The Three D's of Derivatives: Demand, Depth & Diversity

 | August 13,2010 04:48 pm IST

Evolution in India
A derivative is a financial contract whose value depends on a risk factor(s) of a single or a combination of assets, such as Price of a bond, commodity, currency, share, a yield or interest rate etc. and allows organization to break financial risk into smaller components to best meet specific risk objectives.


The global economy, in particular the financial markets across the globe showed signs of complexity and volatility. The emerging inclination towards risk management in financial markets paved the way for introduction of derivatives. In India, Derivates first emerged as hedging devices to hedge market and operations risks. Traded over the counter, these instruments were mainly used by Hedgers to reduce or eliminate the risk associated with Price of an asset or commodity like cotton, along with Speculators to get extra leverage in betting on future movements in the price of an asset and Arbitrageurs who take advantage of a discrepancy between prices in two different markets.


Thereafter, The gradual liberalization of Indian economy in the 1990’s, substantial inflow of foreign capital, dismantling of trade barriers, and integration of domestic economy with world economy led to the need for re-introduction of derivatives in the Indian market. The Securities Laws (Amendment) Ordinance promulgated on January 25, 1995 withdrew the prohibitions by repealing section 20 of the SCRA.


In Nov 1996, government led L. C. Gupta Committee helped develop regulatory framework for derivatives trading in India by recommending derivatives to be declared as ‘securities’. This helped catalyze entrepreneurial activity and transfer risks from risk adverse people to risk oriented people. Again the J.R.Verma committee recommendations to develop settlement and risk management systems for derivatives including upfront margins, daily settlement, online surveillance and position monitoring and risk management marked a new development. These structural changes in the equity derivative market made it organized and transparent.


The beginning of index futures trading on June 9, 2000 was perhaps the defining moment for the BSE in the context of equity derivatives The NSE began trading futures with the S&P CNX Nifty as the underlying, three days after the launch of Sensex futures. June 12, 2000. Initially, the creation of derivative market as standardized key to unbundling and managing risk in banking, investment, capital and insurance markets was opposed on various grounds by BSE broker-dealers who dominated the markets as principals for their own benefit (opaque badla) , rather than acting as mere intermediaries between issuers of securities and ultimate investors.


Subsequently, With participation from risk averse people in greater numbers, the trading volumes upsurged. Tata Mutual Fund became country's first fund for investments in the equity derivatives market to have a proper hedging mechanism. Lower risk, lower investments and higher returns made this segment popular with investors. The turnover in the derivatives market spurted by over 5 times during 2002. The derivatives market turnover touched a record high of nearly Rs. 40bn, which was almost 75% of the cash market. This market the beginning of a new era.


Years after their introduction, derivatives markets in India have shown considerable growth in contracted volumes. Since pricing of derivatives is majorly done by arbitrage, the relationship between the spot price and future prices has helped improve the underlying equity market. Derivatives, as a part of a diversified investor portfolio, offer Liquidity and market efficiency. It helps increase savings and investment in the long run.


The NSE today accounts for more than 97 per cent of India's equity derivative market. In addition to the activity associated with expiration of contracts, derivatives' participants have indicated that retail participation has increased in the wake of buoyancy in equities. The leverage that derivatives offer (for instance, a contract value of a couple of lakh rupees require an initial payment of a few thousand rupees) is the key to attracting retail interest said brokers. THE aggregate turnover in the derivatives segment on the National Stock Exchange (NSE) was at an all-time high of Rs 6,073.66 crore on Wednesday.



Though showing volumes, But equity derivative market is not growing as fast as it should in terms of price discovery, the temporal spread of contracts and the range and diversity of contracts and instruments. The problems relating to the market are manifold.

The India’s financial system between market operators and regulators is too prone to political pressure and regulatory capture. this has sub stained the market from opening further.

Low average per capita income, inadequate physical and institutional infrastructure, primitive public services and dysfunctional political and legal systems have made India lag behind many developed financial markets across the globe.

Uncertainty in Indian tax laws and rules whereby derivative transactions are treated as ‘speculative’ discourages active investor participation in the market.

Another problems which the investors face is the lack of proper training to deal in this market, where, unlike the cash market, certification is required

The J.R.Verma committee felt that there was a need to protect particularly the small investors who may be lured by the sheer speculative gains in this market where threshold limit of the transactions has been pegged not below Rs. 2 lakhs. This has compelled the retail investors to approach the markets through the indirect routes like mutual funds etc.

Chauhan & Thomas clearly point out that intermediaries operating in Indian capital markets still lack (a) a single interface for dealing in both spot and derivatives markets thus compounding inefficiency in executing simultaneous trading strategies (b) essential analytical tools and adequate systems to support trading and risk management; (e) proper back office control and containment systems which ultimately hinder the growth in the market.

RBI stipulations restricting entry of players into some part of derivative market and other stringent regulations restrict Free trade in the derivative markets

Price recovery and narrow risk-bearing capacity on the part of option-writers is yet another concern as it makes risk hedging for more than one calendar quarter very difficult for investors.

Prospects:–.The derivatives market in India, which hangs between nascence and maturity stage, holds high prospects.

Introduction of three new products- options on index, options on individuals and covered warrants, Enabling FIIs, foreign insurance companies and mutual funds to participate more fully in derivatives markets, along with the availability of a wider range of derivatives, would enhance the use and quality of equity derivatives as considerably ‘more perfect’ rather than still ‘highly imperfect’ risk-management instruments. The recent ICICI bond issue bundles a twelve- year expiration BSE Sensex warrants with the bond. If this warrant is detached and traded, it would be an exchange-traded index derivatives

The established mind-sets of regulatory and tax authorities on ‘speculation’ is limiting the propensity of option writers to be bolder in market-making for derivatives contracts .Jogani & Fernandes, in their paper make the case that arbitrage is not opportunistic or counterproductive speculation but an essential form of financial intermediation that makes markets more efficient by smoothing out price distortions. Thus, Policies should now shift to ensure the soundness of information and transparency such that wider investor participation can be attained.

Introduction of index derivatives which are less volatile and difficult to manipulate as compared to individual stock prices have large prospects for small retail investors.

since index future do not represent physically deliverable asset ,they are cash settled all over the world on the premise that index value is derived from the cash market, hence these require less margin capital which induces more players to join the market.

the unusual arbitrage opportunities due to the large pricing anomalies persisting between BSE/NSE prices for the same underlying shares again makes the market really attractive.

Expansion in the derivative market would also increase the flow of FII and FDI investment. The currency risk and country risks of these investors can easily be mitigated by diversifying the derivatives market by introducing dollar- rupee futures and options for the first one; and index futures and options for the second one.

While India lacks index derivatives as of today, there is a direct opportunity to make progress on these issues via the dollar-rupee forward market. The constraints that are placed in the way of FII's on using the dollar-rupee forward market are counterproductive. If the FII is allowed to obtain insurance using this market, they will bring more money to India.


Thus India needs to overcome its recent sluggish pace toward derivatives trading and pave the way for a open and developed financial market which have great prospects.


Commodity Derivatives
Existing in India from the nineteenth century, through the establishment of Cotton Trade Association, trading in commodity futures was banned in 1960s due to excessive speculation. To tap the spur growth in commodities, worldwide, Future commodity trading was re-opened in 54 commodities in Feb., 2003. Three national electronic exchanges NCDEX, MCX and NMCE, along with 20 other regional offline commodity exchanges like The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners Futures Exchange of India (COFEI), were authorized to re-introduce commodity derivatives in India.


The daily global volume in Commodity Trading touches 3 times of equity derivative market. With just a few months in action, ICICI bank promoted NCDEX alone registers about 85000 to 100000 trades per day. The reestablishment of commodity derivatives was welcomed by arbitragers and hedgers. Even retail investors showed interest, as unlike equity futures, he could start with as low as Rs.5000 and because of flexibility in contract sizes for different commodities, the ability to leverage was also much higher. MCX allows Indian shipping industry to hedge their freight rate risks. Daily volume of commodity trading of Rs.2500 crores has surpassed 2000 crores turnover at the BSE. Commodity futures involve a large number of small participants from Jan to may 2004 there were 237579 trades of value Rs.3175 crore, giving an average transaction of Rs.133640.