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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