An Analysis of the Impact of Single Stock Futures on Underlying Stocks in India

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An Analysis of the Impact of Single Stock Futures on Underlying Stocks in India

A THESIS SUBMITTED IN PARTIAL FULFILLMENT FOR THE DEGREE OF

DOCTOR OF PHILOSOPHY

IN THE Commerce, Goa Business School GOA UNIVERSITY

By

Ms. Sanjeeta G.Parab

Asst. Professor and Research Scholar, Goa Business School, Goa University

April 2022

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DECLARATION

I, Ms. Sanjeeta Parab, hereby declare that the Thesis titled “An Analysis of the Impact of Single Stock Futures on Underlying Stocks in India” is the outcome of my own research undertaken, under the supervision and supervision of Dr. Guntur Anjana Raju, Professor, Goa Business School, Goa University. All the sources used in the course of this work have been duly acknowledged in the thesis. This work has not previously formed the basis for the award of any Degree, Diploma, or Certificate of this or any other University.

Place: Taleigao Plateau.

Date : Sanjeeta Parab

Research Scholar Goa Business School Goa University

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CERTIFICATE

I hereby certify that the thesis titled “An Analysis of the Impact of Single Stock Futures on Underlying Stocks” in India submitted by Ms. Sanjeeta Parab for the award of the Degree of Doctor of Philosophy is the record of her own work done under my guidance and further that it has not formed the basis for the award of any Degree, Diploma, or Certificate of this or any other University.

Prof. (Dr.) Guntur Anjana Raju Research Guide, Professor, Goa Business School, Goa University,

Taleigao-Goa, 403 406

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Acknowledgment

I thank God with all my heart for sustaining me, for loving me unconditionally, for keeping my family in good health, and for providing His grace to complete this study.

First and foremost, I express my sincere gratefulness towards my chief motivator, mentor, and Guide Prof. Guntur Anjana Raju, for giving me an opportunity to pursue Ph.D. under her. I thank her for being my guiding light, a source of inspiration and a constant motivator. I fall short of words to express my gratitude; I know I couldn’t have had a better advisor and mentor for my doctoral work. This doctoral thesis would not have been possible without her exceptional guidance and inspiration.

I would like to express my gratitude toward VC’s nominee Prof. Y.V. Reddy and Dr.

Suraj Popker for their critical comments and guidance during the course of this research.

I would like to extend my sincere gratitude to the Dean, Prof. M.S. Dayanand, Vice- Dean (Research), Prof. P.K. Sudarshan, Vice-Dean (Academic), Prof. K.B. Subhash of Goa Business School, Goa University for their intellectual research contribution.

I also express my gratefulness to Dr. Gopakumar, Former Librarian of Goa University, In-charge Librarian Mr. Carlos Fernandes and the Library Staff, Goa University for the required support and assistance. I am highly indebted to the late Dr. Anil Kumar, Librarian IIM Ahemadabad, Gujarat and library staff providing me access to their rich resource of highly recognized databases.

My friend and colleague Shripad Marathe has a special contribution in my research and his help cannot be acknowledged in words. I am indebted to him for always being there selflessly. My heartfelt thanks to my friends Ms Karen Fernandes, Ms Yanita Palkar, Ms Prachi Kolamker, Ms Deepali Naik, and Mr Jitendraa Rabada for their unconditional support.

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I am also thankful to Ms. Kalpana Pillai for her motivation, encouragement and moral support which will always be remembered down the memory line. I also thank all the nonteaching staff members of Department of Commerce, Goa University and staff of ARPG section of Goa University for their kind help and assistance.

I would fail in my duty if I do not thank my family. I am deeply grateful to my husband, Mr. Gauresh Parab for his unwavering support and constant motivation. It is his dream and vision for me which has got materialized in the form of this thesis. I warmly thank and appreciate the incredible support by my parents Mr. Vasant Shirodkar and Ms. Geeta Shirodkar, my sister Babita Shirodkar and brother Tulsidas Shirodkar.

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CHAPTER I

An Overview of the Indian Derivatives Market

1.1 Introduction to Derivative Market in India

As we all know that financial market, by its inherent nature is marked by high degree of volatility and risk. Due to the wave of liberalization and globalization across the world, there has been a tremendous increase in the volume of international trade and business over last two decades. This has made the corporate world more susceptible to the exposure unmanageable financial risk and has led to speedy and volatile variations in prices of financial asset, interest rates and exchange rates. Due to this highly uncertain business scenario, risk management has become the need of an hour. The primary objective of any investor is to minimize the risk and maximize the profit. Derivatives are the contracts, which have been originated from the need to minimize the risk. Derivatives serve as an efficient tool of risk management, which are capable of transferring the price risk by locking-in the asset prices. A Derivative is financial instrument whose value is ‘derived’ from one or more underlying assets. The underlying can be commodity, precious metals, currency, bonds, Stocks, indices etc.

Traders can presume highly leveraged positions at low transaction costs using different Derivative products.

Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as: a) “a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security; b)

“a contract which derives its value from the prices, or index of prices, of underlying securities”.

The Derivatives market performs number of economic functions:

 Derivatives play a key role in discovering the present and Futures prices of the underlying asset. In simple words, through Futures Market information about Futures cash market prices is being revealed. Prices of organized Derivative market reflect the perception of market participants about Futures. At expiry

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An Overview of the Indian Derivatives Market prices of Derivative as well as the underlying asset are at par. Hence it helps in the discovery of present as well Futures prices.

 Although it is impossible to eliminate the risk, Derivatives help in reducing the severity of risk or in other words, help in management of risk. Through Derivative market it is possible to transfer the risk from a person who is bearing a risk but do not intend to have it, to a person having a high appetite for risk. It offers various strategies like hedging, arbitraging, spreading etc.

which are extremely beneficial for efficiently managing the risk.

 Derivatives play a key role in improving the market efficiency, by offering an effective mechanism for hedging the risk. The underlying markets have witnessed higher trading volumes with the introduction of Derivative, since it has encouraged more traders to participate in the underlying assets, by making a provision for transferring the risk

 Derivatives perform a Price stabilization function for the underlying Spot Market. It helps in keeping the prices of Spot Market stable by reducing the short-term fluctuations. In other words, Derivatives reduce both peak and depths and leads to price stabilization effect in the cash market for underlying asset.

1.2 Different Types of Derivatives Contracts

The Derivatives market has been broadly classified into financial Derivatives and Commodity Derivatives. But since our study is only limited to financial Derivatives, liberty has been taken to overlook the Commodity Derivatives. Although as the time is passing, Derivatives market has started offering several fancy and innovative products like LEAPS, Swaptions, Warrents etc. this study has confined the discussion to Forward, Futures and Option contract.

 Forward contract:

Forward contract is a customized contract between buyer and seller where settlement takes place at specific Futures date at predefined price. In forward contract buyer assumes a long position and agrees to buy the underlying asset,

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An Overview of the Indian Derivatives Market specific Futures date at predefined price. Forward contracts are traded over-the- counter, and unlike Futures contract, these are not traded in an exchange. For instance, if there is a farmer who has 500 kg’s of rice to be sold six months from now, and he is worried about a potential decline in the price of rice. On the contrary there is one trader who is of an opinion that the price of rice is going to shoot up in Futures. Therefore, the producer enters in a contract with the trader to sell 500 kg’s of rice at a price of Rs.30 per kg after six months, with settlement on cash basis. By entering in a contract, he can lock in a price by selling a forward contract that obligates him to sell 500 Kg of rice at Rs. 30 per Kg.

In six months, the Spot price of corn has three possibilities:

a. If the Spot price of rice after six months is exactly Rs.30 per kg, then no monies are owned by the producer or trader to each other and the contract is closed.

b. If the Spot price of rice is more than the contract price, so in this case the trader will be able to fetch the rice at lower price than the market rate.

Hence producer will lose an opportunity to make more profit.

c. If the Spot price is less than the contract price than producer will be in a position to eliminate the risk of falling price.

 Futures contract :

Futures is a standardized forward contact to buy (long) or sell (short) the underlying asset at a specified price at a specified Futures date through a specified exchange. These are exchange-traded contracts in which Futures contracts are traded on exchanges that work as a buyer or seller for the counterparty. Exchange sets the standardized terms in term of quality, quantity, price quotation, and date.

To give an example of a Futures contract, if an investor holds 1000 shares of ABC Ltd. Current (Spot) price of ABC Ltd shares is Rs 115 at National Stock Exchange (NSE). The investor is afraid about the decline in share price. Therefore, the investor decides to enter into Futures Market to protect his position at Rs 115 per share for delivery at expiry date. Each contract in Futures Market is of 100 Shares. This is an example of equity Futures in which investor takes short position on ABC Ltd. Shares by selling 1000 shares at Rs 115 and locks into Futures price.

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An Overview of the Indian Derivatives Market Options are Derivative contract that give the right, either buy or sell a specific underlying security for a specified price on or before a specific date, but there is no obligation for an investor to honor the contract. Options are of two types - calls and puts. Call option give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

Put option give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

1.3 Brief History of Derivatives Market in India

Promulgation of the Securities Laws (Amendment) Ordinance, 1995, which removed the prohibition on options in securities, marks the first step toward the introduction of Derivative trading in India. But there was lack of proper regulatory framework for governing the Derivatives market. In November 1996 SEBI constituted L. C. Gupta committee to provide a regulatory framework for the Indian Derivatives market. The committee strongly recommended the introduction of financial Derivatives for facilitating the hedging of risk in a most cost-effective manner. It had emphasized the need of introducing equity Derivatives, interest Derivatives and currency Derivatives. It also recommended that Derivatives trading should take place on the separate segments of existing Stock exchanges. SEBI accepted the recommendations made by the L. C. Gupta committee in 1998.

In 1998, SEBI had set up a group under the Chairmanship of Prof. J. R. Varma to recommend risk containment measures in Derivatives market in India. The report, which was submitted in October 1998, helped in carving the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. SEBI granted the final approval in May 2000 on the recommendation of L. C Gupta committee and derivatives trading commenced in India in June 2000.

In May 2000, SEBI gave approval for Derivative trading in India and in June 2000 trading in Derivatives formally started at the NSE and BSE. CNX Nifty and BSE Sensex launched Index Futures in the year 2000. June 2001 witnessed trading in Derivatives on individual securities. Futures contracts on individual Stocks came in November 2001. Table 3 highlights all the crucial events in the history of Indian

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Derivative market.

Table 1.1

Chronology of Events in Financial Derivatives in India Sr.

No.

Progress Date

Progress of Financial Derivatives

1 1952 Enactment of the forward contracts (Regulation) Act.

2 1953 Setting up of the forward market commission.

3 1956 Enactment of Securities Contract Regulation Act 1956

4 1969 Prohibition of all forms of forward trading under section 16 of SCRA.

5 1980 Informal carry forward trades between two settlement cycles began on BSE.

6 1983 Khuso Committee recommends reintroduction of Futures in most commodities.

7 1992 Govt. amends bye-laws of exchange of Bombay, Calcutta and Ahmadabad and introduced carry forward trading in specified shares.

8 1993 Enactment of the SEBI Act.

9 1994 SEBI Prohibits carry forward transactions

10 1994 Kabra Committee recommends Futures trading in 9 commodities 11 1995 G.S. Patel Committee recommends revised carry forward system.

12 1995 NSE asked SEBI for permission to trade index Futures 13 1996 Revised system restarted on BSE.

14 1996 SEBI setup LC Gupta committee to draft frame work for index Futures 15 1998 LC Gupta committee submitted report

16 1999 Interest rate swaps/forward rate agreements allowed at BSE

17 1999 RBI gave permission to OTC for interest rate swaps/forward rate agreements

18 2000 SIMEX chose Nifty for trading Futures and options on an Indian index 19 2000 SEBI gave permission to NSE & BSE to do index Futures trading 20 2000 Equity Derivatives introduced at BSE

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Sr.

No.

21 2000 Commencement of Derivatives trading (index Futures) at NSE 22 2000 Commencement of trading Futures & options on Nifty at SIMEX 23 2001 Index option launched at BSE

24 2001 Trading on equity index options at NSE 25 2001 Trading at Stock options at NSE 26 2001 Stock options launched at BSE

27 2001 Commencement of trading in options on individual securities 28 2001 Stock Futures launched at BSE

29 2001 Commencement of trading in Futures on individual security 30 2001 Trading of Single Stock Futures at BSE

31 2003 Trading of Interest rate Futures at NSE 32 2003 Launch of Futures & options in CNX IT index 33 2004 Weekly options of BSE

34 2005 Launch of Futures & options in Bank Nifty index 35 2006 'Derivative Exchange of the Year by Asia risk magazine 36 2007 NSE launches Derivatives on Nifty Junior & CNX 100 37 2007 NSE launches Derivatives on Nifty Midcap -50 38 2008 Trading of Chhota (Mini) Sensex at BSE

39 2008 Trading of mini index Futures & options at NSE 40 2008 Long term options contracts on S&P CNX Nifty index

41 2008 Futures & options on sectoral indices ( BSE TECK, BSE FMCG, BSE Metal, BSE Bankex & BSE oil & gas)

42 2008 Trading of currency Futures at NSE 43 2008 Launch of interest rate Futures

44 2008 Currency Derivative introduced at BSE 45 2008 S&P CNX Defty Futures & options at NSE

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Sr.

No.

46 2009 Launch of interest rate Futures at NSE

47 2009 BSE-USE form alliance to develop currency & interest rate Derivative markets

48 2009 BSE's new Derivatives rate to lower transaction cost for all 49 2009 Launch of currency Futures on additional currency pairs at NSE

50 2010 Financial Derivatives exchange award of the year by Asian Banker to NSE 51 2010 Commencement trading of S&P CNX Nifty Futures on CME at NSE 52 2010 Introduction of European style Stock option at NSE

53 2010 Introduction of Currency options on USD INR by NSE 54 2010 Commencement of 91 day GOI trading Bill Futures by NSE 55 2011 Launch of Derivative on Global Indices at NSE

56 2011 Launch of Derivative on CNX PSE & CNX infrastructure Indices at NSE 57 2012 BSE launched trading in BRICSMART indices Derivatives

58 2013 BSE launched currency Derivative segment 59 2014 Launch of Interest Rate Futures (BSE – IRF)

60 2014 Launched Trading on India VIX Index Futures at NSE 61 2014 Launched NBF II segment for interest rate futures at NSE 62 2016 Launched NIFTY 50 index futures trading on TAIFEX 63 2018 Launched currency derivatives on Non-FCYINR pairs 64 2018 Weekly option on NIFTY 50 was launched

65 2020 NSE declared world’s largest derivatives exchange 2019 by WFE 66 2020 Launch of Interest Rate Options on Government of India bonds Source: NSE and BSE compilation

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1.4 Growth of Derivative Market in India Table 1.2

Business Growth of Capital Market Segment of National Stock Exchange Month/Year No. of

trades (lakh)

Traded Quantity

(lakh)

Turnover Demat Turnover

Market Capitalisation 2000-2001 1,676 3,29,536 13,39,510 12,64,337 6,57,847 2001-2002 1,753 2,78,408 5,13,167 5,12,866 6,36,861 2002-2003 2,398 3,64,065 6,17,989 6,17,984 5,37,133 2003-2004 3,780 7,13,301 10,99,535 10,99,535 11,20,976 2004-2005 4,510 7,97,684 11,40,071 11,40,071 15,85,585 2005-2006 6,088 8,44,486 15,69,556 15,69,556 28,13,201 2006-2007 7,846 8,55,456 19,45,285 19,45,285 33,67,350 2007-2008 11,727 14,98,469 35,51,038 35,51,038 48,58,122 2008-2009 13,651 14,26,354 27,52,023 27,52,023 28,96,194 2009-2010 16,816 22,15,530 41,38,024 41,38,024 60,09,173 2010-2011 15,507 18,24,515 35,77,412 35,77,412 67,02,616 2011-2012 14,377 16,16,978 28,10,893 28,10,893 60,96,518 2012-2013 13605 16,59,160 27,08,279 27,08,279 62,39,035 2013-2014 14,432 15,33,716 28,08,488 28,08,488 72,77,720 2014-2015 18,328 23,61,779 43,29,655 43,29,655 99,30,122 2015-2016 18518 22,01,771 42,36,983 42,36,983 93,10,471 2016-2017 19,760 26,24,534 50,55,913 50,55,913 1,19,78,421 2017-2018 24,914 37,71,836 72,34,826 72,34,826 1,40,44,152 2018-2019 28,532 37,49,976 79,49,004 79,49,004 1,49,34,227 Source: https://www.nseindia.com

The Indian Equity Derivatives market has witnessed sharp growth over the past years, a trend that experts anticipate to continue. Since its establishment in the year 2000, the market has shown growth both in terms of the number of contracts and the monetary value of transactions. Currently, about 99% of the derivatives sold in the

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An Overview of the Indian Derivatives Market Indian market are through the NSE market. Although the growth introduced a variety of challenges, such as the need for strict regulation, the stakeholders received the derivatives positively. As a result, the trade of derivatives grew to surpass the contracts turnover in the NSE market. In the year 2008, for instance, the NSE Derivatives markets were valued at about Rs. 130, 90,477.75 Cr. In comparison, the NSE cash markets were valued at about Rs. 3,551,038 Cr. The derivatives turnover in the financial year 2003-04 was Rs. 21,30,408 crore which later grew to Rs.

1,68,07,782 crore in 2012-13.

Figure 1.1

Turnover of the Different Instruments Traded at the F&O Segment of NSE from 2004-2005 to 2017-2018

Source: Compiled from NSE’s Website

India is one of the fastest-growing capital markets in the world. This factor reiterates the competitiveness of modern development, especially because they are anchored in the anonymity of transactions, electronic safety, and widespread accessibility. Due to these changes, experts observe that the Indian Derivatives market largely shapes the discovery of price. Factors such as increased volatility of the asset prices and the globalization of financial markets fasten the growth of the global derivatives market. Other contributing factors include a wide selection of risk

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An Overview of the Indian Derivatives Market management strategies, innovation in financial engineering, and sophisticated risk management tools.

India’s rendezvous with derivatives started in 2000 when both the BSE and NSE started trading through equity derivatives. The immediate effect was the growth of the Total Turnover of the Derivatives Market, which rose from 2,365 Crores in 2001 to 101,926 Crores in 2002. In comparison, the capital markets declined by 41.25% between the financial years 2001 and 2002. Also, a critical analysis of the trends in the Indian Derivative market indicates that both NSE and BSE show a constant positive trend between 2000-2001 to 2012-2013 except for the year 2008- 2009. In 2008-2009, the turnover dropped from 13,090,477.75 Crores to 11,010,428.20 Crores. In the same year, the turnover in the Capital Market spiked to 8,915,083,510 Crores from 51,298,934 Crores.

Figure 1.2

Turnover of the Equity Segment and F&O Segment of NSE from 2010-2011 to 2019-2020

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An Overview of the Indian Derivatives Market In the year 2009-2008, the Derivatives Market Turnover rose from 11,010,482 Crores to 17,663,663.57 Crores. In the same year, the Capital Market’s turnover fell from 8,915,083,510 to 55,168,324 Crores in 2008-2009 and 2009-2010, respectively.

The index options continued to dominate the futures and options segment of NSE in the year 2016–17. In particular, the notional turnover was 75.5% of the F&O’s Turnover in the NSE. The percentage share of index futures and stocks showed a marginal decline in 2016-2017. In the first six months of 2017–18, index options were about 80.6% of the aggregate turnover in the F&O. On the other hand, the turnover of stock future and index futures reduced to 10.16% and 2.91% of the turnover, respectively.

Table 1.3

Market Growth of Capital Market segment and Derivatives Market Segment of NSE and BSE

Month/

Year

NSE BSE TOTAL

Turnover (Rsbn

Turnover (US$bn

Turnover (Rsbn)

Turnover (US$bn

Turnover (Rsbn

Turnover (US$bn

2010-11 2,92,482 6,551 1.5 0 2,92,484 6,551

2011-12 3,13,497 6,269 8,084.80 158.9 3,21,582 6,428 2012-13 3,15,330 5,800 71,635.20 1,317.70 3,86,965 7,118 2013-14 3,82,114 6,375 92,194.30 1,538.20 4,74,308 7,913 2014-15 5,56,065 9,095 2,03,627.40 3,330.50 7,59,692 12,425 2015-16 6,48,258 9,773 44,750.10 674.6 6,93,008 10,447

2016-17 9,43,703 14,494 69.4 1.1 9,43,772 14,495

2017-18 16,49,849 25,599 32.6 0.5 16,49,881 25,599 Source: Compiled from ISMR (NSE)

The total turnover in equity derivatives at both BSE and NSE rose from Rs 944 tn in 2016-17 to Rs1,650 tn in 2017-18, thereby showing an increase of 75%.

This increase was largely due to NSE, which accounted for the 75% increment. On

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An Overview of the Indian Derivatives Market 1,913 mn contracts and a turnover of Rs1,649 tn. In comparison, BSE recorded 44,701 contracts valued at Rs 32.6bn.

Consequently, nearly 100% of the contracts occurred at NSE in the financial year 2017-18. Besides, investors prefer derivatives over cash markets (see Table 3).

From 2010-11, the aggregate turnover in the derivatives market remained around three times that of the cash market in the equity with the exemption of year 2012-13.

Table 1.4

Derivatives to Cash Ratio in Equity Segment

Year Futures Turnover and Options Premium (Rsbn)

Cash Turnover (Rsbn)

Derivatives to Cash Ratio

2010-11 1,00,656 35,774 2.8

2011-12 79,254 28,109 2.8

2012-13 69,697 27,083 2.6

2013-14 83,251 28,085 3

2014-15 1,27,283 43,297 2.9

2015-16 1,27,981 42,370 3

2016-17 1,59,111 50,559 3.1

2017-18 2,10,168 72,348 2.9

2018-19 2,25,700 79,490 2.8

Source: ISMR Report 2019

The Indian NSE surpassed America’s CME Group Inc. hence becoming the largest derivatives market in volume. Last year, the Mumbai-based derivatives market traded the largest volume of contracts. In particular, the volume in the Indian NSE rose by 58%, thereby reaching 6 billion derivative contracts by the end of 2019. This increment enabled it to surpass the CME, which had a volume of 4.83 billion. The NSE adds that the voluminous growth was due to the increasing number of investors.

Over the same period, the volume of the cash market remained consistent three times.

Another observation is that India’s stock market was valued at $2.2 trillion, only a small fraction of the US’s market valued at $35.5.

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An Overview of the Indian Derivatives Market 1.5 A Comparison of Indian Derivatives Market with the Global Derivatives Market

The Single stock futures increased by 16.2% in 2019, where contracts worth 1.7 billion traded. This category was the least actively traded equity derivatives product and accounted for 10.5% of total traded derivatives.

Table 1.5

Top 10 exchanges by number of single stock futures contracts traded in 2019

Stock Exchanges

Volume Notional Value Open Interest

2019 YoY

Change

2019 YoY

Change

2019 YoY

Change Korea

Exchange

616,946,569 23% 296,031 -12% 5,165,115 68%

National Stock Exchange

255,120,205 1% 2,055,257 -15% 1,846,372 5%

Eurex 232,226,570 32% 746,928 20% 8,469,519 42%

Moscow Exchange

205,898,967 -13% 70,154 10% 1,586,442 7%

Borsa Istanbul 196,631,519 260% 28,271 196% 2,830,090 281%

Thailand Futures Exchange

52,098,173 -6% 0 NA 2,917,490 37%

ICE Futures Europe

39,181,471 -62% 3,134,410 -12% 189,567 -35%

Taiwan Futures Exchange

19,788,425 -13% 173,221 0% 163,555 42%

B3 - Brasil Bolsa Balcão

11,077,800 NA 95 NA 2,187,900 NA

Athens Stock Exchange

9,656,078 -27% 2,281 23% 340,861 41%

Others 33,680,578 24% 86,831 69% 3,572,379 20%

Total 1,672,306,355 15.9% 6,593,480 -9% 29,269,290 56%

Source: IOMA Report 2019

The EMEA and Asia-Pacific regions accounted for the largest global volume.

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An Overview of the Indian Derivatives Market volumes increase by 13.3% and 17.5% for EMEA and Asia-Pacific, respectively. The increase attributed to America was as a result of B3 – Brasil Bolsa Balsao. The product was introduced in the market in the year 2019. Worthy to note, the three largest exchanges, namely Korea Exchange, the National Stock Exchange of India, and Eurex Exchange, accounted for 66% of total trade.

Table 1.6

Exchanges by number of stock index options contracts traded in 2019

2019 YoY

change

2019 YoY

change

2019 YoY

change National Stock

Exchange of India

4,165,447,121 88% 33,477,121 22% 1,936,926 -3%

Korea Exchange 668,775,772 -1% 38,914,957 -12% 2,726,479 -7%

Eurex 431,575,858 3% 15,965,111 -2% 43,598,835 5%

Cboe Global Markets

347,834,727 -11% 95,120,000 -9% 18,308,070 11%

170,194,590 -13% 3,066,370 -9% 605,441 6%

CME Group 162,279,982 -22% 28,353,445 -19% 3,468,387 -11%

B3 - Brasil Bolsa Balcão

41,785,034 69% 445,361 -12% 533,799 27%

Hong Kong Exchanges and Clearing

38,297,384 -4% 3,867,243 -8% 2,334,663 -11%

Japan Exchange Group

30,699,470 -15% 0 NA 1,646,864 -17%

Tel-Aviv Stock Exchange

23,749,755 -28% 1,092,303 -20% 170,329 -15%

Others 77,738,148 -21% 1,850,663 -13% 4,341,023 -16%

Total 6,158,377,841 42% 222,152,574 -7% 79,670,816 2%

The volume of the Stock index options increased by 41.8% compared to 2018, thereby reaching about 6.17 billion contracts. This increase caused it to surpass the 6 billion level in a decade. In 2019, the stock index options emerged as the most actively traded equity derivatives. They had a 38.2% of the equity derivatives and an 18.5% of the entire products.

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An Overview of the Indian Derivatives Market Also, the Stock index options market had a high concentration at a regional and global level. Three of the largest exchanges had 86% of the aggregate trade. In particular, the Asia-Pacific region, the National Stock Exchange of India, and the Korea Exchange together had 79% of the regional volume. In comparison, Eurex had 7% of the same volume. In 2019, Korea Exchange’s DRV KOSPI 200, the National Stock Exchange of India’s Bank Nifty Index, options were among the most actively traded contracts.

Table 1.7

Top 10 exchanges by number of stock index futures contracts traded in 2019

2019 YoY

change

2019 YoY

change

2019 YoY

change B3 - Brasil Bolsa

Balcão

1,454,364,476 98% 7,958,289 117% 925,126 63%

CME Group 709,464,213 2% 88,643,988 -4% 4,312,102 3%

Eurex 504,431,237 2% 24,894,993 -2% 10,228,038 8%

Japan Exchange Group

299,896,154 -12% 13,238,290 -12% 1,716,495 -31%

Hong Kong Exchanges and Clearing

112,193,367 -11% 12,319,179 -14% 604,384 -15%

Moscow Exchange

102,759,520 -26% 266,472 -3% 490,498 103%

Korea Exchange 97,821,400 -1% 4,062,632 -14% 789,831 26%

National Stock Exchange of India

83,490,232 21% 842,530 1% 244,548 -38%

68,026,954 -22% 3,096,680 -22% 148,862 -3%

Borsa Istanbul 62,350,402 12% 131,664 -1% 472,425 15%

Others 324,061,329 -9% 14,039,533 -16% 5,511,981 2%

Total 3,818,859,284 19.4% 169,494,250 -4% 25,444,290 3%

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An Overview of the Indian Derivatives Market and 2019. This category represented the fourth highly sold derivatives. In terms of the equity derivative, it is the third-largest product. Also, it accounted for about 24.8% of equity derivatives and 12% of the total derivatives volumes. In the Asia-Pacific, the volumes reduced by 1.4%, while in the EMEA, there was a reduction by 10.7%. The American region rose by 49.8% due to CME Group and B3 – Brasil Bolsa Balcao.

Two of the three most traded volumes were from the American, while one was from the EMEA region. These three totaled 70% of the contracts.

Figure 1.3

Share of total volumes: breakdown by region

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

America APAC EMEA

20.3%

37.3%

42.4%

20.9%

36.6%

42.5%

21.3%

34.1%

44.6%

22.8%

31.6%

45.5%

22.6%

32.5%

44.9%

22.2%

39.0%

38.8%

23.4%

36.0%

40.6%

22.4%

35.0%

42.7%

19.5%

36.8%

43.7%

17.0%

42.5%

40.5%

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Trading activity by asset class

Equity derivatives: The volume in this category increased by 18.4%. The reason for the increase was the rise in stock index options, the sale of single stock futures, and stock index futures. The equity derivatives, therefore, accounted for 48.5% of the total contracts in the year 2019. Over the 10-year period reviewed, 2019 recorded the highest volume estimated at 16.1 billion.

1. ETF derivatives: A total of 1.7 billion ETF derivatives contracts occurred in 2019. The total volumes declined by 8.8% each year due to an 8.9% decrease in the trades recorded in America, where about 99.7% of the total contracts occur.

2. Interest rate derivatives: In 2019, the interest rate derivatives were reduced by 1.3%. This decrease led to contracts valued at 4.52 billion. The decrease was caused by the reducing contracts of STIR futures (1.9%) and STIR options (6.5%). In comparison, the LTIR options rose by 2.6%, while the LTIR futures rose by 0.04%. In America, where about 70.8% of the contracts occur, there was an increase of about 3.6%. At the same time, APAC showed an increase of about 2.6%, while its share in the global interest rate derivatives was 5.1%). On the other hand, EMEA decreased by 13.9%. Normally, it accounts for a 24.1% share of the total volume.

3. Currency derivatives: Between 2018 and 2019, the volume of Currency derivatives traded rose by 1.8% (3.7 billion). In the Asia-Pacific and American regions, 63.2% and 19.5% of contracts were traded in 2018. In 2019, the volumes rose by 7.2% and 15.5%, respectively. The only reduction was in the EMEA region, where the volumes fell by 22.8%. Usually, 17.2% share of the currency derivatives is accounted for by EMEA accounts.

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Figure 1.4

Volumes of Exchange-Traded Derivatives Contracts

The volumes the American region added up to about 40.5% of total global derivatives traded. The increase depended on the increase of the equity, currency derivatives and interest rates by 9.3%, 15.5% and 3.6% respectively. In the ETF, the remaining derivatives decreased by decreases 8.9%, 12.1% and 16.3% respectively.

At the same time, the Volumes traded in the Asia-Pacific region were about 42.5% of the total contracts. This value shows an increase caused by the rise in the trades across all types of products. Some of the categories include ETF (21.4%), equity (37.6%), currency (7.2%), %), interest rate (2.6%), as well as the commodity derivatives (32.7%).

In comparison, the volumes of the EMEA region which were 17% of total reduced by 4.9%. This decline was due to the reduction in the currency (22.8%), interest rate (13.9%), ETF (80%), and other derivatives (60.8%). Nevertheless, the region registered increased volumes commodity derivatives (16.3%) and across equity (41.9%). The options and futures, totaled to about 44.9% and 55.1% of global derivatives respectively. The volumes of the two categories rose by 12% and 7.4%

respectively between the years 2018 and 2019.

16,000 35,000

14,000 30,000

12,000 10,000 8,000 6,000 4,000 2,000

-

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Total Americas APAC EMEA

25,000 20,000 15,000 10,000 5,000

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1.6 Theories of Futures Pricing

Several theories have made an attempt to explain the relationship between Spot and Futures prices. A few important of them are as follows:

Cost-of-Carry Approach

The cost-of-carry model is the classical model which defines relationship between Spot and Futures price. Some prominent economics like Keynes and Hicks have argued that the Futures prices essentially reflect the carrying cost of the underlying asset. Carrying cost is the amount to be paid in order to store the asset from the present time to the Futures maturity date. It is based on the assumption that the price of the Futures contract is equal to the price of the underlying asset in the Spot Market plus the cost of carrying the asset for the period of the Futures contract.

A general principle of arbitrage pervades the pricing of all financial assets, which states that any two assets having identical characteristics trades at the same time.

The methods of pricing Futures can be divided into two groups. The first method relates to the carry able assets such as currencies, bonds, equities, indices etc, which can be purchased in the Spot Market at the same time as the Futures contract is entered into and held for the duration of the contract. The second group of contracts relates to non-carriable assets; i.e. those assets which cannot be carried, simply because they do not exist at the time when the Futures contract is entered into.

Assumptions:

The following are the assumptions of this approach:

 There is no information or transaction cost connected with the buying and selling of the asset.

 No restriction limit for borrowing and lending.

 Borrowing and lending rates are homogeneous.

 No credit risk associated and margin requirement.

 Goods can be stored for an indefinite period without loss to the quality of the goods.

 There are no taxes.

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An Overview of the Indian Derivatives Market As far as financial assets are concern, it is reasonable to assume that the investors who invest in the financial assets hold it only to make financial gain in return for bearing the associated risk. The fair price of the Futures is the price at which arbitrage between the underlying asset and the derivative is equal, i.e. there is neither profit nor loss. If the derivative is overvalued, then the arbitrager will sell it, buy the underlying asset with the borrowed funds and deliver the underlying asset into a derivatives contract. On the contrary, if the derivative is undervalued then the arbitrager will buy it and sell short the asset against it. Such arbitrage transactions are known as cash and carry arbitrage.

Futures contracts make it possible to have the delivery of the underlying asset at the future date (T). Whether the arbitrager uses own funds or borrowed funds for acquiring the asset on that date (t) both the strategies result in holding the underlying asset at the future rate. Therefore both should have the identical price today otherwise arbitrage profits would be possible. Assuming that the assets does not earn any income nor incur storage costs and r is the appropriate rate of profit for the period T-t, which represents the life of the Futures contract, then the arbitrage free Futures price will be as follows :

𝑭_𝒕=𝑷_𝒕(𝑰 + 𝒓_𝑻)^{(𝑻−𝒕)} Where--

Ft = price of the Futures contract on date t Pt = price of the underlying asset on date t r = appropriate interest rate for the period (T - t)

The Above formula is based on the assumption of a compound interest charge.

But in Stock Markets where the prices of the underlying assets change every moment, a continuous compounding method is more useful and appropriate to the circumstances. Therefore, the equation for ascertaining the Futures price becomes:

𝑭_𝒕 = 𝑷_𝒕𝒆^{(𝑻−𝒕)} Where

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F_t= price of the Futures contract on date t Pt = price of the underlying asset on date t

r = appropriate interest rate per annum for the period (T - t)

Therefore, we can conclude saying that the price of the Futures contract is equivalent to the present price of the underlying asset plus the cost of carrying the asset for the period (T-t), which could be represented with the help of an equation as follow: F_t= P_t+ C

In the above equation C is the net cost of carry, which considers the cost of funds borrowed to purchase the asset as well as the storage costs (i.e. custody charges) and any other income flowing from the asset during the life of the Futures contract. The whole net cost of carry can be treated as an annual rate, if storage costs; borrowing costs and Income accrue at the same time.

The Theory of Normal Backwardation

Backwardation is the market in which the Futures price is lesser than the Spot price, i.e., difference between cash price and future price is positive. Such situation occurs when the Futures prices are determined by considerations other than, or in addition, to cost-of-carry factors. Further, if the Futures prices are higher than the cash prices, this condition is usually referred to as a contango- market; and the basis is negative. Normal backwardation exists when the price of Futures contracts is below the expected delivery date Spot price. Prices for contracts with nearer maturity dates are higher than those with later maturities.

Contango exists when the price of Futures contracts is higher than the expected Spot price on the delivery date, and the price of Futures contracts with later delivery dates are higher than those with sooner delivery dates.

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Figure 1.5

Patterns of Futures prices

Fig. 1.5 illustrates the price pattern of Futures which is expected under different situations. The expected Futures Spot price will be equivalent to the actual Spot price at the maturity, only if the traders are able to correctly assess the Futures Spot price. If the Futures price is equal to the expected Futures Spot price then it will lie on the dotted line. Alternative conceptions like normal backwardation and contango exist, if the investor is unable to correctly access the Future Spot price. Normal backwardation exists when the price of Futures contracts is below the expected delivery date Spot price. Prices for contracts with nearer maturity dates are higher than those with later maturities. Contango exists when the price of Futures contracts is higher than the expected Spot price on the delivery date, and the price of Futures contracts with later delivery dates are higher than those with sooner delivery dates.

Prices

Contango

Expected Futures prices Net hedging

Normal backwardation Time

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Capital Asset Pricing Model

CAPM is the techniques which explains the risk and return relationship and signifies how systematic risk is important in calculation of returns. It can be also used effectively in determining the prices of the Futures. Because of unevenly distributed demand by hedgers for Futures positions, the Futures prices differ from expected future Spot prices even after adjusting for systematic risk. For example, if hedgers are dominating in the market through short sales then long hedgers will receive an expected profit in addition to any systematic risk premium. This theory is called hedging pressure explanation.

CAPM defines the relationship between risk and return as follows:

𝒓_𝒕^∗ = 𝒓_𝒇+ 𝜷_𝒊(𝒓_𝒎^∗ − 𝒓_𝒇)

𝜷

_𝒊

=

^𝝆^𝒊𝒎^𝝈^𝒊

𝝈_𝒎

Where

𝒓_𝒎^∗ = expected rate of return on the market portfolio 𝒓_𝒇 = riskless return

𝝆

_𝒊𝒎

=

correlation between return on individual and market return

𝝈

_𝒊 = deviation of rate of return on the asset

𝝈

_𝒎 = standard deviation of rate of return on market portfolio

The expected return on each pure asset is earned from the difference between the current Spot price and expected Futures Spot price. The CAPM shows this difference as to be:

𝑬_𝒕(𝑺_𝒕) − 𝑷_𝒕^∗ = 𝑹_𝒊^∗𝑷_𝒕^∗𝜷_𝒊(𝑹_𝒎^∗ − 𝑹_𝒇)𝑷_𝒕^∗

The difference between the future price and the expected Futures Spot price must be equal to this differential, where βisignifies systematic risk.

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𝑬_𝒕(𝑺_𝒕) − 𝑭_𝒕,𝑻 = 𝜷_𝒊(𝒓_𝒎^∗ − 𝒓_𝒇)𝑷_𝒕^∗

The earlier equation has an important view that if the asset has zero systematic risk, then Futures prices can be unbiased predictor of Futures Spot price, i.e., βi = 0. In such situation, the investor can diversify away the risk of the Futures position. In general, Futures prices will reflect an equilibrium bias. If βi

> 0 (is positive) then, Ft,T < Et – (ST), and if Bi < 0, a long Futures position has negative systematic risk, such a position will yield an expected loss, so Ft,T > Et– (St). This situation purely reflects the CAPM. In brief, according to CAPM, the expected return on a long Futures position depends on the beta of the Futures contract if β_i > 0, the Futures price should rise overtime; if β_i = 0, the Futures price should not change, and if β_i < 0, the Futures price should fall over time and vice-versa in the case of short futures.

1.7 Chapter Plan of the Thesis

Chapter 1: Overview of Indian Derivatives Market

This chapter will introduce the concept of financial Derivatives. Along with this it will also offer a brief historical background about the Derivative market in India.

Here, the current trends and growth of Derivative market will be presented.

Chapter 2: Review of Literature

This chapter summarizes the literature review and describes the methodology adopted in conducting the research. The chapter also lists out the literature reviewed during the research process and presents a summary of the literature reviewed. The objectives of the study are established, hypotheses are drawn and the methodology adopted to test the hypotheses is explained along with the scope and limitations of the study.

Chapter 3: Research Design and Methodology

This chapter begins with a discussion on the problem of the study and brought out the research gap, significance of the study, the scope of the study, research questions, set of research objectives, and methodology used to perform this

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An Overview of the Indian Derivatives Market research. In particular under methodology detailed out the data sources, data periods, sample variables and step-by-step approach on how the framework of various methods applied to carry out the analysis of research objectives.

Chapter 4: The Lead Lag Relationship between Spot and Futures Markets:

Empirical Evidence from Indian Markets

This chapter will deal with Price Discovery and Market Efficiency of the Futures Market with regard to price discovery and efficiency of the market. The Individual Stock Futures has proved immensely successful Financial Instrument on Indian bourses, and NSE has continued to account for the majority of total volumes traded in Stock Futures Segment all over the World. We analyze Single Stock Futures (SSFs) to understand their contribution to price leadership using the most liquid markets for the SSFs in the World. The study aims at analyzing the intraday Lead-Lag association between 100 most liquid and actively-traded and their Underlying Stocks by applying 1-Minute Price Returns from 1st April 2017 to 31st March 2019. The study explores Price discovery between Stock Futures and their Underlying Stocks by applying VECM, Hasbrouck (1995) Information Shares, and Common Factor Component Weights of Gonzalo and Granger (1995).

Chapter 5: Derivative trading and structural breaks in volatility in India: an ICSS approach

This chapter deals with the study of the impact of Stock Futures on the volatility of the underlying Stocks Market in India. Researchers argue that ignoring the structural breaks in the time-series variance can cause significant upward biases in the degree of persistence in estimated GARCH models. Against this backdrop, the present study empirically examines the effect of stock futures on the underlying stock’s volatility in India by incorporating the structural breaks with the help of ICSS test and AR (1)-GARCH (1, 1) model for 100 most liquid and actively traded underlying stocks and their associated futures contracts. The period of the study ranges from the 1st January 2000 or the listing date of the particular stock (whichever is prior) till 31st March 2019. The study contributes to the on-going debate regarding the effect of derivatives on the underlying stock market’s volatility in two ways. Firstly, by taking into consideration the breaks in the

An Analysis of the Impact of Single Stock Futures on Underlying Stocks in India