Chapter-3

Derivative Market in India

 Chapter-3 Derivatives Market in India

3.1 History of Derivative Markets

History of financial markets is replete with crises. such as the break down of the
fixed exchange rate system in 1971 and the Black Monday of October 1987 in US
Markets. the steep fall in the Nikkei in 1989. the bond debacle of 1994 in US. All these
events occur because of vcry high degree of volatility of financial markets and thcir
unpredictability. With increased global integration of markets, such disasters have
become more frequent. Since such volatility and associated disasters cannot be wished
away, innovative financial instruments emerged to protect against these hazards. These
included Futures and Options, which are the most dominant forms of financial
derivatives. They are called derivatives because their prices depend on the values of other
more basic underlying financial instruments. For example, the price of a stock option
depends on the value of the underlying stock; a commodity futures price depends on the
value of the underlying commodity and so on. These derivatives provide a mechanism,
which market participants use to hedge their positions against adverse movement of
variables over which they have no control. Financial derivatives came into the spotlight
along with the growing instability in current markets during the post-1970 period. when
the US announced its decision to give up gold-dollar parity, the basic king pin of the
Bretton Woods System of fixed exchange rates. In less than three decades of their
emergence, derivatives markets have become an integral part of modern financial system.
According to MLGreenspan Ex-Federal Governor of USA "By far the most significant
event in finance during the past decade has been the extraordinary development and
expansion of financial derivatives .... "
The Indian financial markets took a giant leap ahead with the introduction of
derivatives trading on the stock exchanges. The derivatives trading in India commenced
with the introduction of index futures in June 2000. The advent of stock futures and
options in 200 I resulted in a dramatic increase in the volumes of clerivatives. In less than
five years, the volumes in the Futures and Options segment rose more than that of the
cash market. Since then, the volumes in the F&O segment have witnessed huge growth.
Currently. the volumes in F&O are consistently around four to five times more than the

61
cash market volumes. This in itself reflects the huge popularity of these instruments
among the retail and institutional investors alike. Going ahead, the derivative markets arc
expected to see a further rise with the increase in knowledge levels among the investors
about these products. They also act as a very useful hedging tool for institutional
investors who would like to protect their holdings against any negative surprises. With
the government liberalizing norms for Mutual Funds participation in the derivatives
segment, the participation is expected to rise further in the future. The Mutual Fund
industry is also launching derivative funds where the primary focus would be to generate
returns through investment in derivatives. Moreover with the Indian stock markets
generating astronomical returns in the last few years, the future prospects of derivatives
looks extremely bright.
Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2000. SEBI permitted the derivative segments of two stock
exchanges, viz NSE and BSE, and their clearing house/corporation to commence trading
and settlement in approved derivative contracts. To begin with, SEBI approved trading in
index futures contracts based on S&P CNX Nifty Index and BSE-30 (Sensex) Index. This
was followed by approval [or trading in options based on these two indices and options
on individual securities. The trading in index options commenced in June 2001 and those
in options on individual securities commenced in July 2001. Futures contracts on
individual stock were launched in November 200 I. The sequence of events leading to the
introduction of trading of derivatives is presented in [Link] details of
participation of various players in Futures & Options markets are given in Table-3.2.

62
 Table-3.t Chronology of E,'ents leading to Derivatives Trading

1956 Enactment of the Securities Contracts (Regulation) Act which prohibited all
Options in securities

1969 Issue of Notification which prohibited forward trading in securities

1995 Promulgation of the Securities Laws (Amendment) Ordinance which
Withdrew prohibition on options

1996 Setting up of L. C. Gupta Committee to develop regulatory framework for

Derivatives trading in India
1998 Constitution of J, R. Varma Group to develop measures for risk containment
for derivatives

1999 Enactment of the Securities Laws (Amendment) Act which defined

Derivatives as securities

2000 Withdrawal of 1969 Notification

May 2000 SEBI granted approval to NSE and BSE to commence trading of derivatives

June 2000 Trading in index futures commenced

June 2001 Trading in index options commenced

Ban on all deferral products imposed
July 2001 Trading in stock options commenced
Rolling settlement introduced for active securities
November Trading in stock futures commenced
2001

63
 Table-3.2 Market contribution by different players in NSE F &0 Market

Month Institutional Proprietary

Retaillnvcstors
Tnv .."nr, Tnvestors
September -2005 6.95% 61.76'70 31.29'70
Octmber-2005 7.84% 59.87% 32.29'70
November-200S 7.12% 62.15'70 30.73'70
December-2005 6.28% 62.53'70 31.19'70
January-2006 7.61% 63.20'70 29.19'70
February-2006 8.36% 63.34'70 28.30'70
May-2006 8.21% 64.10% 27.69'70
April-2007 .
9.50% -- '.63.50'70 - 26.00%'

3.2 Types of Derivative Markets in India

Derivative markets can broadly be classified as commodity derivative market and
financial derivatives markets. As the name suggest. commodity derivatives markets
trade contracts for which the underlying asset is a cOlllmodity. It can be an
agricultural commodity like wheat. soybeans. rapeseed. cotton. etc or precious metals
like gold. silver. etc. Financial derivatives markets trade contracts that have a
financial asset or variable as the underlying. The more popular financial derivatives
are those, which have equity, interest rates and exchange rates as the underlying. The
most commonly used derivatives contracts are forwards, futures and options. Details
of various Derivative markets are given below.

3.2.1 Equity Derivatives

There are various types of Equity Derivatives instruments in India details of these
instruments are given below.
Forwards: A forward contract is a customized contract between two entities,
where settlement takes place on a specific date in the future at today's pre-agreed
pncc.
Futures: A futures contract is an agreement between two pm1ies to buy or sell an
asset at a certain time in the future at a certain price. Futures contracts are special

64
types of forward contracts in the sense that the fonner are standardized exchange-
traded contracts
Options: Options are of two types - calls and puts. Calls give the buyer the right
but not the obligation to buy a given quantity of the underlying asset. at a given
price on or before a given future date. Puts give the buyer the right, but not the
obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.
Warrants: Options generally have lives of up to one year, the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer-
dated options are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities.
These arc options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average or a basket of assets. Equity index
options are a form of basket options.
Swaps: Swaps are private agreements between two paIties to exchange cash tlows
in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:
o Interest rate swaps: These entail swapping only the interest related cash
tlows between the parties in the same cUlTency.
o Currency swaps: These entail swapping both principal and interest
between the parties, with the cash tlows in one direction being in a
different currency than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a swaption is an option on a forward
swap. Rather than have calls and puts, the swaptions market has receiver
swaptions and payer swaptions. A receiver swaption is an option to receive fixed
and pay tloating. A payer swaption is an option to pay fixed and receive tloating.

65
3.2.2 Commodity Derivatives
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 cOlllmence in the near
future. The sugar industry is explOling the merits of trading sugar futures contracts.

The policy initiatives and the modernization programme include extensive

training, structuring a reliable clearinghouse, establishment of a system of warehouse
receipts, and the thrust towards the establishment of a national cOlllmodity 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 affected using warehouse receipts (which are like
dematerialized 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 J998.

3.2.3 Foreign Exchange Derivatives

During the period J975-1992, the exchange rate of the rupee was officially set
by the Reserve Bank of India (RBI) in terms of a (weighted) basket of currencies of
India's major trading partners and there were significant restrictions on not only
capital but current account transactions as well. Since the early nineties. India is on
the path of a gradual progress towards capital account convertibility. The emphasis
has been shifting away from debt creating to non-debt creating intlows. with focus on
more stable long tenn inflows in the form of foreign direct invcstmcnt and portfolio

66
investment. The exchange rate regIme has evolved from a single-cunency fixed-
exchange rate system to fixing the value of the rupee against a basket of currcncics
and further to a market-determined floating exchange rate regime.

The Indian foreign exchange derivatives market owes its ongll1 to the
impol1ant step that the RBI took in 1978 to allow banks to undertake intra-day trading
in foreign exchange; as a consequence, the stipulation of maintaining square or near
square position was to be complied with only at the close of each business day. This
was followed by use of products like cross-currency options, interest rate and
cunency swaps, caps/collars and forward rate agreements in the international foreign
exchange market; development of a rupee-foreign currency swap market; and
introduction of additional hedging instruments such as foreign cuneney-rupee
options.

3.2.4 Exchange Traded Derivatives (ETD) & Over The Counter (OTC)
Derivatives markets
Derivatives have probably been around for as long as people have been trading
with one another. Forward contracting dates back at least to the 12th century, and
may well have been around before then. These contracts were typically OTe kind of
contracts. Over the counter (OTe) derivatives are privately negotiated contracts.
Merchants entered into contracts with one another for future delivery of specified
amount of commodities at specified price. A primary motivation for pre ananging a
buyer or seller for a stock of commodities in early forward contracts was to lessen the
possibility that large swing would inhibit marketing the commodity after a harvest.
Later many of these contracts were standardized in terms of quantity and delivery
dates and began to trade on an exchange.

The OTe derivatives markets have witnessed rather sharp growth over the last
few years, which have accompanied the modernization of commercial and investment
banking and globalization of financial activities. The recent developments in
information technology have contributed to a great extent to these developments.
While both exchange-traded and OTe derivative contracts offer many benefits, the

67
 former have rigid structures compared to the latter. Thc OTC derivatives markets
havc thc following features compared to exchange-traded derivatives:
• The management of counter-party (credit) risk is decentralized and
located within individual institutions,
• Thcre are no formal centralized limits on individual positions, leverage,
or margllllllg,
• Thcrc arc no formal rules for risk and burden-sharing,
• There are no formal rulcs or mcchanisms for ensuring market stability
and integrity, and for safeguarding the collective interests of market
participants, and
• The OTC contracts are generally not regulated by a regulatory authority
and the cxchange's self-regulatory organization, although they are
affected indirectly by national legal systems, banking supervision and
market surveillance.

3.3 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
futurcs industry. In 1952 thc 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 exchangcs were
created.
In the equity markcts, a system of trading called "BadIa" ("Badia" allowed
investors to trade single stocks on margin and to carry forward positions to the next
settlement cycle. Earlier, it was possible to carry forward a position indefinitely but later
the maximum carry forward period was 90 days. Unlike a futures or options, howcver, in
a "Badia" trade there is no fixed expiration date. and contract terms and margin
requirements arc not standardized) involving some elements of forwards trading had been

68
in existence for decades. 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-Ievel regulation (i.e., self-regulation by exchanges with SEBI providing a
supervisory and advisory role). Another report, by the J. R. Vanna Committee in 1998,
worked out various operational details such as the margining systems. In 1999, the
Securities Contracts (Regulation) Act of 1956, or SeeR) A, was amended so that
derivatives could be declared "securities." This allowed the regulatory framework for
trading secUlities to be extended to derivatives. The Act considers derivatives to be legal
and valid, but only if they are traded on exchanges.
Finally, a 3D-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. The casing of various
restrictions on the free movement of interest rates resulted in the need to manage interest
rate risk.

3.3.1 Derivatives: Developments in India

• Developments Prior to 1998-99
In the last few years there have been substantial improvements in the
functioning of the securities market. Requirements of adequate capitalization,
margining and establishment of clearing corporations have reduced market and

69
credit risks. Systemic improvements have been effected through introduction of
screen based trading system and electronic transfer and maintenance of ownership
records of securities. However there are inadequate advanced risk management
tools. In order to provide such tools and to deepen and strengthen cash market, a
need was felt for trading of derivatives like futures and options.
But it was not possible in view of prohibitions in the SCRA. Its preamble
stated that the Act is to prevent undesirable transactions in securities by regulating
business of dealing therein, by prohibiting options and by providing for certain
other matters connected therewith. Section 20 of the Act explicitly prohibited all
options in securities. The Act empowered Central Government to prohibit by
notification any type of transaction in any security. In exercise of this power,
Government by its notification in 1969 prohibited all forward trading in securities.
As the need for derivatives was felt, it was thought that if these prohibitions were
withdrawn, trading in derivatives could commence. The Securities Laws
(Amcndment) Ordinance, 1995, promulgated on 25 'h January 1995, lifted the ban
by repcaling section 20 of the SCRA and amending its preamble.

The market for derivatives, however, did not take off, as there was no
regulatory framework to govern trading of derivatives. SEBI set up a 24 member
Committee under the Chairmanship of Dr. L. C. Gupta on 18th November 1996 to
develop appropriate regulatory framework for derivatives trading in India. The
Committee submitted its report on March \7, 1998.
Market went ahead with preparation. It was soon realized that there was
no law under which the regulations could be framed for derivatives. It was felt
that if derivatives could be treated as "securities" under the SCRA, trading in
derivatives would be possible within the framework of that Act. According to
section 2 (h) of the SCRA, 'Securities' includes shares, scrips. stocks, bonds,
debentures, debenture stock, or other marketable securities of a like nature in or of
any incorporated company or other body corporate, government securities, such
other instruments as may be declared by the Central Government to be securities,
and rights and interests in securities. SEBI felt that the definition of "Securities"
under SC(R)A could be expanded by declaring derivative contracts based on

70
( index of prices of securities and other derivative contracts as securities. It was
thought that Government could declare derivatives to be securities under its
delegated powers. Governmcnt. however did not declare derivatives as
"securities". probably because its power was circumscribed by the words slIch
other. Only those instruments, which resemble the ones listed in the Act, could he
declared.

• Developments During 1998-99

A. L. C. Gupta Committee (LCGC) Report
The major recommendations of LCGC were accepted by SEBI on Illh May 1998.
Major Recommendations of L. C. Gupta Committee (LCGC)
I. The Committec strongly favors the introduction of financial derivatives to
facilitate hedging in a most cost-efficient way against market risk
2. There is a need for equity derivatives, interest rate derivative and currency
derivatives.
3. There should phased introduction of derivatives product. To start with,
index futures will be introduced, which will be followed by options on
index and btcr options on stocks.
4. Regulatory framework for derivatives trading envisaged two-level
regulation i.e. exchange-level and SEBllevel. with considerable emphasis
on self-regulatory competence of derivative exchanges under the overall
supervision and guidance of SEB!.
5. The derivative trading should take place on a separate segment of the
existing stock exchanges with an independent governing council where the
number of trading members will be limited to 40% of the total number.
The Chairn1an of the governing council will not be permitted to trade on
any of the stock exchanges.
6. TI1e settlement of derivatives will be through an independent clearing
corporationlclearing house. which will become counter party for all trades
or alternatively guarantee the settlement of all trades. The clearing

71
 corporation will have adequate risk containment measures and will collect
margins through EFT.
7. The derivative exchange will have on-line trading and surveillance
systems. It will disseminate trade and price information on real time hasis
through two information vending networks. It should inspect 100% of
members every year.
8. There will be complete segregation of client money at the level of trading
& clearing member and even at the level of clearing corporation.
9. The trading and clearing member will have stringent eligibility conditions.
At least two persons should have passed the certification programme
approved by SEBI.
10. The elearing members should deposit m1Jllmum Rs. 50 lakh with the
clearing corporation and should have a net worth of Rs. 3 crore.
11. Removal of the regulatory prohibition on the use of derivatives by mutual
funds while making the trustees responsible to restrict the use of
derivatives by mutual funds only to hedging and p0l1folio balancing and
not for speculation.
12. The operations of the cash market, on which the derivatives market will be
based, needed improvement in many respects.
13. Creation of Derivatives Cell, a Derivatives Advisory Committee, and
Economic Research Wing by SEBI.
14. Declaration of derivatives as securities under section 2(h)(iia) of the
SCRA and suitable amendment in the notification issued by the Central
Government in June 1969 under section 16 of the SCRA

B. Securities Contracts (Regulation) Amendment Bill, 1998

As the derivatives could not be declared to be "securities", government
explored the possibility of amending the SCRA to explicitly define securities to
include derivatives. The Securities Contracts (Regulation) Amendment Bill, 1998
was introduced in the Indian Parlamcnt on 41h July 1998 proposing to expand the
definition of "securities" to include derivatives within its ambit so that trading in

72
 derivatives could be introduced and regulated under the SCRA. The Bill was
referred to the Standing Committee on Finance (SCF) on 10'h July 1998 for
examination and report thereon. The Committee submitted its report on 171h
March 1999. The committee was of the opinion that the introduction of
derivatives. if implemented with proper safeguards and risk containment measures
will certainly gives a fillip to the sagging market. result in enhanced investment
activity and instill greater confidence among the investors/participants. The
committee after having examined the Bill and being convinced of the needs and
objectives of the Bill approved the same for enactment by Parliament with certain
modifications.

• Developments in 1999-2000
The Securities Laws (Amelldment) Act, 1999
The Securities Laws (Amendment) Bill, 1999 was introduced in Indian Parlament
on 28 1h October 1999. This Bill incorporated the amendments proposed in the
Securities Contracts Regulation (Amendment) Bill, 1998 as well as the
modifications suggested by the SCF. It became the Securities Laws (Amendment)
Act 1999 on receiving the assent of the President on 161h December 1999. The Act
would, however, come into force on such date as the Central Government may, by
notification in the official gazette, appoint.

3.4 Present scenario of Derivatives Markets in India

In India, the derivative market is still in a nascent stage. Derivatives in India were
gIVen a new lease of life last year. On January 25, 1995, the Securities Contract
(Regulation) Act, 1956 (SCRA) was amended with an intention to make options legal.
Prior to this date all options in securities were considered illegal. Securities covered by
this legislation include shares, scripts, stocks, bonds, debentures and other marketable
securities. In fact. this amendment also renders obsolete a notification issued by the
Government of India, dated June 27 1969, which imposed restrictions on the sale or
purchase of securities sans delivery. Thus under SCRA, 'option in securities' is no longer

73
illegal. This term includes a contract for the purchase or sale of a right to buy or sell
securities in future and includes a put, a call or a put and call in securities. Besides the
provisions of SCRA, marketable securities based derivatives fall within the purview of
the regulations framed by the Securities and Exchange Board of India (SEBI) and the
rules and regulations of the regional stock exchanges.
The first steps towards index-based futures trading in India have been taken.
Recently, on September 141h, 1997, the committee headed by L.c. Gupta which was
appointed by SEBI to look into the possibility of futures trading in India, has submitted
PaIt I of its report and recommended the introduction of index-based futures trading, as a
first step towards introduction of equity derivative products. It will be submitting Part II
of its report a month later. In Part II the committee will deal basically with devising a
regulatory framework for derivatives. In the report already submitted, the committee has
tried to remove the misconception prevailing about derivative trading and has
recommended its introduction in a phased manner.
While the committee has concentrated mainly on derivatives in equities it has also
touched upon interest rate futures and forward exchange futures. Currently, the
committee has not recommended the use of any particular index for index-based futures
trading. This leaves the field wide open, Nifty Midcap, Crisil 500, BSE Sensitive Index
and National Index arc the base indices that could be adopted by any stock exchange.
Later, in PaIt II of its report the committee will deal with the rules and regulations for
derivative trading. In addition, it is also likely to set criteria such as the minimum base
requirement and other eligibility norms for those stock exchanges which would be
interested in introducing derivative trading.
The depositories system is in place III India and the L.C. Gupta committee is
optimistic that this mechanism will provide a cheaper option for derivative trading. The
logic is that, dematerialized shares will provide the much-needed arbitrage, between the
current and the futures market. Taking delivery, holding and finally ornoading of the
stocks will have a much lower cost and will be more efficient in the dematerialized
segment of trading. Timing is of the essence in derivative trading and hcnec the
depository mode is more apt for derivatives.

74
 Under the depository mechanism, an investor can invest in the entire index by
buying up to one share in each of the index stocks and thereby drastically rcduce his
investment cost. If shares are not dematerialized, it may even necessitate purchase of the
market lot of each index stock. The report has also emphasized that mutual funds will
benefit greatly from derivatives trading.
While SEBI is likely to playa predominant role in the futures market, trading in
currency derivatives in India, is regulated under the Foreign Exchange Regulation Act,
1973 (FERA) and specific guidelines of the Reserve Bank of India (RBI). Credit policy
announcement in April this year, by India's central bank i.e. RBI, has boosted activities
relating to currency swaps. Commercial banks are allowed to run swap books by offering
currency swaps to corporate entities having foreign currency exposures. Further, banks
can now book forward contracts for importers and exporters on the basis of a declaration
instead of documented transactions. However, such swaps have to be within the
commercial bank's open positions or gap limits. Leeway on foreign currency borrowings
has also been given to these authorized dealers (commercial banks) regarding foreign
currency borrowings. Banks can borrow up to $ 10 million (Rs35 crore) from their
overseas branches without any restrictions on the end use of such funds in India.
A further impetus to derivative trading has come from an unexpected quat1er. A
committee chaired by a former director of the RBI ([Link]) submitted its report on
Capital Account Convertibility (CAC) to the apex bank on June 3, 1997. This report
advocates a phased implemcntation of capital account convertibility over a three-year
period: Phase I (1997-98), Phase II (1998-99) and Phase III (1999-2000).
This report emphasizes that CAC will usher in a variety of derivative and risk
management products. It mentions that currently, companies are allowed to usc
derivatives for hedging their currency or interest rate through authorized dealers in India
and arc not allowed to access the overseas markets directly. The Committee has
recommended that in Phase II corporate entities may be allowed to access overseas
markets directly for derivatives without having to route such transactions through
authorized dealers in India.
The L.c. Gupta committee has taken into cognisance this rep0l1 Oil CAC, while
touching upon interest rate futures and foreign exchange futures. However, this

75
committee has emphasized the need for a strong cash market. It states that: The futures
products delive their value from the cash market. if the cash market is not functioning
properly, then the cash asset will not be properly valued.
Trading in derivatives is yet to catch on in India and no specific tax provisions
exist. Courts have also not yet dealt with issues pertaining to tax liabilities mising out of
currency derivatives. However, India has had a mature dollar - rupee forward market with
contracts being traded for one, two or evcn six months maturity. The daily trading
volume on this forward market is around Rs SO() million.

3.5 Participants in Derivative Markets

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 cun'cncies, and derivatives to manage credit risk. Non-
financial 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 vallie of NSE trades being less than 8%
in October 200S. 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 (Chitale, 2003).
Corporations are active in the currency forwards and swaps markets, buying these
instruments from banks.
Why do institutions not participate to a greater extent 111 derivatives markets?
Some institutions such as banks and mutual funds are only allowed to use derivatives to
hedge their existing positions in the spot market. or to rebalance their existing portfolios.
Since banks have little exposure to equity markets due to banking regulations, they have

76
little incentive to trade equity derivatives. Foreign investors must register as foreign
institutional investors (FIll to trade exchange-traded derivatives, and be subject to
position limits as specified by SEB!. Alternatively. they can incorporate locally as a
broker-dealer. FlIs have a small but increasing presence in the equity derivatives markets.
They have no incentive to trade interest rate derivatives since they have little investments
in the domcstic bond markets (Chitale, 2(03). It is possible that unregistered foreign
investors and hedge funds trade indirectly. using a local proprietary trader as a front (Lee,
2(04).
Retail investors (including small brokerages trading for themselves) are the major
participants in equity derivatives. accounting for about 60'70 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 "Badia" trades. which shared some fcatures 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 "lIm'ala" or forwards markets.
Table-3.3 Participation in Derivatives Markets as on lune-2007

Hedging Speculation Arbitrage Intermediation

29.79o/c 29.77% 31.91% 31.91 %
Equity

Currency 12.77% 14.89% 21.28'70 17.02'70

Interest rate 27.66% 21.28'70 25.53% 14.89'70
Commodities 10.64% 14.89% 14.89'70 19.15'70

For the retail traders, derivatives offer an undoubted advantage of leveraging 4-6
times their investable amount. The minimum amount one would require to trade in
futures could be as minimal as Rs.20000. Options on the other hand can allow you to
take positions even with a meager principal amount, catering even to the most
marginal traders. Larger investors can make use of this 'leverage' for the purpose of
investing. People holding substantial shares in any derivative stocks can dilute the

77
 same 111 the cash market and pick up the same asset Via its underlying derivative
contract, as this would scale down their investment substantially and free up cash.
Hedging is the most sail able feature of any derivative instrument and also the primary
purpose for their creation.

Institutions funds often use these instruments to hedge their cash market
positions or make use of writing options to earn some money in range bound markets.
As funds can only limit themselves to heuging and cannot take speculative positions,
arbitrage opportunities offer scope to make safe money. This free money would add
in to their regular capital appreciation and dividend incomes.

Market Participants
Derivatives have a very wide range of applications in business as well as in
finance. There are four main participants in the derivatives market: dealers, hedgers,
speculators and arbitrageurs. The same individuals and organizations may play different
roles in different market circumstances. There are also large numbers of individuals and
organizations supporting the market in various ways.
• Dealers
Derivative contracts are bought and sold by dealers who work for major banks
and securities houses. Some contracts are traueu on exchanges, others are OTC
transactions. In a large investment bank the uerivatives operation is now a highly
specializeu affair. Marketing anu sales staff speaks to clients about their
requirements. Experts help to assemble solutions to those problems using
combinations of forwards, swaps and options. Any risks that the bank assumes as
a result of providing tailored products for clients is managed by the trauers who
run the bank's uerivatives books. Meantime, risk managers keep an eye on the
overall level of risk the bank is running, and mathematicians known as 'quants'
devise the tools required to price new products.
• Hedgers
Corporations, investing institutions, banks and governments all use derivative
prouucts to heuge or reduce their exposures to market variables such as interest
rates, share values, bond prices, cunency exchange rates and commouity prices.

78
 The classic example is the fanner who sells futures contracts to lock into a price
for delivering a crop on a future date. The buyer might be a food-processing
company, which wishes to fix a price for taking delivery of the crop in the future,
or a speculator. Another typical case is that of a company due to receive a
payment in a foreign currency on a future date. It enters into a forward transaction
with a bank agreeing to sell the foreign currency and receive a predetermined
quantity of domestic currency. Or it buys an option, which gives it the right but
not the obligation to sell the foreign currency at a set exchange rate.

o Speculators
Derivatives are very well suited to speculating on the prices of commodities and
financial assets and on key market variables such as interest rates, stock market
indices and currency exchange rates. Generally speaking, it is much less
expensive to create a speculative position using derivatives than by actually
trading the underlying commodity or asset. As a result, the potential returns are
that much greater. A classic application is the trader who believes that increasing
demand or reduced production is likely to boost the market price of a commodity.
As it would be too expensive to buy and store the physical commodity, the trader
buys an exchange-traded futures contract, agreeing to take delivery on a future
date at a fixed price. If the commodity price increases, the value of the contract
will also rise and can then be sold back into the market at a profit.

o Arbitrageurs
An arbitrage is a deal that produces risk-free profits by exploiting a mispricing in
the market. A simple example occurs when a trader can purchase an asset cheaply
in one location and simultaneously arrange to sell it in another at a higher price.
Such opportunities are unlikely to persist for very long, since arbitrageurs would
rush in to buy the asset in the 'cheap' location, thus closing the pricing gap. In the
derivatives business arbitrage opportunities typically arise because a product can
be assembled in different ways out of different building blocks. If it is possible to
sell a product for more than it costs to buy the constituent parts, then a risk-free
profit can be generated. In practice the presence of transaction costs often means
that only the larger market players can benefit from such opportunities.

79
3.6 Use of Derivatives by India's Institutional Investors
The Institutional Investors in India could be meaningfully classified into:

• Banks
• All India Financial Institutions (FIs)
• Mutual Funds (MFs)
• Foreign Institutional Investors (FIls)

• Life & General Insurers

Issues and impediments in the use of following types of derivatives by these institutional
investors in India:

• Equity Derivatives
• Fixed Income Derivatives
• Foreign Currency Derivatives
• Commodity Derivatives
The intensity of derivatives usage by any institutional investor is a function of its ability
and willingness to use derivatives for one or more of the following purposes:
a. Risk Containment: Using derivatives for hedging and risk containment purposes;
b. Risk Trading / Market Making: Running derivatives trading book for profits and
arbitrage; and/or
c. Covered Intermediation: On balance sheet derivatives intermediation for client
transactions, without retaining any net risk on the balance sheet (except credit
risk).
Role of above FI in Equity Derivatives are as follows.

3.6.1 Banks
Types of Banks
Based on the differences III governance structure, business practices and
organizational ethos, it is meaningful to classify the Indian banking sector into the
following:
i. Public Sector Banks (PSBs);
ii. Private Sector Banks (Old Generation);
iii. Private Sector Banks (New Generation); and

80
 iv. Foreign Banks (with banking and authorized dealer license).

Equity Derivatives in Banks

Given the highly leveraged nature of banking business. and the attendant
regulatory concerns of their investment in equities. banks in India can. at best. be
termed as marginal investors in equities. Use of equity derivatives by banks ought
to be inherently limited to risk containment (hedging) and arbitrage trading
between the cash market and options and futures market. J]owever. for the
following reasons, banks with direct or indirect equity market exposure are yet to
usc exchange traded equity derivatives (viz .. index futures. index options, security
specific futures or security specific options) currently available on the National
Stock Exchange (NSE) or Bombay Stock Exchange (BSE):

I. RBI guidelines on investment by banks in capital market instruments do

not authorize banks to use equity derivatives for any purpose. RBI
guidelines also do not authorize banks to undertake securities lending
and/or borrowing of equities. This disables also banks possessing arbitrage
trading skills and institutionalized risk management processes for running
an arbitrage trading book to capture risk free pricing mismatch spreads
between the equity cash and options and futures market an activity banks
currently any way undertake in the fixed income and FX cash and forward
markets;
II. Direct and indirect equity exposure of banks is negligible and does not
warrant serious management attention and resources for hedging purposes;
II\. The internal resources and processes in most bank treasuries are
inadequate to manage the risk of equity market exposures, and monitor use
of equity derivatives (even if used only for risk containment purposes);
IV. Inadequate technological and husiness process readiness of their treasuries
to run an equity arbitrage-trading book. and manage related risks.

81
3.6.2 All India Financial Institutions (FJ)
The All India FI Universe
With the mcrger of ICICI into ICICI Bank, the universe of all India Fls
comprises IDB!. IFCI, liB!. SIDBI, EXIM. NABARD and IDFC. In the contcxt
of use of financial derivatives. the universe of FIs could perhaps be extended to
include a few other financially significant players such as HDFC and NHB.

ECluity Derivathes in FIs

Equity risk exposure of most FIs is rather insignificant, and often limited
to equity devolved on them under underwriting commitments they made in the era
up to the mid- I 990s. Use of equity derivatives by FIs could be for risk
containment (hedging) purposes, and for arbitrage trading purposes between the
cash market and options and futures market. For reasons identical to those
outlined earlier vis-a-vis banks, FIs too are not users of equity derivatives.
However. there is no RBI guideline disabling FIs from running an equities
arbitrage trading book to capture risk free pricing mismatch spreads between the
equity cash and options and futures market. Yet. it appears that most FIs do not
run an equities arbitrage-trading book. Possible reasons could include inadequate
readiness in terms of possessing arbitrage-trading skills and institutionalized risk
management processes for running an arbitrage-trading book.

3.6.3 Mutual Funds

Mutual Funds Profile
Mutual Funds came in limelight in 1960 with the rise of UTI (Unit Trust
of India) later on after globalization many domestic as well as MNC have entered
in to India. There are number of popular names like Fidelity. Reliance, HDI'C,
IISBC, ICICI. Franklin Templeton etc. As on today MF size in Indian market is
about US$ 50 bn and its size increasing day by day. Basically MF caters to those
risks averse investors who afraid to invest directly in stock market. Hence through
MF different retail as wellllNI can invest in stock market.

82
 Equity Derivatives in Mutual Funds
Mutual Funds ought to be natural players in the equity derivativcs market.
SEB! (Mutual Funds) Regulations also authorize usc of exchange traded equity
derivatives by mutual funds for hedging and portfolio rebalancing purposes. And.
being tax exempt. therc arc also no tax issucs relating to use of equity derivativcs
by thcm. However. most mutual funds (whether managed by Indian or foreign
owncd asset management companies) arc not yet active in use of equity
derivatives available on the NSE or BSE.
The following impedimcnts seem to hindcr use of exchange trade equity
derivatives by mutual funds:
1. SEBI (l\lutual Funds) Regulations restrict usc of exchange traded
equity derivatives to 'hedging and portfolio rebalancing purposes'.
The popular view in the mutual fund industry is that this regulation is
very open to interpretation; and the trustees of mutual funds do not
wish to be caught on the wrong foot! The mutual fund industry
therefore wants SEBI to clarify the scope of this regulatory provision;
11. Inadequate technological and business process readiness of several
players in the mutual fund industry to use equity derivatives and
manage related risks;
Ill. The regulatory prohibition on use of equity derivatives for Portfolio
optimization return enhancement strategies, and arbitrage strategies
constricts their ability to use equity derivatives; and
IV. Relatively insignificant investor interest in equity funds ever since
exchange traded options and futures were launched in June 2000 (on
NSE, later on BSE).

3.6.4 Foreign Institutional Investors (FII)

Foreign Institutional Investors (FIll
Indian capital markets has permitted FJI to invest in various listed as well
as unlisted companies in year 1995 and from that year onwards there investment
has increased in leap and frog manner. Today Indian Capital markets both cash

83
 and dClivatives markets are largely depend on Fll money because they provide
liquidity and stability to Indian markets.
Equity Derivatives in FIls
Till January 2002, applicable SEBI & RBI Guidelines permitted FIls to
trade only in index futures contracts on NSE & BSE. It is only since 4 February
2002 that RBI has permittcd (as a sequel to SEBI permission in December 200 I)
FIls to trade in all exchange traded derivatives contracts within the position limits
for trading of Fils and their sub accounts. l Thcse open position limits have been
spelt out in SEBI circular dated 12 February 2002.J With the enabling regulatory
framework available to FIls from February 2002, their activity in the exchange
traded equity derivatives market in India should increase noticeably in the
emerging future. Evidently. several FIls are still in the process of completing the
process of their internal approvals for use of exchange traded equity derivatives
on the NSE or BSE. Perhaps, the two years of successful track record of the NSE
in managing the systemic risk associated with its futures and options (F&O)
segment would also pave way for greater FII activity in the equity derivatives
market in India in the emerging future.

3.6.5 Life & General Insurers

Life & General Insurance companies
Insurance companies both life and general insurers are also very active in
Indian capital market after getting permission from IRDA (Insurance Regulatory
Developmcnt Authority a parent body for insurance companies) these companies
have started investing portion of insurance premium money (mainly ULIP money)
in capital markets. Some popular names like LIC, HDFC, ICICI. and Reliance etc.

Elluity Derivatives in Life & General Insurers

The Insurance Act as well as the IRDA (Investment) Regulations 2000 are
silent about use of equity (or other) derivatives by life or general insurance
com panics. It is the view of the Insurance Regulatory and Development Authority
(IRDA) that life and general insurers are not permitted to use equity (or other
financial) derivatives until IRDA frames guidclineslregulations relating to their

84
 use. And. IRDA is yet to frame these guidelines/regulations, though it is seized of
the urgent need to frame them. Life or general insurers would have to wait for
these guidelineslregulations to fall in place before they can use equity (or other
financial) derivatives. Assuming this happens sooner than later, most new life and
general insurers have been established only in the past two years or so, and they
currently have little or no equity investments at all. Given the nascent stage at
which they are, it will take at least a few years before they become active
investors in the equity market.
Till then, use of equity derivatives would be of relevance primarily to the
incumbent public sector insurance majors, namely, Life Insurance Corporation of
India (L1C), General Insurance Corporation of India (GIC), New India Assurance
Company Limited (NIA), United India Insurance Company Limited, National
Insurance Company Limited. and Oriental Insurance Company Limited. And,
these incumbents would have to overcome the following key impediments before
they actively use equity (or other financial) derivatives:
I. Inadequate technological and business process readiness of their
investment management function to run a derivatives trading book,
and manage related risks;
II. Inadequate readiness of human resources/talent in their investment
management function to run a derivatives trading book, and manage
related risks; and
Ill. Inadequate willingness of insurer managements to 'risk' being held
accountable for bonafide losses in the derivatives trading book
(assuming regulations permitting use of equity derivatives for purposes
other than hedging), and be exposed to subsequent onerous
investigative reviews.

3.7 Derivatives in India: Myths and Realities

Despite tremendous popularity of derivative instruments all over the world, there
are apprehensions about their need and desirahility in India. This can be attributed

85
precisely to the phenomenon of fear of the unknown. Therefore. it becomes imperative to
demystify the myths surrounding the utility of derivatives trading in India.

• J\1yth-I: Indian J\1arkct is not ready for derivativc trading.

Reality-I: It is argued in some circles that the Indian securities market is not ready
for derivatives trading. The securities market in India is accustomed to the style of
settlemcnt in the futures market. Market participants are used to trading. clearing and
settlement systems. which arc akin to futures market.
In addition. the basie requiremcnts of futures markets such as Initial Margin. Daily
Mark to Market Margin, Clearing Corporations for Trade Guarantee. Surveillance
System, Netting of Trades for Specific Period etc. have been in place for quite some
time now. All the stocks in the Senscx and the Nifty are traded in Demat
(Dematerialization) form. There is complete transparency in order execution through
on-line trading system and 100% of the trades are conducted on-line. The NSE
collects the margin from its members through EFT facility. SEBI has worked out risk
containment measures for the futures markets, which include the collection of initial
margin. based on 99% value-at-risk in advance. The Dr. L. C. Gupta Committee
recognized the state of preparedness of the market and therefore had recommended a
phased introduction of derivatives products in the sequence of index futures, index
options and options on stocks. What more needed is separation of cash market from
futures market, which would shift some of the speculative transactions from the
former to the latter. This is being achieved by introducing rolling settlement for all
transactions on stock exchanges. There is, however, no barometer to judge the
preparedness of the market for introduction of derivatives trading. It is also not
necessary that all the pre-conditions must be in place before trading of derivatives is
introduced. Moreover, when market participants feel the need for derivatives trading
but are deprived of it, it is likely that the derivatives market on the Indian indices may
develop elsewhere in the world.

86
• Myth-2: Disasters prove that deriYatiYes arc very risky.
Reality-2: Disasters can happen. These have happencd III the cash segment of
securities markct in India. But disasters associated with derivatives catch attention
like crash of an aircraft. while innumerable road accidents do not. Derivatives are like
aircraft in that they are very uscful most of the time. and generate headlines when
things go wrong. Yet. a focus on plane crashes does not accurately convey the extent
to which thousands of planes tly safely every day. We do not abandon tlying just
because it has a rcmote possibility of crash. We build up systems to avoid recurrence
of such crash.
Derivatives are subject to same typc of basic risks as thc securities from which they
derive thcir values. including market risk. liquidity risk. credit risk and settlement
risk. Since these crcate leverage more effectively and cheaply than the underlying,
they need to be handlcd more carefully. Derivatives are like chainsaw - more
powerful. but need greater care in use. The regulation should ensure adequate
information for investment decisions. protect and promote fair competition. prevent
contagion and enable markets to survive systemic shocks.

• Myth-3: Derh'ath-es are too complex and Indians will not be able to handle them
Reality-3: Trading in standard derivatives such as forwards and futures has been
extremely popular in India. Derivatives in commodities have a long history. The first
commodity futures exchange was set up in 1875 in Mumbai under the aegis of
Bombay Cotton Traders Association. A clearing house for clearing and settlement of
these trades was set up in 1918.
In the equities markets also. the derivatives have been in existence for a long time. In
fact, official history of the Native Share and Stock Brokers Association, which is now
known as Stock Exchange, Murnbai. suggests that the concept of options existed as
early as in 1898. All these amply prove that the concept of options and futures has
been well ingrained in the Indian markets for a long time and is not alien as it is made
out to be.

87
• l\Iyth-4: Existing cash market is safer than dcrivatiHs
Reality-4: The trades in cash market accumulate ovcr a trading cycle and at the cnd
of the cycle, these are clubbed together, and positions arc squared up, netted out,
carried forward (on some exchanges), and the balance is settled by payment of cash
and delivery of securities. Thus. the exchanges already follow "futures-style
settlement" in contrast with international practice where trades are settled on rolling
settlement basis. Currently account period trading carries the risks and difficulties of
future market sans gains in price discovery and hedging services. From the regulatory
perspective. the more cff"icient way would be to separate out the futures from the cash
market i.e. introduce rolling settlement in all exchanges and at the same time allow
futures and options to trade separately.

3.8 Regulatory role in Derivative markets

Rapid expansion in newer areas in financial markets naturally brings up the issue
of a regulatory framework that can cope with this growth. The first type of regulation
required for any derivatives market falls under the rubric of orderly market provisions.
These measures, which have been tested over time in securities markets around the
world, are designed to facilitate a liquid. efficient market with a minimum of disruptions.
Registration and reporting requirements, transparency and creation of a level playing
field for all investors alike. a system of mitigation of payments risks and safeguarding
investors' moneys, are essential requirements. Risk containment measures in turn include
capital adequacy requirements of members, monitoring of members' performance and
track record, stringent margin requirements, position limits based on capital, online
monitoring of member positions and automatic disablement from trading when limits are
breached.
In India. pnor to the introduction of derivatives trading, the definition of
securilies was amended (to include derivatives contracts in the definition of securilies) so
as to ensure that derivatives trading takes place under the provisions of the Securilies
Conlraets (Regulalion) ACl, 1956 and the Secltrilies and Exchange Board of India ACl,
1992.26 Derivatives trading in India can take place either on a separate and independent
Derivatives Exchange or on a separate segment of an existing Stock Exchange. The

88
Derivatives Exchange/Segment functions as a Self-Regulatory Organization (SRO) and
SEBI acts as the oversight regulator. The key factor enabling exchange-traueu delivativcs
is the credit guarantee supplied by the clearing corporation. SEBI stipulates that the
clearing anu settlement of all traues on the Derivatives Exchange/ Segment woulu have to
be through a Clearing Corporation/ House. which is independent in governance and
membership from the Derivatives Exchange/Segment. SEBI has also laid the eligibility
conditions for Derivatives Exchange/Segment and its Clearing Corporation/ !louse. The
eligibility conditions have been framed to ensure that Derivatives Exchange/Segment and
Clearing Corporation/House provides a transparent trading environment. safety and
integrity and provides facilities for redressal of inve~;[or grievances anu maintains a
separate investor protection fund. The Clearing Corporation/House in turn is required to
perform jul! novation. i.e .. the Clearing Corporation! House shall interpose itself between
both legs of every trade, becoming the legal counterparty to both. or, alternatively should
provide an unconditional guarantee for settlement of all trades. It shoulu institute
facilities for electronic funds transfer (EFf) for swift movement of payments and have a
separate Trade Guarantee Fund for the trades executed on Derivatives
Exchange/Segment.
There are three critical policy issues that need to be carefully consiuereu before
derivatives markets can be successfully developed: how can liquid cash markets be
expanded; how much regulation is needed in OTC and ETD derivative markets; and what
infrastructure is necessary.

89
 Fig-3.l Three pillars for sound derivative markets

III
!,'
Regulation
!

,
Infras truclurc IJ
!,'

II, --- ] .cad n.'guiartH", capiu :- e<:l', I:-:D. \ ll1aSlcr i

iii uit:s, rep()rring sfanJards I 'lose-our nl'rrin~

! !

I' I !
,

I
,
-- Legal cLlnn:
-'(;}ndard" I~D,\
I'I !
:- DcrnuL l'xchangl's,
enf"rcc'lbilin' "
! , 'tron~ capnal, tnaq.,t1t1s
I, I,
• !

I" •••- \Lukcr detl"nnineti

: rr1c.:t'~, lt1l'1'rl'sl/I' \. ra(L'~
I

I,
--- rules,
. \CC()Lllllitll!: r
!

:- SR( ) rules t'nfoJ'Ct:l

1 ransp;lrc.:ncy, Jisch )SUfl: i nth lilnils, Illoniloring !

! I,I ,

.:. Sy~rl'tn ~r:lbili(y, '! :- Lcvel plowing field, (:" I :- 1

(~L'rtifiL'lJ inn.:,:·a()('s,
no tHora1 h:V::lrd ri~ks
I 'd ' ,
l~lrnHHU/.l' , HHt'gr~Hl()n
I I I ~()JL' of conducr
! Ii
I i,

" " "

3.8.1 Regulatory Objeetives

In India Regul3lOry function being performed by SEBI (Securities and Exchange

Board of India), it has following objectives in regulating Derivative markets in India.
a) Investor Protection: Attention needs to be given to the following four aspects:
• Fairness and Transparency: The trading rules should ensure that trading
is conducted in a fair and transparent Illanner. Experience in other
countries shows that in Illany cases, derivatives brokers/dealers failed to
disclose potential risk to the clients. In this context, sales practices adopted
by dealers for derivatives would require specilic regulation,

• Safeguard for clients' moneys: Moneys and securities deposited by

clients with the trading members should not only be kept in a separate
clients' account but should also not be attachable for meeting the broker's
own debts. It should be ensured that trading by dealers on own account is
totally segregated from that for clients,

• Competent and honest service: The eligibility criteria for trading

members should be designed to encourage competent and qualified

90
 personnel so that investors/clients are served well. This makes it necessary
to prescribe qualification for derivatives brokers/dealers and the sales
persons appointed by them in terms of a knowledge base.
• Market integrity: The trading system should ensure that the market's
integrity is safeguarded by minimizing the possibility of defaults. This
requIres framing appropriate rules about capital adequacy, margll1s.
clearing corporation. etc.
b) Quality of markets: The concept of "Quality of Markets" goes well beyond
market integrity and aims at enhancing important market qualities, such as cost-
efficiency. price-continuity, and price-discovery. This is a much broader objective
than market integrity.
cj Innovation: While curbing any undesirable tendencies. the regulatory framework
should not stifle innovation which is the source of all economic progress, more so
because financial derivatives represent a new rapidly developing area. aided by
advancements in information technology.

3.8.2 Regulatory barriers in Derivatives Markets

Knowledge of derivatives is not highly advanced In many developing markets.

This is true of practitioners, and is perhaps even more acutely the case for regulators. In
fact. one of the main barriers to development of derivatives markets - since the
supply/demand and market/assets constraints, as we have seen above, are not so binding -
is a caution among regulators caused by a failure to understand the nature of derivative
markets. or at a minimum to be at ease with their functioning.
The strongest barriers to derivative markets are often regulatory. There are three linked
reasons:
• Statutory baITiers
• Failure to understand
• Fear of short-selling

Statutory barriers

These fall into three types:

91
 o Laws that specifically prohibit derivatives or do not specifically permit them.
which often come to the same thing.
o Laws that do not clarify which entity has regulatory jurisdiction over derivatives
often this is linked to the legal definition of "securities".
o Laws that prohibits gambling or makes gambling contracts unenforceable and
where derivatives are not clearly distinguished from gambling.
Sometimes. the legal framework supports forward contracts where the norm is
physical delivcry at the time of expiry. But most exchange contracts can be cash-settled,
and even if physical delivery is permitted. it is a very rare occurrence.

Failure to understand

Often regulators do not understand the precise nature of derivative markets. and many
misconceptions arise. Among these are:
a) Derivatives replace or bypass existing markets. Evidence presented here and
elsewhere suggests that derivatives enhance and supplement existing markets
by providing hedging tools. additional opportunities for market users. and
low-cost arbitrage opportunities.

b) Derimtil'es require physical delil'ery to hm'e value or socia/usefulness. In fact.

the "insurance" or risk-transfer benefits which derivatives offer arc achieved
without physical delivery. Indeed. physical delivery can be difficult and
costly. so requiring physical delivery can be a barrier to a market.

c) Derivatives fuel price speculation and lead to increased volatility. In fact. by

offering low-cost mechanisms for taking contrarian positions. derivatives
reduce speculative volatility. In addition. the availability of hedging
mechanisms makes it easier for liquidity providers to offset temporary
imbalances caused by lack of liquidity.

d) Derivatives only benefit new entrants, especially foreign jinns. While it is true
that foreign firms have often had an initial advantage over local finns because
of their global expertise. the local firms are very quick to learn. and any
supposed advantage is shon-lived.

92
 e) Derivatives cause a build-up of risks (lnd exposures that may cause systemic
collapse. In practice, derivative settlements arc always tightly controlled by a
clearing-house, ensuring that there are no scttlemcnt losses. This is not to say
that individual participants may not make losses that are catastrophic for the
entity - like Barings, etc. But this can and docs happen with cash market
trading, and if regulation of capital adequacy is effective, then this will not
cause a systemic collapse.

t) Derimtives make market abuse easier. Derivatives certainly open new

possibilities for market abuse, and so present new challenges for monitoring
and surveillance. However, it is not apparent that markets that have successful
derivative exchanges are more subject to market abuse than those that do not.
It is easier to regulate markets that are open and transparent in comparison to
unofficial markets for derivatives that often exist where exchange markets are
not available.

g) Derivatives increase risk of scandal. Regulators are not paid to take risks, and
are unsurprisingly risk averse. Financial scams and scandals have an impact in
the political world beyond the financial markets. Regulators that allow
scandals to take place on their watch can lose their jobs. So scandals leave
deep scars which last for a long time, leaving regulators very cautious and
negative towards innovation. In fact, most of the scandals do not involve
derivatives - which were not allowed at the time and were attributable to
weak regulation rather than anything else.

l"ear of short selling

Short selling is universally banned in developing Asian markets. The real effect is
not to prevent speculation but to damage the market by preventing profitable trading in
bear markets and by ensuring that market making is practically impossible. (Sometimes
inconsistently. market makers arc required to make continllous two-way prices).
Derivatives naturally make such a ban pointless, since selling futures or options gives the
same exposure as short selling and so regulators wishing to prevent short-selling will be
unlikely to approve of derivatives markets.

93
3.9 Derivative exchanges
Economic reasons and national pride motivate the establishment of derivatives
exchanges. A country's financial infrastructure is enhanced by the links among hedgers,
speculators, and cash markets. A derivatives exchange can improve the allocation of
resources. maintain efficient pricing and information Ilows. and act as a conduit for the
transfer of risk within a country and even across countries. Additionally. because
derivatives exchanges make more information publicly available, credit systems and
capital markets are more responsive, with uniform repayment regulations and market
surveillance; transaction costs are lower; forward prices are more accurate; and resources
are better allocated (Chang. Kaplan, and Knapp 1999. Peck 1985).
Derivatives allow risk-averse market participants (such as banks, farmers,
processors. and traders) to offset risk among themselves or transfer it to other market
participants willing to accept the risk-return ratio. In the process, derivatives attract
additional participants who in turn increase the volume of transactions, thus contributing
to the creation of a liquid market.
By delillition. derivatives contracts traded at all exchange !elld to be standardized;
a clearinghouse guarantees transactions between parties, acting as buyer to all sellers and
seller to all buyers. By requiling that buyers and sellers deposit funds (margins) as
security for their transactions and by adjusting these margins to reflect changes in market
prices. the clearinghouse substantially reduccs, or even eliminates, the perforn1ance
(counterpart) risk among transacting parties.
In many emerging markets the price for an asset is difficult to determine. An
active derivatives exchange plays an important role in facilitating an efficient
determination of prices in the underlying cash (or spot) market by providing improved
and transparent information on both current and future prices for an asset. For example,
in commodity markets spot prices are often pegged to futures prices because the futures
market provides excellent pricing information for the underlying product (for security
markets, see Scott 1992). Prices on derivatives markets rellect anticipated supply and
demand. and derivatives markets thus enhance the ability of market pm1icipants to make
decisions about future production. processing, and trade.

94
 The exchange writes the specifications for contracts traded, setting standards for
grading, measurement, methods of transfer, times of delivery, and contractual
obligations. The standardization makes these contracts conducive to centralized trading
on an exchange. The ease with whieh transactions can be executed and positions opencd
and closed stimulates high trading volumes and higher usage than does the spot market.
This ease of execution opens the exchange to almost anyone who wishes to trade,
whether involved in the physical trade (spot market) or not. and contributes to reducing
transaction costs.

3.9.1 The Microstructure of Derivatives Exchanges

The success of a deri vati ves exchange is determined to a large extent by the
soundness of the foundation on which it is built. Thus, the design of the formal structures
and systems created to ensure orderly trading and execution of exchange transactions is
crucial. The microstructure may become a form of competitive advantage to the degree
that it motivates, facilitates, or enables price discovery and eliminates asymmetric
information. The microstructure of derivatives exchanges is important for several
reasons. It provides insights into the workings of the market through an examination of
the features of the exchange and of the linkages that allow a disciplined flow of orders
and execution of transactions, and it plays an important role in creating and disseminating
market information. Both trading activity and price determination are sensitive to
institutional arrangements. Moreover, the microstructure ensures the smooth execution of
transactions. Finally, market anangements have implications for the long-term properties
of derivatives contracts and the retums on underlying assets. ImpOitant elements of the
microstructure include trading mechanisms. clearing arrangements, the regulatory
structure, and the choice of derivatives products to be traded.

3.9.2 Roadmap towards Sound Derivative Markets

The analysis of benefits and risks of derivative instruments, the 20-year
experience from OTe and ETD derivative markets. and the policy considerations
discussed above lead to a road map that can facilitate the development of sound derivative
markets. The following chart illustrates ten stylized building block. which Icad from cash

95
markets to Repo markets to ETD markets and eventually to OTe derivative markets.
While there are always country specific differences, the following stylized building
blocks should be developed:
• First, there should be an efficient. liquid, and integrated cash markd (either for
bonds, equities, other assets, or commodities) that are broadly market determined
rather than driven by administered prices. Segmented markets and access
restrictions can lead to less liquid and less efficient markets. In bond markets, the
development of on-the-run benchmarks can help foster liquidity. In addition,
modern IT, trading platforms, and Internet trading often enhance liquidity.

• There needs to be a compelling economic rationale to develop new derivative

products. For example, credit derivatives are desirable in order to transfer credit
risk to institutional investors, whereas exotic options may not be desirable if they
mostly serve for retail speculation. Then a derivatives law needs to be enacted that
protects netting arrangements in bankruptcies and enables effective enforcement.
In addition, appropriate regulation (functional and/or institutional) needs to be
estahlished which usually includes self-regulatory organizations (SRO).

• Prior to trading of derivatives, both long and short positions should be allowed in
the underlying cash market. For bond markets, repurchase agreements need to be
established. which requires the development of securities lending, and often is
combined with margin trading. Short positions may be limited to hedge net long
positions, but they are critical to develop liquidity and avoid the primary
motivation for derivatives as substitutes for short cash positions.

• Market participants that intend to deal in derivatives should be licensed and

trained. They should be required to follow best practice governance and
accounting standards and to hold sufficient capital for their respective risk
positions. Also, intermediaries must be accountable to deal only with fit and
proper clients who understand characteristics and risks of derivatives.
• Tax regulations should provide a level playing field for all cash and derivatives
trading. If anyone-market segment is exempted from taxes, it may initially help
market development, but will not be sustainable if that market becomes a

96
 substitute for tax arbitrage reasons. Typically, capital gains taxes are considered
more efficient and less distortionary than transaction taxes.

• The major institutional setup of a derivatives exchange will ideally be

implemented through a single demutualized exchange. Typically. index futures
are among the first products before options on individual assets are introduced.
Safety cushions of the exchange must include appropriate capital and a sound
margining system.

• Clearing and settlement of derivatives products should be executed through a

single counterparty (CCP) with multilateral multi-product close-out netting
anangements. Typically the exchange or its subsidiary will provide these services,
which may also cover OTC trading as it will further strengthen the prevalent OTC
design of bilateral ISDA master agreements.
• Local accounting standards should be upgraded to IFRS, including mark-to-
market principles as required under IAS39. Full disclosure of all derivative
positions should be required.
• Subsequently, more tailored or innovative OTC derivative products may be
designed, such as credit default swaps. Typically, intermediaries are banks, which
should receive specific regulatory clearance and should support their risk
positions with adequate capital. Counter-party credit risk management requires
special emphasis, which is typically facilitated through ISDA master-agreements,
the use of counter-party credit ratings, and the posting of collateral.
• Finally, the investor base may be further broadened, for example by attracting a
larger share of foreign institutional investors or by opening up new ETD markets
for retail investors.
This can be facilitated by strategic partnerships among exchanges, modern trading
platforms, and reduced transaction costs, as well as by innovative products that meet new
hedging needs. In summary, solid product design, strong regulation, and sound market
infrastructure are three key components for the development of sound derivative markets.

97
 Fig-3.2 Building blocks for Derivative Market Exchange

'" '" h l\.·f " ~ In'h "

illui d, l' fficicl1 t,

Investor Base 'i illlq;:1":unl; ~ euul
,-' .... & Lena!
,.,
hnl,l,ring nccd~, iWI1c1l1l1,ll' k~", F ran1ework
prod LJCb, IT, , IC"ri\';Hjvl'~ hw,
1()\H'l' CIJ~I~ :-; R() fLLll C Iion

Cash ;'
~epo Market~ 1
!'l'"
(~P
h '
;ll)I)1"oval
crl'dit ri:-;k,
'"'\.
/ ~
'(["('clivI.'
n;Ll'g111
ShOl't.1
Imdll1g 'i

~.I.I{.&.".I'.:\..1"'-0
-- I'
UCI;v:llivt' ~lcm. lending],
L'I..v:.ll.1 __
<
...., \L1rkcl
j,. Ii ___ B Llildin"h
'"'
Accounting I, V l\locb - _ Intermediary
:ldupl II "R~, Licensing
1\11'\1, L\:-;V), / ILLaL iL1\'est()r~,
fLlll di~c1()c Lll'(' 1 ralLlIng
ETD
Design CCP Taxes level
c!OCl'-O[lf nct, playing field
I~D,\ m:l~I(T, Excbaonf'
tJ . ';[~h=fl'P()=[)'
clll~ un nh'lll )1:11 ((Inn, links. Ivoid ILLL), I,LX
';L piG aI, ma l'gin~
rlr~1 f!lllll(,~

98
 Fig-3.3 Futures Industry Structure and Trade Execution

Proprietary Hedger Arbitrageur Public

Trader (ABC Corp.) Speculator

Clearing
r---------- Member
(Carr Futures)
I
I
I
I
I
I
I
I Locals
I
I Scalpers
I
Clearing Spreaders Local
House Clearing
Day Traders Member
I
I Position Traders
I
I
I
I
I
I
I
,-------------
....--"":""'L----,
Clearing r- - - - - - - Introducing
Member Broker
(FCM)

3.9.3 Derivatives Exchanges in India

In India there arc various types of derivatives markets are there like Equity,
commodity, Forex etc and to cater different demands about these products there are
different exchanges are there. Details of variolls exchanges are as below.

99
 • National Stock Exchange (NSE)
The derivatives trading on the exchange commenced with S&P CNX Nifty
Index futures on June 12,2000. The trading in index options commenced on June
4, 200 I and trading in options on individual securities commenced on July 2,
2001. Single stock futures were launched on November 9. 2001. The index
rutures and options contract on NSE are based on S&P CNX Nifty Index.
Currently. the futures contracts have a maximum of 3-month expiration cycles.
Three contracts are available for trading, with 1 month. 2 months and 3
months expiry. A new contract is introduced on the next trading day following the
expiry of the near month contract.
Table-3.4 Business Growth of F & 0 Segment of NSE (As on March 2007)
Tolal Total Avel
Inde.'\ Futures Stock Futures futur~5. Ind~x 0pli011S Stlxk Options Options Grand Tobl Dai
Trading Tr.1dinp Turnl
Montlv No. of urnO\'~l No. of Ilurnovt'l No. of UflKWfJ No. of umo\'~ No. of Tumove
Rs. Cr. Rs. Cr. Rs.'
'"ear ~>ntra,,·ts (Rs. cr. \ contracts iRs. cr. 'I contr.1cls jR$, cr.1 'COO! ....dCl. jR~. cr.) [Link] IRs. en
1001·11.< 2: L~.oi'b3 ~1951 IOtll b8-t '\ 2SbS.t2 1.10~8.J 4-l2.:!-l-1 Y2~7 _~523062 100134 109381 16768900 4398~ 17:
( 10.0) (65.1) 175.t) (21) (228) (1~.9)
200.'·O~ 17191668 55..J..t62 32.168842 1,105949 1860411 171141.\ 5282) .)58.1071 217212 2700.15 56886776 21J04.\6 B.l1
(~6.0) 161..l) \87 ,.1) (2.5) 110.2) t 12.7)
200./.\); 116.15.\.\9 77217.t 47W3066 1~84067 1 2562.t t 3293558 121954 50.\5112 1688.58 190812 no
I 6-l65 25.t7053 101
(.30..1) (58..1) (88.6) (H) 16.6) ( ItA)
200;-0. 58.5.17&86 151.1791 80905493 2791721 ~'10551 t29.1511, .1.18469 52.t0776 1&0270 5187.19 1576t927I 4824251 192
(.11.4 ) (57.9, (89.2) 0.0) (3.7) IIO.S)
Apr;)-06 5S47D.15 20.t.:!JB 10021529 .\60.\54 6~792 1489t04 52.t21 460485 20625 7.1046 178t8t53 737838 409
(27.7 ) (62.4, (YO.I, O.t) (28) (9.9)
May.D6 7666525 257318 908218~ ~O9401 666731 1655677 58789 359678 168BI 75670 t9764~ 7-12401 337
(J4.7 ) (55.1 ) (89.8) (7.9) 12.1) 110.2)
June-06 B.\37382 2-US72 6241247 24]95-1- 487526 1911.198 57972 26.\.\87 1110B 69280 1685.\514 556806 241
(43.7 ) (U8, (S7.6) ( lOA) (2.01 lilA)
July-06 610.148.1 1S6760 .\61.\0.\.\ 222."i38 409298 1750455 54711 .116876 1.l145 679.\6 13784858 47725-1 227
(.19.1) (.\6.6) (8.\.8) ( 11..1) (2.8) (14.1)
Aug:ust.()6 5250973 17333.\ 75.10.110 2291&2 402116 1596155 5.1106 .\.\6510 I~O.\5 67151 14824058 .\69667 213
(36.9) (48.8) (857) (11.3 ) (3.0) (l4..l)
S~ptemrer-Ot: 5081055 177518 86.\.\ 1.l7 275-1-.10 452948 1524721
5.1">17 507553 1635t ~9998.7~ 15757466 5229.\6 249
(33.9) (527) (86.6) ( 10.3) (3.1 ) t13.4)
October-OS 45569S4 166974 7929~18 272516 .\39490 IJS17S8 49744 4749.16 16.\25 66t69 14.11.1726 505659 252
03.0) (53.9) (86.9) (9.8) (3.2) ( 13.1)
N('l\'ember.(lrf 46-W6J.! 180781 10539507 388800 569581 1546E42 60018 55Jl38 .20~"9 80~47 17284519 M9828 295
127 .8) (59.8) (87 .7) (9.2) (3.t) 1123)
December-06 5798118 215288 9261984 .147747 57.1035 2011995 79719 434Ji19 16.\08 96127 17516716 669162 334
03.7; (!i.!.(l) 185.6) (II. 9) (25) ( 14.4)
Janu31}'-07 ~,7t6,781 190,592 9,.:Vi4~321 350,817 541409 1,~1,585 66,~6 509,759 19,401 861>'17 16-132,44 617456 313
(.lOA) (55.9) (SO.3) (10.6) (3.1) ( 13.7)
Fe~ruOl)'-(J7 73.15.651 242.137 98.5.1884.0 352.65J 5l)439Q 1.771..972 91.817 45B.637 16_785 108602 20821144 703492 370
(3404) (50.1 ) (8-1.6) (13.1) (2.4) 115.4)
M:IIch-07 I5..MB-80o 29Q957 103731;6.( 277.378 568135 589.1846 JI.\.3:!1 496_012 12_100 125428 1_911,89. 693763 33,(
141A) O?.4) IRO.8) 116. I) ( I. 7) 117.8)
. . are Ff l~llt to tl}(aJ .
NQ~. Flt\treS In hralk!;'[
S(wn'~' IVSE IWWlY tI~(·iwtjil m,f

100
• Bombay Stock Exchange (BSE)

Bombay Stock Exchange Limitcd (the Exchange) is the oldest stock

exchange in Asia with a rich heritage. Popularly known as "BSE", it was
established as "The Native Share & Stock Brokers Association" in 1875. It is the
first stock exchange in the country to obtain permanent recognition in 1956 from
the Government of India under the Securities Contracts (Regulation) Act,
[Link] Exchange's pivotal and pre-eminent role in the development of the
Indian capital market is widely recognized and its index, SENSEX, is tracked
worldwide.
l2-1 b 'f ~

BSE created history on June 9, 2000 by launching the first Exchange

traded Index Derivative Contract i.e. futures on the capital market benchmark
index - the BSE Sensex. The inauguration of trading was done by Prof. J.R.
Vmma, member of SEBI and chairman of the committee responsible for
formulation of risk containment measures for the Derivatives market. In the
sequence of product innovation, the exchange commenced trading in Index
Options on Sensex on June 1,2001. Stock options were introduced on 31 stocks
on July 9, 2001 and single stock futures were launched on November 9, 2002.
September 13, 2004 marked another milestone in the history of Indian Capital
Markets, the day on which the Bombay Stock Exchange launched Weekly
Options, a unique product unparallel in derivatives markets, both domestic and
international. BSE permitted trading in weekly contracts in options in the shares
of four leading companies namely Reliance, Sat yam, State Bank of India, and
Tisco in addition to the tlagship index-Sensex.

• Commodity Exchange in India

Commodity markets have existed 111 India for a long time. While the
implementations of the Kabra committee recommendations were rather slow,
today, the commodity derivative market in India seems poised for a
transformation. National level commodity derivatives exchanges seem to be the
new phenomenon. The Forward Markets Commission accorded in principle

101
 approval for the following national level multi commodity exchanges. The
increasing volumes on these exchanges suggest that commodity markets in India
seem to be a promising game.
• National Board of Trade
• Multi Commodity Exchange of India (MCX)
• National Commodity & Derivatives Exchange of India (NCDX)
National Commodity and Derivatives Exchange Ltd (NCDEX) IS a
technology driven commodity exchange. It is a public limited company registered
under the Companies Act, 1956 with the Registrar of Companies, Maharashtra in
Mumbai on April 23, 2003, NCDEX currently facilitates trading of ten
commodities - gold, silver. soybean, refined, soybean oiL rapeseed-mustard seed,
expeller rapeseed-mustard seed oiL RBD palmolein, Crude palm oil and cotton ii
medium and long staple varieties,

Table-3.5 Business Growth 011 Commodity futures markets

(Rs. CTOrs

Exchanges 2004-05 2005-06 2006-07

Multi Commodity Exchange. Mumbai (MCX) 165.147 961,633 1.621,80:

National Commodity Derivatives Exchange. MumbJi (NCDEX) 266.338 1,066.686 944,061
Natronal Multi Commodity Exchange. Ahmedabad (NMCE) 13.988 18,385 101.73
National Board of Trade, Indore (NBOT) 58.463 53,683 57.14!
Others 67.823 54.735 14,59

All Exchanges 571,759 2,155,122 2,739,341

• Till December 31, 2006
Source: Forward Markets Commission.

3_ I 0 Issues in Derivatives Markets

Indian Derivatives Markets are facing following issues_
• In order to facilitate free arbitrage between cash and derivatives market, financial
Institutions and mutual funds may be pcrmitted to short sell in the cash market.
Such short sale may, however, be restricted to the extent of cOITesponding
exposure in the derivatives market. Moreover. such transactions can also be
permitted through a separate dedicated fund.

102
• Arbitrage between eash and futures market will also help in better price discovery
in both the markets.
• RBI has allowed FIls to trade in derivatives market, subject to the condition that
the overall open position of the FIl shall not exceed 100 per cent of market value
of the concerned Firs total investment. Managed future funds should be
permitted to take position in the derivatives market without having any exposure
in the cash market. Also, FIls intending to invest funds in the cash market should
also be permitted to take long position in the futures market to hedge their
transactions.

• Currently, the derivative products are all cash settled. The issue of physical
settlement for single stock derivatives needs resolution. While physical settlement
will certainly help arbitrageurs and hedgers, it Illay also leave open the possibility
of a short s'lueeze. An effective mechanism to lcndlborrow stocks would certainly
go a long way in mitigating this danger.
• Currently derivative products are offered on 213 securities (As on June 2(07)
while investors are actively trading in SOO securities hence there should be spread
of Derivative products which should include remaining securities, which will
facilitate investors to hedge their position.
• Impact of derivatives upon market efficiency and liquidity of the underlying.
• How should we design derivative markets on the equity, fixed income, currency
and commodity markets in India?

• What contract design should be employed on each of the important derivative

products in India? How do we incorporate charactelistics about the users and
about the underlying market into contract design?

• How should options be valued and hedged on the four underlying: Nifty,
MIBID/MIBOR, the long interest rate and the dollar--rupee? How should this
hedging be done if transacting is not frictionless but reflects costs seen in reality?
To what extent do large close-to-open moves hinder hedging?

• Ilow do we optimize arbitrage for index futures and index options? .

103
 • How does the presence of price limits on the equity spot market impact on options
and futures on the index. and on options on individual stocks?

• What is the appropriate regulatory structure for derivatives markets? How do we

address concerns about market manipulation and systemic fragility? To what
extent do derivatives destabilize the financial system. and how should these risks
be addressed')

3.11 Research Contribution

Derivatives market in India is still in its nascent stage even though NSE has
acclaimed no.! position in the world in terms of single stock futures. Though much
needed depth and liquidity in Indian Derivatives markets are missing due to non-
participation of key institutions like Mutual Funds. In order to highlight Impact and role
of Mutual Funds in Derivatives Markets one research paper has been written by liS on
"Impact and Role of Mutual Funds in Derivatives Markets" as mentioned in chapter-I.
Key points of the research paper related to this research are as bclow.

Research paper· "Impact alld Role afMutualfullds ill Derivatives - A Case of NSE"

India's experience with the launch of equity derivatives market has been
extremely positive. by world standards. NSE (National Stock Exchange) is now one of
the prominent exchanges, amongst all emerging markets. in terms of equity derivatives
turnover. There is an increasing sense that the equity derivatives market is playing a
major role in shaping a long lasting and healthy Indian capital markets. Indian equity
market has added one more feather by starting an Equity Derivatives segment in year
2000, since than as on today Equity Derivatives markets has outperformed cash market
by leap and frog manner. Derivatives markets world over arc very volatile and India is
not exceptional but in Capital markets it provide vitalliqllidity, which drives indices. The
derivatives segment of NSE once again found favor in the media recently with SEBI
(Securities and Exchange Board of India) permitting Mutual funds to participate in the
Derivatives segment at par with other players like HNI (High Netwonh Investors) I'll
(Foreign Institutional Investors) and Retail Investors.

104
 Main aim of this paper is to highlight impact and Role of Mutual funds trading in

Derivatives markets and its overall implication on Indian Indices with. Insights into what
is going on with the equity derivatives market, and summarize broad empirical
regularities about pricing and liquidity. With this one thing is sure that Derivatives

segment is again set to witness a new round of evolution waiting for many surprises to be
unveiled as the opportunity unfolds itself and as the mutual funds gear themscIves for the

exploitation of the same.

105