Abstract

The Indian derivative market has become multi-trillion dollar markets over the years. Marked
with the ability to partially and fully transfer the risk by locking in assets prices, derivatives
are gaining popularity among the investors. Since the economic reforms of 1991, maximum
efforts have been made to boost the investors confidence by making the trading process
more users friendly. Still, there are some issues in this market. So, the present paper is an
attempt to study the evolution of Indian derivative market, trading mechanism in its various
products and the future prospects of the Indian Derivative market. The present paper is
descriptive in nature and based on the secondary data. Inspite of the growth in the derivative
market, there are many issue (e.g., the lack of economies of scale, tax and legal bottlenecks,
increased off-balance sheet exposure of Indian banks need for an independent regulator etc),
which need to be immediately resolved to enhance the investors confidence in the Indian
derivative market.
Introduction
The most significant milestone in financial innovation is achieved with the issuance and trading
of derivatives. Along with this positive element, the proponents of derivatives also admit that this
term arouses more controversies and most people look at them with suspicion and few would
believe that they do contribute to the society welfare. But the matter of fact is that derivatives are
a standard risk management tool that enables risk- sharing and facilitates the efficient allocation
of capital to productive investment activities
Concept of Financial Derivatives
At present the Indian stock markets are not having any risk hedged instruments that would allow
the investors to manage and minimize the risk. In industrialized countries apart from money
market and capital market securities, a variety of other securities known as derivatives have now
become available for investment and trading. The derivatives originate in mathematics and refer
to a variable which has been derived from another variable. A derivative is a financial product
which has been derived from another financial product or commodity. In word, these instrument
derive their value from the price and other related variables of the underlying asset. They do not
have worth of their own and derive their value from the claim they give to their owners to own
some other financial assets or security. A simple example of derivative is butter, which is
derivative of milk. The price of butter depends upon price of milk, which in turn depends upon
the demand and supply of milk.
Definition of Financial Derivatives
Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as:
a) a security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security;
b) a contract which derives its value from the prices, or index of prices, of underlying
securities.

Major Players In The Financial Derivative Trading

There are three major players in the financial derivatives trading:
1. Hedgers: Hedgers are traders who use derivatives to reduce the risk associated with the price
of an asset. Majority of the participants in derivatives market belongs to this category.
2. Speculators: Speculators are traders who buy/sell the assets only to sell/buy them back
profitably at a later point in time. They want to assume risk.. They can increase both the potential
gains and potential losses by usage of derivatives in a speculative venture.
3. Arbitrageurs: Arbitrageurs are traders who simultaneously buy and sell the same (or different,
but related) assets in an effort to profit from unrealistic price differentials. They try to earn
riskless profit from discrepancies between futures and spot prices and among different futures
prices.
Uses Of Financial Derivatives
Some of the uses of financial derivatives can be enumerated as following:
1. Financial Derivative provide powerful tool for controling, avoiding, shifting and managing
efficiently different types of risk through various strategies like hedging, arbitraging, spreading
etc.
2. The important application of financial derivatives is the price discovery which means
revealing information about future cash market prices through the future market.
3. Derivatives trading enhance liquidity and reduce transaction cost in the markets of underlying
assets because in derivative market no immediate full amount of transaction is required.
4. Financial derivatives allow for free trading of risk components and that leads to improving
market efficiency.
5. Derivative market helps to keep a stabilizing influence on spot prices by reducing the short
term fluctuations
6. Derivative trading develop the market towards complete markets. complete market concept
refers to that situation where no particular investors be better of than others or there is no further
scope of additional security.
7.The derivatives trading encourage the competitive trading in the market, different risk taking
preference at market operators like speculators, hedgers, traders, arbitrageurs etc. resulting in
increase in trading volume in the country.
8. Derivatives assist the investors, traders and managers of large pools of funds to device such
strategies so that they may make proper asset allocation increase their yields and achieve other
investment goals.
9.The other uses of derivatives are:
a)derivatives have smoothen out price fluctuations.

b)squeeze the price spread.

c)integrate price structure at different points of time.
d) remove gluts and shortage in the markets.

Types of derivatives

derivatives

on the basis of linear and nonlinear

on the basis of financial and nonfinancial

1)On the basis of linear and non-linear: On the basis of this classification the financial
derivatives can be classified into two big class namely :a)linear b)non-linear derivatives
a)Linear derivatives: Those derivatives whose value depend linearly on the underlying value are
called linear derivatives. They are following:

Forwards
Futures
Swaps

b) Non-linear derivatives: Those derivatives whose value is a non-linear function of the

underlying are called non-linear derivatives. They are following:

Options
Convertibles
Equity linked bonds
Reinsurance

2) On the basis of financial and non-financial: On the basis of this classification the derivatives
can be classified into two category:a) financial derivatives b)non-financial derivatives.
a)Financial derivatives: Those derivatives which are of financial nature are called financial
derivatives. They are following:

Forwards
Futures
Options
Swaps

b) Non-financial derivatives: Those derivatives which are not of financial nature are called nonfinancial derivatives. They are following:

Commodities
Metals
Weather
Others

Major elements of derivative market

1. Forwards contracts: A forward contract is a customized contract between the buyer and
the seller where settlement takes place on a specific date in future at a price agreed today.
In case of a forward contract the price which is paid/ received by the parties is decided at
the time of entering into contract. It is simplest form of derivative contract mostly entered
by individual in day to day life. The holder of a long (short) forward contract has an
agreement to buy (sell) an asset at a certain time in the future for a certain price, which is
agreed upon today. The buyer (or seller) in a forward contract:
Acquires a legal obligation to buy (or sell) an asset (known as the underlying asset)
At some specific future date (the expiration date)
At a price (the forward price) which is fixed today.
2. Futures contract: Futures contract is an agreement between two parties to buy or sell a
specified quantity of an asset at a specified price and at a specified time and place. Future
contracts are normally traded on an exchange which sets the certain standardized norms
for trading in futures contracts. The futures contracts are executed on expiry date. The
futures prices are expressed in currency units, with a minimum price movement called a
tick size.
3. Options contract: In case of futures contact, both parties are under obligation to perform
their respective obligations out of a contract. But an options contract, as the name
suggests, is in some sense, an optional contract. An option is the right, but not the
obligation, to buy or sell something at a stated date at a stated price. Options are the
standardized financial contract that allows the buyer (holder) of the option, i.e. the right

at the cost of option premium, not the obligation, to buy (call options) or sell (put
options) a specified asset at a set price on or before a specified date through exchanges.
Options contracts are of two types: call options and put options. A call option gives one
the right to buy; a put option gives one the right to sell.
4. Swap contracts: A swap can be defined as a barter or exchange. It is a contract whereby
parties agree to exchange obligations that each of them have under their respective
underlying contracts or we can say, a swap is an agreement between two or more parties
to exchange stream of cash flows over a period of time in the future. The parties that
agree to the swap are known as counter parties. The two commonly used swaps are: i)
Interest rate swap: which entail swapping only the interest related cash flows between the
parties in the same currency, and ii) Currency swaps: These entail swapping both
principal and interest between the parties, with the cash flows in one direction being in a
different currency than the cash flows in the opposite direction.
Development of Derivatives Markets in India
Indian Derivatives markets 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 in
1875. In 1952, with the ban on cash settlement and option trading by the Government of
India, derivatives trading shifted to informal forwards markets. In recent years, government
policy has shifted in favor of an increased role of market-based pricing and less suspicious
derivatives trading. The first step towards the introduction of financial derivatives trading in
India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. This
provided for withdrawal of prohibition on options in securities. In the last decade, beginning
the year 2000, ban on futures trading in many commodities was lifted out. During 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, NSE and BSE, 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.
Derivatives Products Traded in Derivatives Segment of BSE
The Bombay Stock Exchange (BSE) created history on June 9, 2000 when it launched trading
in Sensex based futures contract for the first time. It was then 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. 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) SENSEX7 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 1 summarily specifies the derivative products and their date of
introduction on the BSE.

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 in index options was introduced on June 4, 2001. On
November 9, 2001, Futures on individual securities started. As stated by the Securities &
Exchange Board of India (SEBI), futures contracts are available on 233 securities. Trading in
options on individual securities commenced w.e.f. July 2, 2001. The options contracts,
available on 233 securities, are of American style and cash settled. Trading in interest rate
futures was started 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 created history by
launching currency futures contract on US Dollar-Rupee on August 29, 2008 in Indian
Derivatives market. Table 2 presents a description of the types of products traded at F& O
segment of NSE.

Trade Details of Derivatives Market

After recording a 60.43 percent growth (20092010) in trading volume on year-on-year basis, the
NSEs derivatives market continued its momentum in 20102011 by having a growth rate of
65.58 percent (Table 3). The NSE further strengthened its dominance in the derivatives segment
in 20102011 by having a share of 99.99 percent of the total turnover in this segment. The share
of the BSE in the total derivatives market turnover fell from 0.0013 percent in 20092010 to
0.0005 percent in 20102011. The total turnover of the derivatives segment increased by 26.56
percent during the first half of 20112012 compared to the turnover in the corresponding period
in the previous fiscal year. In terms of product wise turnover of futures and options segment in
the NSE, index options segment was the clear leader in 20102011

Figure II: Trade details of Derivatives in BSE

Unresolved Issues and Future Prospects

Even though the derivatives market has shown good progress in the last few years, the real
issues facing the future of the market have not yet been resolved. The number of products
allowed for derivative trading have increased and the volume and the value of business has
zoomed, but the objectives of setting up different derivative exchanges may not be achieved
and the growth rates witnessed may not be sustainable unless these real issues are sorted out
as soon as possible. Some of the main unresolved issues are as under.
1. Trading in commodity options contracts has been stopped since 1952. The market for
commodity derivatives is not completed without the presence of this important derivative.
Issues for Market Stability and Development:
2.The enormous size and fast growth of the Over the Counter (OTC) derivatives market has
attracted the attention of regulators and supervisory bodies But OTC markets are less
transparent and highly leveraged, have weaker capital requirements and contain elements of
hidden systemic risk.
3. The growth of derivatives as off-balance sheet (OBS) items of Indian Banks has been an
area of concern for the RBI. The OBS exposure/risk has increased significantly in recent
years. The notional principal amount of OBS exposure increased from Rs.8,42,000 crore at
the end of March 2002 (approximately $181 billion at the exchange rate of Rs.46.6 to a US
$) to Rs.149,69,000 crore (approximately $321 billion) at the end of March 2008. (RBI,
2009)
4.As the market activity pick-up and the volumes rise, the market will definitely need a
strong and independent regulator.
5.CCIL, which started functioning in 2002, is the only centralized clearing party for trade
processing and settlement services in India. there is the need to strengthen more and more
clearing parties.

6. In India, at present there are tax restrictions on the movement of certain goods from one
state to another. These need to be removed so that a truly national market could develop for
commodities and derivatives.

Conclusion
The Indian derivative market has achieved tremendous growth over the years,
and also has a long history of trading in various derivatives products. The derivatives market
has seen ups and downs. The new and innovative derivative products have emerged over the
time to meet the various needs of the different types of investors. Though, the derivative
market is burgeoning with its divergent products, yet there are many issues. Among the issues
that need to be immediately addressed are those related to, lack of economies of scale, tax and
legal bottlenecks, increased off-balance sheet exposure of Indian banks, need for an
independent regulator etc. Solution of these issues will definitely lead to boost the investors
confidence in the Indian derivative market and bring an overall development in all the
segments of this market
References

https://www.indianresearchjournals.com/pdf/IJMFSMR/2013/March/4.pdf
https://www.newyorkfed.org/medialibrary/.../derivatives_in_india.pdf
https://casi.sas.upenn.edu/sites/casi.../Derivatives%20-%20Vashishtha.pdf