1. Rise of Derivatives
The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions.
Price fluctuations make it hard for businesses to estimate their future production costs and revenues.2 Derivative securities provide them a valuable set of tools for managing this risk. This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term.
2. Definition and Uses of Derivatives
A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. In the Appendix, I describe some simple types of derivatives: forwards, futures, options and swaps.
Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (FitchRatings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.3
A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe India’s long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They argue that lack of knowledge, market frictions and regulatory impediments have led to low levels of capital employedin arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved (ISMR, 2004).
3. Exchange-Traded and Over-the-Counter Derivative Instruments
OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “havala” or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE.4 Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchange-traded contracts, relative to OTC contracts.5
4. Development of Derivative Markets in India
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 industry. 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 report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared “securities.” This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.
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 1991.7 The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.
Source: Asani Sarkar
The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions.
Price fluctuations make it hard for businesses to estimate their future production costs and revenues.2 Derivative securities provide them a valuable set of tools for managing this risk. This article describes the evolution of Indian derivatives markets, the popular derivatives instruments, and the main users of derivatives in India. I conclude by assessing the outlook for Indian derivatives markets in the near and medium term.
2. Definition and Uses of Derivatives
A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. In the Appendix, I describe some simple types of derivatives: forwards, futures, options and swaps.
Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge some preexisting risk by taking positions in derivatives markets that offset potential losses in the underlying or spot market. In India, most derivatives users describe themselves as hedgers (FitchRatings, 2004) and Indian laws generally require that derivatives be used for hedging purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to profit from anticipated price movements). In practice, it may be difficult to distinguish whether a particular trade was for hedging or speculation, and active markets require the participation of both hedgers and speculators.3
A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and Fernandes (2003) describe India’s long history in arbitrage trading, with line operators and traders arbitraging prices between exchanges located in different cities, and between two exchanges in the same city. Their study of Indian equity derivatives markets in 2002 indicates that markets were inefficient at that time. They argue that lack of knowledge, market frictions and regulatory impediments have led to low levels of capital employedin arbitrage trading in India. However, more recent evidence suggests that the efficiency of Indian equity derivatives markets may have improved (ISMR, 2004).
3. Exchange-Traded and Over-the-Counter Derivative Instruments
OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. OTC contracts have substantial credit risk, which is the risk that the counterparty that owes money defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities (which are regulated by the Forward Markets Commission), those that trade informally in “havala” or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardized format that specifies the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They trade on organized exchanges with prices determined by the interaction of many buyers and sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE.4 Margin requirements and daily marking-to-market of futures positions substantially reduce the credit risk of exchange-traded contracts, relative to OTC contracts.5
4. Development of Derivative Markets in India
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 industry. 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 report of the L. C. Gupta Committee, set up by SEBI, recommended a phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared “securities.” This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.
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 1991.7 The easing of various restrictions on the free movement of interest rates resulted in the need to manage interest rate risk.
Source: Asani Sarkar
1 comment:
Amazing posst! thanks for sharing...
What is Sensex
Sensitive Index
S&P BSE Sensex
BSE Sensex Index
Post a Comment