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Derivatives will rule the market in future

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance 1995, which withdrew the prohibition on options in securities. The market for derivatives did not take off as there was no regulatory framework to govern trading of derivatives.

Derivatives trading commenced in India in June 2000.

To begin with, SEBI approved trading in Index Futures contracts based on S&P CNX Nifty Index and BSE-30 (SENSEX) Index. This was followed by approval for trading in options based on these two indices and options on individual securities.

The trading in index options commenced in June 2001 and trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in Nov. 2001.

Ever since its launch, the Derivatives market has been growing in size and in line with international standards, is slated to grow bigger than the cash market.

In the month of October 2002, the total turnover in the F&O segment amounted to Rs. 33,441 crore compared to Rs. 27,140 crore in September 2002, a rise of 23 per cent over the previous month. The average daily turnover during the month of October amounted to Rs. 1592 crore. The figures for November 2002 are more heartening. On 28th November, 2002, the last trading day for November contracts, the National Stock Exchange recorded an exceptionally high turnover in the derivatives segment to the tune of Rs. 3113.98 crores. The previous highest record of turnover was on Nov. 26 to the tune of Rs. 3028 crore.

Normally, near-month contracts are more popular than the not so near-month contracts. Futures are more popular than options. Contracts on securities are more popular than those on indices and 'call' options score over 'put' options.

Trading in Derivatives is currently restricted to only 31 stocks which satisfy a certain criteria and since the number here is very few, it was acting as an impediment to the faster growth of the Derivatives market.

SEBI has now addressed the issue and the SEBI board has now allowed stock exchanges to have the freedom to choose the stocks from the top 500 scrips (based on market capitalisation).

This move is expected to give a major boost to the derivatives market.

The small number of stocks available for trading on the Derivatives segment was one of the hurdles affecting the faster growth of the Derivatives market. However, there are other issues also that have been acting as restrictions on faster growth like:

(a) The minimum contract size of Rs. 2 lakhs. Though the official contract size is Rs. 2 lakhs, yet, in reality, based on multiples (market lot) for different stocks, the minimum contract size is much higher for eg. The multiple for Infosys is 100 shares while the market price is Rs. 4500, amounting to a minimum contract size of Rs. 4,50,000. In the case of TELCO, the multiple (market lot) is 3300 shares while the market price is Rs. 165 amountig to Rs. 5,45,000. These are just two of the many instances where based on the current market price the minimum contract size is far in excess of the minimum stipulated contract size which itself is considered high. SEBI is now taking up the matter with the government to reduce the minimum contract size from Rs. 2 lakhs to lower levels.

(b) Presently, contracts on the derivatives markets are cash-settled, which is tilted towards speculation. For e.g. A speculator can sell Satyam futures and keep his position open for as long as he desires since he does not have to deliver the shares, thereby negating a realistic price-discovery mechanism. On the other hand, if derivatives contracts are physically settled, it would lead to a more mature price-discovery mechanism.

It would also increase arbitrage opportunities for e.g. if the price of Satyam in the cash market is quoting at Rs. 270 on Dec. 2, 2002 and the futures expiring on Dec. 26, 2002, is quoting at Rs. 275, arbitrage opportunities are available. An arbitrager can buy 100 satyam in the cash market at Rs. 270 and sell 1000 Satyam futures at Rs. 275. In this transaction, he will make payment of Rs. 27 lakh for 1000 shares of Satyam purchased in the cash market. On the expiry date of the contract, he will cover his sales of Satyam in the futures market by delivering 1000 shares of Satyam and will receive payment of Rs. 2,75,000. The profit of Rs. 5000 on an investment of Rs. 2,70,000 translates into an annual return of 22 per cent. The same holds good for the present system of cash settlement, but it involves reversing of transactions before expiry date, which may at times be not be very advantageous, thus eating into the difference.

This is just one instance. There are many other such advantages of physical settlements but is likely to be introduced at a later stage until the margin trading scheme was properly in place and other issues are ironed out.

(c) Non-participation of sub-brokers: Earlier on, sub-brokers were not allowed to participate in the derivatives market. However, SEBI will now allow sub-brokers to participate in the derivatives market.

The availability of more stocks in the derivative segment, coupled with the reduction in the contract size are expected to bring more depth to the derivatives market. In the years ahead, we will see a derivatives market that is vibrant and many times larger than the cash market.

Clifton DeSilva, director, Altina Securities Pvt. Ltd., can be contacted on e-mail: [email protected]

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