Hence, over the past 15 months, the two indices have moved in the same direction almost all the time, and the Bank index has a higher movement amplitude. The high-beta, high-correlation behaviour is expected since banking
stocks contribute a big chunk of the Nifty’s overall weight.
Bank index has 12 stocks. Four of these are PSU banks. However, the Nifty
Bank index is dominated by private banks
due to the free-float weighting methodology. PSU banks have low market capitalisation and low free-float due to high government ownership. State Bank of India
(SBI) is the only PSU bank
with substantial weight in the Nifty
Bank at 8.9 per cent. In total, the weight of the four PSUs in the Nifty
Bank is less than 12 per cent.
The Nifty PSU Bank
Index is much less tracked because it doesn't offer liquid F&O contracts.
It includes 12 PSU banks. The correlation between the Nifty
Bank and the PSU Bank
indices is not too high. At 0.43 correlation since January 2017, we can say that the Nifty
Bank and the PSU Bank
move in the same direction much of the time but there are also deviations in trends.
The correlation between the PSU Bank
index and the Nifty
is even lower at 0.37. Again, this is expected since SBI is the only PSU bank
in the Nifty
50. However, the correlation is positive which means that PSU bank
shares and the Nifty
tend to move in the same direction. The PSU Bank
index has a very high beta
compared to the Nifty, it has a beta
of 1.7. The beta
of the PSU Bank
index to the Bank Nifty
index is even higher, at 1.8.
Suppose an investor holds a large portfolio of PSU bank
shares, and the portfolio approximately mirrors the PSU Bank
index. That is, the portfolio has a beta
of close to 1 and a correlation of close to 1 versus the PSU Bank
index. The investor is afraid the value of the holdings could fall.
That long portfolio of shares can be offset to a degree with long puts in the Nifty, or Bank Nifty.
Vice versa, if a trader is shorting the futures of PSU bank
stocks, he or she can hedge with long Nifty
calls or long Bank Nifty
calls. But the high-beta, relatively low correlation of the PSU Bank
versus the Nifty
and Bank Nifty
means that the hedges will not be very efficient.
Due to the high beta, on days when the PSU Bank
index moves 1 per cent in either direction, the Nifty
or Bank Nifty
is likely to move only by about 0.55 per cent to 0.6 per cent, in the same direction. The relatively low correlation also means that there will be days of trend divergence. This means there is a higher degree of unsystematic risk in trading PSU bank
futures contracts or shares. Of course, that risk also has an upside in that profitable positions in PSU banks will tend to outscore index returns.