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© Copyright 2002 India Infoline Ltd. All rights reserved. Regd. Off: 24, Nirlon Complex, Off W E Highway, Goregaon(E)Mumbai-400 063.
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BASICS OFDERIVATIVES
BASICS OF DERIVATIVES
2
CONTENTS
FOREWORD...................................................................................................................... 3
1.INTRODUCTION.......................................................................................................... 5
2. FUTURES .................................................................................................................... 11
3. OPTIONS.....................................................................................................................26
4. TRADING STRATEGIES USING FUTURES AND OPTIONS ........................... 40
5. RISK MANAGEMENT IN DERIVATIVES............................................................ 50
6. SETTLEMENT OF DERIVATIVES........................................................................ 52
7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES.................... 57
8. CASE STUDY- WHEN THINGS GO WRONG!..................................................... 58
ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES ...................... 63
ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA ................... 72
ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA .......... 74
ANNEXURE 4- L C GUPTA COMMITTEE REPORT............................................. 75
BASICS OF DERIVATIVES
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Foreword
New ideas and innovations have always been the hallmark of progress made by
mankind. At every stage of development, there have been two core factors that
drives man to ideas and innovation. These are increasing returns and reducing
risk, in all facets of life.
The financial markets are no different. The endeavor has always been to
maximize returns and minimize risk. A lot of innovation goes into developing
financial products centered on these two factors. It has spawned a whole new
area called financial engineering.
Derivatives are among the forefront of the innovations in the financial markets
and aim to increase returns and reduce risk. They provide an outlet for investors
to protect themselves from the vagaries of the financial markets. These
instruments have been very popular with investors all over the world.
Indian financial markets have been on the ascension and catching up with global
standards in financial markets. The advent of screen based trading,
dematerialization, rolling settlement have put our markets on par with
international markets.
BASICS OF DERIVATIVES
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As a logical step to the above progress, derivative trading was introduced in the
country in June 2000. Starting with index futures, we have made rapid strides
and have four types of derivative products- Index future, index option, stock
future and stock options. Today, there are 30 stocks on which one can have
futures and options, apart from the index futures and options.
This market presents a tremendous opportunity for individual investors .The
markets have performed smoothly over the last two years and has stabilized. The
time is ripe for investors to make full use of the advantage offered by this market.
We have tried to present in a lucid and simple manner, the derivatives market, so
that the individual investor is educated and equipped to become a dominant
player in the market.
Editorial Team
July 11, 2002
BASICS OF DERIVATIVES
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1.Introduction
What are derivatives?
A derivative is a financial instrument that derives its value from an underlying
asset. This underlying asset can be stocks, bonds, currency, commodities,
metals and even intangible, pseudo assets like stock indices.
Derivatives can be of different types like futures, options, swaps, caps, floor,
collars etc. The most popular derivative instruments are futures and options.
There are newer derivatives that are becoming popular like weather derivatives
and natural calamity derivatives. These are used as a hedge against any
untoward happenings because of natural causes.
What exactly is meant by “ derives its value from an asset”?
What the phrase means is that the derivative on its own does not have any value.
It is considered important because of the importance of the underlying. When we
say an Infosys future or an Infosys option, these carry a value only because of
the value of Infosys.
BASICS OF DERIVATIVES
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What are financial derivatives?
Financial derivatives are instruments that derive their value from financial assets.
These assets can be stocks, bonds, currency etc. These derivatives can be
forward rate agreements, futures, options swaps etc. As stated earlier, the most
traded instruments are futures and options.
What kind of people will use derivatives?
Derivatives will find use for the following set of people:
• Speculators: People who buy or sell in the market to make profits. For
example, if you will the stock price of Reliance is expected to go upto Rs.400
in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make
profits
• Hedgers: People who buy or sell to minimize their losses. For example, an
importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50
/$ from Rs 48/$, then the importer can minimize his losses by buying a
currency future at Rs 49/$
• Arbitrageurs: People who buy or sell to make money on price differentials in
different markets. For example, a futures price is simply the current price plus
the interest cost. If there is any change in the interest, it presents an arbitrage
opportunity. We will examine this in detail when we look at futures in a
separate chapter.
BASICS OF DERIVATIVES
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Basically, every investor assumes one or more of the above roles and derivatives
are a very good option for him.
How has this market developed over time?
Derivatives have been a recent development in the Indian financial markets. But
there have been derivatives in the commodities market. There is Cotton and
Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin,
Coffee futures in Bangalore etc. But the players in these markets are restricted to
big farmers and industries, who need these as an input to protect themselves
from the vagaries of agriculture sector.
Globally too, the first derivatives started with the commodities, way back in 1894.
Financial derivatives are a relatively late development, coming into existence
only in the 1970’s. The first exchange where derivatives were traded is the
Chicago Board of Trade (CBOT).
In India, the first derivatives were introduced by National Stock Exchange (NSE)
in June 2000. The first derivatives were index futures. The index used was Nifty.
Option trading was started in June 2001, for index as well as stocks. In
November 2001, futures on stocks were allowed. Currently, there are 30 stocks
on which derivative trading is allowed.
BASICS OF DERIVATIVES
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The 30 stocks on which trading is allowed currently are:
Name of the Scrip Lot Size
ACC 1500
Bajaj Auto 800
BHEL 1200
BPCL 1100
BSES 1100
Cipla 200
Digital Global Soft 400
Dr Reddy Laboratories 400
Grasim 700
Gujarat Ambuja 1100
Hindalco 300
Hindustan Lever 1000
HPCL 1300
HDFC 300
Infosys 100
ITC 300
L&T 1000
MTNL 1600
M&M 2500
BASICS OF DERIVATIVES
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Ranbaxy 500
Reliance Industries 600
Reliance Petroleum 4300
Satyam Computers 1200
SBI 1000
Sterlite Opticals 600
TELCO 3300
TISCO 1800
Tata Power 1600
Tata Tea 1100
VSNL 700
NIFTY 200
SENSEX 50
The trading is done on the exchange in the F&O (Futures and Option) segment.
Index F&O is also traded in the market. The indices traded are the Nifty and the
Sensex.
Since we have talked of hedging, can we compare derivatives to
insurance?
You buy a life insurance policy and pay a premium to the insurance agent for a
fixed term as agreed in the policy. In case you survive, you are happy and the
BASICS OF DERIVATIVES
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insurance company is happy. In case you don’t survive, your relatives are happy
as the insurance company pays them the amount for which you are insured.
Insurance is nothing but transfer of risk. An insurance company sells you risk
cover and buys your risk and you sell your risk and buy a risk cover. The risk
involved in life insurance is the death of the policyholder. The insurance
companies bet on your surviving and hence agree to sell a risk cover for some
premium.
There is a transfer of risk here for a financial cost, i.e. the premium. In this sense,
a derivative instrument can be compared to insurance, as there is a transfer of
risk at a financial cost.
Derivatives also work well on the concept of mutual insurance. In mutual
insurance, two people having opposite risks can enter into a contract and reduce
their risk. The most classic example is that of an importer and exporter. An
importer buys goods from country A and has to pay in dollars in 3 months. An
exporter sells goods to country A and has to receive payment in dollars in 3
months. In case of an importer, the risk is of exchange rate moving up. In case of
an exporter, the risk is of exchange rate moving down. They can cover each
others risk by entering into a forward rate after 3 months.
BASICS OF DERIVATIVES
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2. Futures
Future, as the name indicates, is a trade whose settlement is going to take place
in the future. However, before we take a look at futures, it will be beneficial for us
to take a look at forward rate agreements
What is a forward rate agreement
A forward rate agreement is one in which a buyer and a seller enter into a
contract at a specified quantity of an asset at a specified price on a specified
date.
An example for this is the exporters getting into forward rate agreements on
currencies with banks.
But there is always a risk of one of the parties defaulting. The buyer may not pay
up or the seller may not be able to deliver. There may not be any redressal for
the aggrieved party as this is a negotiated contract between two parties.
What is a future?
A future is similar to a forward rate agreement, except that it is not a negotiated
contracted but a standard instrument.
BASICS OF DERIVATIVES
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A future is a contract to buy or sell an asset at a specified future date at a
specified price. These contracts are traded on the stock exchanges and it can
change many hands before final settlement is made.
The advantage of a future is that it eliminates counterparty risk. Since there is an
exchange involved in between, and the exchange guarantees each trade, the
buyer or seller does not get affected with the opposite party defaulting.
Futures Forwards
Futures are traded on a stock
exchange
Forwards are non tradable, negotiated
instruments
Futures are contracts having standard
terms and conditions
Forwards are contracts customized by
the buyer and seller
No default risk as the exchange
provides a counter guarantee
High risk of default by either party
Exit route is provided because of high
liquidity on the stock exchange
No exit route for these contracts
Highly regulated with strong margining
and surveillance systems
No such systems are present in a
forward market.
BASICS OF DERIVATIVES
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There are two kinds of futures traded in the market- index futures and stock
futures.
There are three types of futures, based on the tenure. They are 1, 2 or 3 month
future. They are also known as near and far futures depending on the tenure.
What are Index futures
Index futures are futures contract on the index itself. One can buy a 1, 2 or 3-
month index future. If someone wants to take a call on the index, then index
futures are the ideal instruments for him.
Let us try and understand what an index is. An index is a set of numbers that
represent a change over a period of time.
A stock index is similarly a number that gives a relative measure of the stocks
that constitute the index. Each stock will have a different weight in the index
The Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.
For example, Nifty was formed in 1995 and given a base value of 1000. The
value of Nifty today is 1172. What it means in simple terms is that, if Rs 1000
BASICS OF DERIVATIVES
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was invested in the stocks that form in the index, in the same proportion in which
they are weighted in the index, then Rs 1000 would have become Rs 1172 today.
There are two popular methods of computing the index. They are price weighted
method like Dow Jones Industrial Average (DJIA) or the market capitalization
method like Nifty or Sensex.
What the terminologies used in a Futures contract?
The terminologies used in a futures contract are:
• Spot Price: The current market price of the scrip/index
• Future Price: The price at which the futures contract trades in the futures
market
• Tenure: The period for which the future is traded
• Expiry date: The date on which the futures contract will be settlec
• Basis : The difference between the spot price and the future price
Why are index futures more popular than stock futures?
Globally, it has been observed that index futures are more popular as compared
to stock futures. This is because the index future is a relatively low risk product
compared to a stock future. It is easier to manipulate prices for individual stocks
but very difficult to manipulate the whole index. Besides, the index is less volatile
BASICS OF DERIVATIVES
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as compared to individual stocks and can be better predicted than individual
stock.
How is the future price arrived at?
Future price is nothing but the current market price plus the interest cost for the
tenure of the future.
This interest cost of the future is called as cost of carry.
If F is the future price, S is the spot price and C is the cost of carry or opportunity
cost, then
F=S+C
F = S + Interest cost, since cost of carry for a finance is the interest cost
Thus,
F=S (1+r)T
Where r is the rate of interest and T is the tenure of the futures contract.
BASICS OF DERIVATIVES
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The rate of interest is usually the risk free market rate.
Example 2.1:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will
be the price of one-month future?
Solution
The price of a future is F= S (1+r)T
The one-month Reliance future would be the spot price plus the cost of carry.
Since the bank rate is 10 %, we can take that as the market rate. This rate is an
annualized rate and hence we recalculate it on a monthly basis.
F=300(1+0.10)(1/12)
F= Rs 302.39
Example 2.2:
The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosys
is Rs 3100. The returns expected from the Gsec funds for the same period is 10
%. Is the future of Infosys overpriced or underpriced?
BASICS OF DERIVATIVES
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Solution
The 1 month Future of Infosys will be
F= 3000(1+.0.10) (1/12)
F= Rs 3023.90
But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs
76.
What happens if dividend is going to be declared?
Dividend is an income to the seller of the future. It reduces his cost of carry to
that extent. If dividend is going to be declared, the same has to be deducted from
the cost of carry
Thus the price of the future in this case becomes,
F= S (1+r-d) T
Where d is the dividend.
Example 2.3:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What will
be the price of one-month future? Reliance will be paying a dividend of 50 paise
per share
Solution:
BASICS OF DERIVATIVES
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Since Reliance is paying 50 paise per share and the face value of reliance is Rs
10, the dividend rate is 5%.
So while calculating futures,
F=300(1+0.10-0.05) (1/12)
F= Rs. 301.22
What happens if dividend is declared after buying a future?
If the dividend is declared after buying a one month future, the cost of carry will
be reduced by a pro rata amount. For example, if there is a one month future
ending June 30th and dividend is declared on June 15th, then dividend benefit will
be reduced from the cost of carry for 15 days.
Since the seller is holding the shares and will transfer the shares to the buyer
only after a month, the dividend benefit goes to the seller. The seller will enjoy
the benefit to the extent of interest on dividend.
Thus net cost of carry = cost of carry – dividend benefits
Example 2.4:
The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliance
declares a dividend of 5%. What will be the price of one-month future?
Solution:
BASICS OF DERIVATIVES
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The benefit accrued due to the dividend will be reduced from the cost of the
future.
One month future will be priced at
F= 300(1+0.10) (1/12)
F = 302.39
Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39
The interest benefit of the dividend is available for 15 days, ie 0.5 months.
Dividend for 15 days = 300(1+0.05) (0.5/12)
Dividend Benefit = Rs300.61- Rs 300= Rs0.61
Therefore, net cost of the carry is,
Rs2.39-Rs0.61 = Rs 1.78
Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78
In practice, the market discounts the dividend and the prices are automatically
adjusted. The exchange steps into the picture if the dividend declared is more
than 10 % of the market price. In such cases, there is an official change in the
price. In other cases, the market does the adjustment on its own.
What happens in case a bonus/ stock split is declared on the stock in
which I have a futures position?
If a bonus is declared, the settlement price is adjusted to reflect the bonus. For
example, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the
BASICS OF DERIVATIVES
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position becomes 400 Reliance at Rs 150 so that the contract value is
unaffected.
But is the Future really traded in this way in the market?
What has been discussed above is the theoretical way of arriving at the future
price. This can be used as a base for calculation future price
But the actual market price that we see on the trading screen depends on
liquidity too. So the prices that we observe in real world are also a function of
demand-supply position in that stock.
How do future prices behave compared to spot prices?
Future prices lead the spot prices. The spot prices move towards the future
prices and the gap between the two is always closing with as the time to
Future vs Spot
0
10
20
30
1 2 3 4 5 6 7
Time
Pric
e Future Price
Spot Price
BASICS OF DERIVATIVES
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settlement decreases. On the last day of the future settlement, the spot price
equals the future price.
Is the futures price always higher than the spot price?
The futures price can be lower than the spot price too. This depends on the
fundamentals of the stock. If the stock is not expected to perform well and the
market takes a bearish view on them, then the futures price can be lower than
the spot price.
Future prices can fall also due to declaration of dividend.
What happens in case of index futures?
In case of index futures, the treatment of the futures calculation is the same. The
future value is calculated as the spot index value plus the cost of carry.
What happens if I buy an index future and there is a dividend declared on a
stock that comprises the index?
Practically speaking, the index is corrected for these things in case there is a
dividend declared for such a stock.
Theoretically, dividend is adjusted in the following manner:
BASICS OF DERIVATIVES
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1.The contribution of the stock to the index is calculated. The index, as discussed
earlier, is a market capitalization index.
2. Then the number of shares in the index is calculated. This is obtained by
dividing the contribution to the index by the market price.
3. The dividend on the index is the dividend on the number of shares of the stock
in the index.
4. The interest earned on the dividend is calculated and reduced from the cost of
carry to obtain the net cost of carry.
Example 2.5:
The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLL
contributes to 15 % of the index. The market price of HLL is Rs 150. What will be
the cost of the 1 month future if the bank rate is 10%?
Solution :
The future will be priced at
F= 1000(1+0.10)(1/12)
F= 1008
The weight of HLL in the index is 15% ie 0.15*1000=150.
The market price of HLL is Rs 150
Therefore, the number of shares of HLL in the index=1
The dividend earned on this is Rs 5
BASICS OF DERIVATIVES
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Dividend benefit on Rs 5 is 5(1+0.10) (1/12)
Dividend benefit = Rs 0.04
Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95
But in practice, the market discounts the dividends and price adjustment is made
accordingly.
All that is okay in theory, but what happens in the real world?
In the real world, derivatives are highly volatile instruments and there have been
lot of losses in the various financial markets. The classic examples have been
Long Term Capital Markets (LTCM) and Barings. We will examine what
happened exactly at various places later in the book.
As a result, the regulators have decided that a minimum of Rs 2 lacs should be
the contract size. This is done primarily to keep the small investors away from a
volatile market till enough experience and understanding of the markets is
acquired. So the initial players are institutions and high net worth individuals who
have a risk taking capacity in these markets.
Because of this minimum amount, lots are decided on the market price such that
the value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or in
case of Sensex, 50.
BASICS OF DERIVATIVES
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Similarly minimum lots are decided for individual stocks too. Thus you will find
different stock futures having different market lots. The lots decided for each
stock was such that the contract value was Rs 2 lacs. This was at the point of
introduction of these instruments. However the lot size has remained the same
and has not been adjusted for the price changes. Hence the value of the contract
may be slightly lower in case of certain stocks.
Trading, i.e. Buying and Selling take place in the same manner as the stock
markets. There will be an F & O terminal with the broker and the dealer will enter
the orders for you.
Another fact of the real world is that, since the future is a standard instrument,
you can close out your position at any point of time and need not hold till
maturity.
How is the trading done on the exchange?
Buying of futures is margin based. You pay an up front margin and take a
position in the stock of your choice. Your daily losses/ gains relative to the future
price will be monitored and you will have to pay a mark to market margin. On the
final day settlement is made in cash and is the difference between the futures
price and the spot price prevailing at that time
BASICS OF DERIVATIVES
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For example, if the future price is Rs 300 and the spot price is Rs 330, then you
will make a cash profit of Rs 30. In case the spot price is Rs 290, you make a
cash loss of Rs 10. Thus futures market is a cash market.
In future, there is a possibility that the futures may result in delivery. In such a
scenario, the future market will be merged with the spot market on the expiration
day and it will follow the T+ 3 rolling settlement prevalent in the stock markets
How does the mark to market mechanism work?
Mark to market is a mechanism devised by the stock exchange to minimize risk.
In case you start making losses in your position, exchange collects money to the
extent of the losses up front. For example, if you buy futures at Rs 300 and its
price falls to Rs 295 then you have to pay a mark to market margin of Rs 5. This
is over and above the margin money that you pay to take a position in the future.
BASICS OF DERIVATIVES
26
3. Options
What are options?
As seen earlier, futures are derivative instruments where one can take a position
for an asset to be delivered at a future date. But there is also an obligation as the
seller has to make delivery and buyer has to take delivery.
Options are one better than futures. In option, as the name indicates, gives one
party the option to take or make delivery. But this option is given to only one
party in the transaction while the other party has an obligation to take or make
delivery. The asset can be a stock, bond, index, currency or a commodity
But since the other party has an obligation and a risk associated with making
good the obligation, he receives a payment for that. This payment is called as
premium.
BASICS OF DERIVATIVES
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The party that had the option or the right to buy/sell enjoys low risk. The cost of
this low risk is the premium amount that is paid to the other party.
Thus we have seen an option is a derivative that gives one party a right and the
other party an obligation to buy /sell at a specified price for a specified quantity.
The buyer of the right is called the option holder. The seller of the right (and
buyer of the obligation) is called the option writer. The cost of this transaction is
the premium.
For example, a railway ticket is an option in daily life. Using the ticket, a
passenger has an option to travel. In case he decides not to travel, he can cancel
the ticket and get a refund. But he has to pay a cancellation fee, which is
analogous to the premium paid in an option contract. The railways, on the other
hand, have an obligation to carry the passenger if he decides to travel and refund
his money if he decides not to travel. In case the passenger decides to travel, the
railways get the ticket fare. In case he does not, they get the cancellation fee.
The passenger on the other hand, by booking a ticket, has hedged his position in
case he has to travel as anticipated. In case the travel does not materialize, he
BASICS OF DERIVATIVES
28
can get out of the position by canceling the ticket at a cost, which is the
cancellation fee.
But I hear a lot of jargons about options? What are all these jargons?
There are some basic terminologies used in options. These are universal
terminologies and mean the same everywhere.
a. Option holder : The buyer of the option who gets the right
b. Option writer : The seller of the option who carries the obligation
c. Premium: The consideration paid by the buyer for the right
d. Exercise price: The price at which the option holder has the right to buy or
sell. It is also called as the strike price.
e. Call option: The option that gives the holder a right to buy
f. Put option : The option that gives the holder a right to sell
g. Tenure: The period for which the option is issued
h. Expiration date: The date on which the option is to be settled
i. American option: These are options that can be exercised at any point till the
expiration date
j. European option: These are options that can be exercised only on the
expiration date
k. Covered option: An option that an option writer sells when he has the
underlying shares with him.
BASICS OF DERIVATIVES
29
l. Naked option: An option that an option writer sells when he does not have the
underlying shares with him
m. In the money: An option is in the money if the option holder is making a profit
if the option was exercised immediately
n. Out of money: An option is in the money if the option holder is making a loss
if the option was exercised immediately
o. At the money: An option is in the money if the option holder evens out if the
option was exercised immediately
How is money made in an option?
The money made in an option is called as the option pay off. There can be two
pay off for options, for put and call option
Call option:
A call option gives the holder a right to buy shares. The option holder will make
money if the spot price is higher than the strike price. The pay off assumes that
the option holder will buy at the strike price and sell immediately at the spot price.
But if the spot price is lower than the strike, the option holder can simply ignore
the option. It will be cheaper to buy from the market. The option holder loss is to
the extent of premium he has paid.
BASICS OF DERIVATIVES
30
But if the spot price increases dramatically then he can make wind fall profits.
Thus the profits for an option holder in a call option is unlimited while losses are
capped to the extent of the premium.
Conversely, for the writer, the maximum profit he can make is the premium
amount. But the losses he can make are unlimited.
Put option
The put option gives the right to sell. The option holder will make money if the
spot price is lower than the strike price. The pay off assumes that the option
holder will buy at spot price and sell at the strike price
But if the spot price is higher than the strike, the option holder can simply ignore
the option. It will be beneficial to sell to the market. The option holder loss is to
the extent of premium he has paid.
But if the spot prices falls dramatically then he can make wind fall profits.
Thus the profits for an option holder in a put option is unlimited while losses are
capped to the extent of the premium. This is a theoretical fallacy as the maximum
BASICS OF DERIVATIVES
31
fall a stock can have is till zero, and hence the profit of a option holder in a put
option is capped.
Conversely, the maximum profit that an option writer can make in this case is the
premium amount.
But in the above pay off, we had ignored certain costs like premium and
brokerage. These are also important, especially the premium.
So, in a call option for the option holder to make money, the spot price has to be
more than the strike price plus the premium amount.
If the spot is more than the strike price but less than the sum of strike price and
premium, the option holder can minimize losses but cannot make profits by
exercising the option.
Similarly, for a put option, the option holder makes money if spot is less than the
strike price less the premium amount.
If the spot is less than the strike price but more than the strike price less
premium, the option holder can minimize losses but cannot make profits by
exercising the option.
BASICS OF DERIVATIVES
32
Example 3.1:
The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. What
will be the profit for the option holder if the spot price touches a) Rs. 350 b)337
Solution
a. The option holder can buy Reliance at a price of Rs 330.
He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340.
He can sell the same in the spot market for Rs 350.
He makes a profit of Rs 10
b. The option holder can buy Reliance at a price of Rs 330.
He has also paid a premium of Rs 10 for the same. So his cost of a share of
Reliance is Rs 340.
He can sell the same in the spot market for Rs 337
He makes a loss of Rs 3.
But he has reduced his losses by exercising the option. Had he not exercised the
option, he would have made a loss of Rs 10, which is the premium that he paid
for the option.
BASICS OF DERIVATIVES
33
But should one always buy an option? The buyer seems to enjoy all
advantages, then why should one write an option?
This is not always the case. The writer of the option too can make money.
Basically, the option writers and option holders are people who are taking a
divergent view on the market. So if the option writer feels the markets will be
bearish, he can write call options and pocket the premium. In case the market
falls, the option holder will not exercise the option and the entire premium amount
can be a profit
But if the option writer is bullish on the market, then he can write put options. In
case the market goes up, the option holder will not exercise the option and the
premium amount is a profit for the option writer.
The other area that an option writer makes money is the spot price lying in the
range between the strike price and the strike plus premium
For example, if you write a call option on Reliance for a strike price of Rs 300 at a
premium of Rs 30. If the spot price is Rs 320, then the option holder will exercise
the option to reduce losses and buy it at Rs 300. But you have already got the
premium of Rs 30. So in effect, you have sold the stock at Rs. 330, which is Rs
10 above the spot price! This profit increases even more if you calculate the
opportunity cost of Rs 30 as this amount is received up front.
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Let us look at a typical pay off table for a call option, for the buyer as well as
writer. Let us assume a call option with a strike price of Rs 200 and a premium of
Rs 10
Table 3.1: Pay off Table for buyer and writer of an option
Spot Price Whether
Exercised
Buyer’s
gain/loss
Writer
gain/loss
Net
180 No -10 +10 0
190 No -10 +10 0
195 No -10 +10 0
200(=Strike
Price)
Yes/No -10 +10 0
205 Yes -5 +5 0
210 Yes 0 0 0
220 Yes +10 -10 0
In the above pay off table, if we take 200 as the median value, we see that the
writer has made money 5 out of 7 occasions. He has made money even when
the option is exercised, as long as the spot price is below the strike price plus the
premium.
Thus writers also make money on options, as the buyer is not at an advantage all
the time.
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35
What are the options that are currently traded in the market?
The options that are currently traded in the market are index options and stock
options on the 30 stocks. The index options are European options. They are
settled on the last day. The stock options are American options.
There are 3 options-1, 2,3 month options. There can be a series of option within
the above time span at different strike prices.
Another lingo in option is Near and Far options. A near option means the option
is closer to expiration date. A Far option means the option is farther from
expiration date. A 1 month option is a near option while a 3 month option is a far
option.
In option trading, what gets quoted in the exchange is the premium and all that
people buy and sell is the premium.
We said we could have different option series at various strike prices. How
is this strike price arrived at?
The strike price bands are specified by the exchange. This band is dependent on
the market price.
Market Price Rs. Strike Price Intervals Rs.
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<50 2.5
50-150 5
150-250 10
250-500 20
500-1000 30
>1000 50
Thus if a stock is trading at Rs. 100 then there can be options with strike price of
Rs 105,110,115, 95, 90 etc.
How is the premium of an option calculated?
In practice, it is the market that decides the premium at which an option is traded.
There are mathematical models, which are used to calculate the premium of an
option.
The simplest tool is the expected value concept. For example, for a stock that is
quoting at Rs 95. There is a 20 % probability that it will become Rs 110. There is
a 30 % probability that it will become Rs 105. There is 30% probability that the
stock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90.
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37
If the strike price of a call option is to be Rs 100, then the option will have value
when the spot goes to Rs 105 or Rs 110. It will be un-exercised at Rs 95 and Rs
90.
If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively.
The expected returns for the above distribution is
0.20*15+0.30*10=Rs 6.
Thus this the price that one can pay as a premium for a strike price of Rs 100 for
a stock trading at Rs 95. Rs 6 will also be the price for the seller for giving the
option holder this opportunity.
This is a very simple thumb calculation. Even then, one would require a lot of
background data like variances and expected price movements.
There are more advanced probabilistic models like the Black Scholes model and
the Binomial Pricing model that calculates the options. One need not go deep
into those and it would suffice to say that option calculators are readily available.
Please visit www.indiainfoline.com/stok/ to use an option calculator based on
Black Scholes Model. The Black Scholes Model is presented in greater detail in
Annexure-3.
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I keep reading about option Greeks? What are they? They actually sound
like Greek and Latin to me.
There are something called as option Greeks but they are nothing to be scared
of. The option Greeks help in tracking the volatility of option prices.
The option Greeks are
a. Delta: Delta measures the change in option price (the premium) to the change
in underlying. A delta of 0.5 means if the underlying changes by 100 % the
option price changes by 50 %.
b. Theta: It measures the change in option price to change in time
c. Rho: It is the change in option price to change in interest rate
d. Vega: It is the change in option price to change in variance of the underlying
stock
e. Gamma: It is the change in delta to the change in the underlying. It is a
double derivative (the mathematical one) of the option price with respect to
underlying. It gives the rate of change of delta.
These are just technical tools used by the market players to analyze options and
the movement of the option prices.
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We saw that the stock options are American options and hence can be
exercised any time. What happens when one decided to exercise the
option?
When the option holder decides to exercise the option, the option will be
assigned to the option writer on a random basis, as decided by the software of
the exchange.
The European options are also the similarly decided by the software of the
exchange. The index options are European options.
In future, there is a possibility that the options may result in delivery. In such a
scenario, the option market will be merged with the spot market on the expiration
day and it will follow the T+ 3 rolling settlement prevalent in the stock markets
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4. Trading Strategies using Futures and Options
So far, we have seen a lot of theoretical stuff on derivatives. But how is it
going to help me in practice?
There are a lot of practical uses of derivatives. As we have seen, derivatives can
be used for profits and hedging. We can use derivatives as a leverage tool too.
How do I use derivatives as a leverage?
You can use the derivatives market to raise funds using your stocks. Conversely,
you can also lend funds against stocks.
Does that mean derivatives are badla revisited?
The derivative product that comes closest to Badla is futures. Futures is not
badla, though a lot of people confuse it with badla. The fundamental difference is
badla consisted of contango and backwardation (undha badla and vyaj badla) in
the same market. Futures is a different market segment altogether. Hence
derivatives is not the same as badla, though it is similar.
How do I raise funds from the derivatives market?
This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. You
have shares lying with you and are in urgent need of liquidity. Instead of pledging
your shares and borrowing from banks at a margin, you can sell the stock at Rs
BASICS OF DERIVATIVES
41
3000. Suppose you need this liquidity only for a month and also do not want to
part with Infosys. You can buy a 1 month future at Rs 3050. After a month you
get back your Infosys at the cost of an additional Rs 50. This Rs 50 is the
financing cost for the liquidity.
The other beauty about this is you have already locked in your purchase cost at
Rs 3050. This fixes your liquidity cost also and you are protected against further
price losses.
How do I lend into the market?
The lending into the market is exactly the reverse of borrowing. You have money
to lend. You can buy a stock and sell its future. Say, you buy Infosys at Rs 3000
and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs
3000 to the market for a month and earned Rs 100 on it.
Suppose I don’t want to lend/borrow money. I want to speculate and make
profits?
When you speculate, you normally take a view on the market, either bullish or
bearish. When you take a bullish view on the market, you can always sell futures
and buy in the spot market. If you take a bearish view on the market, you can buy
futures and sell in the spot market.
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Similarly, in the options market, if you are bullish, you should buy call options. If
you are bearish, you should buy put options
Conversely, if you are bullish, you should write put options. This is so because, in
a bull market, there are lower chances of the put option being exercised and you
can profit from the premium
If you are bearish, you should write call options. This is so because, in a bear
market, there are lower chances of the call option being exercised and you can
profit from the premium
How can I arbitrage and make money in derivatives?
Arbitrage is making money on price differentials in different markets. For
example, future is nothing but the future value of the spot price. This future value
is obtained by factoring the interest rate.
But if there are differences in the money market and the interest rates change
then the future price should correct itself to factor the change in interest. But if
there is no factoring of this change then it presents an opportunity to make
money- an arbitrage opportunity.
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Let us take an example.
Example 4.1:
A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005.
The risk free interest rate is 12%. What should be the trading strategy?
Solution:
The strategy for trading should be : Sell Spot and Buy Futures
Sell the stock for Rs 1000. Buy the future at Rs 1005.
Invest the Rs1000 at 12 %. The interest earned on this stock will be
1000(1+.012)(1/12)
=1009
So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4
Thus one can make a risk less profit of Rs 4 because of arbitrage
But an important point is that this opportunity was available due to mis-pricing
and the market not correcting itself. Normally, the time taken for the market to
adjust to corrections is very less. So the time available for arbitrage is also less.
As everyone rushes to cash in on the arbitrage, the market corrects itself.
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How is a future useful for me to hedge my position?
One can hedge one’s position by taking an opposite position in the futures
market. For example, If you are buying in the spot price, the risk you carry is that
of prices falling in the future. You can lock this by selling in the futures price.
Even if the stock continues falling, your position is hedged as you have firmed
the price at which you are selling.
Similarly, you want to buy a stock at a later date but face the risk of prices rising.
You can hedge against this rise by buying futures.
You can use a combination of futures too to hedge yourself. There is always a
correlation between the index and individual stocks. This correlation may be
negative or positive, but there is a correlation. This is given by the beta of the
stock.
In simple terms, what β indicates is the change in the price of a stock to the
change in index. For example, if β of a stock is 0.8, it means that if the index
goes up by 10, the price of the stock goes up by 8. It will also fall by a similar
level when the index falls.
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A negative β means that the price of the stock falls when the index rises. So, if
you have a position in a stock, you can hedge the same by buying the index at β
times the value of the stock.
Example 4.2:
The β of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, I
can hedge my position by selling 8000 of Nifty. Ie I will sell 8 Nifties.
Scenario 1
If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800
The value of my stock however goes up by 8 % ie it becomes Rs 10800 ie a gain
of Rs 800.
Thus my net position is zero and I am perfectly hedged.
Scenario 2
If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800
But the value of the stock also falls by 8 %. The value of this stock becomes Rs
9200 a loss of Rs 800.
Thus my net position is zero and I am perfectly hedged.
But again, β is a predicted value based on regression models. Regression is
nothing but analysis of past data. So there is a chance that the above position
may not be fully hedged if the β does not behave as per the predicted value.
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How do I use options in my trading strategy?
Options are a great tool to use for trading. If you feel the market will go up. You
should buy a call option at a level lower than what you expect the market to go
up.
If you think that the market will fall, you should buy a put option at a level higher
than the level to which you expect the market fall.
When we say market, we mean the index. The same strategy can be used for
individual stocks also.
A combination of futures and options can be used too, to make profits.
We have seen that the risk for an option holder is the premium amount. But
what should be the strategy for an option writer to cover himself?
An option writer can use a combination strategy of futures and options to protect
his position. The risk for an option writer arises only when the option is exercised.
This will be very clear with an example.
Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premium
of Rs 20. The risk arises only when the option is exercised. The option will be
BASICS OF DERIVATIVES
47
exercised when the price exceeds Rs 300. I start making a loss only after the
price exceeds Rs 320(Strike price plus premium).
More importantly, I have to deliver the stock to the opposite party. So to enable
me to deliver the stock to the other party and also make entire profit on premium,
I buy a future of Reliance at Rs 300.
This is just one leg of the risk. The earlier risk was of the call being exercised.
The risk now is that of the call not being exercised. In case the call is not
exercised, what do I do? I will have to take delivery as I have bought a future.
So minimize this risk, I buy a put option on Reliance at Rs 300. But I also need to
pay a premium for buying the option. I pay a premium of Rs 10.Now I am fully
covered and my net cash flow would be
Premium earned from selling call option : Rs 20
Premium paid to buy put option : (Rs 10)
Net cash flow : Rs 10
But the above pay off will be possible only when the premium I am paying for the
put option is lower than the premium that I get for writing the call.
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Similarly, we can arrive at a covered position for writing a put option too,
Another interesting observation is that the above strategy in itself presents an
opportunity to make money. This is so because of the premium differential in the
put and the call option. So if one tracks the derivative markets on a continuous
basis, one can chance upon almost risk less money making opportunities.
What are the other strategies using derivatives?
The other strategies are also various permutations of multiple puts, calls and
futures. They are also called by exotic names , but if one were to observe them
closely, they are relatively simple instruments.
Some of these instruments are:
• Butter fly spread: It is the strategy of simultaneous buying of put and call
• Calendar Spread - An option strategy in which a short-term option is sold and
a longer-term option is bought both having the same striking price. Either puts
or calls may be used.
• Double option – An option that gives the buyer the right to buy and/or sell a
futures contract, at a premium, at the strike price
• Straddle – The simultaneous purchase and sale of option of the same
specification to different periods.
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• Tandem Options – A sequence of options of the same type, with variable
strike price and period.
• Bermuda Option – Like the location of the Bermudas, this option is located
somewhere between a European style option which can be exercised only at
maturity and an American style option which can be exercised any time the
option holder chooses. This option can be exercisable only on predetermined
dates
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5. RISK MANAGEMENT IN DERIVATIVES
Derivatives are high-risk instruments and hence the exchanges have put up a lot
of measures to control this risk.
The most critical aspect of risk management is the daily monitoring of price and
position and the margining of those positions.
NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system that
has origins at the Chicago Mercantile Exchange, one of the oldest derivative
exchanges in the world.
The objective of SPAN is to monitor the positions and determine the maximum
loss that a stock can incur in a single day. This loss is covered by the exchange
by imposing mark to market margins.
SPAN evaluates risk scenarios, which are nothing but market conditions.
The specific set of market conditions evaluated, are called the risk scenarios, and
these are defined in terms of:
(a) how much the price of the underlying instrument is expected to change over
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51
one trading day, and
(b) how much the volatility of that underlying price is expected to change over
one trading day.
Based on the SPAN measurement, margins are imposed and risk covered. Apart
from this, the exchange will have a minimum base capital of Rs 50 lacs and
brokers need to pay additional base capital if they need margins above the
permissible limits.
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6. SETTLEMENT OF DERIVATIVES
How are futures settled on the stock exchange?
Mark to market settlement
There is a daily settlement for Mark to Market .The profits/ losses are computed
as the difference between the trade price or the previous day’s settlement price,
as the case may be, and the current day’s settlement price. The party who have
suffered a loss are required to pay the mark-to-market loss amount to exchange
which is in turn passed on to the party who has made a profit. This is known as
daily mark-to-market settlement.
Theoretical daily settlement price for unexpired futures contracts, which are not
traded during the last half an hour on a day, is currently the price computed as
per the formula detailed below:
F = S * e rt
where :
F = theoretical futures price
S = value of the underlying index/ stock
r = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)
t = time to expiration
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Rate of interest may be the relevant MIBOR rate or such other rate as may be
specified.
After daily settlement, all the open positions are reset to the daily settlement
price.
The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T =
Trade day). The mark to market losses or profits are directly debited or credited
to the broker account from where the broker passes to the client account
Final Settlement
On the expiry of the futures contracts, exchange marks all positions to the final
settlement price and the resulting profit / loss is settled in cash.
The final settlement of the futures contracts is similar to the daily settlement
process except for the method of computation of final settlement price. The final
settlement profit / loss is computed as the difference between trade price or the
previous day’s settlement price, as the case may be, and the final settlement
price of the relevant futures contract.
Final settlement loss/ profit amount is debited/ credited to the relevant broker’s
BASICS OF DERIVATIVES
54
clearing bank account on T+1 day (T= expiry day). This is then passed on the
client from the broker. Open positions in futures contracts cease to exist after
their expiration day
How are options settled on the stock exchange?
Daily Premium Settlement
Premium settlement is cash settled and settlement style is premium style. The
premium payable position and premium receivable positions are netted across all
option contracts for each broker at the client level to determine the net premium
payable or receivable amount, at the end of each day.
The brokers who have a premium payable position are required to pay the
premium amount to exchange which is in turn passed on to the members who
have a premium receivable position. This is known as daily premium settlement.
The brokers in turn would take this from their clients.
The pay-in and pay-out of the premium settlement is on T+1 days ( T = Trade
day). The premium payable amount and premium receivable amount are directly
debited or credited to the broker, from where it is passed on to the client.
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Interim Exercise Settlement for Options on Individual Securities
Interim exercise settlement for Option contracts on Individual Securities is
effected for valid exercised option positions at in-the-money strike prices, at the
close of the trading hours, on the day of exercise. Valid exercised option
contracts are assigned to short positions in option contracts with the same series,
on a random basis. The interim exercise settlement value is the difference
between the strike price and the settlement price of the relevant option contract.
Exercise settlement value is debited/ credited to the relevant broker account on
T+3 day (T= exercise date). From there it is passed on to the clients.
Final Exercise Settlement
Final Exercise settlement is effected for option positions at in-the-money strike
prices existing at the close of trading hours, on the expiration day of an option
contract. Long positions at in-the money strike prices are automatically assigned
to short positions in option contracts with the same series, on a random basis.
For index options contracts, exercise style is European style, while for options
contracts on individual securities, exercise style is American style. Final Exercise
is Automatic on expiry of the option contracts.
Exercise settlement is cash settled by debiting/ crediting of the clearing accounts
BASICS OF DERIVATIVES
56
of the relevant broker with the respective Clearing Bank, from where it is passed
to the client.
Final settlement loss/ profit amount for option contracts on Index is debited/
credited to the relevant broker clearing bank account on T+1 day (T = expiry
day), from where it is passed
Final settlement loss/ profit amount for option contracts on Individual Securities is
debited/ credited to the relevant broker clearing bank account on T+3 day (T =
expiry day), from where it is passed
Open positions, in option contracts, cease to exist after their expiration day.
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7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES
Since derivatives are a highly risky market, as experience world over has shown,
there are tight regulatory controls in this market.
The same is true of India. In India, a committee was set up under Dr L C Gupta
to study the introduction of the derivatives market in India. The report of the LC
Gupta Committee is attached as Annexure-4.
This committee formulated the guidelines and framework for the derivatives
market and paved the way for the derivatives market in India.
There other committee that has far reaching implications in the derivatives
market is the J R Verma Committee. This committee has recommended norms
for trading in the exchange. A lot of emphasis has been laid on margining and
surveillance so as to provide a strong backbone in systems and processes and
ensure stringent controls in a risky market.
As for the taxation aspect, the CBDT is treating gains from derivative
transactions as profit from speculation. Similarly losses in derivative transactions
can be treated as speculation losses for tax purpose.
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8. CASE STUDY- When things go wrong!
In the earlier part, we saw how useful derivatives are as hedging and risk
management tools. However, derivatives do not come without their share of
problems and dangers. Derivatives are highly sophisticated instruments and
users with inadequate information and understanding expose themselves to all
the risks inherent in using derivatives. Spectacular losses have been made and
some companies have even come to the point of collapse after using derivative
instruments. Some examples of the unfortunate use of derivatives are:
• In 1994, American consumer products giant Procter and Gamble (P&G), lost
an estimated US$ 200 million on a complex interest rate Swap. The Swap
was intended to lower funding costs for P&G if interest rates moved in a
certain manner. However, the Swap turned out to be a sophisticated bet on
future interest rate changes. It was the result of speculation and lax controls.
The company ought not to have betted on interest rate changes. This case
can be viewed as a classic case of how not to use derivatives.
• Sumitomo lost 1.17 billion pounds on copper and copper derivative
instruments from 1995- 1996.
• NatWest Markets, in 1997,announced it had lost 77m pounds as a result of
mispriced interest rate Options and Swaps.
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• The German metals and services group, Metallgesellschaft, came to the
verge of destruction in 1994 after losses exceeding DM 2.3 billion on energy
derivatives.
• Barings, Britain’s oldest merchant bank lost 900m pounds sterling on Nikkei
Index contracts on the Singapore and Osaka Derivatives Exchanges,
ultimately leading to the bank’s near collapse in 1995. The main person
involved was Nick Leeson, the bank’s derivatives trader.
• In 1994, Orange County, USA’s richest local authority went bankrupt after
trading in high-risk derivatives. On the advice of Merrill Lynch, county
treasurer, Robert Citron invested the county’s assets in interest sensitive
derivatives. The market moved against him and the county faced losses of
around US$ 1.6 billion. Afterwards, Merrill Lynch agreed to pay Orange
County over US$ 400m rather than face trial, in a friendly agreement.
The above examples are enough to make any potential user of derivatives
apprehensive. However, the stories not told about derivatives represent the
majority of cases where derivatives effectively reduce risk. Today, almost all
large, non-financial organizations use financial derivatives and the number of
users is fast increasing. Derivatives are no different than the majority of modern
inventions: if used in a proper way they are powerful and, indeed valuable tools.
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In wrong hands, they can cause tremendous destruction as the above examples
testify. The function of a corporate financial officer is to reduce risk by using
derivatives and not to speculate. Yet, in any derivative disaster, an element of
speculation seems to be present. Another cause of losses is decisions taken by
people with inadequate knowledge and who do not fully understand the complex
structure of derivatives. Derivatives are highly complex instruments and are often
research-derived and computer generated. The case of the Orange County
derivatives amply demonstrates this. It is clear that the derivative products used
by the county treasurer were not fully comprehended by him.
Barings—What went wrong?
A careful study of the Barings case brings to light several issues. Extensive data
obtained by Singapore inspectors show that Nick Leeson lost 4.8m pounds
sterling between July and October 1992. Leeson covered all the losses by July
’93. But it appeared that Leeson recovered his losses by selling options in a way
that stored up trouble. He used a strategy called “Straddling”. Simply put, Leeson
traded in a way that he was severely exposed to the market movement and a
slight movement against him would lead to huge losses. After the Kobe
earthquake, the volatility of the Nikkei increased sharply and Leeson and
Barings’ were left facing huge losses.
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Leeson did not take the relatively small losses he would have made had he sold
the contracts when the market started to go against him, but waited in the hope
that the situation would reverse and he would make good the losses. But this
was not to be, and the rest, they say, is history.
What Leeson did was to engage in highly speculative trading. He primarily used
derivatives, not as risk mitigating instruments, but as means of earning
speculative profits. The downside risk was huge and the risk of losses was great.
Derivatives—irreplaceable tools or weapons of destruction?
Derivatives have acquired a myth of danger and mystery. One reason is the
sensational media coverage of the derivatives disasters. However, what often
escapes notice is that these disastrous transactions involve speculation
(intentional risks to make profits) or poor oversight. Derivative instruments, per
se, rarely, if ever, cause disasters. It is to be noted that most companies use
derivatives for risk reduction and only very few businesses with poor
management hurt themselves.
As explained earlier, derivative contracts can be geared to many times their
value. In other words, contracts, which may be worth millions, if the market
moves in a certain way, cost only a fraction of that value.
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Usually, the market will not move that much and the contract will be settled or
sold to somebody else for a small gain or loss. However, if it does shift
significantly, big losses can be incurred, which are magnified due to the gearing
effect.
Banks have complex computer programmes to tell them how much they could
lose if the market moves by a certain amount. Regulations require them to put
money aside to protect against possible losses.
On exchanges, traders have to pay any losses incurred on their position at the
end of each day. This "margin" payment is to prevent risks getting out of hand.
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ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES
1. Arbitrage - The simultaneous purchase and sale of a commodity or financial
instrument in different markets to take advantage of a price or exchange rate
discrepancy.
2. Backwardation – The price differential between spot and back months when
the nearby dates are at a premium. It is the opposite of ‘contango.’
3. Butterfly spread – The placing of two inter-delivery spreads in opposite
directions with the centre delivery month common to both. The perfect
butterfly spread would require no net premium paid.
4. Calendar Spread - An option strategy in which a short-term option is sold and
a longer-term option is bought both having the same striking price. Either puts
or calls may be used.
5. Call option – An option that gives the buyer right to buy a futures contract at a
premium, at the strike price.
6. Contango – The price differential between spot and back months when the
marking dates are at a discount. It is the opposite of ‘backwardation.’
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7. Currency swap – A swap in which the counterparties’ exchange equal
amounts of two currencies at the sot exchange rate.
8. Derivative – A derivative is an instrument whose value is derived from the
value of one or more underlying assets, which can be commodities, precious
metals, currency, bonds, stocks, stock indices, etc. Derivatives involve the
trading of rights or obligations based on the underlying product, but do not
directly transfer property.
9. Double option – An option that gives the buyer the right to buy and/or sell a
futures contract, at a premium, at the strike price.
10. Futures contract – A legally binding agreement for the purchase and sale of a
commodity, index or financial instrument some time in the future.
11. Hedge fund – A large pool of private money and assets managed
aggressively and often riskily on any futures exchange, mostly for short-term
gain.
BASICS OF DERIVATIVES
65
12. In-the money option – An option with intrinsic value. A call option is in-the-
money if its strike price is below the current price of the underlying futures
contract and a put option is in-the-money if it is above the underlying.
13. Kerb trading - Trading by telephone or by other means that takes place after
the official market has closed. Originally it took place in the street on the kerb
outside the market.
14. Margin call – A demand from a clearing house to a clearing member or from a
broker to a customer to bring deposits up to a required minimum level to
guarantee performance at ruling prices.
15. Mark to market – A process of valuing an open position on a futures market
against the ruling price of the contract at that time, in order to determine the
size of the margin call.
16. Naked option – An option granted without any offsetting physical or cash
instrument for protection. Such activity can lead to unlimited losses.
17. Option - Gives the buyer the right, but not the obligation, to buy or sell stock
at a set price on or before a given date. Investors who purchase call options
bet the stock will be worth more than the price set by the option (the strike
BASICS OF DERIVATIVES
66
price), plus the price they paid for the option itself. Buyers of put options bet
the stock's price will go down below the price set by the option.
18. Out-of-the money option – An option with no intrinsic value. A call option is
out-of-the money if its strike price is above the underlying and a put option is
so if its below the underlying.
19. Premium - The price of an option contract, determined on the exchange,
which the buyer of the option pays to the option writer for the rights to the
option contract.
20. Spread – The difference between the bid and asked prices in any market.
21. Stop-loss orders – An order placed in the market to buy or sell to close out an
open position in order to limit losses when the market moves the wrong way.
22. Straddle – The simultaneous purchase and sale of the same commodity to
different delivery months or different strategies.
23. Swap – An agreement to exchange one currency or index return for another,
the exchange of fixed interest payments for a floating rate payments or the
BASICS OF DERIVATIVES
67
exchange of an equity index return for a floating interest rate.
24. Underlying – The currency, commodity, security or any other instrument that
forms the basis of a futures or options contract.
25. Writer – The person who originates an option contract by promising to
perform a certain obligation in return for the price of the option. Also known as
Option Writer.
26. All-or nothing Option – An option with a fixed, predetermined payoff if the
underlying instrument is at or beyond the strike price at expiration.
27. Average Options - A path dependant option that calculates the average of the
path traversed by the asset, arithmetic or weighted. The payoff therefore is
the difference between the average price of the underlying asset, over the life
of the option, and the exercise price of the option.
28. Barrier Options - These are options that have an embedded price level,
(barrier), which if reached will either create a vanilla option or eliminate the
existence of a vanilla option. These are referred to as knock-ins/outs that are
further explained below. The existence of predetermined price barriers in an
option makes the probability of pay off all the more difficult. Thus the reason a
BASICS OF DERIVATIVES
68
buyer purchases a barrier option is for the decreased cost and therefore
increased leverage.
29. Basket Option – A third party option or covered warrant on a basket of
underlying stocks, currencies or commodities.
30. Bermuda Option – Like the location of the Bermudas, this option is located
somewhere between a European style option which can be exercised only at
maturity and an American style option which can be exercised any time the
option holder chooses. This option can be exercisable only on predetermined
dates,
31. Compound Options - This is simply an option on an existing option such as a
call on a call, a put on a put etc, a call on a put etc.
32. Cross-Currency Option – An outperformance option struck at an exchange
rate between two currencies.
33. Digital Options - These are options that can be structured as a "one touch"
barrier, "double no touch" barrier and "all or nothing" call/puts. The "one
touch" digital provides an immediate payoff if the currency hits your selected
price barrier chosen at outset. The "double no touch" provides a payoff upon
BASICS OF DERIVATIVES
69
expiration if the currency does not touch both the upper and lower price
barriers selected at the outset. The call/put "all or nothing" digital option
provides a payoff upon expiration if your option finishes in the money
34. Knockin Options - There are two kinds of knock-in options, i) up and in, and ii)
down and in. With knock-in options, the buyer starts out without a vanilla
option. If the buyer has selected an upper price barrier and the currency hits
that level, it creates a vanilla option with maturity date and strike price agreed
upon at the outset. This would be called an up and in. The down and in option
is the same as the up and in, except the currency has to reach a lower
barrier. Upon hitting the chosen lower price level, it creates a vanilla option.
35. Multi-Index Options – An outperformance option with a payoff determined by
the difference in performance of two or more indices.
36. Outperformance Option – An option with a payoff based on the amount by
which one of two underlying instruments or indices outperforms the other.
37. Rainbow Options - This type of option is a combination of two or more options
combined each with its own distinct strike, maturity, etc. In order to achieve a
payoff, all of the options entered into must be correct.
BASICS OF DERIVATIVES
70
38. Quantity Adjusting Options (Quanto) - This is an option designed to eliminate
currency risk by effectively hedging it. It involves combining an equity option
and incorporating a predetermined fx rate. Example, if the holder has an in-
the-money Nikkei index call option upon expiration, the quanto option terms
would trigger by converting the yen proceeds into dollars which was specified
at the outset in the quanto option contract. The rate is agreed upon at the
beginning without the quantity of course, since this is an unknown at the time.
39. Secondary Currency Option – An option with a payoff in a different currency
than the underlying’s trading currency.
40. Swaption – An option to enter into a swap contract.
41. Tandem Options – A sequence of options of the same type, usually covering
non-overlapping time periods and often with variable strikes.
42. Up-and-Out Option – The call pays off early if an early exercise price trigger is
hit. The put expires worthless if the market price of the underlying risks is
above a pre-determined expiration price.
BASICS OF DERIVATIVES
71
43. Zero Strike Price Option – An option with an exercise price of zero, or close to
zero, traded on exchanges where there is transfer tax, owner restriction or
other obstacle to the transfer of the underlying.
BASICS OF DERIVATIVES
72
ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA
The derivatives market in India has rapidly grown and is fast becoming very
popular. It is offering an alternate source for people to deploy investible surplus
and make money out of it
The table below indicates the growth witnessed in the derivatives market.
Month/Year
Index Futures Stock Futures Index Options Stock Options
No. ofcontracts
Turnover(Rs. cr.)
No. ofcontracts
Turnover(Rs. cr.)
Call Put Call Put
No. ofcontracts
NotionalTurnover(Rs. cr.)
No. ofcontracts
NotionalTurnover(Rs. cr.)
No. ofcontracts
NotionalTurnover(Rs. cr.)
No. ofcontracts
NotionalTurnover(Rs. cr.)
Jun.00 1,191 35 - - - - - - - - - -
Jul.00 3,783 108 - - - - - - - - - -
Aug.00 3,301 90 - - - - - - - - - -
Sep.00. 4,376 119 - - - - - - - - - -
Oct.00 6,388 153 - - - - - - - - - -
Nov.00 9,892 247 - - - - - - - - - -
Dec.003 9,208 237 - - - - - - - - - -
Jan.01 17,860 471 - - - - - - - - - -
Feb.01 19,141 524 - - - - - - - - - -
Mar.01 15,440 381 - - - - - - - - - -
00-01 90,580 2,365 - - - - - - - - - -
Apr.01 13,274 292 - - - - - - - - - -
May.01 10,048 230 - - - - - - - - - -
Jun.01 26,805 590 - - 5,232 119 3,429 77 - - - -
Jul.01 60,644 1,309 - - 8,613 191 6,221 135 13,082 290 4,746 106
Aug.01 60,979 1,305 - - 7,598 165 5,533 119 38,971 844 12,508 263
Sep.01 154,298 2,857 - - 12,188 243 8,262 169 64,344 1,322 33,480 690
Oct.01 131,467 2,485 - - 16,787 326 12,324 233 85,844 1,632 43,787 801
Nov.01 121,697 2,484 125,946 2,811 14,994 310 7,189 145 112,499 2,372 31,484 638
Dec.01 109,303 2,339 309,755 7,515 12,890 287 5,513 118 84,134 1,986 28,425 674
Jan.02 122,182 2,660 489,793 13,261 11,285 253 3,933 85 133,947 3,836 44,498 1,253
Feb.02 120,662 2,747 528,947 13,939 13,941 323 4,749 107 133,630 3,635 33,055 864
Mar.02 94,229 2,185 503,415 13,989 10,446 249 4,773 111 101,708 2,863 37,387 1,094
01-02 1,025,588 21,482 1,957,856 51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383
Apr.02 73,635 1,656 552,727 15,065 11,183 260 5,389 122 121,225 3,400 40,443 1,170
May.02 94,312 2,022 605,284 15,981 13.07 294 7,719 169 126,867 3,490 57,984 1,643
Source: www.nseindia.com
Note: 1.Stock futures were started only in November 2001
2.Index options and stock options were started only in June and July 2001 respectively
BASICS OF DERIVATIVES
73
Growth of Derivatives in India
0500
10001500200025003000
Jun.
00
Aug
.00
Oct
.00
Dec
.003
Feb
.01
Apr
.01
Jun.
01
Aug
.01
Oct
.01
Dec
.01
Feb
.02
Apr
.02
From June 2000 to May 2002
Val
ue R
s C
rore
s
BASICS OF DERIVATIVES
74
ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA
The options price for a Call, computed as per the following Black Scholesformula:C = S * N (d1) - X * e- rt * N (d2)
and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)
where :d1� �>OQ��6���;�����U���1
2������ �W@���1� �VTUW�W�d2� �>OQ��6���;�����U���1
2������ �W@���1� �VTUW�W�= d1���1� �VTUW�W�
C = price of a call optionP = price of a put optionS = price of the underlying assetX = Strike price of the optionr = rate of interestt = time to expiration1� �YRODWLOLW\�RI�WKH�XQGHUO\LQJN represents a standard normal distribution with mean = 0 and standarddeviation = 1ln represents the natural logarithm of a number. Natural logarithms are based onthe constant e (2.718).
BASICS OF DERIVATIVES
75
ANNEXURE 4- L C GUPTA COMMITTEE REPORT
EXECUTIVE SUMMARY
1. The Committee strongly favours the introduction of financial derivatives in order to
provide the facility for hedging in the most cost-efficient way against market risk. This is
an important economic purpose. At the same time, it recognises that in order to make
hedging possible, the market should also have speculators who are prepared to be
counter-parties to hedgers. A derivatives market wholly or mostly consisting of
speculators is unlikely to be a sound economic institution. A soundly based derivatives
market requires the presence of both hedgers and speculators.
2. The Committee is of the opinion that there is need for equity derivatives, interest rate
derivatives and currency derivatives. In the case of equity derivatives, while the
Committee believes that the type of derivatives contracts to be introduced will be
determined by market forces under the general oversight of SEBI and that both futures
and options will be needed, the Committee suggests that a beginning may be made with
stock index futures.
3. The Committee favours the introduction of equity derivatives in a phased manner so that
the complex types are introduced after the market participants have acquired some
degree of comfort and familiarity with the simpler types. This would be desirable from the
regulatory angle too.
4. The Committee's recommendations on regulatory framework for derivatives trading
envisage two-level regulation, i.e. exchange-level and SEBI-level. The Committee’s main
emphasis is on exchange-level regulation by ensuring that the derivative exchanges
operate as effective self-regulatory organisations under the overall supervision of SEBI.
5. Since the Committee has placed considerable emphasis on the self-regulatory
competence of derivatives exchanges under the over-all supervision and guidance of
BASICS OF DERIVATIVES
76
SEBI, it is necessary that SEBI should review the working of the governance system of
stock exchanges and strengthen it further. A much stricter governance system is needed
for the derivative exchanges in order to ensure that a derivative exchange will be a totally
disciplined market place.
6. The Committee is of the opinion that the entry requirements for brokers/dealers for
derivatives market have to be more stringent than for the cash market. These include not
only capital adequacy requirements but also knowledge requirements in the form of
mandatory passing of a certification program by the brokers/dealers and the sales
persons. An important regulatory aspect of derivatives trading is the strict regulation of
sales practices.
7. Many of the SEBI's important regulations relating to exchanges, brokers-dealers,
prevention of fraud, investor protection, etc., are of general and over-riding nature and
hence, these should be reviewed in detail in order to be applicable to derivatives
exchanges and their members.
8. The Committee has recommended that the regulatory prohibition on the use of
derivatives by mutual funds should go. At the same time, the Committee is of the opinion
that the use of derivatives by mutual funds should be only for hedging and portfolio
balancing and not for speculation. The responsibility for proper control in this regard
should be cast on the trustees of mutual funds. The Committee does not favour framing
of detailed SEBI regulations for this purpose in order to allow flexibility and development
of ideas.
9. SEBI, as the overseeing authority, will have to ensure that the new futures market
operates fairly, efficiently and on sound principles. The operation of the underlying cash
markets, on which the derivatives market is based, needs improvement in many respects.
The equity derivatives market and the equity cash market are parts of the equity market
mechanism as a whole.
BASICS OF DERIVATIVES
77
10. SEBI should create a Derivatives Cell, a Derivatives Advisory Committee, and Economic
Research Wing. It would need to develop a competence among its personnel in order to
be able to guide this new development along sound lines.
Chapter 1
THE EVOLUTION AND ECONOMIC PURPOSE
OF DERIVATIVES
Appointment of the Committee
1. The Committee was appointed by the Securities and Exchange Board of India (SEBI) by
a Board resolution dated November 18, 1996 in order "to develop appropriate regulatory
framework for derivatives trading in India". List of the Committee members is shown in
the end
2. The Committee’s concern is with financial derivatives in general and equity derivatives in
particular.
The evolution of derivatives
3. The development of futures trading is an advancement over forward trading which has
existed for centuries and grew out of the need for hedging the price-risk involved in many
commercial operations. Futures trading represents a more efficient way of hedging risk.
Futures vs. Forward contracts
4. As both forward contracts and futures contracts are used for hedging, it is important to
understand the distinction between the two and their relative merits. Forward contracts
are private bilateral contracts and have well-established commercial usage. They are
exposed to default risk by counterparty. Each forward contract is unique in terms of
contract size, expiration date and the asset type/quality. The contract price is not
BASICS OF DERIVATIVES
78
transparent, as it is not publicly disclosed. Since the forward contract is not typically
tradable, it has to be settled by delivery of the asset on the expiration date.
5. In contrast, futures contracts are standardized tradable contracts. They are standardized
in terms of size, expiration date and all other features. They are traded on specially
designed exchanges in a highly sophisticated environment of stringent financial
safeguards. They are liquid and transparent. Their market prices and trading volumes are
regularly reported. The futures trading system has effective safeguards against defaults
in the form of Clearing Corporation guarantees for trades and the daily cash adjustment
(mark-to-market) to the accounts of trading members based on daily price change.
Futures are far more cost-efficient than forward contracts for hedging.
6. Forward contracts are being used in India on a fairly large scale in the foreign exchange
market for covering currency risk but there are neither currency futures nor any other
financial futures in India at present. This report deals only with exchange-traded
derivatives. Over-the-Counter derivatives are not covered here.
A world-wide long-term process
7. The evolution of markets in commodities and financial assets may be viewed as a
worldwide long-term historical process. In this process, the emergence of futures has
been recognized in economic literature as a financial development of considerable
significance. A vast economic literature has been built around this subject. From
"forward" trading in commodities emerged the commodity "futures". The emergence of
financial futures is a more recent phenomenon and represents an extension of the idea of
organized futures markets.
8. Among financial futures, the first to emerge were currency futures in 1972 in U.S.A.,
followed soon by interest rate futures. Stock index futures and options first emerged in
1982 only. Since then, financial futures have quickly spread to an increasing number of
developed and developing countries. They are recognized as the best and most cost-
efficient way of meeting the felt need for risk-hedging in certain types of commercial and
BASICS OF DERIVATIVES
79
financial operations. Countries not providing such globally accepted risk-hedging facilities
are disadvantaged in today’s rapidly integrating global economy.
9. The Committee noted that derivatives are not always clearly understood. A few well-
publicized debacles involving derivatives trading in other countries had created
widespread apprehensions in Indian public mind also. While the economic literature
recognizes the efficiency-enhancing effect of derivatives on the economy in general and
the financial markets in particular, the Committee feels that there is need for educating
the public opinion as also the need to ensure effective regulatory checks. Such regulation
should be aimed not only at ensuring the market’s integrity but also at enhancing the
market’s economic efficiency and protecting investors.
Derivatives concept
10. The term "derivative" indicates that it has no independent value, i.e. its value is entirely
"derived" from the value of the cash asset. A derivative contract or product, or simply
"derivative", is to be sharply distinguished from the underlying cash asset, i.e. the asset
bought/sold in the cash market on normal delivery terms. A general definition of
"derivative" may be suggested here as follows: "Derivative" means forward, future or
option contract of pre-determined fixed duration, linked for the purpose of contract
fulfillment to the value of specified real or financial asset or to index of securities.
11. Derivatives are meant essentially to facilitate temporarily (usually for a few months)
hedging of price risk of inventory holding or a financial/commercial transaction over a
certain period. In practice, every derivative "contract" has a fixed expiration date, mostly
in the range of 3 to 12 months from the date of commencement of the contract. In the
market’s idiom, they are "risk management tools". The use of forward/futures contracts as
hedging techniques is a well-established practice in commercial and industrial operations.
Their application to financial transactions is relatively new, having emerged only about 25
years ago.
BASICS OF DERIVATIVES
80
12. In order to illustrate the use of this risk hedging technique, we may take the familiar
example of a processor or manufacturer, for whom an important source of risk is the
fluctuation in the market price of his main raw material. For instance, a maker of gold
jewellery may have accepted an export order to be delivered over the next three months.
If, in the meanwhile, the cash price of gold (the raw material) rises, the jewellery maker’s
manufacturing and exporting activity can become economically unviable. The availability
of gold futures alleviates the manufacturer-exporter’s problem. He can buy gold futures.
Any loss caused by rise in the cash price of gold purchased for the export order will then
be offset by profit on the futures contract. Any extra profit due to fall in gold price will also
be offset as there will be loss on the futures contract. Thus, hedging is the equivalent of
insurance facility against risk from market price variation. A world without hedging facility
is like a world without insurance with respect to the particular kind of risk.
13. The manufacturer-exporter in the example given above could, of course, have bought all
the raw material requirement in advance but that would have entailed heavy interest,
insurance and storage costs. Thus, the facility of futures trading offers a cost-efficient and
convenient way for hedging against price risk.
14. Apart from the risk from variation of raw material price, the manufacturer-exporter, in the
above example, also faces another risk from variation of exchange rate. If the rupee
appreciates before he is able to bring the export proceeds into India, his rupee receipts
would be reduced. He may hedge against such currency risk too.
Both Futures and Options needed
15. Futures and options have many similarities and serve similar purposes but the risk profile
of an option contract is asymmetric and regulatory complexities are greater as compared
to futures contract. Options are contracts giving the holder the right (but not the
obligation) to buy (known as "call option") or sell (known as "put option") securities at a
pre-determined price (known as "strike price" or "exercise price"), within or at the end of a
specified period (known as "expiration period"). American options are exercisable at any
BASICS OF DERIVATIVES
81
time prior to expiration date while European options can be exercised only at the
expiration date. For the call option holder, it is worthwhile to exercise the right only if the
price of the underlying securities rises above the exercise price. For the put option holder,
it is worthwhile to exercise the right only if the price falls below the exercise price. There
can be options on commodities, currencies, securities, stock index, individual stocks and
even on futures. Options strategies can be highly complicated.
16. In order to acquire the right of option, the option buyer pays to the option seller (known as
"option writer") an Option Premium, which is the price paid for the right. The buyer of an
option can lose no more than the option premium paid but his possible gain in
unbounded. On the other hand, the option writer’s possible loss is unbounded but his
maximum gain is limited to the "option premium" charged by him to the holder. The most
critical aspect of options contracts is the evaluation of the fairness of option premium, i.e.
option pricing.
17. The Committee feels that the availability of both financial futures and options would
provide to the users a wider choice of hedging instruments than any of them alone.
Hedgers vs. Speculators
18. Hedging is the key aspect of derivatives and also its basic economic purpose. In the U.S.,
the Commodity Futures Trading Commission (CFTC), the futures regulatory authority,
while considering proposals for approval of a new derivative product, particularly
examines the ability of the product to provide hedging. While the Committee has also
emphasized the hedging aspect of derivatives, it fully recognises that the derivatives
market’s capacity to absorb buying/selling by hedgers is directly dependent on the
availability of speculators to act as counter-parties to hedgers. Hedging will not be
possible if there are no speculators.
19. For the above reason, decisions about many aspects of derivatives trading, e.g., contract
size, design and duration, would have to strike a balance between the needs of the
hedgers and the necessity to attract an adequate number of well-capitalised speculators
BASICS OF DERIVATIVES
82
who are prepared to take upon themselves the price risk which hedgers want to give up.
The fact is that a futures market, to be able to operate and be liquid, should have both
hedging participation and speculative appeal. Some studies of futures markets in the U.S.
have shown that hedging activity accounts for about 50-60 per cent of the market’s total
volume.
Remove prohibition on hedging by institutions
20. The Committee is of the opinion that a futures market based wholly or mostly on
speculation will not be a sound economic institution. There presently exist in India legal
restrictions on the use of derivatives by investment institutions even for purposes of
hedging. Such restrictions should be removed in the interest of the institutions
themselves.
21. In the case of a hedger, seeking to offset the price risk on his holding of inventory of
bonds, equities, foreign currency or commodities by selling futures in the same, his
position will as follows:
Regarding
Inventory
Regarding futures
transactions
Remarks
If price falls There will be loss
on inventory held
There will be profit
on futures Sold
Hedger wants to
insure against the
loss
If price rises There will be Profit
on inventory
There will be loss
on futures sold
The inventory profit
is Unanticipated
and is neutralised
by loss on futures.
In the case of a pure speculator, as distinguished from a hedger, futures trading is a
business by itself as he has no offsetting commercial position. He is not seeking to
reduce or transfer risk. On the contrary, he is accepting risk in the pursuit of profit. It
BASICS OF DERIVATIVES
83
is a highly specialised business. His success depends on his forecasting skills in
regard to future prices of the particular commodity or financial asset traded in the
futures market.
The hedging test: practical importance
21. The test of whether a futures transaction is for hedging or for speculation hinges on
whether there already exists a related commercial position which is exposed to risk of
loss due to price movement. The distinction between hedging and speculation is of great
practical importance because some organisations, either by voluntary choice or by
regulatory restriction, are allowed to hedge but not to speculate in the forward or futures
markets.
Financial Derivative Types
18. The Committee’s main concern is with equity based derivatives but it has tried to
examine the need for financial derivatives in a broader perspective. Financial
transactions and asset-liability positions are exposed to three broad types of price risks,
viz:
a. equities "market risk", also called "systematic risk" (which cannot be
diversified away because the stock market as a whole may go up or down
from time to time).
b. interest rate risk (as in the case of fixed-income securities, like treasury
bond holdings, whose market price could fall heavily if interest rates shot up),
and
c. exchange rate risk (where the position involves a foreign currency, as in
the case of imports, exports, foreign loans or investments).
The above classification of price risks explains the emergence of (a) equity
futures, (b) interest rate futures and (c) currency futures, respectively. Equity
futures have been the last to emerge.
BASICS OF DERIVATIVES
84
Need for coordinated development
23. The recent report of the RBI-appointed Committee on Capital Account Convertibility
(Tarapore Committee) has expressed the view that "time is ripe for introduction of futures
in currencies and interest rates to facilitate various users to have access to a wide
spectrum of cost-efficient hedge mechanism" (p.24). In the same context, the Tarapore
Committee has also opined that "a system of trading in futures ... is more transparent and
cost-efficient than the existing system (of forward contracts)".
24. There are inter-connections among the various kinds of financial futures, mentioned
above, because the various financial markets are closely inter-linked, as the recent
financial market turmoil in East and South-East Asian countries has shown. The basic
principles underlying the running of futures markets and their regulation are the same.
Having a common trading infrastructure will have important advantages. The Co1mmittee,
therefore, feels that the attempt should be to develop an integrated market structure.
SEBI-RBI coordination mechanism
25. As all the three types of financial derivatives are set to emerge in India in the near future,
it is desirable that such development be coordinated. The Committee recommends that a
formal mechanism be established for such coordination between SEBI and RBI in respect
of all financial derivatives markets. This will help to avoid the problem of overlapping
jurisdictions.
Chapter 2
USES OF EQUITY DERIVATIVES
Survey findings about potential for financial derivatives in India
1. The Committee made an assessment of the nature of felt-need and interest
in the various types of financial derivatives among potential market
participants through a Questionnaire-based survey. The survey covered all
BASICS OF DERIVATIVES
85
types of potential players in the derivatives market, such as mutual funds,
other financial institutions, commercial banks, investment bankers and
stockbrokers. Out of about 300 Questionnaires sent out by the Committee in
May 1997, the number of replies received was 112, comprising 67 brokers
and 45 others.
In addition, the Committee held a full day session to interact with groups
representing each of the above categories of interests. A total of about 35
persons attended the group-wise discussions.
2. The survey clearly revealed that there was wide recognition of the need for
all the three major types of financial derivatives, viz., equity derivatives,
interest rate derivatives and currency derivatives. The results of the survey
are summarized in Table 2.1 given at the end of this chapter.
3. Interestingly, the survey findings showed that stock index futures ranked as
the most popular and preferred type of equity derivative, the second being
stock index options and the third being options on individual stocks.
Considerable interest exists in all the three types of equity derivatives
mentioned above. The fourth type, viz. individual stock futures, was favoured
much less. It is pertinent to note that the U.S.A. does not permit individual
stock futures. Only one or two countries in the world are known to have
futures on individual stocks. Stock Index Futures are internationally the most
popular forms of equity derivative.
4. The difference in relative preferences among the various financial derivative
types is shown more sharply when we look at answers to the question:
Which of the derivative products should be introduced first? The respondents
who placed stock index futures as first represented 65% of the sample,
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86
compared to 39 per cent who placed stock index options as first (see Table
2.1).
5. The survey also showed that there exists widespread demand for hedging
facility, as indicated by the finding that nearly 70% of the respondents in our
sample indicated that they would like to use the various types of equity
derivatives for hedging purpose. On the other hand, about 39% of
respondents would like to participate in the derivatives market as
dealer/speculator, 64% as broker and only about 36% as option writer. Many
of the respondents would like to participate in more than one capacity.
6. In terms of contract duration of Stock Index futures and options, the 3 months
duration was the most favoured, as may be expected. As regards the choice
between the American and European types of options, the former was
favoured overwhelmingly.
7. As regards expectations of growth of stock index futures and options trading
in India, about 33% of respondents expected it to grow very fast, 41%
expected it to grow moderately and the remaining 16% expected slow growth
of trading. On the whole, the survey findings are very positive about the need
and prospects of equity derivatives trading in India.
Popularity of Stock Index Futures
There are many reasons for the wide international acceptance of stock index
futures and for the strong preference for this instrument in India too compared to
other forms of equity derivatives. This is because of the following advantages of
stock index futures :
1. Institutional and other large equityholders need portfolio hedging facility.
Hence, index-based derivatives are more suited to them and more cost-
effective than derivatives based on individual stocks. Even pension funds in
U.S.A. are known to use stock index futures for risk hedging purposes.
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2. Stock index is difficult to be manipulated as compared to individual stock
prices, more so in India, and the possibility of cornering is reduced. This is
partly because an individual stock has a limited supply which can be
cornered. Of course, manipulation of stock index can be attempted by
influencing the cash prices of its component securities. While the possibility
of such manipulation is not ruled out, it is reduced by designing the index
appropriately. There is need for minimizing it further by undertaking cash
market reforms, as suggested by the Committee later in this chapter.
3. Stock index futures enjoy distinctly greater popularity, and are, therefore,
likely to be more liquid than all other types of equity derivatives, as shown
both by responses to the Committee’s questionnaire and by international
experience.
4. Stock index, being an average, is much less volatile than individual stock
prices. This implies much lower capital adequacy and margin requirements in
the case of index futures than in the case of derivatives on individual stocks.
The lower margins will induce more players to join the market.
5. In the case of individual stocks, the positions which remain outstanding on
the expiration date will have to be settled by physical delivery. This is an
accepted principle everywhere. The futures and the cash market prices have
to converge on the expiration date. Since Index futures do not represent a
physically deliverable asset, they are cash settled all over the world on the
premise that the index value is derived from the cash market. This, of course,
implies that the cash market is functioning in a reasonably sound manner
and the index values based on it can be safely accepted as the settlement
price.
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6. Regulatory complexity is likely to be less in the case of stock index futures
than for other kinds of equity derivatives, such as stock index options, or
individual stock options.
Cash and futures market relationship
1. The objective of SEBI is to make both derivatives market and cash market
fair, efficient and transparent. Economically, it is important to realise that
equity cash market and equity derivatives market are of one piece. Their
sound development is inter-related closely. The Committee has kept this
objective in view and would like to ensure that the new derivatives market is
developed along sound lines. This objective can best be achieved by
separating cash market and futures market and thereby regulating them
effectively. At present, almost 90 per cent of the trading volume in the cash
market does not settle in deliveries of the stock. The great bulk (over 85 per
cent) of such trading is in 5 scrips only. The Committee noted that several
earlier committees on stock exchange reforms, including the G.S. Patel
Committee (1984-85), had expressed concern at the small percentage of
deliveries in Indian exchanges. They had also lamented the illiquidity of a
majority of listed shares and the practice of switching of positions from one
exchange to another due to different exchanges having different settlement
cycles.
2. The Committee hopes that some of the speculative transactions, which are
presently conducted in the cash market, would be attracted towards the
proposed derivatives market.
3. The Committee recognises that an efficient cash market is required for an
efficient futures market. The Committee also recognises the danger that if the
cash market behaviour is erratic or does not reflect fundamentals, a futures
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89
market, based on such a cash market, will fail to give a correct indication of
future spot prices and its usefulness for price discovery will be reduced.
4. The Committee is of the opinion that the following revisions could lead to a
further strengthening of the underlying cash market:
a. uniform settlement cycle among all the stock exchanges moving towards
rolling settlement cycles to prevent the cash market from effectively being
used as an unregulated futures market;
b. strengthening of administrative machinery of the existing stock exchanges
wherever necessary to tighten the exchange’s regulatory oversight; such
tight supervision being essential for successful derivatives trading.
c. speeding up dematerialisation of securities without which options on
individual securities should not be allowed as non-dematerialised securities
involve settlement delays and problems; allowing options without
dematerialisation is likely to make the options market manipulable; and
d. taking steps to encourage more delivery based transactions in a greater
number of securities.
The Committee is of the view that arbitrage transactions between the index
futures market and the cash market for equities is likely to have a beneficial
effect on the functioning of the cash market in terms of price discovery,
broadening of liquidity and over-all efficiency.
Strengthening the influence of fundamental factors
1. The Committee thought of ways to ensure that fundamental factors
adequately enter into the price discovery process in the cash market and,
through it, in the futures market. In this connection, the Committee noted that
it was important in the case of futures markets, whether commodity futures or
other futures, to assist the price discovery process by promoting the
dissemination of all relevant market information about the "real" factors, such
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90
as supplies, demand, prospects, etc. In regard to stock index futures, the
Committee feels that there are two important ways of promoting its linkage to
fundamental factors. First, there must be a requirement that average P/E
ratio of the index used for futures trading should be made available by the
exchange concerned on daily basis as essential market information. Second,
the arbitrage between the index futures market and the cash market for the
shares composing the index should be facilitated by requiring such shares to
be traded in the depository mode and also by making available the facility of
stock borrowing so that short-selling is rendered possible.
Strategic uses of stock index futures
2. It was represented to the Committee by mutual funds and other financial
institutions that they were handicapped in their investment strategy because
of the non-availability of portfolio hedging facility in India. They need
derivatives, not for generating speculative profits, but for strategic purposes
of controlling risk or restructuring portfolios. Given below are some practical
examples from a presentation made before the Committee by some
institutional representatives :
i. Reducing the equity exposure in a mutual fund scheme: Suppose that a
balanced mutual fund scheme decides to reduce its equity exposure from,
say, 40% to 30% of the corpus. Presently, this can be achieved only by
actual selling of equityholdings. Such selling entails three problems: first, it is
likely to depress equity prices to the disadvantage of the Scheme and the
whole market; second, it cannot be achieved speedily and may take some
months, and third, it is a costly procedure because of brokerage, etc. The
same objective can be achieved through index futures at once, at much less
cost and with much less impact on the cash market. The scheme may
immediately sell index futures. The actual sale of equityholdings may be
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91
done gradually depending on market conditions in order to realise the best
possible prices. As unloading of holdings progresses, the index futures
transaction may be unwound by an opposite transaction to the same extent.
ii. Investing the funds raised by new schemes: When a new scheme is floated,
the money raised does not get fully invested for considerable time. Suitable
securities at reasonable prices may not be immediately available in sufficient
quantity. Rushing to invest the whole money is likely to drive up prices to the
disadvantage of the scheme. Timing is important in the case of equity
schemes. If the scheme is launched to take advantage of low equity prices,
such advantage may be lost due to delay in acquiring suitable securities as
the market situation may change. The availability of stock index futures can
take care of this entire problem.
iii. Partial liquidation of portfolio in case of open-ended fund: In the case of an
open-ended scheme, repurchases may sometimes necessitate liquidation of
a part of the portfolio but there are problems in executing such liquidation.
Selling each holding in proportion to its weight in the portfolio is often
impracticable. Some of the holdings may be relatively illiquid. Rushing to the
cash market to liquidate would drive down prices. The price actually realised
may be different from the price used in NAV computation for repurchase. The
timing of liquidation may not be right because of market depression. Stock
Index Futures can help to overcome these problems to the advantage of
unitholders.
iv. Preserving the value of portfolio during times of market stress: There are
times when the main worry is the possibility that the value of the entire equity
portfolio may fall substantially if, say, event "X" occurs. Sale of Stock Index
Futures can be used to insure against the risk. Such insurance is specially
important if the accounts closing date is nearby because the yearly results
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will get affected if the risk materialises. Stock index futures can neutralise
such risk.
v. International investors: The buying and selling operations of FIIs presently
cause disproportionate price-effect on the Indian equities market because all
transactions are through the cash market only. This is an important factor
making the Indian equities market highly volatile from day to day. The FIIs'
buying/selling is aimed at either increasing or reducing their exposure to the
Indian equities market. In other words, what the FIIs buy/sell is a "piece" of
the whole Indian equities market. If stock index futures are available, this can
be carried out with greater speed and less cost and without adding too much
to market volatility. The FII flows show sudden changes from time to time.
While trying to maximise the net inflow of FII portfolio investment, its
disturbing effects on the cash market for Indian equities can possibly be
minimised if the facility of stock index futures is available. The availability of
such a hedging device is likely to increase the international investors'
appetite for Indian equities.
Phasing needed
1. The Committee believes that the types of equity derivatives to be introduced
in India should ultimately be left to the market forces under over-all general
supervision of SEBI. It is likely to be an evolutionary process, as has been
the case in other countries. The experience in other countries also shows
that only a small proportion of new futures contracts prove to be successful
and survive for long. The market decides which ones will succeed.
2. The consensus in the Committee was that stock index futures would be the
best starting point for equity derivatives in India. The Committee has arrived
at this conclusion after careful examination of all aspects of the problem,
including the survey findings and regulatory preparedness. The Committee
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would favour the introduction of other types of equity derivatives also, as the
derivatives market grows and the market players acquire familiarity with its
operations. Other equity derivatives include options on stock index or on
individual stocks. There may also be room for more than one stock index
futures. It is bound to be a gradual process, shaped by market forces under
the over-all supervision of SEBI. One member of the Committee, i.e. Mr. P.S.
Mistry, formally dissociated himself from the consensus mentioned above by
favouring the introduction of options contracts before the introduction of
futures.
The enabling legal changes
3. It is understood that the Central Government is already considering the legal
action required in order to enable the use of stock index derivatives by
expanding the definition of "securities" under Section 2(h)(iia) of the
Securities Contracts (Regulation) Act, 1956, by declaring derivatives
contracts based on index of prices of securities and other derivatives
contracts to be securities. The Committee recommends that this should be
done expeditiously. The Committee also recommends that the notification
issued by the Central Government in June 1969 under Section 16 of the
SC(R)A be amended so as to enable trading in futures and options contracts.
The prohibition of trading in options on securities has already been
withdrawn by the Securities Laws Amendment Act with effect from January
25, 1995.
Table 2.1
ANALYSIS OF REPLIES TO THE COMMITTEE’S QUESTIONNAIRE
ADDRESSED TO POTENTIAL PLAYERS IN THE FINANCIAL
DERIVATIVE MARKET IN INDIA
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Q. No. Question Number and percentage of
affirmative replies
(Total respondents=112)
Number % to total
1a. Which risks are of most concern in your operations?
i. Systematic risk 96 85.71
Interest rate risk 35 32.25
Exchange rate risk 27 24.11
Default risk 71 63.39
Asset-liability mismatch 23 20.54
Any other 11 9.82
1c. Are you handicapped because index-based futures and
options are not available in India?
85 75.89
2a. Is there a need for having
i. Stock Index Futures 98 87.50
Stock Index Options 92 82.14
Futures on Individual Stocks 71 63.39
Options on Individual Stocks 90 80.36
Interest rate futures 68 60.71
Currency futures 67 59.82
2b. Which of the above do you favour most?
i. Stock Index Futures 73 65.28
Stock Index Options 45 40.18
Futures on Individual Stocks 22 19.64
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Options on Individual Stocks 32 28.57
Interest rate futures 21 18.75
Currency futures 14 12.5
3a. In which of the following would you like to participate?
i. Stock Index Futures 92 82.14
Stock Index Options 82 73.21
Futures on Individual Stocks 61 54.46
Options on Individual Stocks 78 69.64
Interest rate futures 43 38.39
Currency futures 37 33.04
3b. Which of the derivative products mentioned above
should be introduced first?
i. Stock Index Futures 73 65.18
Stock Index Options 44 39.29
Futures on Individual Stocks 14 12.5
Options on Individual Stocks 15 13.39
Interest rate futures 13 11.61
Currency futures 7 6.25
4a. In the case of the first four products mentioned in the
previous question will you like to participate as:
i. hedger 78 69.64
dealers/speculators 44 39.29
broker 72 64.29
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option writer 40 35.71
any other 6 5.36
4c. Which derivative product is likely to be the most
popular in India?
i. Stock Index Futures 63 56.25
Stock Index Options 40 35.71
Futures on Individual Stocks 23 20.54
Options on Individual Stocks 38 33.93
Interest rate futures 8 7.14
Currency futures 7 6.25
5a. Which derivative product are needed most in India for
improving stock market efficiency?
i. Stock Index Futures 66 58.93
Stock Index Options 47 41.96
Futures on Individual Stocks 35 31.25
Options on Individual Stocks 36 32.14
Interest rate futures 6 5.36
Currency futures 2 1.79
6a. Do you expect that the trading in Stock Index Futures
and Options in India will
i. Grow very fast 37 33.03
Grow moderately 46 41.07
Grow slowly 18 16.07
Not grow much 2 1.79
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Can’t say anything 2 1.79
11. What contract maturity period would interest you for
trading in:
i. Stock Index Futures and Options
3 months 93 83.04
6 months 70 62.50
9 months 37 33.04
12 months 35 31.25
(ii) Futures and Options on Individual Stocks
3 months 88 78.57
6 months 60 53.57
9 months 27 24.11
12 months 31 27.68
12. In case of Options do you favour:
i. American 79 70.54
European 30 26.79
Note: Questions 2b, 3b and 4c expected respondents to tick against one type only
but some respondents ticked more than one, resulting in double counting. Hence, the
percentages add to more than 100. This does not, however, vitiate the relative
comparison among the derivative types.
Chapter 3
REGULATORY FRAMEWORK FOR DERIVATIVES:
THE GUIDING PRINCIPLES
Regulatory objectives
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1. The Committee believes that regulation should be designed to achieve
specific, well-defined goals. It is inclined towards positive regulation designed
to encourage healthy activity and behaviour. It has been guided by the
following objectives :
a. Investor Protection: Attention needs to be given to the following four aspects:
i. Fairness and Transparency: The trading rules should ensure that
trading is conducted in a fair and transparent manner. Experience in
other countries shows that in many cases, derivatives
brokers/dealers failed to disclose potential risk to the clients. In this
context, sales practices adopted by dealers for derivatives would
require specific regulation. In some of the most widely reported
mishaps in the derivatives market elsewhere, the underlying reason
was inadequate internal control system at the user-firm itself so that
overall exposure was not controlled and the use of derivatives was
for speculation rather than for risk hedging. These experiences
provide useful lessons for us for designing regulations.
ii. Safeguard for clients' moneys: Moneys and securities deposited by
clients with the trading members should not only be kept in a
separate clients' account but should also not be attachable for
meeting the broker's own debts. It should be ensured that trading by
dealers on own account is totally segregated from that for clients.
iii. Competent and honest service: The eligibility criteria for trading
members should be designed to encourage competent and qualified
personnel so that investors/clients are served well. This makes it
necessary to prescribe qualification for derivatives brokers/dealers
and the sales persons appointed by them in terms of a knowledge
base.
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iv. Market integrity: The trading system should ensure that the market's
integrity is safeguarded by minimising the possibility of defaults. This
requires framing appropriate rules about capital adequacy, margins,
clearing corporation, etc.
a. Quality of markets: The concept of "Quality of Markets" goes well beyond
market integrity and aims at enhancing important market qualities, such as
cost-efficiency, price-continuity, and price-discovery. This is a much broader
objective than market integrity.
b. Innovation: While curbing any undesirable tendencies, the regulatory
framework should not stifle innovation which is the source of all economic
progress, more so because financial derivatives represent a new rapidly
developing area, aided by advancements in information technology.
1. Of course, the ultimate objective of regulation of financial markets has to be
to promote more efficient functioning of markets on the "real" side of the
economy, i.e. economic efficiency.
2. Leaving aside those who use derivatives for hedging of risk to which they are
exposed, the other participants in derivatives trading are attracted by the
speculative opportunities which such trading offers due to inherently high
leverage. For this reason, the risk involved for derivative traders and
speculators is high. This is indicated by some of the widely publicised
mishaps in other countries. Hence, the regulatory frame for derivative
trading, in all its aspects, has to be much stricter than what exists for cash
trading. The scope of regulation should cover derivative exchanges,
derivative traders, brokers and sales-persons, derivative contracts or
products, derivative trading rules and derivative clearing mechanism.
3. In the Committee's view, the regulatory responsibility for derivatives trading
will have to be shared between the exchange conducting derivatives trading
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on the one hand and SEBI on the other. The committee envisages that this
sharing of regulatory responsibility is so designed as to maximise regulatory
effectiveness and to minimise regulatory costs.
Major issues concerning regulatory framework
4. The Committee's attention had been drawn to several important issues in
connection with derivatives trading. The Committee has considered such
issues, some of which have a direct bearing on the design of the regulatory
framework. They are listed below :
a. Should a derivatives exchange be organised as independent and separate
from an existing stock exchange?
b. What exactly should be the division of regulatory responsibility, including
both framing and enforcing the regulations, between SEBI and the
derivatives exchange?
c. How should we ensure that the derivatives exchange will effectively fulfill its
regulatory responsibility.
d. What criteria should SEBI adopt for granting permission for derivatives
trading to an exchange?
e. What conditions should the clearing mechanism for derivatives trading satisfy
in view of high leverage involved?
f. What new regulations or changes in existing regulations will have to be
introduced by SEBI for derivatives trading?
Should derivatives trading be conducted in a separate exchange?
1. A major issue raised before the Committee for its decision was whether
regulations should mandate the creation of a separate exchange for
derivatives trading, or allow an existing stock exchange to conduct such
trading. The Committee has examined various aspects of the problem. It has
also reviewed the position prevailing in other countries. Exchange-traded
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financial derivatives originated in USA and were subsequently introduced in
many other countries. Organisational and regulatory arrangements are not
the same in all countries. Interestingly, in U.S.A., for reasons of history and
regulatory structure, futures trading in financial instruments, including
currency, bonds and equities, was started in early 1970s, under the auspices
of commodity futures markets rather than under securities exchanges where
the underlying bonds and equities were being traded. This may have
happened partly because currency futures, which had nothing to do with
securities markets, were the first to emerge among financial derivatives in
U.S.A. and partly because derivatives were not "securities" under U.S. laws.
Cash trading in securities and options on securities were under the Securities
and Exchange Commission (SEC) while futures trading was under the
Commodities Futures Trading Commission (CFTC). In other countries, the
arrangements have varied.
2. The Committee examined the relative merits of allowing derivatives trading to
be conducted by an existing stock exchange vis-a-vis a separate exchange
for derivatives. The arguments for each are summarised below.
Arguments for allowing existing stock exchanges to start futures trading:
a. The most weighty argument in this regard is the advantage of synergies
arising from the pooling of costs of expensive information technology
networks and the sharing of expertise required for running a modern
exchange. Setting-up a separate derivatives exchange will involve high costs
and require more time.
b. The recent trend in other countries seems to be towards bringing futures and
cash trading under coordinated supervision. The lack of coordination was
recognised as an important problem in U.S.A. in the aftermath of the October
1987 market crash. Exchange-level supervisory coordination between futures
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and cash markets is greatly facilitated if both are parts of the same
exchange.
Arguments for setting-up separate futures exchange:
a. The trading rules and entry requirements for futures trading would have to be
different from those for cash trading.
b. The possibility of collusion among traders for market manipulation seems to
be greater if cash and futures trading are conducted in the same exchange.
c. A separate exchange will start with a clean slate and would not have to
restrict the entry to the existing members only but the entry will be thrown
open to all potential eligible players.
Recommendation
From the purely regulatory angle, a separate exchange for futures trading seems to
be a neater arrangement. However, considering the constraints in infrastructure
facilities, the existing stock exchanges having cash trading may also be permitted to
trade derivatives provided they meet the minimum eligibility conditions as indicated
below :
1. The trading should take place through an online screen-based trading system, which
also has a disaster recovery site. The per-half-hour capacity of the computers and
the network should be at least 4 to 5 times of the anticipated peak load in any half-
hour, or of the actual peak load seen in any half-hour during the preceding six
months. This shall be reviewed from time to time on the basis of experience.
2. The clearing of the derivatives market should be done by an independent clearing
corporation, which satisfies the conditions listed in a later chapter of this report.
3. The exchange must have an online surveillance capability which monitors positions,
prices and volumes in real-time so as to deter market manipulation. Price and
position limits should be used for improving market quality.
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4. Information about trades, quantities, and quotes should be disseminated by the
exchange in real-time over at least two information vending networks which are
accessible to investors in the country.
5. The Exchange should have at least 50 members to start derivatives trading.
6. If derivatives trading is to take place at an existing cash market, it should be done in
a separate segment with a separate membership; i.e., all members of the existing
cash market would not automatically become members of the derivatives market.
7. The derivatives market should have a separate governing council which shall not
have representation of trading/clearing members of the derivatives Exchange beyond
whatever percentage SEBI may prescribe after reviewing the working of the present
governance system of exchanges.
8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be
a member of the Governing Council. If the Chairman is a Broker/Dealer, then, he
shall not carry on any Broking or Dealing Business on any Exchange during his
tenure as Chairman.
9. The exchange should have arbitration and investor grievances redressal mechanism
operative from all the four areas/regions of the country.
10. The exchange should have an adequate inspection capability.
11. No trading/clearing member should be allowed simultaneously to be on the governing
council of both the derivatives market and the cash market.
12. If already existing, the Exchange should have a satisfactory record of monitoring its
members, handling investor complaints and preventing irregularities in trading.
3.9 The next chapter will elaborate how the regulatory responsibilities placed on the
derivative exchange and the SEBI are to be carried out in a dovetailed manner.
Chapter 4
DIVISION OF REGULATORY RESPONSIBILITY
Two levels of regulation
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1. The task entrusted to the Committee is to develop the "regulatory framework
for derivatives trading". Such regulatory framework really comprises two
distinct levels, viz.(1) a derivatives exchange's own operational rules and
regulations and (2) SEBI rules and regulations with which the exchange and
its members must comply. The Committee feels that since the Securities
Contracts (Regulation) Act, 1956 and the Rules framed thereunder, SEBI Act
and various Rules and Regulations regarding stock exchanges and
brokers/dealers are of general and over-riding nature, they could be reviewed
and designed to be applicable equally to derivatives exchanges also.
Emphasis on exchange-level regulation
2. A crucial pre-condition for the success of derivatives trading is that the
derivatives exchange should be capable of acting as an effective self-
regulator on its own. In the Committee's opinion, the derivatives exchange,
being in day to day touch with the market, will be in a position to spot a
problem and take prompt corrective action. As a statutory body, SEBI will first
have to enquire, collect all the facts and go through a certain statutory
procedure before acting. In addition, the regulatory costs can also be
minimised by shifting the administrative and compliance costs as much as
possible to the exchanges which are the beneficiaries from the business
opportunity provided. These considerations have led the Committee to
emphasize that a derivatives exchange should be designed, right from the
start, as a competent and effective regulating organisation in every possible
way.
Governance of derivative exchange
3. The Committee was informed about the regulatory concerns regarding the
working of governance system in many stock exchanges and took note of
reported problems in this area. The Committee regards this as important
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matter in the context of introducing derivatives. The Committee recommends
that SEBI should review its own experience of the present stock exchange
governance system in terms of how far the system has been able to ensure
the functioning of stock exchanges as effective self-regulatory organisations
and what further improvements, if any, are needed. As most of the regulatory
responsibility in regard to derivatives trading has to be carried out by the
exchanges themselves and any slackness in this regard can be disastrous, it
is necessary to ensure that a proper governance structure is in place. If
necessary, SEBI may lay down a separate governance structure for
exchanges which are allowed to have derivatives trading.
4. Most of the new regulations required for derivatives trading are exchange-
level regulations. Such regulations have necessarily to be very detailed and
highly technical. It will require the formulation of detailed rules, regulations
and bye-laws and the creation of a really effective monitoring and
enforcement mechanism, covering all aspects of the exchange's operation.
The exchange-level regulations include entry requirements for derivatives
traders/members, design of derivatives contracts, broker-client relationship
including sales procedures and risk disclosure to clients, trading and
reporting procedures, internal risk control systems, margining, clearing,
settlement and dispute resolution. In the Committee's opinion, a derivatives
exchange must necessarily be consciously designed to play the role of
effective self-regulator. This is so important that if there is any doubt in the
exchange's ability in this regard, SEBI should not allow it to conduct
derivatives trading. The role of SEBI will be to provide over-all supervision
and guidance to the exchange and to act as the regulator of last resort.
5. The Committee is of the view that all the above regulations have to be much
stricter for derivatives trading than the existing regulations for cash trading.
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Another demanding requirement is that derivatives trading, clearing,
settlement, margining, reporting and monitoring, all involve the application of
most modern on-line screen-based systems which should be designed to be
both fool-proof and fail-proof.
6. The Committee also feels that every derivative trader/member (not just 10
per cent of them) should be inspected by the derivative exchange annually,
both to provide guidance in the initial years and to check compliance. This is
particularly important at the initial stage of derivatives trading. The derivative
exchange should be required to have a strong inspection department. Its
staff should be given specialised training for the purpose.
SEBI's Regulatory Responsibility
7. SEBI should approve the rules, bye-laws and regulations of the derivative
exchange and should also approve the proposed derivative contracts before
commencement of trading. Any change in the rules, bye-laws and regulations
of the Derivative Exchange would need prior approval of SEBI.
8. The Committee feels that SEBI need not be involved in framing exchange-
level rules but it should evaluate them, identify deficiencies and suggest
improvements. Its regulatory staff should have a thorough understanding of
the theory and practice of financial derivatives so that it can provide guidance
and can evaluate various kinds of derivative products. SEBI's overseeing
function cannot be delegated. SEBI will have to acquire the necessary
expertise by training its own people and recruiting some specialized
personnel. SEBI will function as an overseeing authority. It would have to be
closely involved in guiding this new and complex development along right
lines. It would have to ensure a successful launch of futures trading in India
by providing appropriate guidance and over-all supervision of the process.
Such success will be beneficial for the country's economy and will bring
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credit to SEBI. SEBI's obligation to oversee the functioning of derivatives
exchange is bound to be a demanding task in terms of new knowledge and
understanding required by its staff.
Regulatory review of Derivative Contract
9. In most countries regulatory approval is required for new derivatives
contracts to be traded. The regulatory authority has to determine whether
such trading would be in public interest. In U.S.A., the Commodities Trading
Futures Commission, before granting its approval to a new contract, has to
be satisfied that the contract would serve an economic purpose, such as
making fairer pricing possible or making hedging possible. Providing an
arena for speculation is not regarded as enough to show that a futures
contract would serve an economic function. According to the information
provided to the Committee by courtesy of Price Waterhouse LLP under
USAID's FIRE Project, more than 90 per cent of countries with established
derivatives markets use a contract review procedure as a threshold test to
permit a new derivatives contract to trade on an authorised derivative
exchange.
10. The Committee suggests that before starting trading in a new derivatives
product, the derivatives exchange should submit the proposal for SEBI's
approval, giving (a) full details of the proposed derivatives contract to be
traded (b) the economic purposes it is intended to serve (c) its likely
contribution to the market's development and (d) the safeguards incorporated
to ensure protection of investors/clients and fair trading. SEBI officers should
be in a position to provide effective supervision and constructive guidance in
this regard.
SEBI Derivative Cell, Advisory Council and Economic Research Wing
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11. In view of what has been said above, the Committee recommends the
following steps to be taken by SEBI :
a. SEBI should immediately create a special Derivatives Cell because
derivatives demand special knowledge. It should encourage its staff
members to undergo training in derivatives and also recruit some specialised
personnel.
b. A Derivatives Advisory Council may also be created to tap the outside
expertise for independent advice on many problems which are bound to arise
from time to time in regard to derivatives.
c. SEBI should urgently consider the creation of an Economic Research Wing.
Complex economic questions arise about derivatives, e.g. their effect on
cash market volatility and price discovery. Many such questions have been
raised from time to time in other countries. Administrative persons are
unlikely to have the time to study and analyse data. They can be usefully
assisted by the Economic Research Wing. SEBI, as the country's capital
market authority, should be regularly conducting studies of critical problems
affecting the market and collecting data.
4.12 The division of regulatory responsibility at two levels as suggested above by the
Committee, is aimed at securing the triple advantages of (a) permitting desirable
flexibility, (b) maximising regulatory effectiveness and (c) minimising regulatory cost.
Chapter 5
SPECIAL ENTRY RULES FOR DERIVATIVES
BROKERS/DEALERS
No automatic entry for existing stock brokers
1. The Committee feels that the derivatives market will have to be subjected to
more stringent requirements than is the case with present cash markets. This
implies that when an existing exchange decides to start derivatives trading,
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the members of the existing cash market will not automatically become
members of the derivatives market. Only those who satisfy the stricter
eligibility conditions of the derivatives market will be admitted to derivatives
trading.
Capital adequacy
2. The experience of Indian exchanges has been that the credibility of the
broker firm’s balance sheet figures of networth is questionable and that, in
any case, a broker’s or dealer’s stated networth is very often not available to
meet the claims payable to the exchange. Hence, for effectively ensuring
capital adequacy, principal reliance has to be placed on the capital and
margins actually deposited by the brokers/dealers with the exchange. Taking
note of the above, the views of the Committee regarding capital adequacy
requirements for derivatives brokers/dealers are presented below:
Guiding considerations
a. The absolute amount of minimum capital adequacy requirement for
derivative brokers/dealers has to be much higher than for cash market.
Further, if a broker/dealer is involved both in cash and futures segments, or
in several exchanges, the capital adequacy requirement should be satisfied
for each exchange/segment separately. A decision on minimum capital
adequacy requirement involves balancing the need for ensuring market’s
integrity against the need for having sufficient participation of brokers/dealers
and sufficient competition. Too high a requirement may keep most Indian
firms out of the derivatives market.
Clearing and Non-clearing members
b. In order to somewhat ease the constraint on participation in the derivatives
market due to high capital adequacy requirements, the Committee
recommends that consideration may be given to a two-level system of
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members, viz., Clearing Members and Non-Clearing Members, as found in
several countries, an example being the Singapore International Monetary
Exchange. Under such a system, networth requirement for the Clearing
Members is higher than for the Non-Clearing members. The Non-Clearing
members have to depend on the Clearing Members for settlement of trades.
The Clearing Member has to take responsibility for the non-clearing
member’s position so far as the Clearing Corporation is concerned. The
Clearing Member thus becomes the guarantor for the Non-Clearing
members. In a sense, a Clearing Member has a number of satellite traders
for whom he takes financial responsibility towards the Clearing Corporation.
The advantage of the two-level system is that it can help to bring in more
traders into derivatives trading, thus enhancing the market’s liquidity.
Networth and initial margin
1. The Committee recommends that the Clearing Members of the derivatives
exchange should have a minimum net worth of Rs. 300 lakh as per SEBI’s
definition and shall make a deposit of Rs.50 lakh with the Exchange/Clearing
Corporation in the form of liquid assets, such as Cash, Fixed Deposits
pledged in the name of the Exchange, or other securities. Bank Guarantee in
lieu of such deposit may also be accepted. The Clearing Corporation can
permit clearing members to clear the trades of non-clearing trading
members. The regulations for the non-clearing trading members shall be
specified by the Derivatives Exchange/Division. The Committee further
recommends that the requirement of minimum networth and deposit in case
of Option writers will need to be still higher.
Certification Requirement
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2. The broker-members, sales persons/dealers in the derivatives market must
have passed a certification programme which is considered adequate by
SEBI.
Registration with SEBI
3. Brokers/dealers of Derivatives Exchange/Division should be required to be
registered as such with SEBI. This would be in addition to their registration
as brokers/dealers of any stock exchange. SEBI may require registration of
sales persons working at Derivatives brokerage firms.
Chapter 6
CLEARING CORPORATION
Importance of separate Clearing Corporation
6.1In the Committee’s view, the clearing mechanism should be organised as
separate and independent entity, preferably in the form of a Clearing Corporation.
Clearing Corporation should become a legal counterparty to all trades and be
responsible for guaranteeing settlement for all open positions. Hence, if any Clearing
Member defaults, settlement for other Clearing Members would not be affected. This
would protect the reputation of the Exchange and would minimise the default risk of
trading/clearing members as the risks arising from insolvency of any individual
Clearing Member are shouldered effectively by the Clearing Corporation. The
credibility of the Clearing Corporation, therefore, will have to be assured.
6.2 The Clearing Corporation will collect initial (i.e. upfront) margin to which the
exposure limits of the broker/dealer would be linked, as explained later. The Clearing
Corporation will enforce the "mark-to-market margin" system. In case of failure of a
clearing/trading member, the Clearing Corporation should have recourse to disable
the Clearing/trading member from trading in order to stop further increase in his
exposure.
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6.3The requirements for capital adequacy and upfront margin should be set taking
into account the volatility of the underlying market. For this purpose, normally, daily
volatility (as measured by standard deviation of average return from one-day holding
periods) is taken into account. Such daily volatility in India for major stock indices is
around 1.3-1.4 per cent compared to just around 1 per cent for the S&P 500 Index in
U.S.A.. In addition, we have to take into account two more facts, viz., first, the
collection of daily mark-to-market margin may take more than one day because
electronic funds transfer facility is not yet universal in India; and second, the worst
scenario possibility, i.e. largest 1-day or 2-day fluctuation experienced over the last
few years.
6.4 Since market volatility changes over time, the Committee feels that the Clearing
Corporation should continuously analyse this problem and may modify the margin
requirements to safeguard the market. The dual objective has to be guaranteeing its
own solvency and avoiding unnecessary tying up of members’ capital.
6.5The Committee recommends that the Clearing Corporation should be an
independent corporation. Its Governing Board should be immune to any interference
or direct/indirect pressure by trading interests. For this reason, there is no need to
have the representation of trading interests on its Governing Board.
6.6The Committee feels that ideally an independent centralised Clearing Corporation
for the stock exchanges would be most effective arrangement. However, since this
may be difficult to achieve in the immediate future, it should remain as the ultimate
goal to be achieved. Efforts should continue to be made in this direction. Until such
an independent centralised entity is created, the Committee recognises that existing
Clearing Corporations/Houses may continue to be used by existing exchanges
provided the following conditions are satisfied:
1. the Clearing Corporation/House becomes counterparty to all trades or
provides unconditional guarantee for settlement of all trades; and
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2. the Exchange agrees to participate in the Central Clearing Corporation as
and when that entity comes up.
The Committee strongly urges SEBI to take the initiatives with potential promoters to
set up a national-level Clearing Corporation.
Maximum exposure limit
6.7 Apart from the minimum networth requirement, there should be a maximum
exposure limit computed on gross basis for each broker/dealer. Such exposure
limit should be linked to the amount of deposits/margins kept by a broker/dealer
as deposit with the Clearing House/Clearing Corporation in the prescribed liquid
assets. It was strongly represented to the Committee, as mentioned earlier, that,
in Indian context, the minimum networth requirement has not proved adequate.
Mark-to-market margins
6.8 The Committee feels that even the system of mark-to-market margins on
daily basis will not be adequate for safeguarding the market’s integrity unless the
margins are actually collected before the start of the next day’s trading. Even a
day’s delay in actual collection of mark-to-market margin can pose a serious
threat to the market’s integrity. The Committee noted that electronic funds
transfer (EFT) was not yet pervasive in India. If the mark-to-market margins
cannot be collected before the start of next day’s trading, the networth
requirement and initial deposit with the exchange would have to be higher. The
Committee recommends that the aim should be to collect mark-to-market
margins before the next day’s trading starts. For this purpose all derivatives
dealers/brokers should be required to be connected to Electronic Funds Transfer
Facility. The capital adequacy requirement for derivatives trading should be
finally decided after taking into account both the extent of volatility and the time
taken for funds transfer from dealers/members to the exchange.
Cross-margining
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6.9 At the initial stage of derivatives market in India, the Committee does not favour
cross-margining which takes into account a dealer’s combined position in the cash
and derivative segments and across all stock exchanges. The Committee recognises
that cross-margining is logical and would economise the use of a trading member’s
capital, but a conservative approach would be more advisable until the reliability of
systems has been fully established. The systems capability has to emerge before
adopting sophisticated systems.
Margin Collection from clients
6.10In the Committee’s view, collection of initial and mark-to-market margins by
brokers from their clients should be insisted upon in the case of derivatives trading. In
other words, margin collection from clients should not be left to the discretion of
brokers/dealers. SEBI should require derivatives exchanges to ensure, through
systems of inspection, reporting, etc., that margins are actually collected from all
clients without exception, including financial institutions. This is necessary because of
the high leverage and consequently higher risk involved in derivatives trading. Two
indirect methods of ensuring this should also be adopted, viz. (1) exposure limits for
dealers/traders in relation to upfront initial margin deposited with the exchange
should be fixed on gross basis and (2) brokers/dealers should be required to disclose
to the exchange the trading done on their own behalf separately from trading on
clients’ behalf at the time of order entry. The trading volume should also be divided
into sales and purchases.
Safeguarding client’s money
11. The Committee further recommends that the Clearing Corporation should
segregate the upfront/initial margins deposited by Clearing Members for
trades on their own account from the margins deposited with it on client
account. The Clearing Corporation shall not utilise the margins deposited
with it on client account for fulfilling the dues which a Clearing Member may
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owe to the Clearing Corporation in respect of trades on the member’s own
account. The principle which the Committee would like to advocate regarding
client moneys is that these should be regarded as held in trust for client
purpose only and should not be allowed to be diverted to any other purpose.
Such moneys are sacrosanct as they usually represent the client’s hard
earned savings.
12. The following process may be adopted by the Clearing Corporation for
segregating the margin money held against a broker’s own position from that
held against the client position. At the time of opening a position, the
dealer/broker should indicate whether the position is for the client or for the
broker himself. On all client positions, both buy or sell, margins should be
collected on gross basis (i.e. on buy and sell positions separately without
netting them). Similarly, when closing a position, the Clearing Corporation
would have to be informed by the Clearing Member whether it was a client
position or Member’s own position. In case of a Clearing Member default, the
margin paid by such Member on his own account only would be allowed to
be used by Clearing Corporation for realising its own dues from the Member.
There should be an independent Investor Protection Fund for the Derivative
Division/Exchange which should be available to compensate clients in case
of Member default.
SEBI approval for clearing corporation
6.13 The Committee feels that a clearing corporation must have SEBI approval
for functioning as such. To be eligible for such approval, it should satisfy the
following conditions :
1. The clearing corporation must perform full novation, i.e. the clearing
corporation should interpose itself between both legs of every trade,
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becoming the legal counterparty to both or alternatively should provide an
unconditional guarantee for settlement of all trades.
2. The clearing corporation should have the capacity to monitor the overall
position of members across both cash and derivatives markets for those
members who are participating in both.
3. The level of initial margin required on a position should be related to the risk
of loss on the position. The concept of "value at risk" should be used in
calculating required levels of initial margin. The initial margin should be large
enough to cover the one-day loss that can be encountered on the position on
99% of the days. These capital adequacy norms should apply intra-day, so
that there is no instant of time where the good funds deposited by the
member to the clearing corporation are smaller than the value at risk of the
position at that point in time. The clearing corporation should have intra-day
monitoring software to ensure that this condition is met at every single instant
within the day. "Good funds" here are defined as the initial margin and the
mark to market margin available with the clearing corporation.
4. In the event of unusual positions of a member, the clearing corporation
should charge special margin over and above the normal margins.
5. The clearing corporation must establish facilities for electronic funds transfer
(EFT) for swift movement of margin payments. In situations where EFT is
unavailable, the clearing corporation should collect correspondingly larger
initial margin to cover the potential for losses over the time elapsed in
collection of mark to market margin. For example, if two days elapse in
moving funds, then the value at risk should be calculated based on the
prospective two-day loss.
6. In the event of a member default in meeting its liabilities, the Clearing
Corporation/House should have processing capability to require either the
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prompt transfer of client positions and assets to another member or to close-
out all open positions.
6.14 The clearing mechanism is the centre-piece of a derivatives market, both for
implementing the margin system and for providing trade guarantee. Hence, the
arrangements must require SEBI approval. The policy should be to nudge the
system towards a single national clearing corporation for all stock exchanges.
Chapter 7
REGULATION OF SALES PRACTICES AND
DISCLOSURES FOR DERIVATIVES
Why derivatives sales practices need regulation
1. The Committee has identified broker-client relationship and sales practices
for derivatives as needing special regulatory focus. The potential risk
involved in speculating (as opposed to hedging) with derivatives is not
understood widely. In the case of pricing of complex derivatives contracts,
there is a real danger of unethical sales practices. Clients may be fooled or
induced to buy unsuitable derivatives contracts at unfair prices and without
properly understanding the risks involved. Many widely reported legal
disputes between broker-dealer and the client have arisen in U.S.A. on some
such ground. That is why it has become a standard practice in other
countries to require a "risk disclosure document" to be provided by
broker/dealer to every client in respect of the particular type of derivatives
contracts being sold.
2. Also, derivatives brokers/dealers are expected to know their clients and to
exercise care to ensure that the derivative product being sold by them to a
particular client is suitable to his understanding and financial capabilities.
Derivatives may tempt many people because of high leverage, which is a
double-edged instrument, having, at the same time, the potential of high
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profitability on the margin money invested and high risk. The concept of
"know-your-client" needs to be implemented and every broker/trader should
obtain a client identity form, as suggested in Model Rules for Derivatives
Exchanges, being formulated by the Committee separately.
Options and their complexity
3. The risk and complexity vary among derivative products. While some
derivatives are relatively simple, many others, specially options, could be
highly complex and would require additional safeguards from investors’
viewpoint. In due course, a derivatives exchange may decide to introduce
options on stock index or on individual stocks. Options are a more complex
derivative product than index futures because evaluating the fairness of
option premium is a complex matter, not being apparent. Regulations in the
U.S.A. clearly recognise the greater complexity of options by requiring stricter
supervision over sales of options contracts.
4. In order to give some idea in this regard, the Committee enquired into sales
practice regulations relating to derivatives in U.S. in order to learn from the
experiences of U.S. regulatory authorities. The U.S. authorities have
recognised that derivatives, based on options trading strategies, could be
highly complex. Hence, there is a special regulatory regime for options. This
is instructive for Indian authorities. In order to give a concrete idea about
what the regulation of sales practices, particularly for complex type of
derivatives, may involve, some special features found in the U.S. are
enumerated below:
a. The options trading rules of a derivative exchange require heightened
suitability standards. Such rules prohibit brokers-dealers from recommending
to any client any options transaction unless they have reasonable grounds to
believe that the entire recommended transaction is not unsuitable for the
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customer on the basis of information furnished after reasonable inquiry
concerning the customer’s investment objectives.
b. In addition, the rules prohibit brokers-dealers from recommending opening
options transaction unless they have a reasonable basis for believing that the
customer has such knowledge and financial experience that he or she can be
expected to be capable of evaluating, and financially able to bear, the risks of
the transaction.
c. The broker-dealer must seek to obtain and verify specific categories of
information about its customers including, but not limited to, their net worth,
annual income and investment experience and knowledge. A separate
approval also may be required for trading in particular types of options
strategies and types of options contracts, such as foreign currencies.
d. In addition, the approval of account opening must be in writing and can be
made only by a senior options supervisor who must ensure that investors are
offered an explanation of the special characteristics and risks applicable to
the trading of options.
e. The derivatives exchange also requires that all the supervisory and sales
personnel pass a general securities examination that includes options
materials. People selling or supervising the sale of options on debt securities
or foreign currency also must pass a separate interest rate options or foreign
currency examination.
f. The exchange also requires the brokers-dealers to keep a current customer
complaint log for all options-related complaints which include: (a) the name of
the complainant; (2) the date when the complaint was received; (3) the sales
person servicing the account; (4) a description of the complaint; and (5) a
record of the action taken.
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g. In addition, the broker-dealer firm is required to submit all sales literature and
educational material to the exchange for pre-use approval.
h. The disclosure document about options should contain information
describing the mechanics and risks of options trading, transaction costs,
margin requirements and tax consequences of margin trading. The broker-
dealer must provide a copy of this document at or prior to the time such
customer’s account is approved for standardized options trading.
i. There are also special trading rules applicable to the options markets. These
rules include separate surveillance procedures, front-running prohibitions and
position limits.
Exchange’s responsibility
1. The Committee recommends that attention be given to proper supervision of
sales practices for derivatives from the very beginning. It should be the
responsibility of the Derivatives Exchange, as a self-regulatory organisation,
to take the necessary steps in this regard under the general oversight of
SEBI. Risk Disclosure to the client is an important aspect of the regulation of
sales practices. In connection with entry requirements for derivative
brokers/dealer, the Committee has earlier recommended that, not only
derivatives brokers/dealers, but also sales persons working for derivatives
brokers should have passed a certification programme. If sufficient attention
is not paid to this initially, we may have a situation analogous to a large
number of ill-trained drivers whom it becomes difficult to control later.
2. Basically, the regulation of derivatives sales practices aims at enforcing
strictly the "know your customer" rule and requires that every client trading in
derivatives should be registered with the derivatives broker. Data base on
clients should be available with the broker. Customers should be given a risk
disclosure document prior to their registration by the derivatives broker.
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Sales to corporate clients
3. In the case of corporate clients, banks, financial institutions and mutual
funds, they should be allowed to trade derivatives only if and to the extent
authorised by their Board of Directors/Trustees. Such authorisation should
specify the scope of permissible derivative trading, i.e. the purposes or
objectives for which derivatives trading may be undertaken, (e.g. hedging
etc.), over-all limits for derivative exposure, the authority level for giving
approval in this regard, the type of derivatives contracts (e.g. futures,
forwards, options, swaps) and broad derivative category (e.g. derivatives on
interest rate, exchange rate, equities and commodities). Derivatives
broker/dealer may execute orders for such clients only if the orders are
supported by the necessary authorisation of the client’s Board of
Directors/Trustees.
Accounting and disclosure requirements
4. The accounting treatment and disclosure requirement about an
organisation’s involvement in derivatives trading is important so that
shareholders and investors can know how such involvement fits into the
organisation’s objectives and affects its revenues, financial position and risk
profile. The Committee was informed that a Study Group on Derivatives
constituted by the Institute of Chartered Accountants of India is examining
the accounting and disclosure norms for derivatives trading by corporate
bodies.
Mutual Funds as clients
5. The SEBI (Mutual Fund) Regulations presently prohibit the use of derivatives
by mutual funds. The Committee is of the opinion that mutual funds need
hedging facility. They will be among the most important users of equity
hedging through stock index derivatives. Hence, the regulatory prohibition
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should be removed. The soundness of the derivatives market depends on
the presence of both hedgers and speculators. A derivatives market
consisting wholly or mostly of speculators is unlikely to be a healthy market.
It is, therefore, all the more important that the regulatory prohibition on the
use of derivatives for hedging by mutual funds should be withdrawn
immediately.
6. Mutual funds should be allowed to use financial derivatives for hedging
purposes (including anticipated hedging) and portfolio re-balancing within a
policy framework and rules laid down by their Board of Trustees who should
specify what derivatives are allowed to be used, within what limits, for what
purposes, for which schemes, and also the authorisation procedure. The
responsibilities of the trustees of mutual funds as per SEBI regulations
should be re-defined to cover this aspect.
7. At this stage, the Committee does not consider it advisable to frame detailed
SEBI regulations about the use of derivatives by mutual funds as this would
stifle the development of ideas. The Committee prefers that the responsibility
for proper control in this regard should be placed on the trustees of mutual
funds. This would help evolution of practices on sound lines without creating
a strait jacket.
8. Further, what has been said earlier about internal control, accounting
treatment and disclosure of derivatives trading by corporate clients should
apply to mutual funds also. The offer documents of mutual fund schemes
should disclose whether the scheme permits the use of derivatives and the
details in this regard. Also the income and balance sheet of each mutual fund
scheme would have to disclose the impact of derivatives trading and of any
open position in this regard.
Concluding observations
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9. There is no doubt that equity derivatives and other financial derivatives have
some definite positive uses and serve an economic purpose, as clearly
recognised in economic literature. They represent a financial innovation of
considerable significance. They can be helpful in making financial markets
more efficient and enhancing economic efficiency in general.
10. At the same time, derivatives trading inherently involves high leverage. For
this reason, it can be a temptation to inadequately capitalised traders or
speculators. Also some users may not fully understand derivatives and use
them inappropriately. The regulatory system has to be designed to minimise
these possible dangers.
11. In drawing up a regulatory framework for derivatives, the Committee has kept
in view not only the need for allowing adequate flexibility in order to permit
the derivatives market to develop in India but also the need for strict watch so
that the development is along sound lines.
CONSTITUTION OF THE COMMITTEE ON DERIVATIVES
Chairman :
1. Dr. L.C. Gupta
Director
Society for Capital Market Research
and Development, 32 Raja Enclave
Pitampura, DELHI-110 034.
Member-Secretary :
2. Mr. O.P. Gahrotra
Sr. Executive Director
Securities & Exchange Board of India
Mittal Court, "B" Wing, Nariman Point,
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MUMBAI-400 021.
Other Members :
3. Dr. Ajay Shah
Indira Gandhi Institute of Dev. Research
Gen. Vaidya Marg, Goregaon (East),
MUMBAI-400 065.
4. Mr. B.G. Daga
Chief General Manager, Unit Trust of India
New Marine Lines, MUMBAI-400 020.
5. Mr. Balaji Srinivasan,
Jardine Fleming, Amerchand Mansion
16, Madame Cama Road, MUMBAI-400 001.
6. Mr. D.C. Anjaria
Asian Capital Partners
38, Jolly Maker Chambers II
3rd Floor, Nariman Point
MUMBAI-400 021.
7. Ms. D.N. Raval
Executive Director (Legal)
Securities & Exchange Board of India
Mittal Court, "B" Wing, Nariman Piont
MUMBAI-400 021.
8. Mr. Dennis Grubb
Price Waterhourse LLP
128 T.V. Industrial Estate
Worli, MUMBAI-400 025.
9. Mr. L.K. Singhvi, Sr. Executive Director
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Securities & Exchange Board of India
Mittal Court, "B" Wing, Nariman Point
MUMBAI-400 021.
10. Mr. M.G. Damani, President
The Bombay Stock Exchange
Dalal Street, Fort, MUMBAI-400 001.
11 Mr. M.R. Mayya
1/19 Kadri Park, Irla, S.V. Road, Vile Parle
MUMBAI-400 056.
12. Mr. Marti Subrahmanyam
Professor New York University
NYU, Saloman Centre
N.Y., 10012-1118, U.S.A.
13. Prof. P.G. Apte
Indian Instt. of Management
Bannerghatta Road, BANGALORE-560076.
14. Mr. Percy Mistry
Oxford International
Oxford Centre, 10, Shroff Lane
Colaba Causeway, Colaba
MUMBAI-400 005.
15. Dr. Prasanna Chandra
Indian Institute of Management
Bannerghatta Road, BANGALORE-560 076.
16. Mr. Pratip Kar, Executive Director
Securities and Exchange Board of India
Mittal Court, "B" Wing, Nariman Point
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MUMBAI-400 021.
17. Prof. R. Vaidyanathan
Indian Instt. of Management
Bannerghatta Road, BANGALORE-560076.
18. Mr. R. Ravi Mohan
Credit Rating Information Services of India
301 A, Neelam Centre
Worli, MUMBAI-400 025.
19. Dr. R.H. Patil, Managing Director
National Stock of India Ltd.
Mahindra Towers, "A" Wing, 1st Floor,
RBC, Worli, MUMBAI-400 018.
20. Mr. Ramachandra
Bangalore Stock Exchange Ltd.
No. 51, 1st Cross, J.C. Road
BANGALORE-560 027.
21. Mr. S.S. Sodhi
Delhi Stock Exchange Assn. Ltd.
Gate A, West Plaza,I.G. Stadium
Indraprastha Estate, NEW DELHI-110 002.
22. Mr. Uday Kotak
Kotak Mahindra Finance Ltd.
Bakhtawar, 2nd Fl., Nariman Point
MUMBAI-400 021.
23. Mr. V.K. Agarwal
Forward Market Commission
"Everest", 3rd Floor, 100 Marine Lines
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MUMBAI-400 002.
24. Mr. Vallabh Bhansali
Enam Financial Services Ltd.
Ambalal Doshi Marg
24 BD Rajabahadur Compound
MUMBAI-400 023.
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