ABSTRACT

All markets face various kinds of risks. This has induced the market participants to
search for ways to manage risk. The derivatives are one of the categories of risk
management tools. Derivatives are used to shift risk and act as a form of insurance.
This shift of risk means that each party involved in the contract should be able to
identify all the risks involved before the contract is agreed. The term ‘derivative’
itself indicates that it has no independent value. A derivative security is a financial
contract whose value is derived from the value of something else, such as a stock
price, a commodity price, an exchange rate, an interest rate, or even an index of
prices. Derivatives may be traded for a variety of reasons. A derivative enables a
trader to hedge some preexisting risk by taking positions in derivatives markets that
offset potential losses in the underlying or spot market. In India, most derivatives
users describe themselves as hedgers and Indian laws generally require that
derivatives be used for hedging purposes only. Exchange-Traded and Over-the-
Counter are Derivative Instruments. 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 industry. 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 use of
derivatives varies by type of institution. Financial institutions, such as banks and
Non-financial institutions are regulated differently from financial institutions, and this
affects their incentives to use derivatives. Indian insurance regulators, for example,
are yet to issue guidelines relating to the use of derivatives by insurance companies.

The present legal framework and piecemeal approach adopted by SEBI is based on
the recommendations of the L.C. Gupta Committee.On the recommendations of the
Committee, definition of securities under the Act was modified to include derivatives.
Derivatives trading finally went underway at NSE and BSE after getting nod from
SEBI to commence index futures trading in June 2000. The Act renders a
comprehensive definition on derivatives and even permits derivatives trading on
derivatives. Only those derivative products which are traded on a recognized stock
exchange and are settled on the clearing house of the recognized stock exchange are
legal and valid. For trading in derivatives, permission from SEBI is mandatory.
However, this permission is required for trading in only those derivatives contracts
that are tradable and hence, no prior permission is mandatory for OTC derivatives.
The Act further prescribes punishment of imprisonment for a term which may extend
to one year, or with fine, or with both, in case of contravention of the Section 18A
and rules made there under by SEBI or Central Government. . Trading and settlement
in derivative contracts is done in accordance with the rules, byelaws and regulations
of the NSE and BSE and their clearing houses, duly approved by SEBI and notified in
the Official Gazette. The minimum contract size for a derivatives transaction is Rs. 2
lakhs. Thus, the enactment of Securities Law (Amendment) Act, 1999 and repeal of
the 1969 notification provided a legal framework for securities based derivatives on

1
stock exchanges in India, which is co-terminus with framework of trading of other
securities allowed under the Act. However, these attempts are not sufficient for
developing a buoyant derivatives market. The principal hindrance lurking before the
hedgers and speculators is taxation on derivatives transactions. There is no apparent
provision dealing with taxation of derivatives transactions. Section 73(1) read with
Section 43(5) of the Income Tax Act, 1961 are two provisions which are of
significant concern. Derivatives are not commodities, stocks or scrips but are a
special class of securities under the Act. Also, derivatives transactions, particularly
index futures are never settled by actual delivery. And most importantly, under
Section 43(5) a hedging or arbitrage transaction in which settlement is otherwise than
actual delivery is regarded as non-speculative only when the participant has an
underlying position, but in derivatives contracts hedgers and speculators have no
underlying position in such transactions. In the light of these readings, derivatives
contracts may be construed as speculative transactions and will be hit by Section
73(1). It is, therefore, imperative to declare derivatives transactions as non-
speculative and it should be taxed as normal business income or capital gains, as the
case may be.

2
INTRODUCTION

All markets face various kinds of risks. This has induced the market participants to
search for ways to manage risk. The derivatives are one of the categories of risk
management tools.Derivatives markets generally are an integral part of capital
markets in developed as well as in emerging market economies.These instruments
also offer protection from possible adverse market movements and can be used to
manage or offset exposures by hedging or shifting risks particularly during periods of
volatility thereby reducing costs.Derivatives have become very important in the field
of finance.They are very important financial instruments for risk management as they
allow risks to be separated and traded. Derivatives are used to shift risk and act as a
form of insurance. This shift of risk means that each party involved in the contract
should be able to identify all the risks involved before the contract is agreed.

Indian capital market finally acquired the much-awaited international flavour when it
introduced trading in futures and options on its premier bourses, National Stock
Exchange (NSE) in 2000 and on Bombay Stock Exchange (BSE) in 2001. Financial
markets are systemically volatile and so, it is the prime concern of all the financial
agents to balance or hedge the related risk factors. Risks can be of various kinds,
including price risks, counter-party risks and operating risks. The concept of
derivatives comes into frame to reduce the price-related risks.

DEFINITION OF DERIVATIVES

The term ‘derivative’ itself indicates that it has no independent value. The value of a
derivative is entirely derived from the value of a cash asset. A derivative contract,
product, instrument or simply ‘derivative’ is to be sharply distinguished from the
underlying cash asset, which is an asset bought or sold in the cash market on normal
delivery terms. A simple derivative instrument hedges the risk component of an
underlying asset. For example, rice farmers may wish to sell their harvest at a price
which they consider is ‘safe’ at a future date to eliminate the risk of a change in prices
by that date. To hedge their risks, farmers can enter into a forward contract and any
loss caused by fall in the cash price of rice will then be offset by profits on the
forward contract. Thus, hedging by derivatives is equivalent of insurance facility
against risk from market price variations.

A derivative security is a financial contract whose value is derived from the value of
something else, such as a stock price, a commodity price, an exchange rate, an
interest rate, or even an index of prices.

USES OF DERIVATIVES

Derivatives may be traded for a variety of reasons. A derivative enables a trader to

hedge some preexisting risk by taking positions in derivatives markets that offset
potential losses in the underlying or spot market. In India, most derivatives users
describe themselves as hedgers and Indian laws generally require that derivatives be

3
used for hedging purposes only. Another motive for derivatives trading is speculation
(i.e. taking positions to profit from anticipated price movements). In practice, it may
be difficult to distinguish whether a particular trade was for hedging or speculation,
and active markets require the participation of both hedgers and speculators.

A third type of trader, called arbitrageurs, profit from discrepancies in the relationship
of spot and derivatives prices, and thereby help to keep markets efficient. Jogani and
Fernandes (2003) describe India’s long history in arbitrage trading, with line
operators and traders arbitraging prices between exchanges located in different cities,
and between two exchanges in the same city. Their study of Indian equity derivatives
markets in 2002 indicates that markets were inefficient at that time. They argue that
lack of knowledge, market frictions and regulatory impediments have led to low
levels of capital employed in arbitrage trading in India. However, more recent
evidence suggests that the efficiency of Indian equity derivatives markets may have
improved .

RISE OF DERIVATIVES

The global economic order that emerged after World War II was a system where
many less developed countries administered prices and centrally allocated resources.
Even the developed economies operated under the Bretton Woods system of fixed
exchange rates.
The system of fixed prices came under stress from the 1970s onwards. High inflation
and unemployment rates made interest rates more volatile. The Bretton Woods
system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed
countries like India began opening up their economies and allowing prices to vary
with market conditions.
Price fluctuations make it hard for businesses to estimate their future production costs
and revenues.Derivative securities provide them a valuable set of tools for managing
this risk.

BENEFITS OF DERIVATIVES

Constant risks have stimulated market participants to manage it through various risk
management tools. Derivative products is a one such risk management tools. With the
increase in awareness about the risk management capacity of derivatives, its market
developed and later expanded. Derivatives have now become an integral part of the
capital markets of developed as well as emerging market economies. Benefits of
derivative products can be enumerated as under:

1. Derivatives help in transferring risks from risk-averse people to risk-oriented

people.

2. Derivatives assist business growth by disseminating effective price signals

concerning exchange rates, indices and reference rates or other assets and thereby,
render both cash and derivatives markets more efficient.

4
3. Derivatives catalyze entrepreneurial activities.

4. By allowing transfer of unwanted risks, derivatives can promote more efficient

allocation of capital across the economy and thus, increasing productivity in the
economy.

5. Derivatives increase the volume traded in markets because of participation of risk-

averse people in greater numbers.

6. Derivatives increase savings and investment in the long run.

EXCHANGE-TRADE AND OVER-THE-COUNTER DERIVATIVES

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 counter party that owes money
defaults on the payment. 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 clearing house, 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.

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 industry. 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

5
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 Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms
of the stock market between 1993 and 1996 paved the way for the development of
exchange-traded equity derivatives markets in India. In 1993, the government created
the NSE in collaboration with state-owned financial institutions. NSE improved the
efficiency and transparency of the stock markets by offering a fully automated screen-
based trading system and real-time price dissemination. In 1995, a prohibition on
trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing
exchange-traded derivatives. The report of the L. C. Gupta Committee, set up by
SEBI, recommended a phased introduction of derivative products, and bi-level
regulation (i.e., self-regulation by exchanges with SEBI providing a supervisory and
advisory role). Another report, by the J. R. Varma Committee in 1998, worked out
various operational details such as the margining systems. In 1999, the Securities
Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives
could be declared “securities.” This allowed the regulatory framework for trading
securities to be extended to derivatives. The Act considers derivatives to be legal and
valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward
trading was also lifted in 1999.

DERIVATIVES USERS IN INDIA

The use of derivatives varies by type of institution. Financial institutions, such as

banks, have assets and liabilities of different maturities and in different currencies,
and are exposed to different risks of default from their borrowers. Thus, they are
likely to use derivatives on interest rates and currencies, and derivatives to manage
credit risk. Non-financial institutions are regulated differently from financial
institutions, and this affects their incentives to use derivatives. Indian insurance
regulators, for example, are yet to issue guidelines relating to the use of derivatives by
insurance companies.
In India, financial institutions have not been heavy users of exchange-traded
derivatives so far, with their contribution to total value of NSE trades being less than
8% in October 2005. However, market insiders feel that this may be changing, as
indicated by the growing share of index derivatives (which are used more by
institutions than by retail investors). In contrast to the exchange-traded markets,
domestic financial institutions and mutual funds have shown great interest in OTC
fixed income instruments. Transactions between banks dominate the market for
interest rate derivatives, while state-owned banks remain a small presence (Chitale,
2003). Corporations are active in the currency forwards and swaps markets, buying
these instruments from banks.
Why do institutions not participate to a greater extent in derivatives markets? Some
institutions such as banks and mutual funds are only allowed to use derivatives to

6
hedge their existing positions in the spot market, or to rebalance their existing
portfolios. Since banks have little exposure to equity markets due to banking
regulations, they have little incentive to trade equity derivatives. Foreign investors
must register as foreign institutional investors (FII) to trade exchange-traded
derivatives, and be subject to position limits as specified by SEBI. Alternatively, they
can incorporate locally as abroker-dealer.FIIs have a small but increasing presence in
the equity derivatives markets. They have no incentive to trade interest rate
derivatives since they have little investments in the domestic bond markets (Chitale,
2003). It is possible that unregistered foreign investors and hedge funds trade
indirectly, using a local proprietary trader as a front (Lee, 2004).
Retail investors (including small brokerages trading for themselves) are the major
participants in equity derivatives, accounting for about 60% of turnover in October
2005, according to NSE. The success of single stock futures in India is unique, as this
instrument has generally failed in most other countries. One reason for this success
may be retail investors’ prior familiarity with “badla” trades which shared some
features of derivatives trading. Another reason may be the small size of the futures
contracts, compared to similar contracts in other countries. Retail investors also
dominate the markets for commodity derivatives, due in part to their long-standing
expertise in trading in the “havala” or forwards markets.

PRESENT LEGAL FRAMEWORK

The present legal framework and piecemeal approach adopted by SEBI is based on
the recommendations of the L.C. Gupta Committee. On the recommendations of the
Committee, definition of securities under the Act was modified to include
derivatives.The 1969 notification was also repealed on March 1, 2000. Derivatives
trading finally went underway at NSE and BSE after getting nod from SEBI to
commence index futures trading in June 2000. To begin with, SEBI approved trading
in index futures contracts based on S&P CNX Nifty and BSE – 30 (Sensex) index.
This was followed by approval for trading in options based on these two indexes and
options on individual securities. At BSE, trading in index options based on BSE
Sensex commenced in June 2001, the trading in options on individual securities
commenced on July 2001 and futures on individual stocks were launched in
November 2001. At NSE too, trading in index options based on S&P CNX Nifty
commenced in June 2001, trading in options on individual securities commenced in
July, 2001 and single stock futures were launched in November 2001.

The Act renders a comprehensive definition on derivatives and even permits

derivatives trading on derivatives. Only those derivative products which are traded on
a recognized stock exchange and are settled on the clearing house of the recognized
stock exchange are legal and valid. Section 18A of the Act is a non-obstante clause
and was recommended by the Parliamentary Standing Committee on Finance, which
examined the Securities Contracts (Regulation) Amendment Bill, 1998. The object of
this provision is that since derivatives, particularly index futures, are cash-settled
contracts, they can be entangled in legal controversy by being classified as ‘wagering

7
agreements’ under Section 30, Indian Contract Act, 1872 and thereby, declared null
and void.

For trading in derivatives, permission from SEBI is mandatory. However, this

permission is required for trading in only those derivatives contracts that are tradable
and hence, no prior permission is mandatory for OTC derivatives. The Act further
prescribes punishment of imprisonment for a term which may extend to one year, or
with fine, or with both, in case of contravention of the Section 18A and rules made
there under by SEBI or Central Government. Trading and settlement in derivative
contracts is done in accordance with the rules, byelaws and regulations of the NSE
and BSE and their clearing houses, duly approved by SEBI and notified in the
Official Gazette. The minimum contract size for a derivatives transaction is Rs. 2
lakhs.

Thus, the enactment of Securities Law (Amendment) Act, 1999 and repeal of the
1969 notification provided a legal framework for securities based derivatives on stock
exchanges in India, which is co-terminus with framework of trading of other
securities allowed under the Act. However, these attempts are not sufficient for
developing a buoyant derivatives market. The principal hindrance lurking before the
hedgers and speculators is taxation on derivatives transactions. There is no apparent
provision dealing with taxation of derivatives transactions. Section 73(1) read with
Section 43(5) of the Income Tax Act, 1961 are two provisions which are of
significant concern. Section 73(1) prescribes that losses of a speculative business
carried on by the assessee can be set-off only against profits and gains of another
speculative business, upto a maximum of eight years. Under Section 43(5) a
transaction is a speculative transaction where (a) the transaction is in commodity,
stocks or scrips, (b) the transaction is settled otherwise actual delivery, (c) the
participant has no underlying position and (d) the transaction is not for jobbing or
arbitrage to guard against losses which may arise in the ordinary course of his
business.

Derivatives are not commodities, stocks or scrips but are a special class of securities
under the Act. Also, derivatives transactions, particularly index futures are never
settled by actual delivery. And most importantly, under Section 43(5) a hedging or
arbitrage transaction in which settlement is otherwise than actual delivery is regarded
as non-speculative only when the participant has an underlying position, but in
derivatives contracts hedgers and speculators have no underlying position in such
transactions. In the light of these readings, derivatives contracts may be construed as
speculative transactions and will be hit by Section 73(1). It is, therefore, imperative to
declare derivatives transactions as non-speculative and it should be taxed as normal
business income or capital gains, as the case may be.

8
CONCLUSION

The initiatives of the Government and SEBI for growth of derivatives market are
admirable, however, there is still much leeway for improvement. This market is
embryonic, which is manifest from the low trading volumes compared with that of
developed capital economies. Still it is felt by market observers that contrary to the
initial promise derivatives never picked up. SEBI has to address many issues.
Foremost is clarity on taxation and accounting front. The number of derivatives
trading exchanges should be increased.

These instruments are designed to reallocate risks among market participants in order
to improve overall market efficiency. But while the new instruments create new
hedging opportunities, they also entail legal risks because the newer instruments tend
to be more difficult to understand and value than existing instruments and thus, more
prone to occasional large losses. Therefore, it is imperative that SEBI endeavours to
create awareness about derivatives and their benefits among investors.

Further, due to its complex nature, tough norms and high entry barriers, small
investors are keeping away from derivative trading. The issue of higher contract size
in derivatives trading is proving to be an impediment in increasing retail investors’
participation. The Parliamentary Standing Committee on Finance in 1999 observed
that because of the swift movement of funds and technical complexities involved in
derivatives transactions, there is a need to protect small investors who may be lured
by the sheer speculative gains by venturing into futures and options. Pursuant to this
object, the present threshold limit of Rs. 2 lakhs has been prescribed for derivatives
transactions. However, the contract size of Rs. 2 lakhs is not only high but is also
beyond the means of a typical investor. The heartening development in this regard is
that the Ministry of Finance has decided to halve the contract size from the current
level of Rs. 2 lakhs per contract to Rs. 1 lakh and SEBI will decide when to introduce
the reduced contracts.

Another roadblock is the restriction on Foreign Institutional Investors (FIIs) to invest

only in index futures. It is accepted that SEBI must have regulatory powers for
trading in securities, however, for increase in trading volumes, SEBI should lay down
only broad eligibility criteria and the exchanges should be free to decide on stocks
and indices on which futures and options could be permitted. Derivatives bring
vibrancy in capital markets and Indian investors can gain immensely from them.
Therefore, it is vital that necessary changes are brought in at the earliest. Also,
stringent disclosure norms on mutual funds for investing in derivatives should be
relaxed to revitalize Indian mutual funds by enabling diversification of risks and risk-
hedging.

9
 BOBLIOGRAPHY

WEBSITES NAME:

1. http://www.igidr.ac.in/~susant/DERBOOK/PAPERS/ss_draft2.

2. http://www.iief.com/Research/CHAP14.

3. http://www.nseindia.com/content/ncfm/ncfm_modules.htm#REFH9.6

4. http://en.wikipedia.org/wiki/Derivatives

10