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Derivatives Market in India - Futures and Options

Mr. Venkatesha
Research Scholar
Department of Studies in Commerce
Vijayanagara Sri Krishnadevaraya University Ballari, Karnataka, India

Abstract: Derivatives are risk management instruments, which derive their value from an underlying asset.
The underlying asset can be index, share, bonds, currency, and interest etc. Banks, securities firms,
companies and investors to hedge risks to gain access to cheaper money and to make profit by using
derivatives. Derivatives are likely to grow even at a faster rate in future. Financial derivatives enable parties
to trade specific financial risks (such as interest rate risk, currency, equity and commodity price risk, and
credit risk, etc.) to other entities who are more willing, or better suited, to take or manage these risks—
typically, but not always, without trading in a primary asset or commodity. The risk embodied in a
derivatives contract can be traded either by trading the contract itself, such as with options, or by creating a
new contract which embodies risk characteristics that match, in a countervailing manner, those of the
existing contract owned. This paper aims to know the various contracts, instruments in derivatives market
for investment to the investors.

Keywords: Derivative, Futures, Options, Bermudan

Introduction:
The emergence of the market for derivatives products, most notably forwards, futures and options, can be
traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties
arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very
high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer
price risks by locking-in asset prices. As instruments of risk management, these generally do not influence
the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative product
minimizes the impact of fluctuations in asset prices on the profitability and cash flow situation of risk averse
investors.
A derivative instrument is a contract between two parties that specifies conditions (especially the dates,
resulting values of the underlying variables and notional amounts) under which payments are to be made
between the parties.
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Literature Review:
Ashutosh Vashishtha and Satish Kumar (2010) conducted a case study on Development of Financial
Derivatives Market in India. In this study they focused conceptual framework of derivatives. This study
helps to know the Derivatives Products Traded in Derivatives Segment of BSE and NSE and its turnover,
number of contracts and average daily transactions of index and stock futures and index and stock options.
The derivatives turnover on the NSE has surpassed the equity market turnover. Significantly, its growth in
the recent years has surpassed the growth of its counterpart globally.

Mohammed Rubani (2017) has focused on the evolution of capital market in India, assessment of
performance of derivative market in India and factors contributing towards the growth of Derivative Market.
The market determined exchange rates and interest rates also created volatility and instability in portfolio
values and securities prices and hedging activities through various derivatives emerged to different risks.

Toopalli Sirisha and Dr. NallaBala Kalyan (2019) in this paper objective is to investigate the effect on the
underlying market volatility of financial derivatives with respect to futures and options. It helps the
investors to construct a diversified portfolio, suggests investors about investment in futures, options, and
swaps and it is used to know the risk management in derivatives. In the study stock futures, stock call and
put options of Tata Consultancy Services are analyzed. From the study it is found that derivatives will
minimize the risk occurred in the stock market. In options investor get profits by using a call or put option.
From the study we come to know that options give more returns and less risk compared to futures.

Dr T.V.S.S.Swathi and M. V. Sai Priya (2021) this paper aims to study futures and options by considering
a company derivative from Indian stock market and suggesting the best possible ways to investors to gain
more profits in derivative markets. From the study it is found that derivatives will mitigate the risk arises in
the stock market. In futures investor cover the loss occurred in near month contract by using mid-month
contract. Options will give more growth to the investors over the future and investor can use margin of
safety and know where to buy and sell the stocks.

Statement of the Problem:

Difficult to find best security, people want to more return at same time risk should be less. Therefore, study
aim is to understand derivatives with special reference to futures and options. And getting the value of
derivatives is very difficult in valuation of derivatives tools are very much complicated but we can take
decision.

Objectives of the Study:

1. To study the concept of derivatives market in India.

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Concept of Derivatives
Derivatives are broad set of instruments whose value depends on some underlying assets. The value is
derived from underlying financial or physical assets. It is a financial instrument which derives its value/price
from the underlying assets.

“A contract which derived its value from price or index of prices at underlying securities.”
-Securities Contracts (Regulation) Act 1956

Features of Financial Derivatives

1. It is a contract:
2. Derives value from underlying asset:
3. Specified obligation:
4. Direct or exchange traded:
5. Related to notional amount:
6. Delivery of underlying asset not involved:
7. May be used as deferred delivery:
8. Secondary market instruments:
9. Exposure to risk:

FUNCTIONS OF DERIVATIVES
1) Discovery of price
2) Risk transfer
3) Enhances liquidity
4) Increases savings and investment
5) Brings perception in market
6) Encourages entrepreneurship or competition

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TYPES OF DERIVATIVES

Derivatives

Financial Commodity

Basic Complex

Forwards Futures Options Warranty & Convertible Swaps Exotics

Forward Contract
A forward contract is a customized contract between two parties where settlement takes place on a
specific date in future at today’s pre agreed price.

Features of Forward Contract

1. Bilateral
2. Customized contracts
3. Long and short positions
4. It is specified terms of contract
5. Mutual obligation
6. No initial investment
7. It removes uncertainty of price
8. Counter party risk
9. Illiquidity

Futures Contract
Future contract is standardized agreement between the parties to exchange and underlined assets at a
predetermined price on a specific date in future.

Features of Future Contract:

 It is a contract:
Future contract is an agreement between two parties of exchange an underlined asset through the
exchange traded.
 It removes uncertainly price:
When we are locked the price of a security because we are deciding today itself it leads to remove
uncertainly of price.
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 It specified obligations:
Future contract specified the obligation to purchase of an underlined asset is to receive the delivery
of goods and make the payment where are obligation of seller is to give the delivery and receive the
cash.
 It is a standardized contract:
a) Exchange traded: Future contract are traded through the exchange traded and the party’s
requirement is not considered into contract because it is readymade contract.
b) Quality & Quantity: Quality and quantity of underlined assets fixed in the future contract.
c) Initial investment: Initial investment is a required for a trading underline security in the future
contract.
d) Daily settlement: It takes place in the future contract that is mark to mark or market to market.
e) Maturity: Three future contract are available in India,
 One month contract – Neat
 Two-month contract – Next
 Three-month contract – Far
 No counter party risk:
Clearing house keeps track of all transactions that take place in the exchange and becomes the
formal counter party to every transaction. These agreement elements the problems of counter party
risk.
 Liquidity:
Future contracts extremely liquid because, it is possible to unwind a contract at any time by
performing a receiving trade.

Types of Futures Contracts:

1. Interest rate futures:
In this type the futures securities traded are interest bearing instruments like T-bills, bonds,
debentures, euro dollar deposits and municipal bonds, notional gilt-contracts, short term deposit
futures and Treasury note futures.
2. Stock index futures:
Here in this type contracts are based on stock market indices. For example, in US, Dow Jones
Industrial Average, Standard and poor's 500 New York Stock Exchange Index. Other futures of this
type include Japanese Nikkei index, TOPIX etc.
3. Foreign currency futures:
These future contracts trade in foreign currency generating used by exporters, importers, bankers,
FIs and large companies.
4. Bond index futures:
These contracts are based on particular bond indices i.e., indices of bond prices. Municipal Bond
Index futures based on Municipal Bonds are traded on CBOT (Chicago Board of Trade).
5. Cost of living index future:
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These are based on inflation measured by CPI and WPI etc. These can be used to hedge against
unanticipated inflationary pressure.

Purpose of Trading Financial Future:

Financial futures are traded either to speculate on prices of securities or to hedge existing exposure to
security price movements. Speculators in financial futures markets take positions to profit from expected
changes in the price of futures contracts over time. They can be classified according to their methods. Day
traders attempt to capitalize on price movements during a single day: normally, they close out their futures
positions on the same day the positions were initiated. Position traders maintain their futures positions for
longer periods of time. And thus, attempt to capitalize on expected price movements over a more extended
time horizon. Hedgers take positions in financial futures to reduce their exposure to future movements in
interest rates or stock price. Many hedgers who maintain large portfolios of stocks or bonds take a futures
position to hedge their risk.

Institutional Trading of Futures Contracts:

Summarizes how various types of financial institutional participate in futures markets. Financial institutions
generally use futures contracts to reduce risk. Some commercial banks, savings institutions, bond mutual
funds, pension funds, and insurance companies trade interest rate futures contracts to protect against a
possible increase in interest rates, thereby insulating their long-term debt securities from interest rate risk.
Types of financial Participation in Futures Markets
institution
Commercial banks Take positions in futures contracts to hedge against interest rate risk
Savings institutions Take positions in futures contracts to hedge against interest rate risk.
Securities firms Execute futures transactions for individual and firms.
Take positions in futures contracts to hedge their own portfolios
against stock market or interest rate movement.
Mutual funds Take positions in futures contracts to speculate on future stock market
or interest rate movements.
Take positions in futures contracts to hedge their portfolios against
stock market or interest rate movements.
Pension funds Take positions in futures contracts to hedge their portfolios against
stock market or interest rate movements.
Insurance Take positions in futures contracts to hedge their portfolios against
companies stock market or interest rate movements.

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Risk of Trading Futures Contracts:
 Market risk: Market risk refers to fluctuations in the value of the instruments as a result of market
conditions firms that use futures contracts to speculate should be concerned about market risk. If
their expectations about future market conditions are wrong, they may suffer losses on their futures
contracts.
 Basis risk: A second type of risk is basis risk, or the risk that the position being hedged by the
futures contracts is not affected in the same manner as the instrument underlying the futures contract.
 Liquidity risk: A third type of risk is liquidity risk, which refers to potential price distortions due to
a lack of liquidity. For example, a firm may purchase a particular bond futures contract to speculate
on expectations of rising bond prices.
 Credit risk: A fourth type of risk is credit risk, which is the risk that a loss will occur because a
counter party defaults on contract. This type of risk exists for over-the-counter transactions, in which
a firm or individual relies on the credit worthiness of counter party.
 Prepayment risk: It refers to the possibility that the assets to be hedged may be prepaid earlier than
their designated maturity. Suppose that a commercial bank sells Treasury bond futures in order to
hedge its holdings of corporate bonds and that just after the futures position is created the bonds are
called by the corporation that initially issued them.
 Operational risk: A sixth type of risk is operational risk, which is the risk of losses as a result of
inadequate management or controls. Firms that use futures contracts to hedge are exposed to the
possibility that the employees responsible for their futures positions do not fully understand how
values of specific futures contract will respond to market conditions.
 Exposure of futures market to systemic risk: To the extent that traders of financial futures
contracts or other derivative securities are unable to cover their derivative contract obligations in
over- the –counter transactions, they could cause financial problems for their respective counter
parties.

Options Contract
An option is the right but not obligation to buy or sell something on a specified date at a specified price. In
the securities market an option is a contract between two parties to buy or sell a specified number of shares
at a later date for an agreed price.

Basic Terms used in Option Trading:

 Contract:
It is a contract to buy or sell an underlying asset.
 Parties:
There are two parties to the contract that is buyer (holder) of the contract and seller (writer) of the
contract the writer guaranty to the option holder a right to buy or sell a particular asset.
 Exercise price or strike price:
The pre determine price at which the underlying assets may be sold or bought by the option holder.
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 Exercise date:
The date on which option is exercise by option holder.
 Expiration date or maturity date:
The date on which the option expires or matures that is the maturity date of the contract.
 Option premium:
It is the price paid by the option holder to the option writer to acquire the write to buy or sell the
underlying assets this is the consideration for the write paid at the time of formation of the contract.

Option Styles:
a) American style:
An option that may be exercised on any trading day on/or before expiration. In other words,
American option provides the holder to buy or sell an underlined asset which can be exercised at any
time before or on the date of expire of the option.
b) European style:
In option that may only be exercised on expire date of the contract. In other words, European option
can be exercised only on the date of expire or maturity.
c) Bermudan style:
An option that may be exercised only on specified dates on/or before expiration of the contract.

Types of Option Contract

 Call Option:
Call Option is on option which grants the holder the right to buy an underlined asset at a specified
date from the writer a particular quality of underlying assets on a specified price within a specified
expiration maturity date.
 Put Option:
Put Option is an option contract where the holder as the right to sell an underlying asset to the writer
of the option at a specified price on or before maturity dates.

Option Strategies
1) Pay off profit for the buyer of call option
a) Long call
b) Short call

2) Pay off profit for the buyer of put option

a) Long put
b) Short put

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Models of Options
 Black-Scholes Option Pricing Model
 Binomial Option Pricing: One Time Period
 Binomial Option Pricing: Multiple Time Periods

Difference between Futures and Options:

Futures Contract Options Contract
1) Exchange traded with notation 1) Same as futures
2) Exchange defines the product 2) Same as futures
3) Price is zero, strike price move 3) Strike price is fixed price moves
4) Linear payoff 4) Nonlinear payoff
5) Both long and short at risk 5) Only short at risk

REFERENCES
Articles
1. Ashutosh Vashishtha and Satish Kumar (2010), “Development of Financial Derivatives Market in
India- A Case Study”, International Research Journal of Finance and Economics, ISSN 1450-2887
Issue 37 (2010)
2. Mohammed Rubani (2017), “A Study of Derivative Market in India”, International Journal of
Business Administration and Management. ISSN 2278-3660 Volume 7, Number 1 (2017), pp 203-
215.
3. Toopalli Sirisha and Dr. NallaBala Kalyan (2019), “A Study on the Derivatives Market in India”,
SSRN Electronic Journal , Vol 9 No.10
4. Dr T.V.S.S.Swathi and M. V. Sai Priya (2021), “A Study of Derivative Market in India”, The
International journal of analytical and experimental modal analysis, ISSN NO:0886-9367, Volume
XIII, Issue VIII, August/2021, Page No: 1115-1119.

Books:
1. Prafulla Kumar Swain, “Fundamentals of Financial Derivatives” Himalaya Publishing House, New
Delhi.
2. N.D. Vohra and B.R. Bargi, “Futures and Options” Tata McGraw-Hill, New Delhi.

Websites:
 www.nseindia.com
 www.bseindia.com

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