Finance

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.

T
he past decade has witnessed
an explosive growth in the use
of financial derivatives by a
wide range of corporate and finan-
cial institutions. This growth has run
in parallel with the increasing direct
reliance of companies on the capital
markets as the major source of long-
term funding. In this respect, deriva-
tives have a vital role to play in en-
hancing shareholder value by ensur-
ing access to the cheapest source of
funds. Furthermore, active use of de-
rivative instruments allows the over-
all business risk profile to be modi-
fied, thereby providing the potential
to improve earnings quality by off-
setting un- desired risks.
The derivatives came into the spot-
light alongwith the rise in uncertainty
of post 1970, when US announced an
end to the Bretton Woods System of
fixed exchange rates leading to intro-
duction of currency derivatives fol-
lowed by other innovations including
stock index futures. Since then, deriva-
Faculty, University Business School,
Panjab University, Chandigarh
tives have quickly spread to an increas-
ing number of developed and devel-
oping countries. They are recognized
as the best and most cost-efficient way
of meeting the felt need for risk hedg-
ing in certain types of commercial and
financial operations. Countries not pro-
viding such globally accepted risk
hedging facilities are disadvantaged in
today's rapidly integrating global
economy. The liberalization and open-
ing up of the Indian economy has pre-
cipitated the process of integration of
India's financial market with the inter-
national financial markets.
The Position of Indian Capital
Market in terms of Global Com-
parison
The importance of capital mar-
ket in any economy can not be over
emphasised. The development of
capital market is vital for the growth
of real economy. A significant fea-
ture of developed capital market is
the degree of its integration and in-
teraction with major sectors of the
Economy. A stronger capital market
promotes sound and sustainable fi-
nancial system. The growth and de-
velopment of Indian Capital Market,
in particular during the last decade
has been spectacular. The impact of
international trends of the developed
and emerging capital markets were
evident in India also. The turnover
is developed markets has grown
more sharply than that in emerging
markets. This is a fact that fin stock
markets worldwide have grown in
size as well as depth during the last
10 years. The aggregate turnover of
all markets has grown nearly 9 times
from US$5.5 Trillion in 1990 to US$
47.9 Trillion in 2000. U.S Securities
Markets doubled its share in total
turnover between 1990 & 2000.
India accounted for 1.1 % total
turnover during the year 2000,
inspite of the fact that it has the larg-
est number of listed companies in the
world. The market capitalisation of
all listed companies taken together
on all markets of the world increased
by 245% from US$ 9.4 Trillion at the
end of 1990 to US$ 32.3 Trillion at
the end of 2000. The share of U.S.

in worldwide market capitalization
increased from 38.5% as at the end
of 1995 to 46.8% as at the end of
2000. The share of India Listed com-
panies accounted for 0.5% of total
market capitalization. The market
capitalization as per out of GDP in
India stood at 41.3% at the end of
the year 1999. The following table
shows the position of Indian Capital
Market in terms of International
comparison. (Table 1 below)
The Deregulation, Liberalization
and Globalization of the Indian
Economy has provided much needed
impetus to the Capital Market for its
growth and development. The earlier
reforms facilitated faster growth and
the latest one focussed on strength-
ening the functioning of the capital
Markets in India by adoption and im-
plementation of best international
practices, systems and products. This
trend will definitely increase the ef-
ficiency and effectiveness of Indian
Stock Market.
Objectives of the Study
(1) What do you mean by deriva-
tives?
(2) To Identify the emerging de-
rivatives Markets structure in
India.
(3) What is the potential of de-
rivatives Market in India?
(a) Benefits of Derivatives
(b) Risk of Derivatives
Findings of the Study
International Comparison end December, 2000.
Particular USA
No.of listed company
Market Cap. ($bn)
Market Capitalization Ratio (%)
Turnover ($bn)
Turnover Ratio (%)
Finance
1. What do you mean by deriva-
tives?
The term derivative instru-
ment is generally accepted to mean
a financial instrument with a payoff
structure determined by the value of
an underlying security, commodity,
interest rate, or index. According to
some notable surveys, over 80% of
private sector corporations consider
derivatives to be important in imple-
menting their financial policies. De-
rivatives have also gained wide ac-
ceptance among national and local
governments, government - spon-
sored entities, such as the Student
Loan Marketing Association and the
Federal Home Loan Mortgage Cor-
poration, and supranational, such as
the World Bank.
Derivatives are used to lower
funding costs by borrowers, to effi-
ciently alter the proportions of fixed
to floating rate debt, to enhance the
yield on assets, to quickly modify the
assets payoff structure to correspond
to the firm's market view, to avoid taxes
and skirt regulations, and perhaps most
importantly, to transfer market risk
(hedge)- where the term market risk is
used to connote the possibility of losses
sustained due to an unforeseen price
or volatility change. A firm may ex-
ecute a derivative transaction to alter
its market risk profile by transferring
to the trade's counter party a particu-
lar type of risk. The price that the firm
must pay for this risk transfer is the
acceptance of another type of risk and/
TABLE-1
UK Japan Germ-
any
7524 1904 2561 1022
15104 2577 3157 1270
358.8 130.7 66.4 50.8
31862 1835 2694 1069
200.8 66.6 69.9 79.1
or a cash payment to the counter party.
The term "derivative" indicates
that it has no independent value, i.e.
its value is entirely "derived" from
the value of the cash asset. A deriva-
tive contract or product, or simply
"derivative", is to be sharply distin-
guished from the underlying cash
asset, i.e. the asset brought / sold in
the cash market on normal delivery
terms. A general definition of "de-
rivative" may be suggested here as
follows: "Derivative" means for-
ward, future or option contract of
pre-determined fixed duration,
linked for the purpose of contract
fulfillment to the value of specified
real or financial asset or to index of
securities. Derivatives offer organi-
zations the opportunity to break fi-
nancial risks into smaller compo-
nents and then to buy and sell those
components to best meet specific risk
management objectives.
As both forward contracts and
futures contracts are used for hedg-
ing, it is important to understand the
distinction between the two and their
relative merits. Forward contracts are
private bilateral contracts and have
well established commercial usage.
They are exposed to default risk by
counter-party. Each forward contract
is unique in term of contract size,
expiration date and the asset type/
quality. The contract price is not
transparent, as it is not publicly dis-
closed. Since the forward contract is
Singa- Hong- China India
pore Kong
418 779 1086 9922
153 623 581 166
95.9 228.8 73.6 54.5
91 378 72.2 621
52.1 61.3 158.3 374.7

not typically tradable, it has to be set-
tled by delivery of the asset on the
expiration date. In contrast, futures
contracts are standardized tradable
contracts. They are standardized in
terms of size, expiration date and all
other features. They are traded on
specially designed exchanges in a
highly sophisticated environment of
stringent financial safeguards. They
are liquid and transparent. Their
market prices and trading volumes
are regularly reported. The futures
trading system has effective safe-
guards against defaults in the form
of Clearing Corporation guarantees
for trades and the daily cash adjust-
ment (mark to market) to the ac-
counts of trading members based on
daily price change. Futures are far
more cost-efficient than forward con-
tracts for hedging.
The various types of derivatives,
commonly used allover the world.
Options - Put / Call
A put or call option gives a right
without the obligation to buy (call)
or sell (put) a given security in the
future at a pre-specified price (i.e.
strike price).
Forward Contract
A forward contract is basically
a contract where the maturity and
amount are flexible, which can be
traded over the counter, or by tel-
ephone, fax, etc. and honouring of
the contract is made generally by tak-
ing and giving delivery and
counterparty risk depends on the
counterparty only.
Future Contract
On the other hand, a future con-
Finance
tract may be for a commodity or for
a security; which is done on a fixed
amount of maturity period and not
flexible like forward contract but
done on fixed dates, like in London
International Financial Futures Ex-
change it happens on 2nd Wednes-
day of March, June, September and
December, trading is done at same
price for all the participants at one
point of time at the exchange floor
(whereas forward contract trading is
normally done over phone or fax and
not across the floor) and most fun-
nily, the transactions on futures are
honoured by cancellation or reverse
transaction. On future contract, ques-
tion of counter party risk does not
arise because of mandatory margin
and daily adjustments of margins on
price movements and further more
the exchange itself is a party to each
and every future contract.
Crux Point
The ultimate world of derivative
is uncertainty. Derivative is not a
synonym of transactions in shares,
currencies, commodities, or mort-
gages, they are mainly transactions
in UNCERTAINTY.
A thing which is sure and certain,
on which there cannot be any risk
factor and, therefore, quantum of
adopting derivative methods does not
arise. Mathematically uncertainties
stay between 0 and 1. If something
is not going to happen under any cir-
cumstances, the chance of happening
of such a thing a naturally 0 (zero),
but otherwise, if the same is sure and
certain, then chance of happening is
confirm and positive and called 1, on
both the counts there cannot be any
probability, because there is no un-
certainty, but if there is something
which mayor may not happen, the
probability of happening or not hap-
pening such a thing lies between 0
and 1. This basic understanding of
probability shall help to create a ba-
sic concept on derivatives, because
derivatives deal with uncertainties.
Derivative always indicate it has no
independent value and are always
separated from the underlying cash
asset i.e., the asset bought or sold in
cash market on normal delivery
terms.
Hedging
Hedging is basically a protection
against risk. Through the following
examples this has been clarified.
(2) To Identify the emerging de-
rivatives Markets structure in
India?
Apart from traditional financial
markets, two more markets are
emerging, namely, the derivatives
market has come into being recently
and the bancassurance market, which
is likely to emerge in an important
way once banks start undertaking
insurance business derivatives in the
Indian financial markets are of recent
origin barring trade related forward
contracts in the forex market. Futures
markets in the commodity segment,
however, have existed for a long
time. Recently, over the counter as
well as exchange traded derivatives
have been introduced, marking an
important development in the struc-
ture of financial markets in India.
Forward contracts in the forex mar-
ket have also been liberalized. Ex-
change traded derivatives tend to be
more standardized and offer greater
liquidity than OTC contracts, which
are negotiated between counter par-
ties and tailored to meet the needs of
the parties to the contract. Exchange
traded derivatives also offer central-
ized limits on individual positions
and have formal rules for risk and
burden sharing.
In India, OTC derivatives, viz,
interest Rate Swaps and Forward
Rate Agreements (FRAs) were intro-
duced in July 1999, while one ex-
change traded derivatives, viz., stock
Index Futures was introduced by the

two largest stock exchanges in June
2000. The FRA is an off balance
sheet contract between two parties
under which one party agrees on the
start date (or trade date) that on a
specified future date (the settlement
date) that party, viz., the party that
agrees, would lodge a notional de-
posit with the other for a specified
sum of money for a specified period
of time (the FRA period) at a speci-
fied rate of interest (the contract
rate). The party that has agreed to
make the notional deposit has, thus,
sold the FRA to the other party who
has bought it. The IRS is a contract
between two counterparties for ex-
changing interest payment for a
specified period based on a notional
principal amount. The notional prin-
cipal is used to calculate interest pay-
ments but is not exchanged. Only
interest payments are exchanged.
The IRS and FRA were introduced
with a view to deepening the money
market as also to enable banks, Pri-
mary Dealers and financial institu-
tions to hedge interest rate risk. The
IRS has emerged as the more popu-
lar of the two instruments. In the In-
dian market, accounting for nearly all
of the 928 outstanding deals,
amounting to Rs. 12620 crore of no-
tional principal as on November
17,2000. The overnight call money
rates and the forex forward rates have
emerged as the most popular bench-
mark rates.
A resident of India who has bor-
rowed foreign exchange in accord-
ance with the FEMA, may enter into
an interest rate swap or currency
swap or coupon swap or foreign cur-
rency option or interest rate cap /
collar or Forward Rate Agreement
contract with an authorised dealer in
India or with a branch outside India
of an authorised dealer for hedging
his loan exposure and unwinding
from such hedges provided that (i)
the contract does not involve rupees,
(ii) foreign currency borrowing has
Finance
been duly approved (iii) the notional
principal amount of the hedge does
not exceed the outstanding amount
of the loan, and (iv) the maturity of
the hedge does not exceed the un-ex-
pired maturity of the underlying loan.
ADs in India may remit foreign ex-
change related to such foreign ex-
change derivative contracts. No resi-
dent in India can enter legally into a
foreign exchange derivative contract
without the prior permission of the
Reserve Bank. Among the non-resi-
dents, while FIIs may enter into a for-
ward contract with rupees as one of
the currencies with an AD in India,
non resident Indians and Overseas
Corporate Bodies could take forward
cover with an AD to hedge (i) divi-
dend due on shares held in India (ii)
balances in FCNR (B) and NR (E)
A, and (iii) the amount of investment
made under portfolio scheme. The
Reserve Bank of India may also con-
sider allowing residents to hedge
their commodity price risk (includ-
ing gold but excluding oil and petro-
leum products) subject to certain
conditions.
Forward contracts market has
emerged as an important segment of
the forex market in India in the re-
cent years. It comprises customers,
such as, corporate, exporters, import-
ers, and individuals,. Authorised
Dealer (ADs) and the Reserve Bank
Of late, FIIs have emerged as major
participants in this segment. The
market operates from major centres
with Mumbai accounting for bulk of
the transactions. Till February 1992,
forward contracts were permitted
only against trade related exposures
and these contracts could not be can-
celled except where the underlying
transactions failed to materialize. In
March 1992, in order to provide op-
erational freedom to corporate enti-
tled, unrestricted booking and can-
cellation of forward contracts for all
genuine exposures, whether trade
related or not, were permitted. At
present, the forward contracts mar-
kets is active up to six months where
two way quotes are available. The
maturity profile has recently elon-
gated with quotes available up to one
year. With the gradual opening up of
the capital account, forward premium
is now increasingly getting aligned
with the interest rate differential.
Importers and exporters also influ-
ence the forward market in many
ways. Besides, banks are allowed to
grant foreign currency loans out of
FCNR (B) liabilities and this too fa-
cilitated Integration of the forex and
the money markets, affecting the for-
ward premium.
The most notable development
concerning the secondary segment of
the Indian capital market is the in-
troduction of derivatives trading in
June 2000. SEBI approved deriva-
tives trading based on futures Con-
tracts at both BSE and NSE in ac-
cordance with the rules / bye laws
and regulations of the Stock Ex-
changes. A beginning with equity
derivatives has been made with the
introduction of stock index futures by
BSE and NSE. Stock Index Futures
contract allows for the buying and
selling of the particular stock index
for a specified price at a specified
future date. Stock Index futures, in-
ter alia, help in overcoming the prob-
lem of asymmetries in information.
Information asymmetry is mainly a
problem in Individual stocks as it is
unlikely that a trader has market-
wide private information. As such,
the asymmetric information compo-
nent is not likely to be present in a
basket of stocks. This provides an-
other rationale for trading in Stock
Index Futures. Also, trading in Index
derivatives involves low transaction
cost in comparison with trading is un-
derlying individual stocks compris-
ing the index. While the BSE intro-
duced stock index futures for BSE
sensex comprising 30 scrips, the
NSE introduced stock index Futures
 Finance

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

Table - 2
INDEX FUTURES CONTRACTS AT BSE AND NSE
Item BSE NSE
Date of Start June 9,2000 June 12. 2000
Security Name BSX N FUTIDX NIFTY
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
derivatives market, subject to the
condition that the overall open posi-
tion of the FII shall not exceed 100
percent of market value of the con-
cerned FII's total investment. Man-
aged future funds should be permit-
ted to take position in the derivatives
market without having any exposure
in the cash market. Also, FIIs intend-
ing to invest funds in the cash mar-
ket should also be permitted to take
long position in the futures market
to hedge their transactions.
SEBI and RBI should jointly ex-
amine the issues concerning trading
in derivatives by FIs and FIIs. (Ta-
ble 2 follows)
(3) What is the potential of de-
rivatives Market in India?
Trading in standard derivative
such as forwards, future and options
is already prevalent in India and has
a long history. Reserve Bank of In-
dia allowed forward trading in Ru-
pee Dollar forward contracts, which
has become a liquid market and also
allowed Cross Currency options trad-
ing. Commodities futures in India are
available in turmeric, black pepper,
coffee, Gur (jaggery), hessian, cas-
tor seed oil etc. There are plans to
set up commodities futures ex-
changes in Soya bean oil as also in
Cotton. International markets have
also been allowed (dollar denomi-
nated contracts) in certain commodi-
ties.
The spot markets / cash market
in equities world over is operated on
a principle of rolling settlement. In
India, most of the stock exchanges
52 Weeks High
52 Weeks Low
3 Years High
3 Years Low
Sources: Economic Times, August 18, 2001
Finance
allow the participants to trade dur-
ing one-week period for settlement
in the following week. The trades are
netted for the settlement for the en-
tire one week period. In that sense,
the Indian markets are already oper-
ating the futures style settlement
rather than cash markets prevalent
internationally. The more efficient
way will be speeding up
dematerialization of securities as non
dematerialized securities involve set-
tlement delays and to separate out the
derivatives from the cash market i.e.
introduce rolling settlement in all ex-
changes and at the same time allow
futures and options initially for the
broad market and then stock specific.
In less than three years, Indian eq-
uity markets have successfully
transited from the earlier paper based
settlement to demat settlement. To-
day more than 99.5 percent of the set-
tlement in both NSE and BSE is in
demat form. There is a substantial
demat coverage of equity markets.
In the Indian context, Bombay
Stock Exchange popularly known as
BSE introduced equity derivative in-
struments, the Sensex Futures on
June 9, 2000 and Options on BSE
Sensex, from June 1, 2001. Though
a beginning was made with the in-
troduction of rolling settlement on a
selected few stocks, effective from
July 2, 2001, rolling settlement was
introduced on a large number of
stock i.e., on highly liquid stocks or
"A" Group shares. The SEBI the
regulatory authority, propose to bring
in the scripts of the companies, which
are presently not under compulsory
rolling settlement w.e.f. January
TABLE-3
SENSEX
4790.63 (September 13, 2000)
3096.51 (April 16, 2000)
6150.69 (Feb. 14,2000)
2741.22 (October 23, 1998)
2,2002. Besides, from July 2, 2001
there is an index based market wide
circuit brakers system at three stages
of movement either way at 10 per-
cent, 15 percent and 20 percent.
These circuit brakers will bring about
a coordinated trading halt and equity
derivative markets nationwide.
Movement of either BSE Sensex or
NSE S & P CNX, which ever is
breached earlier, would trigger the
market wide circuit brakers. As fu-
tures and options were already in
vogue both on BSE and NSE, the op-
tion contracts on Individual securi-
ties was commenced from July 2,
2001 on NSE and from July 9, 2001
in BSE on 31 securities approved by
SEBI. The futures on individual
stocks however is not available at
present.
The underlying security (futures
and options) for broad market was S
& P CNX NIFTY 50 and BSE 30
SENSEX. The 31 individual stocks
as approved by SEBI for options in
securities are common for both the
exchanges i.e., BSE and NSE.
S&P CNX NIFTY 50 is well di-
versified 50 stock index accounting
for 25 sectors of the economy. As on
July 31, 2001 the total market capi-
talization of 50 stocks was Rs.
2,82,608 crore representing about 45
percent of total market capitalization.
Sectorwise, diversified accounted for
20.3 percent, followed by Petro-
chemicals 12.29 percent, Computers
Software 11.16 percent, Refineries
8.88 percent, Pharma 7.15 percent,
Cigarettes 6.88 percent and the other
sector accounting for less than 5 per-
cent respectively. The base period for
NIFTY
1470.55 (Sept. 12,2000) ,
1000.10 (April 16, 2000)
1618.15 (Feb. 23, 2000)
800.10 (Nov. 30, 1998)

the index is November 3, 1995 and the
value of index has been taken at 1000
with a base capital of Rs. 2,06,000 crore.
BSE Sensex on the other hand repre-
sents 30 large well established compa-
nies with sound fundamentals from all
significant sectors of the economy. The
financial year 1978-79 is the base year.
The sector wise representation & the
market capitalization in Shown in Ta-
ble 3. (Table 3 below)
The SEBI has setup a "Technical
Group" headed by Prof. J. R. Verma to
prescribe risk containment measures for
new derivation products. The group has
recommended the introduction of Ex-
change traded Option on Stocks, which
is also in conformity with the sequence
of introduction of derivative product
recommended by Dr. L. C. Gupta Com-
mittee.
The following are the risk contain-
ment measures to be adopted by the de-
rivative exchange/ segment and the
Clearing House / Corporation for the
trading and settlement of Option Con-
tracts on Stocks:
The Stock Option Contracts to be
traded on the derivative exchange/
segments shall have prior approval
of the SEBI. The Contract should
comply with the disclosure re-
quirements, if any, laid down by the
SEBI.
The Exchanges shall introduce
Premium Settled American Style
Stock Options, which shall be set-
tled in cash by exercise, for an ini-
tial period of six months, thereaf-
ter, the Stock Options, at exercise,
shall be settled by delivery.
The Stock Option Contract shall
have a minimum contract size of
Rs. 2 lakhs at the time of its intro-
duction in the market.
The Stock Option contract shall
have a maximum maturity of 12
months and shall have a minimum
of three strikes (in the money, near
the money and out of the money)
The Initial Margin requirements
shall be based on worst case loss
of a portfolio of an individual cli-
ent to cover 99 percent VaR over a
Finance
one day horizon. The Initial Mar-
gin requirement shall be netted at
level of individual client and it
shall be on gross basis at the level
of Trading/Clearing Member. The
Initial margin requirement for the
proprietary position of Trading /
Clearing member shall also be on
net basis.
A portfolio based margining ap-
proach shall be adopted which will
take an integrated view of the risk
involved in the portfolio of each
individual client comprising of his
positions of Derivative Contracts.
The 31 scrips approved by the
SEBI for options are based on the
following criteria, during the last
six months prior to the date of ap-
proval.
Stock in the list of top 200 scrips,
on the basis of average market
capitalization and average free
float market capitalization not less
than Rs. 750 crore. Free float mar-
ket capitalization means the non-
promoter holding in the stock.
Stock in the list of top 200 scripts,
based on the average daily volume,
and further, average daily volume
not less than Rs. 5 crore in the un-
derlying cash market.
Stock traded at least on 90 percent
of the trading days.
Non-promoters holding in the com-
pany should be at least 30 percent.
Ratio of daily volatility of the stock
vis a vis daily volatility of index
should not be more than four, at
any time during the previous six
months. Volatility estimates would
be computed as per Prof. J. R.
Verma Committee report on risk
containment measures for index
futures.
As per the above criteria, 31 scrips
were allowed for options trading. The
eligibility criteria would be reviewed
after a period of six months to examine
whether in the light of the experience;
the list of eligible stocks could be ex-
panded. While the options on the indi-
ces - Nifty and Sensex are European
options, the options on individual stocks
are American options. As of new, how-
ever, all the options that remain alive
till expiration are to be cash settled. This
arrangement is expected to be in placed
till the end of the year. After that, buy-
ers of calls and puts will be permitted
to insist on taking and giving delivery
of the underlying stocks.
The market lot for options of Nifty
is 200 while for that of Sensex and in-
dividual stocks it is 100. The options
created on any day can have three ex-
piry dates - at the NSE, the last Thurs-
day, and at the BSE, the last Friday of
the current and the next two months. On
any day, upto five new options may be
created on a security two in the money,
two out of the money and one (close to)
at the money. For example, if Reliance
share closes at a price of Rs. 343 per
share, the options that may be created
the next day would have exercise prices
of Rs. 380, 360, 340, 320 and 300. In
the case of calls, the first two would be
out of the money, the third wold be
(close to) at the money and the last two
would be in the money option. In the
case of puts, the first two would be in
the money options, the third would be
(close to) at the money and the last two
would be out the money options. As
closing prices fluctuate, over time, in-
vestors will have a large variety of op-
tions to choose from. The stock ex-
change has prescribed a minimum of
five different put and call contracts for
each stock for each month. Thus, at any
point of time, there are atleast 30 dif-
ferent contracts opened for one stock,
with a total of atleast 930 contracts
opened for all the 31 stocks.
(a) Benefits of Derivatives
Derivatives provide a low-cost, ef-
fective method for end users of hedge
and manage their exposures to interest
rates, commodity prices, or exchange
rates. Interest rate futures and swaps, for
example, help banks of all sizes better
manage the repricing mismatches in
funding long term assets, such as mort-
gages, with short term liabilities, such
as certificates of deposits. Around 1980
the first swap contracts were developed.
A swap is another forward based deriva-
tive that obligates two counter parties

to exchange a series of cash flows at
specified settlement dates in the future.
Swaps are entered into through private
negotiations to meet each firm's specific
risk management objectives. There are
two principal types of swaps: Interest
rate swaps and currency swaps. Today
interest rate swaps account for the ma-
jority of banks swap activity, and the
fixed for floating rate swap is the most
common interest rate swap. In such a
swap, one party agrees to make fixed
rate interest payments in return for float-
ing rate interest payments from the
counter party.
Financial derivatives, by reducing
uncertainties, make it possible for
corporations to initiate productive
activities that might not otherwise
be pursued. For example, an U.S.
Company may want to build a
manufacturing facility in India but
is concerned about the projects
overall cost because of exchange
rate volatility between the rupee
and the dollar. To ensure that the
company will have the necessary
cash available when it is needed for
investment, the U.S. manufacturer
should devise a prudent risk-man-
agement strategy that is in harmony
with its broader corporate objec-
tive of building a manufacturing
facility in India. As part of that
strategy, the U.S. firm should use
financial derivatives to hedge
against foreign exchange risk. De-
rivatives used as a hedge can im-
prove the management of cash
flows at the individual firm level.
Corporations, governmental enti-
ties, and financial institutions also
benefit from derivatives through
lower funding costs and more di-
versified funding sources. Cur-
rency and interest rate derivatives
provide the ability to borrower in
the cheapest capital market, do-
mestic or foreign, without regard
to the currency in which the debt
is denominated or the form in
which interest is paid. Derivatives
can covert the foreign borrowing
into a synthetic domestic currency
financing with either fixed or float-
Finance
ing rate interest.
Derivatives allow corporations and
institutional investors to more ef-
fectively manage their portfolio of
assets and liabilities. An equity
funds, for example, can reduce its
exposure to the stock market
quickly and at the relatively low
cost without selling off part of its
equity assets by using stock index
futures or index options. Corporate
borrowers and governmental enti-
ties can effectively manage their
liability structure the ratio of fixed
to floating rate debt and the cur-
rency composition of that debt -
using interest rate and currency fu-
tures and swaps.
Extensive academic literature ad-
dresses the question of whether the
dynamic hedging of options posi-
tions increases market volatility.
These studies examine the effects
of option listing on the volatility
of the under lying stock price and
are particularly relevant because
dynamic hedging of option posi-
tions by market makers is an im-
portant factor linking the markets
for the option and the underlying
stock. The findings are uniform.
Majority of the study concludes
that volatility is reduced with the
introduction of options trading.
These studies are quite powerful
because they span numerous time
periods and literally hundreds of
option listings. The range of com-
modities examined is extensive.
The majority of studies find that
the introduction of future trading
in stock indices does not result in
increased volatility of the under-
lying stocks. Where an increase is
found, moreover, it is usually for
short term volatility. Studies exam-
ining other commodities find that
the introduction of derivatives
trading tends to either decrease
volatility or result in no change.
The FIIs would be pleased, with
the trading systems moving closer
to international methods such as
derivatives. The FIIs inflows in the
stock markets have increased since
banning of badla and introduction
of derivatives. Over the next few
years, there will be fundamental
change in the market structure. By
March 2002, the classification of
scrips intro different categories
such as A, B1 and B2 will come to
an end. The A group stocks hith-
erto enjoying an edge over other
categories due to high liquidity has
come to an end with the introduc-
tion of rolling settlement prevented
the practice of switching of posi-
tion from one exchange to another
due to different exchanges having
different settlement cycles. This
leads to an upward re-rating of a
large number of fundamentally
good scrips which are currently ne-
glected just because they belong to
B1 and B2 categories.
One important aspect is the pric-
ing of the options. With regard to,
whether the premium is fair and
what factors should be considered
while deciding such a price. Math-
ematically, the price can be calcu-
lated by using either the Black-
Scholes model (For European style
options) or Binomial model (for
American Options). Without going
into complex mathematical formu-
las, which can be worked out in
electronic spreadsheets, one must
understand the relation and impact
of factors, which are considered to
determine that price. Some of these
factors include the relationship
between the strike price and the
value of the underlying expected
volatility of the underlying assets,
time to expiration, interest rates
and dividend yield of the underly-
ing over the life of the option.
A great deal of speculation is about
the broad market movement. The
most common topic of discussion
among equity investors is always
where do you see the market three
months down the line, etc. Specu-
lation on an individual stock is a
fairly difficult proposition in view
of insiders knowing more than oth-
ers about the affairs of the com-
pany. In contrast, information

about the index is fairly symmet-
ric i.e. CNX NIFTY 50 and BSE
30 SENSEX. Everyone roughly
knows the same facts about how
the economy is faring, political un-
certainties, etc. Hence speculation
on the index is a fair game. Inter-
estingly, the survey findings (L.C.
Gupta Committee) showed that
stock index futures ranked as the
most popular and preferred type of
equity derivative, the second being
stock index options and the third
being options on individual stocks.
Considerable interest exists in all
the three types of equity deriva-
tives mentioned above. The fourth
type, viz. Individual stock futures,
was favoured much less. It is per-
tinent to note that as of now SEBI
does not permit individual stock fu-
tures.
Banks are permitted to invest upto
five percent of their total outstand-
ing credit as at end of previous year
in capital market. This is huge
money, but Ibanks are traditionally
not active players in the stock mar-
ket. Derivatives help them to ef-
fectively manage the equity port-
folio.
For banking supervisors around the
world including Indian sub-conti-
nent,. probably the most important
question is what could go wrong
go engender systemic risk - the
danger that a failure at a single
bank could cause a domino effect,
precipitating a banking crisis. As
financial derivatives allow differ-
ent risk components to be isolated
and passed around the financial
system, clearly reduces the over-
all cost of risk bearing and enhance
economic efficiency. Those who
are willing and able to bear each
risk component at the least cost
will become the risk holders.
It is expected that arbitrage trans-
actions between the index futures
market and the cash market for eq-
uities is likely to have a beneficial
effect on the functioning of the
cash market in terms of price dis-
covery, broadening of liquidity and
Finance
over all efficiency.
Derivatives help mutual funds and
other financial institutions in their
investment strategy for strategic
purposes of controlling risk or re-
structuring portfolios. Suppose that
a mutual fund scheme decides to
reduce its equity exposure, pres-
ently, this can be achieved only by
actual selling of equity holdings
and selling is likely to depress eq-
uity prices to the disadvantage of
the Scheme and the whole market.
Besides, it is a time consuming
process and increases transaction
costs due to brokerage. By selling
index futures immediately, the ac-
tual sale of equity holdings may be
done gradually depending on mar-
ket conditions in order to realize
the best possible prices. The index
futures transaction may be un-
wound by an opposite transaction
to the same extent as unloading of
holdings progresses. Likewise, se-
curities may not be immediately
available in sufficient quantity at
reasonable prices when a new
scheme is floated as per the broad
objectives of the scheme. In purely
cash market, rushing to invest the
whole money is likely to drive up
prices to the disadvantage of the
scheme. The availability of stock
index futures can take care of this
entire problem. Repurchase may
sometimes necessitate liquidation
of a part of the portfolio in the case
of an open ended scheme. Selling
each holding in proportion of its
weight in the portfolio is often im-
practicable and rushing to the cash
market to liquidate would drive
down prices. Hence, the price used
in computation of NAV may not
match with the actual realization.
Stock Index Futures can help to
overcome these problems to the
advantage of unit holders.
For participants in the derivatives
market, there are various permu-
tations and combinations of call
and put options, with a fuller un-
derstanding, an investor will appre-
ciate that alternatives available to
him are plenty.
If an investor has no information
about individuals stocks, then he
diversifies and holds the market;
if he has information about a spe-
cific industry but neither on indi-
vidual firms within the industry nor
on the market, then he diversifies
across the industry and hedges the
market, and soon.
(b) Risks of Derivatives
So, far, we have examined some of
the economic benefits associated with
derivative products. The appreciation of
these products' effective benefits would
however be partial and incomplete with-
out an analysis of some of the risks in-
herently linked. The major preoccupa-
tion of regulatory bodies, banks and
other market participants would essen-
tially gravitate around the identification
and qualitative appreciation of these
risks. The kinds of risks associated with
derivatives are no different from those
associated with traditional financial in-
struments, although they can be far more
complex i.e., credit, market, operational,
and legal risk. Credit risk is the risk that
a loss will be incurred because
counterparty fails to make payments as
due. In the event of the default, the loss
on a derivatives contract is the cost of
replacing the contract with a new
counterparty. Concern has been ex-
pressed that financial institutions (espe-
cially dealers) may have used deriva-
tives to take on an excessive level of
credit risk that is poorly managed. Mar-
ket risk is the risk that the value of a
position in a contract, financial instru-
ment, asset, or portfolio will decline
when market conditions change. Con-
cern has been expressed that derivatives
expose firms to new market risks, while
increasing the overall level of expo-
sures. A risk that arises in all businesses
is operational risk the risk that losses
will be incurred as a result of inadequate
systems and control, inadequate disas-
ter or contingency planning, human er-
ror, or management failure. Legal risk
is the risk of loss because a contract can-
not be enforced or because the contract
terms fail to achieve her intended goals
of the contracting parties. This risk, of

course, is as old as contracting itself.
Because of the relative newness of de-
rivatives transactions, however, their
treatment under existing laws and regu-
lations is often ambiguous. This legal
uncertainty can result in significant un-
expected losses.
The credit risk from derivatives
activities can be controlled by the tradi-
tional credit risk management function
of dealers. This can be supplemented by
the more precise identification and
measurement made possible by deriva-
tives technology. The technology can
evaluate the creditworthiness if coun-
terparts, set risk limits to avoid exces-
sive concentrations, regularly measur-
ing exposures and monitoring them
against risk limits.
Derivatives generally have not ex-
posed institutions to fundamentally new
sources of market risk and have long
been exposed to these same market
risks.
Interest rate exposure is inherent
in the mismatch of assets and li-
abilities.
Finance
Currency exposure is inherent in
foreign exchange trading and in
foreign currency denominated bor-
rowing or lending.
Equity exposure is inherent in mar-
gin loans.
The market risks of any financial
activity, including derivatives activity,
must be evaluated on the basis of its ef-
fect on the net exposure of an overall
portfolio. Market risk can be effectively
managed through frequent marking to
market of portfolios, coupled with the
identification and measurement of mar-
ket risk, the setting of risk limits, and
monitoring of positions against limits.
These same sound principles and prac-
tices can be, and are, applied to other
activities.
While no aspect of operational risk
is unique to derivatives, however, it is
important for institutions actively en-
gaged in derivatives activities to have
adequate oversight of well trained and
knowledgeable staff by informed and
involved senior management. Users of
derivatives, like other firms, should at-
tempt to manage and minimize legal
risks.
Derivatives related disasters, par-
ticularly the collapse of Barings,
have led to questions about the
ability of individual derivatives
participants to internally manage
the trading operations. In addi-
tion, concern have surfaced
about regulator ability to detect
and control potential derivatives
losses. But regulatory and
legislative restrictions on
derivatives activities are not the
answer, primarily because simple,
standardized rules most likely
would only impair banks' ability
to manage risk effectively. A bet-
ter answer lies in greater reliance
on market forces to control de-
rivatives related risk taking, to-
gether with more emphasis on
government supervision, as
opposed to regulation.
Banking regulators should em-
phasize more disclosure of de-
rivatives positions in financial
statements and be certain that

institutions trading huge deriva-
tives portfolios have adequate
capital. In additions, because
derivatives could have implica-
tions for the stability of the fi-
nancial system, it is important
that users maintain sound risk
management practices. It is the
responsibility of a bank's senior
management to ensure that risks
are effectively controlled and
limited to levels that do not pose
a serious threat to its capital po-
sition. Regulation is an ineffec-
tive substitute for sound risk
management at the individual
firm level
It is important that derivatives
players fully understand the
complexity of financial deriva-
tives contracts and the accom-
panying risks. Users should be
certain that the proper safe-
guards are built into trading
practices.
The following are some of the
essential market monitoring
tools and policies that should
prevent financial disruptions, by
keeping the various risk expo-
sures in the financial market
under control.
Enhancing confidence and
knowledge among all market
participants is a necessary con-
dition in order to guarantee the
stability of the derivatives mar-
kets.
Enhance information standardi-
zation and disclosure at all lev-
els of the derivatives trading in-
dustry. Also, the market value
concept should always be pre-
ferred in order to serve as a
benchmark for the marking to
market or collateralization of
the various risk exposures.
Increase and harmonize the fre-
quency of market, accounting
and credit assessment data dis-
closure in order to allow for
Finance
daily risk monitoring. Market
participants should be able to
effectively monitor and limit
their market, credit and liquid-
ity risk exposures to the extent
of remaining exposed to a "sus-
tainable" price, volume or credit
variation at most.
An efficient risk management
system for the derivatives indus-
try has to be "dynamic" and ex-
plicitly consider and monitor the
evolution of market, credit and
liquidity risk exposures. In this
respect, the credit risk of deriva-
tives positions should be
analyzed across maturities as
well as across counterparties.
In order to enforce the risk man-
agement and monitoring at all
responsibility levels, the per-
formance measurement and fi-
nancial compensation schemes
of the firm employees have to
be incentive compatible. In or-
der to guarantee efficient self
regulation in the derivative mar-
ket, the managers, traders and
other derivative dealers must re-
ceive the proper incentive when
hedging, trading or speculating
with those instruments. Thus,
their performance objective (in
term of risk targets) have to be
clearly specified and their
fulfillment enforced through ex-
plicit penalties. Finally, the ho-
rizon over which a given per-
formance is assessed should be
compatible with the long run
objectives of the institution and
prevent traders from engaging in
short term horizon performance
enhancing strategies that lead
them to adopt exaggerate risk
exposures or turnover activities.
Whenever possible, the reputa-
tion of the market participant in
the derivative business should
be used as a monitoring device
to prevent them from adopting
excessively risky positions or
from engaging in irregular trans-
actions. In an industry where the
competition for market shares is
intense and involves a few ma-
jor players, where the products
are highly substitutable and
where the technology for finan-
cial innovation and transaction
costs reduction is not anymore
the property at a privileged elite,
reputation is a very effective
market monitoring instrument.
Derivatives participants should
adopts more transparent and
standardized accounting and
disclosure rules, putting more
emphasis on the education of
their personal and developing an
expertise in their back office
management and settlement pro-
cedures.
The ultimate and perhaps most
delicate topic is related to the
monitoring of derivatives,
namely the justification of ex-
ternal regulation. Regulation is
clearly not the only monitoring
device that can be used to en-
force market participants risk
exposures. External regulation
should be considered as the ul-
timate enforcement mechanism
whenever self regulation of the
market participants fails to
achieve the monitoring goals.
Thus, one could view the role
of regulation as that of a player
of last resort who guarantees
that the economic benefits asso-
ciated to the derivative trading
activity remain on the efficient
"risk/return" frontier.
It is a well known fact that risk
management is not about the elimi-
nation of risk; it is about the man-
agement of risk; selectively choos-
ing those risks an organisation is
comfortable with the minimizing
those that it does not want. Financial
derivatives serve a useful purpose in
fulfilling risk management objec-
tives. Through derivatives, risk from

traditional instruments can be
efficiently unbundled and man-
aged independently.
Conclusion
The economic benefits of deriva-
tives are not dependent on the size
of the institution trading them. The
decision about whether to use deriva-
tives should be driven, not by the
company's size, but by its strategic
objectives. However, it is important
that all users of derivatives, regard-
less of size, understand how their
contracts are structured, the unique
price and risk characteristics of those
instruments, and how they will per-
form under stressful and volatile eco-
nomic conditions. A prudent risk
management strategy that conforms
to corporate goals and is complete
with market simulation and stress
tests is the most crucial prerequisite
for using financial derivative prod-
ucts. Without a clearly defined risk
management strategy, use of finan-
cial derivatives can be dangerous. It
can threaten the accomplishment of
a firms long range objectives and
result in unsafe and unsound prac-
tices that could lead to the organiza-
tions insolvency. But when used
wisely, financial derivatives can in-
crease shareholder value by provid-
ing a means to better control a firms
risk exposures and cash flows. When
using financial derivatives, however,
organizations should be careful to
use only those instruments that they
understand and that fit best with their
corporate risk management philoso-
phy. It may be prudent to stay away
from the more exotic instruments,
unless the risk/reward tradeoffs are
clearly understood by the firm's sen-
ior management and its independent
risk management review team. Ex-
otic contracts should not be used
unless there is some obvious reason
for doing so.
The SEBI's advisory committee
on derivatives has proposed a set of
Finance
measures to improve liquidity in the
markets. These measures once ap-
proved by the SEBI board, would
permit FII participation in all deriva-
tive products. Allow intuitions lim-
ited short selling up to their expo-
sures in derivatives market, and in-
troduce stock futures and margin
trading. The committee also sug-
gested that banks funds could be
channeled through the stock ex-
change clearing house/ corporation
and allowing banks to participate in
the derivatives markets. Once these
measures are approved and imple-
mented effectively, liquidity should
get a substantial boost and improve
overall market sentiment. Bank par-
ticipation in derivatives and access
to FIIs, which are at present allowed
to trade only in index futures, to all
derivative products need the ap-
proval of the Reserve Bank of India.
The Success of most of these initia-
tive depends on an efficient stock
borrowing and leading mechanism.
But that requires to nationwide in-
frastructure for electronic funds
transfer (the problem is that it takes
three day to receive the proceeds of
a cheque, which means that the short
seller has to fund his position for
those days) and that of course is out-
side the purview of the SEBI & it is
high time that Finance Ministry and
RBI facilitate electronic fund trans-
fer.
In most countries, there are big-
ger arbitrage opportunities, in the
early days of the futures market. As
larger resources and greater skills,
get brought into the arbitrate busi-
ness, these opportunities tend of van-
ish. India is better placed in terms of
arbitrage, as compared with many
other countries thanks to the years of
experience with "line operators" who
are used to doing arbitrage between
exchanges. These skill are well
suited to the index arbitrage. The
minimum value of a contract for
stock derivatives at present is fixed
at Rs. 2 lacs and it is viewed as high
for retail participation. However,
only a fraction of it has to be paid on
the option contract in the form of
premium as the option price. With
only a marginal investment, one can
take large, positions in the market.
The options market would pick up in
Indian sub-continent fairly quickly
despite the nuances of the complex
mathematics involved in the valua-
tion of options, in view of intuitive
understanding of options is excellent.
Hence there is reason to be hopeful
that it would grow rapidly. The glo-
bal experience has shown that in the
long run, rolling settlement and de-
rivatives increases liquidity mani-
fold.
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