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The Indian Derivatives Market Revisited

SUCHISMITA BOSE

I C R A B U L L E T I N

Money

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Abstract
Derivatives products provide certain important economic benefits such as risk management or redistribution of risk away from risk-averse investors towards those more willing and able to bear risk. Derivatives also help price discovery, i.e. the process of determining the price level for any asset based on supply and demand. These functions of derivatives help in efficient capital allocation in the economy; at the same time their misuse also poses a threat to the stability of the financial sector and the overall economy. In the mid-1990s India started reviving the exchange traded commodity derivatives market and introduced a variety of instruments in the foreign exchange derivatives market, while exchange traded financial derivatives were introduced in 2001. Given Indias experience in informal derivatives trading, the exchange traded derivatives were quick to pick up substantial volumes. This paper presents accounts of the major developments in the Indian commodity, exchange rate and financial derivatives markets, and outlines the regulatory provisions that have been introduced to minimise misuse of derivatives.

This paper presents accounts of the major developments in the Indian commodity, exchange rate and financial derivatives markets, and outlines the regulatory provisions that have been introduced to minimise misuse of derivatives.

I. Introduction
Immediately prior to the formal introduction of derivatives contracts in the Indian financial markets, Money & Finance (Bhaumik, 1997, 1998) brought forth a comprehensive account of various derivatives instruments, their uses, pricing mechanisms, portfolio strategies and the associated risks as well as issues on appropriate regulation to be considered in introducing this class of financial instruments to a developing market like India. About half a decade has passed since derivatives have been formally introduced in India; here we review the main trends in the Indian markets for derivatives in commodities, exchange rates and securities. We also touch upon the regulatory provisions for taking care of undesirable effects of derivatives trading. As a sequel, in a forthcoming paper we intend to test for certain hypotheses related to the efficient functioning of the Indian derivatives market. Derivatives are financial contracts whose price is derived from that of an underlying item such as a commodity, security, rate, index or event [Box 1]. The emergence of the market for derivatives contracts originates from the desire of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset

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Box 1: Derivatives Contracts To Recapitulate:

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Futures Contract is a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organised/standardised contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date, which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Options Contract gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at the end of a specified period. The buyer/holder of the option purchases the right from the seller/ writer for a fee, which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. Cash settlement in option contract entails paying/receiving the difference between the strike price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise/assignment of the option contract. This means that an option holder can allow the option to expire if the market price is more favourable compared with the pre-determined option price known as strike price.
An Option to buy is called a Call option and option to sell is called a Put option. Further, an option that is exercisable at any time on or before the expiry date is called an American option and one that is exercisable only on the expiry date, is called an European option. The price at which the option is to be exercised is termed the Strike price or Exercise price. Futures/Options contracts having the underlying asset as a (stock) index are known as Index Futures/Options contracts. These contracts are essentially cash settled on expiry.

Financial derivatives came into the spotlight in the post-1970 period due to growing instability in the global financial markets. However, since their emergence, these products have become very popular and since the 1990s, they account for about two-thirds of the total transactions in derivatives products.

Interest rate swap is an exchange of cash flows between two parties, which generally transforms floating rate obligations in a particular currency into a fixed rate obligation in that same currency or vice versa. Currency swap is an exchange of cash flows denominated in different currencies. The cash flows are based on agreed-upon exchange rates and may or may not include the exchange of principal. Commodity/index swap is an exchange of cash flows, where one of the cash flows is based on the price of a particular commodity/index or basket of commodities, and the other cash flow is based on an interest rate. Interest rate cap limits the maximum interest rate on a floating rate loan regardless of the future level of the market reference rate. Interest rate collar sets a maximum (via the purchase of a cap) and a minimum (via the sale of a floor) interest rate on a floating rate loan.

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prices. By locking-in asset prices, derivatives products minimise the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products globally for almost three hundred years. Financial derivatives came into the spotlight in the post-1970 period due to growing instability in the global financial markets. However, since their emergence, these products have become very popular and since the 1990s, they account for about two-thirds of the total transactions in derivatives products.1

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TABLE 1 The Global Derivatives Industry (Outstanding Contracts, $ billion) Exchange Traded TOTAL CONTRACTS Interest rate futures Interest options Equity index futures Equity index options Currency futures Currency options Over-The-Counter (OTC) 2001 2002 2003 2004 2005 Q1 2005 Q2 2005 Q3 2005 Q4 2006 Q1

23764.1 23855.8 36786.9 46592.4 59467.3 58516.9 58283.9 57815.8 78948.8 9269.5 9955.6 13123.7 18164.9 20510.7 19684.4 19861.2 20708.7 24435.6 12492.8 11759.5 20793.8 24604.1 34327.9 34109.9 32796.2 31588.2 48010.1 333.9 365.5 549.3 635.2 713.8 655.8 727.1 802.7 922 1574.9 1700.8 2202.3 3024 3768.4 3897.5 4726.8 4542.5 5400.6 65.6 47 79.9 103.5 87.1 100.1 109.7 107.6 109.7 27.4 27.4 37.9 60.7 59.4 69.2 62.9 66.1 70.8 Dec. 2001 Dec02 Jun03 Dec03 Jun04 Dec04 Jun05 271282 31081 15801 8236 7045 204795 13973 163749 27072 4551 1086 3464 2940 288 2652 1748 904 27915 Dec. 2005 284819 31609 15915 8501 7193 215237 14483 172869 27885 5057 1111 3946 3608 334 3273 2319 955 29308

TOTAL CONTRACTS 111178 141665 169658 Foreign exchange contracts 16748 18448 22071 Outright forwards and forex swaps 10336 10719 12332 Currency swaps 3942 4503 5159 Options 2470 3226 4580 Interest rate contracts 77568 101658 121799 Forward rate agreements 7737 8792 10271 Interest rate swaps 58897 79120 94583 Options 10933 13746 16946 Equity-linked contracts 1881 2309 2799 Forwards and swaps 320 364 488 Options 1561 1944 2311 Commodity contracts 598 923 1040 Gold 231 315 304 Other commodities 367 608 736 Forwards and swaps 217 402 458 Options 150 206 279 Other 14384 18328 21949 Source: BIS, Derivative Statistics.
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197167 220058 251499 24475 26997 29289 12387 13926 14951 6371 7033 8223 5717 6038 6115 141991 164626 190502 10769 13144 12789 111209 127570 150631 20012 23912 27082 3787 4521 4385 601 691 756 3186 3829 3629 1406 1270 1443 344 318 369 1062 952 1074 420 503 558 642 449 516 25508 22644 25879

The failure of the Bretton Woods system leading to sharp fluctuations in the US dollar, along with volatility in US long term yields sharpened by the oil crisis of 1973 led to the focus on strategies of eliminating low probability events that might upset the entire financial planning of corporates and governments.

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Indias primary securities market also has experience with derivatives of two kinds:

convertible bonds
and warrants. Since these warrants are listed and traded, an options market of a sort already existed; however, trading on these instruments has been very limited.

The market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. According to the Bank for International Settlements (BIS), the approximate size of global derivatives market which was at US$119.15 trillion as of end-June 2001 increased to US$273.06 trillion by end-June 2004 (BIS, 2004). In India the willingness to embark on formal derivatives trading came forth only during the reforms process of the 1990s, though various informal forms of derivatives contracts have existed since time immemorial in the country. Traditionally in the arena of agriculture, which was entirely dependent on nature, various types of forward contracts evolved between large farmers/middlemen and small farmers /landless labourers. A variety of interesting derivatives markets came into existence in the informal financial sector too; these markets trade contracts like teji-mandi, bhav-bhav, and other such strategies that are essentially different combinations of put and call options. However, these informal markets stand outside the mainstream institutions of Indias financial system and enjoy only limited participation. Indias primary securities market also has experience with derivatives of two kinds: convertible bonds and warrants (a slight variant of call options). Since these warrants are listed and traded, an options market of a sort already existed; however, trading on these instruments has been very limited. Trading on the spot market for equity in India has actually always been futures style with weekly or fortnightly settlement. But this system though attended with the risks and difficulties of futures markets, was without the gains in price discovery and hedging services that come with a separation of the spot market from the futures market. Besides informal contracts within the economy, Indian financial derivatives contracts also existed in international markets. The over-thecounter2 (OTC) derivatives industry on Indian underlyings essentially exists abroad. Custom built (OTC) derivatives, specifically, options and swaps on Indian market indexes and baskets of Indian ADR/GDRs (American/Global Depository Receipts), were being traded on the international market. Warrants on mutual fund paper such as Lazard Birla India and Fleming India have been listed abroad. In the exchange rate arena India has had a strong dollar-rupee forward market with contracts being traded for one to six month expiration. Indian users of currency hedging services were also allowed to buy derivatives involving other currencies on foreign markets. India started reviving its exchange traded commodity derivatives market and introduced a variety of instruments in the foreign

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2 A derivative contract that is privately negotiated is called an OTC contract. OTC trades as distinguished from exchange traded contracts have no anonymity, and they generally do not go through a clearing corporation. OTC futures contracts are called forwards (actually, exchangetraded forward contracts have been termed futures).

exchange derivatives market only in the mid-1990s. India went in for formal financial derivatives trading in the exchanges by 2001 introducing index futures, index options stock options and stock futures in a phased manner. About five years have elapsed since the Indian securities market regulator, Securities and Exchange Board of India (SEBI), formally introduced financial derivatives in the securities market. Given its history of informal trading in complicated derivatives contracts the exchange traded derivatives products were quick to pick up substantial amounts of trading. During this period there have been several significant changes in the structure of the Indian capital markets, which include, dematerialisation of shares, rolling settlement on a T+2 basis, and client level and VaR (Value at Risk) based margining in both the derivatives and cash markets. Globalisation of the Indian economy has also picked up pace during the last few years with increasing numbers of foreign institutional (portfolio) investors (FIIs) and mutual funds (MFs) using the Indian securities market, and a number of Indian corporates approaching the global market through ADR/GDR issues; all of these entities use the derivatives market for hedging various risk exposures. Proposals for demutualisation of exchanges as well as a gradual convergence of the commodities and securities derivatives markets are also under serious discussion. This therefore appears to be an appropriate time for a comprehensive review of the developments in the Indian derivatives markets. The rest of the paper is arranged as follows. The next section describes in brief the main benefits of and some caveats linked to the derivatives markets. Sections III, IV and V present accounts of the main trends in the Indian commodity, exchange rate and financial derivatives markets, respectively. Section VI deals with the regulatory provisions intended to minimise misuse of derivatives products. Section VII concludes with a brief on our future research interests.

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Globalisation of the Indian economy has also picked up pace during the last few years with increasing numbers of FIIs and MFs using the Indian securities market, and a number of Indian corporates approaching the global market through ADR/GDR issues; all of these entities use the derivatives market for hedging various risk exposures.

II. Derivatives Trading: Benefits and Caveats


Derivatives markets provide at least two very important benefits to the economy. One is that they facilitate risk shifting, which is also known as risk management or hedging or redistributing risk away from risk averse investors towards those more willing and able to bear risk. People and businesses who have exposure to risk can either hedge against that risk with a derivatives contract or seek insurance against losses that could occur if the contingencies created by the risk materialise. There are various sources of risk associated with traditional capital vehicles such as bank loans, equities, bonds and foreign direct investment [Box 2]. The financial innovation of introducing derivatives to capital markets allows these traditional arrangements of risk to be redesigned so as to better match the desired risk profiles of the issuers and holders of these capital instruments. If the hedging is done using (say) a futures contract, it typically involves having a portfolio of the spot asset, and an equal and opposite position in a

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related futures contract. A perfectly hedged portfolio is one where the price risk of the portfolio is zero. Risk shifting in turn facilitates capital flows by unbundling and then more efficiently reallocating the different sources of risk. It also increases investment flows by bringing in more and more risk-averse investors.

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BOX 2: Some probable risk scenarios


participant exposed to
credit risk exchange rate risk interest rate risk interest rate risk greater credit risk refunding or liquidity risk credit risk; market risk from changes in the exchange rate, market price of the stock, and uncertain dividend payments credit risk and market interest rate risk exchange rate risk.

The other benefit of derivatives markets is that they create price discovery, i.e. the process of determining the price level for a commodity, asset or other item based on supply and demand. An efficient financial market is one, where forecasts about future risk and return determine valuation.

foreign currency loans => fixed interest rate loan => variable rate loan => long-term loan => short-term loan => equities =>

foreign investor domestic borrower (foreign) lender domestic borrower (foreign) lender domestic borrower (foreign) investor

bonds => hard currency bonds =>

(foreign) investor domestic borrower

The other benefit of derivatives markets is that they create price discovery, i.e. the process of determining the price level for a commodity, asset or other item based on supply and demand. An efficient financial market is one, where forecasts about future risk and return determine valuation. Thus the price observed at an instant in time on the ideal efficient market is a good assessment of future risk and return. In an efficient market new information is rapidly captured into prices, a better market being one that reacts faster. However, these prices are not constant, because new information is being continually generated in the economy and speculative and arbitrage activities help in the alignment of the market price in accordance with the new information. Speculators observe the new information, take a fresh view on risk and return, and if they perceive3 that the present valuation on the market is out of date, speculators risk their capital in taking positions on the market. If a speculator thinks that new information justifies a lower valuation he short sells the security, and vice versa. An arbitrageur operates when he sees a pricing error that has given rise to an opportunity for riskless (high) returns. In the derivatives market arbitrage consists of, say, comparing the price of the index futures with the index at any point in time. When the futures are too costly, the

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Based on their knowledge and experience on asset price movements.

arbitrageur will sell futures and buy in the spot market, or vice versa. These activities serve to feed new information into market prices. Efficiency in the derivatives market is an outcome of a combination of factors such as lower costs leading to higher liquidity and higher competition as compared with the cash/spot market.4 Despite their advantages, market participants and regulators need to be cautious regarding derivatives. This concern with derivatives can be divided into two categories. The first is best termed abuse of derivatives and the second can be described as negative consequences from the misuse of derivatives (Dodd, 2003). The former is similar to any financial market manipulation and poses a threat to the integrity of markets and the information content of prices. In other words, they increase capital costs due to malpractices in financial and commodity markets, and they reduce market efficiency by distorting market prices. If incidents of manipulation keep wary investors away from derivatives markets, then market activity suffers from lower trading volume thus reducing liquidity and possibly causing a higher risk premium to be priced in. Cases often involve small changes in prices that generate substantial gains through large derivatives positions. However, small distortions in prices can have a profound impact on the economy especially if they affect major cash crops, commodity exports or key consumer goods. Investors sometimes abuse derivatives in order to manipulate accounting rules and financial reporting requirements, to dodge prudential market regulations such as restrictions on foreign exchange exposure on financial institutions balance sheets, or to evade or avoid taxation.5 It has been pointed out that derivatives allow financial institutions to change the shape of financial instruments in such a way as to circumvent financial regulations in a fully legal way. (Dodd, 2003). The use of derivatives to circumvent or outflank prudential regulation has been acknowledged by the IMF, World Bank and the OECD, among others. The World Banks Global Development Finance 2000 stated it in the following way: Brazils complex system of prudential safeguards was easily circumvented by well-developed financial market and over-the-counter derivatives. Derivatives

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Investors sometimes abuse derivatives to manipulate accounting rules and financial reporting requirements, to dodge prudential market regulations such as restrictions on foreign exchange exposure on financial institutions balance

4 In a derivatives market investors can use a small amount of funds to command more resources as buying a derivatives contract costs a fraction of the amount needed to actually buy the underlying security. This in turn encourages operators to use the market extensively for their hedging, speculative and arbitrage operations adding to market liquidity and creating a competitive market. 5 An example drawn from the US experience involves two financial institutions Fannie Mae and Freddie Mac who are arguably the worlds largest hedgers. They admitted having filed financial reports which falsely understated the value of their derivatives positions by billions of dollars. The collapse of the energy merchant corporation Enron exposed their extensive use of derivatives for the purpose of fabricating income and revenue, hiding debt as well as manipulating market prices. Although these examples are from a developed economy, they serve as a telling example that even in a well regulated financial market derivatives can well be misused.

sheets, or to evade or avoid taxation.

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Together, these features facilitate greater risk taking for a given amount of capital, and the extent of their use for risk taking can result in greater overall levels of exposure to price risk for a given amount of capital in the entire financial system.

allowed Mexican banks to circumvent national regulations and to build up a foreign exchange position outside of official statistics and unknown to policy-makers and a large part of market participants. The second area of concern relates to negative consequences that may arise even if derivatives are not purposely being used for bypassing regulations. One of the key features of derivatives contracts is that they provide leverage to all users. Leverage in this context means the quotient of the size of the price exposure (measured in notional value or the amount of underlying assets or commodities) divided by the amount of initial outlay required to enter the contract. In addition to providing leverage, derivatives sometimes further lower the cost of taking on price exposure because of lower transactions costs and higher levels of liquidity. Together, these features facilitate greater risk taking for a given amount of capital, and the extent of their use for risk taking can result in greater overall levels of exposure to price risk for a given amount of capital in the entire financial system. Such misuse also poses a threat to the stability of the financial sector and the overall economy by increasing systemic risk, risk of contagion and possibly serving as a catalyst or an accelerator to financial disruption or crisis. Liquidity is another critical issue in derivatives markets. Illiquidity due to any set of factors ranging from market concentration to faulty infrastructure or malpractices can pose a serious threat to the derivatives market. While illiquidity is troublesome in securities markets because it hampers the ability of investors to adjust their positions and to observe correct market prices, it is not likely to leave investors with new levels of exposure. In derivatives markets, trading is a critical component of a risk management policy as hedgers and speculators regularly trade in the market in order to dynamically manage an investment strategy. If the continuity in trading were to be interrupted, then it might prevent them from rolling-over positions or offsetting other positions in securities and other asset markets. This could leave a large number of investors with market risk exposures that they did not intend, and could thus lead to a systemic payments failure across markets.

III. Commodity Derivatives Market


Though India is considered a pioneer in some forms of derivatives in commodities, the history of formal commodity derivatives trading is rather chequered. The first derivatives market for cotton futures was set up in Mumbai, followed by the establishment of futures markets in edible oilseeds complex, raw jute and jute goods and bullion. Organised futures market in India dates back to the setting up of Bombay Cotton Trade Association Ltd. in 1875.6 Organised futures
6 Just a year after the establishment of Chicago Produce Exchange (now Chicago Mercantile Exchange) in 1874. The first organised commodity trading exchange, the Chicago Board of Trade, was set up in 1848.

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trading in oilseeds was started in India with the setting up of Gujarati Vyapari Mandali way back in 1900. Futures trading in Raw Jute and Jute Goods began in Kolkata with the establishment of the Calcutta Hessian Exchange Ltd., in 1919. In the case of wheat, futures markets were in existence at several centres in Punjab and Uttar Pradesh; the most notable among them was the Chamber of Commerce at Hapur, which was established in 1913. Futures market in Bullion began in Mumbai as early as 1920. The volumes of trade in these derivatives markets were reported to be extremely large. However, with enactment of Defence of India Act, 1935, futures trading became subject to restrictions/prohibition from time to time. After Independence, the Union Government enacted the Forward Contracts (Regulation), 1952; this Act provided for prohibition of options in commodities and regulation and prohibition of futures trading. By the mid-1960s, the Government imposed a ban on derivatives contracts on most commodities, except very few not so important commodities like pepper and turmeric. The apprehensions about the role of speculation, particularly under scarcity conditions, prompted the Government to continue the prohibition till very recently. After the introduction of economic reforms since June 1991 the gradual withdrawal of the procurement and distribution channels7 necessitated setting in place a market mechanism to introduce price discovery and risk management functions in the sphere of agriculture. It was generally agreed that the derivatives markets play a valuable role in shaping decisions of the market intermediaries, including decisions by farmers about sowing and investments in inputs; smoothing price volatility; and giving farmers and consumers better means of protecting themselves against the adverse effects of seasonal/annual price volatility.8 The argument articulated in the National Agricultural Policy of the Government of India, 2000, was: if derivatives markets can function adequately well, then the core policy goals of reducing volatility of agricultural prices can be addressed in a market-oriented fashion. As a follow-up the Government issued notifications in April 2003, permitting futures trading in commodities.9 The problem, however, with most of the traditional or regional exchanges is that they deal in individual

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By the mid-1960s, the Government imposed a ban on derivatives contracts on most commodities. The apprehensions about the role of speculation, particularly under scarcity conditions, prompted the Government to continue the prohibition till very recently.

Where the Government ensures availability of agricultural produce by trying to maintain buffer stocks, fixing prices, having import-export restrictions and a host of other interventions. 8 A committee on Forward Markets under Chairmanship of Prof. K.N. Kabra, which submitted its report in September 1994, recommended futures trading in select cash crops along with modernisation of some traditional exchanges. Earlier, the Khusro Committee (June 1980) had recommended reintroduction of futures trading in most of the major commodities, including potato and onions in select seasons. 9 From 1998 onwards, domestic entities facing price risk abroad had been given permission to utilise foreign derivatives exchanges in addressing their risk management needs. Options trading in commodity is however presently prohibited in India.

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As of now the country has three national level electronic exchanges and 21 regional exchanges for trading commodity derivatives, which trade in 80 commodities. These demutualised exchanges are technology driven and have adopted international best practices of risk management for trading, clearing and settlement.

commodities and are extremely region centric, and hence derivatives trading is highly fragmented. Thus along with the removal of prohibitions on futures trading in a number of commodities a reforms programme towards building commodity futures exchanges has been initiated under the aegis of the Forward Markets Commission (FMC), constituted under the Ministry of Consumer Affairs and Public Distribution. As of now the country has three national level electronic exchanges and 21 regional exchanges for trading commodity derivatives, which trade in 80 commodities.10 These demutualised exchanges are technology driven and have adopted international best practices of risk management for trading, clearing and settlement.11 The total one-way turnover in value terms in commodity futures registered a jump of about 200 per cent, from about Rs. 35,000 crore in 2001-02 to Rs. 68,000 crore in 2002-03 and to Rs. 1,30,000 crore in 2003-04. The value of trade in 2005-06 has been Rs. 21,34,471.5 crore.12 Daily volumes across the countrys national and regional commodity exchanges now exceed Rs. 5000 crore, with Gold, Silver and Crude Oil, Chana, and Guar Seed registering highest volumes of trade in recent times [Table 2].13 The main players are commodity and stockbrokers, agro-processors, high net worth individuals and corporates. There are certain problems specific to large scale trading in commodity derivatives, as unlike securities, commodities come in different grades and qualities, particularly in a large country like India with varied weather and soil conditions. The prices of commodities are influenced by their quality, grades, seasons of production, quality of storage and warehousing, etc. Commodities are also bulky involving difficulties in transportation, which affect spatial integration. These issues can be addressed by introducing a nationwide warehouse receipt system, which is an important mode of settlement of commodity derivatives contracts internationally. But this will have to be preceded

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10 The development of the pepper futures market at Kochi (The Indian Pepper and Spice Traders Association, IPSTA), the castor seed futures market at Vashi, cotton futures market at Mumbai, and the Coffee Owners Futures Exchange of India (COFEI) are significant milestones in the history of Indian commodity derivatives. 11 One of the Exchanges, i.e., National Multi-commodity Exchange of India Ltd. (NMCEIL), has Central Warehousing Corporation, NAFED (Government of India enterprises) and Gujarat Agro Industries Corporation (Gujarat State Government) as prominent promoters. The National Commodities Derivative Exchange Ltd. (NCDEX) has been promoted by a consortium comprising ICICI Bank, National Stock Exchange, Life Insurance Corporation, and NABARDall of them being leaders in their respective fields. 12 In 2005 Indian capital markets crossed another milestone as for the first time, commodity futures volumes in India overtook stock futures turnover; with over Rs. 1,66,000 crores turnover as against Rs. 1,63,000 crore of futures trades in NSE during the month. 13 Trade in both gold and silver have registered manifold jumps in the last financial year. Brent crude, which was launched in September 2005, registered a total volume of Rs. 5,270 crore (19 million barrels) in just six months.

TABLE 2 Turnover in Commodity Derivatives Exchanges Commodity Total* NCDEX Top 10 commodities on NCDEX Guar Seed Chana Urad Silver Gold Tur Guar gum Refined Soya Oil Sugar % of volumes Pulses Guar Bullion *For 24 Commodity exchanges Source: FMC. Turnover in 2005-06 (Rs. Crore) 21,34,472 10,67,696 306,900 219,000 178,800 85,600 47,600 36,600 35,900 25,900 25,600 Turnover in 2004-05 (Rs. Crore) 13,87,780 7,46,775

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33,200 660

The economic principle is to treat the warehouse receipt as negotiable

40% 30% 12%

and fungible; important gains could be obtained by modifying the legal structure so that warehouse receipts become negotiable and by dematerialising warehouse receipts at NSDL and CDSL.

by appropriate upgrade of the systems and creation of a regulatory apparatus to facilitate development and adoption of uniform standards, and creation of facilities for scientific grading, packing, storage, preservation and certification at the warehouses. A sophisticated warehousing service has yet to come about in India. At present the public sector dominates warehouse facilities and the Central Warehousing Corporation and State Warehousing Corporations account for approximately more than three quarters of the total warehousing capacity in the country. The economic principle is to treat the warehouse receipt as negotiable and fungible; important gains could be obtained by modifying the legal structure so that warehouse receipts become negotiable and by dematerialising warehouse receipts at the National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL). The Food Ministry is in the process of drafting a Warehouse Development & Regulation Act to promote warehouse receipts-based lending and commodity derivatives transactions. The proposed legislation would basically enable the creation of a regulatory authority for accreditation of warehouses and the setting of the relevant standards to be made applicable for scientific grading, packing, storage, preservation and certification of commodities at the warehouses. This would ensure that the warehouse receipts issued by them are tradable and can be used as negotiable collaterals. Indias first National Spot Exchange for Agriculture Produce (NSEAP) has been set

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In a measure that could largely enrich commodity futures trading, the Government is ready to allow banks to trade in commodity derivatives. Banks, mutual funds, foreign institutional investors and primary dealers were so far restricted from participating in commodity futures trading.

up in 2005, paving the way for linking all agriculture produce marketing cooperatives (APMC)14 and other physical market players on an electronic platform. In a measure that could largely enrich commodity futures trading, the Government is ready to allow banks to trade in commodity derivatives.15 Banks, mutual funds, foreign institutional investors and primary dealers were so far restricted from participating in commodity futures trading. The case for allowing banks entry into commodity futures trading has been argued not only to boost liquidity and turnover volumes, but to also provide them with a protective cover against default on agricultural loans. Under the new arrangement, banks would lend to farmers or cooperatives and simultaneously encourage them to sell into futures contracts. This would help reduce the risk of farmers defaulting on their loans in the event of a fall in spot commodity prices. It also appears that there is a potential for gains to the economy from pursuing convergence by removing the present legal and institutional walls that separate the commodity futures market from the securities markets as it would allow the less developed commodities market to reap the benefits of infrastructural and regulatory development in the securities market. To the extent that convergence of financial and commodity derivatives markets helps speed up the migration of commodity futures markets into screen-based, anonymous order matching, it would indirectly assist the strengthening of agricultural spot markets and would also help in the integration of the Indian commodity derivatives market with global markets. Studies on the US market have shown that there is a significant difference in the volatility patterns of these two assets; thus the inclusion of commodity exposures in a diversified portfolio can reduce the overall volatility while significantly improving the return potential of the portfolio16 (Gorton and Rouwenhorst, 2006). Thus availability of financial and physical derivatives on the same platform could help to widen and deepen both markets as investors have more choice and they may benefit from portfolio strategies involving both underlyings.

IV. Foreign Exchange Derivatives


During the period 1975-1992, the exchange rate of the rupee was officially set by the Reserve Bank of India (RBI) in terms of a (weighted) basket of currencies of Indias major trading partners and there were significant restrictions on not only capital but current

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At present 7,325 APMCs of the country dealing in 140 crops. A Working Group on Warehouse Receipts and Commodity Futures (headed by Mr. Prashant Saran) recommended that banks may be permitted to offer futures-based products to farmers in order to enable them to hedge against price risk. 16 Besides diversification, commodity futures could help portfolio managers control inflation risk as commodity futures returns are seen to be positively correlated with inflation, unexpected inflation, and changes in expected inflation.
15

14

account transactions as well. Since the early nineties, India is on the path of a gradual progress towards capital account convertibility. The emphasis has been shifting away from debt creating to non-debt creating inflows, with focus on more stable long term inflows in the form of foreign direct investment and portfolio investment. The exchange rate regime has evolved from a single-currency fixed-exchange rate system to fixing the value of the rupee against a basket of currencies and further to a market-determined floating exchange rate regime.17 The Indian foreign exchange derivatives market owes its origin to the important step that the RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange; as a consequence, the stipulation of maintaining square or near square position was to be complied with only at the close of each business day. This was followed by use of products like cross-currency options, interest rate and currency swaps, caps/collars and forward rate agreements in the international foreign exchange market; development of a rupee-foreign currency swap market; and introduction of additional hedging instruments such as foreign currency-rupee options. Cross-currency derivatives with the rupee as one leg were introduced with some restrictions in the April 1997 Credit Policy by the RBI. In the April 1999 Credit Policy, Rupee OTC interest rate derivatives were permitted using pure rupee benchmarks, while in April 2000, Rupee interest rate derivatives were permitted using implied rupee benchmarks. In 2001, a few select banks introduced Indian National Rupee (INR) Interest Rate Derivatives (IRDs) using Government of India security yields as floating benchmarks. Interest rate futures (long bond and t-bill) were introduced in June 2003 and Rupee-foreign exchange options were allowed in July 2003. The Indian foreign exchange derivatives market is predominantly a transactions based market with the existence of underlying foreign exchange exposure being an essential requirement for market

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The Indian foreign exchange derivatives market owes its origin to the important step that the RBI took in 1978 to allow banks to undertake intraday trading in foreign exchange; as a consequence, the stipulation of maintaining square

The Indian foreign exchange market had been heavily controlled, along with increasing trade controls designed to foster import substitution. Consequently, both the current and capital accounts were closed and foreign exchange was made available by the RBI through a complex licensing system. With the initiation of economic reforms in July 1991, there was a downward adjustment in the exchange rate of the rupee with a view to placing it at an appropriate level in line with the inflation differential to maintain the competitiveness of exports. Subsequently, following the recommendations of the High Level Committee on Balance of Payments (Chaired by Dr. C. Rangarajan), the Liberalised Exchange Rate Management System (LERMS) involving dual exchange rate mechanism was instituted in March 1992, which was followed by the ultimate convergence of the dual rates effective from March 1993 (christened modified LERMS). The unification of the exchange rate of the rupee marks the beginning of the era of market determined exchange rate regime of the rupee, based on demand and supply in the foreign exchange market. It is also an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

17

or near square position was to be complied with only at the close of each business day.

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The foreign exchange derivatives products that are now available in Indian financial markets can be grouped into three broad segments, viz.

users. Similarly, regulations in most cases require end users to repatriate and surrender foreign exchange in the Indian foreign exchange market. The foreign exchange market is made up of Authorised Dealers (ADs, generally banks), some intermediaries with limited authorisation, and end users, viz., individuals, corporates, institutional investors and others. Market making banks (generally foreign banks and new private sector banks) account for a significant percentage of the overall turnover in the market. The foreign exchange derivatives products that are now available in Indian financial markets can be grouped into three broad segments, viz. forwards, options and currency swaps. Foreign exchange derivatives are mainly used for risk management purposes by corporates, for hedging of commodity price risk in international commodity markets, and for hedging exchange rate risk by FIIs, NRIs and other overseas investors. India has a strong dollar-rupee forward market with contracts being traded for one, two, ... six month expiration. The daily trading volume in this forward market is around US$500 million a day. The exposures for which the rupee forward contracts are allowed under the existing RBI notification for various participants are as follows:
Residents: Foreign Institutional Investors: FIIs are allowed to hedge the market value of their entire investment in equity and/or debt in India as on a particular date Hedge value not to exceed 15 per cent of equity as of 31 March 1999 plus increase in market value/inflows Reviews based on the market price movements, fresh inflows, amounts repatriated and other relevant parameters to ensure that the forward cover outstanding is supported by an underlying exposure Non-resident Indians/ Overseas Corporates Dividends from holdings in an Indian company

Genuine underlying exposures out of trade/ business Exposures due to foreign currency loans and bonds approved by the RBI Receipts from GDR issued

forwards, options
and currency swaps.

Deposits in Foreign Currency NonResident (FCNR) and Non-Resident External (NRE) accounts Investments under portfolio scheme in accordance with (the earlier Foreign Ex change Regulation Act, or FERA) the Foreign Exchange Management Act (FEMA)

Balances in Exchange Earners Foreign Currency (EEFC) accounts

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Source: Master Circular No. /06/2005-06; RBI

Forward contracts are also allowed to be booked for foreign currencies (other than Dollar) and Rupee, subject to similar conditions as mentioned above. Banks are allowed to enter into forward contracts to manage their asset-liability portfolios. The Indian forwards market is relatively illiquid for standard maturity contracts as most of the contracts traded are for the month-ends only. Currency options provide a way of availing benefits of the upside from any currency exposure while being protected from the downside, for the payment of an upfront premium; these contracts were allowed in the Indian market to be used as a hedge for foreign currency loans. It was required that the option did not involve the rupee, the face value did not exceed the outstanding amount of the loan, and the maturity of the contract did not exceed the unexpired maturity of the underlying loan. Adding to the spectrum of hedge products available to residents and non-residents for hedging currency exposures, the RBI permitted foreign currencyrupee options with effect from July 2003 to be offered by select ADs who satisfy certain capital adequacy and risk management norms. As of now, ADs have been permitted to offer only plain vanilla European options. Customers can also enter into packaged products involving cost reduction structures18 provided the structure does not increase the underlying risk and does not involve customers receiving premium. Writing of options by customers is, however, not permitted. Option contracts are settled on maturity either by delivery on spot basis or by net cash settlement in Rupees on spot basis as specified in the contract. In case of unwinding of a transaction prior to maturity, the contract may be cash settled based on the market value of an identical offsetting option. ADs in turn can use the product for the purpose of hedging trading books and balance sheet exposures. Market makers are allowed to hedge the Delta of their option portfolio by accessing the spot markets. Other Greeks (Gamma, Vega Theta, Rho) may be hedged by entering into option transactions in the interbank market.19

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Adding to the spectrum of hedge products available to residents and non-residents for hedging currency exposures, the RBI permitted foreign currencyrupee options with effect from July 2003 to be offered by select ADs who satisfy

18 These products are predetermined combinations of options. For example, they may allow one to negotiate a range of rates instead of one single exchange rate. This range will enable the customer to take advantage of favourable changes in the currency, while having a safety net in case of unfavourable fluctuations. They are more cost effective than buying different options for various anticipated risk scenarios. The RBIs requirement that no premiums are earned from them ensures that such options are used solely for hedging purposes. 19 Option premium (price of an option) is affected by volatility of the stock price and by some other factors. These factors are collectively called as the Greeks. Each risk measurement is named after a different letter in the Greek alphabet. Delta, Gamma, Theta, Vega and Rho are the five major factors that affect the option premium. These Greeks do not take a fixed value but are interdependent. For example, Delta measures how much the options premium would change if the underlying stock price changes while Gamma indicates the pace at which the option premium changes with changes in the stock price or effectively the rate at which delta will change.

certain capital adequacy and risk management norms.

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There is some activity in other cross currency derivatives product markets also, which are allowed for hedging foreign currency liabilities provided these have been acquired in accordance with the RBI regulations. The products that may be used are: Currency Swap, Rupee Interest Rate Swap (IRS), Interest Rate Cap or Collar (purchases), and Forward Rate Agreement (FRA) contracts [Box 3]. Among various swap contracts, the Overnight Index Swap (OIS) based on the Mumbai Inter Bank Offer Rate (MIBOR) is a very liquid contract with up to five years maturity as overnight rates have been the most widely accepted benchmark for floating rate bond issues in the cash market and the overnight money market is deep and liquid. The Mumbai Inter Bank Forward Offered Rate (MIFOR20 ) Swap, another liquid floating rate swap contract, is calculated based on the covered interest arbitrage formula using the USD LIBOR (London Inter Bank Offer Rate). CMT Swaps are based on the Constant Maturity INR Government Securities Yield; increasing activity is being seen in this market with a lot of issuers hedging their fixed rate borrowings as the underlying INR
TABLE 3 Foreign Exchange ContractsIndia Turnover in nominal or notional principal amounts* (USD mln.) 2004 Domestic currency against Instruments Spot Outright Forwards over seven days and up to one year (percentage) Foreign Exchange Swaps seven days or less (percentage) over seven days and up to one year (percentage) Currency Swaps OTC Options Sold Bought USD 70218.00 20225.76 14829.00 73.32 57282.00 27580.64 48.1 26826 46.8 2051.00 1365.00 692.00 673.00 All Currencies 71972.00 22539.00 17128.00 75.99 57297.39 27592.75 48.2 26829 46.8 2096.00 1365.00 692.00 673.00 USD 28232.65 7391.42 4952.58 67.00 38530.99 20355.85 52.8 17915.97 46.5 12.25 0.00 0.00 0.00 2001 All Currencies 28232.65 7698.18 5222.70 67.84 38577.17 20364.08 52.8 17953.92 46.5 16.78 0.00 0.00 0.00

*Turnover for the month of April in the respective years. BIS, Central Bank Survey of Foreign Exchange and Derivatives Market Activity.

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20 As published jointly by Fixed Income Money Market and Derivatives Association of India (FIMMDA) and the National Stock Exchange of India (NSE).

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BOX 3: Foreign Exchange Contracts OIS (Overnight Indexed Swap) INR-MIBOR (Mumbai Inter Bank Offer Rate) Overnight Indexed Swaps are benchmarked typically against FIMMDA-NSE MIBOR rates Pay simple Fixed Rate against receipt of overnight Floating Rate for tenures up to (and including) one year. Pay simple semi-annual Fixed Rate against receipt of overnight Floating Rate for tenures longer than one year. Pay simple Fixed Rate against receipt of overnight Floating Rate for tenures up to (and including) one year. Pay simple semi-annual Fixed Rate against receipt of overnight Floating Rate for tenures longer than 1 year. Pay annual Fixed Rate against receipt of three month Floating Rate for tenures up to (and including) one year. Pay semi-annual Fixed Rate against receipt of six month Floating Rate for tenures longer than one year. Pay annual Fixed Rate against receipt of three month Floating Rate for tenures up to (and including) one year. Pay semi-annual Fixed Rate against receipt of six month Floating Rate for tenures longer than one year. Pay annual Fixed Rate against receipt of annualised Floating Rate for all tenures. Pay annual Fixed Rate against receipt of annualised Floating Rate for all tenures. Customer pays, say, USD 12 month LIBOR, in-arrears quantoed into INR (i.e. fixings are in USD LIBOR but all payments made in INR and are calculated based on an INR notional). Parties to exchange a given amount of one currency for another and to pay back with interest these currencies in the future.

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INR-MITOR (Mumbai Inter Bank Tom(orrow) Offer Rate) INR-MIFOR (Mumbai Inter Bank Forward Offered Rate) INR-MIOIS (Mumbai Inter Bank Overnight Indexed Swap) INR-BMK ( Indian government securities benchmark rate) INR-CMT (Indian Constant Maturity Treasury rate) Quanto swap

It has been well documented that the vast size of daily foreign exchange trading, combined with the global interdependencies of the foreign exchange market and payment systems, involves risks stemming from settlement of foreign exchange trades on

XCS (Cross Currency Swap)

Government Securities market is now quite deep and liquid. Quanto Swap is another interesting derivative product which aims to minimise both currency and interest rate risk. It is a dual swap combining the fixing of the exchange rate and interest rate at the same time. An important element in the infrastructure for the efficient functioning of the foreign exchange market has been the clearing and settlement of inter-bank USD-Rupee transactions. It has been well documented that the vast size of daily foreign exchange trading, combined with the global interdependencies of the foreign exchange market and payment systems, involves risks stemming from settlement of foreign exchange trades on gross basis. Settlement of foreign

gross basis.

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The first step towards introduction of financial derivatives

exchange transactions spans different time zones and payment systems. As a result, counterparties assume various types of risks in the course of settlement. As suggested by the Sodhani Committee, the RBI took the initiative to establish Clearing Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets. CCIL undertakes settlement of foreign exchange trades on a multilateral net basis through a process of novation and all trades accepted are guaranteed for settlement.21 In 2006, on an average, CCIL has settled over 4,000 deals daily, covering an average gross volume of around US$4.5 billion. CCIL also launched its foreign exchange trading platform, FXCLEAR, in August 2003, which offers an anonymous order driven dealing platform. It covers the inter-bank dollar-rupee (USD-INR) Spot and Swap transactions and transactions in major cross currencies like euro, pound or yen (EUR/USD, USD/JPY, GBP/USD etc.). The USD-INR deals constitute about 85 per cent of the total transactions in India in terms of value.

V. Exchange Traded Financial Derivatives

trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the existing prohibition on options in securities, after the NSE requested for permission to trade index futures.

The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the existing prohibition on options in securities, after the National Stock Exchange (NSE) requested for permission to trade index futures. However, as there was no regulatory framework to govern trading of derivatives, the financial market regulator SEBI set up a 24-member Committee under the Chairmanship of Dr. L.C. Gupta in November 1996 to develop an appropriate regulatory framework for derivatives trading in India. The Committee recommended that derivatives should be declared as securities so that the regulatory framework applicable to trading of securities could also govern trading in derivatives. SEBI also set up a group in June 1998 under the Chairmanship of Prof. J.R. Varma, whose report, submitted in October 1998, presented the operational details of the margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. The Securities Contracts (Regulation) Act, 1956, was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. Derivatives were formally defined to include: (a) a security derived from a debt instrument, share, loan whether secured or

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21 Every eligible foreign exchange contract, entered into between members, will get novated or be replaced by two new contractsbetween CCIL and each of the two parties, respectively. Following the multilateral netting procedure, the net amount payable to, or receivable from, CCIL in each currency will be arrived at, member-wise. The Rupee leg will be settled through the members current accounts with the RBI and the USD leg through CCILs account with the Settlement Bank at New York.

unsecured, risk instrument or contract for differences or any other form of security, and (b) a contract which derives its value from the prices, or index of prices, or underlying securities. The Act also stipulates that derivatives shall be considered legal and valid only if such contracts are traded on a recognised stock exchange, thus precluding OTC derivatives. Equity derivatives trading finally commenced in India in June 2000. SEBI permitted the derivatives segments of two stock exchanges, viz., NSE and BSE, and their clearing houses/corporations to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on the S&P CNX Nifty Index and BSE-30 (Sensex) Index. These indices were obviously the first choice as the diversification within Nifty/ Sensex serves to cancel out influences of individual companies or industries; thus the underlying Nifty/Sensex reflects the overall prospects of Indias corporate sector and Indias economy. The indices move with events that impact the economy, such as politics,22 macroeconomic policy announcements, interest rates, money supply and government budgets, shocks from overseas, etc. Index futures trading was followed by approval for trading in options based on these two indices and options on individual securities. The trading in index options commenced in June 2001 and trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. In June 2003, SEBI/RBI approved trading in interest rate derivatives instruments and NSE introduced trading in futures contracts in (notional)23 91-day T-bills and 10-year 6 per cent coupon bearing bonds. NSE also introduced trading in futures and options contracts based on the CNX-IT index from August 2003. Exchange traded interest rate futures on a (notional) zero coupon bond priced off a basket of Government Securities were permitted for trading in January 2004. In India, trading and settlement in derivatives contracts are done in accordance with the rules, bye-laws, and regulations of the respective exchanges and their clearing houses/corporations, duly approved by SEBI and notified in the official gazette. National Securities Clearing Corporation (NSCCL) undertakes clearing and settlement of all deals executed on the NSEs F&O (Futures and Options) segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. FIIs, who were initially allowed to buy and sell only index futures contracts traded on a stock exchange, have been permitted to trade in all exchange traded derivatives contracts since February 2002. MFs were initially permitted to participate in the

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In India, trading and settlement in derivatives contracts are done in accordance with the rules, bye-laws, and regulations of the respective exchanges and their clearing houses/ corporations, duly approved by SEBI and notified in the official gazette.

22 Politics has come to play a less important role as there is growing evidence that political instability in the country will not significantly affect its economic policies. 23 Derived from the theoretical zero coupon yield curve.

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Indias experience with the launch of equity derivatives market has been extremely positive; within a few years of its inception NSE stood out as one of the most prominent exchanges among all emerging markets, in terms of equity derivatives turnover.

derivatives market only for the purpose of hedging and rebalancing their portfolio. However following the developments in the MF industry as well as in the derivatives market, MFs are now permitted to participate in the derivatives market at par with FIIs. At the NSE, the exchange which accounts for the bulk of the derivatives trading, three Nifty futures contracts trade at any point in time, expiring in three near months [Box 4]. The expiration date of each contract is the last Thursday of the month. The three futures trade completely independently of each other, each having a distinct price and a distinct limit order book. Open positions are squared off in cash on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date, the last mark to market margin is calculated with respect to the spot Nifty instead of the futures price. As is currently the case, mark-to-market losses will have to be paid by the trader to NSCCL; however, mark-to-market profits are to be paid to traders by NSCCL as opposed to cash market transactions. The market lot is 200 Nifties; thus, if Nifty is at 1,500, the smallest transaction will have a notional value of Rs. 300,000. The initial (upfront) margin on trading Nifty is around 7 to 8 per cent; thus, a position of Rs. 300,000 (around 200 Nifties) will require upfront collateral of Rs. 21,000 to Rs. 24,000. Hedged futures positions attract lower marginsif a person has purchased 200 October Nifties and sold 200 November Nifties, the trade will attract much less than 7 to 8 per cent margin. In the present cash market, all positions attract 15 per cent initial (upfront) margin from NSCCL, regardless of the extent to which they are hedged. Indias experience with the launch of equity derivatives market has been extremely positive; within a few years of its inception NSE stood out as one of the most prominent exchanges among all emerging markets, in terms of equity derivatives turnover24 [Table 5]. In the last few years, volumes in the F&O segment have consistently been more than two times of the cash segment of NSE [Chart 1]. The individual stock futures market also has really taken off since its introduction [Chart 2], and cumulatively surpassed even the index futures market. Contracts of almost all of the 118 underlying stocks get traded regularly in the F&O segment of NSE. One of the puzzles in Indias experience with equity derivatives has been the dominance of individual stock derivatives, so much so that in terms of volumes traded Nifty appeared at third rank for futures and fourth rank for options in December 2002. Only in times when macroeconomic news appears to be important Nifty ranked number one in the derivatives section. This is surprising as, logically, index based derivatives should have been a better alternative instrument in a

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24 NSE accounts for the bulk of volumes in equity derivatives. Its turnover accounted for 98 per cent of the total turnover in the year 2001-2002.

I C R A B U L L E T I N

BOX 4: Types of F&O contracts at NSE


Index Futures
Underlying Instrument S&P CNX NIFTY#

Stock Futures
Futures contracts are available on 118 securities which are traded in the Capital Market segment of the Exchange.

Index Options
S&P CNX NIFTY# (European) CE - Call, PE - Put

Stock Options
Options contracts are available on the same 118 securities on which JAN.JUNE.06 Futures contracts are available. (American) CA - Call , PA - Put.

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Trading cycle Expiry day Strike Price Intervals

maximum of 3-month trading cycle: the near month (one), the next month (two) and the far month (three). last Thursday of the expiry month or on the previous trading day if the last Thursday is a trading holiday. NA NA a minimum of five strike prices for every option type (i.e. call & put) during the trading month. At any time, there are two contracts in-the-money (ITM), two contracts out-ofthe-money (OTM) and one contract at-themoney (ATM). The strike price interval is 10. multiples of 100 and fractions if any, shall be rounded off to the next higher multiple of 100. The value of the option contracts on individual securities may not be less than Rs. 2 lakhs at the time of introduction. the lesser of the following:1% of the marketwide position limit stipulated for open positions on options on individual securities or Notional value of the contract of around Rs.5 crores

Contract size

lot size of Nifty futures contracts is 200 and multiples thereof

multiples of 100 and lot size of Nifty options fractions if any, shall be contracts is 200 and rounded off to the next multiples thereof higher multiple of 100. The permitted lot size for the futures contracts on individual securities shall be the same for options or as specified by the Exchange quantity freeze shall be 20,000 units or the lesser of the follow- greater ing:1% of the marketwide position limit stipulated for open positions on the futures and options on individual securities or Notional value of the contract of around Rs.5 crores

Quantity freeze

20,000 units or greater, after which the Exchange may at its discretion approve further orders, on confirmation by the member that the order is genuine.

Price bands

No day minimum/maximum operating ranges are price ranges applicable, kept at + 20% however, operating ranges are kept at + 10%,after which price freeze would be removed on confirmation by the member that the order is genuine.

operating ranges and day minimum/maximum ranges for options contract are kept at 99% of the base price

Contd. /-

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Money Price steps

Index Futures
The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.

Stock Futures
The price step for futures contracts is Re.0.05. the theoretical futures price on introduction and the daily settlement price of the futures contracts on subsequent trading days.

Index Options

Stock Options

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The price step in The price step for respect of S&P CNX options contracts is Nifty options contracts Re.0.05. is Re.0.05. Base price of the new options contracts would be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums.The base price of the contracts on subsequent trading days, will be the daily close price of the options contracts, which is the last half an hours weighted average price if the contract is traded in the last half an hour, or the last traded price (LTP) of the contract. If a contract is not traded during a day on the next day the base price is calculated as for a new contract.

Base Prices. J U N E . 0 6of S&P CNX Base price JAN Nifty futures contracts on the first day of trading would be theoretical futures price. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts.

Order type

Regular lot order; Stop loss order; Immediate or cancel; Good till day/cancelled*/date; Spread order

CNX-IT and BANK NIFTY indices are also traded now. *Good Till Cancelled (GTC) orders are cancelled at the end of the period of 7 calendar days from the date of entering an order. Source: NSE website.

Though NSE ranked ninth among the world exchanges, by total value of bonds traded in 2004 (in USD terms), surprisingly interest rate futures have not taken off at all in India.

developing market, where there may exist information asymmetry in individual stocks whereas the market index is definitely more transparent. However, in recent times this feature has been corrected and Nifty contracts stand out as the most traded in both the F&O segment [Chart 3]. On the other hand, though NSE ranked ninth among the world exchanges, by total value of bonds traded in 2004 (in USD terms), surprisingly interest rate futures have not taken off at all in India [Table 4].
CHART 1 Monthly Turnover at Cash and Derivatives Segments of NSE (Rs. cr.)

Feb.2001

Feb.2002

Feb.2003

Feb-2004

Feb-2005

Oct.2000

Oct.2001

Oct.2002

Feb-2006

Jun.2000

Jun.2001

Jun.2002

Jun-2003

Jun-2004

Jun-2005

Oct-2003

Oct-2004

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Source : NSE

Oct-2005

Jun-2006

800000 700000 600000 500000 400000 300000 200000 100000 0

Equiites

Derivatives

CHART 2 I C R A B U L L E T I N Share of Various Derivative Instruments in Turnover in Derivatives Segment of NSE

Money

100% 80% 60% 40% 20% 0%

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Jun.2000

Jun.2001

Jun.2002

Sep.2000

Sep.2001

Sep.2002

Dec.2000

Dec.2001

Dec.2002

Jun-2003

Sep-2003

Jun-2004

Jun-2005

Sep-2004

Sep-2005

Mar.2001

Mar.2002

Mar.2003

Dec-2003

Dec-2004

Dec-2005

Index Futures Index Options (Put)

Stock Futures Stock Options (Call)

Mar-2004

Index Options (Call) Stock Options (Put)

CHART 3 Most Traded Contracts on NSE Top 5 Most active Futures contracts, May 2005 Top 5 Traded Symbols in Options segment, May 2005

OTHERS 45%

1. NIFTY MAY 2005 33%

5. RELIANCE 4% 4. SBIN 5%

OTHERS 21%

5. RELIANCE MAY 2005 3%

4. SBIN MAY 2005 3%

2. NIFTY JUNE 2005 11% 3. TISCO MAY 2005 5%

3. 3. SATYAMCOMP SATYAMCO 5% MP

Mar-2005

5%

2. TISCO 7%

1. NIFTY 58%

Top 5 Most active Futures contracts, May 2006

Top 5 Traded Symbols in Options segment, May 2006

OTHERS 46%

1. NIFTY MAY 2006 33% 2. NIFTY JUNE 2006 13% 3. RELIANCE MAY 2006 4%

1. NIFTY 36%

5. HINDALCO MAY 2006 1%

4. TATASTEEL MAY 2006 3%

OTHERS 53% 5.HINDALCO 2%

2. RELIANCE 5% 3. INFOSYS 4. MTNL 2% 2%

Source:

NSE.

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Mar-2006

Jun-2006

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Money

TABLE 4 Derivatves Segment at BSE and NSE


BSE Jun00Mar 01 NSE Jun00Mar 01

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Finance
No. of contracts Turnover (Rs. cr.)

20012002

20022003

20032004

20042005

20012002

20022003

20032004

20042005

Index J A N . No. of E . 0 6 77743 79552 111324 246443 449630 90580 1025588 2126763 17192274 21635449 J U N contracts Futures Turnover (Rs. cr.) 1673.0 1276.0 1811.0 6572.0 13600.0 2365.0 21428.0 43951.0 554462.0 772174.0 Stock Futures Index Options 17951 452.0 1139 39.0 1276 45.0 3605 79.0 1500 35.0 25842 128193 644.0 1571.0 41 1.0 2 0.0 783 21.0 19 0.0 1 0.0 0 0.0 4391 174.0 3230 157.0 6725 213.0 48065 1471.0 27210 827.0 72 2.1 17 0.5 1957856 10675786 32485160 47043066 51516.0 286532.0 1305949.0 1484067.0 113974 2466.0 61926 1300.0 269721 5671.0 172520 3577.0 1043894 31801.0 688520 21022.0 4258595 1870647 69373.0 1422911 52581.0 3946979

Call No. of contracts Notional Turnover (Rs. cr.) Put No. of contracts Notional Turnover (Rs. cr.)

Stock Options

Call No. of contracts Notional Turnover (Rs. cr.) Put No. of contracts Notional Turnover (Rs. cr.) No. of contracts Turnover (Rs. cr.)

768159 2456501 18780.0

69644.0 168174.0 132066.0 1338654 49038.0 1013 20 1098133 36792.0

269370 1066561 6383.0 30490.0

Interest Rate Futures Total

No. of contracts 77743 105527 138037 382258 531719 90580 4196873 16767852 56886776 77017185 Turnover (Rs. cr.) 1673.0 1922.0 2478.0 12452.0 16112.0 2365.0 101925.0 439865.0 2130649.0 2547063.0

Source: Handbook of Securities Markets, 2005, SEBI.

TABLE 5 Rank of India in Global and Asian Derivatives Markets NSE Stock Index Options No. of contracts traded Notional Turnover (mln USD) Stock Index Futures No. of contracts traded Notional Turnover (mln USD) Stock Options No. of contracts traded Notional Turnover (mln USD) Single Stock Futures# No. of contracts traded Notional Turnover (mln USD) global rank* AsiaPacific rank** 4 5

239207 22340

10 12

1447464 134192 590300 47841 5238498 412668

7 16 11 6 1 1

4 8 2 2 1 1

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As of end Dec. 2004. *Among 29 member Derivatives Exchanges of the WFE. **Among 11 member Derivative Exchanges of the WFE. #15 member exchanges trading in stock futures contracts. Source: Focus, World Federation of Exchanges.

VI. Regulatory Safeguards


Rapid expansion in newer areas in financial markets naturally brings up the issue of a regulatory framework that can cope with this growth. As pointed out by the Federal Reserve New York25: when innovation, such as we are now seeing in derivatives, takes place in a period of generally favorable economic and financial conditions, we are necessarily left with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances. The first type of regulation required for any derivatives market falls under the rubric of orderly market provisions. These measures, which have been tested over time in securities markets around the world, are designed to facilitate a liquid, efficient market with a minimum of disruptions. Registration and reporting requirements, transparency and creation of a level playing field for all investors alike, a system of mitigation of payments risks and safeguarding investors moneys, are essential requirements. Risk containment measures in turn include capital adequacy requirements of members, monitoring of members performance and track record, stringent margin requirements, position limits based on capital, online monitoring of member positions and automatic disablement from trading when limits are breached. In India, prior to the introduction of derivatives trading, the definition of securities was amended (to include derivatives contracts in the definition of securities) so as to ensure that derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992.26 Derivatives trading in India can take place either on a separate and independent Derivatives Exchange or on a separate segment of an existing Stock Exchange. The Derivatives Exchange/Segment functions as a Self-Regulatory Organisation (SRO) and SEBI acts as the oversight regulator. The key factor enabling exchange-traded derivatives is the credit guarantee supplied by the clearing corporation. SEBI stipulates that the clearing and settlement of all trades on the Derivatives Exchange/Segment would have to be through a Clearing Corporation/ House, which is independent in governance and membership from the Derivatives Exchange/Segment. SEBI has also laid the eligibility conditions for Derivatives Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivatives Exchange/Segment and Clearing Corporation/House provides a transparent trading environment, safety and integrity and
Geithner, 2006. The commodity derivatives market is regulated by the FMC, a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. It is a regulatory authority, which is overseen by the Ministry of Consumer Affairs and Public Distribution, Govt. of India. The foreign exchange derivatives market comes under the purview of the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000.
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The key factor enabling exchangetraded derivatives is the credit guarantee supplied by the clearing corporation. SEBI stipulates that the clearing and settlement of all trades on the Derivatives Exchange/Segment would have to be through a Clearing Corporation/House.

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Stocks on which stock option and single stock future contracts are introduced need to conform to stringent eligibility criteria, which have been formulated keeping in view adequate liquidity, as well as, the volatility it can cause in market prices.

provides facilities for redressal of investor grievances and maintains a separate investor protection fund.27 The Clearing Corporation/House in turn is required to perform full novation, i.e., the Clearing Corporation/ House shall interpose itself between both legs of every trade, becoming the legal counterparty to both, or, alternatively should provide an unconditional guarantee for settlement of all trades. It should institute facilities for electronic funds transfer (EFT) for swift movement of payments and have a separate Trade Guarantee Fund for the trades executed on Derivatives Exchange/Segment.28 Strict eligibility criteria are adhered to when permitting derivatives on a security. Initially, futures and options were permitted only in the two indices with the highest average daily market capitalisation and traded value in the country, namely the 30 share BSE Sensex and 50 share S&P Nifty. Subsequently, sectoral indices were also permitted for derivatives trading subject to the fulfilment of the eligibility criteria. Derivatives contracts are to be permitted on an index if 80 per cent of the index constituents are individually eligible for derivatives trading.29 Stocks on which stock option and single stock future contracts are introduced need to conform to stringent eligibility criteria, which have been formulated keeping in view adequate liquidity, as well as, the volatility it can cause in market prices. SEBI allows three types of Members to do business in the Indian derivatives market. Trading Members (TMs) can trade on their own behalf and on behalf of their clients; Clearing Members (CMs) are permitted to settle their own trades as well as the trades of (other nonclearing members or) TMs who have agreed to settle the trades through them; Self-clearing Members (SCMs) are clearing members who can clear and settle their own trades only. SEBI prescribes Balance Sheet Networth Requirements as well as Liquid Networth Requirements30 for

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27 These conditions require that derivatives trading take place through an on-line screen based Trading System and there are arrangements for dissemination of information about trades, quantities and quotes on a real time basis. The Derivatives Exchange/Segment should have systems for on-line surveillance to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation. 28 In the commodity derivatives market, some of the main regulatory measures imposed by the FMC include daily mark to market system of margins, creation of trade guarantee fund, back-office computerisation for the existing single commodity Exchanges, online trading for the new Exchanges, demutualisation for the new Exchanges, and one-third representation of independent Directors on the Boards of existing Exchanges, etc. 29 However, no single ineligible stock in the index shall have a weightage of more than 5 per cent in the index. 30 Liquid net worth means the total liquid assets deposited with the clearing house towards initial margin and capital adequacy; this should not be less than Rs. 50 lakh at any point in time. These assets must be in the form of cash, fixed deposits, bank guarantees, T-bills, units of MFs, dated government securities or Group I equity securities. SEBI also stipulates rules for managing and valuing the collateral by the clearing house.

all clearing members to ensure that trading member obligations are commensurate with their networth. Certification requirements exist for all Members. Members are required to do business according to the code of conduct specified under the SEBI Broker Sub-Broker regulations.31 Members are required to extend know-your-customer (KYC) rules to all their clients in order to have all relevant information on their operations. The Clearing Corporation has to build a sophisticated risk containment system in order to function seamlessly. The key element of risk containment is the margining system, which involves taking collateral from traders in such a way as to greatly diminish the incentives for traders to default. Capital and collateral requirements need to be updated for all derivatives dealers, so that capital is held in an amount that is commensurate with not only the exposure to credit loss, but also potential future exposure and value at risk (VaR). CMs and TMs are in turn required to collect initial margins from all their clients. The collection of margins at client level in the derivatives markets is also essential as derivatives are leveraged products and noncollection of margins at the client level would provide zero cost leverage. Thus two type of margins have been specified taking a portfolio based margining approach, which takes an integrated view of the risk involved in the portfolio of each individual client comprising his positions in all derivatives contracts, i.e. Index Futures, Index Option, Stock Options and Single Stock Futures.32 Initial Margin is based on 99 per cent VaR and worst case loss over a specified time horizon. It is adjusted from the available liquid networth of the CM on an online real time basis.33 Mark to Market Margin (MTM) is the net option value (positive for long positions and negative for short positions) to be adjusted from the liquid networth on a real time basis [Box 5]. The daily closing price of Futures Contract for MTM settlement would be calculated on the basis of the last half an hour weighted average price of the contract. The calculation of daily MTM margin is easily done as the net loss associated with a position and is paid up each evening after trading hours. The correct computation of MTM margin is also to focus on the net loss across all different securities on which long (buy) or short (sell) positions are held by the member. Like futures markets

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The Clearing Corporation has to build a sophisticated risk containment system to function seamlessly. The key element of risk containment is the margining system, which involves taking collateral from traders in such a way as to greatly diminish the incentives for

31 These include authorisation of Sales personnel to do business on the exchanges and entering into a Member-Client Agreement with all clients, educating clients regarding the various types of instruments and associated risks. 32 Margin is collateral that the holder of a position in securities, options or futures contracts has to deposit to cover the credit risk of his counterparty. 33 The correct level of initial margin varies strongly with the portfolio composition of the exposure, whereas simple rules like 1/33 times base capital or 1/10 times base capital, do not work correctly as they charge too little initial margin for risky positions and too much initial margin for relatively safe positions.

traders to default.

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BOX 5: SPAN At the NSEs F&O segment, the actual margining and position monitoring are done on-line, on an intra-day basis. NSCCL uses the SPAN (Standard Portfolio Analysis of Risk) (registered under the Chicago Mercantile exchange) system for the purpose of margining, which is a portfolio based system. The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts for each member. The system treats futures and options contracts uniformly, while at the same time recognising the unique exposures associated with options portfolios like extremely deep out-of-the-money short positions, inter-month risk and inter-commodity risk. Because SPAN is used to determine margin requirements its objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next. In standard pricing models five factors most directly affect the value of an option at a given point of time: 1. Underlying market price 2. Volatility (variability) of underlying instrument 3. Time to expiration 4. Interest rate 5. Strike price As these factors change, the value of options maintained within a portfolio also changes. Thus, SPAN constructs scenarios of probable changes in underlying prices and volatilites in order to identify the largest loss a portfolio might suffer from one day to the next. It then sets the margin requirement to cover this one-day loss.

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MFs are considered as TMs like registered FIIs and treated at par with a registered FII in respect of position limits in index futures, index options, stock options and stock futures contracts.

all over the world, profits are paid by the clearinghouse to members on a daily basis, and losses are paid in to the clearinghouse by members. Daily MTM margins are thus used to break the link between time to expiration and default risk.34 Other regulatory safeguards include imposition of position limits in derivatives markets so as to avoid excessive risk taking by individual entities. Member and Client-wise exposure and position limits and disclosure requirements on positions have been specified by SEBI keeping in view adequate safety margins. Limits are revised from time to time to allow more flexibility in operations or impose more restrictions as per the volatility trends in the market.35 SEBI registered FIIs and their sub-accounts (and NRIs) are treated as TMs and required to pay initial margins, exposure margins and mark to market settle-

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34 Daily settlement, if done correctly, ensures that the higher counterparty risk in the longer run is no longer of any concern. However, wrong margin calculations or delay in payments would render the MTM system ineffective. 35 There are also market wide limits for stock specific products.

ments in the derivatives market as required by any other investor. Further, the FII and its sub-account (and NRIs) are also subject to position limits for trading in derivatives contracts. MFs are considered as TMs like registered FIIs and treated at par with a registered FII in respect of position limits in index futures, index options, stock options and stock futures contracts. These restrictions amount to explicit limitations on risk taking, but not hedging. This measure can be very effective in limiting the amount of carry trade or hot money related transactions. While framing regulations for the derivatives market the regulator cannot afford to lose sight of the core need for ensuring high competition and high liquidity in the market in order to yield fair prices. The key role for policy should be to keep entry barriers low and therefore keep the competitive pressure high. One may argue that high capital adequacy requirements ensure that the risk of counterparty failure is reduced. But a fundamental role 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 very high capital adequacy requirements are not generally recommended, since one of the unfavourable outcomes of setting high capital adequacy requirements is low competitiveness of the industry leading to distorted prices, and distorted prices generate an inferior resource allocation in the economy, regardless of who the manipulation is done by (Shah, 1998). Similarly very strict entry or eligibility criteria should be discouraged as they may effectively become entry barriers. Trading based on relationship and trust is also counterproductive in an exchange traded market as the existence of a clearing corporation encourages anonymous trading and ensures that isolated cases of defaults do not have any effect on the investor as well as the market in general.

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While framing regulations for the derivatives market the regulator cannot afford to lose sight of the core need for ensuring high competition and high liquidity in the market in order to yield fair prices. The

VII. Conclusion
We have seen that all segments of the Indian derivatives market have been rapidly evolving in terms of the variety and sophistication of instruments, range of market participants as well as the volume of turnover. Adequate regulatory measures are also being put in place to try and ensure that adverse effects from excessive leverage in derivatives market do not in any way rupture normal financial market transactions. However, there is a always a need to know how efficiently the derivatives market is functioning and how far the core benefit of price discovery or fair pricing in asset markets is actually being aided by the flourishing derivatives market. There are a number of pointers to the efficient functioning of the derivatives markets. Shah and Thomas (2003) have indicated a few important characteristics of the Indian financial derivatives market, which relate to features like liquidity, volatility, costs and width of the market:

key role for policy should be to keep entry barriers low and therefore keep the competitive pressure high.

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Liquidity as pertaining to transactions costs: a more liquid market is one in which large transactions can be undertaken with low transactions costs. One element of liquidity observed from the electronic limit order book market is the impact cost suffered when placing market orders or the bid-offer spread. Liquidity in Futures versus Options contracts: equally liquid markets suggest that the market participants function efficiently across markets.

The fortnightly average of bid-offer spread for the six month forwards along with the daily market turnover from June 1999 to July 2002 shows that the spreads for the six month forwards have indeed decreased from a high of 2 paise in 1999 to the level of around 0.5 paisa. Nifty futures were the most liquid futures in the country, with a bid/ offer spread less than half that of the most liquid individual stock futures. The spreads suggested that futures were much more liquid than options. Call options appeared to be more liquid than put options. Further, the bid/offer spread on the futures market became worse for various underlyings, when the two-month and threemonth contracts were compared with the near month contract. There was a very dramatic drop-off of liquidity, suggesting that futures liquidity was confined to the near month. The range of observed values seemed to suggest that there is a good deal of potential for intra-day trading on the options market. It was found that equity derivatives trading is more concentrated in the top 10 urban centres, when compared with the equity spot market. Turnover from outside the top 10 centres amounted to about 14 per cent for the equity spot, but only 5 per cent for equity derivatives. Along with geographical concentration there was concern over a sharp concentration of derivatives market turnover and positions among a very small set of brokerage firms.

There is a always a need to know how efficiently the derivatives market is functioning and how far the core benefit of price discovery or fair pricing in asset markets is actually being aided by the flourishing derivatives market. There are a number of pointers to the efficient functioning of the derivatives markets.

Volatility: in a rational world, the markets implied volatility should reflect a good forecast of the average volatility expected from trade date till expiration date. Market width: A nationwide network of brokerage firms is a key element of a successful derivatives market.

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Analysis suggested that there are still Efficiency: in the ideal efficient market, transactions costs should be plenty of opportunities in establishing equity derivatives arbitrage zero, and there should be a fair activities. number of sophisticated arbitrageurs.

Thus overall it was found that in the early years of the equity derivatives market there was a degree of concentration in the market and consequent lack of width and depth across segments. Further there were violations of put-call parity, and consequential arbitrage opportunities. There is a need to see how these attributes have changed over time along with increased participation in the market and whether the growing volumes are in corroboration with a move towards more efficient markets.36 An efficient derivatives market ought to play a lead role in the process of price discovery for the underlying. The relationship between spot and futures markets in price discovery has thus been an important area of research. This broadly amounts to analysing whether price innovations appear first in the futures market and are then transmitted down into the spot market. In our future research, we propose to inquire into the presence or absence of this feature in major segments of the Indian derivatives market.
References
Bank for International Settlements (2004), Triennial and Semiannual Surveys on Positions in Global Over-the-counter (OTC) Derivatives Markets at endJune 2004. Bhaumik, Sumon K. (1997), Financial Derivatives I: Birds Eye View of the Products, Money & Finance, No. 4. Bhaumik, Sumon K. (1998), Financial Derivatives II: The Risks and their Management, Money & Finance, No. 5. Dodd, Randall (2003), Consequences of Liberalizing Derivatives Markets, Financial Policy Forum, Derivatives Study Centre, Washington. Geithner, Timothy F. (2006), Risk Management Challenges in the U.S. Financial System, Speech delivered at the Global Association of Risk Professionals (GARP) 7th Annual Risk Management Convention & Exhibition, Federal Reserve Bank of New York. Gorton, Gary B., and K. Geert Rouwenhorst (2006), Facts and Fantasies about Commodity Futures, Financial Analysts Journal, Vol. 62, No. 2. Shah, Ajay (1998), The Price Discovery Mechanism, Ajay Shahs Media Page: http://www.mayin.org/ajayshah/MEDIA/1998/pricediscovery.html. Thomas, Susan (2003), Derivatives Markets in India, Tata McGrawHill. Thomas, Susan and Ajay Shah (2003) Equity Derivatives in India: The State of The Art, in Thomas (ed) Derivatives Markets in India.

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An efficient derivatives market ought to play a lead role in the process of price discovery for the underlying. The relationship between spot and futures markets in price discovery has thus been an important area of research.

36 The data resources required to analyse most of these features are the intra-day series of time-stamped bid/offer, and the intra-day time-series of the limit order book. These, however, are not readily available.

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A list of some abbreviations used above: AD: ADR: BIS: BSE: CCIL: CM: EUR: F&O: FII: FMC: Authorised Dealer American Depository Receipt Bank for International Settlements Bombay Stock Exchange Ltd. Clearing Corporation of India Ltd. Clearing Member Euro Futures and Options Foreign Institutional (portfolio) Investor Forward Markets Commission (set up under the Ministry of Consumer Affairs, Food and Public Distribution, Government of India) Forward Rate Agreement Pound Global Depository Receipt Indian National Rupee Interest rate swap Yen Mutual Fund Mark to Market Margin Non-Resident Indian National Securities Clearing Corporation (a wholly owned subsidiary of NSE) National Stock Exchange of India Ltd. Overnight Index Swap Over-the-counter Reserve Bank of India Securities and Exchange Board of India Trading Member US Dollar Value at Risk

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FRA: GBP: GDR: INR: IRS: JPY: MF: MTM: NRI: NSCCL: NSE: OIS: OTC: RBI: SEBI: TM: USD: VaR:

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