Financial Derivatives Market India Essay Example
Financial Derivatives Market India Essay Example

Financial Derivatives Market India Essay Example

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The emergence of the financial derivatives market in India marks a significant milestone, as financial markets are naturally volatile, posing risk as a major concern for financial players. To manage such risk, derivatives were introduced - products that derive their value from one or more underlying variables referred to as bases.

The use of derivatives in trading has been present throughout history, and today wheat farmers may use them to avoid the risk of price fluctuations when selling their harvest in the future. This type of transaction involves the underlying asset, which in this case is the spot price of wheat, and the derivative itself. The development of exchange-traded derivatives has been ongoing.

Early forward contracts were established in the past to mitigate the risk of selling large amounts of commodities after harvest i


n light of significant market fluctuations. In modern times, the derivatives market serves a variety of economic purposes.

  1. They help in transferring risks from risk averse people to risk oriented people
  2. They help in the discovery of future as well as current prices
  3. They catalyze entrepreneurial activity
  4. They increase the volume traded in markets because of participation of risk averse people in greater numbers
  5. They increase savings and investment in the long run

Individuals involved in a financial market dealing with derivatives.

  • Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.
  • Speculators use futures and options contracts to get extra leverage in betting on future movements in the pric
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of an asset.

Futures contracts are a type of forward contract that is exchanged-traded and standardized. Options come in two varieties, calls, and puts. Calls allow the buyer to purchase a set amount of an underlying asset at a predetermined price on or before a specific future date. Puts give the buyer the right to sell a set amount of the underlying asset at a predetermined price on or before a set date. The majority of options traded on exchanges have a maximum maturity of nine months, although they can have lifetimes up to one year.

Swaps are often seen as collections of forward contracts. The two most frequently utilized types of swaps are:

  • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
  • Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.

In essence, a swaption pertains to an option for a forward swap and operates via receiver swaptions and payer swaptions, instead of calls and puts. A receiver swaption involves an opportunity to obtain fixed payments while disbursing variable payments.

  1. Increased volatility in asset prices in financial markets,
  2. Increased integration of national financial markets with the international markets,
  3. Marked improvement in communication facilities and sharp decline in their costs,
  4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and
  5. Innovations in the derivatives

markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

Due to the lack of a regulatory framework to govern the trading of derivatives, the derivatives market did not flourish.

In June 1998, SEBI created a group led by Prof. J.R. Varma to propose ways to contain risks in the derivatives market in India. The resulting report, submitted in October 1998, outlined various measures for margining systems, initial margin charges, broker net worth, deposit requirements, and real-time monitoring. Eventually, the Securities Contract Regulation Act (SCRA) was amended in December 1999 to cover derivatives as "securities," and regulations were put in place to govern derivatives trading.

The Indian government declared that derivatives would only be considered legitimate if they were traded on a recognized stock exchange and not in OTC transactions. Additionally, in March 2000, the government revoked a longstanding notification that had formerly banned forward trading in securities. Finally, derivatives trading officially began in India in June of 2000 after receiving SEBI approval in May of 2001.

SEBI approved trading in futures contracts based on the S&P CNX Nifty and BSE-30 (Sensex) index, followed by approval for trading in options based on these indexes and individual securities. Trading in BSE Sensex options started on June 4, 2001, while trading in options on individual securities started in July 2001. Futures contracts on individual stocks were introduced in November 2001. Derivatives trading on NSE started on June 12, 2000, with S&P CNX Nifty Index futures.

On June 4, 2001, the trading in index options began,

while options on individual securities began on July 2, 2001. Also, single stock futures were introduced on November 9, 2001. The derivative contracts for index futures and options at NSE are based on S&P CNX, and trading and settlement are carried out according to the approved rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation. It is noteworthy that all Exchange traded derivative products are open for trading by Foreign Institutional Investors (FIIs).

  • Based on the trading statistics in the NSE report on F&O, the following observations can be made:
  • Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.
  • On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips.
  • Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1. 32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the


  • Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.
  • Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements.
  • Considering calls and puts as more than substitutes for spot trading would mean that intra-day stock price changes would not have a direct effect on option premiums. The growth of Over The Counter (OTC) derivatives markets has been significant in recent years, in parallel with the modernization of commercial and investment banking and expansion of financial activities on a global scale. These changes have been greatly aided by advancements in information technology.

    Although exchange-traded and OTC derivative contracts are advantageous, the latter are less structured than the former. The financial market turbulence of 1998 was largely attributed to highly leveraged institutions and their OTC derivative positions. Such occurrences exposed the market stability risks stemming from characteristics specific to OTC derivative markets and instruments. In comparison to exchange-traded derivatives, OTC derivatives markets possess the following properties:

    1. The management of counter-party (credit) risk is decentralized and located within individual institutions.
    2. There are no formal centralized limits on individual positions, leverage, or margining,
    3. There are no formal rules for risk and burden-sharing,
    4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and
    5. The OTC contracts are generally not regulated by a regulatory authority and

    the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

  • Distinguish between future and forward contract
  • A forward contract involves agreeing to exchange assets at a later time according to the terms of the contract, with the price set at the start. The asset is not delivered and paid for until later. An example of this type of contract is a foreign currency forward contract, where a specific quantity of foreign currency is agreed upon for future exchange in return for payment on that date.

    In comparison to a forward contract, a futures contract has more defined and specific conditions.

    Prior to a designated date, the Call Option holder has the right to purchase the underlying asset at an agreed-upon price.

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