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ABSTRACT
The Indian derivative market has become multi-trillion dollar markets over the years. Marked
with the ability to partially and fully transfer the risk by locking in assets prices, derivatives are
gaining popularity among the investors. Since the economic reforms of 1991, maximum efforts
have been made to boost the investors’ confidence by making the trading process more users’
friendly and rigorous efforts have been made to reinforce the investor assurance. Financial
markets are very inventive in augmenting the popularity of derivatives instruments which
exemplifies how resourcefully markets are capable to package and manage risk. At the present in
world markets for trade and business have become further incorporated, derivatives have
strengthened these significant linkages between global markets, increasing market liquidity and
effectiveness. In India, the emergence and growth of derivatives market is relatively a recent
phenomenon. Hence, the present paper is an attempt to study the evolution of Indian derivative
market and analyse the trading statistics of various derivative segments. An attempt has also
been made to review its present scenario vis a via global derivative market and develop an
understanding of the bottlenecks involved in its popularity. These issues need to be resolved to
enhance the investors’ confidence in the Indian derivative market. The present paper is
descriptive in nature and based on the secondary data.
Financial sector has seen significant developments especially towards the end of twentieth
century. The collapse of the Bretton Woods system of fixed exchange rates in 1971, thereafter
progress in financial liberalisation paved the way for growth of international financial
transactions. This new era of financial globalisation came along with numerous kinds of financial
innovations and risk management strategies. Financial derivative was one of them. The
developing countries like India opened up their economies and allowed prices to vary with
market conditions. Price fluctuations made it almost impossible for the corporate sector to
estimate future production costs and revenues. The derivatives provided an effective tool to the
problem of risk and uncertainty due to fluctuations in interest rates, exchange rates, stock market
prices and the other underlying assets. The derivative markets have become an integral part of
modern financial system in less than three decades of their emergence. This paper describes the
evolution of Indian derivatives market, trading statistics in its various segments, the various
unsolved issues and the future prospects of the derivatives market.
Literature Review
According to Greenspan (1997) “By far the most significant event in finance during the past
decades has been the extraordinary development and expansion of financial derivatives…”
Avadhani (2000) stated that a derivative, an innovative financial instrument, emerged to protect
against the risks generated in the past, as the history of financial markets is repleted with crises).
Events like the collapse of the fixed exchange rate system in 1971, the Black Monday of October
1987, the steep fall in the Nikkei in 1989, the US bond debacle of 1994, occurred because of
very high degree of volatility of financial markets and their unpredictability. Such disasters have
become more frequent with increased global integration of markets.
Sahoo (1997) opines “Derivatives products initially emerged, as hedging devices against
fluctuation in commodity prices and the commodity-linked derivatives remained the sole form of
such products for many years. Marlowe (2000) argues that the emergence of the derivative
market 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. It is generally stated that regulation has an important and critical role
to ensure the efficient and smooth functioning of the markets. According to Sahoo (1997) the
legal framework for derivatives trading is a critical part of overall regulatory framework of
derivative markets. The purpose of regulation is to encourage the efficiency and competition
rather than impeding it.
Hathaway (1998) stated that, while there is a perceived similarity of regulatory objective, there is
no single preferred model for regulation of derivative markets.
FINANCIAL DERIVATIVES
A derivative is an instrument whose value is ‘derived’ from another security or economic
variable. The dependence of the derivative’s value on other prices or variables makes it an
excellent vehicle for transferring and managing risk.
According to John C. Hull, “A derivative can be defined as a financial instrument whose value
depends on (or derives from) the values of other, more basic underlying variables.”
Also defined by Robert L. McDonald “A derivative is simply a financial instrument (or even
more simply an agreement between two people) which has a value determined by the price of
something else.”
The International Monetary Fund (2001) defines derivatives as “financial instruments that are
linked to a specific financial instrument or indicator or commodity and through which specific
risks can be traded in financial markets in their own right. The value of a financial derivative
derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no
principal is advanced to be repaid and no investment income accrues.”
According to SCRA (Securities Contract Regulation Act) act 1956, Section 2(ac) derivative
comprises:
Types of Derivatives
The derivatives can be classified in a number of ways.
One way of classifying derivatives is as,
DERIVATIVES
COMMODITY FINANCIAL
1. Commodity Derivatives
These deals with commodities like sugar, gold, wheat, pepper etc. thus, futures or options on
gold, sugar, pepper, jute etc are commodity derivatives.
2. Financial Derivatives
Futures or options or Swaps on currencies, gilt edged securities, stocks and shares, stock market
indices, cost of living indices etc are financial derivatives. Another way of classifying
Derivatives is
DERIVATIVES
BASIC COMPLEX
3. Basic Derivatives
They are forward / futures contracts and option contracts.
4. Complex Derivatives
Other derivatives, such as SWAPS are complex ones because they are built up from either
forward / future contracts or options contracts or both.
Generally derivatives can be classified as follows:
DERIVATIVES
5. Futures
A futures contract is a contract to “buy or sell a standard amount of or predetermined grades of
certain commodity (i.e. commodity futures) or financial instruments or currency (that is financial
futures) on a predetermined future day at an agreed prize.”
6. Forwards
It is “an agreement between two parties to buy or sell a commodity or financial instrument at a
predetermined future date at a prize agreed when the contract is a made”. The forward contracts
are normally traded outside the exchanges. Forward contracts are very useful in hedging and
speculation.
7. Options
They are the second, most important group of derivative securities, first being futures. It is “a
contract between two parties where by one party acquires the right, but not the obligation to buy
or sell a particular commodity or financial instrument at a specified date”. Options are of two
types
(a) Call option (b) Put option
(a) Call Option: Call option gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.
(b) Put Option: Put option gives the holder the right but not the obligation to sell an asset by a
certain date for a certain price.
8. Complex Derivatives
Using futures and options it is possible to build number of complex derivatives. IT is designed
to suit the particular needs and circumstances of a client. Example: SWAPS, Credit Derivatives
9. Weather Derivatives
This is a new tool for risk management. This is a contract between 2 parties that stipulate how
payment will be exchanged between parties depending on certain meteorological conditions
during the contract period. They are based on data such as temperature, rainfall, snowfall etc.
The primary objective of this derivative is to initiate the volume risks, which will influence the
Balance Sheet and Profit and Loss figures.
Derivative markets in India have been in existence in one form or the other for a long time. In the
area of commodities, the Bombay Cotton Trade Association started future trading way back in
1875. This was the first organized futures market. Then Bombay Cotton Exchange Ltd. in 1893,
Gujarat Vyapari Mandall in 1900, Calcutta Hesstan Exchange Ltd. in 1919 had started future
market. After the country attained independence, derivative market came through a full circle
from prohibition of all sorts of derivative trades to their recent reintroduction. In 1952, the
government of India banned cash settlement and options trading, derivatives trading shifted to
informal forwards markets. In recent years government policy has shifted in favour of an
increased role at market based pricing and less suspicious derivatives trading.
The first step towards introduction of financial derivatives trading in India was the promulgation
at the securities laws (Amendment) ordinance 1995. It provided for withdrawal at prohibition on
options in securities. The last decade, beginning the year 2000, saw lifting of ban of futures
trading in many commodities. Around the same period, national electronic commodity
exchanges were set up. Derivatives trading commenced in India in June 2000 after SEBI granted
the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee.
Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock
exchanges, NSE and BSE, and their clearing house/corporation to commence trading and
settlement in approved derivatives contracts. Initially SEBI approved trading in index futures
contracts based on various stock market indices such as, S&P CNX, Nifty and Sensex.
Subsequently, index-based trading was permitted in options as well as individual securities.
The Exchange has also introduced trading in Futures and Options contracts based on Nifty IT,
Nifty Bank, and Nifty Midcap 50, Nifty Infrastructure, Nifty PSE indices. Since the launch of the
Index Derivatives on the popular benchmark Nifty 50 Index in 2000, the National Stock
Exchange of India Limited (NSE) today have moved ahead with a varied product offering in
equity derivatives. The Exchange currently provides trading in Futures and Options contracts on
9 major indices and more than 100 securities. The various kinds of equity derivative contracts
that are traded on NSE are shown in table 1.3 for the fiscal year 2013-14.
60000000
50000000
40000000
30000000
20000000 Total Turnover
10000000 (Rs. Cr.)
0
2008-09
2014-15
2012-13
2010-11
2006-07
2004-05
2002-03
2000-01
The data clearly reveals that there has been a continuous and steep rise in the turnover of
derivative contracts over the years except for the year 2008-09 which witnessed the Sub Prime
crises. The investors’ participation has increased manifold since the introduction of derivatives.
India is one of the most successful developing countries in terms of a vibrant market for
exchange traded derivatives. This reiterates the strengths of the modern development in India’s
securities markets, which are based on nationwide market access, anonymous electronic trading,
and a predominantly retail market. There is an increasing sense that the equity derivatives market
plays a major role in shaping price discovery.
3) Cash vs. Physical Settlement: Only about 1% to 5% of the total commodity derivatives
trade in the country is settled in physical delivery. It is probably due to the inefficiencies in
the present warehousing system. Therefore the warehousing problem obviously has to be
handled on a war footing, as a good delivery system is the backbone of any commodity trade.
A major problem in cash settlement of commodity derivative contracts is that at present,
under the Forward Contracts (Regulation) Act 1952, cash settlement of outstanding contracts
at maturity is disallowed. In other words, all outstanding contracts at maturity should be
settled in physical delivery. To avoid this, participants settle their positions before maturity.
So, in practice, most contracts are settled in cash but before maturity. There is a need to
modify the law to bring it closer to the widespread practice and save the participants from
unnecessary hassles.
5) The Regulator: As the market activity pick-up and the volumes rise, the market will
definitely need a strong and independent regulator; similar to the Securities and Exchange
Board of India (SEBI) that regulates the securities markets. Unlike SEBI which is an
independent body, the Forwards Markets Commission (FMC) is under the Department of
Consumer Affairs (Ministry of Consumer Affairs, Food and Public Distribution) and depends
on it for funds. It is imperative that the Government should grant more powers to the FMC to
ensure an orderly development of the commodity markets. The SEBI and FMC also need to
work closely with each other due to the inter-relationship between the two markets.
6) Tax and Legal bottlenecks: In India, at present there are tax restrictions on the movement of
certain goods from one state to another. These need to be removed so that a truly national
market could develop for commodities and derivatives. Also, regulatory changes are
required to bring about uniformity in octroi and sales taxes etc. VAT has been introduced in
the country in 2005, but has not yet been uniformly implemented by all states.
Conclusion: The Indian derivative market has achieved tremendous growth over the years,
and also has a long history of trading in various derivatives products. The derivatives market has
seen ups and downs. The new and innovative derivative products have emerged over the time to
meet the various needs of the different types of investors. Though, the derivative market is
burgeoning with its divergent products, yet there are many issues. Among the issues that need to
be immediately addressed are those related to, lack of economies of scale, tax and legal
bottlenecks, increased off-balance sheet exposure of Indian banks, need for an independent
regulator etc. Solution of these issues will definitely lead to boost the investors’ confidence in
the Indian derivative market and bring an overall development in all the segments of this market
References
Books Referred:
Articles:
Ahuja, L. Narender (2005). Commodity Derivatives Market in India: Development, Regultion and Future
Prospects.
IBRC Athens 2005. Fitch Ratings (2004). Fixed Income Derivatives---A Survey of the Indian Market,
retrieved from: www.fitchratings.com.
Hathaway, Kate (October 1988), “Regulatory parameters associated with successful derivatives”,
Chartered Secretary, Volume XXVII, Number: 10, Pp. 981-988 Jason Greenspan (1997).
Patwari D.C. and Bhargava A.(2006). Options and Futures An Indian Perspective, Jaico Publishing,
Mumbai. RBI (2009). Report on Trend and Progress of Banking in India, pp. 300.
Websites:
www.ers.usda.gov/Briefing/RiskManagement/glossary.htm
http://wikipedia.org/wiki/derivatives
http://www.investorwords.com/derivatives
www.nseindia.com/research/dynaContent/nsefactbook2015.pdf
www.bseindia.com
http://rbi.org.in/scripts/AnnualReportPublications.aspx?Id=1023
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