A

Project Report
On

DERIVATIVE MARKET IN INDIA

Submitted To:

Submitted By:
Jitendra Jhalani
MBA
Sem-4th
511111411
Jhalanij@gmail.com

Sikkim Manipal Unitversity

1. ACKNOWLEDGEMENT
Director of IBS - Gurgaon: Prof. O.P.Gupta
Faculty in-charge:
The objective of this project DERIVATIVE MARKET IN INDIA was to gain in-depth
knowledge about the derivative market and to get an insight about functioning and future
prospects of derivative market in India.
A project is a combination of views, ideas and suggestions and contribution of many people. The
report is the opportunity to thank those who contributed towards its Fulfillment.
I am thankful to Prof. O.P.Gupta whose guidance and experience helped us in successful
completion of this project.
I am also very thankful to Prof. Nivedita Roy for their vital inputs and valuable suggestions and
continuous guidance, which is very helpful for me to successfully complete of the project.
I am also thankful to our colleagues without whom the project could not have been completed.
Jitendra Jhalani
Enrollment no: 511111411
Sikkim Manipal University
PIIT

TABLE OF CONTENT
1.
2.
3.
4.
5.
6.
7.

Acknowledgement----------------------------------------------------------------------------------------2
Executive Summary--------------------------------------------------------------------------------------5
Objectives of the study-----------------------------------------------------------------------------------6
Limitations of the study----------------------------------------------------------------------------------6
Methodology----------------------------------------------------------------------------------------------6
Introduction To Financial Markets---------------------------------------------------------------------7
Introduction To The Derivatives------------------------------------------------------------------------8
7.1. Broad Classification Of Derivatives -------------------------------------------------------------9
7.2. The Need For A Derivatives Market--------------------------------------------------------------9
7.3. The Participants In A Derivatives Market-------------------------------------------------------9
7.4. Types Of Derivatives-------------------------------------------------------------------------------9
7.5. Derivatives May Be Traded For A Variety Of Reasons--------------------------------------11
7.6. Risks Of Derivative--------------------------------------------------------------------------------14
8. Development Of Derivative Markets In India-------------------------------------------------------15
9. Recommendations And Guidelines Of SEBI Advisory Committee On Derivatives
Development And Regulation Of Derivative Markets In India-----------------------------------17
9.1. Background-----------------------------------------------------------------------------------------17
9.2. Regulatory Objectives ----------------------------------------------------------------------------17
9.3. Derivative Products--------------------------------------------------------------------------------18
9.3.1. Single Stock Derivatives -----------------------------------------------------------------18
9.3.2. Position Limits Of Various Derivative Instruments-----------------------------------19
9.3.3. Margins -------------------------------------------------------------------------------------20
9.3.4. Eligibility Requirements------------------------------------------------------------------20
9.3.5. Contracts On New Indices ---------------------------------------------------------------24
9.3.6. Minimum Contract Size ------------------------------------------------------------------24
9.3.7. Adjustment For Corporate Actions -----------------------------------------------------25
9.4. Risk Containment ---------------------------------------------------------------------------------26
9.4.1. Var Framework ----------------------------------------------------------------------------26
9.4.2. Cross Margining: Basic Principles ------------------------------------------------------31
9.5. Market Structure And Governance -------------------------------------------------------------31
9.5.1. Separation Of Cash And Derivatives Markets-----------------------------------------31
9.5.2. Sub Brokers --------------------------------------------------------------------------------32
9.5.3. Inspection-----------------------------------------------------------------------------------32
9.5.4. Surveillance --------------------------------------------------------------------------------33
9.5.5. Physical Settlement -----------------------------------------------------------------------34
9.6. Use Of Derivatives By Mutual Funds-----------------------------------------------------------37
9.6.1. New Schemes: Utilising Mainstream Governance and Disclosure Mechanisms.-37
9.6.2. Existing Schemes: Rules Governing Hedging and Portfolio Rebalancing---------38
9.6.3. Ongoing Disclosure Requirements------------------------------------------------------41
9.7. SEBI Related Issues ------------------------------------------------------------------------------41
9.7.1. Derivatives Cell And Advisory Committee--------------------------------------------41
9.7.2. SEBI And RBI-----------------------------------------------------------------------------42
10. Some Of The Essential Market Monitoring Tools And Policies----------------------------------42
11. Derivative Markets At Present ------------------------------------------------------------------------43

1.1. Market Lot Of Index Derivatives----------------------------------------------------------------43

1.2. BSE's And NSEs Plans --------------------------------------------------------------------------43
1.3. Membership ----------------------------------------------------------------------------------------44
1.4. Trading Systems -----------------------------------------------------------------------------------45
1.5. Settlement And Risk Management Systems.---------------------------------------------------45
1.6. NSCCL SPAN--------------------------------------------------------------------------------------45
1.7. Rules And Laws -----------------------------------------------------------------------------------50
12. Scheme For FIIs And NRIs Trading In Exchange Traded Derivatives-------------------------50
13. Financial Derivatives Instruments Traded In India-------------------------------------------------51
14. Accounting Of Index Futures Transactions----------------------------------------------------------52
14.1. Indian Accounting Practices--------------------------------------------------------------------52
14.2. International Practices---------------------------------------------------------------------------57
15. Taxation--------------------------------------------------------------------------------------------------59
16. Is The Derivatives Market Model A Weak Link? --------------------------------------------------59
17. Current Developments
Status Report of the Developments In The Derivative Market------------------------------------61
17.1. Equity Derivatives Segment--------------------------------------------------------------------61
17.2 Currency Derivatives Segment-----------------------------------------------------------------64
18. Findings Of The Study---------------------------------------------------------------------------------67
19. Bibliography---------------------------------------------------------------------------------------------68

2. EXECUTIVE SUMMARY
Title of the project: Derivative market in India.
The initial days covered up the aspects of the meaning and detailed description of Financial
Derivatives and its various instrument traded
The main idea was to get a deeper insight of the Derivative market and their working
mechanisms. It also helped to get a better understanding of Derivatives as a Financial Instrument
and its presence and growth prospects in India
This information would eventually help us to better understand Indian Financial system. This
helped to improving our confidence level and gaining in depth knowledge of the market.

Description of the project in brief:

The project includes a detail study and analysis of the development of derivatives market in
India.
It encapsulate

The study of types of derivatives

Various type derivative instruments traded
Development of derivative markets
Regulatory framework
A brief about the margins collected and pricing of the derivatives.
It would also involve a study of derivatives as a risk management tool.
It also includes the role of Mutual Funds, NRI and FII in the Indian derivative Market.
Current developments in the derivative segment.

This study helped to conclude the Indian Derivative Market has one of the best derivative
frameworks among of the developing countries, which not only make it more liquid and
transparent in its functioning but also turns out to be an attractive destination for foreign
investment as well.

3. OBJECTIVES OF THE STUDY:

The primary objective of undertaking the project Derivative market in India was understand
about the financial markets in India with focusing the area of study specially towards the
derivative segment. This helped in getting a deeper insight about
The Derivative market and their working mechanisms.
To carry out a detail study and analysis of the development of derivatives market in India.
To Encapsulate the study of types of derivatives, development of derivative markets,
regulatory framework and a getting brief outlook about pricing, futures and options.
To study of derivatives as a risk management tool.
To study various instruments used the derivative segment.
To understand the working of the BSE-30 Sensex Futures and S&P CNX Nifty Futures

4. LIMITATIONS OF THE STUDY:

Time limit.
Dependency on secondary source of information.

5. METHODOLOGY:
Secondary Data Analysis Through magazines, ICFAI and other journals, Internet,
reports on Indian derivative market by SEBI, World Bank Survey Report and other
government reports and lot of books from library.
Analysis of data collected.
Drawing Inferences and conclusions.

6. INTRODUCTION TO FINANCIAL MARKETS

Financial markets are forums and sets of rules that allow participants to conduct investment,
financial, and hedging operations via different intermediaries, through the trading of various
financial instruments. Financial Markets are where financial Instruments/products are
exchanged. A Financial Market is known by type of product traded in it.
The financial system seeks the efficient allocation of resources among savers and borrowers. A
healthy financial system requires, among other things, efficient and solvent financial
intermediaries, efficient and deep markets, and a legal framework that defines clearly the rights
and obligations of all agents involved.
Figure 1: Different Financial Markets

Source: ICFAI Journal

6.1 MONEY MARKET:

Money Markets is basically meant to facilitate short term Borrowing and Lending. These market
are Primarily used by Banks for maintaining their liquidity requirements.
Typical Financial Instruments
Bankers Acceptance
Certificate of Deposit (CD)
Treasury Bills
Repos
6.2 DEBT MARKET:
The Debt market helps facilitating various Debt Contract were one party lends to another party
predetermined at a fixed Interest Rates for a fixed Term.
Major participants of debt market are:
Banks
Financial Institutions
Mutual Funds
Insurance Companies etc.
Instruments primarily used are:
Government Securities (G-Secs)
Public Sector Units Bonds

 Corporate Securities
6.3 FOREIGN EXCHANGE MARKET:
The foreign exchange or FOREX market facilitates international transaction of goods and
services and helps investors in investing beyond the their national boundaries.
Participants in the Forex market are
Government
Payments for Imports
Repayment of Loans
Importers
6.4 CAPITAL MARKET:
The capital market is the market for securities, where companies and governments can raise long
term funds. The capital market includes the stock market and the bond market. Financial
regulators, such as the Securities and Exchange Board of India (SEBI), oversee the capital
markets in their designated countries to ensure that investors are protected against fraud. The
capital markets consist of the primary market, where new issues are distributed to investors, and
the secondary market, where existing securities are traded.
Trading Instruments used
Shares
Derivatives
Units of Mutual Funds
7. INTRODUCTION TO THE DERIVATIVES
Financial markets are, by nature, extremely volatile and hence the risk factor is an important
concern for financial agents. To reduce this risk, the concept of derivatives comes into the
picture. Derivatives are products whose values are derived from one or more basic variables
called bases. These bases can be underlying assets (for example forex, equity, a commodity
price, an exchange rate, an interest rate , even an index of prices etc), bases or reference rates.
For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of
a change in prices by that date. The transaction in this case would be the derivative, while the
spot price of wheat would be the underlying asset.
In other words, Derivative means a forward, future, option or any other hybrid contract of pre
determined fixed duration, linked for the purpose of contract fulfillment to the value of a
specified real or financial asset or to an index of securities.
With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the
definition of Securities. The term Derivative has been defined in Securities Contracts
(Regulations) Act, as:- A Derivative includes
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.

A contract which derives its value from the prices, or index of prices, of underlying
securities.

7.1 Broad Classification of derivatives

Exchange-traded derivatives
Derivatives have probably been around for as long as people have been trading with one another.
Forward contracting dates back at least to the 12th century, and well have been around before
then. Merchants entered into contracts with one another for future delivery of specified amount
of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a
stock of commodities in early forward contracts was to lessen the possibility that large swings
would inhibit marketing the commodity after a harvest.
OTC Equity Derivatives

Traditionally equity derivatives have a long history in India in the OTC market.
Options of various kinds (called Teji and Mandi and Fatak) in un-organized markets were
traded as early as 1900 in Mumbai
The SCRA however banned all kind of options in 1956.

7.2 The need for a derivatives market

1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk averse people in
greater numbers
5. They increase savings and investment in the long run
7.3 The participants in a derivatives market
Hedgers use futures or options markets to reduce or eliminate the risk associated
with price of an asset.
Speculators use futures and options contracts to get extra leverage in betting on
future movements in the price of an asset. They can increase both the potential
gains and potential losses by usage of derivatives in a speculative venture.
Arbitrageurs are in business to take advantage of a discrepancy between prices in
two different markets. If, for example, they see the futures price of an asset getting
out of line with the cash price, they will take offsetting positions in the two markets
to lock in a profit.
7.4 Types of Derivatives
Forwards: A forward contract is an agreement between two parties to buy or sell an asset at a
specified point of time in the future. The price of the underlying instrument, in whatever form, is

paid before control of the instrument changes. This is one of the many forms of buy/sell orders
where the time of trade is not the time where the securities themselves are exchanged.
Futures: Futures Contract means a legally binding agreement to buy or sell the underlying
security on a future date. Future contracts are the organized/standardized 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 the expiry date of the
contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash
settlement enables the settlement of obligations arising out of the future/option contract in cash.
Options: Derivatives Contract which gives the buyer/holder of the contract the right(not the
obligation) to buy/sell the underlying asset at a predetermined price within or at end of a
specified period. The buyer / holder of the option purchase the right from the seller/writer for a
consideration 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. The
underlying asset could include securities, an index of prices of securities etc.
Warrants: Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum maturity of nine months. Longer-dated options are called
warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is
usually a moving average or a basket of assets.Equity index options are a form of basket options.
Swaps: A swap is an agreement between two parties to exchange future cash flows according to
a prearranged formula. They can be regarded as portfolios of forward contracts. The streams of
cash flows are called legs of the swap. Usually at the time when the contract is initiated at
least one of these series of cash flows is determined by a random or uncertain variable such as
an interest rate, foreign exchange rate, equity price or commodity price. Around 1980 the first
swap contracts were developed. A swap is another forward based derivative that obligates two
counter parties to exchange a series of cash flows at specified settlement dates in the future.
Swaps are entered into through private negotiations to meet each firm's specific risk
management objectives. The two commonly used swaps are :
Interest rate swaps: These entail swapping only the interest related cash flows between the
parties in the same currency. Today interest rate swaps account for the majority of banks swap
activity, and the fixed for floating rate swap is the most common interest rate swap. In such a
swap, one party agrees to make fixed rate interest payments in return for floating rate interest
payments from the counter party.
Currency swaps: These entail swapping both principal and interest between the parties, with
the cash flows in one direction being in a different currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry
of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts,
the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an
option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive
floating.
7.5 Derivatives may be traded for a variety of reasons.
Derivatives provide a low-cost, effective method for end users of hedge and manage their
exposures to interest rates, commodity prices, or exchange rates. Various reasons for derivatives
gaining importance in trading are:
A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives
markets that offset potential losses in the underlying or spot derivatives. In India, most
derivatives users describe themselves as hedgers and Indian laws generally require that
derivatives be used for hedging purposes only.
Table 1 Hedging strategy
Position in cash market
Proposed strategy
Long Index Futures
Short Index Futures

Long Security

Short Security

Error
Hedging

Hedging
Error

Source: Self structured

Another motive for derivatives trading is speculation (i.e. taking positions to profit from
anticipated price movements). In practice, it may be difficult to distinguish whether a
particular trade was for hedging or speculation, and active markets require the participation
of both hedgers and speculators.

Table 2: Speculation strategy

Perception for Cash Market
Proposed strategy
Long Index Futures
Short Index Futures

Bullish
Index

Bearish
Index

Error
Speculation

Speculation
Error

Source: Self structured

A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot
and derivatives prices, and thereby help to keep markets efficient. A study conducted of
Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time.
Arguing that lack of knowledge, market frictions and regulatory impediments have led to low
levels of capital employed in arbitrage trading in India However, more recent evidence
suggests that the efficiency of Indian equity derivatives markets may have improved.

Table 3: Arbitrage strategy

Perception for Cash Market
Proposed strategy

Have Funds

Have Securities

Long Index Futures

Short Index Futures

Error
Arbitrage
Long Spot

Arbitrage
Error
Short Spot

Source: Self structured

Financial derivatives, by reducing uncertainties, make it possible for corporations to initiate

productive activities that might not otherwise be pursued. For example, an U.S. Company
may want to build a manufacturing facility in India but is concerned about the projects
overall cost because of exchange rate volatility between the rupee and the dollar. To ensure
that the company will have the necessary cash available when it is needed for investment, the
U.S. manufacturer should devise a prudent risk-management strategy that is in harmony with
its broader corporate objective of building a manufacturing facility in India. As part of that
strategy, the U.S. firm should use financial derivatives to hedge against foreign exchange
risk. Derivatives used as a hedge can improve the management of cash flows at the individual
firm level.

Corporations, governmental entities, and financial institutions also benefit from derivatives
through lower funding costs and more diversified funding sources. Currency and interest rate
derivatives provide the ability to borrower in the cheapest capital market, domestic or
foreign, without regard to the currency in which the debt is denominated or the form in
which interest is paid. Derivatives can covert the foreign borrowing into a synthetic domestic
currency financing with either fixed or floating rate interest.

Derivatives allow corporations and institutional investors to more effectively manage their
portfolio of assets and liabilities. An equity funds, for example, can reduce its exposure to the
stock market quickly and at the relatively low cost without selling off part of its equity assets
by using stock index futures or index options. Corporate borrowers and governmental entities
can effectively manage their liability structure the ratio of fixed to floating rate debt and the
currency composition of that debt - using interest rate and currency futures and swaps.

The question of whether the dynamic hedging of options positions increases market
volatility, the studies examine the effects of option listing on the volatility of the under lying
stock price and are particularly relevant because dynamic hedging of option positions by
market makers is an important factor linking the markets for the option and the underlying
stock. Majority of the study concludes that volatility is reduced with the introduction of
options trading. The range of commodities examined is extensive. The majority of studies
find that the introduction of future trading in stock indices does not result in increased
volatility of the underlying stocks. Where an increase is found, moreover, it is usually for
short term volatility. Studies examining other commodities find that the introduction of
derivatives trading tends to either decrease volatility or result in no change.

The FIIs are more pleased, with the trading systems moving closer to international methods
such as derivatives. The FIIs inflows in the stock markets have increased since banning of
badla and introduction of derivatives. In March 2002, the classification of scrips intro
different categories such as A, B1 and B2 was done. The A group stocks hitherto enjoying an
edge over other categories due to high liquidity has come to an end with the introduction of
rolling settlement prevented the practice of switching of position from one exchange to

another due to different exchanges having different settlement cycles. This leads to an
upward re-rating of a large number of fundamentally good scrips which are currently
neglected just because they belong to B1 and B2 categories

One important aspect is the pricing of the options. With regard to, whether the premium is
fair and what factors should be considered while deciding such a price. Mathematically, the
price can be calculated by using either the Black- Scholes model (For European style
options) or Binomial model (for American Options). Without going into complex
mathematical formulas, which can be worked out in electronic spreadsheets, one must
understand the relation and impact of factors, which are considered to determine that price.
Some of these factors include the relationship between the strike price and the value of the
underlying expected volatility of the underlying assets, time to expiration, interest rates and
dividend yield of the underlying over the life of the option.
A great deal of speculation is about the broad market movement. Speculation on an
individual stock is a fairly difficult proposition in view of insiders knowing more than others
about the affairs of the company. In contrast, information about the index is fairly symmetric
i.e. CNX NIFTY 50 and BSE 30 SENSEX. Everyone roughly knows the same facts about
how the economy is faring, political uncertainties, etc. Hence speculation on the index is a
fair game. Interestingly, the survey findings (L.C. Gupta Committee) showed that stock index
futures ranked as the most popular and preferred type of equity derivative, the second being
stock index options and the third being options on individual stocks. Considerable interest
exists in all the three types of equity derivatives mentioned above.

Indian banks are traditionally not active players in the stock market. Derivatives help them to
effectively manage the equity portfolio. For banking supervisors, probably the most
important question is of engendering systemic risk the danger that a failure at a single bank
could cause a domino effect, precipitating a banking crisis. As financial derivatives allow
different risk components to be isolated and passed around the financial system, clearly
reduces the overall cost of risk bearing and enhance economic efficiency. Those who are
willing and able to bear each risk component at the least cost will become the risk holders.

The arbitrage transactions between the index futures market and the cash market for equities
have a beneficial effect on the functioning of the cash market in terms of price discovery,
broadening of liquidity and overall efficiency.

Derivatives help mutual funds and other financial institutions in their investment strategy for
strategic purposes of controlling risk or restructuring portfolios. Suppose that a mutual fund
scheme decides to reduce its equity exposure, presently, this can be achieved only by actual
selling of equity holdings and selling is likely to depress equity prices to the disadvantage of
the Scheme and the whole market. Besides, it is a time consuming process and increases
transaction costs due to brokerage. By selling index futures immediately, the actual sale of
equity holdings may be done gradually depending on market conditions in order to realize the
best possible prices. The index futures transaction may be unwound by an opposite
transaction to the same extent as unloading of holdings progresses. Likewise, securities may
not be immediately available in sufficient quantity at reasonable prices when a new scheme is
floated as per the broad objectives of the scheme. In purely cash market, rushing to invest the

whole money is likely to drive up prices to the disadvantage of the scheme. The availability
of stock index futures can take care of this entire problem. Stock Index Futures can help to
overcome these problems to the advantage of unit holders.

For participants in the derivatives market, there are various permutations and combinations
of call and put options, with a fuller understanding, an investor can use alternatives available

If an investor has no information about individuals stocks, then he diversifies and holds the
market; if he has information about a specific industry but neither on individual firms within
the industry nor on the market, then he diversifies across the industry and hedges the market,
and soon.

7.6 Risks of Derivatives

So, far, only the economic benefits associated with derivative products have been discussed. The
appreciation of these products' effective benefits would however be partial and incomplete
without an analysis of some of the risks inherently linked. The kinds of risks associated with
derivatives are no different from those associated with traditional financial instruments, although
they can be far more complex i.e., credit, market, operational, and legal risk.

Credit Risk: Credit risk is the risk that a loss will be incurred because counterparty fails to
make payments as due. In the event of the default, the loss on a derivatives contract is the
cost of replacing the contract with a new counterparty. Concern has been expressed that
financial institutions (especially dealers) may have used derivatives to take on an excessive
level of credit risk that is poorly managed.

Market Risk: Market risk is the risk that the value of a position in a contract, financial
instrument, asset, or portfolio will decline when market conditions change. Concern has been
expressed that derivatives expose firms to new market risks, while increasing the overall
level of exposures.

Operational Risk: A risk that arises in all businesses is operational risk the risk that losses
will be incurred as a result of inadequate systems and control, inadequate disaster or
contingency planning, human error, or management failure.

Legal Risk: Legal risk is the risk of loss because a contract cannot be enforced or because
the contract terms fail to achieve her intended goals of the contracting parties. This risk, of
course, is as old as contracting itself. Because of the relative newness of derivatives
transactions, however, their treatment under existing laws and regulations is often
ambiguous. This legal uncertainty can result in significant unexpected losses.

The credit risk from derivatives activities can be controlled by the traditional credit risk
management function of dealers. This can be supplemented by the more precise identification
and measurement made possible by derivatives technology. The technology can evaluate the
creditworthiness if counterparts, set risk limit to avoid excessive concentrations, regularly
measuring exposures and monitoring them against risk limits.

Derivatives generally have not exposed institutions to fundamentally new sources of market risk
and have long been exposed to these same market risks such as,
o Interest rate exposure is inherent in the mismatch of assets and liabilities.
o Currency exposure is inherent in foreign exchange trading and in foreign currency
denominated borrowing or lending.
o Equity exposure is inherent in margin loans.
The market risks of any financial activity, including derivatives activity, must be evaluated on the
basis of its effect on the net exposure of an overall portfolio. Market risk can be effectively
managed through frequent marking to market of portfolios, coupled with the identification and
measurement of market risk, the setting of risk limits, and monitoring of positions against limits.
While no aspect of operational risk is unique to derivatives, however, it is important for
institutions actively engaged in derivatives activities to have adequate oversight of well trained
and knowledgeable staff by informed and involved senior management.
Users of derivatives, like other firms, should attempt to manage and minimize legal risks.
o Derivatives related disasters, particularly the collapse of Barings, have led to questions about
the ability of individual derivatives participants to internally manage the trading operations.
Regulatory and legislative restrictions on derivatives activities are not the answer, primarily
because simple, standardized rules most likely would only impair banks' ability to manage
risk and potential losses effectively. A better answer lies in greater reliance on market forces
to control derivatives related risk taking, together with more emphasis on government
supervision, as opposed to regulation.
o Banking regulators should emphasize more disclosure of derivatives positions in financial
statements and be certain that institutions trading huge derivatives portfolios have adequate
capital. In additions, because derivatives could have implications for the stability of the
financial system, it is important that users maintain sound risk management practices. It is the
responsibility of a bank's senior management to ensure that risks are effectively controlled
and limited to levels that do not pose a serious threat to its capital position. It is important
that derivatives players fully understand the complexity of financial derivatives contracts and
the accompanying risks. Users should be certain that the proper safeguards are built into
trading practices.

8 DEVELOPMENT OF DERIVATIVE MARKETS IN INDIA

Derivatives markets have been in existence in India. In the area of commodities, the Bombay
Cotton Trade Association started futures trading in 1875 and, by the early 1900s India had one of
the worlds largest futures industries. In 1952 the government banned cash settlement and
options trading and derivatives trading shifted to informal forwards markets. In recent years,
government policy has changed, allowing for an increased role for market-based pricing and less

suspicion of derivatives trading. The ban on futures trading of many commodities was lifted
starting in the early 2000s, and national electronic commodity exchanges were created.
In the equity markets, a system of trading called badla involving some elements of forwards
trading had been in existence for decades. However, the system led to a number of undesirable
practices and it was banned by the Securities and Exchange Board of India (SEBI) in 2001.
A series of reforms of the stock market between 1993 and 1996 paved the way for the
development of exchange traded equity derivatives markets in India. In 1993, the government
created the NSE in collaboration with state-owned financial institutions. NSE improved the
efficiency and transparency of the stock markets by offering a fully automated screen-based
trading system and real-time price dissemination. In 1995, a prohibition on trading options was
lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives.
The economic liberalization of the early nineties facilitated the introduction of derivatives based
on interest rates and foreign exchange. A system of market-determined exchange rates was
adopted by India in March 1993. In August 1994, the rupee was made fully convertible on
current account. These reforms and easing of various restrictions on the free movement of
interest rates allowed increased integration between domestic and international markets, and
created a need to manage currency risk.
The first step towards introduction of derivatives trading in India was the promulgation of the
Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in
securities. Later SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta
on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in
India. The committee submitted its report on March 17, 1998 prescribing necessary pre
conditions for introduction of derivatives trading in India. The committee recommended that
derivatives should be declared as securities so that regulatory framework applicable to trading
of securities could also govern trading of securities. SEBI also set up a group in June 1998
under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in
derivatives market in India. The report, which was submitted in October 1998, worked out the
operational details of margining system, methodology for charging initial margins, broker net
worth, deposit requirement and realtime monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include
derivatives within the ambit of securities and the regulatory framework were developed for
governing derivatives trading. The act also made it clear that derivatives shall be legal and valid
only if such contracts are traded on a recognized stock exchange, thus precluding OTC
derivatives. Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2001. 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. To begin with, SEBI approved trading in index
futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by
approval for trading in options based on these two indexes and options on individual securities.

9. RECOMMENDATIONS AND GUIDELINES OF SEBI ADVISORY

COMMITTEE ON DERIVATIVES DEVELOPMENT AND REGULATION
OF DERIVATIVE MARKETS IN INDIA
9.1 Background
The SEBI Board in its meeting on June 24, 2002 considered some important issues relating to the
derivative markets including:

Physical settlement of stock options and stock futures contracts.

Review of the eligibility criteria of stocks on which derivative products are permitted.
Use of sub-brokers in the derivative markets.
Norms for use of derivatives by mutual funds
A review of the recommendations given by L. C. Gupta Committee (LCGC) as on
March 1998.

The recommendations of the Advisory Committee on Derivatives on some of these issues were
also placed before the SEBI Board. The Board desired that these issues be reconsidered by the
Advisory Committee on Derivatives (ACD). Ten years have elapsed since the LCGC Report of
March 1998. During this period there have been several significant changes in the structure of
the Indian Capital Markets which include, dematerialization of shares, rolling settlement on a
T+3 basis, client level and Value at Risk (VaR) based margining in both the derivative and cash
markets and proposed demutualization of Exchanges.
9.2 Regulatory Objectives
Objectives of LCGC committee recommendations which were adopted by ADC are:
The Committee believes that regulation should be designed to achieve specific, well-defined
goals. It aimed at a positive regulation designed to encourage healthy activity and behavior.
(a) Investor Protection: Attention needs to be given to the following four aspects:
(i) Fairness and Transparency: The trading rules should ensure that trading is conducted in a
fair and transparent manner. Experience in other countries shows that in many cases, derivatives
brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices
adopted by dealers for derivatives would require specific regulation.
(ii) Safeguard for clients moneys: Moneys and securities deposited by clients with the trading
members should not only be kept in a separate clients account but should also not be attachable
for meeting the brokers own debts. It should be ensured that trading by dealers on own account
is totally segregated from that for clients.
(iii) Competent and honest service: The eligibility criteria for trading members should be
designed to encourage competent and qualified personnel so that investors/clients are served

well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the
sales persons appointed by them in terms of a knowledge base.
(iv) Market integrity: The trading system should ensure that the markets integrity is
safeguarded by minimizing the possibility of defaults. This requires framing appropriate rules
about capital adequacy, margins, clearing corporation, etc.
(b) Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity
and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and
price-discovery. This is a much broader objective than market integrity.
(c) Innovation: While curbing any undesirable tendencies, the regulatory framework should not
stifle innovation which is the source of all economic progress, more so because financial
derivatives represent a new rapidly developing area, aided by advancements in information
technology."
9.3 Derivative Products
9.3.1 Single Stock Derivatives
Introduction of Single Stock Derivatives
The LCGC advocated a phased introduction of different equity derivatives in India in its report:
This phased approach was adopted in India with index futures being introduced in June 2000,
index options in June 2001 and individual stock options in July 2001.
The LCGC was not much inclined towards the fourth type of equity derivatives (individual stock
futures) given its then limited popularity globally:
Since the time of the LCGC report, the world has changed a great deal. Towards the end of 2000,
the United States passed the Commodity Futures Modernization Act that demarcated the
jurisdiction of the CFTC and the SEC and thereby removed the regulatory obstacle to single
stock futures in that country. In India, the regulatory debate on single stock futures intensified
when SEBI started work in early 2000 on adapting the carry-forward system to the rolling
settlement regime.
Stock futures started trading in November 2001. Thereafter, there has been a continuing debate
on single stock futures in the press and elsewhere. In December 2001, the ACD discussed a note
from former office bearers of the BSE stating that the regulatory regime for single stock futures
was more liberal than that for the erstwhile carry forward system as well as that for the cash
market. In its meeting in August 2002, the ACDs attention was drawn to several press reports
making similar arguments.

9.3.2 Position Limits of various Derivative Instruments

Table 4: Summary of Position Limits

Client level

Trading
Member
level

Marketwide

Index Options

Index Futures

Stock Options

Stock Futures

Disclosure
requirement
for any person
or persons
acting in
concert
holding 15%
or more of the
open interest
of all
derivative
contracts on a
particular
underlying
index
15% of the
total Open
Interest of the
market or Rs.
250 crores,
whichever is
higher

Disclosure
requirement for
any person or
persons acting
in concert
holding 15% or
more of the
open interest of
all derivative
contracts on a
particular
underlying
index

1% of free float
or 5% of open
interest
whichever is
higher

1% of free float
or 5% of open
interest
whichever is
higher

Interest Rate
Futures
Rs.100 crore or
15% of the open
interest,
whichever is
higher.

15% of the total

Open Interest of
the market or
Rs. 250 crores,
whichever is
higher

20% of Market
Wide Limit
subject to a
ceiling of Rs.50
cr.

20% of Market
Wide Limit
subject to a
ceiling of Rs.50
cr.

Rs. 500 Cr or
15% of open
interest
whichever is
higher.

30 times the
average number
of shares traded
daily, during the
previous calendar
month, in the
relevant
underlying
security in the
underlying
segment or,
- 20% of the
number of shares
held by nonpromoters in the
relevant
underlying
security,
whichever is
lower

30 times the
average number
of shares traded
daily, during the
previous calendar
month, in the
relevant
underlying
security in the
underlying
segment or,
- 20% of the
number of shares
held by nonpromoters in the
relevant
underlying
security,
whichever is
lower

Source: Internet

9.3.3 Margins
Table 5: Summary of parameters specified for Initial Margin Computation
Index Options
3 sigma

Index
Futures
3 sigma

Volatility Scan
Range
Minimum
margin
requirement

4%

Short option
minimum charge
Calendar Spread
Mark to Market

3%

Stock
Options
3.5
sigma

Stock Futures
For order size of
Rs.5 Lakh, if mean
value of impact
cost > 1%, the
Price Scan Range
be scaled up by
3(in addition to
look ahead days)

Interest Rate
Futures
3.5 sigma For order
size of Rs.5 Lakh, if
mean value of impact
cost > 1%, the Price
Scan Range be scaled
up by 3(in addition
to look ahead days)
For long bond
futures, 3.5 sigma
and for notional TBill futures, 3.5
sigma.

Price Scan Range

7.5%

For long bond

futures, minimum
margin is 2%. For
notional T-Bill
futures minimum
margin is 0.2%.

10%
5%

7.5%

0.5% per month on the far month contract (min of 1% and max 3%)
Net Option Value (positive for long positions and negative for short positions) to be
adjusted from the liquid networth on a real time basis.
The daily closing price of Futures Contract for Mark to Market settlement would be
calculated on the basis of the last half an hour weighted average price of the contract.

Source: Internet

Non-fulfillment of either the whole or part of the margin obligations will be treated as a violation
of the Rules, Bye-Laws and Regulations of NSCCL and will attract penal charges @ 0.07% per
day of the amount not paid throughout the period of non-payment.
9.3.4 Eligibility Requirements
Globally, the choice of stocks on which derivative contracts (stock futures or stock options) are
traded is left to the exchanges. However, when the decision to introduce stock options in India
was taken, the Indian markets were just emerging from the acute market turbulence of MarchApril 2001. Under these conditions, it was thought fit to limit the list of stocks to a small number
where the threat of market manipulation was low and where there were no significant risk

containment issues. Large cap, well traded stocks with a large free float were chosen to limit the
possibility of market manipulation, and it was also decided to exclude highly volatile stocks. The
following criteria were therefore adopted:

Stock should figure in the list of top 200 scrips, on the basis of average market
capitalization, during the last six months and average free float market capitalization
should not be less than Rs. 7.5 billion. and
Stock should appear in the list of top 200 scrips, based on the average daily volume,
during the last six months. Further, average daily volume should not be less than Rs. 50
million in the underlying cash market; and
Stock should be traded at least on 90% of the trading days, during the last six months;
and Non promoters holding in the company should be at least 30%; and
Ratio of daily volatility of the stock vis--vis daily volatility of index should not be more
than 4, at any time during the previous six months.

These criteria were intended to be highly restrictive under the presumption that they would be
reviewed after six months with a view to expanding the list. The ACD has revisited the issue of
eligibility criteria several times and come to the conclusion that SEBI should now lay down only
broad eligibility criteria and the Exchanges should be free to decide on the stocks and indices on
which futures and options could be permitted. The committee took into account the concern that
the competitive dynamics of the Indian markets may push exchanges to choose low quality
stocks and that this may impact the safety and integrity of the markets. Hence, there is a need for
a balance between the goal of improving broad-based liquidity of the market, and the risk of
suffering an episode of market misconduct involving derivatives on a highly illiquid underlying.
The ACD was of the view that the order book snapshots contain a lot of valuable information
about the liquidity and manipulability of the stock, and requested the NSE and BSE to carry out
an empirical study in this regard. Accordingly, the NSE presented the results of an exercise that
looked at four daily snapshots of the order book in the past six months.Based on these snapshots,
they computed the order size (value) required to cause a change in the stock price equal to onequarter of a standard deviation, referred to as the quarter-sigma order size. The NSE also
presented data on impact costs for various order sizes on the basis of the same snapshots.
The ACD believes that the impact cost provides a good measure of liquidity while the quartersigma order size is a useful direct measure of the manipulaility of the stock.
On the basis of this empirical study and on the basis of extensive discussions, the ACD
recommends the following broad eligibility criteria:

The stock should be among the top 500 stocks in terms of market capitalization and average
daily volumes.
The median quarter-sigma order size over the last six months should be at least Rs 0.5
million.

The stocks that meet the above broad eligibility criteria would include some that are less liquid
or more volatile or smaller (in terms of market capitalization) than the current list of 31 stocks on
which derivatives are traded. To deal with these stocks, the committee proposes some changes :

If a stock is illiquid, the exchange may not able to close out a position on the same day as
assumed in the VaR calculations. To deal with close-out risk, the margins need to be adjusted
to account for the longer close-out time (say three days). Accordingly if the mean value of
the impact cost (for an order size of Rs. 0.5 million) exceeds 1%, the price scanning range
would be scaled up by the square root of three ( 73 . 1 3 ) to cover the close-out risk.
Scaling up the price scanning range scales up the margins for futures by the same ratio, while
margins for options are impacted in a non linear fashion.
As far as volatility is concerned, there is no problem with the VaR computations themselves
as they are based on stock specific volatility. The only problem is regarding the second line
of defence (the exposure limit) and this problem is easily addressed by linking that also to the
volatility of the underlying stock. The second line of defence is currently set at 5%. This
would be changed to the higher of 5% or 1.5 standard deviations. Accordingly, the exchanges
would be required to ensure that for a particular stock, the higher of 5% or 1.5 standard
deviations times the notional value of gross open position in futures and option contracts on
that particular stock is collected /adjusted from the liquid net worth of a member on a real
time basis. The rationale for the multiplier of 1.5
As far as small cap stocks are concerned, there are no problems regarding the position limits
that are stated in terms of market cap or trading volume. The only problem would have been
with the absolute amount of Rs 0.5 billion that is currently used in the definition of the
member level position limit. However, the majority view of the committee recommends that
this limit be linked to the market wide position limit.

The universe of eligible stocks would vary from month to month as the impact cost and the
quarter-sigma order size are calculated every month on a rolling basis considering the previous
six months. It is therefore necessary to lay down the procedure for introducing and dropping
stocks:

Options and futures contracts may be introduced on new stocks when they meet the
eligibility criteria for three months in succession.
If a stock fails to meet the aforesaid eligibility criteria for three months consecutively
then no fresh month contracts should be issued on that stock. However, the existing
unexpired contracts may be permitted to trade till expiry and new strikes may also be
introduced in the existing contract months.
However, the Exchanges should be empowered to compulsorily close out all derivative
contract positions in a particular underlying when that underlying has ceased to satisfy
the new eligibility criteria and the exchanges are of the view that continuance of
derivative contracts on these stocks would pose a threat to market integrity and safety.
If the impact cost for a stock moves from less than or equal to 1% to more than 1%, the
price scan range in such stock should be scaled up by 3 and the scaling should be dropped
when the impact cost drops to 1% or below. Such changes should be applicable on all
existing open position in the underlying from a pre specified date.

For the purpose of computing 1.5 standard deviations, the standard deviation of the daily
logarithmic returns of prices in the scrip during the last six months would be computed.
This value would be applicable for a month and would be re-calculated at the end of the
month by once again taking price data on a rolling basis for the past six months.

The Committee would like to lay down some guidelines on the actual computation of impact cost
and quarter sigma order size:

Impact cost and the quarter sigma order size should be calculated by taking four
snapshots in a day from the order book in the past six months. These four snapshots
should be at times randomly chosen from within four fixed ten-minute windows spread
through the day. The Exchanges should work together and use a common methodology
for carrying out the calculations. Further, for a stock, lowest impact cost across any
exchange in India would be considered.
The details of calculation methodology and relevant data should be made available to the
public at large through the web sites of the exchanges.

The committee feels that when an unlisted company come out with a large initial public offering
(IPO), it may be desirable to have derivative contracts trade on these stocks from the very first
day of their listing to assist in efficient price discovery. The committee therefore proposes that in
such cases if net public offer in the IPO is greater than or equal to Rs 5 billion then the
exchanges may consider introducing stock options and stock futures contracts on such stocks at
the time of their listing in the cash market.I n this regard the exchanges submit their proposal to
SEBI for approval on a case basis. As regard the risk containment measures, the price scan range
could be a multiple of the volatility indices. Subsequently, after sometime the volatility and the
impact cost of the underlying stock could be used when price and order book data is available.
"The Committee suggests that before starting trading in a new derivatives product, the
derivatives exchange should submit the proposal for SEBI's approval, giving (a) full details of
the proposed derivatives contract to be traded (b) the economic purposes it is intended to serve
(c) its likely contribution to the market's development and (d) the safeguards incorporated to
ensure protection of investors/clients and fair trading. SEBI officers should be in a position to
provide effective supervision and constructive guidance in this regard."
However it would not be necessary for SEBI to apply its mind ab initio to each such contract that
is proposed by an exchange. However, SEBI would retain the right under exceptional situations
to deny permission for a contract that meets the eligibility conditions if it has particular reason to
believe that clause (d) would not be met in that particular case.

9.3.5 Contracts on New Indices

The eligibility criteria laid down above for single stock derivatives can be extended to the case of
narrow stock indices as well. A stock index would normally be eligible for derivatives trading if
most of the weightage in the index (say 90%) is accounted for by constituent stocks that are
themselves eligible for derivatives trading. This would also of course be subject to the right of
SEBI to refuse permission in exceptional cases of the LCGC report.
The ACD also endorses futures and options on dollar-denominated indexes, which are cashsettled in rupees provided the index meets the above eligibility criteria.
9.3.6 Minimum Contract Size
The LCGC Report did not make any recommendation regarding minimum contract size.
However, the Standing Committee on Finance of Parliament while considering the amendment to
SC(R)A pertaining to derivatives recommended that the threshold limit of the derivative
transactions should be pegged not below Rs. 0.2 million. Based on this recommendation SEBI
has specified that the value of a derivative contract should not be less than Rs. 0.2 million at the
time of introducing the contract in the market.
SEBI has been receiving various representations on the issue of minimum contract size. The
following reasons have been cited for withdrawing the stipulation of minimum contract size:

At the time when the decision to stipulate a minimum contract size of Rs. 0.2 million was
taken, there were other products/systems like, Badla, ALBM, BLESS available to
investors through which they could take a long term view on the markets. However, in
the present scenario, with rolling settlement in place, investors can take a long term view
only through derivative products. The stipulation of minimum contract size of Rs. 0.2
million is a deterrent for many investors to participate in the derivative market, as the cost
of entering the derivative markets is high.
Derivative products provide investors with an efficient and a cost- effective tool for risk
management and hedging the market risk on their portfolio. However, the minimum
contract size of Rs. 0.2 million may not match with the size of the portfolio of every
investor.
One of the economic purposes of the Derivative markets is that they provide an efficient
mechanism for future price discovery. Price is arrived on the basis of the collective
perception of all players in the market who have diversified views on the market. A large
cross section of persons participating in the market would increase the diversity of the
views expressed, which would lead to fair price discovery. The stipulation of minimum
contract size may act as a deterrent to many investors and may exclude them for
expressing their views in the mechanism of price discovery.

The Committee sees merit in some of these arguments. More importantly, it recognizes that
globally the contract size is determined by the exchanges without any intervention from the
regulators. The environment under which the Rs 0.2 million limit was introduced has undergone
a dramatic change and the time has now come to do away with the minimum contract size in
value terms.
9.3.7 Adjustment for Corporate Actions
At the time of recommending introduction of stock options, SEBI laid down procedures for
adjustment in derivative contracts at the time of corporate action in line with international best
practices. It was decided that the adjustment for corporate action on the same underlying should
be uniform across markets and should be based on the following principles:

The basis for any adjustment for corporate action shall be such that the value of the
position of the market participants on cum and ex-date for corporate action shall continue
to remain the same as far as possible. This will facilitate in retaining the relative status of
positions viz. in-the-money, at-the-money and out-of-money. This will also address issues
related to exercise and assignments.
Any adjustment for corporate actions shall be carried out on the last day on which a
security is traded on a cum basis in the underlying cash market.
Adjustments may be carried out by modifying the Strike Price, Position or Market Lot /
Multiplier. The adjustments shall be carried out on any or all of the above based on the
nature of the corporate action.
The adjustments for corporate actions shall be carried out on all open, exercised as well
as assigned positions.

The adjustment methodology for certain corporate actions like rights, bonus, and stock split was
also laid down at that time. At the same time a group was set up comprising NSE, BSE and other
knowledgeable persons which would decide a uniform course of action for adjusting stock option
contracts on corporate actions, taking into account best practices followed internationally
On the basis of the experience accumulated so far, the ACD is of the view that the task of
deciding on adjustments for corporate action should now be left to the exchanges with the
stipulation that:

The basis for any adjustment for corporate action shall be such that the value of the
position of the market participants on cum and ex-date for corporate action shall continue
to remain the same as far as possible.
The exchanges should take into account best practices followed internationally.
The exchanges must act consistent with SEBIs circular on adjustment for corporate
actions as well as the decisions of the erstwhile subgroup on corporate actions.
The Exchanges must consider the circumstances of the particular case and the general
interest of investors in the market

9.4 Risk Containment

9.4.1 VaR Framework
The LCGC Report laid down the fundamental principle of 99% VaR based margins:
The methodology for operationalizing these recommendations in the context of index futures was
laid down by another committee that submitted its report in November 1998.The principal
elements of this framework were:

SEBI should not lay down the margins but should approve a VaR estimation methodology
under which the margins are automatically updated every day The exponentially weighted
moving average method (also known as the IGARCH or Risk Metrics method) should be
used to estimate volatility daily.
The 99% VaR should be operationalized by using three standard deviations to account for the
fat tails
Since even a 99% VaR implies a margin shortfall once every hundred trading days
(approximately once every six months), it is necessary to have a second line of defence of
3% (an exposure limit of 33) in the form of a liquid net worth requirement.
The derivatives exchange and clearing corporation should be encouraged to refine the VaR
methodology continuously on the basis of further experience.

This VaR framework was further extended when index options were introduced. Essentially, the
VaR was now based on a portfolio approach similar to that of the SPAN system employed by
leading derivative exchanges worldwide:

The possible loss on the entire portfolio of any client is estimated under a variety of price and
volatility scenarios.
The range of prices considered for this purpose is set at three standard deviations in
conformity with the value used when only index futures were traded.
The range of volatility changes for option valuation was set at 4%. The Black-Scholes or
other alternative models could be used for option valuation
The margin is computed as the worst case loss under these various price and volatility
scenarios
The margin shall not however be less than 3% of the notional value of all short options. This
minimum margin is intended to cover model risk and impacts option portfolios which are
approximately delta, gamma and vega neutral and therefore attract very low margins under
the Black-Scholes valuation model.
The second line of defence was set at 3% for index options on the basis of notional value.

When stock options were introduced the same framework was extended by stipulating:

The range of price movements considered was set at 3.5 standard deviations to account for
the fatter tails of movements of stock prices as compared to index movements.
The range of volatilities to be considered was set at 10% to account for the higher volatility
of stocks.
The second line of defence was set at 5% to account for the higher volatility of stocks.

The ACD regards this risk containment framework as adequate except for changing the second
line of defence to the higher of 5% or 1.5 standard deviations.The underlying rationale for the
multiplier 1.5 is that under the assumption of power law tails, the expected price change
conditional on the change being greater than x is h/(h-1)x where h is the tail index. Since the first
line of margins is equal to x, the second line must cover the excess over x or [h/(h-1)-1]x. If we
assume h to be in the range of 3.25 to 3.75 and x is 3.5 standard deviations, then the second line
is about 1.5 standard deviations. We put a floor of 5% on this to deal with situations where the
estimated volatility is very low because of a long period of very low actual volatility.
9.4.2 Cross Margining: Basic Principles
The LCGC was of the view that cross margining should be introduced only after the derivative
markets have become fully established and the systems capability for adopting sophisticated
systems has emerged:
The ACD is of the view that the initial stage referred to by the LCGC is now over. Derivative
markets are now well established and the systems capability for implementing complex
margining systems now exists. Cross-margining is now the logical next step. The ACD
recommends the following method of implementing cross margining without commingling the
cash and derivative segments:

Cross margining should be implemented at the client level. The margin should be computed
on the integrated position of a client across cash and derivative market.
To achieve efficiency in client level cross margining, it would be desirable that a client has
the same clearing member across both the cash and derivative segment. In the event if a
client chooses to settle trades through more than one clearing member, the client would
decide by way of an agreement which clearing member would collect margin from the client
and in event of a default what would be the obligation of other clearing members.
In the event of default the clearing corporations would liquidate the positions in their
respective markets and under an agreement transfer the surplus, if any to the clearing
corporation where there is a deficit.
This method of cross margining avoids commingling the two segments of the exchange.
However, it does involve each clearing corporation taking a credit exposure on the other. This
must be limited by internal prudential guidelines and embodied in the agreement between the
two clearing bodies.
To achieve cross margining certain legal changes would have to be made in the cash /
derivative markets. These are

Legal provisions as regard default, TGF/SGF would have to be modified.

Agreement between clearing corporation, client/clearing member/ trading member to

be framed and bye-laws suitably amended.

Common client identification is necessary to implement cross margining at the client level.
The quickest way to do this would be to make a global unique client identification (say PAN
number) a pre-requisite for those clients who wish to avail of cross margining. Those who do
not have this global unique client identification will still be able to trade but they will not get
the benefit of cross margining.

From a risk management point of view, there are technical issues to be resolved for cross
margining between an index derivative position and an offsetting cash market position in a
basket of stocks that tracks the index.
Cross Margining between single stock derivative and the underlying
The positions in the underlying that are eligible for cross margining against positions in single
stock derivatives are:

The underlying in dematerialized form transferred to or pledged with the clearing

corporation
Short or long positions in any cash market segment that has a cross margining agreement
with the derivative market segment under consideration

A position in the underlying offset by an equal opposite position in the stock future would be
margined like a calendar spread. For calculating the spread margin, the maturity difference
between the underlying and the near month contract will be taken as one month and the maturity
difference between the underlying and a far month contract will be taken as one month plus the
maturity difference between the near month contract and the far month contract. Calendar spread
treatment will also be accorded to stock option positions whose deltas are offset by opposite
positions in the underlying in the same manner in which the calendar spread treatment is applied
to option positions of one maturity delta-hedged with futures of a different maturity.
Just as for calendar spreads between two futures contracts, calendar spreads between the
underlying and the derivative will also cease three days before expiry of the relevant derivative
contract. This has to be done because of the basis risk that arises on settlement. The only possible
exception would be where the derivative is a futures contract that is physically settled and the
underlying position consists of a position in the cash market segment whose settlement
obligations can be netted against the settlement obligations arising on expiry of the future.
Strictly speaking there is a settlement related basis risk whenever an American option is delta
hedged with futures or with positions in the underlying. This is because the American option can
be exercised at any time. This basis risk is ignored under the assumption that it can be managed
by (a) requiring a one day notice before exercise, (b) imposing daily exercise and assignment
limits, and (c) withdrawing the spread treatment when the option position has been given notice
of assignment for exercise.

Cross margining between index futures and a basket of constituent stocks

Cross margining would be allowed between positions in index futures and a basket of positions
in the constituent stocks provided the client designates the basket of positions as an index basket.
The permissible positions in the constituent stocks would be:

Actual holdings in the stock in unencumbered dematerialized form that are transferred or
pledged with the clearing corporation
Short or long positions in the stock in any cash market segment that has a cross margining
agreement with the derivative market segment under consideration
Short or long positions in the stock futures
An exchange traded fund (ETF) that tracks the index could also be regarded as a basket of
constituent stocks after applying an appropriate haircut to cover redemption costs and
tracking error

A basket of positions in index constituents can be decomposed into three portfolios:

(a) an exact index replica that has the same value as the basket at current market prices,
(b) a short deviation portfolio consisting of short positions in some constituent stocks and
(c) a long deviation portfolio consisting of long positions in some constituent stocks.
Portfolios (b) and (c) can be combined into a total deviation portfolio consisting of the absolute
deviations between the index and basket. The construction of these portfolios is illustrated below
with the following example of a hypothetical index that has only five stocks:
Table 6: Portfolio construction using derivatives
Stock

A
B
C
D
E
Total

Index
weight
s
Xi
30%
25%
10%
15%
20%
100%

Basket
weights

Replica
portfolio

Short
deviation Long
deviation Total
deviation
portfolio
portfolio
portfolio

Bi
28%
26%
11%
16%
19%
100%

Ri = Xi
30%
25%
10%
15%
20%
100%

Si =Min(Bi- Xi, 0)
-2%
0
0
0
-1%
-3%

Li = Max(Bi-Xi,0)
0
1%
1%
1%
0
3%

Ti =|Bi-Xi| =Li-Si
2%
1%
1%
1%
1%
6%

Source: Internet

It may be seen that the replica portfolio has the same value as the basket at current market prices
because the short deviation portfolio and the long deviation portfolio have equal but opposite
values. For the same reason, the value of the total deviation portfolio is twice that of the long or
short deviation portfolios.
Eligibility Condition for Cross Margining with Basket
Cross margining between the basket and the index future will be permitted only if the following
eligibility condition is satisfied:

The total deviation portfolio must have a value not exceeding 5% of the value of the basket. In
other words, the basket must approximate the index quite closely. The Committee recommends
that the limit of 5% be reviewed after six months of experience of cross margining.

Margin offset between index futures and replica portfolio

The margin offset between index futures and the replica portfolio will be identical to that
between single stock futures and the underlying. In other words, the position will be treated as a
calendar spread and margined as such.
Margin on total deviation portfolio
There are two options here:

The total deviation portfolio can be margined as a portfolio of positions on individual

constituents of the portfolio. This would require that the volatility and other margin
parameters must be computed for even those index constituents that do not have options
or stock futures trading on them.
A simpler solution is to margin the total deviation portfolio as if it were a position in a
single hypothetical stock whose volatility is twice that of the index and which is assumed
to be sufficiently liquid (impact cost less than 1%) not to require a 3 scaling for
illiquidity. The smallness of the total deviation portfolio is a critical factor in using this
approximation.

Cross margining between index options and options on constituent stocks

No cross margining will be permitted between positions in index options and a basket of
positions in options on constituent stocks in the index. The reasons for this stand are:

It is unlikely that any arbitrageur will delta hedge index options with a basket of constituent
stock options. It is much easier to delta hedge index options with index futures and stock
options with stock futures. Therefore, though it is not too difficult to give a cross margin
benefit for the offsetting deltas of the two positions, there are little practical benefits from it.
An arbitrageur might indeed to want vega hedge index options with a basket of constituent
stock options under the belief that the index implied volatility must be a weighted average of
constituent implied volatilities. Price discovery might indeed be aided by giving a cross
margining benefit for such a vega hedge, but the methodology for doing so would be too
complex to implement.

Cross margining between two indices

No cross margining will be permitted between two indices even if they are highly correlated.
Cross margining between two stocks

No cross margining will be permitted between two stocks even if they are highly correlated.

9.5 Market Structure and Governance

9.5.1 Separation of cash and derivatives markets
The LCGC discussed the issue of separation of the cash and derivative markets at length:
The Committee examined the relative merits of allowing derivatives trading to be conducted by
an existing stock exchange vis--vis a separate exchange for derivatives. The arguments for each
are summarised below.
Arguments for allowing existing stock exchanges to start futures trading:
(a) The most weighty argument in this regard is the advantage of synergies arising from the
pooling of costs of expensive information technology networks and the sharing of expertise
required for running a modern exchange. Setting-up a separate derivatives exchange will involve
high costs and require more time.
(b) The recent trend in other countries seems to be towards bringing futures and cash trading
under coordinated supervision. The lack of coordination was recognized as an important problem
in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level supervisory
coordination between futures and cash markets is greatly facilitated if both are parts of the same
exchange.
Arguments for setting-up separate futures exchange:
(a) The trading rules and entry requirements for futures trading would have to be different from
those for cash trading.
(b) The possibility of collusion among traders for market manipulation seems to be greater if
cash and futures trading are conducted in the same exchange.
(c) A separate exchange will start with a clean slate and would not have to restrict the entry to the
existing members only but the entry will be thrown open to all potential eligible players.
The ACD has discussed this matter extensively, and noted that one of the major considerations
of the LCGC in recommending a separate derivatives segment was the desire to start with a
clean slate without being bound by the trading rules and practices of the cash segment. The
Committee noted that the LCGCs recommendations were made keeping in mind the
circumstances prevalent during that period and its deliberations. Since then, there have been
significant changes with regard to the governance of Exchanges and market structure. They also
noted that in many areas, the procedures and practices in the derivative segment are being
adopted by cash segment. Moreover, internationally, different markets like equity, derivatives
and debt are merging to achieve operational efficiency and to reduce transactions cost.

So finally ACD decided that the functional, operational and administrative modalities should be
left to the discretion of the exchanges. The cash and derivative segments could have common
personnel, trading terminal and infrastructure. The committee specified the areas in the
derivative segment which should be separate from the cash segment. These are as under:

The legal framework governing trading, clearing & settlement of the Derivative segment
should be separate from the cash market segment. In other words, the Regulations & Byelaws of derivative segment, as the case may be for specific exchanges, should be
separate.
TGF/SGF of the derivative segment should be separate from the cash market segment
and merging / pooling of TGF/SGF may be considered at a later date.
Membership of the derivative segment should be separate from the cash market segment.
The Governing Council / Clearing Council / Executive Committees of the derivative
segment should be separate from the cash market segment.

9.5.2 Sub brokers

The LCGC Report made no mention of sub brokers though it recommended a two tier market
structure consisting of trading members and trading members.
The ACD has discussed the issue of sub brokers on several occasions. Its view has consistently
been that there can be no compromise on
(a) Client level gross margins
(b) Regulation of sales practices at client level.
Sub brokers as they operate in cash market are inconsistent with this. However, the ACD has
consistently taken the view that other forms of multi-tier broking relationships are possible
consistent with the above two requirements.
The Trading member Clearing Member structure itself is two-tier structure and the
regulatory regime imposes no minimum capital requirement on trading members as the
clearing member is responsible for all settlement obligations. It is therefore possible for a
sub broker to be registered as a trading member with fairly low capital requirements. The
ACD has also been of the view that exchanges should be allowed to use any terminology
that they like for such sub-broker turned trading member so long as they are registered
with SEBI as trading members.
It is also possible to adopt a remisier model in which client of the sub broker receive
contract notes issued in the name of and on behalf of the main broker.
The ACD is of the view that SEBI should be open to any proposal from the exchanges for
assimilating sub brokers into the market structure so long as these are consistent with the twin
requirements of client level gross margins and regulation of sales practices at client level.
9.5.3 Inspection
The LCGC recommended 100% inspection of all derivative brokers every year:

The advisory committee reviewed the recommendation of 100% inspection of trading / clearing
members in a year by the LCGC. The committee was informed that while reviewing the
functioning of derivative segment of the two exchanges (NSE and BSE), SEBI had observed that
in an effort to complete 100% inspection the quality of inspection was being compromised. The
Exchanges also agreed with the observation of SEBI and requested that the condition of 100%
inspection be done away with as it is practically difficult to inspect all members irrespective of
their share in the total trading in the market.
The advisory committee after deliberating on the issue was of the view that inspection should be
linked to the level of activity of the member and other criteria as the circumstances demand. The
committee was of the view that condition of 100% inspection may be done away with and the
quantum of members to be inspected could be linked to the cost and benefit of inspections and
the criteria decided in this regard. The Exchange should work out an appropriate inspection
strategy in consultation with SEBI. This inspection strategy should lay down:

the criteria for identifying the top members to be taken up for 100% inspection
the percentage of remaining members to be inspected on a sampling basis
mechanisms to ensure that active members do not go uninspected for several years in
succession

9.5.4 Surveillance
The committee also deliberated on the issues which would be covered in the Surveillance
Systems / Mechanism in the derivative markets. While many aspects of surveillance would be
the same for derivatives and for other securities, the committee felt that some areas of
differencesdo exist. In particular, the Committee is of the view that the exchanges should
consider developing a specific stock watch system for derivative markets. The cash market
surveillance mechanism may not meet all the requirements of the derivatives market. Some of
the important issues that arise are as follows:

There should be monitoring of open interest, cost of carry, impact cost, and volatility.
The open positions in the derivative market should be seen in conjunction with the open
positions in the cash market i.e. the position deltas should be monitored.
The timing of information disclosure by corporates should be monitored as this could
influence the prices of the contract at the time of contract introduction and expiry.
Strike prices with large open positions should be monitored as such strike prices could be
a target price to be achieved in the cash market to derive maximum benefit from the
derivative position.
It is also necessary to monitor contract expirations very carefully. The ACD has
sometimes reviewed this on an ad hoc basis. For example, in one of its meetings, it
reviewed the contract expirations coinciding with large volumes and high volatility on
February 28, 2002 (budget announcement) and March end (close of the financial year).
Both BSE & NSE submitted details of the analysis that they had carried out in this regard
and stated unequivocally that there was no risk management or market integrity concerns
associated with these expirations. Expiration monitoring should be done systematically
from a surveillance point of view.

Unified surveillance of the cash and derivatives markets is essential both at the exchange
level and at the level of SEBI.
SEBI and the Exchanges should study surveillance practices in various global equity
derivative markets. Surveillance practices in global commodities and bullion derivative
markets could also be studied where appropriate as some of the well publicized cases of
market manipulation in derivatives have been in these markets. Case studies on some
market manipulations in various derivatives markets could be looked at to see what
lessons could be drawn.

9.5.5 Physical Settlement

The LCGC Report took it for granted that physical settlement would be used for derivative
contracts on individual stocks:
However, when single stock derivatives were introduced in India, it was decided to use cash
settlement to begin with because the exchanges did not then have the software, legal framework
and administrative infrastructure for physical settlement. It was proposed that cash settlement
would be replaced by physical settlement within a period of six months as the exchanges
developed the capabilities to achieve physical settlement efficiently.
In April 2002, the ACD proposed a broad framework for physical settlement. The SEBI Board
desired that the committee should present a report highlighting the risks and benefits of physical
settlements along with possible risk containment measures.
Accordingly, the ACD reconsidered its recommendation on the risks and benefits of physical
settlement. The ACD notes the principal issues involved in physical settlement:

In the absence of a vibrant mechanism for securities lending and borrowing, physical
settlement of stock specific derivative contracts, especially stock options, may raise concerns
on the possibility of a short squeeze.
Globally, cash settlement is cheaper than physical settlement, but the economics may be less
clear cut in India where the modernization of the payment system has lagged that of the
securities settlement system.
Under the existing procedure of cash settlement, hedgers and arbitrageurs incur overnight
price risk for liquidating one leg of the transaction in the cash markets. A hedger (who by
definition has a position in the underlying) would have to liquidate that position in the cash
market and then bears the risk that the price realized in the cash market would differ from the
settlement price used for cash settlement in the derivative markets. The same argument
applies to arbitrageurs. Speculators on the other hand would find cash settlement beneficial
since they do not (by definition) have an offsetting cash market position and cash settlement
saves them the burden of operating in two markets. Physical settlement of derivative contract
helps hedgers and arbitragers avoid basis risk while imposing some additional costs on
speculators.

The committee is of the view that the regulatory regime should be more in tune with the
requirements of hedgers and arbitrageurs than the needs of speculators. For this reason, it

recommends physical settlement which protects hedgers and arbitrageurs from basis risk in the
settlement process. At the same time, the Committee recognizes the concerns regarding short
squeezes in physical settlement. To address these concerns, the committee recommends the
following measures to reduce the risk of short squeeze:

The exchanges should lay down limits on daily exercise and assignment of stock options.
Since these options are American, the squeeze can arise at any time during the contract
cycle. Daily limits on exercise and assignment limit the ability to squeeze the market in
the middle of the contract month.
That leaves the possibility of a short squeeze at expiry. One important defence against
this is the position limits that apply in the derivative market. In fact, market manipulation
can take place even under cash settlement and position limits are the principal defence
available to the regulator.
The Committee also believes that there is greater need for surveillance as the contract
approaches expiry. Large positions tend to be closed out or rolled over into the next
contract month as the contract approaches expiry. Large positions that are maintained or
enhanced during the last days of the life of the contract need to be monitored closely.
Greater availability of information is another powerful force to guard against market
manipulation (regardless of whether the settlement is cash or physical). Information on
large positions must be disclosed to the market on a regular basis and the exchanges
should be empowered and encouraged to disclose information in greater detail especially
towards contract expiry.

The committee therefore recommends that derivatives on individual stocks should shift to
physical settlement. The committee also recommends that physical settlement be implemented
for all stock based derivative product simultaneously by giving at least 45 days notice to the
market.
The mechanism of physical settlement, 3 different models appear to be prevalent globally:
1. At one extreme is the system of completely separate and independent settlement processes for
derivatives and cash equities. This might be a reasonable description of the London Clearing
House (LCH)s independent settlement processes for Liffe and LSE. However, LCH settlement
systems have been continuously evolving and LSE/LCH started net settlement of cash equities
only recently.
2. Use cash market transactions to settle derivatives. This might be a reasonable description of
what MEFF does in Spain. In this model, every derivatives member must appoint a cash market
member to carry out the execution of cash market transactions deriving from the exercise or
settlement of derivative contracts traded by it for itself or on behalf of its clients.
3. Use cash market clearing corporation to settle derivatives. This might be a reasonable
description of what the Option Clearing Corporation (OCC) does in the US. Under this model,
settlement obligations among derivative market members resulting from the exercise or
settlement of derivatives are discharged through a cash market clearing corporation. The OCC
carries this model further by stipulating that When an exercise is submitted to a stock clearing

corporation for settlement and not rejected by it, the responsibility for completing the settlement
passes from OCC to the stock clearing corporation. After that time, OCC has no further
responsibility to its Clearing Members for the exercise. Instead, rights and responsibilities run
between the exercising and assigned Clearing Members and the stock clearing corporation
(OCC, Rule 913).
The ACD is of the view that the first model (completely separate settlement) would require a
duplication of the entire settlement infrastructure in the derivatives market clearing corporation
without any attendant benefits. At the same time, the second model (settlement through cash
market transactions) commingles the cash and derivative markets and is undesirable as the cost
and efficiency benefits of that model could be achieved by intertwining the two clearing
corporations rather than the two markets themselves.
Accordingly, the ACD recommends the third model: the mechanism of physical settlement
should be such that at no point in time are trades on the derivative segment commingled with
trades on cash market. However, the clearing corporation of the derivative segment could use the
facility of the clearing corporation of cash market as its agent.
This would neither dilute the guarantee mechanism nor would it cast a burden on Trade
guarantee fund of the other segment. The role of clearing corporation of derivative segment and
clearing corporation of the cash segment would be defined in an agreement/arrangement which
could be in line with the agreement between the various clearing corporations which are carrying
out clearing between two markets internationally.
The committee considered the need of reducing the cost of transaction by giving margin benefit
in the case of offsetting position in cash and derivative market. The committee was of view that
it would be better to implement cross margining in cash and derivative market instead of merging
the trades in cash and derivative market.. However, until full fledged cross margining is adopted,
there should be a margin offset only for deliverable positions.
In the light of the above broad policy framework, committee recommends the following
operational parameters for physical settlement:

Clearing Corporation of the cash market would act as an agent of the clearing
corporation of the derivative segment, for clearing the exercised / expired stock option
and stock futures contracts. The delivery obligation at the Trading Member level in the
derivative markets would be settled through the cash market clearing corporation as per
the delivery mechanism prevalent in the cash market clearing corporation.
The trading member of the derivative market would enter into an agreement/arrangement
with a clearing member of the cash market and such clearing member of the cash market
would act as an agent of the trading member/clearing member of the derivative market
for the purpose of settling the delivery obligation of such member.
The Clearing Corporations of the Cash segment and the Derivative segment may enter
into an agreement/arrangement which could address the issues of risk management, cross
margining system, and the other concerned areas. In the event of default the proportion in

which the burden of default would be shared between the Settlement Guarantee Funds of
cash and derivative segment, could also be specified in the agreement/arrangement.
Similarly, a tripartite agreement between the client, the trading member of derivative
segment and the clearing member of the cash segment could be entered which could
specify issues pertaining to delivery offsets, margin requirement and any other concerned
issue.
The delivery obligation of the derivative segment would be netted at Trading Member
level and passed on to the clearing member of the cash market for settlement as an agent.
To allow option writers to deliver stock in time, one days notice shall be given for the
exercise of options. On exercise, the delivery would be settled in the time frame specified
in the cash market.
The margin set off at the client level would be made available by adopting the cross
margining between the clearing corporation of derivatives segment and the cash segment
The effective date from which stock futures and stock option contracts change to
physical settlement mode should coincide with the date of inception of a new contract
month. From the effective date the outstanding stock futures and stock option contracts,
would also change to physical settlement, though at inception, these contracts were stated
to be for cash settlement.
The effective date for physical settlement should be announced 45 days in advance.

9.6 Use of Derivatives by Mutual Funds

The LCGC recommended that mutual funds should be permitted to use derivatives for hedging
and portfolio rebalancing.
The ACD discussed the issue of mutual funds participation in derivatives at great length. On the
one hand, there was the question of whether mutual funds should be allowed to go beyond
hedging and portfolio rebalancing. On the other hand, there were a number of questions about
what the term hedging and portfolio rebalancing actually means.
After considerable discussion, the Committee was of the view that it is necessary to distinguish
between New funds that have come to the public with full disclosure of their derivative trading
strategy. This category would also include existing schemes that undergo the process for
changing its fundamental attributes to enable the use of additional derivative strategies. Existing
funds whose offer documents did not have a complete disclosure of the derivative strategies that
they would adopt or explicitly limited the use of derivatives to hedging and portfolio
rebalancing.
9.6.1 New Schemes: Utilising mainstream governance and disclosure mechanisms
Under normal circumstances, the trading strategies and ideas in portfolio management used by
the AMC should be fully disclosed in the offer document, and the AMC should be closely
interacting with the trustees who perform governance functions on behalf of investors on all
aspects of the operations of the scheme. In this environment, the role of SEBI is limited to
certain improvements in disclosure norms, using which mutual funds would give investors and
potential investors sound information about the portfolio strategies associated with a given
scheme.

Hence, the first mechanism through which mutual fund schemes can engage in derivatives
trading consists of three steps:
Additional text in the prospectus which fully explains the ways in a given scheme would
use financial derivatives, including numerical examples,
An ongoing dialogue with the trustees, whereby the trustees would establish that the
actual functioning of the AMC is consistent with these promises,
An enhanced disclosure program.
By these principles, if a mutual fund house can persuade investors that a beta leveraged equity
index fund is an attractive product, and thus raise resources which should be deployed through
such a strategy, then it should be free to implement this using index futures and/or index options.
This path can be utilized when new schemes are created. For existing mutual fund schemes,
utilizing this path involves a modification to the offer document, which entails obtaining the
consent of existing unit-holders.
9.6.2 Existing Schemes: Rules governing hedging and portfolio rebalancing.
The bulk of mutual fund assets today are in existing open-end schemes. It is likely that the bulk
of new resources coming into mutual funds in the future will come into open-end schemes that
exist as of today. In the absence of any changes to a mutual fund prospectus, the rules governing
derivatives trading by mutual funds should limit mutual funds to certain strategies:
What does hedging mean?
The term hedging is fairly clear. It would cover derivative market positions that are designed to
offset the potential losses from existing cash market positions. Some examples of this are as
follows:
An income fund has a large portfolio of bonds. This portfolio stands to make losses when interest
rates go up. Hence, the fund may choose to short an interest rate futures product in order to offset
this loss.
Every equity portfolio has exposure to the market index. Hence, the fund may choose to sell
index futures, or buy index put options, in order to reduce the losses that would take place in the
event that the market index drops.
The regulatory concerns are about (a) the effectiveness of the hedge and (b) its size.
Hedging a Rs.1 billion equity portfolio with an average beta of 1.1 with a Rs. 1.3 billion short
position in index futures is not an acceptable hedge because the over hedged position is
equivalent to a naked short position in the future of Rs. 0.2 billion. Similarly, hedging a
diversified equity portfolio with an equal short position in a narrow sectoral index would not be
acceptable because of the concern on effectiveness. A hedge of only that part of the portfolio that
is invested in stocks belonging to the same sector of the sectoral index by an equal short position
in the sectoral index futures would be acceptable.
Hedging an investment in a stock with a short position in another stocks futures is not an
acceptable hedge because of effectiveness concerns. This would be true even for merger
arbitrage where long and short positions in two merging companies are combined to benefit from
deviations of market prices from the swap ratio.

Hedging with options would be regarded as over-hedging if the notional value of the hedge
exceeds the underlying position of the fund even if the option delta is less than the underlying
position. For example, a Rs.2 billion index put purchased at the money is not an acceptable
hedge of a Rs.1 billion, beta=1.1 fund though the option delta of approximately Rs. 1 billion is
less than the underlying exposure of the fund of Rs. 1.1 billion.
Covered call writing is hedging if the effectiveness and size conditions are met. Again the size of
the hedge in terms of notional value and not option delta must not exceed the underlying
portfolio.
The position is more complicated if the option position includes long calls or short puts. The
worst-case short exposure considering all possible expiration prices should meet the size
condition.
What does portfolio rebalancing mean?
The use of derivatives for portfolio rebalancing covers situations where a particular desired
portfolio position can be achieved more efficiently or a lower cost using derivatives rather than
cash market transactions. The basic idea is that the mutual fund has a fiduciary obligation to its
unit holders to buy assets at the best possible price.
Thus if it is cheaper (after adjusting for cost of carry) to buy a stock future rather than the stock
itself, the fund does have a fiduciary obligation to use stock futures unless there are other
tangible or intangible disadvantages to using derivatives. If a fund can improve upon a buy-andhold strategy by selling a stock or an index portfolio today, investing the proceeds in the money
market, and having a locked-in price to buy it back at a future date, then it would have a
fiduciary obligation to do so.
The general principle here would be that a fund is permitted to do using derivatives whatever it
could have done directly - no more and no less. For example, a funds position in a stock
-underlying and derivatives taken together - should be within the funds maximum permissible
limit in the stock. For this purpose, stock option long calls should be counted as notional value.
The position is more complicated if there are short calls or long puts. The worst-case long
exposure considering all possible expiration prices should be less than the funds permissible
limit.
There is another complication in case of long index positions. One could regard this as an
equivalent exposure in each constituent of the index. This may be severely limiting where the
fund already has a long position in a stock which has a long weight in the index. Another
possibility is to say that a fund is permitted to deploy any part of its assets in a broad index and a
sectoral fund is permitted to do the same in a sectoral index. Then the stock wise limits would be
applied to the remaining part of the portfolio.
In any case, a long index position cannot be used to leverage a portfolio beyond the leverage that
is otherwise permissible. Thus a fund with Rs.1 billion assets cannot have a Rs. 1.5 billion
notional value of long index futures and index options.
Computation of worst case exposure for complex option positions

A simple example to illustrate the worst case exposure method of determining whether a
portfolio of option positions on the same underlying is an acceptable hedging and portfolio
rebalancing strategy. Considering the following stock option strategy:
a. Long call options on 5 million shares at a strike price of Rs 80.
b. Long put options on 2 million shares at a strike price of Rs 90
c. Short call options on 1 million shares at a strike price of Rs 110.36
d. Long put options on 3 million shares at a strike price of Rs 120
e. Long call options on 4 million shares at a strike price of Rs 130
f. Short call options on 3 million shares at a strike price of Rs 140
Since the fund has a bullish position on 9 million shares (a plus e) and a bearish position on 9
million shares (b plus c plus d plus f), its option delta could be comparatively small especially
when the stock price is not far from the weighted average strike price. However, depending on
what the stock price turns out to be at expiry, only some of the options will end up in the money
and will therefore get exercised by or against the fund. Consequently, the fund could end up with
a long or short position in the stock at expiry depending on what the stock price turns out to be at
that point of time. The worst case long and short exposures can be worked out as follows:
Table 7: Computing different funds under the worst case scenario
Price at expiry
Below 80
80-90
90-110
110-120
120-130
130-140
above 140

Options that end up in the money and

therefore get exercised by or against
the fund
b and d
a, b and d
a and d
a, c and d
a and c
a, c and e
a, c, e and f

Net number of shares (short or long) the

fund ends up holding as a result of the
5 million shares short
Nil
2 million shares long
1 million shares long
4 million shares long
8 million shares long
5 million shares long

Source: Internet

The worst case short exposure arises when the share price at expiry is below 80 and the fund
ends up delivering 5 million shares to exercise the in-the-money puts. This would be an
acceptable level of hedging only if the funds position in the underlying and the futures were at
least 5 million shares.
Its worst case long position (8 million shares) is when the share price is above 130 and below
140. The fund receives 9 million shares from exercising its in-the-money calls (a and e) and
delivers 1 million shares against its short calls (c) which are also in the money. This means that
the fund can take up this option strategy only if this 8 million shares plus its position in the
underlying shares and futures is together less than the maximum permissible limit for the funds
holding in the stock.
The fund must therefore satisfy two conditions before it can take up this option strategy as part
of hedging and portfolio rebalancing:
the funds position in the underlying and the futures must be at least 5 million shares so
that the position does not become over-hedged

the funds existing position in the underlying shares and futures plus the 8 million shares
worst case long exposure of the option strategy must together be less than the maximum
permissible limit for the funds holding in the stock

Some fund managers may regard the worst case exposure analysis as an excessively harsh view
of what they might consider a legitimate and relatively low risk derivative strategy. In particular,
it might be objected that the worst case long exposure of 8 million shares should be treated more
leniently since it applies only in a narrow range of share prices (130-140). The Committee is
however of the view that even if strategies of this kind are attractive and low risk ways of
creating and profiting from gamma and vega exposures to a stock, the creation of such exposures
does not per se constitute hedging and portfolio rebalancing. To justify the strategy in a
hedging and portfolio rebalancing framework, it is necessary to show that the worst case short
position resulting from the strategy is an acceptable hedging activity and that the worst case long
position resulting from it is an acceptable portfolio rebalancing activity.
9.6.3 Ongoing disclosure requirements
In addition to the existing disclosures, each mutual fund scheme should make the following
information available to investors and to the public at large on its website at a monthly
frequency:
Gross turnover on derivatives, reported separately by product categories (such as index
futures, index options, stock futures, etc.).
Outstanding position on derivatives as of the end-of-month, reported separately by
product categories.
Lowest, median and highest values in the month of the overall scheme delta with respect
to the market index.
This should report the sensitivity of the portfolio to a unit change in the market index,
incorporating direct equity holdings, index derivatives positions and stock derivatives
positions. Internally, these values would be computed by each scheme which uses derivatives
every day at closing prices. The three summary statistics (min, median, max) over the month
would be publicly reported.
If adding the derivative positions to the positions in the underlying would significantly change
the list or ranking of the top 10 stocks in the portfolio, the top 10 holdings on the basis of
underlying plus single stock derivative positions should be disclosed alongside the disclosure of
the top 10 holdings of the scheme. For this purpose, option positions will be converted into
equivalent positions in the underlying on the basis of the option deltas. The same procedure
should be adopted if the schemes positions in derivatives on any narrow index are such as to
significantly change the list or ranking of the top 10 stocks in the portfolio.
9.7 SEBI Related Issues
9.7.1 Derivatives Cell and Advisory Committee

The LCGC very rightly emphasized the need for SEBI to build competencies in the area of
derivatives:
SEBI should immediately create a special Derivatives Cell because derivatives demand special
knowledge. It should encourage its staff members to undergo training in derivatives and also
recruit some specialized personnel.
A Derivatives Advisory Council may also be created to tap the outside expertise for independent
advice on many problems which are bound to arise from time to time in regard to derivatives.
In the area of risk management, there is a need to create mechanisms that can facilitate an
integrated view of risk management in both cash and derivative markets simultaneously
Accordingly, the ACD recommends:
Strengthening of the Derivative Cell both quantitatively and qualitatively to shoulder
most of the responsibility for operational issues regarding the derivatives market.
Strengthened unified surveillance of the cash and derivative markets.
Develop mechanisms to facilitate an integrated view of risk management in both cash and
derivative markets simultaneously.
9.7.2

SEBI and RBI

The Committee recommends that SEBI and RBI should work together on moving towards
exchange traded derivatives in the area of interest rates and currencies.

10. SOME OF THE ESSENTIAL MARKET MONITORING TOOLS AND

POLICIES
To prevent financial disruptions, and help keeping the various risk exposures in the financial
market under control.
o Enhancing confidence and knowledge among all market participants is a necessary condition
in order to guarantee the stability of the derivatives markets.
o Enhance information standardization and disclosure at all levels of the derivatives trading
industry. Also, the market value concept should always be preferred in order to serve as a
benchmark for the marking to market or collateralization of the various risk exposures.
o Increase and harmonize the frequency of market, accounting and credit assessment data
disclosure in order to allow for daily risk monitoring. Market participants should be able to
effectively monitor and limit their market, credit and liquidity risk exposures to the extent of
remaining exposed to a "sustainable" price, volume or credit variation at most.
o An efficient risk management system for the derivatives industry has to be "dynamic" and
explicitly consider and monitor the evolution of market, credit and liquidity risk exposures.
In this respect, the credit risk of derivatives positions should be analyzed across maturities as
well as across counterparties.
o In order to enforce the risk management and monitoring at all responsibility levels, the
performance measurement and financial compensation schemes of the firm employees have
to be incentive compatible. In order to guarantee efficient self regulation in the derivative
market, the managers, traders and other derivative dealers must receive the proper
incentive(explicit penalties) when hedging, trading or speculating with those instruments.

Finally, the horizon over which a given performance is assessed should be compatible with
the long run objectives of the institution.
o Derivatives participants should adopts more transparent and standardized accounting and
disclosure rules, putting more emphasis on the education of their personal and developing an
expertise in their back office management and settlement procedures.
o The most delicate topic is related to the monitoring of derivatives, namely the justification of
external regulation. Regulation is clearly not the only monitoring device that can be used to
enforce market participants risk exposures. External regulation should be considered as the
ultimate enforcement mechanism whenever self regulation of the market participants fails to
achieve the monitoring goals. Thus,the role of regulation as that of a player of last resort who
guarantees that the economic benefits associated to the derivative trading activity remain on
the efficient "risk/return" frontier.
Risk management is not about the elimination of risk; it is about the management of risk;
selectively choosing those risks an organization is comfortable with the minimizing those that it
does not want. Financial derivatives serve a useful purpose in fulfilling risk management
objectives. Through derivatives, risk from traditional instruments can be efficiently unbundled
and managed independently.

11. DERIVATIVE MARKETS AT PRESENT

The prohibition on options in SCRA was removed in 1995. Foreign currency options in
currency pairs other than Rupee were the first options permitted by RBI.
The Reserve Bank of India has permitted options, interest rate swaps, currency swaps and
other risk reductions OTC derivative products.
Besides the Forward market in currencies has been a vibrant market in India for decades.
In addition the Forward Markets Commission has allowed the setting up of commodities
futures exchanges. Today we have 18 commodities exchanges most of which trade
futures .e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee
Owners Futures Exchange of India (COFEI).
In 2000 an amendment to the SCRA expanded the definition of securities to included
Derivatives thereby enabling stock exchanges to trade derivative products.
The year 2000 has herald the introduction of exchange traded equity derivatives in India
for the first time.

11.1 Market Lot of Index Derivatives

Table 8: Market Lot of Index Derivatives trading
Underlying

Symbol

Market Lot

BANK Nifty
CNX 100
CNX IT
CNX Nifty Junior
Nifty Midcap 50
S&P CNX Nifty

BANKNIFTY
CNX100
CNXIT
JUNIOR
NFTYMCAP50
NIFTY

25
50
50
25
75
50

S&P CNX Nifty

MINIFTY

20

Source: NSE India

11.2 BSE's and NSEs plans

Both the exchanges have set-up an in-house segment instead of setting up a separate exchange
for derivatives.

BSEs Derivatives Segment, will start with Sensex futures as its first product.
NSEs Futures & Options Segment will be launched with Nifty futures as the first
product.

Table 9: Product Specifications of futures

Product Specifications
Contract Size
Tick Size
Expiry day

BSE-30 Sensex Futures

Rs. 50 times the Index
0.1 points or Rs. 5
last Thursday of the month

S&P CNX Nifty Futures

Rs. 200 times the Index
0.05 points or Rs. 10
last Thursday of the month

Settlement basis
Contract cycle
Active contracts

cash settled
3 months
3 nearest months

cash settled
3 months
3 nearest months

Source: Self Formulated by data collected from BSE and NSE website

11.3 Membership

Membership for the new segment in both the exchanges is not automatic and has to be
separately applied for.
Membership is currently open on both the exchanges.
All members will also have to be separately registered with SEBI before they can be
accepted.

Table 10. Membership Criteria

Clearing Member (CM)

Networth Interest-Free Security Deposits Collateral Security Deposit Non-refundable Deposit Annual Subscription Fees -

NSE
Rs. 300 lakh
Rs. 25 lakh
Rs. 25 lakh
-----

Trading Member (TM)

Networth Non-refundable Deposit Interest-Free Security Deposit Annual Subscription Fees -

Rs. 100 lakh

--Rs. 8 lakh
Rs. 1 lakh

BSE
Rs.300 lakh
Rs. 25 lakh
Rs. 25 lakh
Rs. 5 lakh
Rs. 50 thousand
Rs. 50 lakh
Rs. 3 lakh
--Rs. 25 thousand

TM if wishes to clear for the CM has to deposit

Rs. 10 lakh

Rs. 10 lakh
( Cash - Rs. 2.5 lakh
Cash Equivalents Rs. 25 lakh
Collateral Security
Deposit - Rs. 5 lakh )

Source: Self Formulated

NOTE: The Non-refundable fees paid by the members are exclusive and will be a total of Rs.8 lakhs if
the member has both Clearing and Trading rights.

11.4 Trading Systems

NSEs Trading system for its futures and options segment is called NEAT F&O. It is
based on the NEAT system for the cash segment.
BSEs trading system for its derivatives segment is called DTSS. It is built on a platform
different from the BOLT system though most of the features are common.

11.5 Settlement and Risk Management systems

Systems for settlement and risk management are required to satisfy the conditions specified
by the L.C. Gupta Committee and the J.R. Verma committee.
These include upfront margins, daily settlement, online surveillance and position monitoring
and risk management using the Value-at-Risk concept.

11.6 NSCCL SPAN

The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts
for each member. The system treats futures and options contracts uniformly, while at the same
time recognizing the unique exposures associated with options portfolios like extremely deep
out-of-the-money short positions, inter-month risk and inter-commodity risk.
Because SPAN is used to determine performance bond requirements (margin requirements), its
overriding objective is to determine the largest loss that a portfolio might reasonably be expected
to
suffer
from
one
day
to
the
next
day.
In standard pricing models, three factors most directly affect the value of an option at a given
point
in
time:
1.Underlying market price
2. Volatility (variability) of underlying instrument
3. Time to expiration

.
.
.

As these factors change, so too will the value of futures and options maintained within a
portfolio. SPAN constructs scenarios of probable changes in underlying prices and volatilities in

order to identify the largest loss a portfolio might suffer from one day to the next. It then sets the
margin requirement at a level sufficient to cover this one-day loss.
11.6.1 Mechanics of SPAN
The complex calculations (e.g. the pricing of options) in SPAN are executed by the Clearing
Corporation. The results of these calculations are called Risk arrays. Risk arrays, and other
necessary data inputs for margin calculation are then provided to members in a file called the
SPAN Risk Parameter file. This file will be provided to members on a daily basis.
Members can apply the data contained in the Risk parameter files, to their specific portfolios of
futures and options contracts, to determine their SPAN margin requirements.
Hence members need not execute complex option pricing calculations, which would be
performed by NSCCL. SPAN has the ability to estimate risk for combined futures and options
portfolios, and re-value the same under various scenarios of changing market conditions.
11.6.2 Risk Arrays
The SPAN risk array represents how a specific derivative instrument (for example, an option on
NIFTY index at a specific strike price) will gain or lose value, from the current point in time to a
specific point in time in the near future (typically it calculates risk over a one day period called
the look ahead time), for a specific set of market conditions which may occur over this time
duration.
The specific set of market conditions evaluated, are called the risk scenarios, and these are
defined in terms of:
.
(a) how much the price of the underlying instrument is expected to change over one trading day,
and
(b) how much the volatility of that underlying price is expected to change over one trading day.
The results of the calculation for each risk scenario i.e. the amount by which the futures and
options contracts will gain or lose value over the look-ahead time under that risk scenario - is
called the risk array value for that scenario. The set of risk array values for each futures and
options contract under the full set of risk scenarios, constitutes the Risk Array for that contract.
In the Risk Array, losses are represented as positive values, and gains as negative values. Risk
array values are typically represented in the currency (Indian Rupees) in which the futures or
options contract is denominated
.
11.6.3 SPAN further uses a standardized definition of the risk scenarios, defined in terms of
(i) the underlying price scan range or probable price change over a one day period,
(ii) and the underlying price volatility scan range or probable volatility change of the
underlying over a one day period.
.

These two values are often simply referred to as the price scan range and the volatility scan
range. There are sixteen risk scenarios in the standard definition. These scenarios are listed as
under:
1. Underlying unchanged; volatility up
2. Underlying unchanged; volatility down
3. Underlying up by 1/3 of price scanning range; volatility up
4. Underlying up by 1/3 of price scanning range; volatility down
5. Underlying down by 1/3 of price scanning range; volatility up
6. Underlying down by 1/3 of price scanning range; volatility down
7. Underlying up by 2/3 of price scanning range; volatility up
8. Underlying up by 2/3 of price scanning range; volatility down
9. Underlying down by 2/3 of price scanning range; volatility up
10.Underlying down by 2/3 of price scanning range; volatility down
11.Underlying up by 3/3 of price scanning range; volatility up
12.Underlying up by 3/3 of price scanning range; volatility down
13.Underlying down by 3/3 of price scanning range; volatility up
14.Underlying down by 3/3 of price scanning range; volatility down
15. Underlying up extreme move, double the price scanning range (cover 35% of loss)
16.Underlying down extreme move, double the price scanning range (cover 35% of loss)

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

SPAN uses the risk arrays to scan probable underlying market price changes and probable
volatility changes for all contracts in a portfolio, in order to determine value gains and losses at
the portfolio level. This is the single most important calculation executed by the system.
As shown above in the sixteen standard risk scenarios, SPAN starts at the last underlying market
settlement price and scans up and down three even intervals of price changes (price scan range).
At each price scan point, the program also scans up and down a range of probable volatility
from the underlying market's current volatility (volatility scan range). SPAN calculates the
probable premium value at each price scan point for volatility up and volatility down scenario. It
then compares this probable premium value to the theoretical premium value (based on last
closing value of the underlying) to determine profit or loss.
.
Deep-out-of-the-money short options positions pose a special risk identification problem. As
they move towards expiration, they may not be significantly exposed to "normal" price moves in
the underlying. However, unusually large underlying price changes may cause these options to
move into-the-money, thus creating large losses to the holders of short option positions. In order
to account for this possibility, two of the standard risk scenarios in the Risk Array (sr. no. 15 and
16) reflect an "extreme" underlying price movement, currently defined as double the maximum
price scan range for a given underlying. However, because price changes of these magnitudes are
rare, the system only covers 35% of the resulting losses.
.
After SPAN has scanned the 16 different scenarios of underlying market price and volatility
changes, it selects the largest loss from among these 16 observations. This "largest reasonable

loss" is the Scanning Risk Charge for the portfolio - in other words, for all futures and options
contracts.
11.6.4 Composite Delta
SPAN uses delta information to form spreads between futures and options contracts. Delta values
measure the manner in which a future's or option's value will change in relation to changes in the
value of the underlying instrument. Futures deltas are always 1.0; options deltas range from -1.0
to +1.0. Moreover, options deltas are dynamic: a change in value of the underlying instrument
will affect not only the option's price, but also its delta.
.
In the interest of simplicity, SPAN employs only one delta value per contract, called the
"Composite Delta." It is the weighted average of the deltas associated with each underlying
price scan point. The weights associated with each price scan point are based upon the
probability of the associated price movement, with more likely price changes receiving higher
weights and less likely price changes receiving lower weights. Please note that Composite Delta
for an options contract is an estimate of the contract's delta after the lookahead - in other words,
after one trading day has passed.
.
11.6.5 Calendar Spread or Intra-commodity or Inter-month Risk Charge
As SPAN scans futures prices within a single underlying instrument, it assumes that price moves
correlate perfectly across contract months. Since price moves across contract months do not
generally exhibit perfect correlation, SPAN adds an Calendar Spread Charge (also called the
Inter-month Spread Charge) to the Scanning Risk Charge associated with each futures and
options contract. To put it in a different way, the Calendar Spread Charge covers the calendar
(inter-month etc.) basis risk that may exist for portfolios containing futures and options with
different expirations.
.
For each futures and options contract, SPAN identifies the delta associated each futures and
option position, for a contract month. It then forms spreads using these deltas across contract
months. For each spread formed, SPAN assesses a specific charge per spread which constitutes
the Calendar Spread Charge.
.
The margin for calendar spread shall be calculated on the basis of delta of the portfolio in each
month. Thus a portfolio consisting of a near month option with a delta of 100 and a far month
option with a delta of 100 would bear a spread charge equivalent to the calendar spread charge
for a portfolio which is long 100 near month futures contract and short 100 far month futures
contract.
A calendar spread would be treated as a naked position in the far month contract three trading
days before the near month contract expires.
.
11.6.6 Short Option Minimum Charge:

Short options positions in extremely deep-out-of-the-money strikes may appear to have little or
no risk across the entire scanning range. However, in the event that underlying market conditions
change sufficiently, these options may move into-the-money, thereby generating large losses for

the short positions in these options. To cover the risks associated with deep-out-of-the-money
short options positions, SPAN assesses a minimum margin for each short option position in the
portfolio called the Short Option Minimum charge, which is set by the NSCCL. The Short
Option Minimum charge serves as a minimum charge towards margin requirements for each
short position in an option contract.
.
For example, suppose that the Short Option Minimum charge is Rs. 50 per short position. A
portfolio containing 20 short options will have a margin requirement of at least Rs. 1,000, even if
the scanning risk charge plus the inter month spread charge on the position is only Rs. 500.
11.6.7 Net Buy Premium (only for option contracts)

In the above scenario only sell positions are margined and offsetting benefits for buy positions
are given to the extent of long positions in the portfolio by computing the net option value.
To cover the one day risk on long option positions (for which premium shall be payable on T+1
day), net buy premium to the extent of the net long options position value is deducted from the
Liquid Networth of the member on a real time basis. This would be applicable only for trades
done on a given day. The Net Buy Premium margin shall be released towards the Liquid
Networth of the member on T+1 day after the completion of pay-in towards premium settlement.
11.6.8 Computation of Initial Margin - Overall Portfolio Margin Requirement
The total margin requirements for a member for a portfolio of futures and options contract would
be computed as follows:
.
(i) SPAN will add up the Scanning Risk Charges and the Intra commodity Spread Charges.
(ii) SPAN will compares this figure (as per i above) to the Short Option Minimum charge
(iii) It will select the larger of the two values between (i) and (ii)
(iv) Total SPAN Margin requirement is equal to SPAN Risk Requirement (as per iii above), less
the net option value, which is mark to market value of difference in long option positions and
short option positions.
.
(v) Initial Margin requirement = Total SPAN Margin Requirement + Net Buy Premium
11.6.9 Black-Scholes Option Price calculation model

The options price for a Call, computed as per the following Black Scholes formula:
C=S*N(d1)-X*e-rt*N(d2)
and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)
where
d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t)
d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t)
= d1 - * sqrt(t)

.
:
.
.
.

C = price of a call option

.
P = price of a put option
.
S = price of the underlying asset
.
X = Strike price of the option
.
r = rate of interest
.
t = time to expiration
.
= volatility of the underlying
.
N represents a standard normal distribution with mean = 0 and standard deviation = 1
ln represents the natural logarithm of a number. Natural logarithms are based on the constant e
(2.71828182845904).
Rate of interest may be the relevant MIBOR rate or such other rate as may be specified.
SPAN is a registered trademark of the Chicago Mercantile Exchange, used herein under
License. The Chicago Mercantile Exchange assumes no liability in connection with the use of
SPAN by any person or entity.
11.7 Rules and Laws

Both the BSE and the NSE have been give in-principle approval on their rule and laws by
SEBI.
According to the SEBI chairman, the Gazette notification of the Bye-Laws after the final
approval is completed by May 2000.
Trading started by June 2000.

12. SCHEME FOR FIIS AND NRIS TRADING IN EXCHANGE TRADED

DERIVATIVES
Table 11: The requirements for a FII, its sub-account and NRIs to invest in Derivatives

FII
Level

Index Options

Index Futures

Stock Options

Rs. 250 crores or

15% of the OI in
Index options,
whichever is
higher.
In addition, hedge
positions are
permitted.

Rs. 250 crores or

15% of the OI in
Index futures,
whichever is
higher.
In addition, hedge
positions are
permitted.

20% of Market
Wide Limit
subject to a
ceiling of Rs.
50 crores.

Single stock
Futures
20% of Market
Wide Limit
subject to a
ceiling of Rs.
50 crores.

Interest rate
futures
Rs. USD 100
million. In addition
to the above, the
FII may take
exposure in
exchange traded in
interest rate
derivative contracts
to the extent of the
book value of their
cash market
exposure in
Government
Securities.

Subaccount
level

NRI
level

Disclosure
requirement for any
person or persons
acting in concert
holding 15% or
more of the open
interest of all
derivative contracts
on a particular
underlying index
Disclosure
requirement for any
person or persons
acting in concert
holding 15% or
more of the open
interest of all
derivative contracts
on a particular
underlying index

Disclosure
requirement for any
person or persons
acting in concert
holding 15% or
more of the open
interest of all
derivative contracts
on a particular
underlying index
Disclosure
requirement for any
person or persons
acting in concert
holding 15% or
more of the open
interest of all
derivative contracts
on a particular
underlying index

1% of free float
market
capitalization or
5% of open
interest on a
particular
underlying
whichever is
higher

1% of free
float market
capitalization
or 5% of open
interest on a
particular
underlying
whichever is
higher

Rs. 100 Cr or 15%

of total open
interest in the
market in exchange
traded interest rate
derivative
contracts,
whichever is
higher.

1% of free float
market
capitalization or
5% of open
interest on a
particular
underlying
whichever is
higher

1% of free
float market
capitalization
or 5% of open
interest on a
particular
underlying
whichever is
higher

Rs. 100 Cr or 15%

of total open
interest in the
market in exchange
traded interest rate
derivative
contracts,
whichever is
higher.

Equation 1Source: Self formulated

13. FINANCIAL DERIVATIVES INSTRUMENTS TRADED IN INDIA

Table 12: List of the Derivative Instruments available in India
The National stock Exchange (NSE) has the following derivative products:
Products
Index Futures
Index Options
Futures
on
Individual
Securities
Underlying
S&P CNX Nifty
S&P CNX Nifty
30
securities
Instrument
stipulated
by
SEBI
Type
European
Trading Cycle
maximum of 3-month trading Same as index Same as index
cycle.At any point in time,there futures
futures
will be 3 contracts available :
1) near month,
2) mid month &
3) far month duration
Expiry Day
Last Thursday of the expiry Same as index Same as index
month
futures
futures
Contract Size
Permitted lot size is 200 & Same as index As stipulated by
multiples thereof
futures
NSE (not less
than Rs.2 lacs)
Price Steps

Re.0.05

Re.0.05

Options
on
Individual
Securities
30 securities
stipulated by
SEBI
American
Same as index
futures

Same as index
futures
As stipulated
by NSE (not
less than Rs.2
lacs)

Base
Price- previous day closing Nifty Theoretical value
First day of value
of the options
trading
contract arrived at
based on BlackScholes model
Base
Price- Daily settlement price
daily close price
Subsequent
Price Bands
Operating ranges are kept at + Operating ranges
10 %
for are kept at
99% of the base
price
Quantity
20,000 units or greater
20,000 units or
Freeze
greater

previous
day Same as Index
closing value of options
underlying
security
Daily
settlement price
Operating
ranges are kept
at + 20 %

Same as Index
options
Operating
ranges for are
kept at 99% of
the base price
Lower of 1% of Same
as
marketwide
individual
position limit futures
stipulated for
open positions
or Rs.5 crores

Source: Self Formulated by data collected from BSE and NSE website

Reasons why institutions do not participate to a greater extent in derivatives markets are:Some institutions such as banks and mutual funds are only allowed to use derivatives to hedge
their existing positions in the spot market, or to rebalance their existing portfolios. Since banks
have little exposure to equity markets due to banking regulations, they have little incentive to
trade equity derivatives. Foreign investors must register as foreign institutional investors (FII) to
trade exchange-traded derivatives, and be subject to position limits as specified by SEBI.
Alternatively, they can incorporate locally as a broker-dealer. FIIs have a small but increasing
presence in the equity derivatives markets. They have no incentive to trade interest rate
derivatives since they have little investments in the domestic bond markets. It is possible that
unregistered foreign investors and hedge funds trade indirectly, using a local proprietary trader as
a front.
Retail investors (including small brokerages trading for themselves) are the major participants in
equity derivatives, accounting for about 60% of turnover in October 2005, according to NSE.
The success of single stock futures in India is unique, as this instrument has generally failed in
most other countries. One reason for this success may be retail investors prior familiarity with
badla trades which shared some features of derivatives trading. Another reason may be the
small size of the futures contracts, compared to similar contracts in other countries. Retail
investors also dominate the markets for commodity derivatives, due in part to their long-standing
expertise in trading in the havala or forwards markets.

14. ACCOUNTING OF INDEX FUTURES TRANSACTIONS

This Section deals with Accounting of Derivatives and attempts to cover the Indian scenario in
some depth. The areas covered are Accounting for Foreign Exchange Derivatives and Stock
Index Futures. Stock Index Futures are provided more coverage as these have been introduced
recently and would be of immediate benefit to practitioners.

International perspective is also provided with a short discussion on fair value accounting. The
implications of Accounting practices in the US (FASB-133) are also discussed.
The Institute of Chartered Accountants of India has come out with a Guidance Note for
Accounting of Index Futures in December 2000. The guidelines provided here in this Section
below are in accordance with the contents of this Guidance Note.
14.1 Indian Accounting Practices
Accounting for foreign exchange derivatives is guided by Accounting Standard 11. Accounting
for Stock Index futures is expected to be governed by a Guidance Note shortly expected to be
issued by the Institute of Chartered Accountants of India.
14.1.1 Foreign Exchange Forwards
An enterprise may enter into a forward exchange contract, or another financial instrument that is
in substance a forward exchange contract to establish the amount of the reporting currency
required or available at the settlement date of transaction. Accounting Standard 11 provides that
the difference between the forward rate and the exchange rate at the date of the transaction
should be recognised as income or expense over the life of the contract. Further the profit or loss
arising on cancellation or renewal of a forward exchange contract should be recognised as
income or as expense for the period.
Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of loan installment and
interest. As on 1st December 1999, it appears to the company that the US $ may be dearer as
compared to the exchange rate prevailing on that date, say US $ 1 = Rs. 43.50. Accordingly,
XYZ Ltd may enter into a forward contract with a banker for US $ 3,00,000. The forward rate
may be higher or lower than the spot rate prevailing on the date of the forward contract. Let us
assume forward rate as on 1st December 1999 was US$ 1 = Rs. 44 as against the spot rate of Rs.
43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ Ltd $ 3,00,000 at Rs.
44 irrespective of the spot rate as on that date. Let us assume that the Spot rate as on that date be
US $ 1 = Rs. 44.80
In the given example XYZ Ltd gained Rs. 2,40,000 by entering into the forward contract.
Payment to be made as per forward contract (US $ 3,00,000 * Rs. 44) Rs 1,32,00,000
Amount payable had the forward contract not been in place (US $ 3,00,000 * Rs. 44.80)
Rs 1,34,40,000
Gain arising out of the forward exchange contract Rs 2,40,000
Recognition of expense/income of forward contract at the inception
AS-11 suggests that difference between the forward rate and Exchange rate of the transaction
should be recognised as income or expense over the life of the contract. In the above example,

the difference between the spot rate and forward rate as on 1st December is Rs.0.50 per US $. In
other words the total loss was Rs. 1,50,000 as on the date of forward contract.
Since the financial year of the company ends on 31st March every year, the loss arising out of the
forward contract should be apportioned on time basis. In the given example, the time ratio would
be 4 : 1; so a loss of Rs. 1,20,000 should be apportioned to the accounting year 1999-2000 and
the balance Rs. 30,000 should be apportioned to 2000-2001.
The Standard requires that the exchange difference between forward rate and spot rate on the
date of forward contract be accounted. As a result, the benefits or losses accruing due to the
forward cover are not accounted.
Profit/loss on cancellation of forward contract
AS-11 suggests that profit/loss arising on cancellation of renewal of a forward exchange should
recognised as income or as expense for the period.
In the given example, if the forward contract were to be cancelled on 1st March 2000 @ US $ 1
Rs. 44.90, XYZ Ltd would have sustained a loss @ Re. 0.10 per US $. The total loss on
cancellation of forward contract would be Rs. 30,000. The Standard requires recognition of this
loss in the financial year 1999-2000.
14.1.2 Stock Index Futures
Stock index futures are instruments where the underlying variable is a stock index future. Both
the Bombay Stock Exchange and the National Stock Exchange have introduced index futures in
June 2000 and permit trading on the Sensex Futures and the Nifty Futures respectively.
For example, if an investor buys one contract on the Bombay Stock Exchange, this will represent
50 units of the underlying Sensex Futures. Currently, both exchanges have listed Futures upto 3
months expiry. For example, in the month of September 2000, an investor can buy September
Series, October Series and November Series. The September Series will expire on the last
Thursday of September. From the next day (i.e. Friday), the December Series will be quoted on
the exchange.
Accounting of Index Futures
Internationally, fair value accounting plays an important role in accounting for investments and
stock index futures. Fair value is the amount for which an asset could be exchanged between a
knowledgeable, willing buyer and a knowledgeable, willing seller in an arms length transaction.
Simply stated, fair value accounting requires that underlying securities and associated derivative
instruments be valued at market values at the financial year end.
This practice is currently not recognised in India. Accounting Standard 13 provides that the
current investments should be carried in the financial statements as lower of cost and fair value
determined either on an individual investment basis or by category of investment. Current

investment is an investment that is by its nature readily realisable and is intended to be held for
not more than one year from the date of investment. Any reduction in the carrying amount and
any reversals of such reductions should be charged or credited to the profit and loss account.
On the disposal of an investment, the difference between the carrying amount and net disposal
proceeds should be charged or credited to the profit and loss statement.
The accounting suggestions provided in the Indian context in the following paragraphs should be
read in this perspective. The suggestions contained are based on the authors personal views on
the subject.
Daily Mark to Market
Stock index futures transactions are settled on a daily basis. Each evening, the closing price
would be compared with the closing price of the previous evening and profit or loss computed by
the exchange. The exchange would collect or pay the difference to the member-brokers on a
daily basis. The broker could further pay the difference to his clients on a daily basis.
Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements
could be difficult especially at the retail level).
Example: Mr. X purchases following two lots of Sensex Futures Contracts on 1st January 2009:
February 1, 2009 series
March 1, 2009 series

1 contract @
1 contract @

Rs.4,500
Rs.4,850

Mr X will be required to pay an Initial Margin before entering into these transactions. Suppose
the Initial Margin is 6%, the amount of Margin will come to Rs 28,050 (50 Units per Contract on
the Bombay Stock Exchange). The accounting entry will be :
Initial Margin Account Dr
To Bank

28,050
28050

If the daily settlement prices of the above Sensex Futures were as follows:
Date
February. Series
March. Series
01/01/09
4520
4850
02/01/09
4510
4800
03/01/09
4480
-04/01/09
4500
-05/01/09
4490
-Let us assume that Mr X he sold the November Series contract at Rs 4,810 . The amount of
Mark- to - Market Margin Money Sensex receivable/payable due to increase/decrease in daily
settlement prices is as below. Please note that one Contract on the Bombay Stock Exchange
implies 50 underlying Units of the Sensex.
Date

October Series October Series November Series

November Series

st

1 January 2009
2nd January 2009
3rd January 2009
4th January 2009
5th January 2009

Receive(RS)
1,000
1,000
-

Pay(RS)
500
1,500
500

Receive(RS)
-

Pay(RS)
2,500
-

The amount of Mark-to-Market Margin Money received/paid will be credited/debited to Markto-Market Margin Account on a day to day basis. For example, on the 4th of September the
following entry will be passed:
Bank A/c
To Mark-to-market Margin A/c

Dr. 1,000
1,000

On the 3rd of Jan 2009, Mr X will account for the profit or loss on the November Series Contract.
He purchased the Contract at Rs 4,850 and sold at Rs 4,810. He therefore suffered a loss of Rs 40
per Sensex Unit or Rs 2,000 on the Contract. This loss will be accounted on 6th Sept. Further, the
Initial Margin paid on the November Series will be refunded back on squaring up of the
transaction. This receipt will be accounted by crediting the Initial Margin Account so that this
Account is reduced to zero. The Mark to Margin Account will contain transactions pertaining to
this Futures Series. This component will also be reversed on 3rd of Jan 2009.
Bank Account
Dr
Loss on November Series Dr
Initial Margin
Mark to Market Margin

15,050
2,000
14,550
2,500

Margins maintained with Brokers

Brokers are expected to ensure that clients pay adequate margins on time. Brokers are not
permitted to pay up shortfalls from their pocket. Brokers may therefore insist that the clients
should pay them slightly higher margins than that demanded by the exchange and use this extra
collection to pay up daily margins as and when required.
If a client is called upon to pay further daily margins or receives a refund of daily margins from
his broker, the client would again account for this payment or refund in the Balance Sheet. The
margins paid would get reflected as Assets in the Balance Sheet and refunds would reduce these
Assets.
The client could square up any of his transactions any time. If transactions are not squared up,
the exchange would automatically square up all transactions on the day of expiry of the futures
series. For example, an October 2000 future would expire on the last Thursday, i.e. 26th October
2000. On this day, all futures transactions remaining outstanding on the system would be
compulsorily squared up.
Recognition of Profit or Loss

A basic issue which arises in the context of daily settlement is whether profits and losses accrue
from day to day or do they accrue only at the point of squaring up. It is widely believed that daily
settlement does not mean daily squaring up. The daily settlement system is an administrative
mechanism whereby the stock exchanges maintain a healthy system of controls. From an
accounting perspective, profits or losses do not arise on a day to day basis.
Thus, a profit or loss would arise at the point of squaring up. This profit or loss would be
recognized in the Profit & Loss Account of the period in which the squaring up takes place.
If a series of transactions were to take place and the client is unable to identify which particular
transaction was squared up, the client could follow the First In First Out method of accounting.
For example, if the October series of SENSEX futures was purchased on 11th October and again
on 12th October and sold on 16th October, it will be understood that the 11th October purchases
are sold first. The FIFO would be applied independently for each series for each stock index
future. For example, if November series of NIFTY are also purchased and sold, these would be
tracked separately and not mixed up with the October series of SENSEX.

Accounting at Financial Year End

In view of the underlying securities being valued at lower of cost or market value, a similar
principle would be applied to index futures also. Thus, losses if any would be recognized at the
year end, while unrealized profits would not be recognized.
A global system could be adopted whereby the client lists down all his stock index futures
contracts and compares the cost with the market values as at the financial year end. A total of
such profits and losses is struck. If the total is a profit, it is taken as a Current Liability. If the
total is a loss, a relevant provision would be created in the Profit & Loss Account.
The actual profit or loss would occur in the next year at the point of squaring up of the
transaction. This would be accounted net of the provision towards losses (if any) already effected
in the previous year at the time of closing of the accounts.
Example
A client has bought Sensex futures for Rs 2,00,000 on 1st March and Nifty futures for Rs
2,50,000 on 7th March. On the 31st of March, the market values of these futures are Rs 2,20,000
and Rs 2,35,000 respectively. He has not squared up these transactions as on 31st March.
The client has an unrealised profit of Rs 20,000 on the Sensex futures and an unrealised loss of
Rs 15,000 on the Nifty futures. As the net result is a profit, he will not account for any profit or
loss in this accounting period.

14.2 International Practices

Statement of Financial Accounting Standard No. 133 issued by the Financial Accounting
Standard Board, US defines the criteria /attributes which an instrument should have to be called
as derivative and also provides guidance for accounting of derivatives. The Standard is facing
tough opposition and controversies from the US business and industry.
What is a Derivative?
The standard defines a derivative as an instrument having following characteristics:

A derivatives cash flows or fair value must fluctuate or vary based on the changes in an
underlying variable.
The contract must be based on a notional amount of quantity. The notional amount is the
fixed amount or quantity that determines the size of change caused by the movement of
the underlying.
The contract can be readily settled by net cash payment

Accounting for Derivatives as per FAS 133\

The standard requires that every derivative instrument should be recorded in the Balance Sheet
as assets or liability at fair value and changes in fair value should be recognised in the year in
which it takes place.
The standard also calls for accounting the gains and losses arising from derivatives contracts. It
is important to understand the purpose of the enterprise while entering into the transaction
relating to the derivative instrument. The derivative instrument could be used as a tool for
hedging or could be a trading transaction unrelated to hedging. If it is not used as an hedging
instrument, the gain or loss on the derivative instrument is required to be recognised as profit or
loss in current earnings.
Derivatives used as hedging instruments
Derivative instruments used for hedging the fair value of a recognised asset or liability, are called
Fair Value Hedges. The gain or loss on such derivative instruments as well as the off setting loss
or gain on the hedged item shall be recognised currently in income.
Example
An individual having a portfolio consisting of shares of Infosys and BSES, may decide to hedge
this portfolio using the Sensex Futures Contract. The gain or loss on the index futures contract
would compensate the loss or gain on the portfolio. Both the gains and losses will be recognised

in the Profit and Loss Statement. If the hedge is perfect, gains and losses will offset each other
and hence will not have any impact on the current earnings. However, if the hedge is not a
perfect hedge, there would be a difference between the gain and the compensating loss. This
would affect the current reported earnings of the individual.
If the derivative instrument hedges risk of variations in cash flow on a recognised asset and
liability, it is called Cash Flow hedge. The gain or loss on such derivative instruments will be
transferred to current earnings of the same period or the periods during which the forecasted
transaction affects the earnings. The remaining gain or loss on the derivative instrument if any
shall be recognised currently in earnings.
Similarly if the derivative instrument hedges risk of exposures arising out of foreign currency
transactions or investments overseas or in subsidiaries, it is called Foreign Currency Hedge.
Hedge Recognition
Accounting treatment for trading and hedging is completely different. In order to qualify as a
hedge transaction, the company should at the inception of the transaction:

Designate the hedge relationship

Document such relationship
Identifying hedge item, hedge instrument and risks being hedged
Expect hedge to be highly effective
Lay down reasonable basis for assessment effectiveness. Ineffectiveness may be reported
in the current financial statements earnings.

Earlier there was no concept of partial effectiveness of hedge. However FASB recognised that
not all hedging transactions can be perfect. There can be a degree of ineffectiveness which
should be recognized. The Statement requires that the assessment of effectiveness must be
consistent with risk management strategies documented for that particular hedge relationship.
Further the assessment of effectiveness is required whenever financial statements or earnings are
reported.
Conclusion
The Indian accounting guidelines in this area need to be carefully reviewed. The international
trend is moving towards marking the underlying securities as well as associated derivative
instruments to market. Such a practice would bring into the accounts a clear picture of the impact
of derivatives related operations. Indian accounting is based on traditional prudence where
profits are not recognised till realisation. This practice, though sound in general, appears to be
inconsistent with reality in a highly liquid and vibrant area like derivatives.

15. TAXATION
The income-tax Act does not have any specific provision regarding taxability from derivatives.
The only provisions which have an indirect bearing on derivative transactions are sections 73(1)

and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business
carried on by the assessee, shall not be set off except against profits and gains, if any, of
speculative business. In the absence of a specific provision, it is apprehended that the derivatives
contracts, particularly the index futures which are essentially cash-settled, may be construed as
speculative transactions and therefore the losses, if any, will not be eligible for set off against
other income of the assessee and will be carried forward and set off against speculative income
only up to a maximum of eight years .As a result an investors losses or profits out of derivatives
even though they are of hedging nature in real sense, are treated as speculative and can be set off
only against speculative income.

16. IS THE DERIVATIVES MARKET MODEL A WEAK LINK?

Share futures are most successful in India than anywhere else in the world because they are
seen as a substitute for badla. The new system has to be better than the old one and not add
to risk in the market.
THE rise of 2007-08 in the Bombay Stock Exchange Sensitive Index (Sensex) is largely credited
to a robust economy, FII (foreign institutional investment) flows and the large liquidity in the
system on the back of reduced interest rates and the absence of more profitable avenues of
investment. A less talked about reason that needs equal consideration is the structure of the
derivatives market and the absence of physical deliveries.
The L. C. Gupta Committee the starting point and guiding beacon for the derivatives market
in India advocated that stock futures should be introduced only after a system for lending and
borrowing of shares is in place. It, therefore, visualized physical exchange of shares for settling
the trades executed in the futures market for individual stock futures. Instead of introducing the
lending and borrowing system, a short-cut was adopted and cash settlement insisted upon even
for individual stock futures.
The erstwhile Committee on Secondary Market believed that introducing a share lending and
borrowing mechanism would amount to badla. It, therefore, advocated that if stock futures are
introduced, they should be cash settled; no lending and borrowing mechanism was thought
necessary in such a model. All suggestions for making the Margin Trading System workable
were rejected as also ideas of lending and borrowing. The Committee put up its report twice on
its Web site, but did not accept any feedback from the market participants.
The connection between the current boom and the impact of cash settlement in the derivatives
market is physical settlement is a logical conclusion of the transactions done on the exchange.
Physical settlement implies that at the end of the contract period the investor's position would
lead to either giving or taking delivery. For purchases, the investor would get delivery and vice
versa. A lending and borrowing system is required for investors who have gone short and would
like to cover the position later on and hence would want to borrow stock. Margin trading is
needed for investors who require leveraging facility to take delivery.
One class of investors would like to square the position before the closing date and would hence
do a reverse trade in the market. Thus, every buy position results in a counter sale and vice versa.

Every investor who has short sold would have to go to the cash market and buy and give
delivery, or buy in the futures before the closing date.
In the absence of physical delivery, the system simply flushes out all trades at the end of the
month when the contract expires. There is no logical conclusion to the futures trade. On the last
day, cash is exchanged and the one-way traffic of buy does not have any speed-breaker of sale
transactions. The continuous balancing of buy and sell does not happen and the populist view
gets further propagated as the buyer does not have any obligation to take delivery.
He can pay a nominal margin and be rid of any further obligation to complete the trade.
Similarly, in a bear market the investor simply sells and then the trade is swept off the
outstanding book. Experts argue that as the deliveries in the derivatives markets are only in the 25 per cent range, why have them at all. It must be understood that this is resultant delivery after
the open positions have been squared, hence 98 per cent were counter trades. If it does not
provide for these counter trades then there will be no balancing factor in the market. For those
who want to manipulate the market it is easy to maintain the last day prices so that the square off
rates are high/low as desired. If all trades have to logically close, then such manipulations have
no place in the market.
A reverse trend in the market would follow the same path of one-way fall and the market would
just technically keep going down without any reason. Share futures are most successful in India
than anywhere else in the world because they are seen as a substitute for badla.
The new system has to be better than the old one and not add to risk in the market. The current
futures market without deliveries is more of a speculative avenue rather than fulfilling the need
of hedging. The fact that futures prices are at a discount shows that the underlying cash and the
futures markets are not in sync and operate in their own orbits. It is well known that the
derivatives market has been used to heavily short sell when the going was not good in banking
and PSU stocks.
The country takes great pride in following international best practices. In all developed countries,
derivative trades are delivery settled. The danger of a cash settled system is highlighted above.
After the experience of five years in the derivatives market, the regulator must look at the issue
on hand objectively. The size of derivatives market being bigger than the cash market,India
cannot afford a structurally weak system.

17. CURRENT DEVELOPMENTS

STATUS REPORT OF THE DEVELOPMENTS IN THE DERIVATIVE MARKET
The Board at its meeting on November 29, 2002 had desired that a quarterly report be submitted
to the Board on the developments in the derivative market. Accordingly, this memorandum
presents a status report for the quarter July-September 2008-09 on the developments in the
derivative market.
17.1 Equity Derivatives Segment

A. Observations on the quarterly data for July-September, 2008-09

During July-September 2008-09, the turnover at BSE was Rs.1,510 crore, which was
insignificant as compared to that of NSE at Rs. 3,315,491 crore.
Table-13: Fact file of July-September 2008-09 with respect to the previous quarter
MARKET

PRODUCT

DEPTH
VOLUME AND TURNOVER
INDEX FUTURE
INDEX OPTION
SINGLE STOCK
FUTURE
STOCK OPTION
TOTAL
MARKET SHARE (%)
INDEX FUTURE
INDEX OPTION
SINGLE STOCK
FUTURE
STOCK OPTION
Turnover in F&Oas multiple
of turnover in cash segment

APRIL - JUNE 2008-09

NO
OF TURNOVER
CONTRACTS
(LAKHS)
Rs
'000
CRORES

JULY - SEPTEMBER 2008-09

NO
OF TURNOVER
CONTRACTS
(LAKHS)
Rs
'000
CRORES

415.7
240.1
514.5

935.6
571.3
1093.1

542.6
521.2
599

1077.5
1130.9
1039.3

25.5
1195.8

58.3
2658.4

35.9
1698.7

69.1
3317

34.77
20.07
43.03

35.2
21.49
41.12

31.94
30.68
35.36

32.48
34.09
31.33

2.13
3.26

2.19

2.11
4.19

2.08

Market Concentration

Reliance

Reliance

(average
months)
of
3

5
most
active Reliance Petro. Ltd
scrips in
the F&O Segment Tata Steel
Reliance Capital Ltd
Infosys Tech. Ltd
contribution of the 23.72
above 5 to total
Derivatives
turnover (%)

Reliance Capital Ltd

client (excluding 59.77

FII
trades)
proprietary
27.88
FII
12.35

60.17

Reliance Petro. Ltd

State Bank of India
ICICI bank Ltd
25.12

31.07
8.76

Source: Internet

Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while turnover increased by
24.77% to Rs. 3,317 thousand crore in July-September 2008-09 over April-June 2008-09.

Futures (Index Future + Stock Future) constituted 67.20% of the total number of contracts
traded in the F&O Segment. Stock Future and Index Future accounted for 35.26% and
31.94% respectively.
Options constituted 32.80% of the total volumes. This mainly comprised of trading in Index
Option (30.68%).
Turnover at F&O segment was 4.19 times that of its cash segment.
Reliance, Reliance Capital Ltd, Reliance Petro. Ltd, State Bank of India and ICICI Bank Ltd
were the most actively traded scrips in the derivatives segment.
Together they contributed 25.12% of derivatives turnover in individual stocks.
Client trading constituted 60.17%, Propriety trading constituted 31.07% and FII trading
constituted remaining 8.76% of the total turnover.

Table- 14: Data for Shorter Dated and Longer dated Derivative Contracts
Time Period
(Quarter)

July - September
2008-09
April June
2008-09

Trades in Shorter Dated

Upto 3 months
No of
Contracts
Turnover
(lakh)
(Rs. '000 cr.)
1694.64
3307.11

Trades in Longer Dated

More than 3 months
No of
Contracts
Turnover
(lakh)
(Rs. '000 cr.)
3.99
9.87

1194.97

4.83

2655.88

12.5

Source: Internet

Volume in longer dated derivative contracts (contracts with maturity of more than three
months and upto 3 years) was 3.99 lakh and total turnover was Rs. 9870 crore.
Total volume in shorter dated derivative contracts (contracts with maturity upto 3 months)
was 1,695 lakh and total turnover was Rs. 3,307 thousand crore.

Table-15: Minimum, Maximum and Average Daily Volatility of the F&O segment at
NSE for S&P CNX Nifty since April 2008
Month
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08

Average
volatility (%)
2.47
1.71
1.8
2.85
2.27
2.28

Maximum
volatility (%)
2.98
1.99
2.28
3.08
2.61
2.51

Minimum
volatility (%)
2.05
1.56
1.61
2.38
2.1
2.09

Source: Internet

1. During July-September, 2008, S&P CNX Nifty futures recorded highest average daily
volatility of 2.85% in July 2008.
Table-16: Standing of India in World Derivatives Market (in terms of volume)

Products
Stock Future
Index Future
Stock Option
Index Option

Jul-08
1
2
9
4

Aug-08
1
2
15
4

Sep-08
2
2
16
4

Source: Internet

India stands 2nd in Stock

Futures, 2nd in Index Futures,
16th in Stock Option and 4th in

Index Options
(as on November 10, 2008) in World Derivatives Market (in terms of volume) at the end of
September 2008.
Derivative contracts were launched on 38 securities at National Stock Exchange during JulySeptember 2008-09.
B. Salient points for the 2nd quarter 2008-09

The volume (no. of contracts) and open interest in the derivatives market has increased even
when the underlying market is witnessing a downward trend. This indicates that there are
sufficient long position holders who anticipate value proposition in a falling market. Falling
or rising markets on the back of low volumes may be a cause of concern from the point of
market integrity. However, as observed from the data, under the present scenario the fall in
the market has been accompanied by high volumes.
In Index Option, there is a sharp increase in turnover (97.95%) and volume (117.08%) during
July-September 2008-09 over April-June 2008-09. Possible reasons for increase in options
trading activity can be attributed to increase in volatility. Market observers believe that
conditions across markets and asset classes have become more volatile and uncertain in the
recent past. Generally in such conditions, many people believe that options act as "insurance"
against adverse price movements while offering the flexibility to benefit from possible.
Favourable price movements at the same time. Another reason which can be attributed to
theincrease in activity is the new directive as per the Budget 2008-09 which states that STT
would now be levied on the Option premium instead of the strike price.
In Index Future, both turnover (15.17%) and volume (30.53%) have increased during JulySeptember 2008-09 as compared to April-June 2008-09.
There is a decrease in turnover (4.92%) in Single Stock Futures during July-September 200809 as compared to April-June 2008-09.
Except Index Option, the market share of all other products has decreased (both in terms of
volume and turnover) in second quarter of 2008-09 as compared to first quarter of 2008-09.
There is a decrease in turnover (21.04%) and volume (17.39%) in Longer Dated derivative
contracts in second quarter of 2008-09 as compared to the first quarter of 2008-09.
Longer dated derivatives were launched in March 2008, but the volumes have not picked up
consequently.
For shorter dated derivative contracts, turnover increased by 24.52% whereas volume
increased by 4.81% in second quarter of 2008-09 as compared to the first quarter of 2008-09.
During 2008-09, Mini Nifty volumes increased by 49.15% and turnover increased by 33.43%
during July-September 2008-09 over April-June 2008-09.

17.2

Currency Derivatives Segment

A. Observations for July-September, 2008-09

Trading in currency derivatives started on August 29, 2008 at NSE, on October 1, 2008 at BSE
and on October 7, 2008 at MCX-SX. Therefore, for the quarter (July-September, 2008-09), data
for currency derivatives trading on NSE has been analysed using data for September 2008.
Table-17: Status of Currency Futures trading for the month of September, 2008
PARAMETER

Volume
turnover

& For the Current Month

For the Previous Month*(* - Only 1 Trading day in the
month of August 2008)

Market Depth Market share of top 10 members (%)(Note a)

during
the
month
SGF at the end of the month
No. of members who did Rs. 1 crore or more of turnover
during the month (Note a)
Open Interest For the Current Month*(*- As on 30-Sep-2008)(Note b)
at the end of
the month

NSE
No of
Contracts
1,192,301
65,798

Turnover (Rs
crore)
5,471.97
291.05

1,250,493 5,736.98
52.44%
52.42%
Rs.131.17 crore
136 members

90,871

Rs.428.38
crore

16,332

Rs.72.12
crore

86,567

Rs.408.08
crore
47.63%

For the Previous Month*(*-As on 29-Aug-2008)(Note b)

Open Interest Share of top 10 members in Open Interest (As on 30-Sep(%)

2008)(Note c)

Volatility (%)

Turnover(%)

No.of
members
registered

Source: Internet

Notes:

Average Volatility (Note d)

Maximum Volatility
Minimum Volatility
Clients
Trading Member (Non-Bank)
Trading Member (Bank)
Trading Members (Banks)
Trading Members (non-Banks)
Clearing Member (Banks)
Clearing Member (non-Banks)
Tradingcum-Clearing Member (Banks)
Tradingcum-Clearing Member (non-Banks)
Total

47.63%
0.6125
0.7237
0.498
45.93
46.6
7.47
3
241
NIL
3
13
82
342

a) Data for Market share of Top 10 members, No. of members who did Rs.1 crore or more of
turnover and participant-wise turnover is on the basis of gross turnover
b) Open Interest is computed as (Settlement Price * Open Interest Contract)
c) Data for share of top 10 members in Open Interest is on the basis of gross open position
d) Volatility numbers pertain to end of day volatility for near month futures contracts computed
using exponential moving average.

During the month of September 2008, 1,192,301 contracts were traded in the currency
futures segment and the value of traded contracts was Rs. 5,472 crore.
Open interest at the end of September 2008, in terms of number of contracts was 90,871 and
in terms of value of contracts, was Rs. 428 crore.
Top ten members in the currency derivatives segment of NSE contributed 52.42% of the total
turnover and 52.44% of the total contracts traded during the month of September 2008.
The Settlement Guarantee Fund at the end of the month amounted to Rs.131 crore.
There were 136 members who did Rs 1 crore or more of turnover during September 2008.
Average, maximum and minimum volatility during September, 2008 was 0.6125%, 0.7237%
and 0.4980% respectively.
During September 2008, clients contributed 45.93%, trading members (Non-Banks)
contributed 46.60% and trading member (Banks) contributed 7.47% of the total turnover.
342 members were registered in the currency futures segment of NSE at the end of
September 2008.

Table-18: Status of Currency Futures trading for the month of October, 2008
Name of the Exchange
No. of Contracts
Turnover (Rs. cr)
Open Interest (No.of Contracts)
Open Interest (Turnover, Rs. cr.)

NSE
2,275,261
11,141.93
170,202
851.27

BSE
161,502
765.13
10,546
52.83

MCX-SX
1,119,968
5,521.20
60,055
299.94

Source: Internet

During the month of October 2008, at NSE 2,275,261 contracts, at BSE 161,502 contracts
and at MCX-SX 1,119,968 contracts were traded in the currency futures segment.

Total turnover during October 2008, at NSE was Rs. 11,142 crore at BSE Rs.765 crore and at
MCX-SX was Rs.5,521 crore, in the currency futures segment.
Open interest at the end of October 2008, in terms of number of contracts was 170,202 for
NSE, 10,546 for BSE and 60,055 for MCX-SX.

Status of Derivatives Market Review Committee

The Committee had its meeting on October 21-22, 2008 to take into account developments since
February 2008 and finalise its report for submission to SEBI. The Committee is expected to
submit the same at an early date.
Policy developments during July-September 2008

i. Extending calendar spread treatment till expiry of the near month contract:
SEBI, vide Circular No. SEBI/DNPD/Cir-39/2008 dated August 8, 2008 the benefit of the
calendar spread treatment was extended till the expiry of the near month contract. The margin on
calendar spread remains unchanged at a flat rate of 0.5% per month of spread on the far month
contract subject to a minimum margin of 1% and a maximum margin of 3% on the far side of the
spread with legs upto 1 year
apart.
ii. Exchange traded Currency Derivatives: SEBI, vide Circular No. SEBI/DNPD/Cir-38/2008
dated August 06, 2008 issued guidelines on Exchange Traded Currency Derivatives. The Circular
lays down the framework for the launch of Exchange Traded Currency Futures in terms of
eligibility norms for existing and new Exchanges and their Clearing Corporations/Houses,
eligibility criteria for members of such Exchanges/Clearing Corporations/Houses, product
design, risk management measures, surveillance mechanism and other related issues.
iii. Exchange traded Interest Rate Derivatives: The first meeting of RBI-SEBI Standing
Technical Committee was held on September 8, 2008 followed by another meeting on September
30, 2008 for operationalising Exchange Traded Interest Rate Derivatives. The Committee is
examining various risk management measures with regard to 3 products i.e., 91-day Treasury
Bill Futures, Short Term
Interest Rate Future based on an Index of actual call rates and Notional Coupon Bearing 10 Year
Long Bond Futures and is expected to take a final decision on the various issues shortly.
The memorandum is placed before the Board for its perusal.

18. FINDINGS OF THE STUDY

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.

Many Foreign brokers are boosting their presence in India in reaction to

the growth in derivatives.

The variety of derivatives instruments available for trading is also

expanding.

Liquidity and transparency are important properties of any developed

market.

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.

Institutions are required to devote more resources to develop the

business processes and technology necessary for derivatives trading.

Regulatory reforms are required to help markets grow faster. For

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.

A proper framework to account for derivatives needs to be developed.

The use of value at risk (VaR) model, which predicts the amount of
money that a bank might loose in trading activities during a given time
horizon, has prompted the introduction of more sophisticated methods
to measure market risk and to implement the corresponding risk
management procedures.

19. BIBLIOGRAPHY
Knowledge Base Websites:

http://www.capitalmarket.com/personal/pfdebent.htm
http://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf
http://www.sebi.gov.in/faq/derivativesfaq.html
http://library.thinkquest.org/11372/data/c-cmi.htm
http://en.wikipedia.org/wiki/Derivatives_market
http://www.ivestopedia.com
http://www.yahoofinance.com

Database Websites:

 http://www.nseindia.com
http://www.bseindia.com
http://www.amfiindia.com
Magzines And Newspapers and Survey Reports:

Economic Times Newspaper

Business World Magazine
Mutual Funds Insights
Investime
Investment Horizon
IOMA Derivatives Market Survey 2008
ICFAI journals derivatives : Literature Review
A Report formulated by The author, Deena Mehta a former President of the Bombay
Stock Exchange