43

CHAPTER - 3

CONCEPTUAL FRAMEWORK

The previous chapter dealt with review of literature on various research concepts of

the study. The literature is classified in to six groups and reviewed accordingly. The

literature is grouped as (i) lead- lag relationship between the futures and spot prices

(ii) Empirical testing of futures pricing models (iii) Comparison of pricing

performance of different futures pricing models (iv) The mispricing and arbitrage of

stock index futures market (v) The relationship between futures price & market

volatility and trading volume (vi) Finally, the last group contains several

miscellaneous studies that do not fit into the above groups. The review helped to

understand the concepts of futures pricing, various futures pricing models,

applications of futures pricing models and various factors which influence futures

pricing performance. Further, review of available literature helped to understand

research methodologies, analytical tools, sources of data used by the authors in

different markets across the globe. Finally, the research gaps have been identified

based on the review of literature.

This chapter deals with conceptual framework of the study. The objective of this

chapter is to understand the various theoretical concepts of the study. The theoretical

concepts of the study is classified as follows

3.1 Indian Securities Market

3.1.1 Introduction

3.1.2 National Stock Exchange (NSE)

3.1.3 History of Derivatives in India

3.1.4 Introduction to Derivatives

3.1.4.1 Introduction to Futures Contracts, Terminologies and Mechanism

3.2 Business Growth of Global Derivatives Market

3.3 Business Growth of Indian Futures Market

3.4 Futures Pricing Models

3.5 Operational definitions

44

3.1 Indian Securities Market

3.1.1 Introduction

Securities market facilitates people to invest their savings based on their risk bearing

capabilities and return expectations, by these way financial securities market

contributes growth, development and there by strengthen the emerging market

economy. People’s savings can be converted in to investments by a number of

intermediaries through complex financial products called “securities”. As per

Securities Contracts Regulation Act (1956) “securities” include (i) shares, scrips,

stocks, debentures, bonds or any other marketable securities of similar in nature (ii)

derivative securities (iii) any instrument issued to the investor under any collective

investment schemes and mutual fund schemes (iv) Government securities (v) other

instruments declared by the central government to be security (vi) rights or interest in

securities. In general, securities are broadly classified in to three categories (1)

Equities (2) Derivatives (3) Debt securities.

Securities market is a place where purchasing and selling of securities take place.

Further, it provides an opportunity to all the corporate and entrepreneurs to raise

money for their business organizations through public issues. Transfer of people’s

savings money to corporate people in a most regulated and efficient manner through

various intermediaries and the financial securities market.

Market Segments `

Securities market can be divided in to two independent segments namely (1) Primary

Market (2) Secondary Market. Primary market is the market where issue of new

securities takes place. Primary market provides opportunity to government and

corporate to raise resources through issue of securities. In the primary market new

securities can be created either through public issue or private placement. As per the

companies act 1956 section 67(3) if an issuer, issue the securities to fifty or more

persons/ investors then is referred as public issue. However , issue of securities to a

selected group of investors not more than forty nine then is referred as private

placement ( provided that issue is neither a right issue nor a public issue). In general,

corporate and governments issue equity and debt securities.

45

Secondary market is the market where buying and selling of securities takes place in

the listed stock exchange after securities being offered to the public in the primary

market. Secondary market is operated through mediums namely exchange traded

markets and Over- the- Counter markets (OTC). Currently there are 25 stock

exchanges operating in India including two major stock exchanges the Bombay Stock

Exchange (BSE) & National Stock Exchange (NSE). Stock exchanges provide a

systematic, fair, transparent and efficient security market to investors by using

electronic trading systems and technology. Stock exchanges and all the financial

intermediaries in India are constantly regulated by SEBI to protect the interest of

investors in securities market. OTC markets are informal, less transparent, less liquid,

dealers dependent market with customised procedures and trades are negotiable

through various communication modes such as telephone, email.

Security market participants

The securities market participants are generally classified in to three categories (i) The

issuer of securities (ii) The investors in securities (iii) The intermediaries

The issuers of securities are generally corporates, entrepreneurs and governments,

who are in need of resources to develop their business. The investors in securities are

generally Foreign Institutional Investors (FII), corporate investors, venture capital

investors and individual investors, who have surplus money or savings. Intermediaries

are act as middleman between issuers and investors such as stock exchanges, brokers,

portfolio manager, custodians, primary dealers, merchant bankers, underwriters etc.

All the participants of securities market are regulated by the Security and Exchange

Board of India (SEBI), Ministry of Corporate Affairs (MCA), Reserve Bank of India

(RBI) and the department of Economic Affairs of Ministry of Finance.

3.1.2 National Stock Exchange

National Stock Exchange (NSE) India, is country’s leading stock exchange was

incorporated in the year November 1992 and recognized as a stock exchange in April

1993. Just two and half years after it got recognized as stock exchange, it became

largest stock exchange in the country in terms of market capitalization. Today NSE

operates across the nation, connects more than 1500 locations and supports 230, 000

terminals in the country. NSE offering trading in capital markets, derivatives market

and debt markets. Currently there are more than 1600 companies listed in the National

46

Stock Exchange which includes almost all the major segments of the industry. NSE

was the first to introduce an automated Screen Based Trading System (SBTS) on the

capital market segment on November 3 1994 to provide transparency, efficiency,

liquidity, speed, market integrity and safety. Before NSE introduced SBTS, stocks

exchanges in India were trading based on an open autocracy system which was time

consuming and inefficient in trading operation.

NSE is providing a platform to trade all types of securities. After recognition as stock

exchange in April 1993. It commenced trading in the WDM (Wholesale Debt Market)

in June 1994, Capital Market in November, 1994, F&O (June, 2000) and Retail Debt

of Government Securities (January, 2003).

Technology and application system of NSE

NSE, India introduced National Exchange for Automated Trading (NEAT) system

which provides a fully automated screen based trading system for easy and efficient

trading. NSE was the first stock exchange in the world to trade using satellite

communication technology to connect more than 1500 locations and supports 230,000

terminals across the country. Using NEAT, investors can be traded from their places

located any part of the country. NSE’s F &O segment trading terminals are present in

different locations across the country.

NEAT is a highly technological server based application. In this server, all the trading

related information is stored and provides very quick responses with minimum time to

all the market participants. Any trade orders enters in to NSE’s NEAT system, it takes

less than 1.5 seconds to response that trade order. NSE is a technology driven

exchange. It has been implementing various technological applications systems to

provide efficient, speedy, transparency, liquidity, well clearing and settlement system

and safety to all the market participants.

The application system of NSE can be divided into (i) Front end (ii) Back office

applications. In the front end, there are 6 different applications (NEAT- WDM,

NEAT- F&O, NEAT- IPO, NEAT- MF and surveillance systems). Similarly in back

offices there are 8 application systems (NCSS- Nationwide Clearing & Settlement

System, FOCASS, PRISM- Parallel Risk Management System, - Clearing and

settlement for F&O, OPMS- Online Position Monitoring System, Data warehousing,

Listing System, and Membership System.

47

3.1.3 History of Derivatives in India

Derivatives in India can be traced back at nineteenth century (1875) the cotton trade

association was initiated the derivative futures trading. The NSE, the largest exchange

in India commenced futures trading on CNX Nifty Index in June 2000. National Stock

Exchange (NSE) was incorporated in the year November 1992 and recognized as a

stock exchange in April 1993. NSE was the first to introduce an Automated Screen

Based Trading System (SBTS) on the capital market segment on November 3 1994 to

provide transparency, efficiency & Liquidity of the stock market. As per the

recommendations by the L.C Guptha committee and J R Verma committee formed by

SEBI on exchange traded derivatives, in 1999. The Securities Contract (Regulation)

act 1956 was amended and declared derivatives as securities.

The Tables 3.1 & 3.2 present the history and milestones of derivatives in NSE. In a

span of one year after introduction of CNX Nifty index futures, NSE, India introduced

index options, individual stock options and individual stock futures. Later, NSE also

introduced currency derivatives, interest rate derivatives, 91 day Government of India

(GOI) treasury bill- futures. First time in India NSE introduced derivatives on global

indices – S & P 500, FTSE 100 and DIJA. Table 3.1 clearly shows the chronology of

derivatives in NSE in terms of introduction and developments. Table 3.2 presents all

the products traded in futures and options segments of NSE with introduction dates.

Currently there are 9 indices including 3 global indices (CNX Nifty, Bank Nifty,

CNX Infra, CNX IT, NFTY Mid Cap 500, DJIA, S& P 500 and FTSE 100) and 145

individual stocks are available for trading in futures derivatives in NSE. Similarly,

there are 5 indices including 2 global index (CNX Nifty, Bank Nifty, CNX IT, FTSE

100 and S& P 500 index) and 145 individual stocks are available for trading in

options derivatives in NSE. (As of February 2015).

48

Table: 3.1 Historical developments of derivatives in NSE, India - A Chronology

Sl

No Progress Developments of Financial derivatives

1 November 18,

1996

SEBI set up L.C. Gupta Committee to draft a policy

framework for introducing derivatives

2 May 11, 1998

L.C. Gupta committee submits its report on the policy framework for introducing derivatives

3 May 25, 2000 SEBI allows stock exchanges to trade in index futures

4 June 12, 2000 Trading of CNX Nifty index futures commences on the NSE

5 June 4, 2001 Trading of CNX Nifty options commences at NSE

6 July 2, 2001 Trading of Stock options commences at NSE

7 November 9,

2001

Trading of Stock futures commences at NSE

8 August 29, 2008 Trading of Currency derivatives commences at NSE

9 August 31, 2009 Trading of Interest rate derivatives commences at NSE

10 February 2010

Trading of Currency futures on additional currency pairs

commences at NSE

11 October 28, 2010

Trading of European style stock options commences at NSE

12 October 29,

2010

Trading of currency options commences at NSE

13 July 2011 Trading of 91 day GOI Treasury Bill – Futures commences at

NSE

14 August 2011 Trading of derivatives on global indices commences at NSE

15 January 21, 2014 NSE Introduces ‘NSE Bond Futures II’

16 February 26,

2014

Trading of futures on India VIX index (NVIX Futures)

commences at NSE

17 March 24, 2014 Trading of CNX Nifty futures commences at Osaka Securities

Exchange , Japan

(Source: Retrieved & Adapted from www.nseindia.com)

49

Table: 3.2 Products Traded in Futures & Options Segment of NSE

Sl

No Progress Products of Financial derivatives in NSE

1 June 2000 Trading of CNX NIFTY Futures (Index Futures) commences

2 June 2001 Trading of CNX NIFTY Options ( Index Options) commences

3 July 2001 Trading of Options on individual securities commences

4 November 2001 Trading in Futures on individual securities commences

5 August 2003 Trading of Futures & Options in CNXIT Index commences

6 June 2005 Trading of Futures & Options in BANK Nifty Index commences

7 June 2007 Trading of derivatives on Nifty Junior & CNX 100 commences

8 October 2007 Trading of derivatives on Nifty Midcap 50 commences

9 January 2008 Launch of Mini Nifty derivative contracts

10 March 2008 Launch of long term option contracts on CNX Nifty Index

11 August 2008 Introduction of Currency Derivatives

12 August 2009 Introduction of Interest rate futures

13 July 2010 Trading of CNX Nifty Futures on CME commences

14 July 2011 Trading in 91 Day GOI Treasury Bill – Futures commences

15 August, 2011 Introduction of derivatives on S&P 500 and DIJA Index (Global

Indices )

16 September 2011 Trading of derivatives on CNX PSE and CNX Infrastructure Indices

17 May 2012 Introduction of Futures and Options contracts on FTSE 100

18 February 2014 Introduction of NVIX Futures – Futures on India VIX index

(Source: Retrieved & Adapted from www.nseindia.com)

3.1.4 Introduction to Derivatives

According to securities contracts (regulation) act, 1956 ‘Derivative ‘includes (a). A

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

risk instrument or contract for differences or any other form of security (b) a contract

which derives its value from the prices or index of prices of underlying securities.

Basically derivative is a contract its value derived from the value of an underlying

asset. Underlying asset could be commodities such as gold, metal, energy and

financial asset such as equity shares, debt instruments like bonds, T- bills, commercial

paper, currencies and indices of these respective assets such as CNX Nifty, Bank

Nifty, and CNXIT Index. If the underlying asset is a financial asset it is called

financial derivative and if the underlying asset is commodity, it is called commodities

derivative. If the underlying asset is currency then it is known as currency derivatives.

50

Participants

As Indian capital market developed and outstandingly successful, different types of

investors/traders attracting and participating in derivatives market. These investors

use the derivatives market to minimize the risk, to earn profit and as a part of the

investment strategy. Three broad categories of participants can be found in financial

derivatives market: a) Hedgers b) Speculators c) Arbitragers

a) Hedgers: Hedging is the process of minimizing the risk involved in the

underlying market by entering opposite position in the derivatives market due

to unfavorable change in the underlying asset price. Hedgers try to

avoid/minimize the risk of unfavorable change in the underlying asset price by

locking the price through holding a position in the derivatives market.

Hedger’s position in the derivatives market decided based on the type of

exposures, they have taken in the spot market. Indian laws emphasize

derivatives should be used for hedging purpose only ( Dr.kamalesh & Neetu (

2013) )

there are two types of hedging generally investors carried out in the futures

market: i.) Short Hedge ii.) Long Hedge

i.) Short Hedge: It involves an investor enters short position in the futures

market with anticipation of decrease in the price of underlying asset which he

is already own. For example : An investor bought SBI share in the cash

market, worries that price may come down in the future and he can hedge this

price risk by entering opposite position (short) in the futures market at NSE.

This process protect the investor from incurring losses on the underlying

market. Suppose the price of SBI falls, the investor incurs loss in the cash

market, but he can compensate this loss by earning profit in the SBI futures.

In this way an investor can manage his price risk by participating in the

derivatives market (Futures).

ii.) Long Hedge: It involves an investor enters a long position in the futures

market. It involves an investor who is planning to buy underlying asset in the

near future, enters a long position in the futures market. By this process an

investor can lock the prevailing price in the market. Because he thinks that

prevailing price is very low.

51

b. Speculators: A speculator is the one who anticipate the future price of the

index/stock. They wish to take positions in the market by betting that price of the

index/ stock will go up or go down. Generally, speculators, view on the movement of

asset price. They take calculated risk and expect quick large profits from the trade.

For example: currently SBI share trading at Rs 302 in the futures market. A speculator

expects that post union budget announcement is positive towards banking sector and

SBI share will go up. Thus, the speculator can have positions of one lot of SBI shares.

In case the post union budget announcements price of SBI increases ( more than

302), then he can make profit, suppose the post union budget announcement price of

SBI share comes down then he incurs loss.

c. Arbitragers: These are the one who have potential to earn riskless profit by

simultaneously buying in one market and selling in another market. Arbitrageurs are

basically risk averse in nature and they can earn risk less profit by taking advantage of

price discrepancy between two markets. For example: Currently (06/02/2015) Unitech

Ltd, is trading at Rs 17 per share in the cash market and Unitech futures contract

trading at Rs 17.5 in the futures market. The arbitragers can earn riskless profit by

buying the Unitech share in the cash market at Rs 17 and sell (short) the same

quantity of Unitech futures contracts at Rs 17.5. Assume that on expiry day

(26/02/2015) the price of Unitech in the spot market and the price of the futures

contract converges and closes at Rs 17.2. Then the arbitrager earn profit of Rs 0.2

(17.2- 17) from the spot market and the profit of Rs 0.3 (17.5-17.2) from the futures

market respectively. Thus, finally arbitragers earn net profit of Rs 0.5 (0.2+ 0.3) from

the arbitrage process. (Assume that there is no trading cost)

Applications of Derivatives

Risk Management

Derivatives are financial instruments that are used as risk management tools. They

help to transfer risk from the risk averse to the risk taker. Futures are used as risk

management tool through hedging technique. In this technique, hedgers try to avoid

price risk through holding a position in the futures market. Further, the investor can

use derivatives to assess the level of risk he is willing to bear and accordingly he can

take the risk.

52

Risk can be defined as “The possibility or probability of loss”. In simple terms, may

be defined as the uncertainty of returns.

Market Efficiency

Efficient Market Hypothesis (EMH) states that capital markets are “Informational

efficient” that is, at the time of investment; if new information is publically available

without any bias then the investor is not possible to earn more than average market

return consistently. Further it explains an “efficient market” is the one in which the

prices of the stock always “fully reflect” all the available information.

Further, Fama (1965, 1970) explains a market conditions which support the efficiency

of the market. The efficient market is the one in which (1) the current price of a

security “fully reflects” all the publically available information (2) There are no

transaction costs (3) Market participants easily access all the available information

with low cost . Further, he says that in efficient markets investors not possible to

predict current stock prices solely by following historical price patterns and can’t earn

abnormal profits and stock prices are random walk in nature i.e. the stock prices in the

capital market will not follow any particular pattern rather a unpredictable pattern.

The current price is not depend on the past historical share prices, it purely exhibits

randomness behaviour; the past rates of return of stock market are independent. If

stock price reflects all the available information, then the investor can’t benefit over

selling or buying of stock, using that information.

Generally, derivatives help to improve the efficiency of the capital market through

self-correcting mechanism. Arbitragers are one of the market participants who have

potential to earn riskless profit. They enter the market whenever price discrepancy

exist in the market and earn risk free profit by simultaneously buying in one market at

low price and selling in another market at high price. Arbitrager’s actions will

continue till this price deviation will be adjusted back to equilibrium simultaneously

and risk less profitable arbitrage opportunity will be eliminated.

Price Discovery

Price discovery is one of the important application of financial derivatives. Price of

the futures contract reveals the future cash market prices. Market participants can

expect future underlying market prices by analysing the price of the futures contract

(one month, two month and three month futures contract). According to CCM theory,

the futures prices will more than spot prices by the cost of carry. The cost of carry

53

equals to the interest to be paid (cost) to hold the underlying asset less the cash

dividend received (benefit). Based on CCM and prices of the futures contracts

investors predict market prices and strategically invest on cash and futures market.

Liquidity and transaction cost: Futures contracts are highly liquid. To facilitate

liquidity NSE specified some standards in derivatives contracts in terms of quantity,

price, delivery and settlement. Open interest figure of derivatives contracts is a good

indicator of the liquidity. The number of outstanding contracts is known as “open

interest” and generally maximum trading volume and open interest found in near

month contracts. T Daigler (1990) found that significantly lower transaction cost of

futures over cash and the greater liquidity in the futures market. Further, only margin

money required to trade futures contracts rather than full transaction value. This

margin money is very less, generally 20 to 30% of the total transaction value, but

investor’s entitle to get profit or incur loss based on total transaction value.

For example, Unitech stock futures price /share = Rs 17.7 and lot size = 9000 then the

contract value = 17.7×9000 = Rs159300. Say margin money = 28% of the total

contract value. If a person wants to buy one lot of Unitech stock futures then he has to

deposit margin money of Rs 44604 (Initial Margin amount = 159300 × 0.28 = Rs

44604). In case the Unitech share price increases to Rs 20.5 then investor earns profit

of = Rs 0.8 /share (20.5-17.7= Rs 0.8). Totally Rs 7200 (0.8×9000= Rs7200). Thus,

actually the investor earned a profit of Rs 7200 by investing only margin money of Rs

44604.

Types of Derivatives

1. Forward Contract.

Forward contract is relatively simple contract. It is an agreement between two

parties to buy or sell an asset at a certain future time for a price agreed on today.

In forward contract, one party assumes long position and agrees to buy the

underlying asset at a certain future time for a certain price agreed on today. The

other party of the forward contract assumes short position and agrees sell the

underlying asset on the specified date for same price.

In forward contract, both the parties have an obligation to buy or sell an asset (

underlying asset), both the parties agrees to buy or sell an underlying asset at a

54

certain future time (known as expiration date) for a specified price agreed on

today ( known as Forward price)

The basic Feature of Forward contract

1. Since Forward contracts do not trade in regulated exchanges, they generally

exposed to counter party risk. The risk arises when one of the parties of the

forward contract not fulfil the obligations.

2. Forward contract is, Unique, customized and flexible in terms of contract size,

price, expiration date and settlement.

3. A forward contract is generally traded in the over- the- counter- market between

two individual or two financial institutions & one of its clients

4. Forward contracts on foreign exchange and interest rate are highly popular

5. Forward contracts are not standardized and illiquid compare to futures contracts.

2. Options

Options derivatives provide a right to an investor who buys an options but not an

obligation to either buy or sell a specific asset on a certain price on or before certain

date. An investor who buys an options is known as option buyer or option holder.

Conversely, an investor who sells an options is known as seller or option writer. There

are two types of options: 1. Call options 2. Put options

1. Call options : In this contract, the person who buys an options has a right but

not an obligation to buy a underlying asset on a certain price on or before

certain date

2. Put options: In this contract the person who buys an options has a right but not

an obligation to sell an underlying asset on a certain price on or before certain

date.

An investor who buys an options is said to be having long position and an investor

who sells an options is said to be having short position.

In both forward & futures contracts both buyer and seller have an obligation but in

case of options derivatives only option seller (option writer) has an obligation and not

the option buyer or purchaser. Here option buyer or purchaser has only an option or

right to buy or sell the underlying asset but he need not to exercise his right. More

importantly if option buyer does exercise his right then option sellers must fulfil his

obligations both in the case of call and put options contracts. Generally options can be

55

classified in to two types based on the timing of options exercise: 1. European options

contracts 2. American options contracts.

1. European options contracts: An options exercised exactly on the expiry of the

contract

2. American options contracts: An options exercised anytime on or before the

expiry date.

3.1.4.1 Introduction to Futures Contracts , terminologies and Mechanism

Futures is an exchange traded and standardized contract between two parties to buy

(long) or sell (short) an underlying asset for a certain price at a specified future date.

Futures investors can square off the transactions in any time prior to the maturity by

closing out the futures contract. There is no counter party risk for the buyers and

sellers of futures contracts because futures derivative contracts are traded through

organised exchanges, and the clearing corporation of the exchange take care the final

settlement of the contract. Futures contract is standardized in terms of underlying

quantity, price, and delivery date & month and settlement procedure.

The basic Feature of Futures contract

1. Futures investors can square off the transactions in any time prior to the maturity

by closing out the futures contract.

2. There is no counter party risk for the buyers and sellers of futures contracts

because futures derivative contracts are traded through organized exchanges, the

clearing corporation of the exchange take care the final settlement of the

contract.

3. Futures contract is standardized in terms of underlying quantity, price, delivery

date & month, settlement procedure.

4. Investors required only a margin money (The minimum percentage of total

contract value) to trade in futures market.

5. Futures markets are regulated by Security Exchange Board of India (SEBI)

56

Essential Futures terminologies

Expiry date: The date on which the final settlement of the contract takes place. NSE

futures contracts mature on the last Thursday of every month. If the last Thursday of

every month is happened to be a trading holiday, the contracts expire on immediate

previous trading day.

Contract cycle: NSE futures contracts have a maximum of 3- month trading cycle -

one month (near), the two month (next) and the three month (far). A new futures

contract is introduced on the immediate next trading day of the expiry of the first

month (near month) contract. The new contract will be introduced for three month

duration. This way, at any point in time, there will be 3 contracts available for trading

in the market i.e., one near month, one second month and one far month duration

respectively.

Contract size (Lot size): The fixed quantity of asset that has to be bought and sold

under one contract.

Contract Value - It is a transaction value of one contract is bought or sold. This can

be determined by multiplying contract size (quantities) with price of the futures. For

example, Unitech stock futures price /share = Rs 17.7 and Lot size = 9000 then the

contract value = 17.7×9000 = Rs159300. Further, Tables 3.3 & 3.4 present illustrative

example of contract value calculation for individual stock futures and stock index

futures respectively. (As on 11/01/2013)

Table: 3.3 Illustrative example of contract value calculation for individual stock

futures

Sl

No Stocks

Underlying

Price

Lot

Size

Stock Futures

Price

Total Contract

Value

A B (A × B)

1 Axis Bank Limited 1,407 250 1,409 352125

2 BHEL 231 1000 230 230150

3 Infosys Limited 2,789 125 2,799 349875

4 Maruti Suzuki India Ltd.

1,575 250 1,573 39317

5 Asian Paints Limited 4,438 125 4,449 556125

6 Colgate Palmolive Ltd.

1,435 250 1,443 360725

(Source: Retrieved & Adapted from www.nseindia.com)

57

Table: 3.4 Illustrative example of contract value calculation for stock index

futures

Sl

No Stock Index

Underlying

Value

Lot Size Index Futures Total Contract

Value

A B (A × B)

1 Nifty Midcap 50 2,395 150 2,451 3,67,665

2 CNX

Infrastructure 2,544 1,000 2,560 25,59,800

3 CNX IT 6,640 125 6,651 8,31,363

4 CNX Bank index 12,618 250 12,683 31,70,675

5 S&P CNX Nifty 5,951 125 5,977 7,47,163

(Source: Retrieved & Adapted from www.nseindia.com)

Initial margin: The minimum percentage of total contract value, futures buyer or

seller must be deposited in the margin account at the time a futures contract is first

entered. For earlier Unitech stock example, say margin money = 28% of the total

contract value. If a person wants to buy one lot of Unitech stock futures then he has to

deposit margin money of Rs 44604 (Initial Margin amount = 159300 × 0.28 = Rs

44604)

Maintenance Margin – The clearing corporation of the exchange covers the counter

party risk through mark to market settlement process. It is the process of adjusting the

margin balance based on the daily gains or losses of the futures buyers or sellers in the

futures account. If the investor gains on a particular day then that gain to be added to

previous day’s margin balance. If he loses, then that day loss amount to be deducted

from previous day’s margin balance. This type of daily settlement is known as

marking to market settlement. The minimum level of margin money, the futures

buyers and sellers must maintain throughout the holding period of the contract is

known as maintenance margin. In case the futures investor daily losses are more than

gains and margin falls to maintenance margin or below, then future investor must

transfer the additional fund to top up the margin account to the initial margin level

before commencement of next day trading.

Basis:

The difference between futures price and spot price is known as basis. Normally basis

will be positive (Futures price > Spot Price). The variation of basis differs from month

to month but near to expiry date the futures price starts converge to spot price. On the

date of expiration the basis will be zero. Fig 3.1 clearly shows the variation of basis

over January, 2013 month. It’s clearly indicating that in the beginning of the month

58

the variation of basis is larger and time passes towards the expiry the futures price

gradually started to converge to spot price. On the date of expiration the basis was

almost zero.

Figure: 3.1 Variation of Basis over a month of January, 2013

(Source: Retrieved & Adapted from www.nseindia.com)

Futures contracts are available for trading on various financial products. The

important types of futures as follows

1. Individual stock futures

2. Stock Index futures

3. Currency futures

4. Interest Rate futures

Stock Index Futures

If futures contracts traded on stock index then it is known as index futures. Here, the

underlying asset is the index itself. For example, the underlying asset for CNX Nifty

index futures traded on NSE is spot CNX Nifty Index. Currently nine major indices

are available for trading in futures and options in NSE. They are CNX NIFTY,

CNXIT, and BANKNIFTY, CNXMIDCAP50, CNX INFRA, CNXPSE, S&P 500,

DIJA and FTSE100.

Individual Stock Futures

If futures contracts traded on individual stocks then it is known as stock futures. Here,

the underlying asset is the individual company stocks which are traded in spot market.

Currently 145 individual securities are available for trading in futures and options in

NSE.

5930

5980

6030

6080

6130

1-J

an-1

3

3-J

an-1

3

5-J

an-1

3

7-J

an-1

3

9-J

an-1

3

11

-Jan

-13

13

-Jan

-13

15

-Jan

-13

17

-Jan

-13

19

-Jan

-13

21

-Jan

-13

23

-Jan

-13

25

-Jan

-13

27

-Jan

-13

29

-Jan

-13

31

-Jan

-13

Ind

ex

valu

e

Days

Basis

Futures Price Spot Price

59

Currency Futures

Currency futures is basically a futures contract to buy (long) or sell (short) or

exchange one currency against other currency for a certain price at a specified future

date. NSE was the first stock exchange got approval from SEBI for trading currency

derivatives in its exchange. NSE launched currency futures on 29th August 2008. First

Indian Rupees against US Dollars (USD/INR) were introduced for trading at NSE,

subsequently INR against other foreign currencies were introduced – Euro (EUR),

Great Britain Pound (GBP) and Japanese Yen (JPY). In NSE’s currency futures,

currently INR was allowed to trade against four foreign currencies only.

Interest Futures

Interest rate futures is basically futures contract or an agreement to buy (long) or sell

(short) a debt asset for a certain price at a specified future date. Here, the underlying

asset for interest rate futures contract is the debt instrument of either 91 day

Government of India Treasury Bill or 10 – Year government of India security (NSE

Bond Futures II). NSE introduced interest rate futures on August 31, 2009. In today’s

market environment interest rate is the one of the important macro-economic indicator

that influence various economical activities of the country. To meet this increasing

demand of debt instruments, Government of India issuing more and more long term

debt instruments and the strong need of the same required for hedging.

Table: 3.5 Specifications of the stock index and Individual stock futures of NSE

Particulars Index Futures Individual Stock

Futures

Opening Date June 12, 2000 November 2001

Products 9 Indices 141 Securities

Contract months

The near month (one), the next month

(two) and the far month (three). at any point in time, there will be 3 contracts

available for trading in the market

Same as Index Futures

Last trading

day Last Thursday of delivery month

Last Thursday of delivery

month

Price limits +/- 10% LTP +/- 10% LTP

Price steps 0.05 0.05

Base prices Daily settlement price of the futures

contracts.

Daily settlement price of

the futures contracts.

(Source: Retrieved & Adapted from www.nseindia.com)

60

NSE is India’s leading Stock Exchange incorporated in the year 1992. Indices values

of NSE calculate based on Free Float market capitalization Method (After 2008).

Currently more than 1500 securities are listed in NSE.

Table 3.5 shows the specifications of the stock index futures and individual stocks of

NSE. NSE commenced trading of index futures on June 12 2000. CNX Nifty index

futures was the first futures contract launched on NSE. Further, NSE commenced

trading of stock futures on November 2001. As per SEBI st ipulation, currently 141

individual stock futures and 9 major stock index futures including three global indices

are available for trading in NSE. NSE futures contracts have a maximum of 3- month

trading cycle - one month (near), the two month (next) and the three month (far). A

new futures contract is introduced on the immediate next trading day of the expiry of

the first month (near month) contract. NSE futures contracts both stock index futures

and individual stocks mature on the last Thursday of every month.

Table: 3.6 Main specifications of the CNX NIFTY, BANK NIFTY & CNX IT

Futures contracts of NSE

Particulars CNX Nifty Index

Futures

Bank Nifty Index

Futures

CNX IT Index

Futures

Opening Date June 12, 2000. June 2005 August 2003

Underlying Index CNX NIFTY Bank NIFTY CNX IT

Contract Size

The value of the

futures contracts on Nifty may not be

less than Rs. 2

lakhs at the time of

introduction. Lot Size- 25

The value of the

futures contracts on BANK Nifty may

not be less than Rs.

2 lakhs at the time

of introduction. Lot Size- 25

The value of the

futures contracts on CNX IT may not be

less than Rs. 2

lakhs at the time of

introduction. Lot Size- 25

Minimum price

change 0.05 0.05 0.05

Price limits +/- 10% LTP +/- 10% LTP +/- 10% LTP

Last trading Day Last Thursday of delivery month

Last Thursday of delivery month

Last Thursday of delivery month

Settlement Cash Cash Cash

(Source: Retrieved & Adapted from www.nseindia.com)

Table 3.6 shows specifications of three stock index futures of NSE - CNX NIFTY,

BANK NIFTY & CNX IT. The CNX Nifty index futures is based on popular market

bench mark CNX Nifty underlying index which is having highest trading history of

14 years, constitutes 50 major stocks and 66.85% of free float market capitalization of

NSE as on June 30, 2014. The CNXIT index futures is based on the underlying index

61

of CNXIT Index, which is having trading history of 11 years, constitutes 20 major

stocks of IT sectors, represents 97.25% of the free float market capitalization of the IT

sectors and constitutes 11.27% of the free float market capitalization of all the stocks

of NSE as on June 30, 2014. The Bank Nifty index futures is based on the underlying

index of CNX Bank Nifty index, which is having trading history of 9 years,

constitutes 12 stocks of banking sectors, represents 89.90% of the free float market

capitalization of the banking stocks which are listed in NSE and finally constituents

15.55% of the free float market capitalization of all the stocks which are listed in NSE

Selection Criteria

Eligibility Criteria of Individual Stocks to trade in F&O

1. The individual stocks will be selected from top 500 individual stocks based on

average daily turnover and average daily market capitalization from the last six

months period on a rolling basis

2. The individual stocks median quarter sigma order size should be minimum 10

lakhs.

3. The marketwise position limit (number of shares) should be minimum Rs 300

crores. The value will be calculated based on the closing price of the underlying

asset trading on expiry date of the F&O contract. Additionally the number of

underlying stocks of the F&O contract should be 20% of the total number of

underlying stocks held by non- promoters of relevant underlying security.

4. Further an existing F&O stock in order to continue eligible in trading F&O

segment, the individual stocks average monthly turnover in F&O segment from

last 3 months should be greater than 100 crores. The market wide position limit in

the stock should be greater than 100 crores. The market wide position limit in the

stock should be greater than 200 crores and stock’s median quarter – sigma order

size from last six months should be greater than 5 lakh rupees.

Procedure to calculate the quarter sigma order size

Assume that VAR (Value at Risk) is 0.03 (VAR formula suggested by J R Verma

committee guidelines), VAR value is also known as standard deviation – the

probability of stock can vary ± 3% from the current closing price on the next trading

day.

62

Quarter sigma can be calculated by multiplying 0.25 with calculated standard

deviation (one sigma). For example assume one sigma = 0.06 then, Quarter sigma=

0.25 × 0.06 = 0.015.

Quarter Sigma price (QSP) can be calculated by multiplying quarter sigma with

average price of the stock (Best buy price+ Best sell price)/ 2. For example, security

ABC, best buy (in Rs) = 200 and Best sell (in Rs) = 210 (Best buy and sell prices

taken four times a in day from NSE’s capital market segment order book). Average

price = (200+210)/2 = 205. QSP = 0.015× 205 = 3.075.

Eligibility Criteria for Indices to trade in F & O

Indices whose 80% of the constituent stocks are individually eligible for F&O

segment trading, then such indices can be introduced for trading in F&O segment.

However, the index will be ineligible if any one of the constituent ineligible

individual stock having weightage of more than 5%. SEBI applies the above criteria

every month. If index unable to meet the above criteria for 3 months continuously

then no fresh month contracts will be issued for that index.

Clearing and Settlement

National Securities Clearing Corporation Limited (NSCCL) act as legal counterparty

and completely undertakes clearing mechanism, settlement procedure and risk

management systems for all the trade contracts of F &O segment. NSCCL achieves

the clearing and settlement activities of F&O with help of (i).Clearing Member (CM)

(ii).Clearing Banks

(i). Clearing Member: Generally three different types of clearing member are found in

NSE, F&O segment. (a). Self-clearing members : Members who clear and settle the

trades executed by themselves or their clients. (b). Trading Member –cum- clearing

member: members who clears and settle the trades executed by themselves (own) and

trades executed by other trading members. (c). Professional clearing members (PCM):

The special members who clear and settle only the trades executed by trading

members.

(ii). Clearing Banks: The banks through which F&O funds settlement takes place are

known as clearing banks. NSCCL mandate to all the clearing members to open a

separate bank account with NSCCL designated clearing banks for the purpose of all

63

F&O funds settlement process. NSE’s F& O clearing and settlement process includes

the following three important activities.

1. Clearing Mechanism

2. Settlement Procedure

3. Risk Management

1. Clearing Mechanism: The objective of clearing mechanism of F & O segment

contracts are mainly two fold. First one is to identify open positions of all the

clearing members and the second one finds out the obligations of all the clearing

members. The purpose of considering open positions is to know the participants

risk exposure and daily margin status.

Trading Member’s (TM) open positions can be determined by adding proprietary

open positions with client open positions (both long and short positions)

(ii). Final Settlement of Futures contracts.

Futures contracts on both individual stocks and indices are cash settled. The final

settlement of futures contracts take place on the expiry date of contract. NSCCL

considers expiry day’s closing price and the resulting profit or loss amount is

credited or debited to the relevant clearing member’s clearing bank account on the

next day of expiry date of the contract. In NSE the last half an hour weighted

average price of the futures contract is considered as closing price of the futures

contract.

Settlement of Futures Contracts

Settlement of futures contracts (both stocks and index) are generally two types. Daily

settlement (Mark- Market settlement) and final settlement which takes place on expiry

date of the futures contract.

Mark- to Market (MTM) Settlement

In futures contracts trading, the clearing corporation of the exchange covers the

counter party risk through mark to market settlement process. It is the process of

adjusting the margin balance based on the daily gains or losses of the futures buyers

or sellers in the futures account. If the investor gains on a particular day then that gain

to be added to previous day’s margin balance. If he loses, then that day loss amount to

be deducted from previous day’s margin balance. This type of daily settlement is

64

known as marking to market settlement. The minimum level of margin money, the

futures buyers and sellers must maintain throughout the holding period of the contract

is known as maintenance margin. In case the futures investor daily losses are more

than gains and margin falls to maintenance margin or below, then future investor must

transfer the additional fund to top up the margin account to the initial margin level

before commencement of trading on the next day. Table 3.7 shows the illustrative

example of futures Mark - to - Market (MTM) settlement process.

For example

Initial Futures Price = Rs 10000 (1000 × 10); Initial Margin Requirement = Rs 5000;

Maintenance Margin Requirement - Rs 3000; Contract Size= 10

Table: 3.7 Illustrative example of futures contracts Mark- to - Market (MTM)

settlement process

Day

Beginning

Balance

(Rs)

Funds

Deposited

(Rs)

Settlement

Price (Rs)

(1000×10)

Future

Price

Changes

Gain/Loss

for entire

contract

size

End of

the day

Balance

0 0 5000 10000 - - -

1 5000 0 9200 -80 -800 4200

2 4200 0 6000 -320 -3200 1000

3 1000 4000 11000 500 5000 10000

4 10000 0 13500 250 2500 12500

5 12500 0 13000 -50 -500 12000

6 12000 0 14000 100 1000 13000

(Source: Developed by Researcher)

Risk Management

Though derivative instruments can be used as risk management tools but exposed to

high risk if it is used for trading purposes. Thus, NSCCL has taken essential measures

to reduce counterparty risk. Risk management mechanism is one of the important

components of NCSSL. Risk management mechanism includes margin requirements,

capital based position limits, online position monitoring of clearing members, capital

adequacy requirements of members, automatic stop of trading members from further

trading when limits are breached.

The paramount activities of risk management mechanism for F&O segment is

monitoring on line positions and margining system. NCSSL carried out these two

important activities. PRISM (Parallel Risk Management System) and another

65

important system called SPAN (Standard Portfolio Analysis of Risk) are used to

assess the overall risk involved in all F&O contracts of each member. Further, PRISM

monitors whether Clearing Member (CM) is collecting adequate initial margin for

futures trading and premium margin for options trading from Trading Members (TM)

and his respective clients.

Free float methodology

Free float methodology is an index construction methodology which considers free

float market capitalization of a stock to calculate the value of indices by assigning

respective weights to each stock in the index. Free float methodology considers only

the shares of the company which are readily available for trading in the stock market

(float). It generally excludes the stocks, held by government, promoters and group,

other associate/ companies (cross holding), employee welfare trusts and other locked

in shares.

Free float market capitalization is computed by multiplying Investible Weight Factors

(IWF) with total market capitalization of respective constituent stock in the index.

Total market capitalization is the product of market price per share and the total

number of outstanding shares of the company.

Example- Determination of CNX Nifty Index value

The CNX Nifty index value to be determined relative to the base period of November

3, 1995 and Base index value of 1000. The base index value derived by the market

capitalization value of CNX Nifty during the base period is equated to index value of

1000.

Total Market Capitalization = Total number of outstanding shares of all the

constituent companies of the index * Price/ share.

Free Float Market Capitalization = Total Market Capitalization * IWF

Index Value = Current Market Value / Base Market Capital * Base Index Value

(1000)

66

Determination of IWF

Ex – ABC Company

Total number of shares – 1000

Table: 3.8 Illustrative Example of percentage of shareholding for Index

Calculation

Particulars Shares %

Promoter and group 200 20

Government holding 10 1

Group of companies ( Cross holding) 20 2

Employee welfare trust 5 0.5

Lock in category shares 100 10

Total 335 33.5%

(Source: Developed by Researcher)

Table 3.8 shows the illustrative example of percentage of shareholding for index

calculation. Table 3.8 shows 33.5% of the shares hold by the people or groups other

than public.

IWF= (1000- 335) / 1000 = 0.665

IWF = 0.665 means that only 66.5% of the total market capitalization of the

ABC company will be considered for Index calculation.

67

3.2 Business Growth of Global Derivatives Market

Table: 3.9 Historical growth of Global individual stock futures and index futures

Year

Stock Futures Stock Index Futures

No of contracts

(Million)

Notional Value

(Billion $)

No of contracts

(Million)

Notional Value

(Billion $)

Volume Growth Value Growth Volume Growth Value Growth

2000 3.36 ---- ---- ---- 185.91 ---- ---- ----

2001 12.79 280.65 ---- ---- 318.23 71.17 ---- ----

2002 54.86 328.93 52.88 ---- 528.18 65.97 95739.29 ----

2003 48.13 -12.27 211.65 300.25 623.8 18.10 40283.24 -57.92

2004 81.95 70.27 447.76 111.56 738.51 18.38 42051.06 4.39

2005 140.06 70.91 650 45.17 875.16 18.50 51402.25 22.24

2006 278.43 98.79 1538.82 136.74 1160.6 32.61 75496.65 46.87

2007 618.44 122.12 2597.47 68.8 1656.25 42.70 123978.6 64.22

2008 997.61 61.31 2174.68 -16.28 2201.58 32.92 118376.4 -4.52

2009 656.46 -34.2 2096.03 -3.62 1898.29 -13.77 79145.57 -33.14

2010 847.35 29.08 2854.44 36.18 1991.55 4.91 101303.5 28

2011 1109.22 30.9 2645.93 -7.3 2504.54 25.75 118704.2 17.18

2012 1018.12 -8.21 2167.23 -18.09 2202.82 -12.04 104099.1 -12.3

2013 883.55 -13.22 2176.99 0.45 2201.1 -0.07 125484.4 20.54

2014 1022.24 15.7 2479.49 13.9 2323.54 5.56 133055.9 6.03

CAGR (%) 74.34

55.64

22.19

8.46

(Source: Developed by Researcher)

68

Table: 3.10 Historical growth of global individual stock options and index

options

Year

Stock Options Stock Index Options

No of Contracts

(Million)

Notional Value

(Billion $ )

No of Contracts

(Million)

Notional Value

(Billion $ )

Volume Growth

(%) Value

Growth

(%) Volume

Growth

(%) Value

Growth

(%)

2000 762.87 ---- ---- ---- 353.7 ---- ---- ----

2001 1126.75 47.7 ---- ---- 1161.06 228.26 ---- ----

2002 1190.99 5.7 2370.61 ---- 2312.16 99.14 10958.45 ----

2003 931.85 -21.76 1286.42 -45.73 3207.7 38.73 27516.95 151.1

2004 1669.87 79.2 2139.73 66.33 2996.72 -6.58 43430.85 57.83

2005 2139.86 28.15 3277.81 53.19 3195.77 6.64 59374.1 36.71

2006 2668.03 24.68 5610.51 71.17 3290.75 2.97 85158.57 43.43

2007 3775.04 41.49 10105.1 80.11 3794.14 15.3 131637.9 54.58

2008 4680.23 23.98 6546.44 -35.22 4115.57 8.47 103145.6 -21.64

2009 4592.45 -1.88 5240.45 -19.95 4207.24 2.23 86967.36 -15.68

2010 3808.44 -17.07 6878.67 31.26 5067.14 20.44 124768.9 43.47

2011 3877.34 1.81 7176.48 4.33 5801.51 14.49 147297.9 18.06

2012 3803.72 -1.9 8769.53 22.2 3738.82 -35.55 101403.6 -31.16

2013 3922.2 3.11 6742.63 -23.11 2916.88 -21.98 146036 44.01

2014 3714.46 -5.3 3986.66 -40.87 3329.7 14.15 99117.89 -32.13

CAGR (%) 14.85

13.64

27.62

29.04

(Source: Developed by Researcher)

The global financial derivatives market comprises of individual stock options &

futures and stock index options and futures. It is the fastest growing segment of the

global financial sector. Table 3.9 reports the statistical figures, revealed by Word

Federation of Exchange (WFE) on growth of global derivative markets .Table 3.9

shows that, since 2000, global individual stock futures size has been increased by on

average 74.43%, per year in terms of volume of contracts traded. Volume of contracts

traded for individual stock futures has been increased from 3.36 million in 2000 to

1022.24 million in 2014. Global stock index futures size has been increased by on

average 22.19%, per year in terms of volume of contracts traded. Volume of contracts

traded for stock index futures has been increased from 185.91 million in 2000 to

2323.54 million in 2014. Further, Global individual stock futures notional value has

been increased by on average 13.64%, per year. Its notional value has been increased

from 2370.61 bn $ in 2002 to 3986.66 bn $ in 2014. Global stock index futures

notional value has been increased by on average 29%, per year. Its notional value has

been increased from 10958.45 bn $ in 2002 to 99117 bn $ in 2014.

69

Table 3.10 shows global individual options stocks size has been increased by on

average 14.85%, per year in terms of volume of contracts traded. Volume of contracts

traded for individual options stocks has been increased from 762.57 million in 2000 to

3714.24 million in 2014. Global stock index options size has been increased by on

average 27.62%, per year in terms of volume of contracts traded. Volume of contracts

traded for stock index options has been increased from 353.7 million in 2000 to

3329.7 million in 2014. Further, Global individual options stocks notional value has

been increased by on average 13.64%, per year. Its notional value has been increased

from 2370.61 bn $ in 2002 to 3986.66 bn $ in 2014. Global stock index options

notional value has been increased by on average 29.04%, per year. Its notional value

has been increased from 10958.45 bn $ in 2002 to 99117 bn $ in 2014.

Further, Tables 3.9 & 3.10 clearly show that highest global derivatives growth

recorded in the year 2007 for both options and futures category. Further, it shows that

lowest global derivatives growth recorded in the year 2009 and 2012 respectively for

both options and futures category.

In the year 2007, volume of global individual stock futures and stock index futures

increased to 122.2% and 42.70 % from the previous year respectively. Notional value

of global individual stock futures and stock index futures increased to 68.8% and

64.2% from the previous year respectively. Similarly, volume of global individual

stock options and stock index options increased to 41.49% and 15.3 % from the

previous year respectively. Notional value of global individual stock options and

stock index options increased to 80.11% and 54.58 % from the previous year

respectively

Additionally, in the year 2009, volume of global individual stock futures and stock

index futures decreased to 34.2% and 13.7 % from the previous year respectively.

Notional value of global individual stock futures and stock index futures decreased to

3.6% and 33.1% from the previous year respectively. Similarly, volume of global

individual stock options and stock index options decreased to 1.88 % and increased to

2.23 % from the previous year respectively. Notional value of global individual stock

options and stock index options decreased to 19.9% and 15.6 % from the previous

year respectively.

Further, in the year 2012, volume of global individual stock futures and stock index

futures decreased to 8.21% and 12 % from the previous year respectively. Notional

70

value of global individual stock futures and stock index futures decreased to 18.09 %

and 12.3% from the previous year respectively. Similarly, volume of global individual

stock options and stock index options decreased to 1.9% and 35.5 % from the

previous year respectively. Notional value of global individual stock options and

stock index options increased to 22.2% and decreased to 31.16% from the previous

year respectively

Though volume and turnover of global derivatives remarkably increased from 2002,

the growth of global derivatives slightly decreased from last three years (2012, 2013

and 2014). From the last three years, volume of global individual stock futures and

stock index futures decreased by on average 1.91% and 14.46% per year respectively.

Notional value of global individual stock futures and stock index futures decreased by

on average 1.2 % and increased by on average 4.7 % per year respectively. Similarly,

volume of global individual stock options and stock index options decreased by on

average 1.3% and 14.4 % per year respectively. Notional value of global individual

stock options and stock index options decreased by on average 13.9 % and 6.4% per

year respectively.

Top 10 world stock exchanges by volume of derivatives contracts traded in the

year 2013.

Figure: 3.2 The Top 10 world stock exchanges by volume of single stock futures

contracts traded in the year 2013

(Source: Retrieved & Adapted from www.world-exchanges.org)

303

179 166

120 96

26 15 8 7 7 19

0

50

100

150

200

250

300

350

Mo

sco

w

Eure

x

NSE

Ind

ia

NYS

E Li

ffe

Ko

rea

Joh

ann

esb

urg

MEF

F

Thai

lan

d

On

e C

hic

ago

Ath

ens

Oth

ers

Co

ntr

acts

Tra

de

d

Stock Exchange

Number of Single Stock Futures Contracts Millions of Contracts Traded

71

Figure: 3.3 The Top 10 world stock exchanges by volume of index futures

contracts traded in the year 2013

(Source: Retrieved & Adapted from www.world-exchanges.org)

Figure: 3.4 The Top 10 world stock exchanges by volume of single stock options

contracts traded in the year 2013

(Source: Retrieved & Adapted from www.world-exchanges.org)

574

327 268 265

193 102 100 82 74 51

297

0

100

200

300

400

500

600

CM

E G

rou

p

Eure

x

Mo

sco

w

Jap

an

Ch

ina

NSE

Ind

ia

Sin

gap

ore

NYS

E Li

ffe

BM

&FB

OV

ESP

A

Ho

ng

Ko

ng

Oth

ers

Co

ntr

acts

tra

de

d

Stock Exchange

Number of Index Futures Contracts Millions of Contracts …

909

704

584

434 334

142 124 99 82 63

248

0

200

400

600

800

BM

&FB

OV

ESP

A

NA

SDA

Q O

MX

NYS

E Eu

ron

ext

CB

OE

ISE

Eu

rex

ASE

NYS

E Li

ffe

NSE

Ind

ia

BO

E

Oth

ers

Co

ntr

acts

Tra

de

d

Stock Exchange

Number of single stock options contracts Millions of Contracts …

72

Figure: 3.5 The Top 10 world stock exchanges by volume of index options

contracts traded in the year 2013

(Source: Retrieved & Adapted from www.world-exchanges.org)

Figure: 3.6 The Top 10 world stock exchanges by volume of currency derivatives

contracts traded in the year 2013

(Source: Retrieved & Adapted from www.world-exchanges.org)

930

580

317 250 230

110 92 57 48 42 121

0 100 200 300 400 500 600 700 800 900

NSE

Ind

ia

Ko

rea

Eu

rex

BSE

Lim

ited

CB

OE

TAIF

EX

CM

E G

rou

p

NYS

E Li

ffe

Tel-

Avi

v SE

Mo

sco

w

Oth

ers

Co

ntr

acts

Tra

de

d

Stock Exchange

Stcok Index Options Contracts

85

6

52

9

46

0

22

3

12

1

55

53

51

48

34

74

0

200

400

600

800

NSE

Ind

ia

MC

X-S

X

Mo

sco

w

CM

E G

rou

p

BM

&FB

OV

ESP

A

Toky

o

Ko

rea

Ro

fex

USE

Ind

ia

Joh

ann

esb

urg

Oth

ers

Co

ntr

acts

Tra

de

d

Stock Exchange

Number of Currencty Derivative Contracts Traded

73

Figure: 3.7 The Top 10 world stock exchanges by EOB number of trades in the

year 2013

(Source: Retrieved & Adapted from www.world-exchanges.org)

According to survey conducted by World Federation of Exchanges on the

performance of 62 stock exchanges across the world during the year 2013, Figures

3.2 to 3.7 present the top 10 world stock exchanges by volume of derivatives contracts

traded in the year 2013.

The Figures 3.2 to 3.7 clearly indicate that, National Stock Exchange of India has

ranked for six different reasons in top 10. Fig 3.6 shows that NSE, India, has been

ranked No 1 for number of currency derivatives contracts traded (34.19%) followed

by MCX-SX, India (21.13%), Moscow, Russia (18.37%). Fig 3.5 shows that NSE,

India, has been ranked No 1 for, number of stock index options contracts traded

(34.4%) followed by Korean Stock exchange (20.8%) and Eurex, German derivative

exchange (11.4%).

Fig 3.7 shows, it has been ranked again No 1 for Electronic Order Book (EOB)

number of trades (16.74%), followed by Shenzhen, China (14.89%), NYSE and USA

(13.73%) in the year 2013. Additionally, Fig 3.2 shows, the NSE, India has been

ranked No 3 for number of single stock futures contracts traded (17.5%), after Eurex,

German derivative exchange (18.92%) and Moscow, Russia (32.03%). Further, Fig

3.3 shows the NSE India, ranked No 6 for number of stock index futures contracts

traded (4.32%), after China (8.27%), Japan (11.3%), Moscow, Russia (11.4), Eurex,

14

49

12

89

11

88

11

53

11

52

10

32

59

9

34

5

23

6

21

1

0

200

400

600

800

1000

1200

1400

1600

NSE

Ind

ia

Shen

zhen

NYS

E

Shan

ghai

NA

SDA

Q

Ko

rea

Jap

an

BSE

Ind

ia

TM

X G

rou

p

Lo

nd

on

EOB

Nu

mb

er

Stock Exchange

EOB Number of Trades Millions of EOB traded

74

Germany (14%), CME Group Chicago Mercantile Exchange, and USA (24.6%).

Finally,

Fig 3.4 shows, the NSE , India, has been ranked No 9 for number of single stock

options contracts traded (2.17%), after NYSE Liffe - Europian Markets (2.62%), ASE

(3.28%), Eurex (3.75%), ISE- International Stock Exchange (8.82%), CBOE -

Chicago Board Options Exchange (11.47%), NYSE Euronext- US Markets (15.43%),

NASDAQ OMX – US Markets (18.36%) , BM&FBOVESPA, Brazil (24.02%)

Breakdown of global derivatives volume and notional value by region.

Figure: 3.8 The Breakdown of notional value of global single stock options by

region in the year 2013.

(Source: Retrieved & Adapted from www.world-exchanges.org)

Figure: 3.9 The Breakdown of volume of global single stock options by region in

the year 2013.

(Source: Retrieved & Adapted from www.world-exchanges.org)

Americas 68%

Asia - Pacific 13%

Europe - Africa - Middle East

19%

SINGLE STOCK OPTIONS -NOTIONAL VALUE ( USD MILLION $)

Americas 82%

Asia - Pacific 7%

Europe - Africa - Middle East

11%

GLOBAL SINGLE STOCK OPTIONS - NUMBER OF CONTRACTS TRADED

75

Figure: 3.10 The Breakdown of notional value of global index options by region

in the year 2013.

(Source: Retrieved & Adapted from www.world-exchanges.org)

Figure: 3.11 The Breakdown of volume of global index options by region in the

year 2013.

(Source: Retrieved & Adapted from www.world-exchanges.org)

Americas 33%

Asia - Pacific 54%

Europe - Africa - Middle East

13%

STOCK INDEX OPTIONS - NOTIONAL VALUE

Americas 12%

Asia - Pacific 71%

Europe - Africa - Middle East

17%

GLOBAL STOCK INDEX OPTIONS - NUMBER OF CONTRACTS TRADRD

76

Figure: 3.12 The Breakdown of notional value of global index futures by region

in the year 2013.

(Source: Retrieved & Adapted from www.world-exchanges.org)

Figure: 3.13 The Breakdown of volume of global index futures by region in the

year 2013.

(Source: Retrieved & Adapted from www.world-exchanges.org)

Americas 29%

Asia - Pacific 26%

Europe - Africa - Middle East 45%

STOCK INDEX FUTURES - NOTIONAL VALUE

Americas 29%

Asia - Pacific 37%

Europe - Africa - Middle East 34%

GLOBAL STOCK INDEX FUTURES - NUMBER OF CONTRACTS TRADED

77

Figure: 3.14 The Breakdown of notional value of global individual stock futures

by region in the year 2013

(Source: Retrieved & Adapted from www.world-exchanges.org)

Figure: 3.15 The Breakdown of volume of global individual stock futures by

region in the year 2013.

(Source: Retrieved & Adapted from www.world-exchanges.org)

According to survey conducted by World Federation of Exchanges on the

performance of world stock exchanges during the year 2013, Figures 3.8 to 3.15

present breakdown of global derivatives volume and notional value by region.

Fig 3.8 clearly indicates breakdown of global notional value of individual stock

options. After the American region stock exchanges which constitutes about 68%,

[CELLRANGE]% [CATEGORY NAME]

[CATEGORY NAME]

40.23%

[CATEGORY NAME] 59.74%

GLOBAL STOCK FUTURES- NOTIONAL VALUE

Americas 1% Asia - Pacific

29%

Europe - Africa - Middle East

70%

GLOBAL STOCK FUTURES - NUMBER OF CONTRACTS TRADED

78

Stock exchanges of Europe - Africa- Middle east region occupies second slot by

contributing 19% and Stock exchanges of Asia – Pacific region occupies third slot

with a share of 13%.

Fig.3.9 clearly shows breakdown of volume of global individual stock options. After

the American region stock exchanges which constitutes major proportions about 82%,

Stock Exchanges of Europe- Africa- Middle east region occupies second slot with a

share of 11%. Stock Exchanges of Asia – Pacific region occupies third slot by

contributing 7%.

Fig.3.10 clearly indicates breakdown of notional value of global stock index options.

After the Asia – Pacific region stock exchanges with a share of 54%, Stock exchanges

of American region occupies second slot by contributing 33% and Stock exchanges of

Europe- Africa- Middle east region occupies third slot with a share of 13%.

Fig.3.11 clearly presents breakdown of volume of global stock index options. After

the Asia – Pacific region stock exchanges with a share of 71%, Europe- Africa-

Middle east region Stock exchanges of occupies second slot by contributing 17% and

Stock exchanges of American region occupies third slot with a share of 12%.

Fig.3.12 clearly shows breakdown of notional value of global stock index futures.

After the Europe- Africa- Middle east stock exchanges with a share of 45%, American

region stock exchanges occupies second slot by contributing 29% and Stock

exchanges of Asia – Pacific region occupies third slot with a share of 26%.

Fig.3.13 clearly presents breakdown of volume of global stock index futures. After

the Asia – Pacific region stock exchanges with a share of 37%, Europe- Africa-

Middle east region Stock exchanges of occupies second slot by contributing 34% and

Stock exchanges of American region occupies third slot with a share of 29%.

Fig.3.14 clearly presents breakdown of notional value of global individual stock

futures. After the Europe- Africa- Middle east stock exchanges with a share of

59.74%, Asia – Pacific region Stock exchanges of occupies second slot with a share

79

of 40.23% and American Stock exchanges of occupies third slot with a least share of

0.02%.

Fig.3.15 clearly shows breakdown of volume of global individual stock futures. After

the Europe- Africa- Middle east stock exchanges with a major share of 70%, Asia –

Pacific region Stock exchanges of occupies second slot with a share of 29% and

American Stock exchanges occupies third slot with a least share of 1%.

Overall from the Figures 3.8 to 3.15, it can be summarize that American stock

exchanges dominates Trading of Major proportion of global individual stock options

in terms of both notional value and trading volume. Asia – Pacific region Stock

exchanges dominates trading of major proportion of global stock index options in

terms of both notional value and trading volume. Europe- Africa- Middle east stock

exchanges dominates trading of major proportion of individual stock futures in terms

of both notional value and trading volume. Though all the three regions contribute

major proportion of trading of stock index futures, Asia – Pacific region Stock

exchanges and Europe- Africa- Middle east stock exchanges dominates trading of

major proportion of global stock index futures in terms of trading volume and

notional value respectively. Finally Figures 3.14 & 3.15 show that American Stock

Exchanges occupies very minute share (0.02 % and 1%) in trading global individual

stock futures both in terms of notional value and trading volume.

80

Table: 3.11 largest global domestic equity market capitalization at year-end 2013

Sl

No Stock Exchange

Market

Capitalisation Number of

Domestic

Companies

Number of

Foreign

Companies

Total USD

Billion %

1 NYSE Euronext (US) 17950 29.85 1852 519 2371

2 NASDAQ OMX (US) 6085 10.12 2328 309 2637

3 Japan Exchange Group 4543 7.55 3408 11 3419

4 London Stock Exchange

Group 4429 7.36 - - 2490

5 NYSE Euronext (Europe) 3584 5.96 935 127 1062

6 Hong Kong Exchanges 3101 5.16 1553 90 1643

7 Shanghai SE 2497 4.15 1536 NA 1536

8 TMX Group 2114 3.52 3810 76 3886

9 Deutsche Börse 1936 3.22 639 81 720

10 SIX Swiss Exchange 1541 2.56 236 36 272

11 Shenzhen SE 1452 2.41 1536 NA 1536

12 Australian stock exchange 1365 2.27 1955 100 2055

13 NASDAQ OMX Nordic

Exchange 1269 2.11 755 27 728

14 BSE ,India 1138 1.89 5294 NA 5294

15 BME Spanish Exchanges 1116 1.86 3213 32 3245

16 NSE, India 1112 1.85 1678 1 1679

17 BM&FBOVESPA 1020 1.70 352 11 363

18 Johannesburg SE 942 1.57 322 53 375

19 Taiwan SE 822 1.37 802 64 866

20 Others 2124 3.53 - - 7311

Total 60140 100 32204

43488

(Source: Retrieved & Adapted from www.world-exchanges.org)

According to survey conducted by World Federation of Exchanges on the

performance of 62 world stock exchanges during the year 2013. Table 3.11 presents

largest global domestic equity market capitalization at the year-end 2013. It clearly

indicates that in the year 2013 global equity market capitalization reached 60140

Billion US $. Out of 62 world stock exchanges 19 world stock exchanges alone

constituents 96.47% of total global domestic equity market capitalization. Top 7

world stock exchanges (NYSE Euronext (US) , NASDAQ OMX (US) , Japan

Exchange Group, London Stock Exchange Group, NYSE Euronext (Europe) , Hong

Kong Exchanges and Shanghai SE alone constitutes 70% of the total global

domestic market capitalization in the year 2013. Further BSE, and NSE, India

occupies 14th and 16th slot with a share of 1.89% and 1.85% of world domestic equity

market capitalization respectively.

81

Further, the Table 3.11 shows that number of domestic companies and foreign

companies listed in each major stock exchanges of the world. There are totally 32204

domestic companies listed in global stock exchanges. BSE, India, is the top stock

exchange in terms of number of domestic companies listed (5295) followed by TMX

Group (3810), Japan Exchange Group (3408), BME Spanish Exchanges (3213) and

NASDAQ OMX (US) (2328), Australian stock exchange (1955), NYSE Euronext

(US) (1852) and NSE, India (1678).

3.3 Business Growth of Indian Derivatives Market

Business Growth of F & O at NSE

Figure: 3.16 Product-wise distribution of turnover of F&O segment of NSE

(2013–2014)

(Source: Retrieved & Adapted from www.nseindia.com)

Fig.3.16 presents product wise turnover of derivative (Futures and Options) segment

in NSE in the year 2013-2014. Fig.3.16 clearly indicates that index options is the

leader in the product wise turnover of futures and options segment of the NSE. The

turnover of index options contributed highest share of 73 % of the total turnover in the

Futures & Options segment of the NSE followed by stock futures and index futures

which account of 13% and 8% of the total turnover in the F & O segment of NSE

respectively. The turnover of stock options contributed lowest share of 6% of the total

turnover in the futures & options segment of the NSE. This statistics are revealed that

more investors are attracting and preferring index options segment of the NSE than

other products of F&O.

Index Futures 8%

Stock Futures 13%

Index Options 73%

Stock Options 6%

F& O TURNOVER

82

Table: 3.12 Business growth of index futures at NSE

Year

Index Futures

No of contracts Turnover

Volume

(Million) Growth (%)

Volume

(Rs. Billion) Growth (%)

2000-01 0.09 --- 23.65 ---

2001-02 1.03 1032.25 214.83 808.37

2002-03 2.13 107.37 439.52 104.59

2003-04 17.19 708.35 5544.46 1161.48

2004-05 21.64 25.85 7721.47 39.26

2005-06 58.54 170.56 15137.55 96.04

2006-07 81.49 39.20 25395.74 67.77

2007-08 156.60 92.18 38206.67 50.45

2008-09 210.43 34.37 35701.11 -6.56

2009-10 178.31 -15.26 39343.89 10.20

2010-11 165.02 -7.45 43567.55 10.74

2011-12 146.19 -11.41 35779.98 -17.87

2012-13 96.10 -34.26 25271.31 -29.37

2013-14 105.25 9.52 30831.03 22.00

CAGR (%)

66.55

66.90

(Source: Retrieved & Adapted from www.nseindia.com)

Figure: 3.17 The historical business growth of index futures in terms of number

of contracts traded at NSE, India

(Source: Table: 3.12)

0.0

9

1.0

3

2.1

3

17

.19

21

.64

58

.54

81

.49

15

6.6

0 2

10

.43

17

8.3

1

16

5.0

2

14

6.1

9

96

.10

10

5.2

5

0.00

50.00

100.00

150.00

200.00

250.00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Nu

mb

er

of

Co

ntr

acts

( M

n)

Year

83

Figure: 3.18 The historical business growth of index futures in terms of turnover

at NSE, India

(Source: Table: 3.12)

NSE, commenced trading of derivatives first time in India by introducing CNX Nifty

index futures on June 2000. Right from introduction of Nifty index futures on June

2000, over a period time NSE introduced many more indices on futures. Currently (as

of march 2015) there are 9 indices including 3 global indices are available for trading

in futures derivatives in NSE). In fact, NSE India, ranked top 6 among 62 world stock

exchanges for number of index futures contracts traded (4.32%) globally during the

year 2013. As index futures is in the third slot by contributing 8% of the total turnover

in the F &O segment in the year 2013-14 at NSE after index options (73%) and stock

futures ( 13%) respectively, there is a huge scope for significant growth of index

futures turnover.

Table 3.12 shows the business growth of index futures at NSE in terms of number of

contracts traded and turnover from 2000 -01 to 2013 -14. The size of the index futures

at NSE in terms of number of contracts traded has increased from 0.09 million in 200-

2001 to 105.25 million in 2013-14. Similarly, the index futures turnover at NSE has

increased from 23.65 Rs Billion in 2000-01 to 30831.03 Rs Billion in 2013- 14.

Additionally, the size of the index futures at NSE in terms of number of contracts

traded witnessed a CAGR (Compounded Annual Growth Rate) of 66.55% in last 14

years. Similarly, the index futures turnover at NSE witnessed a CAGR of 66.90 % in

last 14 years.

Further, Table 3.12 and Fig. 3.17 clearly show that growth of index futures in terms

of number of contracts traded has increased remarkably from 2001-02 to 2008 -09

23

.65

21

4.8

3

43

9.5

2

55

44

.46

77

21

.47

15

13

7.5

5

25

39

5.7

4

38

20

6.6

7

35

70

1.1

1

39

34

3.8

9

43

56

7.5

5

35

77

9.9

8

25

27

1.3

1

30

83

1.0

3

0.00 5000.00

10000.00 15000.00 20000.00 25000.00 30000.00 35000.00 40000.00 45000.00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Turn

ove

r (

Rs

Bn

)

Year

Turnover- Index Futures

84

but the growth is declined continuously from the year 2009-10 to 2012-13 due to

global financial crisis like recession and euro zone debt crisis. Similarly, Table 3.12

and Fig. 3.18 indicate that the growth of index futures in terms of turnover has

increased significantly year after year excluding 2008-09, 2011-12 and 2012-13 with

decline of 6.56%, 17.37% and 29.37 % respectively due to global financial crisis.

Table: 3.13 Business growth of individual stock futures at NSE

Year

Stock Futures

No of Contracts (Million) Turnover (Rs Billion)

Volume Growth (%) Value Growth (%)

2001-02 1.96 ---- 515.15 ----

2002-03 10.68 444.90 2865.33 456.21

2003-04 32.37 203.09 13059.39 355.77

2004-05 47.04 45.32 14840.56 13.64

2005-06 80.91 72.00 27916.97 88.11

2006-07 104.96 29.72 38309.67 37.23

2007-08 203.59 93.97 75485.63 97.04

2008-09 221.58 8.84 34796.42 -53.90

2009-10 145.59 -34.29 51952.47 49.30

2010-11 186.04 27.78 54957.57 5.78

2011-12 158.34 -14.89 40746.71 -25.86

2012-13 147.71 -6.71 42238.72 3.66

2013-14 170.71 15.57 49492.82 17.17

CAGR (%)

41

42

(Source: Retrieved & Adapted from www.nseindia.com)

85

Figure: 3.19 The historical business growth of stock futures in terms of number

of contracts traded at NSE, India

(Source: Table: 3.13)

Figure: 3.20 The historical business growth of stock futures in terms of turnover

at NSE, India

(Source: Table: 3.13)

NSE, commenced trading of individual stock futures on November 2001. Over a

period time NSE introduced many more individual stocks on futures. Currently (as of

march 2015) there are 145 individual stocks are available for trading in futures

1.9

6

10

.68

32

.37

47

.04

80

.91

10

4.9

6

20

3.5

9

22

1.5

8

14

5.5

9 18

6.0

4

15

8.3

4

14

7.7

1

17

0.7

1

0.00

25.00

50.00

75.00

100.00

125.00

150.00

175.00

200.00

225.00

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Co

ntr

acts

( m

illio

n)

Year

Number of Contarcts- Stock Futures

51

5.1

5

28

65

.33

13

05

9.3

9

14

84

0.5

6

27

91

6.9

7

38

30

9.6

7

75

48

5.6

3

34

79

6.4

2

51

95

2.4

7

54

95

7.5

7

40

74

6.7

1

42

23

8.7

2

49

49

2.8

2

0.00

10000.00

20000.00

30000.00

40000.00

50000.00

60000.00

70000.00

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Turn

ove

r (

Rs

Bn

)

Year

Turnover- Stock Futures

86

derivatives in NSE. In fact, NSE India, ranked top 3 among 62 world stock exchanges

for number of stock futures contracts traded (17.5%) globally during the year 2013

and stock futures is in the second slot by contributing 13% of the total turnover in the

F &O segment in the year 2013-14 at NSE after index options (73%).

Table 3.13 reveals that the business growth of stock futures at NSE in terms of

number of contracts traded and turnover from 2001 - 02 to 2013 -14. The size of the

stock futures at NSE in terms of number of contracts traded has increased from 1.96

million in 2001- 02 to 170.71 million in 2013-14. Similarly, the stock futures turnover

at NSE has increased from 515.15 Rs Billion in 2001-02 to 49492. 82 Rs Billion in

2013- 14. Additionally, the size of the stock futures at NSE in terms of number of

contracts traded witnessed a CAGR (Compounded Annual Growth Rate) of 41 % in

the last 13 years. Similarly, the stock futures turnover at NSE witnessed a CAGR of

42 % in the last 13 years.

Further, Table 3.13 and Fig.3.19 clearly show that growth of stock futures in terms of

number of contracts traded has increased significantly from 2001- 02 to 2008 -09 but

the growth declined in the year 2009-10 , 2011-12 and 2012- 13 due to global

financial crisis like recession and euro zone debt crisis. Similarly, Table 3.13 and Fig.

3.20 indicate that the growth of stock futures in terms of turnover has increased

significantly year after year especially from the year 2006-07 to 2008-09. But stock

futures declined in the year 2008- 09 (53.90%) and 2011-12 (25.86%) respectively

due to global financial crisis.

87

Table: 3.14 Business growth of index options at NSE

Year

Index Options

No of contracts (Million) Turnover (Rs Billion)

Volume

(Million)

Growth

(%)

Value

(Rs Billion)

Growth

(%)

2001-02 0.18 ---- 37.65 ----

2002-03 0.44 151.42 92.46 145.58

2003-04 1.73 291.74 528.16 471.23

2004-05 3.29 90.11 1219.43 130.88

2005-06 12.94 292.74 3384.69 177.56

2006-07 25.16 94.49 7919.06 133.97

2007-08 55.37 120.08 13621.11 72.00

2008-09 212.09 283.07 37315.02 173.95

2009-10 341.38 60.96 80279.64 115.14

2010-11 650.64 90.59 183653.66 128.77

2011-12 864.02 32.80 227200.32 23.71

2012-13 820.88 -4.99 227815.74 0.27

2013-14 928.57 13.12 277673.41 21.89

CAGR (%)

93.33

98.39

(Source: Retrieved & Adapted from www.nseindia.com)

Figure: 3.21 The historical business growth of index options in terms of number

of contracts traded at NSE, India

(Source: Table: 3.14)

0.1

8

0.4

4

1.7

3

3.2

9

12

.94

25

.16

55

.37

21

2.0

9

34

1.3

8 6

50

.64

86

4.0

2

82

0.8

8

92

8.5

7

0.00

200.00

400.00

600.00

800.00

1000.00

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

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20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Nu

mb

er

of

Co

ntr

acts

( M

n)

Year

Number of Contracts- Index Options

88

Figure: 3.22 The historical business growth of index options in terms of turnover

at NSE, India

(Source: Table: 3.14)

NSE, commenced trading of index options on June 2001. Over a period of time NSE

introduced many more indices on options. Currently (as of march 2015) there are 5

indices including 2 global index ( CNX Nifty, Bank Nifty, CNX IT, FTSE 100 and S

& P 500 index ) are available for trading in index options in NSE. In fact, NSE India,

has been ranked No 1 among 62 world stock exchanges for number of index options

contracts traded (34.4%) globally during the year 2013 and more importantly index

options in the first slot by contributing 73% of the total turnover in the F &O segment

in the year 2013-14 at NSE, followed by stock futures and Index futures which

account of 13% and 8% respectively.

Table 3.14 presents that the growth of stock futures at NSE in terms of number of

contracts traded and turnover from 2001 -02 to 2013 -14. The size of the index

options at NSE in terms of number of contracts traded has tremendously increased

from 0.18 million in 2001-02 to 928.57 million in 2013-14. Similarly, index options

turnover at NSE has increased from 37.65 Rs Billion in 2001-02 to 277673.41 Rs

Billion in 2013- 14. Additionally, the size of the index options at NSE in terms of

number of contracts traded witnessed a highest CAGR (Compounded Annual Growth

Rate) of 93.33 % in the last 13 years. Similarly, the index options turnover at NSE

witnessed a highest CAGR of 98.39 % in last 13 years.

Further, Table 3.14 and Fig.3.21 clearly show that growth of index options in terms of

number of contracts traded has increased continuously from 2001-02 to 2013-14

excluding in the year 2012-13 due to global financial crisis. Similarly, Table 3.14 and

37

.65

92

.46

52

8.1

6

12

19

.43

33

84

.69

79

19

.06

13

62

1.1

1

37

31

5.0

2

80

27

9.6

4

18

36

53

.66

22

72

00

.32

22

78

15

.74

27

76

73

.41

0.00

50000.00

100000.00

150000.00

200000.00

250000.00

300000.00

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Turn

ove

r( R

s B

n)

Year

Turnover- Index Option

89

Fig 3.22 indicate that the growth of index options in terms of turnover has

tremendously increased continuously year after year from 2001-02 to 2013-14. This

statistics clearly indicates that index options is the leader in the product wise turnover

of F&O segment of NSE. More and more investors are attracting and preferring index

options segment of the NSE than other products of F&O.

Table: 3.15 Business growth of individual stock options at NSE

Year

Stock Options

No of Contracts Turnover

Volume

(Million) Growth (%)

Value

(Rs Billion) Growth (%)

2001-02 1.04 ---- 251.63 ----

2002-03 3.52 239.56 1001.31 297.93

2003-04 5.58 58.47 2172.07 116.92

2004-05 5.05 -9.64 1688.36 -22.27

2005-06 5.24 3.88 1802.53 6.76

2006-07 5.28 0.81 1937.95 7.51

2007-08 9.46 79.07 3591.37 85.32

2008-09 13.30 40.54 2292.27 -36.17

2009-10 14.02 5.42 5060.65 120.77

2010-11 32.51 131.93 10303.44 103.60

2011-12 36.49 12.26 9770.31 -5.17

2012-13 66.78 82.98 20004.27 104.75

2013-14 80.17 20.06 24094.89 20.45

CAGR (%)

39.71

49.03

(Source: Retrieved & Adapted from www.nseindia.com)

Figure: 3.23 The historical business growth of stock options in terms of number

of contracts traded at NSE, India

(Source: Table: 3.15)

1.0

4

3.5

2

5.5

8

5.0

5

5.2

4

5.2

8

9.4

6

13

.30

14

.02

32

.51

36

.49

66

.78

80

.17

0.00 10.00 20.00 30.00 40.00 50.00 60.00 70.00 80.00

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Nu

mb

er

of

Co

trac

ts (

Mn

)

Year

Number of Contracts -Stock Options

90

Figure: 3.24 The historical business growth of stock options in terms of turnover

at NSE, India

(Source: Table: 3.15)

NSE, commenced trading of individual stock options on July 2001. Over a period

time NSE introduced many more individual stocks on options. Currently (as of march

2015) there are 145 individual stocks are available for trading in stock options in

NSE. In fact, NSE India, ranked top 9 among 62 world stock exchanges for number of

stock futures contracts traded (2.17%) globally during the year 2013 and Stock

options is in the last slot by contributing only 6% of the total turnover in the F &O

segment in the year 2013-14 at NSE after index options (73%), stock futures (13%)

and index futures (8%) respectively.

Table 3.15 reveals that the growth of stock options at NSE in terms of number of

contracts traded and turnover from 2001-02 to 2013 -14. The size of the stock options

at NSE in terms of number of contracts traded has increased from 1.04 million in

2001-02 to 80.17 million in 2013-14. Similarly, the stock options turnover at NSE has

increased from 251.63 Rs Billion in 2001-02 to 24094.89 Rs Billion in 2013- 14.

Additionally, the size of the stock options at NSE in terms of number of contracts

traded witnessed a CAGR (Compounded Annual Growth Rate) of 39.71% in the last

13 years. Similarly, the stock options turnover at NSE witnessed a CAGR of 49.03 %

in last 13 years.

Further, Table 3.15 and Fig. 3.23 clearly show that growth of stock options in terms

of number of contracts traded has increased slightly from 2001-02 (1.04mn) to 2009 -

10 (14.02 mn) . Moreover the growth is almost constant from the year 2003-04 to

2006-07 (5.58 mn, 5.05 mn, 5.24 mn and 5.28mn) but the growth significantly

increased from the year 2009-10 to 2013-14. Similarly, Table 3.15 and Fig.3.24

25

1.6

3

10

01

.31

21

72

.07

16

88

.36

18

02

.53

19

37

.95

35

91

.37

22

92

.27

50

60

.65

10

30

3.4

4

97

70

.31

20

00

4.2

7

24

09

4.8

9

0.00

5000.00

10000.00

15000.00

20000.00

25000.00

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Turn

ove

r (

Rs

Bn

)

Year

Stock Options - Turnover

91

indicate that the growth of stock options in terms of turnover has increased

significantly in the beginning and later it has slightly increased from the year 2004-05

to 2008-09. Moreover the growth of stock options turnover has increased significantly

from the year 2009-10 to 2013-14. This statistics clearly revealed that investors are

not preferring and attracting stock options of NSE compared to other products of F&

O. Stock options of NSE has a huge scope of improvement in terms of volume and

turnover.

Table: 3.16 Business growth of Futures & Options at NSE

Year

Futures & Options

No of contracts Turnover Average Daily

Turnover

Volume

(Million)

Growth

(%)

Value

(Rs Billion)

Growth

(%)

Value

(Rs Billion)

2000-01 0.09 ---- 23.65 ---- 0.11

2001-02 4.20 4533.33 1019.26 4209.77 4.10

2002-03 16.77 299.56 4398.62 331.55 17.52

2003-04 56.89 239.24 21306.10 384.38 83.88

2004-05 77.02 35.39 25469.82 19.54 101.07

2005-06 157.62 104.65 48241.74 89.41 192.20

2006-07 216.88 37.60 73562.42 52.49 295.43

2007-08 425.01 95.96 130904.78 77.95 521.53

2008-09 657.39 54.68 110104.82 -15.89 453.11

2009-10 679.29 3.33 176636.65 60.43 723.92

2010-11 1034.21 52.25 292482.21 65.58 1151.50

2011-12 1205.05 16.52 313497.32 7.19 1259.03

2012-13 1131.47 -6.11 315330.04 0.58 1266.39

2013-14 1284.42 13.52 382114.08 21.18 1522.37

CAGR (%)

97.40

99.80 97.6

(Source: Retrieved & Adapted from www.nseindia.com)

92

Figure: 3.25 The historical business growth of both Futures & Options in terms

of number of contracts traded at NSE, India

(Source: Table: 3.16)

Figure: 3.26 The historical business growth of both Futures & Options in terms

of turnover at NSE, India

(Source: Table: 3.16)

0.0

9

4.2

0

16

.77

56

.89

77

.02

15

7.6

2

21

6.8

8

42

5.0

1

65

7.3

9

67

9.2

9

10

34

.21

12

05

.05

11

31

.47

12

84

.42

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Nu

mb

er

of

Co

ntr

acts

( M

n)

Year

Number of Contracts- F &O

23

.65

10

19

.26

43

98

.62

21

30

6.1

0

25

46

9.8

2

48

24

1.7

4

73

56

2.4

2

13

09

04

.78

11

01

04

.82

17

66

36

.65

29

24

82

.21

31

34

97

.32

31

53

30

.04

38

21

14

.08

0.00

100000.00

200000.00

300000.00

400000.00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Turn

ove

r (

Rs

Bn

)

Year

Turnover - F &O

93

Figure: 3.27 The historical business growth of both Futures & Options in terms

of daily turnover at NSE, India

(Source: Table: 3.16)

NSE, commenced trading of derivatives on June 2000 by introducing index futures.

Over a period of time NSE introduced many more indices on options and futures.

Currently (as of march 2015) there are nine major indices including 3 global are

available for trading at NSE.

Table 3.16 presents that the growth of F& O at NSE in terms of number of contracts

traded and turnover from 2000 -01 to 2013 -14. The size of the F&O at NSE in terms

of number of contracts traded has tremendously increased from 0.09 million in 2000-

01 to1284.42 million in 2013-14. Similarly, F&O turnover at NSE has significantly

increased from 23.65 Rs Billion in 2000-01 to 382114.08 Rs Billion in 2013- 14.

Additionally, the size of the F & O at NSE in terms of number of contracts traded

witnessed a highest CAGR (Compounded Annual Growth Rate) of 97.40 % in the last

14 years. Similarly, the F&O turnover at NSE witnessed a highest CAGR of 90.80 %

in last 14 years.

Further, Table 3.16 and Fig .3.25 clearly show that growth of F & O in terms of

number of contracts traded has increased continuously from 2000-01 to 2013-14

excluding in the year 2012-13 due to global financial. Similarly, Table 3.16 and

Fig.3.26 indicate that the growth of F& O in terms of turnover has tremendously

increased continuously year after year from 2001-02 to 2013-14. Moreover, the

growth of F&O in terms of volume and turnover is declined in the years 2011-12 to

2013-14 compared to previous years.

0.1

1

4.1

0

17

.52

83

.88

10

1.0

7

19

2.2

0

29

5.4

3

52

1.5

3

45

3.1

1

72

3.9

2

11

51

.50

12

59

.03

12

66

.39

15

22

.37

0.00

200.00

400.00

600.00

800.00

1000.00

1200.00

1400.00

1600.00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Ave

rage

Dai

ly T

urn

ove

r (

Rs

Bn

)

Year

Average Daily Turnover - F &O

94

Additionally Table 3.16 and Fig.3.27 clearly show the average daily turnover of

overall F&O at NSE from 2000-01 to 2013-14. The overall average daily turnover of

F& O at NSE has significantly increased from 0.11 Rs Billion in 2000-01 to 1522.37

Rs Billion in 2013-14. The size of the F & O at NSE in terms of turnover witnessed a

highest CAGR (Compounded Annual Growth Rate) of 97.6 % in the last 14 years.

Figure: 3.28 Product-wise distribution of turnover of F&O segment of NSE

(Source: Retrieved & Adapted from www.nseindia.com)

Fig.3.28 shows product wise turnover of derivative (Futures and Options) segment in

the NSE from 2000-01 to 2013-14. Fig.3.28 clearly indicates that in the year 2000-

01, index futures alone contributed 100% turnover because it was the only product

available for trading in F &O at NSE. Further Fig.3.28 shows that the following years

(2001-02 to 2007-09) stock futures dominated F & O segment followed by index

futures, index options and stock options respectively at NSE. However, from the year

2008-09 to 2013 -14 index options gradually occupied first slot by contributing

highest turnover in product wise distribution of turnover of F &O segment. The

turnover growth of index options has tremendously increased from 10% in the year

2007- 08 to 73% in the year 2013-14 followed by stock futures, index futures and

stock options.

10

0

21

10

26

30

31

35

29

32

22

15

11

8

8

51

65

61

58

58

52

58

32

29

19

13

13

13

4 2

2 5 7

11

10

34

45

63

72

72

73

25

23

10

7 4 3

3 2

3

4

3

6

6

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

% T

urn

ove

r

index futures stock Futures Index Options stock Options

95

Figure: 3.29 CAGR Analysis of F&O Segment of NSE

(Source: Retrieved & Adapted from www.nseindia.com)

The Fig 3.29 shows CAGR (Compound Annual Growth Rate) analysis of futures and

options (F & O) segment at NSE from the year 2000-01 to 2013-14. It’s clearly

indicating that index options witnessed phenomenal and highest growth rate (93.33%

and 98.39%) in terms of both number of contracts traded and turnover followed by

index futures, stock options and stock futures.

66

.55

41

93

.33

39

.71

66

.9

42

98

.39

49

.03

0

10

20

30

40

50

60

70

80

90

100

index futures stock futures Index options stock options

CA

GR

(%)

No of contracts Turnover

96

Table: 3.17 Business growth of equity segment at NSE

Year

No. of

Compa

nies

Listed

Market

Capitalizati

on

(Rs Billion)

Growth

(%)

Turnover

(Rs

Billion)

Growth

(%)

Avg.

Daily

Turnover

(Rs

Billion)

Growth

(%)

1994-95 135 3633.5 --- 18.05 --- 0.17 ---

1995-96 422 4014.59 10.49 672.87 3627.81 2.76 1523.53

1996-97 550 4193.67 4.46 2945.03 337.68 11.76 326.09

1997-98 612 4815.03 14.82 3701.93 25.70 15.2 29.25

1998-99 648 4911.75 2.01 4144.74 11.96 16.51 8.62

1999-

2000 720 10204.26 107.75 8390.52 102.44 33.03 100.06

2000-01 785 6578.47 -35.53 13395.1 59.65 53.37 61.58

2001-02 793 6368.61 -3.19 5131.67 -61.69 20.78 -61.06

2002-03 818 5371.33 -15.66 6179.89 20.43 24.62 18.48

2003-04 909 11209.76 108.70 10995.35 77.92 43.28 75.79

2004-05 970 15855.85 41.45 11400.71 3.69 45.06 4.11

2005-06 1,069 28132.01 77.42 15695.56 37.67 62.53 38.77

2006-07 1,228 33673.5 19.70 19452.85 23.94 78.12 24.93

2007-08 1,381 48581.22 44.27 35510.38 82.55 141.48 81.11

2008-09 1,432 28961.94 -40.38 27520.23 -22.50 113.25 -19.95

2009-10 1,470 60091.73 107.49 41380.24 50.36 169.59 49.75

2010-11 1,574 67026.16 11.54 35774.12 -13.55 140.48 -17.16

2011-12 1,646 60965.18 -9.04 28108.93 -21.43 112.89 -19.64

2012-13 1,666 62390.35 2.34 27082.79 -3.65 108.33 -4.03

2013-14 1695 64205.4 2.91 23429.96 -13.48 111.18 2.63

CAGR

(%) 1.15

1.43

1.38

(Source: Retrieved & Adapted from www.nseindia.com)

97

Figure: 3.30 The historical business growth of equity segment in terms of

turnover at NSE, India

(Source: Table: 3.17)

Table 3.17 and Fig.3.30 present equity segment turnover at NSE has tremendously

increased from Rs 18.05 Billion in 1994-95 to Rs Billion 23429.96 in 2013- 14.

Additionally, the size of the equity segment at NSE in terms of turnover witnessed a

high CAGR (Compounded Annual Growth Rate) of 43 % in last 20 years. Further,

Table 3.17 and Fig.3.30 clearly show that growth of equity turnover has increased

continuously from 1994-95 to 2000-01 excluding in the year 2001- 02 and 2008-09

due to global financial crisis. Finally, the growth of equity turnover is continuously

decreasing from 2009-10.

Figure: 3.31 The historical business growth of equity segment in terms of

average daily turnover at NSE, India

(Source: Table: 3.17)

18

.05

67

3

2,9

45

3,7

02

4,1

45

8,3

91

13

,39

5

5,1

32

6,1

80

10

,99

5

11

,40

1

15

,69

6

19

,45

3

35

,51

0

27

,52

0

41

,38

0 3

57

74

.12

28

10

8.9

3

27

08

2.7

9

23

42

9.9

6

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

19

94

-95

19

95

-96

19

96

-97

19

97

-98

19

98

-99

19

99

-20

00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Turn

ove

r (R

s B

n)

Year

NSE- Equity Turnover

0.1

7

2.7

6

11

.76

15

.2

17

33

53

21

25

43

45

63

78

14

1.4

8

11

3

17

0

14

0

11

3

10

8

11

1.1

8

0 25 50 75

100 125 150 175

19

94

-95

19

95

-96

19

96

-97

19

97

-98

19

98

-99

19

99

-20

00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Ave

rage

Dai

ly T

urn

ove

r( R

s B

illio

n)

Year

Average Daily Turnover

98

The Table 3.17 and Fig.3.31 clearly show the average daily turnover of equity

segment at NSE from 1994-95 to 2013-14. The average daily turnover of equity

segment at NSE has significantly increased from Rs 0.17 Billion in 1994-95 to Rs

111.18 Billion in 2013-14. The size of the equity segment at NSE in terms of average

daily turnover witnessed a CAGR (Compounded Annual Growth Rate) of 38 % in last

20 years. Fig.3.31 show that the growth of average daily turnover of equity segment is

in decreasing trend from 2009-10.

Figure: 3.32 The historical business growth of equity segment in terms of market

capitalization at NSE, India

(Source: Table: 3.17)

The Table 3.17 and Fig.3.32 present the market capitalization of equity segment at

NSE from 1994-95 to 2013-14. The market capitalization of equity segment at NSE

has significantly increased from Rs 3633.5 Billion in 1994-95 to Rs 64205.4 Billion

in 2013-14. The size of the equity segment at NSE in terms of market capitalization

witnessed a CAGR (Compounded Annual Growth Rate) of 15 % in last 20 years. Fig.

3.32 clearly shows that the growth of market capitalization is almost constant in the

initial years and continuously increased from 2001-03 to 2007-08. Then suddenly

decreased (40%) in the year 2008-09 due to global financial crisis. Market

capitalization of equity segment is in decreasing trend from 2009-10. Finally the

growth of market capitalization increased (107%) within one year and almost constant

from 2011-12 to 2013-14.

36

33

.5

4,0

15

4,1

94

4,8

15

4,9

12

10

,20

4

6,5

78

6,3

69

5,3

71

11

,21

0

15

,85

6

28

,13

2

33

,67

4

48

,58

1

28

,96

2 6

0,0

92

67

02

6.1

6

60

96

5.1

8

62

39

0.3

5

64

20

5.4

0

10000

20000

30000

40000

50000

60000

70000

19

94

-95

19

95

-96

19

96

-97

19

97

-98

19

98

-99

19

99

-20

00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Mar

ket C

apit

aliz

atio

n (

Rs

Bill

ion

)

Year

Market Capitlizaion

99

Table: 3.18 Relative analysis of Equity and F&O turnover at NSE

Year Turnover Rs (Billion) Number of times F&O is

Bigger than Equity Equity F&O

2000-01 13,395 24 0.00

2001-02 5,132 1,019 0.20

2002-03 6,180 4,399 0.71

2003-04 10,995 21,306 1.94

2004-05 11,401 25,470 2.23

2005-06 15,696 48,242 3.07

2006-07 19,453 73,562 3.78

2007-08 35,510 1,30,905 3.69

2008-09 27,520 1,10,105 4.00

2009-10 41,380 1,76,637 4.27

2010-11 35,774 2,92,482 8.18

2011-12 28,109 3,13,497 11.15

2012-13 27,083 3,15,330 11.64

2013-14 23,430 3,82,114 16.31

(Source: Retrieved & Adapted from www.nseindia.com)

Figure: 3.33 Relative analysis of Equity and F&O turnover of NSE

(Source: Table: 3.18)

Table 3.18 & Fig.3.33 clearly show that comparison of equity and F&O turnover from

2001- 01 to 2013-14. Right from launching of derivatives in the year 2000-01 ,

turnover of F&O continuously increasing year after year remarkably. Fig.3.33 clearly

shows, how big the derivatives market in terms of turnover compared to equity

segment. The equity turnover is continuously decreasing from the year 2009-10,

whereas the growth of F&O is tremendously increasing right from its launching at

NSE. Table 3.18 shows that the size of F&O in terms of turnover surpassed the cash

market within three years of its launching at NSE. More importantly in the year 2013-

0 50,000

100,000 150,000 200,000 250,000 300,000 350,000 400,000

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

Turn

ove

r (R

s B

n)

Turnover of F&O and Equity

Equity F&O

100

14 the size of the F&O in terms of turnover is 16.31 times bigger than the cash

market.

3.4 Futures Pricing Models

The study considered three futures pricing models to predict futures prices. They are

(1) Cost of Carry Model (CCM) (2) Hemler and Longstaff Model (HLM) (3) Hsu and

Wang Model (HWM). The CCM incorporates risk-free interest rates and constant

dividend Yield and developed an assumption that capital markets are perfect and

arbitrage mechanism completes. HLM incorporates risk free interest rates and market

volatility and developed with an assumption of capital markets are perfect. The HWM

incorporates price expectation parameter and developed an assumption that capital

markets are imperfect. The detail discussions about these models are as follows.

1. Cost of Carry Model ( CCM)

Cornell and French (1983) derived CCM in perfect market based on following

assumptions.

1. Capital Markets are perfect – There are no taxes or transaction costs, there are

no restrictions on short sales and assets are perfectly divisible.

2. The risk –free borrowing and lending rates are equal and constant.

3. The underlying stock index pays a continuous constant dividend yield, q,

during the life of the futures contract

Ft = St e (r−q) (T−t),

Where Ft is the theoretical futures price at time t for a contract that matures at a time

T, St is the current stock price at time t; r is the annualized risk free interest rate (Cost

of financing); q is constant annual dividend yield, T-t represents time to maturity.

CCM was developed under the assumption of perfect market and no arbitrage

arguments. According to CCM, the futures prices will exceed the spot prices by the

cost of carry. The cost of carry equal to the cost of holding the underlying asset

(interest forgone) less the benefit (cash dividend received). Suppose if any deviation

of actual futures price from its theoretical ‘Fair Price’ estimated by CCM then

arbitragers use an opportunity and earn riskless profit by simultaneously buying in

one market at low price and selling in another market at high price. Arbitrager’s

101

actions will continue till this price deviation will be adjusted back to equilibrium

simultaneously and risk less profitable arbitrage opportunity will be eliminated.

Cost of carry Model and arbitrage Mechanism.

CCM is based on familiar ‘Cost of Carry’ principle. It argues that, the cost of carry for

a dividend paying stock is equal to the difference between interest rate and dividend

yield. In a perfect Market, the futures price for a dividend paying stock must equal to

the deferred value of the current stock price. In case, if any violations from equality, it

leads an arbitrage opportunity for an investor to earn riskless profit.

An investor earns arbitrage profit by undertaking two kinds of trades.

A. Trade 1- Ft > St e (r-q)T

Suppose, futures price at a time t greater than the cost of purchasing the stock less the

dividend and carrying till maturity of the futures contract, Investor can earn riskless

profit by Short the futures and buy the Underlying stock. The transaction as follows

i. Borrow St rupees at risk free interest rate of r and purchase one unit of

underlying stock.

ii. Short one futures contract

The total payoff an investor gets at maturity period T equals to the difference

between a futures price and underlying stock price with interest less the dividend

for T-t period

Total Payoff = Ft - St e (r-q) T

B. Trade 2- St e (r-q)T > Ft

Suppose Futures price at a time t lesser than the cost of purchasing the stock (r-q) and

carrying till maturity of the futures contract, Investor can earn riskless profit by Short

the underlying stock and invest the same at the risk free rate of interest ( r) and buy

one futures contract. The transaction as follows

i. Short the underlying stock and invest the same at the risk free rate of interest

(r).

ii. Long one futures contract

The total payoff of an investor gets at maturity period T equals to the difference

between the underlying stock price with interest for T-t period and a futures price

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Total Payoff = St e (r-q)T - Ft.

Finally perfect markets are fair and competitive and do not allow an investor to make

risk free profits. When trading occurs, there is a possibility of deviation of actual

futures price from theoretical futures price estimated by CCM. The arbitrageurs step

in to take advantage of this deviation by buying from the market at cheaper price and

selling in the market at higher price. Their actions quickly narrow the prices and

thereby minimizing the imperfections. By this way derivative futures reduce the

market inefficiencies by providing a self-correcting mechanism.

2. Hemler and Longstaff Model

In determining stock index futures prices. Nevertheless, stock market volatility is

excluded from the CCM and states that Market volatility should not have explanatory

power for futures prices.

Motivated by these considerations Michael L. Hemler and Francis A. Longstaff

(1991) followed the CIR (Cox et al., 1985a,b) framework and developed a closed

form general equilibrium model of stock index futures prices in a continuous

economy with risk free interest rate and market volatility. The implications of this

general equilibrium model for stock index futures prices are generally quite different

from those of the CCM and are testable using regression analysis. When the natural

logarithm of the dividend adjusted futures to spot price ratio can be represented as

linear function of two variables, the risk free interest rate and the market volatility,

they find that market volatility has significant explanatory power. These results are

consistent with the general equilibrium model, but not the cost of carry model. The

regression equation is

Lt = α+β1 rt+ β2 vt +εt

Where Lt = ln (Fteqτ /St ) is the logarithm of the dividend adjusted futures / Spot price

ratio,

Ft is the theoretical Futures price, St is the underlying spot index, τ is the time to

maturity ( T-t) , rt is the Risk free interest rate, Vt is the market volatility , α,β1& β2

are the regression coefficients. ε is the error part assumed to be normally distributed

with mean zero.

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The empirical testing of HLM involves two stage procedures. One , it is assumed that

theoretical futures price is derived from HLM is differed from actual or observed

futures prices by a mean of zero . Hence the regression coefficients of α, β1 & β2 can

be obtained. Second stage involves substituting the estimated α, β1 & β2 to the HLM

to generate the estimate of the dividend adjusted futures / Spot price ratio Lt . Finally

the theoretical futures price (Ft) can obtain by inferring Lt.

Similarly, the natural logarithm of the CCM forward price can be represented as a

linear regression equation. In contrast to the equilibrium model, the CCM implies that

the logarithm of the dividend adjusted futures / spot price ratio depends on the risk-

free rate only and the market volatility should not have explanatory power for Lt i.e

β2= 0 . Finally the CCM implies that the interest rate coefficients (β1) should be

equivalent to the average contract maturity in years i.e β1= T-t .From the discussion it

clearly indicates that the CCM can be nested within the equilibrium regression model

(1), thus restrictions imposed by the CCM can be tested within same framework by

substituting α = 0, β1= T-t and β2= 0, then HLM equation reduces to Lt = rtτ

3. Hsu & Wang Model

Hsu & Wang (2004) incorporated price expectation parameter (uα) and developed

futures pricing model in imperfect market.

This study uses the following assumptions to develop a futures pricing model of stock

index futures in imperfect markets: (1) the underlying stock index pays a continuous

constant dividend yield, q, during the life of the futures contract. (2) The

instantaneous DOMI remains constant throughout the life of the futures contract. (3)

The underlying stock index price, S, follows a geometric Wiener process, as follows:

HWM considered a hedged portfolio that comprises one unit of spot index and x units

of index futures. The model assumes that initially cash outflow is not required for the

futures contract. Then the rate of return of the hedged portfolio is illustrated by

(wf uf + u ) dt + (wf σf +σ ) dZ (14)

Where P is the hedged portfolio, wf =

, S represents the price of the underlying

stock index , F denotes the price of the index futures, U & σ represents constant

expected growth rate and constant volatility of the underlying stock index (S)

respectively. uf & σf denotes the instantaneous expected return on futures and

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instantaneous standard deviation of return on futures respectively and dz is a

geometric wiener process.

Further, If Wf = -

then wf σf +σ =0. uf & u remain same but second part in

equation (14) become zero. It indicates that, the hedged portfolio (P) can be expected

certainly and hedged portfolio becomes riskless. However, in order to keep this

portfolio risk free, it is necessary to rebalance wf continuously until expiration of the

futures contract. Figlewski (1989) found that, forming riskless portfolio hedge and

continuously rebalancing hedged positions is only possible in perfect markets.

Because of incomplete arbitrage mechanism and arbitrage process are exposed to

heavy risk, the hedged portfolio is not possible to riskless at any point of time.

Let up & σp represents the instantaneous expected rate of return of the hedged portfolio

(P) & the coefficient of winear process dz in the equation (14) respectively. This can

be obtained as follows.

wf uf+ u = up (15)

wf σf + σ= σp (16)

From equation (15) & (16) the result of partial differential equation can be obtained as

follows

σ2 S2Fss + uα SFs + Ft = 0 (17)

Where uα is the Hsu & Wang’s price expectation parameter uα = [ up-q) – (u-q)

] / (

1-

)

The second order partial differential equation (17) along with the following index

futures price terminal condition at expiry date (T), fully characterizes the index

futures price.

F(S, T) = St

Finally the solution of Partial Differential Equation is given by

F (S, T) = St euα(T-t)

Degree of market imperfection (DOMI)

Hsu & Wang also proposes the concept of DOMI for imperfect markets and its

valuation model. Using the argument of completion of arbitrage argument for perfect

markets & PDE technology. Hsu & Wang also derived the second order partial

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differential equation for stock index futures prices in perfect markets, given by as

follows

σ2 S2Fss + (r-q) SFs + Ft = 0 (18)

Hsu and Wang compare PDE (17) for imperfect markets & PDE (18) for perfect

markets. As discusses earlier, in perfect markets arbitrage mechanism works

completely. Whenever the arbitrage mechanism completes, the portfolio comprises

underlying stocks & stock futures becomes perfectly hedged portfolio and portfolio

becomes riskless, thus σp =0 . If σp =0, then the price expectation parameter uα = [ up-

q) – (u-q)

] / ( 1-

) equals to (r-q).

[If σp =0, then σ

σ also equals to zero, as

σ

σ = 0, then (1-

σ

σ equals to 1]

PDE (17) for imperfect markets now is identical to PDE ( 18) for perfect markets,

thus it indicates that , whenever the capital market is perfect and arbitrage mechanism

works completely , the PDE of futures pricing model for stock index in imperfect

markets is similar to the PDE for standard CCM in perfect markets. Conversely

whenever the capital markets are imperfect and the arbitrage mechanism is not able to

complete, then the arbitrage process is exposes to large risk, thus the hedged portfolio

is not possible to continuously riskless and σp > 0, then, σ

σ also greater than zero and

PDE (17) & PDE (18) are not identical. Thus, Hsu & Wang concludes ‘ σ

σ ‘as the

degree of market imperfection.

3.5 Operational definitions

Perfect Market

Cornell and French (1983) explained perfect market is the one in which

i. There are no taxes

ii. No trading costs or transaction costs

iii. No constraints on short sales- short selling process involves selling the

security at higher price and buying back the same security at lower price.

In short selling investors can sell the security even does not own or he gas

borrowed. There is no constrains on a security even its price declines any

parentage in a day.

iv. Securities are perfectly divisible – it is possible to buy fractional shares.

v. It’s possible to borrow and lend at the same risk free interest rate

vi. traders may have homogeneous or symmetric information

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If any new information disseminating in to the market which interpreted

and traded by both futures and cash market investors immediately and

simultaneously as a result there will be no lagged responses and arbitrage

opportunities.

Imperfect Market or Market Imperfection

Hsu and Wang (2004) explained market imperfection or imperfect market is the one

which involves

i. Transaction Costs including brokerage commission, bid &ask spread,

ii. Taxes including service tax on brokerage, stamp duty, security transaction

tax

iii. There are constraints on short sales –. Restrictions on short sales means. If

any of the security declines more than a particular percentage in a day ,

the circuit breaker would be triggered and prevented from further trading

of that security in that day.

iv. Securities are not perfectly divisible or indivisible - preventing investors

from buying or selling exact quantity of securities.

v. It’s not possible to borrow and lend at the same risk free interest rate.

vi. Traders may have heterogeneous or asymmetric information.

Under-price (Premium) - The actual futures price is lower than the theoretical price

estimated by the pricing model.

Overprice (Discount) - The actual price is higher than the theoretical price estimated

by the pricing model.

Lead- Lag relationship - Lead - lag relationship basically determines which of the

two markets (Underlying and Futures market) reacts most quickly to new information

thus leading it.