Financial Derivatives Market and its Development in India Financial markets are, by nature, extremely volatile and hence

the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets for example forex, e!uity, etc", bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset. Development of exchange#traded derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the $%th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. & primary motivation for pre#arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. The need for a derivatives market The derivatives market performs a number of economic functions' $. They help in transferring risks from risk averse people to risk oriented people %. They help in the discovery of future as well as current prices (. They cataly)e entrepreneurial activity *. They increase the volume traded in markets because of participation of risk averse people in greater numbers +. They increase savings and investment in the long run The participants in a derivatives market , -edgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. , .peculators use 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. , &rbitrageurs are in business to take advantage of a discrepancy between prices in two 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. Types of Derivatives Forwards' & forward contract is a customi)ed contract between two entities, where settlement takes place on a specific date in the future at today/s pre#agreed price.

Futures' & 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 standardi)ed exchange#traded contracts 0ptions' 0ptions are of two types # calls and puts. 1alls give the buyer the right but not the obligation to buy a given !uantity of the underlying asset, at a given price on or before a given future date. 2uts give the buyer the right, but not the obligation to sell a given !uantity of the underlying asset at a given price on or before a given date. 3arrants' 0ptions generally have lives of upto one year, the ma4ority of options traded on options exchanges having a maximum maturity of nine months. 5onger#dated options are called warrants and are generally traded over#the#counter. 56&2.' The acronym 56&2. means 5ong#Term 6!uity &nticipation .ecurities. These are options having a maturity of upto three years. 7askets' 7asket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. 6!uity index options are a form of basket options. .waps' .waps 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. , 1urrency swaps' These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. .waptions' .waptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. 8ather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. & receiver swaption is an option to receive fixed and pay floating. & payer swaption is an option to pay fixed and receive floating. Table $ The global derivatives industry' 0utstanding contracts, in 9 billion" $::+ $::; $::< $::= $::: %>>> 6xchange traded instruments :%=( $>>$= $%*>( $(:(% $(+%% $*(>% Interest rate futures and options =;$= :%+< $$%%$ $%;*( $$;;: $%;%; 1urrency futures and options $+* $<$ $;$ =$ +: :; .tock Index futures and options +$$ +:$ $>%$ $%>= $<:( $+=> .ome 0T1 instruments $<<$( %+*+( %:>(+ =>($< ==%>$ :+$:: Interest rate swaps and options $;+$+ %(=:* %<%$$ **%+: +(($; +=%**

1urrency swaps and options $$:< $+;> $=%* +:*= *<+$ ++(% 0ther instruments ###(>$$> (>$(* ($*%( Total %;::; (+*<$ *$*(= :*%*: $>$<%( $>:+>$ .ource' 7ank for International .ettlements 0T1 ' 0ver The 1ounter traded instruments, discussed later."

Factors driving the growth of financial derivatives $. Increased volatility in asset prices in financial markets, %. Increased integration of national financial markets with the international markets, (. Marked improvement in communication facilities and sharp decline in their costs, *. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and +. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. Table % Turnover in derivatives contracts traded on exchanges, in ?.9 trillion" $::( $::* $::+ $::; $::< $::= $::: %>>> Interest rate futures $<<.( %<$.: %;;.* %+(.; %*<.= %:;.; %;(.= %:%.( Interest rate options (%.= *;.< *(.( *$ *=.; ++.= *+.; *<.+ 1urrency futures %.= (.( (.% %.; %.< %.+ %.; %.* 1urrency options $.* $.* $.( $.( >.: >.+ >.( >.% .tock market index futures <.$ :.* $>.; $%.: $;.* $:.; %$.< %%.< .tock market index options ;.( = :.( $>.% $(.$ $*.< $+.< $=.< Total %%<.< (*>.< ((*.$ (%$.; (+;.+ (=:.< (*:.< (=(.= .ource' 7ank for International .ettlements Development of derivatives market in India The first step towards introduction of derivatives trading in India was the promulgation of the .ecurities 5aws &mendment" 0rdinance, $::+, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. .67I set up a %*@member committee under the 1hairmanship of Dr.5.1.Aupta on Bovember $=, $::; to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March $<, $::= prescribing necessary pre@conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as Csecurities/ so that regulatory framework applicable to trading of Csecurities/ could also govern trading of securities. .67I also set up a group in Dune $::= under the 1hairmanship of 2rof.D.8.Earma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in 0ctober $::=, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit re!uirement and real@time monitoring re!uirements. The .ecurities 1ontract 8egulation &ct .18&" was amended in December $::: to

include derivatives within the ambit of Csecurities/ and the regulatory framework was 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 recogni)ed stock exchange, thus precluding 0T1 derivatives. The government also rescinded in March %>>>, the three@ decade old notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in Dune %>>> after .67I granted the final approval to this effect in May %>>$. .67I permitted the derivative segments of two stock exchanges, B.6 and 7.6, and their clearing houseFcorporation to commence trading and settlement in approved derivatives contracts. To begin with, .67I approved trading in index futures contracts based on .G2 1BH Bifty and 7.6@(> .ensex" index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in 7.6 .ensex options commenced on Dune *, %>>$ and the trading in options on individual securities commenced in Duly %>>$. Futures contracts on individual stocks were launched in Bovember %>>$. The derivatives trading on B.6 commenced with .G2 1BH Bifty Index futures on Dune $%, %>>>. The trading in index options commenced on Dune *, %>>$ and trading in options on individual securities commenced on Duly %, %>>$. .ingle stock futures were launched on Bovember :, %>>$. The index futures and options contract on B.6 are based on .G2 1BH Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing houseFcorporation duly approved by .67I and notified in the official ga)ette. Foreign Institutional Investors FIIs" are permitted to trade in all 6xchange traded derivative products. The following are some observations based on the trading statistics provided in the B.6 report on the futures and options FG0"' , .ingle#stock futures continue to account for a si)able proportion of the FG0 segment. It constituted <> per cent of the total turnover during Dune %>>%. & primary reason attributed to this phenomenon is that traders are comfortable with single#stock futures than e!uity options, as the former closely resembles the erstwhile badla system. , 0n relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying in this case, the index" is high. & related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round#trips. , 2ut volumes in the index options and e!uity options segment have increased since Danuary %>>%. The call#put volumes in index options have decreased from %.=; in Danuary %>>% to $.(% in Dune. The fall in call#put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.

, Farther month futures contracts are still not actively traded. Trading in e!uity options on most stocks for even the next month was non#existent.

, Daily option price variations suggest that traders use the FG0 segment as a less risky alternative read substitute" to generate profits from the stock price movements. The fact that the option premiums tail intra#day stock prices is evidence to this. 1alls on .atyam fall, while puts rise when .atyam falls intra#day. If calls and puts are not looked as 4ust substitutes for spot trading, the intra#day stock price variations should not have a one#to#one impact on the option premiums. Table ( 7usiness growth of futures and options market' B.6 Turnover 8s.cr" Month Index futures .tock futures Index options .tock options Total Dun#>> (+ ###(+ Dul#>> $>= ###$>= &ug#>> :> ###:> .ep#>> $$: ###$$: 0ct#>> $+( ###$+( Bov#>> %*< ###%*< Dec#>> %(< ###%(< >$#Dan *<$ ###*<$ >$#Feb +%* ###+%* >$#Mar (=$ ###(=$ >$#&pr %:% ###%:% >$#May %(> ###%(> >$#Dun +:> #$:; #<=+ >$#Dul $(>: #(%; (:; %>($ >$#&ug $(>+ #%=* $$>< %;:; >$#.ep %=+< #++: %>$% +%=$ >$#0ct %*=+ #++: %*(( +*<< >$#Bov %*=* %=$$ *++ (>$> =<;> >$#Dec %((: <+$+ *>+ %;;> $%:$: >%#Dan %;;> $(%;$ ((= +>=: %$(*= >%#Feb %<*< $(:(: *(> **:: %$;$; >%#Mar %$=+ $(:=: (;> (:+< %>*:> %>>$#>% %$*=% +$+$; (<;; %+$;( $>$:%+ .ource' Bational .tock 6xchange

Instruments available in India Financial derivative instruments' The Bational stock 6xchange B.6" has the following derivative products' 2roducts Index Futures Index 0ptions Futures on Individual .ecurities 0ptions on Individual .ecurities ?nderlying Instrument .G2 1BH Bifty .G2 1BH Bifty (> securities stipulated by .67I (> securities stipulated by .67I Type 6uropean &merican Trading 1ycle maximum of (month trading cycle. &t any point in time, there will be ( contracts available ' $" near month, %" mid month G (" far month duration .ame as index futures .ame as index futures .ame as index futures 6xpiry Day 5ast Thursday of the expiry month .ame as index futures .ame as index futures .ame as index futures 1ontract .i)e 2ermitted lot si)e is %>> G multiples

thereof .ame as index futures &s stipulated by B.6 not less than 8s.% lacs" &s stipulated by B.6 not less than 8s.% lacs" 2rice .teps 8e.>.>+ 8e.>.>+ 7ase 2rice# First day of trading previous day closing Bifty value Theoretical value of the options contract arrived at based on 7lack# .choles model previous day closing value of underlying security .ame as Index options 7ase 2rice# .ubse!uent Daily settlement price daily close price Daily settlement price .ame as Index options 2rice 7ands 0perating ranges are kept at I $> J 0perating ranges for are kept at ::J of the base price 0perating ranges are kept at I %> J 0perating ranges for are kept at ::J of

the base price Kuantity Free)e %>,>>> units or greater %>,>>> units or greater 5ower of $J of marketwide position limit stipulated for open positions or 8s.+ crores .ame as individual futures 7.6 also offers similar products in the derivatives segment.

1ommodity Derivatives Futures contracts in pepper, turmeric, gur 4aggery", hessian 4ute fabric", 4ute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in $= commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Aovernment of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. 3ith commodity futures, delivery is best effected using warehouse receipts which are like dematerialised securities". 3arehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The 1offee Futures 6xchange India 10F6I" has operated a system of warehouse receipts since $::= 6xchange#traded vs. 0T1 0ver The 1ounter" derivatives markets The 0T1 derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the moderni)ation of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. 3hile both exchange#traded and 0T1 derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their 0T1 derivative positions were the main cause of turbulence in financial markets in $::=. These episodes of turbulence revealed the risks posed to market stability originating in features of 0T1 derivative instruments and markets. The 0T1 derivatives markets have the following features compared to exchange#traded derivatives' $. The management of counter#party credit" risk is decentrali)ed and located within individual institutions,

%. There are no formal centrali)ed limits on individual positions, leverage, or margining, (. There are no formal rules for risk and burden#sharing, *. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and +. The 0T1 contracts are generally not regulated by a regulatory authority and the exchange/s self#regulatory organi)ation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

&ccounting of Derivatives ' The Institute of 1hartered &ccountants of India I1&I" has issued guidance notes on accounting of index futures contracts from the view point of parties who enter into such futures contracts as buyers or sellers. For other parties involved in the trading process, like brokers, trading members, clearing members and clearing corporations, a trade in e!uity index futures is similar to a trade in, say shares, and does not pose any peculiar accounting problems Taxation The income#tax &ct does not have any specific provision regarding taxability from derivatives.The only provisions which have an indirect bearing on derivative transactions are sections <( $" and *( +". .ection <( $" provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business. In the absence of a specific provision, it is apprehended that the derivatives contracts, particularly the index futures which are essentially cash#settled, may be construed as speculative transactions and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to a maximum of eight years .&s a result an investor/s losses or profits out of derivatives even though they are of hedging nature in real sense, are treated as speculative and can be set off only against speculative income. &nu4 Thakur 8ahul Larkun .ameer Lalra 8eferences' Bational .tock 6xchange website 7usiness 5ine Duly %<,%>>% 7ombay .tock 6xchange website D.2 Merrill 5ynch website M0ptions, Futures, &nd 0ther FderivativesM # Dohn 1. -ull