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PN-wary FIIs make India entry via equity swaps

The restrictions imposed on investments in Indian equities through participatory notes (PNs) last year have seen those foreign investors, who prefer to stay away from the regulatory glare, tapping other routes for investment in the local market. In the past few months, these investors, including global hedge funds, have been increasingly using the equity swap — an unregulated over-the-counter (OTC) derivative contract — to take exposure to the Indian market.

An equity swap is an arrangement where a series of future cash flows are made by two counterparties to each other. The pre-determined set of payments, which is based on a notional principal amount, may be determined by returns on stocks or indices or a fixed or floating rate.

Global hedge funds favour equity swaps, as the product enables them to get the economic benefits of ownership of shares, without the costs attached and the ownership burden. Even though transaction costs may be a little higher than exchange-listed derivatives, the popularity of equity swaps has been enhanced by flexibility in tenure and portfolio compositions.

In the Indian context, a simple equity swap could work this way. Say, a US-based hedge fund, which does not want to be registered with SEBI or with poor credentials, wants to bet on India. It is bearish on India and wants to get the benefits of going short in the markets here.

The hedge fund enters into an equity swap agreement with an international brokerage, with a presence in India, to receive payments on shorting Nifty futures for one year. In turn, the brokerage may demand returns from one of the security in the hedge fund’s portfolio, possibly a country where the brokerage does not have access, but is keen on investing there. So, if the Nifty futures fall, the hedge funds receives payments from the brokerage on the agreed intervals while the brokerage gets returns from the security. In live situations, the equity swap structure is far more complex than the one mentioned here, with many more variations.

Hedge funds have been using this route, especially to gain exposure to India’s futures and options market, where trading through participatory notes have been completely banned since last October.

“It (equity swap) is a convenient way of investing in Indian markets, especially with restrictions in place for investments through participatory notes,” said Vinod Kothari, a Kolkata-based expert on credit derivatives and securitisation.

Another person familiar with the matter said such deals have been one of the reasons for the spurt in activity in India’s futures and options market after a brief lull in the segment, following the ban on investment through participatory notes in derivatives. But, there is no official data to back this as equity swaps are private transactions that need not be reported to any regulatory authority. In the absence of fund flows inside and outside the country through equity swaps, it has been very difficult for authorities to keep a close watch on the beneficiaries of such deals.

Source: Economic Times

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