Indian Derivative Market

TABLE OF CONTENTS
S. No. 1. 2. 3. 4. . 6. !. ". #. 10. 10 20 30 40 i0 ii0 iii0 iv0 0 11. 12. 10 20 i0 ii0 30 40 0 i0 ii0 iii0 iv0 13. TOPICS PAGE NO.

Executive Summary ...... 06 Company Profile................... 10 Introduction ................... 16 $eed of t%e Study............................................................................ 1! &iteratural 'evie(............................................................................ 1" )*+ective of t%e Study..................................................................... 1# Scope of t%e Study.......................................................................... 20 'e,earc% -et%odolo.y.................................................................... 21 &imitation, of Study......................................................................... 22 -ain /opic, of Study Introduction to 1erivative............................................................. 23 1erivative 1efined......................................................................... 24 /ype, of 1erivative, -ar2et........................................................... 2 /ype, of 1erivative,...................................................................... 2 3or(ard Contract,...................................................................... 26 3uture Contract,........................................................................ 2! )ption,....................................................................................... 32 S(ap....................................................................................... 33 )t%er 4ind, of 1erivative,......................................................... 34 5i,tory of 1erivative,......................................................................... 3 Indian 1erivative -ar2et .......... 3" $eed of 1erivative, in India today................................ 3# -yt%, and realitie, a*out derivative,.................. 3# 1erivative, increa,e ,peculation and do not ,erve any economic purpo,e ..................................................................... 40 Indian -ar2et i, not ready for derivative tradin.......................... 41 Compari,on of $e( Sy,tem (it% Exi,tin. Sy,tem......... 43 Exc%an.e6traded v,. )/C derivative, mar2et,............................... 4 3actor, Contri*utin. /o /%e 7ro(t% )f 1erivative,........................ 4! Price 8olatility.............................................................................. 4! 7lo*ali,ation of -ar2et,.............................................................. 4" /ec%nolo.ical 9dvance,.............................................................. 4# 9dvance, in 3inancial /%eorie,........................................ 4# 1evelopment of 1erivative -ar2et, in India....... 0
2

14. 10 20 30 40 0 1 . 16. 1!. 1". 1#. 20. 21. 22.

:enifit, of 1erivative,................................... 'i,2 -ana.ement............................................................................ Price 1i,covery.............................................................................. )perational 9dvanta.e,................................................................. -ar2et Efficiency............................................................................ Ea,y to Speculation......................................................................... $ational Exc%an.e,......................................................................... Pre,ent Statu,................................................................................. Statu, 'eport of t%e development in 1erivative -ar2et................. :u,ine,, 7ro(t% in 1erivative, ,e.ment ;$SE0............................. 3indin., < Conclu,ion..................................................................... 'ecommendation, < Su..e,tion,.................................................. :i*lio.rap%y ........ 9**revation,...................................................................................

4 4 4 4 # 60 62 6# "1 "2 "3 "4

EXECUTIVE SUMMARY
3ir,tly I am *riefin. t%e current Indian mar2et and compairin. it (it% it pa,t. I am al,o .ivin. *rief data a*out forei.n mar2et. /%en at t%e la,t I am .ivin. my ,u..e,tion, and recommendation,. =it% over 2 million ,%are%older,> India %a, t%e t%ird lar.e,t inve,tor *a,e in t%e (orld after ?S9 and @apan. )ver ! 00 companie, are li,ted on t%e Indian ,toc2 exc%an.e, ;more t%an t%e num*er of companie, li,ted in developed mar2et, of @apan> ?4> 7ermany> 3rance> 9u,tralia> S(itAerland> Canada and 5on. 4on..0. /%e Indian capital mar2et i, ,i.nificant in term, of t%e de.ree of development> volume of tradin.> tran,parency and it, tremendou, .ro(t% potential. IndiaB, mar2et capitaliAation (a, t%e %i.%e,t amon. t%e emer.in. mar2et,. /otal mar2et capitaliAation of /%e :om*ay Stoc2 Exc%an.e ;:SE0> (%ic%> a, on @uly 31> 1##!> (a, ?SC 1! *illion %a, .ro(n *y 3!. D percent every t(elve mont%, and (a, over ?SC "34 *illion a, of @anuary> 200!. :om*ay Stoc2 Exc%an.e, ;:SE0> one of t%e olde,t in t%e (orld> account, for t%e lar.e,t num*er of li,ted companie, tran,actin. t%eir ,%are, on a nation(ide online tradin. ,y,tem. /%e t(o ma+or exc%an.e, namely t%e $ational Stoc2 Exc%an.e ;$SE0 and t%e :om*ay Stoc2 Exc%an.e ;:SE0 ran2ed no. 3 < in t%e (orld> calculated *y t%e num*er of daily tran,action, done on t%e exc%an.e,. /%e /otal /urnover of Indian 3inancial -ar2et, cro,,ed ?SC 22 6 *illion in 2006 E 9n increa,e of "2D from ?S C 123! *illion in 2004 in a ,%ort ,pan of 2 year, only. /urnover in t%e Spot and 1erivative, ,e.ment *ot% in $SE < :SE (a, %i.%er *y 4 D into 2006 a, compared to 200 . =it% daily avera.e volume of ?S C #.4 *illion> t%e Sen,ex %a, po,ted excellent return, in t%e recent year,.

Currently the market cap of the Sensex as on July 4th !""# $as %s 4&.4 'akh Crore $(th a P)E of more than !". 1erivative, tradin. in t%e ,toc2 mar2et %ave *een a ,u*+ect of ent%u,ia,m of re,earc% in t%e field of finance t%e mo,t de,ired in,trument, t%at allo( mar2et participant, to mana.e ri,2 in t%e modern ,ecuritie, tradin. are 2no(n a, derivative,. /%e derivative, are defined a, t%e future contract, (%o,e value depend, upon t%e underlyin. a,,et,. If derivative, are introduced in t%e ,toc2 mar2et> t%e underlyin. a,,et may *e anyt%in. a, component of ,toc2 mar2et li2e> ,toc2 price, or mar2et indice,> intere,t rate,> etc. /%e main lo.ic *e%ind derivative, tradin. i, t%at derivative, reduce t%e ri,2 *y providin. an additional c%annel to inve,t (it% lo(er tradin. co,t and it facilitate, t%e inve,tor, to extend t%eir ,ettlement t%rou.% t%e future contract,. It provide, extra liFuidity in t%e ,toc2 mar2et. 1erivative, are a,,et,> (%ic% derive t%eir value, from an underlyin. a,,et. /%e,e underlyin. a,,et, are of variou, cate.orie, li2e G Commoditie, includin. .rain,> coffee *ean,> etc. G Preciou, metal, li2e .old and ,ilver. G 3orei.n exc%an.e rate. G:ond, of different type,> includin. medium to lon.6term ne.otia*le de*t ,ecuritie, i,,ued *y .overnment,> companie,> etc. G S%ort6term de*t ,ecuritie, ,uc% a, /6*ill,. G )ver6/%e6Counter ;)/C0 money mar2et product, ,uc% a, loan, or depo,it,. G EFuitie, 3or example> a dollar for(ard i, a derivative contract> (%ic% .ive, t%e *uyer a ri.%t < an o*li.ation to *uy dollar, at ,ome future date. /%e price, of t%e derivative, are driven *y t%e ,pot price, of t%e,e underlyin. a,,et,. 5o(ever> t%e mo,t important u,e of derivative, i, in tran,ferrin. mar2et ri,2> called Hedging, (%ic% i, a protection a.ain,t lo,,e, re,ultin. from unfore,een

price or volatility c%an.e,. /%u,> derivative, are a very important tool of ri,2 mana.ement.

/%ere are variou, derivative product, traded. /%ey areH *. 3or(ard, !. 3uture, +. )ption, 4. S(ap, A ,or$ar- 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 ,uture 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 Opt(ons 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 %rice is called %remium and is paid by buyer of the option to the seller or writer of the option. 9 call opt(on .ive, t%e %older t%e ri.%t to *uy an underlyin. a,,et *y a certain date for a certain price. /%e ,eller i, under an o*li.ation to fulfill t%e contract and i, paid a price of t%i,> (%ic% i, called It%e call option premium or call option priceI.

9 put opt(on> on t%e ot%er %and .ive, t%e %older t%e ri.%t to ,ell an underlyin. a,,et *y a certain date for a certain price. /%e *uyer i, under an o*li.ation to fulfill t%e contract and i, paid a price for t%i,> (%ic% i, called It%e put option premium or put option priceI. .S$aps are tran,action, (%ic% o*li.ate, t%e t(o partie, to t%e contract to exc%an.e a ,erie, of ca,% flo(, at ,pecified interval, 2no(n a, payment or ,ettlement date,. /%ey can *e re.arded a, portfolio, of for(ardJ, contract,. 9 contract (%ere*y t(o partie, a.ree to exc%an.e ;,(ap0 payment,> *a,ed on ,ome notional principle amount i, called a, a KS=9PB. In ca,e of ,(ap> only t%e payment flo(, are exc%an.ed and not t%e principle amountL

INTRODUCTION
9 1erivative i, a financial in,trument (%o,e value depend, on ot%er> more *a,ic> underlyin. varia*le,. /%e varia*le, underlyin. could *e price, of traded ,ecuritie, and ,toc2> price, of .old or copper. 1erivative, %ave *ecome increa,in.ly important in t%e field of finance> )ption, and 3uture, are traded actively on many exc%an.e,> 3or(ard contract,> S(ap and different type, of option, are re.ularly traded out,ide exc%an.e, *y financial intuition,> *an2, and t%eir corporate client, in (%at are termed a, over6t%e6counter mar2et, E in ot%er (ord,> t%ere i, no ,in.le mar2et place or or.aniAed exc%an.e,.

NEED OF THE STUDY

/%e ,tudy %a, *een done to 2no( t%e different type, of derivative, and al,o to 2no( t%e derivative mar2et in India. /%i, ,tudy al,o cover, t%e recent development, in t%e derivative mar2et ta2in. into account t%e tradin. in pa,t year,. /%rou.% t%i, ,tudy I came to 2no( t%e tradin. done in derivative, and t%eir u,e in t%e ,toc2 mar2et,.

OB ECTIVES OF THE STUDY

/o under,tand t%e concept of t%e 1erivative, and 1erivative /radin.. /o 2no( different type, of 3inancial 1erivative, /o 2no( t%e role of derivative, tradin. in India. /o analy,e t%e performance of 1erivative, /radin. ,ince 2001(it% ,pecial reference to 3uture, < )ption,

SCO!E OF THE !RO ECT

/%e pro+ect cover, t%e derivative, mar2et and it, in,trument,. 3or *etter under,tandin. variou, ,trate.ie, (it% different ,ituation, and action, %ave *een .iven. It include, t%e data collected in t%e recent year, and al,o t%e mar2et in t%e derivative, in t%e recent year,. /%i, ,tudy extend, to t%e tradin. of derivative, done in t%e $ational Stoc2 -ar2et,.

10

MAIN TO!ICS OF STUDY

"# INTRODUCTION TO DERIVATIVE
/%e ori.in of derivative, can *e traced *ac2 to t%e need of farmer, to protect t%em,elve, a.ain,t fluctuation, in t%e price of t%eir crop. 3rom t%e time it (a, ,o(n to t%e time it (a, ready for %arve,t> farmer, (ould face price uncertainty. /%rou.% t%e u,e of ,imple derivative product,> it (a, po,,i*le for t%e farmer to partially or fully tran,fer price ri,2, *y loc2in.6in a,,et price,. /%e,e (ere ,imple contract, developed to meet t%e need, of farmer, and (ere *a,ically a mean, of reducin. ri,2. 9 farmer (%o ,o(ed %i, crop in @une faced uncertainty over t%e price %e (ould receive for %i, %arve,t in Septem*er. In year, of ,carcity> %e (ould pro*a*ly o*tain attractive price,. 5o(ever> durin. time, of over,upply> %e (ould %ave to di,po,e off %i, %arve,t at a very lo( price. Clearly t%i, meant t%at t%e farmer and %i, family (ere expo,ed to a %i.% ri,2 of price uncertainty. )n t%e ot%er %and> a merc%ant (it% an on.oin. reFuirement of .rain, too (ould face a price ri,2 t%at of %avin. to pay exor*itant price, durin. deart%> alt%ou.% favoura*le price, could *e o*tained durin. period, of over,upply. ?nder ,uc% circum,tance,> it clearly made ,en,e for t%e farmer and t%e merc%ant to come to.et%er and enter into contract (%ere*y t%e price of t%e .rain to *e delivered in Septem*er could *e decided earlier. =%at t%ey (ould t%en ne.otiate %appened to *e future,6type contract> (%ic% (ould ena*le *ot% partie, to eliminate t%e price ri,2. In 1"4"> t%e C%ica.o :oard )f /rade> or C:)/> (a, e,ta*li,%ed to *rin. farmer, and merc%ant, to.et%er. 9 .roup of trader, .ot to.et%er and created

11

t%e Kto6arriveB contract t%at permitted farmer, to loc2 into price upfront and deliver t%e .rain later. /%e,e to6arrive contract, proved u,eful a, a device for %ed.in. and ,peculation on price c%ar.e,. /%e,e (ere eventually ,tandardiAed> and in 1#2 t%e fir,t future, clearin. %ou,e came into exi,tence. /oday derivative, contract, exi,t on variety of commoditie, ,uc% a, corn> pepper> cotton> (%eat> ,ilver etc. :e,ide, commoditie,> derivative, contract, al,o exi,t on a lot of financial underlyin. li2e ,toc2,> intere,t rate> exc%an.e rate> etc. $# DERIVATIVE DEFINED 9 derivative i, a product (%o,e value i, derived from t%e value of one or more underlyin. varia*le, or a,,et, in a contractual manner. /%e underlyin. a,,et can *e eFuity> forex> commodity or any ot%er a,,et. In our earlier di,cu,,ion> (e ,a( t%at (%eat farmer, may (i,% to ,ell t%eir %arve,t at a future date to eliminate t%e ri,2 of c%an.e in price *y t%at date. Suc% a tran,action i, an example of a derivative. /%e price of t%i, derivative i, driven *y t%e ,pot price of (%eat (%ic% i, t%e Munderlyin.L in t%i, ca,e. /%e 3or(ard, Contract, ;'e.ulation0 9ct> 1# 2> re.ulate, t%e for(ardNfuture, contract, in commoditie, all over India. 9, per t%i, t%e 3or(ard -ar2et, Commi,,ion ;3-C0 continue, to %ave +uri,diction over commodity future, contract,. 5o(ever (%en derivative, tradin. in ,ecuritie, (a, introduced in 2001> t%e term M,ecurityL in t%e Securitie, Contract, ;'e.ulation0 9ct> 1# 6 ;SC'90> (a, amended to include derivative contract, in ,ecuritie,. Con,eFuently> re.ulation of derivative, came under t%e purvie( of Securitie, Exc%an.e :oard of India ;SE:I0. =e t%u, %ave ,eparate re.ulatory aut%oritie, for ,ecuritie, and commodity derivative mar2et,. 1erivative, are ,ecuritie, under t%e SC'9 and %ence t%e tradin. of derivative, i, .overned *y t%e re.ulatory frame(or2 under t%e SC'9. /%e Securitie, Contract, ;'e.ulation0 9ct> 1# 6 define, MderivativeL to include6

12

9 ,ecurity derived from a de*t in,trument> ,%are> loan (%et%er ,ecured or un,ecured> ri,2 in,trument or contract difference, or any ot%er form of ,ecurity. 9 contract (%ic% derive, it, value from t%e price,> or index of price,> of underlyin. ,ecuritie,. %# TY!ES OF DERIVATIVES MAR&ET

Exc%an.e /raded 1erivative,

)ver /%e Counter 1erivative,

$ational Stoc2 Exc%an.e

:om*ay Stoc2 < Exc%an.e Exc%an.e

$ational Commodity 1erivative

Index 3uture

Index option

Stoc2 option

Stoc2 future

Fi'(re#" T)*e+ ,- Derivative+ Market

.# TY!ES OF DERIVATIVES

Derivatives

Future

Option
13

Forward

Swaps

Fi'(re#$ T)*e+ ,- Derivative+

/i0

FOR1ARD CONTRACTS

9 for(ard contract i, an a.reement to *uy or ,ell an a,,et on a ,pecified date for a ,pecified price. )ne of t%e partie, to t%e contract a,,ume, a lon. po,ition and a.ree, to *uy t%e underlyin. a,,et on a certain ,pecified future date for a certain ,pecified price. /%e ot%er party a,,ume, a ,%ort po,ition and a.ree, to ,ell t%e a,,et on t%e ,ame date for t%e ,ame price. )t%er contract detail, li2e delivery date> price and Fuantity are ne.otiated *ilaterally *y t%e partie, to t%e contract. /%e for(ard contract, are n o r m a l l y traded out,ide t%e exc%an.e,.

BASIC FEATURES OF FOR1ARD CONTRACT

G G G G G /%ey are *ilateral contract, and %ence expo,ed to counter6party ri,2. Eac% contract i, cu,tom de,i.ned> and %ence i, uniFue in term, of contract ,iAe> expiration date and t%e a,,et type and Fuality. /%e contract price i, .enerally not availa*le in pu*lic domain. )n t%e expiration date> t%e contract %a, to *e ,ettled *y delivery of t%e a,,et. If t%e party (i,%e, to rever,e t%e contract> it %a, to compul,orily .o to t%e ,ame counter6party> (%ic% often re,ult, in %i.% price, *ein. c%ar.ed. 5o(ever for(ard contract, in certain very ,tandardiAed> reducin. tran,action a, in t%e ca,e of co,t, and increa,in. mar2et, %ave forei.n tran,action, *ecome t%ere*y /%i, volume.

exc%an.e>

14

proce,, of ,tandardiAation reac%e, it, limit in t%e or.aniAed future, mar2et. 3or(ard contract, are often confu,ed (it% future, contract,. /%e confu,ion i, primarily *ecau,e *ot% ,erve e,,entially t % e ,ame economic fun ction , of allocatin. ri,2 in t%e pre,ence of future price uncertainty. 5o(ever future, are a ,i.nificant improvement over t%e for(ard contract, a, t%ey eliminate counterparty ri,2 and offer more liFuidity.

/ii0

FUTURE CONTRACT

In finance> a future, contract i, a ,tandardiAed contract> traded on a future, exc%an.e> to *uy or ,ell a certain underlyin. in,trument at a certain date in t%e future> at a pre6,et price. /%e future date i, called t%e delivery date or final ,ettlement date. /%e pre6,et price i, called t%e future, price. /%e price of t%e underlyin. a,,et on t%e delivery date i, called t%e ,ettlement price. /%e ,ettlement price> normally> conver.e, to(ard, t%e future, price on t%e delivery date. 9 future, contract .ive, t%e %older t%e ri.%t and t%e o*li.ation to *uy or ,ell> (%ic% differ, from an option, contract> (%ic% .ive, t%e *uyer t%e ri.%t> *ut not t%e o*li.ation> and t%e option (riter ;,eller0 t%e o*li.ation> *ut not t%e ri.%t. /o exit t%e commitment> t%e %older of a future, po,ition %a, to ,ell %i, lon. po,ition or *uy *ac2 %i, ,%ort po,ition> effectively clo,in. out t%e future, po,ition and it, contract o*li.ation,. 3uture, contract, are exc%an.e traded derivative,. /%e exc%an.e act, a, counterparty on all contract,> ,et, mar.in reFuirement,> etc.

BASIC FEATURES OF FUTURE CONTRACT

"# Standardi2ati,n3 3uture, contract, en,ure t%eir liFuidity *y *ein. %i.%ly ,tandardiAed> u,ually *y ,pecifyin.O

15

/%e underlying. /%i, can *e anyt%in. from a *arrel of ,(eet crude oil to a ,%ort term intere,t rate. /%e type of ,ettlement> eit%er ca,% ,ettlement or p%y,ical ,ettlement. /%e amount and unit, of t%e underlyin. a,,et per contract. /%i, can *e t%e notional amount of *ond,> a fixed num*er of *arrel, of oil> unit, of forei.n currency> t%e notional amount of t%e depo,it over (%ic% t%e ,%ort term intere,t rate i, traded> etc.

/%e currency in (%ic% t%e future, contract i, Fuoted. /%e grade of t%e delivera*le. In ca,e of *ond,> t%i, ,pecifie, (%ic% *ond, can *e delivered. In ca,e of p%y,ical commoditie,> t%i, ,pecifie, not only t%e Fuality of t%e underlyin. .ood, *ut al,o t%e manner and location of delivery. /%e delivery mont%.

/%e la,t tradin. date. )t%er detail, ,uc% a, t%e tic2> t%e minimum permi,,i*le price fluctuation.

$# Mar'in3 9lt%ou.% t%e value of a contract at time of tradin. ,%ould *e Aero> it, price con,tantly fluctuate,. /%i, render, t%e o(ner lia*le to adver,e c%an.e, in value> and create, a credit ri,2 to t%e exc%an.e> (%o al(ay, act, a, counterparty. /o minimiAe t%i, ri,2> t%e exc%an.e demand, t%at contract o(ner, po,t a form of collateral> commonly 2no(n a, -ar.in reFuirement, are (aived or reduced in ,ome ca,e, for %ed.er, (%o %ave p%y,ical o(ner,%ip of t%e covered commodity or ,pread trader, (%o %ave off,ettin. contract, *alancin. t%e po,ition. In(t(al /ar0(n1 i, paid *y *ot% *uyer and ,eller. It repre,ent, t%e lo,, on t%at contract> a, determined *y %i,torical price c%an.e,> (%ic% i, not li2ely to *e exceeded on a u,ual dayJ, tradin.. It may *e D or 10D of total contract price. /ark to market /ar0(n1 :ecau,e a ,erie, of adver,e price c%an.e, may ex%au,t t%e initial mar.in> a furt%er mar.in> u,ually called variation or maintenance mar.in> i, reFuired *y t%e exc%an.e. /%i, i, calculated *y t%e

16

future, contract> i.e. a.reein. on a price at t%e end of eac% day> called t%e I,ettlementI or mar26to6mar2et price of t%e contract. /o under,tand t%e ori.inal practice> con,ider t%at a future, trader> (%en ta2in. a po,ition> depo,it, money (it% t%e exc%an.e> called a Imar.inI. /%i, i, intended to protect t%e exc%an.e a.ain,t lo,,. 9t t%e end of every tradin. day> t%e contract i, mar2ed to it, pre,ent mar2et value. If t%e trader i, on t%e (innin. ,ide of a deal> %i, contract %a, increa,ed in value t%at day> and t%e exc%an.e pay, t%i, profit into %i, account. )n t%e ot%er %and> if %e i, on t%e lo,in. ,ide> t%e exc%an.e (ill de*it %i, account. If %e cannot pay> t%en t%e mar.in i, u,ed a, t%e collateral from (%ic% t%e lo,, i, paid. %# Sett4e5ent Settlement i, t%e act of con,ummatin. t%e contract> and can *e done in one of t(o (ay,> a, ,pecified per type of future, contractO Phys(cal -el(2ery 3 t%e amount ,pecified of t%e underlyin. a,,et of t%e contract i, delivered *y t%e ,eller of t%e contract to t%e exc%an.e> and *y t%e exc%an.e to t%e *uyer, of t%e contract. In practice> it occur, only on a minority of contract,. -o,t are cancelled out *y purc%a,in. a coverin. po,ition 6 t%at i,> *uyin. a contract to cancel out an earlier ,ale ;coverin. a ,%ort0> or ,ellin. a contract to liFuidate an earlier purc%a,e ;coverin. a lon.0. Cash settlement 3 a ca,% payment i, made *a,ed on t%e underlyin. reference rate> ,uc% a, a ,%ort term intere,t rate index ,uc% a, Euri*or> or t%e clo,in. value of a ,toc2 mar2et index. 9 future, contract mi.%t al,o opt to ,ettle a.ain,t an index *a,ed on trade in a related ,pot mar2et. Exp(ry i, t%e time (%en t%e final price, of t%e future are determined. 3or many eFuity index and intere,t rate future, contract,> t%i, %appen, on t%e &a,t /%ur,day of certain tradin. mont%. )n t%i, day t%e tP2 future, contract *ecome, t%e t for(ard contract.

17

!RICIN6 OF FUTURE CONTRACT In a future, contract> for no ar*itra.e to *e po,,i*le> t%e price paid on delivery ;t%e for(ard price0 mu,t *e t%e ,ame a, t%e co,t ;includin. intere,t0 of *uyin. and ,torin. t%e a,,et. In ot%er (ord,> t%e rational for(ard price repre,ent, t%e expected future value of t%e underlyin. di,counted at t%e ri,2 free rate. /%u,> for a ,imple> non6dividend payin. a,,et> t%e value of t%e futureNfor(ard> *e found *y di,countin. t%e pre,ent value of ri,26free return . at time to maturity > (ill *y t%e rate

/%i, relation,%ip may *e modified for ,tora.e co,t,> dividend,> dividend yield,> and convenience yield,. 9ny deviation from t%i, eFuality allo(, for ar*itra.e a, follo(,. In t%e ca,e (%ere t%e for(ard price i, %i.%erO *. /%e ar*itra.eur ,ell, t%e future, contract and *uy, t%e underlyin. today ;on t%e ,pot mar2et0 (it% *orro(ed money. !. )n t%e delivery date> t%e ar*itra.eur %and, over t%e underlyin.> and receive, t%e a.reed for(ard price. +. 5e t%en repay, t%e lender t%e *orro(ed amount plu, intere,t. 4. /%e difference *et(een t%e t(o amount, i, t%e ar*itra.e profit. In t%e ca,e (%ere t%e for(ard price i, lo(erO *. /%e ar*itra.eur *uy, t%e future, contract and ,ell, t%e underlyin. today ;on t%e ,pot mar2et0H %e inve,t, t%e proceed,. !. )n t%e delivery date> %e ca,%e, in t%e matured inve,tment> (%ic% %a, appreciated at t%e ri,2 free rate. +. 5e t%en receive, t%e underlyin. and pay, t%e a.reed for(ard price u,in. t%e matured inve,tment. QIf %e (a, ,%ort t%e underlyin.> %e return, it no(.R 4. /%e difference *et(een t%e t(o amount, i, t%e ar*itra.e profit.

18

TABLE "7 DISTINCTION BET1EEN FUTURES AND FOR1ARDS CONTRACTS ,EAT4%E Operat(onal /echan(sm ,O%5A%6 CONT%ACT ,4T4%E CONT%ACT

/raded directly *et(een /raded on t%e exc%an.e,. t(o partie, ;not traded on t%e exc%an.e,0.

Contract Spec(f(cat(ons Counter3party r(sk

1iffer from trade to trade.

Contract, contract,.

are

,tandardiAed

Exi,t,.

Exi,t,. 5o(ever> a,,umed *y t%e clearin. corp.> (%ic% *ecome, t%e counter party to all t%e trade, or unconditionally ,ettlement. .uarantee, t%eir

'(7u(-at(on Prof(le

&o(> tailor

a,

contract,

are 5i.%> a, contract, are ,tandardiAed

made

contract, exc%an.e traded contract,.

caterin. to t%e need, of t%e need, of t%e partie,. Pr(ce -(sco2ery $ot efficient> a, mar2et, Efficient> a, mar2et, are centraliAed are ,cattered. and all *uyer, and ,eller, come to a common platform to di,cover t%e Examples Currency mar2et in India. price. Commoditie,> future,> Index 3uture, and Individual ,toc2 3uture, in India.

19

O!TIONS 7
9 derivative tran,action t%at .ive, t%e option %older t%e ri.%t *ut not t%e o*li.ation to *uy or ,ell t%e underlyin. a,,et at a price> called t%e ,tri2e price> durin. a period or on a ,pecific date in exc%an.e for payment of a premium i, 2no(n a, KoptionB. ?nderlyin. a,,et refer, to any a,,et t%at i, traded. /%e price at (%ic% t%e underlyin. i, traded i, called t%e K,tri2e priceB. /%ere are t(o type, of option, i.e.> CA'' OPTION 8 P4T OPTION. CALL O!TION3 9 contract t%at .ive, it, o(ner t%e ri.%t *ut not t%e o*li.ation to *uy an underlyin. a,,et6,toc2 or any financial a,,et> at a ,pecified price on or *efore a ,pecified date i, 2no(n a, a KCall optionB. /%e o(ner ma2e, a profit provided %e ,ell, at a %i.%er current price and *uy, at a lo(er future price. !UT O!TION3 9 contract t%at .ive, it, o(ner t%e ri.%t *ut not t%e o*li.ation to ,ell an underlyin. a,,et6,toc2 or any financial a,,et> at a ,pecified price on or *efore a ,pecified date i, 2no(n a, a KPut optionB. /%e o(ner ma2e, a profit provided %e *uy, at a lo(er current price and ,ell, at a %i.%er future price. 5ence> no option (ill *e exerci,ed if t%e future price doe, not increa,e.

Put and call, are almo,t al(ay, (ritten on eFuitie,> alt%ou.% occa,ionally preference ,%are,> *ond, and (arrant, *ecome t%e ,u*+ect of option,.

20

S1A!S 7
S(ap, are tran,action, (%ic% o*li.ate, t%e t(o partie, to t%e contract to exc%an.e a ,erie, of ca,% flo(, at ,pecified interval, 2no(n a, payment or ,ettlement date,. /%ey can *e re.arded a, portfolio, of for(ardJ, contract,. 9 contract (%ere*y t(o partie, a.ree to exc%an.e ;,(ap0 payment,> *a,ed on ,ome notional principle amount i, called a, a KS=9PB. In ca,e of ,(ap> only t%e payment flo(, are exc%an.ed and not t%e principle amount. /%e t(o commonly u,ed ,(ap, areO INTE%EST %ATE S5APS1 Intere,t rate ,(ap, i, an arran.ement *y (%ic% one party a.ree, to exc%an.e %i, ,erie, of fixed rate intere,t payment, to a party in exc%an.e for %i, varia*le rate intere,t payment,. /%e fixed rate payer ta2e, a ,%ort po,ition in t%e for(ard contract (%erea, t%e floatin. rate payer ta2e, a lon. po,ition in t%e for(ard contract. C4%%ENC9 S5APS1 Currency ,(ap, i, an arran.ement in (%ic% *ot% t%e principle amount and t%e intere,t on loan in one currency are ,(apped for t%e principle and t%e intere,t payment, on loan in anot%er currency. /%e partie, to t%e ,(ap contract of currency .enerally %ail from t(o different countrie,. /%i, arran.ement allo(, t%e counter partie, to *orro( ea,ily and c%eaply in t%eir %ome currencie,. ?nder a currency ,(ap> ca,% flo(, to *e exc%an.ed are determined at t%e ,pot rate at a time (%en ,(ap i, done. Suc% ca,% flo(, are ,uppo,ed to remain unaffected *y ,u*,eFuent c%an.e, in t%e exc%an.e rate,. ,INANCIA' S5AP1 3inancial ,(ap, con,titute a fundin. tec%niFue (%ic% permit a *orro(er to acce,, one mar2et and t%en exc%an.e t%e lia*ility for anot%er type of lia*ility. It al,o allo(, t%e inve,tor, to exc%an.e one type of a,,et for anot%er type of a,,et (it% a preferred income ,tream.

21

"$# INDIAN DERIVATIVES MAR&ET

Startin. from a controlled economy> India %a, moved to(ard, a (orld (%ere price, fluctuate every day. /%e introduction of ri,2 mana.ement in,trument, in India .ained momentum in t%e la,t fe( year, due to li*erali,ation proce,, and 'e,erve :an2 of IndiaB, ;':I0 effort, in creatin. currency for(ard mar2et. 1erivative, are an inte.ral part of li*erali,ation proce,, to mana.e ri,2. $SE .au.in. t%e mar2et reFuirement, initiated t%e proce,, of ,ettin. up derivative mar2et, in India. In @uly 1###> derivative, tradin. commenced in India Table 2 !"ronolo#$ o% instru&ents 1##1 14 1ecem*er 1## 1" $ovem*er 1##6 11 -ay 1##" ! @uly 1### 24 -ay 2000 2 -ay 2000 &i*erali,ation proce,, initiated $SE a,2ed SE:I for permi,,ion to trade index future,. SE:I ,etup &.C.7upta Committee to draft a policy frame(or2 for index future,. &.C.7upta Committee ,u*mitted report. ':I .ave permi,,ion for )/C for(ard rate a.reement, ;3'9,0 and intere,t rate ,(ap,. SI-ES c%o,e $ifty for tradin. future, and option, on an Indian index. SE:I .ave permi,,ion to $SE and :SE to do index

future, tradin.. # @une 2000 /radin. of :SE Sen,ex future, commenced at :SE. 12 @une 2000 /radin. of $ifty future, commenced at $SE. 2 Septem*er $ifty future, tradin. commenced at S7S. 2000 2 @une 2001 Individual Stoc2 )ption, < 1erivative,

/"0 Need -,r derivative+ in India t,da)

22

In le,, t%an t%ree decade, of t%eir comin. into vo.ue> derivative, mar2et, %ave *ecome t%e mo,t important mar2et, in t%e (orld. /oday> derivative, %ave *ecome part and parcel of t%e day6to6day life for ordinary people in ma+or part of t%e (orld. ?ntil t%e advent of $SE> t%e Indian capital mar2et %ad no acce,, to t%e late,t tradin. met%od, and (a, u,in. traditional out6dated met%od, of tradin.. /%ere (a, a %u.e .ap *et(een t%e inve,tor,B a,piration, of t%e mar2et, and t%e availa*le mean, of tradin.. /%e openin. of Indian economy %a, precipitated t%e proce,, of inte.ration of IndiaB, financial mar2et, (it% t%e international financial mar2et,. Introduction of ri,2 mana.ement in,trument, in India %a, .ained momentum in la,t fe( year, t%an2, to 'e,erve :an2 of IndiaB, effort, in allo(in. for(ard contract,> cro,, currency option, etc. (%ic% %ave developed into a very lar.e mar2et. /$0 M)t8+ and rea4itie+ a9,(t derivative+ In le,, t%an t%ree decade, of t%eir comin. into vo.ue> derivative, mar2et, %ave *ecome t%e mo,t important mar2et, in t%e (orld. 3inancial derivative, came into t%e ,potli.%t alon. (it% t%e ri,e in uncertainty of po,t61#!0> (%en ?S announced an end to t%e :retton =ood, Sy,tem of fixed exc%an.e rate, leadin. to introduction of currency derivative, follo(ed *y ot%er innovation, includin. ,toc2 index future,. /oday> derivative, %ave *ecome part and parcel of t%e day6to6day life for ordinary people in ma+or part, of t%e (orld. =%ile t%i, i, true for many countrie,> t%ere are ,till appre%en,ion, a*out t%e introduction of derivative,. /%ere are many myt%, a*out derivative, *ut t%e realitie, t%at are different e,pecially for Exc%an.e traded derivative,> (%ic% are (ell re.ulated (it% all t%e ,afety mec%ani,m, in place. =%at are t%e,e myt%, *e%ind derivative,T 1erivative, increa,e ,peculation and do not ,erve any economic purpo,e Indian -ar2et i, not ready for derivative tradin. 1i,a,ter, prove t%at derivative, are very ri,2y and %i.%ly levera.ed in,trument,.

23

1erivative, are complex and exotic in,trument, t%at Indian inve,tor, (ill find difficulty in under,tandin. I, t%e exi,tin. capital mar2et ,afer t%an 1erivative,T

/i0 Derivative+ in:rea+e +*e:(4ati,n and d, n,t +erve an) e:,n,5i: *(r*,+e3 $umerou, ,tudie, of derivative, activity %ave led to a *road con,en,u,> *ot% in t%e private and pu*lic ,ector, t%at derivative, provide numerou, and ,u*,tantial *enefit, to t%e u,er,. 1erivative, are a lo(6co,t> effective met%od for u,er, to %ed.e and mana.e t%eir expo,ure, to intere,t rate,> commodity price, or exc%an.e rate,. /%e need for derivative, a, %ed.in. tool (a, felt fir,t in t%e commoditie, mar2et. 9.ricultural future, and option, %elped farmer, and proce,,or, %ed.e a.ain,t commodity price ri,2. 9fter t%e fallout of :retton (ood a.reement> t%e financial mar2et, in t%e (orld ,tarted under.oin. radical c%an.e,. /%i, period i, mar2ed *y remar2a*le innovation, in t%e financial mar2et, ,uc% a, introduction of floatin. rate, for t%e currencie,> increa,ed tradin. in variety of derivative, in,trument,> on6line tradin. in t%e capital mar2et,> etc. 9, t%e complexity of in,trument, increa,ed many fold,> t%e accompanyin. ri,2 factor, .re( in .i.antic proportion,. /%i, ,ituation led to development derivative, a, effective ri,2 mana.ement tool, for t%e mar2et participant,.

&oo2in. at t%e eFuity mar2et> derivative, allo( corporation, and in,titutional inve,tor, to effectively mana.e t%eir portfolio, of a,,et, and lia*ilitie, t%rou.% in,trument, li2e ,toc2 index future, and option,. 9n eFuity fund> for example> can reduce it, expo,ure to t%e ,toc2 mar2et Fuic2ly and at a relatively lo( co,t (it%out ,ellin. off part of it, eFuity a,,et, *y u,in. ,toc2 index future, or index option,.

:y providin. inve,tor, and i,,uer, (it% a (ider array of tool, for mana.in. ri,2, and rai,in. capital> derivative, improve t%e allocation of credit

24

and t%e ,%arin. of ri,2 in t%e .lo*al economy> lo(erin. t%e co,t of capital formation and ,timulatin. economic .ro(t%. $o( t%at (orld mar2et, for trade and finance %ave *ecome more inte.rated> derivative, %ave ,tren.t%ened t%e,e important lin2a.e, *et(een .lo*al mar2et,> increa,in. mar2et liFuidity and efficiency and facilitatin. t%e flo( of trade and finance /ii0 Indian Market i+ n,t read) -,r derivative tradin' )ften t%e ar.ument put fort% a.ain,t derivative, tradin. i, t%at t%e Indian capital mar2et i, not ready for derivative, tradin.. 5ere> (e loo2 into t%e pre6 reFui,ite,> (%ic% are needed for t%e introduction of derivative,> and %o( Indian mar2et fare,O TA:'E +. P'E6'EU?ISI/ES I$1I9$ SCE$9'I) &ar.e mar2et India i, one of t%e lar.e,t mar2et6capitali,ed Capitali,ation countrie, in 9,ia (it% a mar2et capitali,ation of more t%an ',.!6 000 crore,. 5i.% &iFuidity underlyin. in t%e /%e daily avera.e traded volume in Indian capital mar2et today i, around ! 00 crore,. =%ic% mean, on an avera.e every mont% 14D of t%e countryB, -ar2et capitali,ation .et, traded. /%e,e are clear indicator, of %i.% liFuidity in t%e underlyin.. /%e fir,t clearin. corporation .uaranteein. trade, %a, *ecome fully functional from @uly 1##6 in t%e form of $ational Securitie, Clearin. Corporation ;$SCC&0. $SCC& i, re,pon,i*le for .uaranteein. all open po,ition, on t%e $ational Stoc2 Exc%an.e ;$SE0 for (%ic% it doe, t%e clearin.. $ational Securitie, 1epo,itorie, &imited ;$S1&0 (%ic% ,tarted functionin. in t%e year 1##! %a, revolutionali,ed t%e ,ecurity ,ettlement in our country. In t%e In,titution of SE:I ;Securitie, and Exc%an.e :oard of India0 today t%e Indian capital mar2et en+oy, a ,tron.> independent> and innovative le.al .uardian (%o i, %elpin. t%e mar2et to evolve to a

/rade .uarantee

9 Stron. 1epo,itory

9 7ood le.al .uardian

25

%ealt%ier place for trade practice,. /%0 C,5*ari+,n ,- Ne; S)+te5 ;it8 E<i+tin' S)+te5 -any people and *ro2er, in India t%in2 t%at t%e ne( ,y,tem of 3uture, < )ption, and *annin. of :adla i, di,advanta.eou, and introduced early> *ut I feel t%at t%i, ne( ,y,tem i, very u,eful e,pecially to retail inve,tor,. It increa,e, t%e no of option, inve,tor, for inve,tment. In fact it ,%ould %ave *een introduced muc% *efore and $SE %ad approved it *ut (a, not active *ecau,e of politiciAation in SE:I. /%e fi.ure 3.3a E3.3d ,%o(, %o( advanta.e, of ne( ,y,tem ;implemented from @une 200010 vN, t%e old ,y,tem i.e. *efore @une 2001 $e( Sy,tem 8, Exi,tin. Sy,tem for -ar2et Player,

,(0ure +.+a

Speculator,
Exi,tin. Approach 8Pr(;e
10 1eliver *a,ed /radin.> mar.in po,,i*le tradin. < carry for(ard tran,action,. 20 :uy Index 3uture, %old till expiry.

SVS/EPer(l 8Pr(;e
10 :ot% profit < lo,, to extent of price c%an.e.

$e( Per(l

Approach

10:uy <Sell ,toc2, 10-aximum on delivery *a,i, lo,, 20 :uy Call <Put *y payin. premium to premium paid

Advanta'e+
7reater &evera.e a, to pay only t%e premium. 7reater variety of ,tri2e price option, at a .iven time.

26

,(0ure +.+<

9r*itra.eur,
Exi,tin. Approach 8Pr(;e SVS/EPer(l 8Pr(;e Approach $e( Per(l

10 :uyin. Stoc2, in 10 -a2e money 10 : 7roup more 10 'i,2 free one and ,ellin. in (%ic%ever (ay promi,in. a, ,till .ame. anot%er exc%an.e. t%e -ar2et move,. in (ee2ly ,ettlement for(ard tran,action,. 20 Ca,% <Carry 20 If 3uture Contract ar*itra.e continue, more or le,, t%an 3air price 3air Price W Ca,% Price P Co,t of Carry.

Figure 3.3c

'ed#ers
()istin# -pproa." 0/ri1e
12 Di%%i.ult to o%%load "oldin# durin# adverse &ar4et .onditions as .ir.uit %ilters li&it to .urtail losses

S*ST(+ /eril 0/ri1e -pproa."

,ew /eril

12 ,o 3evera#e available ris4 reward dependant on &ar4et pri.es

12Fi) pri.e toda$ to bu$ 12 -dditional latter b$ pa$in# pre&iu& .ost is onl$ 22For 3on#5 bu$ -T+ /ut pre&iu& Option 6% &ar4et #oes up5 lon# position bene%it else e)er.ise t"e option

27

32Sell deep OT+ .all option wit" underl$in# s"ares5 earn pre&iu& 7 pro%it wit" in.rease pr.ie

Advanta'e+
9vaila*ility of &evera.e Figure 3.3d

S&all 6nvestors
()istin# -pproa." 0/ri1e
12 6% 8ullis" bu$ sto.4s else sell it

S*ST(+ /eril 0/ri1e

12 /lain 8u$9Sell i&plies unli&ited pro%it9loss

,ew -pproa." /eril

12 Downside re&ains prote.ted 0 upside unli&ited

12 8u$ !all9/ut options based on &ar4et outloo4 22 'ed#e position i% "oldin# underl$in# sto.4

Advanta'e+
&o,,e, Protected.

28

.# E<:8an'e7traded v+# OTC derivative+ 5arket+ /%e )/C derivative, mar2et, %ave (itne,,ed rat%er ,%arp .ro(t% over t%e la,t fe( year,> (%ic% %a, accompanied t%e moderniAation of commercial and inve,tment *an2in. and .lo*ali,ation of financial activitie,. /%e recent development, in information tec%nolo.y %ave contri*uted to a .reat extent to t%e,e development,. =%ile *ot% exc%an.e6traded and )/C derivative contract, offer many *enefit,> t%e former %ave ri.id ,tructure, compared to t%e latter. It %a, *een (idely di,cu,,ed t%at t%e %i.%ly levera.ed in,titution, and t%eir )/C derivative po,ition, (ere t%e main cau,e of tur*ulence in financial mar2et, in 1##". /%e,e epi,ode, of tur*ulence revealed t%e ri,2, po,ed to mar2et ,ta*ility ori.inatin. in feature, of )/C derivative in,trument, and mar2et,. /%e )/C derivative, mar2et, %ave t%e follo(in. feature, compared to exc%an.e6traded derivative,O *. /%e mana.ement of counter6party ;credit0 ri,2 i, decentraliAed and located (it%in individual in,titution,> !. /%ere are no formal centraliAed limit, on individual po,ition,> levera.e> or mar.inin.> +. /%ere are no formal rule, for ri,2 and *urden6,%arin.> 4. /%ere are no formal rule, or mec%ani,m, for en,urin. mar2et ,ta*ility and inte.rity> and for ,afe.uardin. t%e collective intere,t, of mar2et participant,> and =. /%e )/C contract, are .enerally not re.ulated *y a re.ulatory aut%ority and t%e exc%an.eB, ,elf6re.ulatory or.aniAation> alt%ou.% t%ey are affected indirectly *y national le.al ,y,tem,> *an2in. ,upervi,ion and mar2et ,urveillance. Some of t%e feature, of )/C derivative, mar2et, em*ody ri,2, to financial mar2et ,ta*ility.

29

/%e follo(in. feature, of )/C derivative, mar2et, can .ive ri,e to in,ta*ility in in,titution,> mar2et,> and t%e international financial ,y,temO ;i0 t%e dynamic nature of .ro,, credit expo,ure,H ;ii0 information a,ymmetrie,H ;iii0 t%e effect, of )/C derivative activitie, on availa*le a..re.ate creditH ;iv0 t%e %i.% concentration of )/C derivative activitie, in ma+or in,titution,H and ;v0 t%e central role of )/C derivative, mar2et, in t%e .lo*al financial ,y,tem. In,ta*ility ari,e, (%en ,%oc2,> ,uc% a, counter6party credit event, and ,%arp movement, in a,,et price, t%at underlie derivative contract,> occur (%ic% ,i.nificantly alter t%e perception, of current and potential future credit expo,ure,. =%en a,,et price, c%an.e rapidly> t%e ,iAe and confi.uration of counter6party expo,ure, can *ecome un,u,taina*ly lar.e and provo2e a rapid un(indin. of po,ition,. /%ere %a, *een ,ome pro.re,, in addre,,in. t%e,e ri,2, and perception,. 5o(ever> t%e pro.re,, %a, *een limited in implementin. reform, in ri,2 mana.ement> includin. counter6party> liFuidity and operational ri,2,> and )/C derivative, mar2et, continue to po,e a t%reat to international financial ,ta*ility. /%e pro*lem i, more acute a, %eavy reliance on )/C derivative, create, t%e po,,i*ility of ,y,temic financial event,> (%ic% fall out,ide t%e more formal clearin. %ou,e ,tructure,. -oreover> t%o,e (%o provide )/C derivative product,> %ed.e t%eir ri,2, t%rou.% t%e u,e of exc%an.e traded derivative,. In vie( of t%e in%erent ri,2, a,,ociated (it% )/C derivative,> and t%eir dependence on exc%an.e traded derivative,> Indian la( con,ider, t%em ille.al.

30

=#

FACTORS

CONTRIBUTIN6

TO

THE

6RO1TH

OF

DERIVATIVES3 3actor, contri*utin. to t%e explo,ive .ro(t% of derivative, are price volatility> .lo*ali,ation of t%e mar2et,> tec%nolo.ical development, and advance, in t%e financial t%eorie,. DEVELO!MENT OF DERIVATIVES MAR&ET IN INDIA /%e fir,t ,tep to(ard, introduction of derivative, tradin. in India (a, t%e promul.ation of t%e Securitie, &a(, ;9mendment0 )rdinance> 1## > (%ic% (it%dre( t%e pro%i*ition on option, in ,ecuritie,. /%e mar2et for derivative,> %o(ever> did not ta2e off> a, t%ere (a, no re.ulatory frame(or2 to .overn tradin. of derivative,. SE:I ,et up a 24Emem*er committee under t%e C%airman,%ip of 1r.&.C.7upta on $ovem*er 1"> 1##6 to develop appropriate re.ulatory frame(or2 for derivative, tradin. in India. /%e committee ,u*mitted it, report on -arc% 1!> 1##" pre,cri*in. nece,,ary preEcondition, for introduction of derivative, tradin. in India. /%e committee recommended t%at derivative, ,%ould *e declared a, K,ecuritie,B ,o t%at re.ulatory frame(or2 applica*le to tradin. of K,ecuritie,B could al,o .overn tradin. of ,ecuritie,. SE:I al,o ,et up a .roup in @une 1##" under t%e C%airman,%ip of Prof.@.'.8arma> to recommend mea,ure, for ri,2 containment in derivative, mar2et in India. /%e report> (%ic% (a, ,u*mitted in )cto*er 1##"> (or2ed out t%e operational detail, of mar.inin. ,y,tem> met%odolo.y for c%ar.in. initial mar.in,> *ro2er net (ort%> depo,it reFuirement and realEtime monitorin. reFuirement,. /%e Securitie, Contract 'e.ulation 9ct ;SC'90 (a, amended in 1ecem*er 1### to include derivative, (it%in t%e am*it of K,ecuritie,B and t%e re.ulatory frame(or2 (ere developed for .overnin. derivative, tradin.. /%e act al,o made it clear t%at derivative, ,%all *e le.al and valid only if ,uc% contract, are traded on a reco.niAed ,toc2 exc%an.e> t%u, precludin. )/C derivative,. /%e .overnment al,o re,cinded in -arc% 2000> t%e t%ree decade old notification> (%ic%

31

pro%i*ited for(ard tradin. in ,ecuritie,. 1erivative, tradin. commenced in India in @une 2000 after SE:I .ranted t%e final approval to t%i, effect in -ay 2001. SE:I permitted t%e derivative ,e.ment, of t(o ,toc2 exc%an.e,> $SE and :SE> and t%eir clearin. %ou,eNcorporation to commence tradin. and ,ettlement in approved derivative, contract,. /o *e.in (it%> SE:I approved tradin. in index future, contract, *a,ed on S<P C$S $ifty and :SEE30 ;Sen,e0 index. /%i, (a, follo(ed *y approval for tradin. in option, *a,ed on t%e,e t(o indexe, and option, on individual ,ecuritie,. /%e tradin. in :SE Sen,ex option, commenced on @une 4> 2001 and t%e tradin. in option, on individual ,ecuritie, commenced in @uly 2001. 3uture, contract, on individual ,toc2, (ere launc%ed in $ovem*er 2001. /%e derivative, tradin. on $SE commenced (it% S<P C$S $ifty Index future, on @une 12> 2000. /%e tradin. in index option, commenced on @une 4> 2001 and tradin. in option, on individual ,ecuritie, commenced on @uly 2> 2001. Sin.le ,toc2 future, (ere launc%ed on $ovem*er #> 2001. /%e index future, and option, contract on $SE are *a,ed on S<P C$S /radin. and ,ettlement in derivative contract, i, done in accordance (it% t%e rule,> *yela(,> and re.ulation, of t%e re,pective exc%an.e, and t%eir clearin. %ou,eNcorporation duly approved *y SE:I and notified in t%e official .aAette. 3orei.n In,titutional Inve,tor, ;3II,0 are permitted to trade in all Exc%an.e traded derivative product,. /%e follo(in. are ,ome o*,ervation, *a,ed on t%e tradin. ,tati,tic, provided in t%e $SE report on t%e future, and option, ;3<)0O G Sin.le6,toc2 future, continue to account for a ,iAa*le proportion of t%e

3<) ,e.ment. It con,tituted !0 per cent of t%e total turnover durin. @une 2002. 9 primary rea,on attri*uted to t%i, p%enomenon i, t%at trader, are comforta*le (it% ,in.le6,toc2 future, t%an eFuity option,> a, t%e former clo,ely re,em*le, t%e er,t(%ile *adla ,y,tem.

32

)n relative term,> volume, in t%e index option, ,e.ment continue to

remain poor. /%i, may *e due to t%e lo( volatility of t%e ,pot index. /ypically> option, are con,idered more valua*le (%en t%e volatility of t%e underlyin. ;in t%i, ca,e> t%e index0 i, %i.%. 9 related i,,ue i, t%at *ro2er, do not earn %i.% commi,,ion, *y recommendin. index option, to t%eir client,> *ecau,e lo( volatility lead, to %i.%er (aitin. time for round6trip,. G Put volume, in t%e index option, and eFuity option, ,e.ment %ave

increa,ed ,ince @anuary 2002. /%e call6put volume, in index option, %ave decrea,ed from 2."6 in @anuary 2002 to 1.32 in @une. /%e fall in call6put volume, ratio ,u..e,t, t%at t%e trader, are increa,in.ly *ecomin. pe,,imi,tic on t%e mar2et. G 3art%er mont% future, contract, are ,till not actively traded. /radin. in

eFuity option, on mo,t ,toc2, for even t%e next mont% (a, non6exi,tent. G 1aily option price variation, ,u..e,t t%at trader, u,e t%e 3<) ,e.ment

a, a le,, ri,2y alternative ;read ,u*,titute0 to .enerate profit, from t%e ,toc2 price movement,. /%e fact t%at t%e option premium, tail intra6day ,toc2 price, i, evidence to t%i,. If call, and put, are not loo2ed a, +u,t ,u*,titute, for ,pot tradin.> t%e intra6day ,toc2 price variation, ,%ould not %ave a one6to6one impact on t%e option premium,. /%e ,pot forei.n exc%an.e mar2et remain, t%e mo,t important In t%e derivative and option,. %ave

,e.ment *ut t%e derivative ,e.ment %a , al,o .ro(n. turnover *een of derivative, in India follo(ed *y

mar2et forei.n exc%an.e ,(ap, account for t%e lar.e,t ,%are of t%e total for(ard, Si.nificant mile,tone, in t%e development of derivative, mar2et ;i0 permi,,ion

to *an2, to underta2e cro,, currency derivative

tran,action, ,u*+ect to certain condition, ;1##60 ;ii0 allo(in. corporate, to

33

underta2e lon. term forei.n currency ,(ap, t%at contri*uted rupee option, ;20030 and ;iv0 introduction

to t%e

development of t%e term currency ,(ap mar2et ;1##!0 ;iii0 allo(in. dollar of currency future, ;200"0. I (ould li2e to emp%a,i,e t%at currency ,(ap, allo(ed companie, (it% EC:, to ,(ap t%eir forei.n currency lia*ilitie, into rupee,. 5o(ever> ,ince *an2, could not carry open po,ition, t%e ri,2 (a, allo(ed to *e tran,ferred to any ot%er re,ident corporate. $ormally ,uc% ri,2, ,%ould *e ta2en *y corporate, (%o %ave natural %ed.e or %ave potential forei.n exc%an.e earnin.,. vie(, on currencie,. /%i, period %a, al,o (itne,,ed ,everal relaxation, in re.ulation, relatin. to forex mar2et, and al,o .reater li*erali,ation in capital account re.ulation, leadin. to .reater inte.ration (it% t%e .lo*al economy. Ca,% ,ettled exc%an.e traded currency future, %ave made forei.n :ut often corporate a,,ume t%e,e ri,2, due to intere,t rate differential, and

currency a ,eparate a,,et cla,, t%at can *e traded (it%out any underlyin. need or expo,ure a n d on a levera.ed *a,i, on t%e reco.niAed ,toc2 exc%an.e, (it% credit ri,2, *ein. a,,umed *y t%e central counterparty Since t%e commencement of tradin. of currency future, in all t%e t%ree exc%an.e,> t%e value of t%e trade, %a, .one up ,teadily from ', 1!> 42# crore, in )cto*er 200" to ', 4 > "03 crore, in 1ecem*er 200". /%e avera.e daily turnover in all t%e exc%an.e, %a, al,o increa,ed from ',"!1 crore, to ', 2>1"1 crore, durin. t%e ,ame period. /%e turnover in t%e currency future, mar2et i, in line (it% t%e international ,cenario> (%ere I under,tand t%e ,%are of future, mar2et ran.e, *et(een 2 E 3 per cent. Ta94e .#"F,re<MarketA:tivit)

9prilB0 6 -arB06
34

9prilB066 -arB0!

9prilB0!6 -arB0"

9prilB0"6 1ecB0"

".# BENEFITS OF DERIVATIVES 1erivative mar2et, %elp inve,tor, in many different (ay,O *.> %IS? /ANAGE/ENT @ 3uture, and option, contract can *e u,ed for alterin. t%e ri,2 of inve,tin. in ,pot mar2et. 3or in,tance> con,ider an inve,tor (%o o(n, an a,,et. 5e (ill al(ay, *e (orried t%at t%e price may fall *efore %e can ,ell t%e a,,et. 5e can protect %im,elf *y ,ellin. a future, contract> or *y *uyin. a Put option. If t%e ,pot price fall,> t%e ,%ort %ed.er, (ill .ain in t%e future, mar2et> a, you (ill ,ee later. /%i, (ill %elp off,et t%eir lo,,e, in t%e ,pot mar2et. Similarly> if t%e ,pot price fall, *elo( t%e exerci,e price> t%e put option can al(ay, *e exerci,ed. !.> P%ICE 6ISCOAE%9 @ Price di,covery refer, to t%e mar2et, a*ility to determine true eFuili*rium price,. 3uture, price, are *elieved to contain information a*out future ,pot price, and %elp in di,,eminatin. ,uc% information. 9, (e %ave ,een> future, mar2et, provide a lo( co,t tradin. mec%ani,m. /%u, information pertainin. to ,upply and demand ea,ily percolate, into ,uc% mar2et,. 9ccurate price, are e,,ential for en,urin. t%e correct allocation of re,ource, in a free mar2et economy. )ption, mar2et, provide information a*out t%e volatility or ri,2 of t%e underlyin. a,,et. +.> OPE%ATIONA' A6AANTAGES @ 9, oppo,ed to ,pot mar2et,> derivative, mar2et, involve lo(er tran,action co,t,. Secondly> t%ey offer .reater liFuidity. &ar.e ,pot tran,action, can often lead to ,i.nificant price c%an.e,. 5o(ever> future, mar2et, tend to *e more liFuid t%an ,pot mar2et,> *ecau,e %erein you can ta2e lar.e po,ition, *y depo,itin. relatively ,mall mar.in,. Con,eFuently> a lar.e po,ition in derivative, mar2et, i, relatively ea,ier to ta2e and %a, le,, of a price impact a, oppo,ed to a tran,action of t%e ,ame ma.nitude in t%e ,pot mar2et. 3inally> it i, ea,ier to ta2e a ,%ort po,ition in derivative, mar2et, t%an it i, to ,ell ,%ort in ,pot mar2et,.
35

4.>

/A%?ET E,,ICIENC9 @

/%e availa*ility of derivative, ma2e, mar2et, more efficientH ,pot> future, and option, mar2et, are inextrica*ly lin2ed. Since it i, ea,ier and c%eaper to trade in derivative,> it i, po,,i*le to exploit ar*itra.e opportunitie, Fuic2ly and to 2eep price, in ali.nment. 5ence t%e,e mar2et, %elp to en,ure t%at price, reflect true value,.

=.>

EASE O, SPEC4'ATION @

1erivative mar2et, provide ,peculator, (it% a c%eaper alternative to en.a.in. in ,pot tran,action,. 9l,o> t%e amount of capital reFuired to ta2e a compara*le po,ition i, le,, in t%i, ca,e. /%i, i, important *ecau,e facilitation of ,peculation i, critical for en,urin. free and fair mar2et,. Speculator, al(ay, ta2e calculated ri,2,. 9 ,peculator (ill accept a level of ri,2 only if %e i, convinced t%at t%e a,,ociated expected return i, commen,urate (it% t%e ri,2 t%at %e i, ta2in..

/%e derivative mar2et perform, a num*er of economic function,. /%e price, of derivative, conver.e (it% t%e price, of t%e underlyin. at t%e expiration of derivative contract. /%u, derivative, %elp in di,covery of future a, (ell a, current price,. 9n important incidental *enefit t%at flo(, from derivative, tradin. i, t%at it act, a, a cataly,t for ne( entrepreneurial activity. 1erivative, mar2et, %elp increa,e ,avin., and inve,tment in t%e lon. run. /ran,fer of ri,2 ena*le, mar2et participant, to expand t%eir volume of activity.

36

THE CURRENT !ROFILE OF FUTURES TRADIN6 IN INDIA 1ITH RES!ECT TO THE VARIOUS EXCHAN6ES IN INDIA37

37

*B. The Present Status1 Pre,ently future,B tradin. i, permitted in all t%e commoditie,. /radin. i, ta2in. place in a*out !" commoditie, t%rou.% 2 .iven in t%e ta*le *elo(O6 %e0(stere- commo-(ty exchan0es (n In-(a No. *. !. +. 4. =. B. C. &. Exchan0e India Pepper CO//O6IT9 /rade Pepper ;*ot% dome,tic and international contract,0 &td.> 7ur> -u,tard ,eed Exc%an.e,N9,,ociation, a,

<

Spice

9,,ociation> 4oc%i ;IPS/90 8i+ai :eopar C%am*er,

-uAaffarna.ar 'a+d%ani )il, < )il,eed, Exc%an.e 7ur> -u,tard ,eed it, oil < &td.> 1el%i oilca2e :%atinda )m < )il Exc%an.e &td.> 7ur :%atinda /%e C%am*er of Commerce> 5apur /%e -eerut 9.ro 7ur> Potatoe, and -u,tard

,eed Commoditie, 7ur

Exc%an.e &td.> -eerut /%e :om*ay Commodity Exc%an.e )il,eed Complex> Ca,tor &td.> -um*ai 'a+2ot Seed,> )il < oil international contract, :ullion Ca,tor ,eed> 7roundnut> it, oil < ca2e> cotton,eed> it, oil < ca2e> and cotton ':1 ;2apa,0

-erc%ant, 9,,ociation> 'a+2ot

#. *". **. *!. *+.

/%e

9%meda*ad

palmolein. Commodity Ca,tor,eed> cotton,eed> it,

Exc%an.e> 9%meda*ad oil and oilca2e /%e Ea,t India @ute < 5e,,ian 5e,,ian < Sac2in. Exc%an.e &td.> Calcutta /%e Ea,t India Cotton 9,,ociation Cotton &td.> -um*ai /%e Spice, < )il,eed, Exc%an.e /urmeric &td.> San.li. $ational :oard of /rade> Indore Soya ,eed> Soyaoil and

38

*4. *=. *B. *C. *&. *#. !". !*. !!. !+.

Soya meal,> 'ape,eedN-u,tard,eed it, oil and oilca2e and ':1 Palmolien /%e 3ir,t Commoditie, Exc%an.e of CopraNcoconut> it, oil < India &td.> 4oc%i Central India oilca2e Commercial 7ur and -u,tard ,eed

Exc%an.e &td.> 7(alior E6,u.ar India &td.> -um*ai Su.ar $ational -ulti6Commodity Several Commoditie, Exc%an.e of India &td.> 9%meda*ad Coffee 3uture, Exc%an.e India Coffee &td.> :an.alore Surendrana.ar Cotton )il < Cotton> Cotton,eed> 4apa, Su.ar ;tradin. yet to

)il,eed,> Surendrana.ar E6Commoditie, &td.> $e( 1el%i

commence0 $ational Commodity < 1erivative,> Several Commoditie, Exc%an.e &td.> -um*ai -ulti Commodity Exc%an.e &td.> Several Commoditie,

-um*ai :i2aner commodity Exc%an.e &td.> -u,tard ,eed, it, oil < oilca2e> 7ram. 7uar ,eed. :i2aner 7uar 7um !4. 5aryana Commoditie, &td.> 5i,,ar -u,tard ,eed complex !=. :ullion 9,,ociation &td.> @aipur -u,tard ,eed Complex STATUS RE!ORT OF THE DEVELO!MENTS IN THE DERIVATIVE MAR&ET *. /%e :oard at it, meetin. on $ovem*er 2#> 2002 %ad de,ired t%at a Fuarterly report *e ,u*mitted to t%e :oard on t%e development, in t%e derivative mar2et. 9ccordin.ly> t%i, memorandum pre,ent, a ,tatu, report for t%e Fuarter @uly6Septem*er 200"60# on t%e development, in t%e derivative mar2et. !. EFuity 1erivative, Se.ment 9. )*,ervation, on t%e Fuarterly data for @uly6Septem*er> 200"60#
39

1urin. @uly6Septem*er 200"60#> t%e turnover at :SE (a, ',.1> 10 crore> (%ic% (a, in,i.nificant a, compared to t%at of $SE at ',. 3>31 >4#1 crore.

40

"># B(+ine++ 6r,;t8 in Derivative+ +e'5ent /NSE0

Vear 201162012 201062011 200#62010 200"6200# 200!6200" 20066200! 200 62006 20046200 $o. of contract, 4>116>64# 1 6> #"> !# "1>4"!>424 "> 3!>""6 21>63 >44# 1!>1#1>66" 2>126>!63 1>02 > ""

,IG4%E **A Num<er of contracts per year

41

*B""""""" *4""""""" *!""""""" *"""""""" &""""""" B""""""" 4""""""" !""""""" " !"**3!"*! !"*"3!"** !""#3!"*" !""&3!""# !""C3!""& !""B3!""C !""=3!""B !""43!""= year

INTE%P%ETATION1 3rom t%e data and t%e *ar dia.ram a*ove> t%ere i, %i.% *u,ine,, .ro(t% in t%e derivative ,e.ment in India. In t%e year 20046200 > t%e num*er of contract, in Index 3uture (ere 102 "" (%ere a, a ,i.nificant increa,e of 41166!# i, o*,erved in t%e year 201162012.

OAE%A'' T%A6ING Vear 201162012 201062011 200#62010 200"6200# 200!6200" 20066200! 200 62006 20046200 200362004 $o. of contract, 11#>1!1>00" 42 >013>200 216>""3> !3 1 !>61#>2!1 !!>01!>1" 6>""6>!!6 16>!6">#0# 4>1#6>"!3 #0> "0 /urnover ;',. cr.0 2>64">403.30 13>0#0>4!!.! !>3 6>242 4>"24>1!4 2> 46>#"2 2>130>610 43#>"62 101>#26 2>36

A2era0e turno2ers

42

B"""" ="""" 4"""" +"""" !"""" *"""" " year !""+3!""4 !""43!""= !""=3!""B !""B3!""C !""C3!""& !""&3!""# !""#3!"*" !"*"3!"** !"**3!"*!

Interpretat(on1 3rom t%e data and *ar c%art a*ove> t%e overall tradin. contract, in t%e year 200062001 (a, #0 "0 and %u.e increa,e of 11#1!100" in t%e year 200"6200#. 3rom t%e data and *ar c%art a*ove t%e overall tradin. turnover in t%e year 20006 2001 (a, a, lo( a, 236 *ut a predominant increa,e of 264"403.30 o*,erved in t%e year 200"6200#.

FINDIN6S ? CONCLUSION
3rom t%e a*ove analy,i, it can *e concluded t%atO *. 1erivative mar2et i, .ro(in. very fa,t in t%e Indian Economy. /%e turnover of 1erivative -ar2et i, increa,in. year *y year in t%e IndiaB, lar.e,t ,toc2 exc%an.e $SE. In t%e ca,e of index future t%ere i, a p%enomenal increa,e in t%e num*er of contract,. :ut (%erea, t%e turnover i, declined con,idera*ly. In t%e ca,e of ,toc2 future t%ere (a, a ,lo( increa,e o*,erved in t%e num*er of contract, (%erea, a decline (a, al,o o*,erved in it, turnover. In t%e ca,e of index option t%ere (a, a %u.e increa,e o*,erved *ot% in t%e num*er of contract, and turnover. !. 9fter analyAin. data it i, clear t%at t%e main factor, t%at are drivin. t%e .ro(t% of 1erivative -ar2et are -ar2et improvement in communication

43

facilitie, a, (ell a, lon. term ,avin. < inve,tment i, al,o po,,i*le t%rou.% enterin. into 1erivative Contract. So t%e,e factor, encoura.e t%e 1erivative -ar2et in India. +. It encoura.e, entrepreneur,%ip in India. It encoura.e, t%e inve,tor to ta2e more ri,2 < earn more return. So in t%i, (ay it %elp, t%e Indian Economy *y developin. entrepreneur,%ip. 1erivative -ar2et i, more re.ulated < ,tandardiAed ,o in t%i, (ay it provide, a more controlled environment. In nut,%ell> (e can ,ay t%at t%e rule of 5i.% ri,2 < 5i.% return apply in 1erivative,. If (e are a*le to ta2e more ri,2 t%en (e can earn more profit under 1erivative,. Commodity derivative, %ave a crucial role to play in t%e price ri,2 mana.ement proce,, for t%e commoditie, in (%ic% it deal,. 9nd it can *e extremely *eneficial in a.riculture6dominated economy> li2e India> a, t%e commodity mar2et al,o involve, a.ricultural produce. 1erivative, li2e for(ard,> future,> option,> ,(ap, etc are exten,ively u,ed in t%e country. 5o(ever> t%e commodity derivative, %ave *een utiliAed in a very limited ,cale. )nly for(ard, and future, tradin. are permitted in certain commodity item,. 'E&I9$CE i, t%e mo,t active future contract, on individual ,ecuritie, traded (it% #00#0 contract, and '$'& i, t%e next mo,t active future, contract, (it% 63 22 contract, *ein. traded.

RECOMMENDATIONS ? SU66ESTIONS
':I ,%ould play a .reater role in ,upportin. derivative,. 1erivative, mar2et ,%ould *e developed in order to 2eep it at par (it% ot%er derivative mar2et, in t%e (orld. Speculation ,%ould *e di,coura.ed. /%ere mu,t *e more derivative in,trument, aimed at individual inve,tor,.

44

SE:I ,%ould conduct ,eminar, re.ardin. t%e u,e of derivative, to educate individual inve,tor,.

9fter ,tudy it i, clear t%at 1erivative influence our Indian Economy up to muc% extent. So> SE:I ,%ould ta2e nece,,ary ,tep, for improvement in 1erivative -ar2et ,o t%at more inve,tor, can inve,t in 1erivative mar2et. /%ere i, a need of more innovation in 1erivative -ar2et *ecau,e in today ,cenario even educated people al,o fear for inve,tin. in 1erivative -ar2et :ecau,e of %i.% ri,2 involved in 1erivative,.

45

BIBLIO6RA!HY
:ooks referre-1 )ption, 3uture,> and ot%er 1erivative, *y @o%n C 5ull 1erivative, 39U *y 9+ay S%a% $SEB, Certification in 3inancial -ar2et,O 6 1erivative, Core module 3inancial -ar2et, < Service, *y 7ordon < $atara+an

%eports1 'eport of t%e ':I6SE:I ,tandard tec%nical committee on exc%an.e traded Currency 3uture, 'e.ulatory 3rame(or2 for 3inancial 1erivative, in India *y 1r.&.C.7?P/9 5e<s(tes 2(s(te-1 (((.n,e6india.com (((.*,eindia.com (((.,e*i..ov.in (((.ncdex.com (((..oo.le.com (((.derivative,india.com

46

47