DECLERATION

I,Ramchandra dwivedi, a student of M.B.A. (2010-12) studying at Indian

Institute of Planning and Management Indore, I declare that the project work

titled- “INDIAN DERIVATIVE MARKET” was carried out by me at RELIGARE

SECURITIES Ltd.; Indore, in partial fulfillment of the M.B.A. Summer training

program. This program was undertaken as a part of academic curriculum

according to the college rules and norms and by no commercial interest and

motives.

Place: - Indore RAMCHANDRA DWIVEDIDate: - IIPM/ISBE-B/SS/2010-12

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

I, RAMCHANDRA DWIVEDI hereby take this opportunity to express

my sincere gratitude to the following eminent personalities whose aid and

advice helped me to complete this project work successfully without any

difficulty.

I am sincerely thankful to Management Team of Religare Securities

Ltd. Indore, for their valuable support and the interest they have shown in

me during the course of the project.

I am thankful to MR. ASHISH DEODIA , (Religare Securities Ltd.

Indore) for giving me an opportunity to take up this Project.

I would also like to extend my gratitude to my Faculty Guide MR.

ABHISHEK BARUA & BHUPENDRA RAGHUVANSHI who spared her

valuable time and effort to ably guide me in the completion of the project.

I would like to extend my sincere thanks to Mr.SHUSANT JAIN,

(Religare Securities Ltd. Indore), who spent their valuable time in

providing us the best information & knowledge,.

RAMCHANDRA DWIVEDI

TABLE OF CONTENTS

S. No. TOPICS .

1. Introduction.2.3.4.

Company ProfileNeed of the Study.Objective of the Study.Scope of the Study.

5. Main Topics of Study 1) Introduction to Derivative. 2) Derivative Defined. 3) Types of Derivatives Market. 4) Types of Derivatives.

i) Forward Contracts. ii) Future Contracts. iii) iv)

Options. Swap.

5) Other Kinds of Derivatives.

6. History of Derivatives.

7.8.9.

10.

Indian Derivative Market.Development of Derivative Market In India.Benefits Of Derivative.

National Exchange.

Bibliography.

Abbreviations.

INTRODUCTION

A Derivative is a financial instrument whose value depends on other, more

basic, underlying variables. The variables underlying could be prices of traded

securities and stock, prices of gold or copper.

Derivatives have become increasingly important in the field of finance,

Options and Futures are traded actively on many exchanges, Forward

contracts, Swap and different types of options are regularly traded outside

exchanges by financial intuitions, banks and their corporate clients in what

are termed as over-the-counter markets – in other words, there is no single

market place or organized exchanges.

NEED OF THE STUDY

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

to know the derivative market in India. This study also covers the recent

developments in the derivative market taking into account the trading in past

years.

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

their use in the stock markets.

OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives

To know the role of derivatives trading in India.

MAIN TOPICS OF STUDY

1. INTRODUCTION TO DERIVATIVE

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

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

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

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

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

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

reducing risk.

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

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

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

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

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

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

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

although favourable prices could be obtained during periods of oversupply.

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

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

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

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

to eliminate the price risk.

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

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

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

2. DERIVATIVE DEFINED

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

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

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

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

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

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

is the “underlying” in this case.

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

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

Markets Commission (FMC) continues to have jurisdiction over commodity

futures contracts. However when derivatives trading in securities was introduced

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

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

Consequently, regulation of derivatives came under the purview of Securities

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

for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of

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

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

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

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

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

underlying securities.

3. TYPES OF DERIVATIVES MARKET

Derivatives

Future Option Forward Swaps

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Bombay Stock National Commodity & Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES

Figure.2 Types of Derivatives

(i) FORWARD CONTRACTS

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

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

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

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

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

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

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

outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

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

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

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

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

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

asset.

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

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

However forward contracts in certain markets have become very

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

transaction costs and increasing transactions volume. This process of

standardization reaches its limit in the organized futures market. Forward

contracts are often confused with futures contracts. The confusion is

primarily because both serve essentially the same economic funct ions

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

are a significant improvement over the forward contracts as they

eliminate counterparty risk and offer more liquidity.

(ii) FUTURE CONTRACT

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

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

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

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

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

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

date.

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

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

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

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

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

contract obligations. Futures contracts are exchange traded derivatives. The

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

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:

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

specifying:

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

short term interest rate.

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

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

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

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

interest rate is traded, etc.

The currency in which the futures contract is quoted.

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

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

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

delivery. The delivery month.

The last trading date.

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

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

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

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

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

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

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

or spread traders who have offsetting contracts balancing the position.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

collateral from which the loss is paid.

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

two ways, as specified per type of futures contract:

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

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

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

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

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

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

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

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

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

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

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

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

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

the t forward contract.

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

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

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

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

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

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

of risk-free return .

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

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

follows.

In the case where the forward price is higher:

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

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

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

In the case where the forward price is lower:

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

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

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

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

TABLE 1-DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between

two parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes the

counter party to all the trades or

unconditionally guarantees their

settlement.

Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs of

the needs of the parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets

are scattered.

Efficient, as markets are centralized

and all buyers and sellers come to a

common platform to discover the

price.

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

and Individual stock Futures in India.

OPTIONS -

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

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

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

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

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

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

CALL OPTION:

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

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

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

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

PUT OPTION:

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

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

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

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

exercised if the future price does not increase.

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

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

SWAPS -

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

INTEREST RATE SWAPS:

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

CURRENCY SWAPS:

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

FINANCIAL SWAP:

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

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

BASKETS -

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

are most popular form of baskets.

LEAPS -

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

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

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

Equity Anticipation Securities.

WARRANTS -

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

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

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

SWAPTIONS -

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

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

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

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

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

6. HISTORY OF DERIVATIVES:

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

people think. Forward delivery contracts, stating what is to be delivered for a

fixed price at a specified place on a specified date, existed in ancient Greece and

Rome. Roman emperors entered forward contracts to provide the masses with

their supply of Egyptian grain. These contracts were also undertaken between

farmers and merchants to eliminate risk arising out of uncertain future prices of

grains. Thus, forward contracts have existed for centuries for hedging price risk.

The first organized commodity exchange came into existence

in the early 1700’s in Japan. The first formal commodities exchange, the Chicago

Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem

of ‘credit risk’ and to provide centralised location to negotiate forward contracts.

From ‘forward’ trading in commodities emerged the commodity ‘futures’. The first

type of futures contract was called ‘to arrive at’. Trading in futures began on the

CBOT in the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives

contract, known as the futures contracts. Futures trading grew out of the need for

hedging the price risk involved in many commercial operations. The Chicago

Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it

did exist before in 1874 under the names of ‘Chicago Produce Exchange’ (CPE)

and ‘Chicago Egg and Butter Board’ (CEBB). The first financial futures to emerge

were the currency in 1972 in the US. The first foreign currency futures were

traded on May 16, 1972, on International Monetary Market (IMM), a division of

CME. The currency futures traded on the IMM are the British Pound, the

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

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

interest rate futures. Interest rate futures contracts were traded for the first time

on the CBOT on October 20, 1975. Stock index futures and options emerged in

1982. The first stock index futures contracts were traded on Kansas City Board of

Trade on February 24, 1982.The first of the several networks, which offered a

trading link between two exchanges, was formed between the Singapore

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

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

and Rome. Options are very popular with speculators in the tulip craze of

seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol

of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers

and dealers traded in tulip bulb options. There was so much speculation that

people even mortgaged their homes and businesses. These speculators were

wiped out when the tulip craze collapsed in 1637 as there was no mechanism to

guarantee the performance of the option terms.

The first call and put options were invented by an American

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

Agricultural commodities options were traded in the nineteenth century in

England and the US. Options on shares were available in the US on the over the

counter (OTC) market only until 1973 without much knowledge of valuation. A

group of firms known as Put and Call brokers and Dealer’s Association was set

up in early 1900’s to provide a mechanism for bringing buyers and sellers

together.

On April 26, 1973, the Chicago Board options Exchange

(CBOE) was set up at CBOT for the purpose of trading stock options. It was in

1973 again that black, Merton, and Scholes invented the famous Black-Scholes

Option Formula. This model helped in assessing the fair price of an option which

led to an increased interest in trading of options. With the options markets

becoming increasingly popular, the American Stock Exchange (AMEX) and the

Philadelphia Stock Exchange (PHLX) began trading in options in 1975.

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

nineties. The collapse of the Bretton Woods regime of fixed parties and the

introduction of floating rates for currencies in the international financial markets

paved the way for development of a number of financial derivatives which served

as effective risk management tools to cope with market uncertainties.

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

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

contracts (with the annual volume at more than 211 million in 2001).The CBOE is

the largest exchange for trading stock options. The CBOE trades options on the

S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the

premier exchange for trading foreign options.

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

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

Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago

Mercantile Exchange.

7. INDIAN DERIVATIVES MARKET

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

fluctuate every day. The introduction of risk management instruments in India gained

momentum in the last few years due to liberalisation process and Reserve Bank of India’s

(RBI) efforts in creating currency forward market. Derivatives are an integral part of

liberalisation process to manage risk. NSE gauging the market requirements initiated the

process of setting up derivative markets in India. In July 1999, derivatives trading

commenced in India

Table 2. Chronology of instruments

1991                        Liberalisation process initiated 

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

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

framework for index futures.

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

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps.

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

Indian index.

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

futures trading.

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

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September

2000

Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

(1) Need for derivatives in India today

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

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

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

the world.

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

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

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

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

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

markets. Introduction of risk management instruments in India has gained

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

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

large market.

5. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

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

globalisation of the markets, technological developments and advances in the

financial theories.

A.} PRICE VOLATILITY –

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

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

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

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

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

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

is called as an exchange rate.

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

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

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

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

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

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

magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

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

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

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

markets and rapid industrialisation of many underdeveloped countries brought a

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

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

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

surface. The advent of telecommunication and data processing bought

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

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

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

rapidly.

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

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

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

bonds.

B.} GLOBALISATION OF MARKETS –

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

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

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

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

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

profit margins

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

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

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

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

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

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

globalisation of industrial and financial activities necessitates use of derivatives to

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

derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES –

A significant growth of derivative instruments has been driven by technological

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

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

related to advances in computer technology are advances in

telecommunications. Improvement in communications allow for instantaneous

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

were significant advances in software programmes without which computer and

telecommunication advances would be meaningless. These facilitated the more

rapid movement of information and consequently its instantaneous impact on

market price.

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

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

overtime the greater price volatility exposes producers and consumers to greater

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

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

market economy. To the extent the technological developments increase

volatility, derivatives and risk management products become that much more

important.

D.} ADVANCES IN FINANCIAL THEORIES –

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

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

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

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

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

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

which led to the growth of derivatives in financial markets.

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

instruments

8. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

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

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

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

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

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

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

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

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

derivatives trading in India. The committee recommended that derivatives should

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

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

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

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

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

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

requirement and real–time monitoring requirements. The Securities Contract

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

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

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

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

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

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

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

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

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

commence trading and settlement in approved derivatives contracts. To begin

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

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

based on these two indexes and options on individual securities.

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

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

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

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

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

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

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

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

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

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

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

Exchange traded derivative products.

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

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

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

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

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

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

erstwhile badla system.

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

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

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

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

commissions by recommending index options to their clients, because low

volatility leads to higher waiting time for round-trips.

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

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

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

ratio suggests that the traders are increasingly becoming pessimistic on the

market.

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

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

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

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

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

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

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

on the option premiums.

The spot foreign exchange market remains the most important segment

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

exchange swaps account for the largest share of the total turnover of

derivatives in India followed by forwards and options. Significant

milestones in the development of derivatives market have been (i)

permission to banks to undertake cross currency derivative transactions

subject to certain conditions (1996) (ii) allowing corporates to undertake long

term foreign currency swaps that contributed to the development of the

term currency swap market (1997) (iii) allowing dollar rupee options (2003)

and (iv) introduction of currency futures (2008). I would like to emphasise

that currency swaps allowed companies with ECBs to swap their foreign

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

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

corporate. Normally such risks should be taken by corporates who have

natural hedge or have potential foreign exchange earnings. But often

corporate assume these risks due to interest rate differentials and views on

currencies.

This period has also witnessed several relaxations in regulations relating to

forex markets and also greater liberalisation in capital account regulations

leading to greater integration with the global economy.

Cash settled exchange traded currency futures have made foreign

currency a separate asset class that can be traded without any underlying

need or exposure a n d on a leveraged basis on the recognized stock

exchanges with credit risks being assumed by the central counterparty

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

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

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

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

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

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

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

9. BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT –

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

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

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

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

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

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

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

2.] PRICE DISCOVERY –

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

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

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

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

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

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

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

3.] OPERATIONAL ADVANTAGES –

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

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

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

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

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

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

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

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

4.] MARKET EFFICIENCY –

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

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

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

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

values.

5.] EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative to engaging in

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

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

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

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

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

The derivative market performs a number of economic functions.

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

expiration of derivative contract. Thus derivatives help in discovery of

future as well as current prices.

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

acts as a catalyst for new entrepreneurial activity.

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

Transfer of risk enables market participants to expand their volume of

activity.

10. National Exchanges

In enhancing the institutional capabilities for futures trading the idea of

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

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

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

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

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

automatically permitted to conduct futures trading in all commodities subject to

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

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

Mumbai commenced operations in October/ December 2003 respectively.

MCX

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

mutulised multi commodity exchange has permanent recognition from

Government of India for facilitating online trading, clearing and settlement

operations for commodity futures markets across the country. Key shareholders

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

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

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

Canera Bank, Corporation Bank Headquartered in Mumbai, MCX is led by an

expert management team with deep domain knowledge of the commodity futures

markets. Today MCX is offering spectacular growth opportunities and

advantages to a large cross section of the participants including Producers /

Processors, Traders, Corporate, Regional Trading Canters, Importers, Exporters,

Cooperatives, Industry Associations, amongst others MCX being nation-wide

commodity exchange, offering multiple commodities for trading with wide reach

and penetration and robust infrastructure.

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

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

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

settlement operations for a commodities futures trading.

NMCE

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

by Central Warehousing Corporation (CWC), National Agricultural Cooperative

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

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

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

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

cooperatives, private and public sector marketing of agricultural commodities,

research and training were adequately addressed in structuring the Exchange,

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

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

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

relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested

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

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

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

transparent rule-based procedures and demonstrated total commitment towards

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

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

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

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

NMCE follows best international risk management practices. The

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

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

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

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

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

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

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

Warehouse Receipt System, leading to guaranteed clearing and settlement.

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology

driven commodity exchange. It is a public limited company registered under the

Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai

on April 23,2003. It has an independent Board of Directors and professionals not

having any vested interest in commodity markets. It has been launched to

provide a world-class commodity exchange platform for market participants to

trade in a wide spectrum of commodity derivatives driven by best global

practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures

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

like the Companies Act, Stamp Act, Contracts Act, Forward Commission

(Regulation) Act and various other legislations, which impinge on its working. It is

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

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

NCDEX currently facilitates trading of thirty six commodities - Cashew,

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

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

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

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

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

Peas, Yellow Red Maize & Yellow Soybean Meal.

BIBLIOGRAPHY

Books referred:

Options Futures, and other Derivatives by John C Hull

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

Financial Markets & Services by Gordon & Natarajan

Websites visited:

www.nse-india.com

www.bseindia.com

www.sebi.gov.in

www.ncdex.com

www.google.com

www.derivativesindia.com

ABBREVATIONS

A

AMEX- America Stock Exchange

B

BSE- Bombay Stock Exchange

BSI- British Standard Institute

C

CBOE - Chicago Board options Exchange

CBOT - Chicago Board of Trade

CEBB - Chicago Egg and Butter Board

CME - Chicago Mercantile Exchange

CNX- Crisil Nse 50 Index

CPE - Chicago Produce Exchange

CWC- Central Warehousing Corporation

D

DTSS- Derivative Trading Settlement System

F

FIIs- Foreign Institutional Investors

F & O – Future and Options

FMC- Forward Markets Commission

FRAs- Forward Rate Agreements

G

GAICL-Gujarat Agro Industries Corporation Limited

GSAMB- Gujarat State Agricultural Marketing Board

I

IMM - International Monetary Market

IPSTA- India Pepper & Spice Trade Association

M

MCX – Multi Commodity Exchange

N

NAFED-National Agricultural Co-Operative Marketing Federation Of India

NCDEX – National Commodities and Derivatives Exchange

NIAM- National Institute Of Agricultural Marketing

NMSE- National Multi Commodity Exchange

NOL- Neptune Overseas Limited

NSCCL- National Securities Clearing Corporation

NSDL- National Securities Depositories Limited

NSE - National Stock Exchange

O

OTC- Over The Counter

P

PHLX - Philadelphia Stock Exchange

PNB- Punjab National Bank

R

RBI- Reserve Bank Of India

S

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

SEBI- Securities Exchange Board Of India

SGX- Singapore Stock Exchange

SIMEX - Singapore International Monetary Exchange

V

VPN- Virtual Private Network

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