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
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•
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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
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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
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Introduction ………………………………….
Pg 4
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History of Derivatives………………………………
Pg 7
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Regulations of Derivative trade in India…………….
Pg 9
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Pros and Cons of Derivative Market………………
Pg 11
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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
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Investopedia.com
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https://www.indiainfoline.com/derivative-market-guide/what-are-derivatives
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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