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Derivative market in India: Prospects & Issues

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 InternationalMultidiciplenery
International Multidisciplinarye-Journal/
e-Journal Dr. Priyanka Saroha, Dr. S.K.S. Yadav
ISSN 2277 - 4262
(90-111)

Derivative market in India: Prospects & Issues

Dr. Priyanka Saroha 1

1Assistant Professor,
College of Vocational Studies, Delhi University, Delhi
Dr. S.K.S. Yadav 2
2Associate Professor,
Department of Commerce, Meerut College, Meerut
Paper Received on: 09/09/2013
Paper Reviewed on: 16/09/2013
Paper Accepted on: 18/09/2013

Abstract
The emergence and growth of the market for derivative instruments can be traced back to
the willingness of risk averse economic agents to guard themselves against uncertainties
arising out of fluctuations in asset prices. Derivatives are meant to facilitate the hedging of
price risks of inventory holdings or a financial/commercial transaction over a certain period.
By locking in asset prices, derivative products minimize the impact of fluctuations in asset
prices on the profitability and cash flow situation of risk-averse investors, and thereby, serve
as instruments of risk management. By providing investors and issuers with a wider array of
tools for managing risks and raising capital, derivatives improve the allocation of credit and
the sharing of risk in the global economy, lowering the cost of capital formation and
stimulating economic growth. Now that world markets for trade and finance have become
more integrated, derivatives have strengthened these important linkages between global
markets, increasing market liquidity and efficiency, and have facilitated the flow of trade and
finance.
Following the growing instability in the financial markets, the financial derivatives gained
prominence after 1970. In recent years, the market for financial derivatives has grown in
terms of the variety of instruments available, as well as their complexity and turnover.
Financial derivatives have changed the world of finance through the creation of innovative
ways to comprehend, measure, and manage risks.
India’s tryst with derivatives began in 2000 when both the NSE and the BSE commenced
trading in equity derivatives. In June 2000, index futures became the first type of derivate
instruments to be launched in the Indian markets, followed by index options in June 2001,
options in individual stocks in July 2001, and futures in single stock derivatives in November
2001. Since then, equity derivatives have come a long way. New products, an expanding list
of eligible investors, rising volumes, and the best risk management framework for exchange-
traded derivatives have been the hallmark of the journey of equity derivatives in India so far.

Key words: Derivatives, Forwards, Futures, Swaps and Options

1. Introduction
The derivative market has become multi-trillion dollar markets over the years. Derivatives
are financial commitments indexed or linked in some capacity to changes in the value of
underlying assets. The bulk of the derivatives trading internationally are linked to currencies
and interest rates, other derivatives are linked to equity or equity indices. A very small
volume of derivatives, compared to the total, is indexed to traditional commodities. Small by
comparison to other derivatives markets, these commodities-indexed derivatives markets are
large compared to the underlying physical commodity markets.

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The Aims and Objectives of this research are to have an in-depth knowledge of the derivative
markets in India and in this report entitled ‘A Study on Derivatives Market in India – Current
Scenario and Future Trends’, I have tried my level best to make it simple and understandable.
Questionnaires, sampling and personal interviews were conducted for answering the research
questions and achieving aims and objectives of research.

The findings were in favour of derivatives being vital for the stock market and they are not
diminishing in today’s world, but they are at the booming stage; and every institutional
investor would want to use derivative as a tool to maximise its profits. The research deals
with basics of derivatives and its evolution in India. Also statistics about the global
th
derivatives market is given and it is heartening to know that India’s NSE ranked 20 during
2006 in the global derivative market. In the later part of the research evolution, current
scenario and prospects of equity derivatives are discussed. In the concluding section, the use
of derivatives by various financial institutions and obstacles to derivative market
development is debated. In the report it is concluded that the derivatives market will continue
to grow, and there is a need to remove the obstacles in its way. Also, more products should be
introduced in the derivatives market.

2. Objectives of Study:
The objectives of the study are as follows:
• To have an overview of the Indian Derivative Market.
• To assess risk management tools and its strategies.
• To evaluate products of derivatives i.e. Forwards, Futures, Swaps and Options.
• To critically analyse its participants i.e. Hedgers, Speculators and Arbitrageurs.
• To evaluate the functions of derivatives.

3. Literature Review
Several studies examined the use of derivatives by banks. Deshmukh, Greenbaum, and
Kanatas (1983) argue that an increase in interest rate uncertainty encourages depository
institutions to decrease their lending activities, which entail interest rate risk, and to increase
their fee for service activities, which do not. Therefore, they argue that if interest rate risk can
be controlled by derivatives, then perhaps banks that use derivatives would experience less
interest rate uncertainty and can increase their lending activities which result in greater
returns relative to the return on fixed fee for service activities. Thus their overall profitability
would be higher compared to those banks that do not use derivatives to control for interest
rate uncertainty. (Brewer 482) Brewer, Jackson, Moser and Saunders found that there is a
negative correlation between risk and derivative usage for savings and loan institutions.
In fact, it was found that S&Ls that used derivatives experienced relatively greater growth in
their fixed rate mortgage portfolios. (Brewer 481) These results indicate that financial
institutions use derivatives for hedging purposes, which would explain the reduction in the
volatility risk with an increase in derivative use. Jason and Taylor (1994), and Stern and
Linan (1994) found that tradingderivatives for profit is risky and may expose firms to large
losses. (Brewer 482) In an earlier study, Katerina Simmons used quarterly Call Report data
to examine the pattern of derivative use by banks between 1988 and 1993. She found that
banks with weaker asset quality tend to use derivatives more intensely than banks with better
asset quality. Simmons found no relationship between duration gap measures and derivative
use. Thus, her study provided no indication as to whether banks use derivatives to increase or
reduce interest rate risk. (Simmons 104)
While some studies indicate that derivatives may be useful to banks because they give firms a
chance to hedge their exposure to interest rate risk, others have found that derivatives can

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impose a significant amount of risk on an institution, resulting in large financial losses. It is

the goal of this study to determine Derivative market in India: Prospective & Issues

4. Derivatives: Meaning
Derivatives are financial contracts, which derive their value off a spot price time-series,
which is called "the underlying". The underlying asset can be equity, index, commodity or
any other asset. Some common examples of derivatives are Forwards, Futures, Options and
Swaps.
Derivatives help to improve market efficiencies because risks can be isolated and sold to
those who are willing to accept them at the least cost. Using derivatives breaks risk into
pieces that can be managed independently. From a market-oriented perspective, derivatives
offer the free trading of financial risks.

4.1. Importance of derivatives

There are several risks inherent in financial transactions. Derivatives are used to separate
risks from traditional instruments and transfer these risks to parties willing to bear these risks.
The fundamental risks involved in derivative business includes:
4.2. Credit Risk
This is the risk of failure of a counter party to perform its obligation as per the contract. Also
known as default or counterparty risk, it differs with different instruments.
4.3. Market Risk
Market risk is a risk of financial loss as a result of adverse movements of prices of the
underlying asset/instrument.
4.4. Liquidity Risk
The inability of a firm to arrange a transaction at prevailing market prices is termed as
liquidity risk. A firm faces two types of liquidity risks

1. Related to liquidity of separate products

2. Related to the funding of activities of the firm including derivatives.

4.5. Legal Risk

Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal
should be looked into carefully.
4.6. The various types of derivatives
Derivatives can be classified into four types:
 Forwards
 Futures
 Options
 Swaps
4.7. Operators in the derivatives market
Hedgers - Operators, who want to transfer a risk component of their portfolio.

 Speculators - Operators, who intentionally take the risk from hedgers in pursuit of
profit.
 Arbitrageurs - Operators who operate in the different markets simultaneously, in
pursuit of profit and eliminate mis-pricing.

5. Forward contract

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In a forward contract, two parties agree to do a trade at some future date, at a price and
quantity agreed today. No money changes hands at the time the deal is signed.

5.1. Features of Forward contract

The main features of forward contracts are

 They are bilateral contracts and hence exposed to counter-party risk.
 Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
 The contract price is generally not available in public domain.
 The contract has to be settled by delivery of the asset on expiration date.
In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter
party, which being in a monopoly situation can command the price it wants.

6. Index Futures

6.1. Index Futures: Its Meaning

Index Futures are Future contracts where the underlying asset is the Index. This is of great
help when one wants to take a position on market movements.
6.2. Uses of Index Futures
Index futures can be used for hedging, speculating, arbitrage, cash flow management and
asset allocation.
6.3. How are Index Futures valued?
The theoretical way of valuing any future contract is as follows:

Future value = Spot price + carry cost – carry returns

Where,
Spot price = current index
Carry cost = Holding cost of the future index
Carry return = Dividends accrued during the period of carry.

6.4. Pricing Futures

Cost and carry model of Futures pricing

Fair price = Spot price + Cost of carry - Inflows

FPtT = CPt + CPt * (RtT - DtT) * (T-t)/365

Where,

 FPtT - Fair price of the asset at time t for time T.

 CPt - Cash price of the asset.
 RtT - Interest rate at time t for the period up to T.
 DtT - Inflows in terms of dividend or interest between t and T.
 Cost of carry = Financing cost, Storage cost and insurance cost.
 If Futures price > Fair price; Buy in the cash market and simultaneously sell in the
futures market.
 If Futures price < Fair price; Sell in the cash market and simultaneously buy in the
futures market.

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This arbitrage between Cash and Future markets will remain till prices in the Cash
and Future markets get aligned.
6.5. Set of assumptions
 No seasonal demand and supply in the underlying asset.
 Storability of the underlying asset is not a problem.
 The underlying asset can be sold short.
 No transaction cost; no taxes.

No margin requirements, and so the analysis relates to a forward contract, rather than a
futures contract.

7. Hedging
7.1. Meaning of Hedging
Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are
widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce
the volatility of a portfolio, by reducing the risk. Hedging does not mean maximization of
return. It only means reduction in variation of return. It is quite possible that the return is
higher in the absence of the hedge, but so also is the possibility of a much lower return.
7.2. General Hedging Strategies
The basic logic is "If long in cash underlying - Short Future and If short in cash underlying -
Long Future". If you have bought 100 shares of Company A and want to Hedge against
market movements, you should short an appropriate amount of Index Futures. This will
reduce your overall exposure to events affecting the whole market (systematic risk). In case a
war breaks out, the entire market will fall (most likely including Company A). So your loss in
Company A would be offset by the gains in your short position in Index Futures.
Some examples of where hedging strategies are useful include:
 Reducing the equity exposure of a Mutual Fund by selling Index Futures;
 Investing funds raised by new schemes in Index Futures so that market exposure is
immediately taken; and
 Partial liquidation of portfolio by selling the index future instead of the actual shares
where the cost of transaction is higher.
7.3. Hedge Ratio
The hedge ratio is defined as the number of Futures contracts required to buy or sell so as to
provide the maximum offset of risk. This depends on the:
 Value of a Futures contract;
 Value of the portfolio to be Hedged; and
 Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).
The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to
be hedged and underlying (index) from which Future is derived.
7.4. Hedgers, Speculators and Arbitrageurs

Hedgers wish to eliminate or reduce the price risk to which they are already exposed.
Speculators are those class of investors who willingly take price risks to profit from price
changes in the underlying. Arbitrageurs profit from price differential existing in two markets
by simultaneously operating in two different markets. All class of investors are required for a
healthy functioning of the market.
Hedgers and investors provide the economic substance to any financial market. Without them
the markets would lose their purpose and become mere tools of gambling. Speculators
provide liquidity and depth to the market. Arbitrageurs bring price uniformity and help price
discovery.

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The market provides a mechanism by which diverse and scattered opinions are reflected in
one single price of the underlying. Markets help in efficient transfer of risk from Hedgers to
speculators. Hedging only makes an outcome more certain. It does not necessarily lead to a
better outcome.
7.5. Hedge funds
A hedge fund is a term commonly used to describe any fund that isn’t a conventional
investment fund, i.e., it uses strategies other than investing long. For example:
 Short selling
 Using arbitrage
 Trading derivatives
 Leveraging or borrowing
 Investing in out-of-favour or unrecognized undervalued securities

The name hedge fund is a misnomer as the funds may not actually hedge against risk. The
returns can be high, but so can be losses. These investments require expertise in particular
investment strategies. The hedge funds tend to be specialized, operating within a given niche,
specialty or industry that requires the particular expertise.

8. Speculation Strategies
8.1. General strategies for speculating
In general, the speculator takes a view on the market and plays accordingly. If one is bullish
on the market, one can buy Futures, and vice versa for a bearish outlook.
There is another strategy of playing the spreads, in which case the speculator trades the
"basis". When a basis risk is taken, the speculator primarily bets on either the cost of carry
(interest rate in case of index futures) going up (in which case he would pay the basis) or
going down (receive the basis).
Pay the basis implies going short on a future with near month maturity while at the same time
going long on a future with longer term maturity.
Receiving the basis implies going long on a future with near month maturity while at the
same time going short on a future with longer term maturity.
8.2. Long/ Short Positions
In simple terms, long and short positions indicate whether you have a net over-bought
position (long) or over-sold position (short).
8.3. Gearing or Leveraging

Gearing (or leveraging) measures the value of your position as a ratio of the value of the risk
capital actually invested. In case of index futures, if the margin requirement is 5%, the
gearing possible is 20times as on a given fund availability, an investor can take a position 20
times in size.

9. Price Risk
9.1. Meaning of price risk

Price risk is defined as the standard deviation of returns generated by any asset. This indicates
how much individual outcomes deviate from the mean. For example, an asset with possible
returns of 5%, 10% and 15% is more risky than one with possible returns of –10%, 1% and
25%.
9.2. Different types of price risk

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Diversifiable risk (also known as non market risk or unsystematic risk) of a security arises
from the security specific factors like strike in factory, legal claims, non availability of raw
material, etc. This component of risk can be reduced by diversification.
Non-diversifiable risk (also known as systematic risk or market risk) is an outcome of
economy related events like diesel price hike, budget announcements, etc that affect all the
companies. As the name suggests, this risk cannot be diversified away using diversification
or adding stocks in portfolio.
9.3. Can price risk be controlled?

Yes, but to an extent. As mentioned earlier, the different types of price risk impacting any
stock or company can be classified into two categories:

1. Company specific; and

2. Economy or market related.
The Company specific risks (also known as diversifiable risk or non-market risk or
unsystematic risk) can be reduced by proper diversification.

10. Beta & Tick Size

10.1. Meaning of beta and a tick size

Beta measures the sensitivity of the stock compared to the index. Tick size is the minimum
price difference between the two quotes of a similar nature. The tick size is 0.1 point of the
BSE Sensex, which is equivalent to Rs 5. In case of Nifty, tick size is 0.05 which is equal to
Rs 10.

11. Circuit Breakers

11.1. Circuit Breakers or Circuit Filters

Circuit breaker means trading is halted for a specified period in stocks or / and stock index
futures, if the market price moves out of a pre-specified band. Circuit filters do not result in
trading halt but no order is permitted if it falls out of the specified price range.

11.2. Advantages
1. Allows participants to gather new information and to assess the situation - controls
panic.
2. Brokerages firms can check on customer funding and compliance.
3. Exchanges/ Clearing houses can monitor their members.
11.3. Disadvantages
1. Only postpones the inevitable.
2.Limits the flow of market information – no one knows the real value of a stock.
3.They precipitate the matter during volatile moves as participants’ rush to execute their
orders before anticipated trading halt.

12. Margins
12.1. Meaning of Margin Money
The aim of margin money is to minimize the risk of default by either counter-party. The
payment of margin ensures that the risk is limited to the previous day’s price movement on
each outstanding position. However, even this exposure is offset by the initial margin
holdings.
Margin money is like a security deposit or insurance against a possible Future loss of value.

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12.2. Different types of margin

There can be different types of margin like initial margin, variation margin, maintenance
margin and additional margin.
12.3. Objective of initial margin
The basic aim of initial margin is to cover the largest potential loss in one day. Both buyer
and seller have to deposit margins. The initial margin is deposited before the opening of the
day of the Futures transaction. Normally this margin is calculated on the basis of variance
observed in daily price of the underlying (say the index) over a specified historical period
(say immediately preceding 1 year). The margin is kept in a way that it covers price
movements more than 99% of the time. Usually three sigma (standard deviation) is used for
this measurement. This technique is also called value at risk (or VAR).
Based on the volatility of market indices in India, the initial margin is expected to be around
8-10%.
12.4. Variation or mark-to-market margin
All daily losses must be met by depositing of further collateral - known as variation margin,
which is required by the close of business, the following day. Any profits on the contract are
credited to the client’s variation margin account.
12.5. The concept of maintenance margin
Some exchanges work on the system of maintenance margin, which is set at a level slightly
less than initial margin. The margin is required to be replenished to the level of initial margin,
only if the margin level drops below the maintenance margin limit. For e.g.. If Initial Margin
is fixed at 100 and Maintenance margin is at 80, then the broker is permitted to trade till such
time that the balance in this initial margin account is 80 or more. If it drops below 80, say it
drops to 70, then a margin of 30 (and not 10) is to be paid to replenish the levels of initial
margin. This concept is not expected to be used in India.
12.6. The concept of additional margin
In case of sudden higher than expected volatility, additional margin may be called for by the
exchange. This is generally imposed when the exchange fears that the markets have become
too volatile and may result in some crisis, like payments crisis, etc. This is a preemptive
move by exchange to prevent breakdown.
12.7. The concept of cross margining
This is a method of calculating margin after taking into account combined positions in
Futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-
Hedges. This is unlikely to be introduced in India immediately.

13. Market Maker

13.1. Who is a market maker?

A dealer is said to make a market when he quotes both bid and offer prices at which he stands
ready to buy and sell the security. Thus, he is a person that brings buyers and sellers together.
He lends liquidity in the system by making trading feasible.
13.2. What is marked-to-market?

This is an arrangement whereby the profits or losses on the position are settled each day. This
enables the exchange to keep appropriate margin so that it is not so low that it increases
chances of defaults to an unacceptable level (by collecting MTM losses) and is not so high
that it increases the cost of transactions to an unreasonable level ( by giving MTM profits).
14. Futures in India
14.1. Nifty Futures

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The National Stock Exchange commenced trading in Index Futures on 12 June, 2000. The
NIFTY futures contracts are based on the popular market benchmark S&P CNX NIFTY
Index.
14.2. Security descriptor
The security descriptor for the S&P CNX Nifty futures contracts will be:
Market type : N
Instrument Type : FUTIDX
Underlying : NIFTY
Expiry date : Date of contract expiry
14.3. Trading cycle

S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the near
month (one), the next month (two) and the far month (three). A new contract will be
introduced on the trading day following the expiry of the near month contract.

14.4. Expiry day

S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the last
Thursday is a trading holiday, the contracts shall expire on the previous trading day.

14.5. Contract size

The permitted lot size of S&P CNX NIFTY contracts is 200 and multiples

14.6. Price steps for contracts

The price step in respect of NIFTY futures contracts is Re. 0.05.

14.7. Price bands

There is no day minimum/maximum price ranges applicable for Futures contract. However in
order to prevent erroneous order entry by trading members the operating ranges are kept at +
10 %. In respect of orders which have come under price freeze, the members would be
required to confirm to the Exchange that there is no inadvertent error in the order entry and
that the order is genuine. On such confirmation the Exchange may approve such order.

14.8. BSE SENSEX Futures

The underlying for Sensex Futures:
The underlying for the Sensex Futures is the BSE Sensitive Index of 30 scrips, popularly
called the Sensex.
14.9. The contract multiplier
The contract multiplier is 50. This means that the Rupee notional value of a futures contract
would be 50 times the contracted value.
14.10. Maturity of the futures contract

Regulations permit introduction of futures up to 12 months maturity. Initially, however,

futures for the three near months have been introduced. On 9 June the three futures for June,
July and August 2000 were started. These futures would expire on 29 June, 27 July and 31
August respectively. This is because the expiry date has been fixed as the last Thursday of the
month for each month. The day after the expiry, a new future would come into existence for
three-month maturity. For example on 30 June, the September future would come into
existence. This future would expire on 28 September, being the last Thursday of the month.

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14.11. Tick size

The tick size is "0.1". This means that the minimum price fluctuation in the value of a future
can be only 0.1. In Rupee terms, this translates to minimum price fluctuation of Rs. 5 ( Tick
size X Contract Multiplier = 0.1 X Rs. 50).
14.12. Determining final settlement price

The futures closing price will be calculated based on a set of 120 price points of the cash
sensex values taken between the last half an hour of trading. The highest and lowest 20 price
points will be ignored and the closing price computed as an average of the remaining 80 price
points. This process will ensure that manipulation of the closing price by moving it in one
direction for a short duration or for only a few contracts is eliminated.
14.13. What happens to the profit or loss due to daily settlement?

In case the position is not closed the same day, the daily settlement would alter the cash flows
depending on the settlement price fixed by the exchange every day. However the net total of
all the flows every day would always be equal to the profit or loss calculated above. Profit or
loss would only depend upon the opening and closing price of the position, irrespective of
how the rates have moved in the intervening days.
14.14. How does the initial margin affect the above profit or loss?

The initial margin is only a security provided by the client through the clearing member to the
exchange. It can be withdrawn in full after the position is closed. Therefore it does not affect
the above calculation of profit or loss.
However there would may be a funding cost / transaction cost in providing the security. This
cost must be added to your total transaction costs to arrive at the true picture. Other items in
transaction costs would include brokerage, stamp duty etc.

15. Options
15.1. Meaning of an Option
Options are contracts that confer on the buyer of the contract certain rights (rights to buy or
sell an asset) for a predetermined price on or before a pre-specified date. The buyer of the
option has the right but not the obligation to exercise the option.
Options come in a variety of forms. Some Option contracts, which have been standardized,
are traded on recognized exchanges. Other Option contracts exist that are traded "over-the-
counter", i.e., a market where financial institutions and corporates trade directly with each
other over the phone. Besides these, options also exist in an embedded form in several
instruments.
They popular basic instruments/variables underlying options are:
 Equity – Index Options, Options on individual stocks, Employee Stock Options
 Interest rates – Bond Options, Interest rate Futures Options, Options embedded in
bonds, caps & floors, etc
 Foreign exchange – Plain vanilla calls and puts, barrier Options, various kinds of
exotic Options
 Others – including commodities, weather, electricity, etc.
15.2. Classification of Optons
 Option Seller - One who gives/writes the option. He has an obligation to perform, in
case option buyer desires to exercise his option.

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 Option Buyer - One who buys the option. He has the right to exercise the option but
no obligation.
 Call Option - Option to buy.
 Put Option - Option to sell.
 American Option - An option, which can be exercised anytime on or before the expiry
date.
 European Option - An option, which can be exercised only on expiry date.
 Strike Price/ Exercise Price - Price at which the option is to be exercised.
 Expiration Date - Date on which the option expires.
 Exercise Date - Date on which the option gets exercised by the option holder/buyer.
 Option Premium - The price paid by the option buyer to the option seller for granting
the option.
15.3. Call Options

A call option gives the holder (buyer/ one who is long call), the right to buy specified
quantity of the underlying asset at the strike price on or before expiration date.
The seller (one who is short call) however, has the obligation to sell the underlying asset if
the buyer of the call option decides to exercise his option to buy.

15.4. Put Options

A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity
of the underlying asset at the strike price on or before a expiry date.
The seller of the put option (one who is short Put) however, has the obligation to buy the
underlying asset at the strike price if the buyer decides to exercise his option to sell.
15.5. Covered and Naked Calls

A call option position that is covered by an opposite position in the underlying instrument
(for example shares, commodities etc), is called a covered call.
Writing covered calls involves writing call options when the shares that might have to be
delivered (if option holder exercises his right to buy), are already owned.
E.g. A writer writes a call on Reliance and at the same time holds shares of Reliance so that if
the call is exercised by the buyer, he can deliver the stock.
Covered calls are far less risky than naked calls (where there is no opposite position in the
underlying), since the worst that can happen is that the investor is required to sell shares
already owned at below their market value.
When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have
to purchase the underlying asset to meet his call obligation and his loss will be the excess of
the purchase price over the exercise price of the call reduced by the premium received for
writing the call.
15.6. Intrinsic Value of an option
The intrinsic value of an option is defined as the amount by which an option is in-the-money,
or the immediate exercise value of the option when the underlying position is marked-to-
market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be a positive number or 0. It cannot be negative. For a
call option, the strike price must be less than the price of the underlying asset for the call to

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have an intrinsic value greater than 0. For a put option, the strike price must be greater than
the underlying asset price for it to have intrinsic value.
15.7. Players in the Options Market
Developmental institutions, Mutual Funds, FIs, FIIs, Brokers, Retail Participants are the
likely players in the Options Market.

16. Nifty Options

An option gives a person the right but not the obligation to buy or sell something. An option
is between two parties wherein the buyer receives a privilege for which he pays a fee
(premium) and the seller accepts an obligation for which he receives a fee. The premium is
the price negotiated and set when the option is bought or sold. A person who buys an option
is said to be long in the option. A person who sells (or writes) an option is said to be short in
the option.
16.1. How Nifty Options will work?
NSE plans to commence trading in Index options shortly. The proposed contract
specifications for Index options are as below:
Underlying Index: S&P CNX Nifty
Contract Size: Permitted lot size shall be 200 or multiples thereof
Price steps for contracts: The price step in respect of NIFTY options contracts
is Re. 0.05.
Price bands: not applicable
Style: European/American
16.2. Trading cycle

The options contract will have a maximum of three months trading cycle- the near month
(one), the next month (two) and the far month (three). New contract will be introduced on the
next trading day following the expiry of the near month contract
16.3. Expiry day
The last Thursday of the expiry month or the previous trading day if the last Thursday is a
trading holiday.
16.3. Settlement basis
Cash settlement on a T + 1 basis
16.4. Settlement prices
Based on expiration price as may be decided by the Exchange

17. SWAPS
17.1. Meaning of a swap

A swap is nothing but a barter or exchange but it plays a very important role in international
finance. A swap is the exchange of one set of cash flows for another. A swap is a contract
between two parties in which the first party promises to make a payment to the second and
the second party promises to make a payment to the first. Both payments take place on
specified dates. Different formulas are used to determine what the two sets of payments will
be.
Classification of swaps is done on the basis of what the payments are based on. The different
types of swaps are as follows.
 Interest rate swaps
 Currency Swaps
 Commodity swaps
 Equity swaps

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17.2. Interest rate swaps

The interest rate swap is the most frequently used swap. An interest rate swap generally
involves one set of payments determined by the Eurodollar (LIBOR) rate. Although, it can be
pegged to other rates. The other set is fixed at an agreed-upon rate. This other agreed upon
rate usually corresponds to the yield on a Treasury Note with a comparable maturity.
Although, this can also be variable.
Additionally, there will be a spread of a pre-determined amount of basis points. This is just
one type of interest rate swap. Sometimes payments tied to floating rates are used for interest
rate swaps. The notional principal is the exchange of interest payments based on face value.
The notional principal itself is not exchanged. On the day of each payment, the party who
owes more to the other makes a net payment. Only one party makes a payment.
17.3. Currency swaps

A currency swap is an agreement between two parties in which one party promises to make
payments in one currency and the other promises to make payments in another currency.
Currency swaps are similar yet notably different from interest rate swaps and are often
combined with interest rate swaps.
Currency swaps help eliminate the differences between international capital markets. Interest
rates swaps help eliminate barriers caused by regulatory structures. While currency swaps
result in exchange of one currency with another, interest rate swaps help exchange a fixed
rate of interest with a variable rate. The needs of the parties in a swap transaction are
diametrically different. Swaps are not traded or listed on exchange but they do have an
informal market and are traded among dealers.
A swap is a contract, which can be effectively combined with other type of derivative
instruments. An option on a swap gives the party the right, but not the obligation to enter into
a swap at a later date.
17.4. Commodity swaps

In commodity swaps, the cash flows to be exchanged are linked to commodity prices.
Commodities are physical assets such as metals, energy stores and food including cattle. E.g.
in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a
fixed cash flow. Commodity swaps are used for hedging against:
 Fluctuations in commodity prices or
 Fluctuations in spreads between final product and raw material prices (E.g. Cracking
spread which indicates the spread between crude prices and refined product prices
significantly affect the margins of oil refineries)
A Company that uses commodities as input may find its profits becoming very volatile if the
commodity prices become volatile. This is particularly so when the output prices may not
change as frequently as the commodity prices change. In such cases, the company would
enter into a swap whereby it receives payment linked to commodity prices and pays a fixed
rate in exchange. A producer of a commodity may want to reduce the variability of his
revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity
prices.
17.5. Equity swaps
Under an equity swap, the shareholder effectively sells his holdings to a bank, promising to
buy it back at market price at a future date. However, he retains a voting right on the shares.
17.6. Components of a swap price
There are four major components of a swap price.

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 Benchmark price
 Liquidity (availability of counter parties to offset the swap).
 Transaction cost
 Credit risk
17.7. Benchmark price: Swap rates are based on a series of benchmark instruments. They
may be quoted as a spread over the yield on these benchmark instruments or on an absolute
interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 &
364 day T-bills, CP rates and PLR rates.
17.8. Liquidity: Liquidity, which is function of supply and demand, plays an important role
in swaps pricing. This is also affected by the swap duration. It may be difficult to have
counterparties for long duration swaps, especially so in India.
17.9. Transaction Costs: Transaction costs include the cost of hedging a swap. Say in case
of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank
would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction
cost would thus involve such a difference.
Yield on 91 day T. Bill - 9.5%.
Cost of fund (e.g.- Repo rate) – 10%
The transaction cost in this case would involve 0.5%
17.10. Credit Risk:
Credit risk must also be built into the swap pricing. Based upon the credit rating of the
counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an
AAA rating.

18. Development of Derivatives Markets in India

Indian Derivatives markets 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 in
1875. In 1952, with the ban on cash settlement and option trading by the Government of
India, derivatives trading shifted to informal forwards markets. In recent years, government
policy has shifted in favor of an increased role of market-based pricing and less suspicious
derivatives trading. The first step towards the introduction of financial derivatives trading in
India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. This
provided for withdrawal of prohibition on options in securities. In the last decade, beginning
the year 2000, ban on futures trading in many commodities was lifted out. During 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.

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Table 1: Benchmark Indices—Contrac

Contracts
ts and Volume in Futures and Options Segment of NSE for the
Fiscal Year 2010
2010–2011 and the first half of 2011–2012

India’s experience with the equity derivatives market has been extremely positive. The
derivatives turnover on the NSE has surpassed the equity
equity market turnover. The turnover of
derivatives on the NSE increased from ` 23,654 million in 2000–2001
2000 2001 to ` 292,482,211
million in 2010–2011,
2011, and reached ` 157,585,925 million in the first half of 2011
2011–2012. The
average daily turnover in these market segments
segments on the NSE was ` 1,151,505 million in
2010–2011
2011 compared to ` 723,921 in 2009–2010.
2009
India is one of the most successful developing countries in terms of a vibrant market for
exchange-traded
traded derivatives. This reiterates the strengths of the modern dev development in
India’s securities markets, which are based on nationwide market access, anonymous
electronic trading, and a predominant retail market. There is an increasing sense that the
equity derivatives market plays a major role in shaping price discovery.
discover

19. Global Derivatives Markets

After the credit crisis took its toll in 2009, the global futures and options industry returned to
rapid growth in 2010 after levelling off in 2009. Looking at the global trends in derivatives
volume by category, we find that the currency sector was the most most powerful driver of
increase in the volumes of exchange-traded
exchange traded derivative contracts in 2010, followed by trading
in agricultural derivative products, which grew at 40.73 percent (Table 6-2). 6 2). The trading

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volume in non-precious
precious metals, on the other hand, continued
continued to gain in 2010 when compared
to the volume in 2009, with an increase in volume by 39.17 percent.
Table 2: Global Exchange
Exchange-traded Derivatives Volume by Category
(in millions)

Table3: Trade Details of Derivatives Market

20. Trading Volumes

After recording a staggering year-on-year
year year growth of 60.43 percent in trading volumn in
2009–2010,
2010, the NSE’s derivatives market continued its momentum in 2010 2010–2011 by
clocking a growth of 65.58 percent (Table 66-5).
5). The NSE further strengthened its dominance
in the derivatives segment in 2010–2011
2010 2011 with a share of 99.99 percent of the total turnover in
this segment. The share of the BSE in the total derivatives market turnover fell from 0.0013
percent in 2009–2010
2010 to 0.0005 percent in 2010–2011.
2010 The total turnover
over of the derivatives
segment jumped by 26.56 percent during the first half of 2011–20122011 2012 compared to the
turnover in the corresponding period in the previous fiscal year.

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The index options segment was the clear leader in the product-wise turnover of the futures
and options segment in the NSE in 2010–2011 (Table 6-6 and Chart 6-1). The turnover in the
index options category was 62.79 percent of the total turnover in the F&O segment of the
NSE, followed by the stock futures and index futures that saw a year-on-year growth of 18.79
percent and 14.90 percent, respectively. This trend continued in the first half of 2011–2012,
with index options constituting around 72.89 percent of the total turnover in this segment.
The turnover of index options zoomed by 59.93 percent during the first half of 2011–2012,
compared to the turnover in the corresponding period in the previous fiscal year.

21.An Emerging prospect

21.1.Credit derivatives:
Credit derivatives are contracts seeking to transfer an asset’s risk and returns from one
counter party to another without transferring the ownership. Credit derivatives trades today
are more trading tools (as a proxy tool to allow trading in the general credit of a reference
entity, and thereby replicating a cash bond) than hedging tools (to protect against credit risks,
default risks inherent in exposures held by banks) these derivatives are traded over-the-
counter (OTC) in developed markets.
Credit derivatives like Total Return Swaps, Credit Default Swaps, Credit Spread Options and
Credit Linked Notes help Reduce a particular risk concentration in the portfolio, Control
credit risks of any debt instrument, and gain exposure to another bank's loan portfolio. The
recent bankruptcies in US, for e.g. Enron, WorldCom and Swissair etc. could have
completely devastated even the giant economy of US, if the risk was not mitigated and the
losses effectively spread from such defaults, with short term leverage to insurance firms, and
others, by using CDS .
Though these tools currently have a limited presence in India, their market could see an
explosive growth given the needs for the product and thrust from key areas. Most Indian
nationalized banks, saddled with NPAs to the tune of 5-6% of their total asset base, creates an
obvious need for credit protection. However, in the Indian context, the sell side market is
absent. For the segment to develop, the sellers of credit protection need to be able to hedge
their risks, enabling them to quote a price for the protection they are selling. The scenarios
and factors such as opening up of the insurance sector, relief to investors, tax benefits to
corporate would provide the necessary impetus to the credit derivatives market to develop in
India, boosting yields and lowering risk for both the corporate as well as the banking sector.
21.2.Energy derivatives
India is the sixth largest producer and consumer of energy in the world. According to global
estimates, total energy trading in the world is around $8 trillion, and growing at a
phenomenal rate of 30 percent per annum. Deregulation has changed the dynamics of energy
markets from a supply market at a pre-determined price to a price-sensitive market where
energy is traded on exchanges. Energy commodities are fast moving, non-storage products
with volatile prices. Recent casualties of major electricity generators in California has
explained that companies owing physical assets or retail obligations like electric generators,
power and gas distributors, and oil refiners have large physical ,spot price-risk exposure that
can be effectively managed and optimized using sophisticated risk management strategies.
In India, where the energy markets are plagued by losses in extraction, conversion and
transmission, resulting into losses for producers, marketers and consumers, effective risk
management through the use of energy derivatives has become crucial.
Participation from multiple players in the areas of production, trading and marketing of
energy products will further brighten the prospects. One of the Delhi based IT majors Vedaris
provides energy trading and derivative risk management software the ‘Contango’ designed as
an integrated solution for multi-commodity and multi-currency trading, within the energy

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derivatives market. The market for this product is principally gas and electricity, but also
includes oil, coal, weather, bandwidth and emissions trading.
Indian Oil Minister Mani Shankar Aiyar told a regional energy conference that India, which
has a vital interest in stable oil markets as it sources 70 percent of its crude oil needs abroad,
should allow for derivatives trading keeping a check on oil price fluctuations and hedge risk.
21.3. Weather Derivative: Prospects
The emergence of the wholesale power market in response to the deregulation of the Power
Industry and changed role of utility has helped weather derivative market to develop and
stabilise volatility in revenue and expenses, caused by unpredictability of weather conditions.
Unofficially the OTC weather derivative market began in 1996 when Entergy-Koch and
Enron completed a HDD swap for the winter of 1997 in Milwaukee, WI. According to a Price
Waterhouse Survey, this is estimated at $12 billion by the end of this year.
In an agrarian economy like India, where Fifty per cent of irrigation is rain-fed and monsoons
determine rural demand patterns, fertilizer off take, agricultural commodity prices, water
utilities, energy consumption and construction costs, Weather derivatives can aptly be
positioned as hedging instruments for farmers. These prospects in Weather risk management
will also benefit the Utility and energy companies to protect their volume-related revenues
against unnatural weather, Distributors of crude oil to make up for reduced business in the
winter, Agricultural companies to minimise the uncertainty in revenue due to flood, freeze or
drought and also Insurance companies to reduce their own exposure to weather-related
claims.
In India, RaboBank and ABN Amro have been the first off the block to introduce weather
derivatives help manage weather risk, which has now expanded to include end user industries
such as beverage sales, agriculture, power generation, oil exploration, tourism, insurance ,
cold drink breweries, wind farms and sugar industries.
As a start (Jan 11, 2005), With all the necessary infrastructure to offer deliveries through
dematerialized warehouse receipts by linking up with panchayats and anticipating a strong
demand , NCDEX is in favour of launching this product. More demand can be generated by
an amendment of the existing Securities Contract (Regulation) Act, where derivative trading
is allowed in a commodity, which can be physically delivered.
The phase I, whereby NCDEX will offer trading in futures of bullion and seven agri-
products — soybean, Soya oil, mustard seed and its oil; crude palm oil, RBD palmolein and
cotton, is expected to attract many counterparts who would be more than willing to absorb the
risk
• The institutional segment of the capital market has not yet begun to use derivatives for risk
hedging or for position taking in the way that such investors should. First, the development of
derivatives has so far been excessively skewed toward derivatives used in the equity rather
than debtor forex markets. Second, One the one side India have foreign and privately owned
(new generation) domestic banks who run a (interest rate) derivative trading book but do not
have the ability to set significant counter party credit limits on a large segment of corporate
customers of PSBs. On the other side, are PSBs who have the ability to set significant counter
party credit limits, but are unable or unwilling to write IRS’ or FRAs with them.
• Regulatory conservatism and failure are inhibiting the emergence of more types of
derivatives – e.g. currency, interest-rate and credit derivatives as well as long-term tailored as
well as traded swaps and swaptions.
Without speculative counter-parties, financial markets would be illiquid, inefficient and
ineffective in fulfilling their main purpose as resource mobilizing and allocating mechanisms.
In financial markets it is speculators (or, in more neutral parlance, insurers, market-makers
and options-writers) who enable efficient price-discovery in real-time and allow for efficient,
continuous two-way, ‘bid-ask’ market-making.

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22. Issues of Derivatives Market:

Though showing volumes, But equity derivative market is not growing as fast as it should in
terms of price discovery, the temporal spread of contracts and the range and diversity of
contracts and instruments. The problems relating to the market are manifold.
• The India’s financial system between market operators and regulators is too prone to
political pressure and regulatory capture. This has sub stained the market from opening
further.
• Low average per capita income, inadequate physical and institutional infrastructure,
primitive public services and dysfunctional political and legal systems have made India lag
behind many developed financial markets across the globe.
• Uncertainty in Indian tax laws and rules whereby derivative transactions are treated as
‘speculative’ discourages active investor participation in the market.
• Another problems which the investors face is the lack of proper training to deal in this
market, where, unlike the cash market, certification is required
• The J.R.Verma committee felt that there was a need to protect particularly the small
investors who may be lured by the sheer speculative gains in this market where threshold
limit of the transactions has been pegged not below Rs. 2 lakhs. This has compelled the retail
investors to approach the markets through the indirect routes like mutual funds etc.
• Chauhan & Thomas clearly point out that intermediaries operating in Indian capital markets
still lack (a) a single interface for dealing in both spot and derivatives markets thus
compounding inefficiency in executing simultaneous trading strategies (b) essential analytical
tools and adequate systems to support trading and risk management; (e) proper back office
control and containment systems which ultimately hinder the growth in the market.
• RBI stipulations restricting entry of players into some part of derivative market and other
stringent regulations restrict Free trade in the derivative markets
• Price recovery and narrow risk-bearing capacity on the part of option-writers is yet another
concern as it makes risk hedging for more than one calendar quarter very difficult for
investors.
• Prospects:–.The derivatives market in India, which hangs between nascence and maturity
stage, holds high prospects.
• Introduction of three new products- options on index, options on individuals and covered
warrants, Enabling FIIs, foreign insurance companies and mutual funds to participate more
fully in derivatives markets, along with the availability of a wider range of derivatives, would
enhance the use and quality of equity derivatives as considerably ‘more perfect’ rather than
still ‘highly imperfect’ risk-management instruments. The recent ICICI bond issue bundles a
twelve- year expiration BSE Sensex warrants with the bond. If this warrant is detached and
traded, it would be exchange-traded index derivatives
• The established mind-sets of regulatory and tax authorities on ‘speculation’ is limiting the
propensity of option writers to be bolder in market-making for derivatives contracts .Jogani &
Fernandes, in their paper make the case that arbitrage is not opportunistic or
counterproductive speculation but an essential form of financial intermediation that makes
markets more efficient by smoothing out price distortions. Thus, Policies should now shift to
ensure the soundness of information and transparency such that wider investor participation
can be attained.
• Introduction of index derivatives which are less volatile and difficult to manipulate as
compared to individual stock prices have large prospects for small retail investors.
• since index future do not represent physically deliverable asset ,they are cash settled all over
the world on the premise that index value is derived from the cash market, hence these
require less margin capital which induces more players to join the market.

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• the unusual arbitrage opportunities due to the large pricing anomalies persisting between
BSE/NSE prices for the same underlying shares again makes the market really attractive.
• Expansion in the derivative market would also increase the flow of FII and FDI investment.
The currency risk and country risks of these investors can easily be mitigated by diversifying
the derivatives market by introducing dollar- rupee futures and options for the first one; and
index futures and options for the second one.
• While India lacks index derivatives as of today, there is a direct opportunity to make
progress on these issues via the dollar-rupee forward market. The constraints that are placed
in the way of FII's on using the dollar-rupee forward market are counterproductive. If the FII
is allowed to obtain insurance using this market, they will bring more money to India.

Thus India needs to overcome its recent sluggish pace toward derivatives trading and pave
the way for a open and developed financial market which have great prospects.

23. Conclusion:
Derivatives products provide certain important economic benefits such as risk management
or redistribution of risk away from risk-averse investors towards those more willing and able
to bear risk. Derivatives also help price discovery, i.e. the process of determining the price
level for any asset based on supply and demand. These functions of derivatives help in
efficient capital allocation in the economy; at the same time their misuse also poses a threat to
the stability of the financial sector and the overall economy. In the mid-1990s India started
reviving the exchange traded commodity derivatives market and introduced a variety of
instruments in the foreign exchange derivatives market, while exchange traded financial
derivatives were introduced in 2001. Given India’s experience in informal derivatives
trading, the exchange traded derivatives were quick to pick up substantial volumes. This
paper presents accounts of the major developments in the Indian commodity, exchange rate
and financial derivatives markets, and outlines the regulatory provisions that have been
introduced to minimise misuse of derivatives.
For investors with additional concerns, portfolio selection need not only be looked at within a
mean-variance framework. Steps can now be taken to integrate additional concerns into the
portfolio optimization process more in accordance with their criterion status. Instead of
attempting to interject additional concerns into portfolio election by means of constraints -
an ad hoc process that often ends prematurely because of losses in user patience – the
methods that have been outlined form the basis for a new era of solution methodologies
whose purposes are to converge to a final portfolio that more formally achieves optimal
trade-offs among all of the criteria that the investor wishes to deem important. Of course, as
with any area that is gaining momentum, more work needs to be done.
Thus overall it was found that in the early years of the equity derivatives market there was a
degree of concentration in the market and consequent lack of width and depth across
segments. Further there were violations of put-call parity, and consequential arbitrage
opportunities. There is a need to see how these attributes have changed over time along with
increased participation in the market and whether the growing volumes are in corroboration
with a move towards more efficient markets. An efficient derivatives market ought to play a
lead role in the process of price discovery for the underlying. The relationship between spot
and futures markets in price discovery has thus been an important area of research. This
broadly amounts to analysing whether price innovations appear first in the futures market and
are then transmitted down into the spot market. In our future research, we propose to inquire
into the presence or absence of this feature in major segments of the Indian derivatives
market.

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