             

    

A Study of Derivative Market in India

Mohammed Rubani
Ph.D Scholar (Commerce)
(2014-2017)
Kalinga University, Raipur, C.G.
Enrollment No. 15020086 (KU002MMXIV02010138)

Abstract

S ince 1991, due t o liberalizat ion o f eco nomic po licy, t he I ndian eco no my
has ent ered an era in which I ndian companies cannot ignore glo bal
market s. Before t he ninet ies, pr ices o f many co mmodit ies, met als and
ot her asset s were cont rolled. Ot hers, which were not cont rolled, were
largely based on regulat ed pr ices o f input s. As such t h ere was limit ed
uncert aint y, and hence, limit ed vo lat ilit y o f pr ices. But aft er 1991,
st art ing t he process o f deregulat io n, pr ices o f most commodit ies are
decont rolled. It has also resu lt ed in part ly deregulat ing t he exchange
rat es, removing t he t rade cont rols, reducing t he int erest rat es, making
major changes for t he capit al mar ket ent r y o f foreign inst it ut iona l
invest ors, int roducing market based pr icing o f gover nment secur it ies, et c.
All t hese measur es have increased t he vo lat ilit y o f pr ices o f var io us g oods
and ser vices in I ndia t o producers and consumer s alike. Furt her, market
det er mined exchange rat es and int erest rat es also creat ed vo lat ilit y and
inst abilit y in port fo lio values and secur it ies pr ices. Hence, hedging
act ivit ies t hrough var ious der ivat iv es emerged t o different r isks. T his
paper will st udy t he capit al market in I ndia wit h reference to Der ivat ives.


              
    

1. Introduction to Capital Market

Capit a l Market is t he market for lo ng t erm finance wit h t he mat ur it y

per iod more t han one year. The Capit al Market deals wit h t he st ock
market s which pro vide financing t hrough t he issuance o f shar es or
co mmo n st ock in t he pr imar y market , and enable t he subsequent t rading i n
t he seco ndar y market . Capit al Market s also deals wit h Bo nd Market whic h
provide financing t hrough issuance o f Bonds in t he pr imar y market and
subsequent trading t her eo f in t he secondary market 1.

Financia l syst em is a co mplex set up for any count y, which inc ludes
financial inst it ut ions like banks, NBFCs (No n Banking Financia l
Co mpanies), regu lat ors, product s et c. Broadly t he I ndian Financia l S yst em
can be classified in t o t wo heads, viz, t he inst it ut ions and regulat ors in
t he filed o f banking and allied ser vices and t he inst it ut ion and regulat ors
in t he filed o f financial mar ket . Banking sect or inst it ut ions include
Reser ve Bank o f I ndia, Pubic Sect or Banks, Pr ivat e Sect or Banks, Co -
operat ive Banks, and Foreign Banks. NBFCs and organizat ions like LI C,
GIC et c also play a major role in t he financial syst em.

The past decade has wit nessed t he mult ipl e growt hs in t he vo lume o f
int er nat ional t rade and business due t o t he wave o f glo balizat io n and
liber alizat ion all over t he wor ld. As a result , t he demand for t he
int er nat ional mo ney and financial inst rument s increased significant ly at
t he glo bal level. I n t his respect , changes in t he int erest rat es, exchange
rat es and st ock market pr ices at t he different financial mar ket s have
incr eased t he financial r isks t o t he corporat e world. Adverse changes have
even t hr eat ened t he ver y sur vival o f t he business wor ld . It is, t herefore, t o
manage such r isks; t he new financial inst rument s have been developed in
t he financia l mar ket s, which are also popular ly known as financia l
der ivat ives. The basic purpose o f t hese inst rument s is t o provide


          


              
    

co mmit ment s t o prices for fu t ure dat es for giving prot ect ion against
adverse mo vement s in fut ure pr ices, in order to reduce t he ext ent of
financial r isks. Not only t his, t hey als o provide opport unit ies t o earn
profit for t hose persons who are ready to go for higher r isks. In ot her
wo rds, t hese inst rument s, indeed, facilit at e t o t ransfer t he r isk fro m t hose
who wish t o avo id it to t hose who are willing t o accept t he same.

2 Objectives and Research Methodology

Objectives of study:

1. To explore t he evo lut io n of Capit al Market in I ndia.

2. To assess per for mance of I ndian Der ivat ive M arket .
3. To analyze t he fact ors cont r ibut ing towards t he growt h of
Der ivat ive Market s.

Research Methodology

It is always import ant to be cr it ical o f t he infor mat io n pr esent ed in

sources, especia lly since t he mat er i al might have been gat her ed t o address
a differ ent problem area. Moreover, many secondar y sources do not
clear ly descr ibe issues such as t he purpose o f a st udy, how t he dat a has
been gat hered, analysed and int erpr et ed making it difficult for t he
resear cher t o assess t heir usefulness. I n order to address t his proble m I
have t r ied to t riangulat e t he seco ndar y dat a by using numerous
independent sources.

The infor mat io n about t he problem is collect ed fro m t he Researc h

Journals, Trade Magazines, Annual Report s of Banks and t he I nt ernet . For
evaluat ing E vo lut io n o f der ivat ives and import ant fact ors! , I have
focused on as recent mat er ial as possible. In order t o get access t o t he


              
    

lat est development s in t his area I have used a nu mber o f art icles published
in academic jour nals and t rade magazines. We have also used seco ndar y
infor mat io n fro m I nt ernet based discussio n forums.

3. Findings and Discussions

S ince 1991, due t o liberalizat ion o f eco nomic po licy, t he I ndian eco no my
has ent ered an era in which I ndian compa nies cannot ignore glo bal
market s. Before t he ninet ies, pr ices o f many co mmodit ies, met als and
ot her asset s were cont rolled. Ot hers, which were not cont rolled, were
largely based on regulat ed pr ices o f input s. As such t here was limit ed
uncert aint y, and hence, limit ed vo lat ilit y o f pr ices. But aft er 1991,
st art ing t he process o f deregulat io n, pr ices o f most commodit ies are
decont rolled. It has also resu lt ed in part ly deregulat ing t he exchange
rat es, removing t he t rade cont rols, reducing t he int erest rat es, m aking
major changes for t he capit al mar ket ent r y o f foreign inst it ut iona l
invest ors, int roducing market based pr icing o f gover nment secur it ies, et c.
All t hese measur es have increased t he vo lat ilit y o f pr ices o f var io us goods
and ser vices in I ndia t o produc ers and consumer s alike. Furt her, market
det er mined exchange rat es and int erest rat es also creat ed vo lat ilit y and
inst abilit y in port fo lio values and secur it ies pr ices. Hence, hedging
act ivit ies t hrough var ious der ivat ives eme rged to different r isks.

Futures t rading o ffer a r isk-reduct ion mechanis m t o t he far mer s,

producers, export ers, import ers, invest ors, banker s, t rader, et c. which are
essent ial for any count r y. I n t he words of Alan Greenspan, Chair man o f
t he US Feder al Reser ve Board, "T he array o f de r ivat ive product s t hat has
been developed in recent year s has enhanced econo mic effic ienc y. T he
econo mic funct io n o f t hese cont ract s , is to allow r isks t hat for mer ly had
been co mbined t o be unbundled and t ransferred t o t hose mo st willing t o
assume and manage each r isk co mpo nent s." Development o f fut ures
market s in many count r ies has co nt r ibut ed significant ly in t er ms o f


              
    

invis ible ear nings in t he balance o f payment s, t hrough t he fees and ot her
charges paid by t he foreigners for using the market s.

Furt her, econo mic progress o f any count ry, t oday, much depends upon t he
ser vice sect or as on agr icult ur e or indust ry. Ser vices are now backbone o f
t he eco no my o f t he fut ure. India has alr eady crossed t he roads o f
revo lut ion in indust r y and agr icult ur e sect or and has allowed t he same
now m ser vices like financial fut ures. India has all t he infrast ruct ure
facilit ies and pot ent ial exist s for t he whole spect rum o f financial fut ures
t rading in like st ock market indices, t reasur y bills, gilt -edged secur it ies,
foreign curre ncies, cost of living index, st ock market index, et c. For all
t hese reaso ns, t here is a major pot ent ial for t he growt h o f financia l
der ivat ives market s in I ndia.

3.1 EVO LUTION O F DERIVATIVES IN INDIA ma y be t racked st art ing

fro m a cont rolled econo my, I ndia has mo ved t owards a wor ld where pr ices
fluct uat e ever y day. T he int roduct ion o f r isk management inst rument s in
India gained mo ment um in t he last few years due to liberalisat io n process
                   
market . Der ivat ives are an int egral part of liber alisat ion process t o
manage r isk. NSE gauging t he market requir ement s init iat ed t he process
of set t ing up der ivat ive market s in I ndia. In July 1999, der ivat ives t rading
co mmenced in I ndia. 2

Evolution of Derivatives

14 December 1995 NSE asked SEBI for per missio n t o t rade index
fut ures.
18 November 1996 SEBI set up L. C. Gupt a Co mmit t ee t o draft a
polic y fr amework for index fut ures.
11 May 1998 L. C. Gupt a Commit t ee submit t ed report.


              


              
    

7 July 1999 RBI gave per missio n for OTC forward rat e
agreement s ( FRAs) and int erest rat e swaps
24 May 2000 SIMEX chose N ift y for t rading fut ures and
opt io ns on an I ndian index.
25 May 2000 SEBI gave per missio n t o NSE and BSE to do
index fut ures t rading.
9 June 2000 Trading of BSE Sensex fut ures
co mmenced at BSE.
12 June 2000 Trading o f Nift y fut ures co mmenced at NSE.
31 August 2000 Trading o f fut ures and opt io ns o n Nift y t o
co mmence at SIMEX.
June 2001 Trading o f Equit y I ndex Opt io ns at NSE
July 2001 Trading o f St ock Opt ions at NSE
NSE November 9, 2002 Trading o f S ingle St ock fut ures at BSE
June 2003 Trading o f I nt erest Rat e Fut ures at NSE
Sept ember 13, 2004 Weekly Opt ions at BSE
Januar y 1, 2008 Trading o f Chhot a(Mini) Sensex at BSE
Januar y 1, 2008 Trading o f Mini I ndex Fut ures & opt ion at
BSE
NSE August 29,2008 Fut ures at Trading o f Currency
NSE
Oct ober 2,2008 Fut ures at BSE Trading o f Currency

Commodit ies fut ures t rading in I ndia were init iat ed lo ng back in 1950s;
however, t he 1960s marked a per iod o f great decline in fut ures t rading.
Market aft er market was clo sed usua lly because differ ent commodit ies'
pr ices incr eases were at t ribut ed to speculat io n on t hese market s.
According ly, t he Cent ral Gover nment imposed t he ban on t rading in
der ivat ives in 1969 under a not ificat io n issue. The lat e 1990s shows t his


              
    

signs of opposit e t rends-a large scale reviva l o f fut ures market s in

India28, and hence, t he Cent ral Gover nment revoked t he ban on fut ures
t rading in Oct ober, 1999. T he Civil S upplies Minist r y agreed , in pr inciple
for st art ing o f fut ures t rading in Basmat i r ice, furt her, in 1996 t he
Gover nment grant ed per missio n t o t he Indian P epper and Spice Trade
Associat io n t o convert it s P epper Fut ures Exchange int o an I nt ernat iona l
Pepper E xchange. As such, on No vember 17, 1997, I ndia's first
int er nat ional fut ures. E xchange at Kochi, known as t he I ndia Pepper and
Spice Trade Associat io n-Int er nat io nal Commodit y E xchange (IPSTA -ICE)
was est ablished.

S imilar ly, t he Cochin Oil Millers Associat io n, in June 1996, de manded

t he int roduct ion o f fut ures t rading in co conut oils. T he Cent ral Minist er
for Agr icult ure announced in June 1996 t hat he was in favour o f
int roduct ion o f fut ures t rading bot h domest ic and int er nat io nal. Furt her, a
new co ffee fut ures exchange (The Co ffe e Fut ures E xchange o f India) is
being st art ed at Bangalor e. In August , 1997, t he Cent ral Gover nment
proposed t hat Indian co mpanies wit h commodit y pr ice exposures should
be allo wed t o use foreign fut ures and opt io n market s. The t rend is not
confined t o t he commodit y market s alo ne, it has init iat ed in financia l
fut ures t oo.

The Reser ve Bank o f I ndia set up t he Sodhani E xpert Group whic h

reco mmended major liber alizat io n o f t he forward exchange market and
had urged t he set t ing up o f rupee based der ivat iv es in financia l
inst rument s. The RBI accept ed several o f it s reco mmendat io ns in August ,
199629. A landmark st ep t aken in t his regard when t he S ecur it ies and
Exchange Board of I ndia (SEBI) appo int ed a Co mmit t ee named t he Dr.
LC. Gupt a Co mmit t ee (LCGC) by it s resolut io n, dat ed November 18, 1996
in order to develo p appropr iat e regulat ory framework for der ivat ives
t rading in I ndia. While t he Co mmit t ee's focus was on equit y der ivat ives
but it had ma int ained a broad perspect ive of der ivat ives in gener al.


              
    

The Board of SEBI, on May 11, 1998, accept ed t he reco mmendat io ns o f

t he Dr. L C. Gupt a Co mmit t ee and appr oved int roduct ion o f der ivat ives
t rading in I ndia in t he phased manner 3. The reco mmendat ion sequence is
st ock, index fut ures, index opt io ns and opt io ns on st ocks. The Board also
approved t he 'S uggest ive Bye - Laws' recommended by t he Co mmit t ee for
                  
in I ndia. Subsequent ly, t he SEBI appo int ed J.R. Ver ma Co mmit t ee t o look
int o t he operat ional aspect s o f der ivat ives market s. To remove t he road -
blo ck o f no n- recognit io n of der ivat ives as secur it ies under Secur it ies
Cont ract Regulat ion Act , t he Secur it ies Law (Amendment ) Bill, 1999 was
int roduced t o br ing about t he much needed changes. Accordingl y, in
December, 1999, t he new fr amework has been approved and 'Der ivat ives '
have been accorded t he st at us o f 'S ecur it ies', however, due t o cert ain
co mplet io n o f for malit ies, t he launch o f t he I ndex Fut ures was dela yed by
more t han t wo years. In June, 2000, t he Nat ional St ock Exchange and t he
Bo mbay St ock Exchange st art ed st ock index based fut ures t rading in
                    
This is mainly at t ribut ed t o t he low awareness about t he product and
mechanis m amo ng t he market player s and invest ors.

3.2 FACTO RS CONTRIBUTING TO THE GROWTH OF

DERIVATIVES: Fact ors cont ribut ing to t he explo sive growt h of
der ivat ives ar e pr ice vo lat ilit y, glo balizat ion of t he market s, t echno logical
development s and advances in t he financial t heor ies.

Price Volatility: A pr ice is what one pays t o acquire or use so met hing o f
value. T he object s having value maybe co mmodit ies, local currency or
foreign currencies. The concept of pr ice is clear t o almo st ever ybody
when we discuss co mmo d it ies. T here is a pr ice t o be paid for t he purchase
of food grain, o il, pet rol, met al, et c. t he pr ice one pays for use o f a unit o f
anot her persons mo ne y is called int erest rat e. And t he pr ice one pays in

              


              
    

           is called as an exchange
rat e.

Pr ices are generally det er mined by market forces. In a market , consumer s

           
co llect ive int er act ion o f demand and supply in t he market det ermines t he
pr ice. T hese fact ors are const ant ly int eract ing in t he market causing
changes in t he pr ice over a short per iod of t ime. Such changes in t he pr ice
                      
changes, t he frequency o f pr ice changes and t he magnit ude o f pr ice
changes. 4

The changes in demand and supply influencing fact ors culminat e in

market adjust ment s t hrough pr ice changes. T hese pr ice changes expose
individuals, producing fir ms and government s t o significant r isks. T he
break down o f t he BRE TTON WOODS agreement brought and end t o t he
st abiliz ing ro le o f fixed exchange rat es and t he go ld co nvert ibilit y o f t he
dollars. The glo balizat ion o f t he market s and rapid indust rializat ion o f
many underdeveloped count r ies brought a new scale and dimens io n t o t he
market s. Nat io ns t hat were poor suddenly became a major source o f
supply o f goods. The Mexican cr is is in t he sout h east -As ian currency
                      
The advent o f t eleco mmunicat ion and dat a processing bought infor mat io n
ver y quickly t o t he mar ket s. I nfor mat ion which would have t aken mo nt hs
to impact t he market ear lier can now be obt ained in mat t er of mo ment s.
Even equit y ho lders are exposed t o pr ice risk o f corporat e share fluct uat es
rapidly. T his pr ice vo lat ilit y r isk pushed t he use o f der ivat ives like
fut ures and opt io ns increasingly as t hese inst rument s can be used as hedge
to prot ect against adverse pr ice changes in co mmodit y, foreign exchange,
equit y shares and bonds.


              
              


              
    

Globalisation of Markets:

Ear lier, manager s had t o deal wit h domest ic eco no mic concer ns; what
happened in ot her part of t he wor ld was mo st ly irrelevant . Now
glo balizat ion has increased t he size o f market s and as great ly enhanced
co mpet it io n . it has benefit ed consumer s who cannot obt ain bet t er qualit y
goods at a lower cost . It has also exposed t he moder n business t o
significant risks and, in many cases, led to cut profit margins I n I ndia n
cont ext , sout h East Asian currencies cr is is o f 1997 had affect ed t he
co mpet it ivene ss o f our product s vis-à- vis depreciat ed currencies. E xport
of cert ain goods fro m I ndia declined because o f t his cr is is. St eel indust r y
in 1998 suffered it s worst set back due t o cheap import of st eel fro m sout h
East As ian count r ies. Suddenly blue chip com panies had t urned in t o red.
The fear o f china devalu ing it s currency creat ed inst abilit y in I ndia n
export s. Thus, it is evident t hat glo balizat io n of indust r ial and financia l
act ivit ies necessit at es use of der ivat ives to guard against fut ure losses 5.
This fact or alo ne has co nt ribut ed to the growt h of der ivat ives t o a
significant ext ent .

Technological Advances:

A significant growt h of der ivat ive inst rument s has been dr iven b y
t echno logical break t hrough. Advances in t his area inc lude t he
development o f high speed processors, net work syst ems and enhanced
met hod of dat a ent r y. Clo sely r elat ed t o advances in co mput er t echno log y
are advances in t eleco mmunicat io ns. I mprovement in co mmunicat ions
allow for inst ant aneous wor ld wide conferencing, Dat a t ransmissio n b y
sat ellit e. At t he same t ime t her e wer e significant advances in so ft war e
programmed wit hout which co mput er and t eleco mmunicat io n advances


              
          


              
    

would be meaning less. T hese fac ilit at ed t he more r apid mo vement o f

infor mat io n and co nsequent ly it s inst ant aneous i mpact on market price.

Alt hough pr ice sensit ivit y t o market forces is benefic ial t o t he econo my
as a who le resources are rapid ly re locat ed to more product ive use and
bet t er rat ioned overt ime t he great er pr ice vo lat ilit y exposes producers and
consu mers t o great er price r isk. The effect of t his r isk can easily dest roy a
business which is ot herwise well managed. Der ivat ives can help a fir m
manage t he pr ice r isk inherent in a mar ket econo my. To t he ext ent t he
t echno logical development s increase volat ilit y, der ivat ives and r isk
management product s beco me t hat much more import ant .

Advances in Financi al Theories:

Advances in financia l t heor ies gave birt h to der ivat ives. Init ia lly forward
cont ract s in it s t radit io na l for m, was t he only hedging t ool available.
Opt ion pr ic ing models developed by B lack and Scho les in 1973 were used
                   
Edeingt on ext ended t he ear ly work o f Johnson and st art ed t he hedging o f
financial pr ice r isks wit h financial fut u res. The work o f econo mic
t heor ist s gave r ise t o new product s for risk management which led t o t he
6
growt h of der ivat ives in financial market s.

4. Conclusion

A derivative product, or simply 'derivative', is to be sharply distinguished from the

underlying cash asset. Cash asset is the asset which is bought or sold in the cash market
on normal delivery terms. Thus, the term 'derivative' indicates that it has no independent
value. It means that its value is entirely 'derived' from the value of the cash asset. The
main point is that derivatives are forward or futures contracts, i.e., contracts for delivery


                 



              
    

and payment on a-specified future date. They are essentially to facilitate hedging of price
risk of the cash asset. In the market term, they are called as 'Risk Management Tools'.7

Commodities futures trading in India were initiated long back in 1950s; however, the
1960s marked a period of great decline in futures trading. Market after market was closed
usually because different commodities' prices increases were attributed to speculation on
these markets. Accordingly, the Central Government imposed the ban on trading in
derivatives in 1969 under a notification issue. The late 1990s shows this signs of opposite
trends-a large scale revival of futures markets in India28, and hence, the Central
Government revoked the ban on futures trading in October, 1999. The Civil Supplies
Ministry agreed, in principle for starting of futures trading in Basmati rice, further, in
1996 the Government granted permission to the Indian Pepper and Spice Trade
Association to convert its Pepper Futures Exchange into an International Pepper
Exchange. The study has established the importance of derivative in capital market of
India.

5. References

1. Bharati, Pathak, Indian Financial Systems, (Delhi, Pearson Education, 2008), pp.
42-45.

2. Susan, Thomas (ed), Derivative Markets in India ,( New Delhi, Tata McGraw-Hill,
2003), pp. 45-67.

3. Reforms in Secondary Markets in India, Working paper from National stock

exchange (NSE), India, (2000).

4. Pati,          
           
Management, VI, 3 & 4, (2009), 7-10.


        


              
    

5.           on, Information
           
2002), 459-67.

6. John C. Hull, Introduction to Futures and Options Market, (New Delhi, Prentice
Hall of India,2004 ) pp. 295-97.

7. 1 L. C, Gupta, (Chairman) et al, Report of the Committee on Regulatory Framework

for Derivatives Trading, SEBI, (September 1997 and March 1998.)

8. T.V.,Somanathan, Derivatives, (New Delhi, Tata McGraw-Hill, 2000), pp. 238-239.

9.           
Markets India, (New Delhi, Tata McGraw-Hill, 2003)

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