The market regulator has allowed exchanges to offer European- or American-style stock options contracts, as well as a liquidity enhancement scheme
“Iview derivatives as time bombs, both for the parties that deal in them and the economic system,” said Warren Buffett in 2002. He did not stop there, going on to add, “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Buffett was remembered for his statements in 2008, when the world was hit by the sub-prime crisis.
While there are many who would counter Buffett — known as the world’s most successful investor — on his views, it is no secret that derivatives have been one of the few arenas that has been subject to a lot of innovation, leading to newer and more exotic products. India, however, has been dealing only in plain vanilla derivative products, and only recently saw the introduction of new products or tweaking of existing offerings.
Derivatives, also known as futures and options (F&Os), have long been limited to the equity segment — stock and index-based F&O — in India. A few years back, currency derivatives were introduced and the volumes have been impressive. Currency options that were allowed by the regulator only last year have also been a big hit. Interest rate futures (IRFs), meanwhile, have seen few takers with almost zero volumes.
The popularity of derivatives in India is clearly visible. The National Stock Exchange (NSE) features among the top derivative exchanges of the world in terms of the number of contracts traded. If one takes into account commodity futures, MCX occupies the top slot in some commodities.
There has been talk of enhancing the bouquet of offerings in the F&O space for many years, but things have been moving at a slow pace. In a report released in December 2008, the derivatives market review committee set up by the Securities and Exchange Board of India (Sebi) had suggested the introduction of various new instruments like mini contracts on equity indices, bond indices, exchange-traded credit derivatives, options contracts with longer tenures, over-the-counter products, a volatility index and derivatives based on it, and options on futures.
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Options on futures, meanwhile, are derivative products where, on exercising it, the option’s position is converted into a futures position instead of delivery of the underlying. That is, a put option on futures is an option to sell a futures contract, and a call option on futures is an option to buy a futures contract. While some of the products envisaged in the report have been launched, there is still a long way to go.
The coming months will see the introduction of derivatives based on foreign indices, namely S&P 500 and Dow Jones Industrial Average. This will be the first-time that Indian investors will get an opportunity to bet on the US market, and that too, in their local currency. The National Stock Exchange (NSE) has already received regulatory approval for the launch, which is expected any time soon.
Going ahead, one will also see the launch of derivative contracts based on the volatility index, more popularly known as VIX. Globally, VIX is looked upon as an important barometer for predicting the direction of the market. While India has its own VIX, launched by NSE, there has not been much progress since then. However, with regulatory approvals in place, F&O based on VIX could be a reality soon.
Another notable change in the derivatives space has been the switch to physical settlement in the single stock F&O space, which was a long-standing demand of a section of market players. The Bombay Stock Exchange (BSE) has already moved to the physical settlement system, where contracts are settled with the underlying shares instead of cash.
Further development of the equity derivatives segment is high on the regulator’s radar too. Recently, it gave its go-ahead to a liquidity enhancement scheme by which exchanges can appoint market makers to create liquidity in the derivatives space. It has also allowed the BSE to launch mid-month expiry contracts. Earlier, all derivative contracts expired on the last Thursday of every month.
The regulator has allowed stock exchanges the flexibility to offer either European-style or American-style stock options contracts. Currently, only American-style contracts are allowed in the stock options segment. A European option is one that can be squared off only on the day of expiry (maturity). This is in sharp contrast to an American option, which can be squared off even before expiry.
From a trader’s perspective, however, the advantages are more theoretical in nature and hence there has not been any spurt in volumes after the tweaking. While European options cannot be exercised before maturity, they can always be sold before maturity.
Even the IRF segment — launched for the second time in 2009 — is likely to see some regulatory changes in the near future to make it more acceptable to the industry. There is already talk that Sebi is evaluating proposals to move the entire segment on a cash settled basis. Currently, contracts are settled with Government of India (GOI) securities with a tenor of between nine and 12 years.