Dr. M.D Baby
Reader & Head-Dept of Commerce,
St. Dominic’s College, Kanjirappally, Kerala
drbabymukalel@rediffmail.com
____________________________
Introduction
Price fluctuations make it hard for businesses to estimate their future production costs and revenues.1 Derivative securities provide them a valuable set of tools for managing this risk. In industrially advanced countries, besides money market and capital market securities, a variety of other securities like derivatives have now become available for investment and trading. A derivative security is a financial contract whose value is derived from the value of something else such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices.
Financial derivatives came into spot light along with rise in uncertainty of post 1970, when the US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations, including stock index futures. Need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped the farmers and processors hedge against commodity price risk. After the collapse of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets, such as introduction of floating rates for currencies, increased trading in a variety of derivative instruments and online trading in the capital market.
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 world’s largest futures industries. In 1952 the government banned cash settlement and options trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created.
Objective:
Today derivatives have become part of the day to day life for ordinary people in most parts of the world. This paper describes the evolution of Indian derivatives market, the popular derivatives instruments in India, with the objective of making an assessment of the outlook of the Indian derivatives market.
Results & Discussion
In the equity markets, a system of trading called “badla” involving some elements of forwards trading had been in existence for decades.2 However, the system led to a number of undesirable practices and it was prohibited off and on till the SEBI banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved 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.
1. Price volatility may reflect changes in the underlying demand and supply conditions and thereby provide useful information about the market. Thus, economists do not view volatility as necessarily harmful.
2. “Badla” allowed investors to trade single stocks on margin and to carry forward positions to the next settlement cycle. Earlier, it was possible to carry forward a position indefinitely but later the maximum carry forward period was 90 days. Unlike a futures or options, however, in a “badla” trade there is no fixed expiration date, and contract terms and margin requirements are not standardized.
In 1995, a prohibition on trading options was lifted. In 1999, the Securities Contracts (Regulation) Act of 1956 was amended so that derivatives could be declared “securities.” This allowed the regulatory framework for trading securities to be extended to derivatives.
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). 3 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 NSE’s 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 increasingly popular, and accounted for close to 40% of traded value in October 2005.
NSE launched interest rate futures in June 2003 but, in contrast to equity derivatives, there has been little trading in them. Institutional investors have preferred to trade in the OTC markets, where instruments such as interest rate swaps and forward rate agreements are thriving.
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).
Conclusion
Derivatives are complex and exotic instruments that Indian investors will have difficulty in understanding. It is necessary to organise more no of investor awareness programmes.
India has a long history of derivatives trading. In terms of the growth of derivatives markets and the variety of derivatives users, the Indian market has equalled or exceeded many other regional markets.4 In fact in commodities market, Indian exchanges are inviting foreigners to participate for which the approvals have also been granted. The popularity of single stock options is less. If it is made popular its trading will definitely increase. More no. of institutional investors is to be encouraged to participate in the equity derivatives market also.
There is a large gap exist between the trading of equity derivatives. I.e. NSE figures show that 90% of the activity is due to stock futures and index futures as compared to the trading of options. Therefore necessary step has to be b taken for enhancing the trading of options.
There is no consistent method of accounting for gains and losses from derivatives trading. Thus, a proper framework to account for derivatives needs to be developed.
3. Settlement represents the exchange of a security and its payment.
4. Among exchange-traded derivative markets in Asia, India was ranked second behind S. Korea for
the first quarter of 2005.
* Reader, Research Guide & Head of the Department, Research and Post graduate Department of Commerce, St. Dominic’s College, Kanjirappally, Kottayam District. E-mail: babymukalel@reddifmail.com.com
References:
Asani Sarkar, 2006, Indian Derivatives Markets, The Oxford companion to Economics in India, Oxford university press, New Delhi
Dr V Radha, P.T Oommen and N.S Nair, 2000, Derivatives, capital market and financial services, Lions Publications, Chennai -5
Business lines Investment world, June 11, 2000- Myths behind Investments
www.nseindia.com/marketlist/dupdate.
FitchRatings, 2004, Fixed Income Derivatives---A Survey of the Indian Market,
www.fitchratings.com
Gambhir, Neeraj and Manoj Goel, 2003, Foreign Exchange Derivatives Market in India- Status and Prospects, Susan Thomas (ed.), Derivatives Markets in India, Tata McGraw Hill Publishing Company Limited, New Delhi, India.
ISMR, Indian Securities Market: A Review, 2004, National Stock Exchange of India
Limited, Mumbai, India.
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