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

to be more expensive and provide no statistically superior return over index futures.e.200 billion. with the recent downturn in the economy. with daily settlement (i. Reduction of fraud. a buy and a sell order of the same person made on a day shell be set off). With growing evidence According to the capital Asset Pricing Model. Empirical evidence has shoe that the most efficient and cost effective means of holding the market portfolio is by buying index futures. 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. 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. have seen double digit growth almost every month over the last year (the month of February saw a turnover of over Rs. study after study. though they took off with a tepid start. Unfortunately. That small investors benefit greatly from investing in stock futures rather than from investing in mutual funds.takes place and beginning 1st April 2002 the exchanges have moved to a T+3 settlement. 2 lakh per contract (lakh=0. The markets in derivatives.). Mutual funds have shown up.1 million)) and therefore access to more investors i.e. technology and costs. the minimum contract size had been fixed to discourage small and presumably unsophisticated investors from investing in the derivatives market. liquidity has dried up and exchanges are facing larger volatility in stocks. The exchanges are clamoring for a smaller contract size (The current limit is Rs. the case of protecting smaller investors by keeping them away from the derivatives market might not sound very noble in the future. easing of costs. .

Derivatives In Emerging Markets: From 1995 onwards. from when on NSE has been awaiting clearance from SEBI which is needed to launch the derivatives market. These steps in policy²making are supported by NSE¶s efforts in this direction. and the 1997 Union Budget announced policy measures towards more commodity future markets. The pepper futures markets of cochin is set to go international in a few weeks.Gupta committee to formulate the regulations through which exchange-traded derivatives can commence in India.C. The recently released report of the Tara pore Committee on Convertibility has recommended that exchange-traded derivatives should come about on the dollarrupee and on treasury bills. SEBI has constituted the L. NSE¶s developmental work towards exchange²traded derivatives began in 1995. . The focus of the work of this committee has been on equity index derivatives. a variety of developments have taking places in India on the subject of derivatives markets. This work was completed in middle 1996.

The first trade in derivatives was culmination of legislative and legal efforts which had begun as early 1995. 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. India managed to leapfrog as far as not just technology but also regulations. making a case for or against early introduction of and creating a regulatory frame work for a derivatives market. The entire exercise was a long dance without many consequences because. Their introduction took 20 years. This was done simply by defining securities to include and removing certain probations on forward and options trading. SEBI appointed a committee for exploring issues in introduction of. . it is easy to create a future on individual securities with the existing options available in the market by that standard. 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. After the committee report was tabled. In 1995. This is in sharp contrast to the introduction futures on individual stocks in the US. the first action was to wet nurse the derivatives market by adopting the entire regulatory frame work of securities. The introduction of new product has seen more of changes in the micro regulations like margining and default which are discussed subsequently.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. endless bickering between the two regulators SEC and CFTC.

These computers use the exchange¶s proprietary system and are not connected through internet-though one can trade in derivates through the internet. Bid-ask spreads are under 0. Trading terminals are spread over 100 cities in the country. no gesticulating people. which indicates the efficiency of the markets even without markets makers. There are no market pits. .2 percent on an average. People enter their trades through trading members who use their computer terminals which are connected to each other through VSATs (very small aperture terminals).Technology The derivatives segments of the two exchanges are fully screen based. no scraps of paper. and no market makers in any derivatives contract.

This was followed by approval for trading in options based on these two indexes and options on individual securities. which withdrew the prohibition on the securities. worked out the operational details of margining system. The report which was submitted in October 1998. did not take off.L. thus precluding OTC derivatives. . To begin with.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. the three-decade old notification which prohibited forward in securities.C. methodology for charging initial margins. NSE and BSE. The market for derivatives. 1996. SEBI approved trading in index futures contracts based on S & P CNX Nifty and BSE-30 (SENSEX) index. 1998. and their clearing house/corporations to commence trading and settlement in approved derivatives contracts. as there was no regulatory framework to govern trading of derivatives. SEBI permitted the derivatives segments of two stock exchanges. deposit requirement and real-time monitoring requirement. The government also rescinded in March 2000. SEBI also set a group to recommend measures for risk containment in derivatives market in India.Gupta on Nov 18. Derivatives trading commence in India in june-2000 SEBI granted the final approval to this effect in may-2001. broker net worth. however. The committee recommended that derivatives should be declared as µsecurities¶ so that regulatory framework Applicable to trading of µsecurities¶ could also govern trading of securities. SEBI set up a 24member committee under the chairmanship of Dr. to develop appropriate regulatory frame work for derivatives trading in India. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange. The committee submitted its report on March 17. The securities contract regulation act (SCRA) was amended in December 1999 to include derivatives within the ambit of µsecurities¶ and the regulatory frame work were developed for governing derivatives trading. prescribing necessary pre ± condition for introduction of derivatives trading in India. 1995.

The spot market involves both the transfer of ownership and the delivery of the commodity or instrument on the spot or immediately. 2000. 2001. 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. where the position involves equities. 2001 and trading in options on individual securities commenced in July 2001. The derivatives trading on NSE commenced S & P CNS Nifty index futures on june-12. The trading in index options commenced on June 4 3001 and trading on options on individual securities commenced on July 2. Currency futures. 2001. Single stock futures were launched on Nov 9. where the position involved fixed income securities. Equity futures. The futures contracts on individual stocks were launched in nov-2001. where the position involves foreign currencies.The trading in BSE SENSEX options commanded on june-04. The index futures and options contracted on NSE are based on S & P CNX. Financial Derivatives There are three types of financial derivatives viz. . Interest rate futures.. The price at which the exchange takes place is called the µcash¶ or µspot price¶. Spot Market The spot market is also called µcash market¶ where the sale and purchase of commodity takes place for immediate delivery.

the larger are the potential price movements. the larger the time period over which the forward contract is open. the other suffers. Problem of forward contracting ± the forward contracts are affected by the following problems: I. at a stated price and quantity. 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. For example. The forward market is like the real estate market in that any two consenting adults can form contracts against each other. but delivery of the commodity or instrument does not occur until some future date. The agreed upon price is called the µforward price¶ with a forward market the transfer of ownership occurs on the spot. .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. Such transaction would take place through a forward market. the basic problem is that of too much flexibility and generality. Lack of centralization of trading Illiquidity Counter party risk In the first two of these. Forward markets have one basic property. Counter party risk in forward markets arises when one of the two parties of the transaction chooses to declare bankruptcy. No money changes hands at the time the deal is signed. Even when forward markets trade standardized contracts. and hence avoid the problem of illiquidity. In a forward contract. and hence the larger is the counterpart risk. This often specific situation. II. but makes the contracts non-tradable. two parties agree to do a trade at some future date. the counterpart risk remains a very real problem. III.

security or currency at a predetermined future date at a price upon today. There is no counterparty risk. The only negotiable. Future markets were designed to solve all the three problems mentioned above of forward markets.e. Futures markets are exactly like forward markets in terms of basic economics.Future Contract A futures contract is a financial security. security or currency on a specified future date at a price agreed when the contract is entered into. Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price. it is this element which makes the agreement tradable ± i. . so that futures markets are highly liquid. unlike in forward markets. traded for itself. contracts are standardized and trading is centralized. issued by an organized exchange to buy or a commodity. However. changeable element must be the price agreed when entering into the contract. A futures contract provides both a right and an obligation to buy or sell a standard amount of a commodity. 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 agreed upon price is calls the µfutures¶ price. A key element of any successful traded futures contract must be the characteristic of standardization. In India. increasing the time to expiration does not increase the counterparty risk. In futures markets. the futures market is started and regulated for castor and black pepper. The contracts have certain standardized specifications.

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 .

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

The OTC contracts are generally not regulated by a regulatory authority and the exchange¶s self regulatory organization. which has accompanied of financial activities the recent developments in information technologies have contributed o a great extent to these developments. leverages. and for safe guarding the collective interest of market participants. There are no formal rules for mechanisms for ensuring market stability and integrity. the former have rigid structures compared to the latter. The management of the counter party (credit) risk is decentralized and located within individual institutions. although they are affected indirectly by national legal system. 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. banking supervision and market surveillance. 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. .Exchange traded v/s OTC (Over The Counter) derivatives market: The OTC derivatives markets have witnessed rather sharp growth over the last few years. or margining. There are no formal rules for risk and burden sharing. There are no formal centralized limits on individual positions. While both exchange-trade and OTC derivatives contracts offer many benefits.

This will protect against a fall in price in the spot market as it produces a gain if spot price fall.Mechanism in Futures Contracts The selling and buying of futures contracts is a way of describing commitments. .  Finance cost that is interest forgone on funds used for purchase of the commodity.  Sell a future to agree to market delivery of a commodity. Selling a future is said to be going short.  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. a seller of a future can sell without previously having bought. Buying a future is said to be going long. 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. 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.

Then the futures price tends to rise over time to equal the spot price on the delivery. In general. exclusive of commission. the future price may be lower than spot price. especially perishable commodities than in financial futures. the futures price tends to fall over time towards the spot. the basis is zero and future price equals spot price. the settlement price is determined by the spot price. If the spot price is greater than the futures price it is called µbackwardation¶. are determined by supply and demand. In special cases. 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. . Therefore there in a close relationship between spot and future prices. These factors play a much more important in commodities. In this case. Generally basis will decrease with time. the actual value may vary depending on demand on supply of the underlying at present and expectations about the future. On the delivery date itself. particularly as the delivery date becomes due. This is known as the contango market. Prices. And on expiry. the basis is not constant. equaling the spot price on delivery day. but prior to this the future price could above or below the spot. the future price is greater than the spot price. Under normal market conditions futures contracts are priced above the spot price. The futures price is the markets expectation of what the spot price will be on the delivery date on the particular contracts. If the futures price is greater than the spot it is called µcontango¶. when cost of carry is negative.Apart from the theoretical value.

The direction of the change in price tends to hold for cycles of contracts with different delivery dates. a contract with a positive basis. although this will be lower in nearby delivery dates than in far-off delivery dates. If the spot price is expected to be stable over the life of the contract. . where nearer maturing contracts have higher futures prices than far-off maturing contracts. 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. Conversely.This may happen when the cost of carry is negative. This is a normal contango. normal backwardation is the result of a negative basis.