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Financial derivatives : Potential of derivative

market in India and emerging derivatives
market structure in India
Parmjit Kaur

Derivatives are recognized as the best and most cost-efficient way of meeting
the felt need for risk hedging in certain types of commercial and financial
operations. Countries not providing such globally accepted risk hedging facili-
ties are disadvantaged in today's rapidly integrating global economy.

he past decade has witnessed tives have quickly spread to an increas- nancial system. The growth and de-
an explosive growth in the use ing number of developed and devel- velopment of Indian Capital Market,
of financial derivatives by a oping countries. They are recognized in particular during the last decade
wide range of corporate and finan- as the best and most cost-efficient way has been spectacular. The impact of
cial institutions. This growth has run of meeting the felt need for risk hedg- international trends of the developed
in parallel with the increasing direct ing in certain types of commercial and and emerging capital markets were
reliance of companies on the capital financial operations. Countries not pro- evident in India also. The turnover
markets as the major source of long- viding such globally accepted risk is developed markets has grown
term funding. In this respect, deriva- hedging facilities are disadvantaged in more sharply than that in emerging
tives have a vital role to play in en- today's rapidly integrating global markets. This is a fact that fin stock
hancing shareholder value by ensur- economy. The liberalization and open- markets worldwide have grown in
ing access to the cheapest source of ing up of the Indian economy has pre- size as well as depth during the last
funds. Furthermore, active use of de- cipitated the process of integration of 10 years. The aggregate turnover of
rivative instruments allows the over- India's financial market with the inter- all markets has grown nearly 9 times
all business risk profile to be modi- national financial markets. from US$5.5 Trillion in 1990 to US$
fied, thereby providing the potential 47.9 Trillion in 2000. U.S Securities
The Position of Indian Capital
to improve earnings quality by off- Markets doubled its share in total
Market in terms of Global Com-
setting un- desired risks. turnover between 1990 & 2000.
The derivatives came into the spot- India accounted for 1.1 % total
The importance of capital mar-
light alongwith the rise in uncertainty turnover during the year 2000,
ket in any economy can not be over
of post 1970, when US announced an inspite of the fact that it has the larg-
emphasised. The development of
end to the Bretton Woods System of est number of listed companies in the
capital market is vital for the growth
fixed exchange rates leading to intro- world. The market capitalisation of
of real economy. A significant fea-
duction of currency derivatives fol- all listed companies taken together
ture of developed capital market is
lowed by other innovations including on all markets of the world increased
the degree of its integration and in-
stock index futures. Since then, deriva- by 245% from US$ 9.4 Trillion at the
teraction with major sectors of the
Economy. A stronger capital market end of 1990 to US$ 32.3 Trillion at
Faculty, University Business School, the end of 2000. The share of U.S.
Panjab University, Chandigarh promotes sound and sustainable fi-

in worldwide market capitalization 1. What do you mean by deriva- or a cash payment to the counter party.
increased from 38.5% as at the end tives? The term "derivative" indicates
of 1995 to 46.8% as at the end of The term derivative instru- that it has no independent value, i.e.
2000. The share of India Listed com- ment is generally accepted to mean its value is entirely "derived" from
panies accounted for 0.5% of total a financial instrument with a payoff the value of the cash asset. A deriva-
market capitalization. The market structure determined by the value of tive contract or product, or simply
capitalization as per out of GDP in an underlying security, commodity, "derivative", is to be sharply distin-
India stood at 41.3% at the end of interest rate, or index. According to guished from the underlying cash
the year 1999. The following table some notable surveys, over 80% of asset, i.e. the asset brought / sold in
shows the position of Indian Capital private sector corporations consider the cash market on normal delivery
Market in terms of International derivatives to be important in imple- terms. A general definition of "de-
comparison. (Table 1 below) menting their financial policies. De- rivative" may be suggested here as
The Deregulation, Liberalization rivatives have also gained wide ac- follows: "Derivative" means for-
and Globalization of the Indian ceptance among national and local ward, future or option contract of
Economy has provided much needed governments, government - spon- pre-determined fixed duration,
impetus to the Capital Market for its sored entities, such as the Student linked for the purpose of contract
growth and development. The earlier Loan Marketing Association and the fulfillment to the value of specified
reforms facilitated faster growth and Federal Home Loan Mortgage Cor- real or financial asset or to index of
the latest one focussed on strength- poration, and supranational, such as securities. Derivatives offer organi-
ening the functioning of the capital the World Bank. zations the opportunity to break fi-
Markets in India by adoption and im- Derivatives are used to lower nancial risks into smaller compo-
plementation of best international funding costs by borrowers, to effi- nents and then to buy and sell those
practices, systems and products. This ciently alter the proportions of fixed components to best meet specific risk
trend will definitely increase the ef- to floating rate debt, to enhance the management objectives.
ficiency and effectiveness of Indian yield on assets, to quickly modify the As both forward contracts and
Stock Market. assets payoff structure to correspond futures contracts are used for hedg-
Objectives of the Study to the firm's market view, to avoid taxes ing, it is important to understand the
and skirt regulations, and perhaps most distinction between the two and their
(1) What do you mean by deriva-
importantly, to transfer market risk relative merits. Forward contracts are
(hedge)- where the term market risk is private bilateral contracts and have
(2) To Identify the emerging de- used to connote the possibility of losses well established commercial usage.
rivatives Markets structure in sustained due to an unforeseen price They are exposed to default risk by
India. or volatility change. A firm may ex- counter-party. Each forward contract
(3) What is the potential of de- ecute a derivative transaction to alter is unique in term of contract size,
rivatives Market in India? its market risk profile by transferring expiration date and the asset type/
(a) Benefits of Derivatives to the trade's counter party a particu- quality. The contract price is not
(b) Risk of Derivatives lar type of risk. The price that the firm transparent, as it is not publicly dis-
must pay for this risk transfer is the closed. Since the forward contract is
Findings of the Study
acceptance of another type of risk and/

International Comparison end December, 2000.
Particular USA UK Japan Germ- Singa- Hong- China India
any pore Kong
No.of listed company 7524 1904 2561 1022 418 779 1086 9922
Market Cap. ($bn) 15104 2577 3157 1270 153 623 581 166
Market Capitalization Ratio (%) 358.8 130.7 66.4 50.8 95.9 228.8 73.6 54.5
Turnover ($bn) 31862 1835 2694 1069 91 378 72.2 621
Turnover Ratio (%) 200.8 66.6 69.9 79.1 52.1 61.3 158.3 374.7

not typically tradable, it has to be set- tract may be for a commodity or for derivatives deal with uncertainties.
tled by delivery of the asset on the a security; which is done on a fixed Derivative always indicate it has no
expiration date. In contrast, futures amount of maturity period and not independent value and are always
contracts are standardized tradable flexible like forward contract but separated from the underlying cash
contracts. They are standardized in done on fixed dates, like in London asset i.e., the asset bought or sold in
terms of size, expiration date and all International Financial Futures Ex- cash market on normal delivery
other features. They are traded on change it happens on 2nd Wednes- terms.
specially designed exchanges in a day of March, June, September and
highly sophisticated environment of December, trading is done at same Hedging
stringent financial safeguards. They price for all the participants at one Hedging is basically a protection
are liquid and transparent. Their point of time at the exchange floor against risk. Through the following
market prices and trading volumes (whereas forward contract trading is examples this has been clarified.
are regularly reported. The futures normally done over phone or fax and (2) To Identify the emerging de-
trading system has effective safe- not across the floor) and most fun- rivatives Markets structure in
guards against defaults in the form nily, the transactions on futures are India?
of Clearing Corporation guarantees honoured by cancellation or reverse Apart from traditional financial
for trades and the daily cash adjust- transaction. On future contract, ques-
markets, two more markets are
ment (mark to market) to the ac- tion of counter party risk does not
emerging, namely, the derivatives
counts of trading members based on arise because of mandatory margin
market has come into being recently
daily price change. Futures are far and daily adjustments of margins on
and the bancassurance market, which
more cost-efficient than forward con- price movements and further more
is likely to emerge in an important
tracts for hedging. the exchange itself is a party to each
way once banks start undertaking
The various types of derivatives, and every future contract.
insurance business derivatives in the
commonly used allover the world. Crux Point Indian financial markets are of recent
The ultimate world of derivative origin barring trade related forward
is uncertainty. Derivative is not a contracts in the forex market. Futures
synonym of transactions in shares, markets in the commodity segment,
currencies, commodities, or mort- however, have existed for a long
gages, they are mainly transactions time. Recently, over the counter as
in UNCERTAINTY. well as exchange traded derivatives
A thing which is sure and certain, have been introduced, marking an
on which there cannot be any risk important development in the struc-
Options - Put / Call factor and, therefore, quantum of ture of financial markets in India.
A put or call option gives a right adopting derivative methods does not Forward contracts in the forex mar-
without the obligation to buy (call) arise. Mathematically uncertainties ket have also been liberalized. Ex-
or sell (put) a given security in the stay between 0 and 1. If something change traded derivatives tend to be
future at a pre-specified price (i.e. is not going to happen under any cir- more standardized and offer greater
strike price). cumstances, the chance of happening liquidity than OTC contracts, which
Forward Contract of such a thing a naturally 0 (zero), are negotiated between counter par-
but otherwise, if the same is sure and ties and tailored to meet the needs of
A forward contract is basically
certain, then chance of happening is the parties to the contract. Exchange
a contract where the maturity and
confirm and positive and called 1, on traded derivatives also offer central-
amount are flexible, which can be
both the counts there cannot be any ized limits on individual positions
traded over the counter, or by tel-
probability, because there is no un- and have formal rules for risk and
ephone, fax, etc. and honouring of
certainty, but if there is something burden sharing.
the contract is made generally by tak-
ing and giving delivery and which mayor may not happen, the In India, OTC derivatives, viz,
counterparty risk depends on the probability of happening or not hap- interest Rate Swaps and Forward
counterparty only. pening such a thing lies between 0 Rate Agreements (FRAs) were intro-
and 1. This basic understanding of duced in July 1999, while one ex-
Future Contract probability shall help to create a ba- change traded derivatives, viz., stock
On the other hand, a future con- sic concept on derivatives, because Index Futures was introduced by the

two largest stock exchanges in June been duly approved (iii) the notional present, the forward contracts mar-
2000. The FRA is an off balance principal amount of the hedge does kets is active up to six months where
sheet contract between two parties not exceed the outstanding amount two way quotes are available. The
under which one party agrees on the of the loan, and (iv) the maturity of maturity profile has recently elon-
start date (or trade date) that on a the hedge does not exceed the un-ex- gated with quotes available up to one
specified future date (the settlement pired maturity of the underlying loan. year. With the gradual opening up of
date) that party, viz., the party that ADs in India may remit foreign ex- the capital account, forward premium
agrees, would lodge a notional de- change related to such foreign ex- is now increasingly getting aligned
posit with the other for a specified change derivative contracts. No resi- with the interest rate differential.
sum of money for a specified period dent in India can enter legally into a Importers and exporters also influ-
of time (the FRA period) at a speci- foreign exchange derivative contract ence the forward market in many
fied rate of interest (the contract without the prior permission of the ways. Besides, banks are allowed to
rate). The party that has agreed to Reserve Bank. Among the non-resi- grant foreign currency loans out of
make the notional deposit has, thus, dents, while FIIs may enter into a for- FCNR (B) liabilities and this too fa-
sold the FRA to the other party who ward contract with rupees as one of cilitated Integration of the forex and
has bought it. The IRS is a contract the currencies with an AD in India, the money markets, affecting the for-
between two counterparties for ex- non resident Indians and Overseas ward premium.
changing interest payment for a Corporate Bodies could take forward The most notable development
specified period based on a notional cover with an AD to hedge (i) divi- concerning the secondary segment of
principal amount. The notional prin- dend due on shares held in India (ii) the Indian capital market is the in-
cipal is used to calculate interest pay- balances in FCNR (B) and NR (E) troduction of derivatives trading in
ments but is not exchanged. Only A, and (iii) the amount of investment June 2000. SEBI approved deriva-
interest payments are exchanged. made under portfolio scheme. The tives trading based on futures Con-
The IRS and FRA were introduced Reserve Bank of India may also con- tracts at both BSE and NSE in ac-
with a view to deepening the money sider allowing residents to hedge cordance with the rules / bye laws
market as also to enable banks, Pri- their commodity price risk (includ- and regulations of the Stock Ex-
mary Dealers and financial institu- ing gold but excluding oil and petro- changes. A beginning with equity
tions to hedge interest rate risk. The leum products) subject to certain derivatives has been made with the
IRS has emerged as the more popu- conditions. introduction of stock index futures by
lar of the two instruments. In the In- Forward contracts market has BSE and NSE. Stock Index Futures
dian market, accounting for nearly all emerged as an important segment of contract allows for the buying and
of the 928 outstanding deals, the forex market in India in the re- selling of the particular stock index
amounting to Rs. 12620 crore of no- cent years. It comprises customers, for a specified price at a specified
tional principal as on November such as, corporate, exporters, import- future date. Stock Index futures, in-
17,2000. The overnight call money ers, and individuals,. Authorised ter alia, help in overcoming the prob-
rates and the forex forward rates have Dealer (ADs) and the Reserve Bank lem of asymmetries in information.
emerged as the most popular bench- Of late, FIIs have emerged as major Information asymmetry is mainly a
mark rates. participants in this segment. The problem in Individual stocks as it is
A resident of India who has bor- market operates from major centres unlikely that a trader has market-
rowed foreign exchange in accord- with Mumbai accounting for bulk of wide private information. As such,
ance with the FEMA, may enter into the transactions. Till February 1992, the asymmetric information compo-
an interest rate swap or currency forward contracts were permitted nent is not likely to be present in a
swap or coupon swap or foreign cur- only against trade related exposures basket of stocks. This provides an-
rency option or interest rate cap / and these contracts could not be can- other rationale for trading in Stock
collar or Forward Rate Agreement celled except where the underlying Index Futures. Also, trading in Index
contract with an authorised dealer in transactions failed to materialize. In derivatives involves low transaction
India or with a branch outside India March 1992, in order to provide op- cost in comparison with trading is un-
of an authorised dealer for hedging erational freedom to corporate enti- derlying individual stocks compris-
his loan exposure and unwinding tled, unrestricted booking and can- ing the index. While the BSE intro-
from such hedges provided that (i) cellation of forward contracts for all duced stock index futures for BSE
the contract does not involve rupees, genuine exposures, whether trade sensex comprising 30 scrips, the
(ii) foreign currency borrowing has related or not, were permitted. At NSE introduced stock index Futures

for S & P CNX Nifty comprising 50 for various participants and mecha- tives market. SEBIs Technical Group
scrips. Stock index futures in India nism for collection / enforcement of on New Derivative Products has re-
are available with one month, two margins have been put in place. It is cently examined this issue, and made
month and three months maturities. also proposed to introduce stock in- the following recommendations:
While derivatives trading based on dex options in the near future. Till In order to generate volumes,
the Sensitive Index (Sensex) com- November 8, 2000 both the stock the system of sub-brokers be
menced at the BSE on June 9,2000 exchanges had recorded a cumulative used for trading in derivatives
derivatives trading based on S & P combined turnover of Rs. 1210 crore. market.
CNX Nifty commenced at the NSE To effectively manage risk in the de- In order to facilitate free
on June 12, 2000 SIF is the first at- rivative segment, adequate risk con- arbitrage between cash and de-
tempt in the development of the de- taining measures have been put in rivatives market, financial insti-
rivatives trading (Table-2). All the place. They include specifying mini- tutions and mutual funds may be
open positions in the Index contracts mum net worth requirement of bro- permitted to short sell in the
are settled daily. Both buyer and kers and its composition, margining cash market. Such short sale
seller are required to deposit initial system based on 99 percent Value at may, however, be restricted to
margin with the Stock Exchange. The risk (VaR) model, position limit for the extent of corresponding ex-
value of the contract is marked to various participants and guidelines posure in the derivatives market.
market on a daily basis and settle- for collection and enforcement of Moreover, such transactions can
ment is made in cash. In order to fa- margins. Another equity derivative also be permitted through a
cilitate effective risk management in product in the equity market viz., separate dedicated fund.
the derivatives segment, measures stock index options is likely to be
Arbitrage between cash and fu-
like minimum net worth requirement introduced shortly. Contrary to inter-
tures market will also help in
of broker, margining system based on national experience, the volumes
better price discovery in both
Value at Risk model, position limit have been low in the Indian deriva-
the markets.

Table - 2
Date of Start June 9,2000 June 12. 2000
Underlying BSE Sensitive Index (SENSEX) S & P CNX Nifty
Contract size Sensex Value x 50 200 or Multiples of 200
Tick size/ price step 0.1 point of Sensex (equivalent to Rs. 5) Rs. 0.05
Minimum Price Fluctuation Rs. 5 Not Applicable
Price Bands Not Applicable Not Applicable
Expiration months 3 near months 3 near months
Trading Cycle A maximum of 3 months; the near month As in previous column
(1), the next month (2) & the far month (3)
Last Trading/ Expiry Day Last Thursday of the month or the preceding As in previous column
trading day
Settlement In Cash on T + 1 basis As in previous column
Final Settlement Price Index closing price on the last trading day@ Index Closing price on the
last trading day $
Daily Settlement Price Closing of Futures Contract Price @@ Closing of Futures Contract
Trading Hours 9:30- am to 3:30 pm
Margins Upfront initial margin on daily basis As in previous column
@ Computed on the basis of the weighted average of the last 15 minutes trading.
@@ Computed on the basis of weighted average of the last 5 minutes, or if the no. weighted average of last 5 trades.
$ Weighted average price for the last half an hour's trade.

RBI has allowed FIIs to trade in allow the participants to trade dur- 2,2002. Besides, from July 2, 2001
derivatives market, subject to the ing one-week period for settlement there is an index based market wide
condition that the overall open posi- in the following week. The trades are circuit brakers system at three stages
tion of the FII shall not exceed 100 netted for the settlement for the en- of movement either way at 10 per-
percent of market value of the con- tire one week period. In that sense, cent, 15 percent and 20 percent.
cerned FII's total investment. Man- the Indian markets are already oper- These circuit brakers will bring about
aged future funds should be permit- ating the futures style settlement a coordinated trading halt and equity
ted to take position in the derivatives rather than cash markets prevalent derivative markets nationwide.
market without having any exposure internationally. The more efficient Movement of either BSE Sensex or
in the cash market. Also, FIIs intend- way will be speeding up NSE S & P CNX, which ever is
ing to invest funds in the cash mar- dematerialization of securities as non breached earlier, would trigger the
ket should also be permitted to take dematerialized securities involve set- market wide circuit brakers. As fu-
long position in the futures market tlement delays and to separate out the tures and options were already in
to hedge their transactions. derivatives from the cash market i.e. vogue both on BSE and NSE, the op-
SEBI and RBI should jointly ex- introduce rolling settlement in all ex- tion contracts on Individual securi-
amine the issues concerning trading changes and at the same time allow ties was commenced from July 2,
in derivatives by FIs and FIIs. (Ta- futures and options initially for the 2001 on NSE and from July 9, 2001
ble 2 follows) broad market and then stock specific. in BSE on 31 securities approved by
(3) What is the potential of de- In less than three years, Indian eq- SEBI. The futures on individual
rivatives Market in India? uity markets have successfully stocks however is not available at
transited from the earlier paper based present.
Trading in standard derivative
settlement to demat settlement. To- The underlying security (futures
such as forwards, future and options
day more than 99.5 percent of the set- and options) for broad market was S
is already prevalent in India and has
tlement in both NSE and BSE is in & P CNX NIFTY 50 and BSE 30
a long history. Reserve Bank of In-
demat form. There is a substantial SENSEX. The 31 individual stocks
dia allowed forward trading in Ru-
demat coverage of equity markets. as approved by SEBI for options in
pee Dollar forward contracts, which
has become a liquid market and also In the Indian context, Bombay securities are common for both the
allowed Cross Currency options trad- Stock Exchange popularly known as exchanges i.e., BSE and NSE.
ing. Commodities futures in India are BSE introduced equity derivative in- S&P CNX NIFTY 50 is well di-
available in turmeric, black pepper, struments, the Sensex Futures on versified 50 stock index accounting
coffee, Gur (jaggery), hessian, cas- June 9, 2000 and Options on BSE for 25 sectors of the economy. As on
tor seed oil etc. There are plans to Sensex, from June 1, 2001. Though July 31, 2001 the total market capi-
set up commodities futures ex- a beginning was made with the in- talization of 50 stocks was Rs.
changes in Soya bean oil as also in troduction of rolling settlement on a 2,82,608 crore representing about 45
Cotton. International markets have selected few stocks, effective from percent of total market capitalization.
also been allowed (dollar denomi- July 2, 2001, rolling settlement was Sectorwise, diversified accounted for
nated contracts) in certain commodi- introduced on a large number of 20.3 percent, followed by Petro-
ties. stock i.e., on highly liquid stocks or chemicals 12.29 percent, Computers
"A" Group shares. The SEBI the Software 11.16 percent, Refineries
The spot markets / cash market
regulatory authority, propose to bring 8.88 percent, Pharma 7.15 percent,
in equities world over is operated on
in the scripts of the companies, which Cigarettes 6.88 percent and the other
a principle of rolling settlement. In
are presently not under compulsory sector accounting for less than 5 per-
India, most of the stock exchanges
rolling settlement w.e.f. January cent respectively. The base period for
52 Weeks High 4790.63 (September 13, 2000) 1470.55 (Sept. 12,2000) ,
52 Weeks Low 3096.51 (April 16, 2000) 1000.10 (April 16, 2000)
3 Years High 6150.69 (Feb. 14,2000) 1618.15 (Feb. 23, 2000)
3 Years Low 2741.22 (October 23, 1998) 800.10 (Nov. 30, 1998)

Sources: Economic Times, August 18, 2001


the index is November 3, 1995 and the one day horizon. The Initial Mar- are American options. As of new, how-
value of index has been taken at 1000 gin requirement shall be netted at ever, all the options that remain alive
with a base capital of Rs. 2,06,000 crore. level of individual client and it till expiration are to be cash settled. This
BSE Sensex on the other hand repre- shall be on gross basis at the level arrangement is expected to be in placed
sents 30 large well established compa- of Trading/Clearing Member. The till the end of the year. After that, buy-
nies with sound fundamentals from all Initial margin requirement for the ers of calls and puts will be permitted
significant sectors of the economy. The proprietary position of Trading / to insist on taking and giving delivery
financial year 1978-79 is the base year. Clearing member shall also be on of the underlying stocks.
The sector wise representation & the net basis. The market lot for options of Nifty
market capitalization in Shown in Ta- A portfolio based margining ap- is 200 while for that of Sensex and in-
ble 3. (Table 3 below) proach shall be adopted which will dividual stocks it is 100. The options
The SEBI has setup a "Technical take an integrated view of the risk created on any day can have three ex-
Group" headed by Prof. J. R. Verma to involved in the portfolio of each piry dates - at the NSE, the last Thurs-
prescribe risk containment measures for individual client comprising of his day, and at the BSE, the last Friday of
new derivation products. The group has positions of Derivative Contracts. the current and the next two months. On
recommended the introduction of Ex- The 31 scrips approved by the any day, upto five new options may be
change traded Option on Stocks, which SEBI for options are based on the created on a security two in the money,
is also in conformity with the sequence following criteria, during the last two out of the money and one (close to)
of introduction of derivative product six months prior to the date of ap- at the money. For example, if Reliance
recommended by Dr. L. C. Gupta Com- proval. share closes at a price of Rs. 343 per
mittee. Stock in the list of top 200 scrips, share, the options that may be created
The following are the risk contain- on the basis of average market the next day would have exercise prices
ment measures to be adopted by the de- capitalization and average free of Rs. 380, 360, 340, 320 and 300. In
rivative exchange/ segment and the float market capitalization not less the case of calls, the first two would be
Clearing House / Corporation for the than Rs. 750 crore. Free float mar- out of the money, the third wold be
trading and settlement of Option Con- ket capitalization means the non- (close to) at the money and the last two
tracts on Stocks: promoter holding in the stock. would be in the money option. In the
The Stock Option Contracts to be case of puts, the first two would be in
Stock in the list of top 200 scripts, the money options, the third would be
traded on the derivative exchange/ based on the average daily volume,
segments shall have prior approval (close to) at the money and the last two
and further, average daily volume would be out the money options. As
of the SEBI. The Contract should not less than Rs. 5 crore in the un-
comply with the disclosure re- closing prices fluctuate, over time, in-
derlying cash market. vestors will have a large variety of op-
quirements, if any, laid down by the Stock traded at least on 90 percent
SEBI. tions to choose from. The stock ex-
of the trading days. change has prescribed a minimum of
The Exchanges shall introduce Non-promoters holding in the com- five different put and call contracts for
Premium Settled American Style pany should be at least 30 percent. each stock for each month. Thus, at any
Stock Options, which shall be set- point of time, there are atleast 30 dif-
tled in cash by exercise, for an ini- Ratio of daily volatility of the stock
vis a vis daily volatility of index ferent contracts opened for one stock,
tial period of six months, thereaf- with a total of atleast 930 contracts
ter, the Stock Options, at exercise, should not be more than four, at
any time during the previous six opened for all the 31 stocks.
shall be settled by delivery.
months. Volatility estimates would (a) Benefits of Derivatives
The Stock Option Contract shall be computed as per Prof. J. R.
have a minimum contract size of Derivatives provide a low-cost, ef-
Verma Committee report on risk
Rs. 2 lakhs at the time of its intro- fective method for end users of hedge
containment measures for index
duction in the market. and manage their exposures to interest
The Stock Option contract shall rates, commodity prices, or exchange
As per the above criteria, 31 scrips rates. Interest rate futures and swaps, for
have a maximum maturity of 12 were allowed for options trading. The
months and shall have a minimum example, help banks of all sizes better
eligibility criteria would be reviewed manage the repricing mismatches in
of three strikes (in the money, near after a period of six months to examine
the money and out of the money) funding long term assets, such as mort-
whether in the light of the experience; gages, with short term liabilities, such
The Initial Margin requirements the list of eligible stocks could be ex- as certificates of deposits. Around 1980
shall be based on worst case loss panded. While the options on the indi- the first swap contracts were developed.
of a portfolio of an individual cli- ces - Nifty and Sensex are European A swap is another forward based deriva-
ent to cover 99 percent VaR over a options, the options on individual stocks tive that obligates two counter parties

to exchange a series of cash flows at ing rate interest. banning of badla and introduction
specified settlement dates in the future. Derivatives allow corporations and of derivatives. Over the next few
Swaps are entered into through private institutional investors to more ef- years, there will be fundamental
negotiations to meet each firm's specific fectively manage their portfolio of change in the market structure. By
risk management objectives. There are assets and liabilities. An equity March 2002, the classification of
two principal types of swaps: Interest funds, for example, can reduce its scrips intro different categories
rate swaps and currency swaps. Today exposure to the stock market such as A, B1 and B2 will come to
interest rate swaps account for the ma- quickly and at the relatively low an end. The A group stocks hith-
jority of banks swap activity, and the cost without selling off part of its erto enjoying an edge over other
fixed for floating rate swap is the most equity assets by using stock index categories due to high liquidity has
common interest rate swap. In such a futures or index options. Corporate come to an end with the introduc-
swap, one party agrees to make fixed borrowers and governmental enti- tion of rolling settlement prevented
rate interest payments in return for float- ties can effectively manage their the practice of switching of posi-
ing rate interest payments from the liability structure the ratio of fixed tion from one exchange to another
counter party. to floating rate debt and the cur- due to different exchanges having
Financial derivatives, by reducing rency composition of that debt - different settlement cycles. This
uncertainties, make it possible for using interest rate and currency fu- leads to an upward re-rating of a
corporations to initiate productive tures and swaps. large number of fundamentally
activities that might not otherwise Extensive academic literature ad- good scrips which are currently ne-
be pursued. For example, an U.S. dresses the question of whether the glected just because they belong to
Company may want to build a dynamic hedging of options posi- B1 and B2 categories.
manufacturing facility in India but tions increases market volatility. One important aspect is the pric-
is concerned about the projects These studies examine the effects ing of the options. With regard to,
overall cost because of exchange of option listing on the volatility whether the premium is fair and
rate volatility between the rupee of the under lying stock price and what factors should be considered
and the dollar. To ensure that the are particularly relevant because while deciding such a price. Math-
company will have the necessary dynamic hedging of option posi- ematically, the price can be calcu-
cash available when it is needed for tions by market makers is an im- lated by using either the Black-
investment, the U.S. manufacturer portant factor linking the markets Scholes model (For European style
should devise a prudent risk-man- for the option and the underlying options) or Binomial model (for
agement strategy that is in harmony stock. The findings are uniform. American Options). Without going
with its broader corporate objec- Majority of the study concludes into complex mathematical formu-
tive of building a manufacturing that volatility is reduced with the las, which can be worked out in
facility in India. As part of that introduction of options trading. electronic spreadsheets, one must
strategy, the U.S. firm should use These studies are quite powerful understand the relation and impact
financial derivatives to hedge because they span numerous time of factors, which are considered to
against foreign exchange risk. De- periods and literally hundreds of determine that price. Some of these
rivatives used as a hedge can im- option listings. The range of com- factors include the relationship
prove the management of cash modities examined is extensive. between the strike price and the
flows at the individual firm level. The majority of studies find that value of the underlying expected
Corporations, governmental enti- the introduction of future trading volatility of the underlying assets,
ties, and financial institutions also in stock indices does not result in time to expiration, interest rates
benefit from derivatives through increased volatility of the under- and dividend yield of the underly-
lower funding costs and more di- lying stocks. Where an increase is ing over the life of the option.
versified funding sources. Cur- found, moreover, it is usually for A great deal of speculation is about
rency and interest rate derivatives short term volatility. Studies exam- the broad market movement. The
provide the ability to borrower in ining other commodities find that most common topic of discussion
the cheapest capital market, do- the introduction of derivatives among equity investors is always
mestic or foreign, without regard trading tends to either decrease where do you see the market three
to the currency in which the debt volatility or result in no change. months down the line, etc. Specu-
is denominated or the form in The FIIs would be pleased, with lation on an individual stock is a
which interest is paid. Derivatives the trading systems moving closer fairly difficult proposition in view
can covert the foreign borrowing to international methods such as of insiders knowing more than oth-
into a synthetic domestic currency derivatives. The FIIs inflows in the ers about the affairs of the com-
financing with either fixed or float- stock markets have increased since pany. In contrast, information

about the index is fairly symmet- over all efficiency. him are plenty.
ric i.e. CNX NIFTY 50 and BSE Derivatives help mutual funds and If an investor has no information
30 SENSEX. Everyone roughly other financial institutions in their about individuals stocks, then he
knows the same facts about how investment strategy for strategic diversifies and holds the market;
the economy is faring, political un- purposes of controlling risk or re- if he has information about a spe-
certainties, etc. Hence speculation structuring portfolios. Suppose that cific industry but neither on indi-
on the index is a fair game. Inter- a mutual fund scheme decides to vidual firms within the industry nor
estingly, the survey findings (L.C. reduce its equity exposure, pres- on the market, then he diversifies
Gupta Committee) showed that ently, this can be achieved only by across the industry and hedges the
stock index futures ranked as the actual selling of equity holdings market, and soon.
most popular and preferred type of and selling is likely to depress eq- (b) Risks of Derivatives
equity derivative, the second being uity prices to the disadvantage of
stock index options and the third So, far, we have examined some of
the Scheme and the whole market. the economic benefits associated with
being options on individual stocks. Besides, it is a time consuming
Considerable interest exists in all derivative products. The appreciation of
process and increases transaction these products' effective benefits would
the three types of equity deriva- costs due to brokerage. By selling
tives mentioned above. The fourth however be partial and incomplete with-
index futures immediately, the ac- out an analysis of some of the risks in-
type, viz. Individual stock futures, tual sale of equity holdings may be
was favoured much less. It is per- herently linked. The major preoccupa-
done gradually depending on mar- tion of regulatory bodies, banks and
tinent to note that as of now SEBI ket conditions in order to realize
does not permit individual stock fu- other market participants would essen-
the best possible prices. The index tially gravitate around the identification
tures. futures transaction may be un- and qualitative appreciation of these
Banks are permitted to invest upto wound by an opposite transaction risks. The kinds of risks associated with
five percent of their total outstand- to the same extent as unloading of derivatives are no different from those
ing credit as at end of previous year holdings progresses. Likewise, se- associated with traditional financial in-
in capital market. This is huge curities may not be immediately struments, although they can be far more
money, but Ibanks are traditionally available in sufficient quantity at complex i.e., credit, market, operational,
not active players in the stock mar- reasonable prices when a new and legal risk. Credit risk is the risk that
ket. Derivatives help them to ef- scheme is floated as per the broad a loss will be incurred because
fectively manage the equity port- objectives of the scheme. In purely counterparty fails to make payments as
folio. cash market, rushing to invest the due. In the event of the default, the loss
For banking supervisors around the whole money is likely to drive up on a derivatives contract is the cost of
world including Indian sub-conti- prices to the disadvantage of the replacing the contract with a new
nent,. probably the most important scheme. The availability of stock counterparty. Concern has been ex-
question is what could go wrong index futures can take care of this pressed that financial institutions (espe-
go engender systemic risk - the entire problem. Repurchase may cially dealers) may have used deriva-
danger that a failure at a single sometimes necessitate liquidation tives to take on an excessive level of
bank could cause a domino effect, of a part of the portfolio in the case credit risk that is poorly managed. Mar-
precipitating a banking crisis. As of an open ended scheme. Selling ket risk is the risk that the value of a
financial derivatives allow differ- each holding in proportion of its position in a contract, financial instru-
ent risk components to be isolated weight in the portfolio is often im- ment, asset, or portfolio will decline
and passed around the financial practicable and rushing to the cash when market conditions change. Con-
system, clearly reduces the over- market to liquidate would drive cern has been expressed that derivatives
all cost of risk bearing and enhance down prices. Hence, the price used expose firms to new market risks, while
economic efficiency. Those who in computation of NAV may not increasing the overall level of expo-
are willing and able to bear each match with the actual realization. sures. A risk that arises in all businesses
risk component at the least cost Stock Index Futures can help to is operational risk the risk that losses
will become the risk holders. overcome these problems to the will be incurred as a result of inadequate
It is expected that arbitrage trans- advantage of unit holders. systems and control, inadequate disas-
actions between the index futures For participants in the derivatives ter or contingency planning, human er-
market and the cash market for eq- market, there are various permu- ror, or management failure. Legal risk
uities is likely to have a beneficial tations and combinations of call is the risk of loss because a contract can-
effect on the functioning of the and put options, with a fuller un- not be enforced or because the contract
cash market in terms of price dis- derstanding, an investor will appre- terms fail to achieve her intended goals
covery, broadening of liquidity and ciate that alternatives available to of the contracting parties. This risk, of

course, is as old as contracting itself. Currency exposure is inherent in tempt to manage and minimize legal
Because of the relative newness of de- foreign exchange trading and in risks.
rivatives transactions, however, their foreign currency denominated bor- Derivatives related disasters, par-
treatment under existing laws and regu- rowing or lending. ticularly the collapse of Barings,
lations is often ambiguous. This legal Equity exposure is inherent in mar- have led to questions about the
uncertainty can result in significant un- gin loans. ability of individual derivatives
expected losses. The market risks of any financial participants to internally manage
The credit risk from derivatives activity, including derivatives activity, the trading operations. In addi-
activities can be controlled by the tradi- must be evaluated on the basis of its ef- tion, concern have surfaced
tional credit risk management function fect on the net exposure of an overall about regulator ability to detect
of dealers. This can be supplemented by portfolio. Market risk can be effectively and control potential derivatives
the more precise identification and managed through frequent marking to losses. But regulatory and
measurement made possible by deriva- market of portfolios, coupled with the legislative restrictions on
tives technology. The technology can identification and measurement of mar- derivatives activities are not the
evaluate the creditworthiness if coun- ket risk, the setting of risk limits, and answer, primarily because simple,
terparts, set risk limits to avoid exces- monitoring of positions against limits. standardized rules most likely
sive concentrations, regularly measur- These same sound principles and prac- would only impair banks' ability
ing exposures and monitoring them tices can be, and are, applied to other to manage risk effectively. A bet-
against risk limits. activities. ter answer lies in greater reliance
Derivatives generally have not ex- While no aspect of operational risk on market forces to control de-
posed institutions to fundamentally new is unique to derivatives, however, it is rivatives related risk taking, to-
sources of market risk and have long important for institutions actively en- gether with more emphasis on
been exposed to these same market gaged in derivatives activities to have government supervision, as
risks. adequate oversight of well trained and opposed to regulation.
Interest rate exposure is inherent knowledgeable staff by informed and Banking regulators should em-
in the mismatch of assets and li- involved senior management. Users of phasize more disclosure of de-
abilities. derivatives, like other firms, should at- rivatives positions in financial
statements and be certain that

institutions trading huge deriva- daily risk monitoring. Market from engaging in irregular trans-
tives portfolios have adequate participants should be able to actions. In an industry where the
capital. In additions, because effectively monitor and limit competition for market shares is
derivatives could have implica- their market, credit and liquid- intense and involves a few ma-
tions for the stability of the fi- ity risk exposures to the extent jor players, where the products
nancial system, it is important of remaining exposed to a "sus- are highly substitutable and
that users maintain sound risk tainable" price, volume or credit where the technology for finan-
management practices. It is the variation at most. cial innovation and transaction
responsibility of a bank's senior An efficient risk management costs reduction is not anymore
management to ensure that risks system for the derivatives indus- the property at a privileged elite,
are effectively controlled and try has to be "dynamic" and ex- reputation is a very effective
limited to levels that do not pose plicitly consider and monitor the market monitoring instrument.
a serious threat to its capital po- evolution of market, credit and Derivatives participants should
sition. Regulation is an ineffec- liquidity risk exposures. In this adopts more transparent and
tive substitute for sound risk respect, the credit risk of deriva- standardized accounting and
management at the individual tives positions should be disclosure rules, putting more
firm level analyzed across maturities as emphasis on the education of
It is important that derivatives well as across counterparties. their personal and developing an
players fully understand the In order to enforce the risk man- expertise in their back office
complexity of financial deriva- agement and monitoring at all management and settlement pro-
tives contracts and the accom- responsibility levels, the per- cedures.
panying risks. Users should be formance measurement and fi- The ultimate and perhaps most
certain that the proper safe- nancial compensation schemes delicate topic is related to the
guards are built into trading of the firm employees have to monitoring of derivatives,
practices. be incentive compatible. In or- namely the justification of ex-
The following are some of the der to guarantee efficient self ternal regulation. Regulation is
essential market monitoring regulation in the derivative mar- clearly not the only monitoring
tools and policies that should ket, the managers, traders and device that can be used to en-
prevent financial disruptions, by other derivative dealers must re- force market participants risk
keeping the various risk expo- ceive the proper incentive when exposures. External regulation
sures in the financial market hedging, trading or speculating should be considered as the ul-
under control. with those instruments. Thus, timate enforcement mechanism
Enhancing confidence and their performance objective (in whenever self regulation of the
knowledge among all market term of risk targets) have to be market participants fails to
participants is a necessary con- clearly specified and their achieve the monitoring goals.
dition in order to guarantee the fulfillment enforced through ex- Thus, one could view the role
stability of the derivatives mar- plicit penalties. Finally, the ho- of regulation as that of a player
kets. rizon over which a given per- of last resort who guarantees
Enhance information standardi- formance is assessed should be that the economic benefits asso-
zation and disclosure at all lev- compatible with the long run ciated to the derivative trading
els of the derivatives trading in- objectives of the institution and activity remain on the efficient
dustry. Also, the market value prevent traders from engaging in "risk/return" frontier.
concept should always be pre- short term horizon performance It is a well known fact that risk
ferred in order to serve as a enhancing strategies that lead management is not about the elimi-
benchmark for the marking to them to adopt exaggerate risk nation of risk; it is about the man-
market or collateralization of exposures or turnover activities. agement of risk; selectively choos-
the various risk exposures. Whenever possible, the reputa- ing those risks an organisation is
Increase and harmonize the fre- tion of the market participant in comfortable with the minimizing
quency of market, accounting the derivative business should those that it does not want. Financial
and credit assessment data dis- be used as a monitoring device derivatives serve a useful purpose in
closure in order to allow for to prevent them from adopting fulfilling risk management objec-
excessively risky positions or tives. Through derivatives, risk from

traditional instruments can be measures to improve liquidity in the at Rs. 2 lacs and it is viewed as high
efficiently unbundled and man- markets. These measures once ap- for retail participation. However,
aged independently. proved by the SEBI board, would only a fraction of it has to be paid on
permit FII participation in all deriva- the option contract in the form of
tive products. Allow intuitions lim- premium as the option price. With
The economic benefits of deriva- ited short selling up to their expo- only a marginal investment, one can
tives are not dependent on the size sures in derivatives market, and in- take large, positions in the market.
of the institution trading them. The troduce stock futures and margin The options market would pick up in
decision about whether to use deriva- trading. The committee also sug- Indian sub-continent fairly quickly
tives should be driven, not by the gested that banks funds could be despite the nuances of the complex
company's size, but by its strategic channeled through the stock ex- mathematics involved in the valua-
objectives. However, it is important change clearing house/ corporation tion of options, in view of intuitive
that all users of derivatives, regard- and allowing banks to participate in understanding of options is excellent.
less of size, understand how their the derivatives markets. Once these Hence there is reason to be hopeful
contracts are structured, the unique measures are approved and imple- that it would grow rapidly. The glo-
price and risk characteristics of those mented effectively, liquidity should bal experience has shown that in the
instruments, and how they will per- get a substantial boost and improve long run, rolling settlement and de-
form under stressful and volatile eco- overall market sentiment. Bank par- rivatives increases liquidity mani-
nomic conditions. A prudent risk ticipation in derivatives and access fold.
management strategy that conforms to FIIs, which are at present allowed
to corporate goals and is complete Bibliography
to trade only in index futures, to all 1. J.N. Dhankar, "Capital Market Re-
with market simulation and stress derivative products need the ap- forms", paper presented in the confer-
tests is the most crucial prerequisite proval of the Reserve Bank of India. ence of 2nd Generation Reforms, pp 1-
for using financial derivative prod- The Success of most of these initia- 2, 2001.
ucts. Without a clearly defined risk tive depends on an efficient stock 2. Ranjan Mukherjee "Derivatives - what
management strategy, use of finan- borrowing and leading mechanism. it is?" the Management Accountant,
cial derivatives can be dangerous. It May 1998, pp 335-37.
But that requires to nationwide in-
can threaten the accomplishment of frastructure for electronic funds
3. Sanjive Aggarwal, "Indian Capital
a firms long range objectives and Market" 2nd edition.
transfer (the problem is that it takes 4. Fred. D. Arditti, Derivatives: A com-
result in unsafe and unsound prac- three day to receive the proceeds of prehensive Resource for options, fu-
tices that could lead to the organiza- a cheque, which means that the short tures, Interest Rate Swaps and Mort-
tions insolvency. But when used seller has to fund his position for gage securities, Harward Business
wisely, financial derivatives can in- those days) and that of course is out- School Press.
crease shareholder value by provid- side the purview of the SEBI & it is 5. V. K. Bhalla, Financial Derivatives
ing a means to better control a firms high time that Finance Ministry and (Risk management 2001, S. Chand &
risk exposures and cash flows. When Company Ltd. Publication.
RBI facilitate electronic fund trans-
using financial derivatives, however, 6. A. S. Harish "Potential of Derivatives
fer. Market in India", The ICFAI Journal of
organizations should be careful to
In most countries, there are big- Applied Finance, Vol. 7, No.5, Nov.
use only those instruments that they 2001, pp 1-24.
ger arbitrage opportunities, in the
understand and that fit best with their 7. Andrew Kasapi, Mastering credit deriva-
early days of the futures market. As
corporate risk management philoso- tives, Financial Times prentice Hall, pp
larger resources and greater skills,
phy. It may be prudent to stay away 1-3.
get brought into the arbitrate busi-
from the more exotic instruments, 8. Report of the L. C. Gupta Committee on
ness, these opportunities tend of van- Derivatives and Verma Committee Re-
unless the risk/reward tradeoffs are
ish. India is better placed in terms of port on Risk Containment in the Deriva-
clearly understood by the firm's sen-
arbitrage, as compared with many tives Market.
ior management and its independent
other countries thanks to the years of 9. John C Hull, Options, futures and Other
risk management review team. Ex- Derivatives, Prentice Hall of India Pri-
experience with "line operators" who
otic contracts should not be used vate Limited, 1997.
are used to doing arbitrage between
unless there is some obvious reason 10. Websites: Securities and Exchange Board
exchanges. These skill are well
for doing so. of India (, National Stock
suited to the index arbitrage. The Exchange of India (
The SEBI's advisory committee minimum value of a contract for and Stock Exchange, Mumbai
on derivatives has proposed a set of stock derivatives at present is fixed (