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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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