STRUCTURE OF THE MARKET

Overview of the stock market in India

The stock market in India has developed more over the last few years than it has over
its history of over hundred years. The introduction of screen based trading in 1995 by
the ten newly developed national stock exchange of India (NSE) was responsible for a
similar development by other stock exchanges in the country. The capital market is
essentially comprised of the Bombay Stock Exchange (BSE, perhaps the oldest stock
exchange in Asia) and National Stock Exchange. Together they account for over 90% of
the trades in the secondary markets. Development of a screen based trading system
brought far reaching access and speed, but the market infrastructure still was poorly
developed and a typical clearing and settlement cycle took over 14 days. For registering
a share after a transaction, postal delays, the mercy of the share registers, thefts while
in postal service and mismatched transfer signatures were some of the systematic risks
a buyer of an Indian stock had to face. Over the last few years more and more stocks
have been put on the compulsorily dematerialized list (over 99% of all shares traded
today are in a paperless form). If someone does have a particular fetish for a physical
stock certificate, he/she would still need to buy a dematerialized stock and then have it
sent for conversion into physical mode, since trading in physical stocks is prohibited
while holding is not.

Competition amongst the two largest exchanges has brought enormous benefits
to shareholders in terms of providing better and more cost effective service. As if that
were not enough, a competing depository (established by the BSE) has brought down
prices in that industry by over 80%. The market for exchange-traded derivatives started
in June of 2000 when the stock exchanges almost simultaneously started trading in
future on indices. The exchanges created separate segments where derivatives trading
would take place. These segments would have a separate set of regulations and a
separate clearing and settlement mechanism. The guarantee fund is also separate from
the stock market (also called the cash segment). The last few months have seen a
movement in the cash segment to a T+5.T+n refers to the number of days after the
execution of the contract of sale/purchase that the final exchange of funds/securities
takes place and beginning 1st April 2002 the exchanges have moved to a T+3
settlement, with daily settlement (i.e. a buy and a sell order of the same person made
on a day shell be set off). Reduction of fraud, easing of costs, easing of complications
and a virtual elimination of mistakes in clearing and settlement of securities have made
the Indian capital markets amongst the best in terms of efficiency, technology and costs.
Unfortunately, with the recent downturn in the economy, liquidity has dried up and
exchanges are facing larger volatility in stocks. The markets in derivatives, though they
took off with a tepid start, have seen double digit growth almost every month over the
last year (the month of February saw a turnover of over Rs.200 billion.). The exchanges
are clamoring for a smaller contract size (The current limit is Rs. 2 lakh per contract
(lakh=0.1 million)) and therefore access to more investors i.e. the minimum contract size
had been fixed to discourage small and presumably unsophisticated investors from
investing in the derivatives market. With growing evidence According to the capital
Asset Pricing Model, the most efficient portfolio is a combination of the market portfolio
and risk-less securities – the combination dependent upon the risk averseness of the
investor. Empirical evidence has shoe that the most efficient and cost effective means
of holding the market portfolio is by buying index futures. Mutual funds have shown up,
study after study, to be more expensive and provide no statistically superior return over
index futures.

That small investors benefit greatly from investing in stock futures rather than
from investing in mutual funds, the case of protecting smaller investors by keeping them
away from the derivatives market might not sound very noble in the future.
Derivatives In Emerging Markets:

From 1995 onwards, a variety of developments have taking places in India on the
subject of derivatives markets. The pepper futures markets of cochin is set to go
international in a few weeks, and the 1997 Union Budget announced policy measures
towards more commodity future markets. SEBI has constituted the L.C.Gupta
committee to formulate the regulations through which exchange-traded derivatives can
commence in India. The focus of the work of this committee has been on equity index
derivatives. The recently released report of the Tara pore Committee on Convertibility
has recommended that exchange-traded derivatives should come about on the dollar-
rupee and on treasury bills. These steps in policy—making are supported by NSE’s
efforts in this direction. NSE’s developmental work towards exchange—traded
derivatives began in 1995. This work was completed in middle 1996, from when on NSE
has been awaiting clearance from SEBI which is needed to launch the derivatives
market.
Derivatives Regulations – A Brief Conspectus (SEBI)

June 2000 saw the introduction of financial derivatives in the country for the first
– even though carry forward of positions and weekly settlement had meant that a quasi
– forward market existed for our country. The first trade in derivatives was culmination
of legislative and legal efforts which had begun as early 1995. In 1995, SEBI appointed
a committee for exploring issues in introduction of, making a case for or against early
introduction of and creating a regulatory frame work for a derivatives market.

After the committee report was tabled, the first action was to wet nurse the
derivatives market by adopting the entire regulatory frame work of securities. This was
done simply by defining securities to include and removing certain probations on
forward and options trading. Thus the entire framework of existing securities regulations
including anti-fraud and virus disclosures obligations have become part of the
regulations of derivatives in India. This is in sharp contrast to the introduction futures on
individual stocks in the US. Their introduction took 20 years, endless bickering between
the two regulators SEC and CFTC, a new act which lays down several requirements for
trading which should rightfully be in the buy-laws of the exchange/board of trade and a
not too definitive division of responsibilities between the two agencies which have had a
not too pleasant past. The entire exercise was a long dance without many
consequences because, it is easy to create a future on individual securities with the
existing options available in the market by that standard, India managed to leapfrog as
far as not just technology but also regulations. The introduction of new product has seen
more of changes in the micro regulations like margining and default which are
discussed subsequently.
Technology

The derivatives segments of the two exchanges are fully screen based. There
are no market pits, no gesticulating people, no scraps of paper, and no market makers
in any derivatives contract. Bid-ask spreads are under 0.2 percent on an average, which
indicates the efficiency of the markets even without markets makers. Trading terminals
are spread over 100 cities in the country. People enter their trades through trading
members who use their computer terminals which are connected to each other through
VSATs (very small aperture terminals). These computers use the exchange’s
proprietary system and are not connected through internet-though one can trade in
derivates through the internet.
Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the
promulgation of the securities Laws (Amendment) Ordinance, 1995, which withdrew the
prohibition on the securities. The market for derivatives, however, did not take off, as
there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-
member committee under the chairmanship of Dr.L.C.Gupta on Nov 18, 1996, to
develop appropriate regulatory frame work for derivatives trading in India. The
committee submitted its report on March 17, 1998, prescribing necessary pre –
condition for introduction of derivatives trading in India. The committee recommended
that derivatives should be declared as ‘securities’ so that regulatory framework
Applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set
a group to recommend measures for risk containment in derivatives market in India. The
report which was submitted in October 1998, worked out the operational details of
margining system, methodology for charging initial margins, broker net worth, deposit
requirement and real-time monitoring requirement. The securities contract regulation act
(SCRA) was amended in December 1999 to include derivatives within the ambit of
‘securities’ and the regulatory frame work were developed for governing derivatives
trading. The act also made it clear that derivatives shall be legal and valid only if such
contracts are traded on a recognized stock exchange, thus precluding OTC derivatives.
The government also rescinded in March 2000, the three-decade old notification which
prohibited forward in securities.

Derivatives trading commence in India in june-2000 SEBI granted the final

approval to this effect in may-2001. SEBI permitted the derivatives segments of two
stock exchanges, NSE and BSE, and their clearing house/corporations to commence
trading and settlement in approved derivatives contracts. To begin with, SEBI approved
trading in index futures contracts based on S & P CNX Nifty and BSE-30 (SENSEX)
index. This was followed by approval for trading in options based on these two indexes
and options on individual securities.
 The trading in BSE SENSEX options commanded on june-04, 2001 and trading
in options on individual securities commenced in July 2001. The futures contracts on
individual stocks were launched in nov-2001. The derivatives trading on NSE
commenced S & P CNS Nifty index futures on june-12, 2000. The trading in index
options commenced on June 4 3001 and trading on options on individual securities
commenced on July 2, 2001. Single stock futures were launched on Nov 9, 2001. The
index futures and options contracted on NSE are based on S & P CNX. Trading and
settlement in derivatives contracts is done in accordance with the rules by laws and
regulations of the respective exchanges and their clearing house corporation duly
approved by SEBI and notified in the official gazette. Foreign institutional investors
(FIIs) are permitted to trade in all exchanges treaded derivative product.

Financial Derivatives

There are three types of financial derivatives viz.,

Currency futures, where the position involves foreign currencies.

Interest rate futures, where the position involved fixed income securities.
Equity futures, where the position involves equities.

Spot Market

The spot market is also called ‘cash market’ where the sale and purchase of
commodity takes place for immediate delivery. The price at which the exchange takes
place is called the ‘cash’ or ‘spot price’. The spot market involves both the transfer of
ownership and the delivery of the commodity or instrument on the spot or immediately.
Forward Contract

A forward contract is an agreement made today between a buyer and seller to

exchange the commodity or instrument for cash at a predetermined future date at a
price agreed upon today. The agreed upon price is called the ‘forward price’ with a
forward market the transfer of ownership occurs on the spot, but delivery of the
commodity or instrument does not occur until some future date.

In a forward contract, two parties agree to do a trade at some future date, at a

stated price and quantity. No money changes hands at the time the deal is signed. For
example, a wheat farmer may wish to contract to sell their harvest at a future date to
eliminate the risk of a change in prices by that date. Such transaction would take place
through a forward market. Problem of forward contracting – the forward contracts are
affected by the following problems:

I. Lack of centralization of trading

II. Illiquidity
III. Counter party risk

In the first two of these, the basic problem is that of too much flexibility and
generality. The forward market is like the real estate market in that any two consenting
adults can form contracts against each other. This often specific situation, but makes
the contracts non-tradable.

Counter party risk in forward markets arises when one of the two parties of the
transaction chooses to declare bankruptcy, the other suffers. Forward markets have one
basic property; the larger the time period over which the forward contract is open, the
larger are the potential price movements, and hence the larger is the counterpart risk.
Even when forward markets trade standardized contracts, and hence avoid the problem
of illiquidity, the counterpart risk remains a very real problem.
Future Contract

A futures contract is a financial security, issued by an organized exchange to buy

or a commodity, security or currency at a predetermined future date at a price upon
today. The agreed upon price is calls the ‘futures’ price.

Futures are exchange-traded contracts to sell or buy financial instruments or

physical commodities for future delivery at an agreed price. There is an agreement to
buy or sell a specified quantity of financial instrument/commodity in a designated future
month at a price agreed upon by the buyer and seller. The contracts have certain
standardized specifications.

Future markets were designed to solve all the three problems mentioned above
of forward markets. Futures markets are exactly like forward markets in terms of basic
economics. However, contracts are standardized and trading is centralized, so that
futures markets are highly liquid. There is no counterparty risk. In futures markets,
unlike in forward markets, increasing the time to expiration does not increase the
counterparty risk.

A futures contract provides both a right and an obligation to buy or sell a

standard amount of a commodity, security or currency on a specified future date
at a price agreed when the contract is entered into. A key element of any
successful traded futures contract must be the characteristic of standardization; it
is this element which makes the agreement tradable – i.e. traded for itself. The
only negotiable, changeable element must be the price agreed when entering
into the contract.

In India, the futures market is started and regulated for castor and black pepper.
Standardized term in Futures

The standardized items in any futures contract are:

Quantity of the underlying

Quality of the underlying (not required in financial futures)
The date and month of delivery
The units of price quotation (not the price itself) and minimum change in price
(tick-size)
Location of settlement
Commodity Derivatives:

Futures contracts in pepper, turmeric, gur (jiggery), hessian (jute fabric), jute
sacking, castor seed, potato, coffee, cotton and soya bean and its derivatives are traded
in 18 commodity exchanges located in various parts of the country. Futures trading in
other edible oil, oil seeds and oil caked have been permitted. Trading futures in the new
commodities, especially in edible oil is expected to commence in the near future. The
sugar industries exploring the merits of trading sugar future contracts. The policy
initiatives and the modernization program include extensive training, structuring reliable
clearing house, establishment of a system of warehouse receipts and the thrust towards
the establishment of the national commodity exchange. The government of India has
constituted a committee to explore and evaluate issues pertinent to the establishment
and the funding of the proposed national commodity exchange for the nationwide
trading of commodity futures contracts and the other institutions and institutional
processes such as warehousing and clearing house. With commodity futures, delivery is
best affected using warehouse receipts (which are like dematerialized securities).
Warehousing functions have enabled viable exchanges to augment their strengths in
contracts design and trading. The viability of national commodity exchanges predicted
on the reliability of the warehousing functions. The program for establishing a system of
warehouse receipts is in process. The coffee futures exchange India (COFEI) has
operated a system of warehouse receipts since 1998.
Exchange traded v/s OTC (Over The Counter) derivatives market:

The OTC derivatives markets have witnessed rather sharp growth over the last
few years, which has accompanied of financial activities the recent developments in
information technologies have contributed o a great extent to these developments.
While both exchange-trade and OTC derivatives contracts offer many benefits, the
former have rigid structures compared to the latter. It has been widely discussed that
the highly leveraged institutions an OTC derivatives positions were the main cause of
turbulence in financial markets in 1998. These episodes of turbulence revealed the risk
caused to market stability originating features of OTC derivative instruments and
markets. The OTC derivatives markets have the following features compared to
exchange traded derivatives.

The management of the counter party (credit) risk is decentralized and

located within individual institutions.
There are no formal centralized limits on individual positions, leverages, or
margining.
There are no formal rules for risk and burden sharing.
There are no formal rules for mechanisms for ensuring market stability and
integrity, and for safe guarding the collective interest of market participants.
The OTC contracts are generally not regulated by a regulatory authority and
the exchange’s self regulatory organization, although they are affected
indirectly by national legal system, banking supervision and market
surveillance.
Mechanism in Futures Contracts

The selling and buying of futures contracts is a way of describing commitments, a

seller of a future can sell without previously having bought. In commodities futures
market the following conventions apply:

 Buy a future to agree to take delivery of s commodity. This will protect against a
rise in price in the spot market as it produces a gain if spot prices rise. Buying a
future is said to be going long.
 Sell a future to agree to market delivery of a commodity. This will protect against
a fall in price in the spot market as it produces a gain if spot price fall. Selling a
future is said to be going short.

Determination of Futures Price – The futures price is determined as follows:

Future price = Spot price + Cost of carrying

 The spot price is the current price of commodity.

 The cost of carrying of a commodity will be the aggregate of the following:
 Storage
 Insurance
 Transport costs involved in delivery of commodity at an agreed place.
 Finance cost that is interest forgone on funds used for purchase of the
commodity.
 Apart from the theoretical value, the actual value may vary depending on
demand on supply of the underlying at present and expectations about the future.
These factors play a much more important in commodities, especially perishable
commodities than in financial futures.
In general, the future price is greater than the spot price. In special cases, when
cost of carry is negative, the future price may be lower than spot price.
Prices, exclusive of commission, are determined by supply and demand. The
futures price is the markets expectation of what the spot price will be on the delivery
date on the particular contracts. Therefore there in a close relationship between spot
and future prices, particularly as the delivery date becomes due.
On the delivery date itself, the settlement price is determined by the spot price,
but prior to this the future price could above or below the spot. The difference is known
as the basis where:

Basic = Futures – spot price

Although the spot price and futures prices generally move in line with each other,
the basis is not constant. Generally basis will decrease with time. And on expiry, the
basis is zero and future price equals spot price.
If the futures price is greater than the spot it is called ‘contango’. Under normal
market conditions futures contracts are priced above the spot price. This is known as
the contango market. In this case, the futures price tends to fall over time towards the
spot, equaling the spot price on delivery day. If the spot price is greater than the futures
price it is called ‘backwardation’. Then the futures price tends to rise over time to equal
the spot price on the delivery.
 This may happen when the cost of carry is negative, or when the underlying
asset is in short supply in the cash market but there is an expectation of increased
supply in future – example agricultural products.
The direction of the change in price tends to hold for cycles of contracts with
different delivery dates. If the spot price is expected to be stable over the life of the
contract, a contract with a positive basis, although this will be lower in nearby delivery
dates than in far-off delivery dates. This is a normal contango. Conversely, normal
backwardation is the result of a negative basis, where nearer maturing contracts have
higher futures prices than far-off maturing contracts.