A Report Of Grand Project On Study On Derivatives In Indian

Market
 EXECUTIVE SUMMARY

This project report comprises a study of Derivatives in Indian market. The study covers
major markets in which the derivatives are traded.
The commodities market study includes the agriculture and non- agro based commodities
traded, the study of National Multi Commodity Exchange of India, Futures and forwards
agreements , the trading and settlements in this market.
The capital market study includes the equity derivatives and their importance, their
working and most importantly the trading strategies and the volatility research.
The money market study comprises the credit derivatives, currency swaps and interest
rate swaps and their working.
The foreign exchange markets study comprises the currency swaps , forward rate
agreement and their working and their practicability in real business situations.
 Introduction

Derivative instrument

It is a contract whose value depends on or derives from the value of an underlying asset
[say a share, forex, commodity or an index]. In its broadest sense a derivative attempts to
hedge against the variability of any economic variable. Thus exposures or perceived risks
to a firm arising from the variation in interest rates, exchange rates, commodity prices
and equity prices can be hedged through an appropriate derivative structure. Such a
derivative structure covers a wide variety of financial contracts viz. Futures, Forwards,
Options, Swaps and different variations thereof. These contracts can be traded on the
various Exchanges in a standardized manner or by custom designed for individual
requirements.

For the derivatives market to develop three kinds of participants are necessary. They are
the hedgers, the speculators and the arbitrageurs. All three must co-exist. A hedger is
risk averse. Typically in India he may be a Treasurer in a public sector company who
wants to know with certainty his interest costs for the year 2002. Therefore based on
current information he would enter into a futures contract and lock up his interest rate
four years hence. But in doing so he consciously ignores what is called the upside
potential - here the possibility that the interest rate may be lower in the year 2002 than
what he had contracted four years earlier. A Hedger therefore plays it safe. For a hedging
transaction to be completed there must be another person willing to take advantage of the
price movements. That is the Speculator.

Contrary to the Hedger who avoids uncertainties the Speculator thrives on them. The
speculator may lose plenty of money if his forecast goes wrong but stands to gain
enormously if he is proved correct. The risk taking associated with speculation is an
integral part of a Derivative market. The third category of participant is the Arbitrageur,
who looks at riskless profit by simultaneously buying and selling the same or similar
financial products in different markets. Markets are seldom perfect and there is a
possibility to take advantage of time or space differentials that exist. Arbitrage evens out
the price variations.

With the Government of India permitting futures trading in several commodities and with
futures trading have arrived in the stock markets, index based derivative trading has
finally arrived in India. For smooth functioning of derivative trading the Government of
India has commenced the process of demeterialization of shares, short sale facility,
electronic fund transfer facility and rolling settlements in stock markets. This will
hopefully bring transparency in the process of price discovery of the derivative and also
attract a broad spectrum of hedgers and speculators from out of professionally managed
corporates that not only must have a good balance sheet but also significant trading and
risk management skills. The Stock Holding Corporation of India has commenced
discussions with the premier stock exchanges of India about setting up a clearing house
for derivatives transactions.
Brief History Of Derivatives

1630’s Rice

One of the first examples of futures trading was in the Yodoya Rice Market in
Osaka in Japan. Landlords, who had collected a share of the rice harvest as rent, found
weather and other conditions too unpredictable. so the landlords ,who needed cash
shipped the rice for storage in city warehouses. They then sold warehouse receipts. rice
tickets which gave the holder the right to receive a certain amount of rice, of a certain
quality at a future date at an agreed price, the landlord received a steady income and
merchants had a steady supply of rice plus an opportunity to profit by selling the tickets.

In an effort to predict prices, a successful merchant and money lender from the Honma
family named Munehisha is popularly recorded as having invented the candlestick
method of plotting price movement- the birth of charting or technical analysis.

If the close price is lower than the open price, then the color of the candle is red or black.
If the close is higher then the open, then the candle Is hollow or white

Early 1800’s Puts and Calls

The history of modern futures trading can be traced to the middle of the nineteenth
century and the development of the grain trade in Chicago. In 1848 the Chicago Board of
Trade (CBOT) was formed to provide a place where buyers and sellers could exchange
commodities, originally trading was spot and then ‘to arrive’ these were the contracts
where the delivery of the commodities was at a specified rate and a future date . the
earliest recorded CBOT forwards contracts was made on 13th march 1851 for 3000
bushels of corn to be delivered in June. The problems with these early cash forward
contracts were that they had no standard conditions nor were the can always fulfilled. In
1865 CBOT formalized grain trading by introducing agreements called futures contracts
which standardized :
 • The quality of grain
• The quantity of grain
• The time and location of grain delivery

The price of the futures contracts was open to negotiation on the exchange floor. It is
these early grain futures contracts which have formed the basis of the financial and
commodities futures used today.

The American Civil War provided an opportunity for the rockets scientists of the day to
create a derivative to meet the needs of the day. The Confederate states of America issued
a dual currency optionable bond which allowed the southern states to borrow money in
sterling with an option to pay back the loan in French francs. But the holder of the bond
had the option to convert the repayment into cotton.
Options were traded on commodities and shares on US exchanges by the 1860’s and the
put and call brokers and dealers association was established in the early 1900’s.

1970’s Financial futures

After a long period during which futures and options trading was variously regulated and
banned by different governments worldwide, the International Monetary Market
(IMM), a division of the Chicago Mercantile Exchange (CME), was established in
1972. This was the first exchange to trade financial futures contracts –currency futures.
During the same year CBOT was refused permission to start trading futures on shares and
in response created the Chicago Board Options Exchange (CBOE) for options trading
in 1973. This was also the year that Fisher Black and Myron Scholes published their
options pricing formulae.
Call price = SN(d1) - KerT N(d2)

d1 = ln(S/K) + (r + σ2 /2)T
σ/T

d2 = d1- σ/T
By the late 1970’s exchange traded financial futures were well established and traded on
exchanges world wide.

1980’s on Swaps and OTC Derivatives

Exchange trading involves open outcry where the traders shout their orders to each other
on an exchange floor. In contrast privately negotiated derivatives contracts can be
conducted face to face or using the phone, telex, etc. these contracts are known as the
Over-The-Counter (OTC)

Although privately negotiated OTC forwards and options contracts had been in existence
for a long time. The 1980’s was the period when swaps first became important. Some of
the first swaps involved swapping interest rate repayments on loans in which one party
exchange its fixed rate of interest with the other party having variable interest rate
payments.

In this brief history a number of exchanges have been mentioned. To complete this
section see the timeline which illustrates many of the world wide exchanges now trading
derivatives and the dates when they were established.
Options

An options contracts confers right, but not the obligation to buy(call) or sell (put)a
specific underlying instrument at a specific price-the strike or exercise price –up until or
on a specific futures date- the expiry date.

Calls and Puts are the two basic types of options and can themselves both be bought and
sold. This means that you can both:
• Buy the right to buy the underlying asset.- Buy a call
• Sell the right to buy the underlying asset - Sell a call
In a similar way you can buy a put or sell a put. The buyer of a call or put is referred to
as the holder, whereas the seller of a call or put is referred to as the writer or the grantor.

Rights and obligations call and put holders and writers

Options

Calls Puts

Buyer/Holder Seller/Writer Buyer/Holder Seller/Writer

long Call. Short Call. Long put Short Put
Right but not Obligation to : Right but not Obligation to:
obligation to : Sell underlying the obligation Buy underlying
Buy asset at the to : asset at the strike
underlying strike price if Sell underlying price if the
asset at the the holder asset at the holder decides to
strike price if decides to buy strike price if Sell
the call is the put is
exercised exercised
Options Styles.

Settlement of options is based on the expiry date, however there are three basic styles of
options you will encounter which affect settlement. The styles have geographical names
that have nothing to do with the location where a contract is agreed . the styles are:

• American these options give the holder the right , but not the obligation to buy
or sell the underlying instrument on or before the expiry date. This means that the
options can be exercised earlier than the expiry date .
• European . these options give the holder the right , but not obligation to buy or
sell the underlying instrument only on the expiry date. This means the options
cannot be exercised earlier than the expiry date..
• Exotic. These are the options with a more complicated structure than a standard
call and put, incorporating special elements or restrictions. One type of an exotic
options is an Asian Options

Swaps

A swap transaction is the simultaneous buying and selling of a similar underlying asset or
obligation of equivalent capital amount where the exchange of financial arrangements
provide both the parties to the transaction with more favorable conditions than they
would otherwise expect. This means that swap is an OTC transaction between two parties
in which the first party promised to make a payment to the second party. In turn the
second party usually promises to make a simultaneous payment to the first party. The
payments for both parties are calculated according to different formula but paid according
to an agreed set of future scheduled dates. Swap agreements have been available for
sometime but the growth in use and importance of swaps really started in the early
1980’s. The varying need of the market players five rise to the four main type of swap
described below.
Pros and Cons for derivatives in India

Derivatives are wasting assets, which derive their values from an underlying asset. These
underlying assets are of various categories like equity, bonds, commodities etc. For
example, a dollar Forward is a derivative contract, which gives the buyer a right & an
obligation to buy dollars at some future date. The prices of the derivatives are driven by
the spot prices of these underlying assets.

Pro's of derivatives

• A tool for hedging: Derivatives provides an excellent mechanism to hedge the

future price risk. Think of a farmer, who doesn’t know what price he is going to
get for his crop at the time of harvest. He can sell his crop in the futures’ market
& lock in the price. If the future spot price is more than the futures price, he can
take the off setting position & can get out of the market (with a marginal loss).
Otherwise he will get the locked in price.

• Risk management: Derivatives provide an excellent mechanism to Portfolio

Managers for managing the portfolio risk and to Treasury Managers for managing
interest rate risk. The importance of index futures & Forward Rate Agreement
(FRA) in this process can’t be overstated.

• Better avenues for raising money: With the introduction of currency & interest
rate swaps, Indian corporate will be able to raise finance from global markets at
better terms.

• Price discovery: These derivative instruments make the spot price discovery
more reliable using different models like Normal Backwardation hypothesis.
These instruments will cause any arbitrage opportunities to disappear & will lead
to better price discovery.
 • Increasing the depth of financial markets: When a financial market gets such
sort of risk-management tools, its depth increases since the Institutional Investors
get better ways of hedging their risks against unfavorable market movements.

• Derivatives market on Indian underlying elsewhere: These days, with the

advent of technology, Indian prices are available globally on Reuters &
Knightrider. Nothing prevents any foreign market from launching derivatives on
these Indian underlying. This will put Indians in a disadvantageous position as
they can’t take the advantages of derivatives of securities or commodities traded
in India but someone lese can take.

• Empirical evidence: There is strong empirical evidence from other countries that
after derivative markets have come about, the liquidity and market efficiency of
the underlying market has improved.

Cons of derivative

• Speculation: Many people fear that these instruments will unnecessarily increase
the speculation in the financial markets, which can have far reaching
consequences. The recent Barrings Bank incident is the classic case in point.

• Market efficiency: Many people fear that the Indian markets are not mature &
efficient enough to introduce these instruments. These instruments require a well
functioning & mature spot market. Like recently The Economic Times reported
the strong correlation of Indian equity markets to the NASDAQ. Such type of
market imperfections makes the functioning of derivatives market all the more
difficult.

• Volatility: The increased speculation & inefficient market will make the spot
market more volatile with the introduction of derivatives.
 • Counter party risk: Most of the derivative intruments are not exchange traded.
So there is a counter party default risk in these intruments. Again the same
Barrings case, Barrings declared itself bankrupt when it faced huge losses in these
instruments.

• Liquidity risk: Liquidity of a market means the ease with which one can enter or
get out of the market. There is a continued debate about the Indian market’s
capability to provide enough liquidity to derivative trader.

So one can see that the pros of derivatives far outweigh the cons. And moreover, by
imposing margin requirements, by limiting the exposure one can take and other measures
like that, these vices of derivatives can be controlled. The importance of derivatives for
any financial market can’t be overstated.
 Structure of Indian Derivatives Market in India

Structure of Indian Derivatives Market in India

Commodity Forex Capital Money Others

Market Market Market Market

Commodity Market

Commodity Market is where the agro-based as well as the non agro-based commodities
are traded. The agro-based commodities like seeds, oil, oil cake, spices, pulses, and
others are traded. Non agro-based commodities like metals like aluminum, silver, copper,
tin, gold are traded. The derivative instruments usually used in this market are forwards
and futures.

Forex Market

Forex Market comprises of all the foreign exchange traders who are connected to each
other throughout the world through telecommunication network. They deal with each
other through telephones, telex and electronic systems. The instruments used in forwards,
futures, options, currency swaps, swaptions, etc.

Capital Market

Capital Market is the market of securities having maturity period of more than one year.
Instruments in capital markets are shares, stocks, bonds, government securities, etc.
Derivatives in capital markets are usually traded on the F & O segment of the various
stock exchanges like BSE, NSE, etc.

Money Market

Money market is the market of securities having maturity period up to one year.
Instruments in money market are government securities, commercial papers, certificates
of deposits, etc. The RBI has introduced rupee derivatives and credit derivatives but they
mostly have a OTC market or usually are negotiated deals.

Others

The other derivatives include the weather derivatives, rain derivatives, energy derivatives
etc. These derivatives have not yet been introduced in the Indian market but the days are
not far when even these derivatives will be traded in India. For e.g. the insurance
company is contemplating the use of weather derivatives in the Indian market for the
farmers.
Derivatives in different market

Segments of the Indian

Economy
 Commodities Market

The background of the Commodities exchanges in India.

India has a large number of commodity exchanges, the oldest of which dates from the
19th Century. Forward Market Commission regulates all these exchanges. After a 30
years ban, Government permitted future trades in 54 commodities. Commodities market
regulator, Forward Market Commission allowed four exchanges to commence trading in
all these items. Till now the state control over supply and, hence, price, has not allowed
commodities trading to grow to its potential. Now the government is retreating and
allows market players to takeover the commodities market.

The need of National Commodities Exchange in spite of having regional

commodities exchanges

One serious weakness in India lies in the way individual commodities futures markets are
an outgrowth of trading on individual spot markets. The cotton trading community will
create a cotton futures market; the jute trading community will create a jute futures
market, etc. This is inefficient insofar as it does not foster the growth of specialized skills,
which are common to all futures markets and not specific to one commodity. For a well
functioning derivatives exchange, specialized skills are required on the part of exchange
and clearinghouse staff and on the part of trading members. These skills are primarily in
the derivatives area, and they are easily transferable from one commodity to another.

Difference between the commodity exchange and stock exchange

The basic difference between the commodity exchange and stock exchange is that while
in commodity exchange non-financial commodities i.e. agro products such as castor,
groundnut, sesame etc. and non agro products such as aluminum, zinc, nickel etc. are
traded. However in a stock exchange all financial products are traded such as stocks,
indexes, interest rate, government securities etc. are traded.
NMCEIL is the First de-mutualized, Electronic Multi-Commodity Exchange in
India.

NMCEIL seeks to

Integrate the physical markets for commodities with the derivative markets.

Provide more authentic, efficient price discovery and more efficient price risk
management to producers, stockiest, processors, importers, exporters and other
market participants

NMCEIL was conceptualized on the best international systems and practices being
followed in commodity derivative exchanges. The Exchange made its first application for
grant of recognition to the Government of India in response to the press-note inviting
such applications for organizing derivative trading in the edible oilseeds complex.
Trading in this commodity-group had attracted large trading interest from different parts
of the country, before such trading was suspended or prohibited by the Government on
scarcity grounds. Such trading was permitted again by the Government after a gap of
over three decades.

The need for exchanges:

1. Participation of diverse Interests like importers, exporters, growers, brokers, traders etc.
2. Demutualised Governance Structure,
3. Guarantee of performance of contracts
4. Delivery of underlying commodities backed by a reliable Warehouse Receipt System
5. system of well capitalized professional Brokerage houses.
6. Support from the Institutional investors.
7. Real time price & trade dissemination.
8. Reliable & Effective and impartial, rule-based management by professionals.

Present status of Commodity Exchanges provided a stark contrast to the systems and
practices being followed by National Stock Exchange. This motivated the promoters to
set up NMCEIL on the model of National Stock Exchange. This was the genesis of
National Multi-Commodity Exchange of India Limited(NMCEIL).

After considering about 23 applications, the application made by NMCEIL was rated as
the best by the FMC and the Core-Group appointed by the Government short-listed its
application for grant of recognition as National Commodity Exchange. While
recommending the consortium of MITS, NSE, ICICI and Punjab State Warehousing
Corporation (PSWC) for setting up National Commodity Exchange the Core Group
appointed by Govt. of India specifically opined "M/s. Neptune Overseas Pvt. Ltd.,"
should be allowed to participate in the venture, in view of experience and initiative
displayed by it.

Finally on 25th July, 2001, the NMCEIL has been granted in-principle approval by the
Government to organize futures trading in the edible oil complex. The Exchange is
operationalised from November 26, 2002. NMCEIL has garnered support from major
institutions like Central Warehousing Corporation, NAFED, National Institute of
Agricultural Marketing, Gujarat Agro Industrial Corporation Ltd., Gujarat State
Agricultural Marketing Board, besides Neptune Overseas Limited. Recognition of
NMCEIL by the Government of India in October 2002 is one of the most important
events in commodity markets reforms in India.

Benefits of NMCE

There is a need to move agriculture to a market system of economy from a state owned
economy. This requires agriculture to be organized just like the industrial and service
sectors of the Indian economy. In addition, flow of corporate and institutional investment
in the sector at present is negligible. There is, therefore, the need to facilitate the flow of
easy credit to the farmers as a priority, through the use of warehouse receipts to get
pledge financing from banks. In a nutshell, there is a need to integrate production,
storage, transportation, trading, financing and marketing of agricultural produce in India.
A NMCE would bring about the converge of large-scale processors, traders, and farmers
along with banks. A NMCE would provide a common ground for fixation of future prices
of a number of commodities enabling efficient price discovery/forecast. In addition,
hedging using different and diverse commodities would also be possible with help of a
NMCE.

Banks

Large Processors
Farmers

Traders

NMCE

Future PRICE DISCOVERY

Price

Better Price
Fixation

Benefits to Farmers

Efficient Price Discovery/Forecast made by the NMCE will enable farmers decide
cropping pattern and investment on inputs

Price risk management would be possible via a NMCE

Price Stability resulting from a equilibrium in supply and demand for a
commodity would be possible through a NMCE

WRS introduced for trading in futures on the Exchange would lead to proper
grading, standardization and scientific storage of agricultural commodities
resulting in value addition and better price realization to farmers.

WR’s could be discounted by Farmers with banks and used by farmers to raise
finance quickly. The NMCE would help provide liquidity and a viable secondary
market for WR’s as a good financial instrument.

Salient Features

Some of the features that make NMCEIL an unique Commodity Exchange in India
are:

Demutualised Corporate Structure

Convergence of all the offers and bids emanating from all over the country in a
Single Electronic Order Book of the Exchange ensuring equal access to all
intermediaries.

Participation of diverse interests like Importers, Exporters, Growers, Brokers,
Traders, etc., using an electronic training system providing a fair, efficient and
transparent commodities market.

Fair Trading Practice ensured through checks and balances built-in in the System.

Virtual Trading Environment using the-state-of- art information technology
through an appropriate communication networking.

Efficient, Guaranteed Clearing, Settlement & System enabling book entry
settlement.

Warehouse Receipt System based Delivery of Underlying Commodities
meeting the current international standards, its endeavor is to fulfill its mission in
letter and spirit.

Real Time Price & Trade Data Dissemination

Reliable, Effective & Impartial and Rule-based Management by professionals
having no trade interest Market Surveillance Program

V-Sat based connectivity throughout the country

TRADING MARKETS

• Ready Delivery Market

• Specific Delivery Market
• Futures Market
• Auction Market

Ready Delivery Market

Cash Trades

Cash Trades are done for one hour in the day and are settled the same day. The Seller has
to deliver the warehouse receipt and Buyer has to make payment before the closure of the
banking hours. On receipt of payment from the Buyer, Clearing House will release and
endorse the warehouse receipt in favor of the Buyer. All the trades are settled
individually on trade for trade basis.

Spot Trades

Spot Trades done for two hours in the day are settled on the third day from the date of
transaction. The settlement is done on T+2 day i.e. trade done on Monday will be settled
on Wednesday. The Seller has to deliver the warehouse receipt and Buyer has to make
payment before the closure of the banking hours on the third working day. On receipt of
payment from the Buyer, Clearing House will release and endorse the warehouse receipt
in favour of the Buyer. All the trades are settled individually on trade-for-trade basis.

Weekly Trades
Trades for weekly settlements are done during the prescribed hours in the day are settled
on the fifth day from the date of transaction. The settlement is done on T+5 rolling day
i.e. trade done on Monday will be settled on next Monday. The Seller has to deliver the
warehouse receipt and Buyer has to make payment before the closure of the banking
hours on the fifth working day. On receipt of payment from the Buyer, Clearing House
will release endorse the warehouse receipt in favour of the Buyer. All the trades are
settled individually on trade-for-trade basis. The transactions are not netted for the
purpose of settlement.

Specific Delivery Market

Features of Specific Delivery Contracts are:

 These contracts will have delivery obligation maturing beyond a period of 11 days
 The terms of delivery of commodities may vary from trade to trade as decided by
the contracting parties at the time of entering into transaction. Such specific terms
could be related to delivery date, delivery center, quality of commodity, pricing
basis (FOB, CIF), payment terms etc.
 The transactions are not done on anonymous basis i.e. transactions are done
knowing the counter party.
 Both the parties to trade enter into transactions after knowing the terms of
contract, which may vary from trade to trade. However, there are standard
definitions for various terms of contracts.
 Exchange will monitor performance of these contracts and if required, impose
mark to market margins on the open, unsettled contracts depending upon the
volatility in the commodity.
  All the members entitled to trade in a commodity will be allowed to trade in these
Specific Delivery markets.

Futures Market

The Futures Market is primarily intended for Hedging and Speculation. Contracts in
Futures Market results mostly in Cash Settlement and do not frequently result in delivery.
The Clearing House guarantees trades executed on the exchange. Contracts that are not
closed out and are due for delivery will be delivered and settled through the warehouse
receipts. NMCEIL is having 12 delivery month contracts as separate contracts for each
commodity being traded at NMCEIL. All contracts are settled on daily basis at the daily
settlement price till the final delivery of commodity on the expiry date.

Futures market consists of various book types wherein orders are segregated as Regular
lot orders, Special Term orders, Negotiated Trade Entries and Stop Loss orders
depending on their order attributes. All orders have to be of regular lot size or multiples
thereof.

Auction Market

Auction Market is used by the Exchange to close out the positions of the members who
have failed to pay-in their obligations. In the Auction market, the trading member can
participate in the auctions initiated by the Exchange only. The counter orders can be
entered only during Auction period.

MEMBERSHIP TYPES

Trading Member/Broker

Trading & Clearing Member

Institutional Clearing Member

Introducing Member/Sub Broker

Registered Non Member

Trading Member/Broker (TM)

Trading Member (TM) is a member of NMCEIL who has the right to execute
transactions in the trading system of the exchange and the right to have contracts in its
own name. The TM can also act as a Broker. As a Broker, he can deal on behalf of the
clients (Registered Non-members). All the trades have to be executed only through the
Trading facilities provided by the Exchange. TM will settle the transactions through
Clearing Members (Trading & Clearing Members or Institutional Clearing Members).
TM cum Broker is required to maintain a separate account for client transactions and is
required to maintain the margin deposit and money belonging to clients in segregated
accounts. TMs are responsible for all the transactions of their clients. TM will clear their
Trades through Clearing Members (TCMs or ICMs). A TM will be allowed to have
clearing relationship with only one TCM or ICM at any point of time. The obligations of
the TMs are monitored by the associated TCM or ICM. If the limits are breached by a
TM, they will not be allowed to do further trading unless the limits are reset on receipt of
additional deposits. To provide continuous liquidity in the market, the TMs will be acting
as Jobbers in the Market. However, there are no special privileges or obligations attached
to this function of TMs. TMs will compete in the market place along with customers'
orders to improve the price discovery in the market. TMs will make use of the Order
Based Trading System of the exchange to provide continuous stream of order flows in the
market.

Trading & Clearing Member (TCM)

Trading cum Clearing Member (TCM) is a member of NMCEIL who has the right to
execute transactions in the trading system of the exchange like a TM. TCM also a right to
clear the transactions in contracts executed in NMCEIL either on its own behalf or on
behalf of other TMs. TCMs will be responsible to NMCEIL for all the obligations
(margins, settlement obligations etc) of TMs on whose behalf they have agreed to clear
the trades. NMCEIL will debit the banking account of the TCMs for all the obligations of
the TMs who are clearing through TCMs. TCMs will enter into Clearing Agreements
with their constituent Trading Members. They will also take the required Caution Deposit
from the TMs. They will be allowed to set the limits for trading by TMs. TCMs are
required to maintain segregated accounts of the all the moneys belonging to TMs on
behalf of whom they are clearing the trades. If the clearing limits of TCMs are breached,
all the trading members attached to them will be stopped from further trading until the
limits are reset on receipt of additional deposits. The number of TCMs will be limited
compared to that of TMs in NMCEIL. TCMs will be located in major towns and have
banking accounts with the Designated Clearing Banks who have interface with NMCEIL.

Institutional Clearing Member (ICM)

ICM is a member of NMCEIL who has the right to clear transactions done in NMCEIL
that are executed in the trading system of the exchange by TMs and their clients who are
Registered Non Members with NMCEIL. An ICM does not have the right to have
contracts executed in the trading system of NMCEIL. ICMs are professional clearers in
the market providing clearing services to the institutional clients. Registered Non-
members of NMCEIL who have executed transaction through any TMs can request their
ICMs to settle the trade. ICMs therefore can have independent clearing relationship with
Registered Non Members exclusive of the trading relationship of Registered Non
members with any TMs. If the clearing limits of ICMs are breached, all the trading
members attached to them will be stopped from further trading until the limits are reset
on receipt of additional deposits. Financial Institutions, Commercial Banks and Corporate
Houses who do not have trading interests, but are desirous of providing clearing services
to their clients will become ICMs in NMCEIL. NMCEIL proposes to have a maximum of
only four ICMs. TCMs will be located in major towns and are expected to have banking
accounts with the Designated Clearing Banks who have interface with NMCEIL.
ICMs will be responsible to NMCEIL for all the obligations (margins, settlement
obligations etc) of TMs and Registered Non-members on whose behalf they have agreed
to clear the trades. NMCEIL will debit the banking account of the ICMs for all the
obligations of the TMs and the Registered Non-members who are clearing through
TCMs. ICMs will enter into Clearing Agreements with their constituent TMs and
Registered Non-members. They will also take the required Caution Deposit from the
TMs and Registered Non-members. They will be allowed to set the limits for trading by
TMs. ICMs will also confirm the transaction done on behalf of the Registered Non-
members once the trade is reported to them by NMCEIL. ICMs are required to maintain
segregated accounts of the all the moneys belonging to TMs and Registered Non-
members on behalf of whom they are clearing the trades.

Introducing Broker/Sub Broker

Sub-Broker is a Registered member of the NMCEIL who has the right to execute
transaction in the trading system of the exchange only through a TM/TCM. Sub Broker
enter transactions in NMCEIL through Brokers. Sub Brokers introduce the clients/
Registered Non-members to the Brokers. Sub-Brokers do not have the right to have
contracts in their own name. Sub-Brokers will settle the transactions of clients introduced
by them, through Brokers, who in turn settle through Clearing Members (TCMs or
ICMs). Sub-Brokers will enter into an agreement with the TM/Broker who would provide
trading limits to them. Sub-Brokers are also required to obtain registration from
NMCEIL/Regulator as prescribed.

Registered Non Member

A Registered Non-member or non-member client means any person who is registered

with the Exchange for the purpose of dealing in commodities through a TM. A
Registered Non-member will clear the transaction through TCMs or ICMs. He is a non-
 member client of TM and hence is not a member of the Exchange. A Registered Non-
member has to fulfill such requirements as may be prescribed by the Exchange from time
to time. A Registered Non-member has to pay the prescribed subscription to NMCEIL
and furnish the required information to NMCEIL. A Registered Non-member is required
to enter into an agreement with TCM of the exchange. Every Registered Non-member
will be provided a unique Client Identification (Client Id). This client identification will
be used in every trade done in NMCEIL.

MEMBERSHIP FEES

Revised Membership Fees & Deposit structure (Effective from 21st January 2004)

Amount
No. Details
(Rupees in Lacs)
1 Admission Fees (Non refundable) 1.00
Contribution towards the Trade Guarantee Fund of the
2 1.00
Exchange (Refundable only after the minimum lock in period) *
Initial Base Capital (Refundable only after the minimum lock in
3 1.00
period) *
Additional Base Capital (Refundable only after the minimum
4 10.00
lock in period) *
5 Annual Subscription charges 0.20
Total Amount 13.20
• Minimum "Lock in" Period of 3 years.

VSAT Connectivity

To attain the online connectivity with the Exchange through VSAT members are required
to place their orders for the VSAT directly to the HCL Comnet. Following two options
are available to the members of the Exchange
Connectivity Through KU band VSAT :

Members can take connectivity through 1.2 M KU Band VSAT. The cost for the same
would be Rs. 1,00,000/-(approx), which shall be payable to the HCL Comnet directly.

Connectivity Through Extended C Band VSAT :

Members can take connectivity through 1.8 M extended C Band VSAT. The cost for the
same would be Rs. 1,34,000/-(approx), which shall be payable to the HCL Comnet
directly.

However, irrespective of the above two connectivity options. Clearing/Trading Member

shall pay bandwidth charges for the VSAT to the Exchange only. The current bandwidth
charges are Rs. 2500/- per month per VSAT and Rs. 1,000/- per month for additional
terminal on the same VSAT which are being renegotiated with the vendor for downward
revision and shall be intimated in due course.

Eligibility Criteria for Membership

Entities : Following entities are eligible to apply for membership

1)Individuals,
2)Registered firms,
3)Corporate bodies and
4)Companies as defined in the Companies Act 1956.

Net Worth:

Minimum prescribed net worth for an applicant is Rs. 50 lakh.

Net worth certificate should be computed for this purpose by following a definition of net
worth adopted by practicing Chartered Accountants for finalisation of accounts. Existing
fund based asset , if any should be excluded for calculation of net worth.
In case, the company is a member of any Commodity Exchange(s), it should satisfy the
combined minimum Net Worth requirements of all these Exchanges including NMCEIL.

Paid-up Capital:
Minimum prescribed paid up capital for a corporate is Rs. 30 lakh.
In case of a partnership firm combined capital of all the partners should be at-least Rs.30
lakh.
Forex Market

Evolution of the forex derivatives market in India

This tremendous growth in global derivative markets can be attributed to a number of

factors. They reallocate risk among financial market participants, help to make financial
markets more complete, and provide valuable information to investors about economic
fundamentals. Derivatives also provide an important function of efficient price discovery
and make unbundling of risk easier.

In India, the economic liberalization in the early nineties provided the economic rationale
for the introduction of FX derivatives. Business houses started actively approaching
foreign markets not only with their products but also as a source of capital and direct
investment opportunities. With limited convertibility on the trade account being
introduced in 1993, the environment became even more conducive for the introduction of
these hedge products.

Hence, the development in the Indian forex derivatives market should be seen along with
the steps taken to gradually reform the Indian financial markets. As these steps were
largely instrumental in the integration of the Indian financial markets with the global
markets.

Types of forex derivatives

The forex derivative products that are available in Indian financial markets can be
sectored into three broad segments viz. forwards, options, currency swaps.

Rupee Forwards
An important segment of the forex derivatives market in India is the Rupee forward
contracts market. This has been growing rapidly with increasing participation from
corporates, exporters, importers, banks and FIIs. 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 materialize. 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. Although due to the Asian crisis, freedom to rebook cancelled contracts
was suspended, which has been since relaxed for the exporters but the restriction still
remains for the importers.

Cross Currency Forwards:

Cross currency forwards are also used to hedge the foreign currency exposures,
especially by some of the big Indian corporates. The regulations for the cross currency
forwards are quite similar to those of Rupee forwards, though with minor differences. For
example, a corporate having underlying exposure in Yen, may book forward contract
between Dollar and Sterling. Here even though its exposure is in Yen, it is also exposed
to the movements in Dollar vis a vis other currencies. The regulations for rebooking and
cancellation of these contracts are also relatively relaxed. The activity in this segment is
likely to increase with increasing convertibility of the capital account.

Options

Cross currency options

The Reserve Bank of India has permitted authorised dealers to offer cross currency
options to the corporate clients and other interbank counter parties to hedge their foreign
currency exposures. Before the introduction of these options the corporates were
permitted to hedge their foreign currency exposures only through forwards and swaps
route. Forwards and swaps do remove the uncertainty by hedging the exposure but they
also result in the elimination of potential extraordinary gains from the currency position.
Currency options provide a way of availing of the upside from any currency exposure
while being protected from the downside for the payment of an upfront premium.

VADILAL INDUSTRIES LIMITED

FOREX ADVISORY & FFMC DIVISION

AHMEDABAD

Foreign Exchange Management, Commodity Market Advisory, is gaining importance

now a days on account of its complexity, as also requires expert comments, advise,
guidance, and also utmost important in view of the fact that the whole of FOREX and
Commodity markets becoming very close. Treasury Management concept has been
accepted by large organisations. Forex Advisory as a tool is also accepted widely by
Exporters, Importers and Commodity Traders, because of timely and appropriate advise
in relation to movements of the currency, commodity and money markets.

VADILAL, a Company popularly known by VADILAL brand ICECREAM, has

established FOREX Advisory and Exposure Management service. The basic idea of such
establishment is to provide effective and relevant knowledge, advise, and guidance to
Importers and Exporters and Commodity traders.
The Division offers the area of service in relation to :

• FOREX Advisory and FOREX EXPOSURE MANAGEMENT to Importers and

Exporters. A thorough service connected with Banking, ECD-RBI, FEDAI rules
and guidelines, etc..
• BULLION Informative service of Gold, Silver, and Precious metals on
International trading, quotes, rates, forwards, futures, etc., on various international
markets, inclusive of COMEX/NYMEX;
• LME-METAL Informative service of most base metal quotes at LME, COMEX,
NYMEX, Shanghai, markets, and complete guide and informative service on
forward, futures and relative data.
 • OIL Informative service guide on major traded centres, quotes, rates, etc., with
detailed information on forward, futures quotes;

INFRASTRUCTURE :

• REUTERS 2000 Money Service at Ahmedabad and REUTERS Workstation at

Baroda.
• REUTERS graphic Professional and best in the communication system.

FOREX ADVISORY AND EXPOSURE MANAGEMENT

• website vadilalmarkets.com a continuous process of up-gratation of quotes of

corsses, Indian Rupees, news, comments, etc.,
• FOREX (daily four reports) at different time zones to carry all related information
on INRupee, Cross currencies, forward positions and relative information on
Money and Stock Markets. All these 4 reports are provided on e-mail, and on
web-site, and also includes important one at 10.30 morning on fax to attract direct
attention;
• Weekly, Monthly reports; on e-mail (on request also on fax);
• Periodic Forex up-dates, EXIM up-dates, Ready reckonar on major international
traded currencies; Monthly data of the major currencies and economic positions,
etc., etc..
• Exposure Management (on confirmed arrangement) taken well care by
experienced staff having banking knowledge and expertise;

Arrangement on Import Bill discounting, for exports - Forfeiting and ECB arrangement at
the concessional service cost.
ADDITIONAL SERVICE at No Extra Cost :

• On-line service (real time value information) to ascertain level of the currencies,
forward differences, etc., between 8.30 AM till closing of NY markets.
 • Response to any query on FOREX related matter linked with Banking, RBI,
FEDAI rules, etc.,
• In-house session on FOREX and Risk Management in relation to banking, RBI
and FEDAI directives and EXIM related matters,

Workshops - Seminars on periodic basis on Foreign Exchange and Risk Management and
EXIM related matters.
L M E BASE METAL :

• Daily 2 reports on e-mail at different time zones. Morning to cover entire LME,
COMEX and NYMEX markets, as also on-going Shanghai markets; and Evening
to cover 1st settlement LME quotes, and all related information to cover both spot
and forward markets;
• Periodic and monthly reports with graphic presentation, monthly data of the
movements (spot and 3 months forward), etc.

PRECIOUS (GOLD AND SILVER ) Metal :

• Daily report (both in English and Gujarati) in the morning covering all related
news, data and projections of the precious metal.
• Periodic and monthly reports with graphic presentation, monthly data of the
movements (spot and 3 months forward), etc.
• Besides, for both LME and Precious report subscriber, we offer on-line service
(real time value information) to ascertain level of the metal, forward difference,
etc., between 8.30 AM till closing of NY markets.
• Pager and Mobile telephone informative service at the interval Of 10 / 15 minutes
or as market warrants.

FFMC = FULL FLEDGED MONEY CHANGER

• RBI authorised FFMC agent to release foreign exchange entitlements; in relation

to Business Travels, and BTQ : Basic Travel Quota (general permission)
 • Authorised to market financial products of AMEXCO - American Express
Banking Travel Related Service.
• Deal in almost and all traded currencies at the most competitive rates in favour of
the customers

INSTRUMENT DEFINITIONS

Foreign exchange spot: Single purchase or sale of currency for

settlement not more than two business days after the deal is
contracted.

Foreign exchange forward (outright forward): Currency trade

to be settled at an agreed time in the future—more than two
business days.

Non-deliverable forwards: Forward transaction where settlement

is made by a cash payment reflecting the market value
of the contract instead of the exchange of currencies.

Foreign exchange swap: Simultaneous exchange of two currencies

on a specific date at a rate agreed at the time of the
contract, and a reverse exchange of the same two currencies
at a date further in the future at a rate agreed at the time of
the contract. Short-term swaps carried out as “tomorrow/next
day” transactions are included in this category.

Currency swap: A contract that commits two counterparties to

exchange streams of interest payments in different currencies
for an agreed period of time and to exchange principal
amounts in the respective currencies at an agreed exchange
rate at maturity.

Currency option: Option contract that gives the right to buy

(call option) or sell (put) a currency with another currency at a
specified exchange rate during a specified period. This category
includes currency warrants and multi-currency swaptions.
related to interest rates on a single currency. The swap can be
fixed for floating, or floating for floating, based on different
indices. This group includes those swaps whose notional principal
is amortized according to a fixed schedule independent
of interest rates.

Interest rate option: Option contract that conveys the right to

pay or receive a specific interest rate on a predetermined principal
for a set period of time.

Interest rate cap: Option contract that pays the difference

between a floating interest rate and the cap rate.

Interest rate floor: Option contract that pays the difference

between the floor rate and a floating interest rate.

Interest rate collar: Combination of cap and floor.

Interest rate swaption: Option to enter into an interest rate swap contract.

Interest rate warrant: Long-dated (more than one year) interest rate option.

Bond option: Option contract that conveys the right to purchase or sell a fixed income
security. The survey does not, however, include options embedded in bonds or notes.
Capital Market

Derivatives Markets

Derivatives markets broadly can be classified into two categories, those that are traded on
the exchange and the those traded one to one or ‘over the counter’. They are hence
known as

• Exchange Traded Derivatives

• OTC Derivatives (Over The Counter)

OTC Equity Derivatives

• Traditionally equity derivatives have a long history in India in the OTC market.
• Options of various kinds (called Teji and Mandi and Fatak) in un-organized
markets were traded as early as 1900 in Mumbai
• The SCRA however banned all kind of options in 1956.

Derivative Markets today

• The prohibition on options in SCRA was removed in 1995. Foreign currency

options in currency pairs other than Rupee were the first options permitted by
RBI.
• The Reserve Bank of India has permitted options, interest rate swaps, currency
swaps and other risk reductions OTC derivative products.
• Besides the Forward market in currencies has been a vibrant market in India for
several decades.
• In addition the Forward Markets Commission has allowed the setting up of
commodities futures exchanges. Today we have 18 commodities exchanges most
of which trade futures. e.g. The Indian Pepper and Spice Traders Association
(IPSTA) and the Coffee Owners Futures Exchange of India (COFEI).
 • In 2000 an amendment to the SCRA expanded the definition of securities to
included Derivatives thereby enabling stock exchanges to trade derivative
products.
• The year 2000 will herald the introduction of exchange traded equity derivatives
in India for the first time.

Equity Derivatives Exchanges in India

• In the equity markets both the National Stock Exchange of India Ltd. (NSE) and
The Stock Exchange, Mumbai (BSE) have applied to SEBI for setting up their
derivatives segments.
• The exchanges are expected to start trading in Stock Index futures by mid-May
2000.

BSE's and NSE’s plans

• Both the exchanges have set-up an in-house segment instead of setting up a

separate exchange for derivatives.
• BSE’s Derivatives Segment, will start with Sensex futures as it’s first product.
• NSE’s Futures & Options Segment will be launched with Nifty futures as the first
product.

Product Specifications BSE-30 Sensex Futures

• Contract Size - Rs. 50 times the Index

• Tick Size - 0.1 points or Rs. 5
• Expiry day - last Thursday of the month
• Settlement basis - cash settled
• Contract cycle - 3 months
• Active contracts - 3 nearest months

Product Specifications S&P CNX Nifty Futures

• Contract Size - Rs. 200 times the Index

 • Tick Size - 0.05 points or Rs. 10
• Expiry day - last Thursday of the month
• Settlement basis - cash settled
• Contract cycle - 3 months
• Active contracts - 3 nearest months

Membership

• Membership for the new segment in both the exchanges is not automatic and has
to be separately applied for.
• Membership is currently open on both the exchanges.
• All members will also have to be separately registered with SEBI before they can
be accepted.

Membership Criteria

NSE

Clearing Member (CM)

• Networth - 300 lakh

• Interest-Free Security Deposits - Rs. 25 lakh
• Collateral Security Deposit - Rs. 25 lakh

In addition for every TM he wishes to clear for the CM has to deposit Rs. 10 lakh.

Trading Member (TM)

• Networth - Rs. 100 lakh

• Interest-Free Security Deposit - Rs. 8 lakh
• Annual Subscription Fees - Rs. 1 lakh

BSE

Clearing Member (CM)

 • Networth - 300 lakhs
• Interest-Free Security Deposits - Rs. 25 lakh
• Collateral Security Deposit - Rs. 25 lakh
• Non-refundable Deposit - Rs. 5 lakh
• Annual Subscription Fees - Rs. 50 thousand

In addition for every TM he wishes to clear for the CM has to deposit Rs. 10 lakh with
the following break-up.

• Cash - Rs. 2.5 lakh

• Cash Equivalents - Rs. 25 lakh
• Collateral Security Deposit - Rs. 5 lakh

Trading Member (TM)

• Networth - Rs. 50 lakh

• Non-refundable Deposit - Rs. 3 lakh
• Annual Subscription Fees - Rs. 25 thousand

The Non-refundable fees paid by the members is exclusive and will be a total of Rs.8
lakhs if the member has both Clearing and Trading rights.

Trading Systems

• NSE’s Trading system for it’s futres and options segment is called NEAT F&O. It
is based on the NEAT system for the cash segment.
• BSE’s trading system for its derivatives segment is called DTSS. It is built on a
platform different from the BOLT system though most of the features are
common.

Settlement and Risk Management systems

• Systems for settlement and risk management are required to satisfy the conditions
specified by the L.C. Gupta Committee and the J.R. Verma committee.
 • These include upfront margins, daily settlement, online surveillance and position
monitoring and risk management using the Value-at-Risk concept.

Types of derivatives in equity market

Forward contracts

• A forward contract is one to one bi-partite contract, to be performed in the future,

at the terms decided today.
• Forward contracts offer tremendous flexibility to the parties to design the contract
in terms of the price, quantity, quality, delivery time and place.
• Forward contracts suffer from poor liquidity and default risk.

Future contracts

• Future contracts are organised/ standardised contracts, which are traded on the
exchanges.
• These contracts, being standardised and traded on the exchanges are very liquid in
nature.
• In futures market, clearing corporation/ house provides the settlement guarantee.

Options

Options are instruments whereby the right is given by the option seller to the option
buyer to buy or sell a specific asset at a specific price on or before a specific date.

• Option Seller - One who gives/writes the option. He has an obligation to perform,
in case option buyer desires to exercise his option.
• Option Buyer - One who buys the option. He has the right to exercise the option
but no obligation.
• Call Option - Option to buy.
• Put Option - Option to sell.
 • American Option - An option which can be exercised anytime on or before the
expiry date.
• European Option - An option which can be exercised only on expiry date.
• Strike Price/ Exercise Price - Price at which the option is to be exercised.
• Expiration Date - Date on which the option expires.
• Exercise Date - Date on which the option gets exercised by the option
holder/buyer.
• Option Premium - The price paid by the option buyer to the option seller for
granting the option.

Index Futures

• Index futures are the future contracts for which underlying is the cash market
index.
• For example: BSE may launch a future contract on "BSE Sensitive Index" and
NSE may launch a future contract on "S&P CNX NIFTY".

Operators in the equity derivatives market

• Hedgers - Operators, who want to transfer a risk component of their portfolio.

• Speculators - Operators, who intentionally take the risk from hedgers in pursuit of
profit.
• Arbitrageurs - Operators who operate in the different markets simultaneously, in
pursuit of profit and eliminate mis-pricing.
 Money Market

Interest Rate Swaps

What is an IRS?

An IRS (acronym for Interest Rate Swap) is a transaction in which two

parties agree to swap the coupon payments arising on account on issuing
of investing in fixed income-bearing securities. The essence of the
transaction is the exchange of coupon/interest payments that originally
could have had any characteristic. Extending the logic one step further, it
is again not necessary for the two coupon flows to be in the same currency

Types of IRS

The most common IRS exchanges Fixed Rate coupon payments with
coupon payments linked with some Floating Rate. Again, the two streams
of coupon flows might be in the currency or in different currencies. An
IRS is a derivative instrument and like any derivative it derives its value
from the value of the underlying. In this case the underlying is the Interest
Rate. We shall refrain from the matter of pricing IRS products as it is
beyond the scope of this write-up (and the math is slightly messy!)

These are examples of some popular IRS transactions

• Swap of Rupee Fixed Rate to Rupee Floating Rate (and vice versa)
• Swap of Currency X Fixed Rate to Currency X Floating Rate (and
vice-versa)
• Swap of Currency X Fixed Rate to Currency Y Floating Rate (and
vice-versa)
There are several variants within these options like Spot Start, Delayed
Start etc. As far as the Floating Rate benchmarks go, in developed
economies there are several and the choice is quite wide. However the
most popular ones are based on LIBOR or Treasuries.

IRS in India

Interest Rate Swaps are nascent in India. The market deepened only after
RBI allowed corporates and mutual funds to participate in the market
sometime in late 1999. Unfortunately the market has not seen too much of
development and activity has been restricted between a handful of foreign
and private sector banks and a few large corporates. The shallowness of
the market is also evident in the wide prices that prevail in the market.

The major roadblock in development of the market has been inadequate

benchmark floating rates. Almost all the IRS deals that have been done till
date have been benchmarked on the overnight MIBOR (Mumbai
Overnight Borrowing Rate), released either by the NSE or Reuters, with
the former being more popular. This has effectively truncated the IRS
market in India to that of an OIS (Overnight Indexed Swap). Of late some
swap deals have been reported in which longer term benchmarks have
been used like 90 day Reuters CP Rate (GE Capital) and 5 Year GOI Rate
(IL&FS), but these deals continue to remain sporadic in nature.

How does an OIS work?

The best way to represent an OIS is through a diagram. The following

figure shows the dynamics of an Overnight Indexed Swap
This is the representation of a "Pay Fixed" IRS, in which the user
pays a fixed rate.

In the original scheme of things, Corporate A borrowed money at MIBOR

plus 60 basis points from a Lender (Flows represented by the red arrows).
Apprehensive that the MIBOR rate would go up, and adversely affect his
cost of funds, he enters into an OIS with a Bank/Institution. In the deal,
Corporate A agrees to pay 9.05% fixed. This means the Bank/Institution
will pay Corporate A overnight MIBOR against which Corporate A will
pay the Bank/Institution a fixed rate of 9.05% (flows represented by black
arrows). Note that now Corporate A is hedged against any movement in
MIBOR as whatever is the rate, he will receive the "rate" from the
Bank/Institution and pass it on to the Lender.

It should be remembered that the calculations are made on a daily

compounding basis and the settlement is netted and made at the end of the
transaction.

Benefits of an OIS

Let us turn to the above example. Corporate A has effectively hedged

itself against any movements in the MIBOR. The company has de-risked
his liability book by entering into this transaction. After entering into the
OIS, Corporate A's cost of funds in this transaction has been frozen at
9.05% + 0.60 = 9.65%. Note that the 60 bps is a sunk cost which
Corporate A has to bear anyway.

Looking at the transaction from the perspective of the Bank/Institution it

might seem that it has increased its risk by this transaction. This might not
be the case. The Bank/Institution might have had lent and created a
Floating Rate asset in its books. In that portfolio it runs the risk that the
Floating Rate might fall and diminish its returns. By doing this
transaction, the Bank/Institution has effectively frozen its returns at 9.05%
(ignoring whatever spread it might have earned on the asset).

A take on Ricardo's Theory of Comparative Advantage.

In a nutshell, this theory of trade states that Nations should produce that
product in which it has a comparative advantage and import other products
from other nations. This theory has found extensions in many other
disciplines, including finance. In financial markets, borrowers have a
choice of raising resources on either a fixed rate or floating. This theory
would "urge" the corporate to raise the resource in that form (i.e. floating
or fixed) in which it has comparative advantage. This is best illustrated by
an example as to how a corporate can use the OIS market to get better
rates on its liabilities

Assume Corporate X, which is looking to raise a 12 mth liability. On

preliminary checks with the market it gets quotes of MIBOR + 60 bps for
Floating rate and 9.80% for Fixed Rate. The corporate checks the OIS
market and is quoted 8.95/9.05 for 12-month tenor. What should
Corporate X do? Clearly, Corporate X can beat the Fixed Rate market by
borrowing Floating and doing a OIS back-to-back. In the Floating Rate it
pays MIBOR + 60 bps while in the OIS it receives MIBOR and pays
 9.05% fixed. Thus the all-in-cost for Corporate X comes as 9.05%+0.60%
= 9.65%. This is 15 bps better than the Fixed Cost that was quoted to the
corporate.

Regulations and Documentation for IRS

Regulations for transacting IRS are governed by the Reserve Bank of

India. Foremost, a company needs to have sanctioned lines from
Institutions/Banks for transacting IRS (Given that IRS are low risk
products due to netting conventions, Banks readily sanction such lines).

As far as risk hedging goes, only balance sheet risks can be hedged and the company has
to provide a declaration to that effect while transacting the product. The most important
documentation for conducting an IRS (or any derivative for that matter) is signing the
ISDA (International Swap and Derivatives Dealers Association). This is a compendium
of all the features of the transaction and its risks. The document also clearly defines
various terms that form a part of the transaction and defines the financial liabilities of the
transacting parties. While the ISDA is a standard document for any Institution, the
document typically carries an Annexure that is more specific about the financial liabilities
and risks which are peculiar to the transacting parties.

Rupee interest rate derivative products

OTC Rupee Interest Rate Swaps

Overnight Index Swaps

MIFOR Swaps
 Swaps with floating rates linked to GOI Security yields

Rupee Swaps with LIBOR rate based benchmarks

Forward rate agreements (FRAs)

Exchange Traded Rupee Interest Rate Futures

o Futures on 10-year Notional GOI Security with 6% coupon rate

o Futures on 10 year Zero coupon notional GOI Security
o Futures on 91 day Treasury bills

Latest introduced

Short-term MIBOR Futures Contract

MIFOR Futures Contract

Bond Futures Contract

Long-term Bond Index Futures Contract.

Market Structure for Trading of IRD Contracts

The Group recommends that the present market structure for trading of equity
derivatives on stock exchanges could be used for the proposed exchange-traded market
for interest rate derivatives. The broad details of the market structure are as follows:

Permitted Exchanges

Equity derivatives trading is permitted at present only in NSE and BSE. It is proposed
that interest rate derivatives contracts should be allowed to be traded on the automated,
order-driven system of these exchanges only.
Trading Model

In view of the familiarity of the market and its participants with the systems, processes
and procedures followed for exchange-traded equity derivatives should be applied for
interest rate derivatives on the permitted exchanges. No additional infrastructure or
connectivity issues need to be resolved to use the equity derivatives trading model for
trading in interest rate derivatives. There would also be no requirement for a fresh
membership on the exchanges or on the clearing corporation/clearing houses to trade on
interest rate derivatives provided RBI is satisfied with the present eligibility criteria for
membership. NSE have indicated that they are in a position to commence trading in
interest rate derivatives within a short period.

Entities in the Trading System

Like equity derivatives market, the proposed interest rate derivatives market may have
four entities in the system as detailed below :

• Trading Members (TM) - These are members of the exchange and can trade on
their own behalf as well as on behalf of their clients. Each TM may have more
than one user.

• Clearing Members (CM) - These are members of the clearing corporation and
carry out risk management activities and perform actual settlement. CMs are also
trading members and clear trades for themselves and/or others. Those CMs that
are allowed to clear their own trades as well as on behalf of other TMs are called
Trading-cum-Clearing members(TCM). Those CMs that are allowed to clear only
their own trades (including on behalf of their clients) are called Self-Clearing
Members (SCM).

• Professional Clearing Members (PCM) - A PCM is a CM who is not a TM.

Typically, banks and custodians become PCMs and clear and settle for their TMs.
 • Participants - A participant such as a FI, is a client of TMs. These clients may
trade through multiple TMs but settle through a single CM.

Membership Criteria

The Group feels that the existing two-tier membership structure, viz., Clearing Members
and Non-Clearing Members, of the equity derivatives segment may be retained for the
debt derivative segment as well. Also, members of the existing equity derivative segment
of an exchange will not automatically become members of the interest rate derivatives
market segment. Only those who satisfy the stricter eligibility conditions of the IRD
market will be admitted to debt derivatives trading.

Credit Derivatives.

Definition:

Credit derivatives are over the counter financial contracts. They are usually defined as
"off-balance sheet financial instruments that permit one party (beneficiary) to transfer
credit risk of a reference asset, which it owns, to another party (guarantor) without
actually selling the asset". It, therefore, "unbundles" credit risk from the credit
instrument and trades it separately. Credit Linked Notes (CLNs), another form of credit
derivative product, also achieves the same purpose, though CLNs are on-balance sheet
products.

Conceptual Aspects of Credit Derivatives

The origin of credit derivatives can be traced back to the securitisation of mortgaged-
back market of 1980s. In securitisation, the credit risk was hedged only by eliminating
the credit product from the books of credit provider altogether. The credit derivative, in
the present form, was formally launched by Merrill Lynch in 1991 (with USD 368
million). However, the market did not grow much till 1997. The size of the market was
USD 40 and 50 billions respectively in 1996 and 1997. The market has now acquired a
critical mass of over USD one trillion, half of which is concentrated at London. The
average transaction size is between USD 10 to 25 million and the average tenor, which
was less than two years, has now gone up to five years. However, there are only a few
active players in the market and the secondary market is still illiquid.

Need and Scope for Credit Derivatives in India

Benefits from Credit derivatives

One of the more successful products introduced in India in the recent past has
been the Interest Rate Derivative product. Currently, there has been an increase in
the use of this product with a number of hedging benchmarks and the entry of a
large number of market players. The success of this product is due to the fact that
it has helped the market to transmit the interest rate risk from one participant to
another. This transmission of the interest rate risk allows for the risk to be hedged
away by the risk averse players and reside in players who are risk takers and /or
those who are able to bear the risk.

Similarly, credit risk also requires an effective transmission mechanism. It is now
imperative that a mechanism be developed that will allow for an efficient and cost
effective transmission of credit risk amongst market participants. The current
architecture of the financial market is either characterized by lumpiness in credit
risk with the banks and development financial institutions (DFIs) or lack of access
to credit market by mutual funds, insurance companies, etc.

The major hedging mechanism now available with banks and DFIs to hedge
credit risk is to sell the loan asset or the debentures it holds. Banks and
Development Financial Institutions require a mechanism that would allow them to
provide long term financing without taking the credit risk if they so desire. They
could also like to assume credit risk in certain sectors / obligors.

On the other side, investors, including banks and DFIs, would also be looking for
additional yields. In an environment of declining yields, investors would welcome
mechanisms where they can earn an additional yield by taking on credit risk.
 There exists now in India an investor base, which can be segmented along tenor
lines. The mutual fund industry has investment appetite in the short end - upto 5
years, the banking industry has appetite in the middle segment - between 5 and 8
years, while the insurance companies have appetite at the very long end - over 8
year band. It is now necessary to have a mechanism that will allow credit risk to
be extracted from portfolios, tranched according to tenor and risk profile (i.e.
credit rating) and transferred to those agents that are most comfortable holding the
credit risk with the appropriate characteristics.

Credit derivatives will give substantial benefits to all kinds of participants,
including the financial system as a whole, such as:

• Banks would stand to benefit from credit derivatives mainly due to two reasons –
efficient utilisation of capital and flexibility in developing/ managing a target risk
portfolio. Currently, banks in India face two broad sets of issues on the credit leg
of their asset – blockage of capital and loss of opportunities, for example:

i. Banks generally retain assets – and hence, credit risk – till maturity. This
results in a blocking up of bank’s capital and impairs growth through
churning of assets.
ii. Due to exposure norms that restrict concentration of credit risk on their
books, banks are forced to forego attractive opportunities on existing
relationships.

• Asset portfolio of banks is largely constrained by distribution system and sales

relationships. New banks possess capital but have to overcome high costs in
building an asset portfolio. Similarly, existing banks may want to diversify
portfolio but may be unable to do so because of stickiness of client relationships
and switching costs.

Credit derivatives would help resolve these issues. Banks and the financial
institutions derive four main benefits from credit derivatives; viz:
• Credit derivatives allow banks to transfer credit risk and hence free up capital,
which can be used in productive opportunities.
• Banks can conduct business on existing client relationships in excess of exposure
norms and transfer away the risks. For example, a bank which has hit its exposure
limits with a client group may have to turn down a lucrative guarantee deal under
current scenario. But, with credit derivatives, the bank can take up the guarantee
and maintain its exposure limits by transferring the credit risk on the guarantee or
previous exposures. This will allow banks to maintain client relationships.
• Banks can construct and manage a credit risk portfolio of their own choice and
risk appetite unconstrained by funds, distribution and sales effort. Banks can
acquire exposure to, and returns on, an asset or a portfolio of assets by simply
writing a credit protection.
• Credit risk would be diversified – from "banks/DFIs alone" to other players in the
financial markets and lead to financial stability.
Characteristic Features

The characteristic features of credit derivative are as under:

i. Credit derivative is a contract between two counterparties. One is the credit risk
protection buyer or beneficiary and the other is the credit risk protection seller or
guarantor.
ii. The protection buyer or beneficiary pays a fee, called premium as in insurance
business, to protection seller or guarantor.
iii. The reference asset for which credit risk protection is bought and sold is pre-
defined. It could be a bank loan, corporate bond / debenture, trade receivable,
emerging market debt, municipal debt, etc. It could also be a portfolio of credit
products.
iv. The credit event for which protection is bought or sold is also pre-defined. It
could be bankruptcy, insolvency, payment default, delinquency, price decline or
rating downgrade of the underlying asset / issuer.
v. The settlement between the protection buyer and protection seller on the credit
event can be cash settled. It could also be settled in terms of the physical financial
asset (loan or bond, etc.). If the protection seller is not satisfied with the pricing or
valuation of the asset in the credit event, it has the right to ask for physical
settlement.
vi. Credit derivatives use the International Swaps and Derivatives Association
(ISDA) master agreement and the legal format of a derivative contract.

Types of Credit Derivatives

Credit derivatives can be divided into two broad categories:

(a) Transactions where credit protection is bought and sold; and

(b) Total return swaps.

(a) Transactions Where Credit Protection Is Bought And Sold

It is a bilateral derivative contract on one or more reference assets in which the protection
buyer pays a fee through the life of the contract in return for a contingent payment by the
protection seller following a credit event (e.g. failure to pay, credit rating downgrade,
etc.) of the reference entities. Credit default swap is an example of a credit derivative
transaction where credit protection is bought and sold.

In a Credit Default Swap (CDS), one party agrees to pay another party periodic fixed
payments in exchange for receiving "credit event protection", in the form of a payment,
in the event that a third party or its obligations are subject to one or more pre-agreed
adverse credit events over a pre-agreed time period. Typical credit events include
bankruptcy, failure to pay, obligation acceleration, restructuring, and
repudiation/moratorium.

It is the CDS market’s convention to refer to the party that makes the periodic payments
for credit event protection as the Protection Buyer. Conversely, the party that provides
the credit event protection is referred to as the Protection Seller. The third party and the
specific obligation, if any, on which credit event protection is concurrently bought and
sold are referred to as the Reference Entity and Reference Obligation, respectively.

In most instances, the Protection Buyer makes quarterly payments to the Protection
Seller. The periodic payment is typically expressed in annualized basis points of a
transaction’s notional amount. In the instance that no pre-specified credit event occurs
during the life of the transaction, the Protection Seller receives the periodic payment in
compensation for assuming the credit risk on the Reference Entity/Obligation.
Conversely, in the instance that any one of the credit events occurs during the life of the
transaction, the Protection Buyer will receive a compensating payment.

The form of the compensation will depend on whether the terms of a particular CDS
calls for a physical or cash settlement. In a physically settled transaction, the buyer of
protection would deliver the reference obligation (or an obligation of equal or higher
payment priority) to the Protection Seller and receive the face value of the Reference
Obligation.
Alternatively, in a cash settled transaction, the Protection Seller makes a cash payment to
the Protection Buyer based on a formula that the two parties agree upon at the inception
of the contract. Generally, the formula specifies that the Protection Seller pays the
Protection Buyer the difference between par and the then prevailing market value of a
Reference Obligation following one of the specified credit events. In some cases, the cash
payment is a fixed amount decided at the inception of the contract. The CDS is discussed
in greater details in Appendix A.

The other such credit derivatives are credit default option and credit linked notes. If the
fee is paid fully in advance, the transaction is referred to as a credit default option. If the
credit default swaps or options are embedded in a bond issuance, it is called a credit
linked note. In this case, the investor in the credit linked note is the protection seller,
while the issuer is the protection buyer. The interest rate risk and liquidity risk of the
reference assets remain with the protection buyer until maturity or occurrence of a credit
event, whichever is earlier.

(b) Total Return Swaps

Total Return Swaps (TRS) are bilateral financial contracts designed to synthetically
replicate the economic returns of an underlying asset or a portfolio of assets for a pre-
specified time. One counterparty (the TR payer – the protection seeker) pays the other
counterparty (the TR receiver – the protection provider) the total return of a specified
asset, the reference obligation. In return, the TR receiver typically makes regular floating
payments. These floating payments represent a funding cost of the TR payer. In effect, a
TRS contract allows the TRS receiver to obtain the economic returns of an asset without
having to fund the assets on its balance sheet. As such, a TRS is a primarily off-balance
sheet financing vehicle.

When the underlying obligation is a fixed income instrument, the total return payment
would consist of interest, fees (if any), and any change in the reference obligation’s
value. Any appreciation or depreciation in the reference obligation’s value is typically
determined on the basis of a poll of dealers. TRS contracts can specify that change-in-
value payments be made either on a periodic interim basis (which will reduce the credit
risk between the two parties to the contract) or at maturity.

Should the underlying asset decline in value by more than the coupon payment, the TRS
receiver must pay the negative total return, in addition to the funding cost, to the TRS
payer. At the extreme, a TRS receiver can be liable for the extreme loss that a reference
asset may suffer following, for instance, the issuing company’s default.

In instances when change-in-value payments are to be made at the maturity, the change-
in-value payment is sometimes physically settled. In such cases, the TR payer physically
delivers the reference obligation to the TR receiver at the maturity of the TRS contract in
return for cash payment of the reference obligation’s initial value.

Since a TRS frequently requires periodic exchanges of cash flows based in part on a
mark-to-market of the underlying asset, the reference asset of a TRS is typically liquid
and traded asset. When illiquid assets are referenced, alternate pricing arrangements are
used.

A TRS’s reference obligation can be a single asset—such as a particular bond or loan—or

an index or basket of assets. TRS that reference baskets of credits or indices are
becoming increasingly common due the cost-effective access they provide to portfolios
of credit risk. That is, index-based TRS provide investors with their desired portfolio
exposure while eliminating the cost of executing a large number of individual cash
transactions to obtain it.

The maturity of the TRS does not have to match the maturity of the reference obligation,
and in fact is usually shorter than the maturity of the underlying asset. Though shorter in
maturity, the TRS receiver is naturally exposed to full duration exposure of the
underlying asset. In a number of instances, TRS are drafted to allow either party to cancel
the transaction at the anniversary date of the contract. In most instances, TRS referencing
a single name typically terminate upon default of the underlying asset or other such
defined credit events. At such time, the asset can be delivered and the price shortfall paid
by the TR receiver. A TRS can continue despite default or other credit event if the TR
receiver posts the necessary collateral.

In contrast to credit default swaps—which only transfer credit risk—a TRS transfers
not only credit risk (i.e. the improvement or deterioration in credit profile of an issuer),
but also market risk (i.e. any increase or decrease in general market prices). In addition,
TRS contrasts with CDS since payments are exchanged among counterparties upon
changes in market valuation of the underlying and not only upon the occurrence of a
credit event as is the case with CDS contracts.

There are different types of credit derivatives, viz., Credit Default Swaps (CDS), Credit
Linked Deposits (CLDs), Credit Linked Notes (CLNs), Repackaged Notes, Collateralised
Debt Obligations (CDOs), etc.