CHAPTER-1 INTRODUCTION

CHAPTER-1 INTRODUCTION 1.1 Introduction 1.2 The concept of Derivatives 1.3 Importance of Derivatives 1.4 History of Derivatives 1.5 Growth of Indian Derivatives and Global Derivatives 1.6 Derivative Market in India & Regulatory Framework 1.7 Conclusion References 1

Derivatives are like razor, you can use it to shave yourself or commit suicide. Warren Buffet 1.1 INTRODUCTION The securities markets in India have perceived several policy initiatives, leading to refined market micro-structure, modernized operations and broadened investment choices for the investors. The securities market has two interdependent and inseparable segments, the new issues (primary market) and the stock (secondary) market. The primary market provides the channel for sale of new securities. Primary market provides opportunity to issuers of securities; government as well as corporates, to raise resources to meet their requirements of investment and/or discharge some obligation in domestic market and/or international market. Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets and provides liquidity to the stocks. Majority of trading takes place in India on two stock exchanges namely National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). BSE was founded in 1875 and is the oldest exchange. It includes 30 companies while NSE was founded in 1992 and started trading in 1994. It consists of 50 companies.both of them operates on same rules and mechanisms and consists of most of the India s major firms. Their Indexes are popularly known as SENSEX and the S&P CNX NIFTY. 1.2 THE CONCEPT OF DERIVATIVES A variant of secondary market is the forward market, where securities are traded for future delivery and payment. One is the spot market or cash market and other is derivative or future market. The products traded in derivative market are futures and options. Derivatives are a widely misunderstood term. This word often conjures up visions of speculative dealings, big booms & a big crash. It is nothing but reckless speculation. But this notion is not true. It is rightly said by James Morgan in Financial Times Column- a Derivative is like a razor-you can use it to shave or you can use it to commit suicide. Actually it depends on how u uses it. In fact it helps cover risks which 2

would arise on the trading of securities on which the derivative is based. Derivatives are financial contracts between two parties who have agreed to buy or sell an underlying asset at a particular point of time for a specified period of time. Their value is dependent on the value of underlying asset or price of the stock. The underlying asset can be individual stocks, Indices like Nifty, Sensex, commodities, mutual funds, currencies & Interest rates. Interest rate futures, currency futures and trading of Indian derivatives on global Indices are just the tip of ice berg. World over, exchange traded derivatives are slowly eating into the traditional trading platforms, especially the spot & OTC (Dr. K.S. Jaiswal & DiptiSaha).Still in airline industry (Carter et al. (2004) in currencies, dominance of OTC market is present. Derivatives products provide certain important economic benefits such as risk management or redistribution of risk away from risk-averse investors towards those more wasing and able to bear risk. Derivatives also help price discovery, i.e. the process of determining the price level for any asset based on supply and demand. Derivatives are among the forefront of the innovations in the financial market and aim to increase returns and reduce risk. They provide an outlet for investors to protect themselves from the vagaries of the financial markets. These instruments have been very popular with investors all over the world. Derivatives supplement cash markets as unfunded alternatives to trading underlying reference assets by providing hedging and low-cost arbitrage opportunities. They improve market liquidity and complete financial markets by facilitating the unbundling, transformation and diversification of financial risks, which can be customized to the varying risk preference and tolerance of agents, and, thus, improving the capacity of the financial system overall to bear risk and intermediate capital. In particular, derivatives allow a variety of economic agents to raise capital more cheaply in capital markets. Derivatives are traded in two types of market-over the counter (OTC) market and the exchange traded market. OTC (over-the-counter) contracts are customized contracts negotiated between two parties. The terms of all contracts are decided by the parties suiting to their requirements leading to substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by 3

the Forward Markets Commission), those that trade informally in havala or forwards markets. Forwards and Swaps are traded in this market. An exchange-traded contract has a standardized format that specifies everything about the contract -the underlying asset to be delivered, the size of the contract, price, credit terms and everything. They trade on organized exchanges with prices determined by the demand of buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE for Margin requirements and daily markingto-market of futures positions. 1.3 IMPORTANCE OF DERIVATIVES Derivatives markets generally are an integral part of capital markets in developed as well as in emerging market economies. These instruments assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates or other assets and thereby render both cash and derivatives. Growth of financial derivatives worldwide have increased drastically due to technological developments leading to development of more sophisticated risk management tools; increased volatility in asset prices in financial markets; increased integration of national financial markets with international markets and the inherent characteristic of the derivatives markets to be able to optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets. 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-à-vis derivative products based on individual securities is another reason for their growing use 1.3.1 Uses of Derivatives 4

The derivatives market performs a number of economic functions. 1. Risk Management Tool- It helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 2. Discovery of current and Future prices-prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract 3. Increase in Volume of Cash Market-Derivatives, due to their inherent nature, are linked to the underlying cash markets which lead to higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Controlled Trade Environment-Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets. 5. Catalyst for new entrepreneurial activity- Derivatives has a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities. 1.4 HISTORY OF DERIVATIVES In the recent years, the market for financial derivatives has grown tremendous both in terms of variety of instruments available and turnover. As said by Parmjit Kaur, derivatives are recognized as the best and most cost-efficient way of meeting the felt need for risk hedging in certain types of commercial and financial operations. Countries not providing such globally accepted risk hedging facilities are disadvantaged in today's rapidly integrating global economy. With the promulgation of the Securities Laws (Amendment) Ordinance, 1995,derivatives got introduced which withdrew the prohibition on options in securities but still the market for derivatives, did not take off, since there was no 5

regulatory framework to govern trading of derivatives. So 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 suggested necessary pre-conditions for introduction of derivatives trading in India in March, 1997. One of the major condition was that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. On the other hand, 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, 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. Finally, the SCRA amended in December 1999 to include derivatives within the ambit of securities and accordingly the regulatory framework were developed. 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. Finally, With the SEBI s final approval in May 2000, Derivatives trading started in India in June 2000. SEBI permitted the derivatives 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 followed by approval for trading in options which commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Futures and Options contracts on individual securities are available on more than 200 securities. 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. 6

1.5 GROWTH OF DERIVATIVES AND GLOBAL DERIVATIVES As far as growth is concerned, India is the second highest growing Derivative market in the world after JSE (South Africa) (2008). Journey of Equity Derivatives Market at NSE from 2000-01 to 2016-2017 Equity derivatives trading at NSE, which forms nearly 98 % - 99% of the total market, has become nearly a decade old in the Indian securities market. Today, this market forms an important component of the Indian securities markets. Even though the derivative trading started in the year 2000, it has surpassed the equity market in terms of trading volumes. The trading volumes in equity derivatives have quadrupled the trading volumes in the equity markets. Table 1.1 Growths of Index Futures Percentage share of Index Index Futures Futures in terms of Total Year No. of con- No. of con- Turnover Tracts Tracts (Rs. cr.) Turnover 2000-01 90,580 2,365 100.00 100.00 2001-02 1,025,588 21,483 24.44 21.08 2002-03 2,126,763 43,952 12.68 9.99 2003-04 17,191,668 554,446 30.22 26.02 2004-05 21,635,449 772,147 28.09 30.32 2005-06 58,537,886 1,513,755 37.14 31.38 2006-07 81,487,424 2,539,574 37.57 34.52 2007-08 156,598,579 3,820,667 36.85 29.19 2008-09 210,428,103 3,570,111 32.01 32.42 2009-10 178,306,889 3,934,389 26.25 22.27 2010-11 165,023,656 4,356,754.53 - - 7

2011-12 146,188,740 3,577,998.41 - - 2012-13 9,61,000,385 2,527,130.76 - - 2013-14 105,252,983 3,083,103.23 - - 2014-15 129,303,044 4,107,215.20 - - 2015-16 140,538,674 4,557,113.64 - - 2016-17 36,270,940 2,254,229.91 (Till now) - Source: www.nseindia.com Table 1.1, shows the journey of the index futures since the year 2000. Over a period of time many in-dices have been made available for index futures trading. The index futures turnover at NSE has grown from Rs.2, 365 crore to Rs. 3,934,389 crore in 2009-10. This shows that index futures have witnessed a CAGR of 109.94 % in these 10 years in terms of turnover and a CAGR of 113.51 % in terms of number of contracts traded. Also it is now 4,557,113.64 crores which shows its popularity. Table 1.2-Ranking of NSE Globally Parameters Single Stock Options Single Stock Futures Index options Index Futures Ranks 9 th 3 rd 1 st 10 th Source: WFE (Rankings done for the period August 2016).Rankings on basis of number of contracts traded. The table shows the position of Nifty globally in four derivative products. In an ranking of maximum 10, all products of nifty are covered which demonstrates the power and popularity of NSE worldwide. 8

Table 1.3-Index Options Trading at NSE Growth of Index Options Index Options Percentage Share of Index Options in terms of Year No. of con- Tracts Notional Turnover (Rs. cr.) No. of Contracts Turnover 2000-01 - - - - 2001-02 175,900 3,765 4.19 3.69 2002-03 442,241 9,246 2.64 2.1 2003-04 1,732,414 52,816 3.05 2.48 2004-05 3,293,558 121,943 4.28 4.79 2005-06 12,935,116 338,469 8.21 7.02 2006-07 25,157,438 791,906 11.60 10.77 2007-08 55,366,038 1,362,111 13.03 10.41 2008-09 212,088,444 3,731,502 32.26 33.89 2009-10 341,379,523 8,027,964 50.26 45.45 2010-11 650,638,557 18,365,635.76 - - 2011-12 864,017,736 22,720,031.64 - - 2012-13 820,877,149 22,781,574.14 - - 2013-14 928,565,175 27,767,341.25 - - 2014-15 1378,642,863 39,922,663.48 - - 2015-16 1623,528,486 48,951,930.60 - - 9

2016-17 495,492,914 31,946,632.62 - - The Index options were allowed for trading on S&P CNX Nifty Index on June 4, 2001. Table 3 shows the growth of index options at NSE in terms of number of contracts traded and in terms of turnover since inception. The growth of index options at NSE in terms of turnover has been from Rs 3,765 crore to Rs 8,027,964 crore in 2009-10. This shows that index options witnessed a CAGR of 134.35 % in last nine years in terms of turnover and a CAGR of 131.92% in terms of number of contracts traded. In terms of turnover and number of contracts traded, the share of index options in total derivatives turnover has increased significantly and on a continuous yearly basis. 1.6 DERIVATIVE MARKET IN INDIA & REGULATORY FRAMEWORK 1.6.1 Derivative Market in India Derivatives are traded in OTC market and exchange traded markets. 1.6.1.1 Products and participants 1.6.1.1.1 Products The most commonly used derivatives contracts are forwards, futures, options and swaps. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today s pre-agreed price. 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. Options: Options are contracts which give right but not the obligation to buy or sell the underlying asset at a given price for a given date. Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the 10

buyer 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. 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. 1.6.1.1.1 Participants The following three broad categories of participants are hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers are risk averse. They use futures or options markets to reduce or eliminate the risk faced by position in underlying asset. Speculators are risk takers. They bet the future movements in the price of an asset. Since they take more risk, they earn more returns. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs thrive for market imperfections. They buy and sell from different market to gain the price difference. They are risk averse and wait for market imperfections. 1.6.2 Regulatory Framework SEBI is the Supreme body to look after the overall functioning of the securities market. But in all, there are the five main legislations governing the securities market are: (a) The SEBI Act, 1992 which established SEBI to protect investors and develop and regulate securities market; 11

(b) The Companies Act, 1956, which sets out the code of conduct for the corporate sector in relation to issue, allotment and transfer of securities, and disclosures to be made in public issues; (c) The Securities Contracts (Regulation) Act, 1956, which provides for regulation of transactions in securities through control over stock exchanges; (d) The Depositories Act, 1996 which provides for electronic maintenance and transfer of ownership of demat securities; and (e) The Prevention of Money Laundering Act, 2002 which prevents money laundering and provides for confiscation of property derived from or involved in money laundering 1.6.2.1 New Policy Developments in Derivatives Segment I. Standardized lot size for derivative contracts on individual securities - The SEBI, in consultation with the stock exchanges, standardize the lot size for derivative contracts on individual securities across exchanges and was review it once in six months, based on the average of the closing price of the underlying for the last one month, and wherever warranted, revise the lot size by giving an advance notice of at least two weeks to the market. II. Introduction of derivative contracts on Volatility Index -In continuation to the SEBI circular dated January 15, 2008 regarding the introduction of the volatility index, the capital market regulator, vide its circular dated April 27, 2010, decided to permit stock exchanges to introduce derivatives contracts on volatility index. The introduction of derivatives contracts on volatility index is subject to the condition that the underlying volatility index has a track record of at least one year. III. Introduction of index options with tenure up to five years Further to SEBI s circular dated January 11, 2008 regarding the introduction of index options with tenure up to three years, the SEBI decided to permit the stock exchanges to introduce option contracts on the SENSEX and the Nifty with tenure up to five years. The introduction of such five-year option contracts was be subject to the condition that there are eight semi-annual contracts of 12

the cycle June/December together with three serial monthly contracts, and three quarterly contracts of the cycle March/June/September/December. IV. Revised exposure margin for exchange-traded equity derivatives-in a modification to SEBI s circular on exposure margin, the SEBI decided (vide its circular dated July 7, 2010) that the exposure margin for exchangetraded equity derivatives shall be the higher of 5 percent or 1.5 times the standard deviation (of daily logarithmic returns of the stock price). V. Physical settlement of stock derivatives- In continuation to SEBI s circular dated June 20, 2001 and November 02, 2001 regarding the settlement of stock options and stock futures contracts, respectively, the SEBI based on the recommendations of the Derivatives Market Review Committee and in consultation with stock exchanges decided to provide flexibility to the stock exchanges to offer: a) Cash settlement (settlement by payment of differences) for both stock options and stock futures; or b) Physical settlement (settlement by delivery of underlying stock) for both stock options and stock futures; or c) Cash settlement for stock options and physical settlement for stock futures; or d) Physical settlement for stock options and cash settlement for stock future VI. Options on USD-INR spot rate -The SEBI, vide its circular dated July 30, 2010, has allowed for the introduction of options on USD-INR spot rate on the currency derivatives segment of the stock exchanges. Premium styled European call and put options can be introduced on the USD-INR spot rate. The contract would be settled in cash in Indian rupees, and the final settlement price would be the RBI Reference Rate on the date of expiry of the contracts. VII. European-style stock options- In continuation of SEBI s circular dated June 20, 2001 on the exercise style of stock option contracts, the SEBI (in consultation with the stock exchanges) decided to provide flexibility to the stock exchanges to offer either European style or American-style stock options. After opting for a particular style of exercise, a stock exchange shall offer options contracts of the same style on all eligible stocks. Further, a stock exchange may change to another style of exercise only after seeking prior approval from the SEBI. The contracts specifications, including the risk 13

VIII. IX. management framework applicable for American-style stock options, shall apply to the European-style stock options. Introduction of derivative contracts on foreign stock indices -The SEBI has decided to permit the stock exchanges to introduce derivative contracts (Futures and Options) on foreign stock indices in the equity derivatives segment subject to fulfillment of all requirements. The absolute numerical value of the underlying foreign stock index shall be denominated in Indian Rupees (`). The derivatives contracts on that foreign stock index would be denominated, traded, and settled in Indian Rupees. Trading in derivatives on foreign stock indices shall be restricted to the residents of India. Futures on 91-day Government of India Treasury Bill (T-Bill)-As a continuation of the SEBI circular no. SEBI/DNPD/Cir-46/2009 dated August 28, 2009 regarding Exchange Traded Interest Rate Futures, the SEBI decided to permit the introduction of futures on 91-day Government of India Treasury Bills (T- Bill) on the currency derivatives segment of the stock exchanges. 1.7 CONCLUSION Derivatives have been a part of financial practice for a decade, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis & technical analysis. One of the main obstacles with derivatives is the highly complex nature of Derivatives - the presence of underlying assets, unique variants is often in the eyes of the beholder. To conclude, Derivatives are very versatile instruments. They can be used for hedging, speculation & for arbitrage. It is this versatility that can cause problems. Sometimes traders who have a mandate to hedge risks or follow an arbitrage strategy become (consciously or unconsciously) speculators. The results can be disastrous. Good example is activities of Nick Leeson at Barings Bank in Singapore. 14

References 1. http://www.investopedia.com/articles/stocks/09/indian-stock-market.asp 2. https://www.nseindia.com/content/ncfm/smbm_rev.pdf 3. https://www.nseindia.com/content/us/ismr_full2011.pdf 4. Asani Sarkar (2006) has done the analysis of various derivatives products available for retail investors 15