Project on Indian Financial Market Structure
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Derivatives Market Structure

Apart from traditional financial markets, two more markets are emerging, namely, the derivatives market, which has come into being recently and the bancassurance market, which is likely to emerge in an important way once banks start undertaking insurance business.

Financial derivatives in the Indian financial markets are of recent origin barring trade related forward contracts in the forex market5 . Recently, over-the-counter (OTC) as well as exchange traded derivatives have been introduced, marking an important development in the structure of financial markets in India. Forward contracts in the forex market have also been liberalised. Exchange traded derivatives tend to be more standardised and offer greater liquidity than OTC contracts, which are negotiated between counterparties and tailored to meet the needs of the parties to the contract. Exchange traded derivatives also offer centralised limits on individual positions and have formal rules for risk and burden sharing.

In India, OTC derivatives, viz., Interest Rate Swaps (IRS) and Forward Rate Agreements (FRAs) were introduced in July 1999, while one exchange traded derivative, viz., Stock Index Futures was introduced by the two largest stock exchanges in June 2000. The FRA is an off-balance sheet contract between two parties under which one party agrees on the start date (or trade date) that on a specified future date (the settlement date) that party, viz., the party that agrees, would lodge a notional deposit with the other for a specified sum of money for a specified period of time (the FRA period) at a specified rate of interest (the contract rate). The party that has agreed to make the notional deposit has, thus, sold the FRA to the other party who has bought it. The IRS is a contract between two counter-parties for exchanging interest payment for a specified period based on a notional principal amount. The notional principal is used to calculate interest payments but is not exchanged. Only interest payments are exchanged. The IRS and FRA were introduced with a view to deepening the money market as also to enable banks, Primary Dealers and financial institutions to hedge interest rate risks. The IRS has emerged as the more popular of the two instruments in the Indian market, accounting for nearly all of the 928 outstanding deals, amounting to Rs.12,620 crore of notional principal as on November 17, 2000. The overnight call money rates and the forex forward rates have emerged as the most popular benchmark rates. 4.128 A resident of India who has borrowed foreign exchange in accordance with the FEMA, may enter into an interest rate swap or currency swap or coupon swap or foreign currency option or interest rate cap/collar or Forward Rate Agreement (FRA) contract with an authorised dealer (AD) in India or with a branch outside India of an authorised dealer for hedging his loan exposure and unwinding from such hedges provided that (i) the contract does not involve rupee, (ii) foreign currency borrowing has been duly approved, (iii) the notional principal amount of the hedge does not exceed the outstanding amount of the loan, and (iv) the maturity of the hedge does not exceed the un-expired maturity of the underlying loan. ADs in India may remit foreign exchange related to such foreign exchange derivative contracts. No resident in India can enter legally into a foreign exchange derivative contract without the prior permission of the Reserve Bank. Among the non-residents, while FIIs may enter into a forward contract with rupee as one of the currencies with an AD in India, nonresident Indians and Overseas Corporate Bodies could take forward cover with an AD to hedge (i) dividend due on shares held in India, (ii) balances in FCNR(B) and NR(E)A, and (iii) the amount of investment made under portfolio scheme. The Reserve Bank may also consider allowing residents to hedge their commodity price risk (including gold but excluding oil and petroleum products) subject to certain conditions.

A beginning with equity derivatives has been made with the introduction of stock index futures by BSE and NSE. Stock Index Futures contract allows for the buying and selling of the particular stock index for a specified price at a specified future date. Stock Index Futures, inter alia, help in overcoming the problem of asymmetries in information. Information asymmetry is mainly a problem in individual stocks as it is unlikely that a trader has market-wide private information. As such, the asymmetric information component is not likely to be present in a basket of stocks. This provides another rationale for trading in Stock Index Futures. Also, trading in index derivatives involves low transaction cost in comparison with trading in underlying individual stocks comprising the index. While the BSE introduced stock index futures for BSE Sensex comprising 30 scrips, the NSE introduced Stock Index Futures for S&P CNX Nifty comprising 50 scrips. Stock Index Futures in India are available with one month, two month and three month maturities. Till November 8, 2000, both the stock exchanges had recorded a cumulative combined turnover of Rs.1,210 crore. To effectively manage risk in the derivative segment, adequate risk containing measures have been put in place. They include specifying minimum net worth requirement of brokers and its composition, margining system based on 99 per cent Value at Risk (VaR) model, position limit for various participants and guidelines for collection and enforcement of margins. Another equity derivative product in the equity market, viz., stock index options is likely to be introduced shortly. The SEBI has set January 2001 as the target date for introducing options trading in the Indian market.

Forward contracts market has emerged as an important segment of the forex market in India in the recent years. It comprises customers, such as, corporates, exporters, importers, and individuals, Authorised Dealers (ADs) and the Reserve Bank. Of late, FIIs have emerged as major participants in this segment. The market operates from major centres with Mumbai accounting for bulk of the transactions. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialise. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted. At present, the forward contracts market is active up to six months where two-way quotes are available. The maturity profile has recently elongated with quotes available up to one year. With the gradual opening up of the capital account, forward premium is now increasingly getting aligned with the interest rate differential. Importers and exporters also influence the forward market in many ways. Besides, banks are allowed to grant foreign currency loans out of FCNR (B) liabilities and this too facilitated integration of the forex and the money markets, affecting the forward premium.