 per cent and FIIs pulled out funds to the tune of Rs 4,198 crore with rupee depreciating sharply amid strong demand for dollars and weakening fiscal health.

“Delivery-based volume is not happening in the cash market for a long time. Generally, FIIs take a long-term view in the cash market, but with global uncertainty and signs of slowing growth here, FIIs are looking to dabble in derivatives market to make some returns. Also, with several debt papers giving decent returns compared to other debt papers in the international markets, they are happy infusing funds in the debt market,” said Udaynarayan Dubey, vice-president research & institutional desk at RK Global Securities. In Novmber, total value of participatory notes on equity and debt including derivatives in absolute terms stood at Rs 179,035 crore, while excluding derivatives it was at Rs 117,532 crore. However, total assets under custody of FIIs in absolute terms fell to Rs 938,098 crore from Rs 1,025,530 crore in October.