Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India
Table 2. Chronology of instruments
1991 Liberalisation process initiated
14 December 1995 NSE asked SEBI for permission to trade index futures. 18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy
framework for index futures.
11 May 1998 L.C.Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps.
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index.
25 May 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.
25 September 2000
Nifty futures trading commenced at SGX. 2 June 2001 Individual Stock Options & Derivatives
(1) Need for derivatives in India today
In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have
the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors’ aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India’s financial markets with the international financial markets. Introduction of risk management instruments in India has gained
momentum in last few years thanks to Reserve Bank of India’s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.
(2) Myths and realities about derivatives
In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when 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. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place.
What are these myths behind derivatives?
• Derivatives increase speculation and do not serve any economic purpose
• Indian Market is not ready for derivative trading
• Disasters prove that derivatives are very risky and highly leveraged instruments.
• Derivatives are complex and exotic instruments that Indian investors will find difficulty in understanding
(i) Derivatives increase speculation and do not serve any economicpurpose:
Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage their exposures to interest rates, commodity prices or exchange rates. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout 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 the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants.
Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost
without selling off part of its equity assets by using stock index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital
formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market liquidity and
efficiency and facilitating the flow of trade and finance
(ii) Indian Market is not ready for derivative trading
Often the argument put forth against derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre- requisites, which are needed for the introduction of derivatives, and how Indian market fares:
TABLE 3.
PRE-REQUISITES INDIAN SCENARIO
Large market
Capitalisation
India is one of the largest market-capitalised countries in Asia with a market capitalisation of more than Rs.765000 crores.
High Liquidity in the
underlying The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.
Trade guarantee The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.
A Strong Depository National Securities Depositories Limited (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country.
A Good legal guardian In the Institution of SEBI (Securities and Exchange Board of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.
(3) Comparison of New System with Existing System
new system is very useful especially to retail investors. It increases the no of options investors for investment. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI.
The figure 3.3a –3.3d shows how advantages of new system (implemented from June 20001) v/s the old system i.e. before June 2001
New System Vs Existing System for Market Players
Figure 3.3a
Speculators