INTRODUCTION TO DERIVATIVE

The origin of derivatives can be traced back to the need of farmers to protect

themselves against fluctuations in the price of their crop. From the time it was

sown to the time it was ready for harvest, farmers would face price uncertainty.

Through the use of simple derivative products, it was possible for the farmer to

partially or fully transfer price risks by locking-in asset prices. These were simple

contracts developed to meet the needs of farmers and were basically a means of

reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he

would receive for his harvest in September. In years of scarcity, he would

probably obtain attractive prices. However, during times of oversupply, he would

have to dispose off his harvest at a very low price. Clearly this meant that the

farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too

would face a price risk that of having to pay exorbitant prices during dearth,

although favourable prices could be obtained during periods of oversupply.

Under such circumstances, it clearly made sense for the farmer and the

merchant to come together and enter into contract whereby the price of the grain

to be delivered in September could be decided earlier. What they would then

negotiate happened to be futures-type contract, which would enable both parties

to eliminate the price risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring

farmers and merchants together. A group of traders got together and created the

‘to-arrive’ contract that permitted farmers to lock into price upfront and deliver the

grain later. These to-arrive contracts proved useful as a device for hedging and

speculation on price charges. These were eventually standardized, and in 1925

the first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn,

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also

exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

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DERIVATIVE DEFINED

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset can

be equity, forex, commodity or any other asset. In our earlier discussion, we saw

that wheat farmers may wish to sell their harvest at a future date to eliminate the

risk of change in price by that date. Such a transaction is an example of a

derivative. The price of this derivative is driven by the spot price of wheat which

is the “underlying” in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the

forward/futures contracts in commodities all over India. As per this the Forward

Markets Commission (FMC) continues to have jurisdiction over commodity

futures contracts. However when derivatives trading in securities was introduced

in 2001, the term “security” in the Securities Contracts (Regulation) Act, 1956

(SCRA), was amended to include derivative contracts in securities.

Consequently, regulation of derivatives came under the purview of Securities

Exchange Board of India (SEBI). We thus have separate regulatory authorities

for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of

derivatives is governed by the regulatory framework under the SCRA. The

Securities Contracts (Regulation) Act, 1956 defines “derivative” to include-

A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of

underlying securities.

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TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Bombay Stock National Commodity & Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

TYPES OF DERIVATIVES

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Types of Derivatives

(i) FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified

date for a specified price. One of the parties to the contract assumes a long

position and agrees to buy the underlying asset on a certain specified future

date for a certain specified price. The other party assumes a short position

and agrees to sell the asset on the same date for the same price. Other

contract details like delivery date, price and quantity are negotiated bilaterally

by the parties to the contract. The forward contracts are n o r m a l l y traded

outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of

contract size, expiration date and the asset type and quality.

• The contract price is generally not available in public domain.

• On the expiration date, the contract has to be settled by delivery of the

asset.

• If the party wishes to reverse the contract, it has to compulsorily go to the

same counter-party, which often results in high prices being charged.

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Derivatives

Future Option Forward Swaps

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing

transaction costs and increasing transactions volume. This process of

standardization reaches its limit in the organized futures market. Forward

contracts are often confused with futures contracts. The confusion is

primarily because both serve essentially the same economic funct ions

of allocating risk in the presence of future price uncertainty. However futures

are a significant improvement over the forward contracts as they

eliminate counterparty risk and offer more liquidity.

(ii) FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures

exchange, to buy or sell a certain underlying instrument at a certain date in the

future, at a pre-set price. The future date is called the delivery date or final

settlement date. The pre-set price is called the futures price. The price of the

underlying asset on the delivery date is called the settlement price. The

settlement price, normally, converges towards the futures price on the delivery

date.

A futures contract gives the holder the right and the obligation to buy or sell,

which differs from an options contract, which gives the buyer the right, but not the

obligation, and the option writer (seller) the obligation, but not the right. To exit

the commitment, the holder of a futures position has to sell his long position or

buy back his short position, effectively closing out the futures position and its

contract obligations. Futures contracts are exchange traded derivatives. The

exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

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1. Standardization:

Futures contracts ensure their liquidity by being highly standardized, usually by

specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a

short term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the

notional amount of bonds, a fixed number of barrels of oil, units of foreign

currency, the notional amount of the deposit over which the short term

interest rate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds

can be delivered. In case of physical commodities, this specifies not only

the quality of the underlying goods but also the manner and location of

delivery. The delivery month.

The last trading date.

Other details such as the tick, the minimum permissible price fluctuation.

2. Margin:Although the value of a contract at time of trading should be zero, its price

constantly fluctuates. This renders the owner liable to adverse changes in value,

and creates a credit risk to the exchange, who always acts as counterparty. To

minimize this risk, the exchange demands that contract owners post a form of

collateral, commonly known as Margin requirements are waived or reduced in

some cases for hedgers who have physical ownership of the covered commodity

or spread traders who have offsetting contracts balancing the position.

Initial Margin: is paid by both buyer and seller. It represents the loss on that

contract, as determined by historical price changes, which is not likely to be

exceeded on a usual day's trading. It may be 5% or 10% of total contract price.

Mark to market Margin: Because a series of adverse price changes may

exhaust the initial margin, a further margin, usually called variation or

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maintenance margin, is required by the exchange. This is calculated by the

futures contract, i.e. agreeing on a price at the end of each day, called the

"settlement" or mark-to-market price of the contract.

To understand the original practice, consider that a futures trader, when taking a

position, deposits money with the exchange, called a "margin". This is intended

to protect the exchange against loss. At the end of every trading day, the contract

is marked to its present market value. If the trader is on the winning side of a

deal, his contract has increased in value that day, and the exchange pays this

profit into his account. On the other hand, if he is on the losing side, the

exchange will debit his account. If he cannot pay, then the margin is used as the

collateral from which the loss is paid.

3. SettlementSettlement is the act of consummating the contract, and can be done in one of

two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the

contract is delivered by the seller of the contract to the exchange, and by the

exchange to the buyers of the contract. In practice, it occurs only on a

minority of contracts. Most are cancelled out by purchasing a covering

position - that is, buying a contract to cancel out an earlier sale (covering a

short), or selling a contract to liquidate an earlier purchase (covering a long).

Cash settlement - a cash payment is made based on the underlying

reference rate, such as a short term interest rate index such as Euribor, or

the closing value of a stock market index. A futures contract might also opt to

settle against an index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many

equity index and interest rate futures contracts, this happens on the Last

Thursday of certain trading month. On this day the t+2 futures contract becomes

the t forward contract.

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PRICING OF FUTURE CONTRACTIn a futures contract, for no arbitrage to be possible, the price paid on delivery

(the forward price) must be the same as the cost (including interest) of buying

and storing the asset. In other words, the rational forward price represents the

expected future value of the underlying discounted at the risk free rate. Thus, for

a simple, non-dividend paying asset, the value of the future/forward, , will

be found by discounting the present value at time to maturity by the rate

of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields,

and convenience yields. Any deviation from this equality allows for arbitrage as

follows.

In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price.

3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds.

2. On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate.

3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.]

4. The difference between the two amounts is the arbitrage profit.

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TABLE 1-DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between

two parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes the

counter party to all the trades or

unconditionally guarantees their

settlement.

Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs of

the needs of the parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets

are scattered.

Efficient, as markets are centralized

and all buyers and sellers come to a

common platform to discover the

price.

Examples Currency market in India. Commodities, futures, Index Futures

and Individual stock Futures in India.

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OPTIONS -

A derivative transaction that gives the option holder the right but not the

obligation to buy or sell the underlying asset at a price, called the strike price,

during a period or on a specific date in exchange for payment of a premium is

known as ‘option’. Underlying asset refers to any asset that is traded. The price

at which the underlying is traded is called the ‘strike price’.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an

underlying asset-stock or any financial asset, at a specified price on or before a

specified date is known as a ‘Call option’. The owner makes a profit provided he

sells at a higher current price and buys at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying

asset-stock or any financial asset, at a specified price on or before a specified

date is known as a ‘Put option’. The owner makes a profit provided he buys at a

lower current price and sells at a higher future price. Hence, no option will be

exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally

preference shares, bonds and warrants become the subject of options.

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SWAPS -

Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

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OTHER KINDS OF DERIVATIVESThe other kind of derivatives, which are not, much popular are as follows:

BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options

are most popular form of baskets.

LEAPS -

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years.

These long-term option contracts are popularly known as Leaps or Long term

Equity Anticipation Securities.

WARRANTS -

Options generally have lives of up to one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer-dated

options are called warrants and are generally traded over-the-counter.

SWAPTIONS -

Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather

than have calls and puts, the swaptions market has receiver swaptions and payer

swaptions. A receiver swaption is an option to receive fixed and pay floating. A

payer swaption is an option to pay fixed and receive floating.

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INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where

prices fluctuate every day. The introduction of risk management instruments in

India gained momentum in the last few years due to liberalisation process and

Reserve Bank of India’s (RBI) efforts in creating currency forward market.

Derivatives are an integral part of liberalisation process to manage risk. NSE

gauging the market requirements initiated the process of setting up derivative

markets in India. In July 1999, derivatives trading commenced in India

Table 2. Chronology of instruments1991                        Liberalisation process initiated 

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy

framework for index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an

Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index

futures trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September

2000

Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

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(1) Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have

become the most important markets in the world. Today, derivatives have

become part and parcel of the day-to-day life for ordinary people in major part of

the world.

Until the advent of NSE, the Indian capital market had no access to the latest

trading methods and was using traditional out-dated methods of trading. There

was a huge gap between the investors’ aspirations of the markets and the

available means of trading. The opening of Indian economy has precipitated the

process of integration of India’s financial markets with the international financial

markets. Introduction of risk management instruments in India has gained

momentum in last few years thanks to Reserve Bank of India’s efforts in allowing

forward contracts, cross currency options etc. which have developed into a very

large market.

(2) Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have

become the most important markets in the world. Financial derivatives came into

the spotlight along with the rise in uncertainty of post-1970, when US announced

an end to the Bretton Woods System of fixed exchange rates leading to

introduction of currency derivatives followed by other innovations including stock

index futures. Today, derivatives have become part and parcel of the day-to-day

life for ordinary people in major parts of the world. While this is true for many

countries, there are still apprehensions about the introduction of derivatives.

There are many myths about derivatives but the realities that are different

especially for Exchange traded derivatives, which are well regulated with all the

safety mechanisms in place.

What are these myths behind derivatives? Derivatives increase speculation and do not serve any economic purpose

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Indian Market is not ready for derivative trading

Disasters prove that derivatives are very risky and highly leveraged

instruments.

Derivatives are complex and exotic instruments that Indian investors will

find difficulty in understanding

Is the existing capital market safer than Derivatives?

(i) Derivatives increase speculation and do not serve any

economicpurpose:

Numerous studies of derivatives activity have led to a broad consensus, both in

the private and public sectors that derivatives provide numerous and substantial

benefits to the users. Derivatives are a low-cost, effective method for users to

hedge and manage their exposures to interest rates, commodity prices or

exchange rates. The need for derivatives as hedging tool was felt first in the

commodities market. Agricultural futures and options helped farmers and

processors hedge against commodity price risk. After the fallout of Bretton wood

agreement, the financial markets in the world started undergoing radical

changes. This period is marked by remarkable innovations in the financial

markets such as introduction of floating rates for the currencies, increased

trading in variety of derivatives instruments, on-line trading in the capital markets,

etc. As the complexity of instruments increased many folds, the accompanying

risk factors grew in gigantic proportions. This situation led to development

derivatives as effective risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional

investors to effectively manage their portfolios of assets and liabilities through

instruments like stock index futures and options. An equity fund, for example, can

reduce its exposure to the stock market quickly and at a relatively low cost

without selling off part of its equity assets by using stock index futures or index

options.

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By providing investors and issuers with a wider array of tools for

managing risks and raising capital, derivatives improve the allocation of credit

and the sharing of risk in the global economy, lowering the cost of capital

formation and stimulating economic growth. Now that world markets for trade and

finance have become more integrated, derivatives have strengthened these

important linkages between global markets, increasing market liquidity and

efficiency and facilitating the flow of trade and finance

(ii) Indian Market is not ready for derivative trading

  Often the argument put forth against derivatives trading is that the Indian

capital market is not ready for derivatives trading. Here, we look into the pre-

requisites, which are needed for the introduction of derivatives, and how Indian

market fares:

TABLE 3.

PRE-REQUISITES INDIAN SCENARIOLarge market Capitalisation

India is one of the largest market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores.

High Liquidity in the underlying

The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market

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enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

(3) Comparison of New System with Existing System

Many people and brokers in India think that the new system of Futures & Options

and banning of Badla is disadvantageous and introduced early, but I feel that this

new system is very useful especially to retail investors. It increases the no of

options investors for investment. In fact it should have been introduced much

before and NSE had approved it but was not active because of politicization in

SEBI.

The figure 3.3a –3.3d shows how advantages of new system (implemented from

June 20001) v/s the old system i.e. before June 2001

New System Vs Existing System for Market Players

Figure 3.3a

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premium hold till expiry.

Advantages Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.

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Figure 3.3b

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game. another exchange. the Market moves. in weekly settlement forward transactions. 2) Cash &Carry 2) If Future Contract arbitrage continuesmore or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages

1

Availability of Leverage

Figure 3.3d

Small Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize 1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains profit/loss. 2) Hedge position if protected & holding underlying upside stock unlimited.Advantages Losses Protected.

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4. Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last

few years, which has accompanied the modernization of commercial and

investment banking and globalisation of financial activities. The recent

developments in information technology have contributed to a great extent to

these developments. While both exchange-traded and OTC derivative contracts

offer many benefits, the former have rigid structures compared to the latter. It has

been widely discussed that the highly leveraged institutions and their OTC

derivative positions were the main cause of turbulence in financial markets in

1998. These episodes of turbulence revealed the risks posed to market stability

originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-

traded derivatives:

1. The management of counter-party (credit) risk is decentralized and

located within individual institutions,

2. There are no formal centralized limits on individual positions, leverage, or

margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and

integrity, and for safeguarding the collective interests of market

participants, and

5. The OTC contracts are generally not regulated by a regulatory authority

and the exchange’s self-regulatory organization, although they are

affected indirectly by national legal systems, banking supervision and

market surveillance.

Some of the features of OTC derivatives markets embody risks to financial

market stability.

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The following features of OTC derivatives markets can give rise to instability in

institutions, markets, and the international financial system: (i) the dynamic

nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of

OTC derivative activities on available aggregate credit; (iv) the high concentration

of OTC derivative activities in major institutions; and (v) the central role of OTC

derivatives markets in the global financial system. Instability arises when shocks,

such as counter-party credit events and sharp movements in asset prices that

underlie derivative contracts, occur which significantly alter the perceptions of

current and potential future credit exposures. When asset prices change rapidly,

the size and configuration of counter-party exposures can become unsustainably

large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions.

However, the progress has been limited in implementing reforms in risk

management, including counter-party, liquidity and operational risks, and OTC

derivatives markets continue to pose a threat to international financial stability.

The problem is more acute as heavy reliance on OTC derivatives creates the

possibility of systemic financial events, which fall outside the more formal

clearing house structures. Moreover, those who provide OTC derivative products,

hedge their risks through the use of exchange traded derivatives. In view of the

inherent risks associated with OTC derivatives, and their dependence on

exchange traded derivatives, Indian law considers them illegal.

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5. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the

financial theories.

A.} PRICE VOLATILITY –

A price is what one pays to acquire or use something of value. The objects

having value maybe commodities, local currency or foreign currencies. The

concept of price is clear to almost everybody when we discuss commodities.

There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc.

the price one pays for use of a unit of another persons money is called interest

rate. And the price one pays in one’s own currency for a unit of another currency

is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have

‘demand’ and producers or suppliers have ‘supply’, and the collective interaction

of demand and supply in the market determines the price. These factors are

constantly interacting in the market causing changes in the price over a short

period of time. Such changes in the price are known as ‘price volatility’. This has

three factors: the speed of price changes, the frequency of price changes and the

magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

producing firms and governments to significant risks. The break down of the

BRETTON WOODS agreement brought and end to the stabilising role of fixed

exchange rates and the gold convertibility of the dollars. The globalisation of the

markets and rapid industrialisation of many underdeveloped countries brought a

new scale and dimension to the markets. Nations that were poor suddenly

became a major source of supply of goods. The Mexican crisis in the south east-

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Asian currency crisis of 1990’s has also brought the price volatility factor on the

surface. The advent of telecommunication and data processing bought

information very quickly to the markets. Information which would have taken

months to impact the market earlier can now be obtained in matter of moments.

Even equity holders are exposed to price risk of corporate share fluctuates

rapidly.

These price volatility risks pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against

adverse price changes in commodity, foreign exchange, equity shares and

bonds.

B.} GLOBALISATION OF MARKETS –

Earlier, managers had to deal with domestic economic concerns; what happened

in other part of the world was mostly irrelevant. Now globalisation has increased

the size of markets and as greatly enhanced competition .it has benefited

consumers who cannot obtain better quality goods at a lower cost. It has also

exposed the modern business to significant risks and, in many cases, led to cut

profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the

competitiveness of our products vis-à-vis depreciated currencies. Export of

certain goods from India declined because of this crisis. Steel industry in 1998

suffered its worst set back due to cheap import of steel from south East Asian

countries. Suddenly blue chip companies had turned in to red. The fear of china

devaluing its currency created instability in Indian exports. Thus, it is evident that

globalisation of industrial and financial activities necessitates use of derivatives to

guard against future losses. This factor alone has contributed to the growth of

derivatives to a significant extent.

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C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed

processors, network systems and enhanced method of data entry. Closely

related to advances in computer technology are advances in

telecommunications. Improvement in communications allow for instantaneous

worldwide conferencing, Data transmission by satellite. At the same time there

were significant advances in software programmes without which computer and

telecommunication advances would be meaningless. These facilitated the more

rapid movement of information and consequently its instantaneous impact on

market price.

Although price sensitivity to market forces is beneficial to the economy as a

whole resources are rapidly relocated to more productive use and better rationed

overtime the greater price volatility exposes producers and consumers to greater

price risk. The effect of this risk can easily destroy a business which is otherwise

well managed. Derivatives can help a firm manage the price risk inherent in a

market economy. To the extent the technological developments increase

volatility, derivatives and risk management products become that much more

important.

D.} ADVANCES IN FINANCIAL THEORIES –

Advances in financial theories gave birth to derivatives. Initially forward contracts

in its traditional form, was the only hedging tool available. Option pricing models

developed by Black and Scholes in 1973 were used to determine prices of call

and put options. In late 1970’s, work of Lewis Edeington extended the early work

of Johnson and started the hedging of financial price risks with financial futures.

The work of economic theorists gave rise to new products for risk management

which led to the growth of derivatives in financial markets.

The above factors in combination of lot many factors led to growth of derivatives

instruments

2

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives,

however, did not take off, as there was no regulatory framework to govern trading

of derivatives. SEBI set up a 24–member committee under the Chairmanship of

Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory

framework for derivatives trading in India. The committee submitted its report on

March 17, 1998 prescribing necessary pre–conditions for introduction of

derivatives trading in India. The committee recommended that derivatives should

be declared as ‘securities’ so that regulatory framework applicable to trading of

‘securities’ could also govern trading of securities. SEBI also set up a group in

June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures

for risk containment in derivatives market in India. The report, which was

submitted in October 1998, worked out the operational details of margining

system, methodology for charging initial margins, broker net worth, deposit

requirement and real–time monitoring requirements. The Securities Contract

Regulation Act (SCRA) was amended in December 1999 to include derivatives

within the ambit of ‘securities’ and the regulatory framework were developed for

governing derivatives trading. The act also made it clear that derivatives shall be

legal and valid only if such contracts are traded on a recognized stock exchange,

thus precluding OTC derivatives. The government also rescinded in March 2000,

the three decade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final

approval to this effect in May 2001. SEBI permitted the derivative segments of

two stock exchanges, NSE and BSE, and their clearing house/corporation to

commence trading and settlement in approved derivatives contracts. To begin

with, SEBI approved trading in index futures contracts based on S&P CNX Nifty

and BSE–30 (Sense) index. This was followed by approval for trading in options

based on these two indexes and options on individual securities.

2

The trading in BSE Sensex options commenced on June 4, 2001 and the trading

in options on individual securities commenced in July 2001. Futures contracts on

individual stocks were launched in November 2001. The derivatives trading on

NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The

trading in index options commenced on June 4, 2001 and trading in options on

individual securities commenced on July 2, 2001. Single stock futures were

launched on November 9, 2001. The index futures and options contract on NSE

are based on S&P CNX Trading and settlement in derivative contracts is done in

accordance with the rules, byelaws, and regulations of the respective exchanges

and their clearing house/corporation duly approved by SEBI and notified in the

official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all

Exchange traded derivative products.

The following are some observations based on the trading statistics provided in

the NSE report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the

F&O segment. It constituted 70 per cent of the total turnover during June 2002. A

primary reason attributed to this phenomenon is that traders are comfortable with

single-stock futures than equity options, as the former closely resembles the

erstwhile badla system.

• On relative terms, volumes in the index options segment continue to

remain poor. This may be due to the low volatility of the spot index. Typically,

options are considered more valuable when the volatility of the underlying (in this

case, the index) is high. A related issue is that brokers do not earn high

commissions by recommending index options to their clients, because low

volatility leads to higher waiting time for round-trips.

2

• Put volumes in the index options and equity options segment have

increased since January 2002. The call-put volumes in index options have

decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes

ratio suggests that the traders are increasingly becoming pessimistic on the

market.

• Farther month futures contracts are still not actively traded. Trading in

equity options on most stocks for even the next month was non-existent.

• Daily option price variations suggest that traders use the F&O segment as

a less risky alternative (read substitute) to generate profits from the stock price

movements. The fact that the option premiums tail intra-day stock prices is

evidence to this. If calls and puts are not looked as just substitutes for spot

trading, the intra-day stock price variations should not have a one-to-one impact

on the option premiums.

The spot foreign exchange market remains the most important

segment but the derivative segment has also grown. In the derivative

market foreign exchange swaps account for the largest share of the

total turnover of derivatives in India followed by forwards and

options. Significant milestones in the development of derivatives

market have been (i) permission to banks to undertake cross

currency derivative transactions subject to certain conditions (1996) (ii)

allowing corporates to undertake long term foreign currency swaps

that contributed to the development of the term currency swap market

(1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of

currency futures (2008). I would like to emphasise that currency

swaps allowed companies with ECBs to swap their foreign currency

liabilities into rupees. However, since banks could not carry open

positions the risk was allowed to be transferred to any other resident

corporate. Normally such risks should be taken by corporates who

2

have natural hedge or have potential foreign exchange earnings. But

often corporate assume these risks due to interest rate differentials and

views on currencies.

This period has also witnessed several relaxations in regulations relating to

forex markets and also greater liberalisation in capital account regulations

leading to greater integration with the global economy.

Cash settled exchange traded currency futures have made foreign

currency a separate asset class that can be traded without any

underlying need or exposure a n d on a leveraged basis on the

recognized stock exchanges with credit risks being assumed by the

central counterparty

Since the commencement of trading of currency futures in all the three

exchanges, the value of the trades has gone up steadily from Rs 17, 429

crores in October 2008 to Rs 45, 803 crores in December 2008. The average

daily turnover in all the exchanges has also increased from Rs871 crores to

Rs 2,181 crores during the same period. The turnover in the currency

futures market is in line with the international scenario, where I understand

the share of futures market ranges between 2 – 3 per cent.

Table 4.1ForexMarketActivity

April’05-

Mar’06

April’06-

Mar’07

April’07-

Mar’08

April’08-

Dec’08Total turnover (USD billion) 4,404 6,571 12,304 9,621

Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1

Spot/Total Turnover (%) 50.5 51.9 49.7 45.9

Forward/Total Turnover (%) 19.0 17.9 19.3 21.5

Swap/Total Turnover (%) 30.5 30.1 31.1 32.7

Source: RBI

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14. BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT –

Futures and options contract can be used for altering the risk of investing in spot

market. For instance, consider an investor who owns an asset. He will always be

worried that the price may fall before he can sell the asset. He can protect

himself by selling a futures contract, or by buying a Put option. If the spot price

falls, the short hedgers will gain in the futures market, as you will see later. This

will help offset their losses in the spot market. Similarly, if the spot price falls

below the exercise price, the put option can always be exercised.

2.] PRICE DISCOVERY –

Price discovery refers to the markets ability to determine true equilibrium prices.

Futures prices are believed to contain information about future spot prices and

help in disseminating such information. As we have seen, futures markets

provide a low cost trading mechanism. Thus information pertaining to supply and

demand easily percolates into such markets. Accurate prices are essential for

ensuring the correct allocation of resources in a free market economy. Options

markets provide information about the volatility or risk of the underlying asset.

3.] OPERATIONAL ADVANTAGES –

As opposed to spot markets, derivatives markets involve lower transaction costs.

Secondly, they offer greater liquidity. Large spot transactions can often lead to

significant price changes. However, futures markets tend to be more liquid than

spot markets, because herein you can take large positions by depositing

relatively small margins. Consequently, a large position in derivatives markets is

relatively easier to take and has less of a price impact as opposed to a

transaction of the same magnitude in the spot market. Finally, it is easier to take

a short position in derivatives markets than it is to sell short in spot markets.

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4.] MARKET EFFICIENCY –

The availability of derivatives makes markets more efficient; spot, futures and

options markets are inextricably linked. Since it is easier and cheaper to trade in

derivatives, it is possible to exploit arbitrage opportunities quickly and to keep

prices in alignment. Hence these markets help to ensure that prices reflect true

values.

5.] EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative to engaging in

spot transactions. Also, the amount of capital required to take a comparable

position is less in this case. This is important because facilitation of speculation is

critical for ensuring free and fair markets. Speculators always take calculated

risks. A speculator will accept a level of risk only if he is convinced that the

associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions.

The prices of derivatives converge with the prices of the underlying at the

expiration of derivative contract. Thus derivatives help in discovery of

future as well as current prices.

An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.

Transfer of risk enables market participants to expand their volume of

activity.

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15. National Exchanges

In enhancing the institutional capabilities for futures trading the idea of

setting up of National Commodity Exchange(s) has been pursued since 1999.

Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,

(NMCE), Ahmedabad, National Commodity & Derivatives Exchange  (NCDEX),

Mumbai,  and Multi Commodity Exchange (MCX), Mumbai have  become

operational.  “National Status” implies that these exchanges would be

automatically permitted to conduct futures trading in all commodities subject to

clearance of byelaws and contract specifications by the FMC.  While the NMCE,

Ahmedabad commenced futures trading in November 2002, MCX and NCDEX,

Mumbai commenced operations in October/ December 2003 respectively.

MCX

MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

mutulised multi commodity exchange has permanent recognition from

Government of India for facilitating online trading, clearing and settlement

operations for commodity futures markets across the country. Key shareholders

of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank,

State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI

Life Insurance Co. Ltd., Union Bank of India, Bank of India, Bank of

Baroda, Canera Bank, Corporation Bank

Headquartered in Mumbai, MCX is led by an expert management team

with deep domain knowledge of the commodity futures markets. Today MCX is

offering spectacular growth opportunities and advantages to a large cross section

of the participants including Producers / Processors, Traders, Corporate,

Regional Trading Canters, Importers, Exporters, Cooperatives, Industry

Associations, amongst others MCX being nation-wide commodity exchange,

offering multiple commodities for trading with wide reach and penetration and

robust infrastructure.

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MCX, having a permanent recognition from the Government of India, is

an independent and demutualised multi commodity Exchange. MCX, a state-of-

the-art nationwide, digital Exchange, facilitates online trading, clearing and

settlement operations for a commodities futures trading.

NMCE

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted

by Central Warehousing Corporation (CWC), National Agricultural Cooperative

Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation

Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National

Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).

While various integral aspects of commodity economy, viz., warehousing,

cooperatives, private and public sector marketing of agricultural commodities,

research and training were adequately addressed in structuring the Exchange,

finance was still a vital missing link. Punjab National Bank (PNB) took equity of

the Exchange to establish that linkage. Even today, NMCE is the only Exchange

in India to have such investment and technical support from the commodity

relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested

trading platform, Derivative Trading Settlement System (DTSS), provided by

CMC. It has robust delivery mechanism making it the most suitable for the

participants in the physical commodity markets. It has also established fair and

transparent rule-based procedures and demonstrated total commitment towards

eliminating any conflicts of interest. It is the only Commodity Exchange in the

world to have received ISO 9001:2000 certification from British Standard

Institutions (BSI). NMCE was the first commodity exchange to provide trading

facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The

contracts are marked to market on daily basis. The system of upfront margining

based on Value at Risk is followed to ensure financial security of the market. In

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the event of high volatility in the prices, special intra-day clearing and settlement

is held. NMCE was the first to initiate process of dematerialization and electronic

transfer of warehoused commodity stocks. The unique strength of NMCE is its

settlements via a Delivery Backed System, an imperative in the commodity

trading business. These deliveries are executed through a sound and reliable

Warehouse Receipt System, leading to guaranteed clearing and settlement.

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures trading in

commodities. Besides, NCDEX is subjected to various laws of the land like the

Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act

and various other legislations, which impinge on its working. It is located in

Mumbai and offers facilities to its members in more than 390 centres throughout

India. The reach will gradually be expanded to more centres. 

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm

Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking

bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard

Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds,

Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow

Peas, Yellow Red Maize & Yellow Soybean Meal.

TABLE4: THE CURRENT PROFILE OF FUTURES TRADING IN INDIA WITH

RESPECT TO THE VARIOUS EXCHANGES IN INDIA:-

3

The Present Status:

3

Presently futures’ trading is permitted in all the commodities.  Trading is

taking place in about 78 commodities through 25 Exchanges/Associations as

given in the table below:-

TABLE 4 Registered commodity exchanges in India

No. Exchange COMMODITY

1. India Pepper & Spice Trade

Association, Kochi (IPSTA)

Pepper (both domestic and

international contracts)

2. Vijai Beopar Chambers Ltd.,

Muzaffarnagar

Gur, Mustard seed

3. Rajdhani Oils & Oilseeds Exchange

Ltd., Delhi

Gur, Mustard seed its oil &

oilcake

4. Bhatinda Om & Oil Exchange Ltd.,

Bhatinda

Gur

5. The Chamber of Commerce, Hapur Gur, Potatoes and Mustard

seed

6. The Meerut Agro Commodities

Exchange Ltd., Meerut

Gur

7. The Bombay Commodity Exchange

Ltd., Mumbai

Oilseed Complex, Castor

oil international contracts

8. Rajkot Seeds, Oil & Bullion

Merchants Association, Rajkot

Castor seed, Groundnut,

its oil & cake, cottonseed,

its oil & cake, cotton

(kapas) and RBD

palmolein.

9. The Ahmedabad Commodity

Exchange, Ahmedabad

Castorseed, cottonseed, its

oil and oilcake

10. The East India Jute & Hessian

Exchange Ltd., Calcutta

Hessian & Sacking

11. The East India Cotton Association

Ltd., Mumbai

Cotton

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12. The Spices & Oilseeds Exchange

Ltd., Sangli.

Turmeric

13. National Board of Trade, Indore Soya seed, Soyaoil and Soya meals, Rapeseed/Mustardseed its oil and oilcake  and RBD Palmolien

14. The First Commodities Exchange of

India Ltd., Kochi

Copra/coconut, its oil &

oilcake

15. Central India Commercial

Exchange Ltd., Gwalior

Gur and Mustard seed

16. E-sugar India Ltd., Mumbai Sugar

17. National Multi-Commodity

Exchange of India Ltd., Ahmedabad

Several Commodities

18. Coffee Futures Exchange India

Ltd., Bangalore

Coffee

19. Surendranagar Cotton Oil &

Oilseeds, Surendranagar

Cotton, Cottonseed, Kapas

20. E-Commodities Ltd., New Delhi Sugar (trading yet to

commence)

21. National Commodity & Derivatives,

Exchange Ltd., Mumbai

Several Commodities

22. Multi Commodity Exchange Ltd.,

Mumbai

Several Commodities

23. Bikaner commodity Exchange Ltd.,

Bikaner

Mustard seeds its oil & oilcake, Gram. Guar seed. Guar Gum

24. Haryana Commodities Ltd., Hissar Mustard seed complex

25. Bullion Association Ltd., Jaipur Mustard seed Complex

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STATUS REPORT OF THE D E V E LO P M ENTS IN THE D E RIVATIVE MARKET

1. The Board at its meeting on November 29, 2002 had desired that a quarterly

report be submitted to the Board on the developments in the derivative

market. Accordingly, this memorandum presents a status report for the quarter

July-September 2008-09 on the developments in the derivative market.

2. Equity Derivatives Segment

A. Observations on the quarterly data for July-September, 2008-09

During July-September 2008-09, the turnover at BSE was Rs.1,510 crore,

which was insignificant as compared to that of NSE at Rs. 3,315,491 crore.

Refer Table 1

Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while

turnover increased by 24.77% to Rs. 3,317 thousand crore in July-

September 2008-09 over April-June 2008-09.

Futures (Index Future + Stock Future) constituted 67.20% of the total

number of contracts traded in the F&O Segment. Stock Future and Index

Future accounted for 35.26% and 31.94% respectively.

Options constituted 32.80% of the total volumes. This mainly

comprised of trading in Index Option (30.68%).

Turnover at F&O segment was 4.19 times that of its cash segment.

Reliance, Reliance Capital Ltd, Reliance Petro. Ltd, State Bank of India

and ICICI Bank Ltd were the most actively traded scrips in the

3

derivatives segment. Together they contributed 25.12% of derivatives

turnover in individual stocks.

Client trading constituted 60.17%, Propriety trading constituted 31.07%

and FII trading constituted remaining 8.76% of the total turnover.

Refer Table 2

Volume in longer dated derivative contracts (contracts with maturity of

more than three months and up to 3 years) was 3.99 lakh and total

turnover was Rs. 9870 crore.

Total volume in shorter dated derivative contracts (contracts with maturity

up to 3months) was 1,695 lakh and total turnover was Rs. 3,307 thousand

crore.

Refer Table 3

Volume in Mini Nifty (contracts with minimum lot size of Rs.1 lakh) was

44 lakh and total turnover was Rs. 37 thousand crore.

Refer Table 4

During July-September, 2008, S&P CNX Nifty futures recorded highest

average daily volatility of 2.85% in July 2008.

Refer Table 5

The volume (in terms of no. of contracts traded) of Nifty Future at

SGX as a percentage of the volume of Nifty Future at NSE was

8.55% during July- September 2008-09.

Refer Table 6

India stands 2nd in Stock Futures, 2nd in Index Futures, 16th in Stock Option and

4th in Index Options (as on November 10, 2008) in World Derivatives

Market (in terms of volume) at the end of September 2008.

3

Derivative contracts were launched on 38 securities at National Stock

Exchange during July-September 2008-09.

Table-5: Fact file of July-September 2008-09 with respect to the

previous quarter

Mar

ket

Dep

th

PRODUCT

APRIL-JUNE 2008-09 JULY-SEPTEMBER2008-09No. of Contracts(Lakh)

Turnover(Rs. ‘000)

No. of Contracts(Lakh)

Turnover(Rs. ‘000)

VOLUME & TURNOVER

Index Future 415.7 935.6 542.6 1,077.5Index Option 240.1 571.3 521.2 1,130.9Single Stock Future 514.5 1,093.1 599.0 1,039.3

Stock Option 25.5 58.3 35.9 69.1Total 1,195.8 2,658.4 1,698.7 3,317.0Market Share ( %)Index Future 1,077.5 35.20 31.94 32.48Index Option 1,130.9 21.49 30.68 34.09Single Stock Future 1,039.3 41.12 35.26 31.33

Stock Option 69.1 2.19 2.11 2.08Turnover in F&O as multiple of turnover in cash segment

3.26

4.19

Mar

ket

Co

nce

ntr

atio

n

Five most active

scrips in the

F&O Segment

active scrips in

the F&O

Segment

- Reliance

- Reliance Petro. Ltd.

- Tata Steel

- Reliance Capital Ltd

- Infosys Tech. Ltd

- Reliance

- Reliance Capital Ltd

- Reliance Petro. Ltd

- State Bank of India

- ICICI Bank Ltd

Contribution of the above f ive to total derivatives turnover (%)

23.72 25.12

3

(av

g.

o

f

thre

e

Client (excluding FII

trades)

59.77 60.17

Proprietary 27.88 31.07

FII 12.35 8.76Table-6: Data for Shorter Dated and Longer Dated derivative contracts

Time Period Trades in Shorter Dated

derivative contracts (up t o

3 Months)

Trades in Longer Dated

derivative contracts

more than 3 months)

(more(Quarter) No of

contracts

(lakh)

Turnover

(Rs. ‘000 cr.)

No of

contracts

(lakh)

Turnover

(Rs. ‘000 cr.)

July-September

2008-09 1,694.64 3,307.11 3.99 9.87

Apr-Jun 2008-

091,194.97 2,655.88 4.83 12.5

Table-7: Data for Mini Nifty derivative contracts

Time Period

(Quarter)

No of contract

(lakh)

Turnover (Rs.

‘000 cr.)

July-September

2008-09 43.8 36.9

Apr-Jun 2008-

0929.4 27.7

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Table-8: Minimum, Maximum and Average Daily Volatility of the F&O segment at

NSE for S&P CNX Nifty since April 2008

Month

Average

volatility

(%)

Maximum

Volatility (%)

Minimum

Volatility (%)

April-08 2.47 2.98 2.05

May-08 1.71 1.99 1.56

June-08 1.80 2.28 1.61

July-08 2.85 3.08 2.38

August-08 2.27 2.61 2.10

September-08

2.28 2.51 2.09

Table-9: SGX volume as a percentage of NSE volume for Nifty Future in terms of no. of contracts for the period April – September, 2008-09

Month

NSE Volume

(Nifty Future

volume)

SGX Volume

(Nifty Future

volume)

SGX volume as

% of NSE

VolumeJuly-

September

2008-09 47,977,775 4,104,418 8.55

Apr-Jun 2008-

09 37,764,776 3,241,034 8.58

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Table-10: Standing of India in World Derivatives Market (in terms of volume)

Products July 2008 August 2008September

2008

Stock Future 1 1 2

Index Future 2 2 2

Stock Option 9 15 16

Index Option 4 4 4

Source: www.world-ex c hanges.org (as on November 10, 2008)

Salient points for the 2nd quarter 2008-09

The volume (no. of contracts) and open interest in the derivatives

market has increased even when the underlying market is witnessing a

downward trend. This indicates that there are sufficient long position

holders who anticipate value proposition in a falling market. Falling or

rising markets on the back of low volumes may be a cause of concern

from the point of market integrity. However, as observed from the data,

under the present scenario the fall in the market has been accompanied

by high volumes.

In Index Option, there is a sharp increase in turnover (97.95%) and

volume (117.08%) during July-September 2008-09 over April-June

2008-09. Possible reasons for increase in options trading activity can be

attributed to increase in volatility. Market observers believe that

conditions across markets and asset classes have become more volatile

and uncertain in the recent past. Generally in such conditions, many

people believe that options act as "insurance" against adverse price

movements while offering the flexibility to benefit from possible

4

favourable price movements at the same time. Another reason which

can be attributed to the increase in activity is the new directive as per the

Budget 2008-09 which states that STT would now be levied on the Option

premium instead of the strike price.

In Index Future, both turnover (15.17%) and volume (30.53%) have

increased during July-September 2008-09 as compared to April-June

2008-09.

There is a decrease in turnover (4.92%) in Single Stock Futures

during July- September 2008-09 as compared to April-June 2008-09.

Except Index Option, the market share of all other products has

decreased (both in terms of volume and turnover) in second quarter of

2008-09 as compared to the first quarter of 2008-09.

There is a decrease in turnover (21.04%) and volume (17.39%) in

Longer Dated derivative contracts in second quarter of 2008-09 as

compared to the first quarter of 2008-09.

Longer dated derivatives were launched in March 2008, but the

volumes have not picked up consequently.

For shorter dated derivative contracts, turnover increased by 24.52%

whereas volume increased by 4.81% in second quarter of 2008-09 as

compared to the first quarter of 2008-09.

During 2008-09, Mini Nifty volumes increased by 49.15% and turnover

increased by 33.43% during July-September 2008-09 over April-June

2008-09.

4

18. Business Growth in Derivatives segment (NSE)

TABLE 11A Index futures

FIGURE 11A Number of contracts per year

INTERPRETATION: From the data and the bar diagram above, there is high business growth in the derivative segment in India. In the year 2001-02, the number of contracts in Index Future were 1025588 where as a significant increase of 4116679 is observed in the year 2008-09.

4

Year No. of contracts

2008-09 4116649

2007-08 156598579

2006-07 81487424

2005-06 58537886

2004-05 21635449

2003-04 17191668

2002-03 2126763

2001-02 1025588

Table 11B No of turnovers

Year Turnover (Rs. Cr.)

2008-09 925679.96

2007-08 3820667.27

2006-07 2539574

2005-06 1513755

2004-05 772147

2003-04 554446

2002-03 43952

2001-02 21483

FIGURE 11B Turnover in Rs. Crores

INTERPRETATION:

From the data and above bar chart, there is high turn over in the derivative

segment in India. In the year 2001-02 the turnover of index future was 21483

where as a huge increase of 92567996 in the year 2008-09 are observed.

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TABLE 12A STOCK FUTURES

Year No. of contracts

2008-09 51449737

2007-08 203587952

2006-07 104955401

2005-06 80905493

2004-05 47043066

2003-04 32368842

2002-03 10676843

2001-02 1957856

2000-01 -

FIGURE 12A Number of contracts per year in stock future

INTERPRETATION:

From the data and bar diagram above there were no stock futures available but

in the year 2001-02, it predominently increased to 1957856. Then there was a

huge increase of 20, 35, and 87,952 in the year 2007-08 but there was a steady

decline to 51449737 in the year 2008-09.

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TABLE 12B NO OF TURNOVERS

Year Turnover

(Rs. Crores)

2008-09 1093048.26

2007-08 7548563.23

2006-07 3830967

2005-06 2791697

2004-05 1484056

2003-04 1305939

2002-03 286533

2001-02 51515

2000-01 -

FIGURE 12B Turnover in Rs. Crores

INTERPRETATION:

From the data and bar chart above, there were no stock futures available in the

year 2000-01. There was a steady increase of stock future 51515 in the year

2001-02. but in the year there was a huge increae of 7548563.23 in the year

2007-08 with a considerable decline of 1093048.26 in the year 2008-09.

4

TABLE 13A INDEX OPTIONS

Year No. of contracts

2008-09 24008627

2007-08 55366038

2006-07 25157438

2005-06 12935116

2004-05 3293558

2003-04 1732414

2002-03 442241

2001-02 175900

2000-01 -

FIGURE 13A Number of contracts per year

Interpretation:

From the data and bar chart above, the no of contracts of index option was nil in

the year 2000-2001. But there was a predominant increase of 1,75,900 in the

year 2001-2002. In the year 2007-2008 there was a huge increase in the index

option contracts to 55366038 and a decline of 24008627 in the year 2008-2009.

TABLE 13B Turnover per year in Rs. Crores

4

Year Turnover (Rs. Crores)

2008-09 71340.02

2007-08 1362110.88

2006-07 791906

2005-06 338469

2004-05 121943

2003-04 52816

2002-03 9246

2001-02 3765

2000-01 -

FIGURE 13B Turnover per year in Rs. Crores

Interpretation:

From the data and bar chart above, there was no turnover in the year 2000-2001

for Index option. It slowly started increasing in the year 2000-2001 to 3765.But in

the year 2007-2008 there was a huge increase of 1362110.088 and a sudden

decline to 71340.02 observed in 2008-2009.

TABLE 14A STOCK OPTIONS

Year No. of contracts

4

2008-09 2546175

2007-08 9460631

2006-07 5283310

2005-06 5240776

2004-05 5045112

2003-04 5583071

2002-03 3523062

2001-02 1037529

2000-01 -

FIGURE 14A Number of contracts traded per year in stock option

INTERPRETATION:

From the data and bar chart above the no of contracts of stock option in the year

2000-2001 was nil. But there was a huge increase of 1037529 observed in the

year 2001-2002. It was 9460631 which was the the highest in the year 2007-

2008. But a gradual decline of 2546175 in the year 2008-2009.

TABLE 14B National turnover in Rs. Crores per year

Year Notional turnover (Rs.

5

crores)

2008-09 58335.03

2007-08 359136.55

2006-07 193795

2005-06 180253

2004-05 168836

2003-04 217207

2002-03 100131

2001-02 25163

2000-01 -

FIGURE 14B National turnover in Rs. Crores per year

Interpretation:

From the chart and the bar diagram above the stock option turnover in the year

2000-2001 was nil. There was a slow increase of 25163 in the year 2001-2002.

But a phenomenal increase of 359136.55 in the year 2007-2008, and a decline of

58355.03 in the year 2008-2009.

TABLE 15A OVERALL TRADING

Year No. of contracts Turnover (Rs. cr.)

5

2008-09 119171008 2648403.30

2007-08 425013200 13090477.75

2006-07 216883573 7356242

2005-06 157619271 4824174

2004-05 77017185 2546982

2003-04 56886776 2130610

2002-03 16768909 439862

2001-02 4196873 101926

2000-01 90580 2365

FIGURE 15A Average daily turnovers in Rs. Crores

Interpretation:From the data and bar chart above, the overall trading contracts in the year 2000-2001 was 90580 and huge increase of 119171008 in the year 2008-2009. From the data and bar chart above the overall trading turnover in the year 2000-2001 was as low as 2365 but a predominant increase of 2648403.30 observed in the year 2008-2009.

TABLE 16 Overall trade description under NSE

Index Futures

Stock Futures

Index Options

Stock Options

Interest Rate

Total

5

Futures

Year

No. of contracts

Turnover (Rs. cr.)

No. of contracts

Turnover (Rs. cr.)

No. of contracts

Notional Turnover (Rs. cr.)

No. of contracts

Notional Turnover (Rs. cr.)

No. of contracts

Turnover (Rs. cr.)

No. of contracts

Turnover (Rs. cr.)

2008-09

41166469

925679.9

6

51449737

1093048.26

24008627

571340.02

2546175 58335.03 00.00

119171008

2648403.30

2007-08

156598579

3820667.27

203587952

7548563.23

55366038

1362110.88

9460631359136.55

00.00

425013200

13090477.75

2006-07

81487424

2539574104955401

383096725157438

791906 5283310 193795 0 0216883573

7356242

2005-06

58537886

151375580905493

279169712935116

338469 5240776 180253 0 0157619271

4824174

2 2163544 772147 4704306 1484056 329355 121943 5045112 168836 0 0 77017185 2

5

004-05

9 6 8

546982

2003-04

17191668

55444632368842

13059391732414

52816 5583071 21720710781

202 56886776

2130610

2002-03

2126763 4395210676843

286533 442241 9246 3523062 100131 - - 16768909

439862

2001-02

1025588 21483 1957856 51515 175900 3765 1037529 25163 - - 4196873

101926

2000-01

90580 2365 - - - - - - - 90580

2365

TABLE 17 AVERAGE DAILY TURNOVERS

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Note:

Notional Turnover = (Strike Price + Premium) * Quantity

Index Futures, Index Options, Stock Options and Stock Futures were introduced

in June 2000, June 2001, July 2001 and November 2001 respectively.

FINDINGS & CONCLUSION

From the above analysis it can be concluded that:

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Year Av. daily turnover (Rs. Crores)

2008-09 45390.21

2007-08 52153.30

2006-07 29543

2005-06 19220

2004-05 10167

2003-04 8388

2002-03 1752

2001-02 410

2000-01 11

1. Derivative market is growing very fast in the Indian Economy. The turnover of Derivative Market is increasing year by year in the India’s largest stock exchange NSE. In the case of index future there is a phenomenal increase in the number of contracts. But whereas the turnover is declined considerably. In the case of stock future there was a slow increase observed in the number of contracts whereas a decline was also observed in its turnover. In the case of index option there was a huge increase observed both in the number of contracts and turnover.

2. After analyzing data it is clear that the main factors that are driving the growth of Derivative Market are Market improvement in communication facilities as well as long term saving & investment is also possible through entering into Derivative Contract. So these factors encourage the Derivative Market in India.

3. It encourages entrepreneurship in India. It encourages the investor to take more risk & earn more return. So in this way it helps the Indian Economy by developing entrepreneurship. Derivative Market is more regulated & standardized so in this way it provides a more controlled environment. In nutshell, we can say that the rule of High risk & High return apply in Derivatives. If we are able to take more risk then we can earn more profit under Derivatives.

Commodity derivatives have a crucial role to play in the price risk management

process for the commodities in which it deals. And it can be extremely beneficial

in agriculture-dominated economy, like India, as the commodity market also

involves agricultural produce. Derivatives like forwards, futures, options, swaps

etc are extensively used in the country. However, the commodity derivatives

have been utilized in a very limited scale. Only forwards and futures trading are

permitted in certain commodity items.

RELIANCE is the most active future contracts on individual

securities traded with 90090 contracts and RNRL is the next most active futures

contracts with 63522 contracts being traded.

RECOMMENDATIONS & SUGGESTIONS

5

RBI should play a greater role in supporting derivatives.

Derivatives market should be developed in order to keep it at par with

other derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

After study it is clear that Derivative influence our Indian Economy up

to much extent. So, SEBI should take necessary steps for

improvement in Derivative Market so that more investors can invest in

Derivative market.

There is a need of more innovation in Derivative Market because in

today scenario even educated people also fear for investing in

Derivative Market Because of high risk involved in Derivatives.

5

BIBLIOGRAPHY

Books referred:

Options Futures, and other Derivatives by John C Hull

Derivatives FAQ by Ajay Shah

NSE’s Certification in Financial Markets: - Derivatives Core module

Financial Markets & Services by Gordon & Natarajan

Reports:

Report of the RBI-SEBI standard technical committee on exchange traded

Currency Futures

Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA

Websites visited:

www.nse-india.com

www.bseindia.com

www.sebi.gov.in

www.ncdex.com

www.google.com

www.derivativesindia.com

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ABBREVATIONS

A

AMEX- America Stock Exchange

B

BSE- Bombay Stock Exchange

BSI- British Standard Institute

C

CBOE - Chicago Board options Exchange

CBOT - Chicago Board of Trade

CEBB - Chicago Egg and Butter Board

CME - Chicago Mercantile Exchange

CNX- Crisil Nse 50 Index

CPE - Chicago Produce Exchange

CWC- Central Warehousing Corporation

D

DTSS- Derivative Trading Settlement System

F

FIIs- Foreign Institutional Investors

F & O – Future and Options

FMC- Forward Markets Commission

FRAs- Forward Rate Agreements

G

GAICL-Gujarat Agro Industries Corporation Limited

GSAMB- Gujarat State Agricultural Marketing Board

I

IMM - International Monetary Market

IPSTA- India Pepper & Spice Trade Association

M

MCX – Multi Commodity Exchange

5

N

NAFED-National Agricultural Co-Operative Marketing Federation Of India

NCDEX – National Commodities and Derivatives Exchange

NIAM- National Institute Of Agricultural Marketing

NMSE- National Multi Commodity Exchange

NOL- Neptune Overseas Limited

NSCCL- National Securities Clearing Corporation

NSDL- National Securities Depositories Limited

NSE - National Stock Exchange

O

OTC- Over The Counter

P

PHLX - Philadelphia Stock Exchange

PNB- Punjab National Bank

R

RBI- Reserve Bank Of India

S

SC(R) A - Securities Contracts (Regulation) Act, 1956

SEBI- Securities Exchange Board Of India

SGX- Singapore Stock Exchange

SIMEX - Singapore International Monetary Exchange

V

VPN- Virtual Private Network

6