chapter 2

Derivatives Introduced: Indian Perspective

LEARNING OBJECTIVES

This chapter includes key acts, rules and regulations which provide an insight into the evolution of derivatives in India and their legal status. The contents of this chapter are organized in the following order:

1. Derivatives: Legal Definition

2. Major Types of Derivatives

3. Participants in the Derivatives Market

4. History and Legalization of Derivatives in India

5. Introduction of Currency Futures and Options on Exchanges in India

DERIVATIVES: LEGAL DEFINITION

Clause (a) of Section 45 U of the Reserve Bank of India Act, 1934 defines ‘derivative’ as follows:

‘Derivative means an instrument, to be settled at a future date, whose value is derived from change in underlying interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called ‘underlying’), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the bank from time to time’.

Prima facie such a definition sounds complex but as the subsequent chapters unfold, each of the concepts in the legal definition of derivatives would become clear.

MAJOR TYPES OF DERIVATIVES

• Forwards/futures
• Options
• Swaps
• Others

With an objective to provide readers flavour of derivatives, an example of a forward transaction is given below.

An exporter ‘A’ in India who manufactures pens secures an order for manufacturing and exporting one pen to B in the United States on 1 January 2010. A’s cost of production is INR 42 per pen and his target profit is INR 3. Considering that A needs to invoice in USD such that he receives INR 45, he raises an invoice for USD 1 (prevailing conversion rate USD 1 = INR 45). It took six months for ‘A’ to manufacture and export pens. On 1 July 2010, A receives USD 1 as invoiced. However, since USD/INR does not remain constant, there can be potentially three different scenarios on 1 July 2010, which are provided in Table 2.1.

Table 2.1 Different Scenarios of Market Rate

The ideal situation for ‘A’ would have been to convert USD proceeds into INR at 45 which he had used while invoicing the pen at USD 1. However, as can be seen from Table 2.1, due to exchange rate volatility, ‘A’ can either have windfall gain at 50 or loss at 40. Instead of this, if ‘A’ had entered into foreign exchange forward agreement with the bank on 1 January, whereby he would under all scenarios receive INR 45 for selling USD 1 to the bank (assuming forward rate for six months delivery is 45), then his scenario analysis would be as follows (Table 2.2).

Table 2.2 Scenario Analysis

So, entering into a forward contract has made A happy in the first scenario with neutral position in the second scenario and sad in the third scenario (opportunity loss of INR 5 or more). This is known as entering into a hedging contract (insurance against future market volatility), and such a form of hedging is known as a forward contract.

PARTICIPANTS IN THE DERIVATIVES MARKET

The three broad categories of participants who trade in the derivatives market are as follows:

1. Hedgers: They face the risk associated with the price of an underlying asset. Hence, they use forward/futures or options markets to minimize or eliminate the risk.
2. Speculators: They wish to bet on future movements in the price of an asset. Hence, they use forward, futures and options contracts to bet in the market which can either be profitable or a loss-making proposition.
3. Arbitrageurs: They are in business to take advantage of a discrepancy between prices in two different markets. For example, if they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. This is especially true for equity and commodity markets in India.

HISTORY AND LEGALIZATION OF DERIVATIVES IN INDIA

In India, derivatives were first traded in commodities during the early 1960s. However, due to the war between India and China in 1962, prices of such commodities shot up excessively because of which the government levied a ban on such contracts for a few years.

During 2000–01, people started taking both speculative and trading position in stocks and shares which led to one of the parties winning and the other losing. This consequently led to disputes between counterparties.

Thus, in order to legalize them and provide a legal definition to derivative contracts, certain sections were amended/added in various acts which supersedes Section 30 of the Indian Contract Act, 1872. The details of the said sections and acts are provided in the following pages.

Additions and Amendments to Securities Contract (Regulation) Act, 1956 to Legalize the Derivative as Exchange Traded Contract

On account of above-mentioned changes in SC(R)A, 1956, derivatives trading became legal on exchange traded counters like exchanges.

However, the over-the-counter (OTC) market was yet to be made legal. Recognizing that OTC derivatives play a crucial role in reallocating and mitigating the risks for corporates, banks and financial institutions, and to remove ambiguity regarding the legal validity of OTC derivatives, suitable amendments, effective from 9 January 2007, were carried out by the Reserve Bank of India Act, 1934 (RBI Act), also termed as RBI Amendment Act 2006. The details of the said changes are provided in the following table.

Amendments and Additions to Reserve Bank of India Act, 1934 to Legalize OTC Derivatives

INTRODUCTION OF CURRENCY FUTURES AND OPTIONS ON EXCHANGES IN INDIA

In August 2008, necessary regulatory circulars were issued by RBI and SEBI for introduction of currency futures in recognized exchanges permitting market participants to trade in USD/INR currency pair.

Later on 19 January 2010, necessary circulars (mentioned below) were issued for permitting market participants to hedge a few other currency pairs, viz., EURO-INR, JPY-INR, GBP-INR in addition to USD-INR

Later in July 2010, option trading was also permitted in exchanges and the below-mentioned circulars were issued to give effect to the same.

TEST YOUR UNDERSTANDING

1. What is the definition of derivatives under RBI Act, 1934?
2. What led to legalization of derivatives in India?
3. Describe major changes made to the RBI Act, 1934, while introducing OTC derivatives in India.
4. Describe major changes made to the Securities Contract (Regulation) Act, 1956, for introducing derivatives in India.
5. Who are the main participants of derivative markets in India?