INTRODUCTION TO DERIVATIVE

The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it was
sown to the time it was ready for harvest, farmers would face price uncertainty.
Through the use of simple derivative products, it was possible for the farmer to
partially or fully transfer price risks by locking-in asset prices. These were simple
contracts developed to meet the needs of farmers and were basically a means of
reducing risk.
A farmer who sowed his crop in June faced uncertainty over the price he
would receive for his harvest in September. In years of scarcity, he would
probably obtain attractive prices. However, during times of oversupply, he would
have to dispose off his harvest at a very low price. Clearly this meant that the
farmer and his family were exposed to a high risk of price uncertainty.
On the other hand, a merchant with an ongoing requirement of grains too
would face a price risk that of having to pay exorbitant prices during dearth,
although favourable prices could be obtained during periods of oversupply. Under
such circumstances, it clearly made sense for the farmer and the merchant to
come together and enter into contract whereby the price of the grain to be
delivered in September could be decided earlier. What they would then negotiate
happened to be 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 merchants together. A group of traders got together and created the
to-arrive contract that permitted farmers to lock into price upfront and deliver the
grain later. These to-arrive contracts proved useful as a device for hedging and
speculation on price charges. These were eventually standardized, and in 1925
the first futures clearing house came into existence.
Today derivatives contracts exist on variety of commodities such as corn,
pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also
exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

DERIVATIVE DEFINED
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 asset can
be equity, forex, commodity or any other asset. In our earlier discussion, we saw
that wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of change in price by that date. Such a transaction is an example of a
derivative. The price of this derivative is driven by the spot price of wheat which
is the underlying in this case.
The Forwards Contracts (Regulation) Act, 1952, regulates the
forward/futures contracts in commodities all over India. As per this the Forward
Markets Commission (FMC) continues to have jurisdiction over commodity
futures contracts. However when derivatives trading in securities was introduced
in 2001, the term security in the Securities Contracts (Regulation) Act, 1956
(SCRA),

was

amended

to

include

derivative

contracts

in

securities.

Consequently, regulation of derivatives came under the purview of Securities

Exchange Board of India (SEBI). We thus have separate regulatory authorities
for securities and commodity derivative markets.
Derivatives are securities under the SCRA and hence the trading of
derivatives is governed by the regulatory framework under the SCRA. The
Securities Contracts (Regulation) Act, 1956 defines derivative to includeA security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract differences or any other form of security.
A contract which derives its value from the prices, or index of prices, of
underlying securities.

TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives

National Stock
Exchange

Index Future

Over The Counter Derivatives

Bombay Stock
Exchange

Index option

National Commodity &

Derivative Exchange

Stock option

Figure.1 Types of Derivatives Market

Stock future

TYPES OF DERIVATIVES

Derivatives

Future

Option

Forward

Swaps

Types of Derivatives

(i)

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified

date for a specified price. One of the parties to the contract assumes a long
position and agrees to buy the underlying asset on a certain specified future
date for a certain specified price. The other party assumes a short position
and agrees to sell the asset on the same date for the same price. Other
contract details like delivery date, price and quantity are negotiated bilaterally
by the parties to the contract. The forward contracts are n o r m a l l y traded
outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of

contract

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to the

same counter-party, which often results in high prices being charged.

However forward contracts in certain

markets have

become very

standardized, as in the case of foreign exchange, thereby reducing

transaction

costs and increasing

transactions

volume.

This process of

standardization reaches its limit in the organized futures market. Forward

contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially th e same economic fu nctio ns
of allocating risk in the presence of future price uncertainty. However futures
are a

significant

improvement

over

the

forward

contracts

as

they

eliminate counterparty risk and offer more liquidity.

(ii)

FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures

exchange, to buy or sell a certain underlying instrument at a certain date in the
future, at a pre-set 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. The
settlement price, normally, converges towards the futures price on the delivery
date.
A futures contract gives the holder the right and the obligation to buy or sell,
which differs from an options contract, which gives the buyer the right, but not the
obligation, and the option writer (seller) the obligation, but not the right. To exit
the commitment, the holder of a futures position has to sell his long position or
buy back his short position, effectively closing out the futures position and its
contract obligations. Futures contracts are exchange traded derivatives. The
exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:
Futures contracts ensure their liquidity by being highly standardized, usually by
specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a
short term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term
interest rate is traded, etc.

The currency in which the futures contract is quoted.

The grade of the deliverable. In case of bonds, this specifies which bonds
can be delivered. In case of physical commodities, this specifies not only
the quality of the underlying goods but also the manner and location of
delivery. The delivery month.

The last trading date.

Other details such as the tick, the minimum permissible price fluctuation.

2. Margin:
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in value,
and creates a credit risk to the exchange, who always acts as counterparty. To
minimize this risk, the exchange demands that contract owners post a form of
collateral, commonly known as Margin requirements are waived or reduced in
some cases for hedgers who have physical ownership of the covered commodity
or spread traders who have offsetting contracts balancing the position.

Initial Margin: is paid by both buyer and seller. It represents the loss on that
contract, as determined by historical price changes, which is not likely to be
exceeded on a usual day's trading. It may be 5% or 10% of total contract price.
Mark to market Margin: Because a series of adverse price changes may
exhaust the initial margin, a further margin, usually called variation or
maintenance margin, is required by the exchange. This is calculated by the
futures contract, i.e. agreeing on a price at the end of each day, called the
"settlement" or mark-to-market price of the contract.
To understand the original practice, consider that a futures trader, when taking a
position, deposits money with the exchange, called a "margin". This is intended
to protect the exchange against loss. At the end of every trading day, the contract
is marked to its present market value. If the trader is on the winning side of a
deal, his contract has increased in value that day, and the exchange pays this
profit into his account. On the other hand, if he is on the losing side, the
exchange will debit his account. If he cannot pay, then the margin is used as the
collateral from which the loss is paid.
3. Settlement
Settlement is the act of consummating the contract, and can be done in one of
two ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the

contract is delivered by the seller of the contract to the exchange, and by the
exchange to the buyers of the contract. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering
position - that is, buying a contract to cancel out an earlier sale (covering a
short), or selling a contract to liquidate an earlier purchase (covering a long).

Cash settlement - a cash payment is made based on the underlying

reference rate, such as a short term interest rate index such as Euribor, or
the closing value of a stock market index. A futures contract might also opt to
settle against an index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many
equity index and interest rate futures contracts, this happens on the Last
Thursday of certain trading month. On this day the t+2 futures contract becomes
the t forward contract.
PRICING OF FUTURE CONTRACT
In a futures contract, for no arbitrage to be possible, the price paid on delivery
(the forward price) must be the same as the cost (including interest) of buying
and storing the asset. In other words, the rational forward price represents the
expected future value of the underlying discounted at the risk free rate. Thus, for
a simple, non-dividend paying asset, the value of the future/forward,
be found by discounting the present value

at time to maturity

, will
by the rate

of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields,
and convenience yields. Any deviation from this equality allows for arbitrage as
follows.
In the case where the forward price is higher:
1. The arbitrageur sells the futures contract and buys the underlying today
(on the spot market) with borrowed money.
2. On the delivery date, the arbitrageur hands over the underlying, and
receives the agreed forward price.
3. He then repays the lender the borrowed amount plus interest.
4. The difference between the two amounts is the arbitrage profit.
In the case where the forward price is lower:
1. The arbitrageur buys the futures contract and sells the underlying today
(on the spot market); he invests the proceeds.
2. On the delivery date, he cashes in the matured investment, which has
appreciated at the risk free rate.
3. He then receives the underlying and pays the agreed forward price using
the matured investment. [If he was short the underlying, he returns it now.]
4. The difference between the two amounts is the arbitrage profit.

TABLE 1DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE

FORWARD CONTRACT

FUTURE CONTRACT

Operational

Traded directly between Traded on the exchanges.

Mechanism

two parties (not traded on

the exchanges).

Contract

Differ from trade to trade.

Specifications
Counter-party

Contracts

are

standardized

contracts.
Exists.

Exists. However, assumed by the

risk

clearing corp., which becomes the

counter party to all the trades or
unconditionally

guarantees

their

settlement.

Liquidation

Low,

Profile

tailor

as

contracts

made

are High, as contracts are standardized

contracts exchange traded contracts.

catering to the needs of

the needs of the parties.
Price discovery

Not efficient, as markets Efficient, as markets are centralized

are scattered.

and all buyers and sellers come to a

common platform to discover the

Examples

Currency market in India.

price.
Commodities, futures, Index Futures
and Individual stock Futures in India.

OPTIONS A derivative transaction that gives the option holder the right but not the
obligation to buy or sell the underlying asset at a price, called the strike price,
during a period or on a specific date in exchange for payment of a premium is
known as option. Underlying asset refers to any asset that is traded. The price
at which the underlying is traded is called the strike price.
There are two types of options i.e., CALL OPTION & PUT OPTION.
CALL OPTION:
A contract that gives its owner the right but not the obligation to buy an
underlying asset-stock or any financial asset, at a specified price on or before a
specified date is known as a Call option. The owner makes a profit provided he
sells at a higher current price and buys at a lower future price.
PUT OPTION:
A contract that gives its owner the right but not the obligation to sell an underlying
asset-stock or any financial asset, at a specified price on or before a specified
date is known as a Put option. The owner makes a profit provided he buys at a
lower current price and sells at a higher future price. Hence, no option will be
exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally
preference shares, bonds and warrants become the subject of options.

10

SWAPS Swaps are transactions which obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment or
settlement dates. They can be regarded as portfolios of forward's contracts. A
contract whereby two parties agree to exchange (swap) payments, based on
some notional principle amount is called as a SWAP. In case of swap, only the
payment flows are exchanged and not the principle amount. The two commonly
used swaps are:
INTEREST RATE SWAPS:
Interest rate swaps is an arrangement by which one party agrees to exchange
his series of fixed rate interest payments to a party in exchange for his variable
rate interest payments. The fixed rate payer takes a short position in the forward
contract whereas the floating rate payer takes a long position in the forward
contract.
CURRENCY SWAPS:
Currency swaps is an arrangement in which both the principle amount and the
interest on loan in one currency are swapped for the principle and the interest
payments on loan in another currency. The parties to the swap contract of
currency generally hail from two different countries. This arrangement allows the
counter parties to borrow easily and cheaply in their home currencies. Under a
currency swap, cash flows to be exchanged are determined at the spot rate at a
time when swap is done. Such cash flows are supposed to remain unaffected by
subsequent changes in the exchange rates.
FINANCIAL SWAP:
Financial swaps constitute a funding technique which permit a borrower to
access one market and then exchange the liability for another type of liability. It
also allows the investors to exchange one type of asset for another type of asset
with a preferred income stream.

11

OTHER KINDS OF DERIVATIVES

The other kind of derivatives, which are not, much popular are as follows:

BASKETS Baskets options are option on portfolio of underlying asset. Equity Index Options
are most popular form of baskets.

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 or Long term
Equity Anticipation Securities.

WARRANTS Options generally have lives of up to one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated
options are called warrants and are generally traded over-the-counter.

SWAPTIONS Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus a swaption is an option on a forward swap. Rather
than have calls and puts, the swaptions market has receiver swaptions and payer
swaptions. A receiver swaption is an option to receive fixed and pay floating. A
payer swaption is an option to pay fixed and receive floating.

12

INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where
prices fluctuate every day. The introduction of risk management instruments in
India gained momentum in the last few years due to liberalisation process and
Reserve Bank of Indias (RBI) efforts in creating currency forward market.
Derivatives are an integral part of liberalisation process to manage risk. NSE
gauging the market requirements initiated the process of setting up derivative
markets in India. In July 1999, derivatives trading commenced in India
Table 2. Chronology of instruments
1991
Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy
11 May 1998
7 July 1999

framework for index futures.

L.C.Gupta Committee submitted report.
RBI gave permission for OTC forward rate agreements

24 May 2000

(FRAs) and interest rate swaps.

SIMEX chose Nifty for trading futures and options on an

25 May 2000

Indian index.
SEBI gave permission to NSE and BSE to do index

futures trading.
9 June 2000
Trading of BSE Sensex futures commenced at BSE.
12 June 2000
Trading of Nifty futures commenced at NSE.
25
September Nifty futures trading commenced at SGX.
2000
2 June 2001

Individual Stock Options & Derivatives

13

(1) Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have
become the most important markets in the world. Today, derivatives have
become part and parcel of the day-to-day life for ordinary people in major part of
the world.
Until the advent of NSE, the Indian capital market had no access to the latest
trading methods and was using traditional out-dated methods of trading. There
was a huge gap between the investors aspirations of the markets and the
available means of trading. The opening of Indian economy has precipitated the
process of integration of Indias financial markets with the international financial
markets. Introduction of risk management instruments in India has gained
momentum in last few years thanks to Reserve Bank of Indias efforts in allowing
forward contracts, cross currency options etc. which have developed into a very
large market.
(2) Myths and realities about derivatives
In less than three decades of their coming into vogue, derivatives markets have
become the most important markets in the world. Financial derivatives came into
the spotlight along with the rise in uncertainty of post-1970, when 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. Today, derivatives have become part and parcel of the day-to-day
life for ordinary people in major parts of the world. While this is true for many
countries, there are still apprehensions about the introduction of derivatives.
There are many myths about derivatives but the realities that are 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

Indian Market is not ready for derivative trading

14

Disasters prove that derivatives are very risky and highly leveraged
instruments.

Derivatives are complex and exotic instruments that Indian investors will
find difficulty in understanding

Is the existing capital market safer than Derivatives?

(i) Derivatives increase speculation and do not serve any

economicpurpose:
Numerous 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 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 fallout of 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 the currencies, increased
trading in variety of derivatives instruments, on-line trading in the capital markets,
etc. As the complexity of instruments increased many folds, the accompanying
risk factors grew in gigantic proportions. This situation led to development
derivatives as effective risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional

investors to effectively manage their portfolios of assets and liabilities through
instruments like 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 off part of its equity assets by using stock index futures or index
options.

15

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 between global markets, increasing market liquidity and
efficiency and facilitating the flow of trade and finance
(ii) 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 prerequisites, which are needed for the introduction of derivatives, and how Indian
market fares:
TABLE 3.
PRE-REQUISITES
INDIAN SCENARIO
Large
market India is one of the largest market-capitalised
Capitalisation
countries in Asia with a market capitalisation of
more than Rs.765000 crores.
High Liquidity
underlying

in

the The daily average traded volume in Indian capital

market today is around 7500 crores. Which means
on an average every month 14% of the countrys
Market capitalisation gets traded. These are clear
indicators of high liquidity in the underlying.

Trade guarantee

The first clearing corporation guaranteeing trades

has become fully functional from July 1996 in the
form of National Securities Clearing Corporation
(NSCCL). NSCCL is responsible for guaranteeing
all open positions on the National Stock Exchange
(NSE) for which it does the clearing.

A Strong Depository

National Securities Depositories Limited (NSDL)

which started functioning in the year 1997 has
revolutionalised the security settlement in our
country.

A Good legal guardian

In the Institution of SEBI (Securities and Exchange

Board of India) today the Indian capital market

16

enjoys a strong, independent, and innovative legal

guardian who is helping the market to evolve to a
healthier place for trade practices.
(3) Comparison of New System with Existing System
Many people and brokers in India think that the new system of Futures & Options
and banning of Badla is disadvantageous and introduced early, but I feel that this
new system is very useful especially to retail investors. It increases the no of
options investors for investment. In fact it should have been introduced much
before and NSE had approved it but was not active because of politicization in
SEBI.
The figure 3.3a 3.3d shows how advantages of new system (implemented from
June 20001) v/s the old system i.e. before June 2001
New System Vs Existing System for Market Players

Figure 3.3a

Speculators
Existing
Approach
1) Deliver based
Trading, margin
trading & carry
forward transactions.
2) Buy Index Futures
hold till expiry.

SYSTEM
Peril &Prize

Approach

1) Both profit &

loss to extent of
price change.

Peril &Prize

1)Buy &Sell stocks

on delivery basis
2) Buy Call &Put
by paying
premium

Advantages

New

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.

17

1)Maximum
loss possible
to premium
paid

Figure 3.3b

Arbitrageurs
Existing
Approach

SYSTEM
Peril &Prize

Approach

New
Peril &Prize

1) Buying Stocks in 1) Make money

1) B Group more
1) Risk free
one and selling in
whichever way
promising as still
game.
another exchange.
the Market moves. in weekly settlement
forward transactions.
2) Cash &Carry
2) If Future Contract
arbitrage continues
more or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers
Existing
Approach

SYSTEM
Peril &Prize

1) Difficult to
1) No Leverage
offload holding
available risk
during adverse
reward dependant
market conditions
on market prices
as circuit filters
limit to curtail losses.

Approach

New
Peril &Prize

1)Fix price today to buy

1) Additional
latter by paying premium.
cost is only
2)For Long, buy ATM Put
premium.
Option. If market goes up,
long position benefit else
exercise the option.
3)Sell deep OTM call option
with underlying shares, earn
premium + profit with increase prcie

18

Advantages

Availability of Leverage

Figure 3.3d

Small Investors
Existing
Approach
1) If Bullish buy
stocks else sell it.

SYSTEM
Peril &Prize

Approach

1) Plain Buy/Sell
implies unlimited
profit/loss.

Peril &Prize

1) Buy Call/Put options

based on market outlook
2) Hedge position if
holding underlying
stock

Advantages

New

Losses Protected.

19

1) Downside
remains
protected &
upside
unlimited.

4. Exchange-traded vs. OTC 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 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 exchangetraded 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.
Some of the features of OTC derivatives markets embody risks to financial
market stability.

20

The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system: (i) the dynamic
nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of
OTC derivative activities on available aggregate credit; (iv) the high concentration
of OTC derivative activities in major institutions; and (v) the central role of OTC
derivatives markets in the global financial system. Instability arises when shocks,
such as counter-party credit events and sharp movements in asset prices that
underlie derivative contracts, occur which significantly alter the perceptions of
current and potential future credit exposures. When asset prices change rapidly,
the size and configuration of counter-party exposures can become unsustainably
large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk
management, including counter-party, liquidity and operational risks, and OTC
derivatives markets continue to pose a threat to international financial stability.
The problem is more acute as heavy reliance on OTC derivatives creates the
possibility of systemic financial events, which fall outside the more formal
clearing house structures. Moreover, those who provide OTC derivative products,
hedge their risks through the use of exchange traded derivatives. In view of the
inherent risks associated with OTC derivatives, and their dependence on
exchange traded derivatives, Indian law considers them illegal.

21

5. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,
globalisation of the markets, technological developments and advances in the
financial theories.
A.} PRICE VOLATILITY
A price is what one pays to acquire or use something of value. The objects
having value maybe commodities, local currency or foreign currencies.

The

concept of price is clear to almost everybody when we discuss commodities.

There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc.
the price one pays for use of a unit of another persons money is called interest
rate. And the price one pays in ones own currency for a unit of another currency
is called as an exchange rate.
Prices are generally determined by market forces. In a market, consumers have
demand and producers or suppliers have supply, and the collective interaction
of demand and supply in the market determines the price. These factors are
constantly interacting in the market causing changes in the price over a short
period of time. Such changes in the price are known as price volatility. This has
three factors: the speed of price changes, the frequency of price changes and the
magnitude of price changes.
The changes in demand and supply influencing factors culminate in market
adjustments through price changes. These price changes expose individuals,
producing firms and governments to significant risks. The break down of the
BRETTON WOODS agreement brought and end to the stabilising role of fixed
exchange rates and the gold convertibility of the dollars. The globalisation of the
markets and rapid industrialisation of many underdeveloped countries brought a
new scale and dimension to the markets. Nations that were poor suddenly
became a major source of supply of goods. The Mexican crisis in the south east-

22

Asian currency crisis of 1990s has also brought the price volatility factor on the
surface. The advent of telecommunication and data processing bought
information very quickly to the markets. Information which would have taken
months to impact the market earlier can now be obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates
rapidly.
These price volatility risks pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against
adverse price changes in commodity, foreign exchange, equity shares and
bonds.
B.} GLOBALISATION OF MARKETS
Earlier, managers had to deal with domestic economic concerns; what happened
in other part of the world was mostly irrelevant. Now globalisation has increased
the size of markets and as greatly enhanced competition .it has benefited
consumers who cannot obtain better quality goods at a lower cost. It has also
exposed the modern business to significant risks and, in many cases, led to cut
profit margins
In Indian context, south East Asian currencies crisis of 1997 had affected the
competitiveness of our products vis--vis depreciated currencies. Export of
certain goods from India declined because of this crisis. Steel industry in 1998
suffered its worst set back due to cheap import of steel from south East Asian
countries. Suddenly blue chip companies had turned in to red. The fear of china
devaluing its currency created instability in Indian exports. Thus, it is evident that
globalisation of industrial and financial activities necessitates use of derivatives to
guard against future losses. This factor alone has contributed to the growth of
derivatives to a significant extent.

23

C.} TECHNOLOGICAL ADVANCES

A significant growth of derivative instruments has been driven by technological
breakthrough. Advances in this area include the development of high speed
processors, network systems and enhanced method of data entry. Closely
related

to

advances

in

computer

technology

are

advances

in

telecommunications. Improvement in communications allow for instantaneous

worldwide conferencing, Data transmission by satellite. At the same time there
were significant advances in software programmes without which computer and
telecommunication advances would be meaningless. These facilitated the more
rapid movement of information and consequently its instantaneous impact on
market price.
Although price sensitivity to market forces is beneficial to the economy as a
whole resources are rapidly relocated to more productive use and better rationed
overtime the greater price volatility exposes producers and consumers to greater
price risk. The effect of this risk can easily destroy a business which is otherwise
well managed. Derivatives can help a firm manage the price risk inherent in a
market economy. To the extent the technological developments increase volatility,
derivatives and risk management products become that much more important.
D.} ADVANCES IN FINANCIAL THEORIES
Advances in financial theories gave birth to derivatives. Initially forward contracts
in its traditional form, was the only hedging tool available. Option pricing models
developed by Black and Scholes in 1973 were used to determine prices of call
and put options. In late 1970s, work of Lewis Edeington extended the early work
of Johnson and started the hedging of financial price risks with financial futures.
The work of economic theorists gave rise to new products for risk management
which led to the growth of derivatives in financial markets.
The above factors in combination of lot many factors led to growth of derivatives
instruments

24

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

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 were 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.
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 (Sense) index. This was followed by approval for trading in options
based on these two indexes and options on individual securities.

25

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.
The following are some observations based on the trading statistics provided in
the NSE report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the

F&O segment. It constituted 70 per cent of the total turnover during June 2002. A
primary reason attributed to this phenomenon is that traders are comfortable with
single-stock futures than equity options, as the former closely resembles the
erstwhile badla system.

On relative terms, volumes in the index options segment continue to

remain poor. This may be due to the low volatility of the spot index. Typically,
options are considered more valuable when the volatility of the underlying (in this
case, the index) is high. A related issue is that brokers do not earn high
commissions by recommending index options to their clients, because low
volatility leads to higher waiting time for round-trips.

26

Put volumes in the index options and equity options segment have

increased since January 2002. The call-put volumes in index options have
decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes
ratio suggests that the traders are increasingly becoming pessimistic on the
market.

Farther month futures contracts are still not actively traded. Trading in

equity options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as

a less risky alternative (read substitute) to generate profits from the stock price
movements. The fact that the option premiums tail intra-day stock prices is
evidence to this. If calls and puts are not looked as just substitutes for spot
trading, the intra-day stock price variations should not have a one-to-one impact
on the option premiums.

The spot foreign exchange market remains the most important

segment but the derivative segment ha s also grown. In the derivative
market foreign exchange swaps account for the largest share of the
total turnover of derivatives
options. Significant
market

have

in India followed by forwards and

milestones

been

in the development

(i) permission

of derivatives

to banks to undertake cross

currency derivative transactions subject to certain conditions (1996) (ii)

allowing corporates to undertake long term foreign currency swaps
that contributed to the development of the term currency swap market
(1997) (iii) allowing dollar rupee options (2003) and (iv) introduction of
currency futures (2008). I would like to emphasise that currency
swaps allowed companies with ECBs to swap their foreign currency
liabilities into rupees.

However, since banks could not carry open

positions the risk was allowed to be transferred to any other resident

corporate. Normally such risks should be taken by corporates who

27

have natural hedge or have potential foreign exchange earnings.

But

often corporate assume these risks due to interest rate differentials and
views on currencies.
This period has also witnessed several relaxations in regulations relating to
forex markets and also greater liberalisation in capital account regulations
leading to greater integration with the global economy.

Cash settled exchange traded currency futures have made foreign

currency a separate asset class that can be traded without any
underlying need or exposure a n d

on a leveraged basis on the

recognized stock exchanges with credit risks being assumed by the

central counterparty
Since the commencement of trading of currency futures in all the three
exchanges, the value of the trades has gone up steadily from Rs 17, 429
crores in October 2008 to Rs 45, 803 crores in December 2008. The average
daily turnover in all the exchanges has also increased from Rs871 crores to
Rs 2,181 crores during the same period.

The turnover in the currency

futures market is in line with the international scenario, where I understand

the share of futures market ranges between 2 3 per cent.
Table 4.1ForexMarketActivity

April05-

April06-

April07-

April08-

Total turnover (USD billion)

Mar06
4,404

Mar07
6,571

Mar08
12,304

Dec08
9,621

Inter-bank to Merchant ratio

2.6:1

2.7:1

2.37: 1

2.66:1

Spot/Total Turnover (%)

50.5

51.9

49.7

45.9

Forward/Total Turnover (%)

19.0

17.9

19.3

21.5

Swap/Total Turnover (%)

30.5

30.1

31.1

32.7

Source: RBI

28

14. BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:
1.]

RISK MANAGEMENT

Futures and options contract can be used for altering the risk of investing in spot
market. For instance, consider an investor who owns an asset. He will always be
worried that the price may fall before he can sell the asset. He can protect
himself by selling a futures contract, or by buying a Put option. If the spot price
falls, the short hedgers will gain in the futures market, as you will see later. This
will help offset their losses in the spot market. Similarly, if the spot price falls
below the exercise price, the put option can always be exercised.
2.]

PRICE DISCOVERY

Price discovery refers to the markets ability to determine true equilibrium prices.
Futures prices are believed to contain information about future spot prices and
help in disseminating such information. As we have seen, futures markets
provide a low cost trading mechanism. Thus information pertaining to supply and
demand easily percolates into such markets. Accurate prices are essential for
ensuring the correct allocation of resources in a free market economy. Options
markets provide information about the volatility or risk of the underlying asset.
3.]

OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction costs.

Secondly, they offer greater liquidity. Large spot transactions can often lead to
significant price changes. However, futures markets tend to be more liquid than
spot markets, because herein you can take large positions by depositing
relatively small margins. Consequently, a large position in derivatives markets is
relatively easier to take and has less of a price impact as opposed to a
transaction of the same magnitude in the spot market. Finally, it is easier to take
a short position in derivatives markets than it is to sell short in spot markets.

29

4.]

MARKET EFFICIENCY

The availability of derivatives makes markets more efficient; spot, futures and
options markets are inextricably linked. Since it is easier and cheaper to trade in
derivatives, it is possible to exploit arbitrage opportunities quickly and to keep
prices in alignment. Hence these markets help to ensure that prices reflect true
values.

5.]

EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in

spot transactions. Also, the amount of capital required to take a comparable
position is less in this case. This is important because facilitation of speculation is
critical for ensuring free and fair markets. Speculators always take calculated
risks. A speculator will accept a level of risk only if he is convinced that the
associated expected return is commensurate with the risk that he is taking.

The derivative market performs a number of economic functions.

The prices of derivatives converge with the prices of the underlying at the
expiration of derivative contract. Thus derivatives help in discovery of
future as well as current prices.

An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of
activity.

30

15. National Exchanges

In enhancing the institutional capabilities for futures trading the idea of
setting up of National Commodity Exchange(s) has been pursued since 1999.
Three such Exchanges, viz, National Multi-Commodity Exchange of India Ltd.,
(NMCE), Ahmedabad, National Commodity & Derivatives Exchange (NCDEX),
Mumbai,

and Multi Commodity Exchange (MCX), Mumbai have

operational.

become

National Status implies that these exchanges would be

automatically permitted to conduct futures trading in all commodities subject to

clearance of byelaws and contract specifications by the FMC. While the NMCE,
Ahmedabad commenced futures trading in November 2002, MCX and NCDEX,
Mumbai commenced operations in October/ December 2003 respectively.
MCX
MCX (Multi Commodity Exchange of India Ltd.) an independent and demutulised

multi

commodity

exchange

has

permanent

recognition

from

Government of India for facilitating online trading, clearing and settlement

operations for commodity futures markets across the country. Key shareholders
of MCX are Financial Technologies (India) Ltd., State Bank of India, HDFC Bank,
State Bank of Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI
Life Insurance Co. Ltd., Union Bank of India, Bank
Baroda,

Canera

Bank,

of

India, Bank of

Corporation

Bank

Headquartered in Mumbai, MCX is led by an expert management team

with deep domain knowledge of the commodity futures markets. Today MCX is
offering spectacular growth opportunities and advantages to a large cross section
of the participants including Producers / Processors, Traders, Corporate,
Regional

Trading

Canters,

Importers,

Exporters,

Cooperatives,

Industry

Associations, amongst others MCX being nation-wide commodity exchange,

offering multiple commodities for trading with wide reach and penetration and
robust infrastructure.

31

MCX, having a permanent recognition from the Government of India, is

an independent and demutualised multi commodity Exchange. MCX, a state-ofthe-art nationwide, digital Exchange, facilitates online trading, clearing and
settlement operations for a commodities futures trading.
NMCE
National Multi Commodity Exchange of India Ltd. (NMCE) was promoted
by Central Warehousing Corporation (CWC), National Agricultural Cooperative
Marketing Federation of India (NAFED), Gujarat Agro-Industries Corporation
Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National
Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).
While various integral aspects of commodity economy, viz., warehousing,
cooperatives, private and public sector marketing of agricultural commodities,
research and training were adequately addressed in structuring the Exchange,
finance was still a vital missing link. Punjab National Bank (PNB) took equity of
the Exchange to establish that linkage. Even today, NMCE is the only Exchange
in India to have such investment and technical support from the commodity
relevant institutions.
NMCE facilitates electronic derivatives trading through robust and tested
trading platform, Derivative Trading Settlement System (DTSS), provided by
CMC. It has robust delivery mechanism making it the most suitable for the
participants in the physical commodity markets. It has also established fair and
transparent rule-based procedures and demonstrated total commitment towards
eliminating any conflicts of interest. It is the only Commodity Exchange in the
world to have received ISO 9001:2000 certification from British Standard
Institutions (BSI). NMCE was the first commodity exchange to provide trading
facility through internet, through Virtual Private Network (VPN).
NMCE follows best international risk management practices. The contracts
are marked to market on daily basis. The system of upfront margining based on
Value at Risk is followed to ensure financial security of the market. In the event of

32

high volatility in the prices, special intra-day clearing and settlement is

held. NMCE was the first to initiate process of dematerialization and electronic
transfer of warehoused commodity stocks. The unique strength of NMCE is its
settlements via a Delivery Backed System, an imperative in the commodity
trading business. These deliveries are executed through a sound and reliable
Warehouse Receipt System, leading to guaranteed clearing and settlement.
NCDEX
National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology
driven commodity exchange. It is a public limited company registered under the
Companies Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai
on April 23,2003. It has an independent Board of Directors and professionals not
having any vested interest in commodity markets. It has been launched to
provide a world-class commodity exchange platform for market participants to
trade in a wide spectrum of commodity derivatives driven by best global
practices, professionalism and transparency.
Forward Markets Commission regulates NCDEX in respect of futures trading in
commodities. Besides, NCDEX is subjected to various laws of the land like the
Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act
and various other legislations, which impinge on its working. It is located in
Mumbai and offers facilities to its members in more than 390 centres throughout
India.

The

reach

will

gradually

be

expanded

to

more

centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew,

Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm
Oil, Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking
bags, Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard
Seed ,Raw Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds,
Silk, Silver, Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow
Peas, Yellow Red Maize & Yellow Soybean Meal.

33

TABLE4: THE CURRENT PROFILE OF FUTURES TRADING IN

INDIA WITH RESPECT TO THE VARIOUS EXCHANGES IN INDIA:-

34

The Present Status:

Presently futures trading is permitted in all the commodities. Trading is
taking place in about 78 commodities through 25 Exchanges/Associations as
given in the table below:TABLE 4 Registered commodity exchanges in India
No.
1.

Exchange
India Pepper

2.

Association, Kochi (IPSTA)

Vijai Beopar Chambers

3.

Muzaffarnagar
Rajdhani Oils & Oilseeds Exchange Gur, Mustard seed its oil &

4.

Ltd., Delhi
oilcake
Bhatinda Om & Oil Exchange Ltd., Gur

5.

Bhatinda
The Chamber of Commerce, Hapur
Meerut

&

COMMODITY
Trade Pepper (both domestic and

Spice

Agro

international contracts)
Ltd., Gur, Mustard seed

Gur, Potatoes and Mustard

seed
Commodities Gur

6.

The

7.

Exchange Ltd., Meerut

The Bombay Commodity Exchange Oilseed Complex, Castor

8.

Ltd., Mumbai
Rajkot Seeds,

Oil

&

oil international contracts

Bullion Castor seed, Groundnut,

Merchants Association, Rajkot

its oil & cake, cottonseed,

its

oil

(kapas)
Ahmedabad

&

cake,
and

cotton
RBD

palmolein.
Commodity Castorseed, cottonseed, its

9.

The

10.

Exchange, Ahmedabad
oil and oilcake
The East India Jute & Hessian Hessian & Sacking

11.

Exchange Ltd., Calcutta

The East India Cotton Association Cotton

12.

Ltd., Mumbai
The Spices & Oilseeds Exchange Turmeric

13.

Ltd., Sangli.
National Board of Trade, Indore

35

Soya seed, Soyaoil and

14.

Soya
meals,
Rapeseed/Mustardseed its
oil and oilcake and RBD
Palmolien
The First Commodities Exchange of Copra/coconut, its oil &

15.

India Ltd., Kochi

Central
India

16.
17.

Exchange Ltd., Gwalior

E-sugar India Ltd., Mumbai
Sugar
National
Multi-Commodity Several Commodities

18.

Exchange of India Ltd., Ahmedabad

Coffee Futures Exchange India Coffee

19.

Ltd., Bangalore
Surendranagar

20.

Oilseeds, Surendranagar
E-Commodities Ltd., New Delhi

21.

commence)
National Commodity & Derivatives, Several Commodities

22.

Exchange Ltd., Mumbai

Multi Commodity Exchange Ltd., Several Commodities

23.

24.
25.

oilcake
Commercial Gur and Mustard seed

Cotton

Oil

& Cotton, Cottonseed, Kapas

Sugar

(trading

yet

to

Mumbai
Bikaner commodity Exchange Ltd., Mustard seeds its oil &
oilcake, Gram. Guar seed.
Bikaner
Guar Gum
Haryana Commodities Ltd., Hissar
Mustard seed complex
Bullion Association Ltd., Jaipur
Mustard seed Complex

36

STATUS REPORT OF THE DEVELOPMENTS IN THE DERIVATIVE

MARKET
1. The Board at its meeting on November 29, 2002 had desired that a quarterly
report be

submitted to the Board on the developments in the derivative

market. Accordingly, this memorandum presents a status report for the quarter
July-September 2008-09 on the developments in the derivative market.
2. Equity Derivatives Segment
A. Observations on the quarterly data for July-September, 2008-09
During July-September 2008-09, the turnover at BSE was Rs.1,510 crore,
which was insignificant as compared to that of NSE at Rs. 3,315,491 crore.
Refer Table 1
Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while
turnover increased by 24.77% to Rs. 3,317 thousand crore in JulySeptember 2008-09 over April-June 2008-09.
Futures (Index Future + Stock Future) constituted 67.20% of the total
number of contracts traded in the F&O Segment. Stock Future and Index
Future accounted for 35.26% and 31.94% respectively.
Options constituted

32.80% of the total volumes.

This mainly

comprised of trading in Index Option (30.68%).

Turnover at F&O segment was 4.19 times that of its cash segment.
Reliance, Reliance Capital Ltd, Reliance Petro. Ltd, State Bank of India
and ICICI Bank Ltd were the most actively traded scrips in the
derivatives

segment. Together they contributed 25.12% of derivatives

turnover in individual stocks.

Client trading constituted 60.17%, Propriety trading constituted 31.07%
and FII trading constituted remaining 8.76% of the total turnover.

37

Refer Table 2
Volume in longer dated derivative contracts (contracts with maturity of
more than three months and up to 3 years) was 3.99 lakh and total
turnover was Rs. 9870 crore.
Total volume in shorter dated derivative contracts (contracts with maturity
up to 3months) was 1,695 lakh and total turnover was Rs. 3,307 thousand
crore.

Refer Table 3
Volume in Mini Nifty (contracts with minimum lot size of Rs.1 lakh) was
44 lakh and total turnover was Rs. 37 thousand crore.
Refer Table 4
During July-September, 2008, S&P CNX Nifty futures recorded highest
average daily volatility of 2.85% in July 2008.
Refer Table 5
The volume (in terms of no. of contracts traded) of Nifty Future at
SGX as a percentage of the volume of Nifty Future at NSE was
8.55% during July- September 2008-09.
Refer Table 6
India stands 2nd in Stock Futures, 2nd in Index Futures, 16th in Stock
Option and
4th in Index Options (as on November 10, 2008) in World Derivatives
Market

(in terms of volume) at the end of September 2008.

Derivative contracts were launched on 38 securities at National Stock

Exchange during July-September 2008-09.

38

Depth
Market Depth

Table-5: Fact file of July-September 2008-09 with respect to the

previous quarter

in (avg. of
three months

Market Concentration

APRIL-JUNE 2008-09
JULY-SEPTEMBER2008-09
No.
of Turnover
No.
of Turnover
PRODUCT
Contracts(L (Rs. 000)
Contracts(Lakh) (Rs. 000)
akh)
VOLUME & TURNOVER
Index Future
415.7
935.6
542.6
1,077.5
Index Option
240.1
571.3
521.2
1,130.9
Single
Stock
514.5
1,093.1
599.0
1,039.3
Future
Stock Option
25.5
58.3
35.9
69.1
Total
1,195.8
2,658.4
1,698.7
3,317.0
Market Share ( %)
Index Future
1,077.5
35.20
31.94
32.48
21.49
30.68
34.09
Index Option
1,130.9
Single
Stock
41.12
35.26
31.33
1,039.3
Future
Stock Option
2.19
2.11
2.08
69.1
Turnover in F&O as
multiple of turnover in
4.19
3.26
cash segment
- Reliance
- Reliance
Five most active
- Reliance Petro. Ltd.
- Reliance Capital Ltd
scrips in the
- Tata Steel
- Reliance Petro. Ltd
F&O
Segment
- Reliance Capital Ltd
- State Bank of India
active scrips in
- Infosys Tech. Ltd
- ICICI Bank Ltd
the

F&O

Segment
Contribution of
the above fi ve
to
total 23.72
derivatives
turnover (%)
Client
(excluding FII
trades)
Proprietary

25.12

59.77

27.88

60.17
31.07

FII
12.35
8.76
Table-6: Data for Shorter Dated and Longer Dated derivative

39

contracts

Time
Period

Trades in Shorter Dated Trades in

Longer Dated

derivative contracts (up t o derivative contracts

3 Months)
No

(Quarter)

more
of

No

Turnover

contracts

(more
of

contracts

(Rs. 000 cr.)

(lakh)

than

months)
Turnover
(Rs. 000 cr.)

(lakh)

July-September
2008-09
Apr-Jun

2008-

09

1,694.64

3,307.11

3.99

9.87

1,194.97

2,655.88

4.83

12.5

Table-7: Data for Mini Nifty derivative contracts

Time
(Quarter)

Period No
contract

of Turnover (Rs.
000 cr.)

(lakh)

July-September
2008-09
Apr-Jun

2008-

09

40

43.8

36.9

29.4

27.7

Table-8: Minimum, Maximum and Average Daily Volatility of the F&O

segment at

NSE for S&P CNX Nifty since April 2008

Month

Average

Maximum

Minimum

volatility

Volatility (%)

Volatility

(%)

(%)

April-08

2.47

2.98

2.05

May-08

1.71

1.99

1.56

June-08

1.80

2.28

1.61

July-08

2.85

3.08

2.38

August-08

2.27

2.61

2.10

2.51

2.09

September08

2.28

Table-9: SGX volume as a percentage of NSE volume for Nifty

Future in terms of no. of contracts for the period April
September, 2008-09
NSE
Month

Volume SGX

(Nifty

Volume SGX volume as

Future (Nifty

volume)

Future %

volume)

of

NSE

Volume

JulySeptember
2008-09

47,977,775

4,104,418

8.55

37,764,776

3,241,034

8.58

Apr-Jun 200809

41

Table-10: Standing of India in World Derivatives Market (in terms of

volume)

Products

July 2008

August 2008

September
2008

Stock Future

Index Future

Stock Option

15

16

Index Option

Source: www.world-exchanges.org (as on November 10, 2008)

Salient points for the 2nd quarter 2008-09
The volume (no. of contracts) and open interest in the derivatives
market has increased even when the underlying market is witnessing a
downward trend. This indicates that there are sufficient long position
holders who anticipate value proposition in a falling market. Falling or
rising markets on the back of low volumes may be a cause of concern
from the point of market integrity. However, as observed from the data,
under the present scenario the fall in the market has been accompanied
by high volumes.

In Index Option, there is a sharp increase in turnover (97.95%) and

volume (117.08%) during July-September 2008-09 over April-June
2008-09. Possible reasons for increase in options trading activity can be
attributed to increase in volatility. Market

observers believe

that

conditions across markets and asset classes have become more volatile
and uncertain in the recent past. Generally in such conditions, many

42

people believe that options act as "insurance" against adverse price

movements while offering the flexibility to benefit from possible
favourable price movements at the same time. Another reason which
can be attributed to the increase in activity is the new directive as per the
Budget 2008-09 which states that STT would now be levied on the Option
premium instead of the strike price.
In Index Future, both turnover (15.17%) and volume (30.53%) have
increased during July-September 2008-09 as compared to April-June
2008-09.
There is a decrease in turnover (4.92%) in Single Stock Futures
during July- September 2008-09 as compared to April-June 2008-09.
Except Index Option, the market share of all other products has
decreased (both in terms of volume and turnover) in second quarter of
2008-09 as compared to the first quarter of 2008-09.
There is a decrease in turnover (21.04%) and volume (17.39%) in
Longer Dated derivative contracts in second quarter of 2008-09 as
compared to the first quarter of 2008-09.
Longer dated derivatives were launched in March 2008, but the
volumes have not picked up consequently.
For shorter dated derivative contracts, turnover increased by 24.52%
whereas volume increased by 4.81% in second quarter of 2008-09 as
compared to the first quarter of 2008-09.
During 2008-09, Mini Nifty volumes increased by 49.15% and turnover
increased by 33.43% during July-September 2008-09 over April-June
2008-09.

43

18. Business Growth in Derivatives segment (NSE)

TABLE 11A Index futures
Year

No. of contracts

2008-09

4116649

2007-08

156598579

2006-07

81487424

2005-06

58537886

2004-05

21635449

2003-04

17191668

2002-03

2126763

2001-02

1025588

FIGURE 11A Number of contracts per year

INTERPRETATION: From the data and the bar diagram above, there is high
business growth in the derivative segment in India. In the year 2001-02, the
number of contracts in Index Future were 1025588 where as a significant
increase of 4116679 is observed in the year 2008-09.

44

Table 11B No of turnovers

Year

Turnover (Rs. Cr.)

2008-09

925679.96

2007-08

3820667.27

2006-07

2539574

2005-06

1513755

2004-05

772147

2003-04

554446

2002-03

43952

2001-02

21483

FIGURE 11B Turnover in Rs. Crores

INTERPRETATION:
From the data and above bar chart, there is high turn over in the derivative
segment in India. In the year 2001-02 the turnover of index future was 21483
where as a huge increase of 92567996 in the year 2008-09 are observed.

45

TABLE 12A STOCK FUTURES

Year
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01

No. of contracts
51449737
203587952
104955401
80905493
47043066
32368842
10676843
1957856
-

FIGURE 12A Number of contracts per year in stock future

INTERPRETATION:
From the data and bar diagram above there were no stock futures available but
in the year 2001-02, it predominently increased to 1957856. Then there was a
huge increase of 20, 35, and 87,952 in the year 2007-08 but there was a steady
decline to 51449737 in the year 2008-09.

TABLE 12B NO OF TURNOVERS

46

Year
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
FIGURE 12B Turnover in Rs. Crores

Turnover
(Rs. Crores)
1093048.26
7548563.23
3830967
2791697
1484056
1305939
286533
51515
-

INTERPRETATION:
From the data and bar chart above, there were no stock futures available in the
year 2000-01. There was a steady increase of stock future 51515 in the year
2001-02. but in the year there was a huge increae of 7548563.23 in the year
2007-08 with a considerable decline of 1093048.26 in the year 2008-09.
TABLE 13A INDEX OPTIONS
Year

No. of contracts

2008-09
2007-08
2006-07
2005-06

24008627
55366038
25157438
12935116

47

2004-05
2003-04
2002-03
2001-02
2000-01

3293558
1732414
442241
175900
-

FIGURE 13A Number of contracts per year

Interpretation:
From the data and bar chart above, the no of contracts of index option was nil in
the year 2000-2001. But there was a predominant increase of 1,75,900 in the
year 2001-2002. In the year 2007-2008 there was a huge increase in the index
option contracts to 55366038 and a decline of 24008627 in the year 2008-2009.
TABLE 13B Turnover per year in Rs. Crores

Year

Turnover (Rs. Crores)

2008-09
2007-08
2006-07

71340.02
1362110.88
791906

48

2005-06
2004-05
2003-04
2002-03
2001-02
2000-01

338469
121943
52816
9246
3765
-

FIGURE 13B Turnover per year in Rs. Crores

Interpretation:
From the data and bar chart above, there was no turnover in the year 2000-2001
for Index option. It slowly started increasing in the year 2000-2001 to 3765.But in
the year 2007-2008 there was a huge increase of 1362110.088 and a sudden
decline to 71340.02 observed in 2008-2009.
TABLE 14A STOCK OPTIONS
Year
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04

No. of contracts
2546175
9460631
5283310
5240776
5045112
5583071

49

2002-03
2001-02
2000-01

3523062
1037529
-

FIGURE 14A Number of contracts traded per year in stock option

INTERPRETATION:
From the data and bar chart above the no of contracts of stock option in the year
2000-2001 was nil. But there was a huge increase of 1037529 observed in the
year 2001-2002. It was 9460631 which was the the highest in the year 20072008. But a gradual decline of 2546175 in the year 2008-2009.

TABLE 14B National turnover in Rs. Crores per year

Year

Notional

2008-09
2007-08
2006-07
2005-06
2004-05

crores)
58335.03
359136.55
193795
180253
168836

50

turnover

(Rs.

2003-04
2002-03
2001-02
2000-01

217207
100131
25163
-

FIGURE 14B National turnover in Rs. Crores per year

Interpretation:
From the chart and the bar diagram above the stock option turnover in the year
2000-2001 was nil. There was a slow increase of 25163 in the year 2001-2002.
But a phenomenal increase of 359136.55 in the year 2007-2008, and a decline of
58355.03 in the year 2008-2009.

TABLE 15A OVERALL TRADING

Year

No. of contracts

Turnover (Rs. cr.)

2008-09
2007-08
2006-07
2005-06
2004-05
2003-04

119171008
425013200
216883573
157619271
77017185
56886776

2648403.30
13090477.75
7356242
4824174
2546982
2130610

51

2002-03
2001-02
2000-01

16768909
4196873
90580

439862
101926
2365

FIGURE 15A Average daily turnovers in Rs. Crores

Interpretation:
From the data and bar chart above, the overall trading contracts in the year
2000-2001 was 90580 and huge increase of 119171008 in the year 2008-2009.
From the data and bar chart above the overall trading turnover in the year 20002001 was as low as 2365 but a predominant increase of 2648403.30 observed in
the year 2008-2009.
TABLE 16 Overall trade description under NSE
Index
Futures
Y No.
e
of
a contr
r acts

Stock
Futures
Turnove
r
(Rs.
cr.)

No.
of
contract
s

Index
Options
Turnove
r
(Rs.
cr.)

No.
of
contrac
ts

Stock
Options
Notional
Turnove
r
(Rs.
cr.)

52

No.
of
contract
s

Notional
Turnove
r
(Rs.
cr.)

Interest
Rate
Futures
No.
Tur
of nov
cont er
ract (Rs
s
.
cr.)

Total
No.
of
contracts

T
u
r
n
o
v
e
r

925679.9
2
0
0
8 41166469
0
9

5144973
7

1093048.
26

240086
27

571340.0
2

2546175

58335.03

0.0
0

11917100
8

3820667.
27

2035879
52

7548563.
23

553660
38

1362110.
88

9460631

359136.5
5

0.0
0

42501320
0

8148742
4

2539574

1049554
01

3830967

251574
38

791906

5283310

193795

21688357
3

5853788
6

1513755

8090549
3

2791697

129351
16

338469

5240776

180253

15761927
1

2163544
9

772147

4704306
6

1484056

329355
8

121943

5045112

168836

77017185

52816

5583071

217207

1078
1

202

56886776

2
0
0
1565985
7
79
0
8
2
0
0
6
0
7
2
0
0
5
0
6
2
0
0
4
0
5
2
0
0
3
0

1719166
8

554446

3236884
2

1305939

173241
4

53

(
R
s
.
c
r
.
)
2
6
4
8
4
0
3
.
3
0
1
3
0
9
0
4
7
7
.
7
5
7
3
5
6
2
4
2
4
8
2
4
1
7
4
2
5
4
6
9
8
2
2
1
3
0
6
1

4
2
0
0
2 2126763
0
3
2
0
0
1 1025588
0
2
2
0
0
0 90580
0
1

43952

21483

2365

1067684
3

1957856

286533

51515

442241

175900

9246

3765

3523062

1037529

100131

25163

TABLE 17 AVERAGE DAILY TURNOVERS

Year

Av. daily turnover (Rs. Crores)

2008-09

45390.21

2007-08

52153.30

2006-07

29543

2005-06

19220

2004-05

10167

2003-04

8388

2002-03

1752

2001-02

410

2000-01

11
54

16768909

4
3
9
8
6
2

4196873

1
0
1
9
2
6

90580

2
3
6
5

Note:
Notional Turnover = (Strike Price + Premium) * Quantity
Index Futures, Index Options, Stock Options and Stock Futures were introduced
in June 2000, June 2001, July 2001 and November 2001 respectively.

FINDINGS & CONCLUSION

From the above analysis it can be concluded that:
1. Derivative market is growing very fast in the Indian Economy. The turnover
of Derivative Market is increasing year by year in the Indias largest stock
exchange NSE. In the case of index future there is a phenomenal increase
in the number of contracts. But whereas the turnover is declined
considerably. In the case of stock future there was a slow increase
observed in the number of contracts whereas a decline was also observed
in its turnover. In the case of index option there was a huge increase
observed both in the number of contracts and turnover.
2. After analyzing data it is clear that the main factors that are driving the
growth of Derivative Market are Market improvement in communication
facilities as well as long term saving & investment is also possible through

55

entering into Derivative Contract. So these factors encourage the

Derivative Market in India.
3. It encourages entrepreneurship in India. It encourages the investor to take
more risk & earn more return. So in this way it helps the Indian Economy
by developing entrepreneurship. Derivative Market is more regulated &
standardized so in this way it provides a more controlled environment. In
nutshell, we can say that the rule of High risk & High return apply in
Derivatives. If we are able to take more risk then we can earn more profit
under Derivatives.
Commodity derivatives have a crucial role to play in the price risk management
process for the commodities in which it deals. And it can be extremely beneficial
in agriculture-dominated economy, like India, as the commodity market also
involves agricultural produce. Derivatives like forwards, futures, options, swaps
etc are extensively used in the country. However, the commodity derivatives have
been utilized in a very limited scale. Only forwards and futures trading are
permitted in certain commodity items.
RELIANCE is the most active future contracts on individual
securities traded with 90090 contracts and RNRL is the next most active futures
contracts with 63522 contracts being traded.

RECOMMENDATIONS & SUGGESTIONS

RBI should play a greater role in supporting derivatives.

Derivatives market should be developed in order to keep it at par with

other derivative markets in the world.

Speculation should be discouraged.

There must be more derivative instruments aimed at individual investors.

56

SEBI should conduct seminars regarding the use of derivatives to educate

individual investors.

After study it is clear that Derivative influence our Indian Economy up

to much extent. So, SEBI should take necessary steps for
improvement in Derivative Market so that more investors can invest in
Derivative market.
There is a need of more innovation in Derivative Market because in
today scenario even educated people also fear for investing in
Derivative Market Because of high risk involved in Derivatives.

57

BIBLIOGRAPHY
Books referred:
Options Futures, and other Derivatives by John C Hull
Derivatives FAQ by Ajay Shah
NSEs Certification in Financial Markets: - Derivatives Core module
Financial Markets & Services by Gordon & Natarajan

Reports:
Report of the RBI-SEBI standard technical committee on exchange traded
Currency Futures
Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA
Websites visited:
www.nse-india.com
www.bseindia.com
www.sebi.gov.in
www.ncdex.com
www.google.com
www.derivativesindia.com

58

ABBREVATIONS
A
AMEX- America Stock Exchange
B
BSE- Bombay Stock Exchange
BSI- British Standard Institute
C
CBOE - Chicago Board options Exchange
CBOT - Chicago Board of Trade
CEBB - Chicago Egg and Butter Board
CME - Chicago Mercantile Exchange
CNX- Crisil Nse 50 Index
CPE - Chicago Produce Exchange
CWC- Central Warehousing Corporation
D
DTSS- Derivative Trading Settlement System
F
FIIs- Foreign Institutional Investors
F & O Future and Options
FMC- Forward Markets Commission
FRAs- Forward Rate Agreements
G
GAICL-Gujarat Agro Industries Corporation Limited
GSAMB- Gujarat State Agricultural Marketing Board
I
IMM - International Monetary Market
IPSTA- India Pepper & Spice Trade Association
M
MCX Multi Commodity Exchange

59

N
NAFED-National Agricultural Co-Operative Marketing Federation Of India
NCDEX National Commodities and Derivatives Exchange
NIAM- National Institute Of Agricultural Marketing
NMSE- National Multi Commodity Exchange
NOL- Neptune Overseas Limited
NSCCL- National Securities Clearing Corporation
NSDL- National Securities Depositories Limited
NSE - National Stock Exchange
O
OTC- Over The Counter
P
PHLX - Philadelphia Stock Exchange
PNB- Punjab National Bank
R
RBI- Reserve Bank Of India
S
SC(R) A - Securities Contracts (Regulation) Act, 1956
SEBI- Securities Exchange Board Of India
SGX- Singapore Stock Exchange
SIMEX - Singapore International Monetary Exchange
V
VPN- Virtual Private Network

60