Assignment on Function of Derivative
Market & Derivative Market in India
Subject: Financial derivatives
Submitted by:
Karthik.M
4SX18MBA35
2nd MBA, F1
Department of Business Administration
Sahyadri College of Engineering and Management
Adyar, Mangalore- 07
Submitted to:
Prof. Chandrakanth. S
Department of Business Administration
Sahyadri College of Engineering and Management
Adyar, Mangalore- 07
Submitted on
3rd April 2020
Meaning of Derivative
A derivative is a financial instrument that derives its value from an underlying asset.
The underlying asset can be equity, currency, commodities, or interest rate. Thus, a
change in the underlying asset leads to an equivalent change in the derivative.
Derivative markets are investment markets where derivative trading takes place.
Functions of Derivatives:
1. Risk management: The prices of derivatives are related to their underlying assets, as
mentioned before. They can thus be used to increase or decrease the risk of owning the
asset. For example, you can reduce your risk by buying a spot item and selling a futures
contract or call option. This is how it works. If there is a fall in the spot price, the
corresponding futures and options contract will also fall. You can repurchase the
contract at a lower price, which will result in a gain. This can partially offset the loss on
the spot item. The ease of speculation in the derivatives market makes it easier for an
investor seeking to protect a position or an anticipated position in the spot market.
2.Price discovery: Derivative market serves as an important source of information about
prices. Prices of derivative instruments such as futures and forwards can be used to
determine what the market expects future spot prices to be. In most cases, the
information is accurate and reliable. Thus, the futures and forwards markets are helpful
in price discovery mechanism.
3. Operational advantages: Derivative markets have greater liquidity than the spot
markets. The transactions costs therefore, are lower. This means commissions and other
costs for traders is lower in derivatives markets. Further, unlike securities markets that
discourage shorting, selling short is much easier in derivatives. Therefore, by virtue of
risk management, short selling, price discovery, and improved liquidity, derivatives
make markets more efficient.
Derivative instrument available in India
In the exchange-traded market, the biggest success story has been derivatives on equity
products. Index futures were introduced in June 2000, followed by index options in June
2001, and options and futures on individual securities in July 2001 and November 2001,
respectively. As of 2005, the NSE trades futures and options on 118 individual stocks
and 3 stock indices. All these derivative contracts are settled by cash payment and do
not involve physical delivery of the underlying product (which may be costly).
Derivatives on stock indexes and individual stocks have grown rapidly since inception.
In particular, single stock futures have become hugely popular; accounting for about
half of NSE‟s traded value in October 2005. In fact, NSE has the highest volume (i.e.
number of contracts traded) in the single stock futures globally, enabling it to rank 16
among world exchanges in the first half of 2005. Single stock options are less popular
than futures. Index futures are increasingly popular, and accounted for close to 40% of
traded value in October 2005. The growth in volume of futures and options on the Nifty
index, and shows that index futures have grown more strongly than index options NSE
launched interest rate futures in June 2003 but, in contrast to equity derivatives, there
has been little trading in them. One problem with these instruments was faulty contract
specifications, resulting in the underlying interest rate deviating erratically from the
reference rate used by market participants. Institutional investors have preferred to trade
in the OTC markets, where instruments such as interest rate swaps and forward rate
agreements are thriving. As interest rates in India have fallen, companies have swapped
their fixed rate borrowings into floating rates to reduce funding costs. Activity in OTC
markets dwarfs that of the entire exchange-traded markets, with daily value of trading
estimated to be Rs. 30 billion in 2004.
There are basically four kinds of products or instruments available in Indian stock
market i.e. Individual Stock Futures, Stock Index Futures, Individual Stock Options and
Stock Index Option. The equity derivative market at both the platform on BSE and NSE,
the clearing and settlement cycle is same excluding the stocks and indices and tick size
at both the places.
Participants of Derivative Market:
Patwari and Bhargava (2006) stated that there are three broad categories of participants
in the derivative market. They are: Hedgers, Speculators and Arbitrageurs.
• A Hedger is a trader who enters the derivative market to reduce a pre-existing
risk. In India, most derivatives users describe themselves as hedgers (Fitch
Ratings, (2004) and Indian laws generally require the use of derivatives for
hedging purposes only.
• Speculators, the next participant in the derivative market, buy and sell derivatives
to book the profit and not to reduce their risk. They wish to take a position in the
market by betting on future price movement of an asset. Speculators are attracted
to exchange traded derivative products because of their high liquidity, high
leverage, low impact cost, low transaction cost and default risk behaviour.
Futures and options both add to the potential gain and losses of the speculative
venture. It is the speculators who keep the market going because they bear the
risks, which no one else is willing to bear.
• The third participant, Arbitrageur is basically risk-averse and enters into the
contracts, having the potential to earn riskless profits. It is possible for an
arbitrageur to have riskless profits by buying in one market and simultaneously
selling in another, when markets are imperfect (long in one market and short in
another market). Arbitrageurs always look out for such price differences.
Arbitrageurs fetch enormous liquidity to the products which are exchanges
traded. The liquidity in-turn results in better price discovery, lesser market
manipulation and lesser cost of transaction.
According to Murti 2000, “the hedgers, the speculators and the arbitrageurs all three
must coexist. In simple words, all the three type of participants are required not only for
the healthy functioning of the derivative market, but also to increase the liquidity in the
market. The market would become mere tools of gambling without the hedgers, as they
provide economic substance to the market. Speculators provide depth and liquidity to
the market. Arbitrageurs help price discovery and bring uniformity in prices.
Derivative Users in India
The use of derivatives varies by type of institution. Financial institutions, such as banks,
have assets and liabilities of different maturities and in different currencies, and are
exposed to different risks of default from their borrowers. Thus, they are likely to use
derivatives on interest rates and currencies, and derivatives to manage credit risk.
Nonfinancial institutions are regulated differently from financial institutions, and this
affects their incentives to use derivatives. Indian insurance regulators, for example, are
yet to issue guidelines relating to the use of derivatives by insurance companies. In
India, financial institutions have not been heavy users of exchange-traded derivatives
so far, with their contribution to total value of NSE trades being less than 8% in October
2005. However, market insiders feel that this may be changing, as indicated by the
growing share of index derivatives (which are used more by institutions than by retail
investors). In contrast to the exchange-traded markets, domestic financial institutions
and mutual funds have shown great interest in OTC fixed income instruments.
Transactions between banks dominate the market for interest rate derivatives, while
state-owned banks remain a small presence. Corporations are active in the currency
forwards and swaps markets, buying these instruments from banks.
Retail investors (including small brokerages trading for themselves) are the major
participants in equity derivatives, accounting for about 60% of turnover in October
2005, according to NSE. The success of single stock futures in India is unique, as this
instrument has generally failed in most other countries. One reason for this success may
be retail investors’ prior familiarity with “badla” trades which shared some features of
derivatives trading. Another reason may be the small size of the futures contracts,
compared to similar contracts in other countries. Retail investors also dominate the
markets for commodity derivatives, due in part to their long-standing expertise in
trading in the “havala” or forwards markets.
Development of Derivatives Markets in India
Indian Derivatives markets have been in existence in one form or the other for a long
time. In the area of commodities, the Bombay Cotton Trade Association started futures
trading in 1875. In 1952, with the ban on cash settlement and option trading by the
Government of India, derivatives trading shifted to informal forwards markets. In recent
years, government policy has shifted in favour of an increased role of market-based
pricing and less suspicious derivatives trading. The first step towards the introduction
of financial derivatives trading in India was the promulgation of the Securities Laws
(Amendment) Ordinance, 1995. This provided for withdrawal of prohibition on options
in securities. In the last decade, beginning the year 2000, ban on futures trading in many
commodities was lifted out. During the same period, National Electronic Commodity
Exchanges were also set up. Derivatives trading commenced in India in June 2000 after
SEBI granted the final approval to this effect in May 2001 on the recommendation of
L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the
derivative segments of two stock exchanges, NSE and BSE, and their clearing
house/corporation to commence trading and settlement in approved derivatives
contracts. Initially SEBI approved trading in index futures contracts based on various
stock market indices such as, CNX, Nifty and Sensex. Subsequently, index-based
trading was permitted in options as well as individual securities.
