Derivatives Market in India
Introduction to derivatives:
• The emergence of the market for derivative products, mostly notably forwards, future and options can be traced back to the willingness of riskaverse 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 product, it is possible to partially or fully transfer price risk by locking-in asset prices. • An instrument of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivatives product minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk –adverse investors.
Derivatives defined:
• Derivatives is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity and other such asset. • For instance: Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in price by that date. Such a transaction is an example of derivative. The price of derivatives is driven by the spot price of wheat which is “underlying”. • Derivatives are securities under the sc(r) and hence the trading of derivatives is governed by the regulatory framework under the sc(r) a.
History of derivatives markets:
• Early forward contracts in the US addressed merchant’s concerns about ensuring that there were buyers and sellers for commodities. • However “credit risk” remained a serious problem. To deal with this problem, a group oh Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. • The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts.
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Derivatives Market in India • In 1865, the CBOT went one step further and listed the fires ‘exchange traded’ derivatives contract in the US, these contracts were called as “futures contracts”. • In 1919, Chicago Butter and Egg Board, a spin-off CBOT, was recognized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). • The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest ‘financial’ exchanges of any kind in the world today. • The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on the S&P 500 index, traded in Chicago Mercantile Exchange. • During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. • Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex, etc.
Emergence of financial derivative products:
• Derivative product 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. Financial derivatives came into spotlight in the post-1970 period during growing instability in the financial markets. • However, since their emergence, these products have become very popular and by 1990.They accounted for about two-thirds of total transactions in derivative products. • In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available their complexity and also turnover. • In the class of equity derivatives the world over, 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.
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Derivatives Market in India Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use
Types of Derivative Instruments on the basis of categories;
• Derivatives can be classified on the basis of the nature of contract, underlying asset or market mechanism. a. Underlying Asset: Most derivatives are based on the following four types of assets: i. Commodities, ii. Foreign exchange, iii. Equities, and iv. Interest bearing financial assets. The nature of contract sets upon the right obligations of both positions in the contract. b. Nature of Contract: Based on the nature of the contract, derivatives can be classified into three categories: Forward Rate Contracts and Futures, Options, and Swaps There can be a contract which is similar in all aspects except for the underlying asset. Thus, an option contract can exist on a currency or a stock. Similarly, a futures contract can exist on a commodity or a currency. c. Market Mechanism: OTC products, and Exchange-traded products.
Derivative products:
• Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. • Take a look at various derivatives contracts that have come to be in use. o Forwards: • A forward contract is a customized contract between two entities, where settlements takes place on a specific date in the future at today’s pre-agreed price.
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Derivatives Market in India
o Futures: • A future contract is an agreement between two parties to buy or sell an asset at a certain price. • Futures contracts are special types of forward contracts in the sense that the former are standardized exchange –traded contracts. o Leaps: • The acronym leaps means long term equity anticipation securities. These are options having a maturity of upto three years. o Warrants: • Options generally have lives of upto 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. o Baskets: • Baskets options are options on portfolios of underlying assets the underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. o Swaps: • Swaps are private agreements between two parties to exchange cash flows in the future according to a pre arranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are ? Interest rate swaps: • These entail swapping only the interest related cash flows between the parties in the same currency. ? Currency swaps: • These entail swapping both principal and interest between the parties with the cash flow in one direction being in a different currency than those in the opposite direction. o Swaptions: • Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. • Thus a swaptions is an option on a forward swap.
Purpose of Derivatives:
o Price Discovery: 4
Derivatives Market in India • Price discovery symbolizes the process of providing equilibrium prices that reflect current and prospective demands on current and prospective supplies and making these prices visible to all. • As such, derivative markets not only play a significant role in terms of actual trading, but also provide guidance to the rest of the economy to optimal production and consumption decisions. • Forwards and futures markets are significant sources of information about prices. Future markets are often considered as primary means of information for determining the spot price of the asset. • High degree of correlation exits between forward prices and the price which people expect to prevail for the commodity at the delivery date specified in the futures contract. • By using the information available in the futures price today, market observers try to estimate the price of a given asset at a certain time in future. • Thus, a futures or forward price reflects a price which a market participant can lock- in today in lieu of accepting the uncertainty of future spot price. • Options markets do not directly provide information about future spot prices. However, they provide information about volatility and subsequently, the risk of the underlying spot asset. o Hedging: • Hedging attempts to reduce price risk. It can be defined as a transaction in which investors seeks to protect a position or anticipated position in the spot market by using an opposite position in derivatives. • A person who hedges is called a hedger. These are people who are exposed to risks due to the normal business operations and would like to eliminate or minimize or reduce the risk. • Let us consider an illustration to understand how futures market is used for hedging. Suppose in August 2001, Mr. A, a manufacturer of cotton apparels, is in need of 20,00,000 lot, for which he needs to buy 40 contracts (as minimum contract size is a 50000 lot on NYCE) and locks his price at 57.00 cents per lot (i.e., his total outflow in December will be $2280). • Assume that in December, the cash market price of cotton is 58.55 cents per lot; Mr. A will have to pay the supplier $2342 to procure cotton. 5
Derivatives Market in India • However, the cost of 1.55 cents per pound ( or $62) which A will have to pay for procuring cotton will be offset by a profit of 1.55 cents per lot when the futures contract bought at 57.00 cents is sold at 58.55. • In other words, had the price of cotton declined instead of rising, Mr. A would have incurred a loss on his futures position but this would have been offset by the lower cost of acquiring cotton in cash market. • Hedging is done mainly for the following reasons: a. To protect a purchase against price decline. b. To protect a sale against price increase. c. To protect an anticipated purchase against a price increase. d. To protect an anticipated purchase sale against a price decline. • The result of Hedge can be judge as the ‘net effect’ of he gain or loss on the physical position plus the gain or loss on the Hedging tool. • Two types of Hedging are available, namely Short Hedging and Long Hedging. • Short Hedging is also known as selling Hedge and it happens when the futures are sold in order to hedge the cash commodity against declining prices. • Long Hedging is also known as buying Hedge and it happens when the futures are purchased to hedge against the increase in the prices of a commodity to be acquired either in the spot or future market. • Short and Long Hedges can be with or with or without risk. Depending on the extent of minimization of basis risks, there are four outcomes possible: a. Short Hedge without basis risk. b. Short Hedge with basis risk. c. Long Hedge without basis risk. d. Long Hedge with basis risk. • Of these, the outcomes without basis risk are less practical as the risks can be minimized but seldom nullified.
Uses of derivatives:
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Derivatives Market in India • There are different benefits for corporate enterprises from the derivatives market. It carries out manly functions such as discovery and risk management, deliver safety and advantages of speculation to investors. • Derivatives allows companies to lower funding cost by taking advantage of differences that exist between capital through arbitrage opportunities or issuance of customized instrument . • Derivatives also the allow the principle of comparative advantage to be applied to financing. It is possible to issue debt where it has a comparative advantage and use a currency swap to obtain funding in its desired currency at a lower cost than a direct financing. • Similarly a borrower who generates savings is using a swap to exploit an arbitrage between the financial markets involved. Borrowers are also able to achieve savings by issuing structural securities tailored to meet specific investor requirements. • They use swap to obtain the borrowing currency and structure they need. Other benefits of derivatives are as follows Diversifying funding sources: Issuers can diversify their funding activities across the global market by obtaining finance from one market and then swapping all or part of cash flows in the desired currencies denomination and rate indices placing debt with new investors can also increase liquidity and reduce funding cost for the issuers. Hedging the cost: Volatile interest rates create uncertainly about the future cost of issuing fixed rate debt. Delayed start swaps or forward swaps can be used to lock in the general level of interest rate that exist at the time of funding decision is made. Such hedging eliminates general market risk. International operations: In case of international operations, the corporations would find the whole task of narrowing in the domestic market at cheaper rate and then swapping them into the currencies of needed countries. Managing Asset Portfolios: If a company wants to change the characteristics of its existing debt portfolioeither the mix of currency denominations, interest rate swaps can be used to adjust the ratio of fixed to floating rate debt; while currency swaps can be used to transform an obligation in one currency into an obligation in another currency, thus changing the currency mix of the debt portfolio. Managing foreign exchange: 7
Derivatives Market in India Importers and exporters are exposed to exchange risk. Currency swaps a foreign exchange forwards and options can be use to create hedges of those future cash flows and reduce the risk. Managing commodity price: Volatility in commodity price can be hedged using commodity forward swapscaps or collars and the risk exposures can be managed. Government: Government entities used derivatives in financing activities to diversify their sources of funds and achieve cost savings through arbitrage of international and National capital market and issuance of hedged structured securities. They also use derivatives for debt management purpose, especially by those governments borrowing in different currencies. Institutional Investors: It uses derivatives to create investments with a higher yield than corresponding traditional investments. They may purchase the securities f, neutralize the undesirable feature with a suitable derivatives transaction and create a synthetic fixed-rate investment with a higher yield than comparable fixed rate instruments of the same credit quality.
Participants in the Derivative Markets:
• The following three broad categories of participants –hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an asset. • They use futures or options markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an asset. • Futures and options contract can give them extra leverage that is they can increase both the potential gains and potential losses in a speculative venture. • Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures prices of an asset getting out of line with the cash price, they will take offsetting position in the two markets to lock in a profit.
Factors driving the growth of derivatives:
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Derivatives Market in India Over the last three decades, the derivative market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Development of more sophisticated risk management tools, providing economic agents a wide choice of risk management strategies, 4. Marked improvement in communication facilities and sharp decline in their cost. • Innovation in derivative markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reducing risks as well as transactions costs as compared to individual financial assets.
Global Scenario:
The era of globalization has brought many innovations to the field of financial engineering. Subsequently, a new set of products known as ‘derivatives’ emerged in the financial sector. Derivatives can be defined as financial instruments whose returns are derived from underlying assets. In other words, their performance depends on the movements of underlying assets such as commodities, indices, exchange rates, interest rates, and so on. The growth of these products in the last 20 years has been one of the most extraordinary and important events in the financial markets. The International Options Market Association conducted a derivatives market survey in the year 2006, according to which the growth in equity derivatives, interest rate derivatives and commodity derivatives accelerated in a significant way from 2002 to 2006. Although commodity forwards and futures have been traded actively since the turn of the century, historians find antecedents to options contracts in ancient Greek writings, and it was not until 1972 that the modern derivatives market was born. Towards the Second World War, representatives of 44 nations gathered in 1944 in Bretton Woods, New Hampshire, USA and agreed on a fixed exchange rate system that lasted till the early 1970s. Under fixed
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Derivatives Market in India exchange rate system, the exchange rate of all currencies was fixed against the US dollar. As the US dollar was then convertible to gold at $35 per ounce, all currencies were indirectly fixed in terms of gold. In 1973, the Bretton Woods Agreement collapsed when the US suspended the dollar’s convertibility into gold. This resulted in the increase of exchange rates and interest rate volatility. Two months before the collapse of Bretton Woods System, the Chicago Mercantile Exchange (CME) launched the world’s first exchange-traded currency future. In 1975, interest rate futures contracts started trading in GNMA-CDRs (Government Nation Mortgage Association- Certificates of Deposit Rollover) on the Chicago Board of Trade (CBOT) and in TBills on the CME. As the capital markets continued growing, the derivatives market also continued playing a significant role in facilitating investor’s needs.
Indian Scenario:
In India, the concept of derivatives is not a new one. In December 1999, the Securities Contract Regulation Act (SCRA) was amended to include derivatives within the sphere of ‘securities’ and a regulatory framework was developed for governing derivatives trading. The act specified that derivatives shall be legal and valid only if they are traded on a recognized stock exchange, thus precluding Over-theCounter derivatives. Besides, the government also withdraw in March 2000, the decade old notification, which prohibited forwards trading in securities. Derivatives trading commenced in India in June 2000 with the approval of the SEBI. Subsequently, derivatives trading on the National Stock Exchange (NSE) started with S&P CNX Nifty Index futures. Futures contracts on individual stocks were launched in November 2001, while trading in index options commenced in June 2001 and trading in options on individual securities began in July 2001. Similarly, trading in BSE Sensex options and options on individual securities in June 2001. Trading and settlement in derivative contracts is done in accordance with the rules, bylaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by the SEBI and notified in the official gazette.
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Derivatives Market in India National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the National Stock Exchange (NSE’s) futures and options segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. Foreign Institutional Investors (FIIs) are allowed to trade in all exchange-traded derivatives product
Derivatives in India- prospects and policy:
• India has started the innovations in financial markets very late. Some of the recent developments initiated by the regulatory authorities are very important in this respect. • A futures trading has been permitted in certain commodity exchanges. Mumbai Stock Exchange has started futures trading in cotton seed and cotton under the BOOE and under the East India Cotton Association. • Necessary infrastructure has been created by the National Stock Exchange and the Bombay Stock Exchange for trading in stock index futures and the commencement of the operations in selected scripts. • Liberalized Exchange Rate Management System has been introduced in the year 1992 for regulating the flow of foreign exchange. A committee headed by S. S. Tarapore was constituted to into the merits of full convertibility on capital accounts. • RBI has initiated measures for freeing the interest rate structure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of LIBOR as a step towards introducing futures trading in interest rates and forex. Badla transactions have been banned in all 23 stock exchanges from July, 2001. • NSE has started trading in index options based on the Nifty and certain stocks.
Derivative Markets today
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Derivatives Market in India
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The prohibition on options in SCRA was removed in 1995. Foreign currency options in currency pairs other than Rupee were the first options permitted by RBI. The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions OTC derivative products. Besides the Forward market in currencies has been a vibrant market in India for several decades. In addition the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today we have 18 commodities exchanges most of which trade futures. E.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI). In 2000 an amendment to the SCRA expanded the definition of securities to included Derivatives thereby enabling stock exchanges to trade derivative products. The year 2000 will herald the introduction of exchange traded equity derivatives in India for the first time.
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Indian Derivative Market:
1. Commodity Forwards: • Although the commodity derivatives market has been in existence for long in India, the first organized trade took place in 1875 through the establishment of cotton trade association followed by oilseeds, jute, wheat and some other commodities. • Since then, contracts on various other commodities have been introduced through various local exchange through the country. But the commodities market was in deep slumber post independence, when the country moved down the socialist path. • The Indian government banned cash settlement and option trading for few commodities under the forwards contract (Regulation) Act in 1952 and introduced minimum support prices to many agricultural products directly to protect farmers. • Commodities trading further started in 1970 when the government permitted trading forwards on few commodities, but the volume was quite low. Forward contracts in India can be booked by companies, firms and any person having authentic foreign exchange exposures only to the 12
Derivatives Market in India extent and in the manner allowed by the RBI. Foreign exchange broker are not allowed to book contacts. With a view to improve the exchange functions, prices discovery mechanism and price risk management, the regulatory role went to the forward markets commission. In 2002, the FMC decided to encourage the modern commodity exchange, that can work electronically and at the end of November 2002, the national Multi-Commodity Exchange of Ahmedabad (NMCE) came out with the first electronic commodity exchange. After that in 2003, the Multi-Commodity Exchange (MCX) and the National Multi-Commodity Derivatives Exchange (NCDEX) started, which are promoted by ICICI, NSE and other financial institutions. Presently, futures trading are permitted in all the commodities through 25 Exchanges/Associations. Commodity Futures: Commodity futures picked up with the governments promotion of various exchanges and liberalization of the policies. In India, commodity futures are available on agriculture commodities, metallurgical commodities and so on. Under agriculture commodities, red, beans, corns, wheat etc forma part of grains, while commodities like cocoa, coffee, dried cocoon, cotton yarn and raw sugar etc. form a part of soft commodities, animal products like live hogs, live cattle, pork bellies, eggs and poultry products form a part of meat futures. The metallurgical category includes the genuine metals and petro products, the precious metal are in relative short supply and they retain their value irrespective of the economy. Currency Forwards: The volume of rupee forward has grown tremendously after 19992, when the government permitted unrestricted booking and cancellations of forward contracts for all genuine exposures, whether trade related or not, further, in 2000. Under the new regulations, foreign Exchange Management Act, 2000 (FEMA) the government issued guidelines for hedging in forward contracts. After introducing (FEMA) in 2002, the government has taken various steps for development of the derivative market. In July 2004, the government made further amendments in the condition under which a Foreign Institutional Investor (FII) can enter into a forward contract to hedge its exposure in India. Under the new guidelines, registered FIIS alone can enter into a forward contract and 13
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Derivatives Market in India that too only if “the value of hedge does not exceed the market value of the underline debt or equity instruments”. Further, in the amendment, it has also been mentioned that, “Forward contracts once booked shall be allowed to continue to the original maturity even if the value of the underlying portfolio shrinks.” Currency Futures: In the past few years, currency futures have witnessed significant growth in the use of different hedging techniques to address the FX exposures that companies face. The SEBI constituted the LC Gupta Committee to formulate the regulations through which trading in Exchange –traded derivative can commence in India this step in the policy market has been supported by the NSE and commodity future began in 1995. After that a continuous growth has been seen in the derivative markets. Now, the NSE has index futures, stock futures, interest rate option, and Rupee options. Index Futures: NSE has introduced trading in Index based futures contracts with a cash market index as the underlying asset as well as futures on the underlying stocks. NSE will define the characteristics of a futures contract such as the underlying index, market lot, and the maturity date of the contract. The contract will be available for trading from introduction to the maturity date. Future contracts on BSE Sensex use a multiple of 50. Stock Futures: The Securities and Exchange Board Of India on November 1st, 2001, approved the scheme and risk containment measures for individual stock futures contracts and now 53 scrips are available on which derivatives trading is currently permitted, some of the stock include Electronics Ltd, cipla Ltd, and Hindustan Lever Lts. Stock Options: In India, NSE became the first exchange to launch trading in option on individual securities from July 2, 2001.options contracts are American style and cash Settled and are available on 155 securities stipulated by the SEBI. Some of the securities include Dabur India Ltd, Gujarat Ambuja Cement Ltd, and Reliance Energy Ltd. Interest Rate Futures:
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Derivatives Market in India • The interest rate futures started trading in India on the NSE from June 23, 2003. The current interest rate futures products traded on the NSE are: Notional 10- year Zero Coupon Bond Symbol: NSE 10YZC Notional 10- year Coupon Bearing Bond (6%) Symbol: NSE 10Y06 Notional 91-day Treasury Bill Symbol: NSETB91D • Interest rate futures are the forward contracts based on a benchmark interest rate traded on a stock exchange. It is a contract whose underlying security is a debt interest bearing instrument, at a predetermined future date at a price agreed upon between the parties. • The financial settlement of all trades is guaranteed by the National Securities and Clearing Corporation Ltd. (NSCCL). Interest rate futures allow participants to take a view on movement of interest rates in the foreseeable future and accordingly enter into a contract, which would protect the underlying positions. • For instance, you can sell a futures contract on T- Bill to lock in a borrowing rate, or buy a future contract to lock- in a lending rent. A typical example is the future contract of 3 month sterling LIBOR traded on the London International Financial Futures Exchange (LIFFE), which is known as a short sterling future. • Unlike swaps, where two counterparties exchange streams of payments over a given period, in future, participants enter into contract pay margins on a daily basis over the period of the contract and settle differences due to change in interest rates by paying margins to the stock exchanges.
Types of Risk:
• Risk in general is the possibility of some unpleasant happening or the chance of encountering loss. The same in the context of financial markets can be termed as uncertainty in future cash flows. • This uncertainty arises due to number of factors such as interest rate fluctuations, exchange rate changes, market conditions and changes in prices of commodities etc. The major risk that occur in the financial markets are discussed below: 1. Interest Rate Risk: • The possibility of a reduction in the value of asset (especially a bond) resulting due to interest rate fluctuations is referred to as interest rate risk. Interest rates affect a firm in two ways- by affecting the profits and by affecting the value of its assets or liabilities. For eg., a firm 15
Derivatives Market in India that has borrowed money on a floating rate basis faces the risk of lower profits in an increasing interest rate scenario. Similarly, a firm having fixed rate assets faces the risk of lower value of investments in an increasing interest rate scenario. Interest rate risk becomes prominent when the assets and liabilities of a firm do not match in their exposure to interest rate movements. For eg, a firm that has fixed rate borrowings and floating rate investments has a higher exposure than a firm having fixed rate borrowings and fixed rate investments for the same term. It can also be defined as the risk arising due to sensitivity of the interest income/expenditure or values of assets/liabilities to the interest rate fluctuations. Exchange Rate Risk: The volatility in the exchange rates will have a direct bearing on the values of the assets and liabilities that are denominated in foreign currencies. While appreciation of home currency decreases the value of an asset and liability in terms of home currency, depreciation of home currency will increase the values of assets and liabilities. While increase in the value of asset and decrease in the value of liability has a positive impact on the corporate, increase in the value of liabilities and decrease in the value of assets has a negative impact. Market Risk: Market risk is the risk of the value of a firm’s investments going down as a result of market movements. It is also referred to as price risk. Market risk cannot be distinctly separated from other risks, as it results from the interplay of all risks. In addition to Interest rate risk and exchange risk, adverse movements in equity prices and commodity prices also contribute to the market risk. An instance wherein equity price risks played havoc is the stock market crash of 1929 in the United States. Similarly, commodity prices show a significant impact on the cash flow and profitability of a business. For eg. A baking company can face the risk of falling wheat prices in the domestic as well as international markets, consequently resulting in loss of income. In a financial market, an investor always wishes to minimize or eliminate the risks in order to maximize profits. This can be achieved by hedging the risk through different derivative instruments available in the financial markets.
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Derivatives Market in India
Economic functions of the derivative market:
• Inspite of the fear and criticism with which the derivative markets are currently looked at, these markets perform a number of economic functions. 1. Prices in an organized derivative market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivatives contract. Thus derivatives help in discovery of future as well as current prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to the inherent nature are linked to the underlying cash market witnesses. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative welleducated people with an entrepreneurial attitude. They often energize others to create new business, new products and new employment opportunities, the benefits of which are immense. • In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
NSC’s Derivatives Market:
• The derivatives trading on the NSC commenced with S&P CNX Nifty Index futures on June 12, 2000.
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Derivatives Market in India • The trading in index options commenced on 4,2001 and trading in options on individual securities commenced on July 2, 2001. • Single stock futures were launched on November 9,2001. Today, both in terms of volume and turnover, NSC is the largest derivatives exchange in India. • Currently the derivatives contracts have maximum of 3- month expiration cycles. Three contracts are available for trading, with 1 month, 2months and 3 months expiry. • A new contract is introduced on the next trading following the expiry of the near month contract.
Participants and Functions of NSC’s Derivatives Market :
• NSC admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. • NSC follows 2-tier membership structure stipulated by SEBI to enable wider participation. • Those interested in taking membership on F&O segment or CM,WDM and F&O segment. Trading and clearing members are admitted separately. • Essentially, a clearing member (CM) does clearing for all his trading members, undertakes risk management and performs actual settlement. There are three types of CM: Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients. Trading Member Clearing member: TM-CM is a CM who is also a TM. They may clear and settle his own proprietary trades and client’s trades as well as for other TM’s. Professionally Clearing Member: PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TM’s.
Turnover
• The trading volumes on NSC’s derivatives market has seen a steady increase since the launch of the first derivatives contract, i.e., index futures in June 2000. 18
Derivatives Market in India • The average daily turnover at NSC now exceeds Rs. 10000 crore. A total of 77,017,185 contracts with a total turnover of Rs. 2,547,053 crore were traded during 2004-2005.
Summary
• Derivatives are the innovative tradable financial instruments derived from an underlying asset. Major institutional borrowers and investors use derivatives. • Derivatives are responsible for not only increasing the range of financial products but also fostering more precise ways of understanding, quantifying and managing financial risk . • Types of derivatives are forward contracts, swaps, future contracts and forward rate agreements. • Derivatives are beneficial for price discovery, risk management, deliver safety and advantages of speculation to investors. • The tools used in the derivative market are options and futures. ‘Options’ is a transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price during a period on a specific date in exchange for payment of a premium. • ‘Future’ is an agreement to buy or sell an asset at a certain time in the future for a certain price. The value of the put or call option depends to a large extent on the market behavior of the equity that underlines the option. • The derivatives market exploded in the U.S. around the mid-70s. According to the World Bank, aggregated net inflows of resources to the developing countries increased from U.S. $ 85 billion between19891996. • According to BIS survey, the nominal value of derivatives contract outstanding world wide amounted the U.S. $ 40,000 billion. Fund managers, stockists of goods, processors, investors, traders and others 19
Derivatives Market in India play an active role in the derivatives market. These participants in the derivatives market can be divided into two groups, the end users and dealers. India has started the innovations in the financial markets very late. Futures and options trading have been permitted in certain exchanges. The National Securities Clearing Corporation was set up by NSC has been successfully doing novation on the equity market since 1996. SEBI has established a derivatives cell for supervision and regulation of derivatives market. Indian environment is also suitable for the introduction of asset liability based derivatives such as strips and asset-backed securities. Active use of derivatives requires the existence of the term money market for six months to one year. A deep cash market is imperative before derivatives products are introduced in the market.
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Bibliography:
Reference Books: 1. Derivatives Market and Financial Exchange Market 2. Financial Institutions and Market - Gordan and Natrajan 3. Indian Financial System - Vasant Desai 4. Indian Financial System - Deodar and Abhyankar 5. Financial Institution and Market - L.M Ghole 6. Indian Financial System - Kavita Rawal 7. Derivatives Analysis and Valuation - ICFAI University 8. NCFM-
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doc_553611404.doc
Introduction to derivatives:
• The emergence of the market for derivative products, mostly notably forwards, future and options can be traced back to the willingness of riskaverse 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 product, it is possible to partially or fully transfer price risk by locking-in asset prices. • An instrument of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivatives product minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk –adverse investors.
Derivatives defined:
• Derivatives is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity and other such asset. • For instance: Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in price by that date. Such a transaction is an example of derivative. The price of derivatives is driven by the spot price of wheat which is “underlying”. • Derivatives are securities under the sc(r) and hence the trading of derivatives is governed by the regulatory framework under the sc(r) a.
History of derivatives markets:
• Early forward contracts in the US addressed merchant’s concerns about ensuring that there were buyers and sellers for commodities. • However “credit risk” remained a serious problem. To deal with this problem, a group oh Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. • The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts.
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Derivatives Market in India • In 1865, the CBOT went one step further and listed the fires ‘exchange traded’ derivatives contract in the US, these contracts were called as “futures contracts”. • In 1919, Chicago Butter and Egg Board, a spin-off CBOT, was recognized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). • The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest ‘financial’ exchanges of any kind in the world today. • The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on the S&P 500 index, traded in Chicago Mercantile Exchange. • During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. • Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex, etc.
Emergence of financial derivative products:
• Derivative product 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. Financial derivatives came into spotlight in the post-1970 period during growing instability in the financial markets. • However, since their emergence, these products have become very popular and by 1990.They accounted for about two-thirds of total transactions in derivative products. • In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available their complexity and also turnover. • In the class of equity derivatives the world over, 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.
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Derivatives Market in India Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use
Types of Derivative Instruments on the basis of categories;
• Derivatives can be classified on the basis of the nature of contract, underlying asset or market mechanism. a. Underlying Asset: Most derivatives are based on the following four types of assets: i. Commodities, ii. Foreign exchange, iii. Equities, and iv. Interest bearing financial assets. The nature of contract sets upon the right obligations of both positions in the contract. b. Nature of Contract: Based on the nature of the contract, derivatives can be classified into three categories: Forward Rate Contracts and Futures, Options, and Swaps There can be a contract which is similar in all aspects except for the underlying asset. Thus, an option contract can exist on a currency or a stock. Similarly, a futures contract can exist on a commodity or a currency. c. Market Mechanism: OTC products, and Exchange-traded products.
Derivative products:
• Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. • Take a look at various derivatives contracts that have come to be in use. o Forwards: • A forward contract is a customized contract between two entities, where settlements takes place on a specific date in the future at today’s pre-agreed price.
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Derivatives Market in India
o Futures: • A future contract is an agreement between two parties to buy or sell an asset at a certain price. • Futures contracts are special types of forward contracts in the sense that the former are standardized exchange –traded contracts. o Leaps: • The acronym leaps means long term equity anticipation securities. These are options having a maturity of upto three years. o Warrants: • Options generally have lives of upto 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. o Baskets: • Baskets options are options on portfolios of underlying assets the underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. o Swaps: • Swaps are private agreements between two parties to exchange cash flows in the future according to a pre arranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are ? Interest rate swaps: • These entail swapping only the interest related cash flows between the parties in the same currency. ? Currency swaps: • These entail swapping both principal and interest between the parties with the cash flow in one direction being in a different currency than those in the opposite direction. o Swaptions: • Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. • Thus a swaptions is an option on a forward swap.
Purpose of Derivatives:
o Price Discovery: 4
Derivatives Market in India • Price discovery symbolizes the process of providing equilibrium prices that reflect current and prospective demands on current and prospective supplies and making these prices visible to all. • As such, derivative markets not only play a significant role in terms of actual trading, but also provide guidance to the rest of the economy to optimal production and consumption decisions. • Forwards and futures markets are significant sources of information about prices. Future markets are often considered as primary means of information for determining the spot price of the asset. • High degree of correlation exits between forward prices and the price which people expect to prevail for the commodity at the delivery date specified in the futures contract. • By using the information available in the futures price today, market observers try to estimate the price of a given asset at a certain time in future. • Thus, a futures or forward price reflects a price which a market participant can lock- in today in lieu of accepting the uncertainty of future spot price. • Options markets do not directly provide information about future spot prices. However, they provide information about volatility and subsequently, the risk of the underlying spot asset. o Hedging: • Hedging attempts to reduce price risk. It can be defined as a transaction in which investors seeks to protect a position or anticipated position in the spot market by using an opposite position in derivatives. • A person who hedges is called a hedger. These are people who are exposed to risks due to the normal business operations and would like to eliminate or minimize or reduce the risk. • Let us consider an illustration to understand how futures market is used for hedging. Suppose in August 2001, Mr. A, a manufacturer of cotton apparels, is in need of 20,00,000 lot, for which he needs to buy 40 contracts (as minimum contract size is a 50000 lot on NYCE) and locks his price at 57.00 cents per lot (i.e., his total outflow in December will be $2280). • Assume that in December, the cash market price of cotton is 58.55 cents per lot; Mr. A will have to pay the supplier $2342 to procure cotton. 5
Derivatives Market in India • However, the cost of 1.55 cents per pound ( or $62) which A will have to pay for procuring cotton will be offset by a profit of 1.55 cents per lot when the futures contract bought at 57.00 cents is sold at 58.55. • In other words, had the price of cotton declined instead of rising, Mr. A would have incurred a loss on his futures position but this would have been offset by the lower cost of acquiring cotton in cash market. • Hedging is done mainly for the following reasons: a. To protect a purchase against price decline. b. To protect a sale against price increase. c. To protect an anticipated purchase against a price increase. d. To protect an anticipated purchase sale against a price decline. • The result of Hedge can be judge as the ‘net effect’ of he gain or loss on the physical position plus the gain or loss on the Hedging tool. • Two types of Hedging are available, namely Short Hedging and Long Hedging. • Short Hedging is also known as selling Hedge and it happens when the futures are sold in order to hedge the cash commodity against declining prices. • Long Hedging is also known as buying Hedge and it happens when the futures are purchased to hedge against the increase in the prices of a commodity to be acquired either in the spot or future market. • Short and Long Hedges can be with or with or without risk. Depending on the extent of minimization of basis risks, there are four outcomes possible: a. Short Hedge without basis risk. b. Short Hedge with basis risk. c. Long Hedge without basis risk. d. Long Hedge with basis risk. • Of these, the outcomes without basis risk are less practical as the risks can be minimized but seldom nullified.
Uses of derivatives:
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Derivatives Market in India • There are different benefits for corporate enterprises from the derivatives market. It carries out manly functions such as discovery and risk management, deliver safety and advantages of speculation to investors. • Derivatives allows companies to lower funding cost by taking advantage of differences that exist between capital through arbitrage opportunities or issuance of customized instrument . • Derivatives also the allow the principle of comparative advantage to be applied to financing. It is possible to issue debt where it has a comparative advantage and use a currency swap to obtain funding in its desired currency at a lower cost than a direct financing. • Similarly a borrower who generates savings is using a swap to exploit an arbitrage between the financial markets involved. Borrowers are also able to achieve savings by issuing structural securities tailored to meet specific investor requirements. • They use swap to obtain the borrowing currency and structure they need. Other benefits of derivatives are as follows Diversifying funding sources: Issuers can diversify their funding activities across the global market by obtaining finance from one market and then swapping all or part of cash flows in the desired currencies denomination and rate indices placing debt with new investors can also increase liquidity and reduce funding cost for the issuers. Hedging the cost: Volatile interest rates create uncertainly about the future cost of issuing fixed rate debt. Delayed start swaps or forward swaps can be used to lock in the general level of interest rate that exist at the time of funding decision is made. Such hedging eliminates general market risk. International operations: In case of international operations, the corporations would find the whole task of narrowing in the domestic market at cheaper rate and then swapping them into the currencies of needed countries. Managing Asset Portfolios: If a company wants to change the characteristics of its existing debt portfolioeither the mix of currency denominations, interest rate swaps can be used to adjust the ratio of fixed to floating rate debt; while currency swaps can be used to transform an obligation in one currency into an obligation in another currency, thus changing the currency mix of the debt portfolio. Managing foreign exchange: 7
Derivatives Market in India Importers and exporters are exposed to exchange risk. Currency swaps a foreign exchange forwards and options can be use to create hedges of those future cash flows and reduce the risk. Managing commodity price: Volatility in commodity price can be hedged using commodity forward swapscaps or collars and the risk exposures can be managed. Government: Government entities used derivatives in financing activities to diversify their sources of funds and achieve cost savings through arbitrage of international and National capital market and issuance of hedged structured securities. They also use derivatives for debt management purpose, especially by those governments borrowing in different currencies. Institutional Investors: It uses derivatives to create investments with a higher yield than corresponding traditional investments. They may purchase the securities f, neutralize the undesirable feature with a suitable derivatives transaction and create a synthetic fixed-rate investment with a higher yield than comparable fixed rate instruments of the same credit quality.
Participants in the Derivative Markets:
• The following three broad categories of participants –hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an asset. • They use futures or options markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an asset. • Futures and options contract can give them extra leverage that is they can increase both the potential gains and potential losses in a speculative venture. • Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures prices of an asset getting out of line with the cash price, they will take offsetting position in the two markets to lock in a profit.
Factors driving the growth of derivatives:
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Derivatives Market in India Over the last three decades, the derivative market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international markets, 3. Development of more sophisticated risk management tools, providing economic agents a wide choice of risk management strategies, 4. Marked improvement in communication facilities and sharp decline in their cost. • Innovation in derivative markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reducing risks as well as transactions costs as compared to individual financial assets.
Global Scenario:
The era of globalization has brought many innovations to the field of financial engineering. Subsequently, a new set of products known as ‘derivatives’ emerged in the financial sector. Derivatives can be defined as financial instruments whose returns are derived from underlying assets. In other words, their performance depends on the movements of underlying assets such as commodities, indices, exchange rates, interest rates, and so on. The growth of these products in the last 20 years has been one of the most extraordinary and important events in the financial markets. The International Options Market Association conducted a derivatives market survey in the year 2006, according to which the growth in equity derivatives, interest rate derivatives and commodity derivatives accelerated in a significant way from 2002 to 2006. Although commodity forwards and futures have been traded actively since the turn of the century, historians find antecedents to options contracts in ancient Greek writings, and it was not until 1972 that the modern derivatives market was born. Towards the Second World War, representatives of 44 nations gathered in 1944 in Bretton Woods, New Hampshire, USA and agreed on a fixed exchange rate system that lasted till the early 1970s. Under fixed
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Derivatives Market in India exchange rate system, the exchange rate of all currencies was fixed against the US dollar. As the US dollar was then convertible to gold at $35 per ounce, all currencies were indirectly fixed in terms of gold. In 1973, the Bretton Woods Agreement collapsed when the US suspended the dollar’s convertibility into gold. This resulted in the increase of exchange rates and interest rate volatility. Two months before the collapse of Bretton Woods System, the Chicago Mercantile Exchange (CME) launched the world’s first exchange-traded currency future. In 1975, interest rate futures contracts started trading in GNMA-CDRs (Government Nation Mortgage Association- Certificates of Deposit Rollover) on the Chicago Board of Trade (CBOT) and in TBills on the CME. As the capital markets continued growing, the derivatives market also continued playing a significant role in facilitating investor’s needs.
Indian Scenario:
In India, the concept of derivatives is not a new one. In December 1999, the Securities Contract Regulation Act (SCRA) was amended to include derivatives within the sphere of ‘securities’ and a regulatory framework was developed for governing derivatives trading. The act specified that derivatives shall be legal and valid only if they are traded on a recognized stock exchange, thus precluding Over-theCounter derivatives. Besides, the government also withdraw in March 2000, the decade old notification, which prohibited forwards trading in securities. Derivatives trading commenced in India in June 2000 with the approval of the SEBI. Subsequently, derivatives trading on the National Stock Exchange (NSE) started with S&P CNX Nifty Index futures. Futures contracts on individual stocks were launched in November 2001, while trading in index options commenced in June 2001 and trading in options on individual securities began in July 2001. Similarly, trading in BSE Sensex options and options on individual securities in June 2001. Trading and settlement in derivative contracts is done in accordance with the rules, bylaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by the SEBI and notified in the official gazette.
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Derivatives Market in India National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the National Stock Exchange (NSE’s) futures and options segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. Foreign Institutional Investors (FIIs) are allowed to trade in all exchange-traded derivatives product
Derivatives in India- prospects and policy:
• India has started the innovations in financial markets very late. Some of the recent developments initiated by the regulatory authorities are very important in this respect. • A futures trading has been permitted in certain commodity exchanges. Mumbai Stock Exchange has started futures trading in cotton seed and cotton under the BOOE and under the East India Cotton Association. • Necessary infrastructure has been created by the National Stock Exchange and the Bombay Stock Exchange for trading in stock index futures and the commencement of the operations in selected scripts. • Liberalized Exchange Rate Management System has been introduced in the year 1992 for regulating the flow of foreign exchange. A committee headed by S. S. Tarapore was constituted to into the merits of full convertibility on capital accounts. • RBI has initiated measures for freeing the interest rate structure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of LIBOR as a step towards introducing futures trading in interest rates and forex. Badla transactions have been banned in all 23 stock exchanges from July, 2001. • NSE has started trading in index options based on the Nifty and certain stocks.
Derivative Markets today
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Derivatives Market in India
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The prohibition on options in SCRA was removed in 1995. Foreign currency options in currency pairs other than Rupee were the first options permitted by RBI. The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions OTC derivative products. Besides the Forward market in currencies has been a vibrant market in India for several decades. In addition the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today we have 18 commodities exchanges most of which trade futures. E.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI). In 2000 an amendment to the SCRA expanded the definition of securities to included Derivatives thereby enabling stock exchanges to trade derivative products. The year 2000 will herald the introduction of exchange traded equity derivatives in India for the first time.
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Indian Derivative Market:
1. Commodity Forwards: • Although the commodity derivatives market has been in existence for long in India, the first organized trade took place in 1875 through the establishment of cotton trade association followed by oilseeds, jute, wheat and some other commodities. • Since then, contracts on various other commodities have been introduced through various local exchange through the country. But the commodities market was in deep slumber post independence, when the country moved down the socialist path. • The Indian government banned cash settlement and option trading for few commodities under the forwards contract (Regulation) Act in 1952 and introduced minimum support prices to many agricultural products directly to protect farmers. • Commodities trading further started in 1970 when the government permitted trading forwards on few commodities, but the volume was quite low. Forward contracts in India can be booked by companies, firms and any person having authentic foreign exchange exposures only to the 12
Derivatives Market in India extent and in the manner allowed by the RBI. Foreign exchange broker are not allowed to book contacts. With a view to improve the exchange functions, prices discovery mechanism and price risk management, the regulatory role went to the forward markets commission. In 2002, the FMC decided to encourage the modern commodity exchange, that can work electronically and at the end of November 2002, the national Multi-Commodity Exchange of Ahmedabad (NMCE) came out with the first electronic commodity exchange. After that in 2003, the Multi-Commodity Exchange (MCX) and the National Multi-Commodity Derivatives Exchange (NCDEX) started, which are promoted by ICICI, NSE and other financial institutions. Presently, futures trading are permitted in all the commodities through 25 Exchanges/Associations. Commodity Futures: Commodity futures picked up with the governments promotion of various exchanges and liberalization of the policies. In India, commodity futures are available on agriculture commodities, metallurgical commodities and so on. Under agriculture commodities, red, beans, corns, wheat etc forma part of grains, while commodities like cocoa, coffee, dried cocoon, cotton yarn and raw sugar etc. form a part of soft commodities, animal products like live hogs, live cattle, pork bellies, eggs and poultry products form a part of meat futures. The metallurgical category includes the genuine metals and petro products, the precious metal are in relative short supply and they retain their value irrespective of the economy. Currency Forwards: The volume of rupee forward has grown tremendously after 19992, when the government permitted unrestricted booking and cancellations of forward contracts for all genuine exposures, whether trade related or not, further, in 2000. Under the new regulations, foreign Exchange Management Act, 2000 (FEMA) the government issued guidelines for hedging in forward contracts. After introducing (FEMA) in 2002, the government has taken various steps for development of the derivative market. In July 2004, the government made further amendments in the condition under which a Foreign Institutional Investor (FII) can enter into a forward contract to hedge its exposure in India. Under the new guidelines, registered FIIS alone can enter into a forward contract and 13
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Derivatives Market in India that too only if “the value of hedge does not exceed the market value of the underline debt or equity instruments”. Further, in the amendment, it has also been mentioned that, “Forward contracts once booked shall be allowed to continue to the original maturity even if the value of the underlying portfolio shrinks.” Currency Futures: In the past few years, currency futures have witnessed significant growth in the use of different hedging techniques to address the FX exposures that companies face. The SEBI constituted the LC Gupta Committee to formulate the regulations through which trading in Exchange –traded derivative can commence in India this step in the policy market has been supported by the NSE and commodity future began in 1995. After that a continuous growth has been seen in the derivative markets. Now, the NSE has index futures, stock futures, interest rate option, and Rupee options. Index Futures: NSE has introduced trading in Index based futures contracts with a cash market index as the underlying asset as well as futures on the underlying stocks. NSE will define the characteristics of a futures contract such as the underlying index, market lot, and the maturity date of the contract. The contract will be available for trading from introduction to the maturity date. Future contracts on BSE Sensex use a multiple of 50. Stock Futures: The Securities and Exchange Board Of India on November 1st, 2001, approved the scheme and risk containment measures for individual stock futures contracts and now 53 scrips are available on which derivatives trading is currently permitted, some of the stock include Electronics Ltd, cipla Ltd, and Hindustan Lever Lts. Stock Options: In India, NSE became the first exchange to launch trading in option on individual securities from July 2, 2001.options contracts are American style and cash Settled and are available on 155 securities stipulated by the SEBI. Some of the securities include Dabur India Ltd, Gujarat Ambuja Cement Ltd, and Reliance Energy Ltd. Interest Rate Futures:
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Derivatives Market in India • The interest rate futures started trading in India on the NSE from June 23, 2003. The current interest rate futures products traded on the NSE are: Notional 10- year Zero Coupon Bond Symbol: NSE 10YZC Notional 10- year Coupon Bearing Bond (6%) Symbol: NSE 10Y06 Notional 91-day Treasury Bill Symbol: NSETB91D • Interest rate futures are the forward contracts based on a benchmark interest rate traded on a stock exchange. It is a contract whose underlying security is a debt interest bearing instrument, at a predetermined future date at a price agreed upon between the parties. • The financial settlement of all trades is guaranteed by the National Securities and Clearing Corporation Ltd. (NSCCL). Interest rate futures allow participants to take a view on movement of interest rates in the foreseeable future and accordingly enter into a contract, which would protect the underlying positions. • For instance, you can sell a futures contract on T- Bill to lock in a borrowing rate, or buy a future contract to lock- in a lending rent. A typical example is the future contract of 3 month sterling LIBOR traded on the London International Financial Futures Exchange (LIFFE), which is known as a short sterling future. • Unlike swaps, where two counterparties exchange streams of payments over a given period, in future, participants enter into contract pay margins on a daily basis over the period of the contract and settle differences due to change in interest rates by paying margins to the stock exchanges.
Types of Risk:
• Risk in general is the possibility of some unpleasant happening or the chance of encountering loss. The same in the context of financial markets can be termed as uncertainty in future cash flows. • This uncertainty arises due to number of factors such as interest rate fluctuations, exchange rate changes, market conditions and changes in prices of commodities etc. The major risk that occur in the financial markets are discussed below: 1. Interest Rate Risk: • The possibility of a reduction in the value of asset (especially a bond) resulting due to interest rate fluctuations is referred to as interest rate risk. Interest rates affect a firm in two ways- by affecting the profits and by affecting the value of its assets or liabilities. For eg., a firm 15
Derivatives Market in India that has borrowed money on a floating rate basis faces the risk of lower profits in an increasing interest rate scenario. Similarly, a firm having fixed rate assets faces the risk of lower value of investments in an increasing interest rate scenario. Interest rate risk becomes prominent when the assets and liabilities of a firm do not match in their exposure to interest rate movements. For eg, a firm that has fixed rate borrowings and floating rate investments has a higher exposure than a firm having fixed rate borrowings and fixed rate investments for the same term. It can also be defined as the risk arising due to sensitivity of the interest income/expenditure or values of assets/liabilities to the interest rate fluctuations. Exchange Rate Risk: The volatility in the exchange rates will have a direct bearing on the values of the assets and liabilities that are denominated in foreign currencies. While appreciation of home currency decreases the value of an asset and liability in terms of home currency, depreciation of home currency will increase the values of assets and liabilities. While increase in the value of asset and decrease in the value of liability has a positive impact on the corporate, increase in the value of liabilities and decrease in the value of assets has a negative impact. Market Risk: Market risk is the risk of the value of a firm’s investments going down as a result of market movements. It is also referred to as price risk. Market risk cannot be distinctly separated from other risks, as it results from the interplay of all risks. In addition to Interest rate risk and exchange risk, adverse movements in equity prices and commodity prices also contribute to the market risk. An instance wherein equity price risks played havoc is the stock market crash of 1929 in the United States. Similarly, commodity prices show a significant impact on the cash flow and profitability of a business. For eg. A baking company can face the risk of falling wheat prices in the domestic as well as international markets, consequently resulting in loss of income. In a financial market, an investor always wishes to minimize or eliminate the risks in order to maximize profits. This can be achieved by hedging the risk through different derivative instruments available in the financial markets.
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Derivatives Market in India
Economic functions of the derivative market:
• Inspite of the fear and criticism with which the derivative markets are currently looked at, these markets perform a number of economic functions. 1. Prices in an organized derivative market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivatives contract. Thus derivatives help in discovery of future as well as current prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to the inherent nature are linked to the underlying cash market witnesses. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative welleducated people with an entrepreneurial attitude. They often energize others to create new business, new products and new employment opportunities, the benefits of which are immense. • In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
NSC’s Derivatives Market:
• The derivatives trading on the NSC commenced with S&P CNX Nifty Index futures on June 12, 2000.
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Derivatives Market in India • The trading in index options commenced on 4,2001 and trading in options on individual securities commenced on July 2, 2001. • Single stock futures were launched on November 9,2001. Today, both in terms of volume and turnover, NSC is the largest derivatives exchange in India. • Currently the derivatives contracts have maximum of 3- month expiration cycles. Three contracts are available for trading, with 1 month, 2months and 3 months expiry. • A new contract is introduced on the next trading following the expiry of the near month contract.
Participants and Functions of NSC’s Derivatives Market :
• NSC admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. • NSC follows 2-tier membership structure stipulated by SEBI to enable wider participation. • Those interested in taking membership on F&O segment or CM,WDM and F&O segment. Trading and clearing members are admitted separately. • Essentially, a clearing member (CM) does clearing for all his trading members, undertakes risk management and performs actual settlement. There are three types of CM: Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients. Trading Member Clearing member: TM-CM is a CM who is also a TM. They may clear and settle his own proprietary trades and client’s trades as well as for other TM’s. Professionally Clearing Member: PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TM’s.
Turnover
• The trading volumes on NSC’s derivatives market has seen a steady increase since the launch of the first derivatives contract, i.e., index futures in June 2000. 18
Derivatives Market in India • The average daily turnover at NSC now exceeds Rs. 10000 crore. A total of 77,017,185 contracts with a total turnover of Rs. 2,547,053 crore were traded during 2004-2005.
Summary
• Derivatives are the innovative tradable financial instruments derived from an underlying asset. Major institutional borrowers and investors use derivatives. • Derivatives are responsible for not only increasing the range of financial products but also fostering more precise ways of understanding, quantifying and managing financial risk . • Types of derivatives are forward contracts, swaps, future contracts and forward rate agreements. • Derivatives are beneficial for price discovery, risk management, deliver safety and advantages of speculation to investors. • The tools used in the derivative market are options and futures. ‘Options’ is a transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price during a period on a specific date in exchange for payment of a premium. • ‘Future’ is an agreement to buy or sell an asset at a certain time in the future for a certain price. The value of the put or call option depends to a large extent on the market behavior of the equity that underlines the option. • The derivatives market exploded in the U.S. around the mid-70s. According to the World Bank, aggregated net inflows of resources to the developing countries increased from U.S. $ 85 billion between19891996. • According to BIS survey, the nominal value of derivatives contract outstanding world wide amounted the U.S. $ 40,000 billion. Fund managers, stockists of goods, processors, investors, traders and others 19
Derivatives Market in India play an active role in the derivatives market. These participants in the derivatives market can be divided into two groups, the end users and dealers. India has started the innovations in the financial markets very late. Futures and options trading have been permitted in certain exchanges. The National Securities Clearing Corporation was set up by NSC has been successfully doing novation on the equity market since 1996. SEBI has established a derivatives cell for supervision and regulation of derivatives market. Indian environment is also suitable for the introduction of asset liability based derivatives such as strips and asset-backed securities. Active use of derivatives requires the existence of the term money market for six months to one year. A deep cash market is imperative before derivatives products are introduced in the market.
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Bibliography:
Reference Books: 1. Derivatives Market and Financial Exchange Market 2. Financial Institutions and Market - Gordan and Natrajan 3. Indian Financial System - Vasant Desai 4. Indian Financial System - Deodar and Abhyankar 5. Financial Institution and Market - L.M Ghole 6. Indian Financial System - Kavita Rawal 7. Derivatives Analysis and Valuation - ICFAI University 8. NCFM-
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