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“Indian Derivative Market”

Project report submitted towards fulfillment of PGDM LBSIMT, Bareilly Academic Session [2008-2010] Submitted by UNDER THE GUIDANCE OF

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ACKNOWLEDGEMENT

I wish to extend my sincere gratitude to, Mr. Rahul Kumar Agarwal, Area Sales Manager, IL&FS InvestSmart Securities Ltd., for providing me with all the facilities to carry on this research work efficiently. I also extend my gratitude towards Mr. Amitab, Branch Manager for helping me in the completion of this report, the entire team at IL&FS, for their co-operation and last but not the least the employees at IL&FS for their support and encouragement in fulfilment of this report.

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July 5, 2009 TO WHOMSOEVER IT MAY CONCERN

On behalf of IL&FS InvestSmart Securities Ltd., I take the privilege of recognizing the efforts put in by Mr. Sarang Mani to carry out her Project on “Indian Derivative Market� from 5th May to 5th July 2009. Sarang has not only carried out this study as a part of his curriculum but he has proven to be a key member in bringing positive contribution in our Sales strategies. The project carried out by Sarang has given us some focused reasons to improve our people practices, focus on employee satisfaction level as well contribute to our sales. In fact we are considering adapting a few suggestions given by him in the above context. Lastly, I would like to thank your esteemed institution for providing your students such a platform; for them to learn from their experiences while carrying out these studies.

Warm regards,

(Rahul Kumar Agarwal) Area Sales Manager

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TABLE OF CONTENTS S. No. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 1) 2) 3) 4) i) ii) iii) iv) 5) 11. 12. 1) 2) i) ii) 3) 4) 5) i) ii) iii) iv) 13. 14. 1) 2)

TOPICS

PAGE NO.

Executive Summary …………………………………………………...... 06 Company Profile……………………………………………................... 10 Introduction …………………………………………………................... 16 Need of the Study............................................................................ 17 Literatural Review............................................................................ 18 Objective of the Study..................................................................... 19 Scope of the Study.......................................................................... 20 Research Methodology.................................................................... 21 Limitations of Study......................................................................... 22 Main Topics of Study Introduction to Derivative............................................................. 23 Derivative Defined......................................................................... 24 Types of Derivatives Market........................................................... 25 Types of Derivatives...................................................................... 25 Forward Contracts...................................................................... 26 Future Contracts........................................................................ 27 Options....................................................................................... 32 Swap....................................................................................... 33 Other Kinds of Derivatives......................................................... 34 History of Derivatives......................................................................... 35 Indian Derivative Market ……………………..…………..…………...... 38 Need of Derivatives in India today.......……………......................... 39 Myths and realities about derivatives…………………….................. 39 Derivatives increase speculation and do not serve any economic purpose ..................................................................... 40 Indian Market is not ready for derivative trading......................... 41 Comparison of New System with Existing System.........…………… 43 Exchange-traded vs. OTC derivatives markets............................... 45 Factors Contributing To The Growth Of Derivatives........................ 47 Price Volatility.............................................................................. 47 Globalisation of Markets.............................................................. 48 Technological Advances.............................................................. 49 Advances in Financial Theories………........................................ 49 Development of Derivative Markets in India……………………....... 50 Benifits of Derivatives……………………................................... 54 Risk Management............................................................................ 54 Price Discovery.............................................................................. 54

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3) 4) 5) 15. 16. 17. 18. 19. 20. 21. 22.

Operational Advantages................................................................. Market Efficiency............................................................................ Easy to Speculation......................................................................... National Exchanges......................................................................... Present Status................................................................................. Status Report of the development in Derivative Market................. Business Growth in Derivatives segment (NSE)............................. Findings & Conclusion..................................................................... Recommendations & Suggestions.................................................. Bibliography ………………………………………………………........ Abbrevations...................................................................................

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54 55 55 59 60 62 69 81 82 83 84


EXECUTIVE SUMMARY Firstly I am briefing the current Indian market and compairing 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.

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Currently the market cap of the Sensex as on July 4th, 2009 was Rs 48.4 Lakh Crore with a P/E of more than 20. Derivatives trading in the stock market have been a subject of enthusiasm of research in the field of finance the most desired instruments that allow market participants to manage risk in the modern securities trading are known as derivatives. The derivatives are defined as the future contracts whose value depends upon the underlying assets. If derivatives are introduced in the stock market, the underlying asset may be anything as component of stock market like, stock prices or market indices, interest rates, etc. The 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 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

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

There are various derivative products traded. They are; 1. Forwards 2. Futures 3. Options 4. Swaps “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".

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A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price". “Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount” 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.

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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 prefferd long term financial to a wide base of customer whilst optimizing Stake holder value.

Mission To establish a base of 1 million satisfied customer by 2010 We will crest this by being a responsible trustworthy partner.

Corporate action 10


An approach to business that reflects responsibility, transparency and ethical behaviour. Respect for employee client and stake holder group.

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Retail Business Retail offerings of IIL seek to cover all financial planning requirements of individuals, which include 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

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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 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.

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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. Our Charting Tools

SmartChart Tools to plot Profitable Investments

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.

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Increase your Market Exposure

Margin is offered against the securities you have in your Demat for trading.

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Convenience to trade over the phone

Call & Trade is a service offered by Investsmart online for its customers, which provides customers with a facility to trade over the phone.

SmartSecure

State-of-the-Art Security Platforms

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.

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Smart Alert Service

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.

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Sell Receivable Shares

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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.

INTRODUCTION A Derivative is a financial instrument whose value depends on other, more basic, underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper. Derivatives have become increasingly important in the field of finance, Options and Futures are traded actively on many exchanges, Forward contracts, Swap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as over-the-counter markets – in other words, there is no single market place or organized exchanges.

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NEED OF THE STUDY

The study has been done to know the different types of derivatives and also to know the derivative market in India. This study also covers the recent developments in the derivative market taking into account the trading in past years. Through this study I came to know the trading done in derivatives and their use in the stock markets.

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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.

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OBJECTIVES OF THE STUDY

 To understand the concept of the Derivatives and Derivative Trading.  To know different types of Financial Derivatives  To know the role of derivatives trading in India.  To analyse the performance of Derivatives Trading since 2001with special reference to Futures & Options

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SCOPE OF THE PROJECT

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.

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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

Time: 2 months Statistical Tools Used: Simple tools like bar graphs, tabulation, line diagrams have been used.

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LIMITAITONS OF STUDY 1. LIMITED TIME: The time available to conduct the study was only 2 months. It being a wide topic had a limited time. 2. LIMITED RESOURCES: Limited resources are available to collect the information about the commodity trading. 3. VOLATALITY: Share market is so much volatile and it is difficult to forecast any thing about it whether you trade through online or offline 4. ASPECTS COVERAGE: Some of the aspects may not be covered in my study.

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MAIN TOPICS OF STUDY 1. INTRODUCTION TO DERIVATIVE The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the ‘to-arrive’ contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for

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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. DERIVATIVE DEFINED A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in price by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying” in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term “security” in the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate regulatory authorities for securities and commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines “derivative” to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security.

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A contract which derives its value from the prices, or index of prices, of underlying securities. 3. TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives

National Stock

Over The Counter Derivatives

Bombay Stock

National Commodity &

Exchange

Exchange Exchange

Index Future

Index option

Derivative

Stock option

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES

Derivatives

Future

Option

Forward

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Swaps

Stock future


Figure.2 Types of Derivatives

(i)

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are n o r m a l l y traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT •

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

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

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

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

If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

However forward contracts in certain very standardized, reducing transaction

as

in

the

case

markets have of

costs and increasing

foreign

become

exchange,

transactions

volume.

thereby This

process of standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion 27


is primarily because both serve essentially t h e same economic fun ction s of allocating risk in the presence of future price uncertainty. However futures are a

significant

improvement

over

the

forward

contracts as they eliminate counterparty risk and offer more liquidity.

(ii)

FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT 1. Standardization: Futures contracts ensure their liquidity by being highly standardized, usually by specifying: •

The underlying. This can be anything from a barrel of sweet crude oil to a short term interest rate.

•

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

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The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month.

The last trading date.

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

2. Margin: Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Initial Margin: is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-to-market price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended

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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).

•

Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract. PRICING OF FUTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for

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a simple, non-dividend paying asset, the value of the future/forward, be found by discounting the present value

at time to maturity

, will by the rate

of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows. In the case where the forward price is higher: 1. The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. 2. On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit. In the case where the forward price is lower: 1. The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds. 2. On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. 3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.] 4. The difference between the two amounts is the arbitrage profit.

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TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATURE

FORWARD CONTRACT

FUTURE CONTRACT

Operational

Traded directly between Traded on the exchanges.

Mechanism

two parties (not traded on the exchanges).

Contract

Differ from trade to trade.

Specifications Counter-party

Contracts

are

standardized

contracts. Exists.

Exists. However, assumed by the

risk

clearing corp., which becomes the counter party to all the trades or unconditionally

guarantees

their

settlement.

Liquidation

Low,

Profile

tailor

as

contracts

made

are High, as contracts are standardized

contracts exchange traded contracts.

catering to the needs of the needs of the parties. Price discovery

Not efficient, as markets Efficient, as markets are centralized are scattered.

and all buyers and sellers come to a common platform to discover the

Examples

Currency market in India.

price. Commodities, futures, Index Futures and Individual stock Futures in India.

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OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as ‘option’. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the ‘strike price’. There are two types of options i.e., CALL OPTION & PUT OPTION. CALL OPTION: A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Call option’. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. PUT OPTION: A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a ‘Put option’. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.

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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.

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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.

35


11. HISTORY OF DERIVATIVES: The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700’s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of ‘credit risk’ and to provide centralised location to negotiate forward contracts. From ‘forward’ trading in commodities emerged the commodity ‘futures’. The first type of futures contract was called ‘to arrive at’. Trading in futures began on the CBOT in the 1860’s. In 1865, CBOT listed the first ‘exchange traded’ derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of ‘Chicago Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index

36


futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984. Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealer’s Association was set up in early 1900’s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the

37


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.

38


12. INDIAN DERIVATIVES MARKET Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India Table 2. Chronology of instruments 1991 14 December 1995 18 November 1996

Liberalisation process initiated NSE asked SEBI for permission to trade index futures. SEBI setup L.C.Gupta Committee to draft a policy

11 May 1998 7 July 1999

framework for index futures. L.C.Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements

24 May 2000

(FRAs) and interest rate swaps. SIMEX chose Nifty for trading futures and options on an

25 May 2000

Indian index. 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 Nifty futures trading commenced at SGX. 2000 2 June 2001

Individual Stock Options & Derivatives

(1) Need for derivatives in India today

39


In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major part of the world. Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors’ aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India’s financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of India’s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market. (2) Myths and realities about derivatives In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives? • Derivatives increase speculation and do not serve any economic purpose •

Indian Market is not ready for derivative trading

Disasters prove that derivatives are very risky and highly leveraged instruments.

40


•

Derivatives are complex and exotic instruments that Indian investors will find difficulty in understanding

•

Is the existing capital market safer than Derivatives?

(i) Derivatives increase speculation and do not serve any economicpurpose: Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit

41


and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance (ii) Indian Market is not ready for derivative trading Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the prerequisites, which are needed for the introduction of derivatives, and how Indian market fares: TABLE 3. PRE-REQUISITES INDIAN SCENARIO Large market India is one of the largest market-capitalised Capitalisation countries in Asia with a market capitalisation of more than Rs.765000 crores. High Liquidity underlying

in

the 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

42


healthier place for trade practices. (3) Comparison of New System with Existing System Many people and brokers in India think that the new system of Futures & Options and banning of Badla is disadvantageous and introduced early, but I feel that this new system is very useful especially to retail investors. It increases the no of options investors for investment. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI. The figure 3.3a –3.3d shows how advantages of new system (implemented from June 20001) v/s the old system i.e. before June 2001 New System Vs Existing System for Market Players

Figure 3.3a

Speculators Existing Approach &Prize 1) Deliver based Trading, margin possible trading & carry forward transactions. 2) Buy Index Futures hold till expiry.

SYSTEM Peril &Prize

Approach

Peril

1) Both profit & loss to extent of

1)Buy &Sell stocks 1)Maximum on delivery basis loss

price change.

2) Buy Call &Put by paying premium

Advantages • •

New

Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.

43

to premium paid


Figure 3.3b

Arbitrageurs Existing Approach &Prize

SYSTEM Peril &Prize

New Approach

Peril

1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free one 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 continues more or less than Fair price •

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers Existing Approach &Prize

SYSTEM Peril &Prize

1) Difficult to 1) No Leverage offload holding available risk during adverse reward dependant market conditions on market prices as circuit filters limit to curtail losses.

New Approach

Peril

1)Fix price today to buy 1) Additional latter by paying premium. cost is only 2)For Long, buy ATM Put premium. Option. If market goes up, long position benefit else exercise the option. 3)Sell deep OTM call option 44


with underlying shares, earn premium + profit with increase prcie

Advantages •

Availability of Leverage

Figure 3.3d

Small Investors Existing Approach &Prize 1) If Bullish buy stocks else sell it.

SYSTEM Peril &Prize 1) Plain Buy/Sell implies unlimited profit/loss.

Approach

1) Buy Call/Put options based on market outlook 2) Hedge position if holding underlying stock

Advantages •

New

Losses Protected.

45

Peril 1) Downside remains protected & upside unlimited.


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.

46


The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative 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.

47


5.

FACTORS

CONTRIBUTING

TO

THE

GROWTH

OF

DERIVATIVES: Factors contributing to the explosive growth of derivatives are price volatility, globalisation of the markets, technological developments and advances in the financial theories. A.} PRICE VOLATILITY – A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one’s own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have ‘demand’ and producers or suppliers have ‘supply’, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as ‘price volatility’. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. The globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly

48


became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990’s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. These price volatility risks pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds. B.} GLOBALISATION OF MARKETS – Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalisation has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis-à-vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalisation of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

49


C.} TECHNOLOGICAL ADVANCES – A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related

to

advances

in

computer

technology

are

advances

in

telecommunications. Improvement in communications allow for instantaneous worldwide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important. D.} ADVANCES IN FINANCIAL THEORIES – Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970’s, work of Lewis 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

50


13. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.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

51


was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): •

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

F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. •

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

remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high

52


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 ha s also grown.

In the derivative

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

of

derivatives

in

India

followed

by

forwards

and

Significant milestones in the development of derivatives market been

(i) permission

options. have

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

53


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. Table 4.1ForexMarketActivity

April’05-

April’06-

April’07-

April’08-

Total turnover (USD billion)

Mar’06 4,404

Mar’07 6,571

Mar’08 12,304

Dec’08 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

54


Swap/Total Turnover (%)

30.5

30.1

31.1

32.7

Source: RBI

14. BENEFITS OF DERIVATIVES Derivative markets help investors in many different ways: 1.]

RISK MANAGEMENT –

Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised. 2.]

PRICE DISCOVERY –

Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset. 3.]

OPERATIONAL ADVANTAGES –

As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to

55


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.

56


4.]

MARKET EFFICIENCY –

The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.

5.]

EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions. •

The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices.

An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

57


15. National Exchanges In enhancing the institutional capabilities for futures trading the idea of setting up of National Commodity Exchange(s) has been pursued since 1999. Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become operational.

“National Status� implies that these exchanges would be

automatically permitted to conduct futures trading in all commodities subject to clearance of byelaws and contract specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading in November 2002, MCX and NCDEX, Mumbai commenced operations in October/ December 2003 respectively. MCX MCX (Multi Commodity Exchange of India Ltd.) an independent and demutulised 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 Bank of

Baroda,

Canera

Bank,

Corporation

India, 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.

58


MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-ofthe-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading. NMCE National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).

While

various

integral

aspects

of

commodity

economy,

viz.,

warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. NMCE facilitates electronic derivatives trading through robust and tested trading platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rule-based procedures and demonstrated total commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN). NMCE follows best international risk management practices. The contracts are marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In 59


the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement. NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a worldclass commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres. NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed -

60


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. TABLE4: THE CURRENT PROFILE OF FUTURES TRADING IN INDIA WITH RESPECT TO THE VARIOUS EXCHANGES IN INDIA:-

61


16. The Present Status:

62


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:TABLE 4 Registered commodity exchanges in India No. 1.

Exchange India Pepper

2.

Association, Kochi (IPSTA) Vijai Beopar Chambers

3.

Muzaffarnagar Rajdhani Oils & Oilseeds Exchange Gur, Mustard seed its oil &

4.

Ltd., Delhi oilcake Bhatinda Om & Oil Exchange Ltd., Gur

5.

Bhatinda The Chamber of Commerce, Hapur

6.

The

7.

Exchange Ltd., Meerut The Bombay Commodity Exchange Oilseed Complex, Castor

8.

Ltd., Mumbai Rajkot Seeds,

Meerut

&

Spice

Agro

Oil

COMMODITY Trade Pepper (both domestic and international contracts) Ltd., Gur, Mustard seed

Gur, Potatoes and Mustard

seed Commodities Gur

oil international contracts Bullion Castor seed, Groundnut,

&

Merchants Association, Rajkot

its oil & cake, cottonseed, its

oil

(kapas) Ahmedabad

&

cake, and

cotton RBD

palmolein. Commodity Castorseed, cottonseed, its

9.

The

10.

Exchange, Ahmedabad oil and oilcake The East India Jute & Hessian Hessian & Sacking

11.

Exchange Ltd., Calcutta The East India Cotton Association Cotton

12.

Ltd., Mumbai The Spices & Oilseeds Exchange Turmeric

13.

Ltd., Sangli. National Board of Trade, Indore

63

Soya seed, Soyaoil and Soya meals,


14.

Rapeseed/Mustardseed its oil and oilcake and RBD Palmolien The First Commodities Exchange of Copra/coconut, its oil &

15.

India Ltd., Kochi Central India

16. 17.

Exchange Ltd., Gwalior E-sugar India Ltd., Mumbai Sugar National Multi-Commodity Several Commodities

18.

Exchange of India Ltd., Ahmedabad Coffee Futures Exchange India Coffee

19.

Ltd., Bangalore Surendranagar

20.

Oilseeds, Surendranagar E-Commodities Ltd., New Delhi

21.

commence) National Commodity & Derivatives, Several Commodities

22.

Exchange Ltd., Mumbai Multi Commodity Exchange Ltd., Several Commodities

oilcake Commercial Gur and Mustard seed

Cotton

Oil

& Cotton, Cottonseed, Kapas Sugar

(trading

yet

to

Mumbai Bikaner commodity Exchange Ltd., Mustard seeds its oil & oilcake, Gram. Guar seed. Bikaner Guar Gum 24. Haryana Commodities Ltd., Hissar Mustard seed complex 25. Bullion Association Ltd., Jaipur Mustard seed Complex 17. STATUS REPORT OF THE DEVELOPMENTS IN THE 23.

DERIVATIVE 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 A. Observations on the quarterly data for July-September, 2008-09

64


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. Refer Table 1  Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while turnover increased by 24.77% to Rs. 3,317 thousand crore in JulySeptember 2008-09 over April-June 2008-09.  Futures (Index Future + Stock Future) constituted 67.20% of the total number of contracts traded in the F&O Segment. Stock Future and Index Future accounted for 35.26% and 31.94% respectively.  Options constituted

32.80% of the total volumes.

This mainly

comprised of trading in Index Option (30.68%).  Turnover at F&O segment was 4.19 times that of its cash segment.  Reliance, Reliance Capital Ltd, Reliance Petro. Ltd, State Bank of India and ICICI Bank Ltd were the most actively traded scrips in the derivatives segment. Together they contributed 25.12% of derivatives turnover in individual stocks.  Client trading constituted 60.17%, Propriety trading constituted 31.07% and FII trading constituted remaining 8.76% of the total turnover. Refer Table 2  Volume in longer dated derivative contracts (contracts with maturity of more than three months and up to 3 years) was 3.99 lakh and total turnover was Rs. 9870 crore.  Total volume in shorter dated derivative contracts (contracts with maturity up to 3months) was 1,695 lakh and total turnover was Rs. 3,307 thousand crore.

65


Refer Table 3  Volume in Mini Nifty (contracts with minimum lot size of Rs.1 lakh) was 44 lakh and total turnover was Rs. 37 thousand crore. Refer Table 4  During July-September, 2008, S&P CNX Nifty futures recorded highest average daily volatility of 2.85% in July 2008. Refer Table 5  The volume (in terms of no. of contracts traded) of Nifty Future at SGX as a percentage of the volume of Nifty Future at NSE was 8.55% during July- September 2008-09. Refer Table 6  India stands 2nd in Stock Futures, 2nd in Index Futures, 16th in Stock Option and 4th in Index Options (as on November 10, 2008) in World Derivatives Market

(in terms of volume) at the end of September 2008.

 Derivative contracts were launched on 38 securities at National Stock Exchange during July-September 2008-09.

Depth Market Depth

Table-5: Fact file of July-September 2008-09 with respect to the previous quarter APRIL-JUNE 2008-09 JULY-SEPTEMBER2008-09 No. of Turnover No. of Turnover PRODUCT Contracts(L (Rs. ‘000) Contracts(Lakh) (Rs. ‘000) akh) VOLUME & TURNOVER Index Future 415.7 935.6 542.6 1,077.5 Index Option 240.1 571.3 521.2 1,130.9 Single Stock 514.5 1,093.1 599.0 1,039.3 Future

66


Stock Option Total Market Share ( %) Index Future

25.5 1,195.8

58.3 2,658.4

35.9 1,698.7

69.1 3,317.0

1,077.5

35.20 21.49

31.94 30.68

32.48 34.09

35.26

31.33

2.11

2.08

(avg. of three monthsin

Market Concentration

Index Option 1,130.9 Single Stock 41.12 1,039.3 Future Stock Option 2.19 69.1 Turnover in F&O as multiple of turnover in 3.26 cash segment - Reliance Five most active - Reliance Petro. Ltd. scrips in the - Tata Steel F&O Segment - Reliance Capital Ltd active scrips in - Infosys Tech. Ltd the

4.19 - Reliance - Reliance Capital Ltd - Reliance Petro. Ltd - State Bank of India - ICICI Bank Ltd

F&O

Segment Contribution of the above f i ve to total 23.72 derivatives turnover (%) Client (excluding FII

25.12

59.77

60.17

trades) Proprietary

27.88

31.07

FII

12.35

8.76

Table-6: Data for Shorter Dated and Longer Dated derivative contracts

Time Period

Trades in Shorter Dated Trades in

Longer Dated

derivative contracts (up t o derivative contracts 3 Months)

more

67

than

3

months)


(Quarter)

No

of

No

Turnover

contracts

contracts

(Rs. ‘000 cr.)

(lakh)

(more of

Turnover (Rs. ‘000 cr.)

(lakh)

July-September 2008-09 Apr-Jun

2008-

09

1,694.64

3,307.11

3.99

9.87

1,194.97

2,655.88

4.83

12.5

Table-7: Data for Mini Nifty derivative contracts

Time (Quarter)

Period No contract

of Turnover (Rs. ‘000 cr.)

(lakh)

July-September 2008-09 Apr-Jun

2008-

09

68

43.8

36.9

29.4

27.7


Table-8: Minimum, Maximum and Average Daily Volatility of the F&O segment at

NSE for S&P CNX Nifty since April 2008

Month

Average

Maximum

Minimum

volatility

Volatility (%)

Volatility

(%)

(%)

April-08

2.47

2.98

2.05

May-08

1.71

1.99

1.56

June-08

1.80

2.28

1.61

July-08

2.85

3.08

2.38

August-08

2.27

2.61

2.10

2.51

2.09

September08

2.28

Table-9: SGX volume as a percentage of NSE volume for Nifty Future in terms of no. of contracts for the period April – September, 2008-09 NSE Month

Volume SGX

(Nifty

Future (Nifty

volume)

volume)

Volume SGX volume as Future % of NSE Volume

JulySeptember 2008-09

47,977,775

4,104,418

8.55

37,764,776

3,241,034

8.58

Apr-Jun 200809

69


Table-10: Standing of India in World Derivatives Market (in terms of volume)

Products

July 2008

August 2008

September 2008

Stock Future

1

1

2

Index Future

2

2

2

Stock Option

9

15

16

Index Option

4

4

4

Source: www.world-exchanges.org (as on November 10, 2008) Salient points for the 2nd quarter 2008-09 ďƒź The volume (no. of contracts) and open interest in the derivatives market has increased even when the underlying market is witnessing a downward trend. This indicates that there are sufficient long position holders who anticipate value proposition in a falling market. Falling or rising markets on the back of low volumes may be a cause of concern from the point of market integrity. However, as observed from the data, under the present scenario the fall in the market has been accompanied by high volumes.

ďƒź In Index Option, there is a sharp increase in turnover (97.95%) and volume (117.08%) during July-September 2008-09 over April-June 2008-09. Possible reasons for increase in options trading activity can be attributed to increase in volatility. Market observers believe that conditions across markets and asset classes have become more volatile and uncertain in the recent past. Generally in such conditions,

70


many people believe that options act as "insurance" against adverse price movements while offering the flexibility to benefit from possible favourable price movements at the same time. Another reason which can be attributed to the increase in activity is the new directive as per the Budget 2008-09 which states that STT would now be levied on the Option premium instead of the strike price.  In Index Future, both turnover (15.17%) and volume (30.53%) have increased during July-September 2008-09 as compared to April-June 2008-09.  There is a decrease in turnover (4.92%) in Single Stock Futures during July- September 2008-09 as compared to April-June 2008-09.  Except Index Option, the market share of all other products has decreased (both in terms of volume and turnover) in second quarter of 2008-09 as compared to the first quarter of 2008-09.  There is a decrease in turnover (21.04%) and volume (17.39%) in Longer Dated derivative contracts in second quarter of 2008-09 as compared to the first quarter of 2008-09.  Longer dated derivatives were launched in March 2008, but the volumes have not picked up consequently.  For shorter dated derivative contracts, turnover increased by 24.52% whereas volume increased by 4.81% in second quarter of 2008-09 as compared to the first quarter of 2008-09.  During 2008-09, Mini Nifty volumes increased by 49.15% and turnover increased by 33.43% during July-September 2008-09 over April-June 2008-09.

71


18. Business Growth in Derivatives segment (NSE) TABLE 11A Index futures Year

No. of contracts

2008-09

4116649

2007-08

156598579

2006-07

81487424

2005-06

58537886

2004-05

21635449

2003-04

17191668

2002-03

2126763

2001-02

1025588

FIGURE 11A Number of contracts per year

72


160000000 140000000 120000000

2008-09

100000000 80000000 60000000

2006-07

40000000 20000000

2003-04

2007-08 2005-06 2004-05 2002-03

0 year

2001-02

INTERPRETATION: From the data and the bar diagram above, there is high business growth in the derivative segment in India. In the year 2001-02, the number of contracts in Index Future were 1025588 where as a significant increase of 4116679 is observed in the year 2008-09.

Table 11B No of turnovers Year

Turnover (Rs. Cr.)

2008-09

925679.96

2007-08

3820667.27

2006-07

2539574

2005-06

1513755

2004-05

772147

2003-04

554446

2002-03

43952

2001-02

21483

FIGURE 11B Turnover in Rs. Crores

73


4000000 3500000 3000000 2500000 2000000 1500000 1000000 500000 0

2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 year

INTERPRETATION: From the data and above bar chart, there is high turn over in the derivative segment in India. In the year 2001-02 the turnover of index future was 21483 where as a huge increase of 92567996 in the year 2008-09 are observed.

74


TABLE 12A STOCK FUTURES Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

No. of contracts 51449737 203587952 104955401 80905493 47043066 32368842 10676843 1957856 -

FIGURE 12A Number of contracts per year in stock future

250000000 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

200000000 150000000 100000000 50000000 0 year

INTERPRETATION: From the data and bar diagram above there were no stock futures available but in the year 2001-02, it predominently increased to 1957856. Then there was a huge increase of 20, 35, and 87,952 in the year 2007-08 but there was a steady decline to 51449737 in the year 2008-09.

TABLE 12B NO OF TURNOVERS

75


Year

Turnover (Rs. Crores) 1093048.26 7548563.23 3830967 2791697 1484056 1305939 286533 51515 -

2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 FIGURE 12B Turnover in Rs. Crores 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0

year

2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

INTERPRETATION: From the data and bar chart above, there were no stock futures available in the year 2000-01. There was a steady increase of stock future 51515 in the year 2001-02. but in the year there was a huge increae of 7548563.23 in the year 2007-08 with a considerable decline of 1093048.26 in the year 2008-09. TABLE 13A INDEX OPTIONS Year

No. of contracts

2008-09 2007-08 2006-07

24008627 55366038 25157438

76


2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

12935116 3293558 1732414 442241 175900 -

FIGURE 13A Number of contracts per year

60000000 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

50000000 40000000 30000000 20000000 10000000 0

year

Interpretation: From the data and bar chart above, the no of contracts of index option was nil in the year 2000-2001. But there was a predominant increase of 1,75,900 in the year 2001-2002. In the year 2007-2008 there was a huge increase in the index option contracts to 55366038 and a decline of 24008627 in the year 2008-2009. TABLE 13B Turnover per year in Rs. Crores

Year

Turnover (Rs. Crores)

2008-09 2007-08

71340.02 1362110.88

77


2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

791906 338469 121943 52816 9246 3765 -

FIGURE 13B Turnover per year in Rs. Crores 1400000 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

1200000 1000000 800000 600000 400000 200000 0

year

Interpretation: From the data and bar chart above, there was no turnover in the year 20002001 for Index option. It slowly started increasing in the year 2000-2001 to 3765.But in the year 2007-2008 there was a huge increase of 1362110.088 and a sudden decline to 71340.02 observed in 2008-2009. TABLE 14A STOCK OPTIONS Year 2008-09 2007-08 2006-07 2005-06

No. of contracts 2546175 9460631 5283310 5240776

78


2004-05 2003-04 2002-03 2001-02 2000-01

5045112 5583071 3523062 1037529 -

FIGURE 14A Number of contracts traded per year in stock option 10000000 9000000 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0

2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 year

INTERPRETATION: From the data and bar chart above the no of contracts of stock option in the year 2000-2001 was nil. But there was a huge increase of 1037529 observed in the year 2001-2002. It was 9460631 which was the the highest in the year 2007-2008. But a gradual decline of 2546175 in the year 2008-2009.

TABLE 14B National turnover in Rs. Crores per year Year

Notional

2008-09 2007-08 2006-07

crores) 58335.03 359136.55 193795

79

turnover

(Rs.


2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

180253 168836 217207 100131 25163 -

FIGURE 14B National turnover in Rs. Crores per year 400000 350000

2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

300000 250000 200000 150000 100000 50000 0

year

Interpretation: From the chart and the bar diagram above the stock option turnover in the year 2000-2001 was nil. There was a slow increase of 25163 in the year 2001-2002. But a phenomenal increase of 359136.55 in the year 2007-2008, and a decline of 58355.03 in the year 2008-2009.

TABLE 15A OVERALL TRADING Year

No. of contracts

Turnover (Rs. cr.)

2008-09 2007-08 2006-07 2005-06

119171008 425013200 216883573 157619271

2648403.30 13090477.75 7356242 4824174

80


2004-05 2003-04 2002-03 2001-02 2000-01

77017185 56886776 16768909 4196873 90580

2546982 2130610 439862 101926 2365

FIGURE 15A Average daily turnovers in Rs. Crores

60000 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009

50000 40000 30000 20000 10000 0

year

Interpretation: From the data and bar chart above, the overall trading contracts in the year 2000-2001 was 90580 and huge increase of 119171008 in the year 2008-2009. From the data and bar chart above the overall trading turnover in the year 20002001 was as low as 2365 but a predominant increase of 2648403.30 observed in the year 2008-2009. TABLE 16 Overall trade description under NSE Index Futures Y No. e of a contr r acts

Stock Futures Turnove r (Rs. cr.)

No. of contract s

Index Options Turnove r (Rs. cr.)

No. of contrac ts

Stock Options Notional Turnove r (Rs. cr.)

81

No. of contract s

Notional Turnove r (Rs. cr.)

Interest Rate Futures No. Tu of rno cont ver ract (Rs s .

Total No. of contracts

T u r n o


v e r ( R s .

cr.)

925679.9 2 0 0 4116646 8 9 0 9

5144973 7

1093048. 26

240086 27

571340.0 2

2546175

58335.03

0

0.0 0

11917100 8

3820667. 27

2035879 52

7548563. 23

553660 38

1362110. 88

9460631

359136.5 5

0

0.0 0

42501320 0

8148742 4

2539574

1049554 01

3830967

251574 38

791906

5283310

193795

0

0

21688357 3

5853788 6

1513755

8090549 3

2791697

129351 16

338469

5240776

180253

0

0

15761927 1

2163544 9

772147

4704306 6

1484056

329355 8

121943

5045112

168836

0

0

77017185

2 0 0 1565985 7 79 0 8 2 0 0 6 0 7 2 0 0 5 0 6 2 0 0 4 0 5

6

82

c r . ) 2 6 4 8 4 0 3 . 3 0 1 3 0 9 0 4 7 7 . 7 5 7 3 5 6 2 4 2 4 8 2 4 1 7 4 2 5 4 6 9 8 2


2 0 0 3 0 4 2 0 0 2 0 3 2 0 0 1 0 2 2 0 0 0 0 1

1719166 8

2126763

1025588

90580

554446

43952

21483

2365

3236884 2

1067684 3

1957856

-

1305939

286533

51515

-

173241 4

442241

175900

52816

9246

3765

-

5583071

3523062

1037529

-

TABLE 17 AVERAGE DAILY TURNOVERS

83

217207

100131

25163

-

1078 1

-

-

-

202

-

-

-

56886776

2 1 3 0 6 1 0

16768909

4 3 9 8 6 2

4196873

1 0 1 9 2 6

90580

2 3 6 5


Year

Av. daily turnover (Rs. Crores)

2008-09

45390.21

2007-08

52153.30

2006-07

29543

2005-06

19220

2004-05

10167

2003-04

8388

2002-03

1752

2001-02

410

2000-01

11

Note: Notional Turnover = (Strike Price + Premium) * Quantity Index Futures, Index Options, Stock Options and Stock Futures were introduced in June 2000, June 2001, July 2001 and November 2001 respectively.

84


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. 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

85


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.

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.

 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. 86


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

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

87

Derivatives

in

India

by


ABBREVATIONS A AMEX- America Stock Exchange B BSE- Bombay Stock Exchange BSI- British Standard Institute C CBOE - Chicago Board options Exchange CBOT - Chicago Board of Trade CEBB - Chicago Egg and Butter Board CME - Chicago Mercantile Exchange CNX- Crisil Nse 50 Index CPE - Chicago Produce Exchange CWC- Central Warehousing Corporation D DTSS- Derivative Trading Settlement System F FIIs- Foreign Institutional Investors F & O – Future and Options FMC- Forward Markets Commission FRAs- Forward Rate Agreements G GAICL-Gujarat Agro Industries Corporation Limited GSAMB- Gujarat State Agricultural Marketing Board I IMM - International Monetary Market IPSTA- India Pepper & Spice Trade Association M MCX – Multi Commodity Exchange

88


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

89


Project on Indian Derivative Market