Download Derivatives Market in inDia: a success story

Investment
By:Dr S. Priya
Dr R. Rathiha
Derivatives Market in India:
A Success Story
Derivatives are innovative financial instruments designed to suit an investor’s appetite for
risk. These financial tools help to effectively transfer risk from those who wish to avoid it to
those who wish to accept it. In India, the derivatives market has recorded an impressive CAGR
of 34 per cent, in terms of annual turnover, in the last five years.
India is one of the most successful developing countries in terms of
a vibrant market for exchange-traded derivatives. This reiterates the
strength of modern developments in
India’s securities markets, which are
based on nationwide market access,
anonymous electronic trading and a
predominant retail market. There is
an increasing sense that the equity
derivatives market plays a major
role in shaping price discovery.
Concept and definition
of derivatives
T
he
emergence
and
growth of the market for
derivative instruments
can be traced to the willingness of risk-averse
economic agents to guard themselves
against uncertainties arising out of
fluctuations in asset prices. Derivatives are meant to facilitate the hedging of price risks of inventory holdings
or a financial/commercial transaction
over a certain period. By locking in
asset prices, derivative products minimise the impact of fluctuations in asset prices on the profitability and cash
flow situation of risk-averse investors,
www.ffymag.com
and thereby, serve as instruments of
risk management. 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 have facilitated the flow of
trade and finance.
Derivatives are financial contracts, which derive their value off a
spot price time series, which is called
‘the underlying’. The underlying asset can be equity, index, commodity
or any other asset. Some common
examples of derivatives are forwards, futures, options and swaps.
According to the Securities Contract (Regulation) Act, 1956, derivatives include:
1. A security derived from a debt
instrument, share and loan whether
secured or unsecured, risk instrument or contract for differences or
any other form of security.
2. A contract, which derives its
value from the prices or index of
prices of underlying securities.
June 2014
•
FACTS FOR YOU
9
Investment
History of derivative
markets
Derivative markets in India have
been in existence in one form or the
other for a long time. In the area of
commodities, the Bombay Cotton
Trade Association started future
trading way back in 1875. This was
the first organised futures market.
The Bombay Cotton Exchange Ltd
in 1893, Gujarat Vyapari Mandal
in 1900, and Calcutta Hesstan Exchange Ltd in 1919 then started a
futures market. After the country attained independence, derivative markets came through a full circle—from
prohibition of all sorts of derivative
trades to their recent reintroduction.
In 1952, the Government of India
banned cash settlement and options
trading, and derivatives trading shifted to informal forwards markets. In
recent years, government policy has
shifted in favour of an increased role
in market-based pricing and less suspicious derivatives trading.
The first step towards introduction of financial derivatives trading
in India was the promulgation of
the Securities Laws (Amendment)
Ordinance, 1995. It provided for
withdrawal of prohibition on options
in securities. The year 2000 saw a
lifting of the ban on futures trading
in many commodities. Around the
same time, national electronic commodity exchanges were also set up.
Derivative products
There are four main types of derivative contracts: forwards, futures,
options and swaps.
Forwards and futures contracts. A forwards and futures
contract is an agreement to buy or
sell a specified quantity of an asset
at a specified price with delivery at
a specified date in the future. But
there are important differences in
the ways these contracts are transacted. First, participants trading fu10
FACTS FOR YOU
•
June 2014
Value Traded in Secondary
Market Segment
tures can realise gains and losses on
a daily basis, while forwards transaction requires cash settlement at
delivery. Second, futures contracts
are standardised, while forwards are
customised to meet the special needs
of the two parties involved (counterparties). Third, unlike futures
contracts, which are settled through
an established clearing house, forwards are settled between the counterparties. Fourth, because of being
exchange-traded, futures are regulated, whereas forwards, which are
mostly over-the-counter (OTC) contracts, are loosely regulated.
Options contracts. Options
contracts can be either standardised
or customised. There are two types
of options: ‘call’ and ‘put’ options.
Call options contracts give the purchaser the right to buy a specified
quantity of a commodity or financial asset at a particular price (the
exercise price) on or before a certain
future date (the expiration date).
Similarly, put options contracts give
the buyer the right to sell a specified
quantity of an asset at a particular
price on or before a certain future
date. These definitions are based on
the so-called American-style options.
And for European style options, the
contract can only be exercised on
the expiration date. In an options
transaction, the purchaser pays the
seller—the writer of the options—an
amount for the right to buy or sell.
This amount is known as the option
premium. In the event that options
are not exercised at expiration, the
purchaser simply loses the premium
paid. If the options are exercised,
however, the option writer will be
liable for covering the costs of any
changes in the value of the underlying that benefit the purchasers.
Swaps. Swaps are agreements
between two counterparties to exchange a series of cash payments for
a stated period of time. The periodic
payments can be charged on fixed
or floating interest rates, depending on contract terms. The calculation of these payments is based on
an agreed-upon amount, called the
notional principal amount or, simply,
the notional.
Growth of derivatives
in India
Derivatives trading in India started in the year 2000 with the commencement of BSE Sensex futures at
BSE and Nifty futures at NSE. Trading in equity index options and stock
options was also started the following
year at NSE. As the derivatives business grew in India, the markets have
started offering currency and interest
rate derivatives as well. The market
has come a long way since its inception in 2000, and has recorded an
impressive CAGR of 34 per cent (in
terms of annual turnover) in the last
five years.
Increased derivative trading can
be attributed to discrete periods of
range bound behaviour and phases of
high volatility in Indian markets. The
speculative nature of Indian investors and a drive to hedge investments
among money managers has also
contributed to the business growth
in this segment. Of late, currency
options and futures have also start
gaining traction slowly. The product
composition in derivatives has also
witnessed major changes since its
inception. While the contribution of
index and stock futures to the total
turnover has gone down drastically
in the last 12 years, the contribution
www.ffymag.com
Investment
violation and position limit
violation.
Growth of Derivatives
5. The CMs are provided
Year
Number of Total turnover Average daily with a trading terminal for
contracts
(Rs billion)
turnover
monitoring the open posi
(Rs billion)
tions of all the TMs clearing
2013-14795,751,261 229,788.02
1573.89
and settling through them.
A CM may set the limits for
2012-131,131,467,418 315,330.04
1266.38
the TM clearing and settling
2011-121,205,045,464 313,497.32
1259.02
through her. The NSCCL as2010-111,034,212,062 292,482.21
1151.50
sists the CM in monitoring
2009-10679,293,922 176,636.64
723.92
the intra-day limits set up by
2008-09657,390,497 110,104.82
453.12
a CM, and whenever a TM
2007-08425,013,200 130,904.78
521.53
exceeds the limits, it stops
2006-07216,883,573 73,562.42
295.43
that particular TM from fur2005-06157,619,271 48,241.74
192.20
ther trading.
2004-0577,017,185 25,469.82
101.07
6. A member is alerted
of her position to enable her
2003-0456,886,776 21,306.10
83.88
to adjust her exposure or to
2002-0316,768,909 4398.62
17.52
bring in additional capital.
2001-024,196,873 1019.26
4.10
Margin violations result in
2000-0190,580
23.65
0.11
Risk management
the disablement of the tradframework
Source: SEBI Annual Report 2012-13
ing facility for all TMs of a
CM in case of a violation by
The most critical compothe CM. A separate settlement guarpositions of a clearing member (CM).
nent of the risk containment mechaantee fund for this segment has been
It specifies the initial margin renism for the F&O segment is the
created out of the deposit made by
quirements for each futures/options
margining system and the online
the members.
contract on a daily basis. It follows
position monitoring system. The aca Value-at-Risk (VaR) based margintual position monitoring and margining computed through SPAN. The
ing is carried out online through the
Recent developments in
CM, in turn, collects the initial marParallel Risk Management System
the derivatives market
gin from the trading members (TMs)
(PRISM). The PRISM uses SPAN
and their respective clients.
(Standard Portfolio Analysis of Risk).
Standardised lot size for de3. The open positions of the memThe SPAN system is for the computarivative contracts on individual
bers are marked to market, based
tion of online margins, based on the
securities. The SEBI, in consultaon the contract settlement price for
parameters defined by the SEBI.
tion with the stock exchanges, has
each contract at the end of the day.
The National Securities Clearing
decided to standardise the lot size
The difference is settled in cash on
Corporation Ltd (NSCCL), a wholly
for derivative contracts on individa T+1 basis.
owned subsidiary of the National
ual securities. The stock exchanges
4. The NSCCL’s online position
Stock Exchange (NSE), has develshall review the lot size once in six
monitoring system monitors a CM’s
oped a comprehensive risk containmonths, based on the average of the
open position on a real-time basis.
ment mechanism for the futures &
closing price of the underlying for
Limits are set for each CM based
options (F&O) segment. The salient
the last one month, and wherever
on her effective deposits. The online
features of the risk containment
warranted, revise the lot size by givposition monitoring system genermechanism in the F&O segment are:
ing an advance notice of at least two
ates alert messages whenever a CM
1. The financial soundness of the
weeks to the market.
reaches 70 per cent, 80 per cent and
members is the key to risk manageIntroduction of derivative
90 per cent of the limit, and a disament. Therefore, the requirements
contracts on volatility index. In
blement message at 100 per cent of
for membership in terms of capital
continuation to the SEBI circular
the limit. The NSCCL monitors the
adequacy (net worth, security deposdated January 15, 2008, regarding
CMs for initial margin violation and
its, and so on) are quite stringent.
the introduction of the volatility
exposure margin violation, while the
2. The NSCCL charges an upindex, the capital market regulator,
TMs are monitored for initial margin
front initial margin for all the open
vide its circular dated April 27, 2010,
of index options has recorded
an impressive upsurge from
4.2 per cent in the year 2001 to
72.2 per cent in 2013.
Table 1 shows the growth
of derivative transactions in
India. In the year 2000-2001,
the total contracts were only
90,580 in number. These increased to 795,751,261 in
2013-14. Total turnover increased from ` 23.65 billion to
` 229,788.02 billion over the
same period, while the average
daily turnover went up from `
0.11 billion to ` 1573.89 billion. As can be seen, there has
been a huge growth in transactions over the last decade.
www.ffymag.com
Table I
June 2014
•
FACTS FOR YOU
11
Investment
Options on USDINR
spot rate. The
The Top Ten Derivatives Traded in the Market
SEBI, vide its cirRank
Contract
Number
Traded
Traded Average daily
Share in Number of
cular dated July 30,
symbol
of trades
quantity
value
trading value total trading contracts
2010, has allowed
(Rs billion) (Rs billion) value (per cent)
for the introduction
1
SBIN 1,295,946231,842,875 391.21
19.56
0.011013 1,854,743 of options on USD2 AXISBANK 838,356271,528,250 270.26 13.51
0.007608 1,086,113 INR spot rate on the
3
RCOM
393,2261,746,924,000 261.68
13.08
0.007366 436,731
currency derivatives
4
ICICIBANK 655,596207,769,750 196.47
9.82
0.005531 831,079
segment of the stock
exchanges. Premium
5
RELIANCE 641,781220,208,000 193.66 9.68
0.005452 880,832
styled European call
6 TATAMOTORS436,731547,524,000 184.58
9.23
0.005196 547,524
and put options can
7 MCDOWELL-N350,171 68,802,625 172.92
8.64
0.004868 550,421
8
YESBANK 834,502502,621,000 158.70 7.93
0.004468 1,005,242 be introduced on the
USD-INR spot rate.
9
TCS 227,20779,393,750 157.45 7.87
0.004432 317,575
The contract would be
10 TATASTEEL425,544497,324,000148.94 7.45
0.004193 497,324
settled in cash in InSource: SEBI Annual Report 2012-13
dian rupees, and the
final settlement price
sure margin, SEBI had specified that
would be the RBI Reference Rate on
decided to permit stock exchanges
the margin shall be the higher of 10
the date of expiry of the contracts.
to introduce derivative contracts on
per cent or 1.5 times the standard
Self-clearing member in the
the volatility index. This is subject
deviation (of daily logarithmic recurrency derivatives segment.
to the condition that the underlying
turns of the stock price) of the noWith regard to the newly created
volatility index has a track record of
tional value of the gross open posicategory of self-clearing members
at least one year.
tion in single stock futures, and the
(circular dated May 13, 2011) in the
Introduction of index options
gross short open position in stock opcurrency derivatives segment of a
with tenure up to five years. Furtions in a particular underlying.
stock exchange, SEBI has clarified
ther to its circular dated January
Physical settlement of stock
that such self-clearing members
11, 2008, regarding the introduction
derivatives. In continuation to
should have a minimum net worth
of index options with tenure up to
its circular dated June 20, 2001,
of ` 50 million.
three years, SEBI decided to permit
and November 2, 2001, regarding
Derivatives have redefined and
stock exchanges to introduce options
the settlement of stock options and
revolutionised the financial industry
contracts on the Sensex and the Nifstock futures contracts, respectively,
across the world, and have earned a
ty with tenure up to five years. The
the SEBI—based on the recommenwell-deserved and significant place in
introduction of such five-year opdations of the Derivatives Market
financial markets. Derivatives protions contracts will be subject to the
Review Committee and in consultavide an effective solution to the probcondition that there are eight semition with stock exchanges—decided
lem of risk caused by uncertainty and
annual contracts of the cycle June/
to provide flexibility to the stock exvolatility in underlying assets. These
December, together with three serial
changes to offer:
are risk management tools that help
monthly contracts and three quar1. Cash settlement (settlement
to effectively transfer risk from those
terly contracts.
by payment of differences) for both
who wish to avoid it to those who
Revised exposure margin for
stock options and stock futures; or
wish to accept it. India’s experience
exchange-traded equity deriva2. Physical settlement (settlewith the equity derivatives market
tives. In a modification to its circument by delivery of underlying
has been extremely encouraging
lar on exposure margin, the SEBI
stock) for both stock options and
and successful, with the derivatives
decided (vide its circular dated July
stock futures; or
turnover on the NSE surpassing the
7, 2010) that the exposure margin
3. Cash settlement for stock opequity market turnover.
for exchange-traded equity deriva
tions and physical settlement for
tives shall be the higher of 5 per cent
Dr S. Priya is a guest faculty in commerce
stock futures; or
or 1.5 times the standard deviation
at the All Saints College in Trivandrum,
4. Physical settlement for stock
(of daily logarithmic returns of the
Kerala. Dr R. Rathiha is an associate prooptions and cash settlement for
stock price). In its earlier circular on
fessor in commerce at the Womens’ Chrisstock futures.
October 15, 2008, on the said expotian College in Nagercoil, Tamil Nadu
Table II
12
FACTS FOR YOU
•
June 2014
www.ffymag.com