DERIVATIVES TRADING IN INDIA

Derivatives
Financial markets are a part of the changing business paradigms, across the
globe. In fact, the financial markets are the first to unleash the creativity and
imagination and lead the revolution. Today, all around, there is a fresh thinking on the
financial products, structures and possibilities and the Financial Markets are being
redefined, reinvented and reconfigured, dynamically. Financial Innovation has
become ubiquitous. This innovation is sparked by the challenges posed by the
constantly changing business environment, which has become complex and dynamic
beyond imagination and this complexity is going to augment in the time to come.

Risk and Return Analysis

In the financial arena two basic elements to be calculated are return and risk.
Technically, return has two aspects Ex- Ante (Expected Return) and Ex-post (Actual
Return). The probability of variation of ex-post (actual return) from the ex-ante
(expected return) is the risk. Risk also exists in two ways-systematic or uncontrollable
and unsystematic or controllable risk. Systematic risk has the major components such
as market risk, purchasing power risk and interest rate risk which affect the mass and
are undiversifiable. Market risk is the result of fluctuations occured due to visible or
invisible events such as political unstability, changing economic, legal and social
circumstances and their impact on stock behaviour. Purchasing power risk occurs due
to inflationary condition. These inflationary conditions may by due to the demand
pull or cost push factors. Interest rate risk is subject to the changing monetary policies
of the government and its impact on minimum rate of return in the economy.
Technically, systematic risk is represented by Beta (β ) which affects the degree of
market return on securities.

Unsystematic risk, on the other hand, is the diversifiable risk and affects the
particular or individual entity as individual person or business organisation (firm) in
an industry. The major components of unsystematic risk are business risk and
financial risk which can be avoided by the investors by taking precautionary measures
or strategic planning. The term risk is quantifiable and can be measured by the
quantitative measures in terms of probability. Uncertainty is the worse phase of risk
which can not be forecasted quantitatively. It is imperative to forecast the risk and
take strategic measures such as diversification of portfolio to avoid or minimise the
risk.

Due to probability of change, and so, uncertainly of future, the risk can not be
eliminated totally from the market but it can be reduced to some degree relatively or
can be transferred from those who can not bear it to those who can bear the same. So,
there is dire need of risk management in the arena of finance. The investors prefer the
theme of safety, liquidity and profitability in their investment as it is their hard earned
savings which is converted into investments.

Return is the reward of investors for converting their savings into investment as
they defer their present consumption with transactional, precautionary or speculative

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 motives and invest to cover the future risk or to gain from the time differentials. Total
return is calculated as yield which incorporates frequently earned return and capital
appreciation. On the other hand, “a potent mix of fast interlocking markets and
developments in information technology have increased the speed, frequency and
magnitude of price change both in commodities and financial markets, which in turn
have multiplied both opportunities and challenges.” Alongwith the risk, return can be
saved or increased by increasing the frequency of transactions in terms of value of
assets rather than the assets themselves.

Information dynamics and risk dynamics are the two principal dimensions of
modern capitalism. Only a few countries posses such magical powers to work with
information and risk to their advantage. Information dynamics is very important
factor in increasing return or reducing risk inherent in the investment process. In a
global market it is the inefficiency of the market which creates surplus for proactive
investors. From the information dynamics point of view, the financial markets can be
segregated in four phases of weak, semi-strong, strong and efficient markets. It is the
availability and accessibility of right (reliable price sensitive) information in right
time in right way (unbiased information) and risk taking behaviour of investors over
these information which determine the degree of profitability from investment.
Variations in performances of the people exposed to similar work environment is due
to inner forces and imputes which determine direction and magnitude of the action
taken by an individual. Risk-taking behaviour is the attitude towards taking risk and it
is the expression of one’s value for the risk. “People differ in their willingness to take
chances.” This propensity to assume or avoid risk has an impact on how long it takes
people to make a decision and how much information they require before making
their choice. “The influence of risk in decision-making gets a wide coverage both in
the literature of finance, project management and psychology.” In an efficient market
the available return reflects each of minute information and eliminates the surplus
through risk-return trade-off.

Nature of Financial Derivatives

“In the volatile market it is crucial for the finance experts to construct investments
of investors with prudent risk-reward profiles to match their requirements. This type
of creativity in the form of investor friendly combination of various instruments is a
grooming practice worldwide. This, “any use of derivative in conjunction with
another financial instrument (derivative or otherwise) can be regarded as financial
engineering.”
Operational Definitions
Financial Derivatives is the latest and modern type of financial engineering.
Derivatives have been a very successful innovation in the capital market. Section
2(aa) of the Securities Contracts (Regulation) Act [SC(R)A], 1956 defines derivatives
as “derivative includes-
(A) A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security;
(B) A contract which derives its value from the prices, or index of prices, of
underlying securities.

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 Derivatives are securities under the SC(R)A and hence the trading of
derivatives is governed by the regulatory framework under the SC(R)A.” Basically,
derivatives are those financial assets whose values are determined by the value of
some other asset called as underlying. Derivatives are the result of innovative
financial practices emerged as a shield to protect the financial assets from the risk of
volatility in the financial market. It is the representative instrument which reflects the
value as well as change in value of the asset underlying it. “Derivatives are also
known as ‘deferred delivery’ or ‘deferred payment instruments.’ They do not have
independent existence without underlying product and market.”

Types of Financial Derivatives

Financial derivative assets are assets whose values are determined by the value
of some other asset called the underlying. There are two common types of derivative
contracts, those patterned on forwards and on options. “Derivatives based on
forwards have linear payoffs, meaning their pay-offs move one-for-one with changes
in underlying price. Such contracts are generally relatively easy to understand, value
and manage. Derivatives based on options have non-linear pay-offs, meaning their
pay-offs may move proportionally more or less than the underlying price. Such
contracts can be quite difficult to understand, value and manage.”
The important financial derivatives are the following:
(i) Forwards
(ii) Futures
(iii) Options and
(iv) Swaps

(i) Forwards
Forwards are the oldest of all the derivatives. A forward contract refers to
an agreement between two parties to exchange an agreed quantity of an asset for
cash at a certain date in future at a predetermined price specified in that
agreement. The promised asset may be currency, commodity, instrument etc. This
means that in a forward contract, the contracting parties negotiate on, not only the
price at which the commodity is to be delivered on a future date but also on what
quality and quantity to be delivered and at what place. No part of the contract is
standardised and the two parties sit across and work out each and every detail of
the contract before signing it.

(ii) Futures
A futures contract is very similar to a forward contract in all respects
excepting the fact that it is completely a standardised one. Hence, it is also said
that a futures contract is nothing but a standardised forward contract. It is legally
enforceable and it is always traded on an organised exchange.

The term ‘future trading’ includes both speculative transactions where

futures are bought and sold with the objective of making profits from the price
changes and also the hedging or protective transactions where futures are bought
and sold with a view to avoiding unforeseen losses resulting from price
fluctuations. A futures contract is one where there is an agreement between two
parties to exchange any asset or currency or commodity for cash at a certain

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 future date, at an agreed price. Both the parties to the contract must have mutual
trust in each other. It takes place only in organised futures markets and according
to well established standards. As in a forward contract, the trader who promises to
buy is said to be in ‘Long position’ and the one who promises to sell is said to be
in ‘Short position’ in futures also. The contracting parties need not pay any down
payment at the time of agreement. However, they deposit a certain percentage of
the contract price wit the exchange and it is called initial margin. This gives a
guarantee that the contract will be honoured. Futures instruments are ‘marked to
the market’ and the exchange records profit and loss on them on daily basis. That
is, once a futures contract is entered into, profits or losses to both the parties are
calculated on a daily basis.
(iii) Options
An options is a contract between two parties whereby one party acquires
the right, but not the obligation, to buy or sell a particular commodity or
instrument or asset, at a specified price, on or before a specified date. The Person
who acquires the right is known as options buyer or holder while the person who
confers the right is known as the options seller or writer. The options buyer has
right to play or not to play his role at the expiry of the contract date while the
options seller is in obligation to play his role. The options buyer pays the charge
to options seller for taking high risk which is known as options premium. The
price specified for the contract is known as exercise price or strike price.

By nature, options are of two types- European options and American options.
The European options are exercised on the expiry day of the contract only while
the American options can be exercised on or before the expiry date of the
contract. On the basis of trading practices, the options are segregated as call
options and put options.
(a) Call Option: A call option is one which gives the option holder the right to buy a
underlying asset (commodities, foreign exchange, stocks, shares etc.) at a
predetermined price called ‘exercise price’ or strike price on or before a specified
date in future. In such a case, the writer of call option is under an obligation to sell
the asset at the specified price, in case the buyer exercises his options to buy. Thus,
the obligation to sell arises only when the option is exercised.

(b) Put Option: A put option is one which gives the option holder the right to sell an
underlying asset at a predetermined price on or before a specified date in future. It
means that the writer of a put option is under an obligation to buy the asset at the
exercise price provided the option holder exercises his option to sell.
(c) Double Option: A double option is one which gives the option holder both the
rights either to buy or to sell an underlying asset at a predetermined price on or
before a specified date in future.

(iv) Swaps: Swaps is a combination of forwards by two counterparties. It is arranged to

reap the benefits arising from the fluctuations in the market- either currency market
or interest rate market or any other market for that matter. Swaps requires that two
parties with equal and opposite needs must come into contact with each other. It

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 varies from borrowers to borrowers due to the relative credit worthiness of
borrowers.

Therefore, borrowers enjoying comparative credit advantage in floating rate

debts will enter into a swap agreement to exchange floating rate interest with the
borrowers enjoying comparative advantage in fixed interest rate debt, like bonds. In
a bond market, lending is done at a fixed rate for a long duration and therefore, the
lenders do not have the opportunity to adjust the interest rate according to the
situation prevailing in the market. So, the lenders are very much concerned with the
credit worthiness of borrowers and they expect a premium for the risk involved.
This premium is rather high in the case of less credit worthy borrowers.

Participants in Derivatives Market

1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with
price of an asset. Majority of the participants in derivatives market belongs to this
category.
2. Speculators: They transact futures and options contracts to get extra leverage in
betting on future movements in the price of an asset. They can increase both the potential
gains and potential losses by usage of derivatives in a speculative venture.
3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a
discrepancy between prices of more or less the same assets or competing assets in
different markets. If, 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 a
profit.

1.4. Applications of Financial Derivatives

Some of the applications of financial derivatives can be enumerated as follows:

1. Management of risk: This is most important function of derivatives. Risk

management is not about the elimination of risk rather it is about the management of risk.
Financial derivatives provide a powerful tool for limiting risks that individuals and
organizations face in the ordinary conduct of their businesses. It requires a thorough
understanding of the basic principles that regulate the pricing of financial derivatives.
Effective use of derivatives can save cost, and it can increase returns for the
organisations.

2. Efficiency in trading: Financial derivatives allow for free trading of risk components
and that leads to improving market efficiency. Traders can use a position in one or more
financial derivatives as a substitute for a position in the underlying instruments. In many
instances, traders find financial derivatives to be a more attractive instrument than the
underlying security. This is mainly because of the greater amount of liquidity in the
market offered by derivatives as well as the lower transaction costs associated with
trading a financial derivative as compared to the costs of trading the underlying
instrument in cash market.

3. Speculation: This is not the only use, and probably not the most important use, of
financial derivatives. Financial derivatives are considered to be risky. If not used
properly, these can leads to financial destruction in an organisation like what happened in

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Barings Plc. However, these instruments act as a powerful instrument for knowledgeable
traders to expose themselves to calculated and well understood risks in search of a
reward, that is, profit.

4. Price discover: Another important application of derivatives is the price discovery

which means revealing information about future cash market prices through the futures
market. Derivatives markets provide a mechanism by which diverse and scattered
opinions of future are collected into one readily discernible number which provides a
consensus of knowledgeable thinking.

Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a
long time. In the area of commodities, the Bombay Cotton Trade Association started
futures trading in 1875 and, by the early 1900s India had one of the world’s largest
futures industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years, government
policy has changed, allowing for an increased role for market-based pricing and less
suspicion of derivatives trading. The ban on futures trading of many commodities was
lifted starting in the early 2000s, and national electronic commodity exchanges were
created.
In the equity markets, a system of trading called “badla” involving some elements of
forwards trading had been in existence for decades.6 However, the system led to a
number of undesirable practices and it was prohibited off and on till the Securities and
Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the
stock market between 1993 and 1996 paved the way for the development of exchange-
traded equity derivatives markets in India. In 1993, the government created the NSE in
collaboration with state-owned financial institutions. NSE improved the efficiency and
transparency of the stock markets by offering a fully automated screen-based trading
system and real-time price dissemination. In 1995, a prohibition on trading options was
lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives.
The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased
introduction of derivative products, and bi-level regulation (i.e., self-regulation by
exchanges with SEBI providing a supervisory and advisory role). Another report, by the
J. R. Varma Committee in 1998, worked out various operational details such as the
margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared “securities.” This allowed
the regulatory framework for trading securities to be extended to derivatives. The Act
considers derivatives to be legal and valid, but only if they are traded on exchanges.
Finally, a 30-year ban on forward trading was also lifted in 1999. The economic
liberalization of the early nineties facilitated the introduction of derivatives based on
interest rates and foreign exchange. A system of market-determined exchange rates was
adopted by India in March 1993. In August 1994, the rupee was made fully convertible
on current account. These reforms allowed increased integration between domestic and
international markets, and created a need to manage currency risk. Figure 1 shows how
the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has
increased since 1991.7 The easing of various restrictions on the free movement of interest
rates resulted in the need to manage interest rate risk.

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5. Present Status of Derivatives in India
Derivative trading is not the new word in the dictionary of capital market of
India. But trading in it was legally allowed in June 2000. Earlier there was an illegal
trading in the options in the form of Teji, Mandi, Fatak, Bhav-Bhav, etc. Derivatives
were not included as security in the Securities and Contract Regulation Act, but later
the definition of securities was amended by the Government of India so as to allow
derivative trading in India. This made the derivative trading legal in India.

Derivatives in India: A Chronology

Date Progress
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.
31 August 2000 Trading of futures and options on Nifty to commence at SIMEX.
June 2001 Trading of Equity Index Options at NSE
July 2001 Trading of Stock Options at NSE
November 9, 2002 Trading of Single Stock futures at BSE
June 2003 Trading of Interest Rate Futures at NSE
September 13, 2004 Weekly Options at BSE
January 1, 2008 Trading of Chhota(Mini) Sensex at BSE
January 1, 2008 Trading of Mini Index Futures & Options at NSE
August 29,2008 Trading of Currency Futures at NSE
October 2,2008 Trading of Currency Futures at BSE
Source: Complied from BSE and NSEStock Exchange, Mumbai was the first
stock Exchange of India which launched the derivative segment and started trading for
Stock index Futures named as BSE SENSEX FUTURES on 9th June 2000.
National Stock Exchange had also followed the footprints of the Stock Exchange,
Mumbai and it launched Derivative Segment just three days after the Stock exchange,
Mumbai. It started trading for Stock Index futures named as S&P CNX NIFTY FUTURE
on 12th June 2000.
It was followed by introduction of index options on 1st June, 2001 when both
Stock Exchange, Mumbai and national stock exchange started with another wonderful
product of derivative trading which was Stock Index Options named as BSE SENSEX
Options and S &P CNX NIFTY OPTIONS.
Stock options were introduced in July, 2001 and futures on individual securities
were introduced in November, 2001. Although derivatives are present in all the
underlying assets such as commodities, currencies, equity shares, interest rates and
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securities issued by governments, the Indian derivatives market is primarily dwelling on
stock related derivatives. NSE accounts for over 97 percent of the activity in equity
derivatives in India. Therefore, the status of equity derivatives markets in India can be
measured in terms of performance of the NSE.
The operations in Indian derivatives markets are under examination by the
securities and Exchange Board of India and stock exchanges. The regulatory practices of
the Indian derivatives market are based on the recommendations given by Dr. L.C.Gupta
Committee on regulatory framework for derivatives trading and Dr. J.R. Varma
Committee on measures for risk containment in the derivatives market in India.
As derivatives are at infancy stage in Indian capital market, the growth of the
derivatives and financial innovation in the Indian securities market would depend on the
speed with which market players move forward on the learning curve. The related
reforms in the stock exchange practices have also contributed to change the face of Indian
capital market.
On 2nd July, with the ban on badla and introduction of compulsory rolling
settlement another very important phase occurred. It was launching of Individual Stock
Option Trading by both the Stock exchanges i.e., Stock exchange Mumbai.

Minimum contract size for Exchange traded derivative contracts

The circular is being issued in exercise of powers conferred by section 11 (1) of the
Securities and Exchange Board of India Act, 1992, read with section 10 of the Securities
Contracts(regulation) Act 1956, to protect the interests of investors in securities and to
promote the development of, and to regulate the securities market.
This is in reference to SEBI stipulation on minimum contract size of derivative contracts
specified in various circulars issued to SEBI approved Derivative Exchange / Segment
and their Clearing House / Corporation (hereinafter collectively referred to as Exchange).
It is specified that a derivative contract shall have a value of not less than Rs. 2 Lakhs at
the time of its introduction in the market. It is also specified that that for stock based
derivative contracts, the lot size shall be in the multiples of 100 and the fractions, if any,
shall be rounded off to the next higher multiple of 100.
However, it has been noticed that in the recent past, with the increase in prices of
underlying stock, the contract size/value of most derivative contracts have far exceeded
the stipulated value of Rs. 2 Lakhs. In case of some derivative contracts, due to a fall in
the price of the underlying stock; the contract size/value has fallen below Rs. 2 Lakhs. It
has therefore been decided that the lot size/multiplier shall be reduced for contracts with
value exceeding Rs. 2 Lakhs. It has also been decided that the lot size/multiplier shall be
increased for contracts with value less than Rs. 2 Lakhs.
Accordingly, for derivative contracts which have a contract size/value of Rs.4 Lakh and
above, the lot size/multiplier shall be reduced to one-half of the existing lot
size/multiplier. For derivative contracts which have a contract size/value of Rs.8 Lakh
and above, the lot size/multiplier shall be reduced to one-fourth of the existing lot
size/multiplier.

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Similarly, where the contract size of the derivative contracts is less than Rs. 2 Lakhs, for
the sake of standardisation, the existing lot size / multiplier shall be increased so as to
bring the contract size to Rs. 2 Lakhs. The increase shall be carried out by increasing the
lot size/multiplier in multiples of 2.
To facilitate the aforesaid measures, the stipulation that the lot size/multiplier should be
in the multiple of 100 stands revoked.
Before implementing the aforesaid measures the Exchange shall give a notice of atleast
two weeks to the market. Further, for the purpose of revising the contract size, the
contract size/value shall be determined on the basis of the closing prices of the underlying
on the day prior to the beginning of the notice period. However, both NSE and BSE shall
endeavor to specify the same lot size/multiplier on common underlying

Growth of Derivatives Market in India

Equity derivatives market in India has registered an "explosive growth" and is
expected to continue the same in the years to come. Introduced in 2000, financial
derivatives market in India has shown a remarkable growth both in terms of volumes and
numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading
in Indian markets. The introduction of derivatives has been well received by stock market
players. Trading in derivatives gained popularity soon after its introduction. In due
course, the turnover of the NSE derivatives market exceeded the turnover of the NSE
cash market. For example, in 2008, the value of the NSE derivatives markets was Rs.
130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038
Cr. If we compare the trading figures of NSE and BSE, performance of BSE is not
encouraging both in terms of volumes and numbers of contracts traded in all product
categories Among all the products traded on NSE in F& O segment, single stock futures
also known as equity futures, are most popular in terms of volumes and number of
contract traded, followed by index futures with turnover shares of 52 percent and 31
percent, respectively. In case of BSE, index futures outperform stock futures. An
important feature of the derivative segment of NSE. is the huge gap between average
daily transactions of its derivatives segment and cash segment. In sharp contrast to NSE,
the situation at BSE is just the opposite: its cash segment outperforms the derivatives
segment.

References

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Chitale, Rajendra P., 2003, Use of Derivatives by India’s Institutional Investors: Issues and
Impediments, in Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill
Publishing Company Limited, New Delhi, India.
FitchRatings, 2004, Fixed Income Derivatives---A Survey of the Indian Market,
www.fitchratings.com
www.fitchratings.com
Gambhir, Neeraj and Manoj Goel, 2003, Foreign Exchange Derivatives Market in India---
Status and Prospects, Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill
Publishing Company Limited, New Delhi, India.
Gorham, Michael, Thomas, Susan and Ajay Shah, 2005, India: The Crouching Tiger, Futures
Industry.
Lee, Rupert, 2004, Seeing Double, FOW.
ISMR, Indian Securities Market: A Review, 2004, National Stock Exchange of India
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Jogani, Ashok and Kshama Fernandes, 2003, Arbitrage in India: Past, Present and Future, in
Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw-Hill Publishing Company
Limited, New Delhi, India.
Nair, C. G. K., 2004, Commodity Futures Markets in India: Ready for “Take Off”? National
Stock Exchange of India Limited, Mumbai, India.

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