Upload
neerav-thakker
View
241
Download
5
Embed Size (px)
DESCRIPTION
math games, pandora math games, pandora youtube to mp3 converter, pandora pirate bay, pandora antivirus, pandora
Citation preview
The Growth of Derivatives Market in India1
A C K N O W L E D G E M E N T
The success of any project is never limited to individual undertaking project;
it is a collective efforts of people around, that spell success. This
acknowledgement is humble attempt of earnestly thanking all those who
were directly or indirectly involved in this project.
I would like to extend my sincere, heartfelt gratitude to our Head of the
Department, Prof. Shruti Charvarkar and our internal guide Prof. Arun
under whose guidance I had the privilege of working and learning and whose
constant inspiration at all faces of the project lead to the successful
completion of my work.
Last but not the least I express my deepest regards to all staff members, for
helping me by giving me their time and providing all required facilities.
The Growth of Derivatives Market in India2
EXECUTIVE SUMMARY
Firstly I am briefing the current Indian market and comparing it with it past. I am also
giving brief data about foreign market. Then at the last I am giving my suggestions and
recommendations.
With over 25 million shareholders, India has the third largest investor base in the world
after USA and Japan. Over 7500 companies are listed on the Indian Stock Exchanges
(more than the number of companies listed in developed markets of Japan, UK,
Germany, France, Australia, Switzerland, Canada and Hong Kong.). The Indian Capital
Market is significant in terms of the degree of development, volume of trading,
transparency and its tremendous growth potential.
India’s Market Capitalization was the highest among the emerging markets. Total
market capitalization of The Bombay Stock Exchange (BSE), which, as on July 31,
1997, was US$ 175 billion has grown by 37.5% percent every twelve months and was
over US$ 834 billion as of January, 2007. Bombay Stock Exchanges (BSE), one of the
oldest in the world, accounts for the largest number of listed companies transacting their
shares on a nationwide Online Trading System. The two major exchanges namely the
National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 &
5 in the world, calculated by the number of daily transactions done on the exchanges.
The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 – An
increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years only.
Turnover in the Spot and Derivatives segment both in NSE & BSE was higher by 45%
into 2006 as compared to 2005. With daily average volume of US $ 9.4 billion, the
Sensex has posted excellent returns in the recent years. Currently the Market
Capitalisation of the Sensex as on July 4th, 2009 was Rs 48.4 Lakh Crore with a
P/E of more than 20.
The Growth of Derivatives Market in India3
RESARCH METHODOLOGY
Method of Data Collection :-
Secondary Sources :-
It is the data which has already been collected by some one or an organization for some
other purpose or research study .The data for study has been collected from various
sources:
Books
Journals
Magazines
Internet sources
LIMITATIONS OF STUDY
The Growth of Derivatives Market in India4
1. LIMITED RESOURCES :
Limited resources are available to collect the information about the commodity
trading.
2. VOLATALITY :
Share market is so much volatile and it is difficult to forecast any thing about it
whether you trade through online or offline.
3. ASPECTS COVERAGE :
Some of the aspects may not be covered in my study.
INDEXPage 1 /
2CHAPTER Topic Page
The Growth of Derivatives Market in India5
NO. From To1 Introduction To Derivatives ( 8 - 18 )
1.1 Meaning & Underlying Assets
9 - 9
1.2 History of Derivatives
10 - 12
1.3 Need of the Study
13 - 13
1.4 Literature Review
14 - 14
1.5 Objectives of the Study
15 - 15
1.6 Scope of the Project
16 - 16
1.7 Products
17 - 18
2 Derivatives Markets in India ( 20 - 22 )
2.1
Introduction 20 - 21
2.2
Definitions 21 - 21
2.3
Types 22 - 22
3 Contracts in Derivatives Markets in India ( 24 - 32 )
3.1
Forward Contracts 24 - 25
3.2
Future Contracts 25 - 29
3.3
Option Contracts 30 - 30
3.4
Swap Contracts 31 - 31
3.5
Other Types of Contracts 32 - 32
4 Growth & Development of Derivatives Market
( 34 - 43 ) in India
4.1
Indian Derivatives Market 34 - 34
4.2
Needs for Derivative Markets in India Today 35 - 35
The Growth of Derivatives Market in India6
4.3
Myths & Realities of Derivatives 36 - 43
INDEX Page 2 / 2
CHAPTERTopic
Page
NO. From To5 Factors Contributing to the Growth
( 45 - 51 )
& Development of Derivatives Market in India
5.1
Price Volatility 45 - 46
5.2
Globalisation of Markets 46 - 46
5.3
Technological Advances 46 - 47
5.4
Advances in Finanacial Theory 47 - 47
5.5
Development of Derivatives Market 47 - 51
6Benefits, Types of National Exchanges &
Reports( 53 - 60 )
of Developments in Derivative Markets in
India
6.1
Risk Management 53 - 53
6.2
Price Discovery 53 - 53
6.3
Operational Advantages 53 - 54
6.4
Market Efficiency 54 - 54
6.5
Ease of Speculations 54 - 54
6.6
Types of National Exchanges 55 - 59
6.7
Reports of Developments 60 - 60
The Growth of Derivatives Market in India7
7 Case Study on IL&FS Investsmart 62 - 67 8 Findings & Conclusions 69 - 70 9 Recommendations & Suggestions 72 - 72
Ώ Bibliography 73 - 73
Ώ Abbrevations 73 - 75
CHAPTER 1
Introduction to Derivatives
1.1 Meaning & Underlying Assets
1.2 History of Derivatives
1.3 Need of the Study
1.4 Literature Review
1.5 Objectives of the Study
1.6 Scope of the Project
1.7 Products
The Growth of Derivatives Market in India8
INTRODUCTION TO DERIVATIVES
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.
The Growth of Derivatives Market in India9
1.1 MEANING & UNDERLYING ASSETS
Derivatives trading in the stock market have been a subject of enthusiasm of research
in the field of finance, the most desired instruments that allow market participants to
manage risk in the modern securities trading are known as Derivatives. The Derivatives
are defined as “the future contracts whose value depends upon the underlying assets ”.
If Derivatives are introduced in the Stock Market, the underlying asset may be anything
as component of stock market like, stock prices or market indices, interest rates, etc.
The main logic behind Derivatives Trading is that derivatives reduce the risk by
providing an additional channel to invest with lower trading cost and it facilitates the
investors to extend their settlement through the future contracts. It provides extra
liquidity in the stock market.
Derivatives are assets, which derive their values from an underlying asset. These
underlying assets are of various categories like -
• Commodities including grains, coffee beans, etc.
• Precious metals like gold and silver.
• Foreign Exchange Rate.
•Bonds of different types, including medium to long-term negotiable debt securities
issued by governments, companies, etc.
• Short-term debt securities such as T-bills.
• Over-The-Counter (OTC) money market products such as loans or deposits.
• Equities
The Growth of Derivatives Market in India10
For example, a Dollar($) forward is a Derivative Contract, which gives the buyer a right
& an obligation to buy Dollars($) at some future date. The prices of the derivatives are
driven by the spot prices of these underlying assets.
However, the most important use of derivatives is in transferring market risk, called
Hedging, which is a protection against losses resulting from unforeseen price or
volatility changes. Thus, Derivatives are a very important tool of Risk Management.
1.2 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
The Growth of Derivatives Market in India11
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
The Growth of Derivatives Market in India12
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.
The Growth of Derivatives Market in India13
1.3 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.
The Growth of Derivatives Market in India14
1.4 LITERATURE REVIEW
The emergence of the market for derivative products, most notably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties arising out of fluctuations in asset prices. By
their very nature, the financial markets are marked by a very high degree of volatility.
Through the use of derivative products, it is possible to partially or fully transfer price
risks by locking-in asset prices. As instruments of risk management, these generally do
not influence the fluctuations in the underlying asset prices. However, by locking-in
asset prices, derivative products minimize the impact of fluctuations in asset prices on
the profitability and cash flow situation of risk-averse investors.
Derivative products initially emerged, as hedging devices against fluctuations in
commodity prices and commodity-linked derivatives remained the sole form of such
products for almost three hundred years. The financial derivatives came into spotlight in
post-1970 period due to growing instability in the financial markets. However, since their
emergence, these products have become very popular and by 1990s, they accounted
for about two-thirds of total transactions in derivative products. In recent years, the
market for financial derivatives has grown tremendously both in terms of variety of
instruments available, their complexity and also turnover. In the class of equity
derivatives, futures and options on stock indices have gained more popularity than on
individual stocks, especially among institutional investors, who are major users of index-
linked derivatives.
Even small investors find these useful due to high correlation of the popular indices with
various portfolios and ease of use. The lower costs associated with index derivatives
vis-vis derivative products based on individual securities is another reason for their
growing use.
As in the present scenario, Derivative Trading is fast gaining momentum, I have chosen
this topic .
1.5 OBJECTIVES OF THE STUDY
The Growth of Derivatives Market in India15
To understand the concept of the Derivatives and Derivative Trading.
To know different types of Financial Derivatives
To know the role of Derivatives Trading in India.
To analyse the performance of Derivatives Trading since 2001 with special
reference to Futures & Options
1.6 SCOPE OF THE PROJECT
The Growth of Derivatives Market in India16
The project covers the derivatives market and its instruments. For better
understanding various strategies with different situations and actions have been
given. It includes the data collected in the recent years and also the market in the
derivatives in the recent years. This study extends to the trading of derivatives done
in the National Stock Markets.
1.7 PRODUCTS
The Growth of Derivatives Market in India17
There are various derivative products traded. They are;
1.7.1 Forwards
1.7.2 Futures
1.7.3 Options
1.7.4 Swaps
“A Forward Contract is a transaction in which the buyer and the seller agree
upon a delivery of a specific quality and quantity of asset usually a commodity at a
specified future date. The price may be agreed on in advance or in future.”
“A Future Contract is a firm contractual agreement between a buyer and
seller for a specified as on a fixed date in future. The contract price will vary according
to the market place but it is fixed when the trade is made. The contract also has a
standard specification so both parties know exactly what is being done”.
“An Options Contract confers the right but not the obligation to buy (call
option) or sell (put option) a specified underlying instrument or asset at a specified price
– the Strike or Exercised price up until or an specified future date – the Expiry date. The
Price is called Premium and is paid by buyer of the option to the seller or writer of the
option.”
“A Call option gives the holder the right to buy an underlying asset by a certain
date for a certain price. The seller is under an obligation to fulfill the contract and is paid
a price of this, which is called "the call option premium or call option price".
“A Put option, on the other hand gives the holder the right to sell an underlying
asset by a certain date for a certain price. The buyer is under an obligation to fulfill the
The Growth of Derivatives Market in India18
contract and is paid a price for this, which is called "the put option premium or put option
price".
“Swaps are transactions which obligates the two parties to the contract to exchange
a series of cash flows at specified intervals known as payment or settlement dates.
They can be regarded as portfolios of forward's contracts. A contract whereby two
parties agree to exchange (swap) payments, based on some notional principle amount
is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not
the principle amount”
I had conducted this research to find out whether investing in the Derivative Market is
beneficial or not ? You will be glad to know that Derivative Market in India is the most
booming now days.So the person who is ready to take risk and want to gain more
should invest in the Derivative Market.
On the other hand RBI has to play an important role in Derivative Market. Also SEBI
must encourage investment in Derivative Market so that the investors get the benefit out
of it. Sorry to say that today even educated persons are not willing to invest in
Derivative Market because they have the fear of high risk.
So, SEBI should take necessary steps for improvement in Derivative Market so that
more investors can invest in Derivative market.
The Growth of Derivatives Market in India19
CHAPTER 2
Derivatives Markets in India
2.1 Introduction
2.2 Definitions
2.3 Types
DERIVATIVE MARKET IN INDIA
2.1 INTRODUCTION
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.
The Growth of Derivatives Market in India20
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 death, although favourable
prices could be obtained during periods of oversupply. Under such circumstances, it
clearly made sense for the farmer and the merchant to come together and enter into
contract whereby the price of the grain to be delivered in September could be decided
earlier. What they would then negotiate happened to be Futures-Type Contract, which
would enable both parties to eliminate the price risk.
In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and
merchants together. A group of traders got together and created the ‘to-arrive’ contract
that permitted farmers to lock into price upfront and deliver the grain later. These to-
arrive contracts proved useful as a device for hedging and speculation on price charges.
These were eventually standardized, and in 1925 the first futures clearing house came
into existence.
Today derivatives contracts exist on variety of commodities such as corn, pepper,
cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot
of financial underlying like stocks, interest rate, exchange rate, etc.
2.2 DEFINITION OF DERIVATIVE
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
The Growth of Derivatives Market in India21
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.
2.3 TYPES OF DERIVATIVES MARKET
Types of Derivatives Market
Exchange Traded Derivatives Over The Counter Derivatives
National Stock Bombay Stock National Commodity &
The Growth of Derivatives Market in India22
Exchange Exchange Derivative Exchange
Index Future Index Option Stock Option Stock Future
The Growth of Derivatives Market in India23
CHAPTER 3
Contracts in Derivatives Markets in India
3.1 Forward Contracts
3.2 Future Contracts
3.3 Option Contracts
3.4 Swap Contracts
3.5 Other Types of Contracts
3.1 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.
The Growth of Derivatives Market in India24
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.
3.2 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,
The Growth of Derivatives Market in India25
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
The Growth of Derivatives Market in India26
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. Settlement :Settlement is the act of consummating the contract, and can be done in one of two
ways, as specified per type of futures contract:
Physical Delivery - the amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the
buyers of the contract. In practice, it occurs only on a minority of contracts. Most are
cancelled out by purchasing a covering position - that is, buying a contract to cancel
out an earlier sale (covering a short), or selling a contract to liquidate an earlier
purchase (covering a long).
The Growth of Derivatives Market in India27
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.
3.2.1 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.
The Growth of Derivatives Market in India28
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.
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.
The Growth of Derivatives Market in India29
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.
The Growth of Derivatives Market in India30
3.3 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.
The Growth of Derivatives Market in India31
3.4 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.
The Growth of Derivatives Market in India32
3.5 OTHER KINDS OF DERIVATIVES
The other kind of Derivatives, which are not much popular are as follows :
BASKETS -
Baskets options are option on portfolio of underlying asset. Equity Index Options are
most popular form of baskets.
LEAPS -
Normally option contracts are for a period of 1 to 12 months. However, exchange may
introduce option contracts with a maturity period of 2-3 years. These long-term option
contracts are popularly known as Leaps or Long term Equity Anticipation Securities.
WARRANTS -
Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.
SWAPTIONS -
Swaptions are options to buy or sell a swap that will become operative at the expiry of
the options. Thus a swaption is an option on a forward swap. Rather than have calls
and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver
swaption is an option to receive fixed and pay floating. A payer swaption is an option to
pay fixed and receive floating.
The Growth of Derivatives Market in India33
CHAPTER 4
Growth & Development of Derivatives Markets in India
4.1 Indian Derivatives Market
4.2 Need for Derivatives in India Today
4.3 Myths & Realities of Derivatives
GROWTH & DEVELOPMENT OF DERIVATIVES MARKET IN INDIA
4.1 INDIAN DERIVATIVES MARKET
The Growth of Derivatives Market in India34
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
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
4.2 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.
The Growth of Derivatives Market in India35
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.
4.3 Myths and Realities about Derivatives
In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Financial derivatives came into the spotlight
along with the rise in uncertainty of post-1970, when US announced an end to the
Bretton Woods System of fixed exchange rates leading to introduction of currency
derivatives followed by other innovations including stock index futures. Today,
The Growth of Derivatives Market in India36
derivatives have become part and parcel of the day-to-day life for ordinary people in
major parts of the world. While this is true for many countries, there are still
apprehensions about the introduction of derivatives. There are many myths about
derivatives but the realities that are different especially for Exchange traded derivatives,
which are well regulated with all the safety mechanisms in place.
What are these myths behind derivatives? Derivatives increase speculation and do not serve any economic purpose
Indian Market is not ready for derivative trading
Disasters prove that derivatives are very risky and highly leveraged instruments.
Derivatives are complex and exotic instruments that Indian investors will find
difficulty in understanding
Is the existing capital market safer than Derivatives?
4.3.1 Derivatives increase speculation and do not serve any
economicpurpose:
Numerous studies of derivatives activity have led to a broad consensus, both
in the private and public sectors that derivatives provide numerous and
substantial benefits to the users. Derivatives are a low-cost, effective method
for users to hedge and manage their exposures to interest rates, commodity
prices or exchange rates. The need for derivatives as hedging tool was felt
first in the commodities market. Agricultural futures and options helped
farmers and processors hedge against commodity price risk. After the fallout
of Bretton wood agreement, the financial markets in the world started
undergoing radical changes. This period is marked by remarkable innovations
in the financial markets such as introduction of floating rates for the
currencies, increased trading in variety of derivatives instruments, on-line
trading in the capital markets, etc. As the complexity of instruments increased
many folds, the accompanying risk factors grew in gigantic proportions. This
situation led to development derivatives as effective risk management tools
for the market participants.
The Growth of Derivatives Market in India37
Looking at the equity market, derivatives allow corporations and institutional investors to
effectively manage their portfolios of assets and liabilities through instruments like stock
index futures and options. An equity fund, for example, can reduce its exposure to the
stock market quickly and at a relatively low cost without selling off part of its equity
assets by using stock index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and
raising capital, derivatives improve the allocation of credit and the sharing of risk in the
global economy, lowering the cost of capital formation and stimulating economic growth.
Now that world markets for trade and finance have become more integrated, derivatives
have strengthened these important linkages between global markets, increasing market
liquidity and efficiency and facilitating the flow of trade and finance
4.3.2 Indian Market is not ready for Derivative Trading
Often the argument put forth against derivatives trading is that the Indian capital market
is not ready for derivatives trading. Here, we look into the pre-requisites, which are
needed for the introduction of derivatives, and how Indian market fares
The Growth of Derivatives Market in India38
4.3.3 Comparison of New System with Existing System
PRE-REQUISITES INDIAN SCENARIOLarge market Capitalisation
India is one of the largest market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores.
High Liquidity in the underlying
The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.
Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.
A Strong Depository National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country.
A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
The Growth of Derivatives Market in India39
Many people and brokers in India think that the new system of Futures & Options and
banning of Badla is disadvantageous and introduced early, but I feel that this new
system is very useful especially to retail investors. It increases the no of options
investors for investment. In fact it should have been introduced much before and NSE
had approved it but was not active because of politicization in SEBI.
The figure 3.3a –3.3d shows how advantages of new system (implemented from June
20001) v/s the old system i.e. before June 2001
New System Vs Existing System for Market Players
Speculators
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premium hold till expiry.
Advantages Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.
Arbitrageurs
The Growth of Derivatives Market in India40
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game. another exchange. the Market moves. in weekly settlement forward transactions. 2) Cash &Carry 2) If Future Contract arbitrage continuesmore or less than Fair price
Fair Price = Cash Price + Cost of Carry.
Hedgers
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie
Advantages Availability of Leverage
Small Investors
The Growth of Derivatives Market in India41
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize 1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains profit/loss. 2) Hedge position if protected & holding underlying upside stock unlimited.Advantages Losses Protected.
The Growth of Derivatives Market in India42
4.3.4 Exchange Traded vs. OTC Derivatives Markets
The OTC derivatives markets have witnessed rather sharp growth over the last few
years, which has accompanied the modernization of commercial and investment
banking and globalisation of financial activities. The recent developments in information
technology have contributed to a great extent to these developments. While both
exchange-traded and OTC derivative contracts offer many benefits, the former have
rigid structures compared to the latter. It has been widely discussed that the highly
leveraged institutions and their OTC derivative positions were the main cause of
turbulence in financial markets in 1998. These episodes of turbulence revealed the risks
posed to market stability originating in features of OTC derivative instruments and
markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or
margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange’s self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market
stability.
The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic nature of
gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative
The Growth of Derivatives Market in India43
activities on available aggregate credit; (iv) the high concentration of OTC derivative
activities in major institutions; and (v) the central role of OTC derivatives markets in the
global financial system. Instability arises when shocks, such as counter-party credit
events and sharp movements in asset prices that underlie derivative contracts, occur
which significantly alter the perceptions of current and potential future credit exposures.
When asset prices change rapidly, the size and configuration of counter-party
exposures can become unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However,
the progress has been limited in implementing reforms in risk management, including
counter-party, liquidity and operational risks, and OTC derivatives markets continue to
pose a threat to international financial stability. The problem is more acute as heavy
reliance on OTC derivatives creates the possibility of systemic financial events, which
fall outside the more formal clearing house structures. Moreover, those who provide
OTC derivative products, hedge their risks through the use of exchange traded
derivatives. In view of the inherent risks associated with OTC derivatives, and their
dependence on exchange traded derivatives, Indian law considers them illegal.
The Growth of Derivatives Market in India44
CHAPTER 5
Factors Contributing to the Growth & Development of
Derivatives Markets in India
5.1 Price Volatility
5.2 Globalisation of Markets
5.3 Technological Advances
5.4 Advances in Financial Theories
5.5 Development of Derivative
Markets
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.
The Growth of Derivatives Market in India45
5.1 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.
The Growth of Derivatives Market in India46
5.2 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.
5.3 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.
The Growth of Derivatives Market in India47
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.
5.4 ADVANCES IN FINANCIAL THEORIES –
Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed
by Black and Scholes in 1973 were used to determine prices of call and put options. In
late 1970’s, work of Lewis Edeington extended the early work of Johnson and started
the hedging of financial price risks with financial futures. The work of economic theorists
gave rise to new products for risk management which led to the growth of derivatives in
financial markets.
The above factors in combination of lot many factors led to growth of derivatives
instruments
5.5 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
The Growth of Derivatives Market in India48
trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in
June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk
containment in derivatives market in India. The report, which was submitted in October
1998, worked out the operational details of margining system, methodology for charging
initial margins, broker net worth, deposit requirement and real–time monitoring
requirements. The Securities Contract Regulation Act (SCRA) was amended in
December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory
framework were developed for governing derivatives trading. The act also made it clear
that derivatives shall be legal and valid only if such contracts are traded on a recognized
stock exchange, thus precluding OTC derivatives. The government also rescinded in
March 2000, the three decade old notification, which prohibited forward trading in
securities. Derivatives trading commenced in India in June 2000 after SEBI granted the
final approval to this effect in May 2001. SEBI permitted the derivative segments of two
stock exchanges, NSE and BSE, and their clearing house/corporation to commence
trading and settlement in approved derivatives contracts. To begin with, SEBI approved
trading in index futures contracts based on S&P CNX Nifty and BSE–30 (Sense) index.
This was followed by approval for trading in options based on these two indexes and
options on individual securities.
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 Growth of Derivatives Market in India49
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
The Growth of Derivatives Market in India50
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.
Forex Market Activity
The Growth of Derivatives Market in India51
April’05-
Mar’06
April’06-
Mar’07
April’07-
Mar’08
April’08-
Dec’08Total turnover (USD billion) 4,404 6,571 12,304 9,621
Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1
Spot/Total Turnover (%) 50.5 51.9 49.7 45.9
Forward/Total Turnover (%) 19.0 17.9 19.3 21.5
Swap/Total Turnover (%) 30.5 30.1 31.1 32.7
Source: RBI
The Growth of Derivatives Market in India52
CHAPTER 6
Benefits , Types of National Exchanges & Reports of
Developments in Derivatives Markets in India
6.1 Risk Management
6.2 Price Discovery
6.3 Operational Advantages
6.4 Market Efficiency
6.5 Ease of Speculations
6.6 Types of National Exchanges
6.7 Reports of Developments
BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways :
6.1 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
The Growth of Derivatives Market in India53
losses in the spot market. Similarly, if the spot price falls below the exercise price, the
put option can always be exercised.
6.2 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.
6.3 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.
6.4 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.
6.5 EASE OF SPECULATION –
The Growth of Derivatives Market in India54
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.
6.6 Types of 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.
6.6.1 MCX
The Growth of Derivatives Market in India55
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, Canara 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.
6.6.2 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
The Growth of Derivatives Market in India56
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.
6.6.3 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.
The Growth of Derivatives Market in India57
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.
The Present Status:
Presently futures’ trading is permitted in all the commodities. Trading is taking place in
about 78 commodities through 25 Exchanges/Associations as given in the table below:-
Registered Commodity Exchanges in India
No. Exchange COMMODITY
1. India Pepper & Spice Trade
Association, Kochi (IPSTA)
Pepper (both domestic and
international contracts)
2. Vijai Beopar Chambers Ltd.,
Muzaffarnagar
Gur, Mustard seed
3. Rajdhani Oils & Oilseeds Exchange
Ltd., Delhi
Gur, Mustard seed its oil & oilcake
4. Bhatinda Om & Oil Exchange Ltd.,
Bhatinda
Gur
5. The Chamber of Commerce, Hapur Gur, Potatoes and Mustard seed
The Growth of Derivatives Market in India58
6. The Meerut Agro Commodities
Exchange Ltd., Meerut
Gur
7. The Bombay Commodity Exchange
Ltd., Mumbai
Oilseed Complex, Castor oil
international contracts
8. Rajkot Seeds, Oil & Bullion
Merchants Association, Rajkot
Castor seed, Groundnut, its oil &
cake, cottonseed, its oil & cake,
cotton (kapas) and RBD palmolein.
9. The Ahmedabad Commodity
Exchange, Ahmedabad
Castorseed, cottonseed, its oil and
oilcake
10. The East India Jute & Hessian
Exchange Ltd., Calcutta
Hessian & Sacking
11. The East India Cotton Association
Ltd., Mumbai
Cotton
12. The Spices & Oilseeds Exchange
Ltd., Sangli.
Turmeric
13. National Board of Trade, Indore Soya seed, Soyaoil and Soya meals, Rapeseed/Mustardseed its oil and oilcake and RBD Palmolien
14. The First Commodities Exchange of
India Ltd., Kochi
Copra/coconut, its oil & oilcake
15. Central India Commercial Exchange
Ltd., Gwalior
Gur and Mustard seed
16. E-sugar India Ltd., Mumbai Sugar
17. National Multi-Commodity Exchange
of India Ltd., Ahmedabad
Several Commodities
18. Coffee Futures Exchange India Ltd.,
Bangalore
Coffee
19. Surendranagar Cotton Oil & Oilseeds,
Surendranagar
Cotton, Cottonseed, Kapas
20. E-Commodities Ltd., New Delhi Sugar (trading yet to commence)
The Growth of Derivatives Market in India59
21. National Commodity & Derivatives,
Exchange Ltd., Mumbai
Several Commodities
22. Multi Commodity Exchange Ltd.,
Mumbai
Several Commodities
23. Bikaner commodity Exchange Ltd.,
Bikaner
Mustard seeds its oil & oilcake, Gram. Guar seed. Guar Gum
24. Haryana Commodities Ltd., Hissar Mustard seed complex
25. Bullion Association Ltd., Jaipur Mustard seed Complex
6.7 REPORT OF THE D E V E LO P M ENTS IN THE D E RIVATIVE MARKET
1. The Board at its meeting on November 29, 2002 had desired that a quarterly report
be submitted to the Board on the developments in the derivative market. Accordingly,
this memorandum presents a status report for the quarter July - September
2008-09 on the developments in the derivative market.
2. Equity Derivatives Segment
Observations on the quarterly data for July-September, 2008-09. During July-
September 2008-09, the turnover at BSE was Rs.1,510 crore, which was insignificant
as compared to that of NSE at Rs. 3,315,491 crore.
The Growth of Derivatives Market in India61
COMPANY PROFILE
A Brief about IL&FS Investsmart Limited :
IL&FS Investsmart Limited (IIL) is one of India’s leading financial services organizations
providing individuals and corporates with customized financial management solutions.
At IIL, we believe in "Realizing your goals together". You will find in us - a trusted
investment partner to help you work towards achieving your financial goals. Our
institutional expertise, combined with a thorough understanding of the financial markets
results in appropriate investment solutions for you.
Our strong team of Relationship Managers, Customer Service Executives, Advisory
Managers and Research Analysts offers efficient execution backed by in-depth
research, knowledge and expertise to customers across the country.
Vision
To become a long term preffered financial to a wide base of customer whilst optimizing
Stake holder value.
Mission To establish a base of 1 million satisfied customer by the end of 2011
We will crest this by being a responsible trustworthy partner.
The Growth of Derivatives Market in India62
Corporate action
An approach to business that reflects responsibility, transparency and ethical behaviour.
Respect for Employee, Client and Stake Holder group.
The Growth of Derivatives Market in India63
Institutional Business
IIL’s Institutional business thrives on the strong relationships we have built among
Domestic Mutual Funds, Banks, Financial Institutions, Insurance Companies and
Private Sector Funds over the past few years. Efficient Execution, Quality Research and
Retail Business
Retail offerings of IIL seek to cover all financial planning requirements of
individuals, which includes providing Personalised Investment Management
Services including planning, advisory, execution and monitoring of the full
range of investment services. Broadly the retail services are divided into two
broad categories.
Advisory Services :
Portfolio Management Services, Mutual Funds, Insurance.
Trading Services :
Equities, Derivatives, IPOs
These services are offered across our network of over 300 offices across the
country. You can also enjoy the convenience of availing these services online
through our trading platform www.investsmartonline.com
The Growth of Derivatives Market in India64
high degree of compliance with Stock Exchange Regulations and Ethical Business
Standards back IIL’s services to institutional investors. Our Institutional Services can be
broadly categorized as follows.
Merchant Banking
We offer financial advisory and capital-raising services to corporates. Having
successfully managed IPOs, Follow-on offerings, Open Offers, Mergers, etc, IIL’s
Merchant Banking business has been growing from strength-to-strength.
Institutional Equity & Debt
Combining the efforts of a top-drawer research team & dynamic sales
professionals, we are committed to offer timely & proactive investing & trading
strategies. We are presently empanelled with more than 100 institutions and
Service Customers across geographies.
Promoters
IL&FS Investsmart Limited (IIL) is one of India’s leading companies in the Financial
Services industry. It was promoted in 1997 by Infrastructure Leasing & Financial
Services (IL&FS), one of India's leading infrastructure development and finance
companies.
The company is now held by HSBC, one of the world’s largest banking and financial services organisations.
In India, The HSBC Group offers a range of financial services including corporate, commercial, retail and private banking, insurance, asset management, investment banking, equities and capital markets, institutional brokerage, custodial services. It also provides software development expertise and global services facilities for the HSBC Group’s operations worldwide.
The Growth of Derivatives Market in India65
The Growth of Derivatives Market in India66
The Growth of Derivatives Market in India67
Value Added Products for You!
"Value Added Products for You" - Investsmart Online continually strives to
provide the services and support that our clients need to thrive in the market.
We pride ourselves on offering almost limitless customization possibilities; so
that you can truly "own the trade" We also realize that every trader has unique
and complex needs that sometimes require special attention. With this in mind,
we created Value Added products.
Smart ChartTools to plot Profitable Investments
Our Charting Tools
Provides you a wealth of charting capabilities and timing indicators, which allow you to go right into the action with real-time daily and intra-day charts.
Smart Alert
Smart Exposure
Increase your Market Exposure
Smart CallConvenience to trade over the phone
Smart SecureState-of-the-art Security Platforms
Limit Against Shares
Margin is offered against the securities you have in your Demat for trading.
Phone Trading Services
Call & Trade is a service offered by Investsmart online for its customers, which provides customers with a facility to trade over the phone.State-of-the-Art Security Platforms
At IL&FS Investsmart, we place a very high onus on security and realize that it is one of the vital components of any e-business venture. Our online products are developed on state-of-the-art security platforms.
Sell Receivable Shares
SRS is a facility offered by Investsmart online wherein the customer will be able to sell the shares that he has purchased even before he receives the delivery of the shares from the Exchange. He will not have to wait till the time he receives the delivery from the Exchange thus increasing his liquidity.
Smart NextSell Receivable Shares
Smart Alert Service
Smart Alert Services
Whether you are day trader or a serious investor,we will deliver stock information (Short term and Long term calls) to your cell phone daily.
The Growth of Derivatives Market in India68
CHAPTER 8
Findings & Conclusions
FINDINGS & CONCLUSION
From the above analysis it can be concluded that:
1. Derivative market is growing very fast in the Indian Economy. The turnover of
Derivative Market is increasing year by year in the India’s largest stock exchange
NSE. In the case of index future there is a phenomenal increase in the number of
contracts. But whereas the turnover is declined considerably. In the case of stock
future there was a slow increase observed in the number of contracts whereas a
decline was also observed in its turnover. In the case of index option there was a
huge increase observed both in the number of contracts and turnover.
The Growth of Derivatives Market in India69
2. After analyzing data it is clear that the main factors that are driving the growth of
Derivative Market are Market improvement in communication facilities as well as
long term saving & investment is also possible through entering into Derivative
Contract. So these factors encourage the Derivative Market in India.
3. It encourages entrepreneurship in India. It encourages the investor to take more
risk & earn more return. So in this way it helps the Indian Economy by developing
entrepreneurship. Derivative Market is more regulated & standardized so in this
way it provides a more controlled environment. In nutshell, we can say that the
rule of High risk & High return apply in Derivatives. If we are able to take more
risk then we can earn more profit under Derivatives.
Commodity derivatives have a crucial role to play in the price risk management process
for the commodities in which it deals. And it can be extremely beneficial in agriculture-
dominated economy, like India, as the commodity market also involves agricultural
produce. Derivatives like forwards, futures, options, swaps etc are extensively used in
the country. However, the commodity derivatives have been utilized in a very limited
scale. Only forwards and futures trading are permitted in certain commodity items.
RELIANCE is the most active future contracts on individual securities traded with 90090
contracts and RNRL is the next most active futures contracts with 63522 contracts
being traded.
The Growth of Derivatives Market in India70
The Growth of Derivatives Market in India71
CHAPTER 9
Recommendations & Suggestions
RECOMMENDATIONS & SUGGESTIONS
RBI should play a greater role in supporting derivatives.
Derivatives market should be developed in order to keep it at par with other
derivative markets in the world.
Speculation should be discouraged.
There must be more derivative instruments aimed at individual investors.
SEBI should conduct seminars regarding the use of derivatives to educate
individual investors.
The Growth of Derivatives Market in India72
After study it is clear that Derivative influence our Indian Economy up to much
extent. So, SEBI should take necessary steps for improvement in Derivative
Market so that more investors can invest in Derivative market.
There is a need of more innovation in Derivative Market because in today
scenario even educated people also fear for investing in Derivative Market
Because of high risk involved in Derivatives.
The Growth of Derivatives Market in India73
BIBLIOGRAPHY
Books Referred:
Options Futures, and other Derivatives by John C Hull
Derivatives FAQ by Ajay Shah
NSE’s Certification in Financial Markets: - Derivatives Core module
Financial Markets & Services by Gordon & Natarajan
Reports:
Report of the RBI-SEBI standard technical committee on exchange traded
Currency Futures
Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA
Websites visited:
www.nse-india.com
www.bseindia.com
www.sebi.gov.in
www.ncdex.com
www.google.com
www.derivativesindia.com
The Growth of Derivatives Market in India74
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
The Growth of Derivatives Market in India75
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