We have already discussed in detail earlier in another article about Index futures , methodologies in calculating, Uses of Stock Indices, etc.When SEBI decided to implement derivative trading in the bourses, the first product of this category to be introduced at both NSE & BSE in the year 2000 is Index Futures.

A majority of the respondents to a survey conducted by the L C Gupta committee, favored stock index futures. In terms of users' preference stock index futures ranked number one, followed by stock index options and options on stocks. Even in the US market, the regulatory framework doesn't allow use of futures on individual stocks. Only one or two countries in the world are known to have futures on individual stocks. Stock Index Futures are internationally the most popular forms of equity derivative. Derivatives of three months duration (contract duration) are widely used in the Indian context.

While all equity investors are exposed to risks equally, the problem is more pronounced in the case of institutional investors on account of the sheer size and portfolio management needs. Index futures are cost-effective derivatives instruments than derivatives on individual stocks. Stock index futures are the hot favorites among the mighty pension funds in the US.

Unlike individual stocks, indices are not prone to price manipulation. Therefore, futures on stock indices are regarded as better suited for the Indian securities markets. Prices of individual stocks are prone to manipulation on account of the limited floating stock in the market. While an index being a representative of the stocks, is also prone to this phenomenon, this problem can be taken care of by carefully designing the index to include a variety of stocks. Indices being averages of individual stocks, they tend to be less volatile than the individual stocks. There is underlying assumption that the prices in the cash market and futures market converge on the expiration date. While the underlying individual securities are settled by delivery, index futures are cash settled. The underlying reason being that it will not be cost effective to deliver an index since it involves delivery of all securities in the same proportion. At times it may not be feasible at all. Experience of the global derivatives markets indicates that index futures are the most liquid of the derivatives. This is attributed to their immense popularity in the markets. Among the equity derivatives inter se stock index futures are better placed in terms of regulatory complexities that exist in the case of other equity derivatives such as index options and options on individual stocks.

The L C Gupta committee observed that nearly 90 percent of the trading volume in the Indian stock market does not result in delivery of stocks. Some of the speculative transactions, which are taking place in the cash market, will be transferred to the derivatives market. Once derivatives trading is in place trading by arbitrageurs is likely to result in better price discovery, enhancing the efficiency of the markets in the process.

The emphasis on futures is not without reason. Futures trading is very popular overseas. While futures trading represents a more efficient way of hedging risk, forward contracts represent private bilateral contracts and have well-established commercial usage. But forwards are exposed to default risk by counterparties. Each forward contract is unique in terms of contract size, expiration date and the asset type/quality. The contract price is not transparent, as it is not publicly disclosed. Since the forward contract is not tradable, it has to be settled by delivery of the asset on the expiration date.

In contrast, futures contracts are standardized tradable contracts. They are standardized in terms of size, expiration date and all other features. They are traded on exchanges in a highly sophisticated environment of stringent financial safeguards. They are liquid and transparent. Their market prices and trading volumes are regularly reported. The futures trading system has effective safeguards against defaults in the form of clearing corporation guarantees for trades and the daily cash adjustment (mark-to-market) to the accounts of trading members based on daily price change. Futures are far more cost-efficient than forward contracts for hedging.

The development and growth of the Indian stock market over the last decade has been successful in establishing a fairly active market for Indian securities, the market for risk has not been developed. For the investment and financial institutions derivatives are strategic needs. Hedging the portfolio risks is at the core of portfolio management worldwide. The need for derivatives are manifold in portfolio management. Trading in the underlying securities is costlier compared to trading in derivatives on account of brokerages etc. Moreover frequent trading in the underlying securities causes radical churning of the portfolio, which is not a sound portfolio management strategy. Derivatives allow the portfolio mangers to achieve their goals with relative ease and in a cost-effective manner without being subject to the hassles associated with trading in underlying securities.

From the perspective of mutual funds derivatives bring many advantages. In the case of a new scheme where the money raised is to be parked temporarily before deploying in the targeted securities, index futures offer a better alternative. The trading activity of the open-ended funds depends on the magnitude of sales and repurchases. At times repurchases may compel the fund manager to offload a portion of the portfolio. This would lead to a number of problems. Firstly, it is very difficult to liquidate the stocks in accordance with the portfolio proportion. All the stocks comprising the portfolio may not be highly liquid. The threat of prices coming down also looms large over such activity. While the sale and repurchases are pegged to the NAV, the actual prices at the time of trading tend to be different. Index futures effectively take care of these problems. Index futures can also be employed to neutralize the impact of any possible adverse movement in the markets.

Post-reform, FIIs have become a dominant force in the Indian markets. In the absence of derivatives, FII activity is adding to the volatility in the stock market in great measure. Owing to their sheer clout, FIIs are in a position to influence the market significantly. If FIIs are provided with derivatives like index futures, their activity will move to derivatives market from the cash market, thereby reducing the market volatility. As a bonus, the introduction of derivatives is likely to increase their appetite for Indian paper and result in more funds being channeled to the Indian markets.

The Two major Stock Exchanges of India NSE and BSE commenced Trading as Under:

1. SNX Nifty Futures: September 2000

2. Trading in Individual Stock Futures: December 2001

1. Sensex BSE Futures: June 2000

2. Individual Stock Futures: December 2001

NSC conducts derivative trading at its F & O (Futures & Options) Segment, while BSE conducts derivative trading at the DTSS (Derivatives Trading and Settlement System ). After introducing BSE 30 Sensex Futures initially in June 2000, BSE also followed derivative trading with its other indices viz. BSETECK, BSE100, BSE200, BSE500, BSEPSU.

The Sensex futures contracts are to be on a monthly cycle. The contract month identifies the month and year in which the futures contract ceases to exist. At a given point of time, there would be multiple series (3 in this case) open in the Index futures. The lifetime of each series will currently be a maximum of three months. These monthly series would mature on the last Thursday of the respective month and the new monthly series would come into existence on the immediately following trading day. In case the last Thursday of the month is a holiday the expiry will be on the previous working day.

National Stock Exchange (NSE) accounts for over 97 percent of the activity in equity derivatives in India. Therefore, the status of equity derivatives markets in India can be measured in terms of the NSE's performance. Out of the total derivatives volume at NSE, individual stock futures account for almost 70 percent. Single stock call and put options constitute about 20 percent of the volumes. Index futures constitute about 10 percent and index options constitute about 2 percent of the volumes.

India entered the derivatives league in June 2000 with the introduction of index futures and then India witnessed the introduction of index options in June 2001, stock options in July 2001 and futures on individual securities in November 2001. There has been a steady increase in the volumes. For instance, average daily volumes in NSE derivative segment rose from Rs. 438 crore in October 2001 to Rs. 1073 crore in May 2002. Volumes in derivatives segment have grown phenomenally in the past few months, particularly after the introduction of stock futures and options. This spurt in activity can be attributed to stock futures that have aroused trading interest like no other derivative product.