Derivates market in India has caught the fancy of investors with the turnover increasing over two hundred times in last five years! While derivatives serve an important function as hedging instrument, a sharp increase like this could be a sign of speculation and can lead to huge losses, an apprehension raised by the finance minister some time back . However, before debating on the speculative nature of trade and other ills, here is an attempt to understand the market.
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\u201cDerivatives\u201d is a type of security, also called contract, which derives its value from another asset. This means that it doesn\u2019t have an independent value like say, a stock whose price is dependent upon the company\u2019s performance or say, a commodity, whose price is determined by the demand-supply dynamics of the commodity. The price of the \u201cderivative\u201d is driven by the price of the asset that it is representing.\u00a0 That other asset could be stock of a company, gold, currency or any such product whose value is readily available in the market. (For example, if the aggregate salaries of the CEOs of companies are actively available in the market, you can create a \u201cderivative\u201d product which tracks the aggregate salary and you can buy\/sell the same depending upon your expectation of their future salaries. Or, a CEO can hedge his salary by taking a counter position). In the equity derivative market, underlying assets are either individual stocks or the indices such as Sensex, Nifty 50 etc.<\/p>\n
Derivates are further classified into \u201cfutures\u201d and \u201coptions\u201d. Futures contracts are binding contract to buy\/sell the underlying asset at a specified price on a specified date. A simple example would help understand the concept. Assume an investor is apprehensive that the price of a stock he holds, currently trading at Rs 100, can crash due to market volatility. However, he doesn\u2019t want to sell the stock, so he sells the stock \u201cfutures\u201d at the specified price of Rs 102. At the time of maturity, even if the price falls, he will receive Rs 102 by selling the stock to the counter party and save himself from the loss. And if the price doesn\u2019t fall, he can still purchase the stock from the market and sell to the counter party. In practice, actual delivery rarely happens and the parties concerned only pay\/receive the difference between market and contract price.<\/p>\n
Options contract are where the buyer gets the right but not the obligation to buy\/sell the specified asset at the specified price. The buyer has to pay a premium for acquiring this right which is usually in the range of 0.1-0.2% of the contract value. However, the premium may go up depending upon the volatility in the market or movement in the price of the underlying stock. Options are more popular product accounting for over 80% of derivatives contract.<\/p>\n
Derivatives trade have taken-off spectacularly since FY18 as shown in the chart. As per SEBI annual report, equity derivatives market recorded turnover of Rs 38,000 lakh crore in FY23, double the figure of Rs 17,000 lakh crore in FY22 and only Rs 165 lakh crore in FY18. This corresponds to almost 200% CAGR increase in last five years!<\/em> Sharp increase in turnover has come about with increasing retail participation, renewed interest from foreign institutional investors, newer products like weekly settlement and of course, a sharp bull run. However, it must be understood that the amount is notional and not the money that is actually transacted. In case of options, actual transacted value is largely, the premium paid and in case of futures, the difference between stock price and contract price. Against the above-mentioned turnover, actual settlement was only about Rs 9 lakh crore. Other than equity derivatives markets, India also has active market for commodity derivatives, currency derivatives and interest rate derivatives. However, the turnover in these is quite low at Rs 150 lakh crore, Rs 446 lakh crore and Rs 50,000 crore respectively.<\/p>\n Unlike equity market where one can buy\/sell even one stock, derivatives are traded on minimum lot size basis with Rs 5 lakh as the minimum notional value. In case of NIFTY futures, one lot comprising of 50 units. With current index of about 20,000, minimum exposure in NIFTY futures works out to Rs 10 lakh. However, the trader only needs to put-in the margin money, roughly around 10% of this and not the entire amount.<\/p>\n The other differentiator in comparison to the cash segment is that the derivative contracts expire on the last trading day of the month and cannot be settled before that. To provide greater flexibility to the traders, weekly contract has been started in 2019. So, in case of monthly contract, even if the trader anticipates adverse movement, he cannot settle the contract but would have to take another contrary position to neutralize the impact of the movement.\u00a0 While this would compensate for his losses, he would need additional margin money. In case of options, the buyer has to pay an upfront premium calculated through complex models but normally less than 0.5% of notional value of the contract.<\/p>\n Despite the huge trade in derivatives, they have become high risk and speculative instruments, far more than the equity cash trade. That is so because speculators have over-numbered the hedgers undermining the original objective of acting as a hedging instrument to the owners of the underlying assets. As per a SEBI report, total number of traders in derivates segment has increased over six-fold, from 7.1 lakh in FY19 to over 45 lakhs in FY22 (across top ten broking house only). The attractiveness has become greater as the trader can take a larger exposure with a lower investment. While this increases the potential of profits but also\u00a0that of losses. As per the report, 89% of these traders incurred losses in F&O segment. As per another SEBI report, ratio of equity derivatives trading to equity cash trading rose from 3.2 in FY10 to over 23 times in FY18 and over 200 times now. This ratio is less than 50 times for all other exchanges across the globe. The report also shows that one out of six individual trades in derivatives but not in cash segment, defying the very objective of derivatives.<\/p>\n Other than traders\u2019 speculative tendencies, derivatives trade with domestic indices as underlying across global exchanges has also probably added to the speculation. Indian equity derivatives are traded across ten global exchanges of which, Singapore Exchange (SGX) is the most popular. SGX accounts for over half of turnover in futures although its share in options trading is negligible. SGX NIFTY has been renamed as GIFT NIFTY in July\u201923 and is being traded from the GIFT city in Gujarat.<\/p>\n To counter the speculative tendency, SEBI increased the margin requirement from about 7% to over 10% of the notional trade value in June\u201918. It has also proposed gradual move to physical settlement from the current system of cash settlement whereby the traders would have to sell\/purchase stocks for settlement. However, it would be virtually impossible to alter the fundamental nature of equity trade which is speculative. However, it is important to reduce information asymmetry that may be plaguing the market through insider information.<\/p>\n","protected":false},"excerpt":{"rendered":" Derivates market in India has caught the fancy of investors with the turnover increasing over two hundred times in last five years! While derivatives serve an important function as hedging instrument, a sharp increase like this could be a sign of speculation and can lead to huge losses, an apprehension raised by the finance minister […]<\/p>\n","protected":false},"author":8,"featured_media":19160,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"footnotes":""},"categories":[857],"tags":[],"class_list":["post-9905","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-economy","membership-content","access-restricted"],"yoast_head":"\n