Chapter # 1 Basics of Derivatives

What are derivatives?

Derivatives, such as options or futures, are financial contracts which derive their value of a
spot price time-series, which is called the under-lying". For examples, wheat farmers may
wish to contract to sell their harvest at a future date to eliminate the risk of a change in
prices by that date. Such a transaction would take place through a forward or futures market.
This market is the derivative market” and the prices on this market would be driven by the
spot market price of wheat which is the underlying". The terms contracts" or products" are
often applied to denote the specific traded instrument. The world over, derivatives are a key
part of the financial system. The most important contract- types are futures and options, and
the most important underlying markets are equity, treasury bills, commodities, foreign
exchange and real estate.
Derivatives—contracts that gamble on the future prices of assets--are secondary assets, such
as options and futures, which derive their value from primary assets, such as currency,
commodities, stocks, and bonds. The current price of an asset is determined by the market
demand for and supply of the asset; however, the future price of an asset typically remains
unknown. A week or a month in the future, the price may increase, decrease, or remain the
same. Buyers and sellers often like to hedge their bets against this uncertainty about future
price by making a contract for future trading at a specified price. The contract—a financial
instrument--is called a derivative.
A future or forward contract is formed when both the buyer and the seller are committed and
legally obliged to exchange the underlying asset when the contract matures. An option, on
the other hand, is a contract that gives its owner the right, but not the obligation, to buy or
sell the underlying asset on or before a given date at the agreed-upon price.
EXAMPLES:
Suppose you expect that six months from now the price of the U.S. dollar with respect to the
Canadian dollar will be higher than it is today, and would like to purchase US $1,000 six
months from now at today’s rate. Suppose the current price of US $1,000 is CAN $1,200.
Another person expects that the price of the U.S. dollar will decrease over the coming six
months, and is willing to sell U.S. dollars at today’s rate. Both of you can make a contract
that will be exercised six months from now. Interestingly, neither of you needs to put down
any currency today when signing the contract. When the contract matures, transactions must
be carried out at the agreed-upon rate. This type of contract is called a forward contract.
Alternatively, suppose the contract is sold for a non-refundable fee of $25. If the price of the
U.S. dollar goes up, you are likely to exercise your right. On the other hand, if the price of
the U.S. dollar goes down, you will be better off not exercising your right; in this case, you
are losing only the fee. This type of contract is known as a ’call option.’ Similarly, a ’put
option’ gives the owner the right to sell rather than buy.

What is a forward contract?

In a forward contract, two parties agree to do a trade at some future date, at a stated price
and quantity. No money changes hands at the time the deal is signed.

Why is forward contracting useful?

Forward contracting is very valuable in hedging and speculation. The classic hedging
application would be that of a wheat farmer forward-selling his harvest at a known price in
order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in
order to assist production planning without the risk of price fluctuations. If a speculator has
information or analysis which forecasts an upturn in a price, then she can go long on the
forward market instead of the cash market. The speculator would go long on the forward,

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wait for the price to rise, and then take a reversing transaction. The use of forward markets
here supplies leverage to the speculator.

What are the problems of forward markets?

Forward markets worldwide are afflicted by several problems: (a) lack of centralisation of
trading, (b) illiquidity, and (c) counterparty risk.
In the first two of these, the basic problem is that of too much flexibility and generality. The
forward market is like the real estate market in that any two consenting adults can form
contracts against each other. This often makes them design terms of the deal which are very
convenient in that specific situation, but makes the contracts non-tradable. Also the “phone
market" here is unlike the centralisation of price discovery that is obtained on an exchange.
Counterparty risk in forward markets is a simple idea: when one of the two sides of the
transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic
property: the larger the time period over which the forward contract is open, the larger are
the potential price movements, and hence the larger is the counterparty risk.
Even when forward markets trade standardised contracts, and hence avoid the problem of
illiquidity, the counterparty risk remains a very real problem. A classic example of this was
the famous failure on the Tin forward market at LME.

What is a futures contract?

Futures markets were designed to solve all the three problems (a, b and c listed in Question
above) of forward markets. Futures markets are exactly like forward markets in terms of
basic economics. However, contracts are standardised and trading is centralised, so that
futures markets are highly liquid. There is no counterparty risk (thanks to the institution of a
clearinghouse which becomes counterparty to both sides of each transaction and guarantees
the trade). In futures markets, unlike in forward markets, increasing the time to expiration
does not increase the counterparty risk.

Why is the cash market in India said to have futures-style settlement?

In a true cash market, when a trade takes place today, delivery and payment would also take
place today (or a short time later). Settlement procedures like T+3 would qualify as “cash
markets" in this sense, and of the equity markets in the country, only OTCEI is a cash market
by this definition.
For the rest, markets like the BSE or the NSE are classic futures market in operation. NSE's
equity market, for example, is a weekly futures market with Tuesday expiration. When a
person goes long on Thursday, he is not obligated to do delivery and payment right away,
and this long position can be reversed on Friday thus leaving no net obligations with the
clearinghouse (this would not be possible in a T+3 market). Like all futures markets, trading
at the NSE is centralised, the futures markets are quite liquid, and there is no counterparty
risk.

What is an option?

An option is the right, but not the obligation, to buy or sell something at a stated date at a
stated price. A “call option" gives one the right to buy, a “put option" gives one the right to
sell.
An option is a contract which gives the right, but not the obligation, to buy or sell the
underlying at a stated date and at a stated price. A call option gives the right to buy and a
put option gives the right to sell. A typical options transaction. On July 1, 2005, 'A' sells a call

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option (right to buy), with strike price of Rs.500, which expires after one month on "ABC
Ltd." to 'B' for a price of say Rs.3.00. Now 'B' has the right to approach 'A' on July 31, 2005
and buy 1 share of "ABC Ltd." at Rs.500. Here Rs.3.00 is called the option price, Rs.500 is
the exercise price and July 31, 2005 is called the expiration date. 'B' does not have to
necessarily buy 1 share of "ABC Ltd." on July 31, 2005 at Rs.500 from 'A'. 'B' may find it
worthwhile to exercise his right to buy only if "ABC Ltd." trades above Rs.500. If "B"
exercises his option, A has to necessarily sell "B" one share of "ABC Ltd." at Rs.500 on July
31, 2005. So if the price of "ABC Ltd." Goes above Rs.500 'B' may exercise his option, or else
the option may lapse. Then 'B' loses the original option price of Rs.3.00 and 'A' has gained it.

What is the underlying for an Option?

Options can be traded on any underlying like individual stocks, Indices etc. NSE introduced
trading in S&P CNX Nifty Options from June 4, 2001 and options on individual securities from
July 2, 2001. This booklet tries to bring home certain basic concepts and features of Index
options.

Who should trade in Options?

Investors belonging to the following categories, depending on their financial goals and
Investment objectives generally consider trading in options.
• Investors who want to participate in the market without trading or holding a large stock
portfolio.
• Investors who have strong views on the market and its future movement and want to take
advantage of the same
• Investors who are following the equities market very closely
• Investors who want to protect the value of their diversified equities portfolio

Why should you trade in Options?

Buying options can be compared to buying insurance. For example to cover the risk of
burglary, fire, etc. you buy insurance and pay premium. In the event of any untoward
happening, the insurance cover compensates you for the losses. Otherwise, the insurance
cover expires after the specific period of time. The insurance premium is the cost for the
cover. Similarly, in the case of options, the right to buy or sell the underlying is acquired by
payment of a premium. This affords protection against a general fall in market and thus can
be attractive to various investors including Mutual Funds, who may like to bundle Nifty funds
with Nifty options. The option could be exercised in the event of adverse market movement.
Otherwise, the option will expire after the specific period. The cost of the option, i.e. the
premium, is paid at the time of purchase. There is no further loss that is generated by the
option for the buyer. This feature of option makes it attractive for the market participants.

How Nifty options are settled?

Like Nifty Futures, Nifty options is also cash settled

How Nifty options will work?

Contract specifications (proposed):

Underlying Index: S&P CNX Nifty
Exchange of Trading: National Stock Exchange of India Limited
Contract size: Permitted lot size shall be 100 or multiples thereof
Price steps: Res.0.05

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Strike Price Interval: Rs. 10.00
Price Bands: Not applicable
Trading cycle : The options contracts will have a maximum of three month trading cycle – the
near month (one), the next month (two) and the far month (three) New contract will be
introduced
on the next trading day following the expiry of near month contract
Expiry day: The last Thursday of the expiry month or the previous trading day if the last
Thursday is a trading holiday.
Settlement basis: Cash settlement
Style of option: European

What is the underlying for an Option?

Options can be traded on any underlying like individual stocks, Indices etc. NSE introduced
trading in S&P CNX Nifty Options from June 4, 2001 and options on individual securities from
July 2, 2001. This booklet tries to bring home certain basic concepts and features of Index
options.

How Nifty options would help an investor?

Nifty options allows the investor to trade a large segment of the equities market with one
decision and thus provide a different perspective and new dimension to investing in equities.
Nifty options helps the investors in reflecting their views on the market-bullish, bearish or
neutral, in planning their investment strategies and thus trade efficiently.

What is S&P CNX Nifty?

S&P CNX Nifty (Nifty) is a 50 stock index comprising the largest and the most liquid
companies in India. Nifty covers nearly 23 sectors of the economy and a market capitalization
of almost 60% of the total market capitalization of the Indian stock market. The ownership
and management rights of this index rests with India Index Services & Products Ltd. (IISL), a
corporate body jointly promoted by NSE and the Credit Rating and Information Services of
India Ltd. (CRISIL), a leading rating agency in India. IISL has a co-branding and licensing
agreement with Standard & Poor's (S&P) one of the world's leading index services providers.
Nifty is a scientifically developed market capitalisation weighted index with the advantage of
technical oversight by S&P. Nifty was developed keeping in mind that an index besides being
a true reflection of the stock market, should also be used for modern applications such as
index funds and index derivatives.

Some basic terminology:-

Options – the right but not the obligation either to buy or sell a specified quantity of the
underlying at a fixed exercise price on or before the expiration date.
Call options – the right to buy a specified quantity of the underlying at a fixed exercise price
on or before the expiration date
Example: The holder of ‘ABC’ call option has the right to purchase shares of ‘ABC Limited’ at
the specified exercise price on exercise of the option
Put options – the right to sell a specified quantity of the underlying at a fixed exercise price
on or before the expiration date.
Example: The holder of ‘ABC’ put option has the right to sell shares of ‘ABC Limited’ at the
specified exercise price on exercise of the option:
Option holder – the person who buys the right conveyed by the option

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Option writer – is obligated if and when assigned an exercise to perform according to the
terms of the option. Also referred to as option seller.
Exercise price – is the price at which the contract is settled. In the case of options settled by
delivery, is the price at which the option holder of the call option has the right to purchase or
the price at which the option holder of the put option has the right to sell the underlying, as
the case may be. Exercise price is also referred to as ‘Strike price’. In the case of cash settled
option, exercise price is the base for the determination of the amount of cash, if any, that the
option holder is entitled to receive upon exercise.
Options settled by delivery – gives the owner the right to receive delivery (if it is a call) or to
make the delivery (if it is a put), of the underlying when the option is exercised.
Cash settled options – gives the owner the right to receive a cash payment based on the
difference between a determined value of the underlying at the time of exercise and the fixed
exercise price of the option. Nifty options are cash settled.
Example: You bought Nifty November call at a strike price of 1400. On expiry of November
options, the expiration level was 1430. The cash settlement will be Rs. 30 per Nifty and for
one contract, Rs.6000 (i.e.30*200, the minimum contract size)
Assigned writer – Option writer who has been assigned an exercise is known as an assigned
writer.
Expiration date – the date on which the option expires. If an option has not been exercised
prior to its expiration, it ceases to exist after the expiration date, i.e. the option holder shall
no longer have any right and the option, no value.
Style of option - refers to the time at/ within which the option is exercisable. Two different
styles of options are: American and European

American style – Options which may be exercised at any time prior to their expiration.
European style – Options which may be exercised only on the expiration date.
Premium – the price that the holder of an option pays and the writer of an option receives for
the rights conveyed by the option. The premiums are not fixed by the Exchange and are
subject to fluctuations in response to market and economic forces. The factors affecting
pricing of an option include current value of the underlying, the exercise price, current values
of futures on the underlying, style of option, individual opinion and estimates of the future
volatility of the underlying, historical volatility of the underlying, the time remaining till
expiration, cash dividends payable on the underlying stock, current interest rates, depth of
the market, available information, etc.
Opening transaction – a purchase or a sale transaction by which a person establishes or
increases a position either as the holder or the writer of an option.

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Closing transaction - a transaction by which a person reduces or cancels out previous position
either as the holder or the writer of that option.
For example, an investor, at some point prior to expiration, may make an offsetting sale of
an identical option, if he is an option holder or make an offsetting purchase of an identical
option, if he is an option writer.
Long and short – Long refers to a position as the holder of an option. Short refers to a
position as the writer of an option.
At the money – means that the current market value of the underlying is the same as the
exercise price of the option
Example – If the current Nifty is 1400, Nifty 1400 call (strike price is 1400), is at the money.
In the money – A call option is said to be in the money if the current market value of the
underlying is above the exercise price of the option. A put option is said to be in the money if
the current market value of the underlying is below the exercise price of the option.
Example – If the current Nifty is 1400, Nifty 1390 call (strike price is 1390) and Nifty 1420
put (strike price is 1420) are in the money.
Out of the money - A call option is said to be out of the money if the current market value of
the underlying is below the exercise price of the option. A put option is said to be out of the
money if the current market value of the underlying is above the exercise price of the option.
Example – If the current Nifty is 1400, Nifty 1420 call (strike price is 1420) and Nifty 1390
put (strike price is 1390) are out of the money.
Intrinsic value and time value – The premium of the option may be assumed to consist of two
components – intrinsic value and time value. Intrinsic value reflects the amount, if any, by
which an option is in the money. Time value is the premium of the option, which is in addition
to its intrinsic value.
Example: If the current Nifty is 1400, Nifty 1390 call (strike price is 1390) trading at a
premium of Rs.50 reflects an intrinsic value of Rs.10 and time value of Rs.40 per Nifty.

Have a view on the market?

A. Assumption: Bullish on the market over the short term

Possible Action by you: Buy Nifty calls
Example: Current Nifty is 1400. You buy one contract of Nifty near month calls for Rs.30
each. The strike price is 1430, i.e. 2.14% out of the money. The premium paid by you will be
(Rs.30 * 200) Rs.6000. Given these, your break-even level Nifty is 1460 (1430 + 30). If at
expiration Nifty advances by 5%, i.e. 1470, then:
Nifty Explanation Level 1470.00
Less Strike Price 1430.00
Option Value 40.00 (1470-1430)
Less Purchase Price 30
Profit per Nifty 10
Profit on the Contract Rs. 2000 (Rs. 10*200)
Note:
(1) If Nifty is at or below 1430 at expiration, the call holder would not find it profitable to
exercise the option and would loose the entire premium, i.e. Rs.6000 in this example. If at
expiration, Nifty is between 1430 (the strike price) and 1460 (breakeven), the holder could
exercise the calls and receive the amount by which the index level exceeds the strike price.
This would offset some of the cost.
(2) The holder, depending on the market condition and his perception, may sell the call even
before expiry.

B. Assumption: Bearish on the market over the short term Possible Action by you: Buy Nifty
puts Example: Nifty in the cash market is 1400. You buy one contract of Nifty near month
puts for Rs.23 each. The strike price is 1370, i.e. 2.14% out of the money. The premium paid

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by you will be Rs.4600 (23*200). Given these, your break-even level Nifty is 1347 (i.e. strike
price less the premium). If at expiration Nifty declines by 5%, i.e. 1330, then:
Put Strike Price 1370
Nifty Expiration level 1330
Option Value 40 (1370-1330)
Less Purchase price 23
Profit per Nifty 17
Profit on the Contract Rs. 3400 (17*200)
Note :
1. If Nifty is at or above the strike price 1370 at expiration, the put holder would not find it
profitable to exercise the option and would loose the entire premium, i.e. Rs.4600 in this
example. If at expiration, Nifty is between 1370 (the strike price) and 1347 (breakeven), the
holder could exercise the puts and receive the amount by which the index level exceeds the
strike price. This would offset some of the cost.
2. The holder, depending on the market condition and his perception, may sell the put even
before expiry.

C. Assumption: You are concerned about a downturn in the short term in the market and its
effect on your portfolio. The portfolio has performed well and you expect it to continue to
appreciate over the long term but would like to protect existing profits or prevent further
losses.
Possible Action: Buy Nifty puts.
Example: You held a portfolio with say, a single stock, HLL valued at Rs.10 Lakhs (@ Rs.290
each share). Beta of HLL is 1.13. Current Nifty is at 1440. Nifty near month puts of strike
price 1420 is trading at Rs.26. To hedge, you bought 4 puts [800 Nifties, equivalent to Rs.10
lakhs*1.13 (Beta of HLL) or Rs.1130000]. The premium paid by you is Rs.20800, (i.e. 800 *
26). If at expiration Nifty declines to 1329, and Hindustan Lever falls to Rs.275, then
Put Strike Price 1420
Nifty Expiration Value 1329
Option Value 91(1420-1329)
Less Purchase Price 26
Profit per Nifty 65
Profit on the Contract Rs.52000 (65*800)
Loss on HLL Rs. 51724
Net profit Rs. 276
Note: For advanced applications of Nifty options you may like to consult your trading
member.

What are “exotic” Derivatives?

Options and futures are the mainstream workhorses of derivatives markets worldwide.
However, more complex contracts, often called exotics, are used in more custom situations.
For example, a computer hardware company may want a contract that pays them when the
rupee has depreciated or when computer memory chip prices have risen. Such contracts are
“custom-built” for a client by a large financial house in what is known as the “over the
counter” derivatives market. These contracts are not exchange-traded. This area is also
called the “OTC Derivatives Industry".
An essential feature of derivatives exchanges is contract standardisation. All kinds of wheat
are not tradeable through a futures market, only certain defined grades are. This is the
constraint of farmer who grows a somewhat different grade of wheat. The OTC derivatives
industry is an intermediary which sells the farmer insurance which is customised to his

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needs; the intermediary would in turn use exchange-traded derivatives to strip off as much of
his risk as possible.

What are Over-the-Counter Derivatives?

Financial derivatives are either listed on a financial exchange or are over-the-counter (OTC—
i.e., arranged between two parties). The global OTC derivative market, which is considerably
larger than the exchange-traded market, has been growing rapidly for the past 20 years, a
trend that continued during 2003 (Figure 12) according to the semi-annual data collected by
the Bank for International Settlements (BIS). The International Swaps and Derivatives
Association (ISDA) and the U.S. Office of the Comptroller of the Currency (OCC) have
confirmed the rapid expansion of the OTC market. The ISDA reported a 22% increase in the
global stock of OTC contracts in the first half of 2003, while the OCC reported a 17% rise in
commercial bank holdings of derivatives contracts (most of which are OTC). Currency options
were the most dynamic sub-segment, expanding by 42%. Some of the smaller currency
markets expanded even more rapidly, with options involving the pound sterling, the Swiss
franc and the Canadian dollar growing by 74%, 92% and 152% respectively. The accelerating
downward trend in the U.S. dollar apparently prompted non-financial customers to seek
protection, as holdings of currency options by such users rose by 91% in the BIS’ most recent
review period.

How are derivatives different from badla?

Badla is closer to being a facility for borrowing and lending of shares and funds. Borrowing
and lending of shares is a functionality which is part of the cash market. The borrower of
shares pays a fee for the borrowing. When badla works without a strong marginning system,
it generates counterparty risk, the evidence of which is the numerous payments crises which
were seen in India.
Options are obviously not at all like badla. Futures, in contrast, may seem to be like badla to
some. Some of the key differences may be summarised here. Futures markets avoid
variability of badla financing charges. Futures markets trade distinctly from the cash market
so that each futures prices and cash prices are different things (in contrast with badla, where
the cash market and all futures prices are mixed up in one price). Futures markets lack
counterparty risk through the institution of the clearinghouse which guarantees the trade
coupled with marginning, and this elimination of risk eliminates the “risk premium” that is
embedded inside badla financing charges, thus reducing the financing cost implicit inside the
futures price.

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 BADLA FUTURES
- Expiration date known
-Expiration date unclear. - Spot market and different expiration
-Spot market and different expiration dates dates all trade distinct from each
are mixed up other.

-identity of the counterparty known - Clearing corpration. is counterparty

- Counterparty risk present - No counterparty risk

-Badla financing is additional source of risk - No additional risk.

- Badla financing contains default risk premia
- Asymmetry between long and short
- Position can breakdown if borrowing/lending
proves infeasible.
- Financing cost at close to riskless
thanks to counterparty guarantee
- Long and short are symmetric.
- You can hold till expiration date for
sure, if you want to

Table 1.1: A Comparison of Futures and Badla

Why are derivatives useful?

The key motivation for such instruments is that they are useful in reallocating risk either
across time or among individuals with different risk-bearing preferences. One kind of passing-
on of risk is mutual insurance between two parties who face the opposite kind of risk. For
example, in the context of currency fluctuations exporters face losses if the rupee appreciates
and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee
forward market, they supply insurance to each other and reduce risk. This sort of thing also
takes place in speculative position taking-the person who thinks the price will go up is long a
futures and the person who thinks the price will go down is short the futures. Another style
of functioning works by a risk averse person buying insurance, and a risk tolerant person
selling insurance. An example of this may be found on the options market: an investor who
tries to protect himself against a drop in the index buys put options on the index, and a risk-
taker sells him these options. Obviously, people would be very suspicious about entering into
such trades without the institution of the clearing house which is a legal counterparty to both
sides of the trade. In these ways, derivatives supply a method for people to do hedging and
reduce their risks. As compared with an economy lacking these facilities, it is a considerable
gain.
The ultimate importance of a derivatives market hence hinges upon the extent to which it
helps investors to reduce the risks that they face. Some of the largest derivatives markets in
the world are on treasury bills (to help control interest rate risk), the market index (to help
control risk that is associated with fluctuations in the stock market) and on exchange rates

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(to cope with currency risk).Derivatives are also very convenient in terms of international
investment. For example, Japanese insurance companies fund housing loans in the US by
buying into derivatives on real estate in the US. Such funding patterns would be harder
without derivatives.

What are the instruments traded in the derivatives industry, and what are their
Relative sizes?

1986 1990 1993 1994

Exchange Traded 583 2292 7839 8838

Interest rate futures 370 1454 4960 5757
Interest rate options 146 600 2362 2623
Currency futures 10 16 30 33
Currency options 39 56 81 55
Stock Index Futures 15 70 119 128
Stock Index Options 03 96 286 242
Some of the OTC industry 500 3450 7777 11200
Interest rate swaps 400 2312 6177 8815
Currency swaps 100 578 900 915
Caps, Collars, floors, swaptions - 561 700 1470

Total 1083 5742 16616 20038

Table 1.2: The Global Derivatives Industry (Outstanding Contracts, $ billion)

1874 Commodity futures

1972 Foreign Currency futures
1973 Equity Options
1975 T-Bond Futures
1981 Currency Swaps
1982 Interest rate swaps; T-note futures; Eurodollar futures; Equity index futures;
Options on T-bond futures; Exchange{listed currency options

1983 Options on equity index; Options on T-note futures; Options on currency futures;
Options on equity index futures; Interest rates caps and floors

1985 Eurodollar options; Swaptions

1987 OTC compound options; OTC average options

1989 Futures on interest rate swaps; Quanto options

1990 Equity index swaps

1991 Differential swaps

1993 Captions; Exchange-listed FLEX options
1994 Credit Default Options
Table 1.3: The Global Derivatives Industry: Chronology of Instruments

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Worldwide what kinds of derivatives are seen on the equity market?

Worldwide, the most successful equity derivatives contracts are index futures, followed by
index options, followed by security options.

At the security level, are futures or options better?

The international experience is that at the security level, options markets are almost always
more successful than futures markets.

Why have index derivatives proved to be more important than security derivatives?

Security options are of limited interest because the pool of people who would be interested
(say) in options on ACC is limited. In contrast, every single person in the financial area is
affected by index fluctuations. Hence a risk-management using index derivative is of far
more importance than risk-management using individual security options. This goes back to a
basic principle of financial economics. Portfolio risk is dominated by the market index,
regardless of the composition of the portfolio. In other words, all portfolios of around ten
stocks or more have a pattern of risk where 80% or more of their volatility is index-related.
In such a world, investors would be more interested in using index-based derivative products
rather than security-based derivative products. The actual experience of derivatives markets
worldwide is completely in line with this expectation.

Who uses index derivatives to reduce risk?

There are two important types of people who may not want to “bear the risk” of index
Fluctuations:
• A person who thinks Index fluctuations are peripheral to his activity For example, a
person who works in primary market underwriting effectively has index exposure-if
the index does badly, then the IPO could fail - but this exposure has nothing to do
with his core competence and interests (which are in the IPO market). Such a person
would routinely use measure his index exposure on a day-to-day basis, and index
derivatives to strip off that risk. If full edged book building becomes important in
India, then there is a very important role for index derivatives in the “Price
Stabilisation” that the underwriter does in the bookbuilding process. Similarly, a
person who takes positions in individual stocks implicitly suffers index exposure. A
person who is long ITC is effectively long ITC and long Index. If the index does badly,
then his “long ITC" position suffers. A person like this, who is focussed on ITC and is
not interested in taking a view on the Index would routinely measure the index
exposure that is hidden inside his ITC exposure, and use index derivatives to eliminate
this risk. The NYSE specialist is a prime example of intensive use of index derivatives
in such an application.

• A person who thinks Index fluctuations are painful An investor who buys stocks may
like the peace of mind of capping his downside loss. Put options on the index are the
ideal form of insurance here. Regardless of the composition of a person's portfolio,
index put options will protect him from exposure to a fall in the index. To make this
concrete, consider a person who has a portfolio worth Rs.1 million, and suppose Nifty
is at 1000. Suppose the person decides that he wants to never suffer a loss of worse
than 10%. Then he can buy himself Nifty puts worth Rs.1 million with the strike price
set to 900. If Nifty drops below 900 then his put options reimburse him for his full

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 loss. In this fashion, “portfolio insurance" through index options will greatly reduce the
fear of equity investment in the country. More generally, anytime an investor or a
fund manager becomes uncomfortable, and does not want to bear index fluctuations
in the coming weeks, he can use index futures or index options to reduce (or even
eliminate) his index exposure. This is far more convenient than distress selling of the
underlying equity in the portfolio. Conversely, anytime investors or fund managers
become optimistic about the index, or feel more comfortable and are willing to bear
index fluctuations, they can increase their equity exposure using index derivatives.
This is simpler and cheaper than buying underlying equity. In these ways, the
underlying equity portfolio can be something that is “slowly traded", and index
derivatives are used to implement day-to-day changes in equity exposure.

How will retail investors benefit from index derivatives? What derivatives exist in
India (today) in the interest-rates area?

An investor who buys stocks may like the peace of mind of capping his downside loss. Put
options on the index are the ideal form of insurance here. Regardless of the composition of a
person's portfolio, index put options will protect him from exposure to a fall in the index. To
make this concrete, consider a person who has a portfolio worth Rs.1 million, and suppose
Nifty is at 1000. Suppose the person decides that he wants to never suffer a loss of worse
than 10%. Then he can buy himself Nifty puts worth Rs.1 million with the strike price set to
900. If Nifty drops below 900 then his put options reimburse him for his full loss. In this
fashion, “portfolio insurance" through index options will greatly reduce the fear of equity
investment in the country. More generally, anytime an investor or a fund manager becomes
uncomfortable, and does not want to bear index fluctuations in the coming weeks, he can use
index futures or index options to reduce (or even eliminate) his index exposure. This is far
more convenient than distress selling of the underlying equity in the portfolio. Conversely,
anytime investors or fund managers become optimistic about the index, or feel more
comfortable and are willing to bear index fluctuations, they can increase their equity
exposure using index derivatives. This is simpler and cheaper than buying underlying equity.
In these ways, the underlying equity portfolio can be something that is “slowly traded", and
index derivatives are used to implement day-to-day changes in equity exposure.
One key requirement from the viewpoint of the retail user is contract size. If the minimum
investible lot on the index derivatives market is Rs.1 million or so, then it will not be useful
for retail investors. There are no derivatives based on interest rates in India today.

What derivatives exist in India (today) in the foreign exchange area?

India has a strong dollar-rupee forward market with contracts being traded for one, two, six
Month expiration. Daily trading volume on this forward market is around $500 million a day.
Indian users of hedging services are also allowed to buy derivatives involving other
currencies on foreign markets.

What is the status in India in the area of commodity derivatives?

Futures markets exist on six commodities (castor seed, Hessian, gur, potatoes, turmeric and
pepper). The pepper exchange, which is at Cochin, is being upgraded to the status of an
“international pepper futures market", which will accept orders from all over the world. The
Forward Markets Commission (FMC) oversees these markets. A high level of interest exists on
futures markets for other commodities. In September 1994, the Kabra Committee
recommended that futures trading should additionally be permitted in 17 commodities. These

12
are (a) basmati rice, (b) cotton, (c) kapas, (d) raw jute and jute goods, (e) groundnut, its oil
and cake, (f)rapeseed/mustardseed, its oil and cake, (g) cotton seed, its oil and cake, (h)
sesame seed, its oil and cake (i) sunflower, its oil and cake, (k) copra, coconut oil and its
oilcake, (l) soyabean, its oil and cake, (m) ricebran oil, (n) castor oil and its oilcake, (o)
linseed, (p) silver, and (q) onions. On 4 December 1996, the Coffee Board decided to
recommend that a domestic futures market for coffee should be setup. On 28 February 1997,
the finance minister announced that futures markets would be setup in cotton and jute, and
that an international futures market would be created in castorseed and castor oil.

What is the present status of derivatives in the equity market?

Trading on the “spot market" for equity has actually always been a futures market with
weekly or fortnightly settlement (this is true of every market in the country other than
OTCEI). These futures markets feature the risks and difficulties of futures markets, without
the gains in price discovery and hedging services that come with a separation of the spot
market from the futures market.
India's primary market has experience with derivatives of two kinds: convertible bonds and
warrants (a slight variant of call options). Since these warrants are listed and traded, options
markets of a limited sort already exist. However, the trading on these instruments is very
limited. The recent ICICI bond issue bundles a twelve-year expiration BSE Sensex warrant
with the bond. If this warrant is detached and traded, it would be an exchange-traded index
derivative.
A variety of interesting derivatives markets exist in the informal sector. These markets trade
contracts like bhav-bhav, teji-mandi, etc. For example, the bhav-bhav is a bundle of one in-
the-money call option and one in-the-money put option. These informal markets stand
outside the mainstream institutions of India's financial system and enjoy limited participation.

Why do people talk about “starting derivatives in India" if some derivatives already
exist?

It is useful to note here that there are no exchange-traded financial derivatives in India today
Neither the dollar-rupee forward contract nor the option-like contracts are exchange-traded.
These markets hence lack centralisation of price discovery and can suffer from counterparty
risk. The next step in these areas is institutionalisation, and a broad-basing of access.

What should the time to expiration of these contracts be?

The time to expiration of these contracts “should" be whatever the market wants it to be -if
four-year contracts attract high trading volume, then four-year contracts should exist. The
international experience is that most of the trading volume in index futures is concentrated in
contracts which expire one, two, three and four quarters away. Limited interest is seen in
contracts which go upto two and three years out.
There is a widespread intuition in India, shaped by decades of experience with clearinghouses
that do not guarantee trades, that longer time to expiration is associated with higher
counterparty risk. However, when daily mark-to-market margins are applied, the link
between length of contract life and counterparty risk is broken. A brand-new position today is
no different from an old position (regardless of the history) as long as the person has paid up
his loss in full as of today. This is exactly what the mark-to-market margin does.

13
 Chapter#2 Market Microstructure
How do derivatives trade?

In the cash market, the basic dynamic is that the issuer puts out paper, and people trade this
paper. In contrast, in derivatives, there is no issuer. The net supply of all derivatives
contracts is 0. For each long, there is an equal and opposite short. A contract is born when a
long and a short meet on the market. There would be a clear “contract cycle" which the
exchange defines. For example, using quarterly contracts, we would have something like this:
On Jan 1, four contracts start trading. The nearest contract expires on 31 Mar. On 31 Mar,
this first contract ceases to exist, and the next (30 June) contract starts trading. In the case
of options, the exchange additionally defines the strike prices of the options which are
allowed to trade.

If a contract is just a relationship between long and short, how do we ensure

“contract performance"?

The key innovation of derivatives markets is the notion of the clearinghouse that guarantees
the trade. Here, when A buys from B, (at a legal level) the clearinghouse buys from B and
sells to A. This way, if either A or B fail on their obligations, the clearinghouse fills the gap
and ensures that payments go through without a hitch.
The clearinghouse, in turn, cannot create such a guarantee out of thin air. It uses a system of
initial margin and daily mark-to-market margins, coupled with sophisticated risk containment,
to ensure that it is not bankrupted in the process of supplying this guarantee.

What is the role of arbitrage in the derivatives area?

All pricing of derivatives is done by arbitrage, and by arbitrage alone. In other words, basic
economics dictates a relationship between the price of the spot and the price of a futures. If
this relationship is violated, then an arbitrage opportunity is available, and when people
exploit this opportunity, the price reverts back to its economic value. In this sense, arbitrage
is basic to pricing of derivatives. Without arbitrage, there would be no market efficiency in
the derivatives market: prices would stray away from fair value all the time. Indeed, a basic
fact about derivatives is that the market efficiency of the derivatives market is inversely
proportional to the transactions costs faced by arbitrageurs in that market. When arbitrage is
fluent and effective, market efficiency is obtained, which improves the attractiveness of the
derivatives from the viewpoint of users such as hedgers or speculators.

What happens if there are only a few arbitrageurs ready to function in the early
days of the market?

In most countries, there are bigger arbitrage opportunities in the early days of the futures
market. As larger resources and greater skills get brought into the arbitrage business, these
opportunities tend to vanish. India is better placed in terms of skills in arbitrage, as compared
with many other countries, thanks to years of experience with “line operators" who are used
to doing arbitrage between exchanges. These kinds of traders would be easily able to redirect
their skills into this new market. These “line operators" are fluent with a host of real-world
difficulties, such as different expiration dates on different exchanges, bad paper, etc. Their
skills are well-suited to index arbitrage.

14
Isn't India's cash market much too inefficient to support concepts like derivatives?

There is no evidence to suggest that market inefficiencies on the cash market make it difficult
to sustain derivatives markets. Many emerging markets that have derivatives markets are
more primitive than India on the key determinants of market efficiency, i.e. (a) high
information availability, (b) high skills in keeping accounts and reading accounting reports,
(c) high population of speculative traders and (d) low transactions costs. Derivatives markets
are successful if people face risks that they wish to hedge themselves against; market
inefficiency on the underlying market probably serves to increase the demand for these
hedging services.
This evidence supports the notion that the markets are quite informational efficient, given the
(high) level of transactions costs that has prevailed in the past. One widely prevalent practise
that serves to interlink market prices and corporate news is insider trading. Insider trading is
unfair and detrimental to market liquidity in a subtle fashion, but it does serve to rapidly
bring market prices in line with corporate information.
This research is carried further on which examines the impact of automation and competition
upon the functioning of the BSE. Here the evidence suggests that transactions costs have
come down with automation, and exactly as predicted by economic theory, market efficiency
has improved as a consequence.
One interesting piece of work in this area is where the publication of a research study was
followed by a swift elimination of the market inefficiency which this research study
documented. This is an example of how market efficiency anywhere in the world works:
profit-maximising speculators detect mispricings on the market, and when they trade in
exploiting these mispricings, the inefficiency goes away.
The final litmus test of market efficiency is mutual fund performance. If India's markets were
inefficient, it would be possible for professional fund managers to obtain excess returns
through informed trading. The available evidence suggests that three-quarters of Indian
funds under perform the index, after adjusting for the level of systematic risk adopted. This
fraction is almost exactly the same as that seen in the US. This makes it difficult to support
the hypothesis that India's markets are much less efficient than those seen in OECD
countries, after controlling for the levels of transactions costs.

What is the role of liquidity in enabling good derivatives markets?

The role of liquidity (which is defined as low transactions costs) is in making arbitrage cheap
and convenient. If transactions costs are low, then the smallest mispricings on the derivatives
market will be removed by arbitrageurs, which will make the derivatives market more
efficient.

What should a market index be?

A market index is a large, well-diversified portfolio which is an approximation to returns

obtained in owning “the overall economy". Portfolio diversification is a powerful means of
stripping out firm- and industry-effects, so that the returns on the well-diversified portfolio
reflect only economy wide effects, and are relatively insensitive to the specific companies or
industries in the index portfolio. Market index returns time-series are central to modern
financial economics, and have enormous value for a variety of real-world applications. A good
market index should be highly liquid to support products in the real world, it should have a
high hedging effectiveness against a huge variety of real-world portfolios, and it should be
hard to manipulate.

15
How does liquidity matter for market indexes?

At one level a market index is used as a pure economic time-series. Liquidity affects this
application via the problem of non-trading. If some securities in an index fail to trade today,
then the level of the market index obtained reflects the valuation of the macro economy
today (via securities which traded today), but is contaminated with the valuation of the
macro economy yesterday (via securities which traded yesterday). This is the problem of
stale prices. By this reasoning, securities with a high trading intensity are best-suited for
inclusion into a market index.
As we go closer to applications of market indexes in the indexation industry (such as index
funds, or sector-level active management, or index derivatives), the market index is not just
an economic time-series, but a portfolio which is traded. The key difficulty faced here is again
liquidity, or the transactions costs faced in buying or selling the entire index as a portfolio.

What is special about Nifty for use in index derivatives?

The methodology created for the NSE-50 index explicitly isolates a set of securities for which
the market impact cost is minimised when buying or selling the entire index portfolio. This
makes Nifty well-suited to applications such as index funds, index derivatives, etc. Nifty has a
explicit methodology for regular maintenance of the index set. It is successful at expressing
the market risk inherent in a wide variety of portfolios in the country

What is the impact cost seen in trading Nifty?

Figure 2.1: Impact cost for Nifty for Various Transaction Sizes

In calendar 1996, on average, the impact cost faced in buying Rs.5 million of the Nifty
portfolio was 0.25% or so. This means that if the index level is 1000, then a buy order of
Rs.5 million is executed at 1002.5 and a sell order is executed at 997.5. This is the lowest
level of transactions costs seen in market indexes in India. An example of the impact cost
analysis of Nifty is shown in Figure 2.1, which uses data for 5 June 1996, and shows how the
impact cost in trades on Nifty varies as the transaction size is increased.

16
How does this low impact cost matter?

As is the case in all areas of finance, in the context of index derivatives, there is a direct
mapping between transactions costs and market efficiency. Index futures and options based
on Nifty will benefit from a high degree of market efficiency because arbitrageurs will face low
transactions costs when they eliminate mispricings. This high degree of market efficiency on
the index derivatives market will make it more attractive to pure users of the derivatives,
such as hedgers, speculators and investors. High liquidity also immediately implies that the
index is hard to manipulate, which helps engender public confidence.

Is the liquidity in India adequate to support well-functioning derivatives markets?

The one-way market impact cost faced by arbitrageurs working the NSE-50 is around 0.25%.
This is similar to that seen by arbitrageurs working the S&P 500. This suggests that market
liquidity by itself will not be a serious constraint in the face of an index derivatives market in
India. It should be noted that market impact cost is not the only component of transactions
costs that arbitrageurs face. It is true that post-trade costs are higher in India [thanks to the
small role that the book-entry trading plays (as of today)]. However, market liquidity is not a
constraint in index based products based on Nifty.

What kind of liquidity is expected on index derivatives markets?

Impact cost on index derivatives markets is likely to be much smaller than that seen on the
spot index. One thumb rule which is commonly used internationally is that the round-trip cost
(i.e. twice the impact cost plus brokerage) of trades on index futures of around $0.5 million
are around 0.01%, i.e. the index futures are around 20 times more liquid than the spot
index. [For example, in the US, the S&P 500 futures contract (on the CME) has spreads of
around $100 on a minimum tradable lot of around $400,000; i.e., the one-way impact cost is
around 0.0125%.] High liquidity is the essential appeal of index derivatives. If trading on the
spot market were cheap, then many portfolio modifications would get done there itself.
However, because transactions costs on the cash market are high, using derivatives is an
appealing alternative.

How does spot-futures arbitrage affect the cash market?

Spot-futures arbitrage increases the flow of market orders to the cash market. This increases
the revenues obtained by day traders who place limit orders, and induces an increased supply
of limit orders. Limit orders are the ultimate source of liquidity on the market (indeed, low
impact cost is synonymous with a thick limit order book which is highly populated with limit
orders). Hence the introduction of spot-futures arbitrage will improve the liquidity on the cash
market.

Going beyond spot-futures arbitrage, how do derivatives influence liquidity on the

underlying market?

There are also less direct channels of influence from derivatives to enhanced liquidity on the
underlying market. Day traders in individual stocks, who supply liquidity in these stocks, will
be able to use index futures to offset their index exposure, and hence be able to function at
lower levels of risk. For example, the NYSE specialist makes phone calls to Chicago almost
every half an hour (while trading is going on) adjusting his index futures position as a

17
function of his inventory. Everytime a day trader is long security he will simultaneously be
short index futures (to strip out his index exposure), and vice versa.
Another aspect is rooted in security options markets. When security options markets exist,
speculators on individual securities tend to go trade on the options market, and the focus of
price discovery moves away from the cash market to the options market. More informed
traders tend to cluster on the options market, and less informed orders tend to go to the cash
market. This reduces the risk of trading against an informed speculator on the cash market.
This reduces impact cost (i.e. increases liquidity) on the cash market.

What is the international experience in terms of how the underlying market is

changed once derivatives start trading?

The international experience is that market quality on the underlying market improves once
derivatives come to exist. Liquidity and market efficiency of the underlying market are
increased once derivatives come to exist.

Program trading in the US is often accused of generating difficulties. What does

that mean for us?

Many post-mortems of the October 1987 crash concluded that “program trading was related
to the crash". Some observers distorted this to “program trading caused the crash". A more
accurate depiction of the sequence of events in October 1987 may be expressed as follows:
 A market drop commenced on overseas markets (before NYSE trading time) and on
the futures market (which always shows market movements before the spot market),
 As is always the case, this led to a surge of program trading orders as arbitrageurs
rushed in to exploit the slight mispricings.
 The communications system to the market makers overloaded and could not cope with
the orders. [It should be noted that the biggest 50 to 100 stocks in the S&P 500 were
present in arbitrage transactions in quantities larger than 2100 shares, so that
program trading could not be done for these. Trading in these stocks involved a
human runner carrying the order to the specialist post.]
 This led to confirmations of many trades taking over an hour.
 This led to a panic selling on the part of traders across the world, which produced a
major crash.
Hence, it is correct to say that “program trading had something to do with the October
1987 crash", but it is incorrect to blame the crash upon program trading. The blame, if
any, falls on the computer networking which links up the world to the market maker, and
on the basic methods of functioning at the NYSE. In India, in any case, because the major
markets use no market makers, the entire method of order matching is quite different – it
consists of computers directly talking to the central ordermatching computer. In this
sense “program trading" (i.e., trading by using computers) is routine in India. The NYSE
started out as a labour-intensive market, and computerised communications with the
market maker was put in [The “Designated Order Turnaround" system, which allows
computers to communicate orders to market makers, was setup at NYSE in 1976 and
upgraded to “SuperDOT" in 1984. As of October 1987, orders of smaller than 2100 shares
could be sent electronically.] as a sideshow to the main processes of the market. In
contrast, markets in India are purely computer-driven, and their computer networking is
less fragile.

Will derivatives destabilise the stock market? Could this happen in extreme events?

The available international evidence says that market quality on the underlying market
improves once derivatives come to exist. Derivatives improve liquidity on the underlying

18
market and a more liquid market is one that is able to absorb larger shocks for a smaller
change in prices. This would be the most useful in extreme events - it is in an extreme event
that the liquidity of a market is taxed the most, and at such times a healthier cash market
would be the most valued.

Is there more or less of a “natural monopoly" in derivatives trading, as compared

with the spot market?

In the spot market, the ability for exchanges to differentiate their products is limited by the
fact that they are all trading the same paper. This reduces the avenues for product
differentiation by exchanges. In contrast, in the derivatives area, there are numerous
avenues for product differentiation. Each exchange trading index options has to go through
the following major decisions:
1. Choice of index
2. Choice of contract size (i.e. multiplier)
3. Choice of expiration dates
4. Choice of American vs. European options
5. Choice of rules governing strike prices
6. Choice of trading mechanism (whether market makers, or order-matching market, etc)
7. Choice of time of day when market opens and closes
In the derivatives area, it is easier for exchanges to differentiate themselves, and find
subsets of the user population which require different features in the product. In the US, the
experience of futures markets is that between 1921 and 1983, 180 different futures contracts
had been launched, and a full 40% of these failed to survive four years. Such a steady
process of entry and exit is extremely healthy in terms of the basic economics of competition.
In this sense, the derivatives area is less of a natural monopoly than the cash market.

What are the policy implications of this lack of a natural monopoly?

To the extent that a marketplace is competitive, with a steady pace of entry and exit, the self
interest of exchanges will drive them to do things which their investors like. It will not be
necessary to force them to do these things via regulation. The role for regulation in such
competitive markets is limited to the classic regulatory functions, i.e. “health-safety-
environment" style regulation.

At the operational level, how do security contracts compare versus index-based

contracts?

The basic fact is that index-based contracts attract a much more substantial order-flow,
which helps them have tighter spreads (i.e. greater liquidity). At a more basic economic level,
we say that there is less asymmetric information in the index (as opposed to securities,
where insiders typically know more than others), which helps index based trading have better
liquidity. At settlement, in the case of security-options, there is the possibility of delivery, and
in that case arises the question of depository vs. physical delivery. Both alternatives are quite
feasible. However, in index-based contracts, that question does not arise since all index-
based contracts are cash-settled. The index has much less volatility than individual securities.
That helps index options have lower prices, and index futures can work with lower margins.
The most important difference between the index and individual securities concerns
manipulation. Given that an index is carefully built with liquidity considerations in mind, it is
much harder to manipulate the index as compared with the difficulty of manipulating
individual securities.

19
 CHAPTER#3 Derivatives Disasters

Why do we keep reading about disasters involving derivatives?

Disasters involving derivatives make for good reporting. In an multi-trillion dollar worldwide
industry, some disasters are inevitable.

Why have we seen more disasters in the recent years?

As the derivatives industry grows, more disasters would be observed. This is perhaps like the
airline industry: when more planes fly, more planes will crash (see Table 1.2 for the growth
of the global derivatives industry).

How much money has been lost in these derivatives disasters?

The cumulative losses from 1987 to 1995 add up to $16.7 billion. This is a tiny fraction of the
outstanding positions of the industry, which were around $50 trillion as of 1995. Derivatives
account for a small fraction of the overall picture of financial disasters. Over this same period,
i.e. from 1987 to 1995, the financial industry has seen other large disasters:
1) Malaysia's Central Bank lost $3 billion in 1992 and $2 billion in 1993 in taking
positions on the UK pound.
2) In December 1993, the Bank of Spain took over Spain's fifth biggest bank, which had
$4.7 billion in hidden losses.
3) In 1994, Credit Lyonnais (the biggest state-owned bank in France) was kept afloat
using a $10 billion subsidy from the government.
4) In the 1980s, the “savings and loans" industry of the US lost $150 billion.
5) Japan's financial institutions are said to be sitting on $500 billion of nonperforming
loans.

What happened in Barings?

Mr. Nick Leeson, a trader for Barings Futures in Singapore, had positions on the Japanese
Nikkei 225 index worth $7 billion. In addition, he had other positions on options and bond
markets. Mr. Leeson was able to dodge internal corporate controls and adopt these large
positions unchecked. This was assisted by weak enforcement at the exchanges in Singapore
and Osaka, who did not generate alerts to his large positions.

What should be done to minimise disasters with derivatives?

At the level of exchanges, position limits and surveillance procedures should be sound. At the
level of clearinghouses, margin requirements should be stringently enforced, even when
dealing with a large institution like Barings. At the level of individual companies with positions
on the market, modern risk measurement systems should be established alongside the
creation of capabilities in trading in derivatives. The basic idea which should be steadfastly
used when thinking about returns is that risk also merits measurement.

20
 CHAPTER#4 POLICY ISSUES
What emerging markets have already created derivatives markets?

The status is summarised in Table 4.1, which shows emerging markets that have derivatives
markets today, and Table 4.2 which shows emerging markets which are in the process of
building derivatives markets.

Table 4.1: Derivatives Exchanges in Emerging Markets

Table 4.2: Emerging Markets Working Towards Derivatives

What was China's experience in this area?

China had a mushrooming of derivatives exchanges in the early 1990s. Many of these were
poorly run, and experienced significant episodes of market manipulation and counterparty
risk. In 1994, the 50 exchanges were consolidated into 15. In 1995, China's futures markets
did a trading volume of around $1.2 trillion (for a comparison, India's equity markets do an
annual trading volume of roughly $180 billion).
Many observers have cited China's experience with 50 exchanges as an example of how
poorly- regulated and hasty growth of derivatives markets may be problematic. However, the
other side of the picture is now clear: the experience with these 50 exchanges got the
Chinese markets off the ground, and generated the necessary know-how amongst exchange
staff, regulators and users. In the end, China's derivatives exchanges has stolen a march on
their rivals: they now have significant trading volumes on a world scale.

What financial markets in India are ready for derivatives today?

In India, two areas are ripe for derivatives: the equity market and foreign exchange. In the
case of the dollar-rupee exchange rate, a forward market already exists; it is just a matter of
formally institutionalising it at an exchange, and turning it into a modern futures market.

21
Are derivatives in interest rates viable in India?

In the case of interest-rate risk, derivatives in India are hindered by the poor liquidity on the
fixed-income market.
However, a few approaches towards designing interest-rate derivatives could commence. An
example of this would be a futures contracts on treasury bills, which would give people the
ability to buy or sell treasury bills in the future. The lack of a liquid and transparent market
for treasury bills, and constraints such as the inability to short-sell treasury bills, would hurt
the ability to do arbitrage on this market. Hence, the market efficiency of the interest-rate
futures market would be limited.
However, in an environment where economic agents are exposed to interest-rate risk and
have no alternative risk management facility, such contracts could still prove to be viable. If
interest-rate futures came about, they would generate greater order flow and improve
market quality on the fixed-income market.

Why are commodity futures markets important?

India's farmers, and downstream industrial users of agricultural output, are exposed to
extremely high risks. The creation of commodity derivatives markets will provide them with
the choice of obtaining insurance against price fluctuations. It will improve liquidity and price
discovery in the underlying spot markets. Once futures markets exist, the private sector will
maintain buffer stocks which will reduce spot price volatility, and the private sector will do
this far more efficiently than government-sponsored efforts at maintaining buffer stocks. In
addition, the creation of these markets is consistent with the growth of skills in India's
financial industry in the area of derivatives.

What are the issues in the creation of commodity derivatives markets?

Like most traditional financial markets in India, the commodity futures markets are weak in
terms of modern skills in how exchanges should be run. These markets are weak on a variety
of issues: the use of modern market mechanisms (such as the electronic limit order book
market), enforcement of contract standardisation, dealing with heterogeneous grades, the
counterparty guarantee of the clearinghouse, calculation and enforcement of margins, and
checks against market manipulation. The commodity markets which are now in the spotlight
are: the international pepper market, the proposed markets in cotton and jute, and the
proposed international castor seed market. Ideally, the management of these exchanges will
be able to function to international standards. In this case, the value of having commodity
futures markets would become apparent, and the stage will be set for further expansion of
commodity futures markets in India. If these markets experience a visible episode of
manipulation, or if they experience a payments crisis, then it will be harder to establish a
consensus about the future of commodity futures markets, and the development of India's
financial system will be slowed.
One serious weakness in India lies in the way individual commodity futures markets are an
out growth of trading on individual spot markets. The cotton trading community will create a
cotton futures market; the jute trading community will create a jute futures market, etc. This
is inefficient insofar as it does not foster the growth of specialised skills which are common to
all futures markets and not specific to one commodity. For a well-functioning derivatives
exchange, specialised skills are required on the part of exchange and clearinghouse staff and
on the part of trading members. These skills are primarily in the derivatives area, and they
are easily transferable from one commodity to another.

22
Ideally, a derivatives exchange should have a focus on futures, options, and other derivatives
regardless of what the underlying is, and each futures exchange should trade dozens of
commodity futures contracts. This is similar to markets like CME and CBOT which trade
derivatives on hundreds of commodities, and on a host of other underlyings such as stock
market indexes, treasury bills, foreign exchange, etc.
One useful alternative here is to involve mainstream financial markets into the commodities
area. Exchanges which have clearing corporations (and can hence supply the counterparty
guarantee) can easily introduce cash-settled derivatives on commodities.

What can be done in derivatives on real estate?

In the case of real estate, derivatives can only follow clear asset securitisation. Government
should work towards removing hurdles in the face of real estate asset securitisation, which
would then enable derivatives on real estate to take place. Mutual funds which invest in real
estate are another, easier, stepping stone towards derivatives on real estate: markets could
easily trade units of such funds, and options on such units. This may be a shorter route
towards obtaining derivatives on real estate.

Should foreigners be restricted in India's derivatives markets as a matter of policy?

As in other areas of industry and commerce, the key objective for policy in India should be to
obtain the best quality of products and services for India's economy, ensure conditions of
intense competition on the domestic market, and to employ Indian labour and Indian capital
at the highest possible levels of productivity. Given these objectives, the nationality of the
ultimate owners of a firm operating on Indian soil has little importance.
In the case of all derivatives, foreigners should be allowed free access to trading and
brokerage on India's derivatives markets. This will help improve the quality of India's
derivatives markets, and help the dissemination of knowledge about the risk management
capabilities that these markets supply to the community of foreign investors.
Hurdles to this level of liberalisation make it difficult for us as a country to realise the full
potential of the investment that can be attracted into India given the level of development of
our financial system.

What would access to derivatives do to FII and FDI investment?

Access to derivatives would increase the flow of FII and FDI investment. The two important
kinds of risk that foreign investors are exposed to are currency risk and country risk. The first
would be manageable using dollar-rupee futures and options, and the second would be
manageable using index futures and options.
The details of usage would be subject to the individual requirements. For example, some FIIs
might choose to completely eliminate their dollar-rupee exposure, coupled with “portfolio
insurance" to cap their downside exposure at no worse than x%. Other FIIs might choose to
use index derivatives as a liquid way to increase their equity exposure. Similarly, investors in
India through FDI would be able to use dollar-rupee futures to control their risk of a currency
devaluation, and use index futures to proxy for the overall success of India's economy.
These methods of controlling risk are quite routine in the international financial community. If
India had derivatives markets, then it would be a less risky environment and would better be
able to attract foreign investment.
While India lacks index derivatives as of today, there is a direct opportunity to make progress
on these issues via the dollar-rupee forward market. The constraints that are placed in the
way of FIIs on using the dollar-rupee forward market are counterproductive. If the FII is
allowed to obtain insurance using this market, he will bring more money into India.

23
Is India ready for derivatives today?

There are four key aspects to this question.

Market Size: Derivatives markets need to work off a large foundation of asset value that is
traded on an underlying market. India's debt market has a total market capitalisation of
around Rs.3 trillion, and India's equity market has a market capitalisation of around Rs.5
trillion. India's foreign exchange market also has a considerable underlying market size.
International experience and the success of derivatives in many countries of much smaller
market size (for example, the Johannesburg futures market, and the Brazilian futures
markets) shows that in India, each of the three markets mentioned above is ready for
derivatives.
Liquidity: In India, NSE proposes to launch futures and options contracts on the NSE-50
index. The market impact cost seen with Nifty is comparable to some of the most liquid
market indexes in the world (e.g. the S&P 500 of the US). India's foreign exchange market
also possesses the low transactions costs to support a healthy derivatives market. India's
debt market might currently not ready for trading derivatives since most of the key
instruments traded here are quite illiquid. Thus from the point of view of the liquidity of the
market, two of India's markets are ready for derivatives trading.
Clearing Corporation: For derivatives markets to support large-scale use, it is important to
have a clearing corporation which guarantees the trade. From July 1996 onwards, with NSCC
guaranteeing trades on the NSE, this prerequisite for a derivatives market now exists in
India. The human capabilities that go into creating a clearing corporation can also be easily
redeployed to new markets, such as the foreign exchange market which has such a deep
need for trading derivatives.
Sophistication of traders: Derivatives are complex. The payoffs that buyer and seller face, the
risks that buyer and seller face, and the economic theory that is used for pricing derivatives:
all these are considerably more difficult than that seen on the equity or the debt market.
India's financial industry already has experience with many kinds of derivatives. As compared
with many emerging markets where derivatives exist, India's financial industry possesses
very strong human skills. It appears that the foundations of human capital that are required
for derivatives might well be in place in India.

In the context of the four points above, derivatives on the debt market would be highly
attractive to investors who face interest rate risk, but the debt market suffers from an illiquid
underlying. The foreign exchange market is also an area where derivatives are clearly
valuable; the constraints faced there concern the sequencing of liberalisation of this market.
The Indian equity market satisfies all the four criterion laid out and is the logical candidate to
carry the first exchange traded derivatives in India, with the index as the underlying.

What are the costs and benefits of delaying the onset of exchange-traded financial
derivatives in India?

The costs are on two directions:

1. The most important cost is opportunity cost.
India's investors will benefit from being able to access derivatives. Every investor who
experiences pain owing to index fluctuations could be happier if index derivatives existed.
India's markets will become more liquid and efficient once derivatives are present. India's
financial industry will grow skills and capabilities through working with derivatives which will
help it come up to international standards.
Each of these three developments is put off further into the future when derivatives in India
are delayed.

24
2. The second cost is the threat of foreign exchanges creating derivatives markets on Indian
underlyings. If this took place, it would make it harder for derivatives exchanges in India to
succeed.
The apparent benefit of delay is the opportunity to create a concerted effort in training and
improving skills as a preparation for the launch of a market. This benefit is illusory, for two
reasons:
(a) A concerted effort to pickup skills will not take place unless the market launch is
imminent, &
(b) The best form of training in derivatives is that obtained when actually using the
instruments.

What international derivatives exchanges are working towards launching products

off underlyings in emerging markets?

The Chicago Mercantile Exchange (CME), Chicago Board Of Trade (CBOT), Chicago Board
Options Exchange (CBOE), American Stock Exchange, Sydney Futures Exchange, Hong Kong
Futures Exchange and Singapore International Monetary Exchange (SIMEX) have all launched
emerging market initiatives, whereby they aim to trade derivatives off underlyings from
emerging markets.

What derivatives on Indian underlyings are currently trading abroad?

Examples of contracts that exist abroad as of today fall into the following categories:
Many GDR issues are bundled with warrants (option-like instruments), which are then traded
separately. For example, the Hindalco issue done on 2 Nov 1995 bundled every two shares
with one warrant. Similar issues have taken place on India's primary market - the difference
here is that the warrants are listed and traded, in contrast with India's secondary market
where the warrants are not traded.
Warrants on mutual fund paper such as the Lazard Birla India and Fleming Indian are listed in
London.
Custom built (OTC) derivatives - specifically, options and swaps - on Indian market indexes
and baskets of Indian GDRs already exist on the international market. Essentially 100% of
the OTC derivatives industry on Indian underlyings lies abroad.
Restrictions upon access to the dollar-rupee forward market in India has led to the
development of the “non-deliverable forward" (i.e., cash settled) dollar-rupee market off
shore.

Would foreign derivatives markets be interested in launching trading on Indian

underlyings? Is this a real threat?

Internationally, derivatives-trading is a fiercely competitive area where exchanges are

constantly trying to find interesting new contracts based on which trading volume can be
attracted. Hundreds of new contracts have been attempted in the last few years, only around
half survive more than a few years. In such an atmosphere of hectic innovation in contract
design, Indian currency and stock index products constitute a glaring opportunity.
If India does not progress towards derivatives swiftly enough, contracts based on Indian
underlyings will start trading on markets elsewhere in the world. The NSE-50 time series or
the dollar- rupee exchange rate are available on international information services such as
Reuters or Knight-Ridder, and nothing prevents a foreign market from launching contracts on
these.[ Foreign markets would prefer to have the benefit of cooperation from the Indian
owner of an index before using it for derivatives. But as the example of the Nikkei-225
illustrates, this is not a binding constraint.]

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Such a scenario is not without precedent. Some examples can be cited which show the forces
involved:
In 1989, regulatory errors in Japan led to the market for derivatives based on Japan's Nikkei
225 index moving off to Singapore and partly to Chicago. Today, Japan's markets feature a
better set of regulations, but the market has not yet moved back to Japan.
Similarly, a large part of Sweden's financial markets moved to London after the Government
imposed a tax on trading volume in 1989. After the transactions tax was revoked, most of
this volume did not return.
After prolonged delays in creating a derivatives market in Taiwan, derivatives on the
Taiwanese market index [Taiwan's equity market remains relatively closed to foreign
investment and has short trading hours. Taiwan's SEC tried unsuccessfully to prevent CME
and SIMEX from introducing Taiwanese index futures, but interminable delays afflicted efforts
to get a local derivatives exchange off the ground and CME and SIMEX chose to not wait for
the local market to come about. Taiwan's SEC initially prohibited local brokerage firms from
trading on these contracts offshore. Later, the SEC announced that they “may" allow local
orders to go to derivatives exchanges offshore.] started trading in Chicago and Singapore on
9 January 1997.
India's GDR market experience is a direct example of markets moving off offshore if the
required facilities don't come about in India fast enough.
These examples suggest that the movement of markets indulging in “regulatory arbitrage" is
not just an abstract possibility but a real alternative for investors seeking to meet their
objectives.

What are the implications of derivatives on Indian underlyings trading abroad?

As the Nikkei-225 experience suggests, once a contract gets well-established at a market, it

doesn't easily move, even if the alternative destination proposed is the home country of the
underlying. In this sense, India's financial industry could then face an uphill struggle for order
flow if foreign markets are successful on establishing derivatives markets first. This would
have two ramifications:
1. As long as India lacks capital account convertibility, India's citizens would be
disadvantaged by not being able to access derivatives while foreigners would be able to. This
would generate increased incentives for Indian citizens to use illegal channels through which
positions would be adopted on foreign markets.
2. Such an event would be a setback for the development of skills and businesses in India's
financial industry, and for the potential of Bombay as a world financial centre.

But in the GDR market experience, the foreign market has hardly affected order flow into
India - why are derivatives different?
In the case of the GDR market, two things were different.
1. The GDR market is self-liquidating in the sense that GDRs gradually convert into
underlying shares. Hence the size of the GDR market inherently diminishes over time. This is
not the case with derivatives.
2. In India's GDR episode, GDRs were an alternative in the face of a thriving Indian spot
market. It is always difficult to take away order flow from an existing market. In the case of
derivatives, if foreign markets get established first, this will not be the case.

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 CHAPTER#5 REGULATORY ISSUES
What are the objectives of regulation?

There are three basic objectives of regulation:

• To protect market integrity,
• To ensure fierce levels of competition, and
• To prevent fraud.

What kinds of competition are possible in the financial market scenario?

There are many dimensions of competition:

1. The market should have a large number of traders.
2. There should be easy entry of new traders and investors.
3. No individual trader should be too large as compared with the size of the overall market,
i.e., no single individual trader or coalitions of traders should have market power.

How does deviation from perfect competition (or situations of market power) arise
on financial markets?

One form of market power that is commonly observed in the world arises with an exchange
which limits the supply of seats so as to increase brokerage rates. This behaviour reflects
itself in the price of a seat on the exchange, or the “seat price". In an ideal economy, the
seat price (devoid of any real estate or other facilities) should be close to 0. A high seat price
implies bid-ask spreads and brokerage fees above the level that is found in perfect
competition.
This “implicit elevation" can sometimes even become overt: prior to 1974, NYSE specified a
(elevated) brokerage commission schedule, and members were required to not offer prices
better than the defined schedule.
In addition to this form, every economy has some unusually large traders. This is another
avenue through which deviations from perfect competition are observed.

How should regulation of exchanges work?

The most important intuition in regulation of exchanges is to view the exchange as a

manufacturer of liquidity services. If exchanges do this well, they will get satisfied customers.
Exchanges that fail to do this well will fail to get business and go bankrupt. In India we have
seen numerous industries and services where competition and the steady process of entry
and exit have proved to be a great success in producing high quality and low price. The area
of trading services is no exception.
The key role for public policy is to keep entry barriers low and therefore keep the competitive
pressure upon the incumbents high. It should be easy to start new exchanges; even for
business houses to start exchanges. It should be easy (say) for CBOT to come to India and
start an exchange. That will serve to keep up competitive pressure and steadily improve the
services and costs that end-users, the investors, face.

What can regulation do to encourage competitiveness?

Brokerage fees are elevated as long as a restricted supply of exchange seats is used by
exchanges in India. Hence regulators should pay attention to seat prices, and require
exchanges to increase the supply of seats when seat prices rise to significant levels.

27
There is an intuitive urge to set very high capital adequacy requirements to ensure that the
risk of counterparty failure is reduced. But a fundamental fact of the counterparty guarantee
of a clearing corporation is that it eliminates credit risk, regardless of the size of the company
that is trading. Hence the intuitive urge to set very high capital adequacy requirements
should be checked, since one of the less attractive outcomes of setting high capital adequacy
requirements is low competitiveness of the industry.
Position limits have been proposed as a way of preventing the damage that a large trader can
cause. Position limits are particularly common in the area of commodity futures, where a
short squeeze is the constant danger (with cash-settled contracts, this is less of an issue).
However, position limits have not been very successful in the past, because a manipulator
can always spread his position amongst several entities and avoid the position limit. Famous
episodes of manipulation, like the Hunt brothers in silver, were done in the face of strong
position limits. Thus the regulator should be wary of using position limits in the hope of
preventing abuses of market power.

What should entry or eligibility requirements be for derivatives trading?

The thrust of economic policy in India today is to encourage the competitive forces of the
marketplace to differentiate winners from losers. A firm that unwittingly goes into derivatives
trading without understanding the business is no different (say) from a firm which unwittingly
goes into any other high technology area (like computer software or banking or floriculture).
If the firm is unable to cope with the complexities of this area, it would go bankrupt. Thanks
to the system of margins and counterparty guarantee, such bankruptcies would have no
impact upon the rest of the market.
The danger with eligibility criteria is that they effectively become entry barriers. All too often,
entry barriers are used by incumbents to reduce the degree of competition in an area. The
basic focus of economic policy should always be to maximise the degree of competition in any
industry. The brokerage industry is no exception.

What is fraud?

Fraud consists of market participants making commitments which are not later upheld. A
more tenuous situation is if a market participant is “opaque", which then means that there
are large costs to be paid (a) in establishing antecedents and (b) in confirming that the
promise will actually be upheld, before inter-party transactions take place.
The importance of “trust" and “reputation" in the world is a reflection of relationships which
are able to avoid fear of fraud. Unscrupulous companies have a way of going bankrupt over
time, so that companies with a longstanding reputation are less likely to indulge in fraud.
If many market participants require a great deal of trust and a long-standing relationship
before they do business, this is effectively an entry barrier which limits the competitiveness
of the industry and elevates prices. A well functioning market economy is one where
strangers can trade with each other; the need to establish trust and long-standing
relationships should be as limited as possible.
In this context, the counterparty guarantee of the clearinghouse is a crucial device which
eliminates part of the need for trust, and hence increases the contestability of the market.
The role for regulation is to steadily reduce the role for trust and relationships in the market,
so as to foster free entry and increase competition on the market.

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How can regulation diminish the extent of fraud?

There are two key methods through which public policy can reduce the extent of
fraud: through improved disclosure and by ensuring swift and credible legal redress,
in cases of fraud.

Should there be regulatory control over contract definition?

Some countries require that the regulator have a say in contract design. It is hard to
support the claim that this has played a useful role. When a contract is poorly
designed, it will die a natural death under conditions of low trading volume. For
example, the life cycle of the first index contract to be traded in the U.S., the Kansas
Value Line index contract, which was very complex to price and, therefore, complex
to trade. These contracts had hence suffered poor liquidity since conception, and
have been eventually removed from trading. Worldwide, the derivatives industry features a
hectic pace of contract design. Every year, new contracts are launched and old contracts die.
It is a difficult proposition for regulation to second guess the success of a contract. In the
case of index derivatives, one possible area of concern is the extent to which an index can be
manipulated. However, the marketplace is typically a very effective check here. If futures
start trading on an index which is easy to manipulate, then these contracts will find it difficult
to attract trading volume. This is a more effective way to control poorly thought out contracts
than to use regulation.
On the negative side, regulatory control over contract definition has often been a vehicle for
political lobbying by pressure groups against futures markets. For example, large and
entrenched onion traders have successfully lobbied with the CFTC in the US to prevent CBOT
from allowing the trading of onion futures, even though it is almost certain that onion futures
will be a highly useful contract. Hence the worldwide experience in regulation of contract
definition is ambiguous, and does not show the regulator as adding any improvement over
market forces in defining good vs. bad contracts.

Should the securities that are used in an index be required by regulation to be in

depository mode?

This is an example of the usefulness of the principle about regulatory non-involvement in

contract definition. If the securities are not in depository mode, the transactions costs of
trading the index will be higher. This means that market efficiency of the index will be
reduced, and trading volume on the derivatives market will be reduced. Hence, the self-
interest of the exchanges points towards using securities in the depository. This is a question
that the derivatives exchange should address. There is no role for regulation here.

Should regulation require that derivatives trading be organised at an exchange

which is distinct from the spot market?

This is similar to the question “Should the engine factory of Mahindra & Mahindra be located
at the same place as their paint shop?” To be more precise, this is like the question “Should
Mahindra & Mahindra buy their gearbox from a third party or should they make it
themselves?”
How much vertical integration is optimal is a question for exchanges to address. If there are
benefits of one solution over the other, then certain exchanges will succeed in obtaining order
flow and the exchange industry will end up using one kind of technological solution. Once
again, there is little role for a regulator on this issue.

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At an operational level, is it better to have the spot and futures market under one
roof?

At the operational level, it makes sense to have both index futures and the spot index being
traded on the same exchange in the same time of day, for three reasons:
1. Margining can be done correctly if both legs of the transaction go through the same
exchange; if a person is long index and short the spot then he should ideally be charged less
initial margin. 2. A coordinated effort at manipulation is easier to detect. If the same person
is long the Gujarat Cotex spot and long in call options on Gujarat Cotex, then it can send
alarm bells going. In contrast, genuine inter-exchange coordination in margining and in
surveillance is much more difficult to create - the Barings example shows that SIMEX and
Osaka don't really talk to each other.
3. Arbitrage is made easier since both legs of the transaction are on the same exchange,
which reduces the possibility that the spot and the futures markets can deviate from fair
values even for a short interval of time.
At a mundane level, the distinctions between spot or derivatives (or the distinction between
trading commodities vs. trading equity vs. trading foreign exchange) that are seen in other
countries are typically historical accidents that reflect (a) peculiarities of regulation, and (b)
pretechnological implementations of markets without using computers. We in India have the
advantage of building a financial system in an era of modern technology, with a smaller set of
entrenched interests defending the status quo.

Risk Management at Clearing

Why is the clearinghouse central to derivatives markets?

The key factor enabling exchange-traded derivatives is the credit guarantee supplied by the
clearing corporation. If derivatives involved obligations between individual market
participants, then large positions between two random individuals would be less feasible
thanks to counterparty risk
With the clearinghouse counterparty guarantee accounting for counterparty risk, small
individuals and big individuals can form positions against each other without any special risk
factor favouring any one side. With the counterparty guarantee, derivatives can exist with
both sides being free of the worry that the other will default.

How should margining for derivatives work?

Today, margining systems are accepted as being the foundation through which the
clearinghouse guarantees the trade on a futures market, all over the world. This has become
extremely important in India where futures-style settlement is used in “the cash market" at
all stock exchanges other than OTCEI. At futures markets worldwide, margining works in two
steps:
1. An initial margin is charged, which depends upon the position taken.
In India, unlike in other countries worldwide, the banking system is unable to move funds
swiftly. However, a situation where initial margin is paid after the position is adopted is
unsafe for the clearinghouse. Hence the solution, which has been widely utilised in India, is
the exposure limit. This can be interpreted as an advance payment of initial margin and
members are constrained to not take a position larger than that supported by the funds
deposited in advance. For example, if an exposure limit of 33 times base capital is in place,
and then it means that the exchange requires a 3.33% initial margin.
2. The net profit or loss on a position is paid out to or in by the member on the very same
day, in the form of daily mark-to-market (MTM) margins.

30
A large loss, when accumulated over several days, generates a temptation to default at
settlement. To prevent this from happening, the loss of each day is paid up on that day itself.
The member will not default on the MTM payments as long as the one-day loss is smaller
than the initial margin (which the exchange forfeits if the member defaults).

How is initial margin (i.e. “exposure limit") calculated?

Earlier, we remarked that “the member will not default when the one-day loss is smaller than
the initial margin". Assuming that MTM margin is fully and correctly computed and charged
(i.e., net losses are taken from members on the same day, net profits are paid to members
on the same day), the “correct" level of initial margin is that which is larger than what can be
expected for a one-day loss to the position, with a comfortable safety margin.
Intuitively, the “correct" level has to be sensitive to the composition of the position taken. If
a person has a position with 100% of the exposure in Apollo Tyres, then this is a highly risky
position. The level of initial margin required here would be quite large. If, instead, a person
has a well-spread out position with positions spread over numerous securities, then the risk is
lower because he is diversified. In this case, the “worst one-day loss" scenario becomes less
volatile, and therefore, the level of initial margin required is lower.
We quantify risk in terms of the standard deviation of returns of the portfolio or σ. Typically,
a very high level of safety could be obtained by charging initial margin of four times the σ. In
case a person has a 100% position in Apollo Tyres, the σ is around 8%. So a safe initial
margin for the person with the 100% Apollo Tyres position is around 30%. In other words,
his exposure limit should be around three times of base capital.
At the other end, a person having exposure in a fully diversified portfolio (i.e., he has bought
all the 50 stocks in their correct proportions in the NSE-50 index) has an σ of just 1.3. The
NSE-50 index, being highly diversified, is much less risky as compared with Apollo Tyres. In
this case, the identical level of safety (i.e., four times the σ) is obtained by charging him an
initial margin of 5.2%, i.e., an exposure limit of 20 time’s base capital.
These two examples illustrate a key idea: depending upon the portfolio composition of
exposure, the same level of safety can be obtained by capping exposure of 3 times or 20
times the capital deposited with the clearinghouse. The correct level of initial margin varies
strongly with the portfolio composition of the exposure, whereas simple rules like “33 times
base capital" or “10 times base capital" will not work correctly: they charge too little initial
margin for risky positions and too much initial margin for relatively safe positions.
One more idea that flows from this logic is that gross exposure is an incorrect measure of
risk. We need to focus on the σ of his full portfolio exposure.
A nuance here concerns long vs. short positions. A position which is long Reliance and long
SBI has a certain σ. A position which is long Reliance and short SBI has a smaller σ. This is
because when market index fluctuations take place, then the short position is a hedge against
the long position. In this sense, if a person has Reliance exposure, he can actually reduce his
risk by increasing his gross exposure (i.e. by shorting SBI). This is an example of how gross
exposure is a poor measure of risk. Good portfolio margining would correctly integrate long
vs. short positions into the initial margin calculation.
These ideas are standard procedure at futures markets all over the world. Well-established
software systems named SPAN or TIMS are available to calculate margins, and less-well
established alternatives are available which do more sophisticated calculations of the true σ
of the portfolio. This is the direction which should be adopted in India's markets also.

31
How is daily mark to market (MTM) margin calculated?

The calculation of daily MTM margin is easily done as the net loss associated with a position.
This is paid up each evening after trading has ended. Two nuances are of interest here:
1. The correct computation of MTM margin is to focus on the net loss across all different
securities on which positions are held by the member.
2. On futures markets all over the world, profits are paid by the clearinghouse to members on
a daily basis, just like losses are paid in to the clearinghouse by members. The margins
reflect the symmetry in taking positions on the futures markets - the losses made by one side
of the contract are the profits made by the other side.

How does the slow payments system change these calculations?

Suppose daily MTM payments cannot be confirmed on the same day. In this case, the
clearinghouse takes a risk of a multi-day loss instead of a single-day loss. This is easily
handled using the √T formula: T day exposure has a standard deviation which is √T times
larger than one-day exposure. Hence, if we think that the typical initial margin has to be 4σ,
and if the payments system introduces a three day delay, then the appropriate level of initial
margin is 7σ, where 7 is roughly 4√3.
Many exchanges abroad have the capability of suspending trading at 11:30 in the morning on
days of exceptional market index volatility, and doing a MTM margin call. This obviously
demands a strong banking system which can move funds within five minutes. This capability
allows the exchange to further reduce the size of initial margin required. If the exchange has
this capability, of stopping trading for five minutes halfway in the day on exceptionally
volatile days and charging MTM margin on the spot, then the appropriate level of initial
margin becomes 4/√2σ, or 2:8σ.
In this way, infrastructure in the form of a fast payments system reduces the working capital
required in the financial industry.

What are prospects for improvements of the banking system?

Some banks are already much faster than others on movement of funds. As of today, the
National Securities Clearing Corporation has contracted with HDFC Bank as a clearing bank;
HDFC Bank has Electronic Funds Transfer (EFT) and offers same-day confirmation of funds.
Global Trust Bank also offers 30-minute confirmation of funds.
Canara Bank (also a clearing bank with NSCC) is in the process of setting up EFT. The
Reserve Bank of India has a major initiative to establish a nationwide infrastructure for
electronic funds movement.

How does options margining work?

In the case of futures, both short and long are charged initial margin, and after this, both
sides pay daily mark-to-market margin. This is not how options work. In the options market,
the long pays up the full price of the option on the same day, and the short puts up initial
margin. After this, the long is relieved of all responsibilities to his position, and the short pays
daily mark-to-market margin.
The initial margin of the option short is the largest loss that he can suffer with a one-day
price change that goes against him. This is calculated using theoretical option-pricing
formulae.

32
What are the special difficulties of margining options?

For options series that have a strike price that is far away from the current spot price, the
options market is often quite illiquid. For these options series, mark to market margins
(which are charged to the option short) is hard to calculate - either because the illiquidity of
the options market makes the market's option price less reliable, or because the market fails
to trade the option at all on a given date. In such a situation, theoretical models are used to
impute the fair price of the option, and mark-to-market is done using this notional price.
The initial margin calculation is always concerned with calculating the largest loss which a
position can suffer. This becomes quite complex when options are a part of the portfolio,
given the nonlinear payoffs of options.

What constraints should regulation impose upon the time to expiration of these
contracts?

As discussed earlier, there is a common intuition in India where we know that “forward
contracting becomes more dangerous as the time to expiration increases". This intuition is
out of touch with the functioning of futures markets which have daily mark-to-market
margins. As long as daily mark-to-market margins are charged correctly, it is as if daily
settlement is in force. Daily mark-to-market margins break the link between time to
expiration and default risk.
Hence the time to expiration seen in the market is a question that the exchanges should
address. As long as daily MTM margin is being charged correctly, it is not a regulatory
concern.

How does the margining system change the way people trade?

One of the subtle and valuable things about a good margining system is the way it changes
the behaviour of people who trade. People will always adjust their behaviour to minimise the
margins that they have to pay up. If margins are calculated correctly using portfolio
reasoning, then we will start seeing the phenomenon of “undiversified risk" diminishing. As in
the Apollo Tyres case, the level of initial margin charged there would be very steep (a limit of
three times base capital) and people would start avoiding such risks.
Such understanding, and wisdom in safe speculation, will be good for exchanges and good for
the country. As long as we charge initial margin in the form of flexed rules like “10 times
base capital", we do not give people incentives for improving their skills in diversification and
hedging.

What are the policy issues in clearing corporation failure?

While famous events like Barings have captured the media attention, it should be noted that
these did not interrupt the smooth functioning of the clearing corporation, which is the center
of focus of the regulator. However, it is to be expected that once every few decades, market
fluctuations will take place which are large enough to bankrupt clearinghouse. For such
infrequent events, it makes a lot of sense for the central bank to supply a line of credit for a
few days to a clearinghouse at such a time to tide over the exigency.
It is all too easy for such a guarantee to be counterproductive. Once such a guarantee is
given, there is, what is called, a moral hazard problem. If the clearinghouse thinks that the
central bank is there to take care of difficulties, then the quality of attention that the
clearinghouse puts into its work of ensuring clearinghouse strengths through safe margining
systems would be reduced.
Hence if the central bank wishes to be a lender of last resort to the clearing corporation, then
it should set standards to confirm that the risk containment procedures and margin

33
calculations are strong enough to support a failure of no more than once in 25 years. This
implies that a stress-testing of the clearing corporation should find that the probability of
failure of the clearing corporation is below 0.015 or so. The econometrics profession knows a
fair amount about measuring these probabilities, using models of the data generating process
underlying the returns.

Other Aspects of the Risks

What are the risks that derive from usage of derivatives?

It is observed that because all derivative instruments are equivalent to combinations of

existing securities, they cannot introduce any new or fundamentally different risks into the
financial system. What derivatives do accomplish, however, is a facility for transferring these
risks, and concentrating their risk management into a few entities.
A common classification of the risks in the derivatives area uses three areas (a) risks to
individual users owing to mistakes in their positions, (b) risks to the clearinghouse owing to
large market fluctuations and (c) risks to the economy from a breakdown of all the markets
in the country.

What are the policy issues in individual risk?

Examples like Barings fall into this first category of risks.

Individual users of markets will make mistakes from time to time. But this is not unusual – on
a larger plane, companies make mistakes in manufacturing, or marketing, or in the
relationships with banks, etc. This is one more kind of mistake that companies can make. In
the modern world, a certain collection of skills are required in order to do certain things, and
people who lack those skills will experience difficulties. There are umpteen examples in India
of people who have made losses in short-selling. There is no direct role for regulation here;
the role of regulation would be to assure that the market itself does not breakdown in a
payments crisis.
At the level of an individual company, episodes like Barings reflect “agency conicts", where
employees of the firm fail to act in the interests of the owners (shareholders) of the
company. Agency conicts are a problem well-known to economists and are rampant in the
functioning of all sorts of companies. In all these situations, the economic challenge is one of
creating an organisational structure which encourages employees to act in the interests of the
organisation.
In the specific situation of Barings, several solutions (that should have been built into the
bank's business plans) would have ensured that the individual risk was reduced. One is the
separation of trading and backoffice functions (which was not done at Barings) which would
allow management to get untainted information about the trading activity. Another is by
setting position limits for traders limits the size of the bets, and the worst possible damage,
that they can do. Compensating traders based on long-term performance, in a manner which
is sensitive to the risk adopted, is safer than paying bonuses for short-term trading gains
without regard for risk.
At a policy level, the most pragmatic approach is to create the markets, and then the skills
will come. There is no real incentive for firms to grapple with these risks until derivatives
markets are in India. For example, companies in India did not invest in obtaining computer
skills until computers became available in India. Once the markets arrive, top management
will start looking for consultants in risk management, J. P. Morgan's “Risk metrics" software,
notions like “Value at Risk", etc. This entire process of learning will begin once India has
derivatives markets.

34
What about systemic risk, or risks to the economy?

Systemic risk manifests itself when there is a large and complex organisation of financial
positions in the economy. “Systemic risk" is said to arise when the failure of one big player or
of one clearing corporation somehow puts all other clearing corporations in the economy at
risk.
At the simplest, suppose that an index arbitrageur is long the index on one exchange and
short the futures on another exchange. Such a position generates a mechanism for
transmission of failure - the failure of one of the exchanges could possibly influence the
other.
Systemic risk also appears when very large positions are taken on the OTC derivatives
market by any one player.
Neither of these scenarios are in the offings in India. Hence it is hard to visualise how
exchange traded derivatives could generate systemic risk in India.

How should the use of derivatives by mutual funds be regulated?

Mutual funds are just one special case of “individual risk”. Mutual funds could make mistakes
in the securities that they invest in; they could make mistakes in the way they interact with
their investors, etc. Mistakes in derivatives trading are just one more kind of mistake that
they can make.
Given free entry into the mutual fund industry, funds which are unable to cope with such
complexity will go bankrupt, and funds which are good at figuring out this world will succeed.
There is no role for some agency to protect mutual funds from making mistakes.
There is, however, a useful role for disclosure. Mutual funds should clearly show investors (in
the prospectus) their planned policies about how they would use derivatives. This will enable
investors to use the fund with knowledge. An analogy here would be that a car manufacturer
should be supplying complete information to the potential buyer of the car of the internal
details of how the car would work.

Market manipulation:

What are the issues in terms of manipulation in the context of derivatives markets
in general?

In all areas, a basic fact about derivatives is that they magnify the profit rate from
manipulating the underlying. In other words, if there are profits to be made from
manipulating Gujarat Cotex, then the gains to the manipulator would be magnified if he had
purchased call options on Gujarat Cotex in advance.

What are the issues on short squeezes?

In the commodity markets area, a major concern is the “short squeeze", where a manipulator
knows the amount of physical goods which can possibly show up for delivery and buys
futures contracts worth more than this floating stock (he often tries to also buy the physical
goods to reduce the floating stock. This is another sense in which India's “cash market" for
equity is actually a futures market - we have seen short squeezes taking place on the weekly
futures market.

35
However, with cash settled derivatives (e.g. index-based contracts), this style of
manipulation is not a threat. This is a very important difference between the traditional
reasoning employed in the context of futures markets. Between 1874 (when the CBOT first
started supplying the counterparty guarantee) and the early 1980s (when cash settlement
first appeared), the history of futures markets has been pockmarked with short squeezes. It
is very important to observe that as India moves into futures markets with the most modern
style of product (using cash settlement), this is a very different environment than that which
has characterised a century of experience worldwide.

What kinds of manipulation are found with index derivatives?

Index derivatives are cash settled, hence the short-squeeze style of manipulation is
infeasible.
Typically, the index derivatives are far more liquid than the underlying stocks. Manipulation
would hence work by
1. Adopting a position on the derivatives market and then
2. Trying to move the index in order to make that position yield a profit.
At the policy level, dealing with this style of manipulation has two implications:
1. Understanding manipulation in the context of index derivatives is synonymous with
understanding manipulation of the underlying index, and
2. The exchange which supplies spot prices which are used in an index calculation is the
place where attempts at manipulation would take place, and it is the liquidity and surveillance
procedures on this exchange which should be seen as a check against manipulation. In
general, there is no reason why the spot and the derivatives have to trade at the same
location.

How do manipulators attack an index?

The reasoning of a profit-maximising manipulator leads him to focus on stocks which have a
high weight in the index but have poor liquidity. This would obtain the maximum change in
the index per unit of capital deployed into manipulation.
To cite an example, if a manipulator has Rs.1 million of capital, it makes no sense for him to
spend that on trying to affect the price of State Bank (a highly liquid stock, where a purchase
of Rs.500 million would typically move the price by less than 1%). Instead, that money is
much better spend on Hindustan Lever (a less liquid stock). The best stocks to target would
be those where liquidity is low and weight in the index is high.
A manipulator would choose those index stocks where the number w * i is the highest,
where w = weight of the security in the in index (in percent),
i = impact cost (in percent).
If impact cost is hard to measure, then stocks with large values of w/s would be used, where
s = bid-ask spread (in percent).
These formulae isolate vulnerabilities in the form of largecap stocks which are illiquid.
Obviously, these formulas would use data for liquidity (such as impact cost or the bid-ask
spread) from the exchange which supplies the prices which are used in calculating the index
under question.
The basic index construction methodology of an index like Nifty works via the impact cost
seen in actual index purchases or sales of Rs.5 million. Hence this methodology effectively
requires that stocks should have liquidity in proportion to their market capitalisation. This
ensures that there are no unusually weak points for attack by a manipulator.

36
What kinds of manipulation can take place on security options?

In options markets, manipulation would consist of first adopting a position in the options
market, and then trying to manipulate the underlying so as to obtain a good payoff from the
options position. This is akin to the increased activity that takes place to affect the 3:20pm
Friday price in Calcutta in the context of their teji-mandi market.
Another style of manipulation involves options which use physical delivery, and it is basically
a variant of the short squeeze. The manipulator becomes long on call options to the tune of
more shares than can be obtained for physical delivery. This would lead to a skyrocketing of
the price of the underlying, and hence of the call option price.
A useful policy for derivatives exchanges would be something like this: security options
markets should only be launched for securities which meet a rule such as “the security price
should move by less than 0.5% upon purchases of Rs.0.5 crore". It should be noted that the
liquidity of the underlying stock would improve once security options come about, so that a
security which meets such a criterion would be likely to seen see the price movement upon
purchases of Rs.0.5 crore drop to less than 0.5%.

Are individual securities in India liquid enough to support security options?

The most liquid stocks in the country are. The liquidity of State Bank and Reliance in one
snap-shot of NSE's order book, taken from June 1996, are displayed in Figure 5.1. Here we
see around Rs.50 crore of shares of State Bank being sourced while impact cost stays under
1%; it is the highest liquidity available in India's equity market as of today. Many other
securities which are in the NSE-50 index are also highly liquid.

Figure 5.1: Impact cost on SBI and RIL at Various Transaction Sizes

What would concerns about manipulation imply for the sequencing of index
derivatives vs. security options?

Given the concerns about market manipulation in India, the safer sequencing is to first have
index based contracts.

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Would a slow launch of security options harm the economy?

The vast majority of trading volume in equity derivatives worldwide lies in index derivatives.
This suggests that the economy really finds index -based contracts very valuable; usage of
index derivatives is very widespread, while usage of security options is restricted to a smaller
set of people.
Hence a slow start for security options would have smaller deleterious economic
consequences than delays in availability of index derivatives

What spot market should supply prices which are used for calculating payoffs with
cash-settled security options?

An important principle here is that regardless of where the options trade, the payoffs from
the option should be calculated using the market where the underlying is the most liquid. If
we have options on Reliance trading on an exchange where Reliance is illiquid, and if the
payoffs from the options are calculated using the cash market prices on that same exchange,
then it would encourage market manipulation on that exchange.
Hence, at the level of individual securities, options markets anywhere should only calculate
payoffs using closing prices from an exchange which meets two conditions: (a) strong
surveillance procedures, and (b) it should have the highest liquidity in the country (i.e. it
should have the lowest impact cost at transactions of Rs.0.5 crore or so).
A facility for borrowing and lending of shares will also greatly help reduce the risk of a short
squeeze in the security options market.

To what extent are these issues a regulatory issue?

Given the basic competitive market structure of derivatives markets, there are strong
incentives for the market to be careful about issues surrounding manipulation. If investors
suffer manipulation on one derivatives market, they will move their order flow out to other
derivatives markets or to alternative avenues of investment.
Policy analysis should adopt the framework that the exchange is an entity that tries to attract
order flow and maximise volumes. As long as this is the case, the aims of the exchange and
the needs of the investor are the same. Exchanges that fail to cater to the interests of
investors will lose order flow.
The policy that “cash-settled options payoffs should be calculated with respect to the prices
seen on the most liquid exchange" is an example of this principle. If (say) the Poona
exchange tries to trade options on State Bank, then there are two choices: to use the State
Bank price from PSE or from the most liquid exchange (NSE). If the former is adopted, there
is a greater risk of manipulation. This fear would serve to widen the spreads on the PSE
options market, and hence diminish the order flow to that market. This would spontaneously
generate a strong pressure for PSE to redefine their option contract definition to calculate
payoffs differently. There is little need for regulation to enter the picture.
This is perhaps like the question about the Maruti 800 being an unsafe car. To the extent that
the market for cars lacks entry barriers, the safety of the Maruti 800 is not a regulatory
concern: if consumers feel unsafe with the Maruti 800, they can always buy another car.

38
What does this discussion translate to in terms of specific regulations in the
derivatives area?

Translating these abstract ideas into specific policy avenues:

1. SEBI should not allow any exchange to function without a clearinghouse that guarantees
the trade, and it should conduct inspections to confirm that margin payments are being
calculated as claimed, and actually being charged to members.
2. The clearinghouse must charge initial margin using a portfolio approach to measuring risk.
If the clearinghouse can move funds swiftly enough, then it can be a true “initial margin",
alternatively it should be a “exposure limit". If the payments system is slow, then the initial
margin should be correspondingly larger.
3. SEBI should require exchanges to open up their entry criteria to the extent required so
that the pure seat price (devoid of physical infrastructure) drops to low levels.
4. SEBI should require that exchanges disclose copious information about the trading
(including things like open interest, the standard deviation of member-positions, etc) on the
exchange. This information should be freely available in newspapers and on the Internet.
5. The surveillance department at SEBI should require, and possibly do an investigative follow
up on, reports of positions and trading activity of “large" players on the market. “Large" could
possibly be defined as an open position above Rs.100 crore, or a one-day trading volume
above Rs.50 crore. These are the traders who might command market power and possibly
manipulate the market.
6. SEBI should be accessible to individual users of the market who would be able to complain
about manipulative episodes where they have been hurt.

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 Chapter#6 Derivatives and the Economy
What are the benefits of derivatives to India?

India's financial market system will strongly benefit from smoothly functioning index
derivatives markets.
 Internationally, the launch of derivatives has been associated with substantial
improvements in market quality on the underlying equity market. Liquidity and market
efficiency on India's equity market will improve once the derivatives commence
trading.
 Many risks in the financial markets can be eliminated by diversification. Index
derivatives are special insofar as they can be used by investors to protect themselves
from the one risk in the equity market that cannot be diversified away, i.e., a fall in
the market index. Once investors use index derivatives, they will suffer less when
fluctuations in the market index take place.
 Foreign investors coming into India would be more comfortable if the hedging vehicles
routinely used by them worldwide are available to them.
 The launch of derivatives is a logical next step in the development of human capital in
India. Skills in the financial sector have grown tremendously in the last few years,
thanks to the structural changes in the market, and the economy is now ripe for
derivatives as the next area for addition of skills.
Once India has skills in the core derivatives markets, capabilities in derivatives can be easily
applied into unexpected areas. The world over, innovative contracts such as pollution
permits, electricity prices, garment quotas, etc, are being used to solve economic problems.
Each of these markets is small when taken in isolation, but has a tremendous impact upon
the specific area. But progress in these directions first requires a core capability on the part
of exchanges and traders in mainstream financial derivatives.

How do index derivatives change the overall level of equity investment in the
economy?

We can think of the overall economy making choices about debt vs. equity, based on
decisions by households and firms. In this big picture, derivatives have no role. Recall that all
derivatives are in net zero supply: when one person leverages by going long on index
futures, there is an equal and opposite counterparty who is deleveraging by going short index
futures. If either of a short or a long are unavailable, no trade takes place.
In this sense, when aggregating at the level of the full economy, derivatives are unimportant.
Where derivatives do help, however, is in allowing the repackaging and movement of risk
from people who do not want to bear it to the people who are willing to bear it. Derivatives
allow many economic agents in the economy to sell insurance to others, and the availability
of this insurance enables many economic activities without which the risks would be too high.

How will index derivatives assist capital formation and growth in the economy?

At the larger level of the economy, well-functioning derivatives markets will improve the
market efficiency of the underlying cash market.
It will improve the market's ability to carefully direct resources towards the projects and
industries where the rate of return is highest; this will improve the allocative efficiency of the
market. By improving the allocative efficiency, a given stock of investible funds will be better
used in procuring the highest possible GDP growth for the country.
Hence the real linkages go (a) from derivatives to market liquidity and market efficiency, and
(b) from market efficiency to GDP growth.

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What is the evidence about derivatives and market liquidity and efficiency?

There is strong empirical evidence from other countries that after derivatives markets have
come about, the liquidity and market efficiency of the underlying market have improved.

What is the evidence about market quality and economic growth?

An important study of the relationship between stock market development and long-term
economic growth has been recently conducted by Ross Levine and Sara Zervos (1996). They
create a measure of stock market development which combines three dimensions of market
quality. By this measure, a country is said to have a well-developed stock market when (a)
the assets intermediated by the stock market are large when compared with GDP (b) the
stock market is highly liquid, and (c) the stock market is highly integrated into world
markets.
Their empirical analysis controls for the independent contribution of seven kinds of other
factors. After taking into account the contribution of all these factors, they found that stock
market development is highly significant statistically in forecasting future growth of per capita
GDP. Their regressions imply that stock market development is also highly economically
significant. For example, their regressions forecast that if Mexico or Brazil were to obtain
stock markets as advanced as Malaysia, then they might obtain an additional per capita GDP
growth per year of 1.6 percentage points. Even allowing for the imprecision and hazards of
such extrapolation, this is an extremely large effect.

How do derivatives alter the exposure of different people in the economy?

Derivatives allow a shifting of risk from a person who does not want to bear the risk to a
person who wants to bear the risk. Without derivatives, people suffer risk without much
choice. The only investment decision that can be made is whether to be in a certain area of
business or not. For example, if a garment exporter dislikes currency risk, the only choice
that he faces (in a world before derivatives) is whether to be in garment export or not. With
derivatives, he has the ability and choice to insure against currency exposure. And he is able
to do this by trading this exposure with others in the economy who are equipped to deal with
it.

How do derivatives alter the informational structure of the economy?

Both futures and options markets have a significant impact upon the informational efficiency
of financial markets.
In the case of futures:
1. The simplest and most direct effect is that the launch of a derivatives market is correlated
with improvements in market efficiency in the underlying market. This improved market
efficiency means that the market prices of individual securities are more informative.
2. Once futures markets appear, a certain delinking of roles in the two markets is observed.
The cash market caters to relatively non-speculative orders, and the futures markets takes
over the major brunt of price discovery. The futures market is better suited for this role,
because of high liquidity and leverage. Whenever news strikes, it first appears as a shock in
the futures market prices, which arbitrage then, carries into the cash market.
3. Another unique feature applies for the market index. In today’s economy, speculation on
the level of the index is difficult, because a tradable index does not exist. Hence informed
speculators might try to take positions on individual securities in order to implement views

41
about the index, but this is difficult because of higher transactions costs. Index futures will
hence improve the informational quality of the market index.
In the case of options:
1. Options are important to the market efficiency of the underlying in much the same way
that futures are important,
2. In addition, options play one unique role of revealing the market's perception of volatility.
High-quality volatility forecasts have serious ramifications for decisions in portfolio
optimisation, production planning, physical investment decisions, etc.
By using the option price in the market, it is possible to infer the market's consensus view
about volatility through a simple formula. This is a completely unique role that options play,
that neither the cash market nor the futures market can possibly play.
This is a very important reason why security options are important. If options on TISCO
existed, the entire market would be able to observe the price of options on the market, and
infer a very good forecast about volatility on TISCO in the coming weeks and months.

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 Chapter#7 Myth about Derivatives
What is Need for derivatives in India today?

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
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
NSE is planning to introduce Futures and Options trading in India. NSE proposes to introduce
equity based derivatives with index futures as the first product to be traded on.
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk averse people
in greater numbers
5. They increase savings and investment in the long run.

What are the Myths and realities about derivatives?

In less than three decades of their coming into vogue, derivatives markets have become the
most important markets in the world. Financial derivatives came into the spotlight along with
the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods
System of fixed exchange rates leading to introduction of currency derivatives followed by
other innovations including stock index futures. Today, derivatives have become part and
parcel of the day-to-day life for ordinary people in major parts of the world. While this is true
for many countries, there are still apprehensions about the introduction of derivatives. There
are many myths about derivatives but the realities that are different especially for Exchange
traded derivatives which are well regulated with all the safety mechanisms in place.

Derivatives increase speculation and do not serve any economic purpose

As a Matter of Fact:
Numerous studies of derivatives activity have led to a broad consensus, both in the
private and public sectors, that derivatives provide numerous and substantial
benefits to the users. Derivatives are a low-cost, effective method for users to hedge
and manage their exposures to interest rates, commodity prices, or exchange rates.
The need for derivatives as hedging tool was felt first in the commodities market. Agricultural
futures and options helped farmers and processors hedge against commodity price risk. After
the fallout of Bretton wood agreement, the financial markets in the world started undergoing
radical changes. This period is marked by remarkable innovations in the financial markets

43
such as introduction of floating rates for the currencies, increased trading in variety of
derivatives instruments, on-line trading in the capital markets, etc. As the complexity of
instruments increased many folds, the accompanying risk factors grew in gigantic
proportions. This situation led to development derivatives as effective risk management tools
for the market participants.
Looking at the equity market, derivatives allow corporations and institutional investors to
effectively manage their portfolios of assets and liabilities through instruments like stock
index futures and options. An equity fund, for example, can reduce its exposure to the stock
market quickly and at a relatively low cost without selling off part of its equity assets by using
stock index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and raising
capital, derivatives improve the allocation of credit and the sharing of risk in the global
economy, lowering the cost of capital formation and stimulating economic growth.
Now that world markets for trade and finance have become more integrated, derivatives have
strengthened these important linkages between global markets, increasing market liquidity
and efficiency and facilitating the flow of trade and finance.

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 Chapter#8 Derivative security
In finance, a derivative security is a contract that specifies the rights and obligations
between the issuer of the security and the holder to receive or deliver future cash flows (or
exchange of other securities or assets) based on some future event.

Properties:

A derivate can have a large number of properties, so that its value depend on many factors.
The terms and payments can be derived from the price of a security or commodity, a
published statistics, an event (such as default on payment), or something else. The more
standardized products can be traded through a securities exchange and will usually have
higher liquidity. The more "exotic" ones may have to be traded "over-the-counter".

Cash Flow:

The payments between the parties may be determined by:

• the price of some other, independently traded asset in the future (e.g., a common
stock)
• the level of an independently determined index (e.g., a stock index or heating-degree-
days)
• the occurrence of some well-specified event (e.g., a company defaulting)

Some derivatives are the right to buy or sell the underlying security or commodity at some
point in the future for a predetermined price. If the price of the underlying security or
commodity moves into the right direction, the owner of the derivative makes money;
otherwise, they lose money or the derivative becomes worthless. Depending on the terms of
the contract, the potential gain or loss on a derivative can be much higher than if they had
traded the underlying security or commodity directly.

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 Chapter#9 Financial Derivatives Market and its
Development in India (Suggestion)

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, equity, 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 12th 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. A primary motivation for re-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 participants in a derivatives market:

• Hedgers use futures or options markets to reduce or eliminate the risk associated with
price of an asset.
• Speculators 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.
• Arbitrageurs 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: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price.
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
Options: 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.
Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are
called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset
is usually a moving average or a basket of assets. Equity index options are a form of basket
options.
Swaps: Swaps 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:

46
• Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency.
• Currency 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.
Swaptions: Swaptions 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. Rather than have calls
and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver
swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay
fixed and receive floating.

Factors 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.

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Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the promulgation of the
Securities Laws (Amendment) Ordinance, 1995, 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. SEBI set up a 24–member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India. The committee submitted its report on March 17,
1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The
committee recommended that derivatives should be declared as ‘securities’ so that regulatory
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 Prof.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 operational details of margining system,
methodology for charging initial margins, broker net worth, deposit requirement and real–
time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended
in December 1999 to include derivatives 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 March 2000,
the three– decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted 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/corporation to commence trading and settlement in
approved derivatives contracts. To begin with, SEBI approved trading in index futures
contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval
for trading in options based on these two indexes and options on individual securities.
The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on
individual securities commenced in July 2001. Futures contracts on individual stocks were
launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty
Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001
and trading in options on individual securities commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The index futures and options
contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done
in accordance with the rules, byelaws, and regulations of the respective exchanges and their
clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign
Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative
products.

The following are some observations based on the trading statistics provided in the NSE
report on the futures and options (F&O):

• Single-stock futures continue to account for a sizable proportion of the F&O segment. It
constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to
this phenomenon is that traders are comfortable with single-stock futures than equity
options, as the former closely resembles the erstwhile badla system.

• On relative terms, volumes in the index options segment continue 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. A 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.

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• Put volumes in the index options and equity options segment have increased since January
2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to
1.32 in June. 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 equity options on
most stocks for even the next month was non-existent.

• Daily option price variations suggest that traders use the F&O 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. Calls on Satyam fall,
while puts rise when Satyam falls intra-day. If calls and puts are not looked as just
substitutes for spot trading, the intra-day stock price variations should not have a one-to-one
impact on the option premiums.

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Instruments available in India

Financial derivative instruments:

The National stock Exchange (NSE) has the following derivative products:

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Commodity Derivatives:

Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking,
castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18
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 Government 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.
With commodity futures, delivery is best effected using warehouse receipts (which are like
dematerialised securities). Warehousing 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 Coffee Futures Exchange
India (COFEI) has operated a system of warehouse receipts since 1998

Exchange-traded vs. OTC (Over The Counter) derivatives markets:

The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernization 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. While both exchange-traded and OTC
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 OTC
derivative positions were the main cause of turbulence in financial markets in 1998. These
episodes of turbulence revealed the risks posed to market stability originating in features of
OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and
for safeguarding
the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange’s self-regulatory organization, although they are affected indirectly by national legal
systems, banking supervision and market surveillance.

Accounting of Derivatives:

The Institute of Chartered Accountants of India (ICAI) 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 equity

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index futures is similar to a trade in, say shares, and does not pose any peculiar accounting
problems

Taxation:

The income-tax Act does not have any specific provision regarding taxability from derivatives.
The only provisions which have an indirect bearing on derivative transactions are sections
73(1) and 43(5). Section 73(1) 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 .As 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.

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 CHAPTER#10 Investors Guide to Derivatives

A futures or options contract which is based on a set of underlying securities is called a

Stock Index Futures or Options Contract. When trading takes place in stock index futures, it
means that market participants are taking a view on the way the index will move. By trading
in Index-based Futures and Options you buy or sell the entire stock market as a single entity.

S&P CNX NIFTY:

S&P CNX NIFTY is a scientifically developed index. Top 50 blue chip companies have been
selected to form part of the index. The index covers more than 25 industry sectors and is
professionally managed by India Index & Services Ltd (IISL). IISL has a licensing and co-
branding arrangement with Standard & Poor's (S&P), the World's leading provider of
investable equity indices, for co-branding IISL's equity indices. Daily derivatives trading
based on S&P 500 index is over US $ 50 billion.

Uses of S&P CNX NIFTY:

S&P CNX NIFTY can be used for the purpose of speculation, hedging as well as an arbitrage
tool.

Think market will go up?

Do you sometimes think that the market index is going to rise? That you could make a profit
by adopting a position on the index? After a good budget, or good corporate results, or the
onset of a stable government, many people feel that the index would go up. How does one
implement a trading strategy to benefit from an upward movement in the index? Today, you
have two choices:
Buy selected liquid securities, which move with the index, and sell them at a later date,
OR
Buy the entire index portfolio and then sell it at a later date.
The first alternative is widely used a lot of the trading volume on stocks like HINDLEVER is
based on using HINDLEVER as an index proxy. However, these positions run the risk of
making losses owing to HINDLEVER-specific news; they are not purely focused upon the
index.
The second alternative is hard to implement. An investor needs to buy all the stocks in S&P
CNX Nifty in their correct proportions. Most retail investors do not have such large portfolios.
This strategy is also cumbersome and expensive in terms of transactions costs.
Taking a position on the index is effortless using the index futures market. Using index
futures, an investor can "buy" or "sell" the entire index by trading on one single security.
Once a person buys S&P CNX NIFTY using the futures market, he gains if the index rises and
loses if the index falls.

Example:

• 5/1/2000 - You feel the market will rise

• Buy 100 S&P CNX NIFTY January futures contract at 1450 costing Rs.145000
(100*1450)
• expiration date - 28/1/2000
• 14/1/2000 Nifty January futures have risen to 1470
• You sell off your position at 1470

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 • Make a profit of Rs. 2000 (100* 20)
• Think the market will go down?

Do you sometimes think that the market index is going to fall? That you could make a profit
by adopting a position on the index? After a bad budget, or bad corporate results, or the
onset of a coalition government, many people feel that the index would go down. How does
one implement a trading strategy to benefit from a downward movement in the index?
Today, you have two choices:

Sell selected liquid securities which move with the index, and buy them at a later
date,

Or

Sell the entire index portfolio and then buy it at a later date.

The first alternative is widely used a lot of the trading volume on stocks like ITC is based on
using ITC as an index proxy (ITC has the highest correlation with S&P CNX Nifty amongst all
the stocks in India). However, these positions run the risk of making losses owing to ITC-
specific news; they are not purely focused upon the index. The second alternative is hard to
implement. This strategy is also cumbersome and expensive in terms of transaction costs.
Taking a position on the index is effortless using the index futures market. Using index
futures, an investor can "buy" or "sell" the entire index by trading on one single security.
Once a person sells S&P CNX NIFTY using the futures market, he gains if the index falls and
loses if the index rises.

Example

• 8/2/2000 - You feel the market will fall

• Sell 100 S&P CNX NIFTY February expiry contract
• Expiration date 25/2/2000
• Nifty February contract is trading at 1560
• Your position is worth Rs. 156000
• 15/1/2000 - Nifty February futures have fallen to 1520
• You squares off your position at 1520
• Make a profit of Rs.4000 (100*40)
• Have you bought a share hoping it will go up?

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 Chapter#11 New Eligibility Norms for F&O Contracts
(Conclusion)
The Securities and Exchange Board of India (SEBI) has revised eligibility criteria for stocks
and indices on which futures and options can be introduced. According to the new rules,
which will come into effect from September 1, stocks will be chosen from among the top-500
scrips in terms of average daily market capitalisation and average daily traded value for the
previous six months on a rolling basis. Also, the market wide position limit in the stock
cannot be less than Rs 50 crore. "Since the market wide position limit for a stock is computed
at the end of every month, the exchange shall ensure that stocks comply with this criterion
before introduction of new contracts. Further, the market wide position limit (which is in
number of shares) shall be valued taking the closing prices of stocks in the underlying cash
market on the date of expiry of contract in the month," states the SEBI circular. Derivative
contracts on an index can now be introduced by stock exchanges if 80 per cent of the index
constituents are individually eligible for derivatives trading. However, no single ineligible
stock in the index can have a weightage of more than 5 per cent in the index. The index on
which futures and options contracts are permitted will be required to comply with the
eligibility criteria on a continuous basis, according to the market regulator. The circular issued
to stock exchanges clarifies that if the mark to market margin/settlements (MTM) for
derivative contracts is not collected before the start of the next day's trading, the exchange is
required to collect correspondingly higher initial margins to cover the potential for losses over
the time elapsed in the collection of MTM.

Size Does Matter, for Derivatives contract size:

Indian stock market had seen a major Paradigm shift in its functioning 20 months back,
When Futures & Options were introduced & 100 years old Badla system was done away.
Derivatives were introduced with a view of providing better platform for investors and
traders, specifically retail investor. Today market participants have understood the risk,
functioning and various methods of Future & Option. But we could see that hardly any small
Investor or trader is benefited from trading or hedging point of view by current Derivatives
contract system, as its contract size itself works as major obstacle.Minimum contract size of
F&O was fixed at minimum 2 lakh Rs. of value for any shares, which itself is a big hurdle in
hedging & trading not only for small & retail traders and investors but for majority of market
participants. Today for many scrips contract size has become illogical. As contract size value
was fixed 20 months back and there was no review of that size to make it logical.Today
Telco's contract size value is 3300*150= 4,95,000 Rs . For Hindustan Petro value is Rs
3,73,000. While for scrips like Sterlite Optic it is Rs 19200 only. The point is that for
popularizing derivatives one need to review contract size at every six month & minimum
value of contract size should be brought down to around Rs 50000 per contract. This will
make it possible for retail investors and small Traders to participate in hedging or trading in
derivatives in a big and regular way. Even in today's bearish market, Derivatives volume
could be increased by 2 to 3 times by changing the contract size value around to Rs
50000.Logically if reduction and resizing in contract value could help to generate volume for
brokers, stock exchanges and revenue for Govt, then there should not be any problem in
doing so at the earliest. Every day we see that many people discuss about various strategies
but due to contract size constraint majority of the people are unable to participate in the

55
derivatives. Need of the hour is that serious and quick thinking should be provided on this
matter and value of contract should be reduced to logical and comfortable level.

Turnover battle...F&O segment beats cash market:

When the carry forward system or ‘Badla’ was banned in the wake of the March 2001 stock
market crash, market participants had predicted a big drop in turnover. But, derivatives
trading, which was launched from June 2000 more than made up for the elimination of Badla.
The change is quite evident if one looks at the present day turnover in the derivatives
segment vis-a-vis the cash segment. Trading in derivatives segment is becoming popular by
the day and is likely to outstrip the turnover in the cash market in the near future. Trading in
derivatives is considered to be much safer compared to the cash market as it gives higher
returns in short term and involves lower risks and investment. Moreover, day traders or
operators cannot dictate proceedings in the derivatives market as used to happen when Badla
trading was on. He accompanying table reveals that on July 17th, the derivatives segment
clocked its highest ever turnover of Rs56.55bn. This was better than the combined turnover
at the BSE (Rs15.3bn) and NSE (Rs37.23bn) on that day.

In the past four trading days, turnover in the derivatives segment has surpassed that in the
cash segment (BSE and NSE). Not only that, in the last month or so, derivatives turnover has
been equivalent to nearly 300-400% of that on the BSE and 125-155% of that on the NSE.

On an average, derivatives turnover accounts for about 80-100% of the cash market
turnover. Market experts believe that the derivatives segment is likely to rule the roost in the
future as more and more investors turn away from the cash market.

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 Derivative vs. Cash

BSE NSE Total Dervative Derivative/CASH Turnover

Date Turnover Turnover Turnover Turnover
(Rs bn) (Rs bn) (Rs bn) (Rs bn)
F&O /BSE (%) F&O /NSE (%) F&O /Total Cash (%)
18-Jul-03 12.8 32.0 44.8 50.0 391.2 155.9 111.5
17-Jul-03 15.0 37.2 52.3 56.6 376.2 151.9 108.2
16-Jul-03 13.9 33.5 47.5 46.7 334.9 139.2 98.3
15-Jul-03 14.6 35.7 50.3 51.3 350.8 143.8 102.0
14-Jul-03 13.1 31.7 44.7 39.6 303.4 125.0 88.6
11-Jul-03 15.7 36.8 52.6 44.6 283.7 121.1 84.9
10-Jul-03 18.2 42.6 60.7 49.4 272.0 116.1 81.4
09-Jul-03 13.3 30.8 44.1 34.4 259.4 111.6 78.0
08-Jul-03 14.4 31.0 45.4 34.3 238.0 110.4 75.4
07-Jul-03 11.4 27.4 38.8 33.6 294.6 122.5 86.5
04-Jul-03 11.6 28.2 39.8 32.7 281.0 116.0 82.1
03-Jul-03 18.0 42.8 60.8 49.4 273.7 115.4 81.2
02-Jul-03 14.3 33.1 47.4 39.6 277.3 119.6 83.5
01-Jul-03 12.5 29.5 42.0 35.9 286.7 121.9 85.5
30-Jun-03 14.0 33.4 47.4 36.3 259.4 108.7 76.6
27-Jun-03 15.3 37.2 52.5 43.1 282.7 115.9 82.2
26-Jun-03 14.4 37.4 51.8 51.2 354.7 136.8 98.7
25-Jun-03 12.4 30.9 43.3 45.8 371.0 148.3 105.9
24-Jun-03 10.5 26.3 36.8 38.7 369.7 147.3 105.3
23-Jun-03 11.2 26.4 37.5 39.6 354.9 150.2 105.5
20-Jun-03 11.5 29.1 40.6 35.9 311.5 123.6 88.5
19-Jun-03 12.2 29.1 41.4 38.0 310.2 130.4 91.8
18-Jun-03 12.7 31.6 44.3 39.7 312.3 125.7 89.6
17-Jun-03 13.3 31.1 44.4 39.3 295.4 126.6 88.6

Conclusion:

Trading in Derivatives
Indian securities markets have indeed waited for too long for derivatives trading to emerge.
Mutual Funds, FIIs and other investors who are deprived of hedging opportunities will now
have a derivatives market to bank on. First to emerge are the globally popular variety - index
futures.While derivatives markets flourished in the developed world Indian markets remain

57
deprived of financial derivatives to the beginning of this millenium. While the rest of the world
progressed by leaps and bounds on the derivatives front, Indian market lagged behind.
Having emerged in the markets of the developed nations in the 1970s, derivatives markets
grew from strength to strength. The trading volumes nearly doubled in every three years
making it a trillion-dollar business. They became so ubiquitous that, now, one cannot think of
the existence of financial markets without derivatives.
Two broad approaches of SEBI is to integrate the securities market at the national level, and
also to diversify the trading products, so that more number of traders including banks,
financial institutions, insurance companies, mutual funds, primary dealers etc. choose to
transact through the Exchanges. In this context the introduction of derivatives trading
through Indian Stock Exchanges permitted by SEBI in 2000 AD is a real landmark.
SEBI first appointed the L.C.Gupta Committee in 1998 to recommend the regulatory
framework for derivatives trading and to recommend a suggestive bye-laws for Regulation
and Control of Trading and Settlement of Derivatives Contracts. The Board of SEBI in its
meeting held on May 11, 1998 accepted the recommendations of the Dr. L.C. Gupta
Committee and approved the phased introduction of derivatives trading in India beginning
with Stock Index Futures. The Board also approved the "Suggestive Bye-laws" recommended
by the committee for Regulation and Control of Trading and Settlement of Derivatives
Contracts.
SEBI subsequently appointed the J.R.Verma Committee to recommend Risk Containment
Measures in the Indian Stock Index Futures Market. The report was submitted in the same
year(1998) in the month of November by the said committee.
However the Securities Contracts (Regulation) Act, 1956 (SCRA) needed amendment to
include "derivatives" in the definition of securities to enable SEBI to introduce trading in
derivatives. The necessary amendment was carried out by the Government in the year 1999.
The Securities Laws (Amendment) Bill, 1999 was introduced to bring about the much needed
changes. In December 1999 the new framework has been approved. Derivatives have been
accorded the status of `Securities'. The ban imposed on trading in derivatives way back in
1969 under a notification issued by the Central Government has been revoked. Thereafter
SEBI formulated the necessary regulations/bye-laws and intimated the Stock Exchanges in
the year 2000, while derivative trading started in India at NSE in the same year and BSE
started trading in the year 2001. In this module we are covering the different types of
derivative products and their features, that are traded in the stock exchanges in India.

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 heralded the introduction of exchange traded equity derivative
products

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Equity Derivatives Exchanges in India

• In the equity markets both the National Stock Exchange of India Ltd. (NSE) and The
Stock Exchange, Mumbai (BSE) were quick to apply to SEBI for setting up their
derivatives segments.
• NSE as stated earlier commenced derivatives trading in the same year i.e. 2000 AD,
while BSE followed after a few months in 2001.
• Both the exchanges have set-up an in-house segment instead of setting up a separate
exchange for derivatives.
• NSE's Futures & Options Segment was launched with Nifty futures as the first product.
• BSE's Derivatives Segment, started with Sensex futures as it's first product.
• Stock options and stock futures were introduced in both the Exchanges in the year
2001

Thus started trading in Derivatives in Indian Stock Exchanges (both BSE & NSE) covering
Index Options, Index Futures, Stock Options & Futures at in the wake of the new millennium.
In a short span of three years the volume traded in the derivative market has outstripped the
turnover of the cash market. The arrival of this new financial product in the securities
markets of India, should now interest us to learn more about the origin and development of
the global market in derivatives trading of financial securities. This is equally of a recent
origin since 1070s.

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 WEBLIOGRAPHY:

1. www.Nseindia.com
2. www.bseindia.com
3. www.moneycontrol.com
4. www.equitymaster.com

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