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1. Introduction

V. Shankar 

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Market for derivative products has emergeddue to requirement of risk averse economicagents to guard themselves against

fluctuating asset pricesThrough derivative products, price risks are

transferred (partially or fully) by locking inasset prices

 As risk management instruments, derivativesdo not generally influence the volatility of underlying asset prices

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 A derivative is a product whose value is

derived from the value of one or more

basic variables (called bases)

Bases can be the underlying asset, index

or reference rate

Underlying asset can be equity, forex,

commodity or any other assetPrice of the derivative is driven by the

“spot” price of the underlying

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Derivative defined in the Securities

Contracts (Regulation) Act, 1956

Derivative includes•  A security derived from debt instrument, share,

loan (secured or unsecured), risk instrument,

contract for differences or any other form of 

security

•  A contract which derives its value from the prices

or index of prices of underlying securities

Trading in derivatives governed by SCRA

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Unorganized trading in forward contracts dates back to 12th century

To deal with the problem of “credit risk”, a group of businessmen established the Chicago Board of Trade in 1848

• fixed place for settlement of forward contracts

In 1865, CBOT listed the first exchange-traded futurescontract Chicago Butter & Egg Board (renamed Chicago Mercantile

Exchange) started futures trading in 1919 First stock index futures was traded on Kansas City Board of 

Trade

• S&P500 most popular stock index futures on CME Other important international derivatives exchanges are LIFFE

(London), DTB (Germany), SGX (Singapore), TIFFE (Japan),MATIF (France) and Eurex

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Commodity derivatives• More than 300 years ago

• Hedge against fluctuating prices

Financial derivatives• In 1970s

• Complexity and range of instruments have grown

significantly• Electronic markets facilitate product innovation

and trading growth

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Increased volatility in asset pricesGreater integration of local markets with

international markets

Improvement in communication facilitiesReduction in technology costsEvolution of sophisticated risk

management toolsTremendous innovation – leading to

instruments having different risk/returnprofiles

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Forwards• Customized contract between two parties for settlement on

a future date at today’s pre-agreed price

Futures•  Agreement between two parties to buy or sell an asset on a

future date at a certain price

• Standardized exchange-traded contracts

Options• Gives buyer of contract the right but not the obligation to

buy/sell a given quantity of the underlying asset at givenprice on/before future date

• Call option gives buyer the right to buy

• Put option gives buyer the right to sell

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Warrants• Longer-dated option (more than 1 year, as against 9-12

months for options)• Traded over-the-counter 

Baskets• Options on portfolio of underlying assets• Underlying asset is a moving average of basket of assets

(e.g. Equity index options) Swaps

• Private agreement between two parties for exchangingcash flows in the future as per agreed formula

• Portfolios of forward contracts• E.gs. Interest rate swaps, currency swaps

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Hedgers• Use futures/options to reduce price risk• Downside risk minimized• Lower returns

Speculators• Bet on future movement in prices• Trade on price differentials• Highest returns

 Arbitrageurs

• Take advantage of price discrepancies between twomarkets• Least risk• Lower returns – profit locking strategy

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Prices in derivatives market reflect the perceptionof market participants about the future and lead theprices of the underlying to the perceived futurelevel – convergence at the future point

Transfers risks from those who face them to thosewho have an appetite for them

Boost in trading activity in the underlying market – more participation

Speculative trading shifts to derivatives market Acts as a catalyst for new entrepreneurial activity

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OTC derivatives markets growing at furious pace• Revolution in IT and communications technology• Modernization of commercial and investment banking• Globalization of financial activities

Characteristics of OTC markets• Management of counter-party (credit) risk is decentralized• No formal centralized limits on individual positions,

leveraging and margining• No formal rules for risk and burden sharing

• No formal rules/mechanisms for ensuring market stabilityand integrity• Generally not regulated by a regulator or exchange’s SRO 

OTC derivatives trading banned in India

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NSE accounts for almost 100% of derivatives

trading in India

Progress

• S&P CNX Nifty Index futures: June 12, 2000

• Index options: June 4, 2001

• Options on individual securities: July 2, 2001

• Single stock futures: November 9, 2001

Derivatives contracts have 3-month expiry3 contracts are available for trading: 1-month,

2-month and 3-month expiry

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NSE follows 2-tier membership structure• CM & F&O or CM, WDM & F&O segments

Trading and clearing members are admittedseparately

3 types of clearing members• Self Clearing Member  Clears and settles trades done on his or his clients’ account 

• Trading Member-cum-Clearing Member  Clears and settles trades done by him and other Trading

Members• Professional Clearing Member  Not a Trading Member, only a Clearing Member  – e.g. banks

and custodians

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NEAT-F&O is a fully automated screen-basedtrading system with online monitoring andsurveillance mechanism

 Anonymous order-driven market Order execution on price-time priority Wide range of order types supported: Immediate or 

Cancel, Limit or Market, Stop Loss, etc. Supports 2 types of users

• TM: for order entry, order matching, order & trademanagement

• CM: for monitoring the TMs, entry and setting of positionlimits for TMs and overall

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