BOMBAY, 21 June 2004 — The Indian capital market has indeed made a lot of progress over the last 2-3 years. It has now become more in line with the global markets. From being just a mere equity trading exchange, the Indian bourses now also do derivatives trading, having replaced the age-old technique of badla trading.

Derivatives trading is much better today than what it was when introduced but it still has miles to go. Investors still seem wary of getting into derivatives trading. The most often heard complaint is that they have not been able to grasp what derivatives trading is a actually all about.

So in a bid to make derivatives trading more easy to comprehend, here is a short “lesson” on what derivatives trading is all about.

First and foremost, the basics - what exactly is meant by derivatives trading? A derivative is an instrument whose value is derived from the value of one or more underlying asset, which can be commodities, precious metals, currency, bonds, stocks, indices, etc.

We also hear the term “futures” and “options” mentioned all the while. So is that different from derivatives trading. Actually, forwards, futures, options and swaps are the four most common examples of derivative instruments. Derivatives trading was introduced to allow the investors manage the risks in financial transactions more efficiently by unbundling the risks and allowing either hedging or taking only one risk at a time

Futures’ trading was launched on the BSE on June 9, 2000, and on the NSE on June 12, 2000. Though volumes are very low it is expected to take-off in the long term.

Earlier, the BSE allowed futures and options (F&O) trading only in 31 securities and from Feb 27, it was extended to 13 additional stocks. The new scrips on which F&O trading will be available are BSES, Cipla, GAIL (India), Grasim Industries, Gujarat Ambuja Cements, Hindalco Industries, IOC, Mahindra & Mahindra, Nalco, ONGC, Oriental Bank of Commerce, Shipping Corporation of India and Tata Power.

The BSE also revised the list of securities in its A and B1 group of the cash segment from March 1. Thirteen scrips have been shifted from B1 to A group and 11 scrips have been shifted from A group to B1. After the current revision, the total number of scrips in A and B1 group would be 200 and 751, respectively.

The scrips moving to A group are: Allahabad Bank, Alok Industries, Birla Corporation, CESC, FDC, Gujarat Industries Power Company, Indo Gulf Corporation, Ispat Industries, Maharashtra Seamless, Mangalore Refinery and Petrochemicals, Orchid Chemicals Pharmaceuticals, Welspun Gujarat Stahl Rohren and Wyeth Lederle.

The scrips removed from A group are: Infotech Enterprises, Marico Industries, Mcdowell & Company, MRF, Silverline Industries, State Trading Corporation of India, Tamilnadu Petroproducts, Thomas Cook (India), Trent, Whirlpool and Himachal Futuristic Communication.

Futures are similar to forward contracts, it will be easier to understand futures if we understand what forward contracts are. A forward contract is a contract between two people who agree to buy/sell a specified quantity of a financial instrument/commodity at a certain price at a certain date in future. For example, Mr. X and Mr. Y. Mr. X is a wholesale sugar dealer and Mr. Y is the prospective buyer. Mr. Y agrees to buy 30kg of sugar at Rs. 15 per kg after three months. The price is arrived at on the basis of prevailing market conditions and future perceptions about the price of sugar.

If after three months, the market price of sugar is Rs. 20 per kg, then Mr. Y is a gainer and if the price of sugar is Rs. 10 per kg, then Mr. X is a gainer.

So then the question arises: how are futures different from forward contracts? The basic difference is that while forward contracts are customized, futures contracts are standardized.

Options, on the other hand are very different from futures. As the word suggests, option is a contract that gives you an option, but not the obligation to buy or sell something. Unlike futures, there is an option writer (seller of the contract) who initiates the contract. The biggest differentiating fact is that the investor has the option not to honor his commitment to buy or sell the index or stock. Trading in futures is similar to trading in individual scrips. It is done through a broker and is also screen based just as the cash market. But all the members who trade in cash market cannot trade in the derivatives market. It requires them to apply afresh for derivative trading. Currently more than 150 members of the BSE are trading in futures.