DERIVATIVE TRADING IN SECURITIES MARKET

Sharad Kothari
Roll No. 72
IX Semester-B.B.A.-LL.B. (Hons)

MEANING OF DERIVATIVES.........................................................................................1
FORWARDS AND FUTURES ......................................................................................2
OPTIONS ........................................................................................................................4
SWAPS IN CURRENCIES/ INTEREST RATES ..........................................................5
ADVANTAGES OF DERIVATIVES.............................................................................6
FUTURES AND OPTIONS TRADING SYSTEM.............................................................6
FUTURES AND OPTIONS MARKET INSTRUMENTS..............................................8
REGULATORY FRAMEWORK........................................................................................9
SECURITIES CONTRACTS(REGULATION) ACT, 1956.........................................10
SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992............................10
SEBI (STOCK BROKERS AND SUB–BROKERS) REGULATIONS, 1992.............11
REGULATION FOR DERIVATIVES TRADING.......................................................12
CONCLUSION..................................................................................................................14

MEANING OF DERIVATIVES

AMERICAN DEFINITION1:
Both FAS 133 and IAS 39 define a financial derivative in a generic way based on their
nature rather than the name.
Financial derivatives are those financial instruments:
• Whose value changes in response to the change in a variable (called underlying)
such as interest rate, price of a security, price of a commodity, foreign exchange
rate, index of certain prices credit rating etc. and
• Which require very little initial net investment relative to other types of contracts
that have a similar response to change in market conditions and
• Which are settled at a future date.

INDIAN DEFINITION2:
Derivative includes-
1
Vipul, Dr., “Accounting for Financial Derivatives: U.S., International and Indian Standards”, 52 The
Chartered Accountant pg. 236
2
Section 2(aa) of The Securities Contracts (Regulation) Act, 1956.

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 • 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 the index of prices, of
underlying securities.

DERIVATIVES ARE financial weapons of mass destruction’, said Warren Buffet, the
second richest person in the world and arguably the best known financial wizard in the
U.S. Alan Greenspan, Chairman of Federal Reserve and the most powerful central
banker, has reportedly claimed that derivatives helped the financial system to ward off the
effects of the dotcom bubble; there was no meltdown in the system even though the stock
markets got a severe drubbing.3
Derivatives are contracts that have no intrinsic value, but are based on the value of an
underlying commodity, currency or an instrument like stocks. These were originally used
in commodity markets by merchants and farmers to ensure a firm price for a commodity
at a future date. The four main forms of derivatives are forwards, futures, options and
swaps.
DERIVATIVES

OPTIONS FUTURES SWAPS FORWARDS

PUT CALL INTEREST RATE CURRENCY

COMMODITY SECURITY

FORWARDS AND FUTURES

Forwards and futures have a hoary past. Reports have it that these were used in Japan by
farmers and merchants even in the 1700s and in the U.S. over two centuries ago. For
example, if a miller in the U.S. ordered wheat from Europe (well before the U.S. became
a wheat granary), at say Rs.80 a tonne, the shipping time taken for him to get the wheat
would be a month or so. However, when he sold the goods on arrival in the U.S., he will
3
http://www.hindu.com/2004/03/01/stories/2004030100351600.htm.

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get the then ruling price; if that price was Rs.70, he will lose. To get over this uncertainty,
he entered into a derivative contract with a local dealer by which he agreed to sell the
goods at a firm price (say Rs.85) after one month. This is a typical forward contract and
can be used for hedging, that is, insurance against uncertainty in prices4.
The value of a future is determined by the relationship between the price set in the
contract and the market price, the length of time until the contract is due - and supply and
demand in the market.5
Futures contracts specify the quality, quantity and location for goods to be delivered, but
not many are used to actually sell goods.6
Most are settled by cash payment on the date that delivery is due, with the holder paying
or receiving the difference between the price set in the contract and the market price7.
Fundamentally, forward and futures contracts have the same function: both types
of contracts allow people to buy or sell a specific type of asset at a specific time at a
given price.
However, it is in the specific details that these contracts differ. First of all, futures
contracts are exchange-traded and, therefore, are standardized contracts. Forward
contracts, on the other hand, are private agreements between two parties and are not
as rigid in their stated terms and conditions. Because forward contracts are private
agreements, there is always a chance that a party may default on its side of the agreement.
Futures contracts have clearing houses that guarantee the transactions, which drastically
lowers the probability of default to almost never.8
A futures contract includes the following attributes viz9
INTEREST RATE FUTURES
It is a contract, which sets a purchase yield or rate of interest on a specified debt security
or deposit effective at a future date agreed on at the time of the transaction.
STOCK INDEX FUTURES
A contract that sets a purchase price on a standardised amount of the underlying index for
settlement on a specified future date.
4
Ibid
5
BBC, Business: What are Futures and Options?, online edition, February 7, 2002, Thursday,
http://news.bbc.co.uk/2/hi/business/1806265.stm
6
ibid
7
ibid
8
http://www.investopedia.com/ask/answers/06/forwardsandfutures.asp
9
http://www.expressindia.com/fe/daily/20000129/ffe25116.html

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FOREIGN EXCHANGE FUTURES
A contract which involves booking/swapping of currencies at future dates, depending on
perception of whether currencies are going to strengthen or weaken.
All these aspects are specific to contracts containing financial assets. Meanwhile, a
commodity futures is a contract for physical assets and is used for hedging against the
future price of various commodities.

OPTIONS
Options enable one to “have the cake and eat it too.”10 The buyer of the option gains the
right, but not the obligation, to engage in some specific transaction on the asset, while the
seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price
of an option derives from the difference between the reference price and the value of the
underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a
premium based on the time remaining until the expiration of the option.11 These are
common in stock markets. For example, if a broker buys shares of a company at Rs. 250
per share and intends to sell them after three months at a profit, he can enter into an
option contract for sale at Rs. 270 after three months. He has the option to sell at Rs. 270
but he is not obliged to exercise the option.
If the then ruling price is Rs. 240 he can exercise the option and make a profit; if,
however, it is Rs. 300, he need not use the option. For this right, he has to pay the dealer
(who writes the option) a premium or fee. While the buyer of the option has all the rights
and no obligation, the option writer has only obligations. If the price were just Rs. 100
after three months, he would lose a substantial amount. Therefore, the premium is
calculated in such a manner as to ensure that the losses of option writer are minimised, if
not eliminated. Lot of esoteric arithmetic is used in fixing the premium.
Options were invented because people liked the security of knowing they could buy or
sell at a certain price, but wanted the chance to profit if the market price suited them
better at the time of delivery12. So for a certain fee - called the premium - an option gave
them the right, but not the obligation, to buy or sell at a certain price. An option to sell,

10
ibid
11
http://en.wikipedia.org/wiki/Option_%28finance%29
12
news.bbc.co.uk/2/hi/business/2190776.stm

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known as a put option, would only be exercised if the price set in the futures contract was
higher than the market price at the time of harvest, and vice versa for an option to buy, or
call option. Working out the cost of an option is extraordinarily complicated.
There are many pricing mechanisms in use, most involving complex mathematical
formulas. The most famous options pricing model is known as Black-Scholes13.
There are also many different types of option - with exotic and alarming names such as
knock-in and knock-out, barrier, binary and Asian options - most of which vary either the
time or the price at which the options can be exercised14.

OPTION TYPE BUYER/HOLDER SELLER/WRITER

Call Right but not an obligation Obligation but no right to
to buy the underlying asset. sell the underlying asset.
Put Right but not an obligation Obligation but no right to
to sell the underlying asset. buy the underlying asset.

SWAPS IN CURRENCIES/ INTEREST RATES

Swaps could be in currency or interest rates. A currency swap is a foreign-exchange
agreement between two parties to exchange aspects (namely the principal and/or interest
payments) of a loan in one currency for equivalent aspects of an equal in net present
value loan in another currency. Currency swaps are motivated by comparative
advantage.15 When a U.S. company has a subsidiary in Germany and a German company
has its subsidiary in the U.S., the two can raise funds in their home countries at fairly
reasonable rates but will not be able to do so in the country where their subsidiaries are
located. By raising funds in their respective home currencies and exchanging the funds
between them (dollar from the U.S. company for euro from the German company), both
will benefit.
Interest rate swaps work in a similar manner. Currency swaps are over-the-counter
derivatives, and are closely related to interest rate swaps.16 In an interest rate swap, each
counter party agrees to pay either a fixed or floating rate denominated in a particular
13
news.bbc.co.uk/2/hi/business/1806265.stm
14
ibid
15
http://www.finpipe.com/currswaps.htm
16
ibid

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currency to the other counterparty. The fixed or floating rate is multiplied by a notional
principal amount (say, USD 1 million). This notional amount is generally not exchanged
between counterparties, but is used only for calculating the size of cash flows to be
exchanged. For example, a leading Indian company can raise a five year dollar loan from
a London banker at a low floating interest rate, that is, one that rises and falls with the
London inter Bank Rate. And, a medium sized U.S. company could raise the same loan at
a low fixed rate in the bond markets. By swapping the two interest rates between them
both companies could gain.

ADVANTAGES OF DERIVATIVES
The futures and options market also provides the economy with price discovery. The
futures’ prices are determined by supply and demand. An exchange itself does not set the
price. It simply provides a place where the buyers and sellers can negotiate. If there are
more buyers than sellers, the price goes up. Conversely, if the sellers outnumber the
buyers, the price falls. The price discovered through the futures market offers valuable
economic information on the supply and demand situation in a competitive business
environment.17
The economic benefit of trading in the futures and options market for the investors is the
lowered transaction costs. For instance, an investor wanting to invest in software stocks
could opt for a single transaction by way of the software stock index futures contract
representing 50 stocks. This, instead of buying and paying commission for stocks
separately in 50 different transactions.

FUTURES AND OPTIONS TRADING SYSTEM

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a
fully automated screen-based trading for Nifty futures & options and stock futures & options
on a nationwide basis as well as an online monitoring and surveillance mechanism. It

17
www.expressindia.com/fe/daily/20000129/ffe25116.html

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supports an order driven market and provides complete transparency of trading operations. It
is similar to that of trading of equities in the cash market segment.18
The software for the F&O market has been developed to facilitate efficient and transparent
trading in futures and options instruments. Keeping in view the familiarity of trading
members with the current capital market trading system, modifications have been performed
in the existing capital market trading system so as to make it suitable for trading futures and
options.19

Entities in the trading system

There are four entities in the trading system:
1. Trading members: Trading members are members of NSE. They can trade
either on their own account or on behalf of their clients including participants. The
exchange assigns a Trading member ID to each trading member. Each trading
member can have more than one user. The number of users allowed for each
trading member is notifi ed by the exchange from time to time. Each user of a
trading member must be registered with the exchange and is assigned an unique
user ID. The unique trading member ID functions as a reference for all
orders/trades of different users. This ID is common for all users of a particular
trading member. It is the responsibility of the trading member to maintain
adequate control over persons having access to the fi rm’s User IDs.
2. Clearing members: Clearing members are members of NSCCL. They carry out
risk management activities and confi rmation/inquiry of trades through the trading
system.
3. Professional clearing members: A professional clearing members is a clearing
member who is not a trading member. Typically, banks and custodians become
professional clearing members and clear and settle for their trading members.
4. Participants: A participant is a client of trading members like fi nancial
institutions. These clients may trade through multiple trading members but settle
through a single clearing member.

18
ibid
19
www.articlesuniverse.com/.../Futures-and-options-trading-system/4

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FUTURES AND OPTIONS MARKET INSTRUMENTS
The F&O segment of NSE provides trading facilities for the following derivative
instruments:
1. Index based futures
2. Index based options
3. Individual stock options
4. Individual stock futures

a) Contract specifications for index futures

NSE trades Nifty futures contracts having one-month, two-month and three-month expiry
cycles. All contracts expire on the last Thursday of every month. Thus a January
expiration contract would expire on the last Thursday of January and a February expiry
contract would cease trading on the last Thursday of February. On the Friday following
the last Thursday, a new contract having a three-month expiry would be introduced for
trading. Depending on the time period for which you want to take an exposure in index
futures contracts, you can place buy and sell orders in the respective contracts.20
The Instrument type refers to “Futures contract on index” and Contract symbol - NIFTY
denotes a “Futures contract on Nifty index” and the Expiry date represents the last date
on which the contract will be available for trading. Each futures contract has a separate
limit order book. All passive orders are stacked in the system in terms of price-time
priority and trades take place at the passive order price(similar to the existing capital
market trading system). The best buy order for a given futures contract will be the order
to buy the index at the highest index level whereas the best sell order will be the order to
sell the index at the lowest index level.21
b) Contract specification for index options
On NSE’s index options market, contracts at different strikes, having one-month, two-
month and three-month expiry cycles are available for trading. There are typically one-
month, two-month and three-month options, each with minimum seven different strikes
available for trading.22 Option contracts are specified as follows: DATE-EXPIRY
MONTH-YEAR-CALL/PUT AMERICAN/EUROPEAN-STRIKE. For example the
20
http://www.stockresearch.co.in/contract-specifications-for-index-futures-nifty-futures.php
21
nikhil-barjatya.tripod.com/ncfm/derivative/151-212.pdf
22
http://www.stockresearch.co.in/contract-specifications-for-index-options-nifty-options.php

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European style call option contract on the Nifty index with a strike price of2040 expiring
on the 30th june2005 is specified as ‘30Jun 2005 2040CE’.23

c) Contract specifications for stock futures

Trading in stock futures commenced on the NSE from November 2001. These contracts
are cash settled on a T+1 basis. The expiration cycle for stock futures is the same as for
index futures,index options and stock options. A new contract is introduced on the trading
day following the expiry of the near month contract.24

d) Contract specifications for stock options

Trading in stock options commenced on the NSE from July 2001. These contracts are
American style and are settled in cash. The expiration cycle for stock options is the same
as for index futures and index options. A new contract is introduced on the trading day
following the expiry of the near month contract. NSE provides a minimum of five strike
prices for every option type(i.e. call and put) during the trading month. There are at least
two in–the–money contracts, two out–of–the–money contracts and one at–the–money
contract available for trading. Table 10.4 gives the contract specifications for stock
options.25

REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SC(R)A, the
SEBI Act, the rules and regulations framed thereunder and the rules and bye–laws of
stock exchanges.

23
ibid
24
www.stockresearch.co.in/contract-specifications-for-stock-futures.php
25
www.stockresearch.co.in/contract-specifications-for-stock-options.php

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SECURITIES CONTRACTS(REGULATION) ACT, 1956
SC(R)A aims at preventing undesirable transactions in securities by regulating the
business of dealing therein and by providing for certain other matters connected
therewith. This is the principal Act, which governs the trading of securities in India. The
term “securities” has been defined in the SC(R)A. As per Section 2(h), the ‘Securities’
include:
1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable
securities of a like nature in or of any incorporated company or other body corporate
2. Derivative
3. Units or any other instrument issued by any collective investment scheme to the
investors in such schemes
4. Government securities
5. Such other instruments as may be declared by the Central Government to be securities
6. Rights or interests in securities.
“Derivative” is defined to include:
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.
Section 18A provides that notwithstanding anything contained in any other law for the
time being in force, contracts in derivative shall be legal and valid if such contracts are:
 Traded on a recognized stock exchange
 Settled on the clearing house of the recognized stock exchange, in accordance
with the rules and bye–laws of such stock exchanges.

SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India
(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b)
promoting the development of the securities market and (c) regulating the securities
market. Its regulatory jurisdiction extends over corporates in the issuance of capital and

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transfer of securities, in addition to all intermediaries and persons associated with
securities market.
SEBI has been obligated to perform the aforesaid functions by such measures as it thinks
fit. In particular, it has powers for:
a) regulating the business in stock exchanges and any other securities markets
b) registering and regulating the working of stock brokers, sub–brokers etc.
c) promoting and regulating self-regulatory organizations
d) prohibiting fraudulent and unfair trade practices
e) calling for information from, undertaking inspection, conducting inquiries and
audits of the stock exchanges, mutual funds and other persons associated with the
securities market and intermediaries and self–regulatory organizations in the
securities market performing such functions and exercising according to
Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the
Central Government26

SEBI (STOCK BROKERS AND SUB–BROKERS) REGULATIONS, 1992

A broker is an intermediary who arranges to buy and sell securities on behalf of clients
(the buyer and the seller). According to Section 2(e) of the SEBI (Stock Brokers and Sub-
Brokers) Rules, 1992, a stockbroker means a member of a recognized stock exchange. No
stockbroker is allowed to buy, sell or deal in securities, unless he or she holds a certificate
of registration granted by SEBI. 27 A stockbroker applies for registration to SEBI through
a stock exchange or stock exchanges of which he or she is admitted as a member. SEBI
may grant a certificate to a stock-broker [as per SEBI (Stock Brokers and Sub-Brokers)
Rules, 1992] subject to the conditions that:
1. He holds the membership of any stock exchange;
2. He shall abide by the rules, regulations and bye-laws of the stock exchange or stock
exchanges of which he is a member;
3. In case of any change in the status and constitution, he shall obtain prior permission
of SEBI to continue to buy, sell or deal in securities in any stock exchange;
4. He shall pay the amount of fees for registration in the prescribed manner; and
26
www.sharegyan.com/...market/securities/what-is-sebi-role.php
27
http://www.managementparadise.com/forums/417565-post1.html

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 5. He shall take adequate steps for redressal of grievances of the investors within one
month of the date of the receipt of the complaint and keep SEBI informed about
the number, nature and other particulars of the complaints.
As per SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, SEBI shall take into
account for considering the grant of a certificate all matters relating to buying, selling, or
dealing in securities and in particular the following, namely, whether the stock broker
(a) is eligible to be admitted as a member of a stock exchange;
(b) has the necessary infrastructure like adequate office space, equipment and man
power to effectively discharge his activities;
(c) has any past experience in the business of buying, selling or dealing in securities;
(d) is subjected to disciplinary proceedings under the rules, regulations and bye-laws
of a stock exchange with respect to his business as a stock-broker involving either
himself or any of his partners, directors or employees.

REGULATION FOR DERIVATIVES TRADING

SEBI set up a 24-member committee under the Chairmanship of Dr.L.C. Gupta to
develop the appropriate regulatory framework for derivatives trading in India. The
committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the
recommendations of the committee and approved the phased introduction of derivatives
trading in India beginning with stock index futures. SEBI also approved the “suggestive
bye-laws” recommended by the committee for regulation and control of trading and
settlement of derivatives contracts. The provisions in the SC(R)A and the regulatory
framework developed thereunder govern trading in securities. The amendment of the
SC(R)A to include derivatives within the ambit of ‘securities’ in the SC(R)A made
trading in derivatives possible within the framework of that Act.
1. Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta
committee report may apply to SEBI for grant of recognition under Section 4 of
the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment
should have a separate governing council and representation of trading/clearing
members shall be limited to maximum of 40% of the total members of the
governing council. The exchange shall regulate the sales practices of its members

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 and will obtain prior approval of SEBI before start of trading in any derivative
contract.
2. The Exchange shall have minimum 50 members.
3. The members of an existing segment of the exchange will not automatically
become the members of derivative segment. The members of the derivative
segment need to fulfill the eligibility conditions as laid down by the LC Gupta
committee.
4. The clearing and settlement of derivatives trades shall be through a SEBI approved
clearing corporation/house. Clearing corporations/houses complying with the
eligibility conditions as laid down by the committee have to apply to SEBI for
grant of approval.
5. Derivative brokers/dealers and clearing members are required to seek registration
from SEBI. This is in addition to their registration as brokers of existing stock
exchanges. The minimum net worth for clearing members of the derivatives
clearing corporation/house shall be Rs.300 Lakh. The net worth of the member
shall be computed as follows:
 Capital + Free reserves
 Less non-allowable assets viz.,
(a) Fixed assets
(b) Pledged securities
(c) Member’s card
(d) Non-allowable securities(unlisted securities)
(e) Bad deliveries
(f) Doubtful debts and advances
(g) Prepaid expenses
(h) Intangible assets
(i) 30% marketable securities
6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges should
also submit details of the futures contract they propose to introduce.
7. The initial margin requirement, exposure limits linked to capital adequacy and
margin demands related to the risk of loss on the position shall be prescribed by
SEBI/Exchange from time to time.

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 8. The L.C.Gupta committee report requires strict enforcement of “Know your
customer” rule and requires that every client shall be registered with the
derivatives broker. The members of the derivatives segment are also required to
make their clients aware of the risks involved in derivatives trading by issuing to
the client the Risk Disclosure Document and obtain a copy of the same duly
signed by the client.
9. The trading members are required to have qualified approved user and sales person
who have passed a certification programme approved by SEBI.

CONCLUSION

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

Until the advent of NSE, the Indian capital market had no access to the latest trading
methods and was using traditional out-dated methods of trading. There was a huge gap
between the investors’ aspirations of the markets and the available means of trading. The

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opening of Indian economy has precipitated the process of integration of India’s financial
markets with the international financial markets. Introduction of risk management
instruments in India has gained momentum in last few years thanks to Reserve Bank of
India’s efforts in allowing forward contracts, cross currency options etc. which have
developed into a very large market.
Derivatives can be highly complex contracts and used with little or no knowledge of the
implications, can prove extremely destructive. Highly complex instruments, either
combining two derivatives or leveraging, namely, having a multiplier effect are
introduced in the advanced financial markets, because there the banks and institutions
make very little income from loans and have to develop esoteric products to earn profits.

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