DERIVATIVES FINANCIAL MARKET IN INDIA: PERSPECTIVE AND FUTURE

RAJRUPA SINHAROY

OVERVIEW
HISTORICAL DEVELOPMENT OF DERIVATIVES MEANING AND CONCEPT OF DERIVATIVES VARIOUS TYPES OF DERIVATIVES INSTRUMENTS CONCEPT OF FUTURE CONTRACTS IN INDIA ANALYSIS OF FOREX MARKET IN INDIA PRESENT REGULATORY FRAMEWORK IN INDIA FUTURE OF DERIVATIVES MARKET IN INDIA

HISTORICAL DEVELOPMENT OF THE CONCEPT OF DERIVATIVE

Originated in The Bible in Genesis Chapter 29 Book One of Politics, Aristotle recounts a story about the Greek philosopher Thales. The future trading first started in Chicago in 1874. In United Kingdom the Call and Put Option trading were introduced in the London Stock

Exchange in 1920.
In 1972 the Chicago Mercantile Exchange allowed currency futures. The Equity Options were introduced in 1973.

CONTD..

Derivatives in India: A chronological development

December 14, 1995 November 18, 1996

The NSE sought SEBI's permission to trade index futures. The LC Gupta Committee set up to draft a policy framework for index futures. The LC Gupta Committee submitted a report on the policy framework for index futures. Reserve Bank of India gave permission for OTC forward rate agreements and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. SEBI allowed the NSE and the BSE to trade in index futures. Trading of Nifty futures commenced on the NSE.

May 11, 1998

July 7, 1999

May 24, 2000

May 25, 2000

June 12, 2000

MEANING AND CONCEPT OF DERIVATIVE

The term Derivative has been defined under the section 2(ac) of the

Securities Contract Regulation Act 1956 as derivative includes(a) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; (b) A contract which derives its value from the prices, or index of prices, of underlying securities.

In India Bombay stock exchange launched the first exchange traded Index Derivatives Contract, i.e. Futures in the capital market (BSE SENSEX) on 9th June, 2000. Stock Options were introduced on 31 stocks on 9th July, 2001. Single Stock Futures were launched on 9th November 2002.

On September 13, 2004, BSE permitted trading on weekly contracts in options in the shares of 4 leading companies namely Reliance, Satyam, State Bank of India and TISCO.

Object of introducing Derivatives in India

> The primary objectives of any investors are to maximise return and minimise risks. Derivatives
are contracts that originated from the need to minimise risk. The word derivative originates from mathematics and refers to a variable, which has been derived from another variable.

> Derivatives have no value of their own because they derive their value from the value of some
other asset, which is known as the underlying. For example, derivatives of the shares of Infosys (underlying), will derive its value from the share price of the Infosys. Derivatives are specialised contracts which signify an agreement or an option to buy or sell the underlying asset of the derivative upto a certain time in the future at a prearranged price or the exercise price.

> The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date
of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying assets.

FUNCTIONS OF THE DERIVATIVES MARKET

First; prices in an organised derivatives market reflect the perception of the market participants about the future level. The prices of derivatives converge with the prices of underlying at the expiration of the derivatives contract. Thus derivatives help in the discovery of the future as well as current prices Second; the derivatives market helps to transfer risks from those who have an appetite for them. Third; the derivatives, due to their inherent nature, are linked to the underlying cash market. With the introduction of derivatives, the underlying market witnesses a higher trading volume. Because of participation by more players who, would not otherwise participate for lack of an arrangement to transfer risk. Fourth; an important incidental benefit that flows from derivatives trading is that its act as a catalyst for new entrepreneurial activity. Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

VARIOUS INSTRUMENTS OF DERIVATIVES

FORWARD CONTRACTS FUTURE CONTRACTS OPTION CONTRACTS- CALL AND PUT OPTION SWAPS

MEANING OF FORWARD CONTRACT

A cash market transaction in which a seller agrees to deliver a specific cash commodity to a buyer at some point in the future. Unlike futures contracts (which occur through a clearing firm), cash forward contracts are privately negotiated and are not standardized. Forwards are priced in a manner similar to futures. Like in the case of a futures contract, the first step in pricing a forward is to add the spot price to the cost of carry (interest forgone, convenience yield, storage costs and interest/dividend received on the underlying). Unlike a futures contract though, the price may also include a premium for counterparty credit risk, and the fact that there is not daily marking to market process to minimize default risk. If there is no allowance for these credit risks, then the forward price will equal the futures price.

MEANING OF FUTURE CONTRACT

Future Contract is a standardized contract traded on a future exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.
The future date is called the delivery date or final settlement date. The pre set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. A futures contract gives the holder the obligation to buy or sell, which differs from as option contract, which gives the holder the right, but not the obligation. Both parties of a futures contract must fulfill the contract on the settlement date.

MEANING OF OPTION CONTRACT

Options are financial instruments that convey the right, but not the obligation, to buy or sell a specified quantity of certain underlying assets at a specified price on or before the specified date. On the other hand the seller is under obligation to perform the contract (buy or sell the underlying asset). The underlying asset can be share index , interest rate, bond, rupees, dollar exchange rates, sugar, crude oil, cotton, coffee etc. The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares.

CALL AND PUT OPTIONS

A call option is a financial contract between two parties, the buyer and the seller of this type of option. It is the option to buy shares of stock at a specified time in the future. Often it is simply labelled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity The buyer pays a fee (called a premium) for this right. Put Option is just opposite of the Call Option which gives the holder the right to buy shares. A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price.

SWAP CONTRACTS
A swap is an agreement between parties to exchange streams (Buying and Selling) of payments in the securities market calculated on different basis. In case of any risks by 2 ways that can be covered: Selling up of instruments and invest instead in a floating rate instrument. In that case the client may face a capital gain or loss. Retain the instrument and the client may enter into a interest rate swaps. SCHEDULE I of the Foreign Exchange Derivative Contracts, Regulations 2000 mention Contract other than Forward Contract: A person resident in India who has borrowed foreign exchange in accordance with the provisions of Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000 , may enter into an Interest rate swap or Currency swap or Coupon Swap or contract with an authorised dealer in India or with a branch outside India of an authorised dealer for hedging his loan exposure and unwinding from such hedges, Provided that CONTD

 the contract does not involve rupee, the Reserve Bank has accorded final approval for borrowing in foreign currency, the notional principal amount of the hedge does not exceed the outstanding amount of the foreign currency loan, and the maturity of the hedge does not exceed the un-expired maturity of the underlying loan, A person resident in India, who owes a foreign exchange or rupee liability, may enter into a contract for foreign currency-rupee swap with an authorised dealer in India to hedge long term exposure, The contract, if cancelled shall not be rebooked or re-entered, by whatever name called.

CONCEPT OF FUTURE CONTRACTS IN INDIA

Future contract or future is an agreement between two parties to buy or sell an asset or security at a certain time in future; it follows daily settlement. There are two types of existing stock markets. One is known as 'Capital Market', where all the transactions should be traded in that particular day within 9:55 am to 3:30 pm. The other market is known as 'Future Market', which was established in June, 2000. At that time only indexes were traded but since 9th November 2001 the share contracts are also being traded in the future market. Future Markets are designed to solve the problems that exist in forwards markets. A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, future contracts are standardised and stock exchange traded. To facilitate liquidity in the future contracts, the exchange specifies certain standard features for the contract. A future contract may be offset prior to maturity by entering into an equal and opposite transaction. CONTD

 The standardised items in a futures contract are: Quantity of the underlying; Quality of the underlying; Date or month of delivery; Units of price quotation and minimum price change; Location of settlement Example: In general Cash Market: A bought 400 shares of Maruti Co. @ Rs. 400 per share. A bought this because he thinks that the price will be higher in future days. A bought those shares at cash price and after taking the delivery he has to keep the shares in Demat. Lastly after selling he has to send the Delivery Instruction Book to the Brokers, which is a very costly process .
In Future Market, When one buys a future contract then there is no need to pay the whole money. Then there is no need to open a demat account because the investor is not buying shares, then there is no cost required to demat the contracts. Even no charges are required for the delivery to the brokers. In the future contract, each contract does not mean a share, because each contract has an individual 'Lot size'. 'Lot size' means a particular quantity of shares decided by SEBI.

Example: (in this example 1 lot size contains the mentioned nos. of shares.)

COMPANY Nifty CNXIT Bank Nifty ABB ACC Allahabad Bank BHEL CANBANK HERO HONDA UTI WIPRO

LOT SIZES 100 100 100 200 750 2450 300 1600 400 900 600, etc.

DETERMINATION OF THE PRICE OF FUTURE CONTRACTS The cost of any future contract is a bit higher than the present price if the share in the Capital market. The reason has been explained as follows: A buys 1,000 shares of CIPLA Company @ Rs 280 per share. Suppose A buys those futures on 1st December for the duration of 1 month. Then the total investment of A = 2, 80,000/-. Then the charges of broker will be added with this. If that is Re 1/- per share, then total = 1,000/-. With these charges, another charge will be added, and that is the interest money. Suppose the interest rate is 12% per annum, then the rate for one month is 1%. 1% of 2, 80,000/- is 2,800/-. Lastly we have to calculate demat charges, which is Rs. 200/-. 2, 80,000 + 2,800 + 1,000 + 200 = 2, 84,000/-. So per share the price will become Rs. 284 in future market. Price of each future contract can be calculated through a formula. The formula is given below: F = S (1+r) T Here, F = Future Price S = Spot Price R = Cost of Financing/ Carry T = Time Period

ANALYSIS OF FOREX MARKET IN INDIA

The term FORWARD Contract defines under Regulation 2(iv) of Foreign Exchange Derivative Contracts, Regulations 2000 as: Forward contract means a transaction involving delivery, other than Cash or Spot delivery, of foreign exchange; Regulation 2(v): Foreign exchange derivative contract means a financial transaction or an arrangement in whatever form and by whatever name called, whose value is derived from price movement in one or more underlying assets, and includes, a transaction which involves at least one foreign currency other than currency of Nepal or Bhutan, or a transaction which involves at least one interest rate applicable to a foreign currency not being a currency of Nepal or Bhutan , or a forward contract, but does not include foreign exchange transaction for Cash or Spot deliveries; The financial markets, including derivative markets, in India have been through a reform process over the last decade and a half, witnessed in its growth in terms of size, product profile, nature of participants and the development of market infrastructure across all segments - equity markets, debt markets and Forex markets.

Regulation 7: Remittance related to a Foreign Exchange Derivative contract :An authorised dealer in India may remit outside India foreign exchange in respect of a transaction, undertaken in accordance with these Regulations, in the following cases, namely; option premium payable by a person resident in India to a person resident outside India , remittance by a person resident in India of amount incidental to a foreign exchange derivative contract entered into in accordance with Regulation 4, remittance by a person resident outside India of amount incidental to a foreign exchange derivative contract entered into in accordance with Regulation 5, any other remittance related to a foreign exchange derivative contract approved by Reserve Bank.

PRESENT REGULATORY FRAMEWORK IN INDIA

The trading of the derivatives and its various instruments has been regulated by various laws in India. The Securities Contracts(Regulation) Act, 1956 Definition Section 2(ac): derivative . Contracts in derivative Section 18 A: Notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are (a) traded on a recognised stock exchange; (b) settled on the clearing house of the recognised stock exchange, in accordance with the rules and bye-laws of such stock exchange.

No legal derivative disputes so far.

SEBI NOTIFICATIONS Notification under regulation 3 of the Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007, No. LAD/NRO/GN/2009-10/04/163097: Notification dated May 13, 2009, SEBI mandated that all the existing approved users / sales personnel of the trading members in the currency derivative segment shall obtain certification(certification for approved users and sales personnel of the trading members in the currency derivatives segment) by August 10, 2009. SEBI permitted Mini- Derivatives (F & O) contract on INDEX (SENSEX & NIFTY). RBI REGULATIONS: RBI vide circular A.P.(DIR Series) Circular No.13, dated September 1, 2003 has specified that Foreign Institutional Investors (FIIs) may trade in all exchange traded derivative contracts approved by SEBI from time to time subject to the limit prescribed by SEBI. SEBI guidelines to protect the interest of the investors.

FUTURE OF DERIVATIVES MARKET IN INDIA

Derivatives are an innovation that has redefined the financial services industry and it has assumed a very significant place in the capital markets. However, trading in derivatives is complicated and risky.

Types of Derivatives Risk Credit risk: Credit risk is the risk of loss due to counterpartys failure to perform on an obligation to the institution. Market risk: Market risk is the risk of loss due to adverse changes in the market value (the price) of an instrument or portfolio of instruments. Such exposure occurs with respect to derivative instruments when changes occur in market factors such as underlying interest rates, exchange rates, equity prices, and commodity prices or in the volatility of these factors. Liquidity risk: Liquidity risk is the risk of loss due to failure of an institution to meet its funding requirements or to execute a transaction at a reasonable price. Institutions involved in derivatives activity face two types of liquidity risk: market liquidity risk and funding liquidity risk. CONTD.

 Operational risk: Operational risk is the risk of loss occurring as a result of inadequate systems and control, deficiencies in information systems, human error, or management failure. Derivatives activities can pose challenging operational risk issues because of the complexity of certain products and their continual evolution.
Legal risk: Legal risk is the risk of loss arising from contracts which are not legally enforceable (e.g. the counterparty does not have the power or authority to enter into a particular type of derivatives transaction) or documented correctly. Regulatory risk: Regulatory risk is the risk of loss arising from failure to comply with regulatory or legal requirements. Reputation risk: Reputation risk is the risk of loss arising from adverse public opinion and damage to reputation.

Thank You