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Concept of Financial Derivatives: At present the Indian stock markets are not having any risk

hedged instruments that would allow the investors to manage and minimize the risk. In
industrialized countries apart from money market and capital market securities, a variety of other
securities known as „derivatives‟ have now become available for investment and trading. The
derivatives originate in mathematics and refer to a variable which has been derived from another
variable. A derivative is a financial product which has been derived from another financial
product or commodity. The derivatives do not have independent existence without underlying
product and market. Derivatives are contracts which are written between two parties for easily
marketable.
A derivative is a financial product which has been derived from another financial product or
commodity.

D.G. Gardener definition of derivatives: “A derivative is a financial product which has been
derived from market for another product.”The securities contracts (Regulation) Act 1956 defines
“derivative” as under section 2 (ac). As per this “Derivative” includes
(a) “a security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.”
(b) “a contract which derived its value from the price, or index of prices at underlying securities.”

Accounting standard SFAS133 defines “a derivative instrument is a financial derivative or other


contract which will comprise of all three of the following characteristics:
(i) It has one or more underlying asset, and one or more notional amount or payments
provisions or both. Those terms determine the amount of the settlement or settlements.
(ii) It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contract that would be expected to have a similar response to
changes in market factors.
(iii) Its terms require or permit net settlement. It can be readily settled net by a means outside
the contract or it provides for delivery of an asset that puts the recipients in a position not
substantially different from net settlement.
Hence, financial derivatives are financial instruments whose prices are derived from the prices
of other financial instruments.
As defined above, its value is entirely derived from the value of the underlying asset. The
underlying asset can be securities, commodities, bullion, currency, livestock or anything else. In
other way the underlying asset may assume many forms:
(i) Commodities including grain, coffee beans, orange juice;
(ii) Precious metals like gold & silver;
(iii) Foreign exchange rates or currencies;
(iv) Bonds of different types, including medium to long term negotiable debt, securities issued
by governments, companies etc;
(v) Shares and share warrants of companies traded on recognized stock exchanges and stock
index;
(vi) Short term securities such as T-bills;
(vii) Over the counter (OTC) money market products such as loans or deposits.

MAJOR PLAYERS IN THE FINANCIAL DERIVATIVES TRADING


There are three major players in the financial derivatives trading:
1. Hedgers: Hedgers are traders who use derivatives to reduce the risk that they face from
potential movements in a market variable and they want to avoid exposure to adverse
movements in the price of an asset. Majority of the participants in derivatives market belongs
to this category.
2. Speculators: Speculators are traders who buy/sell the assets only to sell/buy them back
profitably at a later point in time. They want to assume risk. They use derivatives to bet on the
future direction of the price of an asset and take a position in order to make a quick profit. They
can increase both the potential gains and potential losses by usage of derivatives in a
speculative venture.
3. Arbitrageurs: Arbitrageurs are traders who simultaneously buy and sell the same (or different,
but related) assets in an effort to profit from unrealistic price differentials. They attempts to make
profits by locking in a riskless trading by simultaneously entering into transaction in two or more
markets. They try to earn riskless profit from discrepancies between futures and spot prices and
among different futures prices.
TYPES OF DERIVATIVES:
There are three basic types of contracts - options, swaps and futures/forward contracts- with variations
of each. Options are contracts that give the right but not the obligation to buy or sell an asset. Investors
typically will use option contracts when they do not want to risk taking a position in the asset outright,
but they want to increase their exposure in case of a large movement in the price of the underlying asset.
There are many different option trades that an investor can employ, but the most common are:

 Long Call - If you believe a stock's price will increase, you will buy the right (long) to buy (call) the stock.
As the long call holder, the payoff is positive if the stock's price exceeds the exercise price by more than
the premium paid for the call.

Long Put - If you believe a stock's price will decrease, you will buy the right (long) to sell (put) the stock.
As the long put holder, the payoff is positive if the stock's price is below the exercise price by more than
the premium paid for the put.

 Short Call - If you believe a stock's price will decrease, you will sell or write a call. If you sell a call, then
the buyer of the call (the long call) has the control over whether or not the option will be exercised. You
give up the control as the short or seller. As the writer of the call, the payoff is equal to the premium
received by the buyer of the call if the stock's price declines, but if the stock rises more than the exercise
price plus the premium, then the writer will lose money.
 Short Put - If you believe the stock's price will increase, you will sell or write a put. As the writer of the
put, the payoff is equal to the premium received by the buyer of the put if the stock price rises, but if the
stock price falls below the exercise price minus the premium, then the writer will lose money.

Swaps are derivatives where counterparties to exchange cash flows or other variables associated with
different investments. Many times a swap will occur because one party has a comparative advantage in
one area such as borrowing funds under variable interest rates, while another party can borrow more
freely as the fixed rate. A "plain vanilla" swap is a term used for the simplest variation of a swap. There
are many different types of swaps, but three common ones are:

 Interest Rate Swaps - Parties exchange a fixed rate for a floating rate loan. If one party has a fixed rate
loan but has liabilities that are floating, then that party may enter into a swap with another party and
exchange fixed rate for a floating rate to match liabilities. Interest rates swaps can also be entered through
option strategies. A swap gives the owner the right but not the obligation (like an option) to enter into
the swap.

 Currency Swaps - One party exchanges loan payments and principal in one currency for payments and
principal in another currency.

 Commodity Swaps - This type of contract has payments based on the price of the underlying commodity.
Similar to a futures contract, a producer can ensure the price that the commodity will be sold and a
consumer can fix the price which will be paid. Forward and futures contracts are contracts between parties
to buy or sell an asset in the future for a specified price. These contracts are usually written in reference
to the spot or today's price. The difference between the spot price at time of delivery and the forward or
future price is the profit or loss by the purchaser. These contracts are typically used to hedge risk as well
as speculate on future prices. Forwards and futures contracts differ in a few. Futures are standardized
contracts that trade on exchanges whereas forwards are non-standard and trade OTC.
USES OF FINANCIAL DERIVATIVES
Derivatives are supposed to provide some services and these services are used by investors.
Some of the uses and applications of financial derivatives can be enumerated as following:

1) Management of risk: One of the most important services provided by the derivatives is to
control, avoid, shift and manage efficiently different types of risk through various strategies like
hedging, arbitraging, spreading etc. Derivative assist the holders to shift or modify suitable the
risk characteristics of the portfolios. These are specifically useful in highly volatile financial
conditions like erratic trading, highly flexible interest rates, volatile exchange rates and monetary
chaos.
2) Price discovery: The important application of financial derivatives is the price discovery which
means revealing information about future cash market prices through the future market.
Derivative 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.
3) Liquidity and reduce transaction cost : As we see that in derivatives trading no immediate full
amount of the transaction is required since most of them are based on margin trading. As a result,
large number of traders, speculators, arbitrageurs operates in such markets. So, derivatives
trading enhance liquidity and reduce transaction cost in the markets of underlying assets.
Measurement of Market: Derivatives serve as the barometers of the future trends in price which
result in the discovery of new prices both on the spot and future markets. They help in
disseminating different information regarding the future markets trading of various commodities
and securities to the society which enable to discover or form suitable or correct or true
equilibrium price in the markets. As a result, the assets will be in an appropriate and superior
allocation of resources in the society.
4) 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 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 instruments in cash market.
5) Speculation and arbitrage: Derivatives can be used to acquire risk, rather than to hedge
against risk. Thus, some individuals and institutions will enter into a derivative contract to
speculate on the value of the underlying asset, betting that the party seeking insurance will be
wrong about the future value of the underlying asset. Speculators look to buy an asset in the
future at a low price according to a derivative contract when the future market price is high, or
to sell an asset in the future at a high price according to derivative contract when the future
market price is low. Individual and institutions may also look for arbitrage opportunities, as when
the current buying price of an asset falls below the price specified in a futures contract to sell the
asset.
6) Hedging : Hedge or mitigate risk in the underlying, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and cancels part or all of it out.
Hedging also occurs when an individual or institution buys an asset and sells it using a future
contract. They have access to the asset for a specified amount of time, and can then sell it in the
future at a specified price according to the futures contract of course; this allows them the benefit
of holding the asset.
7) Price stabilization function: Derivative market helps to keep a stabilizing influence on spot
prices by reducing the short term fluctuations. In other words, derivatives reduce both peak and
depths and lends to price stabilization effect in the cash market for underlying asset.
8) Gearing of value: Special care and attention about financial derivatives provide leverage (or
gearing), such that a small movement in the underlying value can cause a large difference in the
value of the derivative.
9) Develop the complete markets : It is observed that derivative trading develop the market
towards “complete markets” complete market concept refers to that situation where no
particular investors be better of than others, or patterns of returns of all additional securities are
spanned by the already existing securities in it, or there is no further scope of additional security.
10) Encourage competition : The derivatives trading encourage the competitive trading in the
market, different risk taking preference at market operators like speculators, hedgers, traders,
arbitrageurs etc. resulting in increase in trading volume in the country. They also attract young
investors, professionals and other experts who will act as catalysts to the growth of financial
market.
11) Other uses : The other uses of derivatives are observed from the derivatives trading in the
market that the derivatives have smoothen out price fluctuations, squeeze the price spread,
integrate price structure at different points of time and remove gluts and shortage in the
markets. The derivatives also assist the investors, traders and managers of large pools of funds
to device such strategies so that they may make proper asset allocation increase their yields and
achieve other investment goals.

Figure 1: Effective risk management through derivatives (Source: Motilal oswal)

A Brief History of Derivatives


Derivatives have been traded for centuries. Their usefulness is not new. Derivatives have played
a role in commerce and finance for thousands of years. The first known evidence of derivatives
trading dates to 2000 B.C. when merchants of Bahrain Island in the Arab Gulf, made consignment
transactions for goods to be sold in India. Aristotle also discussed some 2,350 years ago a case of
market manipulation through the use of derivatives on olive oil press capacity in Chapter 9 of his
Politics. Derivatives trading in an exchange environment and with trading rules can be traced
back to Venice in the 12th Century. Forward and options contracts were traded on commodities,
shipments and securities in Amsterdam after 1595 (See Appendix II.1A for Landmarks in
the History of Derivatives). The Royal Exchange in London seems to be the first exchange for
trading derivatives which permitted forward contracting. The first "futures" contract is by and
large traced to the Yodoya rice market in Osaka, Japan around 1650. The Chicago Board of Trade
(CBT) was established in 1848 and was perhaps the next major event in the history of futures
markets. In 1925 the first futures clearinghouse was formed. From that point, futures contracts
got its standard form. In 1972, the Chicago Mercantile Exchange (CME) established the
International Monetary Market (IMM) which allowed trading in currency futures. In 1982, the
Kansas City Board of Trade launched the first stock index futures, a contract on the Value Line
Index. The Chicago Mercantile Exchange quickly followed with their highly successful contract on
the S&P 500 index. The 1980s marked the beginning of the era of swaps and other over-the-
counter derivatives. In 1994 the derivatives world was hit by a series of large losses on derivatives
trading announced by Metallgesellschaft.
Emerging market economies are increasingly adopting derivatives to mitigate risk. In recent
years, some emerging markets like China, Korea, Taiwan, Malaysia, and India have shown
tremendous growth in derivatives trading. In the 1980’s, derivatives market was dominated by
exchanges in the United States. However, the emerging market exchanges are expected to
generate a majority of the world’s derivatives trading volume in coming few years. Certain
emerging markets like China, Korea, Malaysia, Taiwan and India have made tremendous growth
in derivatives trading in recent years (Chance, 1998).
Derivatives trading is not new to India as commodity futures trading has been in existence since
1953. Certain OTC derivatives such as Forward Rate Agreement (FRAs) and Interest Rate Swaps
(IRS) were allowed by the RBI through its guidelines in 1999. The trading of derivatives products
based on securities on stock exchanges was permitted only in June 2000. The forerunner to
exchange based derivatives in India was a kind of ‘forward trading’ in securities in the form of call
option (teji), put option (mandi), and straddles (fatak) etc. These derivatives products were
banned by the Securities Contracts Regulation Act, 1956 (SCRA) in 1969. However, as a result of
this, volumes on stock markets started declining which compelled the Bombay Stock Exchange in
1972 to start an informal system of ‘forward trading’. This system allowed ‘Carry forward’
between two settlement periods. However, SEBI was of the view that carry forward transactions
should be disallowed and transactions conducted strictly on delivery basis and trading in futures
and options should be permitted in separate markets. Consequently, SEBI issued a directive in
December 1993 prohibiting the Carry forward transactions. But it was not possible in view of
prohibition in the SCRA. It was thought that if these prohibitions were withdrawn, trading in
derivatives could commence. The Securities Laws (Amendments) Ordinance, 1995, promulgated
on 25th January 1995, lifted the ban by amending its preamble. The markets for derivatives,
however, did not take off, as there was no regulatory framework to govern trading of derivatives.
SEBI set up a 24-member Committee under the chairmanship of L.C. Gupta in November 1996 to
develop appropriate regulatory framework for derivatives trading in India. The Committee
submitted its report on March 17, 1998. The Committee strongly favours the introduction of
financial derivatives to facilitate hedging in a most cost-efficient way against market risk.
The market went ahead with preparation. It was soon realized that there was no law under which
the regulations could be framed for derivatives. SEBI felt that the definition of "securities" under
SCRA could be expanded by declaring derivatives contracts as securities. It was thought that
Government of India could declare derivatives to be securities under its delegated powers.
However, amendments to existing law in the matter become imminent.
As the derivatives could not be declared to be "securities,” government explored the possibility
of amending the SCRA to explicitly define securities to include derivatives. The Securities
Contracts (Regulation) Amendment Bill, 1998 was introduced in the Lok Sabha on 4th July, 1998
proposing to expand the definition of "securities" to include derivatives within its ambit so that
trading in derivatives could be introduced and regulated under SCRA. The Lok Sabha passed the
Bill on 30th November and the Rajya Sabha on 1st December 1999. It became the Securities Laws
(Amendment) Act 1999 on receiving the assent of the President on 16th December 1999.
Derivatives were formally defined to include:(a) a security derived from a debt instrument, share,
loan whether secured or unsecured, risk instruments or contracts for differences or any other form
of security, and (b) a contract which derives from the prices, or index of prices, or underlying
securities. The Act also ensured that derivatives should be legal and valid only if such contracts
are traded on a recognized stock exchange, thus precluding over-the counter derivatives. The
Government also abolished in March 2000 the three-decade-old notification, which prohibited
forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI
granted the final approval to this effect in May, 2000. Index futures commenced on 9th June,
2000 on BSE and on 12th June on NSE, while trading in index options commenced in July 2001
followed by stock futures in November 2001 (Saksena, 2002).

REGULATION OF DERIVATIVES TRADING IN INDIA


The regulatory frame work in India is based on L.C. Gupta Committee report and J.R. Varma
Committee report. It is mostly consistent with the international organization of securities
commission (IUSCO). The L.C. Gupta Committee report provides a perspective on division of
regulatory responsibility between the exchange and 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
emphasizes the supervisory and advisory role of SEBI. It also suggests establishment of a
separate clearing corporation.

DERIVATIVE PRODUCTS TRADED AT BSE


The BSE started derivatives trading on June 9, 2000 when it launched “Equity derivatives (Index
futures-SENSEX) first time. It was followed by launching various products which are shown in
table no.2. They are index options, stock options, single stock futures, weekly options, and stocks
for: Satyam, SBI, Reliance Industries, Tata Steel, Chhota (Mini) SENSEX, Currency futures, US
dollar-rupee future and BRICSMART indices derivatives. The table No.2 summarily specifies the
derivative products and their date of introduction at BSE.
Source: Compiled from BSE

DERIVATIVE PRODUCTS TRADED AT NSE


The NSE started derivatives trading on June 12, 2000 when it launched “Index Futures S & P CNX
Nifty” first time. It was followed by launching various derivative products which are shown in
table no.3. They are index options, stock options, stock future, interest rate, future CNX IT future
and options, Bank Nifty futures and options, CNX Nifty Junior futures and options, CNX100
futures and options, Nifty Mid Cap-50 future and options, Mini index futures and options, Long
term options. Currency futures on USD-rupee, Defty future and options, interest rate futures,
SKP CNX Nifty futures on CME, European style stock options, currency options on USD INR, 91
days GOI T.B. futures, and derivative global indices and infrastructures indices. The table no.3
presents a description of the types of derivative product traded at NSE and their data of
introduction at NSE.
Source: Compiled from NSE website

One of the most noteworthy achievements of the Indian capital markets over the past 17 years
has been the development of the derivative market. It has significantly enhanced the
sophistication and maturity of the market. In India, derivative trading began in June 2000, with
trading in stock index futures. By the fourth quarter of 2001, each of India’s two largest exchanges
had four equity-derivative products: futures and options for single stocks, and futures and
options for their respective stock indices. The NSE has become the largest exchange in single
stock futures in the world, and by June 2007,it ranked fourth globally in trading index futures, a
sign of an evolving and maturing market.
Market liquidity too has increased greatly since 1992. This was primarily attributed to settlement
rules (discussed below) and the introduction of derivatives trading. The move from
increase in derivatives trading contributed to steadily increasing market liquidity.
EQUITY DERIVATIVE
Equity derivative is a class of derivatives whose value is at least partly derived from one or more
underlying equity securities. Options and futures are by far the most common equity derivatives.
This section provides you with an insight into the daily activities of the equity derivatives market
segment on NSE. 2 major products under Equity derivatives are Futures and Options, which are
available on Indices and Stocks.

Business Growth in FO Segment


FII DERIVATIVE STATISTICS
FII DERIVATIVES STATISTICS FOR 01-Jan-2018

OPEN INTEREST AT
THE END OF THE
BUY SELL DAY

No. of Amt in No. of Amt in No. of Amt in


contracts Crores contracts Crores contracts Crores
INDEX
FUTURES 6404 524.13 8663 712.09 161514 13045.97
INDEX
OPTIONS 77928 7255.56 73192 6831.34 656612 52542.50
STOCK
FUTURES 55975 4153.29 60600 4480.20 914283 67470.63
STOCK
OPTIONS 33452 2521.54 34210 2582.77 30556 2333.78
Notes:

Both buy and sell positions have been


considered
Options Value (Buy/Sell) = Strike price * Qty
Futures Value (Buy/Sell) = Traded Price * Qty

Value & Open Interest at the end of


day:
Options Value (End of day) = Underlying Close Price * Qty
Futures Value (End of day) = Closing Futures Price * Qty (closing price is the daily settlement price of futures
contracts)

Monthly settlement statistics of Capital Markets

Monthly settlement statistics of Future & Options.


CURRENCY DERIVATIVES
A currency future, also known as FX future, is a futures contract to exchange one currency for another at a specified date
in the future at a price (exchange rate) that is fixed on the purchase date. On NSE the price of a future contract is in terms
of INR per unit of other currency e.g. US Dollars. Currency future contracts allow investors to hedge against foreign
exchange risk. Currency Derivatives are available on four currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain
Pound (GBP) and Japanese Yen (JPY). Currency options are currently available on US Dollars.
The history of derivative trading in India can be traced way back to the 19th century. In the initial
days it was mainly in the form of commodity forwards. In 1875, Bombay cotton trade association
started trading commodity futures. During the early 1900s, India had one of the largest futures
industry. However in 1952, the government banned such contracts and the derivative trading
shifted to informal forwards. The ban on commodity derivatives was lifted in the early 2000s. The
derivatives trading on the National Stock Exchange (NSE) commenced on June 12, 2000 with
futures trading on S&P CNX Nifty Index. It was followed by trading in index options and options
on individual securities which started on June 4, 2001 and July 2, 2001 respectively. Single stock
futures were launched on November 9, 2001. Since then, the futures and options (F&O) segment
has been growing continuously in terms of new products, contracts, traded volume and value. At
present, the NSE has established itself as the market leader in this segment in India, with more
than 99.5 percent market share. Indian market is one of the largest derivative markets in the
world. The growth of Indian derivative market is shown in the following figure.