INDEX

Ser. Contents Page No

No.
1. Introduction 3
2. Basics of Derivatives 3
3. Common forms of Derivatives 4-6
4. Advantages and disadvantages of derivatives 6-7
5. Derivatives in Finance 7-10
6. Development of Financial Derivatives Market in India 10-15

7. Conclusion 15
8. References 16
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Introduction.

1. Derivatives are not new financial instruments. For example, the emergence of the first
futures contracts can be traced back to the second millennium BC in Mesopotamia. However,
the financial instrument was not widely used until the 1970s. The introduction of new valuation
techniques sparked the rapid development of the derivatives market. Nowadays, we cannot
imagine modern finance without derivatives.

2. A derivative is a financial security with a value that is reliant upon or derived from, an
underlying asset or group of assets — a benchmark. The derivative itself is a contract between
two or more parties, and the derivative derives its price from fluctuations in the underlying
asset. Derivatives are financial contracts whose value is linked to the value of an
underlying asset. They are complex financial instruments that are used for various purposes,
including hedging and getting access to additional assets or markets.

3. The most common underlying assets for derivatives are stocks, bonds, commodities,
currencies, interest rates, and market indexes. These assets are commonly purchased through
brokerages. Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives
constitute a greater proportion of the derivatives market. OTC-traded derivatives, generally
have a greater possibility of counterparty risk. Counterparty risk is the danger that one of the
parties involved in the transaction might default. These parties trade between two private
parties and are unregulated. Conversely, derivatives that are exchange-traded are standardized
and more heavily regulated.

Basics of Derivative.

4. Derivatives can be used to hedge a position, speculate on the directional movement of

an underlying asset, or give leverage to holdings. Their value comes from the fluctuations of
the values of the underlying asset. Originally, derivatives were used to ensure balanced
exchange rates for goods traded internationally. With the differing values of national
currencies, international traders needed a system to account for differences. Today, derivatives
are based upon a wide variety of transactions and have many more uses. There are even
derivatives based on weather data, such as the amount of rain or the number of sunny days in
a region.

5. For example, imagine a European investor, whose investment accounts are all
denominated in euros (EUR). This investor purchases shares of a U.S. company through a U.S.
exchange using U.S. dollars (USD). Now the investor is exposed to exchange-rate risk while
holding that stock. Exchange-rate risk the threat that the value of the euro will increase in
relation to the USD. If the value of the euro rises, any profits the investor realizes upon selling
the stock become less valuable when they are converted into euros. To hedge this risk, the
investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives
that could be used to hedge this kind of risk include currency futures and currency swaps. A
speculator who expects the euro to appreciate compared to the dollar could profit by using a
derivative that rises in value with the euro. When using derivatives to speculate on the price
movement of an underlying asset, the investor does not need to have a holding or portfolio
presence in the underlying asset.
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Common Forms of Derivatives.

6. There are many different types of derivatives that can be used for risk management,
for speculation, and to leverage a position. Derivatives is a growing marketplace and offer
products to fit nearly any need or risk tolerance.

(a) Futures. A futures contract—also known as simply a futures—is an

agreement between two parties for the purchase and delivery of an asset at an agreed
upon price at a future date. Futures trade on an exchange, and the contracts are
standardized. Traders will use a futures contract to hedge their risk or speculate on the
price of an underlying asset. The parties involved in the futures transaction are
obligated to fulfill a commitment to buy or sell the underlying asset. For example, say
that Nov. 6, 2019, Company-A buys a futures contract for oil at a price of $62.22 per
barrel that expires Dec. 19, 2019. The company does this because it needs oil in
December and is concerned that the price will rise before the company needs to buy.
Buying an oil futures contract hedges the company's risk because the seller on the other
side of the contract is obligated to deliver oil to Company-A for $62.22 per barrel once
the contract has expired. Assume oil prices rise to $80 per barrel by Dec. 19, 2019.
Company-A can accept delivery of the oil from the seller of the futures contract, but if
it no longer needs the oil, it can also sell the contract before expiration and keep the
profits. In this example, it is possible that both the futures buyer and seller were hedging
risk. Company-A needed oil in the future and wanted to offset the risk that the price
may rise in December with a long position in an oil futures contract. The seller could
be an oil company that was concerned about falling oil prices and wanted to eliminate
that risk by selling or "shorting" a futures contract that fixed the price it would get in
December. It is also possible that the seller or buyer—or both—of the oil futures parties
were speculators with the opposite opinion about the direction of December oil. If the
parties involved in the futures contract were speculators, it is unlikely that either of
them would want to make arrangements for delivery of several barrels of crude oil.
Speculators can end their obligation to purchase or delivery the underlying commodity
by closing—unwinding—their contract before expiration with an offsetting contract.
For example, the futures contract for West Texas Intermediate (WTI) oil trades on the
CME represents 1,000 barrels of oil. If the price of oil rose from $62.22 to $80 per
barrel, the trader with the long position—the buyer—in the futures contract would
have profited $17,780 [($80 - $62.22) X 1,000 = $17,780]. The trader with the short
position—the seller—in the contract would have a loss of $17,780. Not all futures
contracts are settled at expiration by delivering the underlying asset. Many derivatives
are cash-settled, which means that the gain or loss in the trade is simply an accounting
cash flow to the trader's brokerage account. Futures contracts that are cash settled
include many interest rate futures, stock index futures, and more unusual instruments
like volatility futures or weather futures.

(b) Forwards. Forward contracts—known simply as forwards—are similar to

futures, but do not trade on an exchange, only over-the-counter. When a forward
contract is created, the buyer and seller may have customized the terms, size and
settlement process for the derivative. As OTC products, forward contracts carry a
greater degree of counterparty risk for both buyers and sellers. Counterparty risks are a
kind of credit risk in that the buyer or seller may not be able to live up to the obligations
outlined in the contract. If one party of the contract becomes insolvent, the other party
may have no recourse and could lose the value of its position. Once created, the parties
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in a forward contract can offset their position with other counterparties, which can
increase the potential for counterparty risks as more traders become involved in the
same contract.

(c) Swaps. Swaps are another common type of derivative, often used to
exchange one kind of cash flow with another. For example, a trader might use
an interest rate swap to switch from a variable interest rate loan to a fixed interest rate
loan, or vice versa. Imagine that Company XYZ has borrowed $1,000,000 and pays a
variable rate of interest on the loan that is currently 6%. XYZ may be concerned about
rising interest rates that will increase the costs of this loan or encounter a lender that is
reluctant to extend more credit while the company has this variable rate risk. Assume
that XYZ creates a swap with Company QRS, which is willing to exchange the
payments owed on the variable rate loan for the payments owed on a fixed rate loan of
7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS
will pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ
will just pay QRS the 1% difference between the two swap rates. If interest rates fall so
that the variable rate on the original loan is now 5%, Company XYZ will have to pay
Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS
would have to pay XYZ the 1% difference between the two swap rates. Regardless of
how interest rates change, the swap has achieved XYZ's original objective of turning a
variable rate loan into a fixed rate loan. Swaps can also be constructed to exchange
currency exchange rate risk or the risk of default on a loan or cash flows from other
business activities. Swaps related to the cash flows and potential defaults of mortgage
bonds are an extremely popular kind of derivative—a bit too popular. In the past. It was
the counterparty risk of swaps like this that eventually spiraled into the credit crisis of
2008.

(d) Options. An options contract is similar to a futures contract in that it is an

agreement between two parties to buy or sell an asset at a predetermined future date for
a specific price. The key difference between options and futures is that, with an option,
the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity
only, not an obligation—futures are obligations. As with futures, options may be used
to hedge or speculate on the price of the underlying asset. Imagine an investor owns
100 shares of a stock worth $50 per share they believe the stock's value will rise in the
future. However, this investor is concerned about potential risks and decides to hedge
their position with an option. The investor could buy a put option that gives them the
right to sell 100 shares of the underlying stock for $50 per share—known as the strike
price—until a specific day in the future—known as the expiration date. Assume that
the stock falls in value to $40 per share by expiration and the put option buyer decides
to exercise their option and sell the stock for the original strike price of $50 per share.
If the put option cost the investor $200 to purchase, then they have only lost the cost of
the option because the strike price was equal to the price of the stock when they
originally bought the put. A strategy like this is called a protective put because it hedges
the stock's downside risk. Alternatively, assume an investor does not own the stock that
is currently worth $50 per share. However, they believe that the stock will rise in value
over the next month. This investor could buy a call option that gives them the right to
buy the stock for $50 before or at expiration. Assume that this call option cost $200 and
the stock rose to $60 before expiration. The call buyer can now exercise their option
and buy a stock worth $60 per share for the $50 strike price, which is an initial profit
of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less
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the cost of the option—the premium—and any brokerage commission fees. In both
examples, the put and call option sellers are obligated to fulfill their side of the contract
if the call or put option buyer chooses to exercise the contract. However, if a stock's
price is above the strike price at expiration, the put will be worthless and the seller—
the option writer—gets to keep the premium as the option expires. If the stock's price
is below the strike price at expiration, the call will be worthless and the call seller will
keep the premium. Some options can be exercised before expiration. These are known
as American-style options, but their use and early exercise are rare.

7. Advantages of Derivatives. As the above examples illustrate, derivatives can be a

useful tool for businesses and investors alike. They provide a way to lock in prices, hedge
against unfavorable movements in rates, and mitigate risks—often for a limited cost. In
addition, derivatives can often be purchased on margin—that is, with borrowed funds—which
makes them even less expensive.

(a) Hedging risk exposure. Since the value of the derivatives is linked to the
value of the underlying asset, the contracts are primarily used for hedging risks. For
example, an investor may purchase a derivative contract whose value moves in the
opposite direction to the value of an asset the investor owns. In this way, profits in the
derivative contract may offset losses in the underlying asset.

(b) Underlying asset price determination. Derivates are frequently used to

determine the price of the underlying asset. For example, the spot prices of the futures
can serve as an approximation of a commodity price.

(c) Market efficiency. It is considered that derivatives increase the efficiency of

financial markets. By using derivative contracts, one can replicate the payoff of the
assets. Therefore, the prices of the underlying asset and the associated derivative tend
to be in equilibrium to avoid arbitrage opportunities.

(d) Access to unavailable assets or markets. Derivatives can help

organizations get access to otherwise unavailable assets or markets. By employing
interest rate swaps, a company may obtain a more favorable interest rate relative to
interest rates available from direct borrowing.

8. Downside of Derivatives. On the downside, derivatives are difficult to value

because they are based on the price of another asset. The risks for OTC derivatives include
counter-party risks that are difficult to predict or value as well. Most derivatives are also
sensitive to changes in the amount of time to expiration, the cost of holding the underlying
asset, and interest rates. These variables make it difficult to perfectly match the value of a
derivative with the underlying asset.

(a) High risk. The high volatility of the derivatives exposes them to potentially
huge losses. The sophisticated design of the contracts makes the valuation extremely
complicated or even impossible. Thus, they bear a high inherent risk.

(b) Speculative features. Derivatives are widely regarded as a tool of speculation.

Due to the extremely risky nature of derivatives and their unpredictable behavior,
unreasonable speculation may lead to huge losses.
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(c) Counter-party risk. Although derivatives traded on the exchanges generally

go through a thorough due diligence process, some of the contracts traded over-the-
counter do not include a benchmark for due diligence. Thus, there is a possibility of
counter-party default.

9. Pros of Derivatives. Lock in prices, hedge against risk, can be leveraged and diversify
portfolio.

10. Cons of Derivatives. Hard to value, subject to counterparty default (if OTC), complex
to understand and sensitive to supply and demand factors.

11. The derivative itself has no intrinsic value—its value comes only from the underlying
asset—it is vulnerable to market sentiment and market risk. It is possible for supply and demand
factors to cause a derivative's price and its liquidity to rise and fall, regardless of what is
happening with the price of the underlying asset. Finally, derivatives are usually leveraged
instruments, and using leverage cuts both ways. While it can increase the rate of return it also
makes losses mount more quickly.

12. Real World Example of Derivatives. Many derivative instruments

are leveraged. That means a small amount of capital is required to have an interest in a large
amount of value in the underlying asset. For example, an investor who expects the S&P 500
Index to rise in value could buy a futures contract based on that venerable equity index of the
largest U.S. publicly traded companies. The notional value of a futures contract on the S&P
500 is $250,000. However, as of April 2019, the exchange where the S&P500 option trades—
the Chicago Mercantile Exchange (CME)—only requires $31,500 in a margin balance to
maintain a long position in it. This gives the futures investor a leverage ratio of approximately
8:1. The required margin to hold a futures or derivative position changes depending on market
conditions and broker requirements.

13. Derivatives in Finance. Derivatives are instruments to manage financial risks.

Since risk is an inherent part of any investment, financial markets devised derivatives as their
own version of managing financial risk. Derivatives are structured as contracts and derive their
returns from other financial instruments. If the market consisted of only simple investments
like stocks and bonds, managing risk would be as easy as changing the portfolio
allocation among risky stocks and risk-free bonds. However, since that is not the case, risk can
be handled in several other ways. Derivatives are one of the ways to insure your investments
against market fluctuations. A derivative is defined as a financial instrument designed to earn
a market return based on the returns of another underlying asset. It is aptly named after its
mechanism; as its payoff is derived from some other financial instrument. Derivatives are
designed as contracts signifying an agreement between two different parties, where both are
expected to do something for each other. It could be as simple as one party paying some money
to the other and in return, receiving coverage against future financial losses. There also could
be a scenario where no money payment is involved up front. In such cases, both the parties
agree to do something for each other at a later date. Derivative contracts also have a limited
and defined life. Every derivative commences on a certain date and expires on a later date.
Generally, the payoff from a certain derivative contract is calculated and/or is made on the
termination date, although this can differ in some cases. As stated in the definition, the
performance of a derivative is dependent on the underlying asset’s performance. Often this
underlying asset is simply called as an “underlying”. This asset is traded in a market where
both the buyers and the sellers mutually decide its price, and then the seller delivers the
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underlying to the buyer and is paid in return. Spot or cash price is the price of the underlying
if bought immediately.

14. Derivative Categories. Generally, the derivatives are classified into two broad
categories i.e. Forward Commitments and Contingent Claims.

15. Forward Commitments. Forward commitments are contracts in which the parties
promise to execute the transaction at a specific later date at a price agreed upon in the
beginning. These contracts are further classified as follows :-

(a) Over the Counter Contracts. Over the counter contracts are of two
types :-

(i) Forward. In this type of contract, one party commits to buy and the
other commits to sell an underlying asset at a certain price on a certain future
date. The underlying can either be a physical asset or a stock. The loss or gain
of a particular party is determined by the price movement of the asset. If the
price increases, the buyer incurs a gain as he still gets to buy the asset at the
older and lower price. On the other hand, the seller incurs a loss in the same
scenario.

(ii) Swap. Swap can be defined as a series of forward derivatives. It is

essentially a contract between two parties where they exchange a series of cash
flows in the future. One party will consent to pay the floating interest rate on a
principal amount while the other party will pay a fixed interest rate on the same
amount in return. Currency and equity returns swaps are the most commonly
used swaps in the markets.

(b) Exchange Traded Contracts. Exchange traded forward commitments

are called futures. A future contract is another version of a forward contract, which is
exchange-traded and standardized. Unlike forward contracts, future contracts are
actively traded in the secondary market, have the backing of the clearinghouse, follow
regulations and involve a daily settlement cycle of gains and losses.
16. Contingent Claims. Contingent claims are contracts in which the payoff depends on
the occurrence of a certain event. Unlike forward commitments where the contract is bound to
be settled on or before the termination date, contingent claims are legally obliged to settle the
contract only when a specific event occurs. Contingent claims are also categorized into OTC
and exchange-traded contracts, depending on the type of contract. The contingent claims are
further sub-divided into the following types of derivatives :-

(a) Options. Options are the type of contingent claims that are dependent on
the price of the underlying at a future date. Unlike the forward commitments derivatives
where payoffs are calculated keeping the movement of the price in mind, the options
have payoffs only if the price of the underlying crosses a certain threshold. Options are
of two types: Call and Put. A call option gives the option holder right to buy the
underlying asset at exercise or strike price. A put option gives the option holder right
to sell the underlying asset at exercise or strike price.
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(b) Interest Rate Options. Options where the underlying is not a physical
asset or a stock, but the interest rates. It includes Interest Rate Cap, floor and collar
agreement. Further forward rate agreement can also be entered upon.

(c) Warrants. Warrants are the options which have a maturity period of more
than one year and hence, are called long-dated options. These are mostly OTC
derivatives.
(d) Convertible Bonds. Convertible bonds are the type of contingent claims that
gives the bondholder an option to participate in the capital gains caused by the upward
movement in the stock price of the company, without any obligation to share the losses.

(e) Callable Bonds. Callable bonds provide an option to the issuer to

completely pay off the bonds before their maturity.

(f) Asset-Backed Securities. Asset-backed securities are also a type of

contingent claim as they contain an optional feature, which is the prepayment option
available to the asset owners.

(g) Options on Futures. A type of options that are based on the futures contracts.

(h) Exotic Options. These are the advanced versions of the standard options,
having more complex features.

17. In addition to the categorization of derivatives on the basis of payoffs, they are also
sub-divided on the basis of their underlying asset. Since a derivative will always have an
underlying asset, it is common to categorize derivatives on the basis of the asset. Equity
derivatives, weather derivatives, interest rate derivatives, commodity derivatives, exchange
derivatives, etc. are the most popular ones that derive their name from the asset they are based
on. There are also credit derivatives where the underlying is the credit risk of the investor or
the government. Derivatives take their inspiration from the history of mankind. Agreements
and contracts have been used for ages to execute commercial transactions and so is the case
with derivatives. Likewise, financial derivatives have also become more important and
complex to execute smooth financial transactions. This makes it important to understand the
basic characteristics and the type of derivatives available to the players in the financial market.

18. Use of Financial Derivatives by Banks. In retail banking a bank attracts deposits
and makes loans. The difference between interest rates on loans and on deposits creates a profit.
So how would low or zero interest rates affect the profit potential from retail banking and can
you see an incentive for larger banks to engage in potentially more profitable activities like
derivatives. Banks play double roles in derivatives markets. Banks are intermediaries in the
OTC (over the counter) market, matching sellers and buyers, and earning commission fees.
However, banks also participate directly in derivatives markets as buyers or sellers; they are
end-users of derivatives. First, let’s see how banks use derivatives to buy protection on their
own behalf. Banks use derivatives to hedge, to reduce the risks involved in the bank’s
operations. For example, a bank’s financial profile might make it vulnerable to losses from
changes in interest rates. The bank could purchase interest rate futures to protect itself. Or a
pension fund can protect itself against credit default. Suppose it has invested in corporate bonds
and would like to purchase insurance against the possibility of default. The pension fund could
purchase a credit default swap (or CDS). The seller (or writer) of the CDS promises to pay the
face value of the bond if the bond becomes worthless. AIG, bailed out in 2008, had written
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CDSs on over $500billion of assets, including $78billion on complex securities backed by

mortgages and other loans. For every derivative transaction there are two sides – one party
wants to protect themselves against risk, and another party is willing to take on that risk, for a
fee. So how do banks take on risk? Suppose you have invested in a stock. To protect yourself
against potential price falls you could purchase a put option from a bank. You pay an option
premium and buy the right to sell the stock at an agreed price at an agreed date. At that date, if
the stock price has fallen significantly, you can exercise the option and sell the stock at the
agreed exercise price. The bank receives the option premium, and they take on the risk that
they may have to buy the stock from you at a price much higher than the market price. Over
the period 2004–08 Berkshire Hathaway earned $4.8billion in premiums for writing 15-year
put option contracts on the S&P500 and FTSE100 indices. An important difference between
banks and non-financial firms is that banks have to abide by capital regulations. Banks cannot
lend all their capital; they are required to hold a proportion of the bank’s total capital (eg, 8%)
to sustain operational losses and to honour withdrawals. What is the significance of this? On
the one hand, banks are motivated to operate in the derivatives market to compensate for the
regulatory capital. On the other hand, losses on derivatives may cause a bank not to have
sufficient regulatory capital, which means the bank is not well prepared to deal with shocks in
the financial system. This happened in the 2007–08 global financial crisis.

Development of Financial Derivatives Market in India

19. Risk is a characteristic feature of all commodity and capital markets. Over time,
variations in the prices of agricultural and non-agricultural commodities occur as a result of
interaction of demand and supply forces. The last two decades have witnessed a many-fold
increase in the volume of international trade and business due to the ever growing wave of
globalization and liberalization sweeping across the world. As a result, financial markets have
experienced rapid variations in interest and exchange rates, stock market prices thus exposing
the corporate world to a state of growing financial risk. Increased financial risk causes losses
to an otherwise profitable organisation. This underlines the importance of risk management to
hedge against uncertainty. Derivatives provide an effective solution to the problem of risk
caused by uncertainty and volatility in underlying asset. Derivatives are risk management tools
that help an organisation to effectively transfer risk. Derivatives are instruments which have no
independent value. Their value depends upon the underlying asset. The underlying asset may
be financial or non-financial. There is a need to discuss the genesis of derivatives trading by
tracing its historical development, types of traded derivatives products, regulation and policy
developments, trend and growth, future prospects and challenges of derivative market in India.
20. Definition of Financial Derivatives. Section 2(ac) of Securities Contract
Regulation Act (SCRA) 1956 defines Derivative as 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 and a contract which derives its value from the prices, or index of prices,
of underlying securities.
21. Underlying Asset in a Derivatives Contract. As defined above, the value of a
derivative instrument depends upon the underlying asset. The underlying asset may assume
many forms i.e. Commodities including grain, coffee beans, orange juice; Precious metals like
gold and silver, Foreign exchange rates or currencies, Bonds of different types, including
medium to long term negotiable debt securities issued by governments, companies etc, Shares
and share warrants of companies traded on recognized stock exchanges and Stock Index, Short
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term securities such as T-bills and Over- the Counter (OTC)1 money market products such as
loans or deposits.
22. Participants in Derivatives Market.
(a) Hedgers. They use derivatives markets to reduce or eliminate the risk
associated with price of an asset. Majority of the participants in derivatives market
belongs to this category.
(b) Speculators. They transact 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.
(c) Arbitrageurs. Their behaviour is guided by the desire to take advantage of a
discrepancy between prices of more or less the same assets or competing assets in
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.
23. Applications of Financial Derivatives. Some of the applications of financial
derivatives can be enumerated as follows :-
(a) Management of risk. This is most important function of derivatives. Risk
management is not about the elimination of risk rather it is about the management of
risk. Financial derivatives provide a powerful tool for limiting risks that individuals and
organizations face in the ordinary conduct of their businesses. It requires a thorough
understanding of the basic principles that regulate the pricing of financial derivatives.
Effective use of derivatives can save cost, and it can increase returns for the
organisations.
(b) Efficiency in trading. Financial derivatives allow for free trading of risk
components and that leads to improving market efficiency. Traders can use a position
in one or more financial derivatives as a substitute for a position in the underlying
instruments. In many instances, traders find financial derivatives to be a more attractive
instrument than the underlying security. This is mainly because of the greater amount
of liquidity in the market offered by derivatives as well as the lower transaction costs
associated with trading a financial derivative as compared to the costs of trading the
underlying instrument in cash market.
(c) Speculation. This is not the only use, and probably not the most important
use, of financial derivatives. Financial derivatives are considered to be risky. If not used
properly, these can leads to financial destruction in an organisation like what happened
in Barings Plc. However, these instruments act as a powerful instrument for
knowledgeable traders to expose themselves to calculated and well understood risks in
search of a reward, that is, profit.
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(d) Price discover. Another important application of derivatives is the price

discovery which means revealing information about future cash market prices through
the futures market. erivatives markets provide a mechanism by which diverse and
scattered opinions of future are collected into one readily discernible number which
provides a consensus of knowledgeable thinking.
(e) Price stabilization function. Derivative market helps to keep a stabilising
influence on spot prices by reducing the short-term fluctuations. In other words,
derivative reduces both peak and depths and leads to price stabilisation effect in the
cash market for underlying asset.
24. History of Derivatives Markets in India. Derivatives markets in India have been in
existence in one form or the other for a long time. In the area of commodities, the Bombay
Cotton Trade Association started futures trading way back in 1875. In 1952, the Government
of India banned cash settlement and options trading. Derivatives trading shifted to informal
forwards markets. In recent years, government policy has shifted in favour of an increased role
of market-based pricing and less suspicious derivatives trading. The first step towards
introduction of financial derivatives trading in India was the promulgation of the Securities
Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in
securities. The last decade, beginning the year 2000, saw lifting of ban on futures trading in
many commodities. Around the same period, national electronic commodity exchanges were
also set up. Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities
and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges,
NSE and BSE, and their clearing house/corporation to commence trading and settlement in
approved derivatives contracts. Initially, SEBI approved trading in index futures contracts
based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently,
index-based trading was permitted in options as well as individual securities. The trading in
BSE Sensex options commenced on June 4, 2001 and the trading in options on individual
securities commenced in July 2001. Futures contracts on individual stocks were launched in
November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index
futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading
in options on individual securities commenced on July 2, 2001. Single stock futures were
launched on November 9, 2001. The index futures and options contract on NSE are based on
S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently
banned due to pricing issue.
25. Regulation of Derivatives Trading in India. The regulatory framework in India
is based on the L.C. Gupta Committee Report, and the J.R. Varma Committee Report. It is
mostly consistent with the IOSCO principles and addresses the common concerns of investor
protection, market efficiency and integrity and financial integrity. The L.C. Gupta Committee
Report provides a perspective on division of regulatory responsibility between the exchange
and the SEBI. It recommends that SEBI’s role should be restricted to approving rules, bye laws
and regulations of a derivatives exchange as also to approving the proposed derivatives
contracts before commencement of their trading. It emphasises the supervisory and advisory
role of SEBI with a view to permitting desirable flexibility, maximizing regulatory
effectiveness and minimizing regulatory cost. Regulatory requirements for authorization of
derivatives brokers/dealers include relating to capital adequacy, net worth, certification
requirement and initial registration with SEBI. It also suggests establishment of a separate
clearing corporation, maximum exposure limits, mark to market margins, margin collection
from clients and segregation of clients’ funds, regulation of sales practice and accounting and
 12

disclosure requirements for derivatives trading. The J.R. Varma committee suggests a
methodology for risk containment measures for index-based futures and options, stock options
and single stock futures. The risk containment measures include calculation of margins,
position limits, exposure limits and reporting and disclosure.

26. Derivatives Market India. As mentioned in the preceding discussion, derivatives

trading commenced in Indian market in 2000 with the introduction of Index futures at BSE,
and subsequently, on National Stock Exchange (NSE). Since then, derivatives market in India
has witnessed tremendous growth in terms of trading value and number of traded contracts.
Here we may discuss the performance of derivatives products in India markets as follows.
27. Derivatives Products Traded in Derivatives Segment of BSE. The BSE created
history on June 9, 2000 when it launched trading in Sensex based futures contract for the first
time. It was followed by trading in index options on June 1, 2001; in stock options and single
stock futures (31 stocks) on July 9, 2001 and November 9, 2002, respectively. Currently, the
number of stocks under single futures and options is 109. BSE achieved another milestone on
September 13, 2004 when it launched Weekly Options, a unique product unparalleled
worldwide in the derivatives markets. It permitted trading in the stocks of four leading
companies namely; Satyam, State Bank of India, Reliance Industries and TISCO (renamed now
Tata Steel). Chhota (mini) SENSEX was launched on January 1, 2008. With a small or 'mini'
market lot of 5, it allows for comparatively lower capital outlay, lower trading costs, more
precise hedging and flexible trading. Currency futures were introduced on October 1, 2008 to
enable participants to hedge their currency risks through trading in the U.S. dollar-rupee future
platforms.

28. Derivatives Products Traded in Derivatives Segment of NSE. NSE started

trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as its first
derivatives product. Trading on index options was introduced on June 4, 2001. Futures on
individual securities started on November 9, 2001. The futures contracts are available on 2338
securities stipulated by the Securities & Exchange Board of India (SEBI). Trading in options
on individual securities commenced from July 2, 2001. The options contracts are American
style and cash settled and are available on 233 securities. Trading in interest rate futures was
introduced on 24 June 2003 but it was closed subsequently due to pricing problem. The NSE
achieved another landmark in product introduction by launching Mini Index Futures & Options
with a minimum contract size of Rs 1 lac. NSE crated history by launching currency futures
contract on US Dollar-Rupee on August 29, 2008 in Indian Derivatives market.

29. Growth of Derivatives Market in India. Equity derivatives market in India has
registered an explosive growth as given in figure below and is expected to continue the same
in the years to come. Introduced in 2000, financial derivatives market in India has shown a
remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone
accounts for 99 percent of the derivatives trading in Indian markets. The introduction of
derivatives has been well received by stock market players. Trading in derivatives gained
popularity soon after its introduction. In due course, the turnover of the NSE derivatives market
exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE
derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash markets was
only Rs. 3,551,038 Cr. If we compare the trading figures of NSE and BSE, performance of
BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product
categories. Among all the products traded on NSE in F& O segment, single stock futures also
known as equity futures, are most popular in terms of volumes and number of contract traded,
 13

followed by index futures with turnover shares of 52 percent and 31 percent, respectively. In
case of BSE, index futures outperform stock futures. An important feature of the derivative
segment of NSE which may be observed that the huge gap between average daily transactions
of its derivatives segment and cash segment. In sharp contrast to NSE, the situation at BSE is
just the opposite: its cash segment outperforms the derivatives segment.

Figure : Business Growth of Derivatives at NSE from 2000-2009

30. Status of Indian Derivatives Market vis-a vis Global Derivatives Market. The
derivatives segment has expanded in the recent years in a substantial way both globally as well
as in the Indian capital market. The figures revealed by Futures Industry Association (FIA)
Annual Volume Survey and reported here under in the figure bring out the fact that more than
15 billion futures and options contracts were traded during 2007 on the 54 important exchanges
that report to the FIA, reflecting a remarkable increase of 28% from the previous year. Looking
back at the last four years, it can be worked out that these figures reflect that the growth rate
was 29 % in 2006, 19% in 2006, 12% in 2005, and 9% in 2004. From the same table it also
follows that of the total volume traded globally over the period 2000-07, the US exchanges
alone constituted as much as 35 percent share. Next figure presents the break down of
derivatives volume by region and it is clearly evident that after North America with a share of
about 40 percent, Asia-Pacific occupies the second slot with a share of 28 percent and Europe
falls at the third place with its contribution of 24 percent. If we compare the turnover-wise
performance of the derivatives segments over the last five years, it may be that the Indian
segment has expanded phenomenally as compared to the global segment. The turnover of the
NSE derivatives segment in 2003-04 stood at Rs. 2130610 crores. It grew to an astonishing
level of Rs.13090477 crores during the year 2007-08, displaying a more than six-time increase
over the fiveyear period. In marked contrast, at the global level the increase was less than even
two-fold: the turnover was $ 8163 million in 2003 and $ 15187 million in 2007.
 14

18
2007
16
14
2006
12
2005
10
2007 2003 2004
8 2007
2006
6 2003 2004 2005 2006 2002
2002
2005
4
2002 2003 2004
2
0
Options Futures Total

Figure : Global Derivatives Volume Growth 2002-2007

31. Conclusion. Innovation of derivatives have redefined and revolutionised the

landscape of financial industry across the world and derivatives have earned a well deserved
and extremely significant place among all the financial products. Derivatives are risk
management tool that help in effective management of risk by various stakeholders. Derivatives
provide an opportunity to transfer risk, from the one who wish to avoid it; to one, who wish to
accept it. India’s experience with the launch of equity derivatives market has been extremely
encouraging and successful. The derivatives turnover on the NSE has surpassed the equity
market turnover. Significantly, its growth in the recent years has surpassed the growth of its
counterpart globally. The turnover of derivatives on the NSE increased from Rs. 23,654 million
(US $ 207 million) in 2000-01 to Rs. 130,904,779 million (US $ 3,275,076 million) in 2007-
08. India is one of the most successful developing countries in terms of a vibrant market for
exchange-traded derivatives. This reiterates the strengths of the modern development of India’s
securities markets, which are based on nationwide market access, anonymous safe and secure
electronic trading, and a predominantly retail market. There is an increasing sense that the
equity derivatives market is playing a major role in shaping price discovery. Factors like
increased volatility in financial asset prices; growing integration of national financial markets
with international markets; development of more sophisticated risk management tools; wider
choices of risk management strategies to economic agents and innovations in financial
engineering, have been driving the growth of financial derivatives worldwide and have also
fuelled the growth of derivatives here, in India. There is no better way to highlight the
significance and contribution of derivatives but the comments of the longest serving Governor
of Federal Reserve, Alan Greenspan: “Although the benefits and costs of derivatives remain
the subject of spirited debate, the performance of the economy and the financial system in
recent years suggests that those benefits have materially exceeded the costs."
 15

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