Benefits of Derivatives in India, in particular Index Derivatives

During December 95, NSE applied to SEBI for permission to undertake trading in Stock Index futures. Later SEBI appointed the LC Gupta Committee, which conducted a survey amongst market participants and observed a overwhelming interest in stock index futures, followed by other derivatives products. The LCGC recommended derivatives trading in the stock exchanges in a phased manner. It is in this context SEBI permitted both NSE and BSE in the year 2000 to commence trading in stock Index futures. The question therefore becomes relevant - what are the benefits of trading in Derivatives for the country and in particular for choosing stock index futures as the first preferred product?

1. Institutional and other large equity holders need portfolio hedging facility. Here index based derivatives are more suited to them and more cost effective than derivative based on security.

2. stock index is difficult to be manipulated as compared to individual stock price. This is partly because individual stock equity has limited supply which can be cornered.

3. stock index future enjoys distinctly greater popularity as shown both by our survey and international experience.

4. stock index, being an average is much less volatile than individual stock prices. This implies much lower capital adequacy and lower margin requirement . This consequently induces more players to join the market.

5. In the case of individual stock the position which remain outstanding on the expiration date will have to be settled by physical delivery. Since index future do not represent physically deliverable asset, they are cash settled all over the world on the premise that index value is derived from the cash market.

6. Regulatory complexity is likely to be less in the case of the stock index future than for the other kind of equity.

1. India's financial market system will strongly benefit from smoothly functioning index derivatives markets.

2. Internationally, the launch of derivatives has been associated with substantial improvements in market quality on the underlying equity market. Liquidity and market efficiency on India's equity market will improve once the derivatives commence trading.

3. Many risks in the financial markets can be eliminated by diversification. Index derivatives are special in so far as they can be used by investors to protect themselves from the one risk in the equity market that cannot be diversified away, i.e. a fall in the market index. Once investors use index derivatives, they will suffer less when fluctuations in the market index take place.

4. Foreign investors coming into India would be more comfortable if the hedging vehicles routinely used by them worldwide are available to them.

5. The launch of derivatives is a logical next step in the development of human capital in India. Skills in the financial sector have grown tremendously in the last few years, thanks to the structural changes in the market, and the economy is now ripe for derivatives as the next area for addition of skills.

[Source: Resources Extracted from article "Derivative Products & its Prospects In India" from the website of Pacific Institute of Management - URL - http://www.pimanagement.org/proj-deriv-products2.htm]