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This article looks at the growth of derivatives in Indian economy. The growth in derivatives is looked upon as maturing of the market. The story for India has been the same. The presence of many derivatives instruments (on currency, commodities and stocks) in the market, their importance in Indian scenario and their rise with time is discussed in the article. The role played by government and regulation is also talked about.
Story of Indian Financial Market with an eye on Derivatives:
Use of derivative as an instrument is not new to India. But the whole trading has seen a big change in current scenario. The government regulations, scams, cause of inflation and other factors have widely affected the whole derivative trade.
The derivatives are used for different purpose by different traders like:
- Hedgers: they use futures or options markets to reduce or eliminate the risk associated with price of an asset.
- Speculators: they use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
- Arbitrageurs: they are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
In an ideal market, these instruments should be used only for hedging and not for speculation. But there are cases of speculators leading to crash of market. Now the derivatives can be divided into two main types. They are:
- Option- Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy and puts give the buyer the right, but not the obligation to sell, the underlying asset at a given price on or before a given future date
- Future- A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price
One can feel that option is more lucrative as it gives the holder an option to buy/sell but there is no compulsion. So normally option's are dearer than future.
Fig: Settlements of futures and options on NSE
Source: RBI Data
We can see here that future has been more popular than options historically. This has been time and again proven that a minority of options are in the money at the time of maturity. This reduces the usage of the option as an instrument for hedging. More and more user prefer future over option, properly used a future nullifies the risk associated with trading. The charts above confirm the trend in the market.
The instruments can also be divided into OTC (Over the Counter) and ETD (Exchange Traded Derivatives). An OTC derivative suffers from credit risk and is illegal in nature. It doesn't follow the rules and regulation of RBI or SEBI. ETD's are traded on one of 23 major exchanges in India. Major share of the trading is done on NSE and BSE. Even among them, as we can see from chart below, NSE dominate BSE.
Fig: a comparison of total derivative trading in BSE and NSE
Fig: Rise of NSE
In India most of the exchange traded derivative is done on NSE. This has virtually been the trend from 2003-04 onwards. The presence of clearinghouse, which is wholly owned subsidiary in case of NSE, removes the credit risk from the exchange traded derivatives. NSE was established as an initiative of government of India, this brings additional credibility to the exchange.
Now we will see some specific derivative instruments which are widely used in the market.
Single Stock Derivatives:
These are the derivatives whose underlying asset is stock of a single entity. The problem with these kinds of derivatives is their impact on the stability of the spot prices of the underlying stock. There are instances when the derivative trading leads to higher volatility in the spot prices of the stocks. There are regulations permitting only a few derivatives in single stocks. These regulations are based on minimum free float market cap and liquidity. These are on the lines of regulation for sectoral indices.
Commodities trading in India are managed by FMC. It's been in its growth stage. MCX is the main commodities exchange in India. It started in 2003 in Mumbai and has reached a turnover of 32 Trillion rupee for the period Apr-Dec 2008. It offers futures trading in Agricultural Commodities, Bullion, Ferrous & Non-ferrous metals, Pulses, Oils & Oilseeds, Energy, Plantations, Spices and other soft commodities. Its popularity can be judged from the fact that the total volume of trade in the commodity futures market rose from Rs.5.72 lakh crore in 2004-05 to Rs.52.5 lakh crore in 2008-09.
There has always been a debate about the derivatives trading in the case of commodities. There has been frequent call for ban on their trading. Major reason put forward is the presence of speculators who leads to price rise of the commodity; this has been termed as the reason for sugar price rise. Government delisted trading on 9 items in 2007 but 5 among those 9 are relisted for trading recently. But these derivatives are an important source of hedging used by both producers and traders from the highly fluctuating prices, Indian farmers dependence on monsoon leads to crop failure often.
The return for the Exchange Traded Futures investor is primarily dependent on the change in the currency rates and so options are largely a play on the currency. It was started very late and is in its nascent phase. It started with US Dollar-Rupee futures in mid ‘09 and recently futures trading on three new pairs-euro-rupee, pound-rupee and yen-rupee-has now been approved. The launch of these new instruments will not affect much of US Dollar- rupee trading as US being a major trade partner and most of the export-import being done in dollar making it useful for the traders for hedging purpose.
Still the whole market is heavily regulated and lots need to be done to bring it at par with other matured market. FII's, unlike equity derivative market and interest rate future market, are not allowed in the currency market yet. The launches of new products are heavily regulated and approval from exchange is required before launch of any new instrument. The launch of three new currency pair took 16 months from the first instrument even though success of dollar-rupee pair. Contract size is $1,000, compared with 12.5 million Japanese yen ($115,000) or 100,000 Australian dollars ($86,000), for a single contract on the Chicago Mercantile Exchange. The trading limit imposed are meager, for individuals $5 million and for trading members $25 million, insufficient even for small traders or banks trading $200-$300 million daily on the forwards market. But the a report from RBI says that the total mark-to-market (MTM) losses due to currency movements was about Rs 31,719 crore for 22 banks, including foreign, and Indian companies at the end of 2008, whereas the actual losses last year for 11 banks was Rs 755.45 crore. These figures in the time when global economy is still coping with recession rings a bell or two about the need for regulation in currency trading market.
Conclusion: From all the discussions above we can see that the use of derivatives has been growing with time. There are hurdles of regulations and unavailability of many instruments needed by traders, but steps are being taken to remove these. With time the market will mature and people will find it easy to get the instrument of their requirement.