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Assignment of IFM

Evolution in the development of currency derivative trading in India

SUBMITTED TO: Mr. Liaqut Ali Class: MBA II C Roll no: 6300

SUBMITTED BY: Sahil Mittal

SCHOOL OF MANAGEMENT STUDIES, PUNJABI UNIVERSITY PATIALA

INTRODUCTION
The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. Gradually, this system of fixed prices came under immense stress. High inflation and unemployment rates made interest rates more volatile. Ultimately, the Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Price fluctuations, more often than not, make it extremely strenuous for businesses to estimate their future production costs and revenues. This has created various kinds of risks. In fact risks are inherent in all kinds of markets. Financial markets are no exception to the above and are systemically volatile. Therefore, it is the prime concern of all the financial agents to balance or hedge the related risk factors. This has induced the market participants to search for ways to manage risk. Derivatives are one of such risk management tools which are getting increased popularity in the current market dynamics. This paper shall discuss at length the legal and financial intricacies of derivatives trading in the Indian regulatory framework. Derivatives are considered to be extremely versatile financial instruments, as they help to manage risks, lower funding costs, enhance yields and diversify portfolios. The contributions made by derivatives have been so great, that they have been credited with having „changed the face of finance‟ in the world. Surprisingly, less than three decades ago, the global markets for derivatives barely even existed. However, today, the derivatives market has multiplied several times of its initial size and stands witness to its own rapid growth. Derivatives markets are an integral part of capital markets in developed as well as in emerging market economies. These instruments assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates or other assets, thereby, rendering both cash and derivatives

to the wide range of financial instruments included under the rubric of „derivatives‟ and also. notwithstanding anything contained in any other law for the time being in force. By allowing for the transfer of unwanted risk. This research paper makes an attempt to clarify that even though derivatives are complex instruments. in part due. to the complex nature of these instruments. thereby. it appears that the world market still has a further unaccounted potential for expansion.markets more efficient. It states that “Derivatives include: (a) a security derived from a debt instrument. increasing productivity. These markets have a tremendous scope for growth which needs to be efficiently tapped. derivatives usage is still a limited phenomenon owing to various factors. they are not conceptually inscrutable. and a subject capable of being understood only by „rocket scientists‟. Ironically. promote more efficient allocation of capital across the economy. which causes loss to an investor. „derivatives‟ continue to remain one of the most widely misused and misunderstood financial term. loan whether secured or unsecured. This is. share. „arcane‟. However. derivatives have often been described as „esoteric‟. The derivatives are not formally defined under any Act in India. risk instrument or contract for differences or any other form of security. and (b) a contract which derives its value from the prices or index of prices or underlying securities. derivatives can. except for a brief reference in Section 2(aa) of Securities Contract (Regulation) Act of India. quantifying the market risks of derivatives or understanding how they are priced requires an advanced knowledge of mathematics. These instruments also offer protection from possible adverse market movements and can be used to manage or offset exposures by hedging or shifting risks particularly during periods of volatility thereby reducing costs. DERIVATIVES: CONCEPT & SCOPE Despite extensive press coverage.” The Act also clarifies that. contracts in derivatives shall be legal and valid only if such contacts are traded on a recognized . There is an unfortunate perception among many that a derivative is anything. also. In many of the lesser-developed financial markets. Despite derivatives activity scaling new heights every year.

for example.” In general. cattle. In almost all common law jurisdictions. the term „derivative‟ itself indicates that it has no independent value. Different industry and regulatory groups have developed their own working definitions of „derivatives‟. When transactions mature. which provide useful insight into the range of financial instruments covered.) a financial asset for instance. which is an asset bought or sold in the cash market on normal delivery terms. It is narrower in scope since it confines the term to instruments to manage risks: “Derivatives are bilateral contracts involving the exchange of cash flows and designed to shift risk between parties. The value of a derivative is entirely derived from the value of a cash asset. oil or gold.” The global Study Derivatives Group has adopted a similar definition that has often been quoted: “A Derivative is a bilateral contract or payments exchange agreement whose value derives. instrument or simply „derivative‟ is to be sharply distinguished from the underlying cash asset. CASAC. the term „derivatives has no precise legal meaning ascribed to it.” Although the International Swaps and Derivatives Association‟s definition is not much different from either of the above definitions. A derivative contract.stock exchange and settled on a clearing entity of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange. thus precluding „OTC derivatives‟. from the value of an underlying asset or underlying reference rate or index. A simple derivative instrument hedges the risk component of an underlying asset. a share price Index) an interest rate a currency Another derivative. shares or bonds) an index (for instance. For example. product. rice farmers may wish to sell their harvest at a price which they consider is „safe‟ at a future date to . such as: • • • • • • A physical commodity (for instance wool. securities or indices. the amounts owed by each party are determined by the prices of underlying commodities. has defined a „derivatives instrument‟ as: “A financial instrument whose value is derived from some other thing. as its name implies.

TYPES OF DERIVATIVES IN INDIA At present the Indian market trades in both exchange-traded and over the counter derivatives on various assets including securities. which „obligates one counterparty to buy. amount and date in the future. currencies. both tangible and intangible. known as speculation. and the other counterparty to sell. a specific underlying at a specific price. FORWARD CONTRACTS A forward contract is defined as an agreement. known as hedging. or reduce their exposure to specific financial risks by transferring these risks to other parties who are willing to bear them at lower cost. Before proceeding with the regulatory issues of derivatives trading. In other words. which is to be performed mutually by the contracting parties. a . Indian and International financial markets trade innumerable derivative products on all kinds of underlying assets. etc. it is important to have a detailed understanding of the four generic derivative products in detail. The primary purpose behind investing in derivative instruments is to enable individual or corporate investors to either increase their exposure to certain specified risks in the hope that they will earn returns more than adequate to compensate them for bearing these added risks. farmers can enter into a forward contract and any loss caused by fall in the cash price of rice will then be offset by profits on the forward contract. 1. both equity and debt commodities. the various types of derivatives being traded in India are discussed below: • GENERIC DERIVATIVE PRODUCTS Today. on the contract date. at the term decided upon. To hedge their risks. in future. bipartite/tripartite contract. It is more clearly a one-to-one.eliminate the risk of a change in prices by that date.

at a specified price. Hence. In this case. Illiquidity and counter party risk were the two issues concerning forward contracts that offered the exchanges a tremendous business opportunity and they started trading these forward contracts. but with a difference. One of the parties to the contract assumes a long position. Assume that there are two parties. agrees to sell the asset. forward contracts offer tremendous flexibility to the contracting parties. FUTURES CONTRACTS A futures contract is similar to a forward contract. quality(in place of commodities). However. future contracts . It can be better understood with the help of an illustration. Mr. agrees to buy the underlying asset while the other assumes a short position. by both the contracting parties. it is called an Over-thecounter product. the counter party risk/default risk/credit risk is considerable in such contracts. B (seller). as thee contracts are mutually settled and generally not guaranteed by any third party. In order to differentiate between the exchange-traded forwards and the OTC forward. Like other OTC products. i. 2. the quantity (500 unites).forward contract is an agreement to buy or sell an asset on a specified future date for a specified price. It is pertinent to note that forward contracts are negotiated by the contracting parties on a one-toone basis and hence offer tremendous flexibility in terms of determining contract terms such as price. at a date in the future. who enter into a contract to buy and sell 500 units of asset X at Rs 100 per unit. the market renamed the exchange-traded forwards as Futures Contract. quantity. Furthermore. in that it is an agreement to buy or sell a specified commodity or instrument. As this contract is traded off the exchange and settled mutually by the contracting parties. i. in advance.e. they suffer from poor liquidity. at a predetermined time of two months from the date of contract. Delivery and payment (settlement of transaction) will take place as per the terms of the contract on the designated date and place. as they are customized. A (buyer) and Mr. delivery time and place. the product price (Rs 100 per unit) and the time of delivery (2 months from the date of contract) have been determined and well understood.e. the product(asset X).

futures markets are more liquid. they attract lower transaction costs. 3. Reasons for using futures contracts can be diversified and complicated. there is no requirement for large capital outlays as initial deposits range between five to fifteen percent only. and through the use of swap obtains financing at a more favorable rate than it would otherwise be able to do so. counterparty risk is minimal as it is unlikely that the clearinghouse would collapse.‟ Swap transactions are broadly classified into interest rate. based on fixed or floating interest rates in the same or different currencies. asset and liability management. the rules of a typical clearinghouse will provide for the allocation of the losses to the surviving participants according to a predetermined formula. Fourth. currency. and therefore. Any investor using futures contracts for hedging would be exposed to basis risk. A swap has been described as „an agreement between two parties to pay each other a series of cash flows. which are traded on the exchanges and settled through the clearing agency of the exchanges. Each counterparty borrows in the market where it enjoys a comparative advantage. The clearing agency also guarantees the settlement of these trades. a concept central to international trade. are customized over-the-counter transactions. In addition. „Basis risk‟ refers to the risk where the futures contract and the instrument that is being hedged may not be perfectly matched. commodity or equity swaps. First. Second. They are normally only a fraction of the costs of trading in the underlying commodity or instrument. Fifth. a major disadvantage of using futures contracts is their inflexibility. and yield enhancement. futures contracts permit anonymity of participants as most brokers act for undisclosed principals.are essentially standardized forward contracts. as it is usually well-backed financially. it is easier for the participants to „close-out‟ or settle their contracts. Third. It is possible to use swaps for a variety of purposes including the reduction of borrowing costs. Swap cash flows can be decomposed into equivalent cash flows from a bundle of simple . if a participant defaults. The principle of comparative advantage. plays an important role in swap transactions. However. SWAPS Swaps like forward contracts.

4. buying the option is called the buyer/holder of the option and the party taking a short position. Swaps are private agreements between two parties and are not traded on exchanges but they do have an informal market and are traded among dealers. which gives the buyer a right to sell the underlying asset is called put option. i. OPTIONS An option is the „right to buy or sell a specific price on or before a specific date in the future‟. has the obligation but no right. Swaps are now hedged with a variety of derivative products.forward contracts. A swap derivative is nothing but barter or an exchange but it plays a critical role in international finance. the option buyer may or may not exercise his option but if he decides to exercise it the option seller/writer is legally bound to honor the contract. or long premium or holder of option. . This has implications for the hedging of swap risks. has the right and no obligation with regard to buying or selling the underlying asset while the option seller/ writer who is also called short on option or short on premium. The party taking a long position. Currency Swaps help eliminate barriers caused by international capital markets. It is a right that the option seller gives to the option buyer to buy or sell an underlying asset at a predetermined price. The right to buy an asset is a „call option‟. While Currency rate swaps result in exchange of one currency with another. The option buyer who is also called long option. Swaptions is an option on swap that gives the party the right. An option which gives the buyer a right to buy the underlying asset. is called a call option and the option. In other words. Interest rate Swaps help eliminate barriers caused by regulatory structure. within or at the end of a specified period. in the contract. but not the obligation to enter into a swap at a later date.e. selling the option is called the seller/writer of the option.e. interst rate swaps help exchange a fixed rate of interest with a variable rate. and no longer only by matching two identical but opposing swaps. while the right to sell an asset is a „put option‟. i.

Options are available on a wide range of assets including commodities. India trades only exchange-traded commodity futures. Recently however. while a European option is one which can be exercised on maturity date. foreign currencies. viz. when futures contracts were introduced at its two major exchanges. This list of stocks was selected. shares. commenced trade in futures on June 9.An American option is one which can be exercise any time until maturity. trading has been regionally concentrated due to the regional nature of the commodity exchanges. • EQUITY DERIVATIVES India joined the league of exchange-traded equity derivatives in June 2000. The buyer of an option is usually called the „option holder‟. in 2001. The BSE sensitive index. 2000 respectively. Furthermore. at present. popularly known as the SENSEX (compromising 30 scrips). The option holder must pay the option writer a price known as the „premium‟ in order to acquire the rights under the option. FCRA does not even allow options on commodities. and the seller of the option. 2000 and June 12. Index options and individual stock options on 31 selected stocks were subsequently added to the derivatives basket. • COMMODITY DERIVATIVE The Forward Contract Regulation Act (FCRA) governs commodity derivatives in India. the „option writer‟. online . floating stock. and S&P CNX Nifty Index (compromising 50 scrips). India began trading in commodity derivatives through two nation-wide. Accordingly. we have only exchange-traded commodity derivatives. based on a predefined eligibility criteria linked to the market capitalization of stocks. November 2001 witnessed the introduction of single stock futures in the Indian market. etc. Though commodity derivatives in the country have existed for a long time. bonds and even other derivatives. the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Therefore. The FCRA specifically prohibits OTC commodity derivatives. liquidity. at this point in time.

There has also been significant progress in interest rate derivatives in the Indian OTC market. the business is concentrated with a limited number of market participants.commodity Exchanges. pension funds. At present. • CURRENCY DERIVATIVES India has been trading forward contracts in currency. CLASSIFICATION OF DERIVATIVES MARKETS Derivatives markets fall in two broad categories: exchange-traded derivatives markets and overthe counter (OTC) derivatives markets. silver. steel. mustard seed. banks. for the last several years. • INTEREST RATE DERIVATIVES An Interest Rate Derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate. the RBI has allowed options in the OTC market. financial institutions. • EXCHANGE-TRADED DERIVATIVES MARKET . The NSE introduced trading in cash settled interest rate futures in the year 2003. rubber.the National Commodities and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange (MCX). Recently. The OTC currency market in the country is considerably large and well-developed. It is important to note that both these exchanges have been recording a very high rate of growth. They started functioning in the last quarter of 2003 with the introduction of futures contracts on various assets such as gold. However. mutual funds. But it is interesting to note that the growth in volume of commodity derivatives has been achieved without institutional participation in the market. insurance companies and Foreign Institutional investors are not allowed to participate in the commodities market. etc.

the National Commodities and Derivatives Exchange(NCDEX) and the Multi Commodity Exchange(MCX). Kuala Lumpur Options and Financial Futures Exchange. Options and Forward Contracts are traded in Over the Counter Derivatives . The derivatives exchanges are a vital component of the global market for exchange-traded derivatives. Commodity and Monetary Exchange of Malaysia. The over-the-counter (OTC) derivatives markets are principal-to-principal dealer markets. Swaps. In a typical transaction. After the trade is executed. and in the other contract. Once the contract between two clearing members is registered. the Bombay Stock Exchange(BSE). Hong Kong Futures Exchange. In one contract. Some of the international exchanges where such derivatives are traded are The Sydney Futures Exchange. the legal nexus between the original buyer and seller is broken. • OVER-THE-COUNTER DERIVATIVES MARKETS. Products/contracts that are traded outside the exchanges are called OTC derivatives. the clearinghouse acts as buyer to the original seller. the contract between the two contracting floor members is then sent to the clearing house for registration. The clearinghouse does not guarantee the performance of the open contracts. the New Zealand Futures And Options Exchange.A derivatives exchange may simply be described as an organized market for the trading of derivatives contracts. the clearinghouse interposes itself between the buyer and seller. The various exchange traded derivatives market in India are the National Stock Exchange(NSE). Singapore Exchange Derivatives Trading Limited. The clearinghouse interposes itself between the buyer and seller and two new contracts come into existence. Rather it assumes the responsibility for performance by acting as the counterparty in both the contracts. They are contracts those which are privately traded between two parties and involve no exchange or intermediary. the client‟s order is routed to a floor member for execution.

Around the same period. government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. the Bombay Cotton Trade Association started futures trading way back in 1875. beginning the year 2000. OTC Contracts have substantial credit risk. History of Derivatives Markets in India Derivatives markets in India have been in existence in one form or the other for a long time. Sponsored Enterprises and Hedge Funds. The main participants of OTC market are the Investment Banks. Commercial Banks. are bilaterally negotiated between two parties. Unlike the exchange traded derivatives. 1995. the OTC derivatives markets are usually unregulated and operate on a caveat emptor basis. Derivatives trading shifted to informal forwards markets. those that trade informally in „havala‟ or forward markets.Market or OTC market. The OTC derivatives markets are predominantly institutional markets and individual transactions tend to be fairly large in size. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest. The OTC derivatives markets are much larger than the exchange-traded derivatives markets. OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve bank of India (RBI) or. and generally suffer from reduced liquidity. in the case of commodities (which are regulated by the forward markets commission). have no margining mechanisms. However. are less transparent. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance. national electronic commodity exchanges were also set up. and are often customized to fit the specific requirements of the user. while the exchange traded derivatives markets. on the other hand. In 1952. . In India. the Government of India banned cash settlement and options trading. which is the risk that the counterparty that owes money may defaults on the payment. have a significant retail component and their average transaction size tend to be much smaller. It provided for withdrawal of prohibition on options in securities. The OTC derivatives markets do not have a formal trading place. The terms of an OTC contract are flexible. saw lifting of ban on futures trading in many commodities. The last decade. In recent years. such as forwards and swaps. Govt. OTC contracts. In the area of commodities.

Trading of Equity Index Options at NSE Trading of Stock Options at NSE Trading of Single Stock futures at BSE Trading of Interest Rate Futures at NSE Weekly Options at BSE Trading of Chhota(Mini) Sensex at BSE Trading of Mini Index Futures & Options at NSE Trading of Currency Futures at NSE . 2008 August 29. RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps SIMEX chose Nifty for trading futures and options on an Indian index. Futures contracts on individual stocks were launched in November 2001. 2002 June 2003 September 13. The trading in BSE Sensex options commenced on June 4. C Gupta committee. L. 2001 and trading in options on individual securities commenced on July 2. index-based trading was permitted in options as well as individual securities. 2001 and the trading in options on individual securities commenced in July 2001. Nifty and Sensex. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges. In June 2003. Trading of Nifty futures commenced at NSE. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12. SEBI approved trading in index futures contracts based on various stock market indices such as. The trading in index options commenced on June 4. The index futures and options contract on NSE are based on S&P CNX. C. Gupta Committee to draft a policy framework for index futures. S&P CNX. C. Table :Derivatives in India: A Chronology Date 14 December 1995 18 November 1996 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 31 August 2000 June 2001 July 2001 November 9. Trading of BSE Sensex futures commenced at BSE. SEBI gave permission to NSE and BSE to do index futures trading. NSE3 and BSE4. Table 1 gives chronology of introduction of derivatives in India. Gupta Committee submitted report. SEBI setup L. Initially. 2008 January 1. Single stock futures were launched on November 9. 2001. 2004 January 1.2008 Progress NSE asked SEBI for permission to trade index futures. 2000. NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue.Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. Trading of futures and options on Nifty to commence at SIMEX. Subsequently. and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. 2001.

Chhota (mini) SENSEX 7 6 was launched on January 1. Reliance Industries and TISCO (renamed now Tata Steel). BSE 7 Bankex and BSE Oil & Gas. dollarrupee future platforms. Table 2 summarily specifies the derivative products and their date of introduction on the BSE Table: S. Currency futures were introduced on October 1. BSE achieved another milestone on September 13. It was followed by trading in index options on June 1. 2002. it allows for comparatively lower capital outlay. BSE FMCG. 8 Currency Futures on US Dollar Rupee Source: Complied from BSE website Derivatives Products Traded in Derivatives Segment of NSE NSE started trading in index futures.S. 2000 when it launched trading in Sensex based futures contract for the first time. on June 12. It permitted trading in the stocks of four leading companies namely.Sensex Stock Option on 109 Stocks Stock futures on 109 Stocks Weekly Option on 4 Stocks Chhota (mini) SENSEX Futures & Options on Sectoral indices namely BSE TECK. respectively.A.2004 January 1. 2001. Currently. With a small or 'mini' market lot of 5. BSE Metal. 2004 when it launched Weekly Options. State Bank of India. 2008 to enable participants to hedge their currency risks through trading in the U. based on popular S&P CNX Index. 2008 N.Sensex Index Options. Satyam. in stock options and single stock futures (31 stocks) on July 9.2008 Trading of Currency Futures at BSE Source: Complied from BSE and NSE Derivatives Products Traded in Derivatives Segment of BSE The BSE created history on June 9.2002 September 13.no 1 2 3 4 5 6 Products Traded in Derivatives Segment of the BSE Introduction Date June 9.October 2.2008 Product Traded with underlying asset Index Futures. 2001 and November 9. a unique product unparalleled worldwide in the derivatives markets.2000 June 1. October 1. the number of stocks under single futures and options is 109 . more precise hedging and flexible trading.2001 July 9. 2008. 2001 November 9. 2000 as its . lower trading costs.

2008 December 10. 2008 8 Growth of Derivatives Market in India Equity derivatives market in India has registered an "explosive growth" (see Fig. 2008 in Indian Derivatives market.S&P CNX Nifty 3 Stock Option on 233 Stocks 4 Stock futures on 233 Stocks 5 Interest Rate Futures. financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. The introduction of derivatives has been well received by stock market players.S&P CNX Nifty index 12 long Term Option contracts on S&P CNX Nifty Index 13 Currency Futures on US Dollar Rupee 14 S& P CNX Defty Futures & Options Source: Complied from NSE website Introduction Date June 12.T – Bills and 10 Years Bond 6 CNX IT Futures & Options 7 Bank Nifty Futures & Options 8 CNX Nifty Junior Futures & Options 9 CNX 100 Futures & Options 10 Nifty Midcap 50 Futures & Options 11 Mini index Futures & Options . 2001 November 9. whereas the value of the NSE .2001 June 23.no Product Traded with underlying asset 1 Index Futures. For example.2000 June 4.477. The futures contracts are available on 233 securities stipulated by the Securities & Exchange Board of India (SEBI) . Trading on index options was introduced on June 4. 130.2001 July 2.2008 August 29. 2001. the value of the NSE derivatives markets was Rs. 90. Table :Products Traded in F&O Segment of NSE S. In due course. The options contracts are American style and cash settled and are available on 233 securities. 2001. 2001. Trading in derivatives gained popularity soon after its introduction. in 2008.S&P CNX Nifty 2 Index Options.2007 October 5.75 Cr. Trading in interest rate futures was introduced on 24 June 2003 but it was closed subsequently due to pricing problem. Futures on individual securities started on November 9. Table 3 presents a description of the types of products traded at F& O segment of NSE. Introduced in 2000.2007 January 1. the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market.2007 June 1. 2008 March 3. Trading in options on individual securities commenced from July 2.first derivatives product.2005 June 1.2003 June 13. 2) and is expected to continue the same in the years to come. The NSE achieved another landmark in product introduction by launching Mini Index Futures & Options with a minimum contract size of Rs 1 lac.2003 August 29. NSE crated history by launching currency futures contract on US Dollar-Rupee on August 29. NSE alone accounts for 99 percent of the derivatives trading in Indian markets.

In recent years. respectively .cash markets was only Rs. followed by index futures with turnover shares of 52 percent and 31 percent. recommended a phased introduction of derivative products. In 1995. index futures outperform stock futures. The report of the L. government policy has changed. A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India. NSE improved the efficiency and transparency of the stock markets by offering a fully automated screen-based trading system and real-time price dissemination.. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. single stock futures also known as equity futures.551. However. In the equity markets. In 1993. a prohibition on trading options was lifted. set up by SEBI. allowing for an increased role for market-based pricing and less suspicion of derivatives trading. the NSE sent a proposal to SEBI for listing exchange-traded derivatives. 3. self-regulation by exchanges with SEBI providing a supervisory and . If we compare the trading figures of NSE and BSE.038 Cr. Gupta Committee. are most popular in terms of volumes and number of contract traded. and bilevel regulation (i. by the early 1900s India had one of the world‟s largest futures industry. performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories . the Bombay Cotton Trade Association started futures trading in 1875 and. In case of BSE. In the area of commodities. The ban on futures trading of many commodities was lifted starting in the early 2000s. Development of Derivative Markets in India Derivatives markets have been in existence in India in some form or other for a long time. the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. Among all the products traded on NSE in F& O segment.e. and national electronic commodity exchanges were created. C. In 1996. the government created the NSE in collaboration with state-owned financial institutions. a system of trading called “badla” involving some elements of forwards trading had been in existence for decades.

followed by index options in June 2001. Single stock options are less popular than futures. enabling it to rank 16 among world exchanges in the first half of 2005. or SC(R)A. accounting for about half of NSE‟s traded value in October 2005.” This allowed the regulatory framework for trading securities to be extended to derivatives. worked out various operational details such as the margining systems. R. Varma Committee in 1998. The Act considers derivatives to be legal and valid. These reforms allowed increased integration between domestic and international markets. single stock futures have become hugely popular. In 1999. respectively. the rupee was made fully convertible on current account. Index futures were introduced in June 2000. Derivatives Instruments Traded in India In the exchange -traded market. Index futures are . Finally. In fact. the Securities Contracts (Regulation) Act of 1956.advisory role). In particular. Derivatives on stock indexes and individual stocks have grown rapidly since inception. In August 1994. dollar has increased since 1991.S.e. Figure 1 shows how the volatility of the exchange rate between the Indian Rupee and the U. As of 2005. by the J. the biggest success story has been derivatives on equity products. and created a need to manage currency risk. but only if they are traded on exchanges. and options and futures on individual securities in July 2001 and November 2001. Another report. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. was amended so that derivatives could be declared “securities. NSE has the highest volume (i. the NSE trades futures and options on 118 individual stocks and 3 stock indices. number of contracts traded) in the single stock futures globally.The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk. A system of market-determined exchange rates was adopted by India in March 1993. All these derivative contracts are settled by cash payment and do not involve physical delivery of the underlying product (which may be costly). a 30-year ban on forward trading was also lifted in 1999.

2004). and shows that index futures have grown more strongly than index options. Importers. in contrast to equity derivatives. Total volume of commodity derivatives is still small. As interest rates in India have fallen. brokerages. 2005). OTC instruments in currency forwards and swaps are the most popular. Trading in OTC currency options is still muted. there has been little trading in them. and accounted for close to 40% of traded value in October 2005. 30 billion in 2004 (FitchRatings. less than half the size of equity derivatives (Gorham et al. and the growth in this market has been uneven. with daily value of trading estimated to be Rs. even though they have been around for longer. One problem with these instruments was faulty contract specifications.increasingly popular. or vice versa. In a currency swap. companies have swapped their fixed rate borrowings into floating rates to reduce funding costs. 2004). Institutional investors have preferred to trade in the OTC markets. and unregulated forwards markets. while the value of trading has increased almost four times in the same period (Nair. . Activity in OTC markets dwarfs that of the entire exchange-traded markets. banks and corporations may swap its rupee denominated debt into another currency (typically the US dollar or Japanese yen). resulting in the underlying interest rate deviating erratically from the reference rate used by market participants. 2003). including central and regional exchanges. Turnover and liquidity in this market has been increasing. although trading is mainly in shorter maturity contracts of one year or less (Gambhir and Goel. many contracts barely trade and. However. Figure 2 illustrates the growth in volume of futures and options on the Nifty index. Foreign exchange derivatives are less active than interest rate derivatives in India. exporters and banks use the rupee forward market to hedge their foreign currency exposure. Exchange-traded commodity derivatives have been trading only since 2000. of those that are active. There are no exchange-traded currency derivatives in India. trading is fragmented over multiple market venues. where instruments such as interest rate swaps and forward rate agreements are thriving.9 NSE launched interest rate futures in June 2003 but. The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004.

market insiders feel that this may be changing. and derivatives to manage credit risk. domestic financial institutions and mutual funds have shown great interest in OTC fixed income instruments. Indian insurance regulators.Foreign investors must register as foreign institutional investors (FII) to trade exchange-traded derivatives. and are exposed to different risks of default from their borrowers. for example. or to rebalance their existing portfolios. as indicated by the growing share of index derivatives (which are used more by institutions than by retail investors).Derivatives Users in India The use of derivatives varies by type of institution. Financial institutions. In contrast to the exchange-traded markets. Corporations are active in the currency forwards and swaps markets. they can incorporate locally as a . such as banks. In India. financial institutions have not been heavy users of exchange-traded derivatives so far. However. Since banks have little exposure to equity markets due to banking regulations. Why do institutions not participate to a greater extent in derivatives markets? Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market. Non-financial institutions are regulated differently from financial institutions. buying these instruments from banks. Thus. while state-owned banks remain a small presence (Chitale. and this affects their incentives to use derivatives. 2003). have assets and liabilities of different maturities and in different currencies. with their contribution to total value of NSE trades being less than 8% in October 2005. Transactions between banks dominate the market for interest rate derivatives. are yet to issue guidelines relating to the use of derivatives by insurance companies. they have little incentive to trade equity derivatives. they are likely to use derivatives on interest rates and currencies. Alternatively. and be subject to position limits as specified by SEBI.

If the derivatives transactions are taxable as “Income from Other Sources”.2008 . . i. Further. And as there was difficulty in managing the currency future along depending on FOREX with other derivatives traded in Security exchange market depending on SENSEX. Various currency derivatives have been introduced by NSE and MCX to make Indian Securities market globally competitive and larger.2007. Conclusion: The entire concept of taxation of derivatives is at crossroads. only the cost of acquisition. RBI and SEBI is now cooperating and working together manage this segment of future and option trading in India . the dilemma is that if the derivatives transactions are regarded as taxable under the head “Capital Gains”. cost of improvement and expenses in connection with the transfer are deductible. there is no provision for deduction of such provision.e.this segment has mostly benefited importer and exporter to manage their future risk by hedging there fund in currency future were they could lock there future currency exchange rate so that they could manage there risk in fluctuating Indian currency in international market. the real income theory would again require the deduction of such provision for loss in determining the taxable income. particularly as the gains would be computed and taxable only on the date of transfer. Therefore the RBI and SEBI came together and jointly formed an standing committee to analyze the trade in currency forward and future market around the world and thus laying down the guideline to introduce and manage the exchange traded currency future market in India. The committee has submitted the report on May 29. and not on any interim date. in computing capital gains. Such provision would therefore not be deductible if the derivatives transaction income is taxable as capital gains.Recent Developments RBI in order to regulate the currency market volatility has allowed the trading in currency future and forward on April 20. the date of squaring up or expiry of the derivatives.

it is likely that the derivative transactions will be put outside the ambit of speculative transactions based on the recommendations of the Committee and looking at the Government's commitment to deepen and modernize capital markets. the income/loss thereon should be assessed as normal business income / loss. In view of the aforesaid. there is a risk of such derivative transactions being treated as speculative transactions under the Act. The committee is of the view that the definition of speculative transaction in Section 43(5) of the Income Tax Act is fairly obsolete when viewed against the latest developments in the capital markets. speculative profits/losses are allowed to be setoff only against speculative losses/profits respectively. to my understanding. However. This conclusion is supported by the fact that derivatives have grown at explosive rates. Therefore. From the above discussion it is evident that derivative trading has left an indelible mark on the face of the global financial markets. derivatives transactions are pure business transactions and hence. more complex and less transparent. and at times trading in derivatives has even surpassed trading in their underlying instruments. one is advised to seriously consider the tax implications of entering into derivative transactions. as government is keen to make Indian securities market globally competitive by introducing innovative derivatives to play globally and fulfill the global market demand of Derivatives from Indian prospering Securities Market . The other view is that derivatives are covered under the definition of speculative transaction under section 43(5) of the Act in absence of delivery of the underlying security or commodity. setoff of such carried forward speculative losses is allowed to be setoff only against speculation profits. derivatives are more risky than other traditional financial products because they are highly leveraged. However. A high level panel consisting of a special three-member committee had been set up by the Department of Revenue to examine the definition of `Speculative Transactions' with respect to trading in financial derivatives. The unabsorbed speculative losses are allowed to be carried forward for 8 immediately succeeding assessment years. There could be two possible interpretations viz.The taxation of derivative transactions is not specifically dealt with under the Indian Income-tax Act (Act). Being relatively . Therefore. Under the Act.

1995) very aptly summarise the nature of derivatives: “Derivatives are not inherently bad or good.” .newer instruments. derivatives trading could prove to be not only safe but highly lucrative. but bearing the potential to do tremendous good. the underlying causes were the improper use of derivatives. and ignorance. It is firmly suggested that with the help of a comprehensive regulatory framework and the concurrent acceptance of the recommendations made above. They are a bit like electricity. Chairman of the United States Securities and Exchange Commission (when testifying before the Senate in January. greed. However. Losses from derivatives trading could have been reduced if there was proper disclosure of the risks involved. a closer scrutiny of the losses suffered by end-users reveals that in many cases. dangerous if mishandled. The following words of Arthur Levitt. there is a general lack of understanding of how they operate or how they should be managed.