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Learning Circle - Trading in Derivatives
Cash and Futures Market
Relationship
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Cash and Futures Market Relationship - Observations of While LC Gupta Committee favoured distinct exchange or separate derivative segment at the existing cash market, it also stressed the importance of integrated development of the securities market and stressed the inter-dependency of the cash and futures market. To quote from its report - "In the case of individual stocks, the positions which remain outstanding on the expiration date will have to be settled by physical delivery. This is an accepted principle everywhere. The futures and the cash market prices have to converge on the expiration date. Since Index futures do not represent a physically deliverable asset, they are cash settled all over the world on the premise that the index value is derived from the cash market. This, of course, implies that the cash market is functioning in a reasonably sound manner and the index values based on it can be safely accepted as the settlement price "The objective of SEBI is to make both derivatives market and cash market fair, efficient and transparent. Economically, it is important to realise that equity cash market and equity derivatives market are of one piece. Their sound development is inter-related closely. The Committee has kept this objective in view and would like to ensure that the new derivatives market is developed along sound lines. This objective can best be achieved by separating cash market and futures market and thereby regulating them effectively. At present, almost 90 per cent of the trading volume in the cash market does not settle in deliveries of the stock. The great bulk (over 85 per cent) of such trading is in 5 scrips only. The Committee noted that several earlier committees on stock exchange reforms, including the G.S. Patel Committee (1984-85), had expressed concern at the small percentage of deliveries in Indian exchanges. They had also lamented the illiquidity of a majority of listed shares and the practice of switching of positions from one exchange to another due to different exchanges having different settlement cycles "The Committee hopes that some of the speculative transactions, which are presently conducted in the cash market, would be attracted towards the proposed derivatives market. "The Committee recognises that an efficient cash market is required for an efficient futures market. The Committee also recognises the danger that if the cash market behaviour is erratic or does not reflect fundamentals, a futures market, based on such a cash market, will fail to give a correct indication of future spot prices and its usefulness for price discovery will be reduced. Measures to Strengthen the Cash Market "The Committee is of the opinion that the following revisions could lead to a further strengthening of the underlying cash market
"The Committee is of the view that arbitrage transactions between the index futures market and the cash market for equities is likely to have a beneficial effect on the functioning of the cash market in terms of price discovery, broadening of liquidity and over-all efficiency" Strengthening the Influence of Fundamental Factor "The Committee thought of ways to ensure that fundamental factors adequately enter into the price discovery process in the cash market and, through it, in the futures market. In this connection, the Committee noted that it was important in the case of futures markets, whether commodity futures or other futures, to assist the price discovery process by promoting the dissemination of all relevant market information about the "real" factors, such as supplies, demand, prospects, etc. In regard to stock index futures, the Committee feels that there are two important ways of promoting its linkage to fundamental factors. First, there must be a requirement that average P/E ratio of the index used for futures trading should be made available by the exchange concerned on daily basis as essential market information. Second, the arbitrage between the index futures market and the cash market for the shares composing the index should be facilitated by requiring such shares to be traded in the depository mode and also by making available the facility of stock borrowing so that short-selling is rendered possible." |
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