CHAPTER-1 INTRODUCTION TO DERIVATIVE MARKET

Transcription

1 CHAPTER-1 INTRODUCTION TO DERIVATIVE MARKET

2 1.1 INTRODUCTION Risk is a characteristic feature of all commodity and capital markets. Prices of all commodities both agricultural and non-agricultural commodities are subject to fluctuations overtime keeping with the prevailing supply and demand conditions. Similarly, the price of shares, debentures, and bonds and other securities are also subject to continuous change. Therefore, the sellers and buyers are constantly and continuously exposed to the risk of losses on account of fluctuations in the prices of such assets. Thus, Derivatives came into being primarily to deal with and also to eliminate such price risks prevent in commodity and security market. The objective of an investment decision is to get required rate of return with minimum risk. To achieve this objective, various instruments, practices and strategies have been devised and developed in the recent past. With the opening of boundaries for international trade and business, the world trade gained momentum. In the last decade, the world has entered into a new phase of global integration and liberalization. The integration of capital markets world-wide has given rise to increased financial risk with the frequent changes in the interest rates, currency exchange rates and stock prices. To overcome the risk arising out of these fluctuating variables and increased dependence of capital markets of one set of countries to the other and risk management practices have also been reshaped by inventing such instruments as can mitigate the risk element. These new popular instruments are known as financial derivatives which not only reduce financial risk but also open new opportunity for high risk takers. As Derivative is a financial instrument of risk management, these generally do not influence the fluctuation in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuation in asset prices on the profitability and cash flow situation of risk-averse

3 investors. Derivatives are used by different investors with different purposes to hedge the risk arising from the investments made on the underlying asset to speculate on the underlying asset and gain from price fluctuations, for arbitrage, or to create synthetic products. These are also used to make investment strategies for safe and risk free investment 1. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. besides commodities. Derivatives contracts also exist on a lot of financial underlying assets like stocks, interest rates, exchange rates, etc. Derivative products initially emerged as hedging devices against fluctuations in commodity prices. Financial derivatives came into the spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become 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 in terms of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than individual stocks and especially institutional investors, who are major users of index linked derivatives. Even small investors find it more useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis derivative products based on individual securities is another reason for the growing use 2. The source 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 of sowing to the time of crop harvest. 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.

4 A farmer who sowed crop in the month of June face uncertainty over the price and farmer may receive harvest in the month of September. In years of scarcity, farmer probably obtains attractive prices. However, during times of oversupply, farmer would have to dispose off his harvest at a very low price. Clearly this meant that the farmer was exposed to a high risk of price uncertainty. On the other hand, a merchant with ongoing requirement of grains too would face a price risk - that of having to pay exorbitant prices during dearth, although favorable 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 a contract where by the price of the grain to be delivered in the month of September could be decided earlier 3. What they would then negotiate happened to be a future-type contract, which would enable both parties to eliminate the price risk. Derivatives are one type of securities whose value is derived from the underlying assets. These underlying assets are most commonly Stocks, Bonds, Currencies and Commodities. Derivatives have a significant place in finance and risk management. Financial markets are by nature extremely volatile and hence, the risk factor is an important concern for financial agents NEED FOR DERIVATIVES MARKET The derivatives market performs a number of meaningful functions: It helps in transferring risk from risk averse to risk takers It helps in predicting future prices based on current prices It catalyzes entrepreneurial activity It increases the volume traded in markets because of participation of risk averse people in greater numbers

5 It increases savings and investments in the long run CONCEPT OF DERIVATIVE In the Indian context the Securities Contracts (Regulation) Act, 1956 SC(R) A, defines "derivative" as A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. A contract which derives its value from the prices, or index of prices, of underlying securities Financial instruments that linked to a specific financial instrument or indicator or commodity and through which specific risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues. -The International Monetary Fund (IMF) A derivative is a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables - John C. Hull A financial instrument which has a value determined by the price of something else. This something else can be almost anything: it can be assets or commodities. - Robert L. Mc Donald 1.4 EMERGENCE OF DERIVATIVES

6 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. Financial derivatives came into the spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become 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 in terms of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, 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 are useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis derivative products based on individual securities is another reason for their growing use FUNCTIONS OF DERIVATIVES MARKET Like other segments of Financial Markets, Derivatives Market serves the following specific functions: Derivatives market helps in improving price discovery based on actual valuations and expectations. Derivatives market helps in transfer of various risks from those who are exposed to risk but have low risk appetite to participants with high risk appetite. For example hedgers want to give away the risk where as traders are willing to take risk.

7 Derivatives market helps shift of speculative trades from unorganized market to organized market. Risk management mechanism and surveillance of activities of various participants in organized space provide stability to the financial system. 1.6 FACTORS DRIVING THE GROWTH OF FINANCIAL DERIVATIVES The following factors are the driving force for the growth of derivatives 1. Increased volatility in asset prices in financial markets 2. Increased integration of national financial markets with the international markets 3. Marked improvement in communication facilities and sharp decline in their costs 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leads to higher returns, reduced risk as well as transactions costs as compared to individual financial assets 7. The following table presents the milestones in the development of Indian financial derivatives.

8 Table: 1.1 Milestones in the development of Indian Financial Derivatives Sl. Progress Progress of Financial Derivatives Enactment of the forward contracts (Regulation) Act Setting up of the forward market commission Enactment of Securities Contract Regulation Act Prohibition of all forms of forward trading under section 16 of SCRA Informal carry forward trades between two settlement cycles began on Khurso Committee recommends reintroduction of futures in most Govt. amends bye-laws of exchange of Bombay, Calcutta and Ahmedabad Enactment of the SEBI Act SEBI Prohibits carry forward transactions Kabra Committee recommends futures trading in 9 commodities G.S. Patel Committee recommends revised carry forward system th Dec. NSE asked SEBI for permission to trade index futures Revised system restarted on BSE th Nov. SEBI setup LC Gupta committee to draft frame work for index futures th May LC Gupta committee submitted report 16 1st June 1999 Interest rate swaps/forward rate agreements allowed at BSE 17 7 th July 1999 RBI gave permission to OTC for interest rate swaps/forward rate th May SIMEX chose Nifty for trading futures and options on an Indian index th May SEBI gave permission to NSE & BSE to do index futures trading

9 20 9 th June 2000 Equity derivatives introduced at BSE th June Commencement of derivatives trading (index futures) at NSE st Aug. Commencement of trading futures & options on Nifty at SIMEX 23 1 st June 2001 Index option launched at BSE 24 Jun 2001 Trading on equity index options at NSE 25 July 2001 Trading at stock options at NSE 26 9 th July 2001 Stock options launched at BSE 27 July 2001 Commencement of trading in options on individual securities 28 1 st Nov Stock futures launched at BSE 29 Nov Commencement of trading in futures on individual security 30 9 th Nov Trading of Single stock futures at BSE 31 June 2003 Trading of Interest rate futures at NSE 32 Aug Launch of futures & options in CNX IT index th Sept. Weekly options of BSE 34 June 2005 Launch of futures & options in Bank Nifty index 35 Dec 'Derivative Exchange of the Year by Asia risk magazine 36 June 2007 NSE launches derivatives on Nifty Junior & CNX Oct NSE launches derivatives on Nifty Midcap st Jan Trading of Chhota (Mini) Sensex at BSE 39 1 st Jan Trading of mini index futures & options at NSE 40 3 rd March Long term options contracts on S&P CNX Nifty index 41 NA Futures & options on sectoral indices ( BSE TECK, BSE FMCG, BSE

10 42 29 th Aug. Trading of currency futures at NSE 43 Aug Launch of interest rate futures 44 1 st Oct Currency derivative introduced at BSE 45 10th Dec. S&P CNX Nifty futures & options at NSE 46 Aug Launch of interest rate futures at NSE 47 7 th Aug BSE-USE form alliance to develop currency & interest rate derivative th Dec2009 BSE's new derivatives rate to lower transaction costs for all 49 Feb Launch of currency future on additional currency pairs at NSE 50 Apr Financial derivatives exchange award of the year by Asian Banker to 51 July 2010 Commencement trading of S&P CNX Nifty futures on CME at NSE 52 Oct Introduction of European style stock option at NSE 53 Oct Introduction of Currency options on USD INR by NSE 54 July 2011 Commencement of 91 day GOI trading Bill futures by NSE 55 Aug Launch of derivative on Global Indices at NSE 56 Sept Launch of derivative on CNX BSE & CNX infrastructure Indices at th March BSE launched trading in BRICSMART indices derivatives 58 29th Nov BSE launched currency derivative segment th Jan 2014 Launch of Interest Rate Futures (BSE IRF) th Feb 2014 Launch of Institutional Trading Platform on BSE SME th Mar 2014 BSE Launches New Debt Segment th Apr 2014 BSE SME exceeds USD 1 billion market capitalization 63 7 th Apr 2014 Launch of Equity Segment on BOLT Plus with Median Response Time of

11 64 27 th May BSE felicitated at The Asian Banker Summit BSE Best Managed th Sept BSE links MoU with BNY Mellon th Oct 2014 BSE inks strategic partnership with YES BANK th Nov 2014 BSE listed companies market cap crosses landmark 100 lakh crore th Dec 2014 Market Cap of BSE SME listed companies crosses landmark 10,000 crore th Jan 2015 BSE commenced live trading from its Disaster Recovery site in Hyderabad th Apr 2015 Asia Index Private Limited launches S&P BSE All Cap, S&P BSE th May BSE introduces overnight investment product th May BSE exceeds 1 billion derivatives contracts on its new Deutsche Borse T th July 2015 BSE celebrated its 140th Foundation Day th July 2015 BSE SME platform successfully completes listing of 100 SMEs under its th Oct 2015 BSE becomes the fastest exchange in the world with a median response th Dec 2015 BSE partners with CII (Confederation of Indian Industry) and IICA (Indian Source: Compiled data from NSE and BSE websites NA: Not Available 1.7 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 the 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 an 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

12 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 8. 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 on 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 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 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities 9. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July Futures contracts on individual stocks were launched in November The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, Single stock futures were

13 launched on November 9, 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 10. 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 percent of the total turnover during June A primary reason attributed to this phenomenon is that traders are more 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 commission by recommending index options to their clients, because low volatility leads to higher waiting time for round- trips. Puts volumes in the index options and equity options segment have increased since January 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. Further month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non- existent.

14 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. Calls on Satyam fall, while puts rise when Satyam fall intra-day. If calls and puts are not looked as just substitutes for spot trading, the intraday stock price variations should not have a one- to- one impact on the option premiums INSTRUMENTS AVAILABLE IN INDIA Table 1.2 and 1.3 presents derivative products traded at BSE and NSE respectively. Table: 1.2 Products Traded in Derivatives Segment at BSE Sl.No Product Traded with underlying asset Introduction Date 1 Index Futures- Sensex June 9 th, Index Options- Sensex June 1 st, Stock Option on 109 Stocks July 9 th, Stock futures on 109 Stocks November 9 th, Weekly Option on 4 Stocks September 13 th, Chhota (mini) SENSEX January 1 st, 2008 Futures & Options on Sectoral indices namely BSE 7 TECK, BSE FMCG, BSE Metal, BSE Bankex and BSE Oil & Gas. NA

15 8 Currency Futures on US Dollar Rupee October 1 st, Launched BRICSMART indices derivatives March 30 th,2012 Source: Compiled from BSE website NA: Not Available Table: 1.3 Derivative Products at NSE Futures on Products Index Futures Index Options Individual Securities 30 securities Underlying S&P CNX Nifty S&P CNX Nifty stipulated by Instrument SEBI Options on Individual Securities 30 securities stipulated by SEBI Type European American Maximum of 3- month trading cycle. At any point in Trading Cycle time, there will be 3 contracts available: 1) near month, Same as index futures Same as index futures Same as index futures 2) mid month & 3)far month duration Expiry Day Last Thursday of Same as index Same as index Same as index

16 the expiry month futures futures futures Contract Size Permitted lot size is 200 & multiples thereof Same as index futures As stipulated by NSE (not less than RS.2 lacs) As stipulated by NSE (not less than RS.2 lacs) Price Steps Re.0.05 Re.0.05 Theoretical value of the Previous day Base Price First Previous day options contract closing value of Same as Index day of trading closing Nifty value arrived at based underlying options on Black- security Scholes model Base price Daily settlement Daily close Daily settlement Same as Index Subsequent price price price options Price Bands Operating ranges are kept at + 10 % Operating ranges for are kept at 99 % of the base price Operating ranges kept at + 20 % Operating ranges for are kept at 99 % of the base price Lower of 1 % of market wide Quantity Freeze 20,000 units or greater 20,000 units or greater position limit stipulated for Same as individual futures open positions or RS.5 crores Source: Compiled from NSE website

17 1.9 EVOLUTION OF DERIVATIVES MARKET WORLD WIDE History of Derivatives may be mapped back to the several centuries. Some of the specific milestones in evolution of Derivatives Market Worldwide are given below: 12th Century - In European trade fairs, sellers signed contracts promising future delivery of the items they sold. 13th Century - There are many examples of contracts entered into by English Cistercian Monasteries, who frequently sold their wool up to 20 years in advance to foreign merchants Tulip Mania in Holland, Fortunes were lost in after a speculative boom in tulip futures burst. Late 17th Century - In Japan at Dojima, near Osaka, a futures market in rice was developed to protect rice producers from bad weather or warfare. In 1848, The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on various commodities. In 1865, the CBOT went a step further and listed the first exchange traded derivative contract in the US. These contracts were called futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Later its name was changed to Chicago Mercantile Exchange (CME). In 1972, Chicago Mercantile Exchange introduced International Monetary Market (IMM), which allowed trading in currency futures. In 1973, Chicago Board Options Exchange (CBOE) became the first marketplace for trading listed options.

18 In 1975, CBOT introduced Treasury bill futures contract. It was the first successful pure interest rate futures. In 1977, CBOT introduced T-bond futures contract. In 1982, CME introduced Eurodollar futures contract. In 1982, Kansas City Board of Trade launched the first stock index futures. In 1983, Chicago Board Options Exchange (CBOE) introduced option on stock indexes with the S&P 100 (OEX) and S&P 500 (SPXSM) Indexes EVOLUTION OF THE COMMODITY DERIVATIVE MARKET IN INDIA The beginning of the modern worldwide commodity derivative market can be traced at Chicago, which had emerged as an important agricultural commodity trading center in the early 1800s. In 1848, the Chicago Board of Trade (CBOT) was founded as a commodity exchange. Commodity derivatives are not new in India too 12. In fact, forward trading in commodities existed in India from ancient times (it was mentioned in Kautilya s Arthashastra ), but the first modern futures market was established in 1875 for cotton contracts by the Bombay Cotton Trade Association. Oilseed and food grain futures followed and before the World War II, futures were being traded on commodities such as wheat, rice, sugar, groundnut, groundnut oil, raw jute, jute products and castor seed as well as precious metals. During World War II futures trading was prohibited to contain runaway speculation and illegal hoarding. After independence, the Forward Contracts (Regulation) Act was enacted in 1952 to regulate the trading in forward and futures. The Forward Markets Commission (FMC) which oversees forward trading was instituted as a regulatory body the following year. The Act applied to all contracts whereby the delivery of goods occurs after a period longer than 11 days. The task of

19 the commission was to monitor and regulate the trading of forward contracts since manipulation in these markets are likely to create severe imbalances with adverse welfare effects 13. Nevertheless, Indian markets did not really blossom over the following four decades. Regulators viewed markets in general with suspicion and derivative markets particularly as the terrain of unscrupulous speculation. Price control was a central feature of economic policy during much of this period. This overly regulated nature of the economy did not bode well for the development of these markets. In 1966, futures trade was altogether banned to give effective powers to government price control. A few select commodities saw a reintroduction of futures in 1980 following the Khusro Committee report. But the real breakthrough came with the liberalization of the Indian economy in the early 1990s. In 1993, the Kabra Committee was appointed to look into forward markets. The committee recommended in 1994 that all futures banned in 1966 be reintroduced as well as many others added. Six years later, the National Agricultural Policy 2000 envisioned the removal of price controls in agricultural markets and widespread use of futures contracts. However, the commodity futures market made the true restart in early 2000s with establishment of a number of nationwide multi commodity exchanges COMMODITY DERIVATIVE MARKETS IN INDIA Commodity futures markets have a long history in India. Cotton was the first commodity to attract futures trading in the country leading to the setting up of the Bombay Cotton Trade Association Ltd in The Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst leading cotton mill owners and merchants over the functioning of Bombay Cotton Trade Association.

20 Subsequently, many exchanges came up in different parts of the country for futures trading in various commodities. Futures trading in oilseeds started in 1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trade in groundnut, castor seed and cotton. Before the Second World War broke out in 1939, several futures markets in oilseeds were functioning in Gujarat and Punjab. Futures trading in wheat existed at several places in Punjab and Uttar Pradesh, the most notable of which was the Chamber of Commerce at Hapur, which began futures trading in wheat in 1913 and served as the price setter in that commodity till the outbreak of the Second World War in Futures trading in bullion began in Mumbai in 1920 and subsequently markets came up in other centers like Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Kolkata. Kolkata Hessian Exchange Ltd. was established in 1919 for futures trading in raw jute and jute goods. But organized futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organized trading in both raw jute and jute goods. In due course several other exchanges were also created in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur (jaggery). After independence, with the subject of `Stock Exchanges and futures markets' being brought under the Union list, responsibility for regulation of commodity futures markets devolved on Government of India. A Bill on forward contracts was referred to an expert committee headed by Prof. A. D. Shroff and select committees of two successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted. 15 The Act 1952 provided a 3-tier regulatory system

21 (a) An association recognized by the Government of India on the recommendation of Forward Markets Commission, (b) The Forward Markets Commission (it was set up in September 1953) and (c) The Central Government. Forward Contracts (Regulation) Rules were notified by the Central Government in July, According to FC(R) Act, commodities are divided into 3 categories with reference to extent of regulation, viz: Commodities in which futures trading can be organized under the auspices of recognized association. Commodities in which futures trading is prohibited. Commodities which have neither been regulated nor prohibited for being traded under the recognized association are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission. India was in an era of physical controls since independence and the pursuance of a mixed economy set up with socialist proclivities had ramifications on the operations of commodity markets and commodity exchanges. Government intervention was in the form of buffer stock operations, administered prices, regulation on trade and input prices, restrictions on movement of goods, etc. Agricultural commodities were associated with the poor and were governed by polices such as Minimum Price Support and Government Procurement 16. Further, as production levels were low and had not stabilized, there was the constant fear of misuse of these platforms which could be manipulated to fix prices by creating artificial scarcities. This was also a period which was associated with wars, natural calamities and disasters which invariably led to

22 shortages and price distortions. Hence, in an era of uncertainty with potential volatility, the government banned futures trading in commodities in the 1960s. The Khusro Committee which was constituted in June 1980 had recommended reintroduction of futures trading in most of the major commodities, including cotton, kapas, raw jute and jute goods and suggested that steps may be taken for introducing futures trading in commodities, like potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh. With the gradual trade and industry liberalization of the Indian economy pursuant to the adoption of the economic reform package in 1991, GOI constituted another committee on Forward Markets under the chairmanship of Prof. K.N. Kabra. The Committee which submitted its report in September 1994 recommended that futures trading be introduced in the following commodities: Basmati Rice Cotton, Kapas, Raw Jute and Jute Goods Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean and oils and oilcakes like Rice bran oil, Castor oil and its oilcake, Linseed, Silver, Onions The committee also recommended that some of the existing commodity exchanges particularly the ones in pepper and castor seed, may be upgraded to the level of international futures markets 17. UNCTAD and World Bank joint Mission Report "India: Managing Price Risk in India's Liberalized Agriculture: Can Futures Market Help? (1996)" highlighted the role of futures

23 markets as market based instruments for managing risks and suggested the strengthening of institutional capacity of the Regulator and the exchanges for efficient performance of these markets. Another major policy statement, the National Agricultural Policy, 2000, also expressed support for commodity futures. The Expert Committee on Strengthening and Developing Agricultural Marketing (Guru Committee: 2001) emphasized the need for and role of futures trading in price risk management and in marketing of agricultural produce. This Committee's Group on Forward and Futures Markets recommended that it should be left to interested exchanges to decide the appropriateness/usefulness of commencing futures trading in products (not necessarily of just commodities) based on concrete studies of feasibility on a case-to-case basis. It, however, noted that all the commodities are not suited for futures trading. For a commodity to be suitable for futures trading it must possess some specific characteristics. The liberalized policy being followed by the Government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management. The National Agriculture Policy announced in July 2000 and the announcements of Hon'ble Finance Minister in the Budget Speech for were indicative of the Governments resolve to put in place a mechanism of futures trade market. As a follow up, the Government issued notifications on permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity are however presently prohibited. The year 2003 is a landmark in the history of commodity futures market witnessing the establishment and recognition of three new national exchanges like National Commodity and

24 Derivatives Exchange of India Ltd. (NCDEX), Multi Commodity Exchange of India Ltd (MCX) and National Multi Commodity Exchange of India Ltd. (NMCE) with on-line trading and professional management. These markets depicted phenomenal growth in terms of number of products on offer, participants, spatial distribution and volume of trade. Majority of the trade volume is contributed by the national level exchanges whereas regional exchanges have a very less share. With developments on way, the commodity futures exchanges registered an impressive growth till it saw the first ban of two pulses (Tur and Urad) towards the end of January Subsequently the ban of two more commodities from cereals group i.e. Wheat and Rice in the next month. The commodity market regulator, Forward Markets Commission as a measure of abundant caution, suspended futures trading in Chana, Soya oil, Rubber and Potato w.e.f. May 7, However, with the easing of inflationary pressure, the suspension was allowed to lapse on November 30, Trading in these commodities resumed on December 4, Later on futures trading in wheat was re-introduced in May In May 2009, a future trading in sugar was suspended. Due to mistaken apprehensions that futures trading contributes to inflation, futures trading in rice, urad, tur and sugar has been temporarily suspended COMMODITY DERIVATIVE TRADING EXCHANGES In the 1970s and 80s, the United States was a leading player in commodity derivatives trading which began there with corn contracts at the Chicago Exchange in the mid-19th century and cotton at the New York Exchange. By the early 1980s, the US was home to 13 major futures and options exchanges, including the Chicago Board of Trade (CBOT), one of the world s biggest futures and options exchange; Chicago Mercantile Exchange (CME); and New York Mercantile Exchange (NYMEX). However, Europe emerged as a clear leader in the mid-1990s,

25 particularly in the non-agricultural commodities and tilted the balance away from the US in its own favour. Table.1.4 contains top 10 Derivative Exchanges Worldwide Based on number of contracts Traded and/or cleared (2013). Table: 1.4 World Wide Top 10 Derivative Exchange Ranking Exchange No. of Contracts 1 CME Group (US) 3,161,476,638 2 Intercontinental Exchange* (US) 2,807,970,132 3 Eurex (Germany) 2,190,548,148 4 National Stock Exchange of India 2,135,637,457 5 BM&F BOVESPA (Brazil) 1,603,600,651 6 CBOE Holdings (US) 1,187,642,669 7 NASDAQ OMX (US) 1,142,955,206 8 Moscow Exchange (Russia) 1,134,477,258 6 BM&F BOVESPA (Brazil) 1,603,600,651 9 Korea Exchange (South Korea) 820,664, MCX India (India) 820,664,621 Source: *Includes NYSE Euro next Since 2005, commodity markets in Asia (primarily China and India) are witnessing huge trading volumes, despite the fact that Chicago, New York and London remain the big hubs for agricultural goods, precious and base metals and oil and gas products. In terms of trading volumes, Asia now accounts for more than half of global commodity futures and options trades. Commodity Exchange, Multi Commodity Exchange of India and some exchanges have merged

26 and carry out trading across borders such as Euro next (Paris, Brussels, Amsterdam, London and Lisbon) and the CME Group Milestones in Commodity Futures Trading in India The following Table presents the milestones in commodity futures trading. Table: 1.5 Milestones in Commodity Futures Trading Years Development 1875 Bombay Cotton Trade Association Between 1st and 2nd World war During 2nd World War 1950s to mid 1960s Mid 1960s to 1970s 1980s Rapid growth of futures markets Defense of India Act- Prohibited Futures trading in major Commodities owing to short supply Thriving Commodity futures markets Banned Commodity Futures trading in most of the Commodities except two minor Commodities Pepper and Turmeric Revival of Futures trading in Potato, Castor Seed and Gur (Jaggery) 1992 Futures trading in Hessian permitted 1999 Futures trading in various edible oilseeds complexes permitted The National Agricultural Policy recognized the positive role of 2000 forward and futures markets in price discovery and price risk management 2001 Futures trading in Sugar permitted 2003 Lifted prohibition on futures trading in all Commodities Recognition

27 to 3 National Commodity Electronic Exchanges MCX, NCDEX and NMCE 2008 Commission issued guidelines on setting up of New National Multi Commodity Exchanges 2009 Recognition to ICEX as 4th National Exchange 2010 Recognition to ACE as 5th National Exchange Notified Iron Ore under section 15 of the FCRA, Recognition to UCX as 6 th National Exchange Source: From Annual reports of Forward Market commision 1.14 TYPES OF DERIVATIVES MARKET IN INDIA The following chart depicts types of derivatives. Figure 1.1 TYPES OF DERIVATIVES MARKET Commodity Derivative Financial Derivative Forwards Futures Equity Debt Forex

28 Futures Options Swaps Forwards Futures Forwards Swaps One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or asset. In a commodity derivative, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soya beans, crude oil, natural gas, gold, silver, copper and so on. In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matter. However, despite the distinction between these two from structure and functioning point of view, both are almost similar in nature. The most commonly used derivatives contracts are forwards, futures, options and swaps Forwards: A forward contract is a customized contract between two parties, where settlement takes place on a specific date in the future at today s pre-agreed price. The main features of forward contracts are 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. The contract has to be settled by delivery of the asset on expiration date.

29 In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange- traded contracts. The main features of futures contracts are: Futures trading is necessarily organized under the auspices of a market association so that such trading is confined to or conducted through members of the association in accordance with the procedure laid down in the rules and bye laws of the association. It is invariably entered into for a standard variety known as the Basis variety with permission to deliver other identified varieties known as tenderable varieties The units of price quotation and trading are fixed in these contract and parties to the contract not being capable of altering these unites. The delivery periods are specified. The seller in a futures market has the choice to decide whether to deliver goods against outstanding sale contracts. In case he decides to deliver goods, he can do so not only at the location of the association through which trading is organized but also at a number of other pre-specified delivery centers Options: Options are of two types calls and puts. While Calls give the buyer the right, but not the obligation, to buy a given quality of the underlying asset at a given price on or before a given

30 future date, puts give the seller the right, but not the obligation, to sell a given quantity of the underlying asset at a given price on or before a given date Warrants: Options generally have lives of up to one year; the majority of options traded on options exchanges have a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over- the-counter Leaps: The acronym leaps means Long- term Equity Anticipation Securities. These are options having a maturity of up to three years Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options Swaps: swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction Swaptions:

31 Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaptions is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaptions is an option to receive fixed and pay floating. A payer swaptions is an option to pay fixed and receive floating MARKET PARTICIPANTS OF DERIVATIVES Derivative instruments are used for varied purposes i.e. managing risk by managing funds; making profit by taking risk, and taking advantage of price differentiation in different markets at any given point of time. Accordingly, there are varied types of trades or participants who trade in the futures and option market. Those are hedgers, speculators and arbitrageurs, who constitute three major classes of such trader Hedgers: To safeguard something, is to construct a protective fence around. It is applied to financial markets. Hedging is nothing but eliminating the risk in an asset or liability. It is applied to stock market, hedging also eliminates the risk in an investment portfolio. Hedging is the process of reducing exposure to risk. Thus, hedge is an act that reduces the price risk of a certain position in the cash market. Futures contract are the primary tools of effective hedging and they enable the market participants to change their risk exposure from unexpected adverse price fluctuations. Futures act as a hedge when a position is taken in them which are just opposite to that taken by the investor in the existing cash position. Hedgers sell futures (short futures) when they have already had a long position on the cash asset, and they buy futures (long futures) in the situation of having a short position (advance sell) on the cash asset 22.

32 Hedging strategies: Essentially, futures contract try to predict what the value of a commodity will be at some date in the future. Speculators in the futures market can use different strategies to take advantage of rising and declining prices. The most common are known as going long and going short, also referred to as long hedge and short hedge respectively Speculators: Speculators are participants who wish to bet on future movements in the price of an asset. Futures contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market. As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses Arbitragers: Arbitrage refers to riskless profit earned by taking position in spot futures market. Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. For example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in the profit COMMODITY DERIVATIVES VS FINANCIAL DERIVATIVES The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However, there are some features which are very peculiar to commodity derivative markets. 22 In the case of financial derivatives, most of these contracts are cash settled. Since financial assets are not bulky, they do not need special facility for storage even in case of physical settlement. On the other hand, due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as

33 financial underlying is concerned. However, in the case of commodities, the quality of the asset underlying a contract can vary largely. This becomes an important issue to be managed Physical Settlement Physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. The seller intending to make delivery would have to take the commodities to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. This may sound simple, but the physical settlement of commodities is a complex process. The issues faced in physical settlement are enormous. There are limits on storage facilities in different states. There are restrictions on interstate movement of commodities. Besides state level octroi and duties have an impact on the cost of movement of goods across locations. The process of taking physical delivery in commodities is quite different from the process of taking physical delivery in financial assets Delivery notice period Unlike in the case of equity futures, typically a seller of commodity futures has the option to give notice of delivery. This option is given during a period identified as `delivery notice period' Assignment Whenever delivery notices are given by the seller, the clearing house of the Exchange identifies the buyer to whom this notice may be assigned. Exchanges follow different practices for the assignment process Delivery

34 The procedure for buyer and seller regarding the physical settlement for different types of contracts is clearly specified by the Exchange. 25 The period available for the buyer to take physical delivery is stipulated by the Exchange. Buyer or his authorized representative in the presence of seller or his representative takes the physical stocks against the delivery order. Proof of physical delivery having been affected is forwarded by the seller to the clearing house and the invoice amount is credited to the seller's account. The clearing house decides on the delivery order rate at which delivery will be settled. Delivery rate depends on the spot rate of the underlying adjusted for discount/ premium for quality and freight costs. The discount/ premium for quality and freight costs are published by the clearing house before introduction of the contract. The most active spot market is normally taken as the benchmark for deciding spot prices Warehousing One of the main differences between financial and commodity derivative is the need for warehousing. In case of most exchange-traded financial derivatives, all the positions are cash settled. Cash settlement involves paying up the difference in prices between the time the contract was entered into and the time the contract was closed. For instance, if a trader buys futures on a stock at Rs.100 and on the day of expiration, the futures on that stock close at Rs.120, he does not really have to buy the underlying stock. All he does is take the difference of Rs.20 in cash. 27 Similarly, the person who sold this futures contract at Rs.100 does not have to deliver the underlying stock. All he has to do is pay up the loss of Rs.20 in cash. In case of commodity derivatives however, there is a possibility of physical settlement. It means that if the seller chooses to hand over the commodity instead of the difference in cash, the buyer must take physical delivery of the underlying asset. This requires the Exchange to make an