DERIVATIVES EXISTING IN INDIA…

FINANCIAL DERIVATIVES

The term derivatives refer to a large number of financial instruments whose value is derived from the underlying assets. Derivative instruments like the options and futures facilitate the trading in financial contracts. The most important underlying instruments in the market are in the form of Equity, treasury bills, and foreign exchange. The trading in the financial derivatives has attracted the prominent players of the equity markets.

The primary purpose of a derivative contract is to transfer risk from one party to another i.e. risk is transferred from a party that wants to get rid of it to another party i.e. willing to take it. The major players seen in the derivatives segment are the SPECULATORS whose sole objective is to buy and sell for a profit alone. The HEDGERS are the other breeds of players, who aim merely to have a hedge positions. They are risk free investors whose intention is to have a safety mechanism and wish to protect their portfolio. Nevertheless, they are pursued as a cheap and efficient way of moving risk within the economic system. But the world of derivatives is riddled with jargons making it more awesome.

The trading in equity through the derivatives in India was introduced in the year 2000 by the Securities And Exchange Board of India [SEBI] and this was described as the “India’s derivative explosion”. Although this took a definite form in 2000 but the idea was initiated in the year 1995. it was then in the year 2000 that SEBI permitted the trading the in the options on the platforms of  India’s premier exchange platforms i.e., the National Stock Exchange Of India limited [NSE] and The Bombay Stock Exchange [BSE] in the individual securities. But the futures contracts took 17 long months to get launched on November 09’ 2001.

The trading in options and futures in the individual stocks were permitted to trade on the stable stocks only. The small and highly volatile stocks were an exemption from the trade in derivatives. Futures and options are important tools that help the investors to derive profit. The futures facilitate the investor to enter into a contract to deliver the underlying security at a future date whereas, the options allow it to his discretion as to whether he wants to buy (call) or sell (put) the contract.

The current trading behavior in the derivatives segment reveals that single stock futures continues to account for a sizeable proportion. A recent report indicates that the trading in the individual stock futures in the Indian exchanges has reached global volumes. One possible reason for such a behavior of the trader could be that futures closely resemble the erstwhile ‘BADLA’ system.

Turnover in Financial Markets and Commodity Market
(Rs in Crore)
S No.	Market segments	2002-03		2003-04		2004-05 (E)
1	Government Securities Market	1,544,376	(63)	2,518,322	(91.2)	2,827,872	(91)
2	Forex Market	658,035	(27)	2,318,531	(84)	3,867,936	(124.4)
3	Total Stock Market Turnover (I+ II)	1,374,405	(56)	3,745,507	(136)	4,160,702	(133.8)
I	National Stock Exchange (a+b)	1,057,854	(43)	3,230,002	(117)	3,641,672	(117.1)
	a) Cash	617,989		1,099,534		1,147,027
	b) Derivatives	439,865		2,130,468		2,494,645
II	Bombay Stock Exchange (a+b)	316,551	(13)	515,505	(18.7)	519,030	(16.7)
	a) Cash	314,073		503,053		499,503
	b) Derivatives	2,478		12,452		19,527
4	Commodities Market	NA		130,215	(4.7)	500,000	(16.1)
Note: Fig. in bracket represents percentage to GDP at market prices                               Source: Sebi bulletin

Indian Derivatives Market …. Looking Ahead

Clearly, in the nascent stage, the derivatives market in India is heading in the right direction. In the terms of the number of contracts in a single commodity/stock it is probably the largest market globally. It is no longer a market that can be ignored by any of the serious participants. The Indian economy, now, is at the verge of greater expansion the any other economies in the globe today. This has attracted a large number of institutional investors, both – the Indian as well as foreign, to invest in to the Indian stocks and commodities, thereby bringing in a lot of forex reserves. As predicted by the popular investment Gurus’ and the great Economists world wide, India will be a major player in the global economy by the end of this decade. We can conclude that, with the institutional participation set to increase and a broader product rollout inevitable, the market can only widen and deepen further.

WHAT IS A DERIVATIVE MARKET?

INTORDUCTION

The derivative is a product whose value is derived form the value of one or more variables/underlying assets called bases in a contractual manner. They have no value of their own but derive it from the underlying asset that is being dealt with under the derivative contract. Thus derivate contracts acquire their value from the spot prices of the assets that are covered by the contract. The primary purpose of a derivative contract is to transfer “risk” from one party to another they have established themselves as irreplaceable tools to hedge against risks in the market. The underlying asset can be equity, forex, commodity or any other asset.

The emergence of the market for derivative product, most notably forwards, futures and options can be traced back to the willingness of the risk-averse economic agents to guard themselves against the uncertainties resulting out of the fluctuations in the underlying assets’ prices. It is because of this nature, that, the markets [financial/commodities] are marked with a higher degree of volatility through the uses of derivative products. The risk of the prices can be transferred fully or partially by, locking-in the asset prices in the form of futures or forwards.

As an instrument of risk management, these do not influence the fluctuations in the prices of the underlying assets. Infact, by locking-in the assets prices, derivative products minimize the impact of the fluctuations in the asset prices on the profitability and cash-flow of the investors.

The Indian derivatives market has a history of more than a century, but is still in a nascent stage vis-à-vis the global derivatives market. Today we have an active derivatives market in the segment of stocks and foreign currency, while the trading in the commodities is just standardized. The OTC derivatives in India are well established and the Indian capital markets have acquired the international flavor and the volumes in the derivatives market in at a pace to climb up. 

A contract bought by paying an upfront margin is calculated as value added risk (VAR) basis. Which traces the volatility in the underlying assets (stock or commodities) prices to arrive at margin that is reflected of this volatility. Stock futures are linear and are absolutely similar to simple stocks i.e., ideally if the stock goes up and payoff.

Trading instruments

Derivatives in the recent times have become very popular because of their wide application. Before getting into the hard talks about the commodities trade, let us know about the trading instruments in the derivatives, as they are similarly applicable to the commodities derivatives. There are 4 types of Derivatives instrument:

Ø   Forward contract

Ø   Future contract

Ø   Options contract

Ø   Swap

Futures and Options are actively used in many exchanges whereas; Forwards and Swaps are mostly trade Over The Counter (OTC).

FORWARDS CONTRACT

A spot or cash market is the most commonly used for trading. A majority of our day-to-day transactions are in the cash market. In addition to the cash purchase, another way trading is by entering into a Forward contract. A Forward contract is an agreement to buy or sell an asset on a specified date of a specified price. These contracts are usually entered between a financial institution and its corporate clients or two financial institutions themselves. In the context to the Commodity trading, prior to the standardization, the trade was carried out as a forwards contract between the Associations, Producers and Traders. Where the Association used to act as counter for the trade. 

A forward contract has been in existence in the organized commodities exchanges for quite sometimes. The first forward contract probably started in Japan in the early 18^th century, while the establishment of the CHICAGO BOARD OF TRADE (CBOT) in 1848 led to the start of a formal commodities exchange in the USA.

Forward contracts are very useful in HEDGING and SPECULATION. The essential idea of entering into the forward contract is to Hedge the price thereto avoid the price risk. By entering into a forward contract one is assured of the price at which the goods/assets are bought and sold. The classic Hedging example would be that of an exporter who expects to receive payment in foreign currency after three months. As he is exposed to greater amount of risk in the fluctuations in the exchange rates, he can, with the use of forwards, lock-in the rate today and reduce the uncertainty. Similarly, if a speculator has the information of an upswing in the prices of the asset, he can go long on the forward market instead of the cash market and book the profit when the target price is achieved. 

The forward contract is settled at the maturity date. The holder of the short position delivers the assets to the holder of the long position on the maturity against a cash payment that equals to the delivery price by the buyer. The price agreed in the forwards contract is the DILIVERY PRICE. Since the delivery price is chosen at the time of entering into the contract, the value of the contract becomes zero to both the parties and costs nothing to either the holder of the long position or to the holder of the short position.

The salient features of a forwards contract are:

q  It is a bilateral contract and hence is exposed to counter-party risk.

q  Every contract is unique and is custom designed in the terms of: expiration date and the asset type and quality.

q  The contract price is not available in the public domain.

q  On the expiration, the contract is to be settled by the delivery of the asset.

q  Of the party wishes to reverse the contract, he has to go to the same counter-party, which may result o attract some charges.

FUTURES CONTRACT

“Financial futures represent the most significant financial innovations of the last twenty years.”                             - As quoted by MERTON MILLER, a noble lauret’ 1999.

The father of financial derivatives is Leo Me lamed. The first exchange that traded in the financial derivatives was INTERNATIONAL MONETARY MARKET, wing of the Chicago Mercantile Exchange, Chicago, in the year 1972.

The futures market was designed to solve the problems, existing in the forwards market. A financial future is an agreement between two parties to buy or sell a standard quantity of a specified good/asset on a future date at an agreed price. Accordingly, future contracts are promises: the person who initially sells the contract promises to deliver a specified underlying asset to a designated delivery point during a certain month, called delivery month.  The underlying asset could, well be, a commodity, stock market index, individual stock, currency, interest rates etc.. The party to the contract who determines to pay a price for the goods is assumed to take a long position, while the other who agrees to sell is assumed to be taking a short position.

The futures contracts are standardized in the terms of:

·         Quantity of the underlying assets.

·         Quality of the underlying assets.

·         Date and month of the delivery.

·         Units of the price quotations and minimum price change, and

·         Location of the settlement.

It is due to the standardization that the futures contract have an edge with the forward contract, in the terms of: Liquidity, safety and the security to honoring the contract which is otherwise not secured in an OTC trading forwards contract.

In short, futures contract is an exchange-traded version of the usual forward contract. There are however, significant differences between the two and the same can be appreciated from the above discussion.

Benefits to Industry from Futures trading:

ü  Hedging the price risk associated with futures contractual commitments.

ü   Spaced out purchases possible rather than large cash purchases and its storage.

ü   Efficient price discovery prevents seasonal price volatility.

ü   Greater flexibility, certainty and transparency in procuring commodities would aid bank lending.

ü   Facilitate informed lending.

ü   Hedged positions of producers and processors would reduce the risk of default faced by banks.

ü   Lending for agricultural sector would go up with greater transparency in pricing and storage.

ü   Commodity Exchanges to act as distribution network to retail agri-finance from Banks to rural households.

ü   Provide trading limit finance to Traders in commodities Exchanges.

OPTIONS CONTRACT

Options have existed over a long period but were traded over the counter (OTC) only. These contracts are fundamentally different from that of futures and forwards. In the recent years options have become fundamental to the working of global capital markets. They are traded on a wide variety of underlying assets on both, the exchanges and OTC. Options like the futures are also available on many traditional products such as equities, stock indices, commodities and foreign exchange interest rates etc., options are used as a derivate instrument only in financial capital market in India and not in commodity derivatives. It is in the process in introduction.

Options, like futures, also speculative in nature. Options is a legal contract which, facilitate the holder of the contract, the right but not the obligations to buy or sell the underlying asset at the fixed rate on a future date. It should be highlighted that, unlike that the futures and forward contract the options gives the buyer of the contract, the right to enter into a contract and he doesn’t have to necessarily exercise the right to give, take the delivery.  When a contract is made the buyer has to pay some money as a ‘Premium’ to the seller to acquire such a right.

Options are basically of two types.

·         Call options

·         Put options

Call options:  A call options gives the buyer the right to buy the underlying asset at a strike price specified in the option. The profit/loss depends on the expiration date of the contract if the spot price exceeds the strike price the holder of the contract books a profit and vice-versa. Higher the spot price more is the profit.

Put options: A put option give the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying asset. If the spot price is below the strike price he makes profit and vice-versa. If the spot price is higher than the strike price he will wait up to the expiry or else book the profit early.

SWAPS:

Swaps were developed as a long-term price risk management instrument available on the over-the-counter market. Swaps are private agreements between two parties to exchange cash flows in the future according to a pre-arranged formula. These agreements are used to manage risk in the financial markets and exploit the available opportunity for arbitrage in the capital market. 

A swap, generically, is an exchange. In the financial parlance it refers to an exchange of a series of cash flows against another series of cash flows. Swaps are also used in the asset/liability management to obtain cost-effective financing and to generate higher risk-adjusted returns. With swaps, producers can effectively fix, i.e. lock in, the prices they receive over the medium to long-term, and consumers can fix the prices they have to pay. No delivery of the asset is involved; the mechanism of swaps is purely financial.

The swaps market originated in the late 1970’s, when simultaneous loans were arrange between British and the US entities to bypass regulatory barriers on the movement of foreign currency .the land mark transaction between the World Bank and the IBM in august 1981, paved the way for the development of a market that has grown from a nominal volume in the early 1980’s to an outstanding turnover of US $ 46.380tn in 1999.

 The swaps market offers several advantages like:

Ø  These agreements are undertaken privately while transactions using exchange traded derivatives are public.

Ø  Since the swaps products are not standardized, counter parties can customize cash-flow streams to suit their requirements

 The swaps can be regarded as portfolios of forward contracts. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
• 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 those in the opposite direction.