CHAPTER-3
OVERVIEW OF INDIAN CAPITAL MARKET 3.1 INTRODUCTION Economic environment of a nation is largely characterized by the efficient mobilization and usage of financial resources. A favorable economic environment attracts investments, which in turn influences the development of the economy. The quantity and quality of assets in a nation at a specific time is one of the essential criteria for the assessment of economic development. Assets in an economy is broadly divided according to their characteristics into Physical, Financial and intangible assets. Financial assets help the physical assets to generate activity. Financial assets have specific properties like monetary value, divisibility, convertibility, reversibility, liquidity and cash flow that distinguish it from physical assets. These properties of financial asset led to the emergence of financial markets. Specific financial markets are evolved to cater to the unique needs of the financial instruments introduced. For instance US stock market came into existence for the purpose of providing liquidity to the rail stocks, Bombay Stock exchange the oldest in Asia was established by the East India Company for business in its loan securities. When an existing stock market was unable to cope with the unique characteristics of a financial instrument, a new financial market will evolve. For instance, Chicago Board of trade (CBOT) was established to cater to the needs of commodities forward and futures contract. Thus financial market is a place where financial instruments are traded (Fig. 3.1). Figure-3.1 Financial Markets Financial Market
Money Market
Capital Market
Derivative Market
83
Insurance Market
Forex Market
In this respect financial markets can be classified on the basis of the nature of instruments exchanged in the economy. On the basis of the nature of financial instruments the financial market is broadly classified as Money Market, Capital Market, derivatives market, Insurance market and forex market. In order to make a financial market more efficient and viable one, the financial system of the country plays a greater role. Financial system of a country acts as channel in efficient distribution of funds from surplus units to deficit units. Efficient Financial systems are indispensible for speedy economic development. The more vibrant and efficient the financial system in a country, the greater is its efficiency of capital formation. The process of capital formation in the country is dependent upon the investment policies and efficient operations of financial intermediaries. The financial intermediaries facilitate the flow of savings into investments by overcoming the geographical and technical barriers. As we know investment is the activity that commits funds in any financial/physical form in the present with an expectation of receiving additional return in the future. So investment is an activity that is undertaken by those who have savings. But all savers are not necessarily investors basing upon the motive behind the savings. The expectation of return is an essential characteristic of investment. In this respect the role of financial intermediaries has become immensely important, since they can help in channelizing the surplus funds from an economy to the deficit units leading to development and growth of the economy at large. From the point of regulatory authority the financial intermediaries of the Indian financial system can be classified as: • Reserve Bank of India (RBI) regulating commercial banks, foreign exchange markets, financial institutions and primary dealers. • Securities and Exchange Board of India (SEBI) regulating Primary market, Secondary market, derivatives market and market intermediaries like mutual funds, brokers, merchant banks and depositaries. The Indian financial system has been characterized by profound transformation after the adoption of Liberalization, Privatization and Globalization (LPG) and 84
launching of economic policy in the year 1991. This reform in the financial sector has been characterized by the establishment of new capital markets, which provide the basic function of mobilizing the investments needed by corporate. This has led to the changes in several policy initiatives which have refined the market micro-structure, modernized operations and broadened investment choices for the investors in the capital market. The irregularities in the securities transactions in the last quarter of 2000-01, hastened the introduction and implementation of several reforms. Decisions were taken to complete the process of demutualization and corporatization of stock exchanges to separate ownership, management and trading rights on stock exchanges and to effect legislative changes for investor protection, and to enhance the effectiveness of SEBI as the capital market regulator. The transition from a closed economy to an open economy has paved the way for development in the capital market segment. Since then capital market plays a pivotal role in the financial system towards disseminating the funds from surplus units to deficit units. This has led to the growth and changes in the structure of Indian capital markets and financial institutions (Bhole, 1982). The development and growth in capital Market has also fuelled innovations in the market place, which led to the introduction of new financial instruments like Index derivatives, stock derivatives, currency derivatives etc. The derivatives trading on the NSE commenced with the S&P CNX Nifty Index Futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. Thereafter, a wide range of products have been introduced in the derivatives segment on the NSE. The Index futures and options are available on Indices - S&P CNX Nifty, CNX Nifty Junior, CNX 100, CNX IT, Bank Nifty and Nifty Midcap 50. Single stock futures are available on more than 250 stocks. The mini derivative contracts (futures and options) on S&P CNX Nifty were introduced for trading on January 1, 2008 while the Long term Options Contracts on S&P CNX Nifty were launched on March 3, 2008.
85
Due to rapid changes in volatility in the securities market from time to time, there was a need felt for a measure of market volatility in the form of an index that would help the market participants. Thus NSE launched the India VIX, a volatility index based on the S&P CNX Nifty Index Option prices. Apart from the introduction of new products in the Indian stock markets, the Indian Stock Market Regulator, Securities & Exchange Board of India (SEBI) allowed the Direct Market Access (DMA) facility to investors in India on April 3, 2008. To begin with, DMA was extended to the institutional investors. In addition to the DMA facility, SEBI also decided to permit all classes of investors to short sell and the facility for securities lending and borrowing scheme was made operational on April 21, 2008. The Debt markets in India have also witnessed a series of reforms, beginning in the year 2001-02 which was quite eventful for debt markets in India, with implementation of several important decisions like setting up of a clearing corporation for government securities, a negotiated dealing system to facilitate transparent electronic bidding in auctions and secondary market transactions on a real time basis and dematerialization of debt instruments. These developments in the securities market, support corporate initiatives, finance the exploitation of new ideas and facilitate management of financial risks, hold out necessary impetus for growth, development and strength of the emerging market economy of India. 3.2 CAPITAL MARKET IN INDIA Transfer of resources from those with idle resources to others who have a productive need for them is perhaps most efficiently achieved through the capital market. Thus, capital market provides channels for reallocation of savings to investments and entrepreneurship and thereby decouples these two activities. As a result, the savers and investors are not constrained by their individual abilities, but by the economy’s abilities to invest and save respectively, which inevitably enhances savings and investment in the economy.
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The existence of Indian capital markets dates back to the 18th century when the securities of the East India Company were traded in Mumbai and Kolkata. When the American Civil War began, the opening of the Suez Canal during the 1860s led to a tremendous increase in exports to the United Kingdom and United States. Several companies were formed during this period and many banks came to the fore to handle the finances relating to these trades. With many of these registered under the British Companies Act, the Stock Exchange, Mumbai, came into existence in 1875. It was an unincorporated body of stockbrokers, which started doing business in the city under a banyan tree. Business was essentially confined to company owners and brokers, with very little interest evinced by the general public. There had been much fluctuation in the stock market on account of the American war and the battles in Europe. However, the orderly growth of the capital market began with the setting up of The Stock Exchange, Bombay in July 1875 and Ahmedabad Stock Exchange in 1894. Eventually, 22 other Exchanges in various cities sprang up. Sir Phiroze Jeejeebhoy was another who dominated the stock market scene from 1946 to 1980. His word was law and he had a great deal of influence over both brokers and the government. He was a good regulator and many crises were averted due to his wisdom and practicality. The BSE building, icon of the Indian capital markets, is called PJ Tower in his memory. The planning process started in India in 1951, with importance being given to the formation of institutions and markets. The Securities Contract Regulation Act 1956 became the parent regulation after the Indian Contract Act 1872, a basic law to be followed by security markets in India. To regulate the issue of share prices, the Controller of Capital Issues Act (CCI) was passed in 1947. The stock markets have had many turbulent times in the last 140 years of their existence. The imposition of wealth and expenditure tax in 1957 by Mr. T.T. Krishnamachari, the then finance minister, led to a huge fall in the markets. The dividend freeze and tax on bonus issues in 1958-59 also had a negative impact. War with China in 1962 was another memorably bad year, with the resultant shortages increasing prices all round. This led to a ban on forward trading in commodity 87
markets in 1966, which was again a very bad period, together with the introduction of the Gold Control Act in 1963. The markets have witnessed several golden times too. Retail investors began participating in the stock markets in a small way with the dilution of the FERA in 1978. Multinational companies, with operations in India, were forced to reduce foreign share holding to below a certain percentage, which led to a compulsory sale of shares or issuance of fresh stock. Indian investors, who applied for these shares, encountered a real lottery because those were the days when the CCI decided the price at which the shares could be issued. There was no free pricing and their formula was very conservative. The next big boom and mass participation by retail investors happened in 1980, with the entry of Dhirubhai Ambani. He can be said to be the father of modern capital markets. The Reliance public issue and subsequent issues on various Reliance companies generated huge interest. The general public was so unfamiliar with share certificates that Dhirubhai is rumoured to have distributed them to educate people. The then prime minister, V.P. Singh’s fiscal budget in 1984 was path-breaking for it started the era of liberalization. The removal of estate duty and reduction of taxes led to as well in the new issue market and there was a deluge of companies in 1985. Manmohan Singh as Finance Minister came with a reform agenda in 1991 and this led to a resurgence of interest in the capital markets, only to be punctured by the Harshad Mehta scam in 1992. The mid-1990s saw a rise in leasing company shares, and hundreds of companies, mainly listed in Gujarat, and got listed in the BSE. The end-1990s saw the emergence of Ketan Parekh and the information; communication and entertainment companies came into the limelight. This period also coincided with the dotcom bubble in the US, with software companies being the most favoured stocks. There was a meltdown in software stock in early 2000. P Chidambaram continued the liberalization and reform process, opening up of the companies, lifting taxes on long-term gains and introducing short-term turnover tax. The markets have recovered since then and we have witnessed a sustained rally that has taken the index 88
over 13000 marks several systemic changes have taken place during the short history of modern capital markets. The setting up of the Securities and Exchange Board (SEBI) in 1992 was a landmark development. It got its act together, obtained the requisite powers and became effective in early 2000. The setting up of the National Stock Exchange in 1984, the introduction of online trading in 1995, the establishment of the depository in 1996, trade guarantee funds and derivatives trading in 2000, have made the markets safer. The introduction of the Fraudulent Trade Practices Act, Prevention of Insider Trading Act, Takeover Code and Corporate Governance Norms, are major developments in the capital markets over the last few years that has made the markets attractive to foreign institutional investors. In every economic system, some units, individuals or institutions, are surplus units who are called savers, while others are deficit units, called spenders. Households are surplus units and corporate and Government are deficit units. Through the platform of securities markets, the savings units place their surplus funds in financial claims or securities at the disposal of the spending community and in turn get benefits like interest, dividend, capital appreciation, bonus etc. These investors and issuers of financial securities constitute two important elements of the securities markets. The third critical element of markets is the intermediaries who act as conduits between the investors and issuers. Regulatory bodies, which regulate the functioning of the securities markets, constitute another significant element of securities markets. The process of mobilization of resources is carried out under the supervision and overview of the regulators. The regulators develop fair market practices and regulate the conduct of issuers of securities and the intermediaries. They are also in charge of protecting the interests of the investors. The regulator ensures a high service standard from the intermediaries and supply of quality securities and non-manipulated demand for them in the market. Table 3.1 presents an overview of market participants in the Indian securities market. The most important elements of security markets are the investors. The history shows us that retail investors are yet to play a substantial role in the market as longterm investors. An investor is the backbone of the capital market of any economy as 89
he is the one lending his surplus resources for funding the setting up or expansion of companies, in return for financial gain. Table-3.1 Market Participants in the Securities Market Market Participants
2009
2010
As on Sept. 2010
Securities Appellate Tribunal (SAT)
1
1
1
Regulators
4
4
4
Depositories
2
2
2
With equities trading
20
20
20
With debt market segment
2
2
2
With derivative trading
2
2
2
With currency derivatives
3
3
4
Brokers (Cash segment)
9628
9772
10018
Corporate brokers (Cash segment)
4308
4424
4618
Brokers (Equity derivatives)
1587
1705
1902
Brokers (Currency derivatives)
1154
1459
1811
Sub brokers
60,947
75577
81713
FIIs
1626
1713
1726
Portfolio managers
232
243
250
Custodians
16
17
17
Registrars to an issue & Share transfer agents
71
74
68
Primary dealers
18
20
20
Merchant bankers
134
164
184
Bankers to an issue
51
48
52
Debenture trustees
30
30
27
Underwriters
19
5
6
Venture capital funds
132
158
168
Foreign venture capital investors
129
143
150
Mutual funds
44
47
48
Collective investment schemes
1
1
1
Stock Exchanges
Source: NSE Fact book 2011
On the contrary the Retail participation in India is very limited considering the overall savings of households. This is well depicted in the following Table 3.2: 90
Table 3.2 Savings of House hold sectors in Financial Assets (%) Financial Assets
2007-08
2008-09
2009-10
2010-11
Currency
11.4
12.7
9.8
13.3
Fixed Income Investments
78.2
88
85.6
87.1
Deposits
52.2
60.7
47.2
47.3
Insurance/Provident & Pension Funds
27.9
31.1
34.1
33.3
Small Savings
-1.9
-3.8
4.3
6.5
Securities Market
10.1
-0.3
4.8
-0.4
Mutual Funds
7.7
-1.4
3.3
-1.8
Government Securities
-2.1
0.0
0.0
0.0
Other Securities
4.5
1.1
1.5
1.4
Total
100
100
100
100
Source: RBI Annual Report 2010-11 The data presented here exhibits net financial savings of the household sector in 2008-09 was 10.9% of GDP at current market prices which was lower than the estimates for 2007-08 at 11.5%. Decline in the household investments in shares and debentures were the main factors responsible for the lower household saving in 200809. However, the household savings in instruments like currency, deposits, contractual savings (pension and provident funds) and investment in government securities remained broadly stable during the year. The household sector accounted for 89.5% of the Gross Domestic Savings in Fixed Income investment instruments during 2008-09, as against 78.2% in 2007-08. The investment of households in securities was -1.9% compared with 10.1% in 2007-08. Table 3.2 shows Indian household investment in different investment avenues since 1990-91 till 2008-09. It can be observed that the household investments in government securities and mutual funds fell in the negative territory while investments in shares and debentures of private corporate, banking and PSU Bonds were at 4.4% at par with investments last year. The fewer participation of the public in the capital market has been studied by L.C. Gupta (1992) concludes that, a) Indian stock market is highly speculative; b) Indian investors are dissatisfied with the service provided to them by the brokers; c) 91
margins levied by the stock exchanges are inadequate and d) liquidity in a large number of stocks in the Indian markets is very low. In the recent time the regulatory bodies as well as the government has brought certain reforms which has created interest among the investor class for larger investments in the capital market. The importance in the study of capital market is vital since it plays a major role in economic development of a country. In this respect the major economic role of a capital market is to match players who have excess funds to players who are in need of funds. Capital market exchange and provide liquidity to both long term fixed claim securities and residual (equity claim) securities. In this exchange process, there is a valuation of the instruments done by the market for the specific risk assumed by the investors. Apart from the risk associated with a security, the return from that security is also important from the investors’ perspective, since for assuming higher risk the investor’s expected return from that security (portfolio) should be higher. This risk return characteristics of the instruments necessitates a subdivision of the capital market into debt and equity market. Figure-3.2 Subdivisions of Capital Market CAPITAL MARKET
DEBT MARKET
EQUITY MARKET
DERIVATIVES MARKET
3.3 DEBT MARKET IN INDIA Debt instruments represent contracts whereby one party lends money to another on pre-determined terms with regard to rate of interest to be paid by the borrower to the lender, the periodicity of such interest payment, and the repayment of the principal amount borrowed. In the Indian securities markets, the term ‘bond’ is used for debt instruments issued by the Central and State governments and public sector organisations, and the term ‘debentures’ for instruments issued by private corporate 92
sector. So, financial Instruments that have a fixed income claim and have a maturity of more than one year are traded in the debt market. The market for government securities is the most dominant part of the debt market in terms of outstanding securities, market capitalization, trading volume and number of participants. The NSE started its trading operations in June 1994 by enabling the Wholesale Debt Market (WDM) segment of the Exchange. This segment provides a trading platform for a wide range of fixed income securities that includes Central government securities, treasury bills (T-bills), state development loans (SDLs), bonds issued by public sector undertakings (PSUs), floating rate bonds (FRBs), zero coupon bonds (ZCBs), index bonds, commercial papers (CPs), certificates of deposit (CDs), corporate debentures, SLR and non-SLR bonds issued by financial institutions (FIs), bonds issued by foreign institutions and units of mutual funds (MFs). To further encourage wider participation of all classes of investors, including the retail investors, the Retail Debt Market segment (RDM) was launched on January 16, 2003. This segment provides for a nationwide, anonymous, order driven, screen based trading system in government securities. In the first phase, all outstanding and newly issued central government securities were traded in the retail debt market segment. Other securities like state government securities, T-bills etc. will be added in subsequent phases. In developed economies, bond markets tend to be bigger in size than the equity market. In India however, corporate bond market is quite small compared to the size of the equity market. One of the main reasons for this is that a large part of corporate debt, being loan from financial intermediaries, is not securitized. The picture however is undergoing a sea change in the last few years. An increasingly larger number of companies are entering the capital market to raise funds directly from the market through issue of convertible and non-convertible debentures. The deregulations on interest rates in the new liberalized environment are resulting in innovative instruments being used by companies to raise resources from the capital markets leading to the growth in the WDM.
93
Debt markets are pre-dominantly wholesale markets, with institutional investors being major participants. Banks, financial institutions, mutual funds, provident funds, insurance companies and corporates are the main investors in debt markets. Many of these participants are also issuers of debt instruments. Most debt issues are privately placed or auctioned to the participants. Secondary market dealings are mostly done on telephone, through negotiations. In some segments, such as the government securities market, market makers in the form of primary dealers have emerged, which enable a broader holding of treasury securities. Debt funds of the mutual fund industry, comprising of liquid funds, bond funds and gilt funds, represent a recent mode of intermediation of retail investments into the debt markets. The major market participants in the debt market are as follows: Central Government raises money through bond and T-bill issues to fund budgetary deficits and other short and long-term funding requirements. Reserve Bank of India (RBI), as investment banker to the government, raises funds for the government through dated securities and T-bill issues, and also participates in the market through open-market operations in the course of conduct of monetary policy. RBI also conducts daily repo and reverse repo to moderate money supply in the economy. RBI also regulates the bank rates and repo rates, and uses these rates as tools of its monetary policy. Changes in these benchmark rates directly impact debt markets and all participants in the market as other interest rates realign themselves with these changes. Primary Dealers (PDs), who are market intermediaries appointed by RBI, underwrite and make market in government securities by providing two-way quotes, and have access to the call and repo markets for funds. Their performance is assessed by RBI on the basis of their bidding commitments and the success ratio achieved at primary auctions. In the secondary market, their outright turnover has to three times their holdings in dated securities and five times their holdings in treasury bills. Satellite dealers constituted the second tier of market makers till December 2002.
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State governments, municipal and local bodies issue securities in the debt markets to fund their developmental projects as well as to finance their budgetary deficits. Public Sector Undertakings (PSUs) and their finance corporations are large issuers of debt securities. They raise funds to meet the long term and working capital needs. These corporations are also investors in bonds issued in the debt markets. Corporate issue short and long-term paper to meet their financial requirements. They are also investors in debt securities issued in the market. Development Financial Institutions (DFIs) regularly issue bonds for funding their financing requirements and working capital needs. They also invest in bonds issued by other entities in the debt markets. Most FIs hold government securities in their investment and trading portfolios. Banks are the largest investors in the debt markets, particularly the government securities market due to SLR requirements. They are also the main participants in the call money and overnight markets. Banks arrange CP issues of corporates and are active in the inter-bank term markets and repo markets for their short term funding requirements. Banks also issue CDs and bonds in the debt markets. They also issue bonds to raise funds for their Tier -II capital requirement. Mutual funds have emerged as important players in the debt market, owing to the growing number of debt funds that have mobilised significant amounts from the investors. Most mutual funds also have specialised debt funds such as gilt funds and liquid funds. Mutual funds are not permitted to borrow funds, except for meeting very short-term liquidity requirements. Therefore, they participate in the debt markets predominantly as investors, and trade on their portfolios quite regularly. The development and growth of WDM can be studied by analyzing various parameters like trading volume, turnover, market capitalization etc. The trading volume on the WDM Segment of the Exchange witnessed a year on year increase of 67.00% from Rs. 335,952 crore (US $ 65,937 million) during 2008-09 to Rs. 563,816 crore (US $ 124,904 million) during 2009-10. The average daily trading volume also accelerated from Rs. 1,412 crore (US $ 277 million) during 2008-09 to Rs. 2,359 crore (US $ 523 million) in fiscal 2009-10. The highest recorded WDM trading volume of 95
Rs. 13,9 912 crore (US $ 3,20 06 million)) was registered on August 25, 2003. Thhe businesss growth of the WDM segment is presented in i Figure-3..3. DM Figure 3.3 Buusiness Groowth of WD
Source: NSE Fact book b 2011 A Although thee WDM is growing Y Y-O-Y basis, but it is nnot clear froom the abovve figure th hat which type t of debbt instrumennt is contriibuting morre to the grrowth of thhe debt marrket segmennt. This cann be examinned from thee Table 3.3 and Figuree 3.3 Table 3.3 Security w wise distribu ution of WD DM Trades Turnoover (Rs. Crr.)
Turnoveer (%)
Year
Govt. securities
T-Bills
PSU Bonds
O Others
Tottal Turno over
Govt. securiti es
T-Bills
PSU Bonds
2000-011
390,952
23,143
7,886
66,600
428,582
91.22
5.40
1.84
2001-022
902,105
25,574
10,987
8 8,619
947,191
95.24
2.70
1.16
2002-033
1,000,518 8
32,275
19,985
15,924
1,068 8,701
93.62
3.02
1.87
2003-044
1,218,705 5
55,671
27,112
14,609
1,316 6,096
92.60
4.23
2.06
1.111
2004-055
724,830
124,842
17,835
19,787
887,294
81.69
14.07
2.01
2.223
2005-066
345,563
105,233
12,173
12,554
475,523
72.67
22.13
2.56
2.664
2006-077
153,370
51,954
4,418
9 9,365
219,106
70.00
23.71
2.02
4.227
2007-088
194,347
66,062
9,232
12,676
282,317
68.84
23.40
3.27
4.449
2008-099
234,288
56,824
30,008
14,831
335,952
69.74
16.91
8.93
4.441
2009-100
327,837
92,961
86,833
56,185
563,816
58.15
16.49
15.40
9.997
2010-111
304,836
98,713
109,586
46,312
559,447
54.49
17.64
19.59
8.228
Source: NSE E Fact book 201 11
96
Others
1.544
0.991 1.499
Figure-3.4 Security wise distribution of WDM Trades 120 100 80
Govt Security
60 40
T‐Bill
20
PSU Bond
0
Others
Source: NSE Fact book 2011 The transactions in government securities accounted for a substantial share of 58.15 % during 2009-10 on the WDM segment. The details of transactions in different securities are presented in Table 3.3 and Figure-3.4. The trading members accounted for 49.23 % of the total WDM trades followed by foreign banks which held a share of 23.67 %. Share of Indian banks in WDM trades increased to 19.84 % during 2009-10 as compared with its share of 18.11 % in the corresponding period last year. Market capitalisation of the WDM segment has witnessed an increase of 11.15 % from Rs. 2,848,315 crore (US $ 559,041 million) as on March 31, 2009 to Rs. 3,165,929 crore (US $ 701,358 million) as on March 31, 2010. Central Government securities accounted for the largest share of the market capitalisation with 61.61%. Although there is an increase in the activities in the debt market segment, yet the debt market segment is not fully utilized in India as compared to western countries. The need of the hour is to tap this market by bringing various innovative products like securitization, CDS, etc., by the government to make it fully operative. 3.4 EQUITY MARKET IN INDIA This market is characterized by the exchange of equity instruments that bestow ownership on the holder of the security. Equity implies ownership rights in the corporate entity that has issued the instruments to the public. The claim of the owners of these instruments is residual in nature and the securities have no maturity. In this respect the Equity market has further been dived into two parts: 97
Primary Market: The primary market acts as a doorway for corporate enterprises to enter the capital market. It provides opportunity to issuers of securities, Government as well as corporate, to raise resources to meet their requirements of investments and/or discharge some obligation. Primary market also known as New Issue Market deals with new securities which were not previously available and offered to the investing public for the first time. They may issue the securities at face value, or at a discount/premium and these securities may take a variety of forms such as equity, debt etc. They may issue the securities in domestic market and/or international market. The primary market enjoys neither any tangible form nor
any
administrative
organizational set-up and is not subject to any centralized control and administration for the execution of its business. It is recognized by the services that it renders to the lenders and borrowers of capital. The main function of primary market is to facilitate the ‘transfer of resources’. The corporate that raise funds through primary market have to compulsorily list their securities in any of the recognized stock exchange for further trading. Listing on stock exchanges provides the qualifying companies with the broadest access to investors, the greatest market depth and liquidity, the highest visibility, the fairest pricing and investor benefits. As per the research is concerned a paucity of research is done in the new issue market in India. What is worse is that much of whatever little work has been done, dates back to the late 1970's and early 1980's prior to the qualitative transformation that took place in the Indian equity markets in the 1980's. Khan (1977, 1978) studied the role of new issues in financing the private corporate sector during the 1960's and early 1970's and concluded that new issues were declining in importance. He also showed that with underwriting becoming almost universal, institutions like the LIC and the UTI were becoming major players. Jain (1979) shed more light on this question with an analysis of UTI's role in the new issue market. He argued that UTI looked at underwriting as a method of acquiring securities at low cost rather than an arrangement for guaranteeing the success of new issues. In the context of the rapidly changing structure of the merchant banking industry in India today, a deeper analysis of the motivations and strengths of different players would be highly useful.
98
Chandra (1989a) and Varma and Venkiteswaran (1990) critically examine the CCI guidelines for valuation of shares and point out that the CCI's methodology is fundamentally flawed. With the abolition of the office of the CCI, the issue of pricing using the CCI methodology has however become redundant. Anshuman and Chandra (1991) examine the government policy of favouring the small shareholders in terms of allotment of shares. They argue that such a policy suffers from several lacunae such as higher issue and servicing costs and lesser vigilance about the functioning of companies because of inadequate knowledge. They suggest that there is a need to eliminate this bias as that would lead to a better functioning capital market and would strengthen investor protection. This highlights the reform that is necessary in terms of market microstructure and transactions will ensure the Indian capital market to be comparable with the capital markets in the most developed countries. The early 1990s saw a greater willingness of the saver to place funds in capital market instruments-on the supply side as well as an enthusiasm of corporate entities to take resource to capital market instruments- on the demand side. The reforms introduced in the Indian primary market in the issue mechanism highlights Book Building Process, Green Shoe Option and Application Supported by Blocked Amount reforms introduced in Indian primary market with the prime objective of investor protection. In this connection SEBI has come out with DIP guideline that will ensure transparency in the new issue market. Apart from that also SEBI acts as a watch dog in the secondary market where the shares are listed for further trading. Secondary Market: Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. It essentially comprises of the stock exchanges which provide platform for trading of securities and a host of intermediaries who assist in trading of securities and clearing and settlement of trades. The securities are traded, cleared and settled as per prescribed regulatory framework under the supervision of the Exchanges and SEBI.
99
The stock exchanges are the exclusive centers for trading of securities. Listing of companies on a Stock Exchange is mandatory to provide an opportunity to investors to invest in the securities of local companies. The Stock Exchange, Bombay in July 1875 and Ahmedabad Stock Exchange in 1894 were the oldest stock exchanges in India. After liberalization and setting up of National Stock Exchange (NSE), eventually 22 other Exchanges in various cities sprang up. However NSE and BSE are the major stock exchanges accounted for 99.98% of the total turnover in India. The trading volumes on exchanges have been witnessing phenomenal growth for last few years. Since the advent of screen based trading system in 1994-95, it has been growing by leaps and bounds and reported a total turnover of Rs.51,30,816 crore during 2007-08. The growth of turnover has, however, not been uniform across exchanges as may be seen from. The increase in turnover took place mostly at big exchanges (NSE and BSE) and it was partly at the cost of small exchanges that failed to keep pace with the changes. The business moved away from small exchanges to big exchanges, which adopted technologically superior trading and settlement systems. The Bombay Stock Exchange (BSE) is the oldest stock exchange in Asia with a rich heritage. It was established as “the Native share & Stock Brokers Association” in the year 1875. It is the first stock exchange in the country to obtain permanent recognition in 1956 from the Govt. of India under the SC(R) Act, 1956. The exchange’s pivotal and pre-eminent role in the development of the Indian capital market is widely recognized. On the other hand as per the recommendation of the High powered committee National stock Exchange of India (NSE) was promoted by the leading Financial institutions at the behest of Government of India and was incorporated in November 1992. After getting recognition as a stock exchange under the SC(R) Act 1956 in April 1993, NSE commenced operations in the Wholesale Debt market segment in June 1994. The capital market segment commenced operation in November 1994 and operations in the derivative segment commenced in the June 2000.
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Bombay Stock Exchange was the first and the oldest stock exchange established by the Native traders under a banyan tree in the year 1875. Since its inception BSE had always functioned as a “club like” regional exchange run by powerful groups of Gujarati operating with high margins, low transparency, bureaucracy and unreliable clearing and settlement systems. Until the late 1980’s Indian state dominated the inefficient financial sector. This led to rents captured by insiders dominating the market. Towards the end of the 1980’s, new economic forces, the economic growth and currency crisis emphasized the need for modernization of the financial system. Government created the Securities and Exchange Board of India (SEBI) in 1988 whose reforms were blocked by BSE. The Indian stock market crashed in April 1992. Investors like Harshad Mehta diverted 35bn INR from the bank system via Ready Forward Deals to the equity market which they manipulated. Minister of Finance stressed “prima facie evidence of a nexus between brokers and bank officials ” and the need to create competition between exchanges. He tapped the Industrial Development Bank (IDB) to take the lead of the project of creating competition for BSE. The above discussed limitations found in BSE and the stock market crash in 1992 had propelled the government of India to establish a capital market which will win the investors’ confidence and act as a competitor for BSE. In this connection in the year 1992 NSE was given birth and commencing its trade in 1994 in the equity market segment. This segment has grown phenomenally in terms of number of companies listed, market capitalization, turnover and trading volume. The popular Index for NSE is Nifty constructed on value weighted basis by taking 50 shares. As regards to the listing on NSE (Table 3.4) there is a spurt in the listing of companies. NSE has about 1470 listed companies in March 2010 which include from hi-tech to heavy industry, software, refinery, public sector units, infrastructure and financial services. The issuers of securities have to adhere to provisions of the Securities Contracts (Regulation) Rules, 1956, the Companies Act 1956, and the Securities and Exchange Board of India Act 1992. All companies seeking listing of their securities on the exchange are required to enter into a formal listing agreement 101
with the exchange. The agreement specifies all the quantitative and qualitative requirements to be continuously complied with by the issuer for continued listing. The exchange monitors such compliance. Companies that are listed in other stock exchanges are also permitted to trade in NSE. Table 3.4: Companies Listed in NSE Year
Companies Listed
Companies Available for Trading *
2000-2001
785
1,029
2001-2002
793
890
2002-2003
818
788
2003-2004
909
787
2004-2005
970
839
2005-2006
1,069
929
2006-2007
1,228
1084
2007-2008
1,381
1236
2008-2009
1,432
1291
2009-2010
1,470
1359
2010-11
1574
1484
* Excluding Suspended Companies, Source: NSE Fact Book, 2010, pp.31.
Every year companies listed in the NSE are increasing cumulatively. The companies available for trading decreased year by year from 2001 to 2004 and it increased in the year 2004–2005. After that the listing of companies starts increasing Y-O-Y basis. Market capitalization is a good indicator of the health of capital markets. Market capitalisation means the total number of outstanding shares of the company multiplied by the share price of that stock. Stock market capitalisation means the total market capitalisation of all the individual stocks that are listed on the exchange. The size and growth of the market capitalisation is a critical measurement of a stock exchange’s success or failure. The stock price movement determines the market capitalisation. Foreign portfolio investment added buoyancy to the Indian capital markets and Indian corporate sector began aggressive acquisition spree overseas, 102
which was reflected in the high volume of outbound direct investment flows. Market capitalisation of securities in the capital market segment is given in Table 3.5. The total market capitalization was very high in the year 2009–2010 due to strong investment by FIIs. The secondary market, recorded a sharp slump in the wake of the global financial crisis during the latter half of 2008, staged a outstanding recovery in 2009 following stimulus measures implemented by the Government and resurgence of foreign portfolio flows displaying renewed interest by foreign investors. Furthermore, election results announced in May 2009 eliminated uncertainty on economic policies and as such boosted Indian equity markets. India ranks 49th out of 133 economies in the Global Competitive Index for the year 2009-2010. Table 3.5: Market Capitalization and Turnover of Securities in the CM Segment (Rs.in Crores) Year
Total Market capitalisation
Turnover
Average daily trading value
2000-2001
6,57,847
1339510
5337
2001-2002
6,36,861
513167
2078
2002- 2003
5,37,133
617989
2462
2003-2004
11,20,976
1099534
4329
2004-2005
15,85,585
1140072
4506
2005-2006
28,13,201
1569558
6253
2006-2007
33,67,250
1945287
7812
2007-2008
48,58,122
3551038
4148
2008-2009
28,96,194
2752023
11325
2009-2010
60,09,173
4138023
16959
2010-2011
67,02,616
3577410
14029
Source: Fact Book, 2005, 2010
The total market capitalization declined in the year 2008–2009 due to significant slowdown of the industrial sector and unsatisfactory performance of infrastructure industries and this set a bear phase in the market. As on 31st March 2009 the total market capitalisation was Rs. 28,96,194 cr., which was regarded as the lowest 103
in the laast 05 years. Since thee capital market m folloows a cycliccal path, th hus after onne bear phaase there will w be bulllish trend aand it is well w exhibiteed from April A 2009 to t March 2011. 2 This bullish b trendd is accomppanied by strong optim mism amongg the traderrs. In spite of the slow wdown because of globbal financiall crisis in thhe year 2008 – 2009 thhe NX Nifty stiill occupiedd more thann 65 per cennt of total m market capitaalization. S&P CN Figure- 3.5 Trend off Market Caapitalizationn of Nifty
A Average Daaily Turnovver a key element e to measure suupply and demand annd often thee primary indicator i off a new pricce trend. When W a stockk moves up p in price oon unusuallly high vollumes it coould indicatte that inveestors are aaccumulatinng the stockk. When a stock movves down inn price on uunusually heavy h volum me, major selling s coulld be the reeason. Manyy investors look at thee value of shhares tradedd on the sto ock exchangge on a day y in comparison with the averagee daily valu ue. The invvestor gets an a insight oof how actiive the stocck was on a certain daay as compaared with thhe previous days. Wheen the majoor news is announced,, a stock caan trade ten n times of iits average daily value. The averrage daily turnover t of NSE is presented in Table T 3.6. Tablee 3.6: Averaage Daily Tu urnover of CM C Segmen nt (Rs. Cr.) Average Daily Turnover
Yeear
verage Daily Av Turnover
Year
Averaage Daily Turnover
2000--2001
5337.00
2004-2005
45506.00
2001--2002
2078.00
2005 – 20006
62253.00
22009 – 2010
16959.00
2002-- 2003
2462.00
2006 – 20007
78812.00
2010-2011
14,048.00
2003--2004
4329.00
2007 – 20008
Source: Fact F Book, 20005, 2010
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14148.00
Year 22008 – 2009
11325.00
During 2008-09, the growth in exports was robust till August 2008. However, in September 2008, export growth evinced a sharp dip and turned negative in October 2008 and remained negative till the end of the financial year. The continued decline in export growth was due to the recessionary trends in the developed markets where the demand had plummeted. For the year as a whole, the growth in merchandise exports during 2008-09 was 3.6 per cent in US dollar terms and 16.9 per cent in rupee terms (compared to 28.9 per cent and 14.7 per cent respectively in 2007-08). The large difference in growth in terms of the US dollar and in terms of the rupee was on account of the depreciation of rupee vis-à-vis US dollar during the year. It was increased from 2001 – 2002 to 2007 -2008 and declined in the year 2008- 2009. The environment improved in 2009-10 and got better with every subsequent quarter. In tandem with the increase in stock prices in 2009-10, there was a significant increase in turnover and market capitalisation across the board. In the cash segment, the turnover at NSE increased by 50.4 percent during 2009-10 as compared to decline witnessed at NSE by 22.5 percent. The sudden growth of the CM segment of NSE and the strong competition shown to BSE is of the following factors: First of all, non-Gujarati traders and/or investors with low needs to be part of the Gujarati financial community were predominantly attracted by the fee structure and customer oriented clearing, settlement and dematerialization processes of NSE. Secondly, traders, investors and public policy makers with a important long-run financial and/or political interest to transform the Indian equity market into a competitive and attractive market were attracted by this potential to reshape the market and by the fee structure and the customer oriented clearing, settlement and dematerialization processes of NSE. Thirdly, traders and/or investors who originally used brokers become member of NSE because of the possibility to trade electronically outside Bombay. Fourthly, price differences attracted arbitrage traders who supported liquidity at both exchanges. The idea is that the governmental intervention in this inefficient market was successful because of BSE’s weaknesses (unfavorable transaction costs, customer processes and narrow geographical scope) and because of visionary 105
market design, technology and governance innovations implemented by a strong NSE management make NSE a strong competitor in the capital market segment. The success of NSE’s capital market segment within a short span of time and the wind of financial innovation that was sweeping across the world after the invention of financial derivatives and its success as a risk management tool compelled the government to adopt the changes in the Indian economy. This has led to the introduction of financial derivatives in India. 3.5 DERIVATIVES MARKET IN INDIA The term ‘derivatives, refers to a broad class of financial instruments which mainly include options and futures. These instruments derive their value from the price and other related variables of the underlying asset. They do not have worth of their own and derive their value from the claim they give to their owners to own some other financial assets or security. A simple example of derivative is butter, which is derivative of milk. The price of butter depends upon price of milk, which in turn depends upon the demand and supply of milk. The general definition of derivatives means to derive something from something else. According to Securities Contract Regulation Act (SCRA) 1956 Derivative may be defined 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” As defined above, the value of a derivative instrument depends upon the underlying asset. The underlying asset may assume many forms: • Commodities including grain, coffee beans, orange juice; • Precious metals like gold and silver; • Foreign exchange rates or currencies; • Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc. 106
• Shares and share warrants of companies traded on recognized stock exchanges and Stock Index • Short term securities such as T-bills; and • Over- the Counter (OTC) • Money market products such as loans or deposits. Derivatives contracts are of many types depending upon the underlying asset upon which the contracts are being written. But broadly derivatives can be classified in to two categories: Commodity derivatives and financial derivatives. In case of commodity derivatives, underlying asset can be commodities like wheat, gold, silver etc., whereas in case of financial derivatives underlying assets are stocks currencies, bonds and other interest rates bearing securities etc. Since, the scope of this case study is limited to only financial derivatives so we will confine our discussion to financial derivatives only. Figure 3.6 Classifications of Derivatives DERIVATIVES
FORWARDS
FUTURES
OPTIONS
SWAPS
a) Forward Contract A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future. In case of a forward contract the price which is paid/ received by the parties is decided at the time of entering into contract. It is the simplest form of derivative contract mostly entered by individuals in day to day’s life. Forward contract is a cash market transaction in which delivery of the instrument is deferred until the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. One of the parties to a forward contract assumes a long position (buyer) and agrees to buy the underlying asset at a certain future date for a certain price. The other party to the contract known
107
as seller assumes a short position and agrees to sell the asset on the same date for the same price. The specified price is referred to as the delivery price. The contract terms like delivery price and quantity are mutually agreed upon by the parties to the contract. No margins are generally payable by any of the parties to the other. Forwards contracts are traded over-the- counter and are not dealt with on an exchange unlike futures contract. Lack of liquidity and counter party default risks are the main drawbacks of a forward contract. b)
Futures Contract Futures is a standardized forward contact to buy (long) or sell (short) the underlying asset at a specified price at a specified future date through a specified exchange. 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, Date and Delivery place (in case of commodity).The features of a futures contract may be specified as follows: • These are traded on an organised exchange like IMM, LIFFE, NSE, BSE, CBOT etc. • These involve standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc. • These are associated with a clearing house to ensure smooth functioning of the market. • There are margin requirements and daily settlement to act as further safeguard. • These provide for supervision and monitoring of contract by a regulatory authority. • Almost ninety percent future contracts are settled via cash settlement instead of actual delivery of underlying asset. Futures contracts being traded on organized exchanges impart liquidity to the transaction. The clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honouring of the contract and ensuring very low level of default (Hirani, 2007). Following are the important types of financial futures contract:108
¾ Stock Future or equity futures, ¾ Stock Index futures, ¾ Currency futures, and ¾ Interest Rate bearing securities like Bonds, T- Bill Futures. c) Options Contract In case of futures contact, both parties are under obligation to perform their respective obligations out of a contract. But an options contract, as the name suggests, is in some sense, an optional contract. An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A “call option” gives one the right to buy; a “put option” gives one the right to sell. Options are the standardized financial contract that allows the buyer (holder) of the option, i.e. the right at the cost of option premium, not the obligation, to buy (call options) or sell (put options) a specified asset at a set price on or before a specified date through exchanges. Options contracts are of two types: call options and put options. Apart from this, options can also be classified as OTC (Over the Counter) options and exchange traded options. In case of exchange traded options contract, contracts are standardized and traded on recognized exchanges, whereas OTC options are customized contracts traded privately between the parties. A call options gives the holder (buyer/one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. d) Swaps Contract A swap can be defined as a barter or exchange. It is a contract whereby parties agree to exchange obligations that each of them have under their respective underlying contracts or we can say, a swap is an agreement between two or more parties to exchange stream of cash flows over a period of time in the future. The parties that agree to the swap are known as counter parties. The two commonly used swaps are: i) Interest rate swaps which entail swapping only the interest related cash flows between the parties in the same currency, and ii) Currency swaps: These entail swapping both 109
principal and interest between the parties, with the cash flows in one direction being in a different currency than the cash flows in the opposite direction. Derivatives contracts are being bought and sold by a large number of individuals, business organizations, governments and others for a variety of purposes. On the basis of the purpose the traders in the derivatives market can be categorized as follows: Hedgers: The prime aim of the introduction of futures markets is to allow for companies and individuals to protect themselves against future unfavourable changes in prices (for financial futures in particular changes in interest and exchange rates). As a result the futures market serves as the way of reducing or even eliminating risk. This is achieved through hedging. An example of a case that requires hedging could be when someone is obliged to hold a large inventory of a commodity that cannot be sold until a later date. A futures contract would be used to hedge against any future price fluctuations (fix the price) by having the hedger going short the commodity futures (short hedging). If the price of the asset goes down the investor does not perform well on the sale of the asset, but makes a gain on the short futures position. If the price of the asset goes up, the investor gains from the sale of the asset, but makes a loss on the futures position. It is quite possible that the prices will fluctuate in such a way that the investor would have been better off if he/she had not undertaken the hedging strategy. However, the purpose of hedging is no other than to reduce the risk being faced or will be faced by making the outcome more certain. It does not necessarily improve the outcome. There is a number of reasons why hedging using futures contracts may not work perfectly in practice and not eliminate risk. 1. There is a possibility that the asset underlying in the futures contract will not be exactly the same as the asset that the investor wishes to hedge. 2. The hedger might not be able to know for certain the precise date when the asset will be bought or sold.
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3. It is also possible that the futures contract expires later than the date that the hedging strategy must be terminated. Speculators: The risk reduced by hedging is transferred to the counterparty to the trade, who may be another hedger with opposite requirements or a speculator. Speculators expose themselves to risk by buying or selling in futures market in order to profit from the future price fluctuations (buy an asset when the price is low and sell it when it is high) and thus, provide liquidity to the market. They are classified according to their methods. Speculators seek to trade profitably based on price movements in the next few minutes. (they try to profit by a few ticks per trade on a large number of transactions). Day traders close out their futures positions on the same day that the positions were initiated, so as. to avoid large price movements when the market is closed. Position traders, keep a futures position for long periods of time (weeks or even months) so that price moves in a favourable way to their position. Arbitrageurs: Arbitrageurs are investors who exploit price discrepancies between markets by entering into transactions in two or more markets. When the opportunity emerges, an arbitrageur tries to take advantage of it by buying in one market at a particular 'price and simultaneously selling in the other market at a higher price. However, these price discrepancies can only be temporary since they can easily be eliminated by the arbitrage process itself. This is done, because the purchase in one market will drive prices up for that market, while the sale in the other will drive prices down. Consequently, arbitrage is very important for keeping futures and underlying spot prices in line. In recent years, arbitrage reflects a wide range of activities. For example, tax arbitrage is a strategy by which gains or losses are shifted from one tax jurisdiction to another in order to profit from differences in tax rates. In a similar manner currency arbitrage is a form of trading which involves buying a currency in one market and selling it in another so as to profit from exchange rate inconsistencies in different money centers. An arbitrage strategy could also involve transacting simultaneously in a futures and a forward contract of similar 111
characteristics but different rates and profit from this discrepancy. A final reference to different types of arbitrage involves the spread arbitrage. Arbitrage trading can also take place by taking advantage of price discrepancies between futures contracts with different expirations- (calendar spread). The arbitrageur in this case profits from identifying whether the size of the difference between the prices of the two contracts will increase or decrease. The applications of financial derivatives can be enumerated as follows: • Management of risk: This is most important function of derivatives. Risk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. It requires a thorough understanding of the basic principles that regulate the pricing of financial derivatives. Effective use of derivatives can save cost, and it can increase returns for the organisations. • Efficiency in trading:
Financial derivatives allow for free trading of risk
components and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in the underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives as well as the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instrument in cash market. • Speculation: This is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can leads to financial destruction in an organisation like what happened in Barings Plc. However, these instruments act as a powerful instrument for knowledgeable traders to expose themselves to calculated and well understood risks in search of a reward, that is, profit.
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• Price discover: Another important application of derivatives is the price discovery which means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking. • Price stabilization function: Derivative market helps to keep a stabilising influence on spot prices by reducing the short-term fluctuations. In other words, derivative reduces both peak and depths and leads to price stabilisation effect in the cash market for underlying asset. The liberalization process that has opened Indian market to overseas investors has fuelled interest among the regulators for introduction of risk management tools. By observing the varied applications of financial derivatives; the Indian financial market woke up to the new generation of financial instruments and currently the following contracts are allowed for trading in Indian markets: Figure- 3.7 Derivatives Contracts permitted for trading in India
The emergence and growth of market for derivative instruments can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. 113
Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities. The last decade, beginning the year 2000, saw lifting of ban on futures trading in many commodities. Around the same period, national electronic commodity exchanges were also set up. Financial Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Table-3.7 Derivatives in India: A chronology December 14, 1995
NSE asked SEBI for permission to trade index futures
November 18, 1996
L.C. Gupta Committee set up to draft a policy framework for introducing derivatives
May 11, 1998
L.C. Gupta committee submits its report on the policy framework
May 25, 2000
SEBI allows exchanges to trade in index futures
June 12, 2000
Trading on Nifty futures commences on the NSE
June 4, 2001
Trading for Nifty options commences o n the NSE
July 2, 2001
Trading on Stock options commences on the NSE
November 9, 2001
Trading on Stock futures commences on the NSE
August 29, 2008
Currency derivatives trading commences on the NSE
August 31, 2009
Interest rate derivatives trading commences on NSE
Source: NSE Publications Initially, SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index114
based trading was permitted in options as well as individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue. Table 3.7 exhibits chronology of introduction of derivatives in India. As mentioned in the preceding discussion, derivatives trading commenced in Indian market in 2000 with the introduction of Index futures at BSE, and subsequently, on National Stock Exchange (NSE). Since then, derivatives market in India has witnessed tremendous growth in terms of trading value and number of traded contracts. The BSE created history on June 9, 2000 when it launched trading in Sensex based futures contract for the first time. It was followed by trading in index options on June 1, 2001; in stock options and single stock futures (31 stocks) on July 9, 2001 and November 9, 2002, respectively. Currently, the number of stocks under single futures and options is 1096. Table-3.8 Products traded on derivative segment of BSE Sl. No.
Product Traded with underlying asset
Introduction Date
1 2 3 4 5 6 7
Index Futures- Sensex Index Options- Sensex Stock Option on 109 Stocks Stock futures on 109 Stocks Weekly Option on 4 Stocks Chhota (mini) SENSEX Currency Futures on US Dollar Rupee
June 9 2000 June 1,2001 July 9, 2001 November 9 2002 September 13,2004 January 1, 2008 October 1,2008
Source: Compiled from BSE website
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BSE achieved another milestone on September 13, 2004 when it launched Weekly Options, a unique product unparalleled worldwide in the derivatives markets. It permitted trading in the stocks of four leading companies namely; Satyam, State Bank of India, Reliance Industries and TISCO (renamed now Tata Steel). Chhota (mini) SENSEX was launched on January 1, 2008. With a small or 'mini' market lot of 5, it allows for comparatively lower capital outlay, lower trading costs, more precise hedging and flexible trading. Currency futures were introduced on October 1, 2008 to enable participants to hedge their currency risks through trading in the U.S. dollarrupee future platforms. The derivative products and their date of introduction on the BSE is summerised in the Table 3.8: NSE started trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as its first derivatives product. Trading on index options was introduced on June 4, 2001. Futures on individual securities started on November 9, 2001. The futures contract is available on 233 securities as stipulated by SEBI. Table 3.9 Products traded on F&O Segment of NSE Sl. No.
Product Traded with Underlying asset
1
Index Futures- S&P CNX NIFTY
June 12, 2000
2
Index Options- S&P CNX NIFTY
June 4, 2001
3
Stock Option on 233 Stocks
July 2, 2001
4
Stock futures on 233 Stocks
November 9, 2001
5
Interest Rate Futures- T – Bills and 10 Years Bond
June 23,2003
6
CNX IT Futures & Options
August 29,2003
7
Bank Nifty Futures & Options
June 13,2005
8
CNX Nifty Junior Futures & Options
June 1,2007
9
CNX 100 Futures & Options
June 1,2007
10
Nifty Midcap 50 Futures & Options
October 5, 2007
11
Mini index Futures & Options - S&P CNX Nifty index
January 1, 2008
12
Long Term Option contracts on S&P CNX Nifty Index
March 3,2008
13
Currency Futures on US Dollar Rupee
August 29,2008
14
S& P CNX Defty Futures & Options
December 10, 2008
Source: NSE website
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Introduction Date
Trading in options on individual securities commenced from July 2, 2001. The options contracts are American style and cash settled and are available on 233 securities. Trading in interest rate futures was introduced on 24 June 2003 but it was closed subsequently due to pricing problem. The NSE achieved another landmark in product introduction by launching Mini Index Futures & Options with a minimum contract size of Rs 1 lac. NSE crated history by launching currency futures contract on US Dollar-Rupee on August 29, 2008 in Indian Derivatives market. Table 2.9 presents a description of the types of products traded at F& O segment of NSE. Among all the products traded on NSE in F& O segment Index derivatives has registered an "explosive growth". Index derivative especially S&P CNX Nifty future has been accepted by the traders as a most prominent instrument in risk management. In this respect it is ideal to explain the brief details about this contract. 3.6 STOCK INDEX FUTURES Stock index future is an index derivative that draws its value from an underlying index like Nifty or Sensex. This type of derivative contract was first pioneered by Kansas City Board of Trade on 24th February, 1982 and the contract was based on Value Line composite Index. Subsequently CME introduced trading in S&P 500 index futures in April 1982 and this was followed by New York futures exchanges contract on NYSE composite Index. Consequent upon their successful trading on the US exchanges, many other exchanges worldwide launched equity index futures (Table-3.10). In India NSE started trading on index futures whose value is derived from the underlying index Nifty. This contract is called as FUTIDX. Table 3.10 Major stock index futures Contracts Stock Exchange
Index Futures contract
Chicago Mercantile Exchange
S&P 100
Korea Stock Exchange
KOSPI 200
Toronto Futures exchange
TSE 300
London Futures exchange
FTSE 100
National Stock Exchange of India
S&P CNX NIFTY
Hong Kong Futures Exchange
Hang Seng
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Index Futures Contract Specifications As a matter of fact the stock index futures contracts are cash settled i.e. the traders are required to settle the contract by taking an offsetting position in the market. Operationally stock index futures contract is an agreement to pay or receive fixed rupee amount times the difference between the index level when the position resulting gains and losses will be paid/received in cash. The monetary value of the index future is obtained by multiplying the underlying index value by some rupee amount. In case of Nifty contract, the multiplier is Rs.200 and for Sensex it is Rs.50. The value of the multiplier is set by the exchange which is guided by the SEBI’s directive and should have a minimum value of Rs. 2,00,000 and accordingly NSE and BSE arrived at those multipliers: Table-3.11 Contract Specification: Index Futures BSE
NSE
Underlying
SENSEX
NIFTY
Contract Multiplier
50
200
Trading Cycle
The near month (one), the next The near month (one), the next month (two) and the far month month (two) and the far month (three). (three).
Tick size
0.05 index points
0.05 index points
Price Quotation
Index Points
Index Points
Last trading/Expiration day
Last Thursday of the contract month. If it is a holiday, the immediately preceding business day.
Last Thursday of the contract month. If it is a holiday, the immediately preceding business day.
Final settlement
Cash settlement. On the last trading Final settlement price shall be day, the closing value of the the closing value of the Nifty underlying index would be the final on the last trading day. settlement price of the expiring futures contract.
Source: Respective websites: www.nseindia.com and www.bseindia.com Within a short span of time financial derivatives market in India has shown a
remarkable growth both in terms of volumes and numbers of contracts traded. NSE
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alone accounts for 99 percent of the derivatives trading in Indian markets. The reasons for such demand in the Index futures can be as follows: a) Index futures are cash settled; b) These are highly liquid since index futures are exchange traded and the investor can offset his position on any day prior to the expiration day; c) The performance of all index futures contract are guaranteed by the exchange’s clearing house; d) It carries margin requirements which ensure that the risk is limited to the previous day’s price movement on each outstanding position. Table-3.12: Turnover of Derivatives in NSE & BSE (Rs. Cr.)
Year 2000-01
NSE
BSE
90580
1673
2001-02
1025588
1922
2002-03
2126763
2478
2003-04
17191668
12452
2004-05
21635449
16112
2005-06
58537886
9
2006-07
81487424
59006
2007-08
156598579
242309
2008-09
210428103
12266
2009-10
178306889
234.13
Source: Compiled from NSE Fact Book The Figure-3.9 exhibits that although BSE and NSE started trading with similar derivative products in the year 2000, they were initially at par with each other generating 50% of the volume traded. Subsequently however, concentration built up on the NSE and the BSE lost heavily and today NSE attracts most of the volume in equity derivatives. The reason for higher trading volume in Nifty futures is because of the impact cost and liquidity differentials. 119
Fig gure 3.8 Com mparisons between b Tuurnovers of BSE and NSE N
P Provision off liquidity is i one of thhe major fuunctions of a stock exxchange. Thhe term liquuidity pertaains to transsaction costts. A more liquid l markket is one inn which largge transactiions can bee undertaken n while sufffering low transactionn costs. Onne element oof liquidity y can be eassily observeed on the eelectronic liimit order bbook markeet: this is thhe ‘impact cost’ suffeered when placing market m orderrs. In the ccase of thee derivativees c haave a transsaction sizee of roughlyy Rs.200,000, a casuaal market, since all contracts o the Futuures contraccts average daily contract volumee and turnov ver is usefuul, perusal of and full--fledged anaalysis of thee order boook is not esssential in obbtaining liqu uidity. Inn the futurees markets, there is noo assurance that a liquiid market may m exist foor offsettinng a contracct at all tim mes. Some future f contrracts and sppecific delivery monthhs tend to have h increaasingly morre trading activity a and d have higheer liquidity y than otherrs. NSE’s trading t voluume is mucch more ahhead from that t of the BSE leadin ng to higheer liquidity y and more investor’s confidence. c W When comp paring tradinng opportunnities offereed by stockk index futuures, anotheer considerration is liq quidity. Thee liquidity oof a contracct is relatedd to the cosst of tradingg, and direectly affectts the profiitability of a futures trade. t Twoo indicatorss of contracct liquidity y are average daily coontract voluume and average a dailly notionall turnover in i Rupees. The stockk index futu ures contraccts examineed after its inception are a displayeed urnover in INR. I Basedd on statisticcs in Tablee 3.13 accorrding to aveerage daily notional tu in Tablee 3.13, it can be inferrred that N Nifty futuress had an avverage dailyy volume of o 120
338050 contracts over 11 years, and an average daily notional turnover of approximately Rs.8004 Crs. These statistics are indicative of the liquidity of the Nifty futures contracts in India. Table-3.13: NSE F&O Segment Turnover (Rs. Cr.) and Volume Index Futures Year
Index Futures
2010-11
4356754.53
2009-10
3934388.67
Avg. Daily Turnover
(No. Of
Avg. daily Trading Volume
contracts)
18153.14
165023653
687598.6
16393.29
178306889
742945.4
2008-09
3583617.92
14875.46
210428103
876783.8
2007-08
3820667.27
15919.45
156598579
652494.1
2006-07
2539574
10581.56
81487424
339530.9
2005-06
1513755
6307.313
58537886
243907.9
2004-05
772147
3217.279
21635449
90147.7
2003-04
554446
2310.192
17191668
71631.95
2002-03
43952
183.1333
2126763
8861.513
2001-02
21483
89.5125
1025588
4273.283
2000-01
2365
9.854167
90580
377.4167
Source: Compiled from NSE Website
From the above discussion it can be inferred that National Stock Exchange plays a dominant role in the F&O segment. The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038 Cr. If we compare the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories single stock futures also known as equity futures, are most popular in terms of volumes and number of contract traded,
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followed by index futures with turnover shares of 52 percent and 31 percent, respectively. Table-3.14 Share of each NSE Derivative contract to total turnover (%)
Year
Index Futures
Index Options
Sock Futures
Stock Options
Total
2010-11
14.89579
62.79139
18.79005
3.522759
100
2009-10
22.27391
45.44903
29.41205
2.865007
100
2008-09
46.83919
30.8319
33.44528
1.953998
100
2007-08
29.18661
10.40536
57.66454
2.743495
100
2006-07
34.52271
10.76509
52.07777
2.634429
100
2005-06
31.37853
7.016103
57.86891
3.736453
100
2004-05
30.31615
4.787745
58.26724
6.628865
100
2003-04
26.02288
2.478914
61.29414
10.19459
100
2002-03
9.992225
2.102023
65.14157
22.76419
100
2001-02
21.07706
3.693856
50.54157
24.68752
100
2000-01
100
---
---
--
100
Among the equity derivatives that are being allowed to be traded on NSE are the Index futures, index options, stock futures, and stock options. The comparative study of the ratio of each contracts turnover to the total turnover in the NSE’s F&O segment is given in the Table 3.14 and Figure 3.9. Figure-3.9 Growth of Individual derivative contracts 120 100 80 60 40 20 0
Index futures Stock futures index options Stock otions
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The above result exhibits a significant share of stock index futures turnover to total turnover. But in NSE there are sectoral index futures like CNX IT, BANKEX etc. is also being traded which is included in the above data. Figure 3.10 will enlighten the S&P CNX Nifty’s share in the total volume of index futures trading: Fig. 3.10 Volume of Each Index Futures Traded at NSE
Source: NSE Fact Book 2011 (For 05 Years)
In NSE there are different Index futures contracts are being traded having different underlying asset like, CNX IT, BANKNIFTY etc. If we look at the percentage of volume of trading of different Index futures contract as exhibited in the Fig. 3.10, it is obvious that S&P CNX NIFTY outperforms other contracts in general. Thus this particular analysis attenuates the need for analyzing CNX Nifty futures contract to know its relationship with respect to the Nifty as regards to market efficiency, market volatility and a causal relationship over a sample period of 10 years will enlighten some stylized facts which are previously not being studied by undertaking a large sample data. 3.7 TO SUM UP The capital market is the barometer of any country’s economy and provides a mechanism for capital formation. Across the world there was a transformation in the financial intermediation from a credit based financial system to a capital market based system which was partly due to a shift in financial policies from financial repression (credit controls and other modes of primary sector promotion) to financial liberalization. This led to an increasing significance of capital markets in the 123
allocation of financial resources. Secondly one of the most profound and far-reaching financial phenomenon in the late twentieth century and the forepart of this century is the explosive growth in international financial transactions and capital flows among various financial markets in developed and developing countries. This phenomenon in international finance is result of the liberalization of capital markets in developed and developing countries. Indian capital market is no way an exception to this direction and embraced the transition from a closed to an open capital market. The Indian stock market is one of the earliest in Asia being in operation since 1875, but remained largely outside the global integration process until the late 1980s. A number of developing countries in concert with the International Finance Corporation and the World Bank took steps in the 1980s to establish and revitalize their stock markets as an effective way of mobilizing and allocation of finance. In line with the global trend, reform of the Indian stock market began with the establishment of Securities and Exchange Board of India in 1988. The Indian capital market went through a major transformation after 1992 and the Sensex hovering around the 10000 mark by the end of the year 2005, which seemed a dream just a few years back, although the beginning of such an initiative could be seen since the second half of 1980’s. Since then the market has been growing in leaps and bounds and has aroused the interests of the investors. The reason for such a development was an increasing uncertainty caused due to liberalization and standardization of the prudential requirements of the banking sector for global integration of the Indian financial system. Further, rise in their non-performing assets led to a decrease in credit from banks to the commercial sector. Liberalization and opening of the gates led to an expansion of three broad channels of financing the private sector namely, Domestic capital market, International capital market (American depository receipts and Global depository receipts) and Foreign direct investment. All these channels of financing has brought about complex financial instruments with different variety, which is a result of the increasing relativity of the developing and developed economies as developing countries become more integrated in international flows of trade and payments. 124
More freedom in the moving of capital flows improves the allocation of capital globally, allowing resources to move to areas with higher rates of return. Contrarily, attempts to restrict capital flows lead to distortions of capital structure that are generally costly to the economies imposing the controls. Thus, the boost in international capital flows and financial transaction is an underway and, to certain extent, irreversible process. In terms of the growth of derivatives markets, and the variety of derivatives users, the Indian market has equaled or exceeded many other regional markets. The variety of derivatives instruments available for trading is expanding. The spectacular growth and success in index futures can be attributable to several reasons. One of the reasons for such success is the liquidity. Since liquidity is a function of the interest of market participants in a product, stock index futures appeal to a large set of market participants including hedgers, speculators and arbitrageurs made it a successful derivative contract. There remain major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures show that almost 90% of activity is due to stock futures or index futures, whereas trading in options is limited to a few stocks, partly because they are settled in cash and not the underlying stocks. Exchange-traded derivatives based on interest rates and currencies are virtually absent. Liquidity and transparency are important properties of any developed market. Liquid markets require market makers who are willing to buy and sell, and be patient while doing so. In India, market making is primarily the province of Indian private and foreign banks, with public sector banks lagging in this area (FitchRatings, 2004). A lack of market liquidity may be responsible for inadequate trading in some markets. Transparency is achieved partly through financial disclosure. Financial statements currently provide misleading information on institutions’ use of derivatives. Further, there is no consistent method of accounting for gains and losses from derivatives trading. Thus, a proper framework to account for derivatives needs to be developed. Further regulatory reform will help the markets grow faster. For 125
example, Indian commodity derivatives have great growth potential but government policies have resulted in the underlying spot/physical market being fragmented (e.g. due to lack of free movement of commodities and differential taxation within India). Similarly, credit derivatives, the fastest growing segment of the market globally, are absent in India and require regulatory action if they are to develop. As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programmes to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading. Because of the strong demand for derivative products, the popular contracts like Foreign Currency Futures, Long term Equity Options, Credit Derivatives, Structured products and exotic derivatives etc. are awaiting their turn in the Indian markets. In this regard NSE as well as the regulatory body and government should work collectively for making these contracts popular in Indian market.
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