Sneha Project Report

8/7/2019 Sneha Project Report

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RESEARCH PROJECT REPORT

ON

A STUDY OF DERIVATIVES IN CAPITAL MARKET

Submitted to:

Uttar Pradesh Technical University, Lucknow

For the pursuing the degree of

MASTER OF BUSINESS ADMINISTRATION

2009-2011

Submitted by: Under the guidance of:

Sneha Sharma Ms Nishi Pathak

0903370151 (Faculty of MBA)

MBA-3rd Semester

2009-2011

Raj Kumar Goel Institute of Technology (MBA Institute)

5-km, Stone Delhi- Meerut Road, Ghaziabad (UP-201003)

STUDY OF DERIVATIVES IN INDIAN CAPITAL MARKET 1


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PREFACE



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A derivative is a product whose value is derived from the value of one or more underlying

variables or assets in a contractual manner. The underlying assets can be equity, forex,

commodity or any other asset. They may take the form of forwards, futures, options, or

swaps. The three main player in the derivative market consist of hedger, speculator &

arbitrageur. In India, we have index future as the first step toward building a more liquid

market.

In India, NSE has introduced index future contract based on S&P CNX Nifty. The S&P CNX

Nifty Futures are traded on NSE as one, two and three month contracts. Whereas BSE has

introduced index future contract based on BSE-30 sensex. They are contracts whos

underlying is the value of the index at any point in time. At the time of delivery, the trade

is settled in cash. Trading in index futures is not just to hedge market risk; it can well be a

source of profit through arbitrage. There are arbitrage opportunities in index futures, just as

in stock.

Financial innovation that led to the issuance and trading of derivative products has been an

important boost to the development of financial markets. While the benefits stemming from

the economic functions performed by derivatives securities have been discussed and proven

by academics , there is increasing concern within the financial community that the growth of

derivative markets- whether standardize or not destabilizes the economy.

The Derivatives Committee strongly favor 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 recognizes that in order to make

hedging possible, the market should also have speculator who are prepared to be counter

parties to the hedger. And if sufficient no. of hedger with genuine hedging needs are not there



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and we still introduce future market, then we would end up having only speculator. Such a

future market would be devoid of any connection with the cash or the spot market and would

have its own life full of speculation and bubbles. So now the question arises, do Indian

investors need future trading? If trading in index future is advocated on the basis of hedging

needs of investors, one must assess the market demand and supply source for trading in the

market risk before introducing the index futures.

The desirability of successful derivatives, such as futures trading, depends crucially on the

solidity and maturity of cash markets in underlying securities. To make cash markets robust

and effective, first let us put in the place the mechanism of margin trading, short sal,

dematerialized settlement and electonics transfer of funds among market participants.

TABLE OF CONTENT

CHAPTER-------------------1

INTRODUCTION TO DERIVATIVES



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Introduction to derivatives

Definition of derivatives

Participants in derivatives market

Types of derivatives

Research methodology

CHAPTER-------------------2

INDIAN CAPITAL MARKET

Overview

Trading pattern of I C M

National Stock exchange

CHAPTER --------------------3

DERIVATIVES MARKET

Introduction to futures & options

Payoff for derivatives contracts

Clearing & settlement

Settlement mechanism

Settlement for futures

Settlement for options

Pros & cons of derivatives

Advantages

Disadvantages

Myths behind derivatives

CHAPTER-----------------4



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INDIAN DERIVATIVES MARKET

Derivatives market of India

Derivatives market at NSE

Users of derivatives

Regulatory frameworks

Regulatory objectives

Recommendations by Dr. L.C. Gupta

Policies for development

Legality of OTC

CHAPTER ---------------------5

CONCLUSION

Concluding remarks

Recommendations

Limitations-

Bibliography

ANNEXURES-------------------6



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CHAPTER-1

INTRODUCTION TO

DERIVATIVES



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INTRODUCTION TO DERIVATIVES

The origin of derivative can be traced back to the need of formers to protect themselves against

fluctuation in the price of their crops. From the time it was sown to the time it was ready for

harvest, farmers would face price uncertainty. Through the use of simple derivatives products, it

was possible for the farmers to partially or fully transfer price risk by locking in assets prices.

These were simple contracts developed to meet the needs of farmers and basically a means of

reducing risks.

A farmer who sowed his crops in June face uncertainty over the price of he would receive for his

harvest in September. In years of scarcity, he would probably obtain attractive prices. However,

during times of over supply, he would have to dispose off his harvest at a very low price. Clearly

this meant that the farmer and his family were exposing to a high risk of uncertainty.

On the other hand, a merchant with an ongoing requirement of grain too would face a price risk

and that of having to pay exorbitant prices during dearth, although favorable prices could be

obtained during period of over supply. Under such circumstances, it clearly made sense for the

farmer and the merchant to come together and enter in a contract whereby the price of the grain to

be delivered in September could be decided earlier. What they would then negotiate happened to

be a futures-type contract, which would enable both parties to eliminate the price risk.

In 1848, the Chicago Board of Trade, or CBOT, was established to bring farmers and merchant

together. A group of traders got together and create the to-arrive contract that permitted farmers

to lock in to price un front and deliver the grain later. These to-arrive contracts proved useful as a

device for hedging and speculation on price changes. These were eventually standardized, and in

1925 the first futures clearing house came into existence.



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Today, derivative contract exist on a variety of commodities such as corn, pepper, cotton,

wheat, silver, etc. besides commodities, derivatives contracts also exist on a lot of financial

underlying like, interest rate, exchange rate etc.

Derivatives

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived

from the value of an underlying primary financial instrument, commodity or index, such as:

interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes

in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging.

Hedging is the most important aspect of derivatives and also its basic economic purpose. There has

to be counter party to hedgers and they are speculators. Speculators dont look at derivatives as

means of reducing risk but its a business for them. Rather he accepts risks from the hedgers in

pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.



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Participants in Derivatives Markets

Hedgers

These are market players who wish to protect an existing asset position from future adverse

price movements.

Speculator

A speculator is a one who accepts the risk that hedgers wish to transfer. Speculators have

no position to protect and do not necessarily have the physical resources to make delivery

of the underlying asset nor do they necessarily need to take delivery of the underlying

asset. They take positions on their expectations of futures price movements and in order to

make a profit. In general they buy futures contracts when they expect futures prices to rise

and sell futures contract when they expect futures prices to fall.

Arbitrageurs

These are traders and market makers who deal in buying and selling futures contracts

hoping to profit from price differentials between markets and/or exchanges.

Types of Derivatives



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The most commonly used derivatives contract is forwards, futures and options:

1. Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the futures at todays pre-agreed price.

2. Futures: A future contract is an agreement between two parties to buy or sell an asset at a

certain time the future at the certain price. Futures contracts are the special types of forward

contracts in the sense that are standardized exchange traded contracts.

3. Options: It is of two types: call and put options. Underlying asset, at a give price on or

before a given future date. PUTS give the buyer the right but not the obligation to sell a

give quantity of the underlying asset at a given price on or before a given date.

4. Leaps: Normally option contracts are for a period of 1 to 12 months. However, exchange

may introduce option contracts with a maturity period of 2-3 years. These long-term option

contracts are popularly known as Leaps pr Long term Equity Anticipation Securities.

5. Baskets: Baskets options are option on portfolio of underlying asset. Equity Index Options

are most popular form of baskets.

6. Swaps: These are private agreements between two parties to exchange cash flows in the

future according to a prearrange formula. They can be regarded as portfolios of forwards

contracts. The two commonly used swaps are:

a) Interest rate swaps: These entail swapping both Principal and interest between the

parties, with the cash flow in one direction being in a different currency than those

in the opposite direction.

b) Currency swaps: These entail swapping both Principal and interest between the

parties, with the cash flow in one direction being in a different currency than those

in the opposite direction.

OBJECTIVES



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1. To find out the risk of the derivatives in the market.

2. To identify the tax planning opportunities.

3. To identify how to manage the assets of the company.

4. To identify the investment opportunities in there market.

5. To find out the impact of derivatives in the economy of the country.

6. To identify the difference between interest rates and maturities across borders of

the derivatives.

http://1.to/http://1.to/


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RESEARCH METHODOLOGY

Research problem

Study of Derivatives in the India capital market

Research Design

A research design specifies the methods and procedure for conducting a particular study. One has

to specify the approach he intends to use with respect to the proposed study. Broadly speaking,

research design con be grouped into three categories.

EXPLORATORY: Focuses on discovery on ideas and generally based on secondary data.

DISCRIPTIVE: It is undertaken when the research wants to know the characteristics of certain

groups such as age, educational level, income, occupation etc.

CAUSAL: It is undertaken when the researcher is interested in knowing the cause and effect

relationship between two or more variables.

The research design of my study is Exploratory

DATA SOURCES

Research is based on secondary data that has been collected from various sources like internet,

journals, magazines and books etc. (see Bibliography also)



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CHAPTER -2

INDIAN CAPITAL

MARKET



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INDIAN CAPITAL MARKET: AN OVERVIEW

Evolution

Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago.

The earliest records of security dealings in India are meager and obscure. The East India Company

was the dominant institution in those days and business in its loan securities used to be transacted

towards the close of the eighteenth century.

By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in

Bombay. Thou the trading list was broader in 1839, there were only half a dozen brokers

recognized by banks and merchants during 1840 and 1850.

The 1850's witnessed a rapid development of commercial enterprise and brokerage business

attracted many men into the field and by 1860 the number of brokers increased into 60.

In 1860-61 the American Civil War broke out and cotton supply from United States of Europe was

stopped; thus, the 'Share Mania' in India begun. The number of brokers increased to about 200 to

250. However, at the end of the American Civil War, in 1865, a disastrous slump began (for

example, Bank of Bombay Share which had touched Rs 2850 could only be sold at Rs. 87).

At the end of the American Civil War, the brokers who thrived out of Civil War in 1874, found a

place in a street (now appropriately called as Dalal Street) where they would conveniently

assemble and transact business. In 1887, they formally established in Bombay, the "Native Share



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and Stock Brokers' Association" (which is alternatively known as " The Stock Exchange "). In

1895, the Stock Exchange acquired a premise in the same street and it was inaugurated in 1899.

Thus, the Stock Exchange at Bombay was consolidated.

Other leading cities in stock market operations

Ahmedabad gained importance next to Bombay with respect to cotton textile industry. After 1880,

many mills originated from Ahmedabad and rapidly forged ahead. As new mills were floated, the

need for a Stock Exchange at Ahmedabad was realized and in 1894 the brokers formed "The

Ahmedabad Share and Stock Brokers' Association".

What the cotton textile industry was to Bombay and Ahmedabad, the jute industry was to Calcutta.

Also tea and coal industries were the other major industrial groups in Calcutta. After the Share

Mania in 1861-65, in the 1870's there was a sharp boom in jute shares, which was followed by a

boom in tea shares in the 1880's and 1890's; and a coal boom between 1904 and 1908. On June

1908, some leading brokers formed "The Calcutta Stock Exchange Association".

In the beginning of the twentieth century, the industrial revolution was on the way in India with the

Swadeshi Movement; and with the inauguration of the Tata Iron and Steel Company Limited in

1907, an important stage in industrial advancement under Indian enterprise was reached.

Indian cotton and jute textiles, steel, sugar, paper and flour mills and all companies generally

enjoyed phenomenal prosperity, due to the First World War.

In 1920, the then demure city of Madras had the maiden thrill of a stock exchange functioning in

its midst, under the name and style of "The Madras Stock Exchange" with 100 members. However,



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when boom faded, the number of members stood reduced from 100 to 3, by 1923, and so it went

out of existence.

In 1935, the stock market activity improved, especially in South India where there was a rapid

increase in the number of textile mills and many plantation companies were floated. In 1937, a

stock exchange was once again organized in Madras - Madras Stock Exchange Association (Pvt)

Limited. (In 1957 the name was changed to Madras Stock Exchange Limited).

Lahore Stock Exchange was formed in 1934 and it had a brief life. It was merged with the Punjab

Stock Exchange Limited, which was incorporated in 1936.

Indian Stock Exchanges - An Umbrella Growth

The Second World War broke out in 1939. It gave a sharp boom which was followed by a slump.

But, in 1943, the situation changed radically, when India was fully mobilized as a supply base.

On account of the restrictive controls on cotton, bullion, seeds and other commodities, those

dealing in them found in the stock market as the only outlet for their activities. They were anxious

to join the trade and their number was swelled by numerous others. Many new associations were

constituted for the purpose and Stock Exchanges in all parts of the country were floated.

The Uttar Pradesh Stock Exchange Limited (1940), Nagpur Stock Exchange Limited (1940) and

Hyderabad Stock Exchange Limited (1944) were incorporated.

In Delhi two stock exchanges - Delhi Stock and Share Brokers' Association Limited and the Delhi

Stocks and Shares Exchange Limited - were floated and later in June 1947, amalgamated into the

Delhi Stock Exchnage Association Limited.



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Post-independence Scenario

Most of the exchanges suffered almost a total eclipse during depression. Lahore Exchange was

closed during partition of the country and later migrated to Delhi and merged with Delhi Stock Exc

Trading Pattern of the Indian Stock Market

Trading in Indian stock exchanges is limited to listed securities of public limited companies. They

are broadly divided into two categories, namely, specified securities (forward list) and non-

specified securities (cash list). Equity shares of dividend paying, growth-oriented companies with a

paid-up capital of atleast Rs.50 million and a market capitalization of atleast Rs.100 million and

having more than 20,000 shareholders are, normally, put in the specified group and the balance in

non-specified group.

Two types of transactions can be carried out on the Indian stock exchanges: (a) spot delivery

transactions "for delivery and payment within the time or on the date stipulated when entering into

the contract which shall not be more than 14 days following the date of the contract" : and (b)

forward transactions "delivery and payment can be extended by further period of 14 days each so

that the overall period does not exceed 90 days from the date of the contract". The latter is

permitted only in the case of specified shares. The brokers who carry over the outstandings pay

carry over charges (cantango or backwardation) which are usually determined by the rates of

interest prevailing.

A member broker in an Indian stock exchange can act as an agent, buy and sell securities for his

clients on a commission basis and also can act as a trader or dealer as a principal, buy and sell



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securities on his own account and risk, in contrast with the practice prevailing on New York and

London Stock Exchanges, where a member can act as a jobber or a broker only.

The nature of trading on Indian Stock Exchanges are that of age old conventional style of face-to-

face trading with bids and offers being made by open outcry. However, there is a great amount of

effort to modernize the Indian stock exchanges in the very recent times.

National Stock Exchange (NSE)

With the liberalization of the Indian economy, it was found inevitable to lift the Indian stock

market trading system on par with the international standards. On the basis of the

recommendations of high powered Pherwani Committee, the National Stock Exchange was

incorporated in 1992 by Industrial Development Bank of India, Industrial Credit and Investment

Corporation of India, Industrial Finance Corporation of India, all Insurance Corporations, selected

commercial banks and others.

Trading at NSE can be classified under two broad categories:

(a) Wholesale debt market and

(b) Capital market.

Wholesale debt market operations are similar to money market operations - institutions and

corporate bodies enter into high value transactions in financial instruments such as government

securities, treasury bills, public sector unit bonds, commercial paper, certificate of deposit, etc.

There are two kinds of players in NSE:



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(a) Trading members and (b) participants.

Recognized members of NSE are called trading members who trade on behalf of themselves and

their clients. Participants include trading members and large players like banks who take direct

settlement responsibility.

Trading at NSE takes place through a fully automated screen-based trading mechanism which

adopts the principle of an order-driven market. Trading members can stay at their offices and

execute the trading, since they are linked through a communication network. The prices at which

the buyer and seller are willing to transact will appear on the screen. When the prices match the

transaction will be completed and a confirmation slip will be printed at the office of the trading

member.

NSE has several advantages over the traditional trading exchanges. They are as follows:

NSE brings an integrated stock market trading network across the nation.

Investors can trade at the same price from anywhere in the country since inter-market

operations are streamlined coupled with the countrywide access to the securities.

Delays in communication, late payments and the malpractices prevailing in the traditional

trading mechanism can be done away with greater operational efficiency and informational

transparency in the stock market operations, with the support of total computerized

network.

Unless stock markets provide professionalised service, small investors and foreign investors will

not be interested in capital market operations. And capital market being one of the major source of



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The writer grants this right to the buyer for a certain sum of money called the option premium. An

option that grants the buyer the right to buy some instrument is called a call option. An options that

grants the buyer the right to sell an instrument is called a put option. The price at which the buyer

an exercise his option is called the exercise price, strike price or the striking price.

Options are available on a large variety of underlying assets like common stock, currencies, debt

instruments and commodities. Also traded are options on stock indices and futures contracts

where the underlying is a futures contract and futures style options.

Options have proved to be a versatile and flexible tool for risk management by themselves as well

as in combination with other instruments. Options also provide a way for individual investors with

limited capital to speculate on the movements of stock prices, exchange rates, commodity prices

etc. The biggest advantage in this context is the limited loss feature of options.

Options Terminology

Call Option

A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of

the underlying asset at the strike price on or before expiration date.

Put Option

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of

the underlying asset at the strike price on or before a expiry date.

Strike Price (also called exercise price)



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The price specified in the option contract at which the option buyer can purchase the currency

(call) or sell the currency (put) Y against X.

Maturity Date

The date on which the option contract expires is the maturity date. Exchange traded options have

standardized maturity dates.

American Option

An option, call or put that can be exercised by the buyer on any business day from initiation to

maturity.

European Option

A European option is an option that can be exercised only on maturity date.

Premium (Option price, Option value)

The fee that the option buyer must pay the option writer at the time the contract is initiated. If the

buyer does not exercise the option, he stands to lose this amount.

Intrinsic value of the option



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The intrinsic value of an option is the gain to the holder on immediate exercise of the option. In

other words, for a call option, it is defined as Max [(S-X), 0], where s is the current spot rate and

X is the strike rate.

If S is greater than X, the intrinsic value is positive and is S is less than X, the intrinsic value will

be zero. For a put option, the intrinsic value is Max [(X-S), 0]. In the case of European options, the

concept of intrinsic value is notional as these options are exercised only on maturity.

Time value of the option

The value of an American option, prior to expiration, must be at least equal to its intrinsic value.

Typically, it will be greater than the intrinsic value. This is because there is some possibility that

the spot price will move further in favor of the option holder. The difference between the value of

an option at any time "t" and its intrinsic value is called the time value of the option.

At-the-Money, In-the-Money and Out-of-the-Money Options

A call option is said to be at-the-money if S=X i.e. the spot price is equal to the exercise price. It is

in-the-money is S>X and out-of-the-money is S


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FUTURES & OPTIONS

An interesting question to ask at this stage is when could one use options instead of futures?

Options are different from future in several interesting senses. At a practical level, the option buyer

faces an interesting situation. He pays for option in full at the time it is purchased. After this, he

only has an upside. There is no possibility of the options position generating any further losses to

him (other than the fund already paid for option). This is different from futures, which is free to

enter into, but can generate very large losses. This characteristic makes options attractive to many

occasional market participants, who can not put in the time to closely monitor their futures

positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy

insurance, which reimburses the full extent to which Nifty drops below the strike price of the put

option. This is attractive to many people, and to mutual funds creating guaranteed return

product.

Distinction between futures and options

Futures Options

Exchange traded with novation Same as futures.

Exchange defines the product Same as futures

Price is zero, strike price moves Strike price is fixed, price moves.

Price is zero Price is always positive.

Linear payoff Nonlinear payoff.

Both long and short at risk Only short at risk.



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PAYOFF FOR DERIVATIVES CONTRACTS

A pay off is likely profit/loss that would accrue to a market participants with change in the price of

the underlying asset. This is generally depicted in the form of payoff diagrams, which show the

price of the underlying asset on the X-axis and the profit/loss on the Y-axis. In this section we shall

take a look at the payoffs for buyers and sellers of futures and options.

Payoff for Futures

Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits

for the buyer and the sellers of a future contract are unlimited. These linear payoffs are fascinating

as they can be combined with options and the underlying to generate various complex payoffs.

Payoff For A Buyer On Nifty Future

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts

an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take

the case of speculator who sells two-month Nifty index futures contracts when the Nifty stands at

1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the

short futures positions start making profits and when the index moves up, it starts making losses

.the following diagram shows the payoff diagram for the seller of a futures contract.



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Payoff for buyer of put option: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the

option. The profit/loss that the buyer makes on the option depends on the spot price of the

underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the

spot price more is the profit he makes. If the spot price is higher than the stike price, he let his

option expire un-exercised. His loss in this case is the premium he paid for buying the option.

Profit

1250 Nifty

061.70

loss

Fig. Payoff for buyer of put option



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Payoff profile for writer of put option: short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the

option. For selling the options, the writer of the option charges a premium. The profit/loss that the

buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer

profit is the seller loss. If upon expiration, the spot prices happen to be below the strike price, the

buyer will exercise the option at write. If upon the expiration the pot price of the underlying is

more than the strike price, the buyer lets his option expired un exercised and the writer gets to keep

the premium.

Profit

61.70

0 1250 Nifty

Loss

Fig. Payoff for writer of put option

Fig shows the payoff for the writer of a three-month put option (often

referred as short put) with a strike price of 1250 sold at a premium of

61.70



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CLEARING AND SETTLEMENT

National Securities Clearing council Limited (NSCCL) undertakes clearing and settlement of all

trades executed on the futures and options (O&P) segment of the NSE. It also act as legal counter

party to all trades on the F&O segment and guarantees their financial settlement.

Clearing Entities

Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the help of

the following entities:

Clearing Members

A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals

executed by Trading Members (TM) on NSE, who clear and settle such deals through them.

Primarily, the CM performs the following functions:

1. Clearing Computing obligations of all his TM's i.e. determining positions to settle.

2. Settlement - Performing actual settlement. Only funds settlement is allowed at present in

Index as well as Stock futures and options contracts

3. Risk Management Setting position limits based on upfront deposits / margins for

each TM and monitoring positions on a continuous basis.

Types of Clearing Members



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Trading Member Clearing Member (TM-CM)

A Clearing Member who is also a TM. Such CMs may clear and settle their own

proprietary trades, their clients trades as well as trades of other TMs.

Professional Clearing Member (PCM)A CM who is not a TM. Typically banks or custodians could become a PCM and clear and

settle for TMs.

Self Clearing Member (SCM)

A Clearing Member who is also a TM. Such CMs may clear and settle only their own

proprietary trades and their clients trades but cannot clear and settle trades of other TMs.

Clearing Banks

NSCCL has empanelled 11 clearing banks namely Canara Bank, HDFC Bank, IndusInd Bank,

ICICI Bank, UTI Bank, Bank of India, IDBI Bank, Hongkong & Shanghai Banking Corporation

Ltd., Standard Chartered Bank, Kotak Mahindra Bank and Union Bank of India.

Every Clearing Member is required to maintain and operate a clearing account with any one of

the empanelled clearing banks at the designated clearing bank branches. The clearing account is to

be used exclusively for clearing & settlement operations.

Settlement Mechanism

http://www.nseindia.com/content/nsccl/nsccl_clgbanks.htmhttp://www.nseindia.com/content/nsccl/nsccl_clgbanks.htm


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All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for

index futures /options of the Nifty index cannot be delivered. These contracts, therefore, have to be

settled in cash. Futures and options on individual securities can be delivered as in the spot market.

However, it has been currently mandated that stock options and futures would also be cash settled.

The settlement amount for a CM is netted across all their TMs/ clients, with respect to their

obligations on MTM, premium and exercise settlement.

Settlement of future contracts

Futures contracts have two types of settlement, the MTM settlement, which happen on a

continuous basis at the end of each day, and the final settlement, which happens on the last trading

day of the futures contracts.

1. Daily Mark-to-Market Settlement

The position in the futures contracts for each member is marked-to-market to the daily

settlement price of the futures contracts at the end of each trade day.

The profits/ losses are computed as the difference between the trade price or the previous days

settlement price, as the case may be, and the current days settlement price. The CMs who have

suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is in turn

passed on to the members who have 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:



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F = S x e rt

where:

F = theoretical futures price

S = value of the underlying index

r = rate of interest (MIBOR)

t = time to expiration

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. CMs are responsible to

collect and settle the daily mark to market profits / losses incurred by the TMs and their clients

clearing and settling through them. The pay-in and payout 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 CMs clearing bank account.

2. Final Settlement

On the expiry of the futures contracts, NSCCL marks all positions of a CM 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 days settlement price, as the case may be, and the final settlement price of the relevant

futures contract.

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Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account

on T+1 day (T= expiry day).

Open positions in futures contracts cease to exist after their expiration day

SETTLEMENT OF OPTIONS CONTRACTS

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 CM at the

client level to determine the net premium payable or receivable amount, at the end of each day.

The CMs who have a premium payable positions are required to pay the premium amount to

NSCCL which is in turn passed on to the members who have a premium receivable position. This

is known as daily premium settlement.

CMs are responsible to collect and settle for the premium amounts from the TMs and their clients

clearing and settling through them.

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 CMs

clearing bank account.

Interim Exercise Settlement

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

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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 CMs clearing bank account on T+1

day (T= exercise date).

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PROS & CONS OF DERIVATIVES

Financial innovation that led to the issuance and trading of derivatives products has been an

important boost to the development of financial market. Derivatives products such as options,

futures or swaps contract have become a standard risk

management tool that enable risk sharing and thus facilitate the efficient allocation of capital to

productive investment opportunities. While the benefits stemming from the economic function

performed by derivative securities have been discussed and proven by academics, there is

increasing concern within the financial community that the growth of the derivative markets-

whether standardize or not-destabilize the economy. In particular, one often hears that the

widespread use of derivatives have been reduced long term investment since it concentrates

capital in short term speculative transactions. In this study, I have tried to look at the various

pros and cons that the derivatives trading pose.

BENEFITS OF DERIVATIVES FOR FIRMS, MARKETS ANDTHE ECONOMY

The recent studies of derivatives activity have led to a broad consensus, both in the private

and public sectors that derivatives provide numerous and substantial benefits to end users.

Derivatives as means of hedging

Derivatives provide a low cost, effective method for end users to hedge and manage their exposure

to interest rate, commodity price, or exchange rates. Interest rate future and swaps, for example,help banks for all sizes better manage the re-pricing mismatches in funding long term assets, such

as mortgages, with short term liabilities, such a certificate of deposits. Agricultural futures and

options helps farmers and processors hedge against commodity price risk. Similarly, multi national

corporations can hedge against currency risk using foreign exchange forwards, futures and options.



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Improves market efficiency and liquidity

Well functioning derivatives improves the efficiency and liquidity of the cash market. The launch

of derivatives has been associated with substantial improvements in the market quality on the

underlying equity market. This happens because of the law transaction cost involved and

arbitrageurs will face low cost when they are eliminating the mispricings. Traders in individual

stock who supply liquidity to these stock use index futures to offset their exposure and hence able

to function at lower level of risk.

Allows institution to raise capital at lower cost

Corporations, governmental entities, and financial institutions also benefit from derivatives

through lower funding costs and more diversified funding sources. Currency and interest rate

derivatives provide the ability to borrow in the cheapest capital market, domestic or foreign,

without regard to currency in which the debt is denominated or the form in which interest is paid.

Derivatives can convert the foreign borrowing into a synthetic domestic currency financing with

their fixed or floating interest rate.

Allows exchange to offer differentiated products

In spot market, the ability for the exchanges to differentiate their product is limited by the fact that

they are trading the same paper. In contrast, in the case of derivatives, there are numerous avenues

for product differentiation. Each exchange trading index option has to take major decision like

choice of index, choice of contract size, choice of expiration dates, American Vs European

options, rules governing strike price etc.

Assists in capital formation in the Economy

By providing investors and issuers with a wider array of tools for managing risk and raising

capital, derivatives improve the allocation of credit and sharing of risk in the global economy,



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lowering the cost of capital formation and stimulating economic growth. It improves the markets

ability to carefully direct resources toward the projects and the industries where the rate of return is

highest. This improves the allocative efficiency of the market and thus a given stock of investable

funds will be better used in procuring the highest possible GDP growth for the economy.

The growth in derivatives activities yields substantial benefits to the economy and by facilitating

the access of the domestic companies to international capital market and enabling them to lower

their cost of funds and diversify their funding source; derivatives improve the position of domestic

firms in an expanding, competitive, global economy.

Improve ROI for institutions

Derivatives are basically off- balance trading in that no transfer of principal sum occurs and no

posting in the balance sheet will be required. Consequently, a fund that corresponds to the

principal sum in traditional financial transactions (on balance trading) is unnecessary, thus

substantially improving the return on investment. Looking at the restriction on the ratio of net

worth, on the other hand, the risk ratio of assets that form the basis for calculating the net worth in

off balance trading is assumed to be lower than that in the traditional on balance trading. In

practice, it is provided that the credit risk equivalence calculated by multiplying the assumed

amount of principal of an off-balance trading by a risk to value ratio is to be weighted by the credit

worthiness of the other party.

Risk sharing:

The major economic function of derivatives is typically seen in risk sharing: derivatives provide a

more efficient allocation of economic risks. Examples of risk management, which have already



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mentioned are illustrative, but they dont address the question why derivatives are necessary to

attain a better social allocation of risks.

Information gathering:

In a perfect market with no transaction cost, no friction and no informational asymmetries, ther

would be no benefit stemming from the use of derivatives instruments. However, in the presence

of trading costs and marketing liquidity, portfolio strategies are often implemented or

supplemented with derivatives at substantial lower cost compare to cash market transactions. In

this respect, the welfare effect of derivative instrument result from a reduction in the transaction

cost. Ute, this is only a part of the real economic benefits of the derivatives. If risk allocation is the

major function of this instrument, and because risk is also related to information, derivatives

markets also affect the information structure of the financial system

DISADVANTAGES OF DERIVATIVES

Risk associated with thederivatives

Apart from the explicit risk, which arises from various market risk exposure stemming from the

pure service or position taken in a derivative instrument, other implicit risks also associated with

derivatives?

Credit risk is the risk that a loss will be incurred because a counter party fails to

make payment as due. Concern has been expressed that financial institutions may have

used derivatives to take on an excessive level of credit risk that is poorly managed.



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Market riskis the risk that the value of a position in a contract,financial instrument,

asset,or porflio will decline when market conditions change. Concern has been

expressed that derivatives expose firm to new market risk while increasing the overall

level of exposure.

Operational risks are the risk that losses will be incurred as a result of inadequate

system and control, inadequate disaster or contingency planning, human error, or

management failure.

Legal risk is the risk of loss because a contract cannot be enforced or because the

contract term fails to achieve the intended goals of the contracting parties. This risk, of

course, is as old as contracting itself. The legal uncertainty can result in significant

unexpected losses.

Implication in global world

Global market for trade and finance has become increasingly integrated and accessible. Derivatives

have both benefited from and contributed to this development. In this circumstances, however,

some observed fear that derivatives make it possible for shocks in one part of the global finance

system to be transmitted farther and faster than before, being reinforce rather than damped.

Concern also have been expressed that derivatives activity may exacerbated market moves through

positive feedback trading.

Accounting standard for derivatives

As far as derivatives are concerned, accounting standard is not homogenized across countries

and/or market player thereby suggesting that lack of precision or ambiguous cross-comparisons

may be common. Market values are not uniformly accepted in accounting rules, and thus their



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absence prevents marketing-to-marketing of derivatives positions as well as their proper

collateralization. Accounting practices measure values and not risk exposure and thus remain poor

figure for risk management purpose

Lack of knowledge

Lack of knowledge about derivatives: derivatives are complex. The payoffs and risks that buyer

and seller face, and the economic theory that is used for pricing derivatives are considerably more

difficult than that seen on the equity market. Thus at times lack of knowledge on part of traders

leads to disaster.

Monetarily Zero sum game

It is impossible for the both the parties in the derivatives transactions to profit concurrently

regardless of the fluctuation of value of underlying assets. Thus one party has to accept the

unprofitable position



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Myths behind derivatives

In less than three decades of their coming into vogue, derivatives markets have become the most

important. Today, derivatives have become part of the day-to-day life for ordinary people in most

parts of the world.

Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when

the US announced an end to the Bretton Woods System of fixed exchange rates leading to

introduction of currency derivatives followed by other innovations, including stock index futures.

There are still apprehensions about derivatives. There are also many myths though the reality is

different especially for exchange-traded derivatives which are well regulated with all the safety

mechanisms in place.

What are these myths behind derivatives?

Derivatives increase speculation and do not serve any economic purpose.

Numerous studies have led to a broad consensus, both in the private and public sectors, that

derivatives provide substantial benefits to the users. Derivatives are a low-cost, effective method

for users to hedge and manage their exposures to interest rates, commodity prices, or exchange

rates.

The need for derivatives as hedging tool was felt first in the commodities market. Agricultural

futures and options helped farmers and processors hedge against commodity price-risk. After the

collapse of the Bretton Wood agreement, the financial markets in the world started undergoing

radical changes. This period is marked by remarkable innovations in the financial markets, such as

introduction of floating rates for currencies, increased trading in a variety of derivatives

instruments, and on-line trading in the capital markets.



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As the complexity of instruments increased, the accompanying risk factors grew. This situation led

to the development derivatives as effective risk-management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to manage

effectively their portfolios of assets and liabilities through instruments such as stock index futures

and options. An equity fund, for example, can reduce its exposure to the stock market quickly and

at a relatively low cost without selling part of its equity assets, by using stock index futures or

index options.

By providing investors and issuers with a wider array of tools for managing risks and raising

capital, derivatives improve the allocation of credit and the sharing of risk in the global economy,

lowering the cost of capital formation and stimulating economic growth.

Now that world markets for trade and finance have become more integrated, derivatives have

strengthened these important linkages among global markets, increasing market liquidity and

efficiency, and facilitating the flow of trade and finance.

Indian market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian capital market

is not ready for derivatives trading. Here, we look into the pre-requisites needed for the

introduction of derivatives and how the Indian market fares.

Disasters can happen in any system. The 1992 security scam is a case in point. Disasters

are not necessarily due to dealing in derivatives, but derivatives make headlines. Careful

observation will show that these disasters, such as the Barings collapse, Metallgesellschaft, Daiwa

Bank scandal (not related to derivatives) and Orange County, occurred due to the lack of internal

controls and/or outright fraud either by employees or promoters.

In essence, these examples suggest that scandals have occurred in the recent past, not

only in derivatives-related instruments, but also in bonds, foreign exchange trading and



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commodities trading. Most failures have taken place on the `over the-counter' deals, except in the

case of Barings, where it was a case of internal fraud, as also with Daiwa Bank, which lost more

than $1 billion in debt portfolio. `Over-the-counter' (OTC) deals lack transparency, sophisticated

margining system and a well-laid-out regulatory framework, which is not the case with the

exchange-traded derivatives.

Many of the failures happened because of the complex nature of transactions while the

exchange-traded derivatives are simple and easy to understand. In that sense, these derivatives

have been found to be the most useful in allowing participants to transfer their risk, without the

problems associated with the OTC deals. Internal controls would be important in any case, for

normal equity or debt trading as much as in derivatives trading and the participants need to be

more careful in implementing and operating good back-office and control systems to avoid any

internal control failures.

Derivatives are complex and exotic instruments that Indian investors will have

difficulty in understanding

Trading in standard derivatives such as forwards, futures and options is already prevalent in India

and has a long history. The Reserve Bank of India allows forward trading in rupee-dollar forward

contracts, which has become a liquid market. The RBI also allows cross currency options trading.

Derivatives in commodities markets have a long history. The first commodity futures

exchange was set up in 1875, in Mumbai, under the aegis of Bombay Cotton Traders Association.

A clearing house for clearing and settlement of these trades was set up in 1918. In oilseeds, a

futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures

market in raw jute was set up in Calcutta in 1912 and the bullion futures market in Bombay in

1920.



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In the equities markets also, derivatives have existed for long. In fact, official history of the Native

Share and Stock Brokers Association, which is now known as the Bombay Stock Exchange

suggests that the concept of options existed from early as in 1898. A quote ascribed to Mr. James

P. McAllen, MP, at the time of the inauguration of BSE's new Brokers Hall in 1898, is: ``...India

being the original home of options, a native broker would give a few points to the brokers of the

other nations in the manipulations of puts and calls.''

This amply proves that the concept of options and futures is well-ingrained in the Indian

equities market and is not as alien as it is made out to be. Even today, complex strategies of

options are traded in many exchanges which are called teji-mandi,jota-phatak, bhav-bhav at

different places. In that sense, the derivatives are not new to India and are current in various

markets including equities markets.

India has a long history of derivatives trading. In fact, in commodities markets, Indian exchanges

are inviting foreigners to participate for which the approvals have also been granted.

Is capital market safer than derivatives?

WORLD OVER, the spot market in equities operates on a principle of rolling settlement. In this

kind of trading, if one trades on a particular day (T), one has to settle these trades on the third

working day from the date of trading (T+3).

Futures market allows you to trade for a period of, say, one or three months and net the transaction

for the settlement at the end of the period. In India, most stock exchanges allow the participants to

trade over a one-week period for settlement in the following week. The trades are netted for the

settlement for the entire one-week period. In that sense, the Indian market is already operating on

the futures-style settlement.

In this system, additionally, many exchanges also allow the forward-trading called badla and

contango, which was prevalent in the UK. This system is prevalent in France, in the monthly



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settlement market. It allows one to even further increase the time to settle for almost three months,

under the current regulations. But this way, a curious mix of futures style settlement with the

facility to carry the settlement obligations forward, creates discrepancies.

The more efficient way will be to separate the derivatives from the cash market, that is, introduce

rolling settlement in all exchanges and, simultaneously, allow futures and options to trade. This

way, the regulators will also be able to regulate both the markets easily and it will provide more

flexibility to the market participants.

In addition, the existing system does not ask for any margins from the clients. Given the volatility

of the equities market in India, this system has become quite prone to systemic collapse.

The Indian capital market operates on a account period system which is actually a seven-day

futures market, while internationally, the cash market operates on T+3 rolling settlement basis _

one of the G-30 recommendations for an efficient clearing and settlement mechanism. In the

futures market, there is a daily mark-to-market settlement (T+1), leading to faster settlement and

risk reduction, unlike the cash market where settlement takes seven days. Client positions are not

segregated from the trading member's proprietary role and clearing members are not segregated,

affecting the system.



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CHAPTER-4

INDIAN

DERIVATIVES

MARKET



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Derivatives Market in India

Approval for Derivatives trading

The first step towards introduction of derivatives trading in India was the promulgation of the

Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in

securities. The market for derivatives, however, did not take off, as there was no regulatory

framework to govern trading of derivatives. SEBI set up a 24member committee under the

Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory

framework for derivatives trading in India. The committee submitted its report on March 17, 1998

prescribing necessary preconditions for introduction of derivatives trading in India. The

committee recommended that derivatives should be declared as securities so that regulatory

framework applicable to trading of securities could also govern trading of securities. SEBI also

set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures

for risk containment in derivatives market in India. The report, which was submitted in October

1998, worked out the operational details of margining system, methodology for charging initial

margins, broker net worth, deposit requirement and realtime monitoring requirements. The

Securities Contract Regulation Act (SCRA) was amended in December 1999 to include

derivatives within the ambit of securities and the regulatory framework was developed for

governing derivatives trading. The act also made it clear that derivatives shall be legal and valid

only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives.

The government also rescinded in March 2000, the three decade old notification, which

prohibited forward trading in securities.



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Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this

effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and

BSE, and their clearing house/corporation to commence trading and

Settlement in approved derivatives contracts. To begin with, SEBI approved trading in index

futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by

approval for trading in options based on these two indexes and options on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options

on individual securities commenced in July 2001. Futures contracts on individual stocks were

launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty

Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and

trading in options on individual securities commenced on July 2, 2001. Single stock futures were

launched on November 9, 2001. The index futures and options contract on NSE are based on S&P

CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws,

and regulations of the respective exchanges and their clearing house/corporation duly approved by

SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to

trade in all Exchange traded derivative products.

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

The OTC derivatives markets have witnessed rather sharp growth over the last few years, which

has accompanied the modernization of commercial and investment banking and globalisation of

financial activities. The recent developments in information technology have contributed to a great

extent to these developments. While both exchange-traded and OTC derivative contracts offer



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many benefits, the former have rigid structures compared to the latter. It has been widely discussed

that the highly leveraged institutions and their OTC derivative positions were the main cause of

turbulence in financial markets in 1998.These episodes of turbulence revealed the risks posed to

market stability originating in features of OTC derivative instruments and markets. The OTC

derivatives markets have the following features compared to exchange-traded derivatives:

1. The management of counter-party (credit) risk is decentralized and located within individual

institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for

safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-

regulatory organization, although they are affected indirectly by national legal systems, banking

supervision and market surveillance.



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DERIVATIVES MARKET AT NSE

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this

effect in May 2000. SEBI permitted the derivative segments of two stock exchanges, vizNSE and

BSE, and their clearing house/corporation to commence trading and settlement in approved

derivative contracts. To begin with, SEBI approved trading in index futures contracts based on

S&P CNX Nifty Index and BSE30 (Sensex) Index. This was followed by approval for trading in

options based on these two indices and options on individual securities. The 3 trading in index

options commenced in June 2001 and those in options on individual securities commenced in July

2001. Futures contracts on individual stock were launched in November 2001.

Table 1 growth of options &future trading at NSE

Month &

year

Stock Future Stock Call Option Stock Put Option

No. of

contract

s

Turnover

(Rs.Crore

)

No. of

contracts

Turnover

(Rs.Crore)

No. of

contracts

Turnover

(Rs.Crore)

Jul-01 ----- ---- 13082 290 4746 106

Aug-01 ----- ---- 38971 844 12508 263

Sep-01 ----- ---- 64344 1322 33480 690

Oct-01 ----- ----- 85844 1632 43747 801

Nov-01 125946 2811 112499 2327 31484 683

Dec-01 309755 7515 84134 1986 28425 674

Jan-02 489793 13261 133947 3836 44498 1253

Feb-02 528947 13939 133630 3635 33055 846

Mar-02 503415 13989 101708 2863 37387 1094

Apr-02 552727 15065 121225 3400 40443 1107

May-02 605284 15981 126867 3490 57984 1643

Jun-02 616461 16178 123493 3325 48919 1317

Jul-02 789290 21205 154089 4341 65530 1837

Aug-02 726310 17881 147646 3437 65630 1725



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USERS OF DERIVATIVE

The institutional investor in India could be meaningfully classified into:

1. Banks

2. All India Financial institution (FIs)

3. Mutual Funds

4. Foreign Institutional Investor

5. Life & General Insurers



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The intensity of derivatives usage by any institutional investor is a function of its ability and

willingness to use derivatives for one or more of the following purposes:

a) Risk containment: Using derivatives for hedging and risk containment purpose,

b) Risk Trading /Market Making: Running derivatives trading book for profits and

arbitrage, and / or

c) Covered Intermediation: On-Balance Sheet derivatives intermediation for client

transaction, without retaining any net risk on the Balance Sheet (except credit risk).

BANKS

Types of Banks

Based on the differences in governance structure, business practices and organizational ethos, it is

meaningful to classify the Indian banking sector into the followings:

I. Public Sector Banks(PSBs)

II. Private Sector Banks(Old generation),

III. Private Sector Banks (new generation),

IV. Foreign Banks( with banking and authorized dealer license)



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Credit Derivatives

The market of fifth type of derivatives namely, credit derivatives, is currently nonexistent in

India, hence has been dealt with in brief here. Credit derivatives seek to transfer credit risk and

returns of an asset from one counter party to another without transferring its ownership. The

market for credit derivatives is currently non-existent in India, though it has the potential to

develop.

Equity Derivatives in Banks

Given the highly leveraged nature of banking business, and the attendant regulatory concerns of

their investment in equities, banks in India can, at best, be turned as marginal investor in equities.

Use of equity derivatives by banks ought to be inherently limited to risk containment (hedging)

and arbitrage trading between the cash market and options and futures markets. However, for the

following reasons, banks with direct and indirect equity market exposure are yet to use exchange

traded equity derivatives (viz.., index futures, index options, security specified futures r options)

currently available on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE).

1) RBI guidelines on investment by the banks in capital market instruments do not

authorize banks to use equity derivatives for any purpose. RBI guidelines also do not

authorized banks to undertake securities lending and/ or borrowings of equities. This

disables also banks possessing arbitrage trading skills and institutionalized risk

management process for running an arbitrage trading book to capture risk free

pricing mismatch spread between the equity cash and options and futures market- an



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activity banks currently any way undertake in the fixed income and FX cash and

forward markets;

2) Direct and indirect equity exposure of banks is negligible and does not warrant

serious management attention and resources for hedging purpose;

3) The internal resources and processes in most bank treasuries are inadequate to mange

the risk of equity market exposure, and monitor use of equity derivatives;

4) Inadequate technological and business process readiness of their treasuries to run

equity arbitrage trading book, and mange related risks.

Fixed Income Derivatives in Bank

Scheduled Commercial banks, Primary Dealers (PDs and All India Financial Institution (FIs have

been allowed by RBI since July 0993 to write Interest Rate Swaps(IRS) and Forward Rate

Agreement(FRAs)as product for their own assets liability management (ALM) or for market

making (risk trading)purpose. The presence of Public Sector Banks major in the rupee IRS market

is marginal. Most PSBs are either unable or unwilling of PSB majors seemingly stem from the

following key are yet to overcome;

1) Inadequate technological and business process readiness of their treasuries to run a

derivatives trading books, and manage related risks;

2) Inadequate of willingness of bank managements to risk being held accountable for

bonafide trading losses in the derivatives book;



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Equity Derivatives in FIs

Equity risk exposure of most FIs is rather insignificantly, and often limited-to-limited to equity

developed on them under underwriting commitments they made in the era upto mid 1990s. use of

equity derivatives by FIs could be for risk containment (hedging purpose, and for arbitrage trading

purposes between the cash market and options and futures market. For reason identical to those

outlined earlier vis--vis banks, FIs too are not users of equity derivatives. However, there are no

RBI guidelines disabling FIs from running equities arbitrage- trading book to capture risk free

pricing mis-match spreads between the equity cash and options and futures markets.

Fixed income Derivatives

Since July 1999, like Banks, even FIs are permitted to write RIS and FRA for their asset liability

management (ALM) as well as for market making purpose. Some FIs actively use IRS and FRA

for their ALM. Also, a few have plans to offer IRS and FRA as products to their corporate

customer (to hedge their liabilities), albeit on a fully covered back-to- back basis, to begin with.

However, none are yet to run a rupee derivatives trading book.

Commodities Derivatives Fis

FIs have no proximate exposure to commodities. There are also no credit products whose interest

rate is benchmarked to any commodity price. Therefore, the issue of they using commodity

derivatives (whether in the overseas or Indian market) does not rise.

MUTUAL FUNDS

Equity Derivatives in Mutual Funds

Mutual Funds ought to be natural players in the equity derivatives market. SEBI (Mutual Funds)

Regulations also authorize use of exchange traded equity derivatives by mutual funds for hedging



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and portfolio rebalancing purpose, and, being tax exempt, there are no tax issues relating to use of

equity derivatives by them. However, most mutual funds are not yet active in use of equity

derivatives available on the NSE and BSE. The following impediments seem to hinder use of

exchange trade equity derivatives by mutual funds:

SEBI (Mutual Funds) Regulation restricts use of exchange traded equity derivatives to hedging

and portfolio rebalancing purpose. The popular view in the mutual fund industry is that this

regulation is very open to interpretation, and the trustees of mutual funds do not wish to be caught

on the wrong foot.

1. Inadequate technological and business process readiness of several players in the mutual

fund industry to use equity derivatives and manage related risks;

2. The regulatory prohibition on the use of equity derivatives for portfolio optimization return

enhancement strategies, and arbitrage strategies constricts their ability to use equity

derivatives; and

1. Relatively insignificant investor interest in equity funds ever since exchange

traded options and futures were launched in June 2000(on NSE, later on BSE).

Fixed Income Derivatives in Mutual Funds

SEBI (Mutual Funds) regulations are silent about use of IRS and FRA by mutual funds. Evidently,

IRS and FRA transactions entered into by mutual funds are not construed by SEBI as derivatives

transaction covered by the restrictive provisions which limit use of derivatives by mutual funds to

exchange traded derivatives for hedging and portfolio balancing purposes. Mutual funds are

emerging as important users of IRS and FRA in the Indian fixed income derivatives market.



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Foreign Currency Derivatives in Mutual Funds

In September 1999, Indian mutual funds were allowed to invest in ADRs/GDRs of Indian

companies in the overseas market within the overall limit of US $ 500 million with a sub ceiling

for individual mutual funds of 10% of net assets managed by them (at previous year end), subject

to maximum of US $ 50 million per mutual fund. Several mutual funds had obtained the requisite

approvals from SBI and RBI for making such investments. However, given that most ADRs

/GDRs of Indian companies traded in the overseas market at a premium to their prices on domestic

equity markets, this facility has remained largely unutilized.

Commodity derivatives in Mutual Funds

Under SEBI (Mutual Funds) Regulations, mutual fund can invest only in the transferable financial

securities. In absence of any financial security linked to commodity prices, mutual funds can not

offer a fund product that entails a proximate exposure to the price of any commodity. Therefore,

the issue of they using commodity derivatives (whether in the overseas or Indian market)does not

arise.

FOREIGN INSTITUTIONAL INVESTORS(FIIs)

Equity Derivatives in FIIs



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Till January 2002, applicable SEBI & RBI Guidelines permitted FIIs to trade only in index future

contracts on NSE & BSE. It is only since 4 February 2002 that RBI has permitted (as a sequel to

SEBI permission in December 2001) FIIs to trade in all exchange traded derivatives contract

within the position limits for trading of FIIs and their sub-accounts. With the enabling regulatory

framework available to FIIs from Feb 2002, their activity in the exchange traded equity derivatives

market in India should increase noticeably in the emerging future. Perhaps, the two years of

successful track record of the NSE in managing the systematic risk associated with its futures and

options segment would also pave way for greater FIIs activity in the equity derivatives market in

India in the emerging future.

Fixed Income Derivatives in FIIs

Since May 2000, FIIs are permitted to invest in domestic sovereign or corporate debt market

under the 100% debt rout subject to an overall cap under the external commercial borrowing

(ECB) category, with individual sub ceilings allocated by SEBI to each FII or sub accounts. FIIs

are also permitted to enter into foreign exchange derivatives contract by RBI to hedge the currency

and interest rate risk to the extent of market value of their debt investment under the 100% debt

route. However, investment by FIIs in the domestic sovereign or corporate debt market has been

negligible till now.



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Foreign Currency Derivatives in FIIs

Equity investing FIIs leave their foreign currency risk largely unhdged since they believe that the

currency risk can be readily absorbed by the expected returns on the equity investments, barring in

periods of unforeseen volatility (such as the Far Eastern crisis). And, as indicated above, FII

investment in the domestic sovereign and corporate debt market has been negligible.

Consequently, FII in the foreign currency derivative market in India has also been negligible till

now.

LIFE & GENERAL INSURERS

Equity Derivatives in Life & General Insurers

The Insurance Act as well as the IRDA (Investment) Regulation 2000 is silent about use of equity

(or other) derivatives by life or general insurance companies. It is the view of the IRDA that life &

general insurers are not permitted to use equity (or other financial) derivatives until IRDA frames

guideline/ regulation related to their use. And IRDA is yet to frame this guidelines/ regulation,

though it is seized of the urgent need to frame them. Life or general insurers would have to wait

for these guidelines /regulations to fall in the place before they can use equity (or other financial)

derivatives.



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Fixed Income Derivatives in Life and General Insurers

As indicate earlier, it is view of the IRDA that use of rupee fixed income derivatives (including

IRS and FRA) by Life & General insurers too would have to wait for IRDA guidelines/regulations

on the use of financial derivatives.

Foreign Currency Derivatives in Life & GeneralInsurers

Given the long term nature of life insurance contracts, insurance regulations in the many parts of

the world apply currency matching principle for assets and liability under life insurance contracts.

Indian insurance law too prohibits investment of fund from insurance business written in India,

into overseas or foreign securities.

REGULATORY FRAMEWORKS

Evolution of a Legal Framework for Derivatives Trading

Derivatives are supposed to be defined as security underSection 2(h) of SC(R) Act, 1956. Present

definition of securities includes shares, stocks, bonds, debentures, debentures stocks or other

marketable securities in or of any incorporated company or other body corporate Government

securities Rights or interest in securities, such other instrument as may be declared by the central

government to be securities. An important step towards introduction of derivatives trading in India

was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which lifted the

prohibition on "options in securities" (NSEIL, 2001). However, since there was no regulatory



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framework to govern trading of securities, the derivatives market could not develop. SEBI set up a

committee in November 1996 under the chairmanship of Dr. L.C. Gupta to develop appropriate

regulatory framework for derivatives trading. The committee suggested that if derivatives could be

declared as "securities" under SCRA, the appropriate regulatory framework of "securities" could

also govern trading of derivatives. SEBI also set up a group under the chairmanship ofProf. J.R.

Varma in 1998 to recommend risk containment measures for derivatives trading. The Government

decided that a legislative amendment in the securities laws was necessary to provide a legal

framework for derivatives trading in India. Consequently, the Securities Contracts (Regulation)

Amendment Bill 1998 was introduced in the Lok Sabha on 4th July 1998 and was referred to the

Parliamentary Standing Committee on Finance for examination and report thereon. The Bill

suggested that derivatives may be included in the definition of "securities" in the SCRA whereby

trading in derivatives may be possible within the framework of that Act. The said Committee

submitted the report on 17th March 1999.

Securities Exchange Board of India (SEBI) the oversight regular for the securities market

appointed a Committee on derivatives under the Chairmanship of Dr. L.C. Gupta on 18,

November 1996 to develop appropriate regulatory framework introducing of derivatives trading in

India, starting with stock index futures.

Regulatory objectives

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

behavior. It has been guided by the following objectives:

A. Investor Protection: Attention needs to be given to the following four aspects:



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1. 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.

2. 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.

3. 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.

4. Market integrity: The trading system should ensure that the market's integrity is

safeguarded by minimizing the possibility of defaults. This requires framing appropriate rules

about capital adequacy, margins, Clearing Corporation, etc.

B. Quality of markets: Th

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