1
The Growth of Derivatives Market in India
A C K N O W L E D G E M E N T
The success of any project is never limited to individual undertaking project; it is a collective efforts of people around, that spell success. This acknowledgement is humble attempt of earnestly thanking all those who were directly or indirectly involved in this project. I would like to extend my sincere, heartfelt gratitude to our Head of the epartment,
Prof. Shruti Charvarkar and our internal guide Prof. Arun under whose guidance I had the privilege of working and learning and whose constant inspiration at all faces of the project lead to the successful completion of my work.
!ast but not the least I express my deepest regards to all staff members, for helping me by giving me their time and providing all re"uired facilities.
2
The Growth of Derivatives Market in India
EXECUTIVE SUMMARY
#irstly I am briefing the current Indian market and comparing it with it past. I am also giving brief data about foreign market. Then at the last I am giving my suggestions and recommendations. $ith over %& million shareholders, India has the third largest investor base in the world after '() and *apan. +ver ,&-- companies are listed on the Indian (tock .xchanges /more than the number of companies listed in developed markets of *apan, '0, 1ermany, #rance, )ustralia, (wit2erland, 3anada and Hong 0ong.4. The Indian 3apital 5arket is significant in terms of the degree of development, volume of trading, transparency and its tremendous growth potential. India6s 5arket 3apitali2ation was the highest among the emerging markets. Total market capitali2ation of The 7ombay (tock .xchange /7(.4, which, as on *uly 89, 9::,, was '(; 9,& billion has grown by 8,.&< percent every twelve months and was over '(; =8> billion as of *anuary, %--,. 7ombay (tock .xchanges /7(.4, one of the oldest in the world, accounts for the largest number of listed companies transacting their shares on a nationwide +nline Trading (ystem. The two major exchanges namely the ?ational (tock .xchange /?(.4 and the 7ombay (tock .xchange /7(.4 ranked no. 8 @ & in the world, calculated by the number of daily transactions done on the exchanges. The Total Turnover of Indian #inancial 5arkets crossed '(; %%&A billion in %--A B )n increase of =%< from '( ; 9%8, billion in %--> in a short span of % years only. Turnover in the (pot and erivatives segment both in ?(. @ 7(. was higher by >&< into %--A as compared to %--&. $ith daily average volume of '( ; :.> billion, the (ensex has posted excellent returns in the recent years. Currently the Market Capitalisation of the Sensex as on July 4th, 2009 was P#$ of %ore than 20. s 4!.4 "akh Crore with a
3
The Growth of Derivatives Market in India
RESARCH METHODOLOGY
Method of Data Collectio !"
Seco da#$ So%#ce& !" It is the data which has already been collected by some one or an organi2ation for some other purpose or research study .The data for study has been collected from various sourcesC ? ? ? ? 7ooks *ournals 5aga2ines Internet sources
4
The Growth of Derivatives Market in India
LIMITATIONS O' STUDY
() LIMITED RESOURCES ! !imited resources are available to collect the information about the commodity trading. *) VOLATALITY ! (hare market is so much volatile and it is difficult to forecast any thing about it whether you trade through online or offline. +) AS,ECTS COVERAGE ! (ome of the aspects may not be covered in my study.
5
The Growth of Derivatives Market in India
INDEX CHAPTER NO.
1 1.1
Topic
Introduction To Derivatives Meaning & Underlying Assets 1.2 History of Derivatives 1.3 Need of the St dy 1.! "iterat re #evie$ 1.% &'(e)tives of the St dy 1.* S)o+e of the ,ro(e)t 1.- ,rod )ts
,a-e ( . * Page From To
( 8 - 18 ) 9 10 13 1! 1% 1* 19 12 13 1! 1% 1* 1.
2
Derivatives Markets in India 2.1 /ntrod )tion 2.2 Definitions 2.3 0y+es
( 20 - 22 ) 20 21 22 21 21 22
3
Contracts in Derivatives Markets in India 3.1 1or$ard 2ontra)ts 3.2 1 t re 2ontra)ts 3.3 &+tion 2ontra)ts 3.! S$a+ 2ontra)ts 3.% &ther 0y+es of 2ontra)ts
( 24 - 32 ) 2! 2% 30 31 32 2% 29 30 31 32
!
Growth
Deve!o"#ent o$ Derivatives Market in India
( 34 - 43 ) 3! 3% 3! 3%
!.1 /ndian Derivatives Mar3et !.2 Needs for Derivative Mar3ets in /ndia 0oday
6
The Growth of Derivatives Market in India
!.3 Myths & #ealities of Derivatives 3* !3
INDEX CHAPTER NO.
%
,a-e * . * Page From To
Topic
%actors Contri&utin' to the Growth Deve!o"#ent o$ Derivatives Market in India %.1 ,ri)e 4olatility %.2 5lo'alisation of Mar3ets %.3 0e)hnologi)al Advan)es %.! Advan)es in 1inana)ial 0heory %.% Develo+6ent of Derivatives Mar3et
( 4( - (1 ) !% !* !* !!!* !* !!%1
*
)ene$its* T+"es o$ ,ationa! -.chan'es /e"orts o$ Deve!o"#ents in Derivative Markets in India *.1 #is3 Manage6ent *.2 ,ri)e Dis)overy *.3 &+erational Advantages *.! Mar3et 7ffi)ien)y *.% 7ase of S+e) lations *.* 0y+es of National 78)hanges *.- #e+orts of Develo+6ents
( (3 - 00 ) %3 %3 %3 %! %! %% *0 %3 %3 %! %! %! %9 *0
. 9
Case 1tud+ on I2 %1 Invests#art %indin's Conc!usions 1u''estions
*2 - **9 - -0 -2 - -2
/eco##endations
7
The Growth of Derivatives Market in India ? ?
)i&!io'ra"h+ 3&&revations -3 - -3 -3 - -%
2HA,07# 1 Introduction to Derivatives 1.1 1.2 1.3 1.! 1.% 1.* 1.Meaning & Underlying Assets History of Derivatives Need of the St dy "iterat re #evie$ &'(e)tives of the St dy S)o+e of the ,ro(e)t ,rod )ts
8
The Growth of Derivatives Market in India
INTRODUCTION TO DERIVATIVES
) erivative 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.
erivatives have become increasingly important in the field of finance, +ptions and #utures are traded actively on many exchanges, #orward 3ontracts, (wap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as +verDTheD 3ounter markets B in other words, there is no single market place or organi2ed exchanges.
9
The Growth of Derivatives Market in India
()( MEANING / UNDERLYING ASSETS
erivatives 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 erivatives. The If erivatives are defined as Ethe future contracts whose value depends upon the underlying assets F. erivatives are introduced in the (tock 5arket, the underlying asset may be anything erivatives Trading is that derivatives reduce the risk by as component of stock market like, stock prices or market indices, interest rates, etc. The main logic behind 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 li"uidity in the stock market. erivatives are assets, which derive their values from an underlying asset. These underlying assets are of various categories like D G 3ommodities including grains, coffee beans, etc. G Hrecious metals like gold and silver. G #oreign .xchange Iate. G7onds of different types, including medium to longDterm negotiable debt securities issued by governments, companies, etc. G (hortDterm debt securities such as TDbills. G +verDTheD3ounter /+T34 money market products such as loans or deposits. G ."uities
10
The Growth of Derivatives Market in India
#or example, a ollar/;4 forward is a erivative 3ontract, which gives the buyer a right @ an obligation to buy ollars/;4 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, erivatives are a very important tool of Iisk 5anagement.
()* HISTORY O' DERIVATIVES !
The history of derivatives is "uite colourful and surprisingly a lot longer than most people think. #orward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient 1reece and Iome. Ioman emperors entered forward contracts to provide the masses with their supply of .gyptian 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 organi2ed commodity exchange came into existence in the early 9,--6s in *apan. The first formal commodities exchange, the 3hicago 7oard of Trade /37+T4, was formed in 9=>= in the '( to deal with the problem of Jcredit risk6 and to provide centralised location to negotiate forward contracts. #rom Jforward6 trading in commodities emerged the commodity Jfutures6. The first type of futures contract was called Jto arrive at6. Trading in futures began on the 37+T in the 9=A-6s. In 9=A&, 37+T listed the first Jexchange traded6 derivatives contract, known as the futures contracts. #utures trading grew out of the need for hedging the price risk involved in many commercial operations. The 3hicago 5ercantile .xchange /35.4, a spinDoff of 37+T, was formed in 9:9:, though it did exist before in 9=,> under the names of J3hicago Hroduce .xchange6 /3H.4 and J3hicago .gg and 7utter 7oard6 /3.774. The first financial futures to emerge were the currency in 9:,% in the '(. The first foreign currency futures were traded on 5ay 9A, 9:,%, on International 5onetary 5arket
11
The Growth of Derivatives Market in India
/I554, a division of 35.. The currency futures traded on the I55 are the 7ritish Hound, the 3anadian the )ustralian ollar, the *apanese Ken, the (wiss #ranc, the 1erman 5ark, ollar, and the .uro dollar. 3urrency futures were followed soon by
interest rate futures. Interest rate futures contracts were traded for the first time on the 37+T on +ctober %-, 9:,&. (tock index futures and options emerged in 9:=%. The first stock index futures contracts were traded on 0ansas 3ity 7oard of Trade on #ebruary %>, 9:=%.The first of the several networks, which offered a trading link between two exchanges, was formed between the (ingapore International 5onetary .xchange /(I5.L4 and the 35. on (eptember ,, 9:=>. +ptions are as old as futures. Their history also dates back to ancient 1reece and Iome. +ptions are very popular with speculators in the tulip cra2e of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. utch 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 cra2e collapsed in 9A8, as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an )merican financier, Iussell (age, in 9=,%. These options were traded over the counter. )gricultural commodities options were traded in the nineteenth century in .ngland and the '(. +ptions on shares were available in the '( on the over the counter /+T34 market only until 9:,8 without much knowledge of valuation. ) group of firms known as Hut and 3all brokers and sellers together. +n )pril %A, 9:,8, the 3hicago 7oard options .xchange /37+.4 was set up at 37+T for the purpose of trading stock options. It was in 9:,8 again that black, 5erton, and (choles invented the famous 7lackD(choles +ption #ormula. This model helped in ealer6s )ssociation was set up in early 9:--6s to provide a mechanism for bringing buyers and
12
The Growth of Derivatives Market in India
assessing the fair price of an option which led to an increased interest in trading of options. $ith the options markets becoming increasingly popular, the )merican (tock .xchange /)5.L4 and the Hhiladelphia (tock .xchange /HH!L4 began trading in options in 9:,&. The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the 7retton $oods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties. The 37+T and the 35. are two largest financial exchanges in the world on which futures contracts are traded. The 37+T now offers >= futures and option contracts /with the annual volume at more than %99 million in %--94.The 37+. is the largest exchange for trading stock options. The 37+. trades options on the (@H 9-- and the (@H &-- stock indices. The Hhiladelphia (tock .xchange is the premier exchange for trading foreign options. The most traded stock indices include (@H &--, the ow *ones Industrial )verage, the
?asda" 9--, and the ?ikkei %%&. The '( indices and the ?ikkei %%& trade almost round the clock. The ?%%& is also traded on the 3hicago 5ercantile .xchange.
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The Growth of Derivatives Market in India
()+ NEED O' 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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The Growth of Derivatives Market in India
()0 LITERATURE REVIEW
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of riskDaverse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. 7y 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 lockingDin asset prices. )s instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by lockingDin asset prices, derivative products minimi2e the impact of fluctuations in asset prices on the profitability and cash flow situation of riskDaverse investors. erivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodityDlinked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in postD9:,- period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 9::-s, they accounted for about twoDthirds 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 e"uity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of indexDlinked derivatives. .ven 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 visDvis derivative products based on individual securities is another reason for their growing use. )s in the present scenario, this topic . erivative Trading is fast gaining momentum, I have chosen
15
The Growth of Derivatives Market in India
()1 O23ECTIVES O' THE STUDY
? To understand the concept of the
erivatives and erivative Trading. erivatives
? To know different types of #inancial
? To know the role of erivatives Trading in India. ? To analyse the performance of erivatives Trading since %--9 with special reference to #utures @ +ptions
16
The Growth of Derivatives Market in India
()4 SCO,E O' THE ,RO3ECT
The project covers the derivatives market and its instruments. #or better understanding various strategies with different situations and actions have been given. It includes the data collected in the recent years and also the market in the derivatives in the recent years. This study extends to the trading of derivatives done in the ?ational (tock 5arkets.
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The Growth of Derivatives Market in India
()5 ,RODUCTS
There are various derivative products traded. They are; &.'.& #orwards &.'.2 #utures &.'.( +ptions &.'.4 (waps “A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified future date. The price may be agreed on in advance or in future.” “A
Future Contract
is a firm contractual agreement between a buyer and seller for
a specified as on a fixed date in future. The contract price will vary according to the market place but it is fixed when the trade is made. The contract also has a standard specification so both parties know exactly what is being done”. “An
Options Contract
confers the right but not the obligation to buy (call option or
sell (put option a specified underlying instrument or asset at a specified price ! the "trike or #xercised price up until or an specified future date ! the #xpiry date. The
18
The Growth of Derivatives Market in India
$rice is called $remium and is paid by buyer of the option to the seller or writer of the option.” “A
Call option
gives the holder the right to buy an underlying asset by a certain date
for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this, which is called Mthe call option premium or call option priceM. “A
Put option , on the other hand gives the holder the right to sell an underlying asset
by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called Mthe put option premium or put option priceM. “Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forwardNs contracts. ) contract whereby two parties agree to exchange /swap4 payments, based on some notional principle amount is called as a J($)H6. In case of swap, only the payment flows are exchanged and not the principle amountF I had conducted this research to find out whether investing in the beneficial or not O Kou will be glad to know that should invest in the erivative 5arket. erivative 5arket. )lso (.7I erivative 5arket is
erivative 5arket in India is the most
booming now days.(o the person who is ready to take risk and want to gain more
+n the other hand I7I has to play an important role in must encourage investment in
erivative 5arket so that the investors get the benefit
out of it. (orry to say that today even educated persons are not willing to invest in erivative 5arket because they have the fear of high risk.
19
The Growth of Derivatives Market in India
"o, "#%& should take necessary steps for improvement in 'erivative (arket so that more investors can invest in 'erivative market.
2HA,07# 2 Derivatives Markets in India 2.1 2.2 2.3 /ntrod )tion Definitions 0y+es
20
The Growth of Derivatives Market in India
DERIVATIVE MARKET IN INDIA *)( INTRODUCTION
The origin of erivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. #rom 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 lockingDin asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. ) farmer who sowed his crop in *une faced uncertainty over the price he would receive for his harvest in (eptember. 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. 3learly this meant that the farmer and his family were exposed to a high risk of price uncertainty. +n the other hand, a merchant with an ongoing re"uirement of grains too would face a price risk that of having to pay exorbitant prices during death, although favourable prices could be obtained during periods of oversupply. 'nder 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 (eptember could be decided earlier. $hat they would then negotiate happened to be #uturesDType 3ontract, which would enable both parties to eliminate the price risk. In 9=>=, the 3hicago 7oard +f Trade, or 37+T, was established to bring farmers and merchants together. ) group of traders got together and created the JtoDarrive6 contract
21
The Growth of Derivatives Market in India
that permitted farmers to lock into price upfront and deliver the grain later. These toD arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardi2ed, and in 9:%& the first futures clearing house came into existence. Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. 7esides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.
*)* DE'INITION O' DERIVATIVE
) erivative 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 e"uity, 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. (uch a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the EunderlyingF in this case. The #orwards 3ontracts /Iegulation4 )ct, 9:&%, regulates the #orward P #utures 3ontracts in commodities all over India. )s per this the #orward 5arkets 3ommission /#534 continues to have jurisdiction over commodity #utures 3ontracts. However when erivatives Trading in securities was introduced in %--9, the term E(ecurityF in the (ecurities 3ontracts /Iegulation4 )ct, 9:&A /(3I)4, was amended to include derivative contracts in securities. 3onse"uently, regulation of derivatives came under the purview of (ecurities .xchange 7oard of India /(.7I4. $e thus have separate Iegulatory )uthorities for (ecurities and 3ommodity erivative 5arkets. erivatives are securities under the (3I) and hence the trading of /Iegulation4 )ct, 9:&A defines E erivativeF to include D erivatives is
governed by the regulatory framework under the (3I). The (ecurities 3ontracts
22
The Growth of Derivatives Market in India
) security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. ) contract which derives its value from the prices, or index of prices, of underlying securities.
*)+ TY,ES O' DERIVATIVES MARKET
T$6e& of De#i7ati7e& Ma#8et
.xchange Traded erivatives
+ver The 3ounter erivatives
?ational (tock .xchange
7ombay (tock .xchange
?ational 3ommodity @ erivative .xchange
Index #uture
Index +ption
(tock +ption
(tock #uture
23
The Growth of Derivatives Market in India
2HA,07# 3 Contracts in Derivatives Markets in India 3.1 3.2 3.3 3.! 3.% 1or$ard 2ontra)ts 1 t re 2ontra)ts &+tion 2ontra)ts S$a+ 2ontra)ts &ther 0y+es of 2ontra)ts
24
The Growth of Derivatives Market in India
+)( 'ORWARD CONTRACTS
) forward contract is an agreement to buy or sell an asset on a specified date for a specified price. +ne 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. +ther contract details like delivery date, price and "uantity 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.
2ASIC 'EATURES O' 'ORWARD CONTRACT
G G G G G They are bilateral contracts and hence exposed to counterDparty risk. .ach contract is custom designed, and hence is uni"ue in terms of contract si2e, expiration date and the asset type and "uality. The contract price is generally not available in public domain. +n the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterDparty, which often results in high prices being charged.
25
The Growth of Derivatives Market in India
However forward contracts in certain standardi2ed, transaction as in the case of costs and increasing markets have foreign exchange, volume. transactions become thereby very reducing
This process of
standardi2ation reaches its limit in the organi2ed futures market. #orward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially t h e same economic fun ction s presence of future price uncertainty. However of allocating risk in the are a significant futures
improvement over the forward contracts as they eliminate counterparty risk and offer more li"uidity.
+)* 'UTURE CONTRACT
In finance, a futures contract is a standardi2ed contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a preDset price. The future date is called the delivery date or final settlement date. The preDset 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. ) 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 /seller4 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. #utures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin re"uirements, etc.
2ASIC 'EATURES O' 'UTURE CONTRACT
26
The Growth of Derivatives Market in India
() Sta da#di9atio !
#utures contracts ensure their li"uidity by being highly standardi2ed, usually by specifyingC • • • 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 "uoted. The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the "uality of the underlying goods but also the manner and location of delivery. The delivery month. • • The last trading date. +ther details such as the tick, the minimum permissible price fluctuation.
*) Ma#-i ! )lthough the value of a contract at time of trading should be 2ero, 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 minimi2e this risk, the exchange demands that contract owners post a form of collateral, commonly known as 5argin re"uirements 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. )nitial Mar*in + 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 dayNs trading. It may be &< or 9-< of total contract price.
27
The Growth of Derivatives Market in India
Mark to %arket Mar*in + 7ecause a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is re"uired by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the MsettlementM or markDtoDmarket 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 MmarginM. This is intended to protect the exchange against loss. )t 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. +n 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. +) Settle:e t ! (ettlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contractC • Physi,al -elivery . 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. 5ost are cancelled out by purchasing a covering position D that is, buying a contract to cancel out an earlier sale /covering a short4, or selling a contract to li"uidate an earlier purchase /covering a long4. • Cash Settle%ent . a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as .uribor, or the closing value of a stock market index. ) futures contract might also opt to settle against an index based on trade in a related spot market.
28
The Growth of Derivatives Market in India
$xpiry is the time when the final prices of the future are determined. #or many e"uity index and interest rate futures contracts, this happens on the !ast Thursday of certain trading month. +n this day the tQ% futures contract becomes the t forward contract. +)*)( ,RICING O' 'UTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery /the forward price4 must be the same as the cost /including interest4 of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, nonDdividend paying asset, the value of the futurePforward, present value at time to maturity , will be found by discounting the
by the rate of riskDfree return .
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. )ny deviation from this e"uality allows for arbitrage as follows D In the case where the forward price is higher C &. The arbitrageur sells the futures contract and buys the underlying today /on the spot market4 with borrowed money. 2. +n the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. (. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit. In the case where the forward price is lower C &. The arbitrageur buys the futures contract and sells the underlying today /on the spot market4; he invests the proceeds. 2. +n the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. (. He then receives the underlying and pays the agreed forward price using the matured investment. RIf he was short the underlying, he returns it now.S 4. The difference between the two amounts is the arbitrage profit.
29
The Growth of Derivatives Market in India
DISTINCTION 2ETWEEN 'UTURES AND 'ORWARDS CONTRACTS /$A01 $ 2perational Me,hanis% /2 3A - C240 AC0 /101 $ C240 AC0
Traded directly between Traded on the exchanges. two parties /not traded on the exchanges4.
Contra,t Spe,ifi,ations Counter.party risk
iffer from trade to trade.
3ontracts contracts.
are
standardi2ed
.xists.
.xists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally settlement. guarantees their
"i5ui6ation Profile
!ow, tailor
as
contracts
are High, as contracts are standardi2ed
made
contracts exchange traded contracts.
catering to the needs of the needs of the parties.
30
The Growth of Derivatives Market in India
Pri,e 6is,overy ?ot efficient, as markets .fficient, as markets are centrali2ed are scattered. and all buyers and sellers come to a common platform to discover the $xa%ples 3urrency market in India. price. 3ommodities, futures, Index #utures and Individual stock #utures in India.
31
The Growth of Derivatives Market in India
+)+ O,TIONS "
) derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as Joption6. 'nderlying asset refers to any asset that is traded. The price at which the underlying is traded is called the Jstrike price6. There are two types of options i.e., CA"" 2P0)24 7 P10 2P0)24 .
CALL O,TION!
) contract that gives its owner the right but not the obligation to buy an underlying assetDstock or any financial asset, at a specified price on or before a specified date is known as a J3all option6. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.
,UT O,TION!
) contract that gives its owner the right but not the obligation to sell an underlying assetDstock or any financial asset, at a specified price on or before a specified date is known as a JHut option6. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase. Hut and calls are almost always written on e"uities, although occasionally preference shares, bonds and warrants become the subject of options.
32
The Growth of Derivatives Market in India
+)0 SWA,S "
(waps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forwardNs contracts. ) contract whereby two parties agree to exchange /swap4 payments, based on some notional principle amount is called as a J($)H6. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps areC )40$ $S0 A0$ S3APS +
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. C1 $4C8 S3APS +
3urrency 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. 'nder a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. (uch cash flows are supposed to remain unaffected by subse"uent changes in the exchange rates. /)4A4C)A" S3AP + #inancial swaps constitute a funding techni"ue 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.
33
The Growth of Derivatives Market in India
+)1 OTHER KINDS O' DERIVATIVES
0he other kin6 of -erivatives, whi,h are not %u,h popular are as follows +
2ASKETS "
7askets options are option on portfolio of underlying asset. ."uity Index +ptions are most popular form of baskets.
LEA,S "
?ormally option contracts are for a period of 9 to 9% months. However, exchange may introduce option contracts with a maturity period of %D8 years. These longDterm option contracts are popularly known as !eaps or !ong term ."uity )nticipation (ecurities.
WARRANTS "
+ptions generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. !ongerDdated options are called warrants and are generally traded overDtheDcounter.
SWA,TIONS "
(waptions 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. Iather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. ) receiver swaption is an option to receive fixed and pay floating. ) payer swaption is an option to pay fixed and receive floating.
34
The Growth of Derivatives Market in India
2HA,07# ! Growth Deve!o"#ent o$ Derivatives Markets in India !.1 !.2 !.3 /ndian Derivatives Mar3et Need for Derivatives in /ndia 0oday Myths & #ealities of Derivatives
35
The Growth of Derivatives Market in India
GROWTH / DEVELO,MENT O' DERIVATIVES MARKET IN INDIA 0)( INDIAN DERIVATIVES MARKET
(tarting 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 Ieserve 7ank of India6s /I7I4 efforts in creating currency forward market. erivatives are an integral part of liberalisation process to manage risk. ?(. gauging the market re"uirements initiated the process of setting up derivative markets in India. In *uly 9:::, derivatives trading commenced in India Chronology of instruments 9::9 9> ecember 9::& 9= ?ovember 9::A 99 5ay 9::= , *uly 9::: %> 5ay %--%& 5ay %--!iberalisation process initiated ?(. asked (.7I for permission to trade index futures. (.7I setup !.3.1upta 3ommittee to draft a policy framework for index futures. !.3.1upta 3ommittee submitted report. I7I gave permission for +T3 forward rate agreements /#I)s4 and interest rate swaps. (I5.L chose ?ifty for trading futures and options on an Indian index. (.7I gave permission to ?(. and 7(. to do index
futures trading. : *une %--Trading of 7(. (ensex futures commenced at 7(.. 9% *une %--Trading of ?ifty futures commenced at ?(.. %& (eptember ?ifty futures trading commenced at (1L. %--% *une %--9 Individual (tock +ptions @ erivatives
0)* Need fo# De#i7ati7e& i
I dia toda$
36
The Growth of Derivatives Market in India
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 dayDtoDday life for ordinary people in major part of the world.
'ntil the advent of ?(., the Indian capital market had no access to the latest trading methods and was using traditional outDdated methods of trading. There was a huge gap between the investors6 aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India6s financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Ieserve 7ank of India6s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.
0)+ M$th& a d Realitie& a;o%t De#i7ati7e&
37
The Growth of Derivatives Market in India
In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. #inancial derivatives came into the spotlight along with the rise in uncertainty of postD9:,-, when '( announced an end to the 7retton $oods (ystem 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 dayDtoDday life for ordinary people in major parts of the world. $hile 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 .xchange traded derivatives, which are well regulated with all the safety mechanisms in place. $hat are these myths behind derivativesO • erivatives increase speculation and do not serve any economic purpose • • • • Indian 5arket is not ready for derivative trading isasters prove that derivatives are very risky and highly leveraged instruments. erivatives are complex and exotic instruments that Indian investors will find difficulty in understanding Is the existing capital market safer than erivativesO
0)+)( De#i7ati7e& i c#ea&e &6ec%latio eco o:ic6%#6o&e!
a d do
ot &e#7e a $
?umerous 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. erivatives are a lowDcost, effective method for users to hedge and manage their exposures to interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. )gricultural futures and options helped farmers and processors hedge against commodity price risk. )fter the fallout of 7retton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable
38
The Growth of Derivatives Market in India
innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, onDline trading in the capital markets, etc. )s 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.
!ooking at the e"uity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. )n e"uity fund, for example, can reduce its exposure to the stock market "uickly and at a relatively low cost without selling off part of its e"uity assets by using stock index futures or index options.
7y 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. ?ow that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market li"uidity and efficiency and facilitating the flow of trade and finance 0)+)* I dia Ma#8et i& ot #ead$ fo# De#i7ati7e T#adi -
+ften the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the preDre"uisites, which are needed for the introduction of derivatives, and how Indian market fares
39
The Growth of Derivatives Market in India
HI.DI.T'I(IT.( I? I)? (3.?)II+ !arge market India is one of the largest marketDcapitalised 3apitalisation countries in )sia with a market capitalisation of more than Is.,A&--- crores. High !i"uidity underlying in the The daily average traded volume in Indian capital market today is around ,&-- crores. $hich means on an average every month 9>< of the country6s 5arket capitalisation gets traded. These are clear indicators of high li"uidity in the underlying. The first clearing corporation guaranteeing trades has become fully functional from *uly 9::A in the form of ?ational (ecurities 3learing 3orporation /?(33!4. ?(33! is responsible for guaranteeing all open positions on the ?ational (tock .xchange /?(.4 for which it does the clearing. ?ational (ecurities epositories !imited /?( !4 which started functioning in the year 9::, has revolutionalised the security settlement in our country. In the Institution of (.7I /(ecurities and .xchange 7oard of India4 today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
Trade guarantee
) (trong
epository
) 1ood legal guardian
40
The Growth of Derivatives Market in India
0)+)+ Co:6a#i&o of Ne< S$&te:
) price is what one pays to ac"uire 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. )nd the price one pays in one6s own currency for a unit of another currency is called as an exchange rate. Hrices are generally determined by market forces. In a market, consumers have Jdemand6 and producers or suppliers have Jsupply6, 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. (uch changes in the price are known as Jprice volatility6. This has three factorsC the speed of price changes, the fre"uency 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 7I.TT+? $++ ( 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
47
The Growth of Derivatives Market in India
to the markets. ?ations that were poor suddenly became a major source of supply of goods. The 5exican crisis in the south eastD)sian currency crisis of 9::-6s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very "uickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. .ven e"uity 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, e"uity shares and bonds.
1)* GLO2ALISATION O' MARKETS >
.arlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. ?ow globalisation has increased the si2e of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better "uality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south .ast )sian currencies crisis of 9::, had affected the competitiveness of our products visDWDvis depreciated currencies. .xport of certain goods from India declined because of this crisis. (teel industry in 9::= suffered its worst set back due to cheap import of steel from south .ast )sian countries. (uddenly 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.
1)+ TECHNOLOGICAL ADVANCES >
48
The Growth of Derivatives Market in India
) significant growth of derivative instruments has been driven by technological breakthrough. )dvances in this area include the development of high speed processors, network systems and enhanced method of data entry. 3losely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous worldwide conferencing, ata transmission by satellite. )t 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 conse"uently its instantaneous impact on market price. )lthough 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. erivatives 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.
1)0 ADVANCES IN 'INANCIAL THEORIES >
)dvances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. +ption pricing models developed by 7lack and (choles in 9:,8 were used to determine prices of call and put options. In late 9:,-6s, work of !ewis .deington extended the early work of *ohnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. The above factors in combination of lot many factors led to growth of derivatives instruments
1)1 DEVELO,MENT O' DERIVATIVES MARKET IN INDIA
49
The Growth of Derivatives Market in India
The first step towards introduction of derivatives trading in India was the promulgation of the (ecurities !aws /)mendment4 +rdinance, 9::&, 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. (.7I set up a %>B member committee under the 3hairmanship of r.!.3.1upta on ?ovember 9=, 9::A to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on 5arch 9,, 9::= prescribing necessary preB conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as Jsecurities6 so that regulatory framework applicable to trading of Jsecurities6 could also govern trading of securities. (.7I also set up a group in *une 9::= under the 3hairmanship of Hrof.*.I.Uarma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in +ctober 9::=, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit re"uirement and realBtime monitoring re"uirements. The (ecurities 3ontract Iegulation )ct /(3I)4 was amended in ecember 9::: to include derivatives within the ambit of Jsecurities6 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 recogni2ed stock exchange, thus precluding +T3 derivatives. The government also rescinded in 5arch %---, the three decade old notification, which prohibited forward trading in securities. erivatives trading commenced in India in *une %--- after (.7I granted the final approval to this effect in 5ay %--9. (.7I permitted the derivative segments of two stock exchanges, ?(. and 7(., and their clearing housePcorporation to commence trading and settlement in approved derivatives contracts. To begin with, (.7I approved trading in index futures contracts based on (@H 3?L ?ifty and 7(.B8- /(ense4 index. This was followed by approval for trading in options based on these two indexes and options on individual securities.
50
The Growth of Derivatives Market in India
The trading in 7(. (ensex options commenced on *une >, %--9 and the trading in options on individual securities commenced in *uly %--9. #utures contracts on individual stocks were launched in ?ovember %--9. The derivatives trading on ?(. commenced with (@H 3?L ?ifty Index futures on *une 9%, %---. The trading in index options commenced on *une >, %--9 and trading in options on individual securities commenced on *uly %, %--9. (ingle stock futures were launched on ?ovember :, %--9. The index futures and options contract on ?(. are based on (@H 3?L Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing housePcorporation duly approved by (.7I and notified in the official ga2ette. #oreign Institutional Investors /#IIs4 are permitted to trade in all .xchange traded derivative products. The following are some observations based on the trading statistics provided in the ?(. report on the futures and options /#@+4C G (ingleDstock futures continue to account for a si2able proportion of the #@+ segment. It constituted ,- per cent of the total turnover during *une %--%. ) primary reason attributed to this phenomenon is that traders are comfortable with singleDstock futures than e"uity options, as the former closely resembles the erstwhile badla system. G +n 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 index4 is high. ) 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 roundD trips. G Hut volumes in the index options and e"uity options segment have increased since *anuary %--%. The callDput volumes in index options have decreased from %.=A in
51
The Growth of Derivatives Market in India
*anuary %--% to 9.8% in *une. The fall in callDput volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. G #arther month futures contracts are still not actively traded. Trading in e"uity options on most stocks for even the next month was nonDexistent. G aily option price variations suggest that traders use the #@+ segment as a less risky
alternative /read substitute4 to generate profits from the stock price movements. The fact that the option premiums tail intraDday stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intraDday stock price variations should not have a oneDtoDone impact on the option premiums. • The spot foreign exchange market remains the most important segment but the
derivative segment h a s also grown. In the derivative market foreign exchange swaps account for the largest share of the total turnover of derivatives in India followed by forwards and options. (ignificant milestones in the development of derivatives market to undertake long have been /i4 permission to banks to undertake cross currency term foreign currency swaps that contributed to the derivative transactions subject to certain conditions /9::A4 /ii4 allowing corporates development of the term currency swap market /9::,4 /iii4 allowing dollar rupee options /%--84 and /iv4 introduction of currency futures /%--=4. I would like to emphasise that currency swaps allowed companies with .37s 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. ?ormally such risks should be taken by corporates who have natural hedge or have potential foreign exchange earnings. 7ut often corporate assume these risks due to interest rate differentials and views on currencies.
52
The Growth of Derivatives Market in India
This period has also witnessed several relaxations in regulations relating to forex markets and also greater liberalisation in capital account regulations leading to greater integration with the global economy. • 3ash settled exchange traded currency futures have made foreign currency
a separate asset class that can be traded without any underlying need or exposure a n d on a leveraged basis on the recogni2ed stock exchanges with credit risks being assumed by the central counterparty (ince the commencement of trading of currency futures in all the three exchanges, the value of the trades has gone up steadily from Is 9,, >%: crores in +ctober %--= to Is >&, =-8 crores in same period. ecember %--=. The average daily turnover in all the exchanges has also increased from Is=,9 crores to Is %,9=9 crores during the The turnover in the currency futures market is in line with the international scenario, where I understand the share of futures market ranges between % B 8 per cent. 'o#e= Ma#8et Acti7it$
)pril6-&D Total turnover /'( billion4 5ar6-A >,>-> %.AC9 &-.& 9:.8-.&
)pril6-AD 5ar6-, A,&,9 %.,C9 &9.: 9,.: 8-.9
)pril6-,D 5ar6-= 9%,8-> %.8,C 9 >:., 9:.8 89.9
)pril6-=D ec6-= :,A%9 %.AAC9 >&.: %9.& 8%.,
InterDbank to 5erchant ratio (potPTotal Turnover /:9 crore.
(eptember %--=D-:, the turnover at 7(. was Is.9,&9- crore, which was insignificant
62
The Growth of Derivatives Market in India
2HA,07# C31- 1T4D5
63
The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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71
The Growth of Derivatives Market in India
2HA,07# .
1indings & 2on)l sions
'INDINGS / CONCLUSION
#rom the above analysis it can be concluded thatC &. erivative market is growing very fast in the Indian .conomy. The turnover of erivative 5arket is increasing year by year in the India6s largest stock exchange ?(.. In the case of index future there is a phenomenal increase in the number of contracts. 7ut whereas the turnover is declined considerably. In the
72
The Growth of Derivatives Market in India
case of stock future there was a slow increase observed in the number of contracts whereas a decline was also observed in its turnover. In the case of index option there was a huge increase observed both in the number of contracts and turnover. 2. )fter analy2ing data it is clear that the main factors that are driving the growth of erivative 5arket are 5arket improvement in communication facilities as well as long term saving @ investment is also possible through entering into 3ontract. (o these factors encourage the erivative 5arket in India. erivative
(. It encourages entrepreneurship in India. It encourages the investor to take more risk @ earn more return. (o in this way it helps the Indian .conomy by developing entrepreneurship. erivative 5arket is more regulated @ standardi2ed so in this way it provides a more controlled environment. In nutshell, we can say that the rule of High risk @ High return apply in erivatives. If we are able to take more risk then we can earn more profit under erivatives. 3ommodity derivatives have a crucial role to play in the price risk management process for the commodities in which it deals. )nd it can be extremely beneficial in agricultureD dominated economy, like India, as the commodity market also involves agricultural produce. erivatives like forwards, futures, options, swaps etc are extensively used in the country. However, the commodity derivatives have been utili2ed in a very limited scale. +nly forwards and futures trading are permitted in certain commodity items.
I.!I)?3. is the most active future contracts on individual securities traded with :--:- contracts and I?I! is the next most active futures contracts with A8&%% contracts being traded.
73
The Growth of Derivatives Market in India
74
The Growth of Derivatives Market in India
2HA,07# 9
#e)o66endations & S ggestions
RECOMMENDATIONS / SUGGESTIONS
? I7I should play a greater role in supporting derivatives. erivatives market should be developed in order to keep it at par with other derivative markets in the world.
?
75
The Growth of Derivatives Market in India
? (peculation should be discouraged. There must be more derivative instruments aimed at individual investors. (.7I should conduct seminars regarding the use of derivatives to educate individual investors.
?
?
? )fter study it is clear that
erivative influence our Indian .conomy up to erivative market. erivative 5arket
much extent. (o, (.7I should take necessary steps for improvement in erivative 5arket so that more investors can invest in ? There is a need of more innovation in 7ecause of high risk involved in erivative 5arket because in today
scenario even educated people also fear for investing in erivatives.
76
The Growth of Derivatives Market in India
2I2LIOGRA,HY
>ooks eferre6+ ? +ptions #utures, and other erivatives by *ohn 3 Hull ? erivatives #)T by )jay (hah
? ?(.6s 3ertification in #inancial 5arketsC D erivatives 3ore module ? #inancial 5arkets @ (ervices by 1ordon @ ?atarajan
eports+ ? Ieport of the I7ID(.7I standard technical committee on exchange traded 3urrency #utures ? Iegulatory #ramework for #inancial 3e?sites visite6+ ? www.nse.in6ia.,o% ? www.?sein6ia.,o% ? www.se?i.*ov.in ? www.n,6ex.,o% ? www.*oo*le.,o% ? www.6erivativesin6ia.,o% erivatives in India by r.!.3.1'HT)
77
The Growth of Derivatives Market in India
A22REVATIONS
A )5.LD )merica (tock .xchange > 7(.D 7ombay (tock .xchange 7(ID 7ritish (tandard Institute C 37+. D 3hicago 7oard options .xchange 37+T D 3hicago 7oard of Trade 3.77 D 3hicago .gg and 7utter 7oard 35. D 3hicago 5ercantile .xchange 3?LD 3risil ?se &- Index 3H. D 3hicago Hroduce .xchange 3$3D 3entral $arehousing 3orporation T((D erivative Trading (ettlement (ystem / #IIsD #oreign Institutional Investors # @ + B #uture and +ptions #53D #orward 5arkets 3ommission #I)sD #orward Iate )greements B 1)I3!D1ujarat )gro Industries 3orporation !imited 1()57D 1ujarat (tate )gricultural 5arketing 7oard ) I55 D International 5onetary 5arket IH(T)D India Hepper @ (pice Trade )ssociation
78
The Growth of Derivatives Market in India
M 53L B 5ulti 3ommodity .xchange 4 ?)#. D?ational )gricultural 3oD+perative 5arketing #ederation +f India ?3 .L B ?ational 3ommodities and erivatives .xchange ?I)5D ?ational Institute +f )gricultural 5arketing ?5(.D ?ational 5ulti 3ommodity .xchange ?+!D ?eptune +verseas !imited ?(33!D ?ational (ecurities 3learing 3orporation ?( !D ?ational (ecurities epositories !imited ?(. D ?ational (tock .xchange 2 +T3D +ver The 3ounter P HH!L D Hhiladelphia (tock .xchange H?7D Hunjab ?ational 7ank I7ID Ieserve 7ank +f India S (3/I4 ) D (ecurities 3ontracts /Iegulation4 )ct, 9:&A (.7ID (ecurities .xchange 7oard +f India (1LD (ingapore (tock .xchange (I5.L D (ingapore International 5onetary .xchange @ UH?D Uirtual Hrivate ?etwork
doc_104510748.doc
The Growth of Derivatives Market in India
A C K N O W L E D G E M E N T
The success of any project is never limited to individual undertaking project; it is a collective efforts of people around, that spell success. This acknowledgement is humble attempt of earnestly thanking all those who were directly or indirectly involved in this project. I would like to extend my sincere, heartfelt gratitude to our Head of the epartment,
Prof. Shruti Charvarkar and our internal guide Prof. Arun under whose guidance I had the privilege of working and learning and whose constant inspiration at all faces of the project lead to the successful completion of my work.
!ast but not the least I express my deepest regards to all staff members, for helping me by giving me their time and providing all re"uired facilities.
2
The Growth of Derivatives Market in India
EXECUTIVE SUMMARY
#irstly I am briefing the current Indian market and comparing it with it past. I am also giving brief data about foreign market. Then at the last I am giving my suggestions and recommendations. $ith over %& million shareholders, India has the third largest investor base in the world after '() and *apan. +ver ,&-- companies are listed on the Indian (tock .xchanges /more than the number of companies listed in developed markets of *apan, '0, 1ermany, #rance, )ustralia, (wit2erland, 3anada and Hong 0ong.4. The Indian 3apital 5arket is significant in terms of the degree of development, volume of trading, transparency and its tremendous growth potential. India6s 5arket 3apitali2ation was the highest among the emerging markets. Total market capitali2ation of The 7ombay (tock .xchange /7(.4, which, as on *uly 89, 9::,, was '(; 9,& billion has grown by 8,.&< percent every twelve months and was over '(; =8> billion as of *anuary, %--,. 7ombay (tock .xchanges /7(.4, one of the oldest in the world, accounts for the largest number of listed companies transacting their shares on a nationwide +nline Trading (ystem. The two major exchanges namely the ?ational (tock .xchange /?(.4 and the 7ombay (tock .xchange /7(.4 ranked no. 8 @ & in the world, calculated by the number of daily transactions done on the exchanges. The Total Turnover of Indian #inancial 5arkets crossed '(; %%&A billion in %--A B )n increase of =%< from '( ; 9%8, billion in %--> in a short span of % years only. Turnover in the (pot and erivatives segment both in ?(. @ 7(. was higher by >&< into %--A as compared to %--&. $ith daily average volume of '( ; :.> billion, the (ensex has posted excellent returns in the recent years. Currently the Market Capitalisation of the Sensex as on July 4th, 2009 was P#$ of %ore than 20. s 4!.4 "akh Crore with a
3
The Growth of Derivatives Market in India
RESARCH METHODOLOGY
Method of Data Collectio !"
Seco da#$ So%#ce& !" It is the data which has already been collected by some one or an organi2ation for some other purpose or research study .The data for study has been collected from various sourcesC ? ? ? ? 7ooks *ournals 5aga2ines Internet sources
4
The Growth of Derivatives Market in India
LIMITATIONS O' STUDY
() LIMITED RESOURCES ! !imited resources are available to collect the information about the commodity trading. *) VOLATALITY ! (hare market is so much volatile and it is difficult to forecast any thing about it whether you trade through online or offline. +) AS,ECTS COVERAGE ! (ome of the aspects may not be covered in my study.
5
The Growth of Derivatives Market in India
INDEX CHAPTER NO.
1 1.1
Topic
Introduction To Derivatives Meaning & Underlying Assets 1.2 History of Derivatives 1.3 Need of the St dy 1.! "iterat re #evie$ 1.% &'(e)tives of the St dy 1.* S)o+e of the ,ro(e)t 1.- ,rod )ts
,a-e ( . * Page From To
( 8 - 18 ) 9 10 13 1! 1% 1* 19 12 13 1! 1% 1* 1.
2
Derivatives Markets in India 2.1 /ntrod )tion 2.2 Definitions 2.3 0y+es
( 20 - 22 ) 20 21 22 21 21 22
3
Contracts in Derivatives Markets in India 3.1 1or$ard 2ontra)ts 3.2 1 t re 2ontra)ts 3.3 &+tion 2ontra)ts 3.! S$a+ 2ontra)ts 3.% &ther 0y+es of 2ontra)ts
( 24 - 32 ) 2! 2% 30 31 32 2% 29 30 31 32
!
Growth
Deve!o"#ent o$ Derivatives Market in India
( 34 - 43 ) 3! 3% 3! 3%
!.1 /ndian Derivatives Mar3et !.2 Needs for Derivative Mar3ets in /ndia 0oday
6
The Growth of Derivatives Market in India
!.3 Myths & #ealities of Derivatives 3* !3
INDEX CHAPTER NO.
%
,a-e * . * Page From To
Topic
%actors Contri&utin' to the Growth Deve!o"#ent o$ Derivatives Market in India %.1 ,ri)e 4olatility %.2 5lo'alisation of Mar3ets %.3 0e)hnologi)al Advan)es %.! Advan)es in 1inana)ial 0heory %.% Develo+6ent of Derivatives Mar3et
( 4( - (1 ) !% !* !* !!!* !* !!%1
*
)ene$its* T+"es o$ ,ationa! -.chan'es /e"orts o$ Deve!o"#ents in Derivative Markets in India *.1 #is3 Manage6ent *.2 ,ri)e Dis)overy *.3 &+erational Advantages *.! Mar3et 7ffi)ien)y *.% 7ase of S+e) lations *.* 0y+es of National 78)hanges *.- #e+orts of Develo+6ents
( (3 - 00 ) %3 %3 %3 %! %! %% *0 %3 %3 %! %! %! %9 *0
. 9
Case 1tud+ on I2 %1 Invests#art %indin's Conc!usions 1u''estions
*2 - **9 - -0 -2 - -2
/eco##endations
7
The Growth of Derivatives Market in India ? ?
)i&!io'ra"h+ 3&&revations -3 - -3 -3 - -%
2HA,07# 1 Introduction to Derivatives 1.1 1.2 1.3 1.! 1.% 1.* 1.Meaning & Underlying Assets History of Derivatives Need of the St dy "iterat re #evie$ &'(e)tives of the St dy S)o+e of the ,ro(e)t ,rod )ts
8
The Growth of Derivatives Market in India
INTRODUCTION TO DERIVATIVES
) erivative 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.
erivatives have become increasingly important in the field of finance, +ptions and #utures are traded actively on many exchanges, #orward 3ontracts, (wap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as +verDTheD 3ounter markets B in other words, there is no single market place or organi2ed exchanges.
9
The Growth of Derivatives Market in India
()( MEANING / UNDERLYING ASSETS
erivatives 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 erivatives. The If erivatives are defined as Ethe future contracts whose value depends upon the underlying assets F. erivatives are introduced in the (tock 5arket, the underlying asset may be anything erivatives Trading is that derivatives reduce the risk by as component of stock market like, stock prices or market indices, interest rates, etc. The main logic behind 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 li"uidity in the stock market. erivatives are assets, which derive their values from an underlying asset. These underlying assets are of various categories like D G 3ommodities including grains, coffee beans, etc. G Hrecious metals like gold and silver. G #oreign .xchange Iate. G7onds of different types, including medium to longDterm negotiable debt securities issued by governments, companies, etc. G (hortDterm debt securities such as TDbills. G +verDTheD3ounter /+T34 money market products such as loans or deposits. G ."uities
10
The Growth of Derivatives Market in India
#or example, a ollar/;4 forward is a erivative 3ontract, which gives the buyer a right @ an obligation to buy ollars/;4 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, erivatives are a very important tool of Iisk 5anagement.
()* HISTORY O' DERIVATIVES !
The history of derivatives is "uite colourful and surprisingly a lot longer than most people think. #orward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient 1reece and Iome. Ioman emperors entered forward contracts to provide the masses with their supply of .gyptian 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 organi2ed commodity exchange came into existence in the early 9,--6s in *apan. The first formal commodities exchange, the 3hicago 7oard of Trade /37+T4, was formed in 9=>= in the '( to deal with the problem of Jcredit risk6 and to provide centralised location to negotiate forward contracts. #rom Jforward6 trading in commodities emerged the commodity Jfutures6. The first type of futures contract was called Jto arrive at6. Trading in futures began on the 37+T in the 9=A-6s. In 9=A&, 37+T listed the first Jexchange traded6 derivatives contract, known as the futures contracts. #utures trading grew out of the need for hedging the price risk involved in many commercial operations. The 3hicago 5ercantile .xchange /35.4, a spinDoff of 37+T, was formed in 9:9:, though it did exist before in 9=,> under the names of J3hicago Hroduce .xchange6 /3H.4 and J3hicago .gg and 7utter 7oard6 /3.774. The first financial futures to emerge were the currency in 9:,% in the '(. The first foreign currency futures were traded on 5ay 9A, 9:,%, on International 5onetary 5arket
11
The Growth of Derivatives Market in India
/I554, a division of 35.. The currency futures traded on the I55 are the 7ritish Hound, the 3anadian the )ustralian ollar, the *apanese Ken, the (wiss #ranc, the 1erman 5ark, ollar, and the .uro dollar. 3urrency futures were followed soon by
interest rate futures. Interest rate futures contracts were traded for the first time on the 37+T on +ctober %-, 9:,&. (tock index futures and options emerged in 9:=%. The first stock index futures contracts were traded on 0ansas 3ity 7oard of Trade on #ebruary %>, 9:=%.The first of the several networks, which offered a trading link between two exchanges, was formed between the (ingapore International 5onetary .xchange /(I5.L4 and the 35. on (eptember ,, 9:=>. +ptions are as old as futures. Their history also dates back to ancient 1reece and Iome. +ptions are very popular with speculators in the tulip cra2e of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. utch 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 cra2e collapsed in 9A8, as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an )merican financier, Iussell (age, in 9=,%. These options were traded over the counter. )gricultural commodities options were traded in the nineteenth century in .ngland and the '(. +ptions on shares were available in the '( on the over the counter /+T34 market only until 9:,8 without much knowledge of valuation. ) group of firms known as Hut and 3all brokers and sellers together. +n )pril %A, 9:,8, the 3hicago 7oard options .xchange /37+.4 was set up at 37+T for the purpose of trading stock options. It was in 9:,8 again that black, 5erton, and (choles invented the famous 7lackD(choles +ption #ormula. This model helped in ealer6s )ssociation was set up in early 9:--6s to provide a mechanism for bringing buyers and
12
The Growth of Derivatives Market in India
assessing the fair price of an option which led to an increased interest in trading of options. $ith the options markets becoming increasingly popular, the )merican (tock .xchange /)5.L4 and the Hhiladelphia (tock .xchange /HH!L4 began trading in options in 9:,&. The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the 7retton $oods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties. The 37+T and the 35. are two largest financial exchanges in the world on which futures contracts are traded. The 37+T now offers >= futures and option contracts /with the annual volume at more than %99 million in %--94.The 37+. is the largest exchange for trading stock options. The 37+. trades options on the (@H 9-- and the (@H &-- stock indices. The Hhiladelphia (tock .xchange is the premier exchange for trading foreign options. The most traded stock indices include (@H &--, the ow *ones Industrial )verage, the
?asda" 9--, and the ?ikkei %%&. The '( indices and the ?ikkei %%& trade almost round the clock. The ?%%& is also traded on the 3hicago 5ercantile .xchange.
13
The Growth of Derivatives Market in India
()+ NEED O' 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.
14
The Growth of Derivatives Market in India
()0 LITERATURE REVIEW
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of riskDaverse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. 7y 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 lockingDin asset prices. )s instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by lockingDin asset prices, derivative products minimi2e the impact of fluctuations in asset prices on the profitability and cash flow situation of riskDaverse investors. erivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodityDlinked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in postD9:,- period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 9::-s, they accounted for about twoDthirds 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 e"uity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of indexDlinked derivatives. .ven 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 visDvis derivative products based on individual securities is another reason for their growing use. )s in the present scenario, this topic . erivative Trading is fast gaining momentum, I have chosen
15
The Growth of Derivatives Market in India
()1 O23ECTIVES O' THE STUDY
? To understand the concept of the
erivatives and erivative Trading. erivatives
? To know different types of #inancial
? To know the role of erivatives Trading in India. ? To analyse the performance of erivatives Trading since %--9 with special reference to #utures @ +ptions
16
The Growth of Derivatives Market in India
()4 SCO,E O' THE ,RO3ECT
The project covers the derivatives market and its instruments. #or better understanding various strategies with different situations and actions have been given. It includes the data collected in the recent years and also the market in the derivatives in the recent years. This study extends to the trading of derivatives done in the ?ational (tock 5arkets.
17
The Growth of Derivatives Market in India
()5 ,RODUCTS
There are various derivative products traded. They are; &.'.& #orwards &.'.2 #utures &.'.( +ptions &.'.4 (waps “A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified future date. The price may be agreed on in advance or in future.” “A
Future Contract
is a firm contractual agreement between a buyer and seller for
a specified as on a fixed date in future. The contract price will vary according to the market place but it is fixed when the trade is made. The contract also has a standard specification so both parties know exactly what is being done”. “An
Options Contract
confers the right but not the obligation to buy (call option or
sell (put option a specified underlying instrument or asset at a specified price ! the "trike or #xercised price up until or an specified future date ! the #xpiry date. The
18
The Growth of Derivatives Market in India
$rice is called $remium and is paid by buyer of the option to the seller or writer of the option.” “A
Call option
gives the holder the right to buy an underlying asset by a certain date
for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this, which is called Mthe call option premium or call option priceM. “A
Put option , on the other hand gives the holder the right to sell an underlying asset
by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called Mthe put option premium or put option priceM. “Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forwardNs contracts. ) contract whereby two parties agree to exchange /swap4 payments, based on some notional principle amount is called as a J($)H6. In case of swap, only the payment flows are exchanged and not the principle amountF I had conducted this research to find out whether investing in the beneficial or not O Kou will be glad to know that should invest in the erivative 5arket. erivative 5arket. )lso (.7I erivative 5arket is
erivative 5arket in India is the most
booming now days.(o the person who is ready to take risk and want to gain more
+n the other hand I7I has to play an important role in must encourage investment in
erivative 5arket so that the investors get the benefit
out of it. (orry to say that today even educated persons are not willing to invest in erivative 5arket because they have the fear of high risk.
19
The Growth of Derivatives Market in India
"o, "#%& should take necessary steps for improvement in 'erivative (arket so that more investors can invest in 'erivative market.
2HA,07# 2 Derivatives Markets in India 2.1 2.2 2.3 /ntrod )tion Definitions 0y+es
20
The Growth of Derivatives Market in India
DERIVATIVE MARKET IN INDIA *)( INTRODUCTION
The origin of erivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. #rom 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 lockingDin asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. ) farmer who sowed his crop in *une faced uncertainty over the price he would receive for his harvest in (eptember. 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. 3learly this meant that the farmer and his family were exposed to a high risk of price uncertainty. +n the other hand, a merchant with an ongoing re"uirement of grains too would face a price risk that of having to pay exorbitant prices during death, although favourable prices could be obtained during periods of oversupply. 'nder 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 (eptember could be decided earlier. $hat they would then negotiate happened to be #uturesDType 3ontract, which would enable both parties to eliminate the price risk. In 9=>=, the 3hicago 7oard +f Trade, or 37+T, was established to bring farmers and merchants together. ) group of traders got together and created the JtoDarrive6 contract
21
The Growth of Derivatives Market in India
that permitted farmers to lock into price upfront and deliver the grain later. These toD arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardi2ed, and in 9:%& the first futures clearing house came into existence. Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. 7esides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.
*)* DE'INITION O' DERIVATIVE
) erivative 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 e"uity, 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. (uch a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the EunderlyingF in this case. The #orwards 3ontracts /Iegulation4 )ct, 9:&%, regulates the #orward P #utures 3ontracts in commodities all over India. )s per this the #orward 5arkets 3ommission /#534 continues to have jurisdiction over commodity #utures 3ontracts. However when erivatives Trading in securities was introduced in %--9, the term E(ecurityF in the (ecurities 3ontracts /Iegulation4 )ct, 9:&A /(3I)4, was amended to include derivative contracts in securities. 3onse"uently, regulation of derivatives came under the purview of (ecurities .xchange 7oard of India /(.7I4. $e thus have separate Iegulatory )uthorities for (ecurities and 3ommodity erivative 5arkets. erivatives are securities under the (3I) and hence the trading of /Iegulation4 )ct, 9:&A defines E erivativeF to include D erivatives is
governed by the regulatory framework under the (3I). The (ecurities 3ontracts
22
The Growth of Derivatives Market in India
) security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. ) contract which derives its value from the prices, or index of prices, of underlying securities.
*)+ TY,ES O' DERIVATIVES MARKET
T$6e& of De#i7ati7e& Ma#8et
.xchange Traded erivatives
+ver The 3ounter erivatives
?ational (tock .xchange
7ombay (tock .xchange
?ational 3ommodity @ erivative .xchange
Index #uture
Index +ption
(tock +ption
(tock #uture
23
The Growth of Derivatives Market in India
2HA,07# 3 Contracts in Derivatives Markets in India 3.1 3.2 3.3 3.! 3.% 1or$ard 2ontra)ts 1 t re 2ontra)ts &+tion 2ontra)ts S$a+ 2ontra)ts &ther 0y+es of 2ontra)ts
24
The Growth of Derivatives Market in India
+)( 'ORWARD CONTRACTS
) forward contract is an agreement to buy or sell an asset on a specified date for a specified price. +ne 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. +ther contract details like delivery date, price and "uantity 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.
2ASIC 'EATURES O' 'ORWARD CONTRACT
G G G G G They are bilateral contracts and hence exposed to counterDparty risk. .ach contract is custom designed, and hence is uni"ue in terms of contract si2e, expiration date and the asset type and "uality. The contract price is generally not available in public domain. +n the expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counterDparty, which often results in high prices being charged.
25
The Growth of Derivatives Market in India
However forward contracts in certain standardi2ed, transaction as in the case of costs and increasing markets have foreign exchange, volume. transactions become thereby very reducing
This process of
standardi2ation reaches its limit in the organi2ed futures market. #orward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially t h e same economic fun ction s presence of future price uncertainty. However of allocating risk in the are a significant futures
improvement over the forward contracts as they eliminate counterparty risk and offer more li"uidity.
+)* 'UTURE CONTRACT
In finance, a futures contract is a standardi2ed contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a preDset price. The future date is called the delivery date or final settlement date. The preDset 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. ) 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 /seller4 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. #utures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin re"uirements, etc.
2ASIC 'EATURES O' 'UTURE CONTRACT
26
The Growth of Derivatives Market in India
() Sta da#di9atio !
#utures contracts ensure their li"uidity by being highly standardi2ed, usually by specifyingC • • • 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 "uoted. The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the "uality of the underlying goods but also the manner and location of delivery. The delivery month. • • The last trading date. +ther details such as the tick, the minimum permissible price fluctuation.
*) Ma#-i ! )lthough the value of a contract at time of trading should be 2ero, 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 minimi2e this risk, the exchange demands that contract owners post a form of collateral, commonly known as 5argin re"uirements 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. )nitial Mar*in + 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 dayNs trading. It may be &< or 9-< of total contract price.
27
The Growth of Derivatives Market in India
Mark to %arket Mar*in + 7ecause a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is re"uired by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the MsettlementM or markDtoDmarket 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 MmarginM. This is intended to protect the exchange against loss. )t 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. +n 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. +) Settle:e t ! (ettlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contractC • Physi,al -elivery . 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. 5ost are cancelled out by purchasing a covering position D that is, buying a contract to cancel out an earlier sale /covering a short4, or selling a contract to li"uidate an earlier purchase /covering a long4. • Cash Settle%ent . a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as .uribor, or the closing value of a stock market index. ) futures contract might also opt to settle against an index based on trade in a related spot market.
28
The Growth of Derivatives Market in India
$xpiry is the time when the final prices of the future are determined. #or many e"uity index and interest rate futures contracts, this happens on the !ast Thursday of certain trading month. +n this day the tQ% futures contract becomes the t forward contract. +)*)( ,RICING O' 'UTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery /the forward price4 must be the same as the cost /including interest4 of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, nonDdividend paying asset, the value of the futurePforward, present value at time to maturity , will be found by discounting the
by the rate of riskDfree return .
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. )ny deviation from this e"uality allows for arbitrage as follows D In the case where the forward price is higher C &. The arbitrageur sells the futures contract and buys the underlying today /on the spot market4 with borrowed money. 2. +n the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. (. He then repays the lender the borrowed amount plus interest. 4. The difference between the two amounts is the arbitrage profit. In the case where the forward price is lower C &. The arbitrageur buys the futures contract and sells the underlying today /on the spot market4; he invests the proceeds. 2. +n the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. (. He then receives the underlying and pays the agreed forward price using the matured investment. RIf he was short the underlying, he returns it now.S 4. The difference between the two amounts is the arbitrage profit.
29
The Growth of Derivatives Market in India
DISTINCTION 2ETWEEN 'UTURES AND 'ORWARDS CONTRACTS /$A01 $ 2perational Me,hanis% /2 3A - C240 AC0 /101 $ C240 AC0
Traded directly between Traded on the exchanges. two parties /not traded on the exchanges4.
Contra,t Spe,ifi,ations Counter.party risk
iffer from trade to trade.
3ontracts contracts.
are
standardi2ed
.xists.
.xists. However, assumed by the clearing corp., which becomes the counter party to all the trades or unconditionally settlement. guarantees their
"i5ui6ation Profile
!ow, tailor
as
contracts
are High, as contracts are standardi2ed
made
contracts exchange traded contracts.
catering to the needs of the needs of the parties.
30
The Growth of Derivatives Market in India
Pri,e 6is,overy ?ot efficient, as markets .fficient, as markets are centrali2ed are scattered. and all buyers and sellers come to a common platform to discover the $xa%ples 3urrency market in India. price. 3ommodities, futures, Index #utures and Individual stock #utures in India.
31
The Growth of Derivatives Market in India
+)+ O,TIONS "
) derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as Joption6. 'nderlying asset refers to any asset that is traded. The price at which the underlying is traded is called the Jstrike price6. There are two types of options i.e., CA"" 2P0)24 7 P10 2P0)24 .
CALL O,TION!
) contract that gives its owner the right but not the obligation to buy an underlying assetDstock or any financial asset, at a specified price on or before a specified date is known as a J3all option6. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.
,UT O,TION!
) contract that gives its owner the right but not the obligation to sell an underlying assetDstock or any financial asset, at a specified price on or before a specified date is known as a JHut option6. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase. Hut and calls are almost always written on e"uities, although occasionally preference shares, bonds and warrants become the subject of options.
32
The Growth of Derivatives Market in India
+)0 SWA,S "
(waps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forwardNs contracts. ) contract whereby two parties agree to exchange /swap4 payments, based on some notional principle amount is called as a J($)H6. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps areC )40$ $S0 A0$ S3APS +
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. C1 $4C8 S3APS +
3urrency 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. 'nder a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. (uch cash flows are supposed to remain unaffected by subse"uent changes in the exchange rates. /)4A4C)A" S3AP + #inancial swaps constitute a funding techni"ue 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.
33
The Growth of Derivatives Market in India
+)1 OTHER KINDS O' DERIVATIVES
0he other kin6 of -erivatives, whi,h are not %u,h popular are as follows +
2ASKETS "
7askets options are option on portfolio of underlying asset. ."uity Index +ptions are most popular form of baskets.
LEA,S "
?ormally option contracts are for a period of 9 to 9% months. However, exchange may introduce option contracts with a maturity period of %D8 years. These longDterm option contracts are popularly known as !eaps or !ong term ."uity )nticipation (ecurities.
WARRANTS "
+ptions generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. !ongerDdated options are called warrants and are generally traded overDtheDcounter.
SWA,TIONS "
(waptions 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. Iather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. ) receiver swaption is an option to receive fixed and pay floating. ) payer swaption is an option to pay fixed and receive floating.
34
The Growth of Derivatives Market in India
2HA,07# ! Growth Deve!o"#ent o$ Derivatives Markets in India !.1 !.2 !.3 /ndian Derivatives Mar3et Need for Derivatives in /ndia 0oday Myths & #ealities of Derivatives
35
The Growth of Derivatives Market in India
GROWTH / DEVELO,MENT O' DERIVATIVES MARKET IN INDIA 0)( INDIAN DERIVATIVES MARKET
(tarting 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 Ieserve 7ank of India6s /I7I4 efforts in creating currency forward market. erivatives are an integral part of liberalisation process to manage risk. ?(. gauging the market re"uirements initiated the process of setting up derivative markets in India. In *uly 9:::, derivatives trading commenced in India Chronology of instruments 9::9 9> ecember 9::& 9= ?ovember 9::A 99 5ay 9::= , *uly 9::: %> 5ay %--%& 5ay %--!iberalisation process initiated ?(. asked (.7I for permission to trade index futures. (.7I setup !.3.1upta 3ommittee to draft a policy framework for index futures. !.3.1upta 3ommittee submitted report. I7I gave permission for +T3 forward rate agreements /#I)s4 and interest rate swaps. (I5.L chose ?ifty for trading futures and options on an Indian index. (.7I gave permission to ?(. and 7(. to do index
futures trading. : *une %--Trading of 7(. (ensex futures commenced at 7(.. 9% *une %--Trading of ?ifty futures commenced at ?(.. %& (eptember ?ifty futures trading commenced at (1L. %--% *une %--9 Individual (tock +ptions @ erivatives
0)* Need fo# De#i7ati7e& i
I dia toda$
36
The Growth of Derivatives Market in India
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 dayDtoDday life for ordinary people in major part of the world.
'ntil the advent of ?(., the Indian capital market had no access to the latest trading methods and was using traditional outDdated methods of trading. There was a huge gap between the investors6 aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India6s financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Ieserve 7ank of India6s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.
0)+ M$th& a d Realitie& a;o%t De#i7ati7e&
37
The Growth of Derivatives Market in India
In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. #inancial derivatives came into the spotlight along with the rise in uncertainty of postD9:,-, when '( announced an end to the 7retton $oods (ystem 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 dayDtoDday life for ordinary people in major parts of the world. $hile 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 .xchange traded derivatives, which are well regulated with all the safety mechanisms in place. $hat are these myths behind derivativesO • erivatives increase speculation and do not serve any economic purpose • • • • Indian 5arket is not ready for derivative trading isasters prove that derivatives are very risky and highly leveraged instruments. erivatives are complex and exotic instruments that Indian investors will find difficulty in understanding Is the existing capital market safer than erivativesO
0)+)( De#i7ati7e& i c#ea&e &6ec%latio eco o:ic6%#6o&e!
a d do
ot &e#7e a $
?umerous 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. erivatives are a lowDcost, effective method for users to hedge and manage their exposures to interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. )gricultural futures and options helped farmers and processors hedge against commodity price risk. )fter the fallout of 7retton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable
38
The Growth of Derivatives Market in India
innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, onDline trading in the capital markets, etc. )s 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.
!ooking at the e"uity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. )n e"uity fund, for example, can reduce its exposure to the stock market "uickly and at a relatively low cost without selling off part of its e"uity assets by using stock index futures or index options.
7y 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. ?ow that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market li"uidity and efficiency and facilitating the flow of trade and finance 0)+)* I dia Ma#8et i& ot #ead$ fo# De#i7ati7e T#adi -
+ften the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the preDre"uisites, which are needed for the introduction of derivatives, and how Indian market fares
39
The Growth of Derivatives Market in India
HI.DI.T'I(IT.( I? I)? (3.?)II+ !arge market India is one of the largest marketDcapitalised 3apitalisation countries in )sia with a market capitalisation of more than Is.,A&--- crores. High !i"uidity underlying in the The daily average traded volume in Indian capital market today is around ,&-- crores. $hich means on an average every month 9>< of the country6s 5arket capitalisation gets traded. These are clear indicators of high li"uidity in the underlying. The first clearing corporation guaranteeing trades has become fully functional from *uly 9::A in the form of ?ational (ecurities 3learing 3orporation /?(33!4. ?(33! is responsible for guaranteeing all open positions on the ?ational (tock .xchange /?(.4 for which it does the clearing. ?ational (ecurities epositories !imited /?( !4 which started functioning in the year 9::, has revolutionalised the security settlement in our country. In the Institution of (.7I /(ecurities and .xchange 7oard of India4 today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
Trade guarantee
) (trong
epository
) 1ood legal guardian
40
The Growth of Derivatives Market in India
0)+)+ Co:6a#i&o of Ne< S$&te:
) price is what one pays to ac"uire 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. )nd the price one pays in one6s own currency for a unit of another currency is called as an exchange rate. Hrices are generally determined by market forces. In a market, consumers have Jdemand6 and producers or suppliers have Jsupply6, 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. (uch changes in the price are known as Jprice volatility6. This has three factorsC the speed of price changes, the fre"uency 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 7I.TT+? $++ ( 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
47
The Growth of Derivatives Market in India
to the markets. ?ations that were poor suddenly became a major source of supply of goods. The 5exican crisis in the south eastD)sian currency crisis of 9::-6s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very "uickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. .ven e"uity 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, e"uity shares and bonds.
1)* GLO2ALISATION O' MARKETS >
.arlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. ?ow globalisation has increased the si2e of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better "uality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south .ast )sian currencies crisis of 9::, had affected the competitiveness of our products visDWDvis depreciated currencies. .xport of certain goods from India declined because of this crisis. (teel industry in 9::= suffered its worst set back due to cheap import of steel from south .ast )sian countries. (uddenly 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.
1)+ TECHNOLOGICAL ADVANCES >
48
The Growth of Derivatives Market in India
) significant growth of derivative instruments has been driven by technological breakthrough. )dvances in this area include the development of high speed processors, network systems and enhanced method of data entry. 3losely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous worldwide conferencing, ata transmission by satellite. )t 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 conse"uently its instantaneous impact on market price. )lthough 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. erivatives 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.
1)0 ADVANCES IN 'INANCIAL THEORIES >
)dvances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. +ption pricing models developed by 7lack and (choles in 9:,8 were used to determine prices of call and put options. In late 9:,-6s, work of !ewis .deington extended the early work of *ohnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets. The above factors in combination of lot many factors led to growth of derivatives instruments
1)1 DEVELO,MENT O' DERIVATIVES MARKET IN INDIA
49
The Growth of Derivatives Market in India
The first step towards introduction of derivatives trading in India was the promulgation of the (ecurities !aws /)mendment4 +rdinance, 9::&, 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. (.7I set up a %>B member committee under the 3hairmanship of r.!.3.1upta on ?ovember 9=, 9::A to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on 5arch 9,, 9::= prescribing necessary preB conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as Jsecurities6 so that regulatory framework applicable to trading of Jsecurities6 could also govern trading of securities. (.7I also set up a group in *une 9::= under the 3hairmanship of Hrof.*.I.Uarma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in +ctober 9::=, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit re"uirement and realBtime monitoring re"uirements. The (ecurities 3ontract Iegulation )ct /(3I)4 was amended in ecember 9::: to include derivatives within the ambit of Jsecurities6 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 recogni2ed stock exchange, thus precluding +T3 derivatives. The government also rescinded in 5arch %---, the three decade old notification, which prohibited forward trading in securities. erivatives trading commenced in India in *une %--- after (.7I granted the final approval to this effect in 5ay %--9. (.7I permitted the derivative segments of two stock exchanges, ?(. and 7(., and their clearing housePcorporation to commence trading and settlement in approved derivatives contracts. To begin with, (.7I approved trading in index futures contracts based on (@H 3?L ?ifty and 7(.B8- /(ense4 index. This was followed by approval for trading in options based on these two indexes and options on individual securities.
50
The Growth of Derivatives Market in India
The trading in 7(. (ensex options commenced on *une >, %--9 and the trading in options on individual securities commenced in *uly %--9. #utures contracts on individual stocks were launched in ?ovember %--9. The derivatives trading on ?(. commenced with (@H 3?L ?ifty Index futures on *une 9%, %---. The trading in index options commenced on *une >, %--9 and trading in options on individual securities commenced on *uly %, %--9. (ingle stock futures were launched on ?ovember :, %--9. The index futures and options contract on ?(. are based on (@H 3?L Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing housePcorporation duly approved by (.7I and notified in the official ga2ette. #oreign Institutional Investors /#IIs4 are permitted to trade in all .xchange traded derivative products. The following are some observations based on the trading statistics provided in the ?(. report on the futures and options /#@+4C G (ingleDstock futures continue to account for a si2able proportion of the #@+ segment. It constituted ,- per cent of the total turnover during *une %--%. ) primary reason attributed to this phenomenon is that traders are comfortable with singleDstock futures than e"uity options, as the former closely resembles the erstwhile badla system. G +n 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 index4 is high. ) 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 roundD trips. G Hut volumes in the index options and e"uity options segment have increased since *anuary %--%. The callDput volumes in index options have decreased from %.=A in
51
The Growth of Derivatives Market in India
*anuary %--% to 9.8% in *une. The fall in callDput volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. G #arther month futures contracts are still not actively traded. Trading in e"uity options on most stocks for even the next month was nonDexistent. G aily option price variations suggest that traders use the #@+ segment as a less risky
alternative /read substitute4 to generate profits from the stock price movements. The fact that the option premiums tail intraDday stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intraDday stock price variations should not have a oneDtoDone impact on the option premiums. • The spot foreign exchange market remains the most important segment but the
derivative segment h a s also grown. In the derivative market foreign exchange swaps account for the largest share of the total turnover of derivatives in India followed by forwards and options. (ignificant milestones in the development of derivatives market to undertake long have been /i4 permission to banks to undertake cross currency term foreign currency swaps that contributed to the derivative transactions subject to certain conditions /9::A4 /ii4 allowing corporates development of the term currency swap market /9::,4 /iii4 allowing dollar rupee options /%--84 and /iv4 introduction of currency futures /%--=4. I would like to emphasise that currency swaps allowed companies with .37s 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. ?ormally such risks should be taken by corporates who have natural hedge or have potential foreign exchange earnings. 7ut often corporate assume these risks due to interest rate differentials and views on currencies.
52
The Growth of Derivatives Market in India
This period has also witnessed several relaxations in regulations relating to forex markets and also greater liberalisation in capital account regulations leading to greater integration with the global economy. • 3ash settled exchange traded currency futures have made foreign currency
a separate asset class that can be traded without any underlying need or exposure a n d on a leveraged basis on the recogni2ed stock exchanges with credit risks being assumed by the central counterparty (ince the commencement of trading of currency futures in all the three exchanges, the value of the trades has gone up steadily from Is 9,, >%: crores in +ctober %--= to Is >&, =-8 crores in same period. ecember %--=. The average daily turnover in all the exchanges has also increased from Is=,9 crores to Is %,9=9 crores during the The turnover in the currency futures market is in line with the international scenario, where I understand the share of futures market ranges between % B 8 per cent. 'o#e= Ma#8et Acti7it$
)pril6-&D Total turnover /'( billion4 5ar6-A >,>-> %.AC9 &-.& 9:.8-.&
)pril6-AD 5ar6-, A,&,9 %.,C9 &9.: 9,.: 8-.9
)pril6-,D 5ar6-= 9%,8-> %.8,C 9 >:., 9:.8 89.9
)pril6-=D ec6-= :,A%9 %.AAC9 >&.: %9.& 8%.,
InterDbank to 5erchant ratio (potPTotal Turnover /:9 crore.
(eptember %--=D-:, the turnover at 7(. was Is.9,&9- crore, which was insignificant
62
The Growth of Derivatives Market in India
2HA,07# C31- 1T4D5
63
The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
)nstitutional >usiness II!6s Institutional business thrives on the strong relationships we have built among omestic 5utual #unds, 7anks, #inancial Institutions, Insurance 3ompanies and Hrivate (ector #unds over the past few years. .fficient .xecution, Tuality Iesearch and high degree of compliance with (tock .xchange Iegulations and .thical 7usiness (tandards back II!6s services to institutional investors. +ur Institutional (ervices can be broadly categori2ed as follows. • Merchant Banking $e offer financial advisory and capitalDraising services to corporates. Having successfully managed IH+s, #ollowDon offerings, +pen +ffers, 5ergers, etc, II!6s 5erchant 7anking business has been growing from strengthDtoDstrength. • Institutional Equity & Debt 3ombining the efforts of a topDdrawer research team @ dynamic sales professionals, we are committed to offer timely @ proactive investing @ trading strategies. $e are presently empanelled with more than 9-- institutions and (ervice 3ustomers across geographies. Pro%oters I!@#( Investsmart !imited /II!4 is one of India6s leading companies in the #inancial (ervices industry. It was promoted in 9::, by Infrastructure !easing @ #inancial (ervices /I!@#(4, one of IndiaNs leading infrastructure development and finance companies. The company is now held by H(73, one of the world6s largest banking and financial services organisations. In India, The H(73 1roup offers a range of financial services including corporate, commercial, retail and private banking, insurance, asset management, investment banking, e"uities and capital markets, institutional brokerage, custodial services. It also provides software development expertise and global services facilities for the H(73 1roup6s operations worldwide.
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
@alue A66e6 Pro6u,ts for 8ouA MUalue )dded Hroducts for KouM D Investsmart +nline continually strives to provide the services and support that our clients need to thrive in the market. $e pride ourselves on offering almost limitless customi2ation possibilities; so that you can truly Mown the tradeM $e also reali2e that every trader has uni"ue and complex needs that sometimes re"uire special attention. $ith this in mind, we created Ualue )dded products.
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The Growth of Derivatives Market in India
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Increase your 5arket .xposure
"i%it A*ainst Shares
5argin is offered against the securities you have in your emat for trading.
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Smart Secure
Phone 0ra6in* Servi,es
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)t I!@#( Investsmart, we place a very high onus on security and reali2e that it is one of the vital components of any eD business venture. +ur online products are developed on stateDofDtheDart security platforms.
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(I( is a facility offered by Investsmart online wherein the customer will be able to sell the shares that he has purchased even before he receives the delivery of the shares from the .xchange. He will not have to wait till the time he receives the delivery from the .xchange thus increasing his li"uidity.
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The Growth of Derivatives Market in India
2HA,07# .
1indings & 2on)l sions
'INDINGS / CONCLUSION
#rom the above analysis it can be concluded thatC &. erivative market is growing very fast in the Indian .conomy. The turnover of erivative 5arket is increasing year by year in the India6s largest stock exchange ?(.. In the case of index future there is a phenomenal increase in the number of contracts. 7ut whereas the turnover is declined considerably. In the
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The Growth of Derivatives Market in India
case of stock future there was a slow increase observed in the number of contracts whereas a decline was also observed in its turnover. In the case of index option there was a huge increase observed both in the number of contracts and turnover. 2. )fter analy2ing data it is clear that the main factors that are driving the growth of erivative 5arket are 5arket improvement in communication facilities as well as long term saving @ investment is also possible through entering into 3ontract. (o these factors encourage the erivative 5arket in India. erivative
(. It encourages entrepreneurship in India. It encourages the investor to take more risk @ earn more return. (o in this way it helps the Indian .conomy by developing entrepreneurship. erivative 5arket is more regulated @ standardi2ed so in this way it provides a more controlled environment. In nutshell, we can say that the rule of High risk @ High return apply in erivatives. If we are able to take more risk then we can earn more profit under erivatives. 3ommodity derivatives have a crucial role to play in the price risk management process for the commodities in which it deals. )nd it can be extremely beneficial in agricultureD dominated economy, like India, as the commodity market also involves agricultural produce. erivatives like forwards, futures, options, swaps etc are extensively used in the country. However, the commodity derivatives have been utili2ed in a very limited scale. +nly forwards and futures trading are permitted in certain commodity items.
I.!I)?3. is the most active future contracts on individual securities traded with :--:- contracts and I?I! is the next most active futures contracts with A8&%% contracts being traded.
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The Growth of Derivatives Market in India
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The Growth of Derivatives Market in India
2HA,07# 9
#e)o66endations & S ggestions
RECOMMENDATIONS / SUGGESTIONS
? I7I should play a greater role in supporting derivatives. erivatives market should be developed in order to keep it at par with other derivative markets in the world.
?
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The Growth of Derivatives Market in India
? (peculation should be discouraged. There must be more derivative instruments aimed at individual investors. (.7I should conduct seminars regarding the use of derivatives to educate individual investors.
?
?
? )fter study it is clear that
erivative influence our Indian .conomy up to erivative market. erivative 5arket
much extent. (o, (.7I should take necessary steps for improvement in erivative 5arket so that more investors can invest in ? There is a need of more innovation in 7ecause of high risk involved in erivative 5arket because in today
scenario even educated people also fear for investing in erivatives.
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The Growth of Derivatives Market in India
2I2LIOGRA,HY
>ooks eferre6+ ? +ptions #utures, and other erivatives by *ohn 3 Hull ? erivatives #)T by )jay (hah
? ?(.6s 3ertification in #inancial 5arketsC D erivatives 3ore module ? #inancial 5arkets @ (ervices by 1ordon @ ?atarajan
eports+ ? Ieport of the I7ID(.7I standard technical committee on exchange traded 3urrency #utures ? Iegulatory #ramework for #inancial 3e?sites visite6+ ? www.nse.in6ia.,o% ? www.?sein6ia.,o% ? www.se?i.*ov.in ? www.n,6ex.,o% ? www.*oo*le.,o% ? www.6erivativesin6ia.,o% erivatives in India by r.!.3.1'HT)
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The Growth of Derivatives Market in India
A22REVATIONS
A )5.LD )merica (tock .xchange > 7(.D 7ombay (tock .xchange 7(ID 7ritish (tandard Institute C 37+. D 3hicago 7oard options .xchange 37+T D 3hicago 7oard of Trade 3.77 D 3hicago .gg and 7utter 7oard 35. D 3hicago 5ercantile .xchange 3?LD 3risil ?se &- Index 3H. D 3hicago Hroduce .xchange 3$3D 3entral $arehousing 3orporation T((D erivative Trading (ettlement (ystem / #IIsD #oreign Institutional Investors # @ + B #uture and +ptions #53D #orward 5arkets 3ommission #I)sD #orward Iate )greements B 1)I3!D1ujarat )gro Industries 3orporation !imited 1()57D 1ujarat (tate )gricultural 5arketing 7oard ) I55 D International 5onetary 5arket IH(T)D India Hepper @ (pice Trade )ssociation
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The Growth of Derivatives Market in India
M 53L B 5ulti 3ommodity .xchange 4 ?)#. D?ational )gricultural 3oD+perative 5arketing #ederation +f India ?3 .L B ?ational 3ommodities and erivatives .xchange ?I)5D ?ational Institute +f )gricultural 5arketing ?5(.D ?ational 5ulti 3ommodity .xchange ?+!D ?eptune +verseas !imited ?(33!D ?ational (ecurities 3learing 3orporation ?( !D ?ational (ecurities epositories !imited ?(. D ?ational (tock .xchange 2 +T3D +ver The 3ounter P HH!L D Hhiladelphia (tock .xchange H?7D Hunjab ?ational 7ank I7ID Ieserve 7ank +f India S (3/I4 ) D (ecurities 3ontracts /Iegulation4 )ct, 9:&A (.7ID (ecurities .xchange 7oard +f India (1LD (ingapore (tock .xchange (I5.L D (ingapore International 5onetary .xchange @ UH?D Uirtual Hrivate ?etwork
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