“Indian Derivative Market”

Project report submitted towards fulfillment

of
PGDM
LBSIMT, Bareilly

Academic Session
[2008-2010]

Submitted by
Sarang Mani

UNDER THE GUIDANCE OF

Mr. Rahul Kumar Agarwal

Area Sales Manager
IL & FS InvestSmart Securities Ltd.

Submitted by:
Name – Sarang Mani

1
 A C K N O W L E D G E M E N T

I wish to extend my sincere gratitude to, Mr. Rahul Kumar Agarwal, Area Sales
Manager, IL&FS InvestSmart Securities Ltd., for providing me with all the
facilities to carry on this research work efficiently.

I also extend my gratitude towards Mr. Amitab, Branch Manager for helping me in
the completion of this report, the entire team at IL&FS, for their co-operation and
last but not the least the employees at IL&FS for their support and
encouragement in fulfilment of this report.

2
 July 5, 2009

TO WHOMSOEVER IT MAY CONCERN

On behalf of IL&FS InvestSmart Securities Ltd., I take the privilege of recognizing

the efforts put in by Mr. Sarang Mani to carry out her Project on “Indian
Derivative Market” from 5th May to 5th July 2009. Sarang has not only carried
out this study as a part of his curriculum but he has proven to be a key member
in bringing positive contribution in our Sales strategies.

The project carried out by Sarang has given us some focused reasons to
improve our people practices, focus on employee satisfaction level as well
contribute to our sales. In fact we are considering adapting a few suggestions
given by him in the above context.

Lastly, I would like to thank your esteemed institution for providing your students
such a platform; for them to learn from their experiences while carrying out these
studies.

Warm regards,

(Rahul Kumar Agarwal)

Area Sales Manager

3
 TABLE OF CONTENTS
S. PAGE
TOPICS
No. NO.

1. Executive Summary …………………………………………………...... 06

2. Company Profile……………………………………………................... 10
3. Introduction …………………………………………………................... 16
4. Need of the Study............................................................................ 17
5. Literatural Review............................................................................ 18
6. Objective of the Study..................................................................... 19
7. Scope of the Study.......................................................................... 20
8. Research Methodology.................................................................... 21
9. Limitations of Study......................................................................... 22
10. Main Topics of Study
1) Introduction to Derivative............................................................. 23
2) Derivative Defined......................................................................... 24
3) Types of Derivatives Market........................................................... 25
4) Types of Derivatives...................................................................... 25
i) Forward Contracts...................................................................... 26
ii) Future Contracts........................................................................ 27
iii) Options....................................................................................... 32
iv) Swap....................................................................................... 33
5) Other Kinds of Derivatives......................................................... 34
11. History of Derivatives......................................................................... 35
12. Indian Derivative Market ……………………..…………..…………...... 38
1) Need of Derivatives in India today.......……………......................... 39
2) Myths and realities about derivatives…………………….................. 39
i) Derivatives increase speculation and do not serve any
economic purpose ..................................................................... 40
ii) Indian Market is not ready for derivative trading......................... 41
3) Comparison of New System with Existing System.........…………… 43
4) Exchange-traded vs. OTC derivatives markets............................... 45
5) Factors Contributing To The Growth Of Derivatives........................ 47
i) Price Volatility.............................................................................. 47
ii) Globalisation of Markets.............................................................. 48
iii) Technological Advances.............................................................. 49
iv) Advances in Financial Theories………........................................ 49
13. Development of Derivative Markets in India……………………....... 50
14. Benifits of Derivatives……………………................................... 54
1) Risk Management............................................................................ 54
2) Price Discovery.............................................................................. 54
3) Operational Advantages................................................................. 54
4) Market Efficiency............................................................................ 55
5) Easy to Speculation......................................................................... 55

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15. National Exchanges......................................................................... 59
16. Present Status................................................................................. 60
17. Status Report of the development in Derivative Market................. 62
18. Business Growth in Derivatives segment (NSE)............................. 69
19. Findings & Conclusion..................................................................... 81
20. Recommendations & Suggestions.................................................. 82
21. Bibliography ………………………………………………………........ 83
22. Abbrevations................................................................................... 84

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 EXECUTIVE SUMMARY
Firstly I am briefing the current Indian market and compairing it with it past. I am
also giving brief data about foreign market. Then at the last I am giving my
suggestions and recommendations.

With over 25 million shareholders, India has the third largest investor base in the
world after USA and Japan. Over 7500 companies are listed on the Indian stock
exchanges (more than the number of companies listed in developed markets of
Japan, UK, Germany, France, Australia, Switzerland, Canada and Hong Kong.).
The Indian capital market is significant in terms of the degree of development,
volume of trading, transparency and its tremendous growth potential.
India’s market capitalization was the highest among the emerging markets. Total
market capitalization of The Bombay Stock Exchange (BSE), which, as on July
31, 1997, was US$ 175 billion has grown by 37.5% percent every twelve months
and was over US$ 834 billion as of January, 2007. Bombay Stock Exchanges
(BSE), one of the oldest in the world, accounts for the largest number of listed
companies transacting their shares on a nationwide online trading system. The
two major exchanges namely the National Stock Exchange (NSE) and the
Bombay Stock Exchange (BSE) ranked no. 3 & 5 in the world, calculated by the
number of daily transactions done on the exchanges.
The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006
– An increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years
only. Turnover in the Spot and Derivatives segment both in NSE & BSE was
higher by 45% into 2006 as compared to 2005. With daily average volume of US
$ 9.4 billion, the Sensex has posted excellent returns in the recent years.
Currently the market cap of the Sensex as on July 4th, 2009 was Rs 48.4
Lakh Crore with a P/E of more than 20.

Derivatives trading in the stock market have been a subject of enthusiasm of

research in the field of finance the most desired instruments that allow market

6
participants to manage risk in the modern securities trading are known as
derivatives. The derivatives are defined as the future contracts whose value
depends upon the underlying assets. If derivatives are introduced in the stock
market, the underlying asset may be anything as component of stock market like,
stock prices or market indices, interest rates, etc. The main logic behind
derivatives trading is that derivatives reduce the risk by providing an additional
channel to invest with lower trading cost and it facilitates the investors to extend
their settlement through the future contracts. It provides extra liquidity in the stock
market.

Derivatives are assets, which derive their values from an underlying asset. These
underlying assets are of various categories like
• Commodities including grains, coffee beans, etc.
• Precious metals like gold and silver.
• Foreign exchange rate.
•Bonds of different types, including medium to long-term negotiable debt
securities issued by governments, companies, etc.
• Short-term debt securities such as T-bills.
• Over-The-Counter (OTC) money market products such as loans or deposits.
• Equities
For example, a dollar forward is a derivative contract, which gives the buyer a
right & an obligation to buy dollars at some future date. The prices of the
derivatives are driven by the spot prices of these underlying assets.
However, the most important use of derivatives is in transferring market risk,
called Hedging, which is a protection against losses resulting from unforeseen
price or volatility changes. Thus, derivatives are a very important tool of risk
management.

7
There are various derivative products traded. They are;
1. Forwards
2. Futures
3. Options
4. Swaps

“A Forward Contract is a transaction in which the buyer and the seller agree
upon a delivery of a specific quality and quantity of asset usually a commodity at
a specified future date. The price may be agreed on in advance or in future.”

“A Future contract is a firm contractual agreement between a buyer and seller

for a specified as on a fixed date in future. The contract price will vary according
to the market place but it is fixed when the trade is made. The contract also has
a standard specification so both parties know exactly what is being done”.

“An Options contract confers the right but not the obligation to buy (call option)
or sell (put option) a specified underlying instrument or asset at a specified price
– the Strike or Exercised price up until or an specified future date – the Expiry
date. The Price is called Premium and is paid by buyer of the option to the seller
or writer of the option.”

A call option gives the holder the right to buy an underlying asset by a certain
date for a certain price. The seller is under an obligation to fulfill the contract and
is paid a price of this, which is called "the call option premium or call option
price".
A put option, on the other hand gives the holder the right to sell an underlying
asset by a certain date for a certain price. The buyer is under an obligation to
fulfill the contract and is paid a price for this, which is called "the put option
premium or put option price".

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“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”

I had conducted this research to find out whether investing in the

derivative market is beneficial or not? You will be glad to know that
derivative market in India is the most booming now days.
So the person who is ready to take risk and want to gain more should
invest in the derivative market.
On the other hand RBI has to play an important role in derivative market.
Also SEBI must encourage investment in derivative market so that the
investors get the benefit out of it. Sorry to say that today even educated
persons are not willing to invest in derivative market because they have the
fear of high risk.

So, SEBI should take necessary steps for improvement in Derivative

Market so that more investors can invest in Derivative market.

9
 COMPANY PROFILE

A Brief about IL&FS Investsmart Limited:

IL&FS Investsmart Limited (IIL) is one of India’s leading financial services

organizations providing individuals and corporates with customized financial
management solutions.
At IIL, we believe in "Realizing your goals together". You will find in us - a trusted
investment partner to help you work towards achieving your financial goals. Our
institutional expertise, combined with a thorough understanding of the financial
markets results in appropriate investment solutions for you.
Our strong team of Relationship Managers, Customer Service Executives,
Advisory Managers and Research Analysts offers efficient execution backed by
in-depth research, knowledge and expertise to customers across the country.

Vision
To become a long term prefferd long term financial to a wide base of customer
whilst optimizing Stake holder value.

Mission
To establish a base of 1 million satisfied customer by 2010
We will crest this by being a responsible trustworthy partner.

Corporate action
An approach to business that reflects responsibility, transparency and ethical
behaviour.
Respect for employee client and stake holder group.

10
Retail Business
Retail offerings of IIL seek to cover all financial
planning requirements of individuals, which include
providing personalised investment management
services including planning, advisory, execution
and monitoring of the full range of investment
services. Broadly the retail services are divided into
two broad categories.

• Advisory Services:
Portfolio Management Services, Mutual
Funds, Insurance.

• Trading Services:
Equities, Derivatives, IPOs

These services are offered across our network of

over 300 offices across the country. You can also
enjoy the convenience of availing these services
online through our trading platform
www.investsmartonline.com

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Institutional Business
IIL’s Institutional business thrives on the strong relationships we have built among
domestic mutual funds, banks, financial institutions, insurance companies and private
sector funds over the past few years. Efficient execution, quality research and high
degree of compliance with stock exchange regulations and ethical business standards
back IIL’s services to institutional investors.
Our Institutional services can be broadly categorized as follows.

Merchant Banking
We offer financial advisory and capital-raising services to corporates. Having
successfully managed IPOs, Follow-on offerings, Open Offers, Mergers, etc, IIL’s
Merchant Banking business has been growing from strength-to-strength.

Institutional Equity & Debt

Combining the efforts of a top-drawer research team & dynamic sales professionals, we
are committed to offer timely & proactive investing & trading strategies. We are
presently empanelled with more than 100 institutions and service customers across
geographies.

Promoters
IL&FS Investsmart Limited (IIL) is one of India’s leading companies in the Financial
Services industry. It was promoted in 1997 by Infrastructure Leasing & Financial
Services (IL&FS), one of India's leading infrastructure development and finance
companies.
The company is now held by HSBC, one of the world’s largest banking and financial
services organisations.
In India, The HSBC Group offers a range of financial services including corporate,
commercial, retail and private banking, insurance, asset management, investment
banking, equities and capital markets, institutional brokerage, custodial services. It also
provides software development expertise and global services facilities for the HSBC
Group’s operations worldwide.

12
13
14
Value Added Products for You!
"Value Added Products for You" - Investsmart Online continually strives to
provide the services and support that our clients need to thrive in the market.
We pride ourselves on offering almost limitless customization possibilities; so
that you can truly "own the trade" We also realize that every trader has unique
and complex needs that sometimes require special attention. With this in mind,
we created Value Added products.
Our Charting Tools
SmartChart
Tools to plot Profitable Investments
Provides you a wealth of charting capabilities and
timing indicators, which allow you to go right into
the action with real-time daily and intra-day charts.

Limit Against Shares

SmartExposure
Increase your Market Exposure
Margin is offered against the securities you have in
your Demat for trading.

Phone Trading Services

SmartCall
Convenience to trade over the phone
Call & Trade is a service offered by Investsmart
online for its customers, which provides customers
with a facility to trade over the phone.

State-of-the-Art Security Platforms

SmartSecure
State-of-the-art Security Platforms
At IL&FS Investsmart, we place a very high onus
on security and realize that it is one of the vital
components of any e-business venture. Our online
products are developed on state-of-the-art security
platforms.

Smart Alert Services

SmartAlert
Smart Alert Service
Whether you are day trader or a serious investor,we
will deliver stock information (Short term and Long
term calls) to your cell phone daily.

Sell Receivable Shares

SmartNext
Sell Receivable Shares
SRS is a facility offered by Investsmart online
wherein the customer will be able to sell the shares
that he has purchased even before he receives the
delivery of the shares from the Exchange. He will
not have to wait till the time he receives the delivery
from the Exchange thus increasing his liquidity.

15
 INTRODUCTION

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

basic, underlying variables. The variables underlying could be prices of traded

securities and stock, prices of gold or copper.

Derivatives have become increasingly important in the field of finance,

Options and Futures are traded actively on many exchanges, Forward

contracts, Swap and different types of options are regularly traded outside

exchanges by financial intuitions, banks and their corporate clients in what

are termed as over-the-counter markets – in other words, there is no single

market place or organized exchanges.

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 NEED OF THE STUDY

The study has been done to know the different types of derivatives and also

to know the derivative market in India. This study also covers the recent

developments in the derivative market taking into account the trading in past

years.

Through this study I came to know the trading done in derivatives and their

use in the stock markets.

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 LITERATURE REVIEW

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

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 OBJECTIVES OF THE STUDY

 To understand the concept of the Derivatives and Derivative Trading.

 To know different types of Financial Derivatives

 To know the role of derivatives trading in India.

 To analyse the performance of Derivatives Trading since 2001with special

reference to Futures & Options

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 SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. For better

understanding various strategies with different situations and actions have

been given. It includes the data collected in the recent years and also the

market in the derivatives in the recent years. This study extends to the trading

of derivatives done in the National Stock Markets.

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 RESARCH METHODOLOGY

Method of data collection:-

Secondary sources:-
It is the data which has already been collected by some one or an
organization for some other purpose or research study .The data for study has
been collected from various sources:
 Books
 Journals
 Magazines
 Internet sources
Time:
2 months
Statistical Tools Used:
Simple tools like bar graphs, tabulation, line diagrams have been used.

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 LIMITAITONS OF STUDY

1. LIMITED TIME:
The time available to conduct the study was only 2 months. It being a wide
topic had a limited time.
2. LIMITED RESOURCES:
Limited resources are available to collect the information about the
commodity trading.
3. VOLATALITY:
Share market is so much volatile and it is difficult to forecast any thing about it
whether you trade through online or offline
4. ASPECTS COVERAGE:
Some of the aspects may not be covered in my study.

22
 MAIN TOPICS OF STUDY
1. INTRODUCTION TO DERIVATIVE
The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it was
sown to the time it was ready for harvest, farmers would face price uncertainty.
Through the use of simple derivative products, it was possible for the farmer to
partially or fully transfer price risks by locking-in asset prices. These were simple
contracts developed to meet the needs of farmers and were basically a means of
reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he
would receive for his harvest in September. In years of scarcity, he would
probably obtain attractive prices. However, during times of oversupply, he would
have to dispose off his harvest at a very low price. Clearly this meant that the
farmer and his family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too

would face a price risk that of having to pay exorbitant prices during dearth,
although favourable prices could be obtained during periods of oversupply.
Under such circumstances, it clearly made sense for the farmer and the
merchant to come together and enter into contract whereby the price of the grain
to be delivered in September could be decided earlier. What they would then
negotiate happened to be futures-type contract, which would enable both parties
to eliminate the price risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring

farmers and merchants together. A group of traders got together and created the
‘to-arrive’ contract that permitted farmers to lock into price upfront and deliver the
grain later. These to-arrive contracts proved useful as a device for hedging and

23
speculation on price charges. These were eventually standardized, and in 1925
the first futures clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn,

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also
exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

2. DERIVATIVE DEFINED
A derivative is a product whose value is derived from the value of one or more
underlying variables or assets in a contractual manner. The underlying asset can
be equity, forex, commodity or any other asset. In our earlier discussion, we saw
that wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of change in price by that date. Such a transaction is an example of a
derivative. The price of this derivative is driven by the spot price of wheat which
is the “underlying” in this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the
forward/futures contracts in commodities all over India. As per this the Forward
Markets Commission (FMC) continues to have jurisdiction over commodity
futures contracts. However when derivatives trading in securities was introduced
in 2001, the term “security” in the Securities Contracts (Regulation) Act, 1956
(SCRA), was amended to include derivative contracts in securities.
Consequently, regulation of derivatives came under the purview of Securities
Exchange Board of India (SEBI). We thus have separate regulatory authorities
for securities and commodity derivative markets.
Derivatives are securities under the SCRA and hence the trading of
derivatives is governed by the regulatory framework under the SCRA. The
Securities Contracts (Regulation) Act, 1956 defines “derivative” to include-
A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract differences or any other form of security.
A contract which derives its value from the prices, or index of prices, of
underlying securities.

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 3. TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Bombay Stock National Commodity &

Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES

Derivatives

Future Option Forward Swaps

Figure.2 Types of Derivatives

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 (i) FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified

date for a specified price. One of the parties to the contract assumes a long
position and agrees to buy the underlying asset on a certain specified future
date for a certain specified price. The other party assumes a short position
and agrees to sell the asset on the same date for the same price. Other
contract details like delivery date, price and quantity are negotiated bilaterally
by the parties to the contract. The forward contracts are n o r m a l l y traded
outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

• They are bilateral contracts and hence exposed to counter-party risk.

• Each contract is custom designed, and hence is unique in terms of
contract size, expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the
asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the
same counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing
transaction costs and increasing transactions volume. This process of
standardization reaches its limit in the organized futures market. Forward
contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially th e same economic fun ction s
of allocating risk in the presence of future price uncertainty. However futures
are a significant improvement over the forward contracts as they
eliminate counterparty risk and offer more liquidity.

26
 (ii) FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures

exchange, to buy or sell a certain underlying instrument at a certain date in the
future, at a pre-set price. The future date is called the delivery date or final
settlement date. The pre-set price is called the futures price. The price of the
underlying asset on the delivery date is called the settlement price. The
settlement price, normally, converges towards the futures price on the delivery
date.

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

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization :

Futures contracts ensure their liquidity by being highly standardized, usually by

specifying:

• The underlying. This can be anything from a barrel of sweet crude oil to a
short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term
interest rate is traded, etc.

27
 • The currency in which the futures contract is quoted.
• The grade of the deliverable. In case of bonds, this specifies which bonds
can be delivered. In case of physical commodities, this specifies not only
the quality of the underlying goods but also the manner and location of
delivery. The delivery month.
• The last trading date.
• Other details such as the tick, the minimum permissible price fluctuation.

2. Margin :
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in value,
and creates a credit risk to the exchange, who always acts as counterparty. To
minimize this risk, the exchange demands that contract owners post a form of
collateral, commonly known as Margin requirements are waived or reduced in
some cases for hedgers who have physical ownership of the covered commodity
or spread traders who have offsetting contracts balancing the position.
Initial Margin: is paid by both buyer and seller. It represents the loss on that
contract, as determined by historical price changes, which is not likely to be
exceeded on a usual day's trading. It may be 5% or 10% of total contract price.
Mark to market Margin: Because a series of adverse price changes may
exhaust the initial margin, a further margin, usually called variation or
maintenance margin, is required by the exchange. This is calculated by the
futures contract, i.e. agreeing on a price at the end of each day, called the
"settlement" or mark-to-market price of the contract.
To understand the original practice, consider that a futures trader, when taking a
position, deposits money with the exchange, called a "margin". This is intended
to protect the exchange against loss. At the end of every trading day, the contract
is marked to its present market value. If the trader is on the winning side of a
deal, his contract has increased in value that day, and the exchange pays this
profit into his account. On the other hand, if he is on the losing side, the

28
 exchange will debit his account. If he cannot pay, then the margin is used as the
collateral from which the loss is paid.

3. Settlement
Settlement is the act of consummating the contract, and can be done in one of
two ways, as specified per type of futures contract:
• Physical delivery - the amount specified of the underlying asset of the
contract is delivered by the seller of the contract to the exchange, and by the
exchange to the buyers of the contract. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering
position - that is, buying a contract to cancel out an earlier sale (covering a
short), or selling a contract to liquidate an earlier purchase (covering a long).
• Cash settlement - a cash payment is made based on the underlying
reference rate, such as a short term interest rate index such as Euribor, or
the closing value of a stock market index. A futures contract might also opt to
settle against an index based on trade in a related spot market.
Expiry is the time when the final prices of the future are determined. For many
equity index and interest rate futures contracts, this happens on the Last
Thursday of certain trading month. On this day the t+2 futures contract becomes
the t forward contract.

PRICING OF FUTURE CONTRACT

In a futures contract, for no arbitrage to be possible, the price paid on delivery
(the forward price) must be the same as the cost (including interest) of buying
and storing the asset. In other words, the rational forward price represents the
expected future value of the underlying discounted at the risk free rate. Thus, for

a simple, non-dividend paying asset, the value of the future/forward, , will

be found by discounting the present value at time to maturity by the rate

of risk-free return .

29
This relationship may be modified for storage costs, dividends, dividend yields,
and convenience yields. Any deviation from this equality allows for arbitrage as
follows.
In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying today
(on the spot market) with borrowed money.
2. On the delivery date, the arbitrageur hands over the underlying, and
receives the agreed forward price.
3. He then repays the lender the borrowed amount plus interest.
4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today
(on the spot market); he invests the proceeds.
2. On the delivery date, he cashes in the matured investment, which has
appreciated at the risk free rate.
3. He then receives the underlying and pays the agreed forward price using
the matured investment. [If he was short the underlying, he returns it now.]
4. The difference between the two amounts is the arbitrage profit.

30
 TABLE 1-
DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational Traded directly between Traded on the exchanges.

Mechanism two parties (not traded on
the exchanges).

Contract Differ from trade to trade. Contracts are standardized

Specifications contracts.

Counter-party Exists. Exists. However, assumed by the

risk clearing corp., which becomes the
counter party to all the trades or
unconditionally guarantees their
settlement.

Liquidation Low, as contracts are High, as contracts are standardized

Profile tailor made contracts exchange traded contracts.
catering to the needs of
the needs of the parties.

Price discovery Not efficient, as markets Efficient, as markets are centralized

are scattered. and all buyers and sellers come to a
common platform to discover the
price.
Examples Currency market in India. Commodities, futures, Index Futures
and Individual stock Futures in India.

31
OPTIONS -
A derivative transaction that gives the option holder the right but not the
obligation to buy or sell the underlying asset at a price, called the strike price,
during a period or on a specific date in exchange for payment of a premium is
known as ‘option’. Underlying asset refers to any asset that is traded. The price
at which the underlying is traded is called the ‘strike price’.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an
underlying asset-stock or any financial asset, at a specified price on or before a
specified date is known as a ‘Call option’. The owner makes a profit provided he
sells at a higher current price and buys at a lower future price.

PUT OPTION:

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

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

32
SWAPS -
Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a ‘SWAP’. In case of swap, only the
payment flows are exchanged and not the principle amount. The two commonly
used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange
his series of fixed rate interest payments to a party in exchange for his variable
rate interest payments. The fixed rate payer takes a short position in the forward
contract whereas the floating rate payer takes a long position in the forward
contract.

CURRENCY SWAPS:
Currency swaps is an arrangement in which both the principle amount and the
interest on loan in one currency are swapped for the principle and the interest
payments on loan in another currency. The parties to the swap contract of
currency generally hail from two different countries. This arrangement allows the
counter parties to borrow easily and cheaply in their home currencies. Under a
currency swap, cash flows to be exchanged are determined at the spot rate at a
time when swap is done. Such cash flows are supposed to remain unaffected by
subsequent changes in the exchange rates.

FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to
access one market and then exchange the liability for another type of liability. It
also allows the investors to exchange one type of asset for another type of asset
with a preferred income stream.

33
5. OTHER KINDS OF DERIVATIVES
The other kind of derivatives, which are not, much popular are as follows:

BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options
are most popular form of baskets.

LEAPS -

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years.
These long-term option contracts are popularly known as Leaps or Long term
Equity Anticipation Securities.

WARRANTS -

Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated
options are called warrants and are generally traded over-the-counter.

SWAPTIONS -

Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a 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.

34
 11. HISTORY OF DERIVATIVES:

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

35
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 floating rates for currencies in the international financial markets

36
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.

37
 12. INDIAN DERIVATIVES MARKET
Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments in
India gained momentum in the last few years due to liberalisation process and
Reserve Bank of India’s (RBI) efforts in creating currency forward market.
Derivatives are an integral part of liberalisation process to manage risk. NSE
gauging the market requirements initiated the process of setting up derivative
markets in India. In July 1999, derivatives trading commenced in India

Table 2. Chronology of instruments

1991 Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy
framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements
(FRAs) and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an
Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index
futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
25 September Nifty futures trading commenced at SGX.
2000
2 June 2001 Individual Stock Options & Derivatives

(1) Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have
become the most important markets in the world. Today, derivatives have
become part and parcel of the day-to-day life for ordinary people in major part of

38
the world.
Until the advent of NSE, the Indian capital market had no access to the latest
trading methods and was using traditional out-dated methods of trading. There
was a huge gap between the investors’ aspirations of the markets and the
available means of trading. The opening of Indian economy has precipitated the
process of integration of India’s financial markets with the international financial
markets. Introduction of risk management instruments in India has gained
momentum in last few years thanks to Reserve Bank of India’s efforts in allowing
forward contracts, cross currency options etc. which have developed into a very
large market.

(2) Myths and realities about derivatives

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

39
(i) Derivatives increase speculation and do not serve any

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

Looking at the equity market, derivatives allow corporations and institutional

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

By providing investors and issuers with a wider array of tools for

managing risks and raising capital, derivatives improve the allocation of credit
and the sharing of risk in the global economy, lowering the cost of capital
formation and stimulating economic growth. Now that world markets for trade and
finance have become more integrated, derivatives have strengthened these
important linkages between global markets, increasing market liquidity and

40
efficiency and facilitating the flow of trade and finance

(ii) Indian Market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian
capital market is not ready for derivatives trading. Here, we look into the pre-
requisites, which are needed for the introduction of derivatives, and how Indian
market fares:
TABLE 3.
PRE-REQUISITES INDIAN SCENARIO
Large market India is one of the largest market-capitalised
Capitalisation countries in Asia with a market capitalisation of
more than Rs.765000 crores.

High Liquidity in the The daily average traded volume in Indian capital
underlying market today is around 7500 crores. Which means
on an average every month 14% of the country’s
Market capitalisation gets traded. These are clear
indicators of high liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing trades

has become fully functional from July 1996 in the
form of National Securities Clearing Corporation
(NSCCL). NSCCL is responsible for guaranteeing
all open positions on the National Stock Exchange
(NSE) for which it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL)

which started functioning in the year 1997 has
revolutionalised the security settlement in our
country.

A Good legal guardian In the Institution of SEBI (Securities and Exchange

Board of India) today the Indian capital market
enjoys a strong, independent, and innovative legal
guardian who is helping the market to evolve to a
healthier place for trade practices.

(3) Comparison of New System with Existing System

Many people and brokers in India think that the new system of Futures & Options
and banning of Badla is disadvantageous and introduced early, but I feel that this

41
new system is very useful especially to retail investors. It increases the no of
options investors for investment. In fact it should have been introduced much
before and NSE had approved it but was not active because of politicization in
SEBI.
The figure 3.3a –3.3d shows how advantages of new system (implemented from
June 20001) v/s the old system i.e. before June 2001
New System Vs Existing System for Market Players

Figure 3.3a
Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)Maximum
Trading, margin loss to extent of on delivery basis loss possible
trading & carry price change. 2) Buy Call &Put to premium
forward transactions. by paying paid
2) Buy Index Futures premium
hold till expiry.

Advantages
• Greater Leverage as to pay only the premium.
• Greater variety of strike price options at a given time.

Figure 3.3b

Arbitrageurs

42
 Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize

1) Buying Stocks in 1) Make money 1) B Group more 1) Risk free
one and selling in whichever way promising as still game.
another exchange. the Market moves. in weekly settlement
forward transactions. 2) Cash &Carry
2) If Future Contract arbitrage continues
more or less than Fair price

• Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril

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

Advantages
• Availability of Leverage

Figure 3.3d
Small Investors

43
 Existing SYSTEM New

Approach Peril &Prize Approach Peril

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

44
4. Exchange-traded vs. OTC derivatives markets
The OTC derivatives markets have witnessed rather sharp growth over the last
few years, which has accompanied the modernization of commercial and
investment banking and globalisation of financial activities. The recent
developments in information technology have contributed to a great extent to
these developments. While both exchange-traded and OTC derivative contracts
offer many benefits, the former have rigid structures compared to the latter. It has
been widely discussed that the highly leveraged institutions and their OTC
derivative positions were the main cause of turbulence in financial markets in
1998. These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-
traded derivatives:
1. The management of counter-party (credit) risk is decentralized and
located within individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or
margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market
participants, and
5. The OTC contracts are generally not regulated by a regulatory authority
and the exchange’s self-regulatory organization, although they are
affected indirectly by national legal systems, banking supervision and
market surveillance.

Some of the features of OTC derivatives markets embody risks to financial

market stability.

45
The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic
nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of
OTC derivative activities on available aggregate credit; (iv) the high concentration
of OTC derivative activities in major institutions; and (v) the central role of OTC
derivatives markets in the global financial system. Instability arises when shocks,
such as counter-party credit events and sharp movements in asset prices that
underlie derivative contracts, occur which significantly alter the perceptions of
current and potential future credit exposures. When asset prices change rapidly,
the size and configuration of counter-party exposures can become unsustainably
large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk
management, including counter-party, liquidity and operational risks, and OTC
derivatives markets continue to pose a threat to international financial stability.
The problem is more acute as heavy reliance on OTC derivatives creates the
possibility of systemic financial events, which fall outside the more formal
clearing house structures. Moreover, those who provide OTC derivative products,
hedge their risks through the use of exchange traded derivatives. In view of the
inherent risks associated with OTC derivatives, and their dependence on
exchange traded derivatives, Indian law considers them illegal.

46
5. 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 are known as ‘price volatility’. This has
three factors: the speed of price changes, the frequency of price changes and the
magnitude of price changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,
producing firms and governments to significant risks. The break down of the
BRETTON WOODS agreement brought and end to the stabilising role of fixed
exchange rates and the gold 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-

47
Asian currency crisis of 1990’s has also brought the price volatility factor on the
surface. The advent of telecommunication and data processing bought
information very quickly to the markets. Information which would have taken
months to impact the market earlier can now be obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates
rapidly.
These price volatility risks pushed the use of derivatives like futures and options
increasingly 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 necessitates use of derivatives to
guard against future losses. This factor alone has contributed to the growth of
derivatives to a significant extent.

48
C.} TECHNOLOGICAL ADVANCES –
A significant growth of derivative instruments has been driven by technological
breakthrough. 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
worldwide 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
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

49
13. DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern trading
of derivatives. SEBI set up a 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 were 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 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.

50
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 continue to

remain poor. This may be due to the low volatility of the spot index. Typically,
options are considered more valuable when the volatility of the underlying (in this
case, the index) is high. A related issue is that brokers do not earn high
commissions by recommending index options to their clients, because low
volatility leads to higher waiting time for round-trips.

51
• 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.

• The spot foreign exchange market remains the most important

segment but the derivative segment ha s also grown. In the derivative
market foreign exchange swaps account for the largest share of the
total turnover of derivatives in India followed by forwards and
options. Significant milestones in the development of derivatives
market have been (i) permission to banks to undertake cross
currency derivative transactions subject to certain conditions (1996) (ii)
allowing corporates to undertake long term foreign currency swaps
that contributed to the development of the term currency swap market
(1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of
currency futures (2008). I would like to emphasise that currency
swaps allowed companies with ECBs to swap their foreign currency
liabilities into rupees. However, since banks could not carry open
positions the risk was allowed to be transferred to any other resident
corporate. Normally such risks should be taken by corporates who

52
 have natural hedge or have potential foreign exchange earnings. But
often corporate assume these risks due to interest rate differentials and
views on currencies.

This period has also witnessed several relaxations in regulations relating to

forex markets and also greater liberalisation in capital account regulations
leading to greater integration with the global economy.

• Cash settled exchange traded currency futures have made foreign

currency a separate asset class that can be traded without any
underlying need or exposure a n d on a leveraged basis on the
recognized stock exchanges with credit risks being assumed by the
central counterparty
Since the commencement of trading of currency futures in all the three
exchanges, the value of the trades has gone up steadily from Rs 17, 429
crores in October 2008 to Rs 45, 803 crores in December 2008. The average
daily turnover in all the exchanges has also increased from Rs871 crores to
Rs 2,181 crores during the same period. The turnover in the currency
futures market is in line with the international scenario, where I understand
the share of futures market ranges between 2 – 3 per cent.

Table 4.1ForexMarketActivity

April’05- April’06- April’07- April’08-

Mar’06 Mar’07 Mar’08 Dec’08
Total turnover (USD billion) 4,404 6,571 12,304 9,621
Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1
Spot/Total Turnover (%) 50.5 51.9 49.7 45.9
Forward/Total Turnover (%) 19.0 17.9 19.3 21.5
Swap/Total Turnover (%) 30.5 30.1 31.1 32.7
Source: RBI

53
14. BENEFITS OF DERIVATIVES
Derivative markets help investors in many different ways:
1.] RISK MANAGEMENT –
Futures and options contract can be used for altering the risk of investing in spot
market. For instance, consider an investor who owns an asset. He will always be
worried that the price may fall before he can sell the asset. He can protect
himself by selling a futures contract, or by buying a Put option. If the spot price
falls, the short hedgers will gain in the futures market, as you will see later. This
will help offset their losses in the spot market. Similarly, if the spot price falls
below the exercise price, the put option can always be exercised.
2.] PRICE DISCOVERY –
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.

54
4.] MARKET EFFICIENCY –
The availability of derivatives makes markets more efficient; spot, futures and
options markets are inextricably linked. Since it is easier and cheaper to trade in
derivatives, it is possible to exploit arbitrage opportunities quickly and to keep
prices in alignment. Hence these markets help to ensure that prices reflect true
values.

5.] EASE OF SPECULATION –

Derivative markets provide speculators with a cheaper alternative 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.

The derivative market performs a number of economic functions.

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

55
15. National Exchanges
In enhancing the institutional capabilities for futures trading the idea of
setting up of National Commodity Exchange(s) has been pursued since 1999.
Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,
(NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX),
Mumbai, and Multi Commodity Exchange (MCX), Mumbai have become
operational. “National Status” implies that these exchanges would be
automatically permitted to conduct futures trading in all commodities subject to
clearance of byelaws and contract specifications by the FMC. While the NMCE,
Ahmedabad commenced futures trading in November 2002, MCX and NCDEX,
Mumbai commenced operations in October/ December 2003 respectively.

MCX

MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

mutulised multi commodity exchange has permanent recognition from
Government of India for facilitating online trading, clearing and settlement
operations for commodity futures markets across the country. Key shareholders
of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank,
State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI
Life Insurance Co. Ltd., Union Bank of India, Bank of India, Bank of
Baroda, Canera Bank, Corporation Bank

Headquartered in Mumbai, MCX is led by an expert management team

with deep domain knowledge of the commodity futures markets. Today MCX is
offering spectacular growth opportunities and advantages to a large cross section
of the participants including Producers / Processors, Traders, Corporate,
Regional Trading Canters, Importers, Exporters, Cooperatives, Industry
Associations, amongst others MCX being nation-wide commodity exchange,
offering multiple commodities for trading with wide reach and penetration and
robust infrastructure.

56
 MCX, having a permanent recognition from the Government of India, is
an independent and demutualised multi commodity Exchange. MCX, a state-of-
the-art nationwide, digital Exchange, facilitates online trading, clearing and
settlement operations for a commodities futures trading.

NMCE
National Multi Commodity Exchange of India Ltd. (NMCE) was promoted
by Central Warehousing Corporation (CWC), National Agricultural Cooperative
Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation
Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National
Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).
While various integral aspects of commodity economy, viz., warehousing,
cooperatives, private and public sector marketing of agricultural commodities,
research and training were adequately addressed in structuring the Exchange,
finance was still a vital missing link. Punjab National Bank (PNB) took equity of
the Exchange to establish that linkage. Even today, NMCE is the only Exchange
in India to have such investment and technical support from the commodity
relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested

trading platform, Derivative Trading Settlement System (DTSS), provided by
CMC. It has robust delivery mechanism making it the most suitable for the
participants in the physical commodity markets. It has also established fair and
transparent rule-based procedures and demonstrated total commitment towards
eliminating any conflicts of interest. It is the only Commodity Exchange in the
world to have received ISO 9001:2000 certification from British Standard
Institutions (BSI). NMCE was the first commodity exchange to provide trading
facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The

contracts are marked to market on daily basis. The system of upfront margining
based on Value at Risk is followed to ensure financial security of the market. In

57
the event of high volatility in the prices, special intra-day clearing and settlement
is held. NMCE was the first to initiate process of dematerialization and electronic
transfer of warehoused commodity stocks. The unique strength of NMCE is its
settlements via a Delivery Backed System, an imperative in the commodity
trading business. These deliveries are executed through a sound and reliable
Warehouse Receipt System, leading to guaranteed clearing and settlement.

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a

technology driven commodity exchange. It is a public limited company
registered under the Companies Act, 1956 with the Registrar of Companies,
Maharashtra in Mumbai on April 23,2003. It has an independent Board of
Directors and professionals not having any vested interest in commodity
markets. It has been launched to provide a world-class commodity
exchange platform for market participants to trade in a wide spectrum of
commodity derivatives driven by best global practices, professionalism and
transparency.

Forward Markets Commission regulates NCDEX in respect of futures

trading in commodities. Besides, NCDEX is subjected to various laws of the land
like the Companies Act, Stamp Act, Contracts Act, Forward Commission
(Regulation) Act and various other legislations, which impinge on its working. It is
located in Mumbai and offers facilities to its members in more than 390 centres
throughout India. The reach will gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm
Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking
bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard
Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds,

58
Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow
Peas, Yellow Red Maize & Yellow Soybean Meal.
TABLE4: THE CURRENT PROFILE OF FUTURES TRADING IN

INDIA WITH RESPECT TO THE VARIOUS EXCHANGES IN INDIA:-

59
16. The Present Status:

60
 Presently futures’ trading is permitted in all the commodities. Trading is
taking place in about 78 commodities through 25 Exchanges/Associations as
given in the table below:-
TABLE 4 Registered commodity exchanges in India

No. Exchange COMMODITY

1. India Pepper & Spice Trade Pepper (both domestic and
Association, Kochi (IPSTA) international contracts)
2. Vijai Beopar Chambers Ltd., Gur, Mustard seed
Muzaffarnagar
3. Rajdhani Oils & Oilseeds Exchange Gur, Mustard seed its oil &
Ltd., Delhi oilcake
4. Bhatinda Om & Oil Exchange Ltd., Gur
Bhatinda
5. The Chamber of Commerce, Hapur Gur, Potatoes and Mustard
seed
6. The Meerut Agro Commodities Gur
Exchange Ltd., Meerut
7. The Bombay Commodity Exchange Oilseed Complex, Castor
Ltd., Mumbai oil international contracts
8. Rajkot Seeds, Oil & Bullion Castor seed, Groundnut,
Merchants Association, Rajkot its oil & cake, cottonseed,
its oil & cake, cotton
(kapas) and RBD
palmolein.
9. The Ahmedabad Commodity Castorseed, cottonseed, its
Exchange, Ahmedabad oil and oilcake
10. The East India Jute & Hessian Hessian & Sacking
Exchange Ltd., Calcutta
11. The East India Cotton Association Cotton
Ltd., Mumbai
12. The Spices & Oilseeds Exchange Turmeric
Ltd., Sangli.
13. National Board of Trade, Indore Soya seed, Soyaoil and
Soya meals,
Rapeseed/Mustardseed its

61
 oil and oilcake and RBD
Palmolien
14. The First Commodities Exchange of Copra/coconut, its oil &
India Ltd., Kochi oilcake
15. Central India Commercial Gur and Mustard seed
Exchange Ltd., Gwalior
16. E-sugar India Ltd., Mumbai Sugar
17. National Multi-Commodity Several Commodities
Exchange of India Ltd., Ahmedabad
18. Coffee Futures Exchange India Coffee
Ltd., Bangalore
19. Surendranagar Cotton Oil & Cotton, Cottonseed, Kapas
Oilseeds, Surendranagar
20. E-Commodities Ltd., New Delhi Sugar (trading yet to
commence)
21. National Commodity & Derivatives, Several Commodities
Exchange Ltd., Mumbai
22. Multi Commodity Exchange Ltd., Several Commodities
Mumbai
23. Bikaner commodity Exchange Ltd., Mustard seeds its oil &
Bikaner oilcake, Gram. Guar seed.
Guar Gum
24. Haryana Commodities Ltd., Hissar Mustard seed complex
25. Bullion Association Ltd., Jaipur Mustard seed Complex
17. STATUS REPORT OF THE DEVELOPMENTS IN THE

DERIVATIVE MARKET
1. The Board at its meeting on November 29, 2002 had desired that a quarterly
report be submitted to the Board on the developments in the derivative
market. Accordingly, this memorandum presents a status report for the quarter
July-September 2008-09 on the developments in the derivative market.

2. Equity Derivatives Segment

A. Observations on the quarterly data for July-September, 2008-09
During July-September 2008-09, the turnover at BSE was Rs.1,510 crore,
which was insignificant as compared to that of NSE at Rs. 3,315,491 crore.

62
Refer Table 1

 Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while

turnover increased by 24.77% to Rs. 3,317 thousand crore in July-
September 2008-09 over April-June 2008-09.
 Futures (Index Future + Stock Future) constituted 67.20% of the total
number of contracts traded in the F&O Segment. Stock Future and Index
Future accounted for 35.26% and 31.94% respectively.
 Options constituted 32.80% of the total volumes. This mainly
comprised of trading in Index Option (30.68%).
 Turnover at F&O segment was 4.19 times that of its cash segment.

 Reliance, Reliance Capital Ltd, Reliance Petro. Ltd, State Bank of India
and ICICI Bank Ltd were the most actively traded scrips in the
derivatives segment. Together they contributed 25.12% of derivatives
turnover in individual stocks.
 Client trading constituted 60.17%, Propriety trading constituted 31.07%
and FII trading constituted remaining 8.76% of the total turnover.

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

 Total volume in shorter dated derivative contracts (contracts with maturity

up to 3months) was 1,695 lakh and total turnover was Rs. 3,307 thousand crore.

Refer Table 3
 Volume in Mini Nifty (contracts with minimum lot size of Rs.1 lakh) was
44 lakh and total turnover was Rs. 37 thousand crore.

63
 Refer Table 4
 During July-September, 2008, S&P CNX Nifty futures recorded highest
average daily volatility of 2.85% in July 2008.

Refer Table 5
 The volume (in terms of no. of contracts traded) of Nifty Future at
SGX as a percentage of the volume of Nifty Future at NSE was 8.55%
during July- September 2008-09.

Refer Table 6

 India stands 2nd in Stock Futures, 2nd in Index Futures, 16th in Stock
Option and

4th in Index Options (as on November 10, 2008) in World Derivatives

Market (in terms of volume) at the end of September 2008.

 Derivative contracts were launched on 38 securities at National Stock

Exchange during July-September 2008-09.

Table-5: Fact file of July-September 2008-09 with respect to the

Market Depth

previous quarter

APRIL-JUNE 2008-09 JULY-SEPTEMBER2008-09

No. of Turnover No. of Turnover
Depth

PRODUCT
Contracts(L (Rs. ‘000) Contracts(Lakh) (Rs. ‘000)
akh)
VOLUME & TURNOVER
Index Future 415.7 935.6 542.6 1,077.5
Index Option 240.1 571.3 521.2 1,130.9
Single Stock
Future 514.5 1,093.1 599.0 1,039.3
Stock Option 25.5 58.3 35.9 69.1
Total 1,195.8 2,658.4 1,698.7 3,317.0
Market Share ( %)
Index Future 1,077.5 35.20 31.94 32.48

64
 Index Option 1,130.9 21.49 30.68 34.09
Single Stock
1,039.3 41.12 35.26 31.33
Future
Stock Option 69.1 2.19 2.11 2.08
Turnover in F&O as
multiple of turnover in 4.19
cash segment 3.26
- Reliance - Reliance
Five most active
Market Concentration

- Reliance Petro. Ltd. - Reliance Capital Ltd

scrips in the
- Tata Steel - Reliance Petro. Ltd
F&O Segment
- Reliance Capital Ltd - State Bank of India
active scrips in - Infosys Tech. Ltd - ICICI Bank Ltd
the F&O
Segment
Contribution of
the above f iv e
to total 23.72 25.12
derivatives
turnover (%)
Client
(avg. of three

(excluding FII 59.77 60.17

monthsin

trades)
Proprietary 27.88 31.07
FII 12.35 8.76

Table-6: Data for Shorter Dated and Longer Dated derivative

contracts

Time
Period Trades in Shorter Dated Trades in Longer Dated
derivative contracts (up t o derivative contracts
3 Months) more than 3 months)
(more
(Quarter) No of No of
Turnover Turnover
contracts contracts
(Rs. ‘000 cr.) (Rs. ‘000 cr.)
(lakh) (lakh)

65
July-September
2008-09 1,694.64 3,307.11 3.99 9.87

Apr-Jun 2008-
1,194.97 2,655.88 4.83 12.5
09

Table-7: Data for Mini Nifty derivative contracts

Time Period No of Turnover (Rs.

contract
(Quarter) ‘000 cr.)
(lakh)
July-September
2008-09 43.8 36.9

Apr-Jun 2008-
29.4 27.7
09

66
Table-8: Minimum, Maximum and Average Daily Volatility of the F&O
segment at
NSE for S&P CNX Nifty since April 2008

Average Maximum Minimum

volatility Volatility (%) Volatility (%)
Month (%)
April-08 2.47 2.98 2.05
May-08 1.71 1.99 1.56
June-08 1.80 2.28 1.61
July-08 2.85 3.08 2.38
August-08 2.27 2.61 2.10
September- 2.28 2.51 2.09
08

Table-9: SGX volume as a percentage of NSE volume for Nifty

Future in terms of no. of contracts for the period April –
September, 2008-09

NSE Volume SGX Volume SGX volume

as
Month (Nifty Future (Nifty Future
% of NSE
volume) volume)
Volume
July-
September
2008-09 47,977,775 4,104,418 8.55

Apr-Jun 2008-
09 37,764,776 3,241,034 8.58

67
Table-10: Standing of India in World Derivatives Market (in terms of
volume)

September
Products July 2008 August 2008
2008
Stock Future 1 1 2
Index Future 2 2 2
Stock Option 9 15 16
Index Option 4 4 4

Source: www.world-exchanges.org (as on November 10, 2008)

Salient points for the 2nd quarter 2008-09

 The volume (no. of contracts) and open interest in the derivatives

market has increased even when the underlying market is witnessing a
downward trend. This indicates that there are sufficient long position holders
who anticipate value proposition in a falling market. Falling or rising markets
on the back of low volumes may be a cause of concern from the point of
market integrity. However, as observed from the data, under the present
scenario the fall in the market has been accompanied by high volumes.

 In Index Option, there is a sharp increase in turnover (97.95%) and

volume (117.08%) during July-September 2008-09 over April-June 2008-09.
Possible reasons for increase in options trading activity can be attributed to
increase in volatility. Market observers believe that conditions across markets
and asset classes have become more volatile and uncertain in the recent past.
Generally in such conditions, many people believe that options act as
"insurance" against adverse price movements while offering the flexibility to

68
benefit from possible favourable price movements at the same time. Another
reason which can be attributed to the increase in activity is the new directive as
per the Budget 2008-09 which states that STT would now be levied on the
Option premium instead of the strike price.

 In Index Future, both turnover (15.17%) and volume (30.53%) have

increased during July-September 2008-09 as compared to April-June 2008-09.

 There is a decrease in turnover (4.92%) in Single Stock Futures

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

 Except Index Option, the market share of all other products has
decreased (both in terms of volume and turnover) in second quarter of 2008-
09 as compared to the first quarter of 2008-09.

 There is a decrease in turnover (21.04%) and volume (17.39%) in

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

 Longer dated derivatives were launched in March 2008, but the

volumes have not picked up consequently.

 For shorter dated derivative contracts, turnover increased by 24.52%

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

 During 2008-09, Mini Nifty volumes increased by 49.15% and turnover

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

69
18. Business Growth in Derivatives segment (NSE)
TABLE 11A Index futures

Year No. of contracts

2008-09 4116649

2007-08 156598579

2006-07 81487424

2005-06 58537886

2004-05 21635449

2003-04 17191668

2002-03 2126763

2001-02 1025588

FIGURE 11A Number of contracts per year

70
 160000000
140000000 2008-09
120000000 2007-08
100000000 2006-07
80000000 2005-06
60000000 2004-05
40000000 2003-04
20000000 2002-03
0 2001-02
year

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

Table 11B No of turnovers

Year Turnover (Rs. Cr.)

2008-09 925679.96

2007-08 3820667.27

2006-07 2539574

2005-06 1513755

2004-05 772147

2003-04 554446

2002-03 43952

2001-02 21483

FIGURE 11B Turnover in Rs. Crores

71
 4000000
3500000 2008-09
3000000 2007-08
2500000 2006-07
2000000 2005-06
1500000 2004-05
1000000 2003-04
500000 2002-03
0 2001-02
year

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

72
TABLE 12A STOCK FUTURES
Year No. of contracts
2008-09 51449737
2007-08 203587952
2006-07 104955401
2005-06 80905493
2004-05 47043066
2003-04 32368842
2002-03 10676843
2001-02 1957856
2000-01 -

FIGURE 12A Number of contracts per year in stock future

250000000

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

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

TABLE 12B NO OF TURNOVERS

73
 Year Turnover
(Rs. Crores)
2008-09 1093048.26
2007-08 7548563.23
2006-07 3830967
2005-06 2791697
2004-05 1484056
2003-04 1305939
2002-03 286533
2001-02 51515
2000-01 -
FIGURE 12B Turnover in Rs. Crores

8000000
2008-09
7000000
2007-08
6000000
2006-07
5000000
2005-06
4000000
2004-05
3000000
2003-04
2000000 2002-03
1000000 2001-02
0 2000-01
year

INTERPRETATION:
From the data and bar chart above, there were no stock futures available in the
year 2000-01. There was a steady increase of stock future 51515 in the year
2001-02. but in the year there was a huge increae of 7548563.23 in the year
2007-08 with a considerable decline of 1093048.26 in the year 2008-09.

TABLE 13A INDEX OPTIONS

Year No. of contracts

2008-09 24008627
2007-08 55366038
2006-07 25157438
2005-06 12935116

74
 2004-05 3293558
2003-04 1732414
2002-03 442241
2001-02 175900
2000-01 -

FIGURE 13A Number of contracts per year

60000000

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

Interpretation:
From the data and bar chart above, the no of contracts of index option was nil in
the year 2000-2001. But there was a predominant increase of 1,75,900 in the
year 2001-2002. In the year 2007-2008 there was a huge increase in the index
option contracts to 55366038 and a decline of 24008627 in the year 2008-2009.

TABLE 13B Turnover per year in Rs. Crores

Year Turnover (Rs. Crores)

2008-09 71340.02
2007-08 1362110.88
2006-07 791906

75
 2005-06 338469
2004-05 121943
2003-04 52816
2002-03 9246
2001-02 3765
2000-01 -

FIGURE 13B Turnover per year in Rs. Crores

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

Interpretation:
From the data and bar chart above, there was no turnover in the year 2000-2001
for Index option. It slowly started increasing in the year 2000-2001 to 3765.But in
the year 2007-2008 there was a huge increase of 1362110.088 and a sudden
decline to 71340.02 observed in 2008-2009.

TABLE 14A STOCK OPTIONS

Year No. of contracts
2008-09 2546175
2007-08 9460631
2006-07 5283310
2005-06 5240776
2004-05 5045112
2003-04 5583071

76
 2002-03 3523062
2001-02 1037529
2000-01 -

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

10000000
9000000
8000000 2008-09
7000000 2007-08
6000000 2006-07
5000000 2005-06
4000000 2004-05
3000000 2003-04
2000000 2002-03
1000000 2001-02
0
year

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

TABLE 14B National turnover in Rs. Crores per year

Year Notional turnover (Rs.
crores)
2008-09 58335.03
2007-08 359136.55
2006-07 193795
2005-06 180253
2004-05 168836

77
 2003-04 217207
2002-03 100131
2001-02 25163
2000-01 -

FIGURE 14B National turnover in Rs. Crores per year

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

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

TABLE 15A OVERALL TRADING

Year No. of contracts Turnover (Rs. cr.)

2008-09 119171008 2648403.30
2007-08 425013200 13090477.75
2006-07 216883573 7356242
2005-06 157619271 4824174
2004-05 77017185 2546982
2003-04 56886776 2130610

78
 2002-03 16768909 439862
2001-02 4196873 101926
2000-01 90580 2365

FIGURE 15A Average daily turnovers in Rs. Crores

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

Interpretation:
From the data and bar chart above, the overall trading contracts in the year
2000-2001 was 90580 and huge increase of 119171008 in the year 2008-2009.
From the data and bar chart above the overall trading turnover in the year 2000-
2001 was as low as 2365 but a predominant increase of 2648403.30 observed in
the year 2008-2009.

TABLE 16 Overall trade description under NSE

Interest
Index Stock Index Stock
Rate Total
Futures Futures Options Options
Futures
Y No. Turnove No. Turnove No. Notional No. Notional No. Tu No. T
e of r (Rs. of r (Rs. of Turnove of Turnove of rno of u
a contr cr.) contract cr.) contrac r (Rs. contract r (Rs. cont ver contracts r
r acts s ts cr.) s cr.) ract (Rs n
s . o
cr.) v
e
r

79
 (
R
s
.

c
r
.
)
925679.9 2
6
2 6
4
0
8
0
4116646 5144973 1093048. 240086 571340.0 0.0 11917100 4
8 2546175 58335.03 0
9 7 26 27 2 0 8 0
-
3
0
.
9
3
0
1
3
2 0
0 9
0 0
1565985 3820667. 2035879 7548563. 553660 1362110. 359136.5 0.0 42501320
7 9460631 0 4
79 27 52 23 38 88 5 0 0
- 7
0 7
8 .
7
5
2 7
0 3
0 5
8148742 1049554 251574 21688357
6 2539574 3830967 791906 5283310 193795 0 0 6
4 01 38 3
- 2
0 4
7 2
2 4
0 8
0 2
5853788 8090549 129351 15761927
5 1513755 2791697 338469 5240776 180253 0 0 4
6 3 16 1
- 1
0 7
6 4
2 2
0 5
0 4
2163544 4704306 329355
4 772147 1484056 121943 5045112 168836 0 0 77017185 6
9 6 8
- 9
0 8
5 2
2 1719166 554446 3236884 1305939 173241 52816 5583071 217207 1078 202 56886776 2
0 8 2 4 1 1
0 3
3 0

80
- 6
0 1
4 0
2
4
0
3
0
1067684 9
2 2126763 43952 286533 442241 9246 3523062 100131 - - 16768909
3 8
-
6
0
2
3
2
1
0
0
0
1
1 1025588 21483 1957856 51515 175900 3765 1037529 25163 - - 4196873
9
-
2
0
6
2
2
0
2
0
3
0 90580 2365 - - - - - - - 90580
6
-
5
0
1

TABLE 17 AVERAGE DAILY TURNOVERS

81
Year Av. daily turnover (Rs. Crores)
2008-09 45390.21
2007-08 52153.30
2006-07 29543
2005-06 19220
2004-05 10167
2003-04 8388
2002-03 1752
2001-02 410
2000-01 11

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

82
 FINDINGS & CONCLUSION

From the above analysis it can be concluded that:

1. Derivative market is growing very fast in the Indian Economy. The

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

Commodity derivatives have a crucial role to play in the price risk management
process for the commodities in which it deals. And it can be extremely beneficial
in agriculture-dominated economy, like India, as the commodity market also
involves agricultural produce. Derivatives like forwards, futures, options, swaps

83
etc are extensively used in the country. However, the commodity derivatives
have been utilized in a very limited scale. Only forwards and futures trading are
permitted in certain commodity items.
RELIANCE is the most active future contracts on individual
securities traded with 90090 contracts and RNRL is the next most active futures
contracts with 63522 contracts being traded.

RECOMMENDATIONS & SUGGESTIONS

 RBI should play a greater role in supporting derivatives.

 Derivatives market should be developed in order to keep it at par with

other derivative markets in the world.

 Speculation should be discouraged.

 There must be more derivative instruments aimed at individual investors.

 SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

 After study it is clear that Derivative influence our Indian Economy up

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

84
 BIBLIOGRAPHY

Books referred:
 Options Futures, and other Derivatives by John C Hull
 Derivatives FAQ by Ajay Shah
 NSE’s Certification in Financial Markets: - Derivatives Core module
 Financial Markets & Services by Gordon & Natarajan

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

Websites visited:
 www.nse-india.com
 www.bseindia.com
 www.sebi.gov.in
 www.ncdex.com
 www.google.com
 www.derivativesindia.com

85
 ABBREVATIONS
A
AMEX- America Stock Exchange
B
BSE- Bombay Stock Exchange
BSI- British Standard Institute
C
CBOE - Chicago Board options Exchange
CBOT - Chicago Board of Trade
CEBB - Chicago Egg and Butter Board
CME - Chicago Mercantile Exchange
CNX- Crisil Nse 50 Index
CPE - Chicago Produce Exchange
CWC- Central Warehousing Corporation
D
DTSS- Derivative Trading Settlement System
F
FIIs- Foreign Institutional Investors
F & O – Future and Options
FMC- Forward Markets Commission
FRAs- Forward Rate Agreements
G
GAICL-Gujarat Agro Industries Corporation Limited
GSAMB- Gujarat State Agricultural Marketing Board
I
IMM - International Monetary Market
IPSTA- India Pepper & Spice Trade Association
M
MCX – Multi Commodity Exchange

86
N
NAFED-National Agricultural Co-Operative Marketing Federation Of India
NCDEX – National Commodities and Derivatives Exchange
NIAM- National Institute Of Agricultural Marketing
NMSE- National Multi Commodity Exchange
NOL- Neptune Overseas Limited
NSCCL- National Securities Clearing Corporation
NSDL- National Securities Depositories Limited
NSE - National Stock Exchange
O
OTC- Over The Counter
P
PHLX - Philadelphia Stock Exchange
PNB- Punjab National Bank
R
RBI- Reserve Bank Of India
S
SC(R) A - Securities Contracts (Regulation) Act, 1956
SEBI- Securities Exchange Board Of India
SGX- Singapore Stock Exchange
SIMEX - Singapore International Monetary Exchange
V
VPN- Virtual Private Network

87