Indian scenario

Indian scenario

Q5.1: What is the status of derivatives in the equity market in
India?
A: As mentioned in Question 3.9, trading on the “spot market” for equity has actually
always been a futures market with weekly or fortnightly settlement. These futures markets
feature the risks and difficulties of futures markets, without the gains in price discovery
and hedging services that come with a separation of the spot market from the futures
market.
India’s primary market has experience with derivatives of two kinds: convertible
bonds and warrants (a slight variant of call options). Since these warrants are listed and
traded, options markets of a limited sort already exist. However, the trading on these
instruments is very limited.
A variety of interesting derivatives markets exist in the informal sector. These markets
trade contracts like bhav-bhav, teji-mandi, etc. For example, the bhav-bhav is a bundle of
one in-the-money call option and one in-the-money put option. These informal markets
stand outside the mainstream institutions of India’s financial system and enjoy limited
participation.
In 1995, NSE asked SEBI whether it could trade index futures. In 2000, SEBI gave
permissions to NSE and BSE to trade index futures. In addition, futures and options on
Nifty will also trade at the Singapore Monetary Exchange (SIMEX) from end–August
2000. ••

Q5.2: What derivatives exist in India in the interest-rates area?
A: The RBI has permitted OTC trades in interest rate forwards and swaps. These markets
have so far had very little liquidity. ••

Q5.3: What derivatives exist in India in the foreign exchange
area?
A: India has a strong dollar-rupee forward market with contracts being traded for one,
, .. six month expiration. Daily trading volume on this forward market is around
$500 million a day. Indian users of hedging services are also allowed to buy derivatives
involving other currencies on foreign markets. Outside India, there is a small market for
cash–settled forward contracts on the dollar–rupee exchange rate. ••

Q5.4: What is the status in India in the area of commodity
derivatives?
A: India produces a range of commodities that enjoy a high global rank in production.
The weighted rank of India in the global supply function pertinent to these commodities
is between two and three. The impact of the commodity sector on the total economy is
considerable.
A reforms program towards building commodity futures exchanges is being effected
under the aegis of the Forward Markets Commission (FMC), which is constituted under
the Ministry of Consumer Affairs and Public Distribution.
Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking,
castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18
commodity exchanges located in various parts of the country. Futures trading in other
edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new
commodities, especially in edible oils, is expected to commence in the near future. The
sugar industry is exploring the merits of trading sugar futures contracts.
The policy initiatives and the modernisation programme include extensive training,
structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and
the thrust towards the establishment of a national commodity exchange. The Government
of India has constituted a committee to explore and evaluate issues pertinent to the
establishment and funding of the proposed national commodity exchange for the nationwide
trading of commodity futures contracts, and the other institutions and institutional
processes such as warehousing and clearinghouses.
With commodity futures, delivery is best effected using warehouse receipts (which
are like dematerialised securities). Warehousing functions have enabled viable exchanges
to augment their strengths in contract design and trading. The viability of the national
commodity exchange is predicated on the reliability of the warehousing functions. The
programme for establishing a system of warehouse receipts is in progress. The Coffee
Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998.
(This text is by G. Ramachandran, gramach@satyamonline.com). ••
Also see: Balasundaram (1998).

Q5.5: Do Indian derivatives users have access to foreign derivatives
markets?
A: The RBI setup a committee, headed by R. V. Gupta, which has established guidelines
through which Indian users can obtain hedging services using derivatives exchanges
outside India. ••

Table 5.1 Derivatives in India: A Chronology
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.

Q5.6: Why do people talk about “starting derivatives in India”
if some derivatives already exist?
A: It is useful to note here that there are no exchange-traded financial derivatives in
India today. Neither the dollar-rupee forward contract (Question 5.3) nor the option-like
contracts (Question 5.1) are exchange-traded. These markets hence lack centralisation of
price discovery and can suffer from counterparty risk.
We do have exchanges trading derivatives, in the form of commodity futures exchanges.
However, they do not use financials as underlyings.
In this sense, the index futures market will be the first exchange–traded derivatives
market, which uses a financial underlying. ••

Q5.7: How did we get to where we are in derivatives in India?
A: Table 5.1 offers a chronology of the developments in derivatives in India in the 1990s.
••

Equity derivatives
Q6.1: Worldwide, what kinds of derivatives are seen on the
equity market?
A:Worldwide, the most successful equity derivatives contracts are index futures, followed
by index options, followed by security options. •• Also see: Gorham (1994).

Q6.2: At the individual stock level, are futures or options better?
A: Internationally, options on individual stocks are commonplace; futures on individual
stocks are rare. This is partly because regulators (e.g. in the US) frown upon the idea of
doing futures trading on individual stocks. ••

Q6.3: Why have index derivatives proved to be more important
than individual stock derivatives?
A: Security options are of limited interest because the pool of people who would be interested
(say) in options on ACC is limited. In contrast, every single person with any involvement
in the equity market is affected by index fluctuations. Hence risk-management
using index derivatives is of far more importance than risk-management using individual
security options.
This goes back to a basic principle of financial economics. Portfolio risk is dominated
by the market index, regardless of the composition of the portfolio. All portfolios of
around ten stocks or more have a pattern of risk where 70% or more of their risk is indexrelated.
Hence investors are more interested in using index–based derivative products.
Index derivatives also present fewer regulatory headaches when compared to leveraged
trading on individual stocks. Internationally, this has led to regulatory encouragement
for index futures and discouragement against futures on individual stocks. ••