Indian Derivative Market - Final Tnr

7/30/2019 Indian Derivative Market - Final Tnr

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RESEARCH PROJECT REPORT

On

Types of Derivatives Traded on NSE and

its Impact

Towards partial fulfillment of

Master of Business Administration (MBA)School of Management, Babu Banarasi Das University,

Lucknow

Guided by Submitted by

Mrs. Shachi Kacker Prabhat

Mishra

Session 2012-2013

School of Management

Babu Banarasi Das University

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Sector I, Dr. Akhilesh Das Nagar, Faizabad Road, Lucknow (U.P.)India

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A C K N O W L E D G E M E N T

Without a proper combination of inspection and perspiration, its not easy to achieve

anything. There is always a sense of gratitude, which we express to others for the help

and the needy services they render during the different phases of our lives. I too would

like to do it as I really wish to express my gratitude toward all those who have been

helpful to me directly or indirectly during the development of this project.

I would like to thankMrs. Shachi Kacker (Faculty of management, BBDU) who was

always there to help and guide me when I needed help. Her perceptive criticism kept me

working to make this project more full proof. I am thankful to her for her encouraging

and valuable support. Working under her was an extremely knowledgeable and

enriching experience for me. I am very thankful to her for all the value addition and

enhancement done to me.

No words can adequately express my overriding debt of gratitude to my parents whose

support helps me in all the way. Above all I shall thank my friends who constantly

encouraged and blessed me so as to enable me to do this work successfully.

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P R E F A C E

My research project report entitled TYPES OF DERIVATIVES TRADED ON NSE

AND ITS IMPACT submitted for the degree of Master of Business Administration, is

my original work.

I believe that my research report will have been very helpful to the organization for the

practical knowledge in the field of Finance.

Place : LUCKNOW

Date : 1 May 2013 PRABHAT MISHRA

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EXECUTIVE SUMMARY

With over 25 million shareholders, India has the third largest investor base in the world

after USA and Japan. Over 7500 companies are listed on the Indian stock exchanges

(more than the number of companies listed in developed markets of Japan, UK,

Germany, France, Australia, Switzerland, Canada and Hong Kong.). The Indian capital

market is significant in terms of the degree of development, volume of trading,

transparency and its tremendous growth potential.

Indias market capitalization was the highest among the emerging markets. Total market

capitalization of The Bombay Stock Exchange (BSE), which, as on July 31, 1997, was

US$ 175 billion has grown by 37.5% percent every twelve months and was over US$

834 billion as of January, 2007. Bombay Stock Exchanges (BSE), one of the oldest in

the world, accounts for the largest number of listed companies transacting their shares

on a nationwide online trading system. The two major exchanges namely the National

Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5 in the

world, calculated by the number of daily transactions done on the exchanges.

The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 An

increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years only.

Turnover in the Spot and Derivatives segment both in NSE & BSE was higher by 45%

into 2006 as compared to 2005. With daily average volume of US $ 9.4 billion, the

Sensex has posted excellent returns in the recent years. Currently the market cap of

the Sensex as on July 4th, 2009 was Rs 48.4 Lakh Crore with a P/E of more than

20.

Derivatives trading in the stock market have been a subject of enthusiasm of research in

the field of finance the most desired instruments that allow market participants to

manage risk in the modern securities trading are known as derivatives. The derivatives

are defined as the future contracts whose value depends upon the underlying assets. If

derivatives are introduced in the stock market, the underlying asset may be anything as

component of stock market like, stock prices or market indices, interest rates, etc. The

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main logic behind derivatives trading is that derivatives reduce the risk by providing an

additional channel to invest with lower trading cost and it facilitates the investors to

extend their settlement through the future contracts. It provides extra liquidity in the

stock market.

Derivatives are assets, which derive their values from an underlying asset. These

underlying assets are of various categories like

Commodities including grains, coffee beans, etc.

Precious metals like gold and silver.

Foreign exchange rate.

Bonds of different types, including medium to long-term negotiable debt secu-

rities issued by governments, companies, etc.

Short-term debt securities such as T-bills.

Over-The-Counter (OTC) money market products such as loans or deposits.

Equities

For example, a dollar forward is a derivative contract, which gives the buyer a right &

an obligation to buy dollars at some future date. The prices of the derivatives are driven

by the spot prices of these underlying assets.

However, the most important use of derivatives is in transferring market risk, called

Hedging, which is a protection against losses resulting from unforeseen price or

volatility changes. Thus, derivatives are a very important tool of risk management.

There are various derivative products traded. They are;

1. Forwards

2. Futures

3. Options

4. Swaps

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A Forward Contractis a transaction in which the buyer and the seller agree upon a

delivery of a specific quality and quantity of asset usually a commodity at a specified

future date. The price may be agreed on in advance or in future.

A Future contractis a firm contractual agreement between a buyer and seller for a

specified as on a fixed date in future. The contract price will vary according to the

market place but it is fixed when the trade is made. The contract also has a standard

specification so both parties know exactly what is being done.

An Options contractconfers the right but not the obligation to buy (call option) or

sell (put option) a specified underlying instrument or asset at a specified price the

Strike or Exercised price up until or an specified future date the Expiry date. ThePrice is called Premium and is paid by buyer of the option to the seller or writer of the

option.

A call option gives the holder the right to buy an underlying asset by a certain date for a

certain price. The seller is under an obligation to fulfill the contract and is paid a price of

this, which is called "the call option premium or call option price".

A put option, on the other hand gives the holder the right to sell an underlying asset by

a certain date for a certain price. The buyer is under an obligation to fulfill the contract

and is paid a price for this, which is called "the put option premium or put option price".

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

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You will be glad to know that derivative market in India is the most booming now

days. So the person who is ready to take risk and want to gain more should invest

in the derivative market.

On the other hand RBI has to play an important role in derivative market. Also

SEBI must encourage investment in derivative market so that the investors get the

benefit out of it. Sorry to say that today even educated persons are not willing to

invest in derivative market because they have the fear of high risk.

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TABLE OF CONTENTS

S.No.

TOPICS PAGENO.

1. Introduction..... 102. Company Profile...................... 113. Organization Chart ......................... 224.

5.

6.

7.

8.

9.

Objective of the Study........................................................................

Need of the Study.......................................................................

Scope of the Project.......................................................................

Literature Review........................................................................

Main Topics of Study..................................................................

Data Interpretation.........................................................................

23

24

25

26

27

5710.

11.

12.

13.

14.

15.

Research Methodology.

Limitations of Study...

Findings & Conclusion..

Recommendations & Suggestions..

Bibliography....

Abbreviations..

69

70

71

73

74

75

INTRODUCTION

A Derivative is a financial instrument whose value depends on other, more basic,underlying variables. The variables underlying could be prices of traded securities

and stock, prices of gold or copper.

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Derivatives have become increasingly important in the field of finance, Options and

Futures are traded actively on many exchanges, Forward contracts, Swap and

different types of options are regularly traded outside exchanges by financial

intuitions, banks and their corporate clients in what are termed as over-the-counter

markets in other words, there is no single market place or organized exchanges.

NSE - A NEW IDEOLOGY

GENESIS

Capital market reforms in India have outstripped the process of liberalization in most

other sectors of the economy. However, the creation of an independent capital market

regulator was the initiation of this reform process. After the formation of the Securities

Market regulator, the Securities and Exchange Board of India (SEBI), attention were

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drawn towards the inefficiencies of the bourses and the need was felt for better

regulation, discipline and accountability. A Committee recommended the creation of a

2nd stock exchange in Mumbai called the "National Stock Exchange". The Committee

suggested the formation of an exchange which would provide investors across the

country a single, screen based trading platform, operated through a VSAT network. It

was on this recommendation that setting up of NSE as a technology driven exchange

was conceptualized. NSE has set up its trading system as a nation-wide, fully automated

screen based trading system. It has written for itself the mandate to create a world-class

exchange and use it as an instrument of change for the industry as a whole through

competitive pressure. NSE was incorporated in 1992 and was given recognition as a

stock exchange in April 1993. It started operations in June 1994, with trading on the

Wholesale Debt Market Segment. Subsequently it launched the Capital Market Segment

in November 1994 as a trading platform for equities and the Futures and Options

Segment in June 2000 for various derivative instruments.

NSE was set up with the objectives of:

Establishing a nationwide trading facility for all types of securities;

Ensuring equal access to investors all over the country through an appropriate

communication network;

Providing a fair, efficient and transparent securities market using electronic

trading system;

Enabling shorter settlement cycles and book entry settlements; and

Meeting international benchmarks and standards.

The broad objective for which the exchange was set up has made it to play a leadingrole

in enlarging the scope of market reforms in securities market in India. During lastone

decade it has been playing the role of a catalytic agent in reforming the markets in terms

of market microstructure and in evolving the best market practices keeping in mind the

investors. The Exchange is set up on a demutualised model wherein the ownership,

management and trading rights are in the hands of three different sets of people. This

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has completely eliminated any conflict of interest. This has helped NSE to aggressively

pursue policies and practices within a public interest framework. NSE's nationwide,

automated trading system has helped in shifting the trading platform from the trading

hall in the premises of the exchange to the computer terminals at the premises of the

trading members located at different geographical locations in the country and

subsequently to the personal computers in the homes of investors and even to hand held

portable devices for the mobile investors. It has been encouraging corporatization of

membership in securities market. It has also proved to be instrumental in ushering in

scrip less trading and providing settlement guarantee for all trades executed on the

Exchange. Settlement risks have also been eliminated with NSE's innovative endeavors

in the area of clearing and settlement viz., establishment of the clearing corporation

(NSCCL), setting up a

settlement guarantee fund (SGF), reduction of settlement cycle, implementing on-line,

real-time risk management systems, dematerialization and electronic transfer of

securities to name few of them. As a consequence, the market today uses state-of-the-art

information technology to provide an efficient and transparent trading, clearing and

settlement mechanism. In order to take care of investors interest, it has also created an

investors protection fund (IPF), that would help investors who have incurred financial

loss due to default of brokers.

Ownership and Management of the NSE

NSE is owned by a set of leading financial institutions, banks, insurance companies and

other financial intermediaries. It is managed by a team of professional managers and the

trading rights are with trading members who offer their services to the investors. The

Board of NSE comprises of senior executives from promoter institutions and eminent

professionals, without having any representation from trading members. While theBoard deals with the broad policy issues, the Executive Committees which include

trading members, formed under the Articles of Association and the Rules of NSE for

different market segments, set out rules and parameters to manage the day-to-day affairs

of the Exchange. The ECs have constituted several committees, like Committee on

Trade Related Issues (COTI), Committee on Settlement Issues (COSI) etc., comprising

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mostly of trading members, to receive inputs from the market participants and

implement suggestions which are in the best interest of the investors and the market.

The day-to-day management of the Exchange is delegated to the Managing Director and

CEO who is supported by a team of professional staff. Therefore, though the role of

trading members at NSE is to the extent of providing only trading services to the

investors, the Exchange involves trading members in the process of consultation and

participation in vital inputs towards decision making.

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Market Segments and Products

NSE provides an electronic trading platform for of all types of securities for investors

under one roof - Equity, Corporate Debt, Central and State Government Securities,

TBills, Commercial Paper, Certificate of Deposits (CDs), Warrants, Mutual Funds units,

Exchange Traded Funds, Derivatives like Index Futures, Index Options, Stock Futures,

Stock Options, Futures on Interest Rates etc., which makes it one of the few exchanges

in the world providing trading facility for all types of securities on a single exchange.

The Exchange provides trading in 3 different segments viz.

Wholesale debt market (WDM)

Capital market (CM) segment and

The futures & options (F&O) segment.

The Wholesale Debt Market segment provides the trading platform for trading of a

wide range of debt securities which includes State and Central Government securities,

T-Bills, PSU Bonds, Corporate Debentures, CPs, CDs etc. However, along with these

financial instruments, NSE has also launched various products (e.g. FIMMDA-NSE

MIBID/MIBOR) owing to the market need. A reference rate is said to be an accurate

measure of the market price. In the fixed income market, it is the interest rate that the

market respects and closely matches. In response to this, NSE started computing and

disseminating the NSE Mumbai Inter-bank Bid Rate (MIBID) and NSE Mumbai Inter-

Bank Offer Rate (MIBOR). Owing to the robust methodology of computation of these

rates and its extensive use, this product has become very popular among the market

participants.

Keeping in mind the requirements of the banking industry, FIs, MFs, insurance

companies, who have substantial investments in sovereign papers, NSE also started the

dissemination of its yet another product, the Zero Coupon Yield Curve. This helps in

valuation of sovereign securities across all maturities irrespective of its liquidity in the

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market. The increased activity in the government securities market in India and

simultaneous emergence of MFs (Gilt MFs) had given rise to the need for a well defined

bond index to measure the returns in the bond market. NSE constructed such an index

the, NSE Government Securities Index. This index provides a benchmark for portfolio

management by various investment managers and gilt funds.

The Capital Market segment offers a fully automated screen based trading system,

known as the National Exchange for Automated Trading (NEAT) system. This operates

on a price/time priority basis and enables members from across the country to trade with

enormous ease and efficiency. Various types of securities e.g. equity shares, warrants,

debentures etc. are traded on this system. NSE started trading in the equities segment

(Capital Market segment) on November 3, 1994 and within a short span of 1 year

became the largest exchange in India in terms of volumes transacted.

The Equities section provides you with an insight into the equities segment of NSE and

also provides real-time quotes and statistics of the equities market. In-depth information

regarding listing of securities, trading systems & processes, clearing and settlement, risk

management, trading statistics etc are available here.

Futures & Options segment of NSE provides trading in derivatives instruments like

Index Futures, Index Options, Stock Options, Stock Futures and Futures on interest

rates. Though only four years into its operations, the futures and options segment of

NSE has made a mark for itself globally. In the Futures and Options segment, trading in

Nifty and CNX IT index and 53 single stocks are available. W.e.f. May 27 2005, futures

and options would be available on 118 single stocks.

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Technology

Technology has been the backbone of the Exchange. Providing the services to the

investing community and the market participants using technology at the cheapest

possible cost has been its main thrust. NSE chose to harness technology in creating a

new market design. It believes that technology provides the necessary impetus for the

organisation to retain its competitive edge and ensure timeliness and satisfaction in

customer service. In recognition of the fact that technology will continue to redefine the

shape of the securities industry, NSE stresses on innovation and sustained investment in

technology to remain ahead of competition.

NSE is the first exchange in the world to use satellite communication technology for

trading. It uses satellite communication technology to energise participation through

about 2,829 VSATs from nearly 345 cities spread all over the country. Its tradingsystem, called National Exchange for Automated Trading (NEAT), is a state of the art

client server based application. At the server end all trading information is stored in an

in-memory database to achieve minimum response time and maximum system

availability for users.

It has uptime record of 99.7%. For all trades entered into NEAT system, there is

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uniform response time of less than 1.5 seconds. NSE has been continuously

undertaking capacity enhancement measures so as to effectively meet the

requirements of increased users and associated trading loads. With recent up gradation

of trading hardware, NSE can handle up to 6 million trades per day. NSE has also put in

place NIBIS (NSE's Internet Based Information System)

for on-line real-time dissemination of trading information over the Internet. As part of

its business continuity plan, NSE has established a disaster back-up site at Chennai

along with its entire infrastructure, including the satellite earth station and the high

speed optical fiber link with its main site at Mumbai. This site at Chennai is a replica of

the production environment at Mumbai. The transaction data is backed up on near real

time basis from the main site to the disaster

back-up site through the 2 mbps high-speed link to keep both the sites all the time

synchronized with each other.

Application SystemThe various application systems that NSE uses for its trading as

well clearing and settlement and other operations form the backbone of the Exchange.

The application systems used for the day-to-day functioning of the Exchange can be

divided into

(a) Front end applications (b) Back office applications.

In the front end application system, there are 6 pplications:

NEAT CM system takes care of trading of securities in the Capital Market

segment that includes equities, debentures/notes as well as retail Gilts. The NEATCM

application has a split architecture wherein the split is on thesecurities and users. The

application runs on two Stratus systems with Open Strata Link (OSL). The application

has been benchmarked to support 15000 users and handle more than 6 million trades

daily. This application also provides data feed for processing to some other systems like

Index, OPMS through TCP/IP. This is a direct interface with the trading members of the

CM segment of the Exchange for entering the orders into the main system. There is a

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two way communication between the NSE main system and the front end terminal of

the trading member.

NEAT WDM system takes care of trading of securities in the Wholesale Debt

Market (WDM) segment that includes Gilts, Corporate Bonds, CPs, T-Bills, etc.

This is a direct interface with the trading members of the WDM segment of the

Exchange for entering the orders/trades into the main system. There is a two way

communication between the NSE main system and the front end terminal of the

trading member.

NEAT F&O system takes care of trading of securities in the Futures and Options

(F&O) segment that includes Futures on Index as well as individual stocks and Options

on Index as well as individual stocks. This is a direct interface

with the trading members of the F&O segment of the Exchange for entering the orders

into the main system. There is a two way communication between the NSE main system

and the front end terminal of the trading member.

NEAT IPO system is an interface to help the initial public offering of companies

which are issuing the stocks to raise capital from the market. This is adirect interface with the trading members who are registered for undertaking order entry

on behalf of their clients for IPOs. NSE uses the NEAT IPO system that allows bidding

in several issues concurrently. There is a two way communication between the NSE

main system and the front end terminal of the trading member.

NEAT MF system is an interface with the trading members for order collection of

designated mutual funds units.

Surveillance system offers the users a facility to comprehensively monitor the

trading activity and analyze the trade data online and offline.

In the back office, the following important application systems are operative:

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(A) NCSS (Nationwide Clearing and Settlement System) is the clearing and

settlement system of the NSCCL for the trades executed in the CM segment of the

Exchange. The system has 3 important interfaces OLTL (Online Trade loading) that

takes each and every trade executed on real time basis and allocates the same to the

clearing members, Depository Interface that connects the depositories for settlement of

securities and Clearing Bank Interface that connects the 10 clearing banks for settlement

of funds. It also interfaces with the clearing members for all required reports. Through

collateral management system it keeps an account of all available collaterals on behalf

of all trading/clearing members and integrates the same with the position monitoring of

the trading/ clearing members. The system also generates base capital adequacy reports.

(B) FOCASS is the clearing and settlement system of the NSCCL for the trades

executed in the F&O segment ofthe Exchange. It interfaces with the clearing members

for all required reports. Through collateral management system it keeps an account of

all available collaterals on behalf of all trading/ clearing members and integrates the

same with the position monitoring of the trading/clearing members. The system also

generates base capital adequacy reports.

(C) OPMS the online position monitoring system that keeps track of all tradesexecuted for a trading member vis--vis its capital adequacy.

(D) PRISM is the parallel risk management system for F&O trades using Standard

Portfolio Analysis (SPAN). It is a system for comprehensive monitoring and load

balancing of an array of parallel processors that provides complete fault tolerance. It

provides real time information on initial margin value, mark to market profit or loss,

collateral amounts, contract-wise latest prices, contract-wise open interest and limits.

The system also tracks online real time client level portfolio, base upfront margining

and monitoring.

(E) Data warehousing, that is the central repository of all data in CM as well as F&O

segment of the Exchange.

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(F) Listing system, that captures the data of companies which are listed on the

Exchange and integrates the same with the trading system for necessary broadcasts,

information dissemination.

(G) Membership system, hat keeps track of all required details of the Trading

Members of the Exchange.

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ORGANIZATION CHART

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OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives.

To know the role of derivatives trading in India.

To analyse the performance of Derivatives Trading since 2001with special

reference to Futures & Options.

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NEED OF THE STUDY

The study has been done to know the different types of derivatives and also to know

the derivative market in India. This study also covers the recent developments in the

derivative market taking into account the trading in past years.

Through this study I came to know the trading done in derivatives and their use in

the stock markets.

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SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. It includes the data

collected in the recent years and also the market in the derivatives in the recent

years. This study extends to the trading of derivatives done in the National Stock

Markets.

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LITERATURE REVIEWThe emergence of the market for derivative products, most notably forwards, futures

and options, can be traced back to the willingness of risk-averse economic agents to

guard themselves against uncertainties arising out of fluctuations in asset prices. By

their very nature, the financial markets are marked by a very high degree of volatility.

Through the use of derivative products, it is possible to partially or fully transfer price

risks by locking-in asset prices. As instruments of risk management, these generally do

not influence the fluctuations in the underlying asset prices. However, by locking-in

asset prices, derivative products minimize the impact of fluctuations in asset prices on

the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in

commodity prices and commodity-linked derivatives remained the sole form of such

products for almost three hundred years. The financial derivatives came into spotlight in

post-1970 period due to growing instability in the financial markets. However, since

their emergence, these products have become very popular and by 1990s, they

accounted for about two-thirds of total transactions in derivative products. In recent

years, the market for financial derivatives has grown tremendously both in terms of

variety of instruments available, their complexity and also turnover. In the class of

equity derivatives, futures and options on stock indices have gained more popularity

than on individual stocks, especially among institutional investors, who are major users

of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indices with

various portfolios and ease of use. The lower costs associated with index derivatives vis-

vis derivative products based on individual securities is another reason for their growing

use.

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MAIN TOPICS OF STUDY

1. 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.

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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.

2. 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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Derivatives

Future Option Forward Swaps

3. 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

Types of Derivatives Market

4. TYPES OF DERIVATIVES

Types of Derivatives

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(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 samecounter-party, whic h often results in high prices being charged.

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 be ca us e b oth serve essenti ally th e same

economic functio ns 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.

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(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

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.

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Thegrade 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 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.

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3. Settlement

Settlement 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.

PRICING OF FUTURE CONTRACT

In 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, andconvenience 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.

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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 twoparties (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 toall 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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(iii) 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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(iv) 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 partiesagree 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 DERIVATIVES

The 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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5. HISTORY OF DERIVATIVES

The history of derivatives is quite colourful and surprisingly a lot longer than most

people think. Forward delivery contracts, stating what is to be delivered for a fixed priceat a specified place on a specified date, existed in ancient Greece and Rome. Roman

emperors entered forward contracts to provide the masses with their supply of Egyptian

grain. These contracts were also undertaken between farmers and merchants to eliminate

risk arising out of uncertain future prices of grains. Thus, forward contracts have existed

for centuries for hedging price risk.

The first organized commodity exchange came into existence in the early

1700s in Japan. The first formal commodities exchange, the Chicago Board of Trade

(CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to

provide centralised location to negotiate forward contracts. From forward trading in

commodities emerged the commodity futures. The first type of futures contract was

called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865,

CBOT listed the first exchange traded derivatives contract, known as the futures

contracts. Futures trading grew out of the need for hedging the price risk involved in

many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of

CBOT, was formed in 1919, though it did exist before in 1874 under the names of

Chicago Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The

first financial futures to emerge were the currency in 1972 in the US. The first foreign

currency futures were traded on May 16, 1972, on International Monetary Market

(IMM), a division of CME. The currency futures traded on the IMM are the British

Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the

Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest

rate futures. Interest rate futures contracts were traded for the first time on the CBOT onOctober 20, 1975. Stock index futures and options emerged in 1982. The first stock

index futures contracts were traded on Kansas City Board of Trade on February 24,

1982.The first of the several networks, which offered a trading link between two

exchanges, was formed between the Singapore International Monetary Exchange

(SIMEX) and the CME on September 7, 1984.

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Options are as old as futures. Their history also dates back to ancient Greece and Rome.

Options are very popular with speculators in the tulip craze of seventeenth century

Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a

high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb

options. There was so much speculation that people even mortgaged their homes and

businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as

there was no mechanism to guarantee the performance of the option terms.

The first call and put options were invented by an American financier,

Russell Sage, in 1872. These options were traded over the counter. Agricultural

commodities options were traded in the nineteenth century in England and the US.

Options on shares were available in the US on the over the counter (OTC) market only

until 1973 without much knowledge of valuation. A group of firms known as Put and

Call brokers and Dealers Association was set up in early 1900s to provide a

mechanism for bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT

for the purpose of trading stock options. It was in 1973 again that black, Merton, and

Scholes invented the famous Black-Scholes Option Formula. This model helped inassessing the fair price of an option which led to an increased interest in trading of

options. With the options markets becoming increasingly popular, the American Stock

Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in

options in 1975.

The market for futures and options grew at a rapid pace in the eighties and nineties. The

collapse of the Bretton Woods regime of fixed parties and the introduction of floating

rates for currencies in the international financial markets paved the way for development

of a number of financial derivatives which served as effective risk management tools to

cope with market uncertainties.

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The CBOT and the CME are two largest financial exchanges in the world on which

futures contracts are traded. The CBOT now offers 48 futures and option contracts (with

the annual volume at more than 211 million in 2001).The CBOE is the largest exchange

for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500

stock indices. The Philadelphia Stock Exchange is the premier exchange for trading

foreign options.

The most traded stock indices include S&P 500, the Dow Jones Industrial

Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade

almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

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6. 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

Indias (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 instruments

1991 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

(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

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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 Indias

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 Indias 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

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

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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. 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 SCENARIO

Large market Capitalisation India is one of the largest market-capitalised countries inAsia with a market capitalisation of more thanRs.765000 crores.

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High Liquidity in theunderlying

The daily average traded volume in Indian capitalmarket today is around 7500 crores. Which means on anaverage every month 14% of the countrys Marketcapitalisation gets traded. These are clear indicators of

high liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing trades hasbecome fully functional from July 1996 in the form ofNational Securities Clearing Corporation (NSCCL).NSCCL is responsible for guaranteeing all openpositions on the National Stock Exchange (NSE) forwhich it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL) whichstarted functioning in the year 1997 has revolutionalised

the security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital market enjoys astrong, independent, and innovative legal guardian whois helping the market to evolve to a healthier place fortrade 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

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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 premiumhold till expiry.

Advantages

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

Figure 3.3b

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) 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 settlementforward transactions. 2) Cash &Carry2) If Future Contract arbitrage continues

more or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

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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 optionwith underlying shares, earnpremium + profit with increase prcie

Advantages 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 upsidestock unlimited.

Advantages Losses Protected.

4. Exchange-traded vs. OTC derivatives markets

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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 andintegrity, and for safeguarding the collective interests of market participants, and

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

exchanges 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.

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

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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.

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 ones own

currency for a unit of another currency is called as an exchange rate.

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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-Asian currency crisis of 1990s 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

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

competitiveness of our products vis--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.

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

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late 1970s, 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.

6. 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 preconditions

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 forcharging initial margins, broker net worth, deposit requirement and realtime

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

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30 (Sense) index. This was followed by approval for trading in options based on these

two indexes and options on individual securities.

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&Osegment. It constituted 70 per cent of the total turnover during June 2012. 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.

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

since January 2012. The call-put volumes in index options have decreased from 2.86 in

January 2012 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 have natural hedge or have

potential foreign exchange earnings. But often corporate assume these risks due to

interest rate differentials and views on currencies.

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7. 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

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spot market. Finally, it is easier to take a short position in derivatives markets than it is

to sell short in spot markets.

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 comm

Indian Derivative Market - Final Tnr

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