Table of Contents
Derivatives Markets
Financial instruments that derive their value from underlying asset are commonly referred to as derivatives. When the need arose to mitigate risk due to vagaries of commodity prices, derivative instruments were developed. Initially, these pertained to linear pay-off structures such as forward and futures contracts. Subsequently, in the early 1980’s, more complicated derivative contracts such as options and swaps were structured.
Risk associated with over-the-counter market instruments is significantly high. This pertains to the risk of default by counterparties to transaction. Legal recourse to such default is usually expensive and time-consuming. There was also the risk of illiquidity, in case the hedger wants to exit from the contract. This was the reason for emergence of organized marketplaces such as commodity exchanges.
The exchange platform enables trading in standardized contracts [for example, the stand lot size of NIFTY futures is 50]. Due to the clarity in the contract terms and conditions for clearing and settlement as well as the standardization of quantity and quality, the liquidity also increased manifold.
Development of exchanges also led to the system of novation, by which, the clearing house became the central counterparty for all transactions. This ensured that there was no risk of default in settlement. The actual settlement of profits and losses was completed on daily basis, giving rise to the concept of mark-to-market settlement.
Derivatives are presently traded in not only commodity markets, but also equity markets, currency markets and debt market. In India, exchange-traded equity derivatives were launched in 1998. Index options, index futures, stock futures and stock options are traded in NSE. Presently, the average daily turnover of derivative segment in NSE is many times more than that of the cash segment.
Exchange-traded commodity futures were launched in India as recently as in 2003. Currency derivatives are traded [since 1998] in the over-the-counter markets under the strict supervision and regulatory control of RBI. Recently RBI and SEBI have launched trading in currency futures on currency derivatives exchanges.
Difference Between The Exchange Markets And Over-The-Counter Markets
Over-The-Counter [OTC] Markets:
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- All transactions that are directly negotiated between entities [also referred to as counterparties to the transaction] outside the exchange trading platform. Such transactions result in counterparty default risk and liquidity risk.
- The Over-The-Counter market is largely a direct market between two counterparties who know and trust each other. Contracts are directly negotiated, tailor-made for the needs of the parties, and are often not easily reversed. Since OTC transactions are directly entered into by counterparties, there is a high risk of default.
- In contrast, public price quotations for the over-the-counter market are only just being introduced, and the quotations are only for the more heavily traded instruments. Even these quotations are not instantaneous, only indicative [as opposed to futures market quotations, which represent prices at which deals actually took place]. To get a fair deal on the over-the-counter market, good information gathering and negotiation skills are required.
- Over-The-Counter market transactions are guaranteed only by the reputation of the counterparty; if the counterparty goes broke [and some very large trading houses and banks have gone broke in recent years], large losses may ensue.
Exchange Markets
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- The organized marketplace with rules and regulations for trading in financial products and instruments.
- Exchange markets are organized trading platforms, whereby; buyers and sellers can transact. The financial products and instruments are standardized in terms of quantity and quality. It is easy to buy and sell contracts [and to reverse positions] and no direct negotiation is required – it is a continuous auction system. These are highly regulated markets, with no possibility of default by market participants.
- The most common form of organized trading of futures and options, the open outcry system with its shouting and hand waving by traders on the exchange trading-floor, is highly transparent. The transactions are, at least in theory, highly competitive; the market reacts very fast and prices and transactions are monitored every second. Prices on the open-outcry market are almost instantly distributed worldwide.
- A clearinghouse guarantees transactions on organized exchanges; a default by an intermediary is unlikely to lead to losses for market users.
Examples Of Over-The-Counter Market Transactions
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- The purchase [or sale] of currency in the spot or forward markets through banks is an example of the over-the-counter market.
- A trader enters into an agreement with a farmer to buy his produce of potato, expected to be harvested after two months, at a fixed price.
Examples Of Exchange Markets Transactions
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- The purchase [or sale] of equity shares on NSE or BSE.
- Trading in commodity futures contract on MCX, NCDEX, NMCE.
- Trading in currency futures.
Forward And Futures Contracts
Forward contract is a contractual agreement between a buyer and a seller to purchase/sell respectively a mutually agreed quantity and quality of an underlying asset on a fixed future date at a pre-determined negotiated price.
Futures contracts are standardized forward contracts. The quality and quantity of the underlying asset is standardized. Futures contracts are transferable in nature. For all practical purposes, a forward contract becomes a futures contract if the quality and quantity are standardized and the contract is traded on a derivatives exchange. This provides for offsetting deals to square off the open position. Futures contracts are traded in equity markets [with the index and equity stock as the underlying assets], commodity markets, currency markets [presently trading is allowed for the USDINR currency exchange pair].
Futures contracts in equity markets were introduced in 1998. Since their introduction, the volume in equity futures markets has increased phenomenally. NSE is one of the largest global exchanges for trading in stock and index futures. Options have also been launched in Indian equity markets successfully.
Commodity futures contracts were permitted to be traded on Nationally recognized exchanges since 2003. Trading in commodity futures has been permitted for bullion, base metals, energy, agriculture, etc. The volumes of increased to more than Rs. 30,000 crores on a daily basis [single side turnover] by all exchanges combined.
Recently, in Aug 2008, RBI-SEBI permitted the launch of USDINR futures trading on nationally recognized exchanges. MCX and NSE have a combined average daily turnover of approximately USD 2.50 to 3 billion.
The latest development in Indian derivatives markets is the introduction of exchange traded interest rate futures [also referred to as ETIRF]. Market participants and even an individual who has exposure to a home loan or personal loan, are exposed to volatility in interest rates. To facilitate mitigation of risk due to interest rate volatility, the RBI – SEBI Standing Technical Committee Report [June 2009] issued guidelines for launch of Exchange Traded Interest Rate Futures [ETIRF] contracts. ETIRF refers to a contractual agreement to buy or sell underlying interest bearing instrument(s) on a future date, at a pre-determined price on the exchange.
Benefits Of Exchange Platform
The launch of futures contracts is significant for the Indian market due to the non availability of a simple and easy to understand risk management tool with high liquidity in the OTC markets. The electronic exchange trading platform is aimed at increasing geographic reach for market participants. The exchange clearing-house ensures zero counterparty default risk, due to the process of novation. The mark-to-market [MTM] profits and losses as well as margin deposits [for taking futures positions] are tracked on a real-time basis. Settlement of MTM is on a T+1 day [rolling settlement] basis, before the commencement of trading on the subsequent business day.
In the years to come, exchange trading platforms will gain immense importance in ensuring an efficient and effective platform for risk mitigation to market participants.
Other Classification Of Markets
We shall analyze characteristics of classification of markets from a perspective based on investment and business activities.
Loan Markets
Loan Market refers to the activities of banks and financial institutions to make available credit for corporate sector. The credit may be extended for trading, manufacturing, infrastructure, service, industrial manufacturing, and financial activity or otherwise. Loans may be for short term or long-term. Usually, credit rating agencies assess the credit worthiness of the corporate. The specific credit rating is used for making decisions by banks and financial institutions to lend to the borrower.
Insurance Markets
The regulator for the insurance market is Insurance Regulatory Development Authority [IRDA]. Until beginning of 1990’s, LIC was the sole life insurer in India. Subsequent to the liberalization of the Indian economy and institution of financial sector reforms, private sector was allowed to commence life insurance and general insurance activities. With a growing population, insurance is required by everybody. But Insurance companies are allowed to operate by adhering to strict compliance measures, due to the high level of risk involved.
Retirement Savings Market
Retirement Savings Market are long term funds pooled from investors by provident funds, pension funds and superannuation funds. They perform the important activity of providing resources and security for individuals in their old age. These funds are invested in long term securities.
Mutual Funds
Mutual Funds provide the means for the small investors to reduce transaction cost, while trading in the securities markets. Professional mutual funds have analysts who take calls on the market for collectively investing the corpus of the funds provided by the investors. Based on the market value of the exposure – Assets Under Management [AUM] – the net asset value [NAV] is communicated to the investors. The investors buy/sell mutual fund units based on the NAV. Mutual funds are regulated by the Association of Mutual Funds in India [AMFI], which is a self regulatory organization.
Savings And Investment Markets
The savings and investment markets consist of several retail financial savings products for the household sector. Whereas the corporate sector relies on banks and financial institutions for credit, the household sector is dependent on not only banks and financial institutions [that provide retail products], but also chit funds, nidhis and mutual benefit societies.
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Money Markets And Capital Markets
Debt Markets In India
Equity Markets In India
Foreign Exchange Market
Commodity Markets
