FUTURE OF DERIVATIVES IN INDIA

FUTURE OF DERIVATIVES IN INDIA

 Introduction

Derivatives trading began in 1865when the Chicago Board of Trade (CBOT) listed the first “exchange traded” derivatives contract in the USA. These contracts were called “futures contracts“. In 1919, the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME).The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on the Standard & Poor’s 500 Index traded on the CME. In April 1973, the Chicago Board of Options Exchangewas set up specifically for the purpose of trading in options. The market for options developed so rapidly that by early 80s the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. And there has been no looking back ever since.

 Derivatives in India

 The word ‘derivative’ originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of their own. They derive their value from the value of some other asset, which is known as the underlying.

“Derivatives are specialized contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.”

The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset. There are many types of financial instruments that are grouped under the term derivatives, but options/futures and swaps are among the most common. Options or futures are different kinds of contracts where one party agrees to pay a fee to another for the right to buy or sell something to the other.

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.

In the equity markets, a system of trading called “badla” involving some elements of forwards trading had been in existence for decades.6 However, the system led to a number of undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the 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. In 1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives.

The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. A system of market-determined exchange rates was adopted by India in March 1993. In August 1994, the rupee was made fully convertible on current account. These reforms allowed increased integration between domestic and international markets, and created a need to manage currency risk. Figure 1 shows how the volatility of the exchange rate between the Indian Rupee and the U.S. dollar has increased since 1991. The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.

The Securities and Exchange Board of India (SEBI) allowed trading in equities-based derivatives on stock exchanges in June 2000. Accordingly the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) introduced trading in futures on June 9, 2000and June 12, 2000 respectively. Currently futures and optionsturnover on the NSE is Rs7,000-8,000 croreapproximately. In India stock index options were introduced from July 2, 2001.

 INTRODUCTION OF FUTURES IN INDIA

  • The first derivative product to be introduced in the Indian securities market is going to be “INDEX FUTURES”.
  • In the world, first index futures were traded in U.S. on Kansas City Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI) in 1982.

 Derivatives in India: chronology

December 14, 1995

The NSE sought SEBI’s permission to trade index futures.

November 18, 1996

The LC Gupta Committee set up to draft a policy framework for index futures.

May 11, 1998

The LC Gupta Committee submitted a report on the policy framework for index futures.

July 7, 1999

Reserve Bank of India gave permission for OTC forward rate agreements and interest rate swaps.

May 24, 2000

SIMEX chose Nifty for trading futures and options on an Indian index.

May 25, 2000

SEBI allowed the NSE and the BSE to trade in index futures.

June 9, 2000

Trading of the BSE Sensex futures commenced on the BSE.

June 12, 2000

Trading of Nifty futures commenced on the NSE.

September 25, 2000

Nifty futures trading commenced on the SGX.

USES OF DERIVATIVES

  • Leveraged positions
  • Lower margins than the margin funding
  • Index trading–market directional trading
  • Hedging of portfolio
  • Through index, covered calls, options buying
  • Structured products for higher yields
  • Allows taking position in any market condition–bullish, bearish, volatile or neutral.

 TYPES OF DERIVATIVE INSTRUMENTS

Derivative instruments are classified as:

  • Forward Contracts
  • Futures Contracts
  • Options
  • Swaps

Derivatives can also be classified as either forward-based (e.g., futures, forward contracts, and swap contracts), option-based (e.g., call or put option), or combinations of the two. A forward-based contract obligates one party to buy and a counter party to sell an underlying asset, such as foreign currency or a commodity, with equal risk at a future date at an agreed-on price. Option-based contracts (e.g., call options, put options, caps and floors) provide the holder with a right, but not an obligation to buy or sell an underlying financial instrument, foreign currency, or commodity at an agreed-on price during a specified time period or at a specified date.

 Forward Contracts Forward contracts are negotiated between two parties, with no formal regulation or exchange, to purchase (long position) and sell (short position) a specific quantity of a specific quantity of a commodity (i.e., corn and gold), foreign currency, or financial instrument (i.e., bonds and stock) at a specified price (delivery price), with delivery or settlement at a specified future date (maturity date). The price of the underlying asset for immediate delivery is known as the spot price.

Forward contracts may be entered into through an agreement without a cash payment, provided the forward rate is equal to the current market rate. Forward contracts are often used to hedge the entire price changed of a commodity, a foreign currency, or a financial instrument irrespective of a price increase or decrease.

 Futures Contracts Futures are standardized contracts traded on a regulated exchange to make or take delivery of a specified quantity of a commodity, a foreign currency, or a financial instrument at a specified price, with delivery or settlement at a specified future date. Futures contracts involve Treasury bonds, agricultural commodities, stock indices, interest-earning assets, and foreign currency.

A futures contract is entered into through an organized exchange, using banks and brokers. These organized exchanges have clearinghouses, which may be financial institutions or part of the futures exchange. They interpose themselves between the buyer and the seller, guarantee obligations, and make futures liquid with low credit risk. Although no payment is made upon entering into a futures contract, since the underlying (i.e. interest rate, share price, or commodity price) is at-the-market, subsequent value changes require daily mark-to-marking by cash settlement (i.e. disbursed gains and daily collected losses). Similarly, margin requirements involve deposits from both parties to ensure any financial liabilities.

Futures contracts are used to hedge the entire price change of a commodity, a foreign currency, or a financial instrument since the contract value and underlying price change symmetrically.

 Options are rights to buy or sell. For example, the purchaser of an option has the right, but not the obligation, to buy or sell a specified quantity of a particular commodity, a foreign currency, or a financial instrument, at a specified price, during a specified period of time (American option) or on a specified date (European option). An option may be settled by taking delivery of the underlying or by cash settlement, with risk limited to the premium.

The two main types of option contracts are call options and put options, while some others include stock (or equity) options, foreign currency options, options on futures, caps, floors, collars, and swaptions.

  • American call options provide the holder with the right to acquire an underlying product (e.g., stock) at an exercise or strike price, throughout the option term. The holder pays a premium for the right to benefit from the appreciation in the underlying.
  • American put options provide the holder with the right to sell the underlying product (e.g., stock) at a certain exercise or strike price, throughout the option term. The holder gains as the market price of the underlying (stock price) falls below the exercise price.
  • An interest rate cap is an option that allows a cap purchaser to limit exposure to increasing interest rates on its variable-rate debt instruments.
  • An interest rate floor is an option that allows a floor purchaser to limit exposure to decreasing interest rates on its variable-rate investments.

Generally, option contracts are used to hedge a one-directional movement in the underlying commodity, foreign currency, or financial instrument.

 Swaps A swap is a flexible, private, forward-based contract or agreement, generally between two counter parties to exchange streams of cash flows based on an agreed-on (or notional) principal amount over a specified period of time in the future.

Swaps are usually entered into at-the-money (i.e. with minimal initial cash payments because fair value is zero), through brokers or dealers who take an up-front cash payment or who ad just the rate to bear default risk. The two most prevalent swaps are interest rate swaps and foreign currency swaps, while others include equity swaps, commodity swaps, and swaptions.

  • Swaptions are options on swaps that provide the holder with the right to enter into a swap at a specified future date at specified terms (stand-alone option in a swap) or to extend or terminate the life of an existing swap (embedded option on a swap).

Swap contracts are used to hedge entire price changes (symmetrically) related to an identified hedged risk, such as interest rate or foreign currency risk, since both counter parties gain or lose equally.

 FORWARD CONTRACTS

  • A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India).
  • Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place.
  • Forward contracts suffer from poor liquidity and default risk.

 FUTURE CONTRACTS

  • Future contracts are organised/ standardised contracts, which are traded on the exchanges.
  • These contracts, being standardised and traded on the exchanges are very liquid in nature.
  • In futures market, clearing corporation/ house provides the settlement guarantee.

 Every futures contract is a forward contract. They:

  • Are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades.
  • Are of standard quantity; standard quality (in case of commodities).
  • Have standard delivery time and place.

Features

Forward Contract

Future Contract

Operational Mechanism

Not traded on exchange

Traded on exchange

Contract Specifications

Differs from trade to trade.

Contracts are standardised contracts.

Counterparty Risk

Exists

Exists, but assumed by Clearing Corporation/ house.

Liquidation Profile

Poor Liquidity as contracts are tailor maid contracts.

Very high Liquidity as contracts are standardised contracts.

Price Discovery

Poor; as markets are fragmented.

Better; as fragmented markets are brought to the common platform.

FUTURES:

            A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Generally, the delivery does not occur; instead, before the contract expires, the holder usually “squares their position” by paying or receiving the difference between the current market price of the underlying asset and the price stipulated in the contract.

            Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. Futures are distinguished from generic forward contracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearinghouses. Also, in order to insure that payment will occur, futures have a margin requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed.

            Trading in futures is regulated by the Securities & Exchange Board of India (SEBI). SEBI exists to guard against traders controlling the market in an illegal or unethical manner, and to prevent fraud in the futures market.

 FEATURES

  • Leveraged positions–only margin required
  • Trading in either direction–short/long
  • Index trading
  • Hedging/Arbitrage opportunity

 ADVANTAGES OF FUTURES OVER CASH TRADING

  • In futures the investor can short sell/buy without having the stock and carry the position for a long time, which is not possible in the cash segment.
  • An investor can buy and sell index components instead of individual securities when he has a general idea of the direction in which the market may move in the next few months.
  • The investor is required to pay a small fraction of the value of the total contract as margin. This means trading in stock index futures is a leveraged activity since the investor is able to control the total value of the contract with a relatively small amount of margin.
  • In the case of individual stocks, the positions, which remain outstanding on the expiration date, will have to be settled by physical delivery, which is not the case in futures.
  • Regulatory complexity is likely to be less in the case of stock index futures compared to the other kinds of equity derivatives, such as stock index options, individual stock options etc.

OPTIONS

Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of certain underlying assets at a specified price on or before a specified date. On the other hand, the seller is under obligation to perform the contract (buy or sell). The underlying asset can be a share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, soya bean, cotton, coffee etc.

 THERE ARE TWO TYPES OF OPTIONS:

  • Call options and
  • Put options

 FEATURES

  • Limited risk, unlimited profit-call options
  • Higher returns, higher risk-put options
  • Positions in all market conditions/views

 CALL OPTIONS

The option that gives the buyer the right to buy is called a call option.

 PUT OPTIONS

The option that gives the buyer the right to sell is called a put option

DIFFERENCE BETWEEN FUTURES AND OPTIONS

FUTURES

OPTIONS

Obligation

Both the buyer and the seller are under obligation to fulfill the contract.

The buyer of the option has the right and not the obligation whereas the seller is under obligation to fulfill the contract.

Risk

The buyer and seller are subject to unlimited risk of losing.

The seller is subject to unlimited risk of losing whereas the buyer has a limited potential to lose.

Profit

The buyer and seller have unlimited potential to gain.

The seller has limited potential to gain while the buyer has unlimited potential to gain.

Price Behavior

It is unidimensional as its price depends on the price of the underlying only.

It is bi-dimensional as its price depends upon both the price and the volatility of the underlying.

 TYPES OF DERIVATIVES

OTC and exchange-traded

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way that they are traded in market:

  • Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge.
  • Exchange-traded derivatives are those derivatives products that are traded via Derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world’s largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), Chicago Mercantile Exchange and the Chicago Board of Trade. According to BIS, the combined turnover in the world’s derivatives exchanges totalled USD 344 trillion during Q4 2005.

 RISK MANAGEMENT

The main types of risk characteristics associated with derivatives are:

  • Basis Risk: This is the spot (cash) price of the underlying asset being hedged, less the price of the derivative contract used to hedge the asset.
  • Credit Risk: Credit risk or default risk evolves from the possibility that one of the parties to a derivative contract will not satisfy its financial obligations under the derivative contract.
  • Market Risk: This is the potential financial loss due to adverse changes in the fair value of a derivative. Market risk encompasses legal risk, control risk, and accounting risk.

RISK MANAGEMENT THROUGH FUTURES

  • Basic objective of introduction of futures is to manage the price risk.
  • Index futures are used to manage the systemic risk, vested in the investment in securities.

Hedge terminology

  • Long hedge- When you hedge by going long in futures market.
  • Short hedge – When you hedge by going short in futures market.
  • Cross hedge – When a futures contract is not available on an asset, you hedge your position in cash market on this asset by going long or short on the futures for another asset whose prices are closely associated with that of your underlying.
  • Hedge Contract Month- Maturity month of the contract through which hedge is accomplished.
  • Hedge Ratio – Number of future contracts required to hedge the position.

Some specific uses of Index Futures

  • Portfolio Restructuring – An act of increasing or decreasing the equity exposure of a portfolio, quickly, with the help of Index Futures.
  • Index Funds – These are the funds which imitate/replicate index with an objective to generate the return equivalent to the Index. This is called Passive Investment Strategy.

Speculation in the Futures market

  • Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take:
  • Naked positions – Position in any future contract.
  • Spread positions – Opposite positions in two future contracts. This is a conservative speculative strategy.

Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market.

Arbitrageurs in Futures market

Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously.

 BONDS

The term bond is commonly used to refer to any securities that are founded on debt. When you purchase a bond, you are lending out your money to a company or government. In return, they agree to give you interest on your money and eventually pay you back the amount you lent out.

The main attraction of bonds is their relative safety. If you are buying bonds from a stable government, your investment is virtually guaranteed, or risk-free. The safety and stability, however, come at a cost. Because there is little risk, there is little potential return. As a result, the rate of return on bonds is generally lower than other securities.

 MUTUAL FUNDS

A mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are pooling your money with a number of other investors, which enables you (as part of a group) to pay a professional manager to select specific securities for you. Mutual funds are all set up with a specific strategy in mind, and their distinct focus can be nearly anything: large stocks, small stocks, bonds from governments, bonds from companies, stocks and bonds, stocks in certain industries, stocks in certain countries, etc.

The primary advantage of a mutual fund is that you can invest your money without the time or the experience that are often needed to choose a sound investment. Theoretically, you should get a better return by giving your money to a professional than you would if you were to choose investments yourself. In reality, there are some aspects about mutual funds that you should be aware of before choosing them, but we won’t discuss them here.

A mutual fund brings together money from many people and invests it in stocks, bonds, or other securities. (The combined holdings of stocks, bonds, or other securities and assets the fund owns are known as its portfolio.) Each investor owns shares, which represent a part of these holdings.

Taxes

You still owe taxes on any distributions and dividends in the year you receive them (or reinvest them). You will also owe taxes on any capital gains you receive when you sell your shares. Keep your account statements in order to figure out your taxes at the end of the year.

If you invest in a tax-exempt fund (such as a municipal bond fund), some or all of your dividends will be exempt from federal (and sometimes state and local) income tax. You will, however, owe taxes on any capital gains.

 BANKS AND MUTUAL FUNDS

Banks now sell mutual funds, some of which carry the bank’s name. But mutual funds sold in banks, including money market funds, are not bank deposits. A money market fund is different with a money market deposit account. Their names are similar, but they are completely different:

  • A money market fund is a type of mutual fund. It is not guaranteed, and comes with a prospectus.
  • A money market deposit account is a bank deposit. It is guaranteed, and comes with a Truth in Savings form.
  • To reiterate, even if you buy a fund through a bank and the fund carries the bank name, there is no guarantee. You can lose your money.

 REFERENCES

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Source: S.Shiny Nair
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