derivative trading in securities market

8/7/2019 Derivative Trading in Securities Market

1/15

DERIVATIVE TRADING IN SECURITIES MARKET

Sharad Kothari

Roll No. 72

IX Semester-B.B.A.-LL.B. (Hons)

MEANING OF DERIVATIVES ......................................................................................... 1FORWARDS AND FUTURES ...................................................................................... 2

OPTIONS ........................................................................................................................4SWAPS IN CURRENCIES/ INTEREST RATES ..........................................................5

ADVANTAGES OF DERIVATIVES .............................................................................6

FUTURES AND OPTIONS TRADING SYSTEM .............................................................6FUTURES AND OPTIONS MARKET INSTRUMENTS ..............................................8

REGULATORY FRAMEWORK ........................................................................................ 9

SECURITIES CONTRACTS(REGULATION) ACT, 1956 ......................................... 10SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992 ............................10

SEBI (STOCK BROKERS AND SUBBROKERS) REGULATIONS, 1992 ........... .. 11

REGULATION FOR DERIVATIVES TRADING ....................................................... 12CONCLUSION ..................................................................................................................14

MEANING OF DERIVATIVES

AMERICAN DEFINITION1:

Both FAS 133 and IAS 39 define a financial derivative in a generic way based on their

nature rather than the name.

Financial derivatives are those financial instruments:

Whose value changes in response to the change in a variable (called underlying)

such as interest rate, price of a security, price of a commodity, foreign exchange

rate, index of certain prices credit rating etc. and

Which require very little initial net investment relative to other types of contracts

that have a similar response to change in market conditions and

Which are settled at a future date.

INDIAN DEFINITION2:

Derivative includes-

1 Vipul, Dr., Accounting for Financial Derivatives: U.S., International and Indian Standards, 52 The

Chartered Accountant pg. 2362 Section 2(aa) of The Securities Contracts (Regulation) Act, 1956.

Page 1 of 15


2/15

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

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

security;

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

underlying securities.

DERIVATIVES ARE financial weapons of mass destruction, said Warren Buffet, the

second richest person in the world and arguably the best known financial wizard in the

U.S. Alan Greenspan, Chairman of Federal Reserve and the most powerful central

banker, has reportedly claimed that derivatives helped the financial system to ward off the

effects of the dotcom bubble; there was no meltdown in the system even though the stock

markets got a severe drubbing.3

Derivatives are contracts that have no intrinsic value, but are based on the value of an

underlying commodity, currency or an instrument like stocks. These were originally used

in commodity markets by merchants and farmers to ensure a firm price for a commodity

at a future date. The four main forms of derivatives are forwards, futures, options and

swaps.

DERIVATIVES

OPTIONS FUTURES SWAPS FORWARDS

PUT CALL INTEREST RATE CURRENCY

COMMODITY SECURITY

FORWARDS AND FUTURES

Forwards and futures have a hoary past. Reports have it that these were used in Japan by

farmers and merchants even in the 1700s and in the U.S. over two centuries ago. For

example, if a miller in the U.S. ordered wheat from Europe (well before the U.S. became

a wheat granary), at say Rs.80 a tonne, the shipping time taken for him to get the wheat

would be a month or so. However, when he sold the goods on arrival in the U.S., he will

3 http://www.hindu.com/2004/03/01/stories/2004030100351600.htm.

Page 2 of 15


3/15

get the then ruling price; if that price was Rs.70, he will lose. To get over this uncertainty,

he entered into a derivative contract with a local dealer by which he agreed to sell the

goods at a firm price (say Rs.85) after one month. This is a typical forward contract and

can be used for hedging, that is, insurance against uncertainty in prices 4.

The value of a future is determined by the relationship between the price set in the

contract and the market price, the length of time until the contract is due - and supply and

demand in the market.5

Futures contracts specify the quality, quantity and location for goods to be delivered, but

not many are used to actually sell goods.6

Most are settled by cash payment on the date that delivery is due, with the holder paying

or receiving the difference between the price set in the contract and the market price7.

Fundamentally, forward and futures contracts have the same function: both types

of contracts allow people to buy or sell a specific type of asset at a specific time at a

given price.

However, it is in the specific details that these contracts differ. First of all, futures

contracts are exchange-traded and, therefore, are standardized contracts. Forward

contracts, on the other hand, are private agreements between two parties and are not

as rigid in their stated terms and conditions. Because forward contracts are private

agreements, there is always a chance that a party may default on its side of the agreement.

Futures contracts have clearing houses that guarantee the transactions, which drasticallylowers the probability of default to almost never.8

A futures contract includes the following attributes viz9

INTEREST RATE FUTURES

It is a contract, which sets a purchase yield or rate of interest on a specified debt security

or deposit effective at a future date agreed on at the time of the transaction.

STOCK INDEX FUTURES

A contract that sets a purchase price on a standardised amount of the underlying index for

settlement on a specified future date.

4Ibid5 BBC,Business: What are Futures and Options?, online edition, February 7, 2002, Thursday,http://news.bbc.co.uk/2/hi/business/1806265.stm6 ibid7 ibid8 http://www.investopedia.com/ask/answers/06/forwardsandfutures.asp9 http://www.expressindia.com/fe/daily/20000129/ffe25116.html

Page 3 of 15


4/15

FOREIGN EXCHANGE FUTURES

A contract which involves booking/swapping of currencies at future dates, depending on

perception of whether currencies are going to strengthen or weaken.

All these aspects are specific to contracts containing financial assets. Meanwhile, a

commodity futures is a contract for physical assets and is used for hedging against the

future price of various commodities.

OPTIONS

Options enable one to have the cake and eat it too.10 The buyer of the option gains the

right, but not the obligation, to engage in some specific transaction on the asset, while the

seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price

of an option derives from the difference between the reference price and the value of the

underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a

premium based on the time remaining until the expiration of the option.11 These are

common in stock markets. For example, if a broker buys shares of a company at Rs. 250

per share and intends to sell them after three months at a profit, he can enter into an

option contract for sale at Rs. 270 after three months. He has the option to sell at Rs. 270

but he is not obliged to exercise the option.

If the then ruling price is Rs. 240 he can exercise the option and make a profit; if,

however, it is Rs. 300, he need not use the option. For this right, he has to pay the dealer

(who writes the option) a premium or fee. While the buyer of the option has all the rights

and no obligation, the option writer has only obligations. If the price were just Rs. 100

after three months, he would lose a substantial amount. Therefore, the premium is

calculated in such a manner as to ensure that the losses of option writer are minimised, if

not eliminated. Lot of esoteric arithmetic is used in fixing the premium.

Options were invented because people liked the security of knowing they could buy or

sell at a certain price, but wanted the chance to profit if the market price suited them

better at the time of delivery12. So for a certain fee - called the premium - an option gave

them the right, but not the obligation, to buy or sell at a certain price. An option to sell,

10 ibid11 http://en.wikipedia.org/wiki/Option_%28finance%2912news.bbc.co.uk/2/hi/business/2190776.stm

Page 4 of 15


5/15

known as a put option, would only be exercised if the price set in the futures contract was

higher than the market price at the time of harvest, and vice versa for an option to buy, or

call option. Working out the cost of an option is extraordinarily complicated.

There are many pricing mechanisms in use, most involving complex mathematical

formulas. The most famous options pricing model is known as Black-Scholes13.

There are also many different types of option - with exotic and alarming names such as

knock-in and knock-out, barrier, binary and Asian options - most of which vary either the

time or the price at which the options can be exercised 14.

OPTION TYPE BUYER/HOLDER SELLER/WRITER

Call Right but not an obligation

to buy the underlying asset.

Obligation but no right to

sell the underlying asset.

Put Right but not an obligation

to sell the underlying asset.

Obligation but no right to

buy the underlying asset.

SWAPS IN CURRENCIES/ INTEREST RATES

Swaps could be in currency or interest rates. A currency swap is a foreign-exchange

agreement between two parties to exchange aspects (namely the principal and/or interest

payments) of a loan in one currency for equivalent aspects of an equal in net present

value loan in another currency. Currency swaps are motivated by comparative

advantage.15When a U.S. company has a subsidiary in Germany and a German company

has its subsidiary in the U.S., the two can raise funds in their home countries at fairly

reasonable rates but will not be able to do so in the country where their subsidiaries are

located. By raising funds in their respective home currencies and exchanging the funds

between them (dollar from the U.S. company for euro from the German company), both

will benefit.

Interest rate swaps work in a similar manner. Currency swaps are over-the-counter

derivatives, and are closely related to interest rate swaps.16 In an interest rate swap, each

counter party agrees to pay either a fixed or floating rate denominated in a particular

13 news.bbc.co.uk/2/hi/business/1806265.stm14 ibid15 http://www.finpipe.com/currswaps.htm16 ibid

Page 5 of 15


6/15

currency to the other counterparty. The fixed or floating rate is multiplied by a notional

principal amount (say, USD 1 million). This notional amount is generally not exchanged

between counterparties, but is used only for calculating the size of cash flows to be

exchanged. For example, a leading Indian company can raise a five year dollar loan from

a London banker at a low floating interest rate, that is, one that rises and falls with the

London inter Bank Rate. And, a medium sized U.S. company could raise the same loan at

a low fixed rate in the bond markets. By swapping the two interest rates between them

both companies could gain.

ADVANTAGES OF DERIVATIVES

The futures and options market also provides the economy with price discovery. The

futures prices are determined by supply and demand. An exchange itself does not set the

price. It simply provides a place where the buyers and sellers can negotiate. If there are

more buyers than sellers, the price goes up. Conversely, if the sellers outnumber the

buyers, the price falls. The price discovered through the futures market offers valuable

economic information on the supply and demand situation in a competitive business

environment.17

The economic benefit of trading in the futures and options market for the investors is the

lowered transaction costs. For instance, an investor wanting to invest in software stocks

could opt for a single transaction by way of the software stock index futures contract

representing 50 stocks. This, instead of buying and paying commission for stocks

separately in 50 different transactions.

FUTURES AND OPTIONS TRADING SYSTEM

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a

fully automated screen-based trading for Nifty futures & options and stock futures & options

on a nationwide basis as well as an online monitoring and surveillance mechanism. It

17 www.expressindia.com/fe/daily/20000129/ffe25116.html

Page 6 of 15


7/15

supports an order driven market and provides complete transparency of trading operations. It

is similar to that of trading of equities in the cash market segment. 18

The software for the F&O market has been developed to facilitate efficient and transparent

trading in futures and options instruments. Keeping in view the familiarity of trading

members with the current capital market trading system, modifications have been performed

in the existing capital market trading system so as to make it suitable for trading futures and

options.19

Entities in the trading system

There are four entities in the trading system:

1. Trading members: Trading members are members of NSE. They can trade

either on their own account or on behalf of their clients including participants. The

exchange assigns a Trading member ID to each trading member. Each trading

member can have more than one user. The number of users allowed for each

trading member is notifi ed by the exchange from time to time. Each user of a

trading member must be registered with the exchange and is assigned an unique

user ID. The unique trading member ID functions as a reference for all

orders/trades of different users. This ID is common for all users of a particular

trading member. It is the responsibility of the trading member to maintain

adequate control over persons having access to the fi rms User IDs.

2. Clearing members: Clearing members are members of NSCCL. They carry out

risk management activities and confi rmation/inquiry of trades through the trading

system.

3.Professional clearing members: A professional clearing members is a clearing

member who is not a trading member. Typically, banks and custodians become

professional clearing members and clear and settle for their trading members.

4. Participants: A participant is a client of trading members like fi nancial

institutions. These clients may trade through multiple trading members but settle

through a single clearing member.

18 ibid19 www.articlesuniverse.com/.../Futures-and-options-trading-system/4

Page 7 of 15


8/15

FUTURES AND OPTIONS MARKET INSTRUMENTS

The F&O segment of NSE provides trading facilities for the following derivative

instruments:

1. Index based futures

2. Index based options3. Individual stock options

4. Individual stock futures

a) Contract specifications for index futures

NSE trades Nifty futures contracts having one-month, two-month and three-month expiry

cycles. All contracts expire on the last Thursday of every month. Thus a January

expiration contract would expire on the last Thursday of January and a February expiry

contract would cease trading on the last Thursday of February. On the Friday following

the last Thursday, a new contract having a three-month expiry would be introduced for

trading. Depending on the time period for which you want to take an exposure in index

futures contracts, you can place buy and sell orders in the respective contracts.20

The Instrument type refers to Futures contract on index and Contract symbol - NIFTY

denotes a Futures contract on Nifty index and the Expiry date represents the last date

on which the contract will be available for trading. Each futures contract has a separate

limit order book. All passive orders are stacked in the system in terms of price-time

priority and trades take place at the passive order price(similar to the existing capital

market trading system). The best buy order for a given futures contract will be the order

to buy the index at the highest index level whereas the best sell order will be the order to

sell the index at the lowest index level.21

b) Contract specification for index options

On NSEs index options market, contracts at different strikes, having one-month, two-

month and three-month expiry cycles are available for trading. There are typically one-

month, two-month and three-month options, each with minimum seven different strikes

available for trading.22 Option contracts are specified as follows: DATE-EXPIRY

MONTH-YEAR-CALL/PUT AMERICAN/EUROPEAN-STRIKE. For example the

20 http://www.stockresearch.co.in/contract-specifications-for-index-futures-nifty-futures.php21nikhil-barjatya.tripod.com/ncfm/derivative/151-212.pdf22 http://www.stockresearch.co.in/contract-specifications-for-index-options-nifty-options.php

Page 8 of 15


9/15

European style call option contract on the Nifty index with a strike price of2040 expiring

on the 30th june2005 is specified as 30Jun 2005 2040CE.23

c) Contract specifications for stock futures

Trading in stock futures commenced on the NSE from November 2001. These contracts

are cash settled on a T+1 basis. The expiration cycle for stock futures is the same as for

index futures,index options and stock options. A new contract is introduced on the trading

day following the expiry of the near month contract.24

d) Contract specifications for stock options

Trading in stock options commenced on the NSE from July 2001. These contracts are

American style and are settled in cash. The expiration cycle for stock options is the same

as for index futures and index options. A new contract is introduced on the trading day

following the expiry of the near month contract. NSE provides a minimum of five strike

prices for every option type(i.e. call and put) during the trading month. There are at least

two inthemoney contracts, two outofthemoney contracts and one atthemoney

contract available for trading. Table 10.4 gives the contract specifications for stock

options.25

REGULATORY FRAMEWORK

The trading of derivatives is governed by the provisions contained in the SC(R)A, the

SEBI Act, the rules and regulations framed thereunder and the rules and byelaws of

stock exchanges.

23 ibid24www.stockresearch.co.in/contract-specifications-for-stock-futures.php25www.stockresearch.co.in/contract-specifications-for-stock-options.php

Page 9 of 15


10/15

SECURITIES CONTRACTS(REGULATION) ACT, 1956

SC(R)A aims at preventing undesirable transactions in securities by regulating the

business of dealing therein and by providing for certain other matters connected

therewith. This is the principal Act, which governs the trading of securities in India. The

term securities has been defined in the SC(R)A. As per Section 2(h), the Securitiesinclude:

1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable

securities of a like nature in or of any incorporated company or other body corporate

2. Derivative

3. Units or any other instrument issued by any collective investment scheme to the

investors in such schemes

4. Government securities

5. Such other instruments as may be declared by the Central Government to be securities

6. Rights or interests in securities.

Derivative is defined to include:

A security derived from a debt instrument, share, loan whether secured or unsecured, risk

instrument or contract for differences or any other form of security

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

securities.

Section 18A provides that notwithstanding anything contained in any other law for the

time being in force, contracts in derivative shall be legal and valid if such contracts are:

Traded on a recognized stock exchange

Settled on the clearing house of the recognized stock exchange, in accordance

with the rules and byelaws of such stock exchanges.

SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India

(SEBI) with statutory powers for (a) protecting the interests of investors in securities (b)

promoting the development of the securities market and (c) regulating the securities

market. Its regulatory jurisdiction extends over corporates in the issuance of capital and

Page 10 of 15


11/15

transfer of securities, in addition to all intermediaries and persons associated with

securities market.

SEBI has been obligated to perform the aforesaid functions by such measures as it thinks

fit. In particular, it has powers for:

a) regulating the business in stock exchanges and any other securities markets

b) registering and regulating the working of stock brokers, subbrokers etc.

c) promoting and regulating self-regulatory organizations

d) prohibiting fraudulent and unfair trade practices

e) calling for information from, undertaking inspection, conducting inquiries and

audits of the stock exchanges, mutual funds and other persons associated with the

securities market and intermediaries and selfregulatory organizations in the

securities market performing such functions and exercising according to

Securities Contracts (Regulation) Act, 1956, as may be delegated to it by the

Central Government26

SEBI (STOCK BROKERS AND SUBBROKERS) REGULATIONS, 1992

A broker is an intermediary who arranges to buy and sell securities on behalf of clients

(the buyer and the seller). According to Section 2(e) of the SEBI (Stock Brokers and Sub-

Brokers) Rules, 1992, a stockbroker means a member of a recognized stock exchange. No

stockbroker is allowed to buy, sell or deal in securities, unless he or she holds a certificate

of registration granted by SEBI. 27A stockbroker applies for registration to SEBI through

a stock exchange or stock exchanges of which he or she is admitted as a member. SEBI

may grant a certificate to a stock-broker [as per SEBI (Stock Brokers and Sub-Brokers)

Rules, 1992] subject to the conditions that:

1. He holds the membership of any stock exchange;

2. He shall abide by the rules, regulations and bye-laws of the stock exchange or stock

exchanges of which he is a member;

3. In case of any change in the status and constitution, he shall obtain prior permission

of SEBI to continue to buy, sell or deal in securities in any stock exchange;

4. He shall pay the amount of fees for registration in the prescribed manner; and

26www.sharegyan.com/...market/securities/what-is-sebi-role.php27 http://www.managementparadise.com/forums/417565-post1.html

Page 11 of 15


12/15

5. He shall take adequate steps for redressal of grievances of the investors within one

month of the date of the receipt of the complaint and keep SEBI informed about

the number, nature and other particulars of the complaints.

As per SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, SEBI shall take into

account for considering the grant of a certificate all matters relating to buying, selling, or

dealing in securities and in particular the following, namely, whether the stock broker

(a) is eligible to be admitted as a member of a stock exchange;

(b) has the necessary infrastructure like adequate office space, equipment and man

power to effectively discharge his activities;

(c) has any past experience in the business of buying, selling or dealing in securities;

(d) is subjected to disciplinary proceedings under the rules, regulations and bye-laws

of a stock exchange with respect to his business as a stock-broker involving either

himself or any of his partners, directors or employees.

REGULATION FOR DERIVATIVES TRADING

SEBI set up a 24-member committee under the Chairmanship of Dr.L.C. Gupta to

develop the appropriate regulatory framework for derivatives trading in India. The

committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the

recommendations of the committee and approved the phased introduction of derivatives

trading in India beginning with stock index futures. SEBI also approved the suggestive

bye-laws recommended by the committee for regulation and control of trading and

settlement of derivatives contracts. The provisions in the SC(R)A and the regulatory

framework developed thereunder govern trading in securities. The amendment of the

SC(R)A to include derivatives within the ambit of securities in the SC(R)A made

trading in derivatives possible within the framework of that Act.

1. Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta

committee report may apply to SEBI for grant of recognition under Section 4 of

the SC(R)A, 1956 to start trading derivatives. The derivatives exchange/segment

should have a separate governing council and representation of trading/clearing

members shall be limited to maximum of 40% of the total members of the

governing council. The exchange shall regulate the sales practices of its members

Page 12 of 15


13/15

and will obtain prior approval of SEBI before start of trading in any derivative

contract.

2. The Exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not automatically

become the members of derivative segment. The members of the derivative

segment need to fulfill the eligibility conditions as laid down by the LC Gupta

committee.

4. The clearing and settlement of derivatives trades shall be through a SEBI approved

clearing corporation/house. Clearing corporations/houses complying with the

eligibility conditions as laid down by the committee have to apply to SEBI for

grant of approval.

5. Derivative brokers/dealers and clearing members are required to seek registration

from SEBI. This is in addition to their registration as brokers of existing stock

exchanges. The minimum net worth for clearing members of the derivatives

clearing corporation/house shall be Rs.300 Lakh. The net worth of the member

shall be computed as follows:

Capital + Free reserves

Less non-allowable assets viz.,

(a) Fixed assets

(b) Pledged securities

(c) Members card

(d) Non-allowable securities(unlisted securities)

(e) Bad deliveries

(f) Doubtful debts and advances

(g) Prepaid expenses

(h) Intangible assets

(i) 30% marketable securities

6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges should

also submit details of the futures contract they propose to introduce.

7. The initial margin requirement, exposure limits linked to capital adequacy and

margin demands related to the risk of loss on the position shall be prescribed by

SEBI/Exchange from time to time.

Page 13 of 15


14/15

8. The L.C.Gupta committee report requires strict enforcement of Know your

customer rule and requires that every client shall be registered with the

derivatives broker. The members of the derivatives segment are also required to

make their clients aware of the risks involved in derivatives trading by issuing to

the client the Risk Disclosure Document and obtain a copy of the same duly

signed by the client.

9. The trading members are required to have qualified approved user and sales person

who have passed a certification programme approved by SEBI.

CONCLUSION

In less than three decades of their coming into vogue, derivatives markets have become

the most important markets in the world. Today, derivatives have become part and parcel

of the day-to-day life for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to the latest trading

methods and was using traditional out-dated methods of trading. There was a huge gap

between the investors aspirations of the markets and the available means of trading. The

Page 14 of 15


15/15

opening of Indian economy has precipitated the process of integration of Indias financial

markets with the international financial markets. Introduction of risk management

instruments in India has gained momentum in last few years thanks to Reserve Bank of

Indias efforts in allowing forward contracts, cross currency options etc. which have

developed into a very large market.

Derivatives can be highly complex contracts and used with little or no knowledge of the

implications, can prove extremely destructive. Highly complex instruments, either

combining two derivatives or leveraging, namely, having a multiplier effect are

introduced in the advanced financial markets, because there the banks and institutions

make very little income from loans and have to develop esoteric products to earn profits.

Page 15 of 15

derivative trading in securities market

Documents