Introduction of derivatives market

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. 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-vis derivative products based on individual securities is another reason for their growing use. The following factors have been driving the growth of financial derivatives: 1.Increased volatility in asset prices in financial markets, 2.Increased integration of national financial markets with the international markets, 3.Marked improvement in communication facilities and sharp decline in their costs, 4.Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5.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. Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. 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. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines "equity derivative" to include 1.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. 2.A contract, which derives its value from the prices, or index of prices, of underlying securities.

What are the Risk Associated with Derivatives?

Most regular investors look at derivatives as the risky investment vehicle that wiped out California's Orange County government to the tune of $1.5 billion in investments and destroyed England's Barings Bank when an ill-informed trader bet against Japanese markets and lost. To professional investors, derivatives are powerful tools for managing risk that, if handled correctly, can be quite lucrative. THe biggest risk in trading derivatives is the fact that you can lose a lot of money, and very quickly, when the event that you though was going to happen failed to occur. A derivative is an investment contract that depends upon prices or rates of other financial securities. For example, a computer manufacturer that buys component parts from Japan, would want to protect the component's prices against a rise in the value of the Japanese Yen against the U.S. dollar. That manufacturer would likely purchase a currency option. In order to manage risk, investors must keep a careful watch on their positions. Another factor affecting the risk exposure in derivatives is a trend toward participants signing net agreements that require only the net value of all parties' positions to be replaced if there is a default. As an example, A owes B $150 million in one derivative contract; B owes A $100 million in a different contract. If A should go under and B is forced by contract to pay the $100 million it owes, B would still be exposed to the $150 million owed to it by A. This would create a gross credit exposure here of $150 million. On the other hand, suppose B and A have agreed that if either defaults, only the net of all contracts will be owed, not the gross. In this case the net exposure of B is only $50 million. Many business schools are preparing students to deal with derivatives by offering MBA students one core course and five electives that include the topic. In addition, ongoing work by faculty members and doctoral students add to the understanding of the field. Today, the concepts of value at risk and volatility of options are becoming standard industry practice. One of the most interesting things about derivatives is that they are a very risky tool that is, itself, used to manage risk. Of all the derivatives, futures contracts are probably the riskiest. When you buy a futures contract, you are obligated to purchase or sell a specific commodity by a set time and for a set price. The commodities involved usually include agricultural products (crops and animals), precious metals (gold and silver), oil and other energy products, and financial products (financial instruments and foreign currency). You can purchase futures contracts from the same brokerage firms you purchase stocks from, and you should expect to pay substantial commission fees. Futures contracts are similar to stock option contracts, but they are much riskier because you have an obligation rather than an option to purchase or sell something. Therefore, you run the risk of losing a lot more than what you paid for your contract

if you predict incorrectly on the way prices are going! And as difficult as it may be to predict the rise and fall of a stock, it's child's play compared to predicting commodity prices. The bottom line is, unless you have great knowledge about a certain item and the market it moves in, or you have absolute, total faith that your broker knows what he's doing, this is not, we repeat, not, the place to put your investment dollars, no matter what age or stage of life you are in. While the profits are huge based on a small investment if the market moves your way, if it doesn't, your loss can easily be astronomical

Function of derivative market

In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions. 1. 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. Thus derivatives help in discovery of future as well as current prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trade volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. 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. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have 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, the benefit of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. According to survey conducted in India regarding the sub brokers opinion on the impact of derivatives market on financial market, the result obtained is given as under. Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Based on the survey results, the authors identified some important policy issues such as the need to bring in more institutional participation to make the derivative market in India more efficient and to bring it in line with the best practices. Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.

Types of traders in derivatives market

Hedgers : Hedgers are those who protect themselves from the risk associated with the price of an asset by using derivatives. A person keeps a close watch upon the prices discovered in trading and when the comfortable price is reflected according to his wants, he sells futures contracts. In this way he gets an assured fixed price of his produce. In general, hedgers use futures for protection against adverse future price movements in the underlying cash commodity. Hedgers are often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take an example: A Hedger pay more to the farmer or dealer of a produce if its prices go up. For protection against higher prices of the produce, he hedge the risk exposure by buying enough future contracts of the produce to cover the amount of produce he expects to buy. Since cash and futures prices do tend to move in tandem, the futures position will profit if the price of the produce rise enough to offset cash loss on the produce. Speculators :

Speculators are some what like a middle man. They are never interested in actual owing the commodity. They will just buy from one end and sell it to the other in anticipation of future price movements. They actually bet on the future movement in the price of an asset. They are the second major group of futures players. These participants include independent floor traders and investors. They handle trades for their personal clients or brokerage firms. Buying a futures contract in anticipation of price increases is known as going long. Selling a futures contract in anticipation of a price decrease is known as going short. Speculative participation in futures trading has increased with the availability of alternative methods of participation. Speculators have certain advantages over other investments they are as follows:

If the traders judgement is good, he can make more money in the futures market faster because prices tend, on average, to change more quickly than real estate or stock prices. Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond. The actual value of the contract is only exchanged on those rare occasions when delivery takes place.

Arbitrators

According to dictionary definition, a person who has been officially chosen to make a decision between two people or groups who do not agree is known as Arbitrator. In commodity market Arbitrators are the person who take the advantage of a discepancy between prices in two different markets. If he finds future prices of a commodity edging out with the cash price, he will take offsetting positions in both the markets to lock in a profit. Moveover the commodity futures investor is not charged interest on the difference between margin and the full contract value.

Types of derivative market

Derivatives Market is the market where the financial instrument like derivatives are traded. Primarily, Derivatives Market has been divided in two parts: Over-the-counter (OTC) Market and Exchange-traded Market where derivatives like Forwards, Futures, Swaps and Options are traded. Normally, these derivatives are tool to manage risk attached to asset, but one needs to have lot of expertise to use them in their trading strategy due to their complexity. Below is the detailed explanation of the various derivative contracts. Forwards: A forward contract is the customized contract between two parties, where settlement takes place on a specific date in future at today's pre-agreed price. Forwards represent the obligation to make a transaction at a set point in time in the future. Once you enter into a forward-based contract, you are obligated to make the transaction unless both parties agree to cancel or otherwise modify the agreement. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. They are unique in terms of contract size, expiry date, asset type and quality. Forward contracts draw in counter-party risk i.e. the counter-party defaults and is unable to pay the cash difference or deliver the asset. 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. When a forward contract is traded on a recognized exchange, it is referred to as a futures contract". Examples of futures include commodities, interest rates, currencies, and stock market indices. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, an airline uses crude oil futures for hedging purpose to lock in a certain price and reduce risk. Similarly, anybody could speculate on the price movement of crude oil by going long or short using futures. Some future contracts may call for physical delivery of the asset, while others are settled in cash. How Futures Contract work? The futures market is a centralized market place for buyers and sellers from around the world who meet and enter into futures contracts. Pricing can be based on an open cry

system, or bids and offers can be matched electronically. The futures contract will state the price that will be paid and the date of delivery, also known as the expiry date. Options: An option gives the contract holder the right to buy or sell on a specified date in the future - but they are under no obligation. 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 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. Players in the Options Market: Developmental institutions, Mutual Funds, Financial Institutions, FIIs, Brokers, Retail Participants are the likely players in the Options Market. Some of the examples of Options are Index Options, Options on individual stocks, Bond options, Interest Rate Futures Options, etc. Swaps: Swaps are the types of Forward contracts and they occupy an important role in International Finance. They are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They are generally an agreement to exchange one stream of cashflows to another. Swaps have been categorised into four parts: Interest rate swaps Currency swaps Commodity swaps Equity swaps

Equity Derivatives in India - An Overview

Derivatives Markets Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and the those traded one to one or over the counter. They are hence known as Exchange Traded Derivatives OTC Derivatives (Over The Counter)

OTC Equity Derivatives Traditionally equity derivatives have a long history in India in the OTC market. Options of various kinds (called Teji and Mandi and Fatak) in un-organized markets were traded as early as 1900 in Mumbai The SCRA however banned all kind of options in 1956.

Derivative Markets today

The prohibition on options in SCRA was removed in 1995. Foreign currency options in currency pairs other than Rupee were the first options permitted by RBI. The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions OTC derivative products. Besides the Forward market in currencies has been a vibrant market in India for several decades. In addition the Forward Markets Commission has allowed the setting up of commodities futures exchanges. Today we have 18 commodities exchanges most of which trade futures. e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI). In 2000 an amendment to the SCRA expanded the definition of securities to included Derivatives thereby enabling stock exchanges to trade derivative products. The year 2000 will herald the introduction of exchange traded equity derivatives in India for the first time.

Equity Derivatives Exchanges in India In the equity markets both the National Stock Exchange of India Ltd. (NSE) and The Stock Exchange, Mumbai (BSE) have applied to SEBI for setting up their derivatives segments. The exchanges are expected to start trading in Stock Index futures by mid-May 2000.

BSE's and NSEs plans Both the exchanges have set-up an in-house segment instead of setting up a separate exchange for derivatives. BSEs Derivatives Segment, will start with Sensex futures as its first product. NSEs Futures & Options Segment will be launched with Nifty futures as the first product.

Trading Systems NSEs Trading system for its futres and options segment is called NEAT F&O. It is based on the NEAT system for the cash segment. BSEs trading system for its derivatives segment is called DTSS. It is built on a platform different from the BOLT system though most of the features are common.

Settlement and Risk Management systems Systems for settlement and risk management are required to satisfy the conditions specified by the L.C. Gupta Committee and the J.R. Verma committee. These include upfront margins, daily settlement, online surveillance and position monitoring and risk management using the Value-at-Risk concept.

Certification Programmes The NSE certification programme is called NCFM (NSEs Certification in Financial Markets). NSE has outsourced training for this to various institutes around the country. The BSE certification programme is called BCDE (BSEs Certification for the Derivatives Exchnage). BSE conducts its own training run by its training institute. Both these programmes are approved by SEBI.

Rules and Laws Both the BSE and the NSE have been give in-principle approval on their rule and laws by SEBI. According to the SEBI chairman, the Gazette notification of the Bye-Laws after the final approval is expected to be completed by May 2000. Trading is expected to start by mid-June

ELIGIBILITY CRITERIA FOR DERIVATIVE EXCHANGE / DERIVATIVE SEGMENT OF THE EXCHANGE 1. The Derivatives Exchange/Segment should have adequate infrastructure, independent Governing Council and should satisfy other eligibility conditions for trading in Derivatives Contracts. 2. Derivative trading shall take place through an on-line screen based Trading System. The Exchange should also have a disaster recovery site. The per half hour capacity of computers and network should be atleast 4 times of the anticipated peak load in any half hour or the actual peak load seen in any half hour during the preceding six months. 3. The Derivatives Exchange will have arrangements for settlement of trades through a separate Clearing Corporation / clearing house, duly approved by SEBI. The Trading Member shall settle all his trades either by himself as a "Clearing Member" or he will make necessary arrangements for clearing trades on his behalf through a Clearing Member. 4. The Exchange must have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation. 5. The Exchange should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks which are easily accessible to investors in the country. 6. The Exchange should have a minimum of 50 Members to start derivatives trading. 7. The Derivative Exchange/Segment should have adequate inspection capabilities to take up annual inspection of all of its Members. 8. If derivatives trading is to take place at an existing Stock Exchange, it should be done in a separate Segment with a separate Membership. Existing Members of the Exchange will not automatically become Members of the Derivatives Exchange/Segment. 9. The Derivatives Exchange/Segment should have a separate Governing Council which shall not have representation of trading / Clearing Members of the Derivatives Exchange / Segment beyond the percentage prescribed by SEBI from time to time. 10. The Members of the Governing Council of the Derivatives Exchange/Segment shall elect a Chairman and if the Chairman of the Governing Council is a Trading Member / Clearing Member, then he shall not carry on any trading or clearing business on any Exchange during his tenure as Chairman. Further, no Trading / Clearing Member shall be allowed to simultaneously be on the Governing Councils of a Derivatives Exchange / Segment and the underlying securities market. 11. The Exchange should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country. 12. Before the start of Derivatives Exchange / Derivatives Segment, the Exchange shall obtain prior approval of SEBI. While granting approval to start derivatives trading to an existing Stock Exchange, SEBI will see that the Exchange has satisfactory record of monitoring its Members, handling investor complaints and preventing irregularities

in trading. The Derivative Exchange / Segment shall submit its Bye-laws and Rules for approval of SEBI before commencement of derivatives trading. Further, it shall also take prior approval of SEBI for any amendment to its Rules and Bye-laws. 13. The Derivatives Exchange / Segment shall prescribe eligibility norms for Trading Members and Clearing Members which shall be more stringent than the eligibility requirements for the underlying securities market. 14. Before the start of trading in a Derivatives Contract, the Derivatives Exchange/Segment shall submit the proposal for approval of the contract to SEBI giving: a. the details of the proposed Derivatives Contract to be traded in the Exchange; b. the economic purposes it is intended to serve; c. its likely contribution to market development; d. the safeguards and the risk protection mechanisms adopted by the Exchange to ensure market integrity, protection of investors and smooth and orderly trading, e. the infrastructure of the Exchange and the surveillance system to effectively monitor trading in such contracts.