ifm assignment 6300.docx

7/29/2019 ifm assignment 6300.docx

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Assignment of

IFM

Evolution in the development of currency

derivative trading in India

SUBMITTED TO: SUBMITTED BY:

Mr. Liaqut Ali Sahil Mittal

Class: MBA II C

Roll no: 6300

SCHOOL OF MANAGEMENT STUDIES, PUNJABI

UNIVERSITY PATIALA


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INTRODUCTION

The global economic order that emerged after World War II was a system where many less

developed countries administered prices and centrally allocated resources. Even the developed

economies operated under the Bretton Woods system of fixed exchange rates. Gradually, this

system of fixed prices came under immense stress. High inflation and unemployment rates made

interest rates more volatile. Ultimately, the Bretton Woods system was dismantled in 1971,

freeing exchange rates to fluctuate.

Price fluctuations, more often than not, make it extremely strenuous for businesses to estimate

their future production costs and revenues. This has created various kinds of risks. In fact risks

are inherent in all kinds of markets. Financial markets are no exception to the above and are

systemically volatile. Therefore, it is the prime concern of all the financial agents to balance or

hedge the related risk factors. This has induced the market participants to search for ways to

manage risk. Derivatives are one of such risk management tools which are getting increasedpopularity in the current market dynamics. This paper shall discuss at length the legal and

financial intricacies of derivatives trading in the Indian regulatory framework.

Derivatives are considered to be extremely versatile financial instruments, as they help to

manage risks, lower funding costs, enhance yields and diversify portfolios. The contributions

made by derivatives have been so great, that they have been credited with having changed the

face of finance in the world. Surprisingly, less than three decades ago, the global markets for

derivatives barely even existed. However, today, the derivatives market has multiplied several

times of its initial size and stands witness to its own rapid growth. Derivatives markets are an

integral part of capital markets in developed as well as in emerging market economies. These

instruments assist business growth by disseminating effective price signals concerning exchange

rates, indices and reference rates or other assets, thereby, rendering both cash and derivatives


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markets more efficient. These instruments also offer protection from possible adverse market

movements and can be used to manage or offset exposures by hedging or shifting risks

particularly during periods of volatility thereby reducing costs. By allowing for the transfer of

unwanted risk, derivatives can, also, promote more efficient allocation of capital across the

economy, thereby, increasing productivity.

Despite derivatives activity scaling new heights every year, it appears that the world market still

has a further unaccounted potential for expansion. In many of the lesser-developed financial

markets, derivatives usage is still a limited phenomenon owing to various factors. These markets

have a tremendous scope for growth which needs to be efficiently tapped.

DERIVATIVES: CONCEPT & SCOPE

Despite extensive press coverage, derivatives continue to remain one of the most widely

misused and misunderstood financial term. This is, in part due, to the wide range of financial

instruments included under the rubric of derivatives and also, to the complex nature of these

instruments. There is an unfortunate perception among many that a derivative is anything, which

causes loss to an investor. Ironically, derivatives have often been described as esoteric,

arcane, and a subject capable of being understood only by rocket scientists. This research

paper makes an attempt to clarify that even though derivatives are complex instruments, they are

not conceptually inscrutable. However, quantifying the market risks of derivatives or

understanding how they are priced requires an advanced knowledge of mathematics.

The derivatives are not formally defined under any Act in India, except for a brief reference in

Section 2(aa) of Securities Contract (Regulation) Act of India. It states that Derivatives include:

(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, and (b) a contract which

derives its value from the prices or index of prices or underlying securities. The Act also

clarifies that, notwithstanding anything contained in any other law for the time being in force,

contracts in derivatives shall be legal and valid only if such contacts are traded on a recognized


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stock exchange and settled on a clearing entity of the recognised stock exchange in accordance

with the rules and bye-laws of such stock exchange, thus precluding OTC derivatives.

In almost all common law jurisdictions, the term derivatives has no precise legal meaning

ascribed to it. Different industry and regulatory groups have developed their own working

definitions of derivatives, which provide useful insight into the range of financial instruments

covered. CASAC, for example, has defined a derivatives instrument as:

A financial instrument whose value is derived from some other thing, such as:

A physical commodity (for instance wool, cattle, oil or gold.)

a financial asset for instance, shares or bonds)

an index (for instance, a share price Index)

an interest rate

a currency

Another derivative.

The global Study Derivatives Group has adopted a similar definition that has often been quoted:

A Derivative is a bilateral contract or payments exchange agreement whose value derives, as its

name implies, from the value of an underlying asset or underlying reference rate or index.Although the International Swaps and Derivatives Associations definition is not much different

from either of the above definitions. It is narrower in scope since it confines the term to

instruments to manage risks: Derivatives are bilateral contracts involving the exchange of cash

flows and designed to shift risk between parties. When transactions mature, the amounts owed by

each party are determined by the prices of underlying commodities, securities or indices.

In general, the term derivative itself indicates that it has no independent value. The value of a

derivative is entirely derived from the value of a cash asset. A derivative contract, product,

instrument or simply derivative is to be sharply distinguished from the underlying cash asset,

which is an asset bought or sold in the cash market on normal delivery terms. A simple

derivative instrument hedges the risk component of an underlying asset. For example, rice

farmers may wish to sell their harvest at a price which they consider is safe at a future date to


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eliminate the risk of a change in prices by that date. To hedge their risks, farmers can enter into a

forward contract and any loss caused by fall in the cash price of rice will then be offset by profits

on the forward contract.

The primary purpose behind investing in derivative instruments is to enable individual or

corporate investors to either increase their exposure to certain specified risks in the hope that

they will earn returns more than adequate to compensate them for bearing these added risks,

known as speculation, or reduce their exposure to specific financial risks by transferring these

risks to other parties who are willing to bear them at lower cost, known as hedging.

TYPES OF DERIVATIVES IN INDIA

At present the Indian market trades in both exchange-traded and over the counter derivatives on

various assets including securities, both equity and debt commodities, currencies, etc. the various

types of derivatives being traded in India are discussed below:

GENERIC DERIVATIVE PRODUCTS

Today, Indian and International financial markets trade innumerable derivative products on all

kinds of underlying assets, both tangible and intangible. Before proceeding with the regulatory

issues of derivatives trading, it is important to have a detailed understanding of the four generic

derivative products in detail.

1. FORWARD CONTRACTS

A forward contract is defined as an agreement, which obligates one counterparty to buy, and the

other counterparty to sell, a specific underlying at a specific price, amount and date in the future.

It is more clearly a one-to-one, bipartite/tripartite contract, which is to be performed mutually by

the contracting parties, in future, at the term decided upon, on the contract date. In other words, a


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forward contract is an agreement to buy or sell an asset on a specified future date for a specified

price. One of the parties to the contract assumes a long position, i.e. agrees to buy the underlying

asset while the other assumes a short position, i.e. agrees to sell the asset. As this contract is

traded off the exchange and settled mutually by the contracting parties, it is called an Over-the-

counter product. It can be better understood with the help of an illustration.

Assume that there are two parties, Mr. A (buyer) and Mr. B (seller), who enter into a contract to

buy and sell 500 units of asset X at Rs 100 per unit, at a predetermined time of two months from

the date of contract. In this case, the product(asset X), the quantity (500 unites), the product price

(Rs 100 per unit) and the time of delivery (2 months from the date of contract) have been

determined and well understood, in advance, by both the contracting parties. Delivery and

payment (settlement of transaction) will take place as per the terms of the contract on thedesignated date and place.

It is pertinent to note that forward contracts are negotiated by the contracting parties on a one-to-

one basis and hence offer tremendous flexibility in terms of determining contract terms such as

price, quantity, quality(in place of commodities), delivery time and place.

Like other OTC products, forward contracts offer tremendous flexibility to the contracting

parties. However, as they are customized, they suffer from poor liquidity. Furthermore, as theecontracts are mutually settled and generally not guaranteed by any third party, the counter party

risk/default risk/credit risk is considerable in such contracts.

2. FUTURES CONTRACTS

A futures contract is similar to a forward contract, in that it is an agreement to buy or sell a

specified commodity or instrument, at a specified price, at a date in the future. Illiquidity and

counter party risk were the two issues concerning forward contracts that offered the exchanges a

tremendous business opportunity and they started trading these forward contracts, but with a

difference. In order to differentiate between the exchange-traded forwards and the OTC forward,

the market renamed the exchange-traded forwards as Futures Contract. Hence, future contracts


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are essentially standardized forward contracts, which are traded on the exchanges and settled

through the clearing agency of the exchanges. The clearing agency also guarantees the settlement

of these trades.

Reasons for using futures contracts can be diversified and complicated. First, they attract lower

transaction costs. They are normally only a fraction of the costs of trading in the underlying

commodity or instrument. Second, counterparty risk is minimal as it is unlikely that the

clearinghouse would collapse, as it is usually well-backed financially. In addition, if a participant

defaults, the rules of a typical clearinghouse will provide for the allocation of the losses to the

surviving participants according to a predetermined formula. Third, futures contracts permit

anonymity of participants as most brokers act for undisclosed principals. Fourth, there is no

requirement for large capital outlays as initial deposits range between five to fifteen percent only.Fifth, futures markets are more liquid, and therefore, it is easier for the participants to close-out

or settle their contracts. However, a major disadvantage of using futures contracts is their

inflexibility. Any investor using futures contracts for hedging would be exposed to basis risk.

Basis risk refers to the risk where the futures contract and the instrument that is being hedged

may not be perfectly matched.

3. SWAPS

Swaps like forward contracts, are customized over-the-counter transactions. A swap has been

described as an agreement between two parties to pay each other a series of cash flows, based

on fixed or floating interest rates in the same or different currencies.

Swap transactions are broadly classified into interest rate, currency, commodity or equity swaps.

It is possible to use swaps for a variety of purposes including the reduction of borrowing costs;

asset and liability management; and yield enhancement. The principle of comparative

advantage, a concept central to international trade, plays an important role in swap transactions.

Each counterparty borrows in the market where it enjoys a comparative advantage, and through

the use of swap obtains financing at a more favorable rate than it would otherwise be able to do

so. Swap cash flows can be decomposed into equivalent cash flows from a bundle of simple


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forward contracts. This has implications for the hedging of swap risks. Swaps are now hedged

with a variety of derivative products, and no longer only by matching two identical but opposing

swaps.

A swap derivative is nothing but barter or an exchange but it plays a critical role in international

finance. Currency Swaps help eliminate barriers caused by international capital markets. Interest

rate Swaps help eliminate barriers caused by regulatory structure. While Currency rate swaps

result in exchange of one currency with another, interst rate swaps help exchange a fixed rate of

interest with a variable rate. Swaps are private agreements between two parties and are not traded

on exchanges but they do have an informal market and are traded among dealers. Swaptions is an

option on swap that gives the party the right, but not the obligation to enter into a swap at a later

date.

4. OPTIONS

An option is the right to buy or sell a specific price on or before a specific date in the future. It

is a right that the option seller gives to the option buyer to buy or sell an underlying asset at a

predetermined price, within or at the end of a specified period. The party taking a long position,

i.e. buying the option is called the buyer/holder of the option and the party taking a short

position, i.e. selling the option is called the seller/writer of the option.

The option buyer who is also called long option, or long premium or holder of option, has the

right and no obligation with regard to buying or selling the underlying asset while the option

seller/ writer who is also called short on option or short on premium, has the obligation but no

right, in the contract. In other words, the option buyer may or may not exercise his option but if

he decides to exercise it the option seller/writer is legally bound to honor the contract.

The right to buy an asset is a call option, while the right to sell an asset is a put option. An

option which gives the buyer a right to buy the underlying asset, is called a call option and the

option, which gives the buyer a right to sell the underlying asset is called put option.


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An American option is one which can be exercise any time until maturity, while a European

option is one which can be exercised on maturity date. The buyer of an option is usually called

the option holder, and the seller of the option, the option writer. The option holder must pay

the option writer a price known as the premium in order to acquire the rights under the option.

Options are available on a wide range of assets including commodities, foreign currencies,

shares, bonds and even other derivatives.

EQUITY DERIVATIVES

India joined the league of exchange-traded equity derivatives in June 2000, when futures

contracts were introduced at its two major exchanges, viz. the Bombay Stock Exchange (BSE)

and National Stock Exchange (NSE). The BSE sensitive index, popularly known as the SENSEX

(compromising 30 scrips), and S&P CNX Nifty Index (compromising 50 scrips), commenced

trade in futures on June 9, 2000 and June 12, 2000 respectively. Index options and individual

stock options on 31 selected stocks were subsequently added to the derivatives basket, in 2001.

November 2001 witnessed the introduction of single stock futures in the Indian market. This list

of stocks was selected, based on a predefined eligibility criteria linked to the market

capitalization of stocks, floating stock, liquidity, etc.

COMMODITY DERIVATIVE

The Forward Contract Regulation Act (FCRA) governs commodity derivatives in India. The

FCRA specifically prohibits OTC commodity derivatives. Accordingly, at this point in time, we

have only exchange-traded commodity derivatives. Furthermore, FCRA does not even allow

options on commodities. Therefore, at present, India trades only exchange-traded commodity

futures.

Though commodity derivatives in the country have existed for a long time, trading has been

regionally concentrated due to the regional nature of the commodity exchanges. Recently

however, India began trading in commodity derivatives through two nation-wide, online


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commodity Exchanges- the National Commodities and Derivatives Exchange (NCDEX) and the

Multi Commodity Exchange (MCX). They started functioning in the last quarter of 2003 with

the introduction of futures contracts on various assets such as gold, silver, rubber, steel, mustard

seed, etc.

It is important to note that both these exchanges have been recording a very high rate of growth.

But it is interesting to note that the growth in volume of commodity derivatives has been

achieved without institutional participation in the market. At present, banks, financial

institutions, mutual funds, pension funds, insurance companies and Foreign Institutional

investors are not allowed to participate in the commodities market.

CURRENCY DERIVATIVES

India has been trading forward contracts in currency, for the last several years. Recently, the RBI

has allowed options in the OTC market. The OTC currency market in the country is considerably

large and well-developed. However, the business is concentrated with a limited number of

market participants.

INTEREST RATE DERIVATIVES

An Interest Rate Derivative is a derivative where the underlying asset is the right to pay or

receive a (usually notional) amount of money at a given interest rate. There has also been

significant progress in interest rate derivatives in the Indian OTC market. The NSE introduced

trading in cash settled interest rate futures in the year 2003.

CLASSIFICATION OF DERIVATIVES MARKETS

Derivatives markets fall in two broad categories: exchange-traded derivatives markets and over-

the counter (OTC) derivatives markets.

EXCHANGE-TRADED DERIVATIVES MARKET


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A derivatives exchange may simply be described as an organized market for the trading of

derivatives contracts. The derivatives exchanges are a vital component of the global market for

exchange-traded derivatives.

In a typical transaction, the clients order is routed to a floor member for execution. After the

trade is executed, the contract between the two contracting floor members is then sent to the

clearing house for registration. Once the contract between two clearing members is registered,

the legal nexus between the original buyer and seller is broken. The clearinghouse interposes

itself between the buyer and seller and two new contracts come into existence. In one contract,

the clearinghouse acts as buyer to the original seller, and in the other contract, the clearinghouse

interposes itself between the buyer and seller. The clearinghouse does not guarantee the

performance of the open contracts. Rather it assumes the responsibility for performance byacting as the counterparty in both the contracts.

The various exchange traded derivatives market in India are the National Stock Exchange(NSE),

the Bombay Stock Exchange(BSE), the National Commodities and Derivatives

Exchange(NCDEX) and the Multi Commodity Exchange(MCX).

Some of the international exchanges where such derivatives are traded are The Sydney Futures

Exchange, the New Zealand Futures And Options Exchange, Singapore Exchange DerivativesTrading Limited, Commodity and Monetary Exchange of Malaysia, Kuala Lumpur Options and

Financial Futures Exchange, Hong Kong Futures Exchange.

OVER-THE-COUNTER DERIVATIVES MARKETS.

The over-the-counter (OTC) derivatives markets are principal-to-principal dealer markets.

Products/contracts that are traded outside the exchanges are called OTC derivatives. They are

contracts those which are privately traded between two parties and involve no exchange or

intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives


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Market or OTC market. The main participants of OTC market are the Investment Banks,

Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks

markets the derivatives through traders to the clients like hedge funds and the rest.

The OTC derivatives markets are much larger than the exchange-traded derivatives markets. The

OTC derivatives markets are predominantly institutional markets and individual transactions

tend to be fairly large in size, while the exchange traded derivatives markets, on the other hand,

have a significant retail component and their average transaction size tend to be much smaller.

Unlike the exchange traded derivatives, the OTC derivatives markets are usually unregulated and

operate on a caveat emptor basis. The OTC derivatives markets do not have a formal trading

place, are less transparent, have no margining mechanisms, and generally suffer from reduced

liquidity.

OTC contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The

terms of an OTC contract are flexible, and are often customized to fit the specific requirements

of the user. However, OTC Contracts have substantial credit risk; which is the risk that the

counterparty that owes money may defaults on the payment. In India, OTC derivatives are

generally prohibited with some exceptions: those that are specifically allowed by the Reserve

bank of India (RBI) or, in the case of commodities (which are regulated by the forward markets

commission), those that trade informally in havala or forward markets.

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.


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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,

NSE3

and BSE4, 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. Table 1 gives chronology of introduction of derivatives in India.

Table :Derivatives in India: A Chronology

Date Progress14December 1995 NSE asked SEBI for permission to trade index futures.18November 1996 SEBI setup L. C. Gupta Committee to draft a policy framework for index futures. 11May 1998 L. C. Gupta Committee submitted report.7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps 24May 2000 SIMEX chose Nifty for trading futures and options on an Indian index. 25May 2000 SEBI gave permission to NSE and BSE to do index futures trading. 9 June 2000 Trading of BSE Sensex futures commenced at BSE.12

June 2000 Trading of Nifty futures commenced at NSE.31August 2000 Trading of futures and options on Nifty to commence at SIMEX. June 2001 Trading of Equity Index Options at NSEJuly 2001 Trading of Stock Options at NSENovember 9, 2002 Trading of Single Stock futures at BSEJune 2003 Trading of Interest Rate Futures at NSESeptember 13, 2004 Weekly Options at BSEJanuary 1, 2008 Trading of Chhota(Mini) Sensex at BSEJanuary 1, 2008 Trading of Mini Index Futures & Options at NSE August 29,2008 Trading of Currency Futures at NSE


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October 2,2008 Trading of Currency Futures at BSESource: Complied from BSE and NSE

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 1096. 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) SENSEX7

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. Table 2 summarily specifies the derivative products and their date of

introduction on the BSE

Table: Products Traded in Derivatives Segment of the BSE

S.no Product Traded with underlying asset Introduction Date1 Index Futures- Sensex June 9,20002 Index Options- Sensex June 1,20013 Stock Option on 109 Stocks July 9, 20014 Stock futures on 109 Stocks November 9,20025 Weekly Option on 4 Stocks September 13,20046 Chhota (mini) SENSEX January 1, 2008

7Futures & Options on Sectoral indices namely BSE TECK, BSE FMCG, BSE Metal, BSE

N.A.Bankex and BSE Oil & Gas.

8 Currency Futures on US Dollar Rupee October 1,2008Source: Complied from BSE website

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


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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

2338securities stipulated by the Securities & Exchange Board of India (SEBI) . Trading in

options on individual securities commenced from July 2, 2001. The options contracts areAmerican 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. Table 3

presents a description of the types of products traded at F& O segment of NSE.

Table :Products Traded in F&O Segment of NSE

S.no Product Traded with underlying asset Introduction Date1 Index Futures- S&P CNX Nifty June 12,20002 Index Options- S&P CNX Nifty June 4,20013 Stock Option on 233 Stocks July 2, 20014 Stock futures on 233 Stocks November 9,20015 Interest Rate Futures- TBills and 10 Years Bond June 23,20036 CNX IT Futures & Options August 29,20037 Bank Nifty Futures & Options June 13,20058 CNX Nifty Junior Futures & Options June 1,20079 CNX 100 Futures & Options June 1,200710 Nifty Midcap 50 Futures & Options October 5,200711 Mini index Futures & Options - S&P CNX Nifty index January 1, 2008

12 long Term Option contracts on S&P CNX Nifty Index March 3,200813 Currency Futures on US Dollar Rupee August 29,200814 S& P CNX Defty Futures & Options December 10, 2008

Source: Complied from NSE website

Growth of Derivatives Market in India

Equity derivatives market in India has registered an "explosive growth" (see Fig. 2) 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


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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,

followed by index futures with turnover shares of 52 percent and 31 percent, respectively . In

case of BSE, index futures outperform stock futures.

Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long time. In the

area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and,

by the early 1900s India had one of the worlds largest futures industry. In 1952 the government

banned cash settlement and options trading and derivatives trading shifted to informal forwards

markets. In recent years, government policy has changed, allowing for an increased role for

market-based pricing and less suspicion of derivatives trading. The ban on futures trading of

many commodities was lifted starting in the early 2000s, and national electronic commodity

exchanges were created.

In the equity markets, a system of trading called badla involving some elements of forwards

trading had been in existence for decades. However, the system led to a number of undesirable

practices and it was prohibited off and on till the Securities and

Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock

market between 1993 and 1996 paved the way for the development of exchange-traded equity

derivatives markets in India. In 1993, the government created the NSE in collaboration with

state-owned financial institutions. NSE improved the efficiency and transparency of the stock

markets by offering a fully automated screen-based trading system and real-time price

dissemination. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a

proposal to SEBI for listing exchange-traded derivatives. The report of the L. C. Gupta

Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-

level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and


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advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various

operational details such as the margining systems. In 1999, the Securities Contracts (Regulation)

Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This

allowed the regulatory framework for trading securities to be extended to derivatives. The Act

considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a

30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivatives based

on interest rates and foreign exchange. A system of market-determined exchange rates was

adopted by India in March 1993. In August 1994, the rupee was made fully convertible on

current account. These reforms allowed increased integration between domestic and international

markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the

exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991.The easing

of various restrictions on the free movement of interest rates resulted in the need to manage

interest rate risk.

Derivatives Instruments Traded in India

In the exchange -traded market, the biggest success story has been derivatives on equity

products. Index futures were introduced in June 2000, followed by index options in June 2001,

and options and futures on individual securities in July 2001 and November 2001, respectively.

As of 2005, the NSE trades futures and options on 118 individual stocks and

3 stock indices. All these derivative contracts are settled by cash payment and do not involve

physical delivery of the underlying product (which may be costly).

Derivatives on stock indexes and individual stocks have grown rapidly since inception. In

particular, single stock futures have become hugely popular, accounting for about half of NSEs

traded value in October 2005. In fact, NSE has the highest volume (i.e. number of contracts

traded) in the single stock futures globally, enabling it to rank 16 among world exchanges in the

first half of 2005. Single stock options are less popular than futures. Index futures are


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increasingly popular, and accounted for close to 40% of traded value in October 2005. Figure 2

illustrates the growth in volume of futures and options on the Nifty index, and shows that index

futures have grown more strongly than index options.9

NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, there has

been little trading in them. One problem with these instruments was faulty contract

specifications, resulting in the underlying interest rate deviating erratically from the reference

rate used by market participants. Institutional investors have preferred to trade in the OTC

markets, where instruments such as interest rate swaps and forward rate agreements are thriving.

As interest rates in India have fallen, companies have swapped their fixed rate borrowings into

floating rates to reduce funding costs. Activity in OTC markets dwarfs that of the entire

exchange-traded markets, with daily value of trading estimated to be Rs. 30 billion in 2004

(FitchRatings, 2004).

Foreign exchange derivatives are less active than interest rate derivatives in India, even though

they have been around for longer. OTC instruments in currency forwards and swaps are the most

popular. Importers, exporters and banks use the rupee forward market

to hedge their foreign currency exposure. Turnover and liquidity in this market has been

increasing, although trading is mainly in shorter maturity contracts of one year or less (Gambhir

and Goel, 2003). In a currency swap, banks and corporations may swap its rupee denominated

debt into another currency (typically the US dollar or Japanese yen), or vice versa. Trading in

OTC currency options is still muted. There are no exchange-traded currency derivatives in India.

Exchange-traded commodity derivatives have been trading only since 2000, and the growth in

this market has been uneven. The number of commodities eligible for futures trading has

increased from 8 in 2000 to 80 in 2004, while the value of trading has increased almost four

times in the same period (Nair, 2004). However, many contracts barely trade and, of those that

are active, trading is fragmented over multiple market venues, including central and regional

exchanges, brokerages, and unregulated forwards markets. Total volume of commodity

derivatives is still small, less than half the size of equity derivatives (Gorham et al, 2005).


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Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have

assets and liabilities of different maturities and in different currencies, and are exposed to

different risks of default from their borrowers. Thus, they are likely to use derivatives on interest

rates and currencies, and derivatives to manage credit risk. Non-financial institutions are

regulated differently from financial institutions, and this affects their incentives to use

derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to the

use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded derivatives so far,

with their contribution to total value of NSE trades being less than 8% in October 2005.

However, market insiders feel that this may be changing, as indicated by the growing share of

index derivatives (which are used more by institutions than by retail investors). In contrast to the

exchange-traded markets, domestic financial institutions and mutual funds have shown great

interest in OTC fixed income instruments. Transactions between banks dominate the market for

interest rate derivatives, while state-owned banks remain a small presence (Chitale, 2003).

Corporations are active in the currency forwards and swaps markets, buying these instruments

from banks.

Why do institutions not participate to a greater extent in derivatives markets? Some institutions

such as banks and mutual funds are only allowed to use derivatives to hedge their existing

positions in the spot market, or to rebalance their existing portfolios. Since banks have little

exposure to equity markets due to banking regulations, they have little incentive to trade equity

derivatives.Foreign investors must register as foreign institutional investors (FII) to trade

exchange-traded derivatives, and be subject to position limits as specified by SEBI.

Alternatively, they can incorporate locally as a


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Recent Developments

RBI in order to regulate the currency market volatility has allowed the trading in currency future

and forward on April 20,2007. And as there was difficulty in managing the currency future along

depending on FOREX with other derivatives traded in Security exchange market depending on

SENSEX, Therefore the RBI and SEBI came together and jointly formed an standing committee

to analyze the trade in currency forward and future market around the world and thus laying

down the guideline to introduce and manage the exchange traded currency future market in

India. The committee has submitted the report on May 29,2008 . RBI and SEBI is now

cooperating and working together manage this segment of future and option trading in India .this

segment has mostly benefited importer and exporter to manage their future risk by hedging there

fund in currency future were they could lock there future currency exchange rate so that they

could manage there risk in fluctuating Indian currency in international market. Various currency

derivatives have been introduced by NSE and MCX to make Indian Securities market globally

competitive and larger.

Conclusion:

The entire concept of taxation of derivatives is at crossroads, the dilemma is that if the

derivatives transactions are regarded as taxable under the head Capital Gains, there is no

provision for deduction of such provision, particularly as the gains would be computed and

taxable only on the date of transfer, i.e. the date of squaring up or expiry of the derivatives, and

not on any interim date. Further, in computing capital gains, only the cost of acquisition, cost of

improvement and expenses in connection with the transfer are deductible. Such provision would

therefore not be deductible if the derivatives transaction income is taxable as capital gains.

If the derivatives transactions are taxable as Income from Other Sources, the real income

theory would again require the deduction of such provision for loss in determining the taxable

income.


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The taxation of derivative transactions is not specifically dealt with under the Indian Income-tax

Act (Act). There could be two possible interpretations viz. derivatives transactions are pure

business transactions and hence, the income/loss thereon should be assessed as normal business

income / loss. The other view is that derivatives are covered under the definition of speculative

transaction under section 43(5) of the Act in absence of delivery of the underlying security or

commodity.

Under the Act, speculative profits/losses are allowed to be setoff only against speculative

losses/profits respectively. The unabsorbed speculative losses are allowed to be carried forward

for 8 immediately succeeding assessment years. However, setoff of such carried forward

speculative losses is allowed to be setoff only against speculation profits.

In view of the aforesaid, there is a risk of such derivative transactions being treated as

speculative transactions under the Act. Therefore, one is advised to seriously consider the tax

implications of entering into derivative transactions.

A high level panel consisting of a special three-member committee had been set up by the

Department of Revenue to examine the definition of `Speculative Transactions' with respect to

trading in financial derivatives. The committee is of the view that the definition of speculative

transaction in Section 43(5) of the Income Tax Act is fairly obsolete when viewed against thelatest developments in the capital markets. Therefore, to my understanding, it is likely that the

derivative transactions will be put outside the ambit of speculative transactions based on the

recommendations of the Committee and looking at the Government's commitment to deepen and

modernize capital markets, as government is keen to make Indian securities market globally

competitive by introducing innovative derivatives to play globally and fulfill the global market

demand of Derivatives from Indian prospering Securities Market .

From the above discussion it is evident that derivative trading has left an indelible mark on the

face of the global financial markets. This conclusion is supported by the fact that derivatives

have grown at explosive rates, and at times trading in derivatives has even surpassed trading in

their underlying instruments. However, derivatives are more risky than other traditional financial

products because they are highly leveraged, more complex and less transparent. Being relatively


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newer instruments, there is a general lack of understanding of how they operate or how they

should be managed.

However, a closer scrutiny of the losses suffered by end-users reveals that in many cases, the

underlying causes were the improper use of derivatives, greed, and ignorance. Losses from

derivatives trading could have been reduced if there was proper disclosure of the risks involved,

It is firmly suggested that with the help of a comprehensive regulatory framework and the

concurrent acceptance of the recommendations made above, derivatives trading could prove to

be not only safe but highly lucrative. The following words of Arthur Levitt, Chairman of the

United States Securities and Exchange Commission (when testifying before the Senate in

January, 1995) very aptly summarise the nature of derivatives:

Derivatives are not inherently bad or good. They are a bit like electricity, dangerous if

mishandled, but bearing the potential to do tremendous good.

ifm assignment 6300.docx

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