Indian capital market and financial system

Indian Capital Market and Financial System MBA Second Year (Financial Management) Paper No 2.1 School of Distance Education Bharathiar University, Coimbatore - 641 046 Author: Prof P Srinivasa Subbarao Copyright © 2008, Bharathiar University All Rights Reserved Produced and Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for SCHOOL OF DISTANCE EDUCATION Bharathiar University Coimbatore-641046 CONTENTS Page No UNIT I Lesson Structure and Constituents of Indian Financial System Lesson Financial Institutions and Markets 18 Lesson Financial Instruments, Services and Economic Development 34 UNIT II Lesson Organisation and Structure of Stock Exchanges 57 Lesson Listing, Trading and Settlement Procedure 72 Lesson Ordinary Shares, Preference Shares and Bonds 86 UNIT III Lesson New Issue Market – Issue Mechanism 97 Lesson IPO, Rights Issue, Private Placement 106 Lesson Book Building and Functions of New Issue Market 124 Lesson 10 Overview of Bond Market in India 135 UNIT IV Lesson 11 Merchant Banking and New Issue Market 145 Lesson 12 Lead Managers, Underwriters, Registrars, Transfer Agents, Brokers and Bankers Debenture Trustees 152 SEBI Guidelines 160 Lesson 13 UNIT V Lesson 14 Market for Financial Derivatives 173 Lesson 15 SWAPS, Warrants and Convertibles 186 Lesson 16 Recent Trends in Derivative Markets in India 196 Model Question Paper 205 INDIAN CAPITAL MARKET AND FINANCIAL SYSTEM SYLLABUS UNIT I Indian financial system: - Structure and constituents of Indian financial system Financial institutions - Financial markets - Financial instruments and Services Financial System and economic development UNIT II Industrial Securities Market - Organisation and Structure of Stock exchanges, Membership - Listing, Trading and Settlement - ordinary shares, preference shares and Bonds UNIT III New issue Market - Issue Mechanism - IPO, Rights issue, private placement processes of Book-Building - Issue of Bonus Shares - Stock Options - functions of new issue market - Overview of Bond market in India UNIT IV Merchant Bankers and new issue market, Lead managers, underwriters, Bankers to an issue - Registrars and Share Transfer Agents - Brokers to the issue - Debenture Trustees – Their role and functions in new issue market - SEBI Guidelines UNIT V Market for Futures, Options and other financial derivatives - SWAPS - Warrants and Convertibles – Recent trends in derivative markets in India Structure and Constituents of Indian Financial System UNIT I Indian Capital Market and Financial System LESSON STRUCTURE AND CONSTITUENTS OF INDIAN FINANCIAL SYSTEM CONTENTS 1.0 Aims and Objectives 1.1 Introduction 1.2 Financial System 1.3 Structure of a Financial System 1.3.1 Financial Institutions 1.3.2 Financial Markets 1.3.3 Financial Instruments (Claims, Assets and Securities) 1.4 Functions of Financial System 1.4.1 Liability-Asset Transformation 1.4.2 Size-Transformation 1.4.3 Risk-Transformation 1.4.4 Maturity-Transformation 1.5 Liberalisation of the Financial System 1.5.1 Reforms in Financial Markets 1.5.2 Reforms in Capital Market Operations 1.5.3 Reforms in Banking Sector 1.5.4 Reforms Relating to NBFCs 1.6 Let us Sum up 1.7 Lesson End Activity 1.8 Keywords 1.9 Questions for Discussion 1.10 Suggested Readings 1.0 AIMS AND OBJECTIVES After studying this lesson, you should be able to: z Know the definition and structure of financial system z Understand the different components of financial system z Know the functions of the financial system z Understand the effects of liberalization policies Structure and Constituents of Indian Financial System Indian Capital Market and Financial System 1.1 INTRODUCTION This lesson explains the basic elements of a financial system which will be discussed in detail in the further chapters It talks about the constituents, functions of the financial system, and performance criteria of the financial system, and certain concepts in its development besides the reforms in Indian financial system after liberalization The growth of output in any economy depends on the increase in the proportion of savings and investment to a nation's output of goods and services The financial system and financial institutions help in the diversion of rising current income into savings/investments A financial system may be defined as a set of institutions, instruments and markets which encourages savings and channels them to their most efficient use The system consists of individuals (savers), intermediaries, markets and users of savings (government, public and private sector entities) Economic activity and growth are greatly facilitated by the existence of a financial system developed in terms of the efficiency of the market in mobilizing savings and allocating them among competing users Well-developed financial markets are required for creating a balanced financial system in which both financial markets and financial institutions play important roles Deep and liquid markets provide liquidity to meet any surge in demand for liquidity in times of financial crisis Such markets are also necessary to derive appropriate reference rates for pricing financial assets 1.2 FINANCIAL SYSTEM We can define financial system as a set of institutions, instruments and markets, which foster savings and channels them to their most efficient use The system consists of individuals (savers), intermediaries, markets and users of savings Economic activity and growth are greatly facilitated by the existence of a financial system developed in terms of the efficiency of the market in mobilizing savings and allocating them among competing users The word "system", in the term "financial system", implies a set of complex and closely connected or interlinked institutions, agents, practices, markets, transactions, claims, and liabilities in the economy The financial system is concerned about money, credit and finance-the three terms are intimately related yet are somewhat different from each other Money refers to the current medium of exchange or means of payment Credit or loan is a sum of money to be returned, normally with interest; it refers to a debt of economic unit Finance is monetary resources comprising debt and ownership funds of the state, company or person 1.3 STRUCTURE OF A FINANCIAL SYSTEM The financial system or the financial sector of any country having specialized and non-specialized financial institutions, organized and unorganized financial markets, financial instruments and services which facilitate transfer of funds Procedures and practices adopted in the markets, and financial interrelationships are also parts of the system These parts are not always mutually exclusive; for example, financial institutions operate in financial markets and are, therefore, a part of such markets 1.3.1 Financial Institutions All business organizations that act as mobilisers and depositories of savings, and as purveyors of credit or finance They also provide various financial services to the community They differ from non-financial (industrial and commercial) business organizations in respect of their dealings, i.e., while the former deal in financial assets such as deposits, loans, securities, and so on, the latter deal in real assets such as machinery, equipment, stocks of goods, real estate, and so on The distinction between the financial sector and the "real sector" should not be taken to mean that there is something temporary or unproductive about finance At the same time, it means that the role of financial sector should not be over emphasized The activities of different financial institutions may be either specialized or they may overlap; quite often they overlap Yet we need to classify financial institutions and this is done on the basis of their primary activity or the degree of their specialization with relation to savers or borrowers with whom they customarily deal or the manner of their creation In other words, the functional, geographic, sectoral scope of activity or the type of ownership are some of the criteria which are often used to classify a large number and variety of financial institutions which exist in the economy However, it should be kept in mind that such classification is likely to be imperfect and tentative Financial System Financial Institutions Regulatory Banking Financial Markets Intermediaries NonIntermediaries Non-Banking Others Organized Financial Instruments (Claims, Assets, Securities) Primary Capital Markets Secondary Unorganized Short Term Primary Financial Services Medium Term Long Term Secondary Money Markets Figure 1.1: Structure of Indian Financial Systems According to one categorisation, financial institutions are divided into banking and non-banking institutions The banking institutions have quite a few things in common with the non-banking ones, but their distinguishing character lies in the fact that, unlike other institutions, they participate in the economy's payments mechanism, i.e., they provide transactions services, their deposit liabilities constitute a major part of the national money supply, and they can, as a whole, create deposits or credit, which is money Banks, subject to legal reserve requirements, can advance credit by creating claims against themselves, while other institutions can lend only out of resources put at their disposal by the savers The distinction between the banking and non-banking has been highlighted by Sayers by characterizing the former as "creators" of credit, and the latter as mere "purveyors" of credit.' While the banking system in India comprises the commercial banks and cooperative banks, the examples of non-banking financial institutions are Life Insurance Structure and Constituents of Indian Financial System 10 Indian Capital Market and Financial System Corporation (LIC), Unit Trust of India (UTI), and Industrial Development Bank of India (IDBI) Financial institutions are also classified as intermediaries and non-intermediaries As the term indicates, intermediaries intermediate between savers and investors; they lend money as well as mobilize savings; their liabilities are towards the ultimate savers, while their assets are from the investors or borrowers Non intermediary institutions the loan business but their resources are not directly obtained from the savers All banking institutions are intermediaries Many non-banking institutions also act as intermediaries and when they so they are known as Non-Banking Financial Intermediaries (NBFI) UTI, LIC, General Insurance Corporation (GIC) are some of the NBFIs in India Non-intermediary institutions like IDBI, Industrial Finance Corporation (lFC), and National Bank for Agriculture and Rural Development (NABARD) have come into existence because of governmental efforts to -provide assistance for specific purposes, sectors, and regions Their creation as a matter of policy has been motivated by the philosophy that the credit needs of certain borrowers might not be otherwise adequately met by the usual private institutions Since they have been set up by the government, we can call them Non-Banking Statutory Financial Organisations (NBSFO) 1.3.2 Financial Markets Financial Markets are the centres or arrangements that provide facilities for buying and selling of financial claims and services The corporations, financial institutions, individuals and governments trade in financial products in these markets either directly or through brokers and dealers on organized exchanges or off-exchanges The participants on the demand and supply sides of these markets are financial institutions, agents, brokers, dealers, borrowers, lenders, savers, and others who are interlinked by the laws, contracts, covenants and communication networks Financial markets are sometimes classified as primary (direct) and secondary (indirect) markets The primary markets deal in the new financial claims or new securities and, therefore, they are also known as new issue markets On the other hand, secondary markets deal in securities already issued or existing or outstanding The primary markets mobilize savings and supply fresh or additional capital to business units Although secondary markets not contribute directly to the supply of additional capital, they so indirectly by rendering securities issued on the primary markets liquid Stock markets have both primary and secondary market segments Very often financial markets are classified as money markets and capital markets, although there is no essential difference between the two as both perform the same function of transferring resources to the producers This conventional distinction is based on the differences in the period of maturity of financial assets issued in these markets While money markets deal in the short-term claims (with a period of maturity of one year or less), capital markets so in the long-term (maturity period above one year) claims Contrary to popular usage, the capital market is not only coextensive with the stock market; but it is also much wider than the stock market Similarly, it is not always possible to include a given participant in either of the two (money and capital) markets alone Commercial banks, for example, belong to both While treasury bills market, call money market, and commercial bills market are examples of money market, stock market and government bonds market are examples of capital market Keeping in view different purposes, financial markets have also been classified into the following categories: (a) Organized and unorganized, (b) Formal and informal, 190 Indian Capital Market and Financial System 15.3 WARRANTS In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is usually higher than the stock price at time of issue Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends They can be used to enhance the yield of the bond, and make them more attractive to potential buyers Warrants can also be used in private equity deals For instance, it was a common practice during the height of the dot-com bubble for a landlord of sought-after commercial real-estate to demand warrants from high-tech startups as part of the lease agreement Frequently, these warrants are detachable, and can be sold independently of the bond or stock Corporations issue warrants enhancing the future value of their stock to the people holding it 15.3.1 Characteristics of Warrants Warrants have similar characteristics to that of other equity derivatives, such as options, for instance: z Exercising: A warrant is exercised when shares are bought through the warrant The warrant parameters, such as exercise price, are fixed shortly after the issue of the bond With warrants, it is important to consider the following main characteristics: z Premium: A warrant's ‘premium’ represents how much extra you have to pay for your shares when buying them through the warrant as compared to buying them in the regular way z Gearing (leverage): A warrant's ‘gearing’ is the way to ascertain how much more exposure you have to the underlying shares using the warrant as compared to the exposure you would have if you buy shares through the market z Expiration Date: This is the date the warrant expires If you plan on exercising the warrant you must so before the expiration date The more time remaining until expiry, the more time for the underlying security to appreciate, which, in turn, will increase the price of the warrant Therefore, the expiry date is the date on which the right to exercise no longer exists 15.3.2 Difference between Warrants and Options z Warrants are much like call options, and will often confer the same rights as an equity option and can even be traded in secondary markets However, warrants have several key differences z Warrants are issued by private parties, typically the corporation on which a warrant is based, rather than a public options exchange z Warrants issued by the company itself are dilutive When the warrant issued by the company is exercised, the company issues new shares of stock, so the number of outstanding shares increases When a call option is exercised, the owner of the call option receives an existing share from an assigned call writer (except in the case of employee stock options, where new shares are created and issued by the company upon exercise) Unlike common stock shares outstanding, warrants not have voting rights z Warrants are considered over the counter instruments, and thus are usually only traded by financial institutions with the capacity to settle and clear these types of transactions z A warrant's lifetime is measured in years (as long as 15 years), while options are typically measured in months Even LEAPS (long-term equity anticipation securities), the longest stock options available, tend to expire in two or three years Upon expiration, the warrants are worthless if not exercised unless the price of the common stock is greater than the exercised price z Warrants are not standardized like exchange-listed options While investors can write stock options on the ASX, they are not permitted to either with ASX-listed warrants, since only companies can issue warrants, and while each option contract is over 100 underlying ordinary shares, the number of warrants that must be exercised by the holder to buy the underlying asset depends on the conversion ratio set out in the offer documentation for the warrant issue 15.3.3 Types of Warrants A wide range of warrants and warrant types are available The reasons you might invest in one type of warrant may be different from the reasons you might invest in another type of warrant z Equity Warrants: Equity warrants can be call and put warrants (a) Call warrants give you the right to buy the underlying securities (b) Put warrants give you the right to sell the underlying securities z Covered Warrants: A covered warrant is a warrant that has some underlying backing, for example the issuer will purchase the stock before hand or will use other instruments to cover the option z Basket Warrants: As with a regular equity index, warrants can be classified at, for example, an industry level Thus, it mirrors the performance of the industry z Index Warrants: Index warrants use an index as the underlying asset Your risk is dispersed—using index call and index put warrants—just like with regular equity indexes It should be noted that they are priced using index points That is, you deal with cash, not directly with shares Traditional Traditional warrants are issued in conjunction with a Bond (known as a warrantlinked bond), and represent the right to acquire shares in the entity issuing the bond In other words, the writer of a traditional warrant is also the issuer of the underlying instrument Warrants are issued in this way as a 'sweetener' to make the bond issue more attractive, and to reduce the interest rate that must be offered in order to sell the bond issue Naked Naked warrants are issued without an accompanying bond, and like traditional warrants, are traded on the stock exchange They are typically issued by banks and securities firms These are also called covered warrants, and are settled for cash, e.g not involve the company who issues the shares that underlay the warrant In most markets around the world, covered warrants are more popular than the traditional warrants described above Financially they are also similar to call options, but are typically bought by retail investors, rather than investment funds or banks, which prefer the more keenly priced options which tend to trade on a different market Covered warrants normally trade alongside equities, which makes them easier for retail investors to buy and sell them 191 Swaps, Warrants and Convertibles 192 Indian Capital Market and Financial System Third Party Warrants Third-party warrant is a derivative issued by the holders of the underlying instrument Suppose Company X issues one million warrants which gives the holder the right to convert each warrant into one share at $ 500 This warrant is company-issued For example a mutual fund that holds 10,000 shares of X sells warrants against those shares, also exercisable at $ 500 per share These are called third-party warrants The primary advantage is that the instrument helps in the price discovery process In the above case, the mutual fund selling a one-year warrant exercisable at $ 500 sends a signal to other investors that the stock may trade at $ 500 levels in one year If volumes in such warrants are high, the price discovery process will be that much better; for it would mean that many investors believe that the stock will trade at that level in one year Third-party warrants are essentially long-term call options The seller of the warrants does a covered call-write That is, the seller will hold the stock and sell warrants against them If the stock does not cross $ 500, the buyer will not exercise the warrant The seller will, therefore, keep the warrant premium Government Agencies issued Warrants Also, when a government agency issues checks which they are unable to pay (due to lack of money) but are redeemable some point in the future, usually with interest, these are also called warrants In the late 1990s, when the State of California had a budget crisis due to a disagreement between the governor and the legislature, the state treasurer was forced to issue warrants paying 18% interest in lieu of being able to pay the state's bills with real money The state had not issued warrants since before the Depression of the 1930s Many institutions accepted them at face value because of the interest provision Interestingly, the comptroller of Los Angeles County was buying the warrants because the county had surplus funds to take advantage of the higher interest rates on the warrants In some states, a warrant is a demand draft drawn on a government's treasury to pay its bills Checks or electronic payments have replaced these warrants, but in Arkansas, some counties and school districts use warrants for non-electronic payments Check Your Progress An asset swap involves (a) Exchange of principal amount (b) Exchange of interest obligation (c) Exchange of interest income (d) Both (a) and (b) (e) Both (a) and (c) In a put swaption (a) The buyer has the right to enter into a swap as a floating rate payer (b) The seller has the right to enter into a swap as a floating rate payer (c) The buyer has the right to enter into a swap as a fixed rate payer (d) The seller has to pay floating rate if the option is exercised (e) None of the above An equity swap involves (a) Exchange of dividends on portfolio with periodic interest payments (b) Exchange of capital gains on a portfolio with periodic interest payments (c) Exchange of dividends on a portfolio with stocks of a particular company (d) All of the above Contd… Plain vanilla interest rate swap involves (a) Fixed to fixed rate swap (b) Fixed to floating rate swap (c) Floating to floating rate swap (d) Currency swap Arbitrage means (a) Obtaining risk-free profits by simultaneously buying and selling identical (or) similar instruments in different markets (b) Obtaining profits by selling instruments in a costlier market (c) Obtaining losses by selling instruments in cheaper markets (d) None of the above 15.4 CONVERTIBLES Hybrid securities, often referred as “hybrids”, are a broad group of securities that combine the elements of the two broader groups of securities Debt and Equity Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until a certain date, at which point the holder has a number of options including converting the securities into the underlying share Therefore, unlike a share of stock (equity) the holder has a 'known' cash flow, and, unlike a fixed interest security (debt) there is an option to convert to the underlying equity More common examples include convertible and converting preference shares It is important to note that a hybrid security is structured differently and while the price of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert Examples: A convertible bond is a bond (i.e a loan by the issuer), but can be exchanged into shares A convertible can be valued as a combination of a straight bond and an option to purchase the company's stock An income security is a hybrid between a stock and a bond The bond portion pays interest, and the stock portion pays dividends Income securities are popular in Canada 15.4.1 Important Terms z Returns: Predictable dividend, often franked therefore possible tax advantage to the holder z Capital price: (a) Price moves in line with share price (fixed conversion terms e.g hybrid convert to share) (b) Bond like, price does not move in line with share price (variable conversion terms, face value (usually $100) convert to $100 worth of shares z Discount: A discount is usually offered to the share price at the time of conversion 193 Swaps, Warrants and Convertibles 194 Indian Capital Market and Financial System z Reset/Resettable: At the reset date the terms of the security (dividend rate, next reset date) may change The holder can elect to accept the new reset terms or convert into shares z Cumulative/Non-cumulative: This refers to the event of missed dividend payments (a) Cumulative: missed dividend payments are added to the next dividend payment (b) Non-cumulative: missed dividend payments are forgone z Redeemable/Non-redeemable: (a) Redeemable: At certain times the holder may have the option to sell the securities back to the company at the face value/issue price (b) Non-redeemable: The company is not offering to buy the securities 15.5 LET US SUM UP Swaps have become popular derivative instruments in recent years all over the world A swap is an agreement between two counter parties to exchange cash flows in the future Under the swap agreement various terms like the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are determined and finalized by the parties Usually the calculation involves the future values of one or more market variables There are two most popular forms of swap contracts, i.e., interest rate swaps and currency swaps In the interest rate swap one party agrees to pay the other party interest at a fixed rate on a no amount, and in return, it receives interest at a floating rate on the same principal notional amount for specified period The currencies of the two sets of cash flows are the same In case of currency swap, it involves exchanging of interest flows, in one currency for interest flows in other currency In other words, it requires the exchange of cash flows in two currencies There are various forms of swaps based upon these two, but having different features in general Warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is usually higher than the stock price at time of issue There are different types of warrants, out of all the popular are interest rate warrants, currency warrants and equity warrants Convertibles are income securities that are hybrids between stocks and bonds The bond portion pays interest, and the stock portion pays dividends 15.6 LESSON END ACTIVITY Write a detailed note on different types of Swaps available in Indian market 15.7 KEYWORDS LIBOR: London Inter Bank Offer Rate TRORS: Total rate of return swap 15.8 QUESTIONS FOR DISCUSSION Explain the importance of Swaps in derivative market Compare warrants with options and explain its characteristics and types of warrants Write a short note on convertibles Check Your Progress: Model Answers CYP 1 The currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest rate payments on an equal loan in another currency An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party’s stream or cash flows CYP c a d b a 15.9 SUGGESTED READINGS Susan, Thomas, Derivatives Markets in India (edited), Tata McGraw-Hill, New Delhi, 2003 Susan, Thomas, Derivatives Markets in India, Tata McGraw-Hill, New Delhi, 1998 Taxmanns SEBI Manual, Taxman Allied Services (P) Ltd., New Delhi, 2002 Corporate Miscellany - Derivatives market in India: A Framework of Economic Purpose, Chartered Secretary, October, 1997 Reforms in Secondary Markets in India, Working paper from National Stock Exchange (NSE), India, 2000 Somanathan, T.V., Derivatives, Tata McGraw-Hill, New Delhi, 1999 195 Swaps, Warrants and Convertibles 196 Indian Capital Market and Financial System LESSON 16 RECENT TRENDS IN DERIVATIVE MARKETS IN INDIA CONTENTS 16.0 Aims and Objectives 16.1 Introduction 16.2 Importance and Need of Derivatives 16.3 Evolution of Derivatives in India 16.4 Dr L.C Gupta Committee Recommendations 16.5 Categories of Derivatives Traded in India 16.5.1 Derivatives Trading at NSE/BSE 16.5.2 Structure of Derivatives Markets in India 16.6 Let us Sum up 16.7 Lesson End Activity 16.8 Keywords 16.9 Questions for Discussion 16.10 Suggested Readings 16.0 AIMS AND OBJECTIVES After studying this lesson, you should be able to: z Know the growth and development of derivative market in India z Understand the role of stock exchanges in derivative market z Know the structure of derivatives market 16.1 INTRODUCTION The individuals and the corporate sector units are freely using derivatives, also popularly known as future market instruments, in most of the developed countries of the world to manage different risks by the individuals and the corporate sector units Emerged in 1970s, the derivatives markets have seen exponential growth and trading volumes have nearly doubled in every three years, making it a multi-trillion dollar business market The future markets in various segments have developed so much that now one can think of the existence of financial markets without the derivatives instruments In other words, the derivatives markets whether belonging to commodities or financials have become, today, an integral part of the financial system of a country The Indian financial markets indeed waited for too long for derivatives trading to emerge The statutory hurdles have been cleared Regulatory issues have been sorted out Stock exchanges are gearing up for derivatives Mutual funds, foreign institutional investors, financial Institutions, banks, insurance companies, investment companies, pension funds and other investors who are deprived of opportunities now find the derivatives market to bank on They would find very soon all other important derivatives instruments in the Indian markets to manage their portfolios and associated risks 16.2 IMPORTANCE AND NEED OF DERIVATIVES Since 1991, due to liberalization of economic policy, the Indian economy has entered an era in which Indian companies cannot ignore global markets Before the nineties, prices of many commodities, and other assets were controlled Others, which were not controlled, were largely based on regulated prices of inputs As such there was limited uncertainty, and hence, limited volatility of prices But, 1991, starting the process of deregulation, prices of most commodities are decontrolled It has resulted in partly deregulating the exchange rates, removing the trade controls, reducing the interest rates, making major changes for the capital market entry of foreign institutional investors, introducing market based pricing of government securities, etc All these measures have increased the volatility prices of various goods and services in India to producers and consumers alike Further, market determined exchange rates and interest rates also created volatility and instability in portfolio values and securities prices Hence, hedging activities through various derivatives emerged to different risks Futures trading offers a risk-reduction mechanism to the farmers, producers, exporters, importers, investors, bankers, trader, etc which are essential for any country In the words of Alan Greenspan, Chairman of the US Federal Reserve Board, "The array of derivative products that has been developed in recent years has enhanced economic efficiency The economic function of these contracts is to allow risks that formerly had been combined to be unbundled and transferred to those most willing to assume and manage each risk components.” Development of futures markets in many countries has contributed significantly in terms of invisible earnings in the balance of payments, through the fees and other charges paid by the foreigners for using the markets Further, economic progress of any country, today, much depends upon the service sector as on agriculture or industry Services are now backbone of the economy of the future India has already crossed the roads of revolution in industry and agriculture sector and has allowed the same now in services like financial futures India has all the infrastructure facilities and potential exists for the whole spectrum of financial futures trading in various financial derivatives like stock market indices, treasury bills, gilt-edged securities, foreign currencies, cost of living index, stock market index, etc For all these reasons, there is a major potential for the growth of financial derivatives markets in India 16.3 EVOLUTION OF DERIVATIVES IN INDIA Commodities futures trading in India were initiated long back in 1950s; however, the 1960s marked a period of great decline in futures trading Market after market was closed usually because different commodities' prices increases were attributed to speculation on these markets Accordingly, the Central Government imposed the ban on trading in derivatives in 1969 under a notification issue The late I 990s shows this signs of opposite trends – a large scale revival of futures markets in India, and hence, the Central Government revoked the ban on futures trading in October, 1995 The Civil Supplies Ministry agreed in principle for starting of futures trading in Basmati rice, further, in 1996 the Government granted permission to the Indian Pepper and Spice Trade Association to convert its Pepper Futures Exchange into an International Pepper Exchange As such on November 17, 1997, India's first international futures at Kochi, known as the India Pepper and Spice Trade Association-International Commodity (lPSTA-ICE) was established 197 Recent Trends in Derivative Markets in India 198 Indian Capital Market and Financial System Similarly, the Cochin Oil Millers Association, in June 1996, demanded the introduction of futures trading in coconut oils The Central Minister for Agriculture announced in June 1996 that he was in favour of introduction of futures trading both domestic and international Further, a new coffee futures exchange (The Coffee Futures Exchange of India) is being started at Bangalore In August, 1997, the Central Government proposed that Indian companies with commodity price exposures should be allowed to use foreign futures and option markets The trend is not confined to the commodity market alone, it has initiated in financial futures too The Reserve Bank of India set up the Sodhani Expert Group which recommended major liberalization of the forward market and had urged the setting up of rupee-based derivatives in financial instruments The RBI accepted several of its recommendations in August, 1996 A landmark step taken in this regard when the Securities and Exchange Board of India (SEBI) appointed a Committee named the L.C Gupta Committee (LCGC) by its resolution, dated November 18, 1996 in order to develop appropriate regulatory framework for derivatives trading in India While the Committee's focus was on equity derivatives but it had maintained a broad perspective of derivatives in general The Board of SEBI, on May 11, 1998, accepted the recommendations of the Dr L.C Gupta Committee approved introduction of derivatives trading in India in the phased manner The recommendation sequence is stock index futures, index options and options on stocks The Board also approved the ‘Suggestive Bye-Laws’ recommended by the Committee for regulation and control of trading and settlement of derivatives contracts in India Subsequently, the SEBI appointed J.R Verma Committee to look the operational aspects of derivatives markets To remove the roadblock of non-recognition of derivatives as securities under Securities Contract Regulation Act, the Securities Law (Amendment) Bill, was introduced to bring about the much needed changes Accordingly, in December, 1999, the new framework has been approved and 'Derivatives' have been accorded the status of 'Securities' However, due to certain completion of formalities, the launch of the Index Futures was delayed by more than two years In June, 2000, the National Stock Exchange and the Bombay Stock Exchange started stock index based futures trading in India Further, the growth of this market did not take off as anticipated This is mainly attributed to the low awareness about the product and mechanism among the market players and investors The volumes, however, are gradually picking up due to active interest of the institutional investors Check Your Progress 1 When did the derivatives market emerged in India? …………………………………………………………………………… …………………………………………………………………………… When did the national stock exchange commenced trading in exchange rate future? …………………………………………………………………………… …………………………………………………………………………… 16.4 DR L.C GUPTA COMMITTEE RECOMMENDATIONS Before discussing the emerging structure of derivatives markets in India, let us have a brief view of the important recommendations made by the Dr L.C Gupta Committee on the introduction of derivatives markets in India These are as under: The Committee is strongly of the view that there is urgent need of introducing of financial derivatives to facilitate market development and hedging in a most costefficient way against market risk by the participants such as mutual funds and other investment institutions There is need for equity derivatives, interest rate derivatives and currency derivatives Futures trading through derivatives should be introduced in phased manner starting with stock index futures, which will be followed by options on index and later options on stocks It will enhance the efficiency and liquidity of cash markets in equities through arbitrage process There should be two-level regulation (regulatory framework for derivatives trading), i.e., exchange level and SEBI level Further, there must be considerable emphasis on self regulatory competence of derivative exchange under the overall supervision and guidance of SEBI The derivative trading should be initiated on a separate segment of existing stock exchanges having an independent governing council The number of the trading members will be limited to 40 percent of the total number The Chairman of the governing council will not b trade on any of the stock exchanges The settlement of derivatives will be through an independent clearing Corporation/Clearing house, which will become counter-party for all trades or alternatively guarantees the settlement of all trades The clearing corporation will have adequate risk containment measures collect margins through EFT The derivatives exchange will have on-line-trading and adequate surveillance systems It will disseminate trade and price information on real time basis through two information networks It should inspect 100 percent of members every year There will be complete segregation of client money at the level of trading/clearing even at the level of clearing corporation The trading and clearing member will have stringent eligibility conditions At least two persons should have passed the certification programme approved by the SEBI 10 The clearing members should deposit minimum Rs 50 lakh with clearing corporation and should have a net worth of Rs crore 11 Removal of the regulatory prohibition on the use of derivatives by mutual funds while making the trustees responsible to restrict the use of derivatives by mutual funds only to hedging and portfolio balancing and not for specification 12 The operations of the cash market on which the derivatives market will be based, need improvement in many respects 13 Creation of a Derivation Cell, a Derivative Advisory Committee, and Economic Research Wing by SEBI 14 Declaration of derivatives as 'securities' under Section (h) of the SCRA and suitable amendments in the notification issued by the Central Government in June, 1969 under Section 16 of the SCRA The SEBI Board approved the suggested Bye-Laws recommended by the L.C Gupta Committee for regulation and control of trading and settlement of derivatives contracts 199 Recent Trends in Derivative Markets in India 200 Indian Capital Market and Financial System 16.5 CATEGORIES OF DERIVATIVES TRADED IN INDIA Commodities futures for coffee, oil seeds, oil, gold, silver, pepper, cotton, jute and jute goods are traded in the commodities futures Forward Markets Commission regulates the trading of commodities futures Index futures based on Sensex and NIFTY index are also traded under the supervision of Securities and Exchange Board of India (SEBI) The RBI has permitted banks, Financial Institutions (FIs) and Primary Dealers (PDs) to enter into forward rate agreements (FRAs)/interest rate swaps in order to facilitate hedging of interest rate risk and ensuring orderly development of the derivatives market The National Stock Exchange (NSE) became the first exchange to launch trading in options on individual securities Trading in options on individual securities commenced from July, 2001 Options contracts are American style and cash settled and are available in about 40 securities stipulated by the Securities and Exchange Board of India The NSE commenced trading in futures on individual securities on November 9, 2001 The futures contracts are available in about 31 securities stipulated by SEBI The BSE also started trading in stock options and futures (both Index and Stocks) around at the same time as the NSE The National Stock Exchange commenced trading in interest rate future on June 2003 Interest rate futures contracts are available on 91-day T-bills, 10-year bonds and 10-year zero coupon bonds as specified by the SEBI Table 16.1: Calendar of Introduction of Derivatives Products in Indian Financial Markets OTC Exchange trades • 1980s – Currency forwards • June, 2000 – Equity index futures • 1997 – Long-term foreign currency-rupee swaps • June, 2001 – Equity index option • July, 1999 – Interest rate swaps and FRAs • July, 2001 – Stock Option • July, 2003 – FC-rupee options • June, 2003 –Interest rate futures Source: www.derivativesportal.com Table 16.2: Financial Derivatives in India: A Chronology Date 14 December, 1995 Progress NSE asked SEBI for permission to trade futures 18 November, 1996 SEBI setup L C Gupta Committee to draft a policy framework for index futures 11 May, 1998 L.C Gupta Committee submitted report July, 1999 RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps 24 May, 2000 SIMES chose NIFTY for trading futures and options on an Indian index 25 May, 2000 SEBI gave permission to NSE and BSE to index futures trading June, 2000 Trading of BSE sensex futures commenced at BSE 12 June, 2000 Trading of NIFTY futures commenced at NSE 31 August, 2000 Trading of futures and options on NIFTY to commence at SIMES July, 2001 Trading on equity futures commenced at NSE on 31 securities June, 2003 Trading on interest rate futures commenced at NSE July, 2003 Trading on FC-rupee options started 16.5.1 Derivatives Trading at NSE/BSE The most notable development in the history of secondary segment of the Indian stock market is the commencement of derivatives trading in June, 2000 The SEBI approved derivatives trading based on futures contracts at National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) in accordance with the rules/bye-laws and regulations of the stock exchanges To begin with, the SEBI permitted equity derivatives named stock index futures The BSE introduced on June, 2000 stock index futures based on the sensitive Index (also called SENSEX comprising 30 scripts) named BSX, and NSE started on June 12, 2000 stock index future based on its index S&P CNX NIFTY (comprised 50 scripts) in the name of NFUTIDX NIFTY Further details of these are given in Table 16.3 Table 16.3: Salient Features of Index Futures Contracts at BSE and NSE S.No Items BSE NSE Date of Introduction June 9, 2000 June 12, 2000 Name of security BSX NFUTIDX NIFTY Underlying asset BSE Sensitive Index (SENSEX) S&P CNX NIFTY Contract size Sensex value × 50 200 or multiples of 200 Tick size/Price step 0.1 point of Sensex (equivalent to Rs 5) Rs 0.05 Minimum price fluctuations Rs Not applicable Price Bands NA NA Expiration months 3-near months 3-near months Trading cycle A maximum of months; the near month(1), the next month(2) and the a month(3) As in previous column 10 Last trading/Expiry day Last Thursday of the month or the preceding day As in previous column 11 Settlement In cash on T+1 basis As in previous column 12 Final settlement price Index closing price on the last trading day (a) 1st trading day(s) 13 Daily settlement price Closing of futures contract(a)(a) Closing of future contract 14 Trading hours 9.30 am to 3.30 pm - 15 Margin Up front margin on daily basis As in previous column (a) Computed on the basis of the weighted average of last 15 minutes trading (a)(a) Computed on the basis of weighted average of the last minutes, or if the no of weighted average of last trade (s) Weighted average price for the last half an hour's trade 16.5.2 Structure of Derivatives Markets in India Derivatives markets in India can be broadly categorized into two markets namely; financial derivatives markets and commodities futures markets Financial derivatives markets deal with the financial futures instruments like stock futures, index futures, stock options, index options, interest rate futures, currency forwards and futures, financial swaps, etc whereas commodity futures markets deal with commodity instruments like agricultural products; food grains, cotton and oil; metals like gold, silver, copper and steel and other assets like live stocks, vegetables and so on Financial derivatives markets in India are regulated and controlled by the Securities and Exchange Board of India (SEBI) The SEBI is authorized under the SEBI Act to 201 Recent Trends in Derivative Markets in India 202 Indian Capital Market and Financial System frame rules and regulations for financial futures trading on the stock exchanges with the objective to protect the interest of the investors in the market Further carry forward trading (Badla trading) is also regulated by the SEE This is traded on the stock exchanges Some of the other financial derivatives like currency options and futures and interest rate futures are controlled by the Reserve Bank of India (RBI) These are dealt on Over-the-Counter (OTC) markets Financial futures on interest rate include both short-term interest rate and long-term interest rate forwards Currencies include options and forwards Since the RBI is the apex body to regulate currencies and interest rates in India, hence, financial derivatives relating to foreign currencies and interest rates are generally come under the RBI regulation Major stock exchanges in India, under the regulation of the SEBI, trade in two kinds of futures products, namely equity and carry forwards Equity futures include stock futures, index futures, stock options and index options Currently these are traded on National Stock Exchange and Bombay Stock Exchange Examples of such companies on which options and futures are available, e.g ACC, SBI, CIPLA, HPCL, TELCO, GRASIM, Dr Reddy Lab, HLL, HDFC, Hero Honda, etc Commodity futures markets are regulated in India by Forward Market Commission (FMC) The Commission is entrusted with to regulate commodities futures trading in India Products like potatoes, pepper, cotton, etc are traded on Coimbatore Commodity Exchange and Calcutta Commodity Exchange Recently the Central Government has allowed futures trading on 54 new commodities of different categories to be eligible for trading on exchanges Check Your Progress Fill in the blanks: Derivatives trading in India is introduced in _ _ Derivatives contracts met with immediate success in the Indian capital market In India presently option contracts are available on a total of _ stocks The regulatory frame work for derivatives in India is recommended by In Indian derivatives market the minimum trade lot size is _ 16.6 LET US SUM UP In this chapter we have discussed about the financial derivatives markets in India by briefly describing the need of derivatives markets in India The need of derivatives in India has arisen due to economic liberalization Since 1991 individuals and corporates were facing exchange risk, interest rate risk and other risks The management of these risks is very important in the globalised world, and derivatives play an important role in this respect This chapter also highlighted the various recommendations of the Dr L.C Gupta Committee on financial derivatives in India which emphasizes the urgent need of introduction of financial derivatives and which should be in phased manner The future of derivatives trading in India is bright and growing day by day More new products and instruments are coming up to be traded on stock and commodity exchanges Very soon we will have trading on interest rate futures on NSE and BSE 16.7 LESSON END ACTIVITY Write a note on evolution of derivative markets in India 16.8 KEYWORDS FMC: Forward Market Commission IPSTA-ICE: India Pepper and Spice Trade Association-International Commodity 16.9 QUESTIONS FOR DISCUSSION Write notes on: (a) Position of financial derivatives in India (b) Evaluation of derivatives in India (c) Historical background of financial derivatives in India Explain the term financial derivative What are its different types of derivatives as given under SEBI guidelines? Explain them Clearly bring out the need of derivatives market in India with suitable arguments in favour and disfavour Check Your Progress: Model Answers CYP 1 The trading market emerged in India in 1970s It manages different risks by individuals and the corporate sector units The national stock exchange commenced trading in exchange rate future on June 2003 CYP June, 2000 Futures on individual stocks 31 stocks L.C Gupta Committee lakhs 16.10 SUGGESTED READINGS Susan, Thomas, Derivatives Markets in India, Tata McGraw-Hill, New Delhi, 1998 Taxmanns SEBI Manual, Taxman Allied Services (P) Ltd., New Delhi, 2002 Corporate Miscellany - Derivatives Market in India: A Framework of Economic Purpose, Chartered Secretary, October, 1997 Reforms in Secondary Markets in India, Working paper from National Stock Exchange (NSE), India, 2000 203 Recent Trends in Derivative Markets in India MODEL QUESTION PAPER MBA Second Year Sub: Indian Capital Market and Financial System Time: hours Total Marks: 100 Direction: There are total eight questions, each carrying 20 marks You have to attempt any five questions Explain the challenges being faced by Indian Financial System and how these challenges are overcome and also explain the role of financial institutions in economic development of country Highlight the major features of new issue market in India and analyze the size and growth and sectoral pattern of the fresh capital in the new issue market Write a short note on: (a) Call Money Market (b) Underwriting (c) Lead Manager (d) Private Placement (e) Hedging with futures contract Elaborate on the SEBI regulations pertaining to Merchant Bankers in India and comment on the Indian Merchant Bankers performance discharging post & pre-issue obligations “The setting up of the SEBI in the early nineties was in response to the need of the growing securities market for a focused /integrated regulatory frame work and its administration by an autonomous body” In the light of this statement, outline the scheme of regulation of the securities market by the SEBI Distinguish between: (a) Futures and Forward contracts (b) Commercial Bank and Investment Bank (c) Primary Market and Secondary Market (d) Pre-issue and Post-issue management (e) IPO and Book building What is the relation between the following? (a) General obligations and responsibilities of Merchant Bankers (b) What are the transformation services provided by financial institutions? Explain their significance (c) How does SCR Act regulate stock exchanges in India? (d) What is Swap and how it plays an important role for the functioning of the derivative market? (e) What is the role of underwriters and brokers in a new issue management? Differentiate between call and put options What are the rights and obligations of the holders of long and short positions? 205 Model Question Paper ... Derivative Markets in India 196 Model Question Paper 205 INDIAN CAPITAL MARKET AND FINANCIAL SYSTEM SYLLABUS UNIT I Indian financial system: - Structure and constituents of Indian financial system Financial. .. Structure and Constituents of Indian Financial System UNIT I Indian Capital Market and Financial System LESSON STRUCTURE AND CONSTITUENTS OF INDIAN FINANCIAL SYSTEM CONTENTS 1.0 Aims and Objectives... Structure and Constituents of Indian Financial System 12 Indian Capital Market and Financial System (v) Transactions costs, (vi) Risk of default or the degree of capital and income uncertainty, and