INTRODUCTION

The most significant event in finance during the past decade has been the

development and expansion of financial derivatives. These instruments enhance

the ability to differentiate risk and allocate it to those investors who are most

able and willing to take it.

Derivative is a product whose value is derived from the value of one or more

basic variables, called bases (underlying asset, index, or reference rate), in a

contractual manner. The underlying asset can be equity, forex, commodity or

any other asset. The price of the derivative is driven by the spot price of the

underlying.

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A)

defines "derivative" to include-

i. A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of

security.

ii. A contract which derives its value from the prices, or index of prices, of

underlying securities.

Derivatives are securities under the SC(R)A and hence the trading of derivatives

is governed by the regulatory framework under the SC(R)A.

Derivative products initially emerged as hedging devices against fluctuations in

commodity prices, and commodity-linked derivatives remained the sole form of

such products for almost three hundred years.

1

Financial derivatives came into spotlight in the post-1970 period due to growing

instability in the financial markets. However, since their emergence, these

products have become very popular and by 1990s, they accounted for about two-

thirds of total transactions in derivative products. In recent years, the market for

financial derivatives has grown tremendously in terms of variety of instruments

available, their complexity and also turnover. Even small investors find these

useful due to high correlation of the popular indexes with various portfolios and

ease of use.

With the opening of the world economy to multinationals and the adoption of the

liberalized economic policies, the economy is driven more towards the free

market economy. The complex nature of financial structuring itself involves the

utilization of multi currency transactions. It exposes the clients to various risks

such as exchange rate risk, interest rate risk, economic risk and political risk.

Derivatives products provide certain important economic benefits such as risk

management or redistribution of risk away from risk-averse investors towards

those more willing and able to bear risk. Through the use of derivative products,

it is possible to partially or fully transfer price risks by locking-in asset prices.

As instruments of risk management, these derivatives generally do not influence

the fluctuations in the underlying asset prices. But impact of any change in the

price of underlying asset may cause swift change in the price of Derivatives

instrument. By locking-in asset prices, derivative products minimize the impact

of fluctuations in asset prices on the profitability and cash flow situation of

risk-averse investors.

Derivatives also help price discovery, i.e. the process of determining the price

level for any asset, based on demand and supply.

2

Derivatives markets generally are an integral part of capital markets in

developed as well as in emerging market economies. These instruments assist

business growth by disseminating effective price signals concerning exchange

rates, indices and reference rates or other assets and thereby render both cash and

derivatives.

In the Indian context, derivatives were introduced in 2001 only, and as such,

awareness about derivatives trading has been quite low. Even though huge

volumes of over 90,000 crores per day are noticed in derivatives segment,

majority of it comes from institutional investors. Also, the trading volumes are

confined to Tier 1 cities of Mumbai, New Delhi, Kolkata, Chennai and Tier II

cities of Ahmedabad, Cochin, Rajkot and Jaipur (84.10 per cent of total turnover

for the year 2011-12 for National Stock Exchange)1. Out of total turnover in

equity market, 60.10 per cent of total transactions were reported from Mumbai

alone. The retail participation in derivatives market in rest of India is

comparatively very low (9.2per cent)2.

Hence, a study on awareness of retail investors towards derivatives and their

perception about derivatives as an investment alternative is considered essential.

This study assumes greater significance in the context of new financial

instruments appearing in the capital market and a view that derivatives are not

just speculative instruments, they were designed to be hedging instruments,

where in the risk can be transferred from those facing it to those who are willing

to bear it, for a price.

1. SEBI annual report 2012

2. Data obtained from National Stock Exchange for the year 2011-12.

3

Also, numerous studies have been undertaken by researchers in the field of

derivatives and on the impact of these derivative contracts over the price and

volatility of the underlying asset. However, the result has been mixed, with

many researchers observing that the introduction of derivatives has not caused

any impact on the underlying asset price movement and an equal number of

researchers arguing that the introduction of derivative contracts have indeed

increased volatility and thus increased risk for the investors. Hence, more

research needs to be done in this area.

1.1 History of Derivatives

The emergence of Derivatives market especially Futures and Options can be

traced back to the willingness of the risk adverse economic agents to guard

against themselves against the fluctuations in the price of underlying asset.

Derivatives, whose price is determined by the price of underlying asset,

generally do not cause any fluctuations in the price of underlying asset. But

impact of any change in the price of underlying asset may cause swift change in

the price of derivatives instrument.

Around 8,000 B.C., writing and mathematics had developed in Sumer, located

in the Tigris and Euphrates river region, to a point they developed a unique

method for accounting. Clay tokens were used to represent the different

commodities and quantities. To keep people from tampering with the tokens,

they baked them into a hollow vessel. Pressed into the exterior of the vessel,

prior to baking, would be markings similar to the tokens inside and a witness

mark to make it official. The beauty of this system is the way it resolves

disputes. If there were any disagreement of the values on the exterior of the

vessel, they would break it open to count the tokens inside. Eventually the

tokens and vessels would become a promise to deliver a quantity of goods by a

certain date - all baked on the vessel.

4

By 3,500 B.C., new forms of writing and math enabled the Sumerians to replace

the vessels with clay tablets. These trades are similar in behavior to forward

contracts.

In ancient Greece, the Athenians used shipping contracts for trading which

resemble forward contracts, with a twist. The buyer would borrow the money up

front. Prior to a trading voyage, an entrepreneur (buyer) looking to profit on a

trade of commodities would make an agreement with a merchant who would

finance the voyage. They would draw up a contract. The contract would state the

amount of money loaned and required interest the entrepreneur would pay the

merchant upon return. Since these voyages were risky, the merchants demanded

a high return in the rage of 30%. After all, there were many ways a ship could

disappear; pirates, unfriendly nations, and storms to name but a few. Further

stipulations would name the commodity to be purchased, state where it was to be

purchased, the ships route, and a time limit for the voyage. To make sure the

entrepreneurs would not cheat them, the merchants had a trustworthy

acquaintance or employee accompany the voyage. Upon reaching the agreed

upon port of call, the entrepreneurs would purchase the commodity - or sell in

the case of exports. In either event, the merchant now had an effective ownership

of the commodities until they were paid back.

The similarity to a forward contract can be seen since the factors of price,

commodity, and time are stipulated in the shipping contract. Profits for the

entrepreneurs would only be realized if they could sell the commodity at a high

enough price to cover the merchant's loan and interest. If they could not cover

the loan, they would end up in court and may find much of their collateral, and

perhaps their freedom, in jeopardy. Because trade was so important, laws and

regulations would develop to ensure each party would be justly treated in

disputes.

5

The ascendancy of Greek civilization began around 1000 BC. Greek

philosophers and historians were not interested in commerce. There is no

evidence to suggest that there were no contracts for future delivery, as

commercial history is littered with laws and ordinances against derivatives that

were ignored by the public. In reality, the Greek were very practical in

commercial affairs. Athens allowed contracts for future delivery in sea-borne

trade because the city depended on the import of grain from Egypt.

Alexander, who invaded the Middle East in the fourth century BC, left the

local commercial and legal system intact, which had descended from

Mesopotamia. Therefore, the use of derivatives continued in the Middle East

under Greek dominance.

The Romans, who copied much of Greek culture, initially adopted the Greek

restrictions on contracts for future delivery. But these restrictions clashed with

the commercial realities of the vast Roman Empire, which reached from

Britannia to Mesopotamia at its peak. Commodities moved along a network of

new roads and the ships of Roman merchants criss-crossed the Mediterranean.

The city of Rome, whose population grew to one million people, depended on

trade with the provinces, particularly the import of wheat from Northern Africa.

During the Third century BC, Roman law caught up with commercial practice,

providing for contracts for future delivery of goods.

Sextus Pomponius, a lawyer who wrote in the second century AD,

distinguished between two types of contracts. The first, vendito re speratae,

which was void if the seller did not have the goods at the delivery date, provided

insurance against crop loss and the hazards of long-distance trade, including the

loss of ships in maritime trade. The second, vendito spei, was a straightforward

forward contract that did not provide for any reprieve to the seller in case he was

unable to deliver the goods.

6

Early Roman law upheld the principle of privity of contract, which implies that a

contract establishes a relationship that is exclusive to the parties in the contract.

A contract was not transferable because a third party was unable to enforce it.

For example, a credit contract established an exclusive relationship between

lender and borrower. The lender could not assign his right to repayment of

principal and interest to someone else because the borrower was only obliged to

pay to the initial lender. Similarly, the holder of a contract for future delivery

could not sell it because only the holder was entitled to receive goods in the

future, and no one else. This principle of privity of contract held back the

emergence of security markets in the Roman economy.

The time after the fall of Roman empire is recorded in history as the Dark Ages.

The barbarian tribes that overran the Roman Empire lacked commercial codes.

Instead, Church bodies, which had increasingly assumed administrative

functions in the late Roman Empire, continued to apply Roman commercial law

during the Dark Ages.

The legal framework for contracts for future delivery remained in place during

the Dark Ages, but there was no further progress in the design of derivatives

because there was not much need for them in the Medieval economy which was

both local and feudal.

The first exchange for trading derivatives appears to be the Royal Exchange

in London, which permitted forward contracting.

7

1636 – 37: The Tulipmania:

Carolus Clusius, an Austrian botanist, introduced tulips in Holland. Tulips,

which belong to the indigenous flora of Turkey, quickly became fashionable

among the affluent. During a speculative frenzy in 1636-37, some bulbs are said

to have been traded at a price equal to the value of a house. The Dutch Tulip

bulb mania was characterized by forward contracting on tulip bulbs.

In the seventeenth century, the country was held back by political strife, which

culminated in the Civil War of 1642-1651. English public finances were a

shambles, preventing a market for government debt in the seventeenth century.

In the Revolution of 1688, a group of Parliamentarians offered the crown jointly

to Mary and her husband William of Orange, both grandchildren of James I of

England. The couple lived in Holland. The move of William and Mary from

Amsterdam to London had a profound impact on English society. There were

improvements in the capital market. In the 1690s, a large number of joint-stock

companies were founded whose shares were traded in the stock market, using

the same techniques as in Amsterdam. Commodity trade, however, moved to

London because England now dominated maritime trade.

In 1734, the British Parliament passed the Sir John Barnard’s Act, which

declared contracts for the future delivery of securities to be “null and void”.

Fines amounted to £500 for “refusals” and “putts” and £100 for short-selling

operations. The Act applied only to derivatives on securities because, as debated

in Parliament, it was feared that commodity markets would move back to

Amsterdam if contracts for the future delivery of commodities were outlawed in

London.

8

Share traders avoided the Royal Exchange because they could not deal with

options and conduct short-selling operations in the open. Commodity traders,

however, stayed at the Royal Exchange because there were no restrictions on

contracts for the future delivery of commodities.

After the defeat of Napoleon in 1815, the Allied powers - Great Britain, Austria

and Russia - asked for financial compensation for a quarter of a century of war

in Europe. Although France had lost the war and there had been a hyperinflation

during the revolutionary period, the French government gained surprisingly

quick access to domestic and international financial markets. This made it

possible to pay for the reparations with a mix of taxes and borrowing that was

politically and economically less damaging than relying on exorbitant taxes

without borrowing. At the same time, the growth in public debt created a market

for government bonds, which provided a pool of fungible assets for derivative

trading.

The remarkable recovery of investor confidence in French public debt was

caused by several favorable circumstances. After the collapse of the Napoleonic

regime, France continued to benefit from Napoleon’s monetary and fiscal

reforms. Napoleon had stabilized the French currency, reforming public finances

and establishing the Bank of France. Thus, at the end of the Napoleonic Wars,

France had a stable currency, the public debt was small, the government was

accepted as legitimate at least by monarchists, and France was supported by

Great Britain in the peace negotiations.

In the 1820s, derivative trading with government bonds flourished in Paris. A

call option was called an “achat à prime” and a put option was a “vente à

prime”.

9

By 1857, derivative trading involved a wide range of government bonds and

shares. In the mid-1850s, the stock exchange opened its doors to the public,

charging a modest entrance fee. The contracts for future delivery were now

lawful if the delivery date did not exceed two months (one month for railway

shares).

Between the sixteenth and the eighteenth centuries, in several German cities,

exchanges sprang up for the trade with bills of exchange. Most exchanges served

a local clientele, but Hamburg maintained links with Amsterdam and the

Hanseatic cities in the Baltic in the seventeenth century, and Frankfurt gained in

importance in the second half of the eighteenth century. In the nineteenth

century, the development of German security markets followed the same pattern

as in France. Bonds of German states were first introduced at exchanges, and

shares of railways, banks, insurance companies and industrial companies

followed later. In 1806 the exchange in Berlin started to quote government

bonds.

Germany contracts for future delivery were called “Zeitgeschäfte”, which is

translated as “time-contracts”.

The first "futures" contracts are generally traced to the Yodoya rice market in

Osaka, Japan around 1650. These were evidently standardized contracts, which

made them much like today's futures, although it is not known if the contracts

were marked to market daily and/or had credit guarantees.

10

The next major event, and the most significant as far as the history of Futures

markets, was the creation of the Chicago Board of Trade in 1848. Due to its

prime location on Lake Michigan, Chicago was developing as a major center for

the storage, sale, and distribution of Midwestern grain. Due to the seasonality of

grain, however, Chicago's storage facilities were unable to accommodate the

enormous increase in supply that occurred following the harvest. Similarly, its

facilities were underutilized in the spring. Chicago spot prices rose and fell

drastically. A group of grain traders created the "to-arrive" contract, which

permitted farmers to lock in the price and deliver the grain later. This allowed

the farmer to store the grain either on the farm or at a storage facility nearby and

deliver it to Chicago months later. These to-arrive contracts proved useful as a

device for hedging and speculating on price changes.

Farmers and traders soon realized that the sale and delivery of the grain itself

was not nearly as important as the ability to transfer the price risk associated

with the grain. The grain could always be sold and delivered anywhere else at

any time. These contracts were eventually standardized around 1865, and in

1925, the first futures clearinghouse was formed.

In the mid 1800s, famed New York financier Russell Sage began creating

synthetic loans using the principle of put-call parity. Sage would buy the stock

and a put from his customer and sell the customer a call. By fixing the put, call,

and strike prices, Sage was creating a synthetic loan with an interest rate

significantly higher than usury laws allowed.

One of the first examples of financial engineering was by the government of the

Confederate States of America, which issued a dual currency optionable bond.

This permitted the Confederate States to borrow money in sterling with an

option to pay back in French francs. The holder of the bond had the option to

convert the claim into cotton, the south's primary cash crop.

11

Interestingly, futures/options/derivatives trading was banned numerous times in

Europe and Japan and even in the United States in the state of Illinois in 1867

though the law was quickly repealed. In 1874 the Chicago Mercantile

Exchange's predecessor, the Chicago Produce Exchange, was formed. It

became the modern day Merc in 1919. Other exchanges had been popping up

around the country and continued to do so.

The early twentieth century was a dark period for derivatives trading as bucket

shops were rampant. Bucket shops are small operators in options and securities

that typically lure customers into transactions and then flee with the money,

setting up shop elsewhere.

In 1922 the federal government made its first effort to regulate the futures

market with the Grain Futures Act. In 1936, options on futures were banned

in the United States. All the while options, futures and various derivatives

continued to be banned from time to time in other countries.

Derivative trading began in 1865, when the Chicago Board of Trade (CBOT)

listed the first exchange traded derivative contracts in the U.S.A. These

contracts were called Future contracts. In 1919, Chicago Butter and Egg

Board, a spin off CBOT was recognized to future trading. Its name was changed

to Chicago Mercantile Exchange (CME).

The first stock index future contracts were traded at Kansas City Board of Trade.

Currently the stock index future contracts in the world are based on the Standard

and Poor’s 500 Index traded on the CME. In April.1973, the Chicago Board of

Options Exchange was set up specifically for the purpose of trading in Options.

12

In 1972, the Chicago Mercantile Exchange, responding to the now-freely

floating international currencies, created the International Monetary Market,

which allowed trading in currency futures. These were the first futures

contracts that were not on physical commodities.

In 1975 the Chicago Board of Trade created the first interest rate futures

contract, one based on Ginnie Mae (GNMA) mortgages. While the contract met

with initial success, it eventually died. During the same year, the Chicago

Mercantile Exchange introduced the Treasury bill futures contract. This contract

was the first successful interest rate futures. In 1977, the CBOT created the

T -bond futures contract, which went on to be the highest volume contract.

In 1982, the CME created the Eurodollar contract, which has now surpassed the

T-bond contract to become the most actively traded of all futures contracts. The

same year, the Kansas City Board of Trade launched the first stock index

futures, a contract on the Value Line Index. The Chicago Mercantile Exchange

quickly followed with their highly successful contract on the S&P 500 Index.

The Chicago Board Options Exchange decided to create an option on an index

of stocks. Though originally known as the CBOE 100 Index, it was soon turned

over to Standard and Poor's and became known as the S&P 100, which remains

the most actively traded exchange-listed option.

The next big development for derivatives was the electronic trading. Launched

initially by the Chicago Mercantile Exchange in 1992, electronic trading has

gained wide acceptance. Benefits have been greater liquidity, reduced

transaction cost, and higher transparency. Today, trading in virtually any

derivative, commodity, or security can be done from one's living room.

13

In 1994 the derivatives world was hit with a series of large losses on derivatives

trading announced by some well-known and highly experienced firms, such as

Procter and Gamble and Metallgesellschaft. One of America's wealthiest

localities, Orange County, California, declared bankruptcy, allegedly due to

derivatives trading, but more accurately, due to the use of leverage in a portfolio

of short- term Treasury securities.

England's venerable Barings Bank declared bankruptcy due to speculative

trading in futures contracts by a 28- year old clerk in its Singapore office. These

and other large losses led to a huge outcry, sometimes against the instruments

and sometimes against the firms that sold them. While some minor changes

occurred in the way in which derivatives were sold, most firms simply instituted

tighter controls and continued to use derivatives.

The year 1995 saw the emergence of credit derivatives - the first Credit Default

Swaps (CDS) and Collaterized Debt Obligation (CDO) structures were

created by JP Morgan. JP Morgan led the industry transformation away from

relationship banking towards credit trading.

The year 2008 saw the implosion of the credit derivative market and the

subsequent liquidity squeeze forced the world economies into financial crisis.

14

1.2 DERIVATIVES IN ASIA:

The influence of forward contracts in Europe spread to Asia. The next revolution

in trading occurred in the East.

In Asia, the first known instance of derivatives trading dates to 2000 B.C, when

merchants of Bahrain Island in the Arab Gulf, made consignment transactions

for goods to be sold in India. Derivatives trading, dating back to the same era,

also occurred in Mesopotamia.

In Feudal Japan around 1700, many rulers in agricultural regions taxed their

subjects in rice. For currency, they would bring the rice to cities such as Osaka

where it was stored and sold at auction. Only authorized wholesalers were

allowed to bid on the rice at auction. The winning bidder would receive a rice

voucher that would be settled shortly thereafter for cash. The vouchers

eventually became transferable; a new market in the buying and selling of

vouchers developed among the merchants.

Around 1730, the Dojima Rice Exchange was established with the full support

of the government.

At the exchange, there were two types of rice markets: the shomai and choaimai.

The shomai market is where actual rice trading took place. Here traders could

buy and sell different grades of rice based on the spot price. Rice vouchers were

issued for each transaction and would be settled within four days.

15

At the choaimai the first future market was operating. Choaimai roughly

translates to rice trading on books. In the spring, summer and fall, different

grades of rice were contracted with standardized agreements. No cash or

vouchers were exchanged; all relevant information was recorded in a book at a

clearinghouse. The contract period was limited to four months at a time. All

contracts had to be settled prior to the closing of the contract period, and no

contract was allowed to carry over to another period. Settlement of the

differences in value between the current rice spot price and the contract had to be

done with cash or an opposing contract position. With a few interruptions and

updates, the rice exchanges operated until 1937.

To be able to participate in the exchange, traders were required to establish lines

of credit with a clearinghouse. Trades were done through the clearinghouse, and

if the trader defaulted on a trade, the clearinghouse was responsible for payment.

Similar to today, the clearinghouse acted as the intermediary and guaranteed

payment on trades. Hence, the Dojima Rice Exchange is considered by many

to be the first futures market. The final metamorphosis in commodities trading

and derivatives was over a century after the establishment of the rice exchange

in the New World.

16

1.3 DERIVATIVES IN INDIA

Derivatives markets have been in existence in India in some form or other for a

long time. In the area of commodities, the Bombay Cotton Trade Association

started futures trading in 1875 and, by the early 1900s India had one of the

world’s largest futures industry.

In 1952 the government banned cash settlement and options trading and

derivatives trading shifted to informal forwards markets.

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 easing of various

restrictions on the free movement of interest rates resulted in the need to manage

interest rate risk.

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 National Stock Exchange (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, the prohibition on trading options was lifted.

17

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 in

December 1997 the introduction of stock index futures in the first place to be

followed by other products once the market matures. Another report, by the

J. R. Varma Committee in 1998, worked out various operational details such as

the margining systems.

In 1999, the Securities Contracts (Regulation) Act of 1956 was amended so that

derivatives could be declared “securities.” This allowed the regulatory

framework for trading securities to be extended to derivatives. The Act considers

derivatives to be legal and valid, but only if they are traded on exchanges.

These derivative contracts are settled by cash payment and do not involve

physical delivery of the underlying product.

In the equity markets, a system of trading called “badla” involving some

elements of forwards trading had been 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 in 2001.

In recent years, government policy has changed, allowing for an increased role

for market-based pricing and less suspicion of derivatives trading. The ban on

futures trading of many commodities was lifted starting in the early 2000s, and

national electronic commodity exchanges were created.

Futures on benchmark indices were introduced in June 2000, Options on

indices in June 2001, Options on individual stocks in July 2001 and Futures

on individual stocks in November 2002.

18

Bombay Stock Exchange (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 first historical trade of five

contracts of June series was done between M/s Kaji & Maulik Securities Pvt.

Ltd. and M/s Emkay Share & Stock Brokers Ltd.

Derivatives on stock indices and individual stocks have grown rapidly since

inception. National Stock Exchange launched Interest Rate Futures in

June 2003, but in contrast to equity derivatives, there has been little trading in

them. One problem with these instruments was faulty contract specifications,

resulting in the underlying interest rate deviating erratically from the reference

rate used by market participants. Institutional investors have preferred to trade in

Over The Counter (OTC) markets, where instruments such as Interest Rate

Swaps and Forward Rate Agreements are being traded.

To enable the small investors to take advantage of derivative instruments,

trading in Mini Index Futures & Options was introduced from January 2008.

These had a lower lot size compared to regular index contracts. However, in

November 2012, SEBI asked NSE and BSE to discontinue these mini derivatives

contracts to protect small and retail investors from the risk associated with these

instruments.

Trading of Currency Derivatives was introduced in NSE from 29 August, 2008

while BSE followed suit from 2 October, 2008. Currency Futures are available

on four currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain Pound

(GBP) and Japanese Yen (JPY). Currency options are currently available on US

Dollars only.

19

1.3.1 Chronology of derivatives introduction in India

Date Progress14 December 1995

18 November 1996

11 May 1998

7 July 1999

25 May 2000

9 June 2000

12 June 2000

June 2001

July 2001

November 9, 2002

June 2003

January 1, 2008

29 August, 2008

2 October, 2008

NSE asked SEBI for permission to trade index futures

SEBI setup L.C Gupta Committee to draft a policy

framework for Index Futures

L.C Gupta Committee submitted report

RBI gave permission for OTC Forward Rate Agreements

(FRAs) and Interest Rate Swaps

SEBI gave permission to NSE and BSE to start index

futures trading

Trading of BSE Sensex futures commenced at BSE

Trading of Nifty futures commenced at NSE

Trading of Equity Index Options at NSE

Trading of Stock Options at NSE

Trading of Single Stock Futures at NSE and BSE

Trading of Interest Rate Futures at NSE

Trading of Mini Index Futures & Options at NSE and

BSE

Trading of Currency Futures at NSE

Trading of Currency Futures at BSE

It should be noted that Bombay Stock Exchange (BSE) was the first to start

derivatives trading in India followed by National Stock Exchange (NSE). But

20

within a very short span, NSE overtook BSE to become the leading derivatives

exchange in India.

In a span of around ten years that derivatives are being traded in Indian capital,

NSE has become the number one exchange in the world in terms of total

turnover in stock options and commands significant position among the world’s

major exchanges as per the data obtained from World Federation of Exchanges

(WFE) as on July, 2013.

1.3.2 Products Traded in Futures & Options Segment

21

A variety of derivative products are traded in the Indian capital market. The

derivative products traded and the date on which these products were introduced

is given below:

Sl.

No Product traded Introduction Date

1

2

3

4

5

6

7

8

9

10

11

12

13

Index Futures on S&P CNX Nifty

Index Options on S&P CNX Nifty

Stock Options on 233 stocks

Stock Futures on 233 stocks

Interest Rate Futures on T-Bills and 10 yr Bond

CNX IT Futures and Options

Bank Nifty Futures and Options

CNX Nifty Junior Futures and Options

CNX 100 Futures and Options

Nifty Midcap 50 Futures and Options

Mini Nifty Futures and Options

Currency Futures on US Dollar Rupee

S&P CNX Defty Futures and Options

June 12, 2000

June 4, 2001

July 2, 2001

November 9, 2001

June 23, 2003

August 29, 2003

June 13, 2005

June 1, 2007

June 1, 2007

October 5, 2007

January 1, 2008

August 29, 2008

December 10, 2008

Among these products traded in derivative segment, high volumes are noticed in

index futures and index options, followed by stock futures and options.

Since currency futures were introduced in 2008 only, the retail participation is

low in this segment. Only Institutional investors and forex dealers are active

22

participants in this segment, as per the data obtained from National Stock

Exchange.

Interest Rate Derivatives have not found favor among the investors and hence,

volumes are very low in this segment.

These derivative products are being used by financial institutions, foreign

investors, mutual funds and portfolio managers for the purpose of arbitrage and

hedging, even though majority of retail investors are not aware of various

strategies that can be employed in derivatives trading and their participation is

comparatively low.

1.3.3 Business Growth of Derivatives in India

23

Chart showing Average Daily Turnover (Rs. in crores)

11 410 1752 8388 1010719220

29543

52153.345310.63

72392.07

115150.48125902.54120124.86

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

2011-12

2012-13

Years

Aver

age D

aily

Tur

nove

r

Average Daily turnover (Rs. in crores)

Derivatives have grown by leaps and bounds over the years after their

introduction in Indian capital market in the financial year 2000-01.

The business growth of derivatives over the years is presented below.

Year

Total Turnover

(Rs. in crores)

Average

Daily turnover

(Rs. in crores)

Percentage

change

2000-01 2365 11 --

2001-02 101926 410 3627.27

2002-03 439862 1752 327.32

2003-04 2130610 8388 378.77

2004-05 2546982 10107 20.49

2005-06 4824174 19220 90.17

2006-07 7356242 29543 53.71

2007-08 13090477.75 52153.30 76.53

2008-09 11010482.2 45310.63 -13.12

2009-10 17663664.57 72392.07 59.77

2010-11 29248221.09 115150.48 59.07

2011-12 31349731.74 125902.54 9.34

2012-13 30631839.30 120124.86 -4.59

24

It can be seen that the growth in derivatives has been tremendous in the initial

years. The growth was moderate in the later years and due to recession in the

global markets, the growth has declined marginally during the years 2008-09 and

2012-13.

It is interesting to see that in a span of just ten years since their introduction, the

daily volume in derivatives has exceeded the annual turnover noticed in the

initial years.

The detailed analysis of the growth in derivatives over the years has been done

in chapter number 6 on the analysis of derivatives trading.

1.3.4 Product wise Turnover of Derivatives in India

Turnover (Rs. in crores)

Year

Index

Futures

Change

(%)

Stock

Futures

Change

(%)

Index

Options

Change

(%)

Stock

Option

Change

(%) Turnover

2000-01 2365 - - - - - - -

2001-02 21483 808 51515 - 3765 - 25163 -

2002-03 43952 105 286533 456 9246 146 100131 298

2003-04 554446 1161 1305939 356 52816 471 217207 117

2004-05 772147 39 1484056 14 121943 131 168836 -22

2005-06 1513755 96 2791697 88 338469 178 180253 7

2006-07 2539574 68 3830967 37 791906 134 193795 8

2007-08 3820667 50 7548563 97 1362111 72 359137 85 13090478

2008-09 3570111 -7 3479642 -54 3731502 174 229227 -36 11010482

25

2009-10 3934389 10 5195247 49 8027964 115 506065 121 17663665

2010-11 4356755 11 5495757 6 18365366 129 1030344 104 29248221

2011-12 3577998 -18 4074671 -26 22720032 24 977031 -5 31349732

2012-13 3037180 -15 3646632 -11 22301096 -2 1286564 32 30271472

It can be seen that turnover in index options is growing tremendously while the

trading in index futures is declining over the years. At the same time, turnover in

stock futures is on an increase, even though it fell in the year 2012-13.

The detailed analysis of the growth in derivatives over the years has been done

in the subsequent chapters.

1.4 Investors Protection Measures

SEBI has taken the following measures to protect the money and interest of

investors in the Derivative market. They are as follows:

Investor's money has to be kept separate at all levels and is permitted to be

used only against the liability of the investor and is not available to the

trading member or clearing member or even any other investor.

26

The Trading Member is required to provide every investor with a risk

disclosure document, which will disclose the risks, associated with the

derivatives trading so that investors can take a conscious decision to trade in

derivatives.

Investor would get the contract note duly time stamped for receipt of the

order and execution of the order. The order will be executed with the identity

of the client and without client ID the order will not be accepted by the

system. The investor could also demand the reconfirmation slip with his ID

in support of the contract note.

In the derivative markets, all money paid by the Investor towards margins on

all open positions is kept in trust with the Clearing House/ Clearing

Corporation and in the event of default of the Trading or Clearing Member

the amounts paid by the client towards margins are segregated and not

utilized towards the default of the member.

In the event of a default of a member, losses suffered by the Investor, if any,

on settled/ closed out position are compensated from the Investor Protection

Fund, as per the rules, byelaws and regulation of the derivative segment of

the exchanges.

Despite of encouraging growth and developments, industry analysts feel that the

derivatives market has not yet realized its full potential in terms of growth &

trading.

Analysts point out that the equity derivative markets on the BSE and NSE has

been limited to only four products: index futures, index options and individual

stock futures and options, which in turn, are limited to certain select stocks only.

Although recently NSE and BSE have added more products in their derivatives

segment (Currency futures and options, Long term options, Mini Index etc.) it

27

still is far less than the depth and variety of products prevailing across many

developed capital markets.

India’s experience with the launch of equity derivatives market has been

extremely positive, by world standards. NSE is now one of the prominent

exchanges amongst all emerging markets, in terms of equity derivatives

turnover.

28