1
DERIVATIVES IN INDIA
PROJECT REPORT ON
DERIVATIVES IN INDIA
SUBMITTED BY
SACHIN YADAV
THIRD YEAR B.COM. [FINANCIAL MARKETS]
SEMESTER – Vth
ACADEMIC YEAR: 2010-2011
PROJECT CO-ORDINATOR
PROF. VIKRAM TRIVEDI
ST.GONSALO GARCIA COLLEGE VASAI (W)
THANE-401201
SUBMITTED TO
THE UNIVERSITY OF MUMBAI
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ACKNOWLEDGMENT.
It is indeed a matter of great pleasure and pride to be able to present this project on
“DERIVATIVES IN INDIA”
Throughout the writing of this project the influence of my Prof. Vikram Trivedi has
been a guiding light. I have been greatly benefited by her guidance, profound knowledge and her
continued interest in my work. I shall ever remain indebted & grateful to her, for her deep sense
of personal attachment & the ever increasing encouragement which she has given to me.
This is special pleasure in acknowledging her under whom I have initiated my work.
Her intense accuracy in respect of the subject had provided the impetus for the commencement
of the study.
My professors and friends have inevitable played a crucial role in helping me while
preparing the project. I do not have words to thanks them enough. I can only extend my sense of
deep hearted affection to all of them.
I am highly obliged to acknowledge
principal “Fr. Solomon Rodrigues” for giving
me an opportunity to conduct a detail study & analysis of my desirable topic relevant to my full
of interest.
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DECLARATION.
I Mr. SACHIN YADAV of Third Year B. Com. [ Financial Markets]
ST. GONSALO GARCIA COLLEGE hereby declare that I have completed this project on
“DERIVATIVES IN INDIA” in the Academic Year 2010-2011. The information submitted is
true and correct to the best of my knowledge.
Signature of Student
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ST. GONSALO GARCIA COLLEGE OF ARTS AND
COMMERCE
VASAI [W] 401201
CERTIFICATE.
I, hereby certify that Mr. SACHIN YADAV student of St. Gonsalo Garcia college of Arts
& commerce, Vasai (w), Third Year Bcom [Financial Markets] Vth Semester, has completed her
project on “DERIVATIVES IN INDIA”, During the Academic Year 2010-2011. The
information submitted is true and correct to the best of our knowledge.
Signature of Principal
[Fr. (Dr.) Solomon Rodrigues]
Signature of coordinator
[ Prof. Jose George]
Signature of Project Guide
[ Prof. Vikram Trevedi]
Signature of External Examiner
Date:
Place
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INDEX
Sr. no.
Particulars
Page no.
EXECUTIVE SUMMARY
6
Objectives Of The Study
7
1
CHAPTER 1
8-18
1.1
Introduction
9
1.2
Definition of Derivatives
11
1.3
History of Derivatives
12
1.4
Derivatives in India
15
2
CHAPTER 2
19-33
2.1
Development of Derivatives Market in India
20
2.2
23
2.3
Factors Contributing to the growth of
Derivatives
Types of Derivatives
2.4
Futures VS. Forward Markets
32
3
CHAPTER 3
34-45
3.1
Participants in Derivatives market
35
3.2
Role of Derivatives
40
3.3
How Banks use Derivatives
43
Conclusion
46
Bibliography
47
27
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EXECUTIVE SUMMARY
In the following project, you are going to have chance to review and understand
virtually every aspect of DERIVATIVES IN INDIA and its important role and functions. It also
provides you with various departments which help DERIVATIVES IN INDIA to provide better
service, departments such as Research department, Risk Management Department, Accounts
Department.
This project also highlights various important concepts of finance sector of India. This
project explains the why DERIVATIVES IN INDIA was formed and the development that has
taken place in market due to DERIVATIVES MARKET its role and objectives. It will give you
knowledge about the requirement of market sector of India. Each concept in this project has been
briefly explained and in an understandable and easier way and has been put in simplistic way.
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OBJECTIVES OF THE STUDY
1. To know what is Derivatives Trading In India.
2. To study Derivatives Market as Financial Intermediary.
3. To study recent trends in Derivatives Market
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CHAPTER 1
1.1
INTRODUCTION TO DERIVATIVES
1.2
DEFINITION OF DERIVATIVES
1.3
HISTORY OF DERIVATIVES
1.4
DERIVATIVES IN INDIA
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CHAPTER 1
1.1 INTRODUCTION :
Derivatives are one of the most complex instruments. The word derivative
comes from the word ‘to derive’. It indicates that it has no independent value. A derivative is
a contract whose value is derived from the value of another asset, known as the underlying
asset, which could be a share, a stock market index, an interest rate, a commodity, or a
currency. The underlying is the identification tag for a derivative contract. When the price of
the underlying changes, the value of the derivative also changes. Without an underlying
asset, derivatives do not have any meaning. For example, the value of a gold futures contract
derives from the value of the underlying asset i.e., gold. The prices in the derivatives market
are driven by the spot or cash market price of the underlying asset, which is gold in this
example.
Derivatives are very similar to insurance. Insurance protects against specific
risks, such as fire, floods, theft and so on. Derivatives on the other hand, take care of market
risks - volatility in interest rates, currency rates, commodity prices, and share prices.
Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the
world of finance. They offer a range of mechanisms to improve redistribution of risk, which
can be extended to every product existing, from coffee to cotton and live cattle to debt
instruments.
In this era of globalisation, the world is a riskier place and exposure to risk is
growing. Risk cannot be avoided or ignored. Man, however is risk averse. The risk averse
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characteristic of human beings has brought about growth in derivatives. Derivatives help the
risk averse individuals by offering a mechanism for hedging risks.
Derivative products, several centuries ago, emerged as hedging devices
against fluctuations in commodity prices. Commodity futures and options have had a lively
existence for several centuries. Financial derivatives came into the limelight in the post-1970
period; today they account for 75 percent of the financial market activity in Europe, North
America, and East Asia. The basic difference between commodity and financial derivatives
lies in the nature of the underlying instrument. In commodity derivatives, the underlying
asset is a commodity; it may be wheat, cotton, pepper, turmeric, corn, orange, oats, Soya
beans, rice, crude oil, natural gas, gold, silver, and so on. In financial derivatives, the
underlying includes treasuries, bonds, stocks, stock index, foreign exchange, and Euro dollar
deposits. The market for financial derivatives has grown tremendously both in terms of
variety of instruments and turnover.
Presently, most major institutional borrowers and investors use derivatives.
Similarly, many act as intermediaries dealing in derivative transactions. Derivatives are
responsible for not only increasing the range of financial products available but also fostering
more precise ways of understanding, quantifying and managing financial risk.
Derivatives contracts are used to counter the price risks involved in assets and
liabilities. Derivatives do not eliminate risks. They divert risks from investors who are risk
averse to those who are risk neutral. The use of derivatives instruments is the part of the
growing trend among financial intermediaries like banks to substitute off-balance sheet
activity for traditional lines of business. The exposure to derivatives by banks have
implications not only from the point of capital adequacy, but also from the point of view of
establishing trading norms, business rules and settlement process. Trading in derivatives
differ from that in equities as most of the derivatives are market to the market.
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1.2 DEFINITION OF DERIVATIVES :
Derivative is a product whose value is derived from the value of one or more
basic variables, called bases (underlying asset, index, or reference rate), in a contractual
manner. The underlying asset can be equity, forex, commodity or any other asset.
According to Securities Contracts (Regulation) Act, 1956 {SC(R)A},
derivatives is
 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.
 A contract which derives its value from the prices, or index of prices, of underlying
securities.
Derivatives are securities under the Securities Contract (Regulation) Act and
hence the trading of derivatives is governed by the regulatory framework under the Securities
Contract (Regulation) Act.
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1.3 HISTORY OF DERIVATIVES :
The history of derivatives is quite colourful and surprisingly a lot longer than
most people think. Forward delivery contracts, stating what is to be delivered for a fixed
price at a specified place on a specified date, existed in ancient Greece and Rome. Roman
emperors entered forward contracts to provide the masses with their supply of Egyptian
grain. These contracts were also undertaken between farmers and merchants to eliminate risk
arising out of uncertain future prices of grains. Thus, forward contracts have existed for
centuries for hedging price risk.
The first organized commodity exchange came into existence in the early
1700’s in Japan. The first formal commodities exchange, the Chicago Board of Trade
(CBOT), was formed in 1848 in the US to deal with the problem of ‘credit risk’ and to
provide centralised location to negotiate forward contracts. From ‘forward’ trading in
commodities emerged the commodity ‘futures’. The first type of futures contract was called
‘to arrive at’. Trading in futures began on the CBOT in the 1860’s. In 1865, CBOT listed the
first ‘exchange traded’ derivatives contract, known as the futures contracts. Futures trading
grew out of the need for hedging the price risk involved in many commercial operations. The
Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it
did exist before in 1874 under the names of ‘Chicago Produce Exchange’ (CPE) and
‘Chicago Egg and Butter Board’ (CEBB). The first financial futures to emerge were the
currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972,
on International Monetary Market (IMM), a division of CME. The currency futures
traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss
Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were
followed soon by interest rate futures. Interest rate futures contracts were traded for the first
time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982.
The first stock index futures contracts were traded on Kansas City Board of Trade on
February 24, 1982.
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The first of the several networks, which offered a trading link between two
exchanges, was formed between the Singapore International Monetary Exchange
(SIMEX) and the CME on September 7, 1984.
Options are as old as futures. Their history also dates back to ancient Greece
and Rome. Options are very popular with speculators in the tulip craze of seventeenth
century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to
a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb
options. There was so much speculation that people even mortgaged their homes and
businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there
was no mechanism to guarantee the performance of the option terms.
The first call and put options were invented by an American financier, Russell
Sage, in 1872. These options were traded over the counter. Agricultural commodities options
were traded in the nineteenth century in England and the US. Options on shares were
available in the US on the over the counter (OTC) market only until 1973 without much
knowledge of valuation. A group of firms known as Put and Call brokers and Dealer’s
Association was set up in early 1900’s to provide a mechanism for bringing buyers and
sellers together.
On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up
at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton,
and Scholes invented the famous Black-Scholes Option Formula. This model helped in
assessing the fair price of an option which led to an increased interest in trading of options.
With the options markets becoming increasingly popular, the American Stock Exchange
(AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975.
The market for futures and options grew at a rapid pace in the eighties and
nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of
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floating rates for currencies in the international financial markets paved the way for
development of a number of financial derivatives which served as effective risk management
tools to cope with market uncertainties.
The CBOT and the CME are two largest financial exchanges in the world on
which futures contracts are traded. The CBOT now offers 48 futures and option contracts
(with the annual volume at more than 211 million in 2001).The CBOE is the largest
exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P
500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading
foreign options.
The most traded stock indices include S&P 500, the Dow Jones Industrial
Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade
almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.
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1.4 DERIVATIVES IN INDIA :
India has started the innovations in financial markets very late. Some of the
recent developments initiated by the regulatory authorities are very important in this respect.
Futures trading have been permitted in certain commodity exchanges. Mumbai Stock
Exchange has started futures trading in cottonseed and cotton under the BOOE and under the
East India Cotton Association. Necessary infrastructure has been created by the National
Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index
futures and the commencement of operations in selected scripts. Liberalised exchange rate
management system has been introduced in the year 1992 for regulating the flow of foreign
exchange. A committee headed by S.S.Tarapore was constituted to go into the merits of full
convertibility on capital accounts. RBI has initiated measures for freeing the interest rate
structure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of
London Inter Bank Offer Rate (LIBOR) as a step towards introducing Futures trading in
Interest Rates and Forex. Badla transactions have been banned in all 23 stock exchanges
from July 2001. NSE has started trading in index options based on the NIFTY and certain
Stocks.
A.} EQUITY DERIVATIVES IN INDIA –
In the decade of 1990’s revolutionary changes took place in the institutional
infrastructure in India’s equity market. It has led to wholly new ideas in market design that
has come to dominate the market. These new institutional arrangements, coupled with the
widespread knowledge and orientation towards equity investment and speculation, have
combined to provide an environment where the equity spot market is now India’s most
sophisticated financial market. One aspect of the sophistication of the equity market is seen
in the levels of market liquidity that are now visible. The market impact cost of doing
program trades of Rs.5 million at the NIFTY index is around 0.2%. This state of liquidity on
the equity spot market does well for the market efficiency, which will be observed if the
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index futures market when trading commences. India’s equity spot market is dominated by a
new practice called ‘Futures – Style settlement’ or account period settlement. In its present
scene, trades on the largest stock exchange (NSE) are netted from Wednesday morning till
Tuesday evening, and only the net open position as of Tuesday evening is settled. The future
style settlement has proved to be an ideal launching pad for the skills that are required for
futures trading.
Stock trading is widely prevalent in India, hence it seems easy to think that
derivatives based on individual securities could be very important. The index is the counter
piece of portfolio analysis in modern financial economies. Index fluctuations affect all
portfolios. The index is much harder to manipulate. This is particularly important given the
weaknesses of Law Enforcement in India, which have made numerous manipulative episodes
possible. The market capitalisation of the NSE-50 index is Rs.2.6 trillion. This is six times
larger than the market capitalisation of the largest stock and 500 times larger than stocks such
as Sterlite, BPL and Videocon. If market manipulation is used to artificially obtain 10%
move in the price of a stock with a 10% weight in the NIFTY, this yields a 1% in the NIFTY.
Cash settlements, which is universally used with index derivatives, also helps in terms of
reducing the vulnerability to market manipulation, in so far as the ‘short-squeeze’ is not a
problem. Thus, index derivatives are inherently less vulnerable to market manipulation.
A good index is a sound trade of between diversification and liquidity. In
India the traditional index- the BSE – sensitive index was created by a committee of
stockbrokers in 1986. It predates a modern understanding of issues in index construction and
recognition of the pivotal role of the market index in modern finance. The flows of this index
and the importance of the market index in modern finance, motivated the development of the
NSE-50 index in late 1995. Many mutual funds have now adopted the NIFTY as the
benchmark for their performance evaluation efforts. If the stock derivatives have to come
about, the should restricted to the most liquid stocks. Membership in the NSE-50 index
appeared to be a fair test of liquidity. The 50 stocks in the NIFTY are assuredly the most
liquid stocks in India.
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The choice of Futures vs. Options is often debated. The difference between
these instruments is smaller than, commonly imagined, for a futures position is identical to an
appropriately chosen long call and short put position. Hence, futures position can always be
created once options exist. Individuals or firms can choose to employ positions where their
downside and exposure is capped by using options. Risk management of the futures clearing
is more complex when options are in the picture. When portfolios contain options, the
calculation of initial price requires greater skill and more powerful computers. The skills
required for pricing options are greater than those required in pricing futures.
B.} COMMODITY DERIVATIVES TRADING IN INDIA –
In India, the futures market for commodities evolved by the setting up of the “Bombay
Cotton Trade Association Ltd.”, in 1875. A separate association by the name "Bombay
Cotton Exchange Ltd” was established following widespread discontent amongst leading
cotton mill owners and merchants over the functioning of the Bombay Cotton Trade
Association. With the setting up of the ‘Gujarati Vyapari Mandali” in 1900, the futures
trading in oilseed began. Commodities like groundnut, castor seed and cotton etc began to be
exchanged.
Raw jute and jute goods began to be traded in Calcutta with the establishment
of the “Calcutta Hessian Exchange Ltd.” in 1919. The most notable centres for existence of
futures market for wheat were the Chamber of Commerce at Hapur, which was established in
1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri,
Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur,
Hathras, Gaziabad, Sikenderabad and Barielly in U.P. The Bullion Futures market began in
Bombay in 1990. After the economic reforms in 1991 and the trade liberalization, the Govt.
of India appointed in June 1993 one more committee on Forward Markets under
Chairmanship of Prof. K.N. Kabra. The Committee recommended that futures trading be
introduced in basmati rice, cotton, raw jute and jute goods, groundnut, rapeseed/mustard
seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils
and oilcakes of all of them, rice bran oil, castor oil and its oilcake, linseed, silver and onions.
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All over the world commodity trade forms the major backbone of the economy. In India,
trading volumes in the commodity market have also seen a steady rise - to Rs 5,71,000 crore
in FY05 from Rs 1,29,000 crore in FY04. In the current fiscal year, trading volumes in the
commodity market have already crossed Rs 3,50,000 crore in the first four months of trading.
Some of the commodities traded in India include Agricultural Commodities like Rice Wheat,
Soya, Groundnut, Tea, Coffee, Jute, Rubber, Spices, Cotton, Precious Metals like Gold &
Silver, Base Metals like Iron Ore, Aluminium, Nickel, Lead, Zinc and Energy Commodities
like crude oil, coal. Commodities form around 50% of the Indian GDP. Though there are no
institutions or banks in commodity exchanges, as yet, the market for commodities is bigger
than the market for securities. Commodities market is estimated to be around Rs 44,00,000
Crores in future. Assuming a future trading multiple is about 4 times the physical market, in
many countries it is much higher at around 10 times.
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CHAPTER 2
2.1
DEVELOPMENT OF DERIVATIVES MARKET IN INDIA
2.2
FACTORS CONTRIBUTING TO THE GROWTH OF
2.3
TYPES OF DERIVATIVES
2.4
FUTURES VS. FORWARD MARKETS
DERIVATIVES
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CHAPTER 2
2.1 DEVELOPMENT OF DERIVATIVES MARKET IN INDIA :
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the
prohibition on options in securities. The market for derivatives, however, did not take off, as
there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member
committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India. The committee submitted its
report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives
trading in India. The committee recommended that derivatives should be declared as ‘securities’
so that regulatory framework applicable to trading of ‘securities’ could also govern trading of
securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives market in India. The report, which was
submitted in October 1998, worked out the operational details of margining system,
methodology for charging initial margins, broker net worth, deposit requirement and real–time
monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in
December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory
framework was developed for governing derivatives trading. The act also made it clear that
derivatives shall be legal and valid only if such contracts are traded on a recognized stock
exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the
three decade old notification, which prohibited forward trading in securities. Derivatives trading
commenced in India in June 2000 after SEBI granted the final approval to this effect in May
2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their
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clearing house/corporation to commence trading and settlement in approved derivatives
contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX
Nifty and BSE–30 (Sense) index. This was followed by approval for trading in options based on
these two indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the
trading in options on individual securities commenced in July 2001. Futures contracts on
individual stocks were launched in November 2001. The derivatives trading on NSE
commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index
options commenced on June 4, 2001 and trading in options on individual securities
commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The
index futures and options contract on NSE are based on S&P CNX Trading and settlement in
derivative contracts is done in accordance with the rules, byelaws, and regulations of the
respective exchanges and their clearing house/corporation duly approved by SEBI and
notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in
all Exchange traded derivative products.
The following are some observations based on the trading statistics provided
in the NSE report on the futures and options (F&O):
•
Single-stock futures continue to account for a sizable proportion of the F&O segment. It
constituted 70 per cent of the total turnover during June 2002. A primary reason
attributed to this phenomenon is that traders are comfortable with single-stock futures
than equity options, as the former closely resembles the erstwhile badla system.
•
On relative terms, volumes in the index options segment continues to remain poor. This
may be due to the low volatility of the spot index. Typically, options are considered more
valuable when the volatility of the underlying (in this case, the index) is high. A related
issue is that brokers do not earn high commissions by recommending index options to
their clients, because low volatility leads to higher waiting time for round-trips.
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•
Put volumes in the index options and equity options segment have increased since
January 2002. The call-put volumes in index options have decreased from 2.86 in January
2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are
increasingly becoming pessimistic on the market.
•
Farther month futures contracts are still not actively traded. Trading in equity options on
most stocks for even the next month was non-existent.
•
Daily option price variations suggest that traders use the F&O segment as a less risky
alternative (read substitute) to generate profits from the stock price movements. The fact that
the option premiums tail intra-day stock prices is evidence to this. If calls and puts are not
looked as just substitutes for spot trading, the intra-day stock price variations should not have
a one-to-one impact on the option premiums.
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2.2 FACTORS CONTRIBUTING TO THE GROWTH OF
DERIVATIVES :
Factors contributing to the explosive growth of derivatives are price volatility,
globalisation of the markets, technological developments and advances in the financial
theories.
A.} PRICE VOLATILITY –
A price is what one pays to acquire or use something of value. The objects
having value maybe commodities, local currency or foreign currencies. The concept of price
is clear to almost everybody when we discuss commodities. There is a price to be paid for the
purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another
persons money is called interest rate. And the price one pays in one’s own currency for a unit
of another currency is called as an exchange rate.
Prices are generally determined by market forces. In a market, consumers
have ‘demand’ and producers or suppliers have ‘supply’, and the collective interaction of
demand and supply in the market determines the price. These factors are constantly
interacting in the market causing changes in the price over a short period of time. Such
changes in the price is known as ‘price volatility’. This has three factors : the speed of price
changes, the frequency of price changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market
adjustments through price changes. These price changes expose individuals, producing firms
and governments to significant risks. The break down of the BRETTON WOODS
agreement brought and end to the stabilising role of fixed exchange rates and the gold
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convertibility of the dollars. The globalisation of the markets and rapid industrialisation of
many underdeveloped countries brought a new scale and dimension to the markets. Nations
that were poor suddenly became a major source of supply of goods. The Mexican crisis in the
south east-Asian currency crisis of 1990’s have also brought the price volatility factor on the
surface. The advent of telecommunication and data processing bought information very
quickly to the markets. Information which would have taken months to impact the market
earlier can now be obtained in matter of moments. Even equity holders are exposed to price
risk of corporate share fluctuates rapidly.
These price volatility risk pushed the use of derivatives like futures and
options increasingly as these instruments can be used as hedge to protect against adverse
price changes in commodity, foreign exchange, equity shares and bonds.
B.} GLOBALISATION OF MARKETS –
Earlier, managers had to deal with domestic economic concerns ; what
happened in other part of the world was mostly irrelevant. Now globalisation has increased
the size of markets and as greatly enhanced competition .it has benefited consumers who
cannot obtain better quality goods at a lower cost. It has also exposed the modern business to
significant risks and, in many cases, led to cut profit margins
In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis-à-vis depreciated currencies. Export of certain goods
from India declined because of this crisis. Steel industry in 1998 suffered its worst set back
due to cheap import of steel from south east asian countries. Suddenly blue chip companies
had turned in to red. The fear of china devaluing its currency created instability in Indian
exports. Thus, it is evident that globalisation of industrial and financial activities necessitiates
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use of derivatives to guard against future losses. This factor alone has contributed to the
growth of derivatives to a significant extent.
C.} TECHNOLOGICAL ADVANCES –
A significant growth of derivative instruments has been driven by
technological break through. Advances in this area include the development of high speed
processors, network systems and enhanced method of data entry. Closely related to advances
in
computer
technology
are
advances
in
telecommunications.
Improvement
in
communications allow for instantaneous world wide conferencing, Data transmission by
satellite. At the same time there were significant advances in software programmes without
which computer and telecommunication advances would be meaningless. These facilitated
the more rapid movement of information and consequently its instantaneous impact on
market price.
Although price sensitivity to market forces is beneficial to the economy as a
whole resources are rapidly relocated to more productive use and better rationed overtime the
greater price volatility exposes producers and consumers to greater price risk. The effect of this
risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm
manage the price risk inherent in a market economy. To the extent the technological
developments increase volatility, derivatives and risk management products become that much
more important.
D.} ADVANCES IN FINANCIAL THEORIES –
Advances in financial theories gave birth to derivatives. Initially forward
contracts in its traditional form, was the only hedging tool available. Option pricing models
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developed by Black and Scholes in 1973 were used to determine prices of call and put options.
In late 1970’s, work of Lewis Edeington extended the early work of Johnson and started the
hedging of financial price risks with financial futures. The work of economic theorists gave rise
to new products for risk management which led to the growth of derivatives in financial markets.
The above factors in combination of lot many factors led to growth of derivatives
instruments.
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2.3 TYPES OF DERIVATIVES :
There are mainly four types of derivatives i.e. Forwards, Futures, Options and swaps.
Derivatives
Forwards
Futures
Options
Swaps
1. FORWARDS A contract that obligates one counter party to buy and the other to sell a
specific underlying asset at a specific price, amount and date in the future is known as a
forward contract. Forward contracts are the important type of forward-based derivatives.
They are the simplest derivatives. There is a separate forward market for multitude of
underlyings, including the traditional agricultural or physical commodities, as well as
currencies and interest rates. The change in the value of a forward contract is roughly
proportional to the change in the value of its underlying asset. These contracts create credit
exposures. As the value of the contract is conveyed only at the maturity, the parties are
exposed to the risk of default during the life of the contract. Forward contracts are
customised with the terms and conditions tailored to fit the particular business, financial or
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risk management objectives of the counter parties. Negotiations often take place with respect
to contract size, delivery grade, delivery locations, delivery dates and credit terms.
2. FUTURES A future contract is an agreement between two parties to buy or sell an asset at a
certain time the future at the certain price. Futures contracts are the special types of forward
contracts in the sense that are standardized exchange-traded contracts.
Equities, bonds, hybrid securities and currencies are the commodities of the
investment business. They are traded on organised exchanges in which a clearing house
interposes itself between buyer and seller and guarantees all transactions, so that the identity
of the buyer or the seller is a matter of indifference to the opposite party. Futures contract
protect those who use these commodities in their business.
Futures trading are to enter into contracts to buy or sell financial instruments,
dealing in commodities or other financial instruments for forward delivery or settlement on
standardised terms. The futures market facilitates stock holding and shifting of risk. They act as a
mechanism for collection and distribution of information and then perform a forward pricing
function. The futures trading can be performed when there is variation in the price of the actual
commodity and there exists economic agents with commitments in the actual market. There must
be a possibility to specify a standard grade of the commodity and to measure deviations from this
grade. A futures market is established specifically to meet purely speculative demands is possible
but is not known. Conditions which are thought of necessary for the establishment of futures
trading are the presence of speculative capital and financial facilities for payment of margins and
contract settlement. In addition, a strong infrastructure is required, including financial, legal and
communication systems.
3. OPTIONS -
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A derivative transaction that gives the option holder the right but not the
obligation to buy or sell the underlying asset at a price, called the strike price, during a period
or on a specific date in exchange for payment of a premium is known as ‘option’.
Underlying asset refers to any asset that is traded. The price at which the underlying is traded
is called the ‘strike price’.
There are two types of options i.e., CALL OPTION AND PUT OPTION.
a. CALL OPTION :
A contract that gives its owner the right but not the obligation to buy an
underlying asset-stock or any financial asset, at a specified price on or before a
specified date is known as a ‘Call option’. The owner makes a profit provided he
sells at a higher current price and buys at a lower future price.
b. PUT OPTION :
A contract that gives its owner the right but not the obligation to sell an
underlying asset-stock or any financial asset, at a specified price on or before a
specified date is known as a ‘Put option’. The owner makes a profit provided he buys
at a lower current price and sells at a higher future price. Hence, no option will be
exercised if the future price does not increase.
Put and calls are almost always written on equities, although occasionally
preference shares, bonds and warrants become the subject of options.
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4.
SWAPS Swaps are transactions which obligates the two parties to the contract to exchange
a series of cash flows at specified intervals known as payment or settlement dates. They can be
regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange
(swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of
swap, only the payment flows are exchanged and not the principle amount. The two commonly
used swaps are:
a. INTEREST RATE SWAPS :
Interest rate swaps is an arrangement by which one party agrees to
exchange his series of fixed rate interest payments to a party in exchange for his
variable rate interest payments. The fixed rate payer takes a short position in the
forward contract whereas, the floating rate payer takes a long position in the forward
contract.
b. CURRENCY SWAPS :
Currency swaps is an arrangement in which both the principle amount
and the interest on loan in one currency are swapped for the principle and the interest
payments on loan in another currency. The parties to the swap contract of currency
generally hail from two different countries. This arrangement allows the counter
parties to borrow easily and cheaply in their home currencies. Under a currency swap,
cash flows to be exchanged are determined at the spot rate at a time when swap is
done. Such cash flows are supposed to remain unaffected by subsequent changes in
the exchange rates.
c. FINANCIAL SWAP :
Financial swaps constitute a funding technique which permit a borrower
to access one market and then exchange the liability for another type of liability. It
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also allows the investors to exchange one type of asset for another type of asset with a
preferred income stream.
The other kind of derivatives, which are not, much popular are as follows :
5.
BASKETS -
Baskets options are option on portfolio of underlying asset. Equity Index Options are
most popular form of baskets.
6. LEAPS Normally option contracts are for a period of 1 to 12 months. However, exchange may
introduce option contracts with a maturity period of 2-3 years. These long-term option contracts
are popularly known as Leaps or Long term Equity Anticipation Securities.
7.
WARRANTS Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.
8.
SWAPTIONS Swaptions are options to buy or sell a swap that will become operative at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the
swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an
option to receive fixed and pay floating. A payer swaption is an option to pay fixed and
receive floating.
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2.4
Futures Market
Forward Market
Margin deposits are to be required of Typically, no money changes hands
all participants.
until delivery, although a small margin
deposit might be required of non-dealer
customers on certain occasions.
Contract terms are standardised with all All contract terms are negotiated
buyers and sellers negotiating only with privately by the parties.
respect to price.
Non-member participants deal through Participants
brokers
(exchange
members
deal
typically
on
a
who principal-to-principal basis.
represent them on the exchange floor)
Participants
corporations,
include
financial
banks, Participants are primarily institutions
institutions, dealing with one other and other
individual investors, and speculators.
interested parties dealing through one
or more dealers.
The clearing house of the exchange A participant must examine the credit
becomes the opposite side to each risk and establish credit limits for each
cleared
credit
transactions;
risk
for
a
therefore,
futures
the opposite party.
market
participant is always the same and there
is no need to analyse the credit of other
market participants.
Settlements are made daily through the
Settlement occurs on date agreed upon
exchange clearing house. Gains on
between the parties to each transaction.
open positions may be withdrawn and
losses are collected daily.
Long and short positions are usually Forward positions are not as easily
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liquidated easily.
offset or transferred to the other
participants.
Settlements are normally made in cash, Most transactions result in delivery.
with only a small percentage of all
contracts resulting actual delivery.
A single, round trip (in and out of the No commission is typically charged if
market) commission is charged. It is the transaction is made directly with
negotiated
between
broker
and another dealer. A commission is
customer and is relatively small in charged to born buyer and seller,
relation to the value of the contract.
however, if transacted through a broker.
Trading is regulated.
Trading is mostly unregulated.
The delivery price is the spot price.
The delivery price is the forward price.
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CHAPTER 3
3.1
PARTICIPANTS IN DERIVATIVES MARKET
3.2
ROLE OF DERIVATIES
3.3
HOW BANKS USE DERIVATIVES
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CHAPTER 3
3.1 PARTICIPANTS IN THE DERIVATIVES MARKET :
The participants in the derivatives market are as follows:
A.} TRADING PARTICIPANTS :
1.] HEDGERS –
The process of managing the risk or risk management is called as hedging.
Hedgers are those individuals or firms who manage their risk with the help of derivative
products. Hedging does not mean maximising of return. The main purpose for hedging is to
reduce the volatility of a portfolio by reducing the risk.
2.] SPECULATORS –
Speculators do not have any position on which they enter into futures and
options Market i.e., they take the positions in the futures market without having position in
the underlying cash market. They only have a particular view about future price of a
commodity, shares, stock index, interest rates or currency. They consider various factors like
demand and supply, market positions, open interests, economic fundamentals, international
events, etc. to make predictions. They take risk in turn from high returns. Speculators are
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essential in all markets – commodities, equity, interest rates and currency. They help in
providing the market the much desired volume and liquidity.
3.] ARBITRAGEURS –
Arbitrage is the simultaneous purchase and sale of the same underlying in two
different markets in an attempt to make profit from price discrepancies between the two
markets. Arbitrage involves activity on several different instruments or assets simultaneously
to take advantage of price distortions judged to be only temporary.
Arbitrage occupies a prominent position in the futures world. It is the
mechanism that keeps prices of futures contracts aligned properly with prices of underlying
assets. The objective is simply to make profits without risk, but the complexity of arbitrage
activity is such that it is reserved to particularly well-informed and experienced professional
traders, equipped with powerful calculating and data processing tools. Arbitrage may not be
as easy and costless as presumed.
B.} INTERMEDIARY PARTICIPANTS :
4.] BROKERS –
For any purchase and sale, brokers perform an important function of bringing
buyers and sellers together. As a member in any futures exchanges, may be any commodity
or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a
commodity or financial futures exchange one get a right to transact with other members of
the same exchange. This transaction can be in the pit of the trading hall or on online
computer terminal. All persons hedging their transaction exposures or speculating on price
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movement, need not be and for that matter cannot be members of futures or options
exchange. A non-member has to deal in futures exchange through member only. This
provides a member the role of a broker. His existence as a broker takes the benefits of the
futures and options exchange to the entire economy all transactions are done in the name of
the member who is also responsible for final settlement and delivery. This activity of a
member is price risk free because he is not taking any position in his account, but his other
risk is clients default risk. He cannot default in his obligation to the clearing house, even if
client defaults. So, this risk premium is also inbuilt in brokerage recharges. More and more
involvement of non-members in hedging and speculation in futures and options market will
increase brokerage business for member and more volume in turn reduces the brokerage.
Thus more and more participation of traders other than members gives liquidity and depth to
the futures and options market. Members can attract involvement of other by providing
efficient services at a reasonable cost. In the absence of well functioning broking houses, the
futures exchange can only function as a club.
5.] MARKET MAKERS AND JOBBERS –
Even in organised futures exchange, every deal cannot get the counter party
immediately. It is here the jobber or market maker plays his role. They are the members of
the exchange who takes the purchase or sale by other members in their books and then square
off on the same day or the next day. They quote their bid-ask rate regularly. The difference
between bid and ask is known as bid-ask spread. When volatility in price is more, the spread
increases since jobbers price risk increases. In less volatile market, it is less. Generally,
jobbers carry limited risk. Even by incurring loss, they square off their position as early as
possible. Since they decide the market price considering the demand and supply of the
commodity or asset, they are also known as market makers. Their role is more important in
the exchange where outcry system of trading is present. A buyer or seller of a particular
futures or option contract can approach that particular jobbing counter and quotes for
executing deals. In automated screen based trading best buy and sell rates are displayed on
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screen, so the role of jobber to some extent. In any case, jobbers provide liquidity and
volume to any futures and option market.
C.} INSTITUTIONAL FRAMEWORK :
6.] EXCHANGE –
Exchange provides buyers and sellers of futures and option contract necessary
infrastructure to trade. In outcry system, exchange has trading pit where members and their
representatives assemble during a fixed trading period and execute transactions. In online
trading system, exchange provide access to members and make available real time
information online and also allow them to execute their orders. For derivative market to be
successful exchange plays a very important role, there may be separate exchange for
financial instruments and commodities or common exchange for both commodities and
financial assets.
7.] CLEARING HOUSE –
A clearing house performs clearing of transactions executed in futures and
option exchanges. Clearing house may be a separate company or it can be a division of
exchange. It guarantees the performance of the contracts and for this purpose clearing house
becomes counter party to each contract. Transactions are between members and clearing
house. Clearing house ensures solvency of the members by putting various limits on him.
Further, clearing house devises a good managing system to ensure performance of contract
even in volatile market. This provides confidence of people in futures and option exchange.
Therefore, it is an important institution for futures and option market.
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8.] CUSTODIAN / WARE HOUSE –
Futures and options contracts do not generally result into delivery but there
has to be smooth and standard delivery mechanism to ensure proper functioning of market. In
stock index futures and options which are cash settled contracts, the issue of delivery may not
arise, but it would be there in stock futures or options, commodity futures and options and
interest rates futures. In the absence of proper custodian or warehouse mechanism, delivery
of financial assets and commodities will be a cumbersome task and futures prices will not
reflect the equilibrium price for convergence of cash price and futures price on maturity,
custodian and warehouse are very relevant.
9.] BANK FOR FUND MOVEMENTS –
Futures and options contracts are daily settled for which large fund movement
from members to clearing house and back is necessary. This can be smoothly handled if a
bank works in association with a clearing house. Bank can make daily accounting entries in
the accounts of members and facilitate daily settlement a routine affair. This also reduces a
possibility of any fraud or misappropriation of fund by any market intermediary.
10.] REGULATORY FRAMEWORK –
A regulator creates confidence in the market besides providing Level playing
field to all concerned, for foreign exchange and money market, RBI is the regulatory
authority so it can take initiative in starting futures and options trade in currency and interest
rates. For capital market, SEBI is playing a lead role, along with physical market in stocks, it
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will also regulate the stock index futures to be started very soon in India. The approach and
outlook of regulator directly affects the strength and volume in the market. For commodities,
Forward Market Commission is working for settling up national National Commodity
Exchange.
3.2 ROLE OF DERIVATIVES :
Derivative markets help investors in many different ways :
1.] RISK MANAGEMENT –
Futures and options contract can be used for altering the risk of investing in
spot market. For instance, consider an investor who owns an asset. He will always be worried
that the price may fall before he can sell the asset. He can protect himself by selling a futures
contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the
futures market, as you will see later. This will help offset their losses in the spot market.
Similarly, if the spot price falls below the exercise price, the put option can always be
exercised.
Derivatives markets help to reallocate risk among investors. A person who
wants to reduce risk, can transfer some of that risk to a person who wants to take more risk.
Consider a risk-averse individual. He can obviously reduce risk by hedging. When he does
so, the opposite position in the market may be taken by a speculator who wishes to take more
risk. Since people can alter their risk exposure using futures and options, derivatives markets
help in the raising of capital. As an investor, you can always invest in an asset and then
change its risk to a level that is more acceptable to you by using derivatives.
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2.] PRICE DISCOVERY –
Price discovery refers to the markets ability to determine true equilibrium
prices. Futures prices are believed to contain information about future spot prices and help in
disseminating such information. As we have seen, futures markets provide a low cost trading
mechanism. Thus information pertaining to supply and demand easily percolates into such
markets. Accurate prices are essential for ensuring the correct allocation of resources in a
free market economy. Options markets provide information about the volatility or risk of the
underlying asset.
3.] OPERATIONAL ADVANTAGES –
As opposed to spot markets, derivatives markets involve lower transaction
costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to
significant price changes. However, futures markets tend to be more liquid than spot markets,
because herein you can take large positions by depositing relatively small margins.
Consequently, a large position in derivatives markets is relatively easier to take and has less
of a price impact as opposed to a transaction of the same magnitude in the spot market.
Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot
markets.
4.] MARKET EFFICIENCY –
The availability of derivatives makes markets more efficient; spot, futures
and options markets are inextricably linked. Since it is easier and cheaper to trade in
derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in
alignment. Hence these markets help to ensure that prices reflect true values.
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5.] EASE OF SPECULATION –
Derivative markets provide speculators with a cheaper alternative to engaging
in spot transactions. Also, the amount of capital required to take a comparable position is less
in this case. This is important because facilitation of speculation is critical for ensuring free
and fair markets. Speculators always take calculated risks. A speculator will accept a level of
risk only if he is convinced that the associated expected return, is commensurate with the risk
that he is taking.
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3.3 HOW BANKS USE DERIVATIVES :
ASSET LIABILITY MANAGEMENT Banks have traditionally taken deposits from their customers and put those deposits to work
as loans. Because the deposits and the loans are dominated in the same currency, this activity
has no associated foreign exchange risk. But it does limit banks to lending to customers
which need to borrow in the currencies which the banks have available on deposits.
If a bank is asked to lend to a customer in a currency other than one of those it has on
deposits it creates a currency exposure for the bank. Suppose a customer wants to borrow
EUROS from a US Bank for 5 years and that the US bank has no natural source of EUROS.
It is possible for the banks to cover this exposure in the forward market by selling EUROS
forwards and buying US dollars. The transaction costs associated with this, in particular the
bid / offer spread in the medium term foreign exchange forward market, would make the
resultant cost of the loan prohibitively expensive for the borrower.
Currency swaps provide an economic alternative to this problem for banks. In order to cover
the exposure created by a loan to a customer in EUROS funded by a bank’s deposit in US
dollar, a bank could receive fixed rate US dollars in a currency swap and pay fixed rate
EUROS.
One of the consequences of the development of the currency swap market is that banks now
often make much more competitive medium term forward foreign exchange prices than they
used to. Most banks quote forward foreign exchange and currency swap prices from the same
desk and increases liquidity in the latter has improved liquidity in the former.
Banks
therefore, need no longer restrict their lending activities to the currencies in which they have
natural deposits. They are free to fund themselves in the most competitively priced currency
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and to lend to their customers in the currency of the customer’s preference, using a currency
swap as an asset and liability matching tool
The “Normal yield curve”, reflects that it is much easier for banks to borrow at the short end
of the curve than the long end. This means that banks can fund themselves much more
effectively in the inter bank market in maturities such as the overnight, tom / next (overnight
from tomorrow, or tomorrow to the next day), spot / next, one week, one month, three
months and six months than they can in maturities such as five years or 20 years.
With the development of the swaps market it is possible for banks to satisfy their customers
demands for fixed rate funding while ensuring that the banks assets and liabilities are
matched. Suppose a bank has a customer who needs 5 years fixed rate funds. Let us say that
the bank finances in this loan in the interbank market at 3 month LIBOR. The bank now has
a 3 month liability and a 5 year asset (Figure 1).
The bank is short floating rate interest at 3 month LIBOR and long fixed rate interest at the rate
at which it lends to its customer. This is called the asset liability mismatch. So in order to hedge
its position the banks needs to match its exposure to 3 month LIBOR by receiving on a floating
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rate basis in an interest rate swap, and match its exposure on a fixed rate basis by paying a fixed
rate in a interest rate swap. This is a hedge which is ideally suited to an interest rate swap which
the bank receives a floating rare of interest and pays a fixed rare (Figure 2).
This structure has the benefit for the bank that it eliminates the bank’s exposure to interest
rate risk. The bank can no longer profit from a fall in interest rates but it cannot lose money
on its asset and liability mismatch as a result of an increase in rates. The bank will make or
lose money based on its pricing of the credit risk in the transaction and its overall loan
exposure rather than on its ability to forecast interest rates. Hence the interest rate swaps
provide banks with an opportunity to change their risks from interest rate to credit.
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CONCLUSION


RBI should play a greater role in supporting derivatives.
Derivatives market should be developed in order to keep it at par with other
derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

SEBI should conduct seminars regarding the use of derivatives to educate
individual investors.
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BIBLIOGRAPHY :
BOOKS
 Futures markets – Sunil. K. Parameswaran
 Understanding futures market – Robert. W. Klob
 Derivatives Market in India – Susan Thomas
 Financial Derivatives – V. K. Bhalla
 Financial Services and Markets – Dr. S. Guruswamy
 Futures and Options – D. C. Gardner
WEBLIOGRAPHY :
Websites:
 http//www.cxotoday.com
 http//www.indiainfoline.com
 http//www.indiamart.com
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