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Impact of Mutual Funds in Derivatives Markets Research Team | Posted On Wednesday, April 08,2009, 04:17 PM

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Impact of Mutual Funds in Derivatives Markets




Derivatives are a broadly misunderstood term. This word very often conjures up visions of speculative dealings, a big boom and a big crash. Bad news spreads fast. So also the Barings Bank collapse as well as Orange County an episode has helped strengthen the idea that derivative trading is nothing but reckless speculation.

Role of Mutual Funds in Derivatives Markets

But this perception is not true. If used carefully, a derivative transaction helps cover risks, which would arise on the trading of securities on which the derivative is based. A derivative security can be termed as a security whose value depends on the values of other underlying variables. Very frequently, the variables underlying the derivative securities are the prices of traded securities. A stock option, for instance, is a derivative security whose value is contingent upon the price of a stock. On the other hand, derivative securities can be contingent upon the price of almost any variable. For this cause, another name accorded to derivative securities are contingent claims.

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Need for a Derivatives Market

The derivatives market performs various numbers of economic functions. Such as they help

  • In transferring risks from risk averse people to risk oriented people
  • In the discovery of future as well as current prices
  • To catalyze entrepreneurial activity
  • the volume traded in markets because of participation of risk averse people in greater numbers
  • To increase savings and investment in the long run

Participants in a Derivatives Market

  • Hedgers use futures or options markets to minimize or eliminate the risk associated with price of an asset.
  • Speculators use futures and options contracts to get additional leverage in betting on future movements in the price of an asset. They can increase both the potential gains as well as potential losses by usage of derivatives in a speculative venture.
  • Arbitrageurs are in business to take benefit of a discrepancy between prices in two different markets. If, for instance, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

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Derivatives Markets in India:

Derivatives trading came to existences in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges they are NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To start with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by sanction for trading in options based on Nifty and Sensex indexes and also options on individual securities.

The trading in BSE Sensex options started on June 4, 2001 and the trading in options on individual securities commenced in July 2001. On November 2001, Futures contracts on individual stocks came into force. The derivatives trading on NSE started with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options began on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001.Single stock futures were came into existence on November 9, 2001. The index futures and options contract on NSE are purely based on S&P CNX.

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Trading and settlement in derivative contracts is exactly done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all kinds of Exchange traded derivative products.

The following are some interpretation based on the trading statistics provided in the NSE report on the futures and options (F&O) :

  • Single-stock futures continue to bank on for a considerable proportion of the F&O segment. It contained about 70 per cent of the total turnover during June 2002. A primary reason attributed to this incident is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.
  • On relative terms, volumes in the index options, segmentation continued to remain poor. This may be mainly due to the low volatility of the spot index. Usually, options are considered more valuable when the volatility of the underlying (in this case, the index) is almost high. A related issue is that brokers do not earn very high commissions by recommending index options to their clients, because very low volatility leads to higher waiting time for round-trips.
  • Put volumes in the index options and equity options segment have increased ever since January 2002. The call-put volumes in index options have decreased to small extent from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.
  • Past month futures contracts are still not vigorously traded. Trading in equity options on most of the stocks for even the next month was non-existent.

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