Derivative and Its Impact on Stock Market

A Paper Presentation Derivative and its impact on capital market Derivative and its impact on capital market On Prepared by Ms. Vidhi Joshi Asst. Professor MBA Department T. N. Rao college of Management Studies Rajkot 1. Introduction to Derivative: The rapidity with which Indian capital market, corporate finance, banking and investment finance has witnessed a major transformation and structural change from the past one decade and this change in recent years has given birth to a new discipline that has come to be known as Financial Engineering. Financial engineering involves the design, the development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance. The last decade has witnessed the introduction of ‘derivatives’ as an innovative financial instrument in the Indian markets. One of the major objectives of these reforms was to bring the Indian capital market up to a certain international standard. Due to such reforming process, one of the significant step taken in the secondary market is the introduction of derivative products in two major Indian stock exchanges viz. National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) , with a view to provide tools for risk management to investors and to improve the informational efficiency of the cash market. A derivative is financial instrument whose value is ‘derived’ from another underlying security or a basket of securities the underlying is the identification tag for a derivative contract. Derivatives are instruments of risk hedging. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines â€Å"derivative† as a security that is derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security, same as a contract which derives its value from the prices, or index of prices, of underlying securities. Derivative products includes futures, forwards, options and swaps, and these can be combined with each other or traditional securities and loans to create hybrid instruments. In other words, a future contract is a standardized agreement between the seller (short position holder) of the contract and the buyer (long position holder), traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. Equity derivatives trading started on June 9, 2000 with introduction of stock index futures by Bombay Stock Exchange (BSE). National Stock Exchange (NSE) also commenced its trading on 12 June, 2000 based on S&P Nifty. Trading on NIFTY futures was introduced on the 12th of July 2000. Trading on stock futures was introduced in the NSE in the 9th November, 2001. Subsequently, other products like stock futures on individual securities, index options and options on individual securities were introduced. Forward Contract: A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified future date. The price may be agreed on in advance or in future. † Future Contract: It involves an obligation on both the parties i. e. the buyer and the seller to fulfill the terms of the contract (i. e. these are pre-determined contracts entered today for a date in the future) * Obligation to buy or sell * Stated quantity * At a specific price * Stated date (Expiration Date) Marked to Market on a daily basis Options: An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. † The Price is called Premium and is paid by buyer of the option to the seller or writer of the option. à ¢â‚¬  Types of option * Call Option * Put option Put Option: The right to sell a futures contract. It provides protection against falling prices and also sets a minimum price target. Call Option: The right to buy a futures contract. It protects against rising prices and it also allows participation in seasonal price rises. Swap: Swap is a contract between two parties to exchange a set of cash flows over a pre-determined period of time. Example ‘A’ agrees to pay cash based on the rate of return of an agreed stock market index to the second counter party ‘B’. Participants in Derivatives Market: 1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category. 2. Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. 3. Arbitrageurs: Their behaviour is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Applications of Financial Derivatives: Some of the applications of financial derivatives can be enumerated as follows: 1. Management of risk: This is most important function of derivatives. Risk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. It requires a thorough understanding of the basic principles that regulate the pricing of financial derivatives. Effective use of derivatives can save cost, and it can increase returns for the organisations. 2. Efficiency in trading: Financial derivatives allow for free trading of risk components and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in the underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives as well as the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instrument in cash market. 3. Speculation: This is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can leads to financial destruction in an organisation like what happened in Barings Plc. However, these instruments act as a powerful instrument for knowledgeable traders to expose themselves to calculated and well understood risks in search of a reward, that is, profit. 4. Price discover: Another important application of derivatives is the price discovery which means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking. MOTIVATION FOR THE STUDY In the last decade, many emerging and transition economies have started introducing derivative contracts. Policy makers and regulators in these markets are concerned about the impact of futures on the underlying cash market. One of the reasons for this concern is the belief that futures trading attract speculators who then destabilize spot prices. Since futures encourage speculation, the debate on the impact of speculators intensified when futures contracts were first introduced for trading, beginning with commodity futures and moving on to financial futures. Before further regulations are introduced, it is essential to determine whether in fact there is a causal link between the introduction of futures and spot market volatility. It, therefore becomes imperative that we seek answers to questions like: What is the impact of derivatives upon market efficiency and liquidity of the underlying cash market? To what extent do derivatives destabilize the financial system, and how should these risks be addressed? Can the results from studies of developed markets be extended to emerging markets? Capital Market and Derivative segment in Indian Stock Market: Today Indian stock market is very sound in terms of participants from all sections, huge turnover and number of listed companies. Cash segment and derivative segment both have grown with each other. NSE and BSE are the major exchanges. Over the years Indian stock market has modernized with the use of high modern Information and Communication technology. Derivative instruments have become part and parcel of business world. Today, derivative instruments are used in all markets such as foreign exchange, shares, commodities etc. New, sophisticated, complex and exotic tools are being developed in different markets. The innovative derivative instruments have been developed in such a manner that these are used even by a common man. Although derivatives have been in existence for long in past in one or another form but present day sophisticated, standardized derivative products. Growth of Derivatives Market in India: Equity derivatives market in India has registered an â€Å"explosive growth† and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130, 90,477. 75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038 Cr. Table 1 : Turnover of Cash segment in India Year| Turnover at BSE| Turnover at NSE| Total Turnover| 1992-93| 45696| -| 45696| 993-94| 84536| -| 84536| 1994-95| 67749| 1805| 69554| 1995-96| 50064| 67287| 117351| 1996-97| 124190| 295403| 419593| 1997-98| 207113| 370193| 577306| 1998-99| 310750| 414474| 725224| 1999-00| 686428| 839052| 1525840| 2000-01| 1000032| 1339510| 2339542| 2001-02| 307292| 513167| 820459| 2002-03| 314073| 617989| 932062| 2003-04| 503053| 1099534| 1602587| 2004-05| 518715| 114007 2| 1658787| 2005-06| 816074| 1569558| 2385632| 2006-07| 956185| 1945287| 2901472| 2007-08| 1578857| 3551038| 5129895| 2008-09| 1100074| 2752023| 3852097| 2009-10| 1136513| 2805878| 3942391|