INTRODUCTION A Derivative is a financial instrument whose value depends on other, more basic,

underlying variables. The variables underlying could be prices of traded securities and stock, prices of gold or copper. Derivatives have become increasingly

important in the field of finance, Options and Futures are traded actively on many

exchanges, Forward contracts, Swap and different types of options are regularly traded outside exchanges by financial intuitions, banks and their corporate clients in what are termed as over-the-counter markets in other
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words, there is no single market place or organized exchanges.

NEED OF THE STUDY

The study has been done to know the different types of derivatives and also to know the derivative market in India. This study also covers the recent developments in the

derivative market taking into account the trading in past years. Through this study I came to know the trading done in derivatives and their use in the stock markets.

LITERATURE REVIEW The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.
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Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives.
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Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis-vis derivative use. As in the present scenario, Derivative Trading is fast gaining momentum, I have chosen this topic. products based on individual securities is another reason for their growing

OBJECTIVES OF THE STUDY

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

SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. For better understanding various strategies with different situations and actions have been given. It includes the data collected in the recent years and also the market in the derivatives in the recent years. This study extends to the trading of derivatives done in the National Stock Markets.

RESARCH METHODOLOGY Method of data collection:Secondary sources:It is the data which has already been collected by some one or an organization for some other purpose or research study .The data for study has been collected from various sources: Books Journals Magazines Internet sources Time: 2 months Statistical Tools Used:

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Simple tools like bar graphs, tabulation, line diagrams have been used.

LIMITAITONS OF STUDY

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1.

LIMITED TIME:

The time available to conduct the study was only 2 months. It being a wide topic had a limited time. 2. LIMITED RESOURCES:

Limited resources are available to collect the information about the commodity trading.
3.

VOLATALITY:

Share market is so much volatile and it is difficult to forecast any thing about it whether you trade through online or offline 4. ASPECTS COVERAGE:

Some of the aspects may not be covered in my study.

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MAIN TOPICS OF STUDY 1. INTRODUCTION TO DERIVATIVE The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price

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uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a
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price risk that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the to-arrive contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and
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speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence. Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc. 2. DERIVATIVE DEFINED A derivative is a product whose value is derived from the value of one or more underlying variables or assets in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. In our earlier discussion, we saw that wheat farmers may wish

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to sell their harvest at a future date to eliminate the risk of change in price by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying in this case. The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contracts in commodities all over India. As per this the Forward Markets Commission (FMC) continues to have jurisdiction over commodity futures contracts. However when derivatives trading in securities was introduced in 2001, the term security include in the Securities contracts in Contracts securities. (Regulation) Act, 1956 (SCRA), was amended to derivative Consequently, regulation of derivatives came under the purview of Securities Exchange Board of India (SEBI). We thus have separate

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regulatory

authorities

for

securities

and

commodity derivative markets. Derivatives are securities under the SCRA and hence the trading of derivatives is governed by the regulatory framework under the SCRA. The Securities Contracts (Regulation) Act, 1956 defines derivative to includeA security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities. 3. TYPES OF DERIVATIVES MARKET

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Exchange Traded Derivatives Counter Derivatives

Over The

National Stock Bombay Stock National Commodity & Exchange Exchange Derivative Exchange

option

Index Future Stock future

Index option

Stock

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES
Derivatives

Future

Option

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Forward

Swaps

Figure.2 Types of Derivatives

(i)

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and

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agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. BASIC FEATURES OF FORWARD

CONTRACT They are bilateral contracts and hence Each contract is custom designed, and hence is unique in terms of contract quality. The contract price is generally not available in public domain. size, expiration date and the asset type and

exposed to counter-party risk.

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On the expiration date, the contract has to asset.

be settled by delivery of the If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. However as in forward the case contracts of foreign in certain exchange, costs and This Forward

markets have thereby increasing the

become very standardized,

reducing transaction transactions futures

volume. market.

process of standardization reaches its limit in organized contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of

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future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. (ii) FUTURE CONTRACT In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from

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an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc. BASIC FEATURES OF FUTURE

CONTRACT 1. Standardization : Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

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

The

type

of

settlement,

either

cash

settlement or physical settlement.

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

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds can be delivered. In case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. The delivery month.
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 The last trading date. Other details such as the tick, the minimum permissible price fluctuation. 2. Margin : Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange demands that contract owners post a form of collateral, commonly known as Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Initial Margin: is paid by both buyer and seller. It represents the loss on that contract, as

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determined by historical price changes, which is not likely to be exceeded on a usual day's trading. It may be 5% or 10% of total contract price. Mark to market Margin: Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing on a price at the end of each day, called the "settlement" or mark-tomarket price of the contract. To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side
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of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if he is on the losing side, the exchange will debit his account. If he cannot pay, then the margin is used as the collateral from which the loss is paid. 3. Settlement Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale

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(covering a short), or selling a contract to liquidate an earlier purchase (covering a long).

Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Expiry is the time when the final prices of the future are determined. For many equity index and interest rate futures contracts, this happens on the Last Thursday of certain trading month. On this day the t+2 futures contract becomes the t forward contract.

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PRICING OF FUTURE CONTRACT In a futures contract, for no arbitrage to be possible, the price paid on delivery (the forward price) must be the same as the cost (including interest) of buying and storing the asset. In other words, the rational forward price represents the expected future value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend paying asset, the value of the future/forward, , will be found by discounting the present value at time to

maturity by the rate of risk-free return . This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. Any deviation from this equality allows for arbitrage as follows. In the case where the forward price is higher:
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The arbitrageur sells the futures contract and buys the underlying today (on the spot market) with borrowed money. 2.On the delivery date, the arbitrageur hands over the underlying, and receives the agreed forward price. 3.He then repays the lender the borrowed amount plus interest. 4.The difference between the two amounts is the arbitrage profit.
1.

In the case where the forward price is lower: 1.The arbitrageur buys the futures contract and sells the underlying today (on the spot market); he invests the proceeds. 2.On the delivery date, he cashes in the matured investment, which has appreciated at the risk free rate. 3. He then receives the underlying and pays the agreed forward price using the matured investment. [If he was short the underlying, he returns it now.] 4.The difference between the two amounts is the arbitrage profit.
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TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS FEATUR E Operatio nal Mechani sm Contract FORWARD FUTURE the

CONTRACT CONTRACT Traded directly Traded on between parties two exchanges. (not

traded on the exchanges). Differ from Contracts standardized contracts. Exists. assumed However, by the are

Specifica trade to trade. tions Counter- Exists. party risk

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

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guarantees settlement.

their

Liquidati Low, on Profile contracts tailor contracts

as High, as contracts are are standardized made exchange contracts. the the traded

catering to the needs needs Price discover y of of

parties. Not efficient, as Efficient, as markets markets scattered. are are centralized and all buyers and sellers come to a common platform to discover the price. Commodities, futures,

Example

Currency

33

market in India. Index

Futures

and stock

Individual Futures in India.

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OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as option. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the strike price. There are two types of options i.e., CALL OPTION & PUT OPTION. CALL OPTION: A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or

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before a specified date is known as a Call option. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. PUT OPTION: A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Put option. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

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

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SWAPS Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a SWAP. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are: INTEREST RATE SWAPS: Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract.

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CURRENCY SWAPS: Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. FINANCIAL SWAP: Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

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5. OTHER KINDS OF DERIVATIVES The other kind of derivatives, which are not, much popular are as follows: BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets. LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity
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period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities. WARRANTS Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. counter. SWAPTIONS Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a Longer-dated options are called warrants and are generally traded over-the-

41

forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

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11. HISTORY OF DERIVATIVES: The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago Board of

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Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralised location to negotiate forward contracts. From forward trading in commodities emerged the commodity futures. The first type of futures contract was called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the first exchange traded derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on
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May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

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Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England
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and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealers Association was set up in early 1900s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975.
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The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices.
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The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

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12. INDIAN DERIVATIVES MARKET Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of Indias (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative

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markets in India. In July 1999, derivatives trading commenced in India Table 2. Chronology of instruments 1991 Liberalisation process initiated 14 December 1995 18 November 1996 11 NSE asked SEBI for permission to trade index futures. SEBI setup L.C.Gupta Committee to draft a policy framework for index futures. May L.C.Gupta Committee submitted

1998 report. 7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) 24 2000 25 2000 and interest rate swaps. May SIMEX chose Nifty for trading futures and options on an Indian index. May SEBI gave permission to NSE and BSE to do index futures trading.
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June Trading of BSE Sensex futures futures

2000 commenced at BSE. 12 June Trading of Nifty 2000 25

commenced at NSE. Nifty futures trading commenced

September at SGX. 2000 2 June Individual 2001 Derivatives Stock Options &

(1) Need for derivatives in India today In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major part
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of the world. Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of Indias financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to Reserve Bank of Indias efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market. (2) Myths and realities about

derivatives
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In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives?
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 Derivatives increase speculation and do not serve any economic purpose Indian Market is not ready for derivative trading

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

Derivatives

instruments that Indian investors will find difficulty in understanding Is the existing capital market safer than Derivatives? (i) and Derivatives do increase not speculation any

serve

economicpurpose: Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users.
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Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development

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derivatives as effective risk management tools for the market participants.

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

By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation

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and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and efficiency and facilitating the flow of trade and finance (ii) Indian Market is not ready for derivative trading Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives, and how Indian market fares: TABLE 3. PREREQUISITES INDIAN SCENARIO

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Large market India is one of the largest Capitalisation market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores. High Liquidity The daily average traded in the volume in Indian capital underlying market today is around 7500 crores. Which means on an average every month 14% of the countrys Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying. Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.

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A Strong National Securities Depository Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country. A Good legal In the Institution of SEBI guardian (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices. (3) Comparison of New System with Existing System Many people and brokers in India think that the new system of Futures & Options and banning of Badla is disadvantageous and introduced early, but I feel that this new system is very

60

useful especially to retail investors. It increases the no of options investors for investment. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI. The figure 3.3a 3.3d shows how advantages of new system (implemented from June 20001) v/s the old system i.e. before June 2001 New System Vs Existing System for Market Players

Figure 3.3a Speculators Existing New Approach Peril &Prize Peril &Prize Approach SYSTEM

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1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum Trading, margin loss to extent of on delivery basis loss possible trading & carry price change. 2) Buy Call &Put to premium forward transactions. by paying paid 2) Buy Index Futures premium hold till expiry. Advantages Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time.

Figure 3.3b Arbitrageurs

62

Existing New

SYSTEM

Approach Peril &Prize Approach Peril &Prize 1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free one and selling in whichever way promising as still game. another exchange. the Market moves. in weekly settlement forward transactions. 2) Cash &Carry 2) If Future Contract arbitrage continues more or less than Fair price Fair Price = Cash Price + Cost of Carry. Figure 3.3c Hedgers

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Existing New

SYSTEM

Approach Peril &Prize Approach Peril &Prize 1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional offload holding available risk latter by paying premium. cost is only during adverse reward dependant 2)For Long, buy ATM Put premium. market conditions on market prices Option. If market goes up, as circuit filters long position benefit else limit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie Advantages Availability of Leverage
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Figure 3.3d Small Investors Existing New SYSTEM

Approach Peril &Prize Approach Peril &Prize 1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downside stocks else sell it. implies unlimited based on market outlook remains profit/loss. 2) Hedge position if protected & holdin g underlying upside stock unlimited. Advantages Losses Protected.

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4. Exchange-traded vs. OTC derivatives markets The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed

66

to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features derivatives: 1.The management of counter-party (credit) risk is decentralized and located within individual institutions, 2.There are no formal centralized limits on individual positions, leverage, or margining, 3.There are no formal rules for risk and burden-sharing, 4.There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5.The OTC contracts are generally not regulated by a regulatory authority and the
67

compared

to

exchange-traded

exchanges

self-regulatory

organization,

although they are affected indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises
68

when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts, occur which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures and can become a rapid unsustainably large provoke

unwinding of positions. There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counterparty, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic
69

financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal.

5. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

70

Factors contributing to the explosive growth of derivatives are price volatility, globalisation of the markets, technological developments and advances in the financial theories. A.} PRICE VOLATILITY A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. almost The concept of price is clear to when we discuss everybody

commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in ones own currency for a unit of another currency is called as an exchange rate.
71

Prices are generally determined by market forces. In a market, consumers have demand and producers or suppliers have supply, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as price volatility. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end
72

to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. The globalisation of the of markets many and rapid industrialisation underdeveloped

countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990s has also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. These price volatility risks pushed the use of derivatives like futures and options increasingly
73

as these instruments can be used as hedge to protect bonds. B.} GLOBALISATION OF MARKETS Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalisation has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis--vis depreciated currencies.
74

against

adverse

price

changes

in

commodity, foreign exchange, equity shares and

Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalisation of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES A significant growth of derivative instruments has been driven by technological breakthrough. Advances in this area include the development
75

of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous worldwide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmes without which computer more and telecommunication of advances and on would be meaningless. These facilitated the rapid movement its information impact consequently market price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can
76

instantaneous

easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological derivatives developments and risk increase important. D.} ADVANCES IN FINANCIAL THEORIES Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970s, work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new
77

volatility,

management products become that much more

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

78

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

79

be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. Regulation ambit of Act The Securities was Contract in (SCRA) amended

December 1999 to include derivatives within the securities were and the for regulatory governing framework developed

derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock
80

exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30 (Sense) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on
81

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

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The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for

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

options segment continue to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers
83

do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for roundtrips. Put volumes in the index options and equity

options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not

actively traded. Trading in equity options on most stocks for even the next month was nonexistent.

84

Daily option price variations suggest that

traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-toone impact on the option premiums. The spot foreign exchange market remains the most important segment but the derivative segment has also grown. In the derivative market foreign exchange swaps account for the largest share of the total turnover of derivatives in India followed by forwards market
85

and have

options. been (i)

Significant milestones in the development of derivatives

permission certain

to banks to undertake cross (1996) (ii) allowing term

currency derivative transactions subject to conditions to corporates undertake long

foreign currency swaps that contributed to the development of the term currency swap market (1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of currency futures (2008). I would like to emphasise that currency swaps allowed companies with ECBs to swap their foreign currency liabilities into positions the risk was allowed rupees. to be

However, since banks could not carry open transferred to any other resident corporate. Normally such risks should be taken by corporates who have natural hedge or have potential foreign exchange earnings. But often corporate assume these risks due to
86

interest rate differentials and views on currencies. This period has also witnessed several in

relaxations

in regulations

relating to forex liberalisation

markets and also greater

capital account regulations leading to greater integration with the global economy. Cash settled exchange traded currency futures have made foreign currency a separate asset class that can be traded without any underlying need or exposure and on a leveraged basis on the recognized stock exchanges with credit risks being assumed by the counterparty Since the commencement of trading of currency futures in all the three exchanges, the
87

central

value of the trades has gone up steadily from Rs 17, 429 crores in October 2008 to Rs 45, 803 crores in December 2008. The average daily turnover in all the exchanges has also increased from Rs871 crores to Rs 2,181 crores during the same period. The turnover in the currency futures market is in line with the international scenario, where I understand the share of futures market ranges between 2 3 per cent. Table 4.1ForexMarketActivity

April0 April0 April07 April08 Total turnover (USD54,404 Inter-bank to2.6:1 Spot/Total Turnover50.5 Forward/Total 19.0 Swap/Total Turnover30.5 Source: RBI 6,571 62.7:1 51.9 17.9 30.1 12,304 2.37: 1 49.7 19.3 31.1 9,621 2.66:1 45.9 21.5 32.7

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14. BENEFITS OF DERIVATIVES Derivative markets help investors in many different ways: 1.] RISK MANAGEMENT Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised. 2.] PRICE DISCOVERY

89

Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset. 3.] OPERATIONAL ADVANTAGES As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid
90

than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.

91

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

5.] EASE OF SPECULATION Derivative markets provide speculators with a cheaper alternative Also, to the engaging amount of in spot capital transactions.

required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated
92

risks. A speculator will accept a level of risk only if he is convinced that the associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives markets help increase savings and investment in the long run. Transfer of

93

risk enables market participants to expand their volume of activity.

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

automatically

permitted to conduct

trading in all commodities subject to clearance

94

of byelaws and contract specifications by the FMC. MCX While and the NMCE, Mumbai Ahmedabad commenced 2003 commenced futures trading in November 2002, NCDEX, in operations respectively. MCX MCX (Multi Commodity Exchange of India Ltd.) an independent and de-mutulised multi commodity recognition facilitating from online exchange has permanent Government trading, of India for and clearing October/ December

settlement operations for commodity futures markets across the country. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State Bank of Hyderabad, State Bank of

95

Saurashtra, SBI Life Insurance Co. Ltd., Union Bank of India, Bank of India, Baroda, Bank of Canera Bank, Corporation Bank

Headquartered in Mumbai, MCX is led by an expert management team with deep domain knowledge of the commodity futures markets. Today MCX is offering spectacular growth opportunities and advantages to a large cross section of the participants including Producers / Processors, Trading others Traders, Corporate, Importers, nation-wide Regional Exporters, commodity Canters, MCX being

Cooperatives, Industry Associations, amongst exchange, offering multiple commodities for trading with wide reach and penetration and robust infrastructure.

96

MCX, having a permanent recognition from the Government of India, is an independent and demutualised multi commodity Exchange. MCX, a state-of-the-art nationwide, digital Exchange, facilitates online trading, clearing and settlement operations for a commodities futures trading. NMCE National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by Central National Warehousing India Corporation Gujarat (CWC),

Agricultural Cooperative Marketing Federation of (NAFED), Agro-Industries Corporation Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral aspects of commodity economy, viz.,

97

warehousing, cooperatives, private and public sector marketing of agricultural commodities, research and training were adequately addressed in structuring the Exchange, finance was still a vital missing link. Punjab National Bank (PNB) took equity of the Exchange to establish that linkage. Even today, NMCE is the only Exchange in India to have such investment and technical support from the commodity relevant institutions. NMCE facilitates electronic derivatives trading

trading through robust

and tested

platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust delivery mechanism making it the most suitable for the participants in the physical commodity markets. It has also established fair and transparent rulebased procedures and
98

demonstrated

total

commitment towards eliminating any conflicts of interest. It is the only Commodity Exchange in the world to have received ISO 9001:2000 certification from British Standard Institutions (BSI). NMCE was the first commodity exchange to provide trading facility through internet, through Virtual Private Network (VPN). NMCE management follows best international The contracts risk are

practices.

marked to market on daily basis. The system of upfront margining based on Value at Risk is followed to ensure financial security of the market. In the event of high volatility in the prices, special intra-day clearing and settlement is held. NMCE was the first to initiate process of dematerialization and electronic transfer of warehoused commodity stocks. The unique strength of NMCE is its settlements via a
99

Delivery Backed System, an imperative in the commodity trading business. These deliveries are executed through a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and settlement.

100

NCDEX National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven commodity exchange. It is a public limited company registered under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It has an independent Board of Directors and professionals not having any vested interest in commodity markets. It has been launched to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency. Forward Markets Commission regulates NCDEX in respect of futures trading in commodities. Besides, NCDEX is subjected to
101

various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. It is located in Mumbai and offers facilities to its members in more than 390 centres throughout India. The reach will gradually be expanded to more centres. NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe),
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Wheat, Yellow Peas, Yellow Red Maize & Yellow Soybean Meal. TABLE4: THE CURRENT PROFILE OF FUTURES RESPECT TRADING IN INDIA WITH TO THE VARIOUS

EXCHANGES IN INDIA:-

103

16. The Present Status:

104

Presently futures trading is permitted in all the commodities. Trading is taking place in about below:TABLE 4 Registered commodity exchanges in India No. Exchange COMMODITY 1. India Pepper & Spice Pepper (both Trade Association, domestic international contracts) Beopar Gur, Mustard Ltd., seed & Gur, Mustard and Kochi (IPSTA) 2. Vijai Chambers 3. Muzaffarnagar Rajdhani Oils Oilseeds 4. 78 commodities through 25 Exchanges/Associations as given in the table

Exchange seed its oil &

Ltd., Delhi oilcake Bhatinda Om & Oil Gur

105

Exchange 5. Bhatinda The Chamber

Ltd., of Gur, and seed Agro Gur Ltd., Bombay Oilseed Complex, Ltd., Castor international oil Potatoes Mustard

Commerce, Hapur 6. The Meerut

Commodities Exchange 7. Meerut The Commodity Exchange Mumbai 8.

contracts Rajkot Seeds, Oil & Castor seed, Bullion Merchants Groundnut, oil oil & & cottonseed, cotton
106

its its

Association, Rajkot

cake, cake, (kapas)

and 9. The

RBD

palmolein. Ahmedabad Castorseed, cottonseed, its oil and oilcake &

Commodity Exchange,

Ahmedabad 10. The East India Jute & Hessian Hessian Exchange Sacking India Cotton Ltd., Calcutta 11. The East Cotton Ltd., Mumbai 12. The Spices Oilseeds Ltd., Sangli. 13. National Board Trade, Indore

Association & Turmeric

Exchange of Soya seed, Soyaoil and Soya meals, Rapeseed/Must ardseed its oil and oilcake and RBD Palmolien

107

14. The Commodities Exchange Ltd., Kochi 15. Central Commercial Exchange Gwalior 16. E-sugar Mumbai 17. National Commodity Exchange of of

First Copra/coconut, its oil & oilcake India India Gur Ltd., India Ltd., Sugar Multi- Several Commodities India and

Mustard seed

Ltd., Ahmedabad 18. Coffee Futures Coffee Exchange India Ltd., Bangalore 19. Surendranagar Cotton Oilseeds, Oil Cotton, & Cottonseed, Kapas

108

Surendranagar 20. E-Commodities Ltd., Sugar New Delhi yet

(trading to

commence) 21. National Commodity Several & Derivatives, Commodities Ltd., Exchange

Mumbai 22. Multi Commodity Several Exchange Ltd., Mumbai 23. Bikaner Commodities

commodity Mustard seeds Exchange Ltd., its oil & oilcake, Gram. Guar Bikaner seed. Guar Gum 24. Haryana Mustard seed Commodities Hissar 25. Bullion Ltd., complex seed

Association Mustard Complex

Ltd., Jaipur

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17. STATUS REPORT OF THE DEVELOPMENTS IN THE DERIVATIVE MARKET 1. The Board at its meeting on November 29, 2002 had desired that a quarterly report be submitted to the Board on the developments in the derivative market. Accordingly, 2008-09 on this the memorandum presents a status report for the quarter July-September developments in the derivative market. 2. Equity Derivatives Segment A. Observations on the quarterly data for JulySeptember, 2008-09 During July-September 2008-09, the turnover at BSE was Rs.1,510 crore, which was insignificant as compared to that of NSE at Rs. 3,315,491 crore.
110

Refer Table 1 Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while turnover increased by 24.77% to Rs. 3,317 thousand crore in July-September 2008-09 over April-June 2008-09.

Futures (Index Future + Stock Future) constituted 67.20% of the total number of contracts traded in the F&O Segment. Stock Future and Index Future accounted for 35.26% and 31.94% respectively. Options constituted 32.80% of the total volumes. This mainly comprised of trading in Index Option (30.68%). Turnover at F&O segment was 4.19 times that of its cash segment.

111

Reliance, Reliance Capital Ltd, Reliance Petro. Ltd, State Bank of India and ICICI Bank Ltd were the most actively traded scrips Together in the they derivatives contributed segment. 25.12% of

derivatives turnover in individual stocks.

Client trading constituted 60.17%, Propriety trading constituted 31.07% and FII trading constituted remaining 8.76% of the total turnover.

Refer Table 2 Volume in longer dated derivative contracts (contracts with maturity of more than three months and up to 3 years) was 3.99 lakh and total turnover was Rs. 9870 crore.

Total volume in shorter dated derivative

contracts (contracts with maturity up to 3months) was 1,695 lakh and total turnover was Rs. 3,307

112

thousand crore. Refer Table 3 Volume in

Mini

Nifty

(contracts

with

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

113

4th in Index Options (as on November 10, 2008) in World Derivatives Market (in terms of volume) at the end of September 2008.

Derivative contracts were launched on 38

securities at National Stock Exchange during July-September 2008-09. Table-5: Fact file of July-September 2008-09 with respect to the previous Depth Depth Market quarter JULYSEPTEMBER200809 PRODUC No. of Turnov No. of Turnove T Contra er Contract r cts(Lak (Rs. s(Lakh) (Rs. h) 000) 000) VOLUME & TURNOVER Index 415. 93 542.6 1,07
114

APRIL-JUNE 2008-09

25. 5 1,19 5.8 Market Share ( %) Index 1,0 Future 77.5 Index 1,1 Option 30.9 Single 1,0 Stock 39.3 Future Stock 69.1 Option Turnover in F&O as multiple of turnover in cash segment

Future Index Option Single Stock Future Stock Option Total

7 240. 1 514. 5

5.6 57 1.3 1,09 3.1 58 .3 2,65 8.4 35. 20 21. 49 41. 12 2. 19 3.26

521.2 599.0 35.9 1,698.7

7.5 1,13 0.9 1,03 9.3 69 .1 3,31 7.0 32. 48 34. 09 31. 33 2. 08 4.19

31.94 30.68 35.26 2.11

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Market Concentration

Five most active scrips in the F&O Segment active scrips in the F&O

- Reliance Reliance Petro. Ltd. - Tata Steel Reliance Capital Ltd - Infosys Tech. Ltd

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

Segment Contribut ion of the above 25.12 five to 23.72 total derivative s turnover (%) Client (excludin 60. g FII 59.77 17 trades) Proprieta 27.88 31.07 ry FII 12.35 8.76 Table-6: Data for Shorter Dated and Longer Dated derivative contracts

in three (avg. of months

116

Time Period

Trades in Shorter

Trades in Longer Dated derivative No of contracts Turnove r (lakh) (Rs. 3. 9. 99 87 4. 12 83 .5

No Dated of contract Turnove r s July(Rs. Septemb er 1,69 3,30 Apr-Jun 4.64 7.11 2008-09 1,19 2,65 20084.97 5.88 (Quarter)

Table-7: Data for Mini Nifty derivative contracts Time Period JulySeptemb er Apr-Jun 2008-09 2008No of Turnove contract r (lakh) (Rs. 43 .8 29 .4 36 .9 27 .7

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Table-8: Minimum, Maximum and Average Daily Volatility of the F&O segment at NSE for S&P CNX Nifty since April 2008 Average Maximum Minimum volatility Volatility Volatility Month April-08 (%) 2. (%) 2. (%) 2. 47 98 05 1. 1. 1. May-08 71 99 56 1. 2. 1. June-08 80 28 61 July-08 2. 3. 2. 85 08 38 August2. 2.1 2. 08 27 0 Septem 2.0 2. 2. ber-08 9

Table-9: SGX volume as a percentage of NSE volume for Nifty Future in terms of no. of contracts for the period April September, 2008-09 Month JulySeptemb er Apr-Jun 200809 NSE Volume (Nifty 47,977 ,775 37,764 ,776
118

SGX Volume (Nifty 4,104, 418 3,241, 034

SGX volume as % of NSE 8. 55 8. 58

Table-10: Standing of India in World Derivatives Market (in terms of volume) Septe Produ July August mber Stock 20 2 cts 2008 1 2008 1 Future Index 2 2 2 Future Stock 9 1 1 Option 5 6 Index 4 4 4 Option Source: www.world-exchanges.org (as November 10, 2008) Salient points for the 2nd quarter 2008-09

on

The volume (no. of contracts) and open

interest in the derivatives market has increased even when the underlying market is witnessing a downward trend. This indicates that there are sufficient long position holders who anticipate value proposition in a falling market. Falling or rising markets on the back of low volumes may

119

be a cause of concern from the point of market integrity. However, as observed from the data, under the present scenario the fall in the market has been accompanied by high volumes.

In Index Option, there is a sharp increase

in turnover (97.95%) and volume (117.08%) during July-September 2008-09 over April-June 2008-09. Possible reasons for increase in options trading activity can be attributed to increase in volatility. Market observers believe that conditions across markets and have become more volatile asset and classes

uncertain in the recent past. Generally in such conditions, many people believe that options act as "insurance" from against adverse favourable price price movements while offering the flexibility to benefit possible
120

movements at the same time. Another reason which can be attributed to the increase in activity is the new directive as per the Budget 2008-09 which states that STT would now be levied on the Option premium instead of the strike price.

In Index Future, both turnover (15.17%)

and volume (30.53%) have increased during July-September 2008-09 as compared to AprilJune 2008-09.

There is a decrease in turnover (4.92%) in

Single Stock Futures during July- September 2008-09 as compared to April-June 2008-09.

Except Index Option, the market share of all

other products has decreased (both in terms of volume and turnover) in second quarter of 2008-09 as compared to the first quarter of
121

2008-09.

There is a decrease in turnover (21.04%) volume (17.39%) in Longer Dated

and

derivative contracts in second quarter of 200809 as compared to the first quarter of 2008-09.

Longer dated derivatives were launched in

March 2008, but the volumes have not picked up consequently.

For shorter dated derivative contracts,

turnover increased by 24.52% whereas volume increased by 4.81% in second quarter of 200809 as compared to the first quarter of 2008-09.

During

2008-09,

Mini

Nifty

volumes

increased by 49.15% and turnover increased by 33.43% during July-September 2008-09 over April-June 2008-09.

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18. Business Growth in Derivatives segment (NSE) TABLE 11A Index futures Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 No. of contracts 4116649 156598579 81487424 58537886 21635449 17191668 2126763 1025588

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FIGURE 11A Number of contracts per year

160000000 140000000 120000000 100000000 80000000 60000000 40000000 20000000 0 year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

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

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Table 11B No of turnovers Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 Turnover (Rs. Cr.) 925679.96 3820667.27 2539574 1513755 772147 554446 43952 21483

FIGURE 11B Turnover in Rs. Crores

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4000000 3500000 3000000 2500000 2000000 1500000 1000000 500000 0

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

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

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TABLE 12A STOCK FUTURES Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 No. of contracts 51449737 203587952 104955401 80905493 47043066 32368842 10676843 1957856 -

FIGURE 12A Number of contracts per year in stock future

250000000 200000000 150000000 100000000 50000000 0 year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

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

TABLE 12B NO OF TURNOVERS Year Turnover (Rs. Crores) 2008-09 1093048.26 2007-08 7548563.23 2006-07 3830967 2005-06 2791697 2004-05 1484056 2003-04 1305939 2002-03 286533 2001-02 51515 2000-01 FIGURE 12B Turnover in Rs. Crores
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8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0 year

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

INTERPRETATION: From the data and bar chart above, there were no stock futures available in the year 2000-01. There was a steady increase of stock future 51515 in the year 2001-02. but in the year there was a huge increae of 7548563.23 in the year 2007-08 with a considerable decline of 1093048.26 in the year 2008-09. TABLE 13A INDEX OPTIONS Year 2008-09 2007-08 No. of contracts 24008627 55366038
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2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

25157438 12935116 3293558 1732414 442241 175900 -

FIGURE 13A Number of contracts per year

60000000 50000000 40000000 30000000 20000000 10000000 0 year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

Interpretation: From the data and bar chart above, the no of contracts of index option was nil in the year 2000-2001. But there was a predominant
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increase of 1,75,900 in the year 2001-2002. In the year 2007-2008 there was a huge increase in the index option contracts to 55366038 and a decline of 24008627 in the year 2008-2009. TABLE 13B Turnover per year in Rs. Crores Turnover (Rs. Crores) 71340.02 1362110.88 791906 338469 121943 52816 9246 3765 -

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

FIGURE 13B Turnover per year in Rs. Crores

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1400000 1200000 1000000 800000 600000 400000 200000 0 year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

Interpretation: From the data and bar chart above, there was no turnover in the year 2000-2001 for Index option. It slowly started increasing in the year 2000-2001 to 3765.But in the year 2007-2008 there was a huge increase of 1362110.088 and a sudden decline to 71340.02 observed in 20082009. TABLE 14A STOCK OPTIONS Year 2008-09 2007-08 No. of contracts 2546175 9460631
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2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

5283310 5240776 5045112 5583071 3523062 1037529 -

FIGURE 14A Number of contracts traded per year in stock option

10000000 9000000 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0

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

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

TABLE 14B National turnover in Rs. Crores per year Year Notional turnover 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 crores) 58335.03 359136.55 193795 180253 168836 217207 100131 25163 (Rs.

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FIGURE 14B National turnover in Rs. Crores per year

400000 350000 300000 250000 200000 150000 100000 50000 0 year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02

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

TABLE 15A OVERALL TRADING

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

No. of contracts 119171008 425013200 216883573 157619271 77017185 56886776 16768909 4196873 90580

Turnover (Rs. cr.) 2648403.30 13090477.75 7356242 4824174 2546982 2130610 439862 101926 2365

FIGURE 15A Average daily turnovers in Rs. Crores

60000 50000 40000 30000 20000 10000 0 year 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009

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Interpretation: From the data and bar chart above, the overall trading contracts in the year 2000-2001 was 90580 and huge increase of 119171008 in the year 2008-2009. From the data and bar chart above the overall trading turnover in the year 2000-2001 was as low as 2365 but a predominant increase of 2648403.30 observed in the year 2008-2009. TABLE 16 Overall trade description under NSE Index Futures YNo e. a of r co ntr act s Tur nov er (Rs. cr.) Stock Futures No. of cont ract s Tur nov er (Rs. cr.) Index Options No. of con tra cts Noti onal Tur nov er (Rs. cr.) Stock Options No. of cont ract s Noti onal Tur nov er (Rs. cr.) Inter est Rate Futu res N T o. u o r f n co o nt v ra e ct r s (

Total No. of cont racts T u r n o v e r

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R s. c r. ) 925 2 679. 0 96 0 514 109 240 571 254 583 4116 8 497 304 086 340. 617 35.0 0 6469 37 8.26 27 02 5 3 0 9 2 1565 382 203 754 553 136 946 359 0 0 9857 066 587 856 660 211 063 136. 09 7.27 952 3.23 38 0.88 1 55 7 0 8

( R s . c r . ) 2 6 4 8 4 0 3 . 3 0 1 3 0 9 0 4 7 7 .

0. 1191 0 7100 0 8

0. 4250 0 1320 0 0

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2 0 0 8148 6 7424 0 7 2 0 0 5853 5 7886 0 6 2 0 0 2163 4 5449 0 5 2 1719 0 1668 0 3 -

253 104 383 251 528 791 957 955 096 574 331 906 4 401 7 38 0

193 0 795

2168 0 8357 3

151 809 279 129 524 338 180 375 054 169 351 077 0 469 253 5 93 7 16 6

1576 0 1927 1

470 148 329 504 772 121 430 405 355 511 147 943 66 6 8 2 554 323 130 173 528 446 688 593 241 16 42 9 4 558 307 1

168 0 836

7701 7185

217 207

10 2 5688 78 0 6776 1 2

7 5 7 3 5 6 2 4 2 4 8 2 4 1 7 4 2 5 4 6 9 8 2 2 1 3 0 6

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0 4 2 0 0 2126 2 763 0 3 2 0 0 1025 1 588 0 2 2 0 0 9058 0 0 0 1

1 0 106 439 286 442 924 768 52 533 241 6 43 352 306 2 4 3 1676 9 8909 8 6 2 1 0 4196 1 873 9 2 6 2 9058 3 0 6 5

100 131

195 214 515 175 376 785 83 15 900 5 6

103 251 752 63 9

236 5

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TABLE 17 AVERAGE DAILY TURNOVERS Year 2008-09 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01 Av. daily turnover (Rs. Crores) 45390.21 52153.30 29543 19220 10167 8388 1752 410 11

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

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FINDINGS & CONCLUSION From the above analysis it can be concluded that:
1.

Derivative market is growing very fast in the Indian Economy. The turnover of Derivative Market is increasing year by year in the Indias largest stock exchange NSE. In the case of index future there is a phenomenal increase in the number of contracts. But whereas the turnover is declined considerably. In the case of stock future
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there was a slow increase observed in the number of contracts whereas a decline was also observed in its turnover. In the case of index option there was a huge increase observed both in the number of contracts and turnover. 2.After analyzing data it is clear that the main factors that are driving the growth of Derivative Market are Market improvement in communication facilities as well as long term saving & investment is also possible through entering into Derivative Contract. So these factors encourage the Derivative Market in India. 3. It encourages entrepreneurship in India. It encourages the investor to take more risk & earn more return. So in this way it helps the Indian Economy by developing entrepreneurship. Derivative Market is more regulated & standardized so in this way it provides a more controlled environment. In nutshell, we can say that the rule of High risk & High return apply in Derivatives. If we

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are able to take more risk then we can earn more profit under Derivatives. Commodity derivatives have a crucial role to play in the price risk management process for the commodities in which it deals. And it can be extremely beneficial in agriculture-dominated economy, like India, as the commodity market also involves agricultural produce. Derivatives like forwards, futures, options, swaps etc are extensively used in the country. However, the commodity derivatives have been utilized in a very limited scale. Only forwards and futures trading are permitted in certain commodity items. RELIANCE is the most active future contracts on individual securities traded with 90090 contracts and RNRL is the next most

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active futures contracts with 63522 contracts being traded.

RECOMMENDATIONS & SUGGESTIONS RBI should play a greater role in supporting derivatives. Derivatives market should be developed in order to keep it at par with other derivative markets in the world. Speculation should be discouraged. There must be more derivative instruments aimed at individual investors.

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 SEBI should conduct seminars regarding the use of derivatives to educate individual investors.

After study it is clear that Derivative influence our Indian Economy up to much extent. So, SEBI should take necessary steps for improvement in Derivative Market so that more investors can invest in Derivative market. There is a need of more innovation in Derivative Market because in today scenario even educated people also fear for investing in Derivative Market Because of high risk involved in Derivatives.

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BIBLIOGRAPHY Books referred:

Options Futures, and other Derivatives by John C Hull Derivatives FAQ by Ajay Shah NSEs Certification in Financial Markets: Derivatives Core module Financial Markets & Services by Gordon

& Natarajan

Reports: Report of the RBI-SEBI standard technical committee on exchange traded Currency Futures Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA

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Websites visited:

www.nse-india.com www.bseindia.com www.sebi.gov.in www.ncdex.com www.google.com www.derivativesindia.com

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ABBREV ATIONS A AMEX- America Stock Exchange B BSE- Bombay Stock Exchange BSI- British Standard Institute C CBOE - Chicago Board options Exchange CBOT - Chicago Board of Trade CEBB - Chicago Egg and Butter Board CME - Chicago Mercantile Exchange CNX- Crisil Nse 50 Index CPE - Chicago Produce Exchange CWC- Central Warehousing Corporation D DTSS- Derivative Trading Settlement System F FIIs- Foreign Institutional Investors

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F & O Future and Options FMC- Forward Markets Commission FRAs- Forward Rate Agreements G GAICL-Gujarat Agro Industries Corporation Limited GSAMB- Gujarat State Agricultural Marketing Board I IMM - International Monetary Market IPSTA- India Pepper & Spice Trade Association M MCX Multi Commodity Exchange

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N NAFED-National Agricultural Co-Operative Marketing Federation Of India NCDEX National Commodities and Derivatives Exchange NIAM- National Institute Of Agricultural Marketing NMSE- National Multi Commodity Exchange NOL- Neptune Overseas Limited NSCCLCorporation NSDL- National Securities Depositories Limited NSE - National Stock Exchange O OTC- Over The Counter P PHLX - Philadelphia Stock Exchange PNB- Punjab National Bank R
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National

Securities

Clearing

RBI- Reserve Bank Of India S SC(R) A - Securities Contracts (Regulation) Act, 1956 SEBI- Securities Exchange Board Of India SGX- Singapore Stock Exchange SIMEX - Singapore International Exchange V VPN- Virtual Private Network Monetary

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