SEMESTER-LLM (I) SUBJECT-GLOBALISATION OF COMPANIES TOPIC-SECURITIES AND DERIVATIVES MARKET OF INDIA ANALYSIS OF INVESTMENT THEIR PROS AND CONS FACULTY-Dr. VIKASH GUPTA NAME-GARIMA MOHAN PRASAD ENROLLMENT NO-A3268621056 pg. 1 Aim of the Project • • • To study financial derivative market in India. To study how the market has developed in last 20 years. To draw conclusion what are the advantages and disadvantages of investing in financial derivative market. Research Questions • • • To see how financial derivative market of India has evolved in India? To draw conclusion for the pros and cons of investment in financial derivatives? To analyze how people invest in financial derivative market? Research Methodology This term paper is based on doctrinal Research, the author has collected information from books, articles and internet source the different books used to collect information are 1.Sushmita Bose(2006) title-“ The Indian derivative market revisited”. 2. Ashitosh vashishta and satish kumar (2010) title- development of financial derivative market in India- a case study” 3.Caroline priyanka koorse and Dr. S.Kavitha (2015) title- “ A analysis of financial derivatives and its growth rate in India” 4. S.Satya ,title “ a comparative study on equity commodity, currency derivatives in India – evidence from future market with special reference to BSE ltd.” pg. 2 Contents • Introduction …………………………………. Pg 4 • History of Derivatives……………………………… Pg 7 • Regulations of Derivative trade in India……………. Pg 9 • Pros and Cons of Derivative Market……………… Pg 11 • Conclusion……………………….. pg. 3 Pg 16 INTRODUCTION Meaning Derivative Market- They are financial contracts whose money is derived from underlying financial assets1. A derivative can be set between two or more parties that can trade between two types of markets one is exchange traded derivative market and the other one is over the counter derivative market these can be used to trade any number of assets and carry their own risks we can determine the price of underlying assets by fluctuations. These contracts can be used to trade any number of assets and carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset. These financial securities are commonly used to access certain markets and may be traded to hedge against risk. We can say say derivative is what is derived from another i.e. the word electric is derived from electricity. We can better understand this with the help of using example. Example I- We can better understand derivate with the help of example A farmer agreed to sell 10 quintals of wheat for Rs2000, if the price of wheat drops to Rs1970 due to market supply the farmers will still get Rs 2000 on the amount agreed for wheat. Example II- If suppose price of wheat increases to 2020 the farmer will still get 2000 as on the amount agreed here the farmer will suffer the loss. Definition of Financial derivative2 Section (2ac) of SCRA defines derivatives as: a) “a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security; 1 2 Definition taken from Investopedia.com Definition derived from Security Control Regulation Act. pg. 4 b) “a contract which derives its value from the prices, or index of prices, of underlying securities”. UNDERLYING ASSETS The underlying assets can be in many forms they are i. Commodities includes grains, coffee beans, orange juice etc. ii. Precious metals like gold and silver iii. Foreign Exchange rate such as currencies iv. Bonds of different types including medium to long negotiable debt securities v. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index vi. Short term securities such as T-bills; and vii. Over the counter (OTC) money market such as loan or deposits. Participants in derivative markets 1.Hedgers-In this they use derivative market to reduce or eliminate the risk associated with price of an assets. Majority of the participants in derivative markets belongs to this category. 2.Speculators-They transact future and options contracts to get extra leverage in betting on future movements in the price of an assets this can increase both the potential gains and potential losses by usage of a derivative in a speculative venture. 3.Arbitrageurs-Here the behavior is guided by the desire to take advantage of a discrepancy between price of more or less the same assets or competing assets in different markets for example they see the future price of an asset getting out of line with cash price they will take pg. 5 off setting positions in two markets to lock in a profit. They help to assist proper price discovery and correct price abnormalities. Applications of Financial derivatives 1.Management of Risk-The most important function of derivative market is risk management which is not only for elimination of risk rather it is about management of risk. Financial derivative provides a powerful tool for limiting risks that individual and organizations face in their ordinary conduct of business. It requires a thorough understanding of the basic principle that helps to regulate financial derivative. Effective use of derivatives helps to save cost and increase return for organizations. 2. Constructiveness in Trading- Financial derivatives allow free trading of risk components and that leads to improve market efficiency this efficiency is because of greater amount of liquidity in the market offered by derivatives as well as the lower transaction cost associated with trading a financial derivative as compared to the cost of trading the underlying instrument in the cash market. 3.Speculations- Financial derivatives if not used properly can be risky which can lead to financial destructions in an organization like what happened in barring plc. However derivative instrument act as powerful instrument for knowledgeable traders to expose themselves to calculate and well understood risk in search e.g. rewards that is profit. 4.Price Discovery- another important application of derivatives is the price discovery which means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking. 5. Price stabilization function- Derivative market helps to keep a stabilising influence on spot prices by lowering the short-term fluctuations. In other words, derivative reduces both peak and depths and leads to price stabilisation effect in the cash market for underlying asset. pg. 6 HISTORY OF DERIVATIVE MARKET OF INDIA Derivative word has originally been taken from mathematicians and refers to that variable which has been taken from another variable for example a KM could be derived from a measure of distance in mile by diving it by 1.61 Similarly measure in temperature could be derived from Fahrenheit scale. Derivative trading is being exited in India from long time back. In 1875 Bombay cotton exchange started traded in India whereas in 1995 came the securities law ordinance act which was withdrawn in 2001 and finally in May 2001, SEBI permitted derivatives in two stock exchange that are Bombay Stock Exchange and National Stock Exchange. Since then the equity derivative in India has seen a huge growth. Firstly, India saw trading in Bombay Sense options which has been started from June 4, 2001 and the trading in options on individual securities from July 2001.The future contacts were launched in November 2001, the derivative trading on National Stock Exchange commenced with S&P CNX Nifty Index futures on June 12,2000. The trading in index options commenced on June 4,2001 and individual securities were launched on November 9,2001. In June 2001 trading commenced in the BSE Sensex options, trading of options in individual securities started in July 2001 and futures contracts on individual stocks was commenced in the same year November.NSE was a head compared to BSE as its derivative trading opened up with S&P CNX Nifty Futures Index in June 2000, the trading in Index Futures and Options contracts on NSE are based on S&P CNX. Trading in index options was started in June 2001 and trading on individual securities commenced in July 2001. While, single stock futures were started in Nov 2001. The table below shows an illustration of how the market of derivative developed in India. pg. 7 Regulations of Derivative trading in India The framework is based on L.C Gupta Committee Report and the J.R Verma Committee Report it is concern with ISCO principles and the common concerns of investor protection, market efficiency and integrity of financial security, the L.C Gupta Committee Report provides a prospective on division of regulatory reasonable framework between exchange and SEBI. The committee recommended supervisory and advisory role of SEBI with a view of permitting desirable, flexibility, regulatory, effective and minimizing the regulatory cost The J.R. Varma committee suggests a methodology for risk containment measures for indexpg. 8 based futures and options, stock options and single stock futures. The risk containment measures include calculation of margins, position limits, exposure limits and reporting and disclosure. Current Scenario of Derivative Market in India The over-the-counter derivatives market costs to approximately $800 trillion and the size of the market traded on exchanges totaled an additional $83 trillion. For the fourth quarter 2017 the European securities market authority estimated the size of European derivatives market at a size of euro 700trillion with 74 million outstanding contracts. However these are national values and some economists say that this value greatly exaggerates the market value and the true credit risk faced by the parties involved, for instance in 2010 while the total of OTC derivatives exceeded $630 trillion, value of the market was estimated much lower at $23 trillion the credit risk equivalent of the derivative contracts was estimated at $22 trillion. The credit risk estimated at $3.4 trillion. Still, even these scaled down figures represent huge amount of money. For perspective, the budget for total expenditure of united states government during 2012 was$3.5 trillion, and the total current value of the U.S. stock market is an estimated $23 trillion the world annual gross domestic product is about $65 trillion. And for any type of derivative at least, credit default swaps(CDS), for which the inherent, nominal value, remains relevant. It was this type of derivative that investment magnate warren buffet referred to in his famous 2002 speech in which he warned against “financial weapons of mass destruction” CDS notion value in early 2012 amounted to $25.5 trillion, down from$55 trillion in 2010. How the derivative market works The derivative markets in two ways one is exchange traded derivative market and the other one is over the counter derivative market Exchange traded derivative pg. 9 Over the counter derivative market • market ETDs are derivative instruments that • The OTC derivative market is the are traded in a derivatives exchange. largest market for derivatives. Here, This exchange acts as an intermediary the derivatives are traded privately in all related transactions. As a without an exchange. Products such guarantee, is as swaps, exotic options, and forward submitted by both the buyer and the rate agreements are traded between seller of the contract. highly sophisticated financial entities an initial margin such as hedge funds and banks in private. PROS AND CONS OF DERIVATIVE MARKET3 Advantages of derivative Market a. Hedging risk exposure-Value of derivative is linked with value of underlying assets, so the contacts are primarily used for hedging risks for example an investor can buy a derivative contact whose value moves in opposite direction to the value of assets of the investor owns. In this way profit in the derivative contract may offsets loses its value in the underlying assets. Investor will purchase those derivative contracts whose value moves opposite to the value of security the investor owns. Therefore, losses in underlying commodities may be offset by profit in contracts of derivatives. 3 https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/derivatives/ pg. 10 b. Underlying assets price determination-Derivatives are used to recognize / determine the price of underlying assets. For example, the spot prices of the future can serve as an approximation of a commodity price. c. Market Efficiency- It is considered that derivatives increase the efficacy of financial markets by using derivative contacts one can replicate the pay off assets, therefore the prices of underlying assets is associated derivative tend to be in equilibrium to avoid arbitrage opportunities. d. Access to unavailable assets or markets-Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favourable interest rate relative to interest rates available from direct borrowing. e. Low transaction Cost-They require low trading cost which is beneficial for the investors this acts as a risk management tool and a protection against price fluctuations. Cost of trading in derivatives is lower as compared to other securities like shares or debentures. f. Leverage Returns- Here investors become capable of making extreme returns that cannot be possible with primary investment like stocks and bonds, unlike stocks when investors invest in the derivative market, it does not take much time but just double the money. g. Nonbinding contacts-When an investor invest in the derivative contract in the open market, it is considered that he is purchasing right to perform its option therefore there is an advantage of investment in non-binding contracts. pg. 11 Disadvantages of derivative market a. High Risk- The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of contracts makes the valuation extremely complicated or even impossible thus they bar an inherent risk. b. Speculative feature-Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behaviour, unreasonable speculation may lead to huge losses. c. Counter-party risk -Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-thecounter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default. Types of Derivative Markets Future- The first and the foremost is the standardized type of contracts enter into by parties for buying and selling of underlying securities at an agreed price for some future date these are traded over an exchange via intermediary and are completely regulated. Future contracts cannot be customized as per the party needs and carry lower counterparty risk. The value of these contracts is decided as per the market movement on a daily basis till the expiration date, further future contact may be specified as follows (i) These are traded on an organised exchange like IMM, LIFFE, NSE, BSE, CBOT etc. (ii) These involve standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc. (iii) These are associated with a clearing house to ensure smooth functioning of the market. (iv) pg. 12 There are margin requirements and daily settlement to act as further safeguard. (v) These provide for supervision and monitoring of contract by a regulatory authority. (vi) Almost ninety percent future contracts are settled via cash settlement instead of actual delivery of underlying asset Futures contracts being traded on organized exchanges impart liquidity to the transaction. The clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honouring of the contract and ensuring very low level of default (Hirani, 2007) Following are the important types of financial futures contract:(i) Stock Future or equity futures, (ii) Stock Index futures, (iii) Currency futures, and (iv) Interest Rate bearing securities like Bonds, T- Bill Futures. To give an example of a futures contract, suppose on November 2007 Ramesh holds 1000 shares of ABC Ltd. Current (spot) price of ABC Ltd shares is Rs 115 at National Stock Exchange (NSE). Ramesh entertains the fear that the share price of ABC Ltd may fall in next two months resulting in a substantial loss to him. Ramesh decides to enter into futures market to protect his position at Rs 115 per share for delivery in January 2008. Each contract in futures market is of 100 Shares. This is an example of equity future in which Ramesh takes short position on ABC Ltd. Shares by selling 1000 shares at Rs 115 and locks into future price. Forwards-In forward type of contract there is an agreement between 2 parties for buying and selling an underlying asset at a specified price at some future date, we can say it is a nonstandardised type of contract which is traded over the counter these contracts can be called as flexible and customised according to the needs of buyers and sellers. These contacts involves large amount of counter party risk as these are unregulated contacts without the involvement of any intermediary. Forward contract is a cash market transaction in which delivery of the instrument is deferred until the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. One of the parties to a forward pg. 13 contract assumes a long position (buyer) and agrees to buy the underlying asset at a certain future date for a certain price. The other party to the contract known as seller assumes a short position and agrees to sell the asset on the same date for the same price. The specified price is referred to as the delivery price. The contract terms like delivery price and quantity are mutually agreed upon by the parties to the contract. Forward contract is a cash market transaction in which delivery of the instrument is deferred until the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. One of the parties to a forward contract assumes a long position (buyer) and agrees to buy the underlying asset at a certain future date for a certain price. The other party to the contract known as seller assumes a short position and agrees to sell the asset on the same date for the same price. The specified price is referred to as the delivery price. The contract terms like delivery price and quantity are mutually agreed upon by the parties to the contract. Options-Options are derivative contracts that provide the buyer a right but not an commitment to buy or sell an underlying asset. The buyer of an option contract pays a premium to the seller for buying such right, whereas the seller is under an obligation to discharge his duty in return for the premium he received. Options are of 2 types: – Call option and Put option. Call option provides the buyer a right but not an obligation to buy an asset at the pre-decided price at some future date. On the other hand, the put option provides the buyer a right but is not under any obligation to sell an asset at some future date at the agreed price. Suppose an investor buys One European call options on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. Apparently, if the market price of Infosys on the day of expiry is more than Rs. 3500, the options will be exercised. In contrast, a put options gives the holder (buyer/ one who is long put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put options (one who is short put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Right to sell is called a Put Options. Suppose X has 100 shares of Bajaj Auto Limited. Current price (March) of Bajaj auto shares is Rs 700 per share. X needs money to finance its requirements after two months which he will realize after selling 100 shares after two months. But he is of the fear that by next two months price of share will decline. He decides to enter into option market by buying Put Option (Right to Sell) with an expiration date in May at a strike price of Rs 685 per share and a premium of Rs 15 per shares. pg. 14 Swaps-Swaps are the most complicated type of derivative contracts which are entered into for exchanging cash flows in the future between 2 parties. These are the private agreements which are done over the counter. Interest rate swaps and currency swaps are the two most common types of swap contracts. These contracts carry a high amount of risk as the interest rate and currency are underlying assets in these contracts which are highly volatile. Swaps can also be called barter or exchange. It is a contract whereby parties agree to exchange obligations that each of them have under their respective underlying contracts or we can say, a swap is an agreement between two or more parties to exchange stream of cash flows over a period of time in the future. The parties that agree to the swap are known as counter parties. The two commonly used swaps are: i) Interest rate swaps which entail swapping only the interest related cash flows between the parties in the same currency, and ii) Currency swaps: This entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than the cash flows in the opposite direction. pg. 15 CONCLUSION Financial derivatives have earned a well-deserved extremely significant place among all the financial instruments (products), due to innovation and revolutionized the landscape. Derivatives are tool for managing risk. Derivatives provide an opportunity to transfer risk from one to another. Launch of equity derivatives in Indian market has been extremely encouraging and successful. The growth of derivatives in the recent years has surpassed the growth of its counterpart globally. India is one of the most successful developing country in terms of a vibrate market for exchange-traded derivatives. The equity derivatives market is playing a major role in shaping price discovery. Volatility in financial asset price, integration of financial market internationally, sophisticated risk management tools, innovations in financial engineering and choices at risk management strategies have been driving the growth of financial derivatives worldwide, also in India. Finally, we can say there is big significance and contribution of derivatives to financial system. What makes a successful trading market is transparency and liquidity .Liquid market requires market makers who are literally willing to buy and sell and while trading the most important factor in a human being is that the person should be patient, the next factor for a successful market is regulatory reform which will help the market to grow faster For example, Indian commodity derivatives have great growth potential but government policies have resulted in the underlying spot/physical market being fragmented (e.g. due to lack of free movement of commodities and differential taxation within India). Similarly, credit derivatives, the fastest growing segment of the market globally, are absent in India and require regulatory action if they are to develop As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programmed to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading. As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programmes to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading. pg. 16 REFERENCES/BIBLIOGRAPHY • Investopedia.com • https://www.indiainfoline.com/derivative-market-guide/what-are-derivatives • https://www.5paisa.com/blog/different-types-of-derivative-contracts • https://casi.sas.upenn.edu/sites/default/files/iit/Derivatives%20-%20Vashishtha.pdf pg. 17