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    Deriv basics Deriv basics Document Transcript

    • BASICS OF DERIVATIVES© Copyright 2002 India Infoline Ltd. All rights reserved. Regd. Off: 24, Nirlon Complex, Off W E Highway, Goregaon(E) Mumbai-400 063. Tel.: +(91 22) 685 0101/0505 Fax: 685 0585
    • BASICS OF DERIVATIVESCONTENTSFOREWORD ...................................................................................................................... 31.INTRODUCTION.......................................................................................................... 52. FUTURES .................................................................................................................... 113. OPTIONS..................................................................................................................... 264. TRADING STRATEGIES USING FUTURES AND OPTIONS ........................... 405. RISK MANAGEMENT IN DERIVATIVES............................................................ 506. SETTLEMENT OF DERIVATIVES ........................................................................ 527. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES.................... 578. CASE STUDY- WHEN THINGS GO WRONG!..................................................... 58ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES ...................... 63ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA ................... 72ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA .......... 74ANNEXURE 4- L C GUPTA COMMITTEE REPORT............................................. 75 2
    • BASICS OF DERIVATIVES ForewordNew ideas and innovations have always been the hallmark of progress made bymankind. At every stage of development, there have been two core factors thatdrives man to ideas and innovation. These are increasing returns and reducingrisk, in all facets of life.The financial markets are no different. The endeavor has always been tomaximize returns and minimize risk. A lot of innovation goes into developingfinancial products centered on these two factors. It has spawned a whole newarea called financial engineering.Derivatives are among the forefront of the innovations in the financial marketsand aim to increase returns and reduce risk. They provide an outlet for investorsto protect themselves from the vagaries of the financial markets. Theseinstruments have been very popular with investors all over the world.Indian financial markets have been on the ascension and catching up with globalstandards in financial markets. The advent of screen based trading,dematerialization, rolling settlement have put our markets on par withinternational markets. 3
    • BASICS OF DERIVATIVESAs a logical step to the above progress, derivative trading was introduced in thecountry in June 2000. Starting with index futures, we have made rapid stridesand have four types of derivative products- Index future, index option, stockfuture and stock options. Today, there are 30 stocks on which one can havefutures and options, apart from the index futures and options.This market presents a tremendous opportunity for individual investors .Themarkets have performed smoothly over the last two years and has stabilized. Thetime is ripe for investors to make full use of the advantage offered by this market.We have tried to present in a lucid and simple manner, the derivatives market, sothat the individual investor is educated and equipped to become a dominantplayer in the market.Editorial TeamJuly 11, 2002 4
    • BASICS OF DERIVATIVES 1.IntroductionWhat are derivatives?A derivative is a financial instrument that derives its value from an underlyingasset. This underlying asset can be stocks, bonds, currency, commodities,metals and even intangible, pseudo assets like stock indices.Derivatives can be of different types like futures, options, swaps, caps, floor,collars etc. The most popular derivative instruments are futures and options.There are newer derivatives that are becoming popular like weather derivativesand natural calamity derivatives. These are used as a hedge against anyuntoward happenings because of natural causes.What exactly is meant by “ derives its value from an asset”?What the phrase means is that the derivative on its own does not have any value.It is considered important because of the importance of the underlying. When wesay an Infosys future or an Infosys option, these carry a value only because ofthe value of Infosys. 5
    • BASICS OF DERIVATIVESWhat are financial derivatives?Financial derivatives are instruments that derive their value from financial assets.These assets can be stocks, bonds, currency etc. These derivatives can beforward rate agreements, futures, options swaps etc. As stated earlier, the mosttraded instruments are futures and options.What kind of people will use derivatives?Derivatives will find use for the following set of people:• Speculators: People who buy or sell in the market to make profits. For example, if you will the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits• Hedgers: People who buy or sell to minimize their losses. For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$• Arbitrageurs: People who buy or sell to make money on price differentials in different markets. For example, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity. We will examine this in detail when we look at futures in a separate chapter. 6
    • BASICS OF DERIVATIVESBasically, every investor assumes one or more of the above roles and derivativesare a very good option for him.How has this market developed over time?Derivatives have been a recent development in the Indian financial markets. Butthere have been derivatives in the commodities market. There is Cotton andOilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin,Coffee futures in Bangalore etc. But the players in these markets are restricted tobig farmers and industries, who need these as an input to protect themselvesfrom the vagaries of agriculture sector.Globally too, the first derivatives started with the commodities, way back in 1894.Financial derivatives are a relatively late development, coming into existenceonly in the 1970’s. The first exchange where derivatives were traded is theChicago Board of Trade (CBOT).In India, the first derivatives were introduced by National Stock Exchange (NSE)in June 2000. The first derivatives were index futures. The index used was Nifty.Option trading was started in June 2001, for index as well as stocks. InNovember 2001, futures on stocks were allowed. Currently, there are 30 stockson which derivative trading is allowed. 7
    • BASICS OF DERIVATIVESThe 30 stocks on which trading is allowed currently are:Name of the Scrip Lot SizeACC 1500Bajaj Auto 800BHEL 1200BPCL 1100BSES 1100Cipla 200Digital Global Soft 400Dr Reddy Laboratories 400Grasim 700Gujarat Ambuja 1100Hindalco 300Hindustan Lever 1000HPCL 1300HDFC 300Infosys 100ITC 300L&T 1000MTNL 1600M&M 2500 8
    • BASICS OF DERIVATIVESRanbaxy 500Reliance Industries 600Reliance Petroleum 4300Satyam Computers 1200SBI 1000Sterlite Opticals 600TELCO 3300TISCO 1800Tata Power 1600Tata Tea 1100VSNL 700NIFTY 200SENSEX 50The trading is done on the exchange in the F&O (Futures and Option) segment.Index F&O is also traded in the market. The indices traded are the Nifty and theSensex.Since we have talked of hedging, can we compare derivatives toinsurance?You buy a life insurance policy and pay a premium to the insurance agent for afixed term as agreed in the policy. In case you survive, you are happy and the 9
    • BASICS OF DERIVATIVESinsurance company is happy. In case you don’t survive, your relatives are happyas the insurance company pays them the amount for which you are insured.Insurance is nothing but transfer of risk. An insurance company sells you riskcover and buys your risk and you sell your risk and buy a risk cover. The riskinvolved in life insurance is the death of the policyholder. The insurancecompanies bet on your surviving and hence agree to sell a risk cover for somepremium.There is a transfer of risk here for a financial cost, i.e. the premium. In this sense,a derivative instrument can be compared to insurance, as there is a transfer ofrisk at a financial cost.Derivatives also work well on the concept of mutual insurance. In mutualinsurance, two people having opposite risks can enter into a contract and reducetheir risk. The most classic example is that of an importer and exporter. Animporter buys goods from country A and has to pay in dollars in 3 months. Anexporter sells goods to country A and has to receive payment in dollars in 3months. In case of an importer, the risk is of exchange rate moving up. In case ofan exporter, the risk is of exchange rate moving down. They can cover eachothers risk by entering into a forward rate after 3 months. 10
    • BASICS OF DERIVATIVES 2. FuturesFuture, as the name indicates, is a trade whose settlement is going to take placein the future. However, before we take a look at futures, it will be beneficial for usto take a look at forward rate agreementsWhat is a forward rate agreementA forward rate agreement is one in which a buyer and a seller enter into acontract at a specified quantity of an asset at a specified price on a specifieddate.An example for this is the exporters getting into forward rate agreements oncurrencies with banks.But there is always a risk of one of the parties defaulting. The buyer may not payup or the seller may not be able to deliver. There may not be any redressal forthe aggrieved party as this is a negotiated contract between two parties.What is a future?A future is similar to a forward rate agreement, except that it is not a negotiatedcontracted but a standard instrument. 11
    • BASICS OF DERIVATIVESA future is a contract to buy or sell an asset at a specified future date at aspecified price. These contracts are traded on the stock exchanges and it canchange many hands before final settlement is made.The advantage of a future is that it eliminates counterparty risk. Since there is anexchange involved in between, and the exchange guarantees each trade, thebuyer or seller does not get affected with the opposite party defaulting.Futures ForwardsFutures are traded on a stock Forwards are non tradable, negotiatedexchange instrumentsFutures are contracts having standard Forwards are contracts customized byterms and conditions the buyer and sellerNo default risk as the exchange High risk of default by either partyprovides a counter guaranteeExit route is provided because of high No exit route for these contractsliquidity on the stock exchangeHighly regulated with strong margining No such systems are present in aand surveillance systems forward market. 12
    • BASICS OF DERIVATIVESThere are two kinds of futures traded in the market- index futures and stockfutures.There are three types of futures, based on the tenure. They are 1, 2 or 3 monthfuture. They are also known as near and far futures depending on the tenure.What are Index futuresIndex futures are futures contract on the index itself. One can buy a 1, 2 or 3-month index future. If someone wants to take a call on the index, then indexfutures are the ideal instruments for him.Let us try and understand what an index is. An index is a set of numbers thatrepresent a change over a period of time.A stock index is similarly a number that gives a relative measure of the stocksthat constitute the index. Each stock will have a different weight in the indexThe Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks.For example, Nifty was formed in 1995 and given a base value of 1000. Thevalue of Nifty today is 1172. What it means in simple terms is that, if Rs 1000 13
    • BASICS OF DERIVATIVESwas invested in the stocks that form in the index, in the same proportion in whichthey are weighted in the index, then Rs 1000 would have become Rs 1172 today.There are two popular methods of computing the index. They are price weightedmethod like Dow Jones Industrial Average (DJIA) or the market capitalizationmethod like Nifty or Sensex.What the terminologies used in a Futures contract?The terminologies used in a futures contract are:• Spot Price: The current market price of the scrip/index• Future Price: The price at which the futures contract trades in the futures market• Tenure: The period for which the future is traded• Expiry date: The date on which the futures contract will be settlec• Basis : The difference between the spot price and the future priceWhy are index futures more popular than stock futures?Globally, it has been observed that index futures are more popular as comparedto stock futures. This is because the index future is a relatively low risk productcompared to a stock future. It is easier to manipulate prices for individual stocksbut very difficult to manipulate the whole index. Besides, the index is less volatile 14
    • BASICS OF DERIVATIVESas compared to individual stocks and can be better predicted than individualstock.How is the future price arrived at?Future price is nothing but the current market price plus the interest cost for thetenure of the future.This interest cost of the future is called as cost of carry.If F is the future price, S is the spot price and C is the cost of carry or opportunitycost, thenF=S+CF = S + Interest cost, since cost of carry for a finance is the interest costThus,F=S (1+r)TWhere r is the rate of interest and T is the tenure of the futures contract. 15
    • BASICS OF DERIVATIVESThe rate of interest is usually the risk free market rate.Example 2.1:The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What willbe the price of one-month future?SolutionThe price of a future is F= S (1+r)TThe one-month Reliance future would be the spot price plus the cost of carry.Since the bank rate is 10 %, we can take that as the market rate. This rate is anannualized rate and hence we recalculate it on a monthly basis.F=300(1+0.10)(1/12)F= Rs 302.39Example 2.2:The shares of Infosys are trading at 3000 rupees. The 1 month future of Infosysis Rs 3100. The returns expected from the Gsec funds for the same period is 10%. Is the future of Infosys overpriced or underpriced? 16
    • BASICS OF DERIVATIVESSolutionThe 1 month Future of Infosys will beF= 3000(1+.0.10) (1/12)F= Rs 3023.90But the price at which Infosys is traded is Rs 3100. Thus it is overpriced by Rs76.What happens if dividend is going to be declared?Dividend is an income to the seller of the future. It reduces his cost of carry tothat extent. If dividend is going to be declared, the same has to be deducted fromthe cost of carryThus the price of the future in this case becomes,F= S (1+r-d) TWhere d is the dividend.Example 2.3:The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. What willbe the price of one-month future? Reliance will be paying a dividend of 50 paiseper shareSolution: 17
    • BASICS OF DERIVATIVESSince Reliance is paying 50 paise per share and the face value of reliance is Rs10, the dividend rate is 5%.So while calculating futures,F=300(1+0.10-0.05) (1/12)F= Rs. 301.22What happens if dividend is declared after buying a future?If the dividend is declared after buying a one month future, the cost of carry willbe reduced by a pro rata amount. For example, if there is a one month futureending June 30th and dividend is declared on June 15th, then dividend benefit willbe reduced from the cost of carry for 15 days.Since the seller is holding the shares and will transfer the shares to the buyeronly after a month, the dividend benefit goes to the seller. The seller will enjoythe benefit to the extent of interest on dividend.Thus net cost of carry = cost of carry – dividend benefitsExample 2.4:The spot price of Reliance is Rs 300. The bank rate prevailing is 10%. Reliancedeclares a dividend of 5%. What will be the price of one-month future?Solution: 18
    • BASICS OF DERIVATIVESThe benefit accrued due to the dividend will be reduced from the cost of thefuture.One month future will be priced atF= 300(1+0.10) (1/12)F = 302.39Cost of Carry= Rs 302.39-Rs 300 = Rs 2.39The interest benefit of the dividend is available for 15 days, ie 0.5 months.Dividend for 15 days = 300(1+0.05) (0.5/12)Dividend Benefit = Rs300.61- Rs 300= Rs0.61Therefore, net cost of the carry is,Rs2.39-Rs0.61 = Rs 1.78Therefore the price of the future is Rs 300+Rs 1.78 = Rs 301.78In practice, the market discounts the dividend and the prices are automaticallyadjusted. The exchange steps into the picture if the dividend declared is morethan 10 % of the market price. In such cases, there is an official change in theprice. In other cases, the market does the adjustment on its own.What happens in case a bonus/ stock split is declared on the stock inwhich I have a futures position?If a bonus is declared, the settlement price is adjusted to reflect the bonus. Forexample, if you have 200 Reliance at Rs 300 and there is a 1:1 bonus, then the 19
    • BASICS OF DERIVATIVESposition becomes 400 Reliance at Rs 150 so that the contract value isunaffected.But is the Future really traded in this way in the market?What has been discussed above is the theoretical way of arriving at the futureprice. This can be used as a base for calculation future priceBut the actual market price that we see on the trading screen depends onliquidity too. So the prices that we observe in real world are also a function ofdemand-supply position in that stock.How do future prices behave compared to spot prices? Future vs Spot 30 20 Future Price Price 10 Spot Price 0 1 2 3 4 5 6 7 Tim eFuture prices lead the spot prices. The spot prices move towards the futureprices and the gap between the two is always closing with as the time to 20
    • BASICS OF DERIVATIVESsettlement decreases. On the last day of the future settlement, the spot priceequals the future price.Is the futures price always higher than the spot price?The futures price can be lower than the spot price too. This depends on thefundamentals of the stock. If the stock is not expected to perform well and themarket takes a bearish view on them, then the futures price can be lower thanthe spot price.Future prices can fall also due to declaration of dividend.What happens in case of index futures?In case of index futures, the treatment of the futures calculation is the same. Thefuture value is calculated as the spot index value plus the cost of carry.What happens if I buy an index future and there is a dividend declared on astock that comprises the index?Practically speaking, the index is corrected for these things in case there is adividend declared for such a stock.Theoretically, dividend is adjusted in the following manner: 21
    • BASICS OF DERIVATIVES1.The contribution of the stock to the index is calculated. The index, as discussedearlier, is a market capitalization index.2. Then the number of shares in the index is calculated. This is obtained bydividing the contribution to the index by the market price.3. The dividend on the index is the dividend on the number of shares of the stockin the index.4. The interest earned on the dividend is calculated and reduced from the cost ofcarry to obtain the net cost of carry.Example 2.5:The index is at 1000. There is a dividend of Rs 5 per share on HLL. HLLcontributes to 15 % of the index. The market price of HLL is Rs 150. What will bethe cost of the 1 month future if the bank rate is 10%?Solution:The future will be priced atF= 1000(1+0.10)(1/12)F= 1008The weight of HLL in the index is 15% ie 0.15*1000=150.The market price of HLL is Rs 150Therefore, the number of shares of HLL in the index=1The dividend earned on this is Rs 5 22
    • BASICS OF DERIVATIVESDividend benefit on Rs 5 is 5(1+0.10) (1/12)Dividend benefit = Rs 0.04Cost of the future will be Rs 1008-Rs 0.05= Rs 1007.95But in practice, the market discounts the dividends and price adjustment is madeaccordingly.All that is okay in theory, but what happens in the real world?In the real world, derivatives are highly volatile instruments and there have beenlot of losses in the various financial markets. The classic examples have beenLong Term Capital Markets (LTCM) and Barings. We will examine whathappened exactly at various places later in the book.As a result, the regulators have decided that a minimum of Rs 2 lacs should bethe contract size. This is done primarily to keep the small investors away from avolatile market till enough experience and understanding of the markets isacquired. So the initial players are institutions and high net worth individuals whohave a risk taking capacity in these markets.Because of this minimum amount, lots are decided on the market price such thatthe value is Rs 2 lacs. As a result one has to buy a minimum of 200 Nifties or incase of Sensex, 50. 23
    • BASICS OF DERIVATIVESSimilarly minimum lots are decided for individual stocks too. Thus you will finddifferent stock futures having different market lots. The lots decided for eachstock was such that the contract value was Rs 2 lacs. This was at the point ofintroduction of these instruments. However the lot size has remained the sameand has not been adjusted for the price changes. Hence the value of the contractmay be slightly lower in case of certain stocks.Trading, i.e. Buying and Selling take place in the same manner as the stockmarkets. There will be an F & O terminal with the broker and the dealer will enterthe orders for you.Another fact of the real world is that, since the future is a standard instrument,you can close out your position at any point of time and need not hold tillmaturity.How is the trading done on the exchange?Buying of futures is margin based. You pay an up front margin and take aposition in the stock of your choice. Your daily losses/ gains relative to the futureprice will be monitored and you will have to pay a mark to market margin. On thefinal day settlement is made in cash and is the difference between the futuresprice and the spot price prevailing at that time 24
    • BASICS OF DERIVATIVESFor example, if the future price is Rs 300 and the spot price is Rs 330, then youwill make a cash profit of Rs 30. In case the spot price is Rs 290, you make acash loss of Rs 10. Thus futures market is a cash market.In future, there is a possibility that the futures may result in delivery. In such ascenario, the future market will be merged with the spot market on the expirationday and it will follow the T+ 3 rolling settlement prevalent in the stock marketsHow does the mark to market mechanism work?Mark to market is a mechanism devised by the stock exchange to minimize risk.In case you start making losses in your position, exchange collects money to theextent of the losses up front. For example, if you buy futures at Rs 300 and itsprice falls to Rs 295 then you have to pay a mark to market margin of Rs 5. Thisis over and above the margin money that you pay to take a position in the future. 25
    • BASICS OF DERIVATIVES 3. OptionsWhat are options?As seen earlier, futures are derivative instruments where one can take a positionfor an asset to be delivered at a future date. But there is also an obligation as theseller has to make delivery and buyer has to take delivery.Options are one better than futures. In option, as the name indicates, gives oneparty the option to take or make delivery. But this option is given to only oneparty in the transaction while the other party has an obligation to take or makedelivery. The asset can be a stock, bond, index, currency or a commodityBut since the other party has an obligation and a risk associated with makinggood the obligation, he receives a payment for that. This payment is called aspremium. 26
    • BASICS OF DERIVATIVESThe party that had the option or the right to buy/sell enjoys low risk. The cost ofthis low risk is the premium amount that is paid to the other party.Thus we have seen an option is a derivative that gives one party a right and theother party an obligation to buy /sell at a specified price for a specified quantity.The buyer of the right is called the option holder. The seller of the right (andbuyer of the obligation) is called the option writer. The cost of this transaction isthe premium.For example, a railway ticket is an option in daily life. Using the ticket, apassenger has an option to travel. In case he decides not to travel, he can cancelthe ticket and get a refund. But he has to pay a cancellation fee, which isanalogous to the premium paid in an option contract. The railways, on the otherhand, have an obligation to carry the passenger if he decides to travel and refundhis money if he decides not to travel. In case the passenger decides to travel, therailways get the ticket fare. In case he does not, they get the cancellation fee.The passenger on the other hand, by booking a ticket, has hedged his position incase he has to travel as anticipated. In case the travel does not materialize, he 27
    • BASICS OF DERIVATIVEScan get out of the position by canceling the ticket at a cost, which is thecancellation fee.But I hear a lot of jargons about options? What are all these jargons?There are some basic terminologies used in options. These are universalterminologies and mean the same everywhere.a. Option holder : The buyer of the option who gets the rightb. Option writer : The seller of the option who carries the obligationc. Premium: The consideration paid by the buyer for the rightd. Exercise price: The price at which the option holder has the right to buy or sell. It is also called as the strike price.e. Call option: The option that gives the holder a right to buyf. Put option : The option that gives the holder a right to sellg. Tenure: The period for which the option is issuedh. Expiration date: The date on which the option is to be settledi. American option: These are options that can be exercised at any point till the expiration datej. European option: These are options that can be exercised only on the expiration datek. Covered option: An option that an option writer sells when he has the underlying shares with him. 28
    • BASICS OF DERIVATIVESl. Naked option: An option that an option writer sells when he does not have the underlying shares with himm. In the money: An option is in the money if the option holder is making a profit if the option was exercised immediatelyn. Out of money: An option is in the money if the option holder is making a loss if the option was exercised immediatelyo. At the money: An option is in the money if the option holder evens out if the option was exercised immediatelyHow is money made in an option?The money made in an option is called as the option pay off. There can be twopay off for options, for put and call option Call option:A call option gives the holder a right to buy shares. The option holder will makemoney if the spot price is higher than the strike price. The pay off assumes thatthe option holder will buy at the strike price and sell immediately at the spot price.But if the spot price is lower than the strike, the option holder can simply ignorethe option. It will be cheaper to buy from the market. The option holder loss is tothe extent of premium he has paid. 29
    • BASICS OF DERIVATIVESBut if the spot price increases dramatically then he can make wind fall profits.Thus the profits for an option holder in a call option is unlimited while losses arecapped to the extent of the premium.Conversely, for the writer, the maximum profit he can make is the premiumamount. But the losses he can make are unlimited.Put optionThe put option gives the right to sell. The option holder will make money if thespot price is lower than the strike price. The pay off assumes that the optionholder will buy at spot price and sell at the strike priceBut if the spot price is higher than the strike, the option holder can simply ignorethe option. It will be beneficial to sell to the market. The option holder loss is tothe extent of premium he has paid.But if the spot prices falls dramatically then he can make wind fall profits.Thus the profits for an option holder in a put option is unlimited while losses arecapped to the extent of the premium. This is a theoretical fallacy as the maximum 30
    • BASICS OF DERIVATIVESfall a stock can have is till zero, and hence the profit of a option holder in a putoption is capped.Conversely, the maximum profit that an option writer can make in this case is thepremium amount.But in the above pay off, we had ignored certain costs like premium andbrokerage. These are also important, especially the premium.So, in a call option for the option holder to make money, the spot price has to bemore than the strike price plus the premium amount.If the spot is more than the strike price but less than the sum of strike price andpremium, the option holder can minimize losses but cannot make profits byexercising the option.Similarly, for a put option, the option holder makes money if spot is less than thestrike price less the premium amount.If the spot is less than the strike price but more than the strike price lesspremium, the option holder can minimize losses but cannot make profits byexercising the option. 31
    • BASICS OF DERIVATIVESExample 3.1:The call option for Reliance is selling at Rs 10 for a strike price of Rs 330. Whatwill be the profit for the option holder if the spot price touches a) Rs. 350 b)337Solutiona. The option holder can buy Reliance at a price of Rs 330.He has also paid a premium of Rs 10 for the same. So his cost of a share ofReliance is Rs 340.He can sell the same in the spot market for Rs 350.He makes a profit of Rs 10b. The option holder can buy Reliance at a price of Rs 330.He has also paid a premium of Rs 10 for the same. So his cost of a share ofReliance is Rs 340.He can sell the same in the spot market for Rs 337He makes a loss of Rs 3.But he has reduced his losses by exercising the option. Had he not exercised theoption, he would have made a loss of Rs 10, which is the premium that he paidfor the option. 32
    • BASICS OF DERIVATIVESBut should one always buy an option? The buyer seems to enjoy alladvantages, then why should one write an option?This is not always the case. The writer of the option too can make money.Basically, the option writers and option holders are people who are taking adivergent view on the market. So if the option writer feels the markets will bebearish, he can write call options and pocket the premium. In case the marketfalls, the option holder will not exercise the option and the entire premium amountcan be a profitBut if the option writer is bullish on the market, then he can write put options. Incase the market goes up, the option holder will not exercise the option and thepremium amount is a profit for the option writer.The other area that an option writer makes money is the spot price lying in therange between the strike price and the strike plus premiumFor example, if you write a call option on Reliance for a strike price of Rs 300 at apremium of Rs 30. If the spot price is Rs 320, then the option holder will exercisethe option to reduce losses and buy it at Rs 300. But you have already got thepremium of Rs 30. So in effect, you have sold the stock at Rs. 330, which is Rs10 above the spot price! This profit increases even more if you calculate theopportunity cost of Rs 30 as this amount is received up front. 33
    • BASICS OF DERIVATIVESLet us look at a typical pay off table for a call option, for the buyer as well aswriter. Let us assume a call option with a strike price of Rs 200 and a premium ofRs 10Table 3.1: Pay off Table for buyer and writer of an optionSpot Price Whether Buyer’s Writer Net Exercised gain/loss gain/loss180 No -10 +10 0190 No -10 +10 0195 No -10 +10 0200(=Strike Yes/No -10 +10 0Price)205 Yes -5 +5 0210 Yes 0 0 0220 Yes +10 -10 0In the above pay off table, if we take 200 as the median value, we see that thewriter has made money 5 out of 7 occasions. He has made money even whenthe option is exercised, as long as the spot price is below the strike price plus thepremium.Thus writers also make money on options, as the buyer is not at an advantage allthe time. 34
    • BASICS OF DERIVATIVESWhat are the options that are currently traded in the market?The options that are currently traded in the market are index options and stockoptions on the 30 stocks. The index options are European options. They aresettled on the last day. The stock options are American options.There are 3 options-1, 2,3 month options. There can be a series of option withinthe above time span at different strike prices.Another lingo in option is Near and Far options. A near option means the optionis closer to expiration date. A Far option means the option is farther fromexpiration date. A 1 month option is a near option while a 3 month option is a faroption.In option trading, what gets quoted in the exchange is the premium and all thatpeople buy and sell is the premium.We said we could have different option series at various strike prices. Howis this strike price arrived at?The strike price bands are specified by the exchange. This band is dependent onthe market price. Market Price Rs. Strike Price Intervals Rs. 35
    • BASICS OF DERIVATIVES <50 2.5 50-150 5 150-250 10 250-500 20 500-1000 30 >1000 50Thus if a stock is trading at Rs. 100 then there can be options with strike price ofRs 105,110,115, 95, 90 etc.How is the premium of an option calculated?In practice, it is the market that decides the premium at which an option is traded.There are mathematical models, which are used to calculate the premium of anoption.The simplest tool is the expected value concept. For example, for a stock that isquoting at Rs 95. There is a 20 % probability that it will become Rs 110. There isa 30 % probability that it will become Rs 105. There is 30% probability that thestock will remain at Rs.95 and a 20 % probability that it will fall to Rs 90. 36
    • BASICS OF DERIVATIVESIf the strike price of a call option is to be Rs 100, then the option will have valuewhen the spot goes to Rs 105 or Rs 110. It will be un-exercised at Rs 95 and Rs90.If it is Rs105 and Rs 110, the money made is Rs 10 and 15 respectively.The expected returns for the above distribution is0.20*15+0.30*10=Rs 6.Thus this the price that one can pay as a premium for a strike price of Rs 100 fora stock trading at Rs 95. Rs 6 will also be the price for the seller for giving theoption holder this opportunity.This is a very simple thumb calculation. Even then, one would require a lot ofbackground data like variances and expected price movements.There are more advanced probabilistic models like the Black Scholes model andthe Binomial Pricing model that calculates the options. One need not go deepinto those and it would suffice to say that option calculators are readily available.Please visit www.indiainfoline.com/stok/ to use an option calculator based onBlack Scholes Model. The Black Scholes Model is presented in greater detail inAnnexure-3. 37
    • BASICS OF DERIVATIVESI keep reading about option Greeks? What are they? They actually soundlike Greek and Latin to me.There are something called as option Greeks but they are nothing to be scaredof. The option Greeks help in tracking the volatility of option prices.The option Greeks area. Delta: Delta measures the change in option price (the premium) to the change in underlying. A delta of 0.5 means if the underlying changes by 100 % the option price changes by 50 %.b. Theta: It measures the change in option price to change in timec. Rho: It is the change in option price to change in interest rated. Vega: It is the change in option price to change in variance of the underlying stocke. Gamma: It is the change in delta to the change in the underlying. It is a double derivative (the mathematical one) of the option price with respect to underlying. It gives the rate of change of delta.These are just technical tools used by the market players to analyze options andthe movement of the option prices. 38
    • BASICS OF DERIVATIVESWe saw that the stock options are American options and hence can beexercised any time. What happens when one decided to exercise theoption?When the option holder decides to exercise the option, the option will beassigned to the option writer on a random basis, as decided by the software ofthe exchange.The European options are also the similarly decided by the software of theexchange. The index options are European options.In future, there is a possibility that the options may result in delivery. In such ascenario, the option market will be merged with the spot market on the expirationday and it will follow the T+ 3 rolling settlement prevalent in the stock markets 39
    • BASICS OF DERIVATIVES 4. Trading Strategies using Futures and OptionsSo far, we have seen a lot of theoretical stuff on derivatives. But how is itgoing to help me in practice?There are a lot of practical uses of derivatives. As we have seen, derivatives canbe used for profits and hedging. We can use derivatives as a leverage tool too.How do I use derivatives as a leverage?You can use the derivatives market to raise funds using your stocks. Conversely,you can also lend funds against stocks.Does that mean derivatives are badla revisited?The derivative product that comes closest to Badla is futures. Futures is notbadla, though a lot of people confuse it with badla. The fundamental difference isbadla consisted of contango and backwardation (undha badla and vyaj badla) inthe same market. Futures is a different market segment altogether. Hencederivatives is not the same as badla, though it is similar.How do I raise funds from the derivatives market?This is fairly simple. Say, you have Infosys, which is trading at Rs 3000. Youhave shares lying with you and are in urgent need of liquidity. Instead of pledgingyour shares and borrowing from banks at a margin, you can sell the stock at Rs 40
    • BASICS OF DERIVATIVES3000. Suppose you need this liquidity only for a month and also do not want topart with Infosys. You can buy a 1 month future at Rs 3050. After a month youget back your Infosys at the cost of an additional Rs 50. This Rs 50 is thefinancing cost for the liquidity.The other beauty about this is you have already locked in your purchase cost atRs 3050. This fixes your liquidity cost also and you are protected against furtherprice losses.How do I lend into the market?The lending into the market is exactly the reverse of borrowing. You have moneyto lend. You can buy a stock and sell its future. Say, you buy Infosys at Rs 3000and sell a 1 month future at Rs 3100. In effect what you have done is lent Rs3000 to the market for a month and earned Rs 100 on it.Suppose I don’t want to lend/borrow money. I want to speculate and makeprofits?When you speculate, you normally take a view on the market, either bullish orbearish. When you take a bullish view on the market, you can always sell futuresand buy in the spot market. If you take a bearish view on the market, you can buyfutures and sell in the spot market. 41
    • BASICS OF DERIVATIVESSimilarly, in the options market, if you are bullish, you should buy call options. Ifyou are bearish, you should buy put optionsConversely, if you are bullish, you should write put options. This is so because, ina bull market, there are lower chances of the put option being exercised and youcan profit from the premiumIf you are bearish, you should write call options. This is so because, in a bearmarket, there are lower chances of the call option being exercised and you canprofit from the premiumHow can I arbitrage and make money in derivatives?Arbitrage is making money on price differentials in different markets. Forexample, future is nothing but the future value of the spot price. This future valueis obtained by factoring the interest rate.But if there are differences in the money market and the interest rates changethen the future price should correct itself to factor the change in interest. But ifthere is no factoring of this change then it presents an opportunity to makemoney- an arbitrage opportunity. 42
    • BASICS OF DERIVATIVESLet us take an example.Example 4.1:A stock is quoting for Rs 1000. The 1-month future of this stock is at Rs 1005.The risk free interest rate is 12%. What should be the trading strategy?Solution:The strategy for trading should be : Sell Spot and Buy FuturesSell the stock for Rs 1000. Buy the future at Rs 1005.Invest the Rs1000 at 12 %. The interest earned on this stock will be1000(1+.012)(1/12)=1009So net gain the above strategy is Rs 1009- Rs 1005 = Rs 4Thus one can make a risk less profit of Rs 4 because of arbitrageBut an important point is that this opportunity was available due to mis-pricingand the market not correcting itself. Normally, the time taken for the market toadjust to corrections is very less. So the time available for arbitrage is also less.As everyone rushes to cash in on the arbitrage, the market corrects itself. 43
    • BASICS OF DERIVATIVESHow is a future useful for me to hedge my position?One can hedge one’s position by taking an opposite position in the futuresmarket. For example, If you are buying in the spot price, the risk you carry is thatof prices falling in the future. You can lock this by selling in the futures price.Even if the stock continues falling, your position is hedged as you have firmedthe price at which you are selling.Similarly, you want to buy a stock at a later date but face the risk of prices rising.You can hedge against this rise by buying futures.You can use a combination of futures too to hedge yourself. There is always acorrelation between the index and individual stocks. This correlation may benegative or positive, but there is a correlation. This is given by the beta of thestock.In simple terms, what β indicates is the change in the price of a stock to thechange in index. For example, if β of a stock is 0.8, it means that if the indexgoes up by 10, the price of the stock goes up by 8. It will also fall by a similarlevel when the index falls. 44
    • BASICS OF DERIVATIVESA negative β means that the price of the stock falls when the index rises. So, ifyou have a position in a stock, you can hedge the same by buying the index at βtimes the value of the stock.Example 4.2:The β of HPCL is 0.8. The Nifty is at 1000 . If I have Rs 10000 worth of HPCL, Ican hedge my position by selling 8000 of Nifty. Ie I will sell 8 Nifties.Scenario 1If index rises by 10 %, the value of the index becomes 8800 ie a loss of Rs 800The value of my stock however goes up by 8 % ie it becomes Rs 10800 ie a gainof Rs 800.Thus my net position is zero and I am perfectly hedged.Scenario 2If index falls by 10 %, the value of the index becomes Rs 7200 a gain of Rs 800But the value of the stock also falls by 8 %. The value of this stock becomes Rs9200 a loss of Rs 800.Thus my net position is zero and I am perfectly hedged.But again, β is a predicted value based on regression models. Regression isnothing but analysis of past data. So there is a chance that the above positionmay not be fully hedged if the β does not behave as per the predicted value. 45
    • BASICS OF DERIVATIVESHow do I use options in my trading strategy?Options are a great tool to use for trading. If you feel the market will go up. Youshould buy a call option at a level lower than what you expect the market to goup.If you think that the market will fall, you should buy a put option at a level higherthan the level to which you expect the market fall.When we say market, we mean the index. The same strategy can be used forindividual stocks also.A combination of futures and options can be used too, to make profits.We have seen that the risk for an option holder is the premium amount. Butwhat should be the strategy for an option writer to cover himself?An option writer can use a combination strategy of futures and options to protecthis position. The risk for an option writer arises only when the option is exercised.This will be very clear with an example.Suppose I sell a call option on Reliance at a strike price of Rs 300 for a premiumof Rs 20. The risk arises only when the option is exercised. The option will be 46
    • BASICS OF DERIVATIVESexercised when the price exceeds Rs 300. I start making a loss only after theprice exceeds Rs 320(Strike price plus premium).More importantly, I have to deliver the stock to the opposite party. So to enableme to deliver the stock to the other party and also make entire profit on premium,I buy a future of Reliance at Rs 300.This is just one leg of the risk. The earlier risk was of the call being exercised.The risk now is that of the call not being exercised. In case the call is notexercised, what do I do? I will have to take delivery as I have bought a future.So minimize this risk, I buy a put option on Reliance at Rs 300. But I also need topay a premium for buying the option. I pay a premium of Rs 10.Now I am fullycovered and my net cash flow would bePremium earned from selling call option : Rs 20Premium paid to buy put option : (Rs 10)Net cash flow : Rs 10But the above pay off will be possible only when the premium I am paying for theput option is lower than the premium that I get for writing the call. 47
    • BASICS OF DERIVATIVESSimilarly, we can arrive at a covered position for writing a put option too,Another interesting observation is that the above strategy in itself presents anopportunity to make money. This is so because of the premium differential in theput and the call option. So if one tracks the derivative markets on a continuousbasis, one can chance upon almost risk less money making opportunities.What are the other strategies using derivatives?The other strategies are also various permutations of multiple puts, calls andfutures. They are also called by exotic names , but if one were to observe themclosely, they are relatively simple instruments.Some of these instruments are:• Butter fly spread: It is the strategy of simultaneous buying of put and call• Calendar Spread - An option strategy in which a short-term option is sold and a longer-term option is bought both having the same striking price. Either puts or calls may be used.• Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price• Straddle – The simultaneous purchase and sale of option of the same specification to different periods. 48
    • BASICS OF DERIVATIVES• Tandem Options – A sequence of options of the same type, with variable strike price and period.• Bermuda Option – Like the location of the Bermudas, this option is located somewhere between a European style option which can be exercised only at maturity and an American style option which can be exercised any time the option holder chooses. This option can be exercisable only on predetermined dates 49
    • BASICS OF DERIVATIVES 5. RISK MANAGEMENT IN DERIVATIVESDerivatives are high-risk instruments and hence the exchanges have put up a lotof measures to control this risk.The most critical aspect of risk management is the daily monitoring of price andposition and the margining of those positions.NSE uses the SPAN (Standard Portfolio Analysis of Risk). SPAN is a system thathas origins at the Chicago Mercantile Exchange, one of the oldest derivativeexchanges in the world.The objective of SPAN is to monitor the positions and determine the maximumloss that a stock can incur in a single day. This loss is covered by the exchangeby imposing mark to market margins.SPAN evaluates risk scenarios, which are nothing but market conditions.The specific set of market conditions evaluated, are called the risk scenarios, andthese are defined in terms of:(a) how much the price of the underlying instrument is expected to change over 50
    • BASICS OF DERIVATIVESone trading day, and(b) how much the volatility of that underlying price is expected to change overone trading day.Based on the SPAN measurement, margins are imposed and risk covered. Apartfrom this, the exchange will have a minimum base capital of Rs 50 lacs andbrokers need to pay additional base capital if they need margins above thepermissible limits. 51
    • BASICS OF DERIVATIVES 6. SETTLEMENT OF DERIVATIVESHow are futures settled on the stock exchange?Mark to market settlementThere is a daily settlement for Mark to Market .The profits/ losses are computedas the difference between the trade price or the previous day’s settlement price,as the case may be, and the current day’s settlement price. The party who havesuffered a loss are required to pay the mark-to-market loss amount to exchangewhich is in turn passed on to the party who has made a profit. This is known asdaily mark-to-market settlement.Theoretical daily settlement price for unexpired futures contracts, which are nottraded during the last half an hour on a day, is currently the price computed asper the formula detailed below:F = S * e rtwhere :F = theoretical futures priceS = value of the underlying index/ stockr = rate of interest (MIBOR- Mumbai Inter bank Offer Rate)t = time to expiration 52
    • BASICS OF DERIVATIVESRate of interest may be the relevant MIBOR rate or such other rate as may bespecified.After daily settlement, all the open positions are reset to the daily settlementprice.The pay-in and pay-out of the mark-to-market settlement is on T+1 days ( T =Trade day). The mark to market losses or profits are directly debited or creditedto the broker account from where the broker passes to the client accountFinal SettlementOn the expiry of the futures contracts, exchange marks all positions to the finalsettlement price and the resulting profit / loss is settled in cash.The final settlement of the futures contracts is similar to the daily settlementprocess except for the method of computation of final settlement price. The finalsettlement profit / loss is computed as the difference between trade price or theprevious day’s settlement price, as the case may be, and the final settlementprice of the relevant futures contract.Final settlement loss/ profit amount is debited/ credited to the relevant broker’s 53
    • BASICS OF DERIVATIVESclearing bank account on T+1 day (T= expiry day). This is then passed on theclient from the broker. Open positions in futures contracts cease to exist aftertheir expiration dayHow are options settled on the stock exchange?Daily Premium SettlementPremium settlement is cash settled and settlement style is premium style. Thepremium payable position and premium receivable positions are netted across alloption contracts for each broker at the client level to determine the net premiumpayable or receivable amount, at the end of each day.The brokers who have a premium payable position are required to pay thepremium amount to exchange which is in turn passed on to the members whohave a premium receivable position. This is known as daily premium settlement.The brokers in turn would take this from their clients.The pay-in and pay-out of the premium settlement is on T+1 days ( T = Tradeday). The premium payable amount and premium receivable amount are directlydebited or credited to the broker, from where it is passed on to the client. 54
    • BASICS OF DERIVATIVESInterim Exercise Settlement for Options on Individual SecuritiesInterim exercise settlement for Option contracts on Individual Securities iseffected for valid exercised option positions at in-the-money strike prices, at theclose of the trading hours, on the day of exercise. Valid exercised optioncontracts are assigned to short positions in option contracts with the same series,on a random basis. The interim exercise settlement value is the differencebetween the strike price and the settlement price of the relevant option contract.Exercise settlement value is debited/ credited to the relevant broker account onT+3 day (T= exercise date). From there it is passed on to the clients.Final Exercise SettlementFinal Exercise settlement is effected for option positions at in-the-money strikeprices existing at the close of trading hours, on the expiration day of an optioncontract. Long positions at in-the money strike prices are automatically assignedto short positions in option contracts with the same series, on a random basis.For index options contracts, exercise style is European style, while for optionscontracts on individual securities, exercise style is American style. Final Exerciseis Automatic on expiry of the option contracts.Exercise settlement is cash settled by debiting/ crediting of the clearing accounts 55
    • BASICS OF DERIVATIVESof the relevant broker with the respective Clearing Bank, from where it is passedto the client.Final settlement loss/ profit amount for option contracts on Index is debited/credited to the relevant broker clearing bank account on T+1 day (T = expiryday), from where it is passedFinal settlement loss/ profit amount for option contracts on Individual Securities isdebited/ credited to the relevant broker clearing bank account on T+3 day (T =expiry day), from where it is passedOpen positions, in option contracts, cease to exist after their expiration day. 56
    • BASICS OF DERIVATIVES 7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVESSince derivatives are a highly risky market, as experience world over has shown,there are tight regulatory controls in this market.The same is true of India. In India, a committee was set up under Dr L C Guptato study the introduction of the derivatives market in India. The report of the LCGupta Committee is attached as Annexure-4.This committee formulated the guidelines and framework for the derivativesmarket and paved the way for the derivatives market in India.There other committee that has far reaching implications in the derivativesmarket is the J R Verma Committee. This committee has recommended normsfor trading in the exchange. A lot of emphasis has been laid on margining andsurveillance so as to provide a strong backbone in systems and processes andensure stringent controls in a risky market.As for the taxation aspect, the CBDT is treating gains from derivativetransactions as profit from speculation. Similarly losses in derivative transactionscan be treated as speculation losses for tax purpose. 57
    • BASICS OF DERIVATIVES 8. CASE STUDY- When things go wrong!In the earlier part, we saw how useful derivatives are as hedging and riskmanagement tools. However, derivatives do not come without their share ofproblems and dangers. Derivatives are highly sophisticated instruments andusers with inadequate information and understanding expose themselves to allthe risks inherent in using derivatives. Spectacular losses have been made andsome companies have even come to the point of collapse after using derivativeinstruments. Some examples of the unfortunate use of derivatives are:• In 1994, American consumer products giant Procter and Gamble (P&G), lost an estimated US$ 200 million on a complex interest rate Swap. The Swap was intended to lower funding costs for P&G if interest rates moved in a certain manner. However, the Swap turned out to be a sophisticated bet on future interest rate changes. It was the result of speculation and lax controls. The company ought not to have betted on interest rate changes. This case can be viewed as a classic case of how not to use derivatives.• Sumitomo lost 1.17 billion pounds on copper and copper derivative instruments from 1995- 1996.• NatWest Markets, in 1997,announced it had lost 77m pounds as a result of mispriced interest rate Options and Swaps. 58
    • BASICS OF DERIVATIVES• The German metals and services group, Metallgesellschaft, came to the verge of destruction in 1994 after losses exceeding DM 2.3 billion on energy derivatives.• Barings, Britain’s oldest merchant bank lost 900m pounds sterling on Nikkei Index contracts on the Singapore and Osaka Derivatives Exchanges, ultimately leading to the bank’s near collapse in 1995. The main person involved was Nick Leeson, the bank’s derivatives trader.• In 1994, Orange County, USA’s richest local authority went bankrupt after trading in high-risk derivatives. On the advice of Merrill Lynch, county treasurer, Robert Citron invested the county’s assets in interest sensitive derivatives. The market moved against him and the county faced losses of around US$ 1.6 billion. Afterwards, Merrill Lynch agreed to pay Orange County over US$ 400m rather than face trial, in a friendly agreement.The above examples are enough to make any potential user of derivativesapprehensive. However, the stories not told about derivatives represent themajority of cases where derivatives effectively reduce risk. Today, almost alllarge, non-financial organizations use financial derivatives and the number ofusers is fast increasing. Derivatives are no different than the majority of moderninventions: if used in a proper way they are powerful and, indeed valuable tools. 59
    • BASICS OF DERIVATIVESIn wrong hands, they can cause tremendous destruction as the above examplestestify. The function of a corporate financial officer is to reduce risk by usingderivatives and not to speculate. Yet, in any derivative disaster, an element ofspeculation seems to be present. Another cause of losses is decisions taken bypeople with inadequate knowledge and who do not fully understand the complexstructure of derivatives. Derivatives are highly complex instruments and are oftenresearch-derived and computer generated. The case of the Orange Countyderivatives amply demonstrates this. It is clear that the derivative products usedby the county treasurer were not fully comprehended by him.Barings—What went wrong?A careful study of the Barings case brings to light several issues. Extensive dataobtained by Singapore inspectors show that Nick Leeson lost 4.8m poundssterling between July and October 1992. Leeson covered all the losses by July’93. But it appeared that Leeson recovered his losses by selling options in a waythat stored up trouble. He used a strategy called “Straddling”. Simply put, Leesontraded in a way that he was severely exposed to the market movement and aslight movement against him would lead to huge losses. After the Kobeearthquake, the volatility of the Nikkei increased sharply and Leeson andBarings’ were left facing huge losses. 60
    • BASICS OF DERIVATIVESLeeson did not take the relatively small losses he would have made had he soldthe contracts when the market started to go against him, but waited in the hopethat the situation would reverse and he would make good the losses. But thiswas not to be, and the rest, they say, is history.What Leeson did was to engage in highly speculative trading. He primarily usedderivatives, not as risk mitigating instruments, but as means of earningspeculative profits. The downside risk was huge and the risk of losses was great.Derivatives—irreplaceable tools or weapons of destruction?Derivatives have acquired a myth of danger and mystery. One reason is thesensational media coverage of the derivatives disasters. However, what oftenescapes notice is that these disastrous transactions involve speculation(intentional risks to make profits) or poor oversight. Derivative instruments, perse, rarely, if ever, cause disasters. It is to be noted that most companies usederivatives for risk reduction and only very few businesses with poormanagement hurt themselves.As explained earlier, derivative contracts can be geared to many times theirvalue. In other words, contracts, which may be worth millions, if the marketmoves in a certain way, cost only a fraction of that value. 61
    • BASICS OF DERIVATIVESUsually, the market will not move that much and the contract will be settled orsold to somebody else for a small gain or loss. However, if it does shiftsignificantly, big losses can be incurred, which are magnified due to the gearingeffect.Banks have complex computer programmes to tell them how much they couldlose if the market moves by a certain amount. Regulations require them to putmoney aside to protect against possible losses.On exchanges, traders have to pay any losses incurred on their position at theend of each day. This "margin" payment is to prevent risks getting out of hand. 62
    • BASICS OF DERIVATIVESANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES1. Arbitrage - The simultaneous purchase and sale of a commodity or financial instrument in different markets to take advantage of a price or exchange rate discrepancy.2. Backwardation – The price differential between spot and back months when the nearby dates are at a premium. It is the opposite of ‘contango.’3. Butterfly spread – The placing of two inter-delivery spreads in opposite directions with the centre delivery month common to both. The perfect butterfly spread would require no net premium paid.4. Calendar Spread - An option strategy in which a short-term option is sold and a longer-term option is bought both having the same striking price. Either puts or calls may be used.5. Call option – An option that gives the buyer right to buy a futures contract at a premium, at the strike price.6. Contango – The price differential between spot and back months when the marking dates are at a discount. It is the opposite of ‘backwardation.’ 63
    • BASICS OF DERIVATIVES7. Currency swap – A swap in which the counterparties’ exchange equal amounts of two currencies at the sot exchange rate.8. Derivative – A derivative is an instrument whose value is derived from the value of one or more underlying assets, which can be commodities, precious metals, currency, bonds, stocks, stock indices, etc. Derivatives involve the trading of rights or obligations based on the underlying product, but do not directly transfer property.9. Double option – An option that gives the buyer the right to buy and/or sell a futures contract, at a premium, at the strike price.10. Futures contract – A legally binding agreement for the purchase and sale of a commodity, index or financial instrument some time in the future.11. Hedge fund – A large pool of private money and assets managed aggressively and often riskily on any futures exchange, mostly for short-term gain. 64
    • BASICS OF DERIVATIVES12. In-the money option – An option with intrinsic value. A call option is in-the- money if its strike price is below the current price of the underlying futures contract and a put option is in-the-money if it is above the underlying.13. Kerb trading - Trading by telephone or by other means that takes place after the official market has closed. Originally it took place in the street on the kerb outside the market.14. Margin call – A demand from a clearing house to a clearing member or from a broker to a customer to bring deposits up to a required minimum level to guarantee performance at ruling prices.15. Mark to market – A process of valuing an open position on a futures market against the ruling price of the contract at that time, in order to determine the size of the margin call.16. Naked option – An option granted without any offsetting physical or cash instrument for protection. Such activity can lead to unlimited losses.17. Option - Gives the buyer the right, but not the obligation, to buy or sell stock at a set price on or before a given date. Investors who purchase call options bet the stock will be worth more than the price set by the option (the strike 65
    • BASICS OF DERIVATIVES price), plus the price they paid for the option itself. Buyers of put options bet the stocks price will go down below the price set by the option.18. Out-of-the money option – An option with no intrinsic value. A call option is out-of-the money if its strike price is above the underlying and a put option is so if its below the underlying.19. Premium - The price of an option contract, determined on the exchange, which the buyer of the option pays to the option writer for the rights to the option contract.20. Spread – The difference between the bid and asked prices in any market.21. Stop-loss orders – An order placed in the market to buy or sell to close out an open position in order to limit losses when the market moves the wrong way.22. Straddle – The simultaneous purchase and sale of the same commodity to different delivery months or different strategies.23. Swap – An agreement to exchange one currency or index return for another, the exchange of fixed interest payments for a floating rate payments or the 66
    • BASICS OF DERIVATIVES exchange of an equity index return for a floating interest rate.24. Underlying – The currency, commodity, security or any other instrument that forms the basis of a futures or options contract.25. Writer – The person who originates an option contract by promising to perform a certain obligation in return for the price of the option. Also known as Option Writer.26. All-or nothing Option – An option with a fixed, predetermined payoff if the underlying instrument is at or beyond the strike price at expiration.27. Average Options - A path dependant option that calculates the average of the path traversed by the asset, arithmetic or weighted. The payoff therefore is the difference between the average price of the underlying asset, over the life of the option, and the exercise price of the option.28. Barrier Options - These are options that have an embedded price level, (barrier), which if reached will either create a vanilla option or eliminate the existence of a vanilla option. These are referred to as knock-ins/outs that are further explained below. The existence of predetermined price barriers in an option makes the probability of pay off all the more difficult. Thus the reason a 67
    • BASICS OF DERIVATIVES buyer purchases a barrier option is for the decreased cost and therefore increased leverage.29. Basket Option – A third party option or covered warrant on a basket of underlying stocks, currencies or commodities.30. Bermuda Option – Like the location of the Bermudas, this option is located somewhere between a European style option which can be exercised only at maturity and an American style option which can be exercised any time the option holder chooses. This option can be exercisable only on predetermined dates,31. Compound Options - This is simply an option on an existing option such as a call on a call, a put on a put etc, a call on a put etc.32. Cross-Currency Option – An outperformance option struck at an exchange rate between two currencies.33. Digital Options - These are options that can be structured as a "one touch" barrier, "double no touch" barrier and "all or nothing" call/puts. The "one touch" digital provides an immediate payoff if the currency hits your selected price barrier chosen at outset. The "double no touch" provides a payoff upon 68
    • BASICS OF DERIVATIVES expiration if the currency does not touch both the upper and lower price barriers selected at the outset. The call/put "all or nothing" digital option provides a payoff upon expiration if your option finishes in the money34. Knockin Options - There are two kinds of knock-in options, i) up and in, and ii) down and in. With knock-in options, the buyer starts out without a vanilla option. If the buyer has selected an upper price barrier and the currency hits that level, it creates a vanilla option with maturity date and strike price agreed upon at the outset. This would be called an up and in. The down and in option is the same as the up and in, except the currency has to reach a lower barrier. Upon hitting the chosen lower price level, it creates a vanilla option.35. Multi-Index Options – An outperformance option with a payoff determined by the difference in performance of two or more indices.36. Outperformance Option – An option with a payoff based on the amount by which one of two underlying instruments or indices outperforms the other.37. Rainbow Options - This type of option is a combination of two or more options combined each with its own distinct strike, maturity, etc. In order to achieve a payoff, all of the options entered into must be correct. 69
    • BASICS OF DERIVATIVES38. Quantity Adjusting Options (Quanto) - This is an option designed to eliminate currency risk by effectively hedging it. It involves combining an equity option and incorporating a predetermined fx rate. Example, if the holder has an in- the-money Nikkei index call option upon expiration, the quanto option terms would trigger by converting the yen proceeds into dollars which was specified at the outset in the quanto option contract. The rate is agreed upon at the beginning without the quantity of course, since this is an unknown at the time.39. Secondary Currency Option – An option with a payoff in a different currency than the underlying’s trading currency.40. Swaption – An option to enter into a swap contract.41. Tandem Options – A sequence of options of the same type, usually covering non-overlapping time periods and often with variable strikes.42. Up-and-Out Option – The call pays off early if an early exercise price trigger is hit. The put expires worthless if the market price of the underlying risks is above a pre-determined expiration price. 70
    • BASICS OF DERIVATIVES43. Zero Strike Price Option – An option with an exercise price of zero, or close to zero, traded on exchanges where there is transfer tax, owner restriction or other obstacle to the transfer of the underlying. 71
    • BASICS OF DERIVATIVESANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIAThe derivatives market in India has rapidly grown and is fast becoming verypopular. It is offering an alternate source for people to deploy investible surplusand make money out of itThe table below indicates the growth witnessed in the derivatives market.Month/ Index Futures Stock Futures Index Options Stock OptionsYear No. of Turnover No. of Turnover Call Put Call Put contracts (Rs. cr.) contracts (Rs. cr.) No. of Notional No. of Notional No. of Notional No. of Notional contracts Turnover contracts Turnover contracts Turnover contracts Turnover (Rs. cr.) (Rs. cr.) (Rs. cr.) (Rs. cr.)Jun.00 1,191 35 - - - - - - - - - -Jul.00 3,783 108 - - - - - - - - - -Aug.00 3,301 90 - - - - - - - - - -Sep.00. 4,376 119 - - - - - - - - - -Oct.00 6,388 153 - - - - - - - - - -Nov.00 9,892 247 - - - - - - - - - -Dec.003 9,208 237 - - - - - - - - - -Jan.01 17,860 471 - - - - - - - - - -Feb.01 19,141 524 - - - - - - - - - -Mar.01 15,440 381 - - - - - - - - - -00-01 90,580 2,365 - - - - - - - - - -Apr.01 13,274 292 - - - - - - - - - -May.01 10,048 230 - - - - - - - - - -Jun.01 26,805 590 - - 5,232 119 3,429 77 - - - -Jul.01 60,644 1,309 - - 8,613 191 6,221 135 13,082 290 4,746 106Aug.01 60,979 1,305 - - 7,598 165 5,533 119 38,971 844 12,508 263Sep.01 154,298 2,857 - - 12,188 243 8,262 169 64,344 1,322 33,480 690Oct.01 131,467 2,485 - - 16,787 326 12,324 233 85,844 1,632 43,787 801Nov.01 121,697 2,484 125,946 2,811 14,994 310 7,189 145 112,499 2,372 31,484 638Dec.01 109,303 2,339 309,755 7,515 12,890 287 5,513 118 84,134 1,986 28,425 674Jan.02 122,182 2,660 489,793 13,261 11,285 253 3,933 85 133,947 3,836 44,498 1,253Feb.02 120,662 2,747 528,947 13,939 13,941 323 4,749 107 133,630 3,635 33,055 864Mar.02 94,229 2,185 503,415 13,989 10,446 249 4,773 111 101,708 2,863 37,387 1,09401-02 1,025,588 21,482 1,957,856 51,516 113,974 2,466 61,926 1,300 768,159 18,780 269,370 6,383Apr.02 73,635 1,656 552,727 15,065 11,183 260 5,389 122 121,225 3,400 40,443 1,170May.02 94,312 2,022 605,284 15,981 13.07 294 7,719 169 126,867 3,490 57,984 1,643 Source: www.nseindia.com Note: 1.Stock futures were started only in November 2001 2.Index options and stock options were started only in June and July 2001 respectively 72
    • BASICS OF DERIVATIVES Growth of Derivatives in India 3000Value Rs Crores 2500 2000 1500 1000 500 0 Jun.00 Jun.01 Aug.00 Aug.01 Feb.01 Feb.02 Dec.003 Apr.01 Apr.02 Oct.00 Oct.01 From June 2000 to May 2002 Dec.01 73
    • BASICS OF DERIVATIVESANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULAThe options price for a Call, computed as per the following Black Scholesformula:C = S * N (d1) - X * e- rt * N (d2)and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)where :d1 >OQ 6;
    •  U12
    • W@1VTUW W
    • d2 >OQ 6;
    •  U12
    • W@1VTUW W
    • = d11VTUW W
    • C = price of a call optionP = price of a put optionS = price of the underlying assetX = Strike price of the optionr = rate of interestt = time to expiration1 YRODWLOLWRIWKHXQGHUOLQJN represents a standard normal distribution with mean = 0 and standarddeviation = 1ln represents the natural logarithm of a number. Natural logarithms are based onthe constant e (2.718). 74
    • BASICS OF DERIVATIVESANNEXURE 4- L C GUPTA COMMITTEE REPORT EXECUTIVE SUMMARY 1. The Committee strongly favours the introduction of financial derivatives in order to provide the facility for hedging in the most cost-efficient way against market risk. This is an important economic purpose. At the same time, it recognises that in order to make hedging possible, the market should also have speculators who are prepared to be counter-parties to hedgers. A derivatives market wholly or mostly consisting of speculators is unlikely to be a sound economic institution. A soundly based derivatives market requires the presence of both hedgers and speculators. 2. The Committee is of the opinion that there is need for equity derivatives, interest rate derivatives and currency derivatives. In the case of equity derivatives, while the Committee believes that the type of derivatives contracts to be introduced will be determined by market forces under the general oversight of SEBI and that both futures and options will be needed, the Committee suggests that a beginning may be made with stock index futures. 3. The Committee favours the introduction of equity derivatives in a phased manner so that the complex types are introduced after the market participants have acquired some degree of comfort and familiarity with the simpler types. This would be desirable from the regulatory angle too. 4. The Committees recommendations on regulatory framework for derivatives trading envisage two-level regulation, i.e. exchange-level and SEBI-level. The Committee’s main emphasis is on exchange-level regulation by ensuring that the derivative exchanges operate as effective self-regulatory organisations under the overall supervision of SEBI. 5. Since the Committee has placed considerable emphasis on the self-regulatory competence of derivatives exchanges under the over-all supervision and guidance of 75
    • BASICS OF DERIVATIVES SEBI, it is necessary that SEBI should review the working of the governance system of stock exchanges and strengthen it further. A much stricter governance system is needed for the derivative exchanges in order to ensure that a derivative exchange will be a totally disciplined market place.6. The Committee is of the opinion that the entry requirements for brokers/dealers for derivatives market have to be more stringent than for the cash market. These include not only capital adequacy requirements but also knowledge requirements in the form of mandatory passing of a certification program by the brokers/dealers and the sales persons. An important regulatory aspect of derivatives trading is the strict regulation of sales practices.7. Many of the SEBIs important regulations relating to exchanges, brokers-dealers, prevention of fraud, investor protection, etc., are of general and over-riding nature and hence, these should be reviewed in detail in order to be applicable to derivatives exchanges and their members.8. The Committee has recommended that the regulatory prohibition on the use of derivatives by mutual funds should go. At the same time, the Committee is of the opinion that the use of derivatives by mutual funds should be only for hedging and portfolio balancing and not for speculation. The responsibility for proper control in this regard should be cast on the trustees of mutual funds. The Committee does not favour framing of detailed SEBI regulations for this purpose in order to allow flexibility and development of ideas.9. SEBI, as the overseeing authority, will have to ensure that the new futures market operates fairly, efficiently and on sound principles. The operation of the underlying cash markets, on which the derivatives market is based, needs improvement in many respects. The equity derivatives market and the equity cash market are parts of the equity market mechanism as a whole. 76
    • BASICS OF DERIVATIVES10. SEBI should create a Derivatives Cell, a Derivatives Advisory Committee, and Economic Research Wing. It would need to develop a competence among its personnel in order to be able to guide this new development along sound lines.Chapter 1THE EVOLUTION AND ECONOMIC PURPOSEOF DERIVATIVES Appointment of the Committee1. The Committee was appointed by the Securities and Exchange Board of India (SEBI) by a Board resolution dated November 18, 1996 in order "to develop appropriate regulatory framework for derivatives trading in India". List of the Committee members is shown in the end2. The Committee’s concern is with financial derivatives in general and equity derivatives in particular. The evolution of derivatives3. The development of futures trading is an advancement over forward trading which has existed for centuries and grew out of the need for hedging the price-risk involved in many commercial operations. Futures trading represents a more efficient way of hedging risk. Futures vs. Forward contracts4. As both forward contracts and futures contracts are used for hedging, it is important to understand the distinction between the two and their relative merits. Forward contracts are private bilateral contracts and have well-established commercial usage. They are exposed to default risk by counterparty. Each forward contract is unique in terms of contract size, expiration date and the asset type/quality. The contract price is not 77
    • BASICS OF DERIVATIVES transparent, as it is not publicly disclosed. Since the forward contract is not typically tradable, it has to be settled by delivery of the asset on the expiration date.5. In contrast, futures contracts are standardized tradable contracts. They are standardized in terms of size, expiration date and all other features. They are traded on specially designed exchanges in a highly sophisticated environment of stringent financial safeguards. They are liquid and transparent. Their market prices and trading volumes are regularly reported. The futures trading system has effective safeguards against defaults in the form of Clearing Corporation guarantees for trades and the daily cash adjustment (mark-to-market) to the accounts of trading members based on daily price change. Futures are far more cost-efficient than forward contracts for hedging.6. Forward contracts are being used in India on a fairly large scale in the foreign exchange market for covering currency risk but there are neither currency futures nor any other financial futures in India at present. This report deals only with exchange-traded derivatives. Over-the-Counter derivatives are not covered here. A world-wide long-term process7. The evolution of markets in commodities and financial assets may be viewed as a worldwide long-term historical process. In this process, the emergence of futures has been recognized in economic literature as a financial development of considerable significance. A vast economic literature has been built around this subject. From "forward" trading in commodities emerged the commodity "futures". The emergence of financial futures is a more recent phenomenon and represents an extension of the idea of organized futures markets.8. Among financial futures, the first to emerge were currency futures in 1972 in U.S.A., followed soon by interest rate futures. Stock index futures and options first emerged in 1982 only. Since then, financial futures have quickly spread to an increasing number of developed and developing countries. They are recognized as the best and most cost- efficient way of meeting the felt need for risk-hedging in certain types of commercial and 78
    • BASICS OF DERIVATIVES financial operations. Countries not providing such globally accepted risk-hedging facilities are disadvantaged in today’s rapidly integrating global economy.9. The Committee noted that derivatives are not always clearly understood. A few well- publicized debacles involving derivatives trading in other countries had created widespread apprehensions in Indian public mind also. While the economic literature recognizes the efficiency-enhancing effect of derivatives on the economy in general and the financial markets in particular, the Committee feels that there is need for educating the public opinion as also the need to ensure effective regulatory checks. Such regulation should be aimed not only at ensuring the market’s integrity but also at enhancing the market’s economic efficiency and protecting investors. Derivatives concept10. The term "derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the cash asset. A derivative contract or product, or simply "derivative", is to be sharply distinguished from the underlying cash asset, i.e. the asset bought/sold in the cash market on normal delivery terms. A general definition of "derivative" may be suggested here as follows: "Derivative" means forward, future or option contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the value of specified real or financial asset or to index of securities.11. Derivatives are meant essentially to facilitate temporarily (usually for a few months) hedging of price risk of inventory holding or a financial/commercial transaction over a certain period. In practice, every derivative "contract" has a fixed expiration date, mostly in the range of 3 to 12 months from the date of commencement of the contract. In the market’s idiom, they are "risk management tools". The use of forward/futures contracts as hedging techniques is a well-established practice in commercial and industrial operations. Their application to financial transactions is relatively new, having emerged only about 25 years ago. 79
    • BASICS OF DERIVATIVES12. In order to illustrate the use of this risk hedging technique, we may take the familiar example of a processor or manufacturer, for whom an important source of risk is the fluctuation in the market price of his main raw material. For instance, a maker of gold jewellery may have accepted an export order to be delivered over the next three months. If, in the meanwhile, the cash price of gold (the raw material) rises, the jewellery maker’s manufacturing and exporting activity can become economically unviable. The availability of gold futures alleviates the manufacturer-exporter’s problem. He can buy gold futures. Any loss caused by rise in the cash price of gold purchased for the export order will then be offset by profit on the futures contract. Any extra profit due to fall in gold price will also be offset as there will be loss on the futures contract. Thus, hedging is the equivalent of insurance facility against risk from market price variation. A world without hedging facility is like a world without insurance with respect to the particular kind of risk.13. The manufacturer-exporter in the example given above could, of course, have bought all the raw material requirement in advance but that would have entailed heavy interest, insurance and storage costs. Thus, the facility of futures trading offers a cost-efficient and convenient way for hedging against price risk.14. Apart from the risk from variation of raw material price, the manufacturer-exporter, in the above example, also faces another risk from variation of exchange rate. If the rupee appreciates before he is able to bring the export proceeds into India, his rupee receipts would be reduced. He may hedge against such currency risk too. Both Futures and Options needed15. Futures and options have many similarities and serve similar purposes but the risk profile of an option contract is asymmetric and regulatory complexities are greater as compared to futures contract. Options are contracts giving the holder the right (but not the obligation) to buy (known as "call option") or sell (known as "put option") securities at a pre-determined price (known as "strike price" or "exercise price"), within or at the end of a specified period (known as "expiration period"). American options are exercisable at any 80
    • BASICS OF DERIVATIVES time prior to expiration date while European options can be exercised only at the expiration date. For the call option holder, it is worthwhile to exercise the right only if the price of the underlying securities rises above the exercise price. For the put option holder, it is worthwhile to exercise the right only if the price falls below the exercise price. There can be options on commodities, currencies, securities, stock index, individual stocks and even on futures. Options strategies can be highly complicated.16. In order to acquire the right of option, the option buyer pays to the option seller (known as "option writer") an Option Premium, which is the price paid for the right. The buyer of an option can lose no more than the option premium paid but his possible gain in unbounded. On the other hand, the option writer’s possible loss is unbounded but his maximum gain is limited to the "option premium" charged by him to the holder. The most critical aspect of options contracts is the evaluation of the fairness of option premium, i.e. option pricing.17. The Committee feels that the availability of both financial futures and options would provide to the users a wider choice of hedging instruments than any of them alone. Hedgers vs. Speculators18. Hedging is the key aspect of derivatives and also its basic economic purpose. In the U.S., the Commodity Futures Trading Commission (CFTC), the futures regulatory authority, while considering proposals for approval of a new derivative product, particularly examines the ability of the product to provide hedging. While the Committee has also emphasized the hedging aspect of derivatives, it fully recognises that the derivatives market’s capacity to absorb buying/selling by hedgers is directly dependent on the availability of speculators to act as counter-parties to hedgers. Hedging will not be possible if there are no speculators.19. For the above reason, decisions about many aspects of derivatives trading, e.g., contract size, design and duration, would have to strike a balance between the needs of the hedgers and the necessity to attract an adequate number of well-capitalised speculators 81
    • BASICS OF DERIVATIVES who are prepared to take upon themselves the price risk which hedgers want to give up. The fact is that a futures market, to be able to operate and be liquid, should have both hedging participation and speculative appeal. Some studies of futures markets in the U.S. have shown that hedging activity accounts for about 50-60 per cent of the market’s total volume. Remove prohibition on hedging by institutions20. The Committee is of the opinion that a futures market based wholly or mostly on speculation will not be a sound economic institution. There presently exist in India legal restrictions on the use of derivatives by investment institutions even for purposes of hedging. Such restrictions should be removed in the interest of the institutions themselves.21. In the case of a hedger, seeking to offset the price risk on his holding of inventory of bonds, equities, foreign currency or commodities by selling futures in the same, his position will as follows: Regarding Regarding futures Remarks Inventory transactions If price falls There will be loss There will be profit Hedger wants to on inventory held on futures Sold insure against the loss If price rises There will be Profit There will be loss The inventory profit on inventory on futures sold is Unanticipated and is neutralised by loss on futures. In the case of a pure speculator, as distinguished from a hedger, futures trading is a business by itself as he has no offsetting commercial position. He is not seeking to reduce or transfer risk. On the contrary, he is accepting risk in the pursuit of profit. It 82
    • BASICS OF DERIVATIVES is a highly specialised business. His success depends on his forecasting skills in regard to future prices of the particular commodity or financial asset traded in the futures market. The hedging test: practical importance21. The test of whether a futures transaction is for hedging or for speculation hinges on whether there already exists a related commercial position which is exposed to risk of loss due to price movement. The distinction between hedging and speculation is of great practical importance because some organisations, either by voluntary choice or by regulatory restriction, are allowed to hedge but not to speculate in the forward or futures markets. Financial Derivative Types18. The Committee’s main concern is with equity based derivatives but it has tried to examine the need for financial derivatives in a broader perspective. Financial transactions and asset-liability positions are exposed to three broad types of price risks, viz: a. equities "market risk", also called "systematic risk" (which cannot be diversified away because the stock market as a whole may go up or down from time to time). b. interest rate risk (as in the case of fixed-income securities, like treasury bond holdings, whose market price could fall heavily if interest rates shot up), and c. exchange rate risk (where the position involves a foreign currency, as in the case of imports, exports, foreign loans or investments). The above classification of price risks explains the emergence of (a) equity futures, (b) interest rate futures and (c) currency futures, respectively. Equity futures have been the last to emerge. 83
    • BASICS OF DERIVATIVES Need for coordinated development23. The recent report of the RBI-appointed Committee on Capital Account Convertibility (Tarapore Committee) has expressed the view that "time is ripe for introduction of futures in currencies and interest rates to facilitate various users to have access to a wide spectrum of cost-efficient hedge mechanism" (p.24). In the same context, the Tarapore Committee has also opined that "a system of trading in futures ... is more transparent and cost-efficient than the existing system (of forward contracts)".24. There are inter-connections among the various kinds of financial futures, mentioned above, because the various financial markets are closely inter-linked, as the recent financial market turmoil in East and South-East Asian countries has shown. The basic principles underlying the running of futures markets and their regulation are the same. 1 Having a common trading infrastructure will have important advantages. The Co mmittee, therefore, feels that the attempt should be to develop an integrated market structure. SEBI-RBI coordination mechanism25. As all the three types of financial derivatives are set to emerge in India in the near future, it is desirable that such development be coordinated. The Committee recommends that a formal mechanism be established for such coordination between SEBI and RBI in respect of all financial derivatives markets. This will help to avoid the problem of overlapping jurisdictions.Chapter 2 USES OF EQUITY DERIVATIVES Survey findings about potential for financial derivatives in India 1. The Committee made an assessment of the nature of felt-need and interest in the various types of financial derivatives among potential market participants through a Questionnaire-based survey. The survey covered all 84
    • BASICS OF DERIVATIVES types of potential players in the derivatives market, such as mutual funds, other financial institutions, commercial banks, investment bankers and stockbrokers. Out of about 300 Questionnaires sent out by the Committee in May 1997, the number of replies received was 112, comprising 67 brokers and 45 others. In addition, the Committee held a full day session to interact with groups representing each of the above categories of interests. A total of about 35 persons attended the group-wise discussions.2. The survey clearly revealed that there was wide recognition of the need for all the three major types of financial derivatives, viz., equity derivatives, interest rate derivatives and currency derivatives. The results of the survey are summarized in Table 2.1 given at the end of this chapter.3. Interestingly, the survey findings showed that stock index futures ranked as the most popular and preferred type of equity derivative, the second being stock index options and the third being options on individual stocks. Considerable interest exists in all the three types of equity derivatives mentioned above. The fourth type, viz. individual stock futures, was favoured much less. It is pertinent to note that the U.S.A. does not permit individual stock futures. Only one or two countries in the world are known to have futures on individual stocks. Stock Index Futures are internationally the most popular forms of equity derivative.4. The difference in relative preferences among the various financial derivative types is shown more sharply when we look at answers to the question: Which of the derivative products should be introduced first? The respondents who placed stock index futures as first represented 65% of the sample, 85
    • BASICS OF DERIVATIVES compared to 39 per cent who placed stock index options as first (see Table 2.1).5. The survey also showed that there exists widespread demand for hedging facility, as indicated by the finding that nearly 70% of the respondents in our sample indicated that they would like to use the various types of equity derivatives for hedging purpose. On the other hand, about 39% of respondents would like to participate in the derivatives market as dealer/speculator, 64% as broker and only about 36% as option writer. Many of the respondents would like to participate in more than one capacity.6. In terms of contract duration of Stock Index futures and options, the 3 months duration was the most favoured, as may be expected. As regards the choice between the American and European types of options, the former was favoured overwhelmingly.7. As regards expectations of growth of stock index futures and options trading in India, about 33% of respondents expected it to grow very fast, 41% expected it to grow moderately and the remaining 16% expected slow growth of trading. On the whole, the survey findings are very positive about the need and prospects of equity derivatives trading in India. Popularity of Stock Index FuturesThere are many reasons for the wide international acceptance of stock indexfutures and for the strong preference for this instrument in India too compared toother forms of equity derivatives. This is because of the following advantages ofstock index futures :1. Institutional and other large equityholders need portfolio hedging facility. Hence, index-based derivatives are more suited to them and more cost- effective than derivatives based on individual stocks. Even pension funds in U.S.A. are known to use stock index futures for risk hedging purposes. 86
    • BASICS OF DERIVATIVES2. Stock index is difficult to be manipulated as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply which can be cornered. Of course, manipulation of stock index can be attempted by influencing the cash prices of its component securities. While the possibility of such manipulation is not ruled out, it is reduced by designing the index appropriately. There is need for minimizing it further by undertaking cash market reforms, as suggested by the Committee later in this chapter.3. Stock index futures enjoy distinctly greater popularity, and are, therefore, likely to be more liquid than all other types of equity derivatives, as shown both by responses to the Committee’s questionnaire and by international experience.4. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements in the case of index futures than in the case of derivatives on individual stocks. The lower margins will induce more players to join the market.5. In the case of individual stocks, the positions which remain outstanding on the expiration date will have to be settled by physical delivery. This is an accepted principle everywhere. The futures and the cash market prices have to converge on the expiration date. Since Index futures do not represent a physically deliverable asset, they are cash settled all over the world on the premise that the index value is derived from the cash market. This, of course, implies that the cash market is functioning in a reasonably sound manner and the index values based on it can be safely accepted as the settlement price. 87
    • BASICS OF DERIVATIVES 6. Regulatory complexity is likely to be less in the case of stock index futures than for other kinds of equity derivatives, such as stock index options, or individual stock options.Cash and futures market relationship 1. The objective of SEBI is to make both derivatives market and cash market fair, efficient and transparent. Economically, it is important to realise that equity cash market and equity derivatives market are of one piece. Their sound development is inter-related closely. The Committee has kept this objective in view and would like to ensure that the new derivatives market is developed along sound lines. This objective can best be achieved by separating cash market and futures market and thereby regulating them effectively. At present, almost 90 per cent of the trading volume in the cash market does not settle in deliveries of the stock. The great bulk (over 85 per cent) of such trading is in 5 scrips only. The Committee noted that several earlier committees on stock exchange reforms, including the G.S. Patel Committee (1984-85), had expressed concern at the small percentage of deliveries in Indian exchanges. They had also lamented the illiquidity of a majority of listed shares and the practice of switching of positions from one exchange to another due to different exchanges having different settlement cycles. 2. The Committee hopes that some of the speculative transactions, which are presently conducted in the cash market, would be attracted towards the proposed derivatives market. 3. The Committee recognises that an efficient cash market is required for an efficient futures market. The Committee also recognises the danger that if the cash market behaviour is erratic or does not reflect fundamentals, a futures 88
    • BASICS OF DERIVATIVES market, based on such a cash market, will fail to give a correct indication of future spot prices and its usefulness for price discovery will be reduced.4. The Committee is of the opinion that the following revisions could lead to a further strengthening of the underlying cash market:a. uniform settlement cycle among all the stock exchanges moving towards rolling settlement cycles to prevent the cash market from effectively being used as an unregulated futures market;b. strengthening of administrative machinery of the existing stock exchanges wherever necessary to tighten the exchange’s regulatory oversight; such tight supervision being essential for successful derivatives trading.c. speeding up dematerialisation of securities without which options on individual securities should not be allowed as non-dematerialised securities involve settlement delays and problems; allowing options without dematerialisation is likely to make the options market manipulable; andd. taking steps to encourage more delivery based transactions in a greater number of securities.The Committee is of the view that arbitrage transactions between the indexfutures market and the cash market for equities is likely to have a beneficialeffect on the functioning of the cash market in terms of price discovery,broadening of liquidity and over-all efficiency. Strengthening the influence of fundamental factors1. The Committee thought of ways to ensure that fundamental factors adequately enter into the price discovery process in the cash market and, through it, in the futures market. In this connection, the Committee noted that it was important in the case of futures markets, whether commodity futures or other futures, to assist the price discovery process by promoting the dissemination of all relevant market information about the "real" factors, such 89
    • BASICS OF DERIVATIVES as supplies, demand, prospects, etc. In regard to stock index futures, the Committee feels that there are two important ways of promoting its linkage to fundamental factors. First, there must be a requirement that average P/E ratio of the index used for futures trading should be made available by the exchange concerned on daily basis as essential market information. Second, the arbitrage between the index futures market and the cash market for the shares composing the index should be facilitated by requiring such shares to be traded in the depository mode and also by making available the facility of stock borrowing so that short-selling is rendered possible. Strategic uses of stock index futures2. It was represented to the Committee by mutual funds and other financial institutions that they were handicapped in their investment strategy because of the non-availability of portfolio hedging facility in India. They need derivatives, not for generating speculative profits, but for strategic purposes of controlling risk or restructuring portfolios. Given below are some practical examples from a presentation made before the Committee by some institutional representatives :i. Reducing the equity exposure in a mutual fund scheme: Suppose that a balanced mutual fund scheme decides to reduce its equity exposure from, say, 40% to 30% of the corpus. Presently, this can be achieved only by actual selling of equityholdings. Such selling entails three problems: first, it is likely to depress equity prices to the disadvantage of the Scheme and the whole market; second, it cannot be achieved speedily and may take some months, and third, it is a costly procedure because of brokerage, etc. The same objective can be achieved through index futures at once, at much less cost and with much less impact on the cash market. The scheme may immediately sell index futures. The actual sale of equityholdings may be 90
    • BASICS OF DERIVATIVES done gradually depending on market conditions in order to realise the best possible prices. As unloading of holdings progresses, the index futures transaction may be unwound by an opposite transaction to the same extent.ii. Investing the funds raised by new schemes: When a new scheme is floated, the money raised does not get fully invested for considerable time. Suitable securities at reasonable prices may not be immediately available in sufficient quantity. Rushing to invest the whole money is likely to drive up prices to the disadvantage of the scheme. Timing is important in the case of equity schemes. If the scheme is launched to take advantage of low equity prices, such advantage may be lost due to delay in acquiring suitable securities as the market situation may change. The availability of stock index futures can take care of this entire problem.iii. Partial liquidation of portfolio in case of open-ended fund: In the case of an open-ended scheme, repurchases may sometimes necessitate liquidation of a part of the portfolio but there are problems in executing such liquidation. Selling each holding in proportion to its weight in the portfolio is often impracticable. Some of the holdings may be relatively illiquid. Rushing to the cash market to liquidate would drive down prices. The price actually realised may be different from the price used in NAV computation for repurchase. The timing of liquidation may not be right because of market depression. Stock Index Futures can help to overcome these problems to the advantage of unitholders.iv. Preserving the value of portfolio during times of market stress: There are times when the main worry is the possibility that the value of the entire equity portfolio may fall substantially if, say, event "X" occurs. Sale of Stock Index Futures can be used to insure against the risk. Such insurance is specially important if the accounts closing date is nearby because the yearly results 91
    • BASICS OF DERIVATIVES will get affected if the risk materialises. Stock index futures can neutralise such risk. v. International investors: The buying and selling operations of FIIs presently cause disproportionate price-effect on the Indian equities market because all transactions are through the cash market only. This is an important factor making the Indian equities market highly volatile from day to day. The FIIs buying/selling is aimed at either increasing or reducing their exposure to the Indian equities market. In other words, what the FIIs buy/sell is a "piece" of the whole Indian equities market. If stock index futures are available, this can be carried out with greater speed and less cost and without adding too much to market volatility. The FII flows show sudden changes from time to time. While trying to maximise the net inflow of FII portfolio investment, its disturbing effects on the cash market for Indian equities can possibly be minimised if the facility of stock index futures is available. The availability of such a hedging device is likely to increase the international investors appetite for Indian equities.Phasing needed 1. The Committee believes that the types of equity derivatives to be introduced in India should ultimately be left to the market forces under over-all general supervision of SEBI. It is likely to be an evolutionary process, as has been the case in other countries. The experience in other countries also shows that only a small proportion of new futures contracts prove to be successful and survive for long. The market decides which ones will succeed. 2. The consensus in the Committee was that stock index futures would be the best starting point for equity derivatives in India. The Committee has arrived at this conclusion after careful examination of all aspects of the problem, including the survey findings and regulatory preparedness. The Committee 92
    • BASICS OF DERIVATIVES would favour the introduction of other types of equity derivatives also, as the derivatives market grows and the market players acquire familiarity with its operations. Other equity derivatives include options on stock index or on individual stocks. There may also be room for more than one stock index futures. It is bound to be a gradual process, shaped by market forces under the over-all supervision of SEBI. One member of the Committee, i.e. Mr. P.S. Mistry, formally dissociated himself from the consensus mentioned above by favouring the introduction of options contracts before the introduction of futures. The enabling legal changes 3. It is understood that the Central Government is already considering the legal action required in order to enable the use of stock index derivatives by expanding the definition of "securities" under Section 2(h)(iia) of the Securities Contracts (Regulation) Act, 1956, by declaring derivatives contracts based on index of prices of securities and other derivatives contracts to be securities. The Committee recommends that this should be done expeditiously. The Committee also recommends that the notification issued by the Central Government in June 1969 under Section 16 of the SC(R)A be amended so as to enable trading in futures and options contracts. The prohibition of trading in options on securities has already been withdrawn by the Securities Laws Amendment Act with effect from January 25, 1995.Table 2.1ANALYSIS OF REPLIES TO THE COMMITTEE’S QUESTIONNAIREADDRESSED TO POTENTIAL PLAYERS IN THE FINANCIALDERIVATIVE MARKET IN INDIA 93
    • BASICS OF DERIVATIVESQ. No. Question Number and percentage of affirmative replies (Total respondents=112) Number % to total1a. Which risks are of most concern in your operations? i. Systematic risk 96 85.71 Interest rate risk 35 32.25 Exchange rate risk 27 24.11 Default risk 71 63.39 Asset-liability mismatch 23 20.54 Any other 11 9.821c. Are you handicapped because index-based futures and 85 75.89 options are not available in India?2a. Is there a need for having i. Stock Index Futures 98 87.50 Stock Index Options 92 82.14 Futures on Individual Stocks 71 63.39 Options on Individual Stocks 90 80.36 Interest rate futures 68 60.71 Currency futures 67 59.822b. Which of the above do you favour most? i. Stock Index Futures 73 65.28 Stock Index Options 45 40.18 Futures on Individual Stocks 22 19.64 94
    • BASICS OF DERIVATIVES Options on Individual Stocks 32 28.57 Interest rate futures 21 18.75 Currency futures 14 12.53a. In which of the following would you like to participate? i. Stock Index Futures 92 82.14 Stock Index Options 82 73.21 Futures on Individual Stocks 61 54.46 Options on Individual Stocks 78 69.64 Interest rate futures 43 38.39 Currency futures 37 33.043b. Which of the derivative products mentioned above should be introduced first? i. Stock Index Futures 73 65.18 Stock Index Options 44 39.29 Futures on Individual Stocks 14 12.5 Options on Individual Stocks 15 13.39 Interest rate futures 13 11.61 Currency futures 7 6.254a. In the case of the first four products mentioned in the previous question will you like to participate as: i. hedger 78 69.64 dealers/speculators 44 39.29 broker 72 64.29 95
    • BASICS OF DERIVATIVES option writer 40 35.71 any other 6 5.364c. Which derivative product is likely to be the most popular in India? i. Stock Index Futures 63 56.25 Stock Index Options 40 35.71 Futures on Individual Stocks 23 20.54 Options on Individual Stocks 38 33.93 Interest rate futures 8 7.14 Currency futures 7 6.255a. Which derivative product are needed most in India for improving stock market efficiency? i. Stock Index Futures 66 58.93 Stock Index Options 47 41.96 Futures on Individual Stocks 35 31.25 Options on Individual Stocks 36 32.14 Interest rate futures 6 5.36 Currency futures 2 1.796a. Do you expect that the trading in Stock Index Futures and Options in India will i. Grow very fast 37 33.03 Grow moderately 46 41.07 Grow slowly 18 16.07 Not grow much 2 1.79 96
    • BASICS OF DERIVATIVES Can’t say anything 2 1.7911. What contract maturity period would interest you for trading in: i. Stock Index Futures and Options 3 months 93 83.04 6 months 70 62.50 9 months 37 33.04 12 months 35 31.25 (ii) Futures and Options on Individual Stocks 3 months 88 78.57 6 months 60 53.57 9 months 27 24.11 12 months 31 27.6812. In case of Options do you favour: i. American 79 70.54 European 30 26.79 Note: Questions 2b, 3b and 4c expected respondents to tick against one type only but some respondents ticked more than one, resulting in double counting. Hence, the percentages add to more than 100. This does not, however, vitiate the relative comparison among the derivative types. Chapter 3 REGULATORY FRAMEWORK FOR DERIVATIVES: THE GUIDING PRINCIPLES Regulatory objectives 97
    • BASICS OF DERIVATIVES1. The Committee believes that regulation should be designed to achieve specific, well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behaviour. It has been guided by the following objectives :a. Investor Protection: Attention needs to be given to the following four aspects: i. Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices adopted by dealers for derivatives would require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere, the underlying reason was inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. These experiences provide useful lessons for us for designing regulations. ii. 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 brokers own debts. It should be ensured that trading by dealers on own account is totally segregated from that for clients. iii. Competent and honest service: The eligibility criteria for trading members should be designed to encourage competent and qualified 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. 98
    • BASICS OF DERIVATIVES iv. Market integrity: The trading system should ensure that the markets integrity is safeguarded by minimising the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation, etc.a. 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.b. 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.1. Of course, the ultimate objective of regulation of financial markets has to be to promote more efficient functioning of markets on the "real" side of the economy, i.e. economic efficiency.2. Leaving aside those who use derivatives for hedging of risk to which they are exposed, the other participants in derivatives trading are attracted by the speculative opportunities which such trading offers due to inherently high leverage. For this reason, the risk involved for derivative traders and speculators is high. This is indicated by some of the widely publicised mishaps in other countries. Hence, the regulatory frame for derivative trading, in all its aspects, has to be much stricter than what exists for cash trading. The scope of regulation should cover derivative exchanges, derivative traders, brokers and sales-persons, derivative contracts or products, derivative trading rules and derivative clearing mechanism.3. In the Committees view, the regulatory responsibility for derivatives trading will have to be shared between the exchange conducting derivatives trading 99
    • BASICS OF DERIVATIVES on the one hand and SEBI on the other. The committee envisages that this sharing of regulatory responsibility is so designed as to maximise regulatory effectiveness and to minimise regulatory costs. Major issues concerning regulatory framework 4. The Committees attention had been drawn to several important issues in connection with derivatives trading. The Committee has considered such issues, some of which have a direct bearing on the design of the regulatory framework. They are listed below : a. Should a derivatives exchange be organised as independent and separate from an existing stock exchange? b. What exactly should be the division of regulatory responsibility, including both framing and enforcing the regulations, between SEBI and the derivatives exchange? c. How should we ensure that the derivatives exchange will effectively fulfill its regulatory responsibility. d. What criteria should SEBI adopt for granting permission for derivatives trading to an exchange? e. What conditions should the clearing mechanism for derivatives trading satisfy in view of high leverage involved? f. What new regulations or changes in existing regulations will have to be introduced by SEBI for derivatives trading?Should derivatives trading be conducted in a separate exchange? 1. A major issue raised before the Committee for its decision was whether regulations should mandate the creation of a separate exchange for derivatives trading, or allow an existing stock exchange to conduct such trading. The Committee has examined various aspects of the problem. It has also reviewed the position prevailing in other countries. Exchange-traded 100
    • BASICS OF DERIVATIVES financial derivatives originated in USA and were subsequently introduced in many other countries. Organisational and regulatory arrangements are not the same in all countries. Interestingly, in U.S.A., for reasons of history and regulatory structure, futures trading in financial instruments, including currency, bonds and equities, was started in early 1970s, under the auspices of commodity futures markets rather than under securities exchanges where the underlying bonds and equities were being traded. This may have happened partly because currency futures, which had nothing to do with securities markets, were the first to emerge among financial derivatives in U.S.A. and partly because derivatives were not "securities" under U.S. laws. Cash trading in securities and options on securities were under the Securities and Exchange Commission (SEC) while futures trading was under the Commodities Futures Trading Commission (CFTC). In other countries, the arrangements have varied. 2. The Committee examined the relative merits of allowing derivatives trading to be conducted by an existing stock exchange vis-a-vis a separate exchange for derivatives. The arguments for each are summarised below.Arguments for allowing existing stock exchanges to start futures trading: a. The most weighty argument in this regard is the advantage of synergies arising from the pooling of costs of expensive information technology networks and the sharing of expertise required for running a modern exchange. Setting-up a separate derivatives exchange will involve high costs and require more time. b. The recent trend in other countries seems to be towards bringing futures and cash trading under coordinated supervision. The lack of coordination was recognised as an important problem in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level supervisory coordination between futures 101
    • BASICS OF DERIVATIVES and cash markets is greatly facilitated if both are parts of the same exchange. Arguments for setting-up separate futures exchange: a. The trading rules and entry requirements for futures trading would have to be different from those for cash trading. b. The possibility of collusion among traders for market manipulation seems to be greater if cash and futures trading are conducted in the same exchange. c. A separate exchange will start with a clean slate and would not have to restrict the entry to the existing members only but the entry will be thrown open to all potential eligible players.Recommendation From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility conditions as indicated below : 1. The trading should take place through an online screen-based trading system, which also has a disaster recovery site. The per-half-hour capacity of the computers and the network should be at least 4 to 5 times of the anticipated peak load in any half- hour, or of the actual peak load seen in any half-hour during the preceding six months. This shall be reviewed from time to time on the basis of experience. 2. The clearing of the derivatives market should be done by an independent clearing corporation, which satisfies the conditions listed in a later chapter of this report. 3. The exchange must have an online surveillance capability which monitors positions, prices and volumes in real-time so as to deter market manipulation. Price and position limits should be used for improving market quality. 102
    • BASICS OF DERIVATIVES 4. Information about trades, quantities, and quotes should be disseminated by the exchange in real-time over at least two information vending networks which are accessible to investors in the country. 5. The Exchange should have at least 50 members to start derivatives trading. 6. If derivatives trading is to take place at an existing cash market, it should be done in a separate segment with a separate membership; i.e., all members of the existing cash market would not automatically become members of the derivatives market. 7. The derivatives market should have a separate governing council which shall not have representation of trading/clearing members of the derivatives Exchange beyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. 8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a member of the Governing Council. If the Chairman is a Broker/Dealer, then, he shall not carry on any Broking or Dealing Business on any Exchange during his tenure as Chairman. 9. The exchange should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country. 10. The exchange should have an adequate inspection capability. 11. No trading/clearing member should be allowed simultaneously to be on the governing council of both the derivatives market and the cash market. 12. If already existing, the Exchange should have a satisfactory record of monitoring its members, handling investor complaints and preventing irregularities in trading. 3.9 The next chapter will elaborate how the regulatory responsibilities placed on the derivative exchange and the SEBI are to be carried out in a dovetailed manner. Chapter 4 DIVISION OF REGULATORY RESPONSIBILITYTwo levels of regulation 103
    • BASICS OF DERIVATIVES1. The task entrusted to the Committee is to develop the "regulatory framework for derivatives trading". Such regulatory framework really comprises two distinct levels, viz.(1) a derivatives exchanges own operational rules and regulations and (2) SEBI rules and regulations with which the exchange and its members must comply. The Committee feels that since the Securities Contracts (Regulation) Act, 1956 and the Rules framed thereunder, SEBI Act and various Rules and Regulations regarding stock exchanges and brokers/dealers are of general and over-riding nature, they could be reviewed and designed to be applicable equally to derivatives exchanges also. Emphasis on exchange-level regulation2. A crucial pre-condition for the success of derivatives trading is that the derivatives exchange should be capable of acting as an effective self- regulator on its own. In the Committees opinion, the derivatives exchange, being in day to day touch with the market, will be in a position to spot a problem and take prompt corrective action. As a statutory body, SEBI will first have to enquire, collect all the facts and go through a certain statutory procedure before acting. In addition, the regulatory costs can also be minimised by shifting the administrative and compliance costs as much as possible to the exchanges which are the beneficiaries from the business opportunity provided. These considerations have led the Committee to emphasize that a derivatives exchange should be designed, right from the start, as a competent and effective regulating organisation in every possible way. Governance of derivative exchange3. The Committee was informed about the regulatory concerns regarding the working of governance system in many stock exchanges and took note of reported problems in this area. The Committee regards this as important 104
    • BASICS OF DERIVATIVES matter in the context of introducing derivatives. The Committee recommends that SEBI should review its own experience of the present stock exchange governance system in terms of how far the system has been able to ensure the functioning of stock exchanges as effective self-regulatory organisations and what further improvements, if any, are needed. As most of the regulatory responsibility in regard to derivatives trading has to be carried out by the exchanges themselves and any slackness in this regard can be disastrous, it is necessary to ensure that a proper governance structure is in place. If necessary, SEBI may lay down a separate governance structure for exchanges which are allowed to have derivatives trading.4. Most of the new regulations required for derivatives trading are exchange- level regulations. Such regulations have necessarily to be very detailed and highly technical. It will require the formulation of detailed rules, regulations and bye-laws and the creation of a really effective monitoring and enforcement mechanism, covering all aspects of the exchanges operation. The exchange-level regulations include entry requirements for derivatives traders/members, design of derivatives contracts, broker-client relationship including sales procedures and risk disclosure to clients, trading and reporting procedures, internal risk control systems, margining, clearing, settlement and dispute resolution. In the Committees opinion, a derivatives exchange must necessarily be consciously designed to play the role of effective self-regulator. This is so important that if there is any doubt in the exchanges ability in this regard, SEBI should not allow it to conduct derivatives trading. The role of SEBI will be to provide over-all supervision and guidance to the exchange and to act as the regulator of last resort.5. The Committee is of the view that all the above regulations have to be much stricter for derivatives trading than the existing regulations for cash trading. 105
    • BASICS OF DERIVATIVES Another demanding requirement is that derivatives trading, clearing, settlement, margining, reporting and monitoring, all involve the application of most modern on-line screen-based systems which should be designed to be both fool-proof and fail-proof.6. The Committee also feels that every derivative trader/member (not just 10 per cent of them) should be inspected by the derivative exchange annually, both to provide guidance in the initial years and to check compliance. This is particularly important at the initial stage of derivatives trading. The derivative exchange should be required to have a strong inspection department. Its staff should be given specialised training for the purpose. SEBIs Regulatory Responsibility7. SEBI should approve the rules, bye-laws and regulations of the derivative exchange and should also approve the proposed derivative contracts before commencement of trading. Any change in the rules, bye-laws and regulations of the Derivative Exchange would need prior approval of SEBI.8. The Committee feels that SEBI need not be involved in framing exchange- level rules but it should evaluate them, identify deficiencies and suggest improvements. Its regulatory staff should have a thorough understanding of the theory and practice of financial derivatives so that it can provide guidance and can evaluate various kinds of derivative products. SEBIs overseeing function cannot be delegated. SEBI will have to acquire the necessary expertise by training its own people and recruiting some specialized personnel. SEBI will function as an overseeing authority. It would have to be closely involved in guiding this new and complex development along right lines. It would have to ensure a successful launch of futures trading in India by providing appropriate guidance and over-all supervision of the process. Such success will be beneficial for the countrys economy and will bring 106
    • BASICS OF DERIVATIVES credit to SEBI. SEBIs obligation to oversee the functioning of derivatives exchange is bound to be a demanding task in terms of new knowledge and understanding required by its staff. Regulatory review of Derivative Contract9. In most countries regulatory approval is required for new derivatives contracts to be traded. The regulatory authority has to determine whether such trading would be in public interest. In U.S.A., the Commodities Trading Futures Commission, before granting its approval to a new contract, has to be satisfied that the contract would serve an economic purpose, such as making fairer pricing possible or making hedging possible. Providing an arena for speculation is not regarded as enough to show that a futures contract would serve an economic function. According to the information provided to the Committee by courtesy of Price Waterhouse LLP under USAIDs FIRE Project, more than 90 per cent of countries with established derivatives markets use a contract review procedure as a threshold test to permit a new derivatives contract to trade on an authorised derivative exchange.10. The Committee suggests that before starting trading in a new derivatives product, the derivatives exchange should submit the proposal for SEBIs approval, giving (a) full details of the proposed derivatives contract to be traded (b) the economic purposes it is intended to serve (c) its likely contribution to the markets development and (d) the safeguards incorporated to ensure protection of investors/clients and fair trading. SEBI officers should be in a position to provide effective supervision and constructive guidance in this regard. SEBI Derivative Cell, Advisory Council and Economic Research Wing 107
    • BASICS OF DERIVATIVES 11. In view of what has been said above, the Committee recommends the following steps to be taken by SEBI : a. SEBI should immediately create a special Derivatives Cell because derivatives demand special knowledge. It should encourage its staff members to undergo training in derivatives and also recruit some specialised personnel. b. A Derivatives Advisory Council may also be created to tap the outside expertise for independent advice on many problems which are bound to arise from time to time in regard to derivatives. c. SEBI should urgently consider the creation of an Economic Research Wing. Complex economic questions arise about derivatives, e.g. their effect on cash market volatility and price discovery. Many such questions have been raised from time to time in other countries. Administrative persons are unlikely to have the time to study and analyse data. They can be usefully assisted by the Economic Research Wing. SEBI, as the countrys capital market authority, should be regularly conducting studies of critical problems affecting the market and collecting data. 4.12 The division of regulatory responsibility at two levels as suggested above by the Committee, is aimed at securing the triple advantages of (a) permitting desirable flexibility, (b) maximising regulatory effectiveness and (c) minimising regulatory cost.Chapter 5 SPECIAL ENTRY RULES FOR DERIVATIVES BROKERS/DEALERS No automatic entry for existing stock brokers 1. The Committee feels that the derivatives market will have to be subjected to more stringent requirements than is the case with present cash markets. This implies that when an existing exchange decides to start derivatives trading, 108
    • BASICS OF DERIVATIVES the members of the existing cash market will not automatically become members of the derivatives market. Only those who satisfy the stricter eligibility conditions of the derivatives market will be admitted to derivatives trading. Capital adequacy2. The experience of Indian exchanges has been that the credibility of the broker firm’s balance sheet figures of networth is questionable and that, in any case, a broker’s or dealer’s stated networth is very often not available to meet the claims payable to the exchange. Hence, for effectively ensuring capital adequacy, principal reliance has to be placed on the capital and margins actually deposited by the brokers/dealers with the exchange. Taking note of the above, the views of the Committee regarding capital adequacy requirements for derivatives brokers/dealers are presented below:Guiding considerationsa. The absolute amount of minimum capital adequacy requirement for derivative brokers/dealers has to be much higher than for cash market. Further, if a broker/dealer is involved both in cash and futures segments, or in several exchanges, the capital adequacy requirement should be satisfied for each exchange/segment separately. A decision on minimum capital adequacy requirement involves balancing the need for ensuring market’s integrity against the need for having sufficient participation of brokers/dealers and sufficient competition. Too high a requirement may keep most Indian firms out of the derivatives market. Clearing and Non-clearing membersb. In order to somewhat ease the constraint on participation in the derivatives market due to high capital adequacy requirements, the Committee recommends that consideration may be given to a two-level system of 109
    • BASICS OF DERIVATIVES members, viz., Clearing Members and Non-Clearing Members, as found in several countries, an example being the Singapore International Monetary Exchange. Under such a system, networth requirement for the Clearing Members is higher than for the Non-Clearing members. The Non-Clearing members have to depend on the Clearing Members for settlement of trades. The Clearing Member has to take responsibility for the non-clearing member’s position so far as the Clearing Corporation is concerned. The Clearing Member thus becomes the guarantor for the Non-Clearing members. In a sense, a Clearing Member has a number of satellite traders for whom he takes financial responsibility towards the Clearing Corporation. The advantage of the two-level system is that it can help to bring in more traders into derivatives trading, thus enhancing the market’s liquidity.Networth and initial margin1. The Committee recommends that the Clearing Members of the derivatives exchange should have a minimum net worth of Rs. 300 lakh as per SEBI’s definition and shall make a deposit of Rs.50 lakh with the Exchange/Clearing Corporation in the form of liquid assets, such as Cash, Fixed Deposits pledged in the name of the Exchange, or other securities. Bank Guarantee in lieu of such deposit may also be accepted. The Clearing Corporation can permit clearing members to clear the trades of non-clearing trading members. The regulations for the non-clearing trading members shall be specified by the Derivatives Exchange/Division. The Committee further recommends that the requirement of minimum networth and deposit in case of Option writers will need to be still higher. Certification Requirement 110
    • BASICS OF DERIVATIVES 2. The broker-members, sales persons/dealers in the derivatives market must have passed a certification programme which is considered adequate by SEBI. Registration with SEBI 3. Brokers/dealers of Derivatives Exchange/Division should be required to be registered as such with SEBI. This would be in addition to their registration as brokers/dealers of any stock exchange. SEBI may require registration of sales persons working at Derivatives brokerage firms.Chapter 6CLEARING CORPORATION Importance of separate Clearing Corporation 6.1In the Committee’s view, the clearing mechanism should be organised as separate and independent entity, preferably in the form of a Clearing Corporation. Clearing Corporation should become a legal counterparty to all trades and be responsible for guaranteeing settlement for all open positions. Hence, if any Clearing Member defaults, settlement for other Clearing Members would not be affected. This would protect the reputation of the Exchange and would minimise the default risk of trading/clearing members as the risks arising from insolvency of any individual Clearing Member are shouldered effectively by the Clearing Corporation. The credibility of the Clearing Corporation, therefore, will have to be assured. 6.2 The Clearing Corporation will collect initial (i.e. upfront) margin to which the exposure limits of the broker/dealer would be linked, as explained later. The Clearing Corporation will enforce the "mark-to-market margin" system. In case of failure of a clearing/trading member, the Clearing Corporation should have recourse to disable the Clearing/trading member from trading in order to stop further increase in his exposure. 111
    • BASICS OF DERIVATIVES6.3The requirements for capital adequacy and upfront margin should be set takinginto account the volatility of the underlying market. For this purpose, normally, dailyvolatility (as measured by standard deviation of average return from one-day holdingperiods) is taken into account. Such daily volatility in India for major stock indices isaround 1.3-1.4 per cent compared to just around 1 per cent for the S&P 500 Index inU.S.A.. In addition, we have to take into account two more facts, viz., first, thecollection of daily mark-to-market margin may take more than one day becauseelectronic funds transfer facility is not yet universal in India; and second, the worstscenario possibility, i.e. largest 1-day or 2-day fluctuation experienced over the lastfew years.6.4 Since market volatility changes over time, the Committee feels that the ClearingCorporation should continuously analyse this problem and may modify the marginrequirements to safeguard the market. The dual objective has to be guaranteeing itsown solvency and avoiding unnecessary tying up of members’ capital.6.5The Committee recommends that the Clearing Corporation should be anindependent corporation. Its Governing Board should be immune to any interferenceor direct/indirect pressure by trading interests. For this reason, there is no need tohave the representation of trading interests on its Governing Board.6.6The Committee feels that ideally an independent centralised Clearing Corporationfor the stock exchanges would be most effective arrangement. However, since thismay be difficult to achieve in the immediate future, it should remain as the ultimategoal to be achieved. Efforts should continue to be made in this direction. Until suchan independent centralised entity is created, the Committee recognises that existingClearing Corporations/Houses may continue to be used by existing exchangesprovided the following conditions are satisfied: 1. the Clearing Corporation/House becomes counterparty to all trades or provides unconditional guarantee for settlement of all trades; and 112
    • BASICS OF DERIVATIVES 2. the Exchange agrees to participate in the Central Clearing Corporation as and when that entity comes up. The Committee strongly urges SEBI to take the initiatives with potential promoters to set up a national-level Clearing Corporation.Maximum exposure limit 6.7 Apart from the minimum networth requirement, there should be a maximum exposure limit computed on gross basis for each broker/dealer. Such exposure limit should be linked to the amount of deposits/margins kept by a broker/dealer as deposit with the Clearing House/Clearing Corporation in the prescribed liquid assets. It was strongly represented to the Committee, as mentioned earlier, that, in Indian context, the minimum networth requirement has not proved adequate.Mark-to-market margins 6.8 The Committee feels that even the system of mark-to-market margins on daily basis will not be adequate for safeguarding the market’s integrity unless the margins are actually collected before the start of the next day’s trading. Even a day’s delay in actual collection of mark-to-market margin can pose a serious threat to the market’s integrity. The Committee noted that electronic funds transfer (EFT) was not yet pervasive in India. If the mark-to-market margins cannot be collected before the start of next day’s trading, the networth requirement and initial deposit with the exchange would have to be higher. The Committee recommends that the aim should be to collect mark-to-market margins before the next day’s trading starts. For this purpose all derivatives dealers/brokers should be required to be connected to Electronic Funds Transfer Facility. The capital adequacy requirement for derivatives trading should be finally decided after taking into account both the extent of volatility and the time taken for funds transfer from dealers/members to the exchange.Cross-margining 113
    • BASICS OF DERIVATIVES 6.9 At the initial stage of derivatives market in India, the Committee does not favour cross-margining which takes into account a dealer’s combined position in the cash and derivative segments and across all stock exchanges. The Committee recognises that cross-margining is logical and would economise the use of a trading member’s capital, but a conservative approach would be more advisable until the reliability of systems has been fully established. The systems capability has to emerge before adopting sophisticated systems.Margin Collection from clients 6.10In the Committee’s view, collection of initial and mark-to-market margins by brokers from their clients should be insisted upon in the case of derivatives trading. In other words, margin collection from clients should not be left to the discretion of brokers/dealers. SEBI should require derivatives exchanges to ensure, through systems of inspection, reporting, etc., that margins are actually collected from all clients without exception, including financial institutions. This is necessary because of the high leverage and consequently higher risk involved in derivatives trading. Two indirect methods of ensuring this should also be adopted, viz. (1) exposure limits for dealers/traders in relation to upfront initial margin deposited with the exchange should be fixed on gross basis and (2) brokers/dealers should be required to disclose to the exchange the trading done on their own behalf separately from trading on clients’ behalf at the time of order entry. The trading volume should also be divided into sales and purchases. Safeguarding client’s money 11. The Committee further recommends that the Clearing Corporation should segregate the upfront/initial margins deposited by Clearing Members for trades on their own account from the margins deposited with it on client account. The Clearing Corporation shall not utilise the margins deposited with it on client account for fulfilling the dues which a Clearing Member may 114
    • BASICS OF DERIVATIVES owe to the Clearing Corporation in respect of trades on the member’s own account. The principle which the Committee would like to advocate regarding client moneys is that these should be regarded as held in trust for client purpose only and should not be allowed to be diverted to any other purpose. Such moneys are sacrosanct as they usually represent the client’s hard earned savings. 12. The following process may be adopted by the Clearing Corporation for segregating the margin money held against a broker’s own position from that held against the client position. At the time of opening a position, the dealer/broker should indicate whether the position is for the client or for the broker himself. On all client positions, both buy or sell, margins should be collected on gross basis (i.e. on buy and sell positions separately without netting them). Similarly, when closing a position, the Clearing Corporation would have to be informed by the Clearing Member whether it was a client position or Member’s own position. In case of a Clearing Member default, the margin paid by such Member on his own account only would be allowed to be used by Clearing Corporation for realising its own dues from the Member. There should be an independent Investor Protection Fund for the Derivative Division/Exchange which should be available to compensate clients in case of Member default.SEBI approval for clearing corporation 6.13 The Committee feels that a clearing corporation must have SEBI approval for functioning as such. To be eligible for such approval, it should satisfy the following conditions : 1. The clearing corporation must perform full novation, i.e. the clearing corporation should interpose itself between both legs of every trade, 115
    • BASICS OF DERIVATIVES becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.2. The clearing corporation should have the capacity to monitor the overall position of members across both cash and derivatives markets for those members who are participating in both.3. The level of initial margin required on a position should be related to the risk of loss on the position. The concept of "value at risk" should be used in calculating required levels of initial margin. The initial margin should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days. These capital adequacy norms should apply intra-day, so that there is no instant of time where the good funds deposited by the member to the clearing corporation are smaller than the value at risk of the position at that point in time. The clearing corporation should have intra-day monitoring software to ensure that this condition is met at every single instant within the day. "Good funds" here are defined as the initial margin and the mark to market margin available with the clearing corporation.4. In the event of unusual positions of a member, the clearing corporation should charge special margin over and above the normal margins.5. The clearing corporation must establish facilities for electronic funds transfer (EFT) for swift movement of margin payments. In situations where EFT is unavailable, the clearing corporation should collect correspondingly larger initial margin to cover the potential for losses over the time elapsed in collection of mark to market margin. For example, if two days elapse in moving funds, then the value at risk should be calculated based on the prospective two-day loss.6. In the event of a member default in meeting its liabilities, the Clearing Corporation/House should have processing capability to require either the 116
    • BASICS OF DERIVATIVES prompt transfer of client positions and assets to another member or to close- out all open positions. 6.14 The clearing mechanism is the centre-piece of a derivatives market, both for implementing the margin system and for providing trade guarantee. Hence, the arrangements must require SEBI approval. The policy should be to nudge the system towards a single national clearing corporation for all stock exchanges. Chapter 7 REGULATION OF SALES PRACTICES AND DISCLOSURES FOR DERIVATIVESWhy derivatives sales practices need regulation 1. The Committee has identified broker-client relationship and sales practices for derivatives as needing special regulatory focus. The potential risk involved in speculating (as opposed to hedging) with derivatives is not understood widely. In the case of pricing of complex derivatives contracts, there is a real danger of unethical sales practices. Clients may be fooled or induced to buy unsuitable derivatives contracts at unfair prices and without properly understanding the risks involved. Many widely reported legal disputes between broker-dealer and the client have arisen in U.S.A. on some such ground. That is why it has become a standard practice in other countries to require a "risk disclosure document" to be provided by broker/dealer to every client in respect of the particular type of derivatives contracts being sold. 2. Also, derivatives brokers/dealers are expected to know their clients and to exercise care to ensure that the derivative product being sold by them to a particular client is suitable to his understanding and financial capabilities. Derivatives may tempt many people because of high leverage, which is a double-edged instrument, having, at the same time, the potential of high 117
    • BASICS OF DERIVATIVES profitability on the margin money invested and high risk. The concept of "know-your-client" needs to be implemented and every broker/trader should obtain a client identity form, as suggested in Model Rules for Derivatives Exchanges, being formulated by the Committee separately. Options and their complexity3. The risk and complexity vary among derivative products. While some derivatives are relatively simple, many others, specially options, could be highly complex and would require additional safeguards from investors’ viewpoint. In due course, a derivatives exchange may decide to introduce options on stock index or on individual stocks. Options are a more complex derivative product than index futures because evaluating the fairness of option premium is a complex matter, not being apparent. Regulations in the U.S.A. clearly recognise the greater complexity of options by requiring stricter supervision over sales of options contracts.4. In order to give some idea in this regard, the Committee enquired into sales practice regulations relating to derivatives in U.S. in order to learn from the experiences of U.S. regulatory authorities. The U.S. authorities have recognised that derivatives, based on options trading strategies, could be highly complex. Hence, there is a special regulatory regime for options. This is instructive for Indian authorities. In order to give a concrete idea about what the regulation of sales practices, particularly for complex type of derivatives, may involve, some special features found in the U.S. are enumerated below:a. The options trading rules of a derivative exchange require heightened suitability standards. Such rules prohibit brokers-dealers from recommending to any client any options transaction unless they have reasonable grounds to believe that the entire recommended transaction is not unsuitable for the 118
    • BASICS OF DERIVATIVES customer on the basis of information furnished after reasonable inquiry concerning the customer’s investment objectives.b. In addition, the rules prohibit brokers-dealers from recommending opening options transaction unless they have a reasonable basis for believing that the customer has such knowledge and financial experience that he or she can be expected to be capable of evaluating, and financially able to bear, the risks of the transaction.c. The broker-dealer must seek to obtain and verify specific categories of information about its customers including, but not limited to, their net worth, annual income and investment experience and knowledge. A separate approval also may be required for trading in particular types of options strategies and types of options contracts, such as foreign currencies.d. In addition, the approval of account opening must be in writing and can be made only by a senior options supervisor who must ensure that investors are offered an explanation of the special characteristics and risks applicable to the trading of options.e. The derivatives exchange also requires that all the supervisory and sales personnel pass a general securities examination that includes options materials. People selling or supervising the sale of options on debt securities or foreign currency also must pass a separate interest rate options or foreign currency examination.f. The exchange also requires the brokers-dealers to keep a current customer complaint log for all options-related complaints which include: (a) the name of the complainant; (2) the date when the complaint was received; (3) the sales person servicing the account; (4) a description of the complaint; and (5) a record of the action taken. 119
    • BASICS OF DERIVATIVES g. In addition, the broker-dealer firm is required to submit all sales literature and educational material to the exchange for pre-use approval. h. The disclosure document about options should contain information describing the mechanics and risks of options trading, transaction costs, margin requirements and tax consequences of margin trading. The broker- dealer must provide a copy of this document at or prior to the time such customer’s account is approved for standardized options trading. i. There are also special trading rules applicable to the options markets. These rules include separate surveillance procedures, front-running prohibitions and position limits.Exchange’s responsibility 1. The Committee recommends that attention be given to proper supervision of sales practices for derivatives from the very beginning. It should be the responsibility of the Derivatives Exchange, as a self-regulatory organisation, to take the necessary steps in this regard under the general oversight of SEBI. Risk Disclosure to the client is an important aspect of the regulation of sales practices. In connection with entry requirements for derivative brokers/dealer, the Committee has earlier recommended that, not only derivatives brokers/dealers, but also sales persons working for derivatives brokers should have passed a certification programme. If sufficient attention is not paid to this initially, we may have a situation analogous to a large number of ill-trained drivers whom it becomes difficult to control later. 2. Basically, the regulation of derivatives sales practices aims at enforcing strictly the "know your customer" rule and requires that every client trading in derivatives should be registered with the derivatives broker. Data base on clients should be available with the broker. Customers should be given a risk disclosure document prior to their registration by the derivatives broker. 120
    • BASICS OF DERIVATIVES Sales to corporate clients3. In the case of corporate clients, banks, financial institutions and mutual funds, they should be allowed to trade derivatives only if and to the extent authorised by their Board of Directors/Trustees. Such authorisation should specify the scope of permissible derivative trading, i.e. the purposes or objectives for which derivatives trading may be undertaken, (e.g. hedging etc.), over-all limits for derivative exposure, the authority level for giving approval in this regard, the type of derivatives contracts (e.g. futures, forwards, options, swaps) and broad derivative category (e.g. derivatives on interest rate, exchange rate, equities and commodities). Derivatives broker/dealer may execute orders for such clients only if the orders are supported by the necessary authorisation of the client’s Board of Directors/Trustees. Accounting and disclosure requirements4. The accounting treatment and disclosure requirement about an organisation’s involvement in derivatives trading is important so that shareholders and investors can know how such involvement fits into the organisation’s objectives and affects its revenues, financial position and risk profile. The Committee was informed that a Study Group on Derivatives constituted by the Institute of Chartered Accountants of India is examining the accounting and disclosure norms for derivatives trading by corporate bodies. Mutual Funds as clients5. The SEBI (Mutual Fund) Regulations presently prohibit the use of derivatives by mutual funds. The Committee is of the opinion that mutual funds need hedging facility. They will be among the most important users of equity hedging through stock index derivatives. Hence, the regulatory prohibition 121
    • BASICS OF DERIVATIVES should be removed. The soundness of the derivatives market depends on the presence of both hedgers and speculators. A derivatives market consisting wholly or mostly of speculators is unlikely to be a healthy market. It is, therefore, all the more important that the regulatory prohibition on the use of derivatives for hedging by mutual funds should be withdrawn immediately.6. Mutual funds should be allowed to use financial derivatives for hedging purposes (including anticipated hedging) and portfolio re-balancing within a policy framework and rules laid down by their Board of Trustees who should specify what derivatives are allowed to be used, within what limits, for what purposes, for which schemes, and also the authorisation procedure. The responsibilities of the trustees of mutual funds as per SEBI regulations should be re-defined to cover this aspect.7. At this stage, the Committee does not consider it advisable to frame detailed SEBI regulations about the use of derivatives by mutual funds as this would stifle the development of ideas. The Committee prefers that the responsibility for proper control in this regard should be placed on the trustees of mutual funds. This would help evolution of practices on sound lines without creating a strait jacket.8. Further, what has been said earlier about internal control, accounting treatment and disclosure of derivatives trading by corporate clients should apply to mutual funds also. The offer documents of mutual fund schemes should disclose whether the scheme permits the use of derivatives and the details in this regard. Also the income and balance sheet of each mutual fund scheme would have to disclose the impact of derivatives trading and of any open position in this regard. Concluding observations 122
    • BASICS OF DERIVATIVES 9. There is no doubt that equity derivatives and other financial derivatives have some definite positive uses and serve an economic purpose, as clearly recognised in economic literature. They represent a financial innovation of considerable significance. They can be helpful in making financial markets more efficient and enhancing economic efficiency in general. 10. At the same time, derivatives trading inherently involves high leverage. For this reason, it can be a temptation to inadequately capitalised traders or speculators. Also some users may not fully understand derivatives and use them inappropriately. The regulatory system has to be designed to minimise these possible dangers. 11. In drawing up a regulatory framework for derivatives, the Committee has kept in view not only the need for allowing adequate flexibility in order to permit the derivatives market to develop in India but also the need for strict watch so that the development is along sound lines.CONSTITUTION OF THE COMMITTEE ON DERIVATIVESChairman : 1. Dr. L.C. Gupta Director Society for Capital Market Research and Development, 32 Raja Enclave Pitampura, DELHI-110 034.Member-Secretary : 2. Mr. O.P. Gahrotra Sr. Executive Director Securities & Exchange Board of India Mittal Court, "B" Wing, Nariman Point, 123
    • BASICS OF DERIVATIVES MUMBAI-400 021.Other Members : 3. Dr. Ajay Shah Indira Gandhi Institute of Dev. Research Gen. Vaidya Marg, Goregaon (East), MUMBAI-400 065. 4. Mr. B.G. Daga Chief General Manager, Unit Trust of India New Marine Lines, MUMBAI-400 020. 5. Mr. Balaji Srinivasan, Jardine Fleming, Amerchand Mansion 16, Madame Cama Road, MUMBAI-400 001. 6. Mr. D.C. Anjaria Asian Capital Partners 38, Jolly Maker Chambers II 3rd Floor, Nariman Point MUMBAI-400 021. 7. Ms. D.N. Raval Executive Director (Legal) Securities & Exchange Board of India Mittal Court, "B" Wing, Nariman Piont MUMBAI-400 021. 8. Mr. Dennis Grubb Price Waterhourse LLP 128 T.V. Industrial Estate Worli, MUMBAI-400 025. 9. Mr. L.K. Singhvi, Sr. Executive Director 124
    • BASICS OF DERIVATIVESSecurities & Exchange Board of IndiaMittal Court, "B" Wing, Nariman PointMUMBAI-400 021.10. Mr. M.G. Damani, PresidentThe Bombay Stock ExchangeDalal Street, Fort, MUMBAI-400 001.11 Mr. M.R. Mayya1/19 Kadri Park, Irla, S.V. Road, Vile ParleMUMBAI-400 056.12. Mr. Marti SubrahmanyamProfessor New York UniversityNYU, Saloman CentreN.Y., 10012-1118, U.S.A.13. Prof. P.G. ApteIndian Instt. of ManagementBannerghatta Road, BANGALORE-560076.14. Mr. Percy MistryOxford InternationalOxford Centre, 10, Shroff LaneColaba Causeway, ColabaMUMBAI-400 005.15. Dr. Prasanna ChandraIndian Institute of ManagementBannerghatta Road, BANGALORE-560 076.16. Mr. Pratip Kar, Executive DirectorSecurities and Exchange Board of IndiaMittal Court, "B" Wing, Nariman Point 125
    • BASICS OF DERIVATIVESMUMBAI-400 021.17. Prof. R. VaidyanathanIndian Instt. of ManagementBannerghatta Road, BANGALORE-560076.18. Mr. R. Ravi MohanCredit Rating Information Services of India301 A, Neelam CentreWorli, MUMBAI-400 025.19. Dr. R.H. Patil, Managing DirectorNational Stock of India Ltd.Mahindra Towers, "A" Wing, 1st Floor,RBC, Worli, MUMBAI-400 018.20. Mr. RamachandraBangalore Stock Exchange Ltd.No. 51, 1st Cross, J.C. RoadBANGALORE-560 027.21. Mr. S.S. SodhiDelhi Stock Exchange Assn. Ltd.Gate A, West Plaza,I.G. StadiumIndraprastha Estate, NEW DELHI-110 002.22. Mr. Uday KotakKotak Mahindra Finance Ltd.Bakhtawar, 2nd Fl., Nariman PointMUMBAI-400 021.23. Mr. V.K. AgarwalForward Market Commission"Everest", 3rd Floor, 100 Marine Lines 126
    • BASICS OF DERIVATIVESMUMBAI-400 002.24. Mr. Vallabh BhansaliEnam Financial Services Ltd.Ambalal Doshi Marg24 BD Rajabahadur CompoundMUMBAI-400 023. 127
    • BASICS OF DERIVATIVES 128