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1 DERIVATIVES DEFINED Derivative is a product whose value is derived from the value of one or more bas ic variables, called bases (underlying asset, index, or reference rate), in a co ntractual manner. The underlying asset can be equity, for ex, commodity or any o ther asset. For ex ample, wheat farmers may wish to sell their harvest at a futu re date to eliminate the risk of a change in prices by that date. Such transacti on is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. In simple word it can be said that Derivatives are financial contracts whose val ue/price is dependent on the behavior of the price of one or more basic underlyi ng assets (often simply known as underlying). These contracts are legally bindin g agreements, made on the trading screen of stock exchanges, to buy or sell an a sset in future. The asset can be a share, index, interest rate, bond, rupee doll ar exchange rate, sugar, crude oil, soybean, cotton, coffee, etc. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative to include 1. A security derived from a debt instrument, share, loan whether secured o r unsecured, risk instrument or contract for differences or any other form of se curity. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Avery simple example of derivatives is curd, which is derivative of milk. The pr ice of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. 1.2 HISTORY OF DERIVATIVESThe history of derivatives is quite colorful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered f or a fixed price at a specified place on a specified date, existed in ancient Gr eece and Rome. Roman emperors entered forward contracts to provide the masses wi th heir supply of Egyptian grain. These contracts were also undertaken between f armers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price ri sk. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provi de centralized location to negotiate forward contracts. From forward trading in commodities emerged the commodity futures. The first type of futures contract was called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the first exchange traded derivatives contract, kn own as the futures contracts. Futures trading grew out of the need for hedging t he price risk involved in many commercial operations. The Chicago Mercantile Exc hange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of Chicago Produce Excha nge (CPE) and Chicago Egg and Butter Board (CEBB). The first financial futures to e merge were the currency in 1972 in the US. The first foreign currency futures we re traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Doll ar, and the Euro dollar. Currency futures were followed soon by interest rate fu tures. Interest rate futures contracts were traded for the first time on the CBO T on October 20, 1975. Stock index futures and options emerged in 1982. The firs t stock index futures contracts were traded on Kansas City Board of Trade on Feb ruary 24, 1982.The first of the several networks, which offered a trading link b etween two exchanges, was formed between the Singapore International Monetary Ex

change (SIMEX) and the CME on September 7, 1984. Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbo l of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that pe ople even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to gu arantee the performance of the option terms. The first call and put options were invented by an American financier, Russell S age, in 1872. These options were traded over the counter. Agricultural commoditi es options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms kno wn as Put and Call brokers and Dealers Association was set up in early 1900s to pr ovide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Mert on, and Scholes invented the famous Black-Scholes Option Formula. This model hel ped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, t he American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) beg an trading in options in 1975. The market for futures and options grew at a rapid pace in the eighties and nine ties. The collapse of the Bretton Woods regime of fixed parties and the introduc tion of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S &P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the pre mier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercant ile Exchange. 1.3 DERIVATIVE MARKET IN INDIAThe first step towards introduction of derivatives trading in India was the prom ulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did n ot take off, as there was no regulatory framework to govern trading of derivativ es. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on N ovember 18, 1996 to develop appropriate regulatory framework for derivatives tra ding in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The co mmittee recommended that derivatives should be declared as securities so that regu latory 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 Pro f.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 operatio nal details of margining system, methodology for charging initial margins, broke

r net worth, deposit requirement and realtime monitoring requirements. The Securi ties Contract Regulation Act (SCRA) was amended in December 1999 to include deri vatives within the ambit of securities and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in Mar ch 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI grant ed the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporati on to commence trading and settlement in approved derivatives contracts. To begi n with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE