TYPES OF DERIVATIVES IN INDIA

TYPES OF DERIVATIVES IN INDIA

At present the Indian market trades in both exchange-traded and over the counter derivatives on various assets including securities, both equity and debt commodities, currencies, etc. the various types of derivatives being traded in India are discussed below:

•           GENERIC DERIVATIVE PRODUCTS

Today, Indian and International financial markets trade innumerable derivative products on all kinds of underlying assets, both tangible and intangible. Before proceeding with the regulatory issues of derivatives trading, it is important to have a detailed understanding of the four generic derivative products in detail.

1. FORWARD CONTRACTS

A forward contract is defined as an agreement, which ‘obligates one counterparty to buy, and the other counterparty to sell, a specific underlying at a specific price, amount and date in the future.

It is more clearly a one-to-one, bipartite/tripartite contract, which is to be performed mutually by the contracting parties, in future, at the term decided upon, on the contract date. In other words, a forward contract is an agreement to buy or sell an asset on a specified future date for a specified price. One of the parties to the contract assumes a long position, i.e. agrees to buy the underlying asset while the other assumes a short position, i.e. agrees to sell the asset. As this contract is traded off the exchange and settled mutually by the contracting parties, it is called an Over-the-counter product. It can be better understood with the help of an illustration.

Assume that there are two parties, Mr. A (buyer) and Mr. B (seller), who enter into a contract to buy and sell 500 units of asset X at Rs 100 per unit, at a predetermined time of two months from the date of contract. In this case, the product(asset X), the quantity (500 unites), the product price (Rs 100 per unit) and the time of delivery (2 months from the date of contract) have been determined and well understood, in advance, by both the contracting parties. Delivery and payment (settlement of transaction) will take place as per the terms of the contract on the designated date and place.

It is pertinent to note that forward contracts are negotiated by the contracting parties on a one-to-one basis and hence offer tremendous flexibility in terms of determining contract terms such as price, quantity, quality(in place of commodities), delivery time and place.

Like other OTC products, forward contracts offer tremendous flexibility to the contracting parties. However, as they are customized, they suffer from poor liquidity. Furthermore, as thee contracts are mutually settled and generally not guaranteed by any third party, the counter party risk/default risk/credit risk is considerable in such contracts.

2. FUTURES CONTRACTS

A futures contract is similar to a forward contract, in that it is an agreement to buy or sell a specified commodity or instrument, at a specified price, at a date in the future. Illiquidity and counter party risk were the two issues concerning forward contracts that offered the exchanges a tremendous business opportunity and they started trading these forward contracts, but with a difference. In order to differentiate between the exchange-traded forwards and the OTC forward, the market renamed the exchange-traded forwards as Futures Contract. Hence, future contracts are essentially standardized forward contracts, which are traded on the exchanges and settled through the clearing agency of the exchanges. The clearing agency also guarantees the settlement of these trades.

Reasons for using futures contracts can be diversified and complicated. First, they attract lower transaction costs. They are normally only a fraction of the costs of trading in the underlying commodity or instrument. Second, counterparty risk is minimal as it is unlikely that the clearinghouse would collapse, as it is usually well-backed financially. In addition, if a participant defaults, the rules of a typical clearinghouse will provide for the allocation of the losses to the surviving participants according to a predetermined formula. Third, futures contracts permit anonymity of participants as most brokers act for undisclosed principals. Fourth, there is no requirement for large capital outlays as initial deposits range between five to fifteen percent only. Fifth, futures markets are more liquid, and therefore, it is easier for the participants to ‘close-out’ or settle their contracts. However, a major disadvantage of using futures contracts is their inflexibility. Any investor using futures contracts for hedging would be exposed to basis risk. ‘Basis risk’ refers to the risk where the futures contract and the instrument that is being hedged may not be perfectly matched.

3. SWAPS

Swaps like forward contracts, are customized over-the-counter transactions. A swap has been described as ‘an agreement between two parties to pay each other a series of cash flows, based on fixed or floating interest rates in the same or different currencies.’

Swap transactions are broadly classified into interest rate, currency, commodity or equity swaps. It is possible to use swaps for a variety of purposes including the reduction of borrowing costs; asset and liability management; and yield enhancement.  The principle of comparative advantage, a concept central to international trade, plays an important role in swap transactions. Each counterparty borrows in the market where it enjoys a comparative advantage, and through the use of swap obtains financing at a more favorable rate than it would otherwise be able to do so. Swap cash flows can be decomposed into equivalent cash flows from a bundle of simple forward contracts. This has implications for the hedging of swap risks. Swaps are now hedged with a variety of derivative products, and no longer only by matching two identical but opposing swaps.

A swap derivative is nothing but barter or an exchange but it plays a critical role in international finance. Currency Swaps help eliminate barriers caused by international capital markets. Interest rate Swaps help eliminate barriers caused by regulatory structure. While Currency rate swaps result in exchange of one currency with another, interst rate swaps help exchange a fixed rate of interest with a variable rate. Swaps are private agreements between two parties and are not traded on exchanges but they do have an informal market and are traded among dealers. Swaptions is an option on swap that gives the party the right, but not the obligation to enter into a swap at a later date.

4. OPTIONS

An option is the ‘right to buy or sell a specific price on or before a specific date in the future’. It is a right that the option seller gives to the option buyer to buy or sell an underlying asset at a predetermined price, within or at the end of a specified period. The party taking a long position, i.e. buying the option is called the buyer/holder of the option and the party taking a short position, i.e. selling the option is called the seller/writer of the option.

The option buyer who is also called long option, or long premium or holder of option, has the right and no obligation with regard to buying or selling the underlying asset while the option seller/ writer who is also called short on option or short on premium, has the obligation but no right, in the contract. In other words, the option buyer may or may not exercise his option but if he decides to exercise it the option seller/writer is legally bound to honor the contract.

The right to buy an asset is a ‘call option’, while the right to sell an asset is a ‘put option’. An option which gives the buyer a right to buy the underlying asset, is called a call option and the option, which gives the buyer a right to sell the underlying asset is called put option.

An American option is one which can be exercise any time until maturity, while a European option is one which can be exercised on maturity date. The buyer of an option is usually called the ‘option holder’, and the seller of the option, the ‘option writer’. The option holder must pay the option writer a price known as the ‘premium’ in order to acquire the rights under the option. Options are available on a wide range of assets including commodities, foreign currencies, shares, bonds and even other derivatives.

•           EQUITY DERIVATIVES

India joined the league of exchange-traded equity derivatives in June 2000, when futures contracts were introduced at its two major exchanges, viz. the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The BSE sensitive index, popularly known as the SENSEX (compromising 30 scrips), and S&P CNX Nifty Index (compromising 50 scrips), commenced trade in futures on June 9, 2000 and June 12, 2000 respectively. Index options and individual stock options on 31 selected stocks were subsequently added to the derivatives basket, in 2001. November 2001 witnessed the introduction of single stock futures in the Indian market. This list of stocks was selected, based on a predefined eligibility criteria linked to the market capitalization of stocks, floating stock, liquidity, etc.

•           COMMODITY DERIVATIVE

The Forward Contract Regulation Act (FCRA) governs commodity derivatives in India. The FCRA specifically prohibits OTC commodity derivatives. Accordingly, at this point in time, we have only exchange-traded commodity derivatives. Furthermore, FCRA does not even allow options on commodities. Therefore, at present, India trades only exchange-traded commodity futures.

Though commodity derivatives in the country have existed for a long time, trading has been regionally concentrated due to the regional nature of the commodity exchanges. Recently however, India began trading in commodity derivatives through two nation-wide, online commodity Exchanges- the National Commodities and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange (MCX). They started functioning in the last quarter of 2003 with the introduction of futures contracts on various assets such as gold, silver, rubber, steel, mustard seed, etc.

It is important to note that both these exchanges have been recording a very high rate of growth. But it is interesting to note that the growth in volume of commodity derivatives has been achieved without institutional participation in the market. At present, banks, financial institutions, mutual funds, pension funds, insurance companies and Foreign Institutional investors are not allowed to participate in the commodities market.

•           CURRENCY DERIVATIVES

India has been trading forward contracts in currency, for the last several years. Recently, the RBI has allowed options in the OTC market. The OTC currency market in the country is considerably large and well-developed. However, the business is concentrated with a limited number of market participants.

•           INTEREST RATE DERIVATIVES

An Interest Rate Derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate. There has also been significant progress in interest rate derivatives in the Indian OTC market. The NSE introduced trading in cash settled interest rate futures in the year 2003.