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The Indian Derivatives MarketRevisited

SUCHISMITA BOSE

AbstractDerivatives products provide certain important economic benefits

such as risk management or redistribution of risk away from risk-averse

investors towards those more willing and able to bear risk. Derivatives also

help price discovery, i.e. the process of determining the price level for any asset

based on supply and demand. These functions of derivatives help in efficient

capital allocation in the economy; at the same time their misuse also poses a

threat to the stability of the financial sector and the overall economy. In the

mid-1990s India started reviving the exchange traded commodity derivatives

market and introduced a variety of instruments in the foreign exchange

derivatives market, while exchange traded financial derivatives were intro-

duced in 2001. Given Indias experience in informal derivatives trading, the

exchange traded derivatives were quick to pick up substantial volumes. This

paper presents accounts of the major developments in the Indian commodity,

exchange rate and financial derivatives markets, and outlines the regulatory

provisions that have been introduced to minimise misuse of derivatives.

I. IntroductionImmediately prior to the formal introduction of derivatives

contracts in the Indian financial markets, Money & Finance (Bhaumik,

1997, 1998) brought forth a comprehensive account of various deriva-

tives instruments, their uses, pricing mechanisms, portfolio strategies

and the associated risks as well as issues on appropriate regulation to

be considered in introducing this class of financial instruments to a

developing market like India. About half a decade has passed since

derivatives have been formally introduced in India; here we review the

main trends in the Indian markets for derivatives in commodities,

exchange rates and securities. We also touch upon the regulatoryprovisions for taking care of undesirable effects of derivatives trading.

As a sequel, in a forthcoming paper we intend to test for certain

hypotheses related to the efficient functioning of the Indian derivatives

market.

Derivatives are financial contracts whose price is derived from

that of an underlying item such as a commodity, security, rate, index or

event [Box 1]. The emergence of the market for derivatives contracts

originates from the desire of risk-averse economic agents to guard

themselves against uncertainties arising out of fluctuations in asset

This paper presents

accounts of the

major developments

in the Indian

commodity,

exchange rate and

financial derivatives

markets, and

outlines the

regulatory

provisions that have

been introduced to

minimise misuse of

derivatives.


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Box 1: Derivatives Contracts

To Recapitulate:

Futures Contractis a legally binding agreement to buy or sell the underlying security

on a future date. Future contracts are the organised/standardised contracts in terms

of quantity, quality (in case of commodities), delivery time and place for settlement

on any date in future. The contract expires on a pre-specified date, which is called theexpiry date of the contract. On expiry, futures can be settled by delivery of the under-

lying asset or cash.

Options Contractgives the buyer/holder of the contract the right (but not the obliga-

tion) to buy/sell the underlying asset at a predetermined price within or at the end of

a specified period. The buyer/holder of the option purchases the right from the seller/

writer for a fee, which is called the premium. The seller/writer of an option is

obligated to settle the option as per the terms of the contract when the buyer/holder

exercises his right. Cash settlement in option contract entails paying/receiving the

difference between the strike price/exercise price and the price of the underlying asset

either at the time of expiry of the contract or at the time of exercise/assignment of theoption contract. This means that an option holder can allow the option to expire if the

market price is more favourable compared with the pre-determined option price

known as strike price.

An Option to buy is called a Call optionand option to sell is called a Put option.

Further, an option that is exercisable at any time on or before the expiry date is called

an American optionand one that is exercisable only on the expiry date, is called an

European option. The price at which the option is to be exercised is termed the Strike

price or Exercise price.

Futures/Options contracts having the underlying asset as a (stock) index are known

as Index Futures/Optionscontracts. These contracts are essentially cash settled onexpiry.

Interest rate swapis an exchange of cash flows between two parties, which generally

transforms floating rate obligations in a particular currency into a fixed rate obliga-

tion in that same currency or vice versa.

Currency swapis an exchange of cash flows denominated in different currencies. The

cash flows are based on agreed-upon exchange rates and may or may not include the

exchange of principal.

Commodity/index swapis an exchange of cash flows, where one of the cash flows is

based on the price of a particular commodity/index or basket of commodities, and the

other cash flow is based on an interest rate.

Interest rate caplimits the maximum interest rate on a floating rate loan regardless of

the future level of the market reference rate.

Interest rate collarsets a maximum (via the purchase of a cap) and a minimum (via

the sale of a floor) interest rate on a floating rate loan.

Financial derivatives

came into the

spotlight in the

post-1970 period

due to growing

instability in the

global financial

markets. However,

since their

emergence, these

products have

become very

popular and since

the 1990s, they

account for about

two-thirds of the

total transactions in

derivatives

products.


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prices. By locking-in asset prices, derivatives products minimise the

impact of fluctuations in asset prices on the profitability and cash flow

situation of risk-averse investors. Derivatives products initially emerged

as hedging devices against fluctuations in commodity prices, and

commodity-linked derivatives remained the sole form of such products

globally for almost three hundred years. Financial derivatives came

into the spotlight in the post-1970 period due to growing instability in

the global financial markets. However, since their emergence, these

products have become very popular and since the 1990s, they account

for about two-thirds of the total transactions in derivatives products.1

1 The failure of the Bretton Woods system leading to sharp fluctuations inthe US dollar, along with volatility in US long term yields sharpened by the oil crisisof 1973 led to the focus on strategies of eliminating low probability events thatmight upset the entire financial planning of corporates and governments.

TABLE 1The Global Derivatives Industry (Outstanding Contracts, $ billion)

Exchange Traded 2001 2002 2003 2004 2005 2005 2005 2005 2006Q1 Q2 Q3 Q4 Q1

TOTAL CONTRACTS 23764.1 23855.8 36786.9 46592.4 59467.3 58516.9 58283.9 57815.8 78948.8

Interest rate futures 9269.5 9955.6 13123.7 18164.9 20510.7 19684.4 19861.2 20708.7 24435.6Interest options 12492.8 11759.5 20793.8 24604.1 34327.9 34109.9 32796.2 31588.2 48010.1

Equity index futures 333.9 365.5 549.3 635.2 713.8 655.8 727.1 802.7 922

Equity index options 1574.9 1700.8 2202.3 3024 3768.4 3897.5 4726.8 4542.5 5400.6

Currency futures 65.6 47 79.9 103.5 87.1 100.1 109.7 107.6 109.7

Currency options 27.4 27.4 37.9 60.7 59.4 69.2 62.9 66.1 70.8

Over-The-Counter (OTC) Dec. Dec- Jun- Dec- Jun- Dec- Jun- Dec.2001 02 03 03 04 04 05 2005

TOTAL CONTRACTS 111178 141665 169658 197167 220058 251499 271282 284819

Foreign exchange contracts 16748 18448 22071 24475 26997 29289 31081 31609

Outright forwards and forex swaps 10336 10719 12332 12387 13926 14951 15801 15915Currency swaps 3942 4503 5159 6371 7033 8223 8236 8501

Options 2470 3226 4580 5717 6038 6115 7045 7193

Interest rate contracts 77568 101658 121799 141991 164626 190502 204795 215237

Forward rate agreements 7737 8792 10271 10769 13144 12789 13973 14483

Interest rate swaps 58897 79120 94583 111209 127570 150631 163749 172869

Options 10933 13746 16946 20012 23912 27082 27072 27885

Equity-linked contracts 1881 2309 2799 3787 4521 4385 4551 5057

Forwards and swaps 320 364 488 601 691 756 1086 1111

Options 1561 1944 2311 3186 3829 3629 3464 3946

Commodity contracts 598 923 1040 1406 1270 1443 2940 3608

Gold 231 315 304 344 318 369 288 334Other commodities 367 608 736 1062 952 1074 2652 3273

Forwards and swaps 217 402 458 420 503 558 1748 2319

Options 150 206 279 642 449 516 904 955

Other 14384 18328 21949 25508 22644 25879 27915 29308

Source: BIS, Derivative Statistics.


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The market for financial derivatives has grown tremendously in terms

of variety of instruments available, their complexity and also turnover.

According to the Bank for International Settlements (BIS), the approxi-

mate size of global derivatives market which was at US$119.15 trillion

as of end-June 2001 increased to US$273.06 trillion by end-June 2004

(BIS, 2004).

In India the willingness to embark on formal derivatives

trading came forth only during the reforms process of the 1990s, though

various informal forms of derivatives contracts have existed since time

immemorial in the country. Traditionally in the arena of agriculture,

which was entirely dependent on nature, various types of forward

contracts evolved between large farmers/middlemen and small farmers

/landless labourers. A variety of interesting derivatives markets came

into existence in the informal financial sector too; these markets trade

contracts like teji-mandi, bhav-bhav, and other such strategies that are

essentially different combinations of put and call options. However,

these informal markets stand outside the mainstream institutions of

Indias financial system and enjoy only limited participation. Indias

primary securities market also has experience with derivatives of two

kinds: convertible bonds and warrants (a slight variant of call options).

Since these warrants are listed and traded, an options market of a sort

already existed; however, trading on these instruments has been very

limited. Trading on the spot market for equity in India has actually

always been futures style with weekly or fortnightly settlement. But this

system though attended with the risks and difficulties of futures mar-

kets, was without the gains in price discovery and hedging services that

come with a separation of the spot market from the futures market.

Besides informal contracts within the economy, Indian financial deriva-

tives contracts also existed in international markets. The over-the-

counter2 (OTC) derivatives industry on Indian underlyings essentially

exists abroad. Custom built (OTC) derivatives, specifically, options and

swaps on Indian market indexes and baskets of Indian ADR/GDRs

(American/Global Depository Receipts), were being traded on the

international market. Warrants on mutual fund paper such as Lazard

Birla India and Fleming India have been listed abroad. In the exchange

rate arena India has had a strong dollar-rupee forward market with

contracts being traded for one to six month expiration. Indian users of

currency hedging services were also allowed to buy derivatives involv-ing other currencies on foreign markets.

India started reviving its exchange traded commodity deriva-

tives market and introduced a variety of instruments in the foreign

2 A derivative contract that is privately negotiated is called an OTCcontract. OTC trades as distinguished from exchange traded contracts have noanonymity, and they generally do not go through a clearing corporation. OTCfutures contracts are called forwards (actually, exchangetraded forward contractshave been termed futures).

Indias primary

securities market

also has experience

with derivatives of

two kinds:

convertible bonds

and warrants. Since

these warrants are

listed and traded, an

options market of a

sort already existed;

however, trading on

these instruments

has been very

limited.


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exchange derivatives market only in the mid-1990s. India went in for

formal financial derivatives trading in the exchanges by 2001 introduc-

ing index futures, index options stock options and stock futures in a

phased manner. About five years have elapsed since the Indian securi-

ties market regulator, Securities and Exchange Board of India (SEBI),

formally introduced financial derivatives in the securities market.

Given its history of informal trading in complicated derivatives con-

tracts the exchange traded derivatives products were quick to pick up

substantial amounts of trading. During this period there have been

several significant changes in the structure of the Indian capital mar-

kets, which include, dematerialisation of shares, rolling settlement on a

T+2 basis, and client level and VaR (Value at Risk) based margining in

both the derivatives and cash markets. Globalisation of the Indian

economy has also picked up pace during the last few years with

increasing numbers of foreign institutional (portfolio) investors (FIIs)

and mutual funds (MFs) using the Indian securities market, and a

number of Indian corporates approaching the global market through

ADR/GDR issues; all of these entities use the derivatives market for

hedging various risk exposures. Proposals for demutualisation of

exchanges as well as a gradual convergence of the commodities and

securities derivatives markets are also under serious discussion. This

therefore appears to be an appropriate time for a comprehensive review

of the developments in the Indian derivatives markets.

The rest of the paper is arranged as follows. The next section

describes in brief the main benefits of and some caveats linked to the

derivatives markets. Sections III, IV and V present accounts of the main

trends in the Indian commodity, exchange rate and financial derivatives

markets, respectively. Section VI deals with the regulatory provisions

intended to minimise misuse of derivatives products. Section VII

concludes with a brief on our future research interests.

II. Derivatives Trading: Benefits and CaveatsDerivatives markets provide at least two very important

benefits to the economy. One is that they facilitate risk shifting, which

is also known as risk management or hedging or redistributing risk

away from risk averse investors towards those more willing and able to

bear risk. People and businesses who have exposure to risk can either

hedge against that risk with a derivatives contract or seek insuranceagainst losses that could occur if the contingencies created by the risk

materialise. There are various sources of risk associated with tradi-

tional capital vehicles such as bank loans, equities, bonds and foreign

direct investment [Box 2]. The financial innovation of introducing

derivatives to capital markets allows these traditional arrangements of

risk to be redesigned so as to better match the desired risk profiles of

the issuers and holders of these capital instruments. If the hedging is

done using (say) a futures contract, it typically involves having a

portfolio of the spot asset, and an equal and opposite position in a

Globalisation of the

Indian economy has

also picked up pace

during the last few

years with

increasing numbers

of FIIs and MFs

using the Indian

securities market,

and a number of

Indian corporates

approaching the

global market

through ADR/GDR

issues; all of these

entities use the

derivatives market

for hedging various

risk exposures.


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related futures contract. A perfectly hedged portfolio is one where the

price risk of the portfolio is zero. Risk shifting in turn facilitates capital

flows by unbundling and then more efficiently reallocating the different

sources of risk. It also increases investment flows by bringing in more

and more risk-averse investors.

BOX 2: Some probable risk scenarios

participant exposed to

foreign currency loans => foreign investor credit risk

domestic borrower exchange rate r isk

f ixed interest rate loan => ( fore ign) lender interest rate risk

variable rate loan => domestic borrower interest rate risk

long-term loan => (foreign) lender greater credit risk

short-term loan => domestic borrower refunding or liquidity risk

equities => (foreign) investor credit risk; market risk from

changes in the exchange rate,market price of the stock, and

uncertain dividend payments

bonds => (foreign) investor credit risk and market interest

rate risk

ha rd cur rency bonds => domest ic bo rrower exchange rate risk.

The other benefit of derivatives markets is that they create

price discovery, i.e. the process of determining the price level for a

commodity, asset or other item based on supply and demand. An

efficientfinancial market is one, where forecasts about future risk and

return determine valuation. Thus the price observed at an instant in

time on the ideal efficient market is a good assessment of future risk

and return. In an efficient market new information is rapidly captured

into prices, a better market being one that reacts faster. However, these

prices are not constant, because new information is being continually

generated in the economy and speculative and arbitrage activities help

in the alignment of the market price in accordance with the new

information. Speculators observe the new information, take a fresh

view on risk and return, and if they perceive3 that the present valuation

on the market is out of date, speculators risk their capital in takingpositions on the market. If a speculator thinks that new information

justifies a lower valuation he short sells the security, and vice versa. An

arbitrageur operates when he sees a pricing error that has given rise to

an opportunity for riskless (high) returns. In the derivatives market

arbitrage consists of, say, comparing the price of the index futures with

the index at any point in time. When the futures are too costly, the

3 Based on their knowledge and experience on asset price movements.

The other benefit of

derivatives markets

is that they create

price discovery, i.e.

the process of

determining the

price level for a

commodity, asset or

other item based on

supply and demand.

An efficientfinancial

market is one,

where forecasts

about future risk and

return determinevaluation.


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arbitrageur will sell futures and buy in the spot market, or vice versa.

These activities serve to feed new information into market prices.

Efficiency in the derivatives market is an outcome of a combination of

factors such as lower costs leading to higher liquidity and higher

competition as compared with the cash/spot market.4

Despite their advantages, market participants and regulators

need to be cautious regarding derivatives. This concern with deriva-

tives can be divided into two categories. The first is best termed abuse

of derivatives and the second can be described as negative conse-

quences from the misuse of derivatives (Dodd, 2003). The former is

similar to any financial market manipulation and poses a threat to the

integrity of markets and the information content of prices. In other

words, they increase capital costs due to malpractices in financial and

commodity markets, and they reduce market efficiency by distorting

market prices. If incidents of manipulation keep wary investors away

from derivatives markets, then market activity suffers from lower

trading volume thus reducing liquidity and possibly causing a higher

risk premium to be priced in. Cases often involve small changes in

prices that generate substantial gains through large derivatives posi-

tions. However, small distortions in prices can have a profound impact

on the economy especially if they affect major cash crops, commodity

exports or key consumer goods. Investors sometimes abuse derivatives

in order to manipulate accounting rules and financial reporting require-

ments, to dodge prudential market regulations such as restrictions on

foreign exchange exposure on financial institutions balance sheets, or

to evade or avoid taxation.5 It has been pointed out that derivatives

allow financial institutions to change the shape of financial instruments

in such a way as to circumvent financial regulations in a fully legal

way. (Dodd, 2003). The use of derivatives to circumvent or outflank

prudential regulation has been acknowledged by the IMF, World Bank

and the OECD, among others. The World Banks Global Development

Finance 2000 stated it in the following way: Brazils complex system

of prudential safeguards was easily circumvented by well-developed

financial market and over-the-counter derivatives. Derivatives

4 In a derivatives market investors can use a small amount of funds to

command more resources as buying a derivatives contract costs a fraction of theamount needed to actually buy the underlying security. This in turn encouragesoperators to use the market extensively for their hedging, speculative and arbitrageoperations adding to market liquidity and creating a competitive market.

5 An example drawn from the US experience involves two financialinstitutions Fannie Mae and Freddie Mac who are arguably the worlds largesthedgers. They admitted having filed financial reports which falsely understated thevalue of their derivatives positions by billions of dollars. The collapse of the energymerchant corporation Enron exposed their extensive use of derivatives for thepurpose of fabricating income and revenue, hiding debt as well as manipulatingmarket prices. Although these examples are from a developed economy, they serve asa telling example that even in a well regulated financial market derivatives can wellbe misused.

Investors sometimes

abuse derivatives to

manipulate

accounting rules

and financial

reporting

requirements, to

dodge prudential

market regulations

such as restrictions

on foreign exchange

exposure on

financial

institutions balance

sheets, or to evade

or avoid taxation.


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allowed Mexican banks to circumvent national regulations and to build

up a foreign exchange position outside of official statistics and un-

known to policy-makers and a large part of market participants.

The second area of concern relates to negative consequences

that may arise even if derivatives are not purposely being used for

bypassing regulations. One of the key features of derivatives contracts

is that they provide leverage to all users. Leverage in this context

means the quotient of the size of the price exposure (measured in

notional value or the amount of underlying assets or commodities)

divided by the amount of initial outlay required to enter the contract. In

addition to providing leverage, derivatives sometimes further lower the

cost of taking on price exposure because of lower transactions costs and

higher levels of liquidity. Together, these features facilitate greater risk

taking for a given amount of capital, and the extent of their use for risk

taking can result in greater overall levels of exposure to price risk for a

given amount of capital in the entire financial system. Such misuse also

poses a threat to the stability of the financial sector and the overall

economy by increasing systemic risk, risk of contagion and possibly

serving as a catalyst or an accelerator to financial disruption or crisis.

Liquidity is another critical issue in derivatives markets. Illiquidity due

to any set of factors ranging from market concentration to faulty

infrastructure or malpractices can pose a serious threat to the deriva-

tives market. While illiquidity is troublesome in securities markets

because it hampers the ability of investors to adjust their positions and

to observe correct market prices, it is not likely to leave investors with

new levels of exposure. In derivatives markets, trading is a critical

component of a risk management policy as hedgers and speculators

regularly trade in the market in order to dynamically manage an

investment strategy. If the continuity in trading were to be interrupted,

then it might prevent them from rolling-over positions or offsetting

other positions in securities and other asset markets. This could leave a

large number of investors with market risk exposures that they did not

intend, and could thus lead to a systemic payments failure across

markets.

III. Commodity Derivatives MarketThough India is considered a pioneer in some forms of deriva-

tives in commodities, the history of formal commodity derivativestrading is rather chequered. The first derivatives market for cotton

futures was set up in Mumbai, followed by the establishment of futures

markets in edible oilseeds complex, raw jute and jute goods and

bullion. Organised futures market in India dates back to the setting up

ofBombay Cotton Trade Association Ltd. in 1875.6 Organised futures

6 Just a year after the establishment of Chicago Produce Exchange (nowChicago Mercantile Exchange) in 1874. The first organised commodity tradingexchange, the Chicago Board of Trade, was set up in 1848.

Together, these

features facilitate

greater risk taking

for a given amount

of capital, and the

extent of their use

for risk taking can

result in greater

overall levels of

exposure to price

risk for a given

amount of capital in

the entire financial

system.


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trading in oilseeds was started in India with the setting up ofGujarati

Vyapari Mandali way back in 1900. Futures trading in Raw Jute and

Jute Goods began in Kolkata with the establishment of the Calcutta

Hessian Exchange Ltd., in 1919. In the case of wheat, futures markets

were in existence at several centres in Punjab and Uttar Pradesh; the

most notable among them was the Chamber of Commerce at Hapur,

which was established in 1913. Futures market in Bullion began in

Mumbai as early as 1920. The volumes of trade in these derivatives

markets were reported to be extremely large. However, with enactment

ofDefence of India Act, 1935, futures trading became subject to

restrictions/prohibition from time to time. After Independence, the

Union Government enacted the Forward Contracts (Regulation), 1952;

this Act provided for prohibition of options in commodities and regula-

tion and prohibition of futures trading. By the mid-1960s, the Govern-

ment imposed a ban on derivatives contracts on most commodities,

except very few not so important commodities like pepper and tur-

meric. The apprehensions about the role of speculation, particularly

under scarcity conditions, prompted the Government to continue the

prohibition till very recently.

After the introduction of economic reforms since June 1991 the

gradual withdrawal of the procurement and distribution channels7

necessitated setting in place a market mechanism to introduce price

discovery and risk management functions in the sphere of agriculture. It

was generally agreed that the derivatives markets play a valuable role

in shaping decisions of the market intermediaries, including decisions

by farmers about sowing and investments in inputs; smoothing price

volatility; and giving farmers and consumers better means of protecting

themselves against the adverse effects of seasonal/annual price volatil-

ity.8 The argument articulated in the National Agricultural Policy of

the Government of India, 2000, was: if derivatives markets can func-

tion adequately well, then the core policy goals of reducing volatility of

agricultural prices can be addressed in a market-oriented fashion. As a

follow-up the Government issued notifications in April 2003, permitting

futures trading in commodities.9 The problem, however, with most of

the traditional or regional exchanges is that they deal in individual

7 Where the Government ensures availability of agricultural produce bytrying to maintain buffer stocks, fixing prices, having import-export restrictions anda host of other interventions.

8 A committee on Forward Markets under Chairmanship of Prof. K.N.Kabra, which submitted its report in September 1994, recommended futures tradingin select cash crops along with modernisation of some traditional exchanges. Earlier,the Khusro Committee (June 1980) had recommended reintroduction of futurestrading in most of the major commodities, including potato and onions in selectseasons.

9 From 1998 onwards, domestic entities facing price risk abroad had beengiven permission to utilise foreign derivatives exchanges in addressing their riskmanagement needs. Options trading in commodity is however presently prohibitedin India.

By the mid-1960s,

the Government

imposed a ban on

derivatives contracts

on most

commodities. The

apprehensions

about the role of

speculation,

particularly under

scarcity conditions,

prompted the

Government to

continue the

prohibition till veryrecently.


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commodities and are extremely region centric, and hence derivatives

trading is highly fragmented. Thus along with the removal of prohibi-

tions on futures trading in a number of commodities a reforms pro-

gramme towards building commodity futures exchanges has been

initiated under the aegis of the Forward Markets Commission (FMC),

constituted under the Ministry of Consumer Affairs and Public Distribu-

tion. As of now the country has three national level electronic ex-

changes and 21 regional exchanges for trading commodity derivatives,

which trade in 80 commodities.10 These demutualised exchanges are

technology driven and have adopted international best practices of risk

management for trading, clearing and settlement.11 The total one-way

turnover in value terms in commodity futures registered a jump of

about 200 per cent, from about Rs. 35,000 crore in 2001-02 to

Rs. 68,000 crore in 2002-03 and to Rs. 1,30,000 crore in 2003-04.

The value of trade in 2005-06 has been Rs. 21,34,471.5 crore.12 Daily

volumes across the countrys national and regional commodity ex-

changes now exceed Rs. 5000 crore, with Gold, Silver and Crude Oil,

Chana, and Guar Seed registering highest volumes of trade in recent

times [Table 2].13 The main players are commodity and stockbrokers,

agro-processors, high net worth individuals and corporates.

There are certain problems specific to large scale trading in

commodity derivatives, as unlike securities, commodities come in

different grades and qualities, particularly in a large country like India

with varied weather and soil conditions. The prices of commodities are

influenced by their quality, grades, seasons of production, quality of

storage and warehousing, etc. Commodities are also bulky involving

difficulties in transportation, which affect spatial integration. These

issues can be addressed by introducing a nationwide warehouse receipt

system, which is an important mode of settlement of commodity

derivatives contracts internationally. But this will have to be preceded

10 The development of the pepper futures market at Kochi (The IndianPepper and Spice Traders Association, IPSTA), the castor seed futures market atVashi, cotton futures market at Mumbai, and the Coffee Owners Futures Exchangeof India (COFEI) are significant milestones in the history of Indian commodityderivatives.

11 One of the Exchanges, i.e., National Multi-commodity Exchange of

India Ltd. (NMCEIL), has Central Warehousing Corporation, NAFED (Governmentof India enterprises) and Gujarat Agro Industries Corporation (Gujarat StateGovernment) as prominent promoters. The National Commodities DerivativeExchange Ltd. (NCDEX) has been promoted by a consortium comprising ICICIBank, National Stock Exchange, Life Insurance Corporation, and NABARDall ofthem being leaders in their respective fields.

12 In 2005 Indian capital markets crossed another milestone as for the firsttime, commodity futures volumes in India overtook stock futures turnover; with overRs. 1,66,000 crores turnover as against Rs. 1,63,000 crore of futures trades in NSEduring the month.

13 Trade in both gold and silver have registered manifold jumps in the lastfinancial year. Brent crude, which was launched in September 2005, registered atotal volume of Rs. 5,270 crore (19 million barrels) in just six months.

As of now the

country has three

national level

electronic

exchanges and 21

regional exchanges

for trading

commodity

derivatives, which

trade in 80

commodities. These

demutualised

exchanges are

technology driven

and have adopted

international best

practices of risk

management for

trading, clearing and

settlement.


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by appropriate upgrade of the systems and creation of a regulatory

apparatus to facilitate development and adoption of uniform standards,

and creation of facilities for scientific grading, packing, storage,

preservation and certification at the warehouses. A sophisticatedwarehousing service has yet to come about in India. At present the

public sector dominates warehouse facilities and the Central Warehous-

ing Corporation and State Warehousing Corporations account for

approximately more than three quarters of the total warehousing

capacity in the country. The economic principle is to treat the ware-

house receipt as negotiable and fungible; important gains could be

obtained by modifying the legal structure so that warehouse receipts

become negotiable and by dematerialising warehouse receipts at the

National Securities Depository Limited (NSDL) and Central Depository

Services Limited (CDSL). The Food Ministry is in the process ofdrafting a Warehouse Development & Regulation Act to promote

warehouse receipts-based lending and commodity derivatives transac-

tions. The proposed legislation would basically enable the creation of a

regulatory authority for accreditation of warehouses and the setting of

the relevant standards to be made applicable for scientific grading,

packing, storage, preservation and certification of commodities at the

warehouses. This would ensure that the warehouse receipts issued by

them are tradable and can be used as negotiable collaterals. Indias first

National Spot Exchange for Agriculture Produce (NSEAP) has been set

TABLE 2Turnover in Commodity Derivatives Exchanges

Commodity Turnover in 2005-06 Turnover in 2004-05(Rs. Crore) (Rs. Crore)

Total* 21,34,472 13,87,780

NCDEX 10,67,696 7,46,775

Top 10 commodities on NCDEX

Guar Seed 306,900

Chana 219,000

Urad 178,800

Silver 85,600 33,200

Gold 47,600 660

Tur 36,600

Guar gum 35,900

Refined Soya Oil 25,900

Sugar 25,600

% of volumesPulses 40%

Guar 30%

Bullion 12%

*For 24 Commodity exchanges

Source: FMC.

The economic

principle is to treat

the warehouse

receipt as negotiable

and fungible;

important gains

could be obtained

by modifying the

legal structure so

that warehouse

receipts become

negotiable and by

dematerialising

warehouse receipts

at NSDL and CDSL.


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up in 2005, paving the way for linking all agriculture produce market-

ing cooperatives (APMC)14 and other physical market players on an

electronic platform.

In a measure that could largely enrich commodity futures

trading, the Government is ready to allow banks to trade in commodity

derivatives.15 Banks, mutual funds, foreign institutional investors and

primary dealers were so far restricted from participating in commodity

futures trading. The case for allowing banks entry into commodity

futures trading has been argued not only to boost liquidity and turnover

volumes, but to also provide them with a protective cover against

default on agricultural loans. Under the new arrangement, banks would

lend to farmers or cooperatives and simultaneously encourage them to

sell into futures contracts. This would help reduce the risk of farmers

defaulting on their loans in the event of a fall in spot commodity prices.

It also appears that there is a potential for gains to the economy from

pursuing convergence by removing the present legal and institutional

walls that separate the commodity futures market from the securities

markets as it would allow the less developed commodities market to

reap the benefits of infrastructural and regulatory development in the

securities market. To the extent that convergence of financial and

commodity derivatives markets helps speed up the migration of com-

modity futures markets into screen-based, anonymous order matching,

it would indirectly assist the strengthening of agricultural spot markets

and would also help in the integration of the Indian commodity deriva-

tives market with global markets. Studies on the US market have shown

that there is a significant difference in the volatility patterns of these

two assets; thus the inclusion of commodity exposures in a diversified

portfolio can reduce the overall volatility while significantly improving

the return potential of the portfolio16 (Gorton and Rouwenhorst, 2006).

Thus availability of financial and physical derivatives on the same

platform could help to widen and deepen both markets as investors

have more choice and they may benefit from portfolio strategies

involving both underlyings.

IV. Foreign Exchange DerivativesDuring the period 1975-1992, the exchange rate of the rupee

was officially set by the Reserve Bank of India (RBI) in terms of a

(weighted) basket of currencies of Indias major trading partners andthere were significant restrictions on not only capital but current

14 At present 7,325 APMCs of the country dealing in 140 crops.15 A Working Group on Warehouse Receipts and Commodity Futures

(headed by Mr. Prashant Saran) recommended that banks may be permitted to offerfutures-based products to farmers in order to enable them to hedge against price risk.

16 Besides diversification, commodity futures could help portfolio managerscontrol inflation risk as commodity futures returns are seen to be positively corre-lated with inflation, unexpected inflation, and changes in expected inflation.

In a measure that

could largely enrich

commodity futures

trading, the

Government is ready

to allow banks to

trade in commodity

derivatives. Banks,

mutual funds,

foreign institutional

investors and

primary dealers

were so far

restricted from

participating incommodity futures

trading.


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account transactions as well. Since the early nineties, India is on the

path of a gradual progress towards capital account convertibility. The

emphasis has been shifting away from debt creating to non-debt creating

inflows, with focus on more stable long term inflows in the form of

foreign direct investment and portfolio investment. The exchange rate

regime has evolved from a single-currency fixed-exchange rate system

to fixing the value of the rupee against a basket of currencies and

further to a market-determined floating exchange rate regime.17

The Indian foreign exchange derivatives market owes its origin

to the important step that the RBI took in 1978 to allow banks to

undertake intra-day trading in foreign exchange; as a consequence, the

stipulation of maintaining square or near square position was to be

complied with only at the close of each business day. This was followed

by use of products like cross-currency options, interest rate and cur-

rency swaps, caps/collars and forward rate agreements in the interna-

tional foreign exchange market; development of a rupee-foreign

currency swap market; and introduction of additional hedging instru-

ments such as foreign currency-rupee options. Cross-currency deriva-

tives with the rupee as one leg were introduced with some restrictions

in the April 1997 Credit Policy by the RBI. In the April 1999 Credit

Policy, Rupee OTC interest rate derivatives were permitted using pure

rupee benchmarks, while in April 2000, Rupee interest rate derivatives

were permitted using implied rupee benchmarks. In 2001, a few select

banks introduced Indian National Rupee (INR) Interest Rate Deriva-

tives (IRDs) using Government of India security yields as floating

benchmarks. Interest rate futures (long bond and t-bill) were introduced

in June 2003 and Rupee-foreign exchange options were allowed in July

2003.

The Indian foreign exchange derivatives market is predomi-

nantly a transactions based market with the existence of underlying

foreign exchange exposure being an essential requirement for market

17 The Indian foreign exchange market had been heavily controlled, alongwith increasing trade controls designed to foster import substitution. Consequently,both the current and capital accounts were closed and foreign exchange was madeavailable by the RBI through a complex licensing system. With the initiation of

economic reforms in July 1991, there was a downward adjustment in the exchangerate of the rupee with a view to placing it at an appropriate level in line with theinflation differential to maintain the competitiveness of exports. Subsequently,following the recommendations of the High Level Committee on Balance ofPayments (Chaired by Dr. C. Rangarajan), the Liberalised Exchange Rate Manage-ment System (LERMS) involving dual exchange rate mechanism was instituted inMarch 1992, which was followed by the ultimate convergence of the dual rateseffective from March 1993 (christened modified LERMS). The unification of theexchange rate of the rupee marks the beginning of the era of market determinedexchange rate regime of the rupee, based on demand and supply in the foreignexchange market. It is also an important step in the progress towards currentaccount convertibility, which was finally achieved in August 1994 by acceptingArticle VIII of the Articles of Agreement of the International Monetary Fund.

The Indian foreign

exchange

derivatives market

owes its origin to

the important step

that the RBI took in

1978 to allow banks

to undertake intra-

day trading in

foreign exchange; as

a consequence, the

stipulation of

maintaining square

or near square

position was to becomplied with only

at the close of each

business day.


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users. Similarly, regulations in most cases require end users to repatri-

ate and surrender foreign exchange in the Indian foreign exchange

market. The foreign exchange market is made up of Authorised Dealers

(ADs, generally banks), some intermediaries with limited authorisation,

and end users, viz., individuals, corporates, institutional investors and

others. Market making banks (generally foreign banks and new private

sector banks) account for a significant percentage of the overall turno-

ver in the market. The foreign exchange derivatives products that are

now available in Indian financial markets can be grouped into three

broad segments, viz. forwards, options and currency swaps. Foreign

exchange derivatives are mainly used for risk management purposes by

corporates, for hedging of commodity price risk in international

commodity markets, and for hedging exchange rate risk by FIIs, NRIs

and other overseas investors.

India has a strong dollar-rupee forward market with contracts

being traded for one, two, ... six month expiration. The daily trading

volume in this forward market is around US$500 million a day. The

exposures for which the rupee forward contracts are allowed under the

existing RBI notification for various participants are as follows:

Residents: Foreign Institutional Non-resident Indians/

Investors: Overseas Corporates

Genuine under- FIIs are allowed to hedge Dividends from

lying exposures the market value of their holdings in an Indian

out of trade/ entire investment in equity company

business and/or debt in India as on

a particular dateExposures due to Hedge value not to exceed Deposits in Foreign

foreign currency 15 per cent of equity as of Currency Non-

loans and bonds 31 March 1999 plus Resident (FCNR) and

approved by the increase in market Non-Resident External

RBI value/inflows (NRE) accounts

Receipts from Reviews based on the market Investments under

GDR issued price movements, fresh portfolio scheme in

inflows, amounts repatriated accordance with (the

and other relevant parame- earlier Foreign Ex

ters to ensure that the change Regulation Act,forward cover outstanding or FERA) the Foreign

is supported by an Exchange Management

underlying exposure Act (FEMA)

Balances in

Exchange Earners

Foreign Currency

(EEFC) accounts

Source: Master Circular No. /06/2005-06; RBI

The foreign

exchange

derivatives products

that are now

available in Indian

financial markets

can be grouped into

three broad

segments, viz.

forwards, options

and currency swaps.


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Forward contracts are also allowed to be booked for foreign

currencies (other than Dollar) and Rupee, subject to similar conditions

as mentioned above. Banks are allowed to enter into forward contracts

to manage their asset-liability portfolios. The Indian forwards market is

relatively illiquid for standard maturity contracts as most of the

contracts traded are for the month-ends only.

Currency options provide a way of availing benefits of the

upside from any currency exposure while being protected from the

downside, for the payment of an upfront premium; these contracts were

allowed in the Indian market to be used as a hedge for foreign currency

loans. It was required that the option did not involve the rupee, the face

value did not exceed the outstanding amount of the loan, and the

maturity of the contract did not exceed the unexpired maturity of the

underlying loan. Adding to the spectrum of hedge products available to

residents and non-residents for hedging currency exposures, the RBI

permitted foreign currencyrupee options with effect from July 2003 to

be offered by select ADs who satisfy certain capital adequacy and risk

management norms. As of now, ADs have been permitted to offer only

plain vanilla European options. Customers can also enter into packaged

products involving cost reduction structures18 provided the structure

does not increase the underlying risk and does not involve customers

receiving premium. Writing of options by customers is, however, not

permitted. Option contracts are settled on maturity either by delivery

on spot basis or by net cash settlement in Rupees on spot basis as

specified in the contract. In case of unwinding of a transaction prior to

maturity, the contract may be cash settled based on the market value of

an identical offsetting option. ADs in turn can use the product for the

purpose of hedging trading books and balance sheet exposures. Market

makers are allowed to hedge the Delta of their option portfolio by

accessing the spot markets. Other Greeks (Gamma, Vega Theta,

Rho) may be hedged by entering into option transactions in the inter-

bank market.19

18 These products are predetermined combinations of options. For example,they may allow one to negotiate a range of rates instead of one single exchangerate. This range will enable the customer to take advantage of favourable changes

in the currency, while having a safety net in case of unfavourable fluctuations. Theyare more cost effective than buying different options for various anticipated riskscenarios. The RBIs requirement that no premiums are earned from them ensuresthat such options are used solely for hedging purposes.

19 Option premium (price of an option) is affected by volatility of thestock price and by some other factors. These factors are collectively called as theGreeks. Each risk measurement is named after a different letter in the Greekalphabet. Delta, Gamma, Theta, Vega and Rho are the five major factors thataffect the option premium. These Greeks do not take a fixed value but are interde-pendent. For example, Delta measures how much the options premium wouldchange if the underlying stock price changes while Gamma indicates the pace atwhich the option premium changes with changes in the stock price or effectively therate at which delta will change.

Adding to the

spectrum of hedge

products available

to residents and

non-residents for

hedging currency

exposures, the RBI

permitted foreign

currencyrupee

options with effect

from July 2003 to

be offered by select

ADs who satisfy

certain capital

adequacy and riskmanagement norms.


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There is some activity in other cross currency derivatives

product markets also, which are allowed for hedging foreign currency

liabilities provided these have been acquired in accordance with the

RBI regulations. The products that may be used are: Currency Swap,

Rupee Interest Rate Swap (IRS), Interest Rate Cap or Collar (pur-

chases), and Forward Rate Agreement (FRA) contracts [Box 3]. Among

various swap contracts, the Overnight Index Swap (OIS) based on the

Mumbai Inter Bank Offer Rate (MIBOR) is a very liquid contract with

up to five years maturity as overnight rates have been the most widely

accepted benchmark for floating rate bond issues in the cash market

and the overnight money market is deep and liquid. The Mumbai Inter

Bank Forward Offered Rate (MIFOR20 ) Swap, another liquid floating

rate swap contract, is calculated based on the covered interest arbitrage

formula using the USD LIBOR (London Inter Bank Offer Rate). CMT

Swaps are based on the Constant Maturity INR Government Securities

Yield; increasing activity is being seen in this market with a lot of

issuers hedging their fixed rate borrowings as the underlying INR

TABLE 3Foreign Exchange ContractsIndia

Turnover in nominal or notional principal amounts* (USD mln.)

2004 2001

Domestic currency against USD All Currencies USD All Currencies

Instruments

Spot 70218.00 71972.00 28232.65 28232.65

Outright Forwards 20225.76 22539.00 7391.42 7698.18

over seven days and up toone year 14829.00 17128.00 4952.58 5222.70

(percentage) 73.32 75.99 67.00 67.84

Foreign Exchange Swaps 57282.00 57297.39 38530.99 38577.17

seven days or less 27580.64 27592.75 20355.85 20364.08

(percentage) 48.1 48.2 52.8 52.8

over seven days and up toone year 26826 26829 17915.97 17953.92

(percentage) 46.8 46.8 46.5 46.5

Currency Swaps 2051.00 2096.00 12.25 16.78

OTC Options 1365.00 1365.00 0.00 0.00Sold 692.00 692.00 0.00 0.00

Bought 673.00 673.00 0.00 0.00

*Turnover for the month of April in the respective years.BIS, Central Bank Survey of Foreign Exchange and Derivatives Market Activity.

20 As published jointly by Fixed Income Money Market and DerivativesAssociation of India (FIMMDA) and the National Stock Exchange of India (NSE).


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Government Securities market is now quite deep and liquid. Quanto

Swap is another interesting derivative product which aims to minimiseboth currency and interest rate risk. It is a dual swap combining the

fixing of the exchange rate and interest rate at the same time.

An important element in the infrastructure for the efficient

functioning of the foreign exchange market has been the clearing and

settlement of inter-bank USD-Rupee transactions. It has been well

documented that the vast size of daily foreign exchange trading,

combined with the global interdependencies of the foreign exchange

market and payment systems,involves risks stemming from settlement

of foreign exchange trades on gross basis. Settlement of foreign

BOX 3: Foreign Exchange Contracts

OIS (Overnight Overnight Indexed Swaps are benchmarked typically

Indexed Swap) against FIMMDA-NSE MIBOR rates

INR-MIBOR (Mumbai Pay simple Fixed Rate against receipt of overnight

Inter Bank Offer Rate) Floating Rate for tenures up to (and including) one year.

Pay simple semi-annual Fixed Rate against receipt ofovernight Floating Rate for tenures longer than one year.

INR-MITOR (Mumbai Pay simple Fixed Rate against receipt of overnight

Inter Bank Tom(orrow) Floating Rate for tenures up to (and including) one year.

Offer Rate) Pay simple semi-annual Fixed Rate against receipt of

overnight Floating Rate for tenures longer than 1 year.

INR-MIFOR (Mumbai Pay annual Fixed Rate against receipt of three month

Inter Bank Forward Floating Rate for tenures up to (and including) one year.

Offered Rate) Pay semi-annual Fixed Rate against receipt of six month

Floating Rate for tenures longer than one year.

INR-MIOIS (Mumbai Pay annual Fixed Rate against receipt of three month

Inter Bank Overnight Floating Rate for tenures up to (and including) one year.

Indexed Swap) Pay semi-annual Fixed Rate against receipt of six month

Floating Rate for tenures longer than one year.

INR-BMK ( Indian Pay annual Fixed Rate against receipt of annualised

government securities Floating Rate for all tenures.

benchmark rate)

INR-CMT (Indian Pay annual Fixed Rate against receipt of annualised

Constant Maturity Floating Rate for all tenures.

Treasury rate)

Quanto swap Customer pays, say, USD 12 month LIBOR, in-arrears

quantoed into INR (i.e. fixings are in USD LIBOR but all

payments made in INR and are calculated based on an

INR notional).

XCS (Cross Currency Parties to exchange a given amount of one currency for

Swap) another and to pay back with interest these currencies in

the future.

It has been well

documented that the

vast size of daily

foreign exchange

trading, combined

with the global

interdependencies

of the foreign

exchange market

and payment

systems,involves

risks stemming from

settlement of foreign

exchange trades on

gross basis.


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exchange transactions spans different time zones and payment systems.

As a result, counterparties assume various types of risks in the course of

settlement. As suggested by the Sodhani Committee, the RBI took the

initiative to establish Clearing Corporation of India Ltd. (CCIL) in 2001

to mitigate risks in the Indian financial markets. CCIL undertakes

settlement of foreign exchange trades on a multilateral net basis

through a process of novation and all trades accepted are guaranteed

for settlement.21 In 2006, on an average, CCIL has settled over 4,000

deals daily, covering an average gross volume of around US$4.5

billion. CCIL also launched its foreign exchange trading platform, FX-

CLEAR, in August 2003, which offers an anonymous order driven

dealing platform. It covers the inter-bank dollar-rupee (USD-INR) Spot

and Swap transactions and transactions in major cross currencies like

euro, pound or yen (EUR/USD, USD/JPY, GBP/USD etc.). The USD-INR

deals constitute about 85 per cent of the total transactions in India in

terms of value.

V. Exchange Traded Financial DerivativesThe first step towards introduction of financial derivatives

trading in India was the promulgation of the Securities Laws (Amend-

ment) Ordinance, 1995, which withdrew the existing prohibition on

options in securities, after the National Stock Exchange (NSE) re-

quested for permission to trade index futures. However, as there was no

regulatory framework to govern trading of derivatives, the financial

market regulator SEBI set up a 24-member Committee under the

Chairmanship of Dr. L.C. Gupta in November 1996 to develop an

appropriate regulatory framework for derivatives trading in India. The

Committee recommended that derivatives should be declared as

securities so that the regulatory framework applicable to trading of

securities could also govern trading in derivatives. SEBI also set up a

group in June 1998 under the Chairmanship of Prof. J.R. Varma, whose

report, submitted in October 1998, presented the operational details of

the margining system, methodology for charging initial margins,

broker net worth, deposit requirement and real-time monitoring re-

quirements. The Securities Contracts (Regulation) Act, 1956, was

amended in December 1999 to include derivatives within the ambit of

securities and the regulatory framework was developed for governing

derivatives trading. Derivatives were formally defined to include: (a) asecurity derived from a debt instrument, share, loan whether secured or

21 Every eligible foreign exchange contract, entered into between members,will get novated or be replaced by two new contractsbetween CCIL and each ofthe two parties, respectively. Following the multilateral netting procedure, the netamount payable to, or receivable from, CCIL in each currency will be arrived at,member-wise. The Rupee leg will be settled through the members current accountswith the RBI and the USD leg through CCILs account with the Settlement Bank atNew York.

The first step

towards

introduction of

financial derivatives

trading in India was

the promulgation of

the Securities Laws

(Amendment)

Ordinance, 1995,

which withdrew the

existing prohibition

on options in

securities, after the

NSE requested for

permission to tradeindex futures.


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

of security, and (b) a contract which derives its value from the prices,

or index of prices, or underlying securities. The Act also stipulates that

derivatives shall be considered legal and valid only if such contracts

are traded on a recognised stock exchange, thus precluding OTC

derivatives. Equity derivatives trading finally commenced in India in

June 2000. SEBI permitted the derivatives segments of two stock

exchanges, viz., NSE and BSE, and their clearing houses/corporations

to commence trading and settlement in approved derivatives contracts.

To begin with, SEBI approved trading in index futures contracts based

on the S&P CNX Nifty Index and BSE-30 (Sensex) Index. These indices

were obviously the first choice as the diversification within Nifty/

Sensex serves to cancel out influences of individual companies or

industries; thus the underlying Nifty/Sensex reflects the overall pros-

pects of Indias corporate sector and Indias economy. The indices move

with events that impact the economy, such as politics,22 macroeco-

nomic policy announcements, interest rates, money supply and govern-

ment budgets, shocks from overseas, etc. Index futures trading was

followed by approval for trading in options based on these two indices

and options on individual securities. The trading in index options

commenced in June 2001 and trading in options on individual securities

commenced in July 2001. Futures contracts on individual stocks were

launched in November 2001. In June 2003, SEBI/RBI approved trading

in interest rate derivatives instruments and NSE introduced trading in

futures contracts in (notional)23 91-day T-bills and 10-year 6 per cent

coupon bearing bonds. NSE also introduced trading in futures and

options contracts based on the CNX-IT index from August 2003.

Exchange traded interest rate futures on a (notional) zero coupon bond

priced off a basket of Government Securities were permitted for trading

in January 2004.

In India, trading and settlement in derivatives contracts are

done in accordance with the rules, bye-laws, and regulations of the

respective exchanges and their clearing houses/corporations, duly

approved by SEBI and notified in the official gazette. National Securi-

ties Clearing Corporation (NSCCL) undertakes clearing and settlement

of all deals executed on the NSEs F&O (Futures and Options) segment.

It acts as legal counterparty to all deals on the F&O segment and

guarantees settlement. FIIs, who were initially allowed to buy and sellonly index futures contracts traded on a stock exchange, have been

permitted to trade in all exchange traded derivatives contracts since

February 2002. MFs were initially permitted to participate in the

22 Politics has come to play a less important role as there is growingevidence that political instability in the country will not significantly affect itseconomic policies.

23 Derived from the theoretical zero coupon yield curve.

In India, trading and

settlement in

derivatives contracts

are done in

accordance with the

rules, bye-laws, and

regulations of the

respective

exchanges and their

clearing houses/

corporations, duly

approved by SEBI

and notified in the

official gazette.


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derivatives market only for the purpose of hedging and rebalancing

their portfolio. However following the developments in the MF industry

as well as in the derivatives market, MFs are now permitted to partici-

pate in the derivatives market at par with FIIs.

At the NSE, the exchange which accounts for the bulk of the

derivatives trading, three Nifty futures contracts trade at any point in

time, expiring in three near months [Box 4]. The expiration date of

each contract is the last Thursday of the month. The three futures trade

completely independently of each other, each having a distinct price

and a distinct limit order book. Open positions are squared off in cash

on the expiration date, with respect to the spot Nifty. Specifically, on

the expiration date, the last mark to market margin is calculated with

respect to the spot Nifty instead of the futures price. As is currently the

case, mark-to-market losses will have to be paid by the trader to

NSCCL; however, mark-to-market profits are to be paid to traders by

NSCCL as opposed to cash market transactions. The market lot is 200

Nifties; thus, if Nifty is at 1,500, the smallest transaction will have a

notional value of Rs. 300,000. The initial (upfront) margin on trading

Nifty is around 7 to 8 per cent; thus, a position of Rs. 300,000 (around

200 Nifties) will require upfront collateral of Rs. 21,000 to Rs. 24,000.

Hedged futures positions attract lower marginsif a person has

purchased 200 October Nifties and sold 200 November Nifties, the

trade will attract much less than 7 to 8 per cent margin. In the present

cash market, all positions attract 15 per cent initial (upfront) margin

from NSCCL, regardless of the extent to which they are hedged.

Indias experience with the launch of equity derivatives market

has been extremely positive; within a few years of its inception NSE

stood out as one of the most prominent exchanges among all emerging

markets, in terms of equity derivatives turnover24 [Table 5]. In the last

few years, volumes in the F&O segment have consistently been more

than two times of the cash segment of NSE [Chart 1]. The individual

stock futures market also has really taken off since its introduction

[Chart 2], and cumulatively surpassed even the index futures market.

Contracts of almost all of the 118 underlying stocks get traded regu-

larly in the F&O segment of NSE.

One of the puzzles in Indias experience with equity derivatives

has been the dominance of individual stock derivatives, so much so that

in terms of volumes traded Nifty appeared at third rank for futures andfourth rank for options in December 2002. Only in times when macr-

oeconomic news appears to be important Nifty ranked number one in

the derivatives section. This is surprising as, logically, index based

derivatives should have been a better alternative instrument in a

24 NSE accounts for the bulk of volumes in equity derivatives. Its turnoveraccounted for 98 per cent of the total turnover in the year 2001-2002.

Indias experience

with the launch of

equity derivatives

market has been

extremely positive;

within a few years of

its inception NSE

stood out as one of

the most prominent

exchanges among

all emerging

markets, in terms of

equity derivatives

turnover.


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BOX 4: Types of F&O contracts at NSE

Index Futures Stock Futures Index Options Stock Options

Underlying S&P CNX NIFTY# Futures contracts are S&P CNX NIFTY# Options contracts are

Instrument available on 118 (European) CE - Call, available on the same

securities which are PE - Put 118 securities on which

traded in the Capital Futures contracts are

Market segment of the available. (American)Exchange. CA - Call , PA - Put.

Trading maximum of 3-month trading cycle: the near month (one), the next month (two) and the far month

cycle (three).

Expiry day last Thursday of the expiry month or on the previous trading day if the last Thursday is a trading

holiday.

Strike Price NA NA a minimum of five strike

Intervals prices for every option

type (i.e. call & put)

during the trading

month. At any time,

there are two contracts

in-the-money (ITM),

two contracts out-of-

the-money (OTM) and

one contract at-the-

money (ATM). The strike

price interval is 10.

Contract lot size of Nifty futures multiples of 100 and lot size of Nifty options multiples of 100 and

size contracts is 200 and fractions if any, shall be contracts is 200 and fract ions if any, shall be

multiples thereof rounded off to the next multiples thereof rounded off to the next

higher multiple of 100. higher multiple of 100.

The permitted lot size for The value of the option

the futures contracts on contracts on individual

individual securities shall securities may not bebe the same for options less than Rs. 2 lakhs at

or as specified by the the time of introduction.

Exchange

Quantity 20,000 units or greater, quantity freeze shall be 20,000 units or the lesser of the

freeze after which the Exchange the lesser of the follow- greater following:1% of the

may at its discretion ing:1% of the marketwide marketwide position

approve further orders, position limit stipulated limit stipulated for open

on confirmation by the for open positions on the positions on options on

member that the order futures and options on individual securities or

is genuine. individual securities or Notional value of the

Notional value of the contract of around

contract of around Rs.5 crores

Rs.5 crores

Price bands No day minimum/maximum operating ranges are operating ranges and day minimum/maximum

price ranges applicable, kept at + 20% ranges for options contract are kept at 99%

however, operating ranges of the base price

are kept at + 10%,after

which price freeze would be

removed on confirmation

by the member that the

order is genuine.

Contd. /-


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developing market, where there may exist information asymmetry in

individual stocks whereas the market index is definitely more transpar-

ent. However, in recent times this feature has been corrected and Nifty

contracts stand out as the most traded in both the F&O segment

[Chart 3]. On the other hand, though NSE ranked ninth among theworld exchanges, by total value of bonds traded in 2004 (in USD

terms), surprisingly interest rate futures have not taken off at all in

India [Table 4].

Index Futures Stock Futures Index Options Stock Options

Price steps The price step in respect The price step for The price step in The price step for

of S&P CNX Nifty futures futures contracts is respect of S&P CNX options contracts is

contracts is Re.0.05. Re.0.05. Nifty options contracts Re.0.05.

is Re.0.05.

Base Prices Base price of S&P CNX the theoretical futures Base price of the new options contracts would

Nifty futures contracts on price on introduction be the theoretical value of the options contract

the first day of trading and the daily settlement arrived at based on Black-Scholes model ofwould be theoretical futures price of the futures calculation of options premiums.The base price

price. The base price of the contracts on subse- of the contracts on subsequent trading days,

contracts on subsequent quent trading days. will be the daily close price of the options

trading days would be the contracts, which is the last half an hours

daily settlement price of the weighted average price if the contract is traded

futures contracts. in the last half an hour, or the last traded price

(LTP) of the contract. If a contract is not traded

during a day on the next day the base price is

calculated as for a new contract.

Order type Regular lot order; Stop loss order; Immediate or cancel; Good till day/cancelled*/date; Spread order

#CNX-IT and BANK NIFTY indices are also traded now.

*Good Till Cancelled (GTC) orders are cancelled at the end of the period of 7 calendar days from the date of

entering an order.

Source: NSE website.

CHART 1Monthly Turnover at Cash and Derivatives Segments of NSE (Rs. cr.)

0

100000

200000

300000

400000

500000600000

700000

800000

Jun.2

000

Oct.2

000

Feb.2

001

Jun.2

001

Oct.2

001

Feb.2

002

Jun.2

002

Oct.2

002

Feb.2

003

Jun-2003

Oct-2003

Feb-2004

Jun-2004

Oct-2004

Feb-2005

Jun-2005

Oct-2005

Feb-2006

Jun-2006

Equiites Derivatives

Source : NSE

Though NSE ranked

ninth among the

world exchanges, by

total value of bonds

traded in 2004 (in

USD terms),

surprisingly interest

rate futures have not

taken off at all in

India.


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CHART 2Share of Various Derivative Instruments in Turnover in Derivatives Segment of NSE

0%

20%

40%

60%

80%

100%

Jun.2

000

Sep.2

000

Dec.2

000

Mar.2

001

Jun.2

001

Sep.2

001

Dec.2

001

Mar.2

002

Jun.2

002

Sep.2

002

Dec.2

002

Mar.2

003

Jun-2003

Sep-2003

Dec-2003

Mar-2004

Jun-2004

Sep-2004

Dec-2004

Mar-2005

Jun-2005

Sep-2005

Dec-2005

Mar-2006

Jun-2006

Index Futures Stock Futures Index Options (Call)

Index Options (Put) Stock Options (Call) Stock Options (Put)

CHART 3Most Traded Contracts on NSE

1. NIFTYMAY 2006

33%

OTHERS

46%

4. TATASTEEL

MAY 2006

3%

5. HINDALCO

MAY 2006

1%

3. RELIANCE

MAY 2006

4%

2. NIFTY

JUNE 2006

13%

2. NIFTY

JUNE 2005

11%

3. TISCO

MAY 2005

5%

5. RELIANCE

MAY 2005

3%4. SBIN

MAY 2005

3%

OTHERS

45%

1. NIFTY

MAY 2005

33%

2. TISCO

7%

OTHERS

21%5. RELIANCE

4%

4. SBIN

5%3.

SATYAMCO

MP

5%

1. NIFTY

58%

1. NIFTY

36%

3. INFOSYS

2%4. MTNL

2%

5.HINDALCO

2%

OTHERS

53%

2. RELIANCE

5%

Source: NSE.

Top 5 Most active Futures contracts, May 2005 Top 5 Traded Symbols in Options segment, May 2005

Top 5 Most active Futures contracts, May 2006 Top 5 Traded Symbols in Options segment, May 2006

3.

SATYAMCOMP

5%


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TABLE 4Derivatves Segment at BSE and NSE

BSE NSE

Jun00- 2001- 2002- 2003- 2004- Jun00- 2001- 2002- 2003- 2004-

Mar 01 2002 2003 2004 2005 Mar 01 2002 2003 2004 2005

Index No. of contracts 77743 79552 111324 246443 449630 90580 1025588 2126763 17192274 21635449

Futures Turnover (Rs. cr.) 1673.0 1276.0 1811.0 6572.0 13600.0 2365.0 21428.0 43951.0 554462.0 772174.0

Stock No. of contracts 17951 25842 128193 6725 1957856 10675786 32485160 47043066

Futures Turnover (Rs. cr.) 452.0 644.0 1571.0 213.0 51516.0 286532.0 1305949.0 1484067.0

Index Call No. of contracts 1139 41 1 48065 113974 269721 1043894 1870647

Options Notional Turnover

(Rs. cr.) 39.0 1.0 0.0 1471.0 2466.0 5671.0 31801.0 69373.0

Put No. of contracts 1276 2 0 27210 61926 172520 688520 1422911

Notional Turnover

(Rs. cr.) 45.0 0.0 0.0 827.0 1300.0 3577.0 21022.0 52581.0

Stock Call No. of contracts 3605 783 4391 72 768159 2456501 4258595 3946979

Options Notional Turnover

(Rs. cr.) 79.0 21.0 174.0 2.1 18780.0 69644.0 168174.0 132066.0

Put No. of contracts 1500 19 3230 17 269370 1066561 1338654 1098133

Notional Turnover

(Rs. cr.) 35.0 0.0 157.0 0.5 6383.0 30490.0 49038.0 36792.0

Interest No. of contracts 1013

Rate Turnover (Rs. cr.) 20

Futures

Total No. of contracts 77743 105527 138037 382258 531719 90580 4196873 16767852 56886776 77017185

Turnover (Rs. cr.) 1673.0 1922.0 2478.0 12452.0 16112.0 2365.0 101925.0 439865.0 2130649.0 2547063.0

Source: Handbook of Securities Markets, 2005, SEBI.

TABLE 5

Rank of India in Global and Asian Derivatives Markets

NSE global rank* AsiaPacificrank**

Stock Index Options

No. of contracts traded 239207 10 4

Notional Turnover (mln USD) 22340 12 5

Stock Index Futures



Stock Options



Single Stock Futures#



As of end Dec. 2004.*Among 29 member Derivatives Exchanges of the WFE.**Among 11 member Derivative Exchanges of the WFE.#15 member exchanges trading in stock futures contracts.

Source: Focus, World Federation of Exchanges.


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VI. Regulatory SafeguardsRapid expansion in newer areas in financial markets naturally

brings up the issue of a regulatory framework that can cope with this

growth. As pointed out by the Federal Reserve New York25: when

innovation, such as we are now seeing in derivatives, takes place in

a period of generally favorable economic and financial conditions, we

are necessarily left with more uncertainty about how exposures will

evolve and markets will function in less favorable circumstances.

The first type of regulation required for any derivatives market

falls under the rubric of orderly market provisions. These measures,

which have been tested over time in securities markets around the

world, are designed to facilitate a liquid, efficient market with a

minimum of disruptions. Registration and reporting requirements,

transparency and creation of a level playing field for all investors

alike, a system of mitigation of payments risks and safeguarding

investors moneys, are essential requirements. Risk containment

measures in turn include capital adequacy requirements of members,

monitoring of members performance and track record, stringent

margin requirements, position limits based on capital, online monitor-

ing of member positions and automatic disablement from trading when

limits are breached.

In India, prior to the introduction of derivatives trading, the

definition ofsecurities was amended (to include derivatives contracts in

the definition ofsecurities) so as to ensure that derivatives trading takes

place under the provisions of the Securities Contracts (Regulation) Act,

1956 and the Securities and Exchange Board of India Act, 1992.26

Derivatives trading in India can take place either on a separate and

independent Derivatives Exchange or on a separate segment of an

existing Stock Exchange. The Derivatives Exchange/Segment functions

as a Self-Regulatory Organisation (SRO) and SEBI acts as the oversight

regulator. The key factor enabling exchange-traded derivatives is the

credit guarantee supplied by the clearing corporation. SEBI stipulates

that the clearing and settlement of all trades on the Derivatives Ex-

change/Segment would have to be through a Clearing Corporation/

House, which is independent in governance and membership from the

Derivatives Exchange/Segment. SEBI has also laid the eligibility

conditions for Derivatives Exchange/Segment and its Clearing Corpora-

tion/House. The eligibility conditions have been framed to ensure thatDerivatives Exchange/Segment and Clearing Corporation/House

provides a transparent trading environment, safety and integrity and

25 Geithner, 2006.26 The commodity derivatives market is regulated by the FMC, a statutory

body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. It is aregulatory authority, which is overseen by the Ministry of Consumer Affairs andPublic Distribution, Govt. of India. The foreign exchange derivatives market comesunder the purview of the Foreign Exchange Management (Foreign ExchangeDerivative Contracts) Regulations, 2000.

The key factor

enabling exchange-

traded derivatives is

the credit guarantee

supplied by the

clearing

corporation. SEBI

stipulates that the

clearing and

settlement of all

trades on the

Derivatives

Exchange/Segment

would have to be

through a ClearingCorporation/House.


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provides facilities for redressal of investor grievances and maintains a

separate investor protection fund.27 The Clearing Corporation/House in

turn is required to perform full novation, i.e., the Clearing Corporation/

House shall interpose itself between both legs of every trade, becoming

the legal counterparty to both, or, alternatively should provide an

unconditional guarantee for settlement of all trades. It should institute

facilities for electronic funds transfer (EFT) for swift movement of

payments and have a separate Trade Guarantee Fund for the trades

executed on Derivatives Exchange/Segment.28

Strict eligibility criteria are adhered to when permitting

derivatives on a security. Initially, futures and options were permitted

only in the two indices with the highest average daily market capitali-

sation and traded value in the country, namely the 30 share BSE Sensex

and 50 share S&P Nifty. Subsequently, sectoral indices were also

permitted for derivatives trading subject to the fulfilment of the eligibil-

ity criteria. Derivatives contracts are to be permitted on an index if 80

per cent of the index constituents are individually eligible for deriva-

tives trading.29 Stocks on which stock option and single stock future

contracts are introduced need to conform to stringent eligibility criteria,

which have been formulated keeping in view adequate liquidity, as well

as, the volatility it can cause in market prices.

SEBI allows three types of Members to do business in the

Indian derivatives market. Trading Members (TMs) can trade on their

own behalf and on behalf of their clients; Clearing Members (CMs) are

permitted to settle their own trades as well as the trades of (other non-

clearing members or) TMs who have agreed to settle the trades through

them; Self-clearing Members (SCMs) are clearing members who can

clear and settle their own trades only. SEBI prescribes Balance Sheet

Networth Requirements as well as Liquid Networth Requirements30 for

27 These conditions require that derivatives trading take place through anon-line screen based Trading System and there are arrangements for dissemination ofinformation about trades, quantities and quotes on a real time basis. The DerivativesExchange/Segment should have systems for on-line surveillance to monitor positions,prices, and volumes on a real time basis so as to deter market manipulation.

28 In the commodity derivatives market, some of the main regulatory

measures imposed by the FMC include daily mark to market system of margins,creation of trade guarantee fund, back-office computerisation for the existing singlecommodity Exchanges, online trading for the new Exchanges, demutualisation forthe new Exchanges, and one-third representation of independent Directors on theBoards of existing Exchanges, etc.

29 However, no single ineligible stock in the index shall

Documents

Derivatives 06