ASSIGNMENT ON DERIVATIVES IN INDIA Department of Management Studies JAMIA HAMDARD UNIVERSITY NEW DELHI

SUBMITTED TO: Mrs.Sana Beg

SUBMITTED BY: Anurag Shukla Binish khan Khadija Ishrat Yusra Fatmi

DERIVATIVES IN INDIA

A derivative is a security or contract designed in such a way that its price is derived from the price of an underlying asset. For instance, the price of a gold futures contract for October maturity is derived from the price of gold. Changes in the price of the underlying asset affect the price of the derivative security in a predictable way. The term derivatives can simply be understood as those items that do not have their own independent values. Rather they have derived values. Derivatives have a significant place in finance and risk management. A Derivative is financial instrument whose pay-off is derived from some other asset which is called an underlying asset. Evolution of derivatives In the 17th century, in Japan, the rice was been grown abundantly; later the trade in rice grew and evolved to the stage where receipts for future delivery were traded with a high degree of standardization. This led to forward trading. In 1730, the market received official recognition from the Tokugawa Shogunate (the ruling clan of shoguns or feudal lords). The Dojima rice market can thus be regarded as the first futures market, in the sense of an organized exchange with standardized trading terms. The first futures markets in the Western hemisphere were developed in the United States in Chicago. These markets had started as spot markets and gradually evolved into futures trading. This evolution occurred in stages. The first stage was the starting of agreements to buy grain in the future at a pre-determined price with the intension of actual delivery. Gradually these contracts became transferable and over a period of time, particularly delivery of the physical produce. Traders found that the agreements were easier to buy and sell if they were standardized in terms of quality of grain, market lot and place of delivery. This is how modern futures contracts first came into being. The Chicago Board of Trade (CBOT) which opened in 1848 is, to this day the largest futures market in the world.

FEATURES/CHARACTERISTICS OF DERIVATIVE MARKETS

1. Derivative are of three kinds future or forward contract, options and swaps and underlying assets can be foreign exchange, equity, commodities markets or financial bearing assets.

As all transactions in derivatives takes place in future specific dates it is easier to short sell then doing the same in cash markets because an individual can take of markets and take the position accordingly because one has more time in derivatives. Since derivatives have standardized terms due to which it has low counterparty risk, also transactions costs are low in derivative market and hence they tend to be more liquid and one can take large positions in derivative markets quite easily.

2. When value of underlying assets change then value of derivatives also changes and hence one can construct portfolio which is needed by one and that too without having the underlying asset. So for example if one want to buy some stock and short the market then he can buy the future of a stock and at the same time short sell the market without having to buy or sell the underlying assets.

EQUITY DERIVATIVES- AN INTRODUCTION

The term derivatives is used to refer to financial instruments which derive their value from some underlying asset. The underlying assets could be equities (shares), debt (bonds, T-bills, notes), currencies and even indices of these various assets, such as the Nifty 50 Index. Derivatives derive their names from their respective underlying asset. Thus, if a derivatives underlying asset is equity, it is called equity derivative. Derivatives can be traded either on a regulated exchange such as the NSE or off the exchanges, i.e., directly between the parties which is called over the counter (OTC) trading. In India only exchange traded equity derivatives are permitted under law. The basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset prices) from one party to another; they facilitate the allocation of the risk to those who are willing to take it. In so doing, derivatives help mitigate the risk arising from the future uncertainty of price. For example, on November 1, 2009 a rice farmer may wish to sell his harvest at a future date (say, January 1, 2010) for a predetermined fixed price to eliminate the risk of change in prices by that date. Such a transaction is an example of a derivatives contract. The price of this derivative is driven by the spot price of rice which is the underlying. The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 208 securities stipulated by SEBI. The Exchange has also introduced trading in Futures and Options contracts based on CNX-IT, BANK NIFTY, and NIFTY MIDCAP 50 indices. Since the launch of the Index Derivatives on the popular benchmark S&P CNX Nifty Index in 2000, the National Stock Exchange of India Limited (NSE) today have moved ahead with a

varied product offering in equity derivatives. The Exchange currently provides trading in Futures and Options contracts on 9 major indices and 226 securities. The Exchange also introduced trading in Mini Derivatives contracts to provide easier access for small investors to invest in Nifty futures and options. At present, the equity derivatives market is the most active derivative market in India. Trading volume in equity derivatives are, on an average, more than three and a half times the trading volumes in the cash equity markets.

November 18, 1996 May 11, 1998 May 25, 2000 June 12, 2000 June 4, 2001 July 2, 2001 November9, 2001 August 29, 2008 August31, 2009 February 2010 October 28, 2010 October 29, 2010

L.C. Gupta Committee set up to draft a policy framework for introducing derivatives. L.C. Gupta Committee submits its report on the policy framework. SEBI allows exchanges to trade in index futures. Trading on Nifty futures commences on the NSE Trading of Nifty options commences on the NSE Trading on stock options commences on the NSE Trading on stock futures commences on the NSE Currency derivatives trading commences on the NSE Interest rate derivatives trading commences on the NSE Launch of currency futures on additional currency pairs Introduction of European style stock options Introduction of currency options

TABLE: MILESTONES IN THE DEVELOPMENT OF INDIAN DERIVATIVES MARKET.

Kinds of financial derivatives

1) Forwards 2) Futures 3) Options 4) Swaps

1) Forwards A forward contract refers to an agreement between two parties, to exchange an agreed quantity of an asset for cash at a certain date in future at a predetermined price specified in that agreement. The promised asset may be currency, commodity, instrument etc, In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a future date is said to be in the long position. On the other hand, the user who promises to sell at an agreed price at a future date is said to be in short position. 2) Futures A futures contract represents a contractual agreement to purchase or sell a specified asset in the future for a specified price that is determined today. The underlying asset could be foreign currency, a stock index, a treasury bill or any commodity. The specified price is known as the future price. Each contract also specifies the delivery month, which may be nearby or more deferred in time. The undertaker in a future market can have two positions in the contract: a) Long position is when the buyer of a futures contract agrees to purchase the underlying asset. b) Short position is when the seller agrees to sell the asset. Futures contract represents an institutionalized, standardized form of forward contracts. They are traded on an organized exchange, which is a physical place of trading floor where listed contract are traded face to face. A futures trade will result in a futures contract between 2 sides- someone going long at a negotiated price and someone going short at that same price. Thus, if there were no transaction costs, futures trading would represent a Zero sum game what one side wins, which exactly match what the other side loses.

Types of futures contracts a) Agricultural futures contracts: These contracts are traded in grains, oil, livestock, forest products, textiles and foodstuff. Several different contracts and months for delivery are available for different grades or types of commodities in question. The contract months depend on the seasonality and trading activity. b) Metallurgical futures contract:-This category includes genuine metal and petroleum contracts. Among the metals, contracts are traded in gold, silver, platinum and Copper. Of the petroleum products, only heating oil, crude oil and gasoline is traded. c) Interest rate futures contract - These contracts are traded on treasury bills, notes, bonds, and banks certification of deposit, as well as Eurodollar. d) Foreign exchange futures contract These contracts are trade in the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc and the Deutsche Mark. Contracts

are also listed on French Francs, Dutch Guilders and the Mexican Peso, but these have met with only limited success. 3) Options An option contract is a contract where it confers the buyer, the right to either buy or to sell an underlying asset (stock, bond, currency, and commodity) etc. at a predetermined price, on or before a specified date in the future. The price so predetermined is called theStrike price or Exercise price. Depending on the contract terms, an option may be exercisable on any date during a specified period or it may be exercisable only on the final or expiration date of the period covered by the option contract. Option Premium In return for the guaranteeing the exercise of an option at its strike price, the option seller or writer charges a premium, which the buyer usually pays upfront. Under favorable circumstances the buyer may choose to exercise it. Alternatively, the buyer may be allowed to sell it. If the option expires without being exercised, the buyer receives no compensation for the premium paid.Writer In an option contract, the seller is usually referred to as writer, since he is said to write the Contract. If an option can be excised on any date during its lifetime it is called an American Option. However, if it can be exercised only on its expiration date, it is called an European Option.Option instruments : a) Call Option - A Call Option is one, which gives the option holder the right to buy an underlying asset at a pre-determined price. b) Put Option - A put option is one, which gives the option holder the right to sell an underlying asset at a pre-determined price on or before the specified date in the future. c) Double Option - A Double Option is one, which gives the Option holder both the right to buy andsell Underlying asset at a pre-determined price on or before a specified date in the future. 4) SWAPS - A SWAP transaction is one where two or more parties exchange (swap) one pre-determined Payment for another. There are three main types of swaps:a) Interest Rate swap - An Interest Rate swap is an agreement between 2 parties to exchange interest obligations or Receipts in the same currency on an agreed amount of notional principal for an agreed period of time. 11 b) Currency swap - A currency swap is an agreement between two parties to exchange payments or receipts in One currency for payment or receipts of another. c) Commodity swap - A commodity swap is an arrangement by which one party (a commodity user/buyer) agrees to Pay a fixed price for a designated quantity of a commodity to the counter party (commodity producer/seller), who in turn pays the first party a price based on the prevailing market price (or an accepted index thereof) for the same quantity.

Derivatives are financial instruments whose values depend on the values of other, more basic underlying assets. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE.

Derivatives are used by:

1. Hedgers: For protecting against adverse movement. Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. 2. Speculators: To make quick fortune by anticipating/forecasting future market movements. Hedgers wish to eliminate or reduce the price risk to which they are already exposed. Speculators, on the other hand are those class of investors who willingly take price risks to profit from price changes in the underlying. While the need to provide hedging avenues by means of derivative instruments is laudable, it calls for the existence of speculative traders to play the role of counter-party to the hedgers. It is for this reason that the role of speculators gains prominence in a derivatives market. 3. Arbitrageurs: To earn risk-free profits by exploiting market imperfections. Arbitrageurs profit from price differential existing in two markets by simultaneously operating in the two different markets.

DERIVATIVE MARKET IN INDIA

An important step towards introduction of derivatives trading in India was the Promulgation of the Securities Laws (Amendment) Ordinance, 1995, which lifted the Prohibition on "options in securities" (NSEIL, 2001). However, since there was no Regulatory framework to govern trading of securities, the market could not develop. SEBI Set up a committee in November 1996 under the chairmanship of Dr. L.C. Gupta to Develop appropriate regulatory framework for derivatives trading. The committee suggested that if derivatives could be declared as "securities" under SCRA, the appropriate regulatory framework of "securities" could also govern trading of derivatives. SEBI also set up a group under the chairmanship of Prof. J.R. Varma in 1998 to recommend risk containment measures for derivatives trading. The Government decided that a legislative amendment in the securities laws was necessary to provide a legal framework for derivatives trading in India. Consequently, the Securities Contracts (Regulation) Amendment Bill 1998 was introduced in the LokSabha on 4th July 1998 and was referred to the Parliamentary Standing Committee on Finance for examination and report thereon. The Bill suggested that derivatives may be included in the definition of "securities" in the SCRA whereby trading in derivatives may be possible within the

framework of that Act. The said Committee submitted the report on 17th March 1999. The Committee was of the opinion that the introduction of derivatives, if implemented, with proper safeguards and risk containment measures, will certainly give a fillip to the sagging market, result in enhanced investment activity and instill greater confidence among investors/participants. The Committee was of the view that since cash settled contracts could be classified as "wagering agreements" which can be null and void under Section 30 of the Indian Contracts Act, 1872, and since index futures are always cash settled, such futures contracts can be entangled in legal controversy. The Committee, therefore, suggested an overriding provision as a matter of abandoned caution"Notwithstanding anything contained in any other Act, contracts in derivatives as per the SCRA shall be legal and valid". Further, since Committee was convinced that stock exchanges would be better equipped to undertake trading in derivatives in sophisticated environment it would be prudent to allow trading in derivatives by such stock exchanges only. The Committee, therefore, suggested a clause- "The derivative shall be traded and settled on stock exchanges and clearing houses of the stock exchanges, respectively in accordance with the rules and bye-laws of the stock exchange". The Proposed Bill, which incorporated the recommendations of the said Parliamentary Committee, was finally enacted in December 1999.

Equity Derivatives in India

Equity index futures are the most widely traded futures contract while single stock futures on the whole contribute to a larger percentage of the traded volumes Equity index options are the most widely traded options contract in the exchange FIIs are very active in the equity derivative markets in India . Retail presence is also high in the equity derivative market Interest Rate and Currency Derivatives in India The market for Overnight Index Swaps (OIS) is the most active interest rate derivative OIS is based on the overnight call money benchmark, NSE Mibor Other interest rate derivatives include swaps on government bond benchmarks Currency derivatives is dominated by forward market though options are picking up. DERIVATIVES PRODUCTS LEGALLY PERMITTED TO BE TRADED IN INDIA 1. Equity Derivatives (Index/stock futures/options) - Legally permitted to be traded through stock exchanges approved by SEBI 2. Commodity Trading - Commodity futures are permitted. Commodity futures permitted only for trading in commodities approved by the Government in Commodity Exchanges recognized by Forward Markets Commission. Option contracts in commodities trading are not permitted.

3. Foreign Exchange Derivatives - Forward Contracts as approved by RBI permitted to be transacted by Banks and other approved foreign-exchange dealers. 4. OTC rupee derivatives in the form of Forward Rate Agreements (FRAs)/Interest Rate Swaps (IRS) - These were introduced by RBI in India in July 1999 in terms powers vested with it Foreign Exchange Management Act, 2000. These derivatives enable banks, primary dealers (PDs) and all-India financial institutions (FIs) to hedge interest Rate risk for their own balance sheet management and for market-making purposes. Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having explicit/implicit option features such as caps/floors/collars are not permitted now. 5. Exchange Traded Interest Rate Derivatives were introduced by RBI/SEBI during June, 2003. These can be traded through stock exchanges by primary dealers subject to conditions stipulated by RBI. OTC Rupee derivatives are presently not permitted.

CATEGORIES OF DERIVATIVES TRADED IN INDIA

1. Commodities Futures for Coffee, Oil Seeds, Oil (Castor, Palmolein), Pepper, Cotton, Jute and Jute Goods are traded in the Commodities Futures. Forward Markets Commission regulates the trading of commodities futures. 2. Index futures based on Sensex and Nifty Index are also traded under the supervision of SEBI. 3. RBI has permitted Banks, FIs and PDs to enter into forward rate agreement (FRAs)/interest rate swaps in order to facilitate hedging of interest rate risks and ensuring orderly development of the derivatives market 4. NSE became the first exchange to launch trading in options on individual securities. Trading in options on individual securities commenced from July 2, 2001. Option contracts are American style and cash settled and are available on 41 securities stipulated by the Securities & Exchange Board of India (SEBI) 5. NSE commenced trading in futures on individual securities on November 9, 2001. The futures contracts are available on 41 securities stipulated by the Securities & Exchange Board of India (SEBI).BSE also has started trading in individual stock options & futures (both Index & Stocks) around the same time as NSE.

DERIVATIVES PRODUCTS AT NSE

Since the launch of the Index Derivatives on the popular benchmark S&P CNX Nifty Index in 2000, the National Stock Exchange of India Limited (NSE) today have moved ahead with a varied product offering in equity derivatives. The Exchange currently provides trading in Futures and Options contracts on 9 major indices and 226 securities. The Exchange also introduced trading in Mini Derivatives contracts to provide easier access for small investors to invest in Nifty futures and options. Derivatives are available on the following products: 1. S&P CNX Nifty Index 2. Mini Derivative Contracts on S&P CNX Nifty Index 3. CNXIT Index 4. Bank Nifty Index 5. Nifty Midcap 50 Index 6. CNX Infrastructure Index 7. CNX PSE Index 8. Individual Securities

TRADING OF DERIVATIVES AT NSE

NSE introduced for the first time in India, fully automated screen based trading. It uses a modern, fully computerised trading system designed to offer investors across the length and breadth of the country a safe and easy way to invest. NSEs automated screen based trading, modern, fully computerised trading system designed to offer investors across the length and breadth of the country a safe and easy way to invest. The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is a fully automated screen based trading system, which adopts the principle of an order driven market.

Advantages and Disadvantages of Derivatives

Basically, derivatives had been introduced in order to hedge against the price risk (risk of price of asset owned going in an unfavorable direction). It enabled transfer of risk from those who were not willing to take it (hedgers) to those who were intentionally willing to assume it (speculators). Besides hedging, they perform some very significant functions discussed below. Advantages/ Benefits/Merits/Functions of Derivatives: 1. Enable Price Discovery: In the first place, derivatives encourage more and more people with objectives of hedging, speculation, arbitrage to take part in the market and hence increase competition. Hence there are more and more people who keep track of prices and trade on slightest of reasons. Individuals with better information and judgment are inclined to participate in the markets to take advantage of such situation. A small change in price and it attracts some action on the part of speculators. Active participation in the market in large no.s of both buyers and sellers ensures a fair price. The increased no. of participants, more trades, more volumes, and greater sensitivity to smallest of price changes facilitates correct and efficient price discovery of assets. 2. Facilitates Transfer of Risk: By their very nature, the derivatives instruments do not involve risk. Instead, they redistribute risk between the various market participants. In this sense, derivatives can be compared to insurance: provides means to hedge against unfavorable market movements in return for a premium, and provides opportunities to those who are willing to take risks and make profits in the process. 3. Provide Leveraging: In order to take position in derivatives, you require very small initial outlay of capital in comparison to taking position in the spot market. Assume that Mr. A believes that price of rice shall be Rs. 50/kg in 3 months from now and that a farmer has agreed to sell it at Rs. 49/kg. To take this benefit, Mr. A has to pay full amount of Rs. 49/kg today and he will realize Rs. 50/kg 3 months later. Instead, if there is a way through which he can escape making a full payment, he shall be really glad to enter into such contract and Derivatives provide those exit routes by letting one enter into a contract and can neutralize their position by booking opposite position on a future date. 4. Completion of Market/Efficient Market: A market is efficient or said to be complete market (theoretically possible) when the available instruments can by itself or jointly provide cover against any possible adverse outcomes. It is a theoretical concept, which is not seen in practice. Though with the presence of derivatives, there is a greater degree of market completeness. 5. Lower Transaction costs: It translates into low transaction costs due to the high no. of participants that take part in the market. Derivatives behave like a two edged sword. If put to use wisely they work very effectively but when used recklessly can cause you severe agonies. Sadly there is no realistic way in which one could demarcate between the two. There is a very thin line that distinguishes gambling with a calculated taken risk.

Below mentioned are disadvantages/ demerits of Derivatives: 1. Raises Volatility: As a large no. of market participants can take part in derivatives with a small initial capital due to leveraging derivatives provide, it leads to speculation and raises volatility in the markets. 2. Higher no. of Bankruptcies: Due to leveraged nature of derivatives, participants assume positions which do not match their financial capabilities and eventually lead to bankruptcies. 3. Increased need of regulation: Large no. of participants take positions in derivatives and take speculative positions. It is necessary to stop these activities and prevent people from getting bankrupt and to stop the chain of defaults.