Indian derivatives market – things you must know before investing

The Indian derivatives market is in existence for very long. In the derivatives market, we deal with derivative securities. In the Indian derivatives market, trade takes place with the help of derivative securities.  Such derivative securities or instruments are forward, futures options and swaps. Participants in derivatives securities not only trade in these simple derivative securities but also trade hybrid derivative instrument.

“Derivatives are financial securities and are financial contracts that obtain value from something else, known as underlying securities. Underlying securities may be stocks, currency, commodities or bonds, etc.”

Let us briefly discuss the origin of the Indian derivatives market. After that, I will explain different types of derivative products or instruments. The understanding of these derivatives instruments and their functioning is crucial to your success in trading with these instruments.

Origin of the derivatives market in India

Derivatives market in India has a history dating back in 1875. The Bombay Cotton Trading Association started future trading in this year. History suggests that by 1900 India became one of the world’s largest futures trading industry.

However after independence, in 1952, the government of India officially put a ban on cash settlement and options trading. This ban on commodities future trading was uplift in the year 2000. The creation of National Electronics Commodity Exchange made it possible.

In 1993, the National stocks Exchange, an electronics based trading exchange came into existence. The Bombay stock exchange was already fully functional for over 100 years then.

Over the BSE, forward trading was there in the form of Badla trading, but formally derivatives trading kicked started in its present form after 2001 only. The NSE started trading in CNX Nifty index futures on June 12, 2000, based on CNX Nifty 50 index

What are the different types of derivatives?

Let us understand the various types of derivatives instruments with the help of examples. The main instruments for derivatives trading in India are future contracts, options contracts, swaps and etc. These instruments are originally meant for hedging purpose. However, their use for speculation can’t be ruled out. 

1. Explaining a forward contract on the Indian derivatives market

 Suppose you need to buy some gold ornaments say from a local jewelry manufacturer Gold Inc. Further, assume you need these gold ornaments some 3 months later in the month of October. You agree to buy the gold ornaments at INR 32000 per 10 gram on 15 October 2018. The current price, however, is INR 31800 per gram.

This will be the forward rate or the delivery price four months from now on the delivery date from the Gold Inc.

This illustrates a forward contract. Please note that during the agreement there is no money transaction between you and Gold Inc. Thus during the time of the creation of the forward contract no monetary transaction takes place. The profit or loss to the Gold Inc. depends rather, on the spot price on the delivery date.

Now assume that the spot price on delivery day becomes INR 32100 per 10 gram. In this situation, Gold Inc will lose INR 100 per 10 gram and you will benefit the same on your forward contract. Thus, the difference between the spot and forward prices on the delivery day is the profit/loss to the buyer/seller.

2. How future contracts differ forward contracts on Indian derivative market?

Along with some exception to forward contracts, there are future contracts. What makes future differ forward contracts is that we trade future on stock exchanges while forward on the OTC market. OTC or the over the counter market is a marketplace for typically forward contracts.

Another distinction relates to the settlement of the contracts. While futures, in general, settle daily whereas forwards settles on expiration. The daily settlement is technically known as marked-to-market.

3. Basics of options trading in the Indian derivatives market 

Consider the same example. Let us now suppose that the seller Gold Inc. believes that the spot price may rise above INR 32000 per 10 gram during the forward contract agreement with you. So to limit loss, Gold Inc. purchases a call option for Rs. 105 at the exercise price of INR 32000 per 10 gram with the three months expiration date.

The exercise price is technically known as a strike price. Similarly, the price of the call option is technically known as the option price or the premium.

Actually, the call option gives the seller the right to buy the gold at the strike price on the expiration date. However, there is no obligation to buy on the expiration date. He may or may not exercise his right on the expiration date.

For instance, if the spot price decline below INR 31800 our Gold Inc will choose not to exercise the option. In this way, his loss would be limited to the premium of INR 105 per 10 gram.

In an alternative situation, when you expect the price to fall below the spot price in the future, you have the option to purchase put options. Buying a put option provides you the advantage to sell at the strike price on the expiration date. Here also you have no obligation to exercise your right.  

4. What are Swaps?

Swaps are derivatives instruments.  The swaps contract involve an exchange of cash flows over time. Swaps are typically done between two parties. One party makes a payment to the other. This depends on whether a price is above or below a reference price. This reference price is the basis of the swap contract and is there is mention regarding it in the contract.

5. What is “Badla” trading?

The “Badla” trading is a mechanism of trade settlement in India. “Badla” is a Hindi term for carryover transactions. This kind of trading facilitates trade shares on the margin on the Bombay Stock Exchange.

Further, it also allows to carry forward the positions to the next settlement cycle. There was no fixed expiration date, contract terms for such carryover transactions. Also, no standard margin requirement was there. Moreover, earlier such transactions were carryforward indefinitely. But this was later fixed for a maximum period of 90 days.

The SEBI put a complete ban on Badla trading in 2001 with the introduction of futures trading.

Where to look for information on the Indian derivatives market?

In India, derivatives instruments are available for stocks, currency, bonds, and commodities. The NSE, the Bombay Stock Exchange, the Multi Commodity Exchange are the main exchanges which facilitate derivatives trading. While MCX purely deals with commodities, NSE and BSE deal exclusively in stocks.

However, you can trade in various currency derivatives on any of the three exchanges. Also, derivatives product for bonds is part of National Stocks Exchange exchange.

The product family of the derivatives market in stocks segment includes stocks future and options. Similarly, there are derivatives product for indices and includes index future and options. Further, commodities derivatives products comprise commodities future.

While currency derivatives instruments in India includes currency future and options in 4 major currency pairs. These pairs are USD-INR, GBP-INR, JPY-INR, and EUR-INR. You can browse live details about Indian currency futures here.

The NSE has a dedicated platform for bonds derivatives products in India. You can trade Interest Rate Futures on this platform. The NSE offers two instruments on Interest Rate Future segment. Futures on 6 years, 10 years and 13 year Government of India Security (NBF II) and 91-day Government of India Treasury Bill (91DTB). You can find details over the bond trading page of NSE.

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