83  

CHAPTER-3 OVERVIEW OF INDIAN CAPITAL MARKET

3.1 INTRODUCTION

Economic environment of a nation is largely characterized by the efficient

mobilization and usage of financial resources. A favorable economic environment

attracts investments, which in turn influences the development of the economy. The

quantity and quality of assets in a nation at a specific time is one of the essential

criteria for the assessment of economic development. Assets in an economy is broadly

divided according to their characteristics into Physical, Financial and intangible assets.

Financial assets help the physical assets to generate activity.

Financial assets have specific properties like monetary value, divisibility,

convertibility, reversibility, liquidity and cash flow that distinguish it from physical

assets. These properties of financial asset led to the emergence of financial markets.

Specific financial markets are evolved to cater to the unique needs of the financial

instruments introduced. For instance US stock market came into existence for the

purpose of providing liquidity to the rail stocks, Bombay Stock exchange the oldest in

Asia was established by the East India Company for business in its loan securities.

When an existing stock market was unable to cope with the unique characteristics of a

financial instrument, a new financial market will evolve. For instance, Chicago Board

of trade (CBOT) was established to cater to the needs of commodities forward and

futures contract. Thus financial market is a place where financial instruments are

traded (Fig. 3.1).

Figure-3.1 Financial Markets

Financial Market

Money Market

Capital Market

Derivative Market

Insurance Market

Forex Market

84  

In this respect financial markets can be classified on the basis of the nature of

instruments exchanged in the economy. On the basis of the nature of financial

instruments the financial market is broadly classified as Money Market, Capital

Market, derivatives market, Insurance market and forex market.

In order to make a financial market more efficient and viable one, the financial

system of the country plays a greater role. Financial system of a country acts as

channel in efficient distribution of funds from surplus units to deficit units. Efficient

Financial systems are indispensible for speedy economic development. The more

vibrant and efficient the financial system in a country, the greater is its efficiency of

capital formation. The process of capital formation in the country is dependent upon

the investment policies and efficient operations of financial intermediaries. The

financial intermediaries facilitate the flow of savings into investments by overcoming

the geographical and technical barriers. As we know investment is the activity that

commits funds in any financial/physical form in the present with an expectation of

receiving additional return in the future. So investment is an activity that is undertaken

by those who have savings. But all savers are not necessarily investors basing upon

the motive behind the savings. The expectation of return is an essential characteristic

of investment. In this respect the role of financial intermediaries has become

immensely important, since they can help in channelizing the surplus funds from an

economy to the deficit units leading to development and growth of the economy at

large.

From the point of regulatory authority the financial intermediaries of the Indian

financial system can be classified as:

• Reserve Bank of India (RBI) regulating commercial banks, foreign exchange

markets, financial institutions and primary dealers.

• Securities and Exchange Board of India (SEBI) regulating Primary market,

Secondary market, derivatives market and market intermediaries like mutual

funds, brokers, merchant banks and depositaries.

The Indian financial system has been characterized by profound transformation

after the adoption of Liberalization, Privatization and Globalization (LPG) and

85  

launching of economic policy in the year 1991. This reform in the financial sector has

been characterized by the establishment of new capital markets, which provide the

basic function of mobilizing the investments needed by corporate. This has led to the

changes in several policy initiatives which have refined the market micro-structure,

modernized operations and broadened investment choices for the investors in the

capital market. The irregularities in the securities transactions in the last quarter of

2000-01, hastened the introduction and implementation of several reforms. Decisions

were taken to complete the process of demutualization and corporatization of stock

exchanges to separate ownership, management and trading rights on stock exchanges

and to effect legislative changes for investor protection, and to enhance the

effectiveness of SEBI as the capital market regulator.

The transition from a closed economy to an open economy has paved the way

for development in the capital market segment. Since then capital market plays a

pivotal role in the financial system towards disseminating the funds from surplus units

to deficit units. This has led to the growth and changes in the structure of Indian

capital markets and financial institutions (Bhole, 1982). The development and growth

in capital Market has also fuelled innovations in the market place, which led to the

introduction of new financial instruments like Index derivatives, stock derivatives,

currency derivatives etc.

The derivatives trading on the NSE commenced with the S&P CNX Nifty

Index Futures on June 12, 2000. The trading in index options commenced on June 4,

2001 and trading in options on individual securities commenced on July 2, 2001.

Single stock futures were launched on November 9, 2001. Thereafter, a wide range of

products have been introduced in the derivatives segment on the NSE. The Index

futures and options are available on Indices - S&P CNX Nifty, CNX Nifty Junior,

CNX 100, CNX IT, Bank Nifty and Nifty Midcap 50. Single stock futures are

available on more than 250 stocks. The mini derivative contracts (futures and options)

on S&P CNX Nifty were introduced for trading on January 1, 2008 while the Long

term Options Contracts on S&P CNX Nifty were launched on March 3, 2008.

86  

Due to rapid changes in volatility in the securities market from time to time,

there was a need felt for a measure of market volatility in the form of an index that

would help the market participants. Thus NSE launched the India VIX, a volatility

index based on the S&P CNX Nifty Index Option prices.

Apart from the introduction of new products in the Indian stock markets, the

Indian Stock Market Regulator, Securities & Exchange Board of India (SEBI) allowed

the Direct Market Access (DMA) facility to investors in India on April 3, 2008. To

begin with, DMA was extended to the institutional investors. In addition to the DMA

facility, SEBI also decided to permit all classes of investors to short sell and the

facility for securities lending and borrowing scheme was made operational on April

21, 2008.

The Debt markets in India have also witnessed a series of reforms, beginning in

the year 2001-02 which was quite eventful for debt markets in India, with

implementation of several important decisions like setting up of a clearing corporation

for government securities, a negotiated dealing system to facilitate transparent

electronic bidding in auctions and secondary market transactions on a real time basis

and dematerialization of debt instruments.

These developments in the securities market, support corporate initiatives,

finance the exploitation of new ideas and facilitate management of financial risks,

hold out necessary impetus for growth, development and strength of the emerging

market economy of India.

3.2 CAPITAL MARKET IN INDIA

Transfer of resources from those with idle resources to others who have a

productive need for them is perhaps most efficiently achieved through the capital

market. Thus, capital market provides channels for reallocation of savings to

investments and entrepreneurship and thereby decouples these two activities. As a

result, the savers and investors are not constrained by their individual abilities, but by

the economy’s abilities to invest and save respectively, which inevitably enhances

savings and investment in the economy.

87  

The existence of Indian capital markets dates back to the 18th century when the

securities of the East India Company were traded in Mumbai and Kolkata. When the

American Civil War began, the opening of the Suez Canal during the 1860s led to a

tremendous increase in exports to the United Kingdom and United States. Several

companies were formed during this period and many banks came to the fore to handle

the finances relating to these trades. With many of these registered under the British

Companies Act, the Stock Exchange, Mumbai, came into existence in 1875. It was an

unincorporated body of stockbrokers, which started doing business in the city under a

banyan tree. Business was essentially confined to company owners and brokers, with

very little interest evinced by the general public. There had been much fluctuation in

the stock market on account of the American war and the battles in Europe. However,

the orderly growth of the capital market began with the setting up of The Stock

Exchange, Bombay in July 1875 and Ahmedabad Stock Exchange in 1894.

Eventually, 22 other Exchanges in various cities sprang up.

Sir Phiroze Jeejeebhoy was another who dominated the stock market scene

from 1946 to 1980. His word was law and he had a great deal of influence over both

brokers and the government. He was a good regulator and many crises were averted

due to his wisdom and practicality. The BSE building, icon of the Indian capital

markets, is called PJ Tower in his memory.

The planning process started in India in 1951, with importance being given to

the formation of institutions and markets. The Securities Contract Regulation Act

1956 became the parent regulation after the Indian Contract Act 1872, a basic law to

be followed by security markets in India. To regulate the issue of share prices, the

Controller of Capital Issues Act (CCI) was passed in 1947.

The stock markets have had many turbulent times in the last 140 years of their

existence. The imposition of wealth and expenditure tax in 1957 by Mr. T.T.

Krishnamachari, the then finance minister, led to a huge fall in the markets. The

dividend freeze and tax on bonus issues in 1958-59 also had a negative impact. War

with China in 1962 was another memorably bad year, with the resultant shortages

increasing prices all round. This led to a ban on forward trading in commodity

88  

markets in 1966, which was again a very bad period, together with the introduction of

the Gold Control Act in 1963.

The markets have witnessed several golden times too. Retail investors began

participating in the stock markets in a small way with the dilution of the FERA in

1978. Multinational companies, with operations in India, were forced to reduce

foreign share holding to below a certain percentage, which led to a compulsory sale of

shares or issuance of fresh stock. Indian investors, who applied for these shares,

encountered a real lottery because those were the days when the CCI decided the price

at which the shares could be issued. There was no free pricing and their formula was

very conservative.

The next big boom and mass participation by retail investors happened in 1980,

with the entry of Dhirubhai Ambani. He can be said to be the father of modern capital

markets. The Reliance public issue and subsequent issues on various Reliance

companies generated huge interest. The general public was so unfamiliar with share

certificates that Dhirubhai is rumoured to have distributed them to educate people.

The then prime minister, V.P. Singh’s fiscal budget in 1984 was path-breaking

for it started the era of liberalization. The removal of estate duty and reduction of

taxes led to as well in the new issue market and there was a deluge of companies in

1985. Manmohan Singh as Finance Minister came with a reform agenda in 1991 and

this led to a resurgence of interest in the capital markets, only to be punctured by the

Harshad Mehta scam in 1992. The mid-1990s saw a rise in leasing company shares,

and hundreds of companies, mainly listed in Gujarat, and got listed in the BSE. The

end-1990s saw the emergence of Ketan Parekh and the information; communication

and entertainment companies came into the limelight. This period also coincided with

the dotcom bubble in the US, with software companies being the most favoured

stocks.

There was a meltdown in software stock in early 2000. P Chidambaram

continued the liberalization and reform process, opening up of the companies, lifting

taxes on long-term gains and introducing short-term turnover tax. The markets have

recovered since then and we have witnessed a sustained rally that has taken the index

89  

over 13000 marks several systemic changes have taken place during the short history

of modern capital markets. The setting up of the Securities and Exchange Board

(SEBI) in 1992 was a landmark development. It got its act together, obtained the

requisite powers and became effective in early 2000. The setting up of the National

Stock Exchange in 1984, the introduction of online trading in 1995, the establishment

of the depository in 1996, trade guarantee funds and derivatives trading in 2000, have

made the markets safer. The introduction of the Fraudulent Trade Practices Act,

Prevention of Insider Trading Act, Takeover Code and Corporate Governance Norms,

are major developments in the capital markets over the last few years that has made

the markets attractive to foreign institutional investors.

In every economic system, some units, individuals or institutions, are surplus

units who are called savers, while others are deficit units, called spenders. Households

are surplus units and corporate and Government are deficit units. Through the

platform of securities markets, the savings units place their surplus funds in financial

claims or securities at the disposal of the spending community and in turn get benefits

like interest, dividend, capital appreciation, bonus etc. These investors and issuers of

financial securities constitute two important elements of the securities markets. The

third critical element of markets is the intermediaries who act as conduits between the

investors and issuers. Regulatory bodies, which regulate the functioning of the

securities markets, constitute another significant element of securities markets. The

process of mobilization of resources is carried out under the supervision and overview

of the regulators. The regulators develop fair market practices and regulate the

conduct of issuers of securities and the intermediaries. They are also in charge of

protecting the interests of the investors. The regulator ensures a high service standard

from the intermediaries and supply of quality securities and non-manipulated demand

for them in the market. Table 3.1 presents an overview of market participants in the

Indian securities market.

The most important elements of security markets are the investors. The history

shows us that retail investors are yet to play a substantial role in the market as long-

term investors. An investor is the backbone of the capital market of any economy as

90  

he is the one lending his surplus resources for funding the setting up or expansion of

companies, in return for financial gain.

Table-3.1 Market Participants in the Securities Market

Market Participants 2009 2010 As on Sept. 2010

Securities Appellate Tribunal (SAT) 1 1 1

Regulators 4 4 4

Depositories 2 2 2

Stock Exchanges

With equities trading 20 20 20

With debt market segment 2 2 2

With derivative trading 2 2 2

With currency derivatives 3 3 4

Brokers (Cash segment) 9628 9772 10018

Corporate brokers (Cash segment) 4308 4424 4618

Brokers (Equity derivatives) 1587 1705 1902

Brokers (Currency derivatives) 1154 1459 1811

Sub brokers 60,947 75577 81713

FIIs 1626 1713 1726

Portfolio managers 232 243 250

Custodians 16 17 17

Registrars to an issue & Share transfer agents 71 74 68

Primary dealers 18 20 20

Merchant bankers 134 164 184

Bankers to an issue 51 48 52

Debenture trustees 30 30 27

Underwriters 19 5 6

Venture capital funds 132 158 168

Foreign venture capital investors 129 143 150

Mutual funds 44 47 48

Collective investment schemes 1 1 1

Source: NSE Fact book 2011

On the contrary the Retail participation in India is very limited considering the overall

savings of households. This is well depicted in the following Table 3.2:

91  

Table 3.2 Savings of House hold sectors in Financial Assets (%)

Financial Assets 2007-08 2008-09 2009-10 2010-11

Currency 11.4 12.7 9.8 13.3

Fixed Income Investments 78.2 88 85.6 87.1

Deposits 52.2 60.7 47.2 47.3

Insurance/Provident & Pension Funds

27.9 31.1 34.1 33.3

Small Savings -1.9 -3.8 4.3 6.5

Securities Market 10.1 -0.3 4.8 -0.4

Mutual Funds 7.7 -1.4 3.3 -1.8

Government Securities -2.1 0.0 0.0 0.0

Other Securities 4.5 1.1 1.5 1.4

Total 100 100 100 100

Source: RBI Annual Report 2010-11

The data presented here exhibits net financial savings of the household sector

in 2008-09 was 10.9% of GDP at current market prices which was lower than the

estimates for 2007-08 at 11.5%. Decline in the household investments in shares and

debentures were the main factors responsible for the lower household saving in 2008-

09. However, the household savings in instruments like currency, deposits, contractual

savings (pension and provident funds) and investment in government securities

remained broadly stable during the year. The household sector accounted for 89.5% of

the Gross Domestic Savings in Fixed Income investment instruments during 2008-09,

as against 78.2% in 2007-08. The investment of households in securities was -1.9%

compared with 10.1% in 2007-08. Table 3.2 shows Indian household investment in

different investment avenues since 1990-91 till 2008-09. It can be observed that the

household investments in government securities and mutual funds fell in the negative

territory while investments in shares and debentures of private corporate, banking and

PSU Bonds were at 4.4% at par with investments last year.

The fewer participation of the public in the capital market has been studied by

L.C. Gupta (1992) concludes that, a) Indian stock market is highly speculative; b)

Indian investors are dissatisfied with the service provided to them by the brokers; c)

92  

margins levied by the stock exchanges are inadequate and d) liquidity in a large

number of stocks in the Indian markets is very low. In the recent time the regulatory

bodies as well as the government has brought certain reforms which has created

interest among the investor class for larger investments in the capital market. The

importance in the study of capital market is vital since it plays a major role in

economic development of a country.

In this respect the major economic role of a capital market is to match players

who have excess funds to players who are in need of funds. Capital market exchange

and provide liquidity to both long term fixed claim securities and residual (equity

claim) securities. In this exchange process, there is a valuation of the instruments done

by the market for the specific risk assumed by the investors. Apart from the risk

associated with a security, the return from that security is also important from the

investors’ perspective, since for assuming higher risk the investor’s expected return

from that security (portfolio) should be higher. This risk return characteristics of the

instruments necessitates a subdivision of the capital market into debt and equity

market.

Figure-3.2 Subdivisions of Capital Market

3.3 DEBT MARKET IN INDIA

Debt instruments represent contracts whereby one party lends money to another

on pre-determined terms with regard to rate of interest to be paid by the borrower to

the lender, the periodicity of such interest payment, and the repayment of the principal

amount borrowed. In the Indian securities markets, the term ‘bond’ is used for debt

instruments issued by the Central and State governments and public sector

organisations, and the term ‘debentures’ for instruments issued by private corporate

CAPITAL MARKET

DEBT MARKET EQUITY MARKET DERIVATIVES MARKET

93  

sector. So, financial Instruments that have a fixed income claim and have a maturity of

more than one year are traded in the debt market. The market for government

securities is the most dominant part of the debt market in terms of outstanding

securities, market capitalization, trading volume and number of participants.

The NSE started its trading operations in June 1994 by enabling the Wholesale

Debt Market (WDM) segment of the Exchange. This segment provides a trading

platform for a wide range of fixed income securities that includes Central government

securities, treasury bills (T-bills), state development loans (SDLs), bonds issued by

public sector undertakings (PSUs), floating rate bonds (FRBs), zero coupon bonds

(ZCBs), index bonds, commercial papers (CPs), certificates of deposit (CDs),

corporate debentures, SLR and non-SLR bonds issued by financial institutions (FIs),

bonds issued by foreign institutions and units of mutual funds (MFs). To further

encourage wider participation of all classes of investors, including the retail investors,

the Retail Debt Market segment (RDM) was launched on January 16, 2003. This

segment provides for a nationwide, anonymous, order driven, screen based trading

system in government securities. In the first phase, all outstanding and newly issued

central government securities were traded in the retail debt market segment. Other

securities like state government securities, T-bills etc. will be added in subsequent

phases.

In developed economies, bond markets tend to be bigger in size than the equity

market. In India however, corporate bond market is quite small compared to the size

of the equity market. One of the main reasons for this is that a large part of corporate

debt, being loan from financial intermediaries, is not securitized. The picture however

is undergoing a sea change in the last few years. An increasingly larger number of

companies are entering the capital market to raise funds directly from the market

through issue of convertible and non-convertible debentures. The deregulations on

interest rates in the new liberalized environment are resulting in innovative

instruments being used by companies to raise resources from the capital markets

leading to the growth in the WDM.

94  

Debt markets are pre-dominantly wholesale markets, with institutional

investors being major participants. Banks, financial institutions, mutual funds,

provident funds, insurance companies and corporates are the main investors in debt

markets. Many of these participants are also issuers of debt instruments. Most debt

issues are privately placed or auctioned to the participants. Secondary market dealings

are mostly done on telephone, through negotiations. In some segments, such as the

government securities market, market makers in the form of primary dealers have

emerged, which enable a broader holding of treasury securities. Debt funds of the

mutual fund industry, comprising of liquid funds, bond funds and gilt funds, represent

a recent mode of intermediation of retail investments into the debt markets.

The major market participants in the debt market are as follows:

Central Government raises money through bond and T-bill issues to fund

budgetary deficits and other short and long-term funding requirements.

Reserve Bank of India (RBI), as investment banker to the government, raises funds

for the government through dated securities and T-bill issues, and also participates

in the market through open-market operations in the course of conduct of monetary

policy. RBI also conducts daily repo and reverse repo to moderate money supply

in the economy. RBI also regulates the bank rates and repo rates, and uses these

rates as tools of its monetary policy. Changes in these benchmark rates directly

impact debt markets and all participants in the market as other interest rates realign

themselves with these changes.

Primary Dealers (PDs), who are market intermediaries appointed by RBI,

underwrite and make market in government securities by providing two-way

quotes, and have access to the call and repo markets for funds. Their performance

is assessed by RBI on the basis of their bidding commitments and the success ratio

achieved at primary auctions. In the secondary market, their outright turnover has

to three times their holdings in dated securities and five times their holdings in

treasury bills. Satellite dealers constituted the second tier of market makers till

December 2002.

95  

State governments, municipal and local bodies issue securities in the debt markets

to fund their developmental projects as well as to finance their budgetary deficits.

Public Sector Undertakings (PSUs) and their finance corporations are large issuers

of debt securities. They raise funds to meet the long term and working capital

needs. These corporations are also investors in bonds issued in the debt markets.

Corporate issue short and long-term paper to meet their financial requirements.

They are also investors in debt securities issued in the market.

Development Financial Institutions (DFIs) regularly issue bonds for funding their

financing requirements and working capital needs. They also invest in bonds

issued by other entities in the debt markets. Most FIs hold government securities in

their investment and trading portfolios.

Banks are the largest investors in the debt markets, particularly the government

securities market due to SLR requirements. They are also the main participants in

the call money and overnight markets. Banks arrange CP issues of corporates and

are active in the inter-bank term markets and repo markets for their short term

funding requirements. Banks also issue CDs and bonds in the debt markets. They

also issue bonds to raise funds for their Tier -II capital requirement.

Mutual funds have emerged as important players in the debt market, owing to

the growing number of debt funds that have mobilised significant amounts from the

investors. Most mutual funds also have specialised debt funds such as gilt funds and

liquid funds. Mutual funds are not permitted to borrow funds, except for meeting very

short-term liquidity requirements. Therefore, they participate in the debt markets pre-

dominantly as investors, and trade on their portfolios quite regularly.

The development and growth of WDM can be studied by analyzing various

parameters like trading volume, turnover, market capitalization etc. The trading

volume on the WDM Segment of the Exchange witnessed a year on year increase of

67.00% from Rs. 335,952 crore (US $ 65,937 million) during 2008-09 to Rs. 563,816

crore (US $ 124,904 million) during 2009-10. The average daily trading volume also

accelerated from Rs. 1,412 crore (US $ 277 million) during 2008-09 to Rs. 2,359 crore

(US $ 523 million) in fiscal 2009-10. The highest recorded WDM trading volume of

Rs. 13,9

business

Source:

A

figure th

debt mar

Year

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11Source: NSE

912 crore

s growth of

NSE Fact b

Although the

hat which t

rket segmen

Govt. securities

1 390,952

2 902,105

3 1,000,518

4 1,218,705

5 724,830

6 345,563

7 153,370

8 194,347

9 234,288

0 327,837

1 304,836

E Fact book 201

(US $ 3,20

the WDM

Fi

book 2011

e WDM is

type of deb

nt. This can

Table 3.3

TurnoT-Bills

23,143

25,574

8 32,275

5 55,671

124,842

105,233

51,954

66,062

56,824

92,961

98,713

11

06 million)

segment is

gure 3.3 Bu

growing Y

bt instrumen

n be examin

Security w

over (Rs. CrPSU

Bonds O

7,886 6

10,987 8

19,985 1

27,112 1

17,835 1

12,173 1

4,418 9

9,232 1

30,008 1

86,833 5

109,586 4

96

) was regi

presented i

usiness Gro

Y-O-Y basis

nt is contri

ned from the

wise distribu

r.) Others Tot

Turno

6,600 428,

8,619 947,

5,924 1,068

4,609 1,316

9,787 887,

2,554 475,

9,365 219,

2,676 282,

4,831 335,

6,185 563,

6,312 559,

stered on

in Figure-3.

owth of WD

, but it is n

ibuting mor

e Table 3.3

ution of WD

tal over

Govt. securiti

es

582 91.22

191 95.24

8,701 93.62

6,096 92.60

294 81.69

523 72.67

106 70.00

317 68.84

952 69.74

816 58.15

447 54.49

August 25

.3.

DM

not clear fro

re to the gr

and Figure

DM Trades

TurnoveT-Bills

5.40

2.70

3.02

4.23

14.07

22.13

23.71

23.40

16.91

16.49

17.64

, 2003. Th

om the abov

rowth of th

e 3.3

er (%) PSU

Bonds Oth

1.84 1.54

1.16 0.9

1.87 1.49

2.06 1.1

2.01 2.2

2.56 2.6

2.02 4.2

3.27 4.4

8.93 4.4

15.40 9.9

19.59 8.2

he

ve

he

ers

4

91

9

11

23

64

27

49

41

97

28

97  

Figure-3.4 Security wise distribution of WDM Trades

Source: NSE Fact book 2011

The transactions in government securities accounted for a substantial share of

58.15 % during 2009-10 on the WDM segment. The details of transactions in different

securities are presented in Table 3.3 and Figure-3.4. The trading members accounted

for 49.23 % of the total WDM trades followed by foreign banks which held a share of

23.67 %. Share of Indian banks in WDM trades increased to 19.84 % during 2009-10

as compared with its share of 18.11 % in the corresponding period last year.

Market capitalisation of the WDM segment has witnessed an increase of 11.15

% from Rs. 2,848,315 crore (US $ 559,041 million) as on March 31, 2009 to Rs.

3,165,929 crore (US $ 701,358 million) as on March 31, 2010. Central Government

securities accounted for the largest share of the market capitalisation with 61.61%.

Although there is an increase in the activities in the debt market segment, yet

the debt market segment is not fully utilized in India as compared to western

countries. The need of the hour is to tap this market by bringing various innovative

products like securitization, CDS, etc., by the government to make it fully operative.

3.4 EQUITY MARKET IN INDIA

This market is characterized by the exchange of equity instruments that bestow

ownership on the holder of the security. Equity implies ownership rights in the

corporate entity that has issued the instruments to the public. The claim of the owners

of these instruments is residual in nature and the securities have no maturity. In this

respect the Equity market has further been dived into two parts:

0

20

40

60

80

100

120

Govt Security

T‐Bill

PSU Bond

Others

98  

Primary Market: The primary market acts as a doorway for corporate enterprises to

enter the capital market. It provides opportunity to issuers of securities, Government

as well as corporate, to raise resources to meet their requirements of investments

and/or discharge some obligation. Primary market also known as New Issue Market

deals with new securities which were not previously available and offered to the

investing public for the first time. They may issue the securities at face value, or at a

discount/premium and these securities may take a variety of forms such as equity, debt

etc. They may issue the securities in domestic market and/or international market. The

primary market enjoys neither any tangible form nor any administrative

organizational set-up and is not subject to any centralized control and

administration for the execution of its business. It is recognized by the services

that it renders to the lenders and borrowers of capital. The main function of

primary market is to facilitate the ‘transfer of resources’. The corporate that raise

funds through primary market have to compulsorily list their securities in any of the

recognized stock exchange for further trading. Listing on stock exchanges provides

the qualifying companies with the broadest access to investors, the greatest market

depth and liquidity, the highest visibility, the fairest pricing and investor benefits.

As per the research is concerned a paucity of research is done in the new issue

market in India. What is worse is that much of whatever little work has been done,

dates back to the late 1970's and early 1980's prior to the qualitative transformation

that took place in the Indian equity markets in the 1980's. Khan (1977, 1978) studied

the role of new issues in financing the private corporate sector during the 1960's and

early 1970's and concluded that new issues were declining in importance. He also

showed that with underwriting becoming almost universal, institutions like the LIC

and the UTI were becoming major players. Jain (1979) shed more light on this

question with an analysis of UTI's role in the new issue market. He argued that UTI

looked at underwriting as a method of acquiring securities at low cost rather than an

arrangement for guaranteeing the success of new issues. In the context of the rapidly

changing structure of the merchant banking industry in India today, a deeper analysis

of the motivations and strengths of different players would be highly useful.

99  

Chandra (1989a) and Varma and Venkiteswaran (1990) critically examine the

CCI guidelines for valuation of shares and point out that the CCI's methodology is

fundamentally flawed. With the abolition of the office of the CCI, the issue of pricing

using the CCI methodology has however become redundant.

Anshuman and Chandra (1991) examine the government policy of favouring

the small shareholders in terms of allotment of shares. They argue that such a policy

suffers from several lacunae such as higher issue and servicing costs and lesser

vigilance about the functioning of companies because of inadequate knowledge. They

suggest that there is a need to eliminate this bias as that would lead to a better

functioning capital market and would strengthen investor protection.

This highlights the reform that is necessary in terms of market microstructure

and transactions will ensure the Indian capital market to be comparable with the

capital markets in the most developed countries. The early 1990s saw a greater

willingness of the saver to place funds in capital market instruments-on the supply

side as well as an enthusiasm of corporate entities to take resource to capital market

instruments- on the demand side. The reforms introduced in the Indian primary

market in the issue mechanism highlights Book Building Process, Green Shoe

Option and Application Supported by Blocked Amount reforms introduced in Indian

primary market with the prime objective of investor protection. In this connection

SEBI has come out with DIP guideline that will ensure transparency in the new issue

market. Apart from that also SEBI acts as a watch dog in the secondary market where

the shares are listed for further trading.

Secondary Market: Secondary market refers to a market where securities are traded

after being initially offered to the public in the primary market and/or listed on the

Stock Exchange. Majority of the trading is done in the secondary market. It essentially

comprises of the stock exchanges which provide platform for trading of securities and

a host of intermediaries who assist in trading of securities and clearing and settlement

of trades. The securities are traded, cleared and settled as per prescribed regulatory

framework under the supervision of the Exchanges and SEBI.

100  

The stock exchanges are the exclusive centers for trading of securities. Listing

of companies on a Stock Exchange is mandatory to provide an opportunity to

investors to invest in the securities of local companies. The Stock Exchange, Bombay

in July 1875 and Ahmedabad Stock Exchange in 1894 were the oldest stock

exchanges in India. After liberalization and setting up of National Stock Exchange

(NSE), eventually 22 other Exchanges in various cities sprang up. However NSE and

BSE are the major stock exchanges accounted for 99.98% of the total turnover in

India.

The trading volumes on exchanges have been witnessing phenomenal growth

for last few years. Since the advent of screen based trading system in 1994-95, it has

been growing by leaps and bounds and reported a total turnover of Rs.51,30,816 crore

during 2007-08. The growth of turnover has, however, not been uniform across

exchanges as may be seen from. The increase in turnover took place mostly at big

exchanges (NSE and BSE) and it was partly at the cost of small exchanges that failed

to keep pace with the changes. The business moved away from small exchanges to big

exchanges, which adopted technologically superior trading and settlement systems.

The Bombay Stock Exchange (BSE) is the oldest stock exchange in Asia with a

rich heritage. It was established as “the Native share & Stock Brokers Association” in

the year 1875. It is the first stock exchange in the country to obtain permanent

recognition in 1956 from the Govt. of India under the SC(R) Act, 1956. The

exchange’s pivotal and pre-eminent role in the development of the Indian capital

market is widely recognized.

On the other hand as per the recommendation of the High powered committee

National stock Exchange of India (NSE) was promoted by the leading Financial

institutions at the behest of Government of India and was incorporated in November

1992. After getting recognition as a stock exchange under the SC(R) Act 1956 in

April 1993, NSE commenced operations in the Wholesale Debt market segment in

June 1994. The capital market segment commenced operation in November 1994 and

operations in the derivative segment commenced in the June 2000.

101  

Bombay Stock Exchange was the first and the oldest stock exchange

established by the Native traders under a banyan tree in the year 1875. Since its

inception BSE had always functioned as a “club like” regional exchange run by

powerful groups of Gujarati operating with high margins, low transparency,

bureaucracy and unreliable clearing and settlement systems. Until the late 1980’s

Indian state dominated the inefficient financial sector. This led to rents captured by

insiders dominating the market. Towards the end of the 1980’s, new economic forces,

the economic growth and currency crisis emphasized the need for modernization of

the financial system. Government created the Securities and Exchange Board of India

(SEBI) in 1988 whose reforms were blocked by BSE. The Indian stock market

crashed in April 1992. Investors like Harshad Mehta diverted 35bn INR from the bank

system via Ready Forward Deals to the equity market which they manipulated.

Minister of Finance stressed “prima facie evidence of a nexus between brokers

and bank officials ” and the need to create competition between exchanges. He

tapped the Industrial Development Bank (IDB) to take the lead of the project of

creating competition for BSE.

The above discussed limitations found in BSE and the stock market crash in

1992 had propelled the government of India to establish a capital market which will

win the investors’ confidence and act as a competitor for BSE. In this connection in

the year 1992 NSE was given birth and commencing its trade in 1994 in the equity

market segment. This segment has grown phenomenally in terms of number of

companies listed, market capitalization, turnover and trading volume. The popular

Index for NSE is Nifty constructed on value weighted basis by taking 50 shares.

As regards to the listing on NSE (Table 3.4) there is a spurt in the listing of

companies. NSE has about 1470 listed companies in March 2010 which include from

hi-tech to heavy industry, software, refinery, public sector units, infrastructure and

financial services. The issuers of securities have to adhere to provisions of the

Securities Contracts (Regulation) Rules, 1956, the Companies Act 1956, and the

Securities and Exchange Board of India Act 1992. All companies seeking listing of

their securities on the exchange are required to enter into a formal listing agreement

102  

with the exchange. The agreement specifies all the quantitative and qualitative

requirements to be continuously complied with by the issuer for continued listing. The

exchange monitors such compliance. Companies that are listed in other stock

exchanges are also permitted to trade in NSE.

Table 3.4: Companies Listed in NSE

Year Companies Listed Companies Available for Trading *

2000-2001 785 1,029

2001-2002 793 890

2002-2003 818 788

2003-2004 909 787

2004-2005 970 839

2005-2006 1,069 929

2006-2007 1,228 1084

2007-2008 1,381 1236

2008-2009 1,432 1291

2009-2010 1,470 1359

2010-11 1574 1484

* Excluding Suspended Companies, Source: NSE Fact Book, 2010, pp.31.

Every year companies listed in the NSE are increasing cumulatively. The

companies available for trading decreased year by year from 2001 to 2004 and it

increased in the year 2004–2005. After that the listing of companies starts increasing

Y-O-Y basis.

Market capitalization is a good indicator of the health of capital markets.

Market capitalisation means the total number of outstanding shares of the company

multiplied by the share price of that stock. Stock market capitalisation means the total

market capitalisation of all the individual stocks that are listed on the exchange. The

size and growth of the market capitalisation is a critical measurement of a stock

exchange’s success or failure. The stock price movement determines the market

capitalisation. Foreign portfolio investment added buoyancy to the Indian capital

markets and Indian corporate sector began aggressive acquisition spree overseas,

103  

which was reflected in the high volume of outbound direct investment flows. Market

capitalisation of securities in the capital market segment is given in Table 3.5.

The total market capitalization was very high in the year 2009–2010 due to

strong investment by FIIs. The secondary market, recorded a sharp slump in the wake

of the global financial crisis during the latter half of 2008, staged a outstanding

recovery in 2009 following stimulus measures implemented by the Government and

resurgence of foreign portfolio flows displaying renewed interest by foreign investors.

Furthermore, election results announced in May 2009 eliminated uncertainty on

economic policies and as such boosted Indian equity markets. India ranks 49th out of

133 economies in the Global Competitive Index for the year 2009-2010.

Table 3.5: Market Capitalization and Turnover of Securities in the CM Segment

(Rs.in Crores)

Year Total Market capitalisation

Turnover Average daily trading

value

2000-2001 6,57,847 1339510 5337

2001-2002 6,36,861 513167 2078

2002- 2003 5,37,133 617989 2462

2003-2004 11,20,976 1099534 4329

2004-2005 15,85,585 1140072 4506

2005-2006 28,13,201 1569558 6253

2006-2007 33,67,250 1945287 7812

2007-2008 48,58,122 3551038 4148

2008-2009 28,96,194 2752023 11325

2009-2010 60,09,173 4138023 16959

2010-2011 67,02,616 3577410 14029

Source: Fact Book, 2005, 2010

The total market capitalization declined in the year 2008–2009 due to

significant slowdown of the industrial sector and unsatisfactory performance of

infrastructure industries and this set a bear phase in the market. As on 31st March 2009

the total market capitalisation was Rs. 28,96,194 cr., which was regarded as the lowest

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104

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105  

During 2008-09, the growth in exports was robust till August 2008. However,

in September 2008, export growth evinced a sharp dip and turned negative in October

2008 and remained negative till the end of the financial year. The continued decline in

export growth was due to the recessionary trends in the developed markets where the

demand had plummeted. For the year as a whole, the growth in merchandise exports

during 2008-09 was 3.6 per cent in US dollar terms and 16.9 per cent in rupee terms

(compared to 28.9 per cent and 14.7 per cent respectively in 2007-08). The large

difference in growth in terms of the US dollar and in terms of the rupee was on

account of the depreciation of rupee vis-à-vis US dollar during the year. It was

increased from 2001 – 2002 to 2007 -2008 and declined in the year 2008- 2009. The

environment improved in 2009-10 and got better with every subsequent quarter. In

tandem with the increase in stock prices in 2009-10, there was a significant increase in

turnover and market capitalisation across the board. In the cash segment, the turnover

at NSE increased by 50.4 percent during 2009-10 as compared to decline witnessed at

NSE by 22.5 percent.

The sudden growth of the CM segment of NSE and the strong competition

shown to BSE is of the following factors: First of all, non-Gujarati traders and/or

investors with low needs to be part of the Gujarati financial community were

predominantly attracted by the fee structure and customer oriented clearing,

settlement and dematerialization processes of NSE. Secondly, traders, investors and

public policy makers with a important long-run financial and/or political interest

to transform the Indian equity market into a competitive and attractive market were

attracted by this potential to reshape the market and by the fee structure and the

customer oriented clearing, settlement and dematerialization processes of NSE.

Thirdly, traders and/or investors who originally used brokers become member of NSE

because of the possibility to trade electronically outside Bombay. Fourthly, price

differences attracted arbitrage traders who supported liquidity at both exchanges.

The idea is that the governmental intervention in this inefficient market

was successful because of BSE’s weaknesses (unfavorable transaction costs,

customer processes and narrow geographical scope) and because of visionary

106  

market design, technology and governance innovations implemented by a strong NSE

management make NSE a strong competitor in the capital market segment.

The success of NSE’s capital market segment within a short span of time and

the wind of financial innovation that was sweeping across the world after the

invention of financial derivatives and its success as a risk management tool compelled

the government to adopt the changes in the Indian economy. This has led to the

introduction of financial derivatives in India.

3.5 DERIVATIVES MARKET IN INDIA

The term ‘derivatives, refers to a broad class of financial instruments which

mainly include options and futures. These instruments derive their value from the

price and other related variables of the underlying asset. They do not have worth of

their own and derive their value from the claim they give to their owners to own some

other financial assets or security. A simple example of derivative is butter, which is

derivative of milk. The price of butter depends upon price of milk, which in turn

depends upon the demand and supply of milk. The general definition of derivatives

means to derive something from something else. According to Securities Contract

Regulation Act (SCRA) 1956 Derivative may be defined as:

a) “A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of

security;

b) “A contract which derives its value from the prices, or index of prices, of

underlying securities”

As defined above, the value of a derivative instrument depends upon the

underlying asset. The underlying asset may assume many forms:

• Commodities including grain, coffee beans, orange juice;

• Precious metals like gold and silver;

• Foreign exchange rates or currencies;

• Bonds of different types, including medium to long term negotiable debt

securities issued by governments, companies, etc.

107  

• Shares and share warrants of companies traded on recognized stock exchanges

and Stock Index

• Short term securities such as T-bills; and

• Over- the Counter (OTC)

• Money market products such as loans or deposits.

Derivatives contracts are of many types depending upon the underlying asset

upon which the contracts are being written. But broadly derivatives can be classified

in to two categories: Commodity derivatives and financial derivatives. In case of

commodity derivatives, underlying asset can be commodities like wheat, gold, silver

etc., whereas in case of financial derivatives underlying assets are stocks currencies,

bonds and other interest rates bearing securities etc. Since, the scope of this case study

is limited to only financial derivatives so we will confine our discussion to financial

derivatives only.

Figure 3.6 Classifications of Derivatives

a) Forward Contract

A forward contract is an agreement between two parties to buy or sell an asset

at a specified point of time in the future. In case of a forward contract the price which

is paid/ received by the parties is decided at the time of entering into contract. It is the

simplest form of derivative contract mostly entered by individuals in day to day’s life.

Forward contract is a cash market transaction in which delivery of the

instrument is deferred until the contract has been made. Although the delivery is made

in the future, the price is determined on the initial trade date. One of the parties to a

forward contract assumes a long position (buyer) and agrees to buy the underlying

asset at a certain future date for a certain price. The other party to the contract known

DERIVATIVES

FORWARDS FUTURES OPTIONS SWAPS

108  

as seller assumes a short position and agrees to sell the asset on the same date for the

same price. The specified price is referred to as the delivery price. The contract terms

like delivery price and quantity are mutually agreed upon by the parties to the

contract.

No margins are generally payable by any of the parties to the other. Forwards

contracts are traded over-the- counter and are not dealt with on an exchange unlike

futures contract. Lack of liquidity and counter party default risks are the main

drawbacks of a forward contract.

b) Futures Contract

Futures is a standardized forward contact to buy (long) or sell (short) the

underlying asset at a specified price at a specified future date through a specified

exchange. Futures contracts are traded on exchanges that work as a buyer or seller for

the counterparty. Exchange sets the standardized terms in term of Quality, quantity,

Price quotation, Date and Delivery place (in case of commodity).The features of a

futures contract may be specified as follows:

• These are traded on an organised exchange like IMM, LIFFE, NSE, BSE, CBOT etc.

• These involve standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc.

• These are associated with a clearing house to ensure smooth functioning of the market.

• There are margin requirements and daily settlement to act as further safeguard.

• These provide for supervision and monitoring of contract by a regulatory authority.

• Almost ninety percent future contracts are settled via cash settlement instead of actual delivery of underlying asset.

Futures contracts being traded on organized exchanges impart liquidity to the

transaction. The clearinghouse, being the counter party to both sides of a transaction,

provides a mechanism that guarantees the honouring of the contract and ensuring very

low level of default (Hirani, 2007). Following are the important types of financial

futures contract:-

109  

Stock Future or equity futures,

Stock Index futures,

Currency futures, and

Interest Rate bearing securities like Bonds, T- Bill Futures.

c) Options Contract

In case of futures contact, both parties are under obligation to perform their

respective obligations out of a contract. But an options contract, as the name suggests,

is in some sense, an optional contract. An option is the right, but not the obligation, to

buy or sell something at a stated date at a stated price. A “call option” gives one the

right to buy; a “put option” gives one the right to sell. Options are the standardized

financial contract that allows the buyer (holder) of the option, i.e. the right at the cost

of option premium, not the obligation, to buy (call options) or sell (put options) a

specified asset at a set price on or before a specified date through exchanges. Options

contracts are of two types: call options and put options. Apart from this, options can

also be classified as OTC (Over the Counter) options and exchange traded options. In

case of exchange traded options contract, contracts are standardized and traded on

recognized exchanges, whereas OTC options are customized contracts traded privately

between the parties. A call options gives the holder (buyer/one who is long call), the

right to buy specified quantity of the underlying asset at the strike price on or before

expiration date. The seller (one who is short call) however, has the obligation to sell

the underlying asset if the buyer of the call option decides to exercise his option to

buy.

d) Swaps Contract

A swap can be defined as a barter or exchange. It is a contract whereby parties

agree to exchange obligations that each of them have under their respective underlying

contracts or we can say, a swap is an agreement between two or more parties to

exchange stream of cash flows over a period of time in the future. The parties that

agree to the swap are known as counter parties. The two commonly used swaps are: i)

Interest rate swaps which entail swapping only the interest related cash flows between

the parties in the same currency, and ii) Currency swaps: These entail swapping both

110  

principal and interest between the parties, with the cash flows in one direction being in

a different currency than the cash flows in the opposite direction.

Derivatives contracts are being bought and sold by a large number of

individuals, business organizations, governments and others for a variety of purposes.

On the basis of the purpose the traders in the derivatives market can be categorized as

follows:

Hedgers: The prime aim of the introduction of futures markets is to allow for

companies and individuals to protect themselves against future unfavourable

changes in prices (for financial futures in particular changes in interest and

exchange rates). As a result the futures market serves as the way of reducing or

even eliminating risk. This is achieved through hedging. An example of a case

that requires hedging could be when someone is obliged to hold a large

inventory of a commodity that cannot be sold until a later date. A futures

contract would be used to hedge against any future price fluctuations (fix the

price) by having the hedger going short the commodity futures (short hedging).

If the price of the asset goes down the investor does not perform well on the

sale of the asset, but makes a gain on the short futures position. If the price

of the asset goes up, the investor gains from the sale of the asset, but makes a

loss on the futures position. It is quite possible that the prices will fluctuate in

such a way that the investor would have been better off if he/she had not

undertaken the hedging strategy. However, the purpose of hedging is no other

than to reduce the risk being faced or will be faced by making the outcome

more certain. It does not necessarily improve the outcome. There is a number of

reasons why hedging using futures contracts may not work perfectly in practice

and not eliminate risk.

1. There is a possibility that the asset underlying in the futures contract

will not be exactly the same as the asset that the investor wishes to hedge.

2. The hedger might not be able to know for certain the precise date

when the asset will be bought or sold.

111  

3. It is also possible that the futures contract expires later than the date

that the hedging strategy must be terminated.

Speculators: The risk reduced by hedging is transferred to the counterparty to

the trade, who may be another hedger with opposite requirements or a

speculator. Speculators expose themselves to risk by buying or selling in futures

market in order to profit from the future price fluctuations (buy an asset when

the price is low and sell it when it is high) and thus, provide liquidity to the

market. They are classified according to their methods. Speculators seek to trade

profitably based on price movements in the next few minutes. (they try to profit

by a few ticks per trade on a large number of transactions). Day traders close

out their futures positions on the same day that the positions were initiated, so

as. to avoid large price movements when the market is closed. Position traders,

keep a futures position for long periods of time (weeks or even months) so that

price moves in a favourable way to their position.

Arbitrageurs: Arbitrageurs are investors who exploit price discrepancies between

markets by entering into transactions in two or more markets. When the

opportunity emerges, an arbitrageur tries to take advantage of it by buying in

one market at a particular 'price and simultaneously selling in the other market at

a higher price. However, these price discrepancies can only be temporary since

they can easily be eliminated by the arbitrage process itself. This is done,

because the purchase in one market will drive prices up for that market, while

the sale in the other will drive prices down. Consequently, arbitrage is very

important for keeping futures and underlying spot prices in line.

In recent years, arbitrage reflects a wide range of activities. For example, tax

arbitrage is a strategy by which gains or losses are shifted from one tax

jurisdiction to another in order to profit from differences in tax rates. In a

similar manner currency arbitrage is a form of trading which involves buying a

currency in one market and selling it in another so as to profit from exchange

rate inconsistencies in different money centers. An arbitrage strategy could also

involve transacting simultaneously in a futures and a forward contract of similar

112  

characteristics but different rates and profit from this discrepancy. A final

reference to different types of arbitrage involves the spread arbitrage. Arbitrage

trading can also take place by taking advantage of price discrepancies between futures

contracts with different expirations- (calendar spread). The arbitrageur in this case

profits from identifying whether the size of the difference between the prices of

the two contracts will increase or decrease.

The applications of financial derivatives can be enumerated as follows:

• Management of risk: This is most important function of derivatives. Risk

management is not about the elimination of risk rather it is about the

management of risk. Financial derivatives provide a powerful tool for limiting

risks that individuals and organizations face in the ordinary conduct of their

businesses. It requires a thorough understanding of the basic principles that

regulate the pricing of financial derivatives. Effective use of derivatives can

save cost, and it can increase returns for the organisations.

• Efficiency in trading: Financial derivatives allow for free trading of risk

components and that leads to improving market efficiency. Traders can use a

position in one or more financial derivatives as a substitute for a position in the

underlying instruments. In many instances, traders find financial derivatives to

be a more attractive instrument than the underlying security. This is mainly

because of the greater amount of liquidity in the market offered by derivatives

as well as the lower transaction costs associated with trading a financial

derivative as compared to the costs of trading the underlying instrument in cash

market.

• Speculation: This is not the only use, and probably not the most important use,

of financial derivatives. Financial derivatives are considered to be risky. If not

used properly, these can leads to financial destruction in an organisation like

what happened in Barings Plc. However, these instruments act as a powerful

instrument for knowledgeable traders to expose themselves to calculated and

well understood risks in search of a reward, that is, profit.

113  

• Price discover: Another important application of derivatives is the price

discovery which means revealing information about future cash market prices

through the futures market. Derivatives markets provide a mechanism by which

diverse and scattered opinions of future are collected into one readily

discernible number which provides a consensus of knowledgeable thinking.

• Price stabilization function: Derivative market helps to keep a stabilising

influence on spot prices by reducing the short-term fluctuations. In other

words, derivative reduces both peak and depths and leads to price stabilisation

effect in the cash market for underlying asset.

The liberalization process that has opened Indian market to overseas investors

has fuelled interest among the regulators for introduction of risk management tools.

By observing the varied applications of financial derivatives; the Indian financial

market woke up to the new generation of financial instruments and currently the

following contracts are allowed for trading in Indian markets:

Figure- 3.7 Derivatives Contracts permitted for trading in India

The emergence and growth of market for derivative instruments can be traced

back to the willingness of risk-averse economic agents to guard themselves against

uncertainties arising out of fluctuations in asset prices. Derivatives markets in India

have been in existence in one form or the other for a long time. In the area of

commodities, the Bombay Cotton Trade Association started futures trading way back

in 1875. In 1952, the Government of India banned cash settlement and options trading.

114  

Derivatives trading shifted to informal forwards markets. In recent years, government

policy has shifted in favour of an increased role of market-based pricing and less

suspicious derivatives trading. The first step towards introduction of financial

derivatives trading in India was the promulgation of the Securities Laws

(Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options

in securities. The last decade, beginning the year 2000, saw lifting of ban on futures

trading in many commodities. Around the same period, national electronic commodity

exchanges were also set up.

Financial Derivatives trading commenced in India in June 2000 after SEBI

granted the final approval to this effect in May 2001 on the recommendation of L. C

Gupta committee. Securities and Exchange Board of India (SEBI) permitted the

derivative segments of two stock exchanges, NSE and BSE and their clearing

house/corporation to commence trading and settlement in approved derivatives

contracts.

Table-3.7 Derivatives in India: A chronology

December 14, 1995 NSE asked SEBI for permission to trade index futures

November 18, 1996 L.C. Gupta Committee set up to draft a policy framework for introducing derivatives

May 11, 1998 L.C. Gupta committee submits its report on the policy framework

May 25, 2000 SEBI allows exchanges to trade in index futures

June 12, 2000 Trading on Nifty futures commences on the NSE

June 4, 2001 Trading for Nifty options commences o n the NSE

July 2, 2001 Trading on Stock options commences on the NSE

November 9, 2001 Trading on Stock futures commences on the NSE

August 29, 2008 Currency derivatives trading commences on the NSE

August 31, 2009 Interest rate derivatives trading commences on NSE

Source: NSE Publications

Initially, SEBI approved trading in index futures contracts based on various

stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index-

115  

based trading was permitted in options as well as individual securities. The trading in

BSE Sensex options commenced on June 4, 2001 and the trading in options on

individual securities commenced in July 2001. Futures contracts on individual stocks

were launched in November 2001. The derivatives trading on NSE commenced with

S&P CNX Nifty Index futures on June 12, 2000. The trading in index options

commenced on June 4, 2001 and trading in options on individual securities

commenced on July 2, 2001. Single stock futures were launched on November 9,

2001. The index futures and options contract on NSE are based on S&P CNX. In June

2003, NSE introduced Interest Rate Futures which were subsequently banned due to

pricing issue. Table 3.7 exhibits chronology of introduction of derivatives in India.

As mentioned in the preceding discussion, derivatives trading commenced in

Indian market in 2000 with the introduction of Index futures at BSE, and

subsequently, on National Stock Exchange (NSE). Since then, derivatives market in

India has witnessed tremendous growth in terms of trading value and number of

traded contracts.

The BSE created history on June 9, 2000 when it launched trading in Sensex

based futures contract for the first time. It was followed by trading in index options on

June 1, 2001; in stock options and single stock futures (31 stocks) on July 9, 2001 and

November 9, 2002, respectively. Currently, the number of stocks under single futures

and options is 1096.

Table-3.8 Products traded on derivative segment of BSE

Sl. No. Product Traded with underlying asset Introduction Date 1 Index Futures- Sensex June 9 2000 2 Index Options- Sensex June 1,2001 3 Stock Option on 109 Stocks July 9, 2001 4 Stock futures on 109 Stocks November 9 2002 5 Weekly Option on 4 Stocks September 13,2004 6 Chhota (mini) SENSEX January 1, 2008 7 Currency Futures on US Dollar Rupee October 1,2008

Source: Compiled from BSE website

116  

BSE achieved another milestone on September 13, 2004 when it launched

Weekly Options, a unique product unparalleled worldwide in the derivatives markets.

It permitted trading in the stocks of four leading companies namely; Satyam, State

Bank of India, Reliance Industries and TISCO (renamed now Tata Steel). Chhota

(mini) SENSEX was launched on January 1, 2008. With a small or 'mini' market lot of

5, it allows for comparatively lower capital outlay, lower trading costs, more precise

hedging and flexible trading. Currency futures were introduced on October 1, 2008 to

enable participants to hedge their currency risks through trading in the U.S. dollar-

rupee future platforms. The derivative products and their date of introduction on the

BSE is summerised in the Table 3.8:

NSE started trading in index futures, based on popular S&P CNX Index, on

June 12, 2000 as its first derivatives product. Trading on index options was introduced

on June 4, 2001. Futures on individual securities started on November 9, 2001. The

futures contract is available on 233 securities as stipulated by SEBI.

Table 3.9 Products traded on F&O Segment of NSE

Sl. No. Product Traded with Underlying asset Introduction Date

1 Index Futures- S&P CNX NIFTY June 12, 2000

2 Index Options- S&P CNX NIFTY June 4, 2001

3 Stock Option on 233 Stocks July 2, 2001

4 Stock futures on 233 Stocks November 9, 2001

5 Interest Rate Futures- T – Bills and 10 Years Bond June 23,2003

6 CNX IT Futures & Options August 29,2003

7 Bank Nifty Futures & Options June 13,2005

8 CNX Nifty Junior Futures & Options June 1,2007

9 CNX 100 Futures & Options June 1,2007

10 Nifty Midcap 50 Futures & Options October 5, 2007

11 Mini index Futures & Options - S&P CNX Nifty index January 1, 2008

12 Long Term Option contracts on S&P CNX Nifty Index March 3,2008

13 Currency Futures on US Dollar Rupee August 29,2008

14 S& P CNX Defty Futures & Options December 10, 2008

Source: NSE website

117  

Trading in options on individual securities commenced from July 2, 2001. The

options contracts are American style and cash settled and are available on 233

securities. Trading in interest rate futures was introduced on 24 June 2003 but it was

closed subsequently due to pricing problem. The NSE achieved another landmark in

product introduction by launching Mini Index Futures & Options with a minimum

contract size of Rs 1 lac. NSE crated history by launching currency futures contract on

US Dollar-Rupee on August 29, 2008 in Indian Derivatives market. Table 2.9 presents

a description of the types of products traded at F& O segment of NSE.

Among all the products traded on NSE in F& O segment Index derivatives has

registered an "explosive growth". Index derivative especially S&P CNX Nifty future

has been accepted by the traders as a most prominent instrument in risk management.

In this respect it is ideal to explain the brief details about this contract.

3.6 STOCK INDEX FUTURES

Stock index future is an index derivative that draws its value from an

underlying index like Nifty or Sensex. This type of derivative contract was first

pioneered by Kansas City Board of Trade on 24th February, 1982 and the contract was

based on Value Line composite Index. Subsequently CME introduced trading in S&P

500 index futures in April 1982 and this was followed by New York futures

exchanges contract on NYSE composite Index. Consequent upon their successful

trading on the US exchanges, many other exchanges worldwide launched equity index

futures (Table-3.10). In India NSE started trading on index futures whose value is

derived from the underlying index Nifty. This contract is called as FUTIDX.

Table 3.10 Major stock index futures Contracts

Stock Exchange Index Futures contract Chicago Mercantile Exchange S&P 100

Korea Stock Exchange KOSPI 200

Toronto Futures exchange TSE 300

London Futures exchange FTSE 100

National Stock Exchange of India S&P CNX NIFTY

Hong Kong Futures Exchange Hang Seng

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Index Futures Contract Specifications

As a matter of fact the stock index futures contracts are cash settled i.e. the

traders are required to settle the contract by taking an offsetting position in the market.

Operationally stock index futures contract is an agreement to pay or receive fixed

rupee amount times the difference between the index level when the position resulting

gains and losses will be paid/received in cash. The monetary value of the index future

is obtained by multiplying the underlying index value by some rupee amount. In case

of Nifty contract, the multiplier is Rs.200 and for Sensex it is Rs.50. The value of the

multiplier is set by the exchange which is guided by the SEBI’s directive and should

have a minimum value of Rs. 2,00,000 and accordingly NSE and BSE arrived at those

multipliers:

Table-3.11 Contract Specification: Index Futures

BSE NSE

Underlying SENSEX NIFTY

Contract Multiplier 50 200

Trading Cycle The near month (one), the next month (two) and the far month (three).

The near month (one), the next month (two) and the far month (three).

Tick size 0.05 index points 0.05 index points

Price Quotation Index Points Index Points

Last trading/Expiration day Last Thursday of the contract month. If it is a holiday, the immediately preceding business day.

Last Thursday of the contract month. If it is a holiday, the immediately preceding business day.

Final settlement Cash settlement. On the last trading day, the closing value of the underlying index would be the final settlement price of the expiring futures contract.

Final settlement price shall be the closing value of the Nifty on the last trading day.

Source: Respective websites: www.nseindia.com and www.bseindia.com

 Within a short span of time financial derivatives market in India has shown a

remarkable growth both in terms of volumes and numbers of contracts traded. NSE

119  

alone accounts for 99 percent of the derivatives trading in Indian markets. The reasons

for such demand in the Index futures can be as follows:

a) Index futures are cash settled;

b) These are highly liquid since index futures are exchange traded and the

investor can offset his position on any day prior to the expiration day;

c) The performance of all index futures contract are guaranteed by the

exchange’s clearing house;

d) It carries margin requirements which ensure that the risk is limited to the

previous day’s price movement on each outstanding position.

Table-3.12: Turnover of Derivatives in NSE & BSE (Rs. Cr.)

Year NSE BSE 2000-01 90580 1673 2001-02 1025588 1922 2002-03 2126763 2478 2003-04 17191668 12452 2004-05 21635449 16112 2005-06 58537886 9 2006-07 81487424 59006 2007-08 156598579 242309 2008-09 210428103 12266 2009-10 178306889 234.13

Source: Compiled from NSE Fact Book

The Figure-3.9 exhibits that although BSE and NSE started trading with similar

derivative products in the year 2000, they were initially at par with each other

generating 50% of the volume traded. Subsequently however, concentration built up

on the NSE and the BSE lost heavily and today NSE attracts most of the volume in

equity derivatives. The reason for higher trading volume in Nifty futures is because of

the impact cost and liquidity differentials.

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121  

338050 contracts over 11 years, and an average daily notional turnover of

approximately Rs.8004 Crs. These statistics are indicative of the liquidity of the Nifty

futures contracts in India.

Table-3.13: NSE F&O Segment Turnover (Rs. Cr.) and Volume

Year Index Futures Avg. Daily Turnover

Index Futures

(No. Of

contracts)

Avg. daily Trading Volume

2010-11 4356754.53 18153.14 165023653 687598.6

2009-10 3934388.67 16393.29 178306889 742945.4

2008-09 3583617.92 14875.46 210428103 876783.8

2007-08 3820667.27 15919.45 156598579 652494.1

2006-07 2539574 10581.56 81487424 339530.9

2005-06 1513755 6307.313 58537886 243907.9

2004-05 772147 3217.279 21635449 90147.7

2003-04 554446 2310.192 17191668 71631.95

2002-03 43952 183.1333 2126763 8861.513

2001-02 21483 89.5125 1025588 4273.283

2000-01 2365 9.854167 90580 377.4167

Source: Compiled from NSE Website

From the above discussion it can be inferred that National Stock Exchange

plays a dominant role in the F&O segment. The introduction of derivatives has been

well received by stock market players. Trading in derivatives gained popularity soon

after its introduction. In due course, the turnover of the NSE derivatives market

exceeded the turnover of the NSE cash market. For example, in 2008, the value of the

NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE

cash markets was only Rs. 3,551,038 Cr. If we compare the trading figures of NSE

and BSE, performance of BSE is not encouraging both in terms of volumes and

numbers of contracts traded in all product categories single stock futures also known

as equity futures, are most popular in terms of volumes and number of contract traded,

122  

followed by index futures with turnover shares of 52 percent and 31 percent,

respectively.

Table-3.14 Share of each NSE Derivative contract to total turnover (%)

Year Index Futures Index Options Sock Futures Stock

Options Total

2010-11 14.89579 62.79139 18.79005 3.522759 100

2009-10 22.27391 45.44903 29.41205 2.865007 100

2008-09 46.83919 30.8319 33.44528 1.953998 100

2007-08 29.18661 10.40536 57.66454 2.743495 100

2006-07 34.52271 10.76509 52.07777 2.634429 100

2005-06 31.37853 7.016103 57.86891 3.736453 100

2004-05 30.31615 4.787745 58.26724 6.628865 100

2003-04 26.02288 2.478914 61.29414 10.19459 100

2002-03 9.992225 2.102023 65.14157 22.76419 100

2001-02 21.07706 3.693856 50.54157 24.68752 100

2000-01 100 --- --- -- 100

Among the equity derivatives that are being allowed to be traded on NSE are

the Index futures, index options, stock futures, and stock options. The comparative

study of the ratio of each contracts turnover to the total turnover in the NSE’s F&O

segment is given in the Table 3.14 and Figure 3.9.

Figure-3.9 Growth of Individual derivative contracts

0

2040

6080

100120

Index futures

Stock futures

index options

Stock otions

123  

The above result exhibits a significant share of stock index futures turnover to

total turnover. But in NSE there are sectoral index futures like CNX IT, BANKEX

etc. is also being traded which is included in the above data. Figure 3.10 will enlighten

the S&P CNX Nifty’s share in the total volume of index futures trading:

Fig. 3.10 Volume of Each Index Futures Traded at NSE

Source: NSE Fact Book 2011 (For 05 Years)

In NSE there are different Index futures contracts are being traded having

different underlying asset like, CNX IT, BANKNIFTY etc. If we look at the

percentage of volume of trading of different Index futures contract as exhibited in the

Fig. 3.10, it is obvious that S&P CNX NIFTY outperforms other contracts in general.

Thus this particular analysis attenuates the need for analyzing CNX Nifty

futures contract to know its relationship with respect to the Nifty as regards to market

efficiency, market volatility and a causal relationship over a sample period of 10 years

will enlighten some stylized facts which are previously not being studied by

undertaking a large sample data.

3.7 TO SUM UP

The capital market is the barometer of any country’s economy and provides a

mechanism for capital formation. Across the world there was a transformation in the

financial intermediation from a credit based financial system to a capital market based

system which was partly due to a shift in financial policies from financial repression

(credit controls and other modes of primary sector promotion) to financial

liberalization. This led to an increasing significance of capital markets in the

124  

allocation of financial resources. Secondly one of the most profound and far-reaching

financial phenomenon in the late twentieth century and the forepart of this century is

the explosive growth in international financial transactions and capital flows among

various financial markets in developed and developing countries. This phenomenon in

international finance is result of the liberalization of capital markets in developed and

developing countries. Indian capital market is no way an exception to this direction

and embraced the transition from a closed to an open capital market.

The Indian stock market is one of the earliest in Asia being in operation since

1875, but remained largely outside the global integration process until the late 1980s.

A number of developing countries in concert with the International Finance

Corporation and the World Bank took steps in the 1980s to establish and revitalize

their stock markets as an effective way of mobilizing and allocation of finance. In line

with the global trend, reform of the Indian stock market began with the establishment

of Securities and Exchange Board of India in 1988.

The Indian capital market went through a major transformation after 1992 and

the Sensex hovering around the 10000 mark by the end of the year 2005, which

seemed a dream just a few years back, although the beginning of such an initiative

could be seen since the second half of 1980’s. Since then the market has been growing

in leaps and bounds and has aroused the interests of the investors. The reason for such

a development was an increasing uncertainty caused due to liberalization and

standardization of the prudential requirements of the banking sector for global

integration of the Indian financial system. Further, rise in their non-performing assets

led to a decrease in credit from banks to the commercial sector. Liberalization and

opening of the gates led to an expansion of three broad channels of financing the

private sector namely, Domestic capital market, International capital market

(American depository receipts and Global depository receipts) and Foreign direct

investment. All these channels of financing has brought about complex financial

instruments with different variety, which is a result of the increasing relativity of the

developing and developed economies as developing countries become more integrated

in international flows of trade and payments.

125  

More freedom in the moving of capital flows improves the allocation of capital

globally, allowing resources to move to areas with higher rates of return. Contrarily,

attempts to restrict capital flows lead to distortions of capital structure that are

generally costly to the economies imposing the controls. Thus, the boost in

international capital flows and financial transaction is an underway and, to certain

extent, irreversible process.

In terms of the growth of derivatives markets, and the variety of derivatives

users, the Indian market has equaled or exceeded many other regional markets. The

variety of derivatives instruments available for trading is expanding.

The spectacular growth and success in index futures can be attributable to

several reasons. One of the reasons for such success is the liquidity. Since liquidity is

a function of the interest of market participants in a product, stock index futures

appeal to a large set of market participants including hedgers, speculators and

arbitrageurs made it a successful derivative contract.

There remain major areas of concern for Indian derivatives users. Large gaps

exist in the range of derivatives products that are traded actively. In equity derivatives,

NSE figures show that almost 90% of activity is due to stock futures or index futures,

whereas trading in options is limited to a few stocks, partly because they are settled in

cash and not the underlying stocks. Exchange-traded derivatives based on interest

rates and currencies are virtually absent.

Liquidity and transparency are important properties of any developed market.

Liquid markets require market makers who are willing to buy and sell, and be patient

while doing so. In India, market making is primarily the province of Indian private

and foreign banks, with public sector banks lagging in this area (FitchRatings, 2004).

A lack of market liquidity may be responsible for inadequate trading in some markets.

Transparency is achieved partly through financial disclosure. Financial

statements currently provide misleading information on institutions’ use of

derivatives. Further, there is no consistent method of accounting for gains and losses

from derivatives trading. Thus, a proper framework to account for derivatives needs to

be developed. Further regulatory reform will help the markets grow faster. For

126  

example, Indian commodity derivatives have great growth potential but government

policies have resulted in the underlying spot/physical market being fragmented (e.g.

due to lack of free movement of commodities and differential taxation within India).

Similarly, credit derivatives, the fastest growing segment of the market globally, are

absent in India and require regulatory action if they are to develop.

As Indian derivatives markets grow more sophisticated, greater investor

awareness will become essential. NSE has programmes to inform and educate brokers,

dealers, traders, and market personnel. In addition, institutions will need to devote

more resources to develop the business processes and technology necessary for

derivatives trading. Because of the strong demand for derivative products, the popular

contracts like Foreign Currency Futures, Long term Equity Options, Credit

Derivatives, Structured products and exotic derivatives etc. are awaiting their turn in

the Indian markets. In this regard NSE as well as the regulatory body and government

should work collectively for making these contracts popular in Indian market.

127  

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