Assignment of IFM

Evolution in the development of currency derivative trading in India

SUBMITTED TO: Mr. Liaqut Ali Class: MBA II C Roll no: 6300

SUBMITTED BY: Sahil Mittal

SCHOOL OF MANAGEMENT STUDIES, PUNJABI UNIVERSITY PATIALA

INTRODUCTION
The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. Gradually, this system of fixed prices came under immense stress. High inflation and unemployment rates made interest rates more volatile. Ultimately, the Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Price fluctuations, more often than not, make it extremely strenuous for businesses to estimate their future production costs and revenues. This has created various kinds of risks. In fact risks are inherent in all kinds of markets. Financial markets are no exception to the above and are systemically volatile. Therefore, it is the prime concern of all the financial agents to balance or hedge the related risk factors. This has induced the market participants to search for ways to manage risk. Derivatives are one of such risk management tools which are getting increased popularity in the current market dynamics. This paper shall discuss at length the legal and financial intricacies of derivatives trading in the Indian regulatory framework. Derivatives are considered to be extremely versatile financial instruments, as they help to manage risks, lower funding costs, enhance yields and diversify portfolios. The contributions made by derivatives have been so great, that they have been credited with having changed the face of finance in the world. Surprisingly, less than three decades ago, the global markets for derivatives barely even existed. However, today, the derivatives market has multiplied several times of its initial size and stands witness to its own rapid growth. Derivatives markets are an integral part of capital markets in developed as well as in emerging market economies. These instruments assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates or other assets, thereby, rendering both cash and derivatives

markets more efficient. These instruments also offer protection from possible adverse market movements and can be used to manage or offset exposures by hedging or shifting risks particularly during periods of volatility thereby reducing costs. By allowing for the transfer of unwanted risk, derivatives can, also, promote more efficient allocation of capital across the economy, thereby, increasing productivity. Despite derivatives activity scaling new heights every year, it appears that the world market still has a further unaccounted potential for expansion. In many of the lesser-developed financial markets, derivatives usage is still a limited phenomenon owing to various factors. These markets have a tremendous scope for growth which needs to be efficiently tapped.

DERIVATIVES: CONCEPT & SCOPE

Despite extensive press coverage, derivatives continue to remain one of the most widely misused and misunderstood financial term. This is, in part due, to the wide range of financial instruments included under the rubric of derivatives and also, to the complex nature of these instruments. There is an unfortunate perception among many that a derivative is anything, which causes loss to an investor. Ironically, derivatives have often been described as esoteric, arcane, and a subject capable of being understood only by rocket scientists. This research paper makes an attempt to clarify that even though derivatives are complex instruments, they are not conceptually inscrutable. However, quantifying the market risks of derivatives or understanding how they are priced requires an advanced knowledge of mathematics. The derivatives are not formally defined under any Act in India, except for a brief reference in Section 2(aa) of Securities Contract (Regulation) Act of India. It states that Derivatives include: (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, and (b) a contract which derives its value from the prices or index of prices or underlying securities. The Act also clarifies that, notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid only if such contacts are traded on a recognized

stock exchange and settled on a clearing entity of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange, thus precluding OTC derivatives. In almost all common law jurisdictions, the term derivatives has no precise legal meaning ascribed to it. Different industry and regulatory groups have developed their own working definitions of derivatives, which provide useful insight into the range of financial instruments covered. CASAC, for example, has defined a derivatives instrument as: A financial instrument whose value is derived from some other thing, such as: A physical commodity (for instance wool, cattle, oil or gold.) a financial asset for instance, shares or bonds) an index (for instance, a share price Index) an interest rate a currency Another derivative.

The global Study Derivatives Group has adopted a similar definition that has often been quoted: A Derivative is a bilateral contract or payments exchange agreement whose value derives, as its name implies, from the value of an underlying asset or underlying reference rate or index. Although the International Swaps and Derivatives Associations definition is not much different from either of the above definitions. It is narrower in scope since it confines the term to instruments to manage risks: Derivatives are bilateral contracts involving the exchange of cash flows and designed to shift risk between parties. When transactions mature, the amounts owed by each party are determined by the prices of underlying commodities, securities or indices. In general, the term derivative itself indicates that it has no independent value. The value of a derivative is entirely derived from the value of a cash asset. A derivative contract, product, instrument or simply derivative is to be sharply distinguished from the underlying cash asset, which is an asset bought or sold in the cash market on normal delivery terms. A simple derivative instrument hedges the risk component of an underlying asset. For example, rice farmers may wish to sell their harvest at a price which they consider is safe at a future date to

eliminate the risk of a change in prices by that date. To hedge their risks, farmers can enter into a forward contract and any loss caused by fall in the cash price of rice will then be offset by profits on the forward contract. The primary purpose behind investing in derivative instruments is to enable individual or corporate investors to either increase their exposure to certain specified risks in the hope that they will earn returns more than adequate to compensate them for bearing these added risks, known as speculation, or reduce their exposure to specific financial risks by transferring these risks to other parties who are willing to bear them at lower cost, known as hedging.

TYPES OF DERIVATIVES IN INDIA

At present the Indian market trades in both exchange-traded and over the counter derivatives on various assets including securities, both equity and debt commodities, currencies, etc. the various types of derivatives being traded in India are discussed below:

GENERIC DERIVATIVE PRODUCTS

Today, Indian and International financial markets trade innumerable derivative products on all kinds of underlying assets, both tangible and intangible. Before proceeding with the regulatory issues of derivatives trading, it is important to have a detailed understanding of the four generic derivative products in detail.

1. FORWARD CONTRACTS A forward contract is defined as an agreement, which obligates one counterparty to buy, and the other counterparty to sell, a specific underlying at a specific price, amount and date in the future. It is more clearly a one-to-one, bipartite/tripartite contract, which is to be performed mutually by the contracting parties, in future, at the term decided upon, on the contract date. In other words, a

forward contract is an agreement to buy or sell an asset on a specified future date for a specified price. One of the parties to the contract assumes a long position, i.e. agrees to buy the underlying asset while the other assumes a short position, i.e. agrees to sell the asset. As this contract is traded off the exchange and settled mutually by the contracting parties, it is called an Over-thecounter product. It can be better understood with the help of an illustration. Assume that there are two parties, Mr. A (buyer) and Mr. B (seller), who enter into a contract to buy and sell 500 units of asset X at Rs 100 per unit, at a predetermined time of two months from the date of contract. In this case, the product(asset X), the quantity (500 unites), the product price (Rs 100 per unit) and the time of delivery (2 months from the date of contract) have been determined and well understood, in advance, by both the contracting parties. Delivery and payment (settlement of transaction) will take place as per the terms of the contract on the designated date and place. It is pertinent to note that forward contracts are negotiated by the contracting parties on a one-toone basis and hence offer tremendous flexibility in terms of determining contract terms such as price, quantity, quality(in place of commodities), delivery time and place. Like other OTC products, forward contracts offer tremendous flexibility to the contracting parties. However, as they are customized, they suffer from poor liquidity. Furthermore, as thee contracts are mutually settled and generally not guaranteed by any third party, the counter party risk/default risk/credit risk is considerable in such contracts.

2. FUTURES CONTRACTS A futures contract is similar to a forward contract, in that it is an agreement to buy or sell a specified commodity or instrument, at a specified price, at a date in the future. Illiquidity and counter party risk were the two issues concerning forward contracts that offered the exchanges a tremendous business opportunity and they started trading these forward contracts, but with a difference. In order to differentiate between the exchange-traded forwards and the OTC forward, the market renamed the exchange-traded forwards as Futures Contract. Hence, future contracts

are essentially standardized forward contracts, which are traded on the exchanges and settled through the clearing agency of the exchanges. The clearing agency also guarantees the settlement of these trades. Reasons for using futures contracts can be diversified and complicated. First, they attract lower transaction costs. They are normally only a fraction of the costs of trading in the underlying commodity or instrument. Second, counterparty risk is minimal as it is unlikely that the clearinghouse would collapse, as it is usually well-backed financially. In addition, if a participant defaults, the rules of a typical clearinghouse will provide for the allocation of the losses to the surviving participants according to a predetermined formula. Third, futures contracts permit anonymity of participants as most brokers act for undisclosed principals. Fourth, there is no requirement for large capital outlays as initial deposits range between five to fifteen percent only. Fifth, futures markets are more liquid, and therefore, it is easier for the participants to close-out or settle their contracts. However, a major disadvantage of using futures contracts is their inflexibility. Any investor using futures contracts for hedging would be exposed to basis risk. Basis risk refers to the risk where the futures contract and the instrument that is being hedged may not be perfectly matched.

3. SWAPS Swaps like forward contracts, are customized over-the-counter transactions. A swap has been described as an agreement between two parties to pay each other a series of cash flows, based on fixed or floating interest rates in the same or different currencies. Swap transactions are broadly classified into interest rate, currency, commodity or equity swaps. It is possible to use swaps for a variety of purposes including the reduction of borrowing costs; asset and liability management; and yield enhancement. The principle of comparative

advantage, a concept central to international trade, plays an important role in swap transactions. Each counterparty borrows in the market where it enjoys a comparative advantage, and through the use of swap obtains financing at a more favorable rate than it would otherwise be able to do so. Swap cash flows can be decomposed into equivalent cash flows from a bundle of simple

forward contracts. This has implications for the hedging of swap risks. Swaps are now hedged with a variety of derivative products, and no longer only by matching two identical but opposing swaps. A swap derivative is nothing but barter or an exchange but it plays a critical role in international finance. Currency Swaps help eliminate barriers caused by international capital markets. Interest rate Swaps help eliminate barriers caused by regulatory structure. While Currency rate swaps result in exchange of one currency with another, interst rate swaps help exchange a fixed rate of interest with a variable rate. Swaps are private agreements between two parties and are not traded on exchanges but they do have an informal market and are traded among dealers. Swaptions is an option on swap that gives the party the right, but not the obligation to enter into a swap at a later date.

4. OPTIONS An option is the right to buy or sell a specific price on or before a specific date in the future. It is a right that the option seller gives to the option buyer to buy or sell an underlying asset at a predetermined price, within or at the end of a specified period. The party taking a long position, i.e. buying the option is called the buyer/holder of the option and the party taking a short position, i.e. selling the option is called the seller/writer of the option. The option buyer who is also called long option, or long premium or holder of option, has the right and no obligation with regard to buying or selling the underlying asset while the option seller/ writer who is also called short on option or short on premium, has the obligation but no right, in the contract. In other words, the option buyer may or may not exercise his option but if he decides to exercise it the option seller/writer is legally bound to honor the contract. The right to buy an asset is a call option, while the right to sell an asset is a put option. An option which gives the buyer a right to buy the underlying asset, is called a call option and the option, which gives the buyer a right to sell the underlying asset is called put option.

An American option is one which can be exercise any time until maturity, while a European option is one which can be exercised on maturity date. The buyer of an option is usually called the option holder, and the seller of the option, the option writer. The option holder must pay the option writer a price known as the premium in order to acquire the rights under the option. Options are available on a wide range of assets including commodities, foreign currencies, shares, bonds and even other derivatives.

EQUITY DERIVATIVES India joined the league of exchange-traded equity derivatives in June 2000, when futures contracts were introduced at its two major exchanges, viz. the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The BSE sensitive index, popularly known as the SENSEX (compromising 30 scrips), and S&P CNX Nifty Index (compromising 50 scrips), commenced trade in futures on June 9, 2000 and June 12, 2000 respectively. Index options and individual stock options on 31 selected stocks were subsequently added to the derivatives basket, in 2001. November 2001 witnessed the introduction of single stock futures in the Indian market. This list of stocks was selected, based on a predefined eligibility criteria linked to the market capitalization of stocks, floating stock, liquidity, etc.

COMMODITY DERIVATIVE

The Forward Contract Regulation Act (FCRA) governs commodity derivatives in India. The FCRA specifically prohibits OTC commodity derivatives. Accordingly, at this point in time, we have only exchange-traded commodity derivatives. Furthermore, FCRA does not even allow options on commodities. Therefore, at present, India trades only exchange-traded commodity futures. Though commodity derivatives in the country have existed for a long time, trading has been regionally concentrated due to the regional nature of the commodity exchanges. Recently however, India began trading in commodity derivatives through two nation-wide, online

commodity Exchanges- the National Commodities and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange (MCX). They started functioning in the last quarter of 2003 with the introduction of futures contracts on various assets such as gold, silver, rubber, steel, mustard seed, etc. It is important to note that both these exchanges have been recording a very high rate of growth. But it is interesting to note that the growth in volume of commodity derivatives has been achieved without institutional participation in the market. At present, banks, financial institutions, mutual funds, pension funds, insurance companies and Foreign Institutional investors are not allowed to participate in the commodities market.

CURRENCY DERIVATIVES

India has been trading forward contracts in currency, for the last several years. Recently, the RBI has allowed options in the OTC market. The OTC currency market in the country is considerably large and well-developed. However, the business is concentrated with a limited number of market participants.

INTEREST RATE DERIVATIVES

An Interest Rate Derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate. There has also been significant progress in interest rate derivatives in the Indian OTC market. The NSE introduced trading in cash settled interest rate futures in the year 2003.

CLASSIFICATION OF DERIVATIVES MARKETS

Derivatives markets fall in two broad categories: exchange-traded derivatives markets and overthe counter (OTC) derivatives markets. EXCHANGE-TRADED DERIVATIVES MARKET

A derivatives exchange may simply be described as an organized market for the trading of derivatives contracts. The derivatives exchanges are a vital component of the global market for exchange-traded derivatives. In a typical transaction, the clients order is routed to a floor member for execution. After the trade is executed, the contract between the two contracting floor members is then sent to the clearing house for registration. Once the contract between two clearing members is registered, the legal nexus between the original buyer and seller is broken. The clearinghouse interposes itself between the buyer and seller and two new contracts come into existence. In one contract, the clearinghouse acts as buyer to the original seller, and in the other contract, the clearinghouse interposes itself between the buyer and seller. The clearinghouse does not guarantee the performance of the open contracts. Rather it assumes the responsibility for performance by acting as the counterparty in both the contracts. The various exchange traded derivatives market in India are the National Stock Exchange(NSE), the Bombay Stock Exchange(BSE), the National Commodities and Derivatives

Exchange(NCDEX) and the Multi Commodity Exchange(MCX). Some of the international exchanges where such derivatives are traded are The Sydney Futures Exchange, the New Zealand Futures And Options Exchange, Singapore Exchange Derivatives Trading Limited, Commodity and Monetary Exchange of Malaysia, Kuala Lumpur Options and Financial Futures Exchange, Hong Kong Futures Exchange.

OVER-THE-COUNTER DERIVATIVES MARKETS.

The over-the-counter (OTC) derivatives markets are principal-to-principal dealer markets. Products/contracts that are traded outside the exchanges are called OTC derivatives. They are contracts those which are privately traded between two parties and involve no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives

Market or OTC market. The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest. The OTC derivatives markets are much larger than the exchange-traded derivatives markets. The OTC derivatives markets are predominantly institutional markets and individual transactions tend to be fairly large in size, while the exchange traded derivatives markets, on the other hand, have a significant retail component and their average transaction size tend to be much smaller. Unlike the exchange traded derivatives, the OTC derivatives markets are usually unregulated and operate on a caveat emptor basis. The OTC derivatives markets do not have a formal trading place, are less transparent, have no margining mechanisms, and generally suffer from reduced liquidity. OTC contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. However, OTC Contracts have substantial credit risk; which is the risk that the counterparty that owes money may defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve bank of India (RBI) or, in the case of commodities (which are regulated by the forward markets commission), those that trade informally in havala or forward markets.

History of Derivatives Markets in India

Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities. The last decade, beginning the year 2000, saw lifting of ban on futures trading in many commodities. Around the same period, national electronic commodity exchanges were also set up.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE3 and BSE4, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index-based trading was permitted in options as well as 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. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue. Table 1 gives chronology of introduction of derivatives in India.

Table :Derivatives in India: A Chronology

Date 14 December 1995 18 November 1996 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 31 August 2000 June 2001 July 2001 November 9, 2002 June 2003 September 13, 2004 January 1, 2008 January 1, 2008 August 29,2008 Progress NSE asked SEBI for permission to trade index futures. SEBI setup L. C. Gupta Committee to draft a policy framework for index futures. L. C. Gupta Committee submitted report. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of Nifty futures commenced at NSE. Trading of futures and options on Nifty to commence at SIMEX. Trading of Equity Index Options at NSE Trading of Stock Options at NSE Trading of Single Stock futures at BSE Trading of Interest Rate Futures at NSE Weekly Options at BSE Trading of Chhota(Mini) Sensex at BSE Trading of Mini Index Futures & Options at NSE Trading of Currency Futures at NSE

October 2,2008 Trading of Currency Futures at BSE Source: Complied from BSE and NSE

Derivatives Products Traded in Derivatives Segment of BSE

The BSE created history on June 9, 2000 when it launched trading in Sensex based futures contract for the first time. It was followed by trading in index options on June 1, 2001; in stock options and single stock futures (31 stocks) on July 9, 2001 and November 9, 2002, respectively. Currently, the number of stocks under single futures and options is 109 . BSE achieved another milestone on September 13, 2004 when it launched Weekly Options, a unique product unparalleled worldwide in the derivatives markets. It permitted trading in the stocks of four leading companies namely; Satyam, State Bank of India, Reliance Industries and TISCO (renamed now Tata Steel). Chhota (mini) SENSEX
7 6

was launched on January 1, 2008. With a

small or 'mini' market lot of 5, it allows for comparatively lower capital outlay, lower trading costs, more precise hedging and flexible trading. Currency futures were introduced on October 1, 2008 to enable participants to hedge their currency risks through trading in the U.S. dollarrupee future platforms. Table 2 summarily specifies the derivative products and their date of introduction on the BSE

Table:
S.no 1 2 3 4 5 6

Products Traded in Derivatives Segment of the BSE

Introduction Date June 9,2000 June 1,2001 July 9, 2001 November 9,2002 September 13,2004 January 1, 2008 N.A. October 1,2008

Product Traded with underlying asset Index Futures- Sensex Index Options- Sensex Stock Option on 109 Stocks Stock futures on 109 Stocks Weekly Option on 4 Stocks Chhota (mini) SENSEX Futures & Options on Sectoral indices namely BSE TECK, BSE FMCG, BSE Metal, BSE 7 Bankex and BSE Oil & Gas. 8 Currency Futures on US Dollar Rupee Source: Complied from BSE website

Derivatives Products Traded in Derivatives Segment of NSE

NSE started trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as its

first derivatives product. Trading on index options was introduced on June 4, 2001. Futures on individual securities started on November 9, 2001. The futures contracts are available on 233 securities stipulated by the Securities & Exchange Board of India (SEBI) . Trading in options on individual securities commenced from July 2, 2001. The options contracts are American style and cash settled and are available on 233 securities. Trading in interest rate futures was introduced on 24 June 2003 but it was closed subsequently due to pricing problem. The NSE achieved another landmark in product introduction by launching Mini Index Futures & Options with a minimum contract size of Rs 1 lac. NSE crated history by launching currency futures contract on US Dollar-Rupee on August 29, 2008 in Indian Derivatives market. Table 3 presents a description of the types of products traded at F& O segment of NSE.
Table :Products Traded in F&O Segment of NSE
S.no Product Traded with underlying asset 1 Index Futures- S&P CNX Nifty 2 Index Options- S&P CNX Nifty 3 Stock Option on 233 Stocks 4 Stock futures on 233 Stocks 5 Interest Rate Futures- T Bills and 10 Years Bond 6 CNX IT Futures & Options 7 Bank Nifty Futures & Options 8 CNX Nifty Junior Futures & Options 9 CNX 100 Futures & Options 10 Nifty Midcap 50 Futures & Options 11 Mini index Futures & Options - S&P CNX Nifty index 12 long Term Option contracts on S&P CNX Nifty Index 13 Currency Futures on US Dollar Rupee 14 S& P CNX Defty Futures & Options Source: Complied from NSE website Introduction Date June 12,2000 June 4,2001 July 2, 2001 November 9,2001 June 23,2003 August 29,2003 June 13,2005 June 1,2007 June 1,2007 October 5,2007 January 1, 2008 March 3,2008 August 29,2008 December 10, 2008 8

Growth of Derivatives Market in India

Equity derivatives market in India has registered an "explosive growth" (see Fig. 2) and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE

cash markets was only Rs. 3,551,038 Cr. If we compare the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories . Among all the products traded on NSE in F& O segment, single stock futures also known as equity futures, are most popular in terms of volumes and number of contract traded, followed by index futures with turnover shares of 52 percent and 31 percent, respectively . In case of BSE, index futures outperform stock futures.

Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. In the equity markets, a system of trading called badla involving some elements of forwards trading had been in existence for decades. However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. In 1993, the government created the NSE in collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bilevel regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and

advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991.The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.

Derivatives Instruments Traded in India

In the exchange -traded market, the biggest success story has been derivatives on equity products. Index futures were introduced in June 2000, followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively. As of 2005, the NSE trades futures and options on 118 individual stocks and 3 stock indices. All these derivative contracts are settled by cash payment and do not involve physical delivery of the underlying product (which may be costly).

Derivatives on stock indexes and individual stocks have grown rapidly since inception. In particular, single stock futures have become hugely popular, accounting for about half of NSEs traded value in October 2005. In fact, NSE has the highest volume (i.e. number of contracts traded) in the single stock futures globally, enabling it to rank 16 among world exchanges in the first half of 2005. Single stock options are less popular than futures. Index futures are

increasingly popular, and accounted for close to 40% of traded value in October 2005. Figure 2 illustrates the growth in volume of futures and options on the Nifty index, and shows that index futures have grown more strongly than index options.9 NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, there has been little trading in them. One problem with these instruments was faulty contract specifications, resulting in the underlying interest rate deviating erratically from the reference rate used by market participants. Institutional investors have preferred to trade in the OTC markets, where instruments such as interest rate swaps and forward rate agreements are thriving. As interest rates in India have fallen, companies have swapped their fixed rate borrowings into floating rates to reduce funding costs. Activity in OTC markets dwarfs that of the entire exchange-traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004 (FitchRatings, 2004).

Foreign exchange derivatives are less active than interest rate derivatives in India, even though they have been around for longer. OTC instruments in currency forwards and swaps are the most popular. Importers, exporters and banks use the rupee forward market to hedge their foreign currency exposure. Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less (Gambhir and Goel, 2003). In a currency swap, banks and corporations may swap its rupee denominated debt into another currency (typically the US dollar or Japanese yen), or vice versa. Trading in OTC currency options is still muted. There are no exchange-traded currency derivatives in India.

Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been uneven. The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004, while the value of trading has increased almost four times in the same period (Nair, 2004). However, many contracts barely trade and, of those that are active, trading is fragmented over multiple market venues, including central and regional exchanges, brokerages, and unregulated forwards markets. Total volume of commodity derivatives is still small, less than half the size of equity derivatives (Gorham et al, 2005).

Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have assets and liabilities of different maturities and in different currencies, and are exposed to different risks of default from their borrowers. Thus, they are likely to use derivatives on interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions are regulated differently from financial institutions, and this affects their incentives to use derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far, with their contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors). In contrast to the exchange-traded markets, domestic financial institutions and mutual funds have shown great interest in OTC fixed income instruments. Transactions between banks dominate the market for interest rate derivatives, while state-owned banks remain a small presence (Chitale, 2003). Corporations are active in the currency forwards and swaps markets, buying these instruments from banks.

Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives.Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives, and be subject to position limits as specified by SEBI. Alternatively, they can incorporate locally as a

Recent Developments
RBI in order to regulate the currency market volatility has allowed the trading in currency future and forward on April 20,2007. And as there was difficulty in managing the currency future along depending on FOREX with other derivatives traded in Security exchange market depending on SENSEX, Therefore the RBI and SEBI came together and jointly formed an standing committee to analyze the trade in currency forward and future market around the world and thus laying down the guideline to introduce and manage the exchange traded currency future market in India. The committee has submitted the report on May 29,2008 . RBI and SEBI is now cooperating and working together manage this segment of future and option trading in India .this segment has mostly benefited importer and exporter to manage their future risk by hedging there fund in currency future were they could lock there future currency exchange rate so that they could manage there risk in fluctuating Indian currency in international market. Various currency derivatives have been introduced by NSE and MCX to make Indian Securities market globally competitive and larger.

Conclusion:
The entire concept of taxation of derivatives is at crossroads, the dilemma is that if the derivatives transactions are regarded as taxable under the head Capital Gains, there is no provision for deduction of such provision, particularly as the gains would be computed and taxable only on the date of transfer, i.e. the date of squaring up or expiry of the derivatives, and not on any interim date. Further, in computing capital gains, only the cost of acquisition, cost of improvement and expenses in connection with the transfer are deductible. Such provision would therefore not be deductible if the derivatives transaction income is taxable as capital gains. If the derivatives transactions are taxable as Income from Other Sources, the real income theory would again require the deduction of such provision for loss in determining the taxable income.

The taxation of derivative transactions is not specifically dealt with under the Indian Income-tax Act (Act). There could be two possible interpretations viz. derivatives transactions are pure business transactions and hence, the income/loss thereon should be assessed as normal business income / loss. The other view is that derivatives are covered under the definition of speculative transaction under section 43(5) of the Act in absence of delivery of the underlying security or commodity. Under the Act, speculative profits/losses are allowed to be setoff only against speculative losses/profits respectively. The unabsorbed speculative losses are allowed to be carried forward for 8 immediately succeeding assessment years. However, setoff of such carried forward speculative losses is allowed to be setoff only against speculation profits. In view of the aforesaid, there is a risk of such derivative transactions being treated as speculative transactions under the Act. Therefore, one is advised to seriously consider the tax implications of entering into derivative transactions. A high level panel consisting of a special three-member committee had been set up by the Department of Revenue to examine the definition of `Speculative Transactions' with respect to trading in financial derivatives. The committee is of the view that the definition of speculative transaction in Section 43(5) of the Income Tax Act is fairly obsolete when viewed against the latest developments in the capital markets. Therefore, to my understanding, it is likely that the derivative transactions will be put outside the ambit of speculative transactions based on the recommendations of the Committee and looking at the Government's commitment to deepen and modernize capital markets, as government is keen to make Indian securities market globally competitive by introducing innovative derivatives to play globally and fulfill the global market demand of Derivatives from Indian prospering Securities Market . From the above discussion it is evident that derivative trading has left an indelible mark on the face of the global financial markets. This conclusion is supported by the fact that derivatives have grown at explosive rates, and at times trading in derivatives has even surpassed trading in their underlying instruments. However, derivatives are more risky than other traditional financial products because they are highly leveraged, more complex and less transparent. Being relatively

newer instruments, there is a general lack of understanding of how they operate or how they should be managed. However, a closer scrutiny of the losses suffered by end-users reveals that in many cases, the underlying causes were the improper use of derivatives, greed, and ignorance. Losses from derivatives trading could have been reduced if there was proper disclosure of the risks involved, It is firmly suggested that with the help of a comprehensive regulatory framework and the concurrent acceptance of the recommendations made above, derivatives trading could prove to be not only safe but highly lucrative. The following words of Arthur Levitt, Chairman of the United States Securities and Exchange Commission (when testifying before the Senate in January, 1995) very aptly summarise the nature of derivatives: Derivatives are not inherently bad or good. They are a bit like electricity, dangerous if mishandled, but bearing the potential to do tremendous good.