indian derivative market - final tnr
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RESEARCH PROJECT REPORT
On
Types of Derivatives Traded on NSE and
its Impact
Towards partial fulfillment of
Master of Business Administration (MBA)School of Management, Babu Banarasi Das University,
Lucknow
Guided by Submitted by
Mrs. Shachi Kacker Prabhat
Mishra
Session 2012-2013
School of Management
Babu Banarasi Das University
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Sector I, Dr. Akhilesh Das Nagar, Faizabad Road, Lucknow (U.P.)India
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A C K N O W L E D G E M E N T
Without a proper combination of inspection and perspiration, its not easy to achieve
anything. There is always a sense of gratitude, which we express to others for the help
and the needy services they render during the different phases of our lives. I too would
like to do it as I really wish to express my gratitude toward all those who have been
helpful to me directly or indirectly during the development of this project.
I would like to thankMrs. Shachi Kacker (Faculty of management, BBDU) who was
always there to help and guide me when I needed help. Her perceptive criticism kept me
working to make this project more full proof. I am thankful to her for her encouraging
and valuable support. Working under her was an extremely knowledgeable and
enriching experience for me. I am very thankful to her for all the value addition and
enhancement done to me.
No words can adequately express my overriding debt of gratitude to my parents whose
support helps me in all the way. Above all I shall thank my friends who constantly
encouraged and blessed me so as to enable me to do this work successfully.
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P R E F A C E
My research project report entitled TYPES OF DERIVATIVES TRADED ON NSE
AND ITS IMPACT submitted for the degree of Master of Business Administration, is
my original work.
I believe that my research report will have been very helpful to the organization for the
practical knowledge in the field of Finance.
Place : LUCKNOW
Date : 1 May 2013 PRABHAT MISHRA
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EXECUTIVE SUMMARY
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.
Indias market capitalization was the highest among the emerging markets. Total market
capitalization of The Bombay Stock Exchange (BSE), which, as on July 31, 1997, was
US$ 175 billion has grown by 37.5% percent every twelve months and was over US$
834 billion as of January, 2007. Bombay Stock Exchanges (BSE), one of the oldest in
the world, accounts for the largest number of listed companies transacting their shares
on a nationwide online trading system. The two major exchanges namely the National
Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5 in the
world, calculated by the number of daily transactions done on the exchanges.
The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 An
increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years only.
Turnover in the Spot and Derivatives segment both in NSE & BSE was higher by 45%
into 2006 as compared to 2005. With daily average volume of US $ 9.4 billion, the
Sensex has posted excellent returns in the recent years. Currently the market 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
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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 secu-
rities 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 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
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A Forward Contractis 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 contractis 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 contractconfers 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. ThePrice is called Premium and is paid by buyer of the option to the seller or writer of the
option.
A call option gives the holder the right to buy an underlying asset by a certain date for a
certain price. The seller is under an obligation to fulfill the contract and is paid a price of
this, which is called "the call option premium or call option price".
A put option, on the other hand gives the holder the right to sell an underlying asset by
a certain date for a certain price. The buyer is under an obligation to fulfill the 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
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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.
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TABLE OF CONTENTS
S.No.
TOPICS PAGENO.
1. Introduction..... 102. Company Profile...................... 113. Organization Chart ......................... 224.
5.
6.
7.
8.
9.
Objective of the Study........................................................................
Need of the Study.......................................................................
Scope of the Project.......................................................................
Literature Review........................................................................
Main Topics of Study..................................................................
Data Interpretation.........................................................................
23
24
25
26
27
5710.
11.
12.
13.
14.
15.
Research Methodology.
Limitations of Study...
Findings & Conclusion..
Recommendations & Suggestions..
Bibliography....
Abbreviations..
69
70
71
73
74
75
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.
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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.
NSE - A NEW IDEOLOGY
GENESIS
Capital market reforms in India have outstripped the process of liberalization in most
other sectors of the economy. However, the creation of an independent capital market
regulator was the initiation of this reform process. After the formation of the Securities
Market regulator, the Securities and Exchange Board of India (SEBI), attention were
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drawn towards the inefficiencies of the bourses and the need was felt for better
regulation, discipline and accountability. A Committee recommended the creation of a
2nd stock exchange in Mumbai called the "National Stock Exchange". The Committee
suggested the formation of an exchange which would provide investors across the
country a single, screen based trading platform, operated through a VSAT network. It
was on this recommendation that setting up of NSE as a technology driven exchange
was conceptualized. NSE has set up its trading system as a nation-wide, fully automated
screen based trading system. It has written for itself the mandate to create a world-class
exchange and use it as an instrument of change for the industry as a whole through
competitive pressure. NSE was incorporated in 1992 and was given recognition as a
stock exchange in April 1993. It started operations in June 1994, with trading on the
Wholesale Debt Market Segment. Subsequently it launched the Capital Market Segment
in November 1994 as a trading platform for equities and the Futures and Options
Segment in June 2000 for various derivative instruments.
NSE was set up with the objectives of:
Establishing a nationwide trading facility for all types of securities;
Ensuring equal access to investors all over the country through an appropriate
communication network;
Providing a fair, efficient and transparent securities market using electronic
trading system;
Enabling shorter settlement cycles and book entry settlements; and
Meeting international benchmarks and standards.
The broad objective for which the exchange was set up has made it to play a leadingrole
in enlarging the scope of market reforms in securities market in India. During lastone
decade it has been playing the role of a catalytic agent in reforming the markets in terms
of market microstructure and in evolving the best market practices keeping in mind the
investors. The Exchange is set up on a demutualised model wherein the ownership,
management and trading rights are in the hands of three different sets of people. This
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has completely eliminated any conflict of interest. This has helped NSE to aggressively
pursue policies and practices within a public interest framework. NSE's nationwide,
automated trading system has helped in shifting the trading platform from the trading
hall in the premises of the exchange to the computer terminals at the premises of the
trading members located at different geographical locations in the country and
subsequently to the personal computers in the homes of investors and even to hand held
portable devices for the mobile investors. It has been encouraging corporatization of
membership in securities market. It has also proved to be instrumental in ushering in
scrip less trading and providing settlement guarantee for all trades executed on the
Exchange. Settlement risks have also been eliminated with NSE's innovative endeavors
in the area of clearing and settlement viz., establishment of the clearing corporation
(NSCCL), setting up a
settlement guarantee fund (SGF), reduction of settlement cycle, implementing on-line,
real-time risk management systems, dematerialization and electronic transfer of
securities to name few of them. As a consequence, the market today uses state-of-the-art
information technology to provide an efficient and transparent trading, clearing and
settlement mechanism. In order to take care of investors interest, it has also created an
investors protection fund (IPF), that would help investors who have incurred financial
loss due to default of brokers.
Ownership and Management of the NSE
NSE is owned by a set of leading financial institutions, banks, insurance companies and
other financial intermediaries. It is managed by a team of professional managers and the
trading rights are with trading members who offer their services to the investors. The
Board of NSE comprises of senior executives from promoter institutions and eminent
professionals, without having any representation from trading members. While theBoard deals with the broad policy issues, the Executive Committees which include
trading members, formed under the Articles of Association and the Rules of NSE for
different market segments, set out rules and parameters to manage the day-to-day affairs
of the Exchange. The ECs have constituted several committees, like Committee on
Trade Related Issues (COTI), Committee on Settlement Issues (COSI) etc., comprising
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mostly of trading members, to receive inputs from the market participants and
implement suggestions which are in the best interest of the investors and the market.
The day-to-day management of the Exchange is delegated to the Managing Director and
CEO who is supported by a team of professional staff. Therefore, though the role of
trading members at NSE is to the extent of providing only trading services to the
investors, the Exchange involves trading members in the process of consultation and
participation in vital inputs towards decision making.
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Market Segments and Products
NSE provides an electronic trading platform for of all types of securities for investors
under one roof - Equity, Corporate Debt, Central and State Government Securities,
TBills, Commercial Paper, Certificate of Deposits (CDs), Warrants, Mutual Funds units,
Exchange Traded Funds, Derivatives like Index Futures, Index Options, Stock Futures,
Stock Options, Futures on Interest Rates etc., which makes it one of the few exchanges
in the world providing trading facility for all types of securities on a single exchange.
The Exchange provides trading in 3 different segments viz.
Wholesale debt market (WDM)
Capital market (CM) segment and
The futures & options (F&O) segment.
The Wholesale Debt Market segment provides the trading platform for trading of a
wide range of debt securities which includes State and Central Government securities,
T-Bills, PSU Bonds, Corporate Debentures, CPs, CDs etc. However, along with these
financial instruments, NSE has also launched various products (e.g. FIMMDA-NSE
MIBID/MIBOR) owing to the market need. A reference rate is said to be an accurate
measure of the market price. In the fixed income market, it is the interest rate that the
market respects and closely matches. In response to this, NSE started computing and
disseminating the NSE Mumbai Inter-bank Bid Rate (MIBID) and NSE Mumbai Inter-
Bank Offer Rate (MIBOR). Owing to the robust methodology of computation of these
rates and its extensive use, this product has become very popular among the market
participants.
Keeping in mind the requirements of the banking industry, FIs, MFs, insurance
companies, who have substantial investments in sovereign papers, NSE also started the
dissemination of its yet another product, the Zero Coupon Yield Curve. This helps in
valuation of sovereign securities across all maturities irrespective of its liquidity in the
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market. The increased activity in the government securities market in India and
simultaneous emergence of MFs (Gilt MFs) had given rise to the need for a well defined
bond index to measure the returns in the bond market. NSE constructed such an index
the, NSE Government Securities Index. This index provides a benchmark for portfolio
management by various investment managers and gilt funds.
The Capital Market segment offers a fully automated screen based trading system,
known as the National Exchange for Automated Trading (NEAT) system. This operates
on a price/time priority basis and enables members from across the country to trade with
enormous ease and efficiency. Various types of securities e.g. equity shares, warrants,
debentures etc. are traded on this system. NSE started trading in the equities segment
(Capital Market segment) on November 3, 1994 and within a short span of 1 year
became the largest exchange in India in terms of volumes transacted.
The Equities section provides you with an insight into the equities segment of NSE and
also provides real-time quotes and statistics of the equities market. In-depth information
regarding listing of securities, trading systems & processes, clearing and settlement, risk
management, trading statistics etc are available here.
Futures & Options segment of NSE provides trading in derivatives instruments like
Index Futures, Index Options, Stock Options, Stock Futures and Futures on interest
rates. Though only four years into its operations, the futures and options segment of
NSE has made a mark for itself globally. In the Futures and Options segment, trading in
Nifty and CNX IT index and 53 single stocks are available. W.e.f. May 27 2005, futures
and options would be available on 118 single stocks.
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Technology
Technology has been the backbone of the Exchange. Providing the services to the
investing community and the market participants using technology at the cheapest
possible cost has been its main thrust. NSE chose to harness technology in creating a
new market design. It believes that technology provides the necessary impetus for the
organisation to retain its competitive edge and ensure timeliness and satisfaction in
customer service. In recognition of the fact that technology will continue to redefine the
shape of the securities industry, NSE stresses on innovation and sustained investment in
technology to remain ahead of competition.
NSE is the first exchange in the world to use satellite communication technology for
trading. It uses satellite communication technology to energise participation through
about 2,829 VSATs from nearly 345 cities spread all over the country. Its tradingsystem, called National Exchange for Automated Trading (NEAT), is a state of the art
client server based application. At the server end all trading information is stored in an
in-memory database to achieve minimum response time and maximum system
availability for users.
It has uptime record of 99.7%. For all trades entered into NEAT system, there is
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uniform response time of less than 1.5 seconds. NSE has been continuously
undertaking capacity enhancement measures so as to effectively meet the
requirements of increased users and associated trading loads. With recent up gradation
of trading hardware, NSE can handle up to 6 million trades per day. NSE has also put in
place NIBIS (NSE's Internet Based Information System)
for on-line real-time dissemination of trading information over the Internet. As part of
its business continuity plan, NSE has established a disaster back-up site at Chennai
along with its entire infrastructure, including the satellite earth station and the high
speed optical fiber link with its main site at Mumbai. This site at Chennai is a replica of
the production environment at Mumbai. The transaction data is backed up on near real
time basis from the main site to the disaster
back-up site through the 2 mbps high-speed link to keep both the sites all the time
synchronized with each other.
Application SystemThe various application systems that NSE uses for its trading as
well clearing and settlement and other operations form the backbone of the Exchange.
The application systems used for the day-to-day functioning of the Exchange can be
divided into
(a) Front end applications (b) Back office applications.
In the front end application system, there are 6 pplications:
NEAT CM system takes care of trading of securities in the Capital Market
segment that includes equities, debentures/notes as well as retail Gilts. The NEATCM
application has a split architecture wherein the split is on thesecurities and users. The
application runs on two Stratus systems with Open Strata Link (OSL). The application
has been benchmarked to support 15000 users and handle more than 6 million trades
daily. This application also provides data feed for processing to some other systems like
Index, OPMS through TCP/IP. This is a direct interface with the trading members of the
CM segment of the Exchange for entering the orders into the main system. There is a
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two way communication between the NSE main system and the front end terminal of
the trading member.
NEAT WDM system takes care of trading of securities in the Wholesale Debt
Market (WDM) segment that includes Gilts, Corporate Bonds, CPs, T-Bills, etc.
This is a direct interface with the trading members of the WDM segment of the
Exchange for entering the orders/trades into the main system. There is a two way
communication between the NSE main system and the front end terminal of the
trading member.
NEAT F&O system takes care of trading of securities in the Futures and Options
(F&O) segment that includes Futures on Index as well as individual stocks and Options
on Index as well as individual stocks. This is a direct interface
with the trading members of the F&O segment of the Exchange for entering the orders
into the main system. There is a two way communication between the NSE main system
and the front end terminal of the trading member.
NEAT IPO system is an interface to help the initial public offering of companies
which are issuing the stocks to raise capital from the market. This is adirect interface with the trading members who are registered for undertaking order entry
on behalf of their clients for IPOs. NSE uses the NEAT IPO system that allows bidding
in several issues concurrently. There is a two way communication between the NSE
main system and the front end terminal of the trading member.
NEAT MF system is an interface with the trading members for order collection of
designated mutual funds units.
Surveillance system offers the users a facility to comprehensively monitor the
trading activity and analyze the trade data online and offline.
In the back office, the following important application systems are operative:
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(A) NCSS (Nationwide Clearing and Settlement System) is the clearing and
settlement system of the NSCCL for the trades executed in the CM segment of the
Exchange. The system has 3 important interfaces OLTL (Online Trade loading) that
takes each and every trade executed on real time basis and allocates the same to the
clearing members, Depository Interface that connects the depositories for settlement of
securities and Clearing Bank Interface that connects the 10 clearing banks for settlement
of funds. It also interfaces with the clearing members for all required reports. Through
collateral management system it keeps an account of all available collaterals on behalf
of all trading/clearing members and integrates the same with the position monitoring of
the trading/ clearing members. The system also generates base capital adequacy reports.
(B) FOCASS is the clearing and settlement system of the NSCCL for the trades
executed in the F&O segment ofthe Exchange. It interfaces with the clearing members
for all required reports. Through collateral management system it keeps an account of
all available collaterals on behalf of all trading/ clearing members and integrates the
same with the position monitoring of the trading/clearing members. The system also
generates base capital adequacy reports.
(C) OPMS the online position monitoring system that keeps track of all tradesexecuted for a trading member vis--vis its capital adequacy.
(D) PRISM is the parallel risk management system for F&O trades using Standard
Portfolio Analysis (SPAN). It is a system for comprehensive monitoring and load
balancing of an array of parallel processors that provides complete fault tolerance. It
provides real time information on initial margin value, mark to market profit or loss,
collateral amounts, contract-wise latest prices, contract-wise open interest and limits.
The system also tracks online real time client level portfolio, base upfront margining
and monitoring.
(E) Data warehousing, that is the central repository of all data in CM as well as F&O
segment of the Exchange.
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(F) Listing system, that captures the data of companies which are listed on the
Exchange and integrates the same with the trading system for necessary broadcasts,
information dissemination.
(G) Membership system, hat keeps track of all required details of the Trading
Members of the Exchange.
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ORGANIZATION CHART
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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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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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SCOPE OF THE PROJECT
The project covers the derivatives market and its instruments. 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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LITERATURE REVIEWThe 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.
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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 hedging and speculation on price
charges. These were eventually standardized, and in 1925 the first futures clearing house
came into existence.
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Today derivatives contracts exist on variety of commodities such as corn, pepper,
cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot
of financial underlying like stocks, interest rate, exchange rate, etc.
2. DERIVATIVE DEFINED
A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can be
equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat
farmers may wish to sell their harvest at a future date to eliminate the risk of change in
price by that date. Such a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the underlying in this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures
contracts in commodities all over India. As per this the Forward Markets Commission
(FMC) continues to have jurisdiction over commodity futures contracts. However when
derivatives trading in securities was introduced in 2001, the term security in the
Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative
contracts in securities. Consequently, regulation of derivatives came under the purview
of Securities Exchange Board of India (SEBI). We thus have separate regulatory
authorities for securities and commodity derivative markets.
Derivatives are securities under the SCRA and hence the trading of derivatives is
governed by the regulatory framework under the SCRA. The Securities Contracts
(Regulation) Act, 1956 defines derivative to include-
A security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract differences or any other form of security.
A contract which derives its value from the prices, or index of prices, of underlying
securities.
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Derivatives
Future Option Forward Swaps
3. TYPES OF DERIVATIVES MARKET
Exchange Traded Derivatives Over The Counter Derivatives
National Stock Bombay Stock National Commodity &Exchange Exchange Derivative Exchange
Index Future Index option Stock option Stock future
Types of Derivatives Market
4. TYPES OF DERIVATIVES
Types of Derivatives
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(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 samecounter-party, whic h often results in high prices being charged.
However forward contracts in certain markets have become very standardized,
as in the case of foreign exchange, thereby reducing transaction costs and
increasing transactions volume. This process of standardization reaches its limit in
the organized futures market. Forward contracts are often confused with futures
contracts. The confusion is primarily be ca us e b oth serve essenti ally th e same
economic functio ns 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.
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(ii) FUTURE CONTRACT
In finance, a futures contract is a standardized contract, traded on a futures exchange, to
buy or sell a certain underlying instrument at a certain date in the future, at a pre-set
price. The future date is called the delivery date or final settlement date. The pre-set
price is called the futures price. The price of the underlying asset on the delivery date is
called the settlement price. The settlement price, normally, converges towards the
futures price on the delivery date.
A futures contract gives the holder the right and the obligation to buy or sell, which
differs from an options contract, which gives the buyer the right, but not the obligation,
and the option writer (seller) the obligation, but not the right. To exit the commitment,
the holder of a futures position has to sell his long position or buy back his short
position, effectively closing out the futures position and its contract obligations. Futures
contracts are exchange traded derivatives. The exchange acts as counterparty on all
contracts, sets margin requirements, etc.
BASIC FEATURES OF FUTURE CONTRACT
1. Standardization:
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:
The underlying. This can be anything from a barrel of sweet crude oil to a short
term interest rate.
The type of settlement, either cash settlement or physical settlement.
The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term interest
rate is traded, etc.
The currency in which the futures contract is quoted.
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Thegrade of the deliverable. In case of bonds, this specifies which bonds can be
delivered. In case of physical commodities, this specifies not only the quality of
the underlying goods but also the manner and location of delivery. The delivery
month.
The last trading date.
Other details such as the tick, the minimum permissible price fluctuation.
2. Margin:
Although the value of a contract at time of trading should be zero, its price constantly
fluctuates. This renders the owner liable to adverse changes in value, and creates a credit
risk to the exchange, who always acts as counterparty. To minimize this risk, the
exchange demands that contract owners post a form of collateral, commonly known as
Margin requirements are waived or reduced in some cases for hedgers who have
physical ownership of the covered commodity or spread traders who have offsetting
contracts balancing the position.
Initial Margin: is paid by both buyer and seller. It represents the loss on that contract,
as determined by historical price changes, which is not likely to be exceeded on a usual
day's trading. It may be 5% or 10% of total contract price.
Mark to market Margin: Because a series of adverse price changes may exhaust the
initial margin, a further margin, usually called variation or maintenance margin, is
required by the exchange. This is calculated by the futures contract, i.e. agreeing on a
price at the end of each day, called the "settlement" or mark-to-market price of the
contract.
To understand the original practice, consider that a futures trader, when taking a
position, deposits money with the exchange, called a "margin". This is intended to
protect the exchange against loss. At the end of every trading day, the contract is
marked to its present market value. If the trader is on the winning side of a deal, his
contract has increased in value that day, and the exchange pays this profit into his
account. On the other hand, if he is on the losing side, the exchange will debit his
account. If he cannot pay, then the margin is used as the collateral from which the loss is
paid.
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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 a simple, non-dividend
paying asset, the value of the future/forward, , will be found by discounting the
present value at time to maturity by the rate of risk-free return .
This relationship may be modified for storage costs, dividends, dividend yields, andconvenience 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.
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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 1-DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS
FEATURE FORWARD CONTRACT FUTURE CONTRACT
Operational
Mechanism
Traded directly between twoparties (not traded on the
exchanges).
Traded on the exchanges.
Contract
Specifications
Differ from trade to trade. Contracts are standardized contracts.
Counter-party
risk
Exists. Exists. However, assumed by the clearing
corp., which becomes the counter party toall the trades or unconditionally
guarantees their settlement.
Liquidation
Profile
Low, as contracts are tailor
made contracts catering to the
needs of the needs of the
parties.
High, as contracts are standardized
exchange traded contracts.
Price discovery Not efficient, as markets are
scattered.
Efficient, as markets are centralized and
all buyers and sellers come to a common
platform to discover the price.
Examples Currency market in India. Commodities, futures, Index Futures and
Individual stock Futures in India.
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(iii) 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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(iv) 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 partiesagree 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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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.
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5. 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 priceat 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
1700s 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 1860s. 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 onOctober 20, 1975. Stock index futures and options emerged in 1982. The first stock
index futures contracts were traded on Kansas City Board of Trade on February 24,
1982.The first of the several networks, which offered a trading link between two
exchanges, was formed between the Singapore International Monetary Exchange
(SIMEX) and the CME on September 7, 1984.
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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 Dealers Association was set up in early 1900s 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 inassessing the fair price of an option which led to an increased interest in trading of
options. With the options markets becoming increasingly popular, the American Stock
Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in
options in 1975.
The market for futures and options grew at a rapid pace in the eighties and nineties. The
collapse of the Bretton Woods regime of fixed parties and the introduction of floating
rates for currencies in the international financial markets paved the way for development
of a number of financial derivatives which served as effective risk management tools to
cope with market uncertainties.
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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.
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6. 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
Indias (RBI) efforts in creating currency forward market. Derivatives are an integral
part of liberalisation process to manage risk. NSE gauging the market requirements
initiated the process of setting up derivative markets in India. In July 1999, derivatives
trading commenced in India
Table 2. Chronology of instruments
1991 Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework
for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs)
and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian
index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures
trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September 2000 Nifty futures trading commenced at SGX.
2 June 2001 Individual Stock Options & Derivatives
(1) Need for derivatives in India today
In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Today, derivatives have become part and
parcel of the day-to-day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading
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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 Indias
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 Indias 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.
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
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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 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 pre-requisites, which
are needed for the introduction of derivatives, and how Indian market fares:
TABLE 3.
PRE-REQUISITES INDIAN SCENARIO
Large market Capitalisation India is one of the largest market-capitalised countries inAsia with a market capitalisation of more thanRs.765000 crores.
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High Liquidity in theunderlying
The daily average traded volume in Indian capitalmarket today is around 7500 crores. Which means on anaverage every month 14% of the countrys Marketcapitalisation gets traded. These are clear indicators of
high liquidity in the underlying.
Trade guarantee The first clearing corporation guaranteeing trades hasbecome fully functional from July 1996 in the form ofNational Securities Clearing Corporation (NSCCL).NSCCL is responsible for guaranteeing all openpositions on the National Stock Exchange (NSE) forwhich it does the clearing.
A Strong Depository National Securities Depositories Limited (NSDL) whichstarted functioning in the year 1997 has revolutionalised
the security settlement in our country.
A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital market enjoys astrong, independent, and innovative legal guardian whois helping the market to evolve to a healthier place fortrade 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
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Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize
1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premiumhold till expiry.
Advantages
Greater Leverage as to pay only the premium.
Greater variety of strike price options at a given time.
Figure 3.3b
Arbitrageurs
Existing SYSTEM New
Approach Peril &Prize Approach Peril &Prize1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game.another exchange. the Market moves. in weekly settlementforward transactions. 2) Cash &Carry2) If Future Contract arbitrage continues
more or less than Fair price
Fair Price = Cash Price + Cost of Carry.
Figure 3.3c
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Hedgers
Existing SYSTEM New
Approach Peril &Prize Approach Peril&Prize
1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.market conditions on market prices Option. If market goes up,as circuit filters long position benefit elselimit to curtail losses. exercise the option.
3)Sell deep OTM call optionwith underlying shares, earnpremium + profit with increase prcie
Advantages Availability of Leverage
Figure 3.3d
Small Investors
Existing SYSTEM New
Approach Peril &Prize Approach Peril&Prize
1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains
profit/loss. 2) Hedge position if protected &
holding underlying upsidestock unlimited.
Advantages Losses Protected.
4. Exchange-traded vs. OTC derivatives markets
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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 andintegrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchanges self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market
stability.
The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic nature of
gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative
activities on available aggregate credit; (iv) the high concentration of OTC derivative
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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.
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 ones own
currency for a unit of another currency is called as an exchange rate.
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Prices are generally determined by market forces. In a market, consumers have
demand and producers or suppliers have supply, and the collective interaction of
demand and supply in the market determines the price. These factors are constantly
interacting in the market causing changes in the price over a short period of time. Such
changes in the price are known as price volatility. This has three factors: the speed of
price changes, the frequency of price changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market adjustments
through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The break down of the BRETTON WOODS
agreement brought and end to the stabilising role of fixed exchange rates and the gold
convertibility of the dollars. The globalisation of the markets and rapid industrialisation
of many underdeveloped countries brought a new scale and dimension to the markets.
Nations that were poor suddenly became a major source of supply of goods. The
Mexican crisis in the south east-Asian currency crisis of 1990s 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
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In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis--vis depreciated currencies. Export of certain
goods from India declined because of this crisis. Steel industry in 1998 suffered its
worst set back due to cheap import of steel from south East Asian countries. Suddenly
blue chip companies had turned in to red. The fear of china devaluing its currency
created instability in Indian exports. Thus, it is evident that globalisation of industrial
and financial activities necessitates use of derivatives to guard against future losses.
This factor alone has contributed to the growth of derivatives to a significant extent.
C.} TECHNOLOGICAL ADVANCES
A significant growth of derivative instruments has been driven by technological
breakthrough. Advances in this area include the development of high speed processors,
network systems and enhanced method of data entry. Closely related to advances in
computer technology are advances in telecommunications. Improvement in
communications allow for instantaneous worldwide conferencing, Data transmission by
satellite. At the same time there were significant advances in software programmes
without which computer and telecommunication advances would be meaningless. These
facilitated the more rapid movement of information and consequently its instantaneous
impact on market price.Although price sensitivity to market forces is beneficial to the economy as a whole
resources are rapidly relocated to more productive use and better rationed overtime the
greater price volatility exposes producers and consumers to greater price risk. The effect
of this risk can easily destroy a business which is otherwise well managed. Derivatives
can help a firm manage the price risk inherent in a market economy. To the extent the
technological developments increase volatility, derivatives and risk management
products become that much more important.
D.} ADVANCES IN FINANCIAL THEORIES
Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed
by Black and Scholes in 1973 were used to determine prices of call and put options. In
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late 1970s, 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.
6. 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 preconditions
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 forcharging initial margins, broker net worth, deposit requirement and realtime
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
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30 (Sense) index. This was followed by approval for trading in options based on these
two indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in
options on individual securities commenced in July 2001. Futures contracts on
individual stocks were launched in November 2001. The derivatives trading on NSE
commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index
options commenced on June 4, 2001 and trading in options on individual securities
commenced on July 2, 2001. Single stock futures were launched on November 9, 2001.
The index futures and options contract on NSE are based on S&P CNX Trading and
settlement in derivative contracts is done in accordance with the rules, byelaws, and
regulations of the respective exchanges and their clearing house/corporation duly
approved by SEBI and notified in the official gazette. Foreign Institutional Investors
(FIIs) are permitted to trade in all Exchange traded derivative products.
The following are some observations based on the trading statistics provided in the NSE
report on the futures and options (F&O):
Single-stock futures continue to account for a sizable proportion of the F&Osegment. It constituted 70 per cent of the total turnover during June 2012. A primary
reason attributed to this phenomenon is that traders are comfortable with single-stock
futures than equity options, as the former closely resembles the erstwhile badla system.
On relative terms, volumes in the index options segment continue to remain
poor. This may be due to the low volatility of the spot index. Typically, options are
considered more valuable when the volatility of the underlying (in this case, the index)
is high. A related issue is that brokers do not earn high commissions by recommending
index options to their clients, because low volatility leads to higher waiting time for
round-trips.
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Put volumes in the index options and equity options segment have increased
since January 2012. The call-put volumes in index options have decreased from 2.86 in
January 2012 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders
are increasingly becoming pessimistic on the market.
Farther month futures contracts are still not actively traded. Trading in equity
options on most stocks for even the next month was non-existent.
Daily option price variations suggest that traders use the F&O segment as a less
risky alternative (read substitute) to generate profits from the stock price movements.
The fact that the option premiums tail intra-day stock prices is evidence to this. If calls
and puts are not looked as just substitutes for spot trading, the intra-day stock price
variations should not have a one-to-one impact on the option premiums.
The spot foreign exchange market remains the most important segment but
the derivative segment has also grown. In the derivative market foreign exchange
swaps account for the largest share of the total turnover of derivatives in India
followed by forwards and options. Significant milestones in the development of
derivatives market have been (i) permission to banks to undertake cross currency
derivative transactions subject to certain conditions (1996) (ii) allowing corporates
to undertake long term foreign currency swaps that contributed to the
development of the term currency swap market (1997) (iii) allowing dollar rupee
options (2003) and (iv) introduction of currency futures (2008). I would like to
emphasise that currency swaps allowed companies with ECBs to swap their foreign
currency liabilities into rupees. However, since banks could not carry open
positions the risk was allowed to be transferred to any other resident corporate.
Normally such risks should be taken by corporates who have natural hedge or have
potential foreign exchange earnings. But often corporate assume these risks due to
interest rate differentials and views on currencies.
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7. BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:
1.] RISK MANAGEMENT
Futures and options contract can be used for altering the risk of investing in spot market.
For instance, consider an investor who owns an asset. He will always be worried that the
price may fall before he can sell the asset. He can protect himself by selling a futures
contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in
the futures market, as you will see later. This will help offset their losses in the spot
market. Similarly, if the spot price falls below the exercise price, the put option can
always be exercised.
2.] PRICE DISCOVERY
Price discovery refers to the markets ability to determine true equilibrium prices.
Futures prices are believed to contain information about future spot prices and help in
disseminating such information. As we have seen, futures markets provide a low cost
trading mechanism. Thus information pertaining to supply and demand easily percolates
into such markets. Accurate prices are essential for ensuring the correct allocation of
resources in a free market economy. Options markets provide information about the
volatility or risk of the underlying asset.
3.] OPERATIONAL ADVANTAGES
As opposed to spot markets, derivatives markets involve lower transaction costs.Secondly, they offer greater liquidity. Large spot transactions can often lead to
significant price changes. However, futures markets tend to be more liquid than spot
markets, because herein you can take large positions by depositing relatively small
margins. Consequently, a large position in derivatives markets is relatively easier to take
and has less of a price impact as opposed to a transaction of the same magnitude in the
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spot market. Finally, it is easier to take a short position in derivatives markets than it is
to sell short in spot markets.
4.] MARKET EFFICIENCY
The availability of derivatives makes markets more efficient; spot, futures and options
markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is
possible to exploit arbitrage opportunities quickly and to keep prices in alignment.
Hence these markets help to ensure that prices reflect true values.
5.] EASE OF SPECULATION
Derivative markets provide speculators with a cheaper alternative to engaging in spot
transactions. Also, the amount of capital required to take a comparable position is less in
this case. This is important because facilitation of speculation is critical for ensuring free
and fair markets. Speculators always take calculated risks. A speculator will accept a
level of risk only if he is convinced that the associated expected return is comm