Introduction of derivative

Introduction
The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse
economic agents to guard themselves against uncertainties arising out of
fluctuations in asset prices. By their very nature, the financial markets are
marked by a very high degree of volatility. Through the use of derivative
products, it is possible to partially or fully transfer price risks by locking–in
asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying asset prices. However, by locking-in
asset prices, derivative products minimize the impact of fluctuations in asset
prices on the profitability and cash flow situation of risk-averse investors.

Derivatives defined
Derivative is a product whose value is derived from the value of one or more
basic variables, called bases (underlying asset, index, or reference rate), in a
contractual manner. The underlying asset can be equity, forex, commodity or
any other asset. For example, wheat farmers may wish to sell their harvest at a
future date to eliminate the risk of a change in prices by that date. Such a
transaction is an example of a derivative. The price of this derivative is driven
by the spot price of wheat which is the “underlying”.
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A)
defines “derivative” to include –
1. 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.
2. A contract which derives its value from the prices, or index of prices, of underlying
securities.
Derivatives are securities under the SC(R)A and hence the trading of derivatives
is governed by the regulatory framework under the SC(R)A.

Products, participants and functions

Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. The following three broad categories of
participants - hedgers, speculators, and arbitrageurs trade in the derivatives
market. Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk. Speculators wish to
bet on future movements in the price of an asset. Futures and options
contracts can give them an extra leverage; that is, they can increase both the
potential gains and potential losses in a speculative venture. Arbitrageurs are
in business to take advantage of a discrepancy between prices in two different
markets. If, for example, they see the futures price of an asset getting out of
line with the cash price, they will take offsetting positions in the two markets
to lock in a profit.
The derivatives market performs a number of economic functions. First,
prices in an organized derivatives market reflect the perception of market
participants about the future and lead the prices of underlying to the perceived
future level. The prices of derivatives converge with the prices of the
underlying at the expiration of the derivative contract. Thus derivatives help in
discovery of future as well as current prices. Second, the derivatives market
helps to transfer risks from those who have them but may not like them to
those who have an appetite for them. Third, derivatives, due to their inherent
nature, are linked to the underlying cash markets. With the introduction of
derivatives, the underlying market witnesses higher trading volumes because
of participation by more players who would not otherwise participate for lack
of an arrangement to transfer risk. Fourth, speculative trades shift to a more
controlled environment of derivatives market. In the absence of an organized
derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these kind of mixed markets. Fifth, an important
incidental benefit that flows from derivatives trading is that it acts as a catalyst
for new entrepreneurial activity. The derivatives have a history of attracting
many bright, creative, well-educated people with an entrepreneurial attitude.
They often energize others to create new businesses, new products and new
employment opportunities, the benefit of which are immense. Finally,
derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
Types of derivatives

The most commonly used derivatives contracts are forwards, futures and
options which we shall discuss in detail later. Here we take a brief look at
various derivatives contracts that have come to be used.

Forwards: Forwards are the oldest of all the derivatives. A forward contract
refers to an agreement between two parties to exchange an agreed quantity
of an asset for cash at certain date in future at a predetermined price
specified in that agreement. The promised asset may be currency,
commodity, instrument etc.

Example: on June 1, x enters into an agreement to buy 50 bales of cotton on

December 1at Rs. 1,000/- per bale from y, a cotton dealer. It is a case of a
forward contract where x has to pay Rs. 50,000 on December 1 to y and y has
to supply 50 bales of cotton.

In a forward contract, a user (holder) who promises to buy the specified asset
at an agreed price at a fixed future date is said to be in the ‘long position’. On
the other hand, the user who promises to sell at an agreed price at a future
date is said to be in ‘short position’. Thus, ‘long position & ‘short position’
take the form of ‘buy & sell’ in a forward contract.

Futures: A futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. Futures contracts
are special types of forward contracts in the sense that the former are
standardized exchange-traded contracts.
Clark has defined future trading “as a special type of futures contract bought
and sold under the rules of organized exchanges.” The term ‘future trading’
includes both speculative transactions where futures are bought and sold
with the objective of making profits from the price changes and also the
hedging or protective transactions where futures are bought and sold with
view to avoiding unforeseen losses resulting from price fluctuations.

A future contract is one where there is an agreement between two parties to

exchange any assets or currency or commodity for cash at a certain future
 date, at an agreed price. Both the parties to the contract must have mutual
trust in each other. It takes place only in organized futures market and
according to well-established standards.

As in a forward contract, the trader who promises to buy is said to be in ‘long

position’ and the one who promises to sell is said to be in ‘short position’ in
futures also.
Options: Options are of two types - calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the underlying asset, at a
given price on or before a given future date. Puts give the buyer the right, but
not the obligation to sell a given quantity of the underlying asset at a given
price on or before a given date.

Swaptions: Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a swaption is an option on a
forward swap. Rather than have calls and puts, the swaptions market has
receiver swaptions and payer swaptions. A receiver swaption is an option to
receive fixed and pay floating. A payer swaption is an option to pay fixed and
receive floating.

History of derivative
With the opening of the economy to multinationals and the adoption of the
liberalized economic policies, the economy is driven more towards the free
market economy. The complex nature of financial structuring itself involves the
utilization of multi-currency transactions. It exposes the clients, particularly
corporate clients to various risks such as exchange rate risk, interest rate risk,
economic risk and political risk.

With the integration of the financial markets and free mobility of capital, risks
also multiplied. For instance, when countries adopt floating exchange rates,
they have to face risks due to fluctuations in the exchange rates. Deregulation
of interest rate cause interest risks. Again, securitization has brought with it
the risk of default or counter party risk. Apart from it, every asset—whether
commodity or metal or share or currency—is subject to depreciation in its
value. It may be due to certain inherent factors and external factors like the
market condition, Government’s policy, economic and political condition
prevailing in the country and so on.

In the present state of the economy, there is an imperative need of the

corporate clients to protect there operating profits by shifting some of the
uncontrollable financial risks to those who are able to bear and manage them.
Thus, risk management becomes a must for survival since there is a high
volatility in the present financial markets.

In this context, derivatives occupy an important place as risk reducing

machinery. Derivatives are useful to reduce many of the risks discussed above.
In fact, the financial service companies can play a very dynamic role in dealing
with such risks. They can ensure that the above risks are hedged by using
derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable
the clients to transfer their financial risks to he financial service companies.
This really protects the clients from unforeseen risks and helps them to get
there due operating profits or to keep the project well within the budget costs.
To hedge the various risks that one faces in the financial market today,
derivatives are absolutely essential.

SEBI Guidelines:

SEBI has laid the eligibility conditions for Derivative Exchange/Segment and its
Clearing Corporation/House to ensure that Derivative Exchange/Segment and
Clearing Corporation/House provide a transparent trading environment, safety
and integrity and provide facilities for redressed of investor grievances. Some
of the important eligibility conditions are:

1. Derivative trading to take place through an on-line screen based Trading

System.
2. The Derivatives Exchange/Segment shall have on-line surveillance
capability to monitor positions, prices, and volumes on a real time basis
so as to deter market manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for
dissemination of information about trades, quantities and quotes on a
real time basis through at least two information vending networks, which
are easily accessible to investors across the country.
4. The Derivatives Exchange/Segment should have arbitration and investor
grievances redressal mechanism operative from all the four
areas/regions of the country.
5. The Derivatives Exchange/Segment should have satisfactory system of
monitoring investor complaints and preventing irregularities in trading.
6. The Derivative Segment of the Exchange would have a separate Investor
Protection Fund.
7. The Clearing Corporation/House shall perform full novation, i.e., the
Clearing Corporation/House shall interpose itself between both legs of
every trade, becoming the legal counterparty to both or alternatively
should provide an unconditional guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the
overall position of Members across both derivatives market and the
underlying securities market for those Members who are participating in
both.
9. The level of initial margin on Index Futures Contracts shall be related to
the risk of loss on the position. The concept of value-at-risk shall be used
in calculating required level of initial margins. The initial margins should
be large enough to cover the one-day loss that can be encountered on
the position on 99 per cent of the days.
10. The Clearing Corporation/House shall establish facilities for
electronic funds transfer (EFT) for swift movement of margin payments.
11. In the event of a Member defaulting in meeting its liabilities, the
Clearing Corporation/House shall transfer client positions and assets to
another solvent Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to
segregate initial margins deposited by Clearing Members for trades on
their own account and on account of his client. The Clearing
Corporation/House shall hold the clients’ margin money in trust for the
client purposes only and should not allow its diversion for any other
purpose.
 13. The Clearing Corporation/House shall have a separate Trade
Guarantee Fund for the trades executed on Derivative
Exchange/Segment.

SEBI has specified measures to enhance protection of the rights of investors in

the Derivative Market. These measures are as follows:

1. Investor’s money has to be kept separate at all levels and is permitted to

be used only against the liability of the Investor and is not available to
the trading member or clearing member or even any other investor.
2. The Trading Member is required to provide every investor with a risk
disclosure document which will disclose the risks associated with the
derivatives trading so that investors can take a conscious decision to
trade in derivatives.
3. Investor would get the contract note duly time stamped for receipt of
the order and execution of the order. The order will be executed with
the identity of the client and without client ID order will not be accepted
by the system. The investor could also demand the trade confirmation
slip with his ID in support of the contract note. This will protect him from
the risk of price favour, if any, extended by the Member.
4. In the derivative markets all money paid by the Investor towards margins
on all open positions is kept in trust with the Clearing House /Clearing
Corporation and in the event of default of the Trading or Clearing
Member the amounts paid by the client towards margins are segregated
and not utilised towards the default of the member. However, in the
event of a default of a member, losses suffered by the Investor, if any, on
settled/closed out position are compensated from the Investor
Protection Fund, as per the rules, bye-laws and regulations of the
derivative segment of the exchanges.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading
with one another. Forward contracting dates back at least to the 12th century,
and may well have been around before then. Merchants entered into contracts
with one another for future delivery of specified amount of commodities at
specified price. A primary motivation for pre-arranging a buyer or seller for a
stock of commodities in early forward contracts was to lessen the possibility
that large swings would inhibit marketing the commodity after a harvest.
The following factors have been driving the growth of financial derivatives:

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.
Derivatives market in India

Approval for derivatives trading

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws(Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market 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 Dr.L.C.Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee
submitted its report on March 17 , 1998 prescribing necessary pre–conditions
for introduction of derivatives trading in India. The committee recommended
that derivatives should be declared as ‘securities’ so that regulatory framework
applicable to trading of ‘securities’ could also govern trading of securities. SEBI
also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives market in India. The
report, which was submitted in October 1998, worked out the operational
details of margining system, methodology for charging initial margins, broker
net worth, deposit requirement and real–time monitoring requirements.
The SCRA was amended in December 1999 to include derivatives within the
ambit of ‘securities’ and the regulatory framework was developed for
governing derivatives trading. The act also made it clear that derivatives shall
be legal and valid only if such contracts are traded on a recognized stock
exchange, thus precluding OTC derivatives. The government also rescinded 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. SEBI permitted the derivative
segments of two stock exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved
derivatives contracts. To begin with, SEBI approved trading in index futures
contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed
by approval for trading in options based on these two indexes and options on
individual securities. The trading in index options commenced in June 2001 and
the trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001. Trading and
settlement in derivative contracts is done in accordance with the rules,
byelaws, and regulations of the respective exchanges and their clearing
house/corporation duly approved by SEBI and notified in the official gazette.
Derivatives market at NSE
The derivatives trading on the exchange 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
Nifty Index. Currently, the futures contracts have a maximum of 3-month
expiration cycles. Three contracts are available for trading, with 1 month, 2
months and 3 months expiry. A new contract is introduced on the next trading
day following the expiry of the near month contract.

Trading mechanism
The futures and options trading system of NSE, called NEAT-F&O trading
system, provides a fully automated screen–based trading for Nifty futures &
options and stock futures & options on a nationwide basis and an online
monitoring and surveillance mechanism. It supports an anonymous order
driven market which provides complete transparency of trading operations and
operates on strict price–time priority. It is similar to that of trading of equities
in the Cash Market(CM) segment. The NEAT-F&O trading system is accessed by
two types of users. The Trading Members(TM) have access to functions such as
order entry, order matching, order and trade management. It provides
tremendous flexibility to users in terms of kinds of orders that can be placed on
the system. Various conditions like Good-till-Day, Good-till-Cancelled, Goodtill-
Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into
an order. The Clearing Members(CM) use the trader workstation for the
purpose of monitoring the trading member(s) for whom they clear the trades.
Additionally,they can enter and set limits to positions, which a trading member
can take.

Membership criteria
NSE admits members on its derivatives segment in accordance with the rules
and regulations of the exchange and the norms specified by SEBI. NSE follows
2–tier membership structure stipulated by SEBI to enable wider participation.
Those interested in taking membership on
F&O segment are required to take membership of CM and F&O segment or
CM, WDM and F&O segment. Trading and clearing members are admitted
separately. Essentially, a clearing member(CM) does clearing for all his trading
members(TMs), undertakes risk management and performs actual settlement.
There are three types of CMs:
 Self Clearing Member: A SCM clears and settles trades executed by him
only either on his own account or on account of his clients.

Trading Member Clearing Member: TM–CM is a CM who is also a TM. TM–

CM may clear and settle his own proprietary trades and client’s trades as
well as clear and settle for other TMs.

Professional Clearing Member PCM is a CM who is not a TM. Typically,

banks or custodians could become a PCM and clear and settle for TMs.

Table 1.3 Business growth of futures and options market: Turnover(Rs.crore)

Month Index futures Stock futures Index options Stock options Total

Jun-00 35 - - - 35
Jul-00 108 - - - 108
Aug-00 90 - - - 90
Sep-00 119 - - - 119
Oct-00 153 - - - 153
Nov-00 247 - - - 247
Dec-00 237 - - - 237
Jan-01 471 - - - 471
Feb-01 524 - - - 524
Mar-01 381 - - - 381
Apr-01 292 - - - 292
May-01 230 - - - 230
Jun-01 590 - 196 - 785
Jul-01 1309 - 326 396 2031
Aug-01 1305 - 284 1107 2696
Sep-01 2857 - 559 2012 5281
Oct-01 2485 - 559 2433 5477
Nov-01 2484 2811 455 3010 8760
Dec-01 2339 7515 405 2660 12919
Jan-02 2660 13261 338 5089 21348
Feb-02 2747 13939 430 4499 21616
Mar-02 2185 13989 360 3957 20490

2001-0221482 51516 3766 25163 101925

 Details of the eligibility criteria for membership on the F&O segment are
provided in Tables 12.1 and 12.2(Chapter 12). The TM–CM and the PCM are
required to bring in additional security deposit in respect of every TM whose
trades they undertake to clear and settle. Besides this, trading members are
required to have qualified users and sales persons, who have passed a
certification programme approved by SEBI.

Turnover

The trading volumes on NSE’s derivatives market has seen a steady increase
since the launch of the first derivatives contract, i.e. index futures in June 2000.
Table 1.3 gives the value of contracts traded on the NSE from the inception of
the market to March 2002. The average daily turnover at NSE now exceeds a
1000 crore. A total of 41,96,873 contracts with a total turnover of Rs.1,01,926
crore was traded during 2001-2002.

Clearing and settlement

NSCCL undertakes clearing and settlement of all deals executed on the NSEs
F&O segment. It acts as legal counterparty to all deals on the F&O segment and
guarantees settlement. We take a brief look at the clearing and settlement
mechanism.

Clearing

The first step in clearing process is working out open positions or obligations of
members. A CM’s open position is arrived at by aggregating the open position
of all the TMs and all custodial participants clearing through him, in the
contracts in which they have traded. A TM’s open position is arrived at as the
summation of his proprietary open position and clients open positions, in the
contracts in which they have traded. While entering orders on the trading
system, TMs are required to identify the orders, whether proprietary (if they
are their own trades) or client ( if entered on behalf of clients). Proprietary
positions are calculated on net basis (buy-sell) for each contract. Clients’
positions are arrived at by summing together net (buy-sell) positions of each
individual client for each contract. A TMs open position is the sum of
proprietary open position, client open long position and client open short
position.

Settlement

All futures and options contracts are cash settled, i.e. through exchange of
cash. The underlying for index futures/options of the Nifty index cannot be
delivered. These contracts, therefore, have to be settled in cash. Futures and
options on individual securities can be delivered as in the spot market.
However, it has been currently mandated that stock options and futures would
also be cash settled. The settlement amount for a CM is netted across all their
TMs/clients in respect of MTM, premium and final exercise settlement. For the
purpose of settlement, all CMs are required to open a separate bank account
with NSCCL designated clearing banks for F&O segment.

Risk management system

The salient features of risk containment measures on the F&O segment are:

Anybody interested in taking membership of F&O segment is required to

take membership of“CM and F&O”or “CM,WDM and F&O”. An existing
member of CM segment can also take membership of F&O segment. The
details of the eligibility criteria for membership of F&O segment are given
in the chapter on regulations in this book.

NSCCL charges an upfront initial margin for all the open positions of a CM
upto client level. It follows the VaR based margining system through SPAN
system. NSCCL computes the initial margin percentage for each Nifty
index futures contract on a daily basis and informs the CMs. The CM in
turn collects the initial margin from the TMs and their respective clients.

NSCCL’s on-line position monitoring system monitors a CM’s open

positions on a real-time basis. Limits are set for each CM based on his
base capital and additional capital deposited with NSCCL. The on-line
position monitoring system generates alerts whenever a CM reaches a
position limit set up by NSCCL. NSCCL monitors the CMs and TMs for mark
to market value violation and for contract-wise position limit violation.

CMs are provided with a trading terminal for the purpose of monitoring
the open positions of all the TMs clearing and settling through them. A
CM may set exposure limits for a TM clearing and settling through him.
NSCCL assists the CM to monitor the intra-day exposure limits set up by a
CM and whenever a TM exceeds the limits, it withdraws the trading
facility provided to such TM.

A separate Settlement Guarantee Fund for this segment has been created
out of the capital deposited by the members with NSCCL.