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Unit 11: Introduction to Derivatives
Stock Index Futures contract allows for the buying and selling of the particular stock index for a Notes
specified price at a specified future date. Stock Index Futures, inter alia, help in overcoming the
problem of asymmetries in information. Information asymmetry is mainly a problem in
individual stocks as it is unlikely that a trader has market-wide private information. As such, the
asymmetric information component is not likely to be present in a basket of stocks. This provides
another rationale for trading in Stock Index Futures. Trading in index derivatives involves low
transaction cost in comparison with trading in underlying individual stocks comprising the
index. While the BSE introduced Stock Index Futures for S&P CNX Nifty comprising of 50 scrips.
Stock Index Futures in India are available with one month, two month and three month maturities.
While derivatives trading based on the Sensitive Index (Sensex) commenced at the BSE on
June 9, 2000, derivatives trading based on S&P CNX Nifty commenced at the NSE on June 12, 2000.
Did u know? SIF is the first attempt in the development of derivatives trading.
11.1.4 Exchange-Traded and Over-the-Counter Derivative Instruments
OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated between
two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific
requirements of the user. OTC contracts have substantial credit risk, which is the risk that the
counterparty that owes money defaults on the payment.
Notes In India, OTC derivatives are generally prohibited with some exceptions: those that
are specifically allowed by the Reserve Bank of India (RBI) or, in the case of commodities
(which are regulated by the Forward Markets Commission), those that trade informally
in ‘havala’ or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardized format that specifies
the underlying asset to be delivered, the size of the contract, and the logistics of delivery. They
trade on organized exchanges with prices determined by the interaction of many buyers and
sellers. In India, two exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and
the National Stock Exchange (NSE). However, NSE now accounts for virtually all exchange-
traded derivatives in India, accounting for more than 99% of volume in 2003-2004. Contract
performance is guaranteed by a clearinghouse, which is a wholly owned subsidiary of the NSE.
Margin requirements and daily marking-to-market of futures positions substantially reduce the
credit risk of exchange-traded contracts, relative to OTC contracts.
11.1.5 Development of Derivative Markets in India
Derivatives markets have been in existence in India in some form or other for a long time. In the
area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and,
by the early 1900s India had one of the world’s largest futures industries. In 1952, the government
banned cash settlement and options trading and derivatives trading shifted to informal forwards
markets. In recent years, government policy has changed, allowing for an increased role for
market-based pricing and less suspicion of derivatives trading. The ban on futures trading of
many commodities was lifted starting in the early 2000s, and national electronic commodity
exchanges were created.
In the equity markets, a system of trading called ‘badla’ involving some elements of forwards
trading had been in existence for decades. However, the system led to a number of undesirable
practices and it was prohibited off and on till the Securities and Derivatives OUP.
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