Equity derivatives in India: The state of the art
Susan Thomas1 and Ajay Shah
Equity derivatives trading started in India in June 2000, after a regulatory process which stretched over more than four years. In July 2001, the equity spot market moved to rolling settlement. Thus, in 2000 and 2001, the Indian equity market reached the logical conclusion of the reforms program which began in 1994. It is important to learn about the behaviour of the equity market in this new regime. India’s experience with the launch of equity derivatives market has been extremely positive, by world standards. NSE is now one of the prominent exchanges amongst all emerging markets, in terms of equity derivatives turnover. There is an increasing sense that the derivatives market is playing a major role in shaping price discovery. The goal of this paper is to convey a detailed sense of the functioning of the equity derivatives market, in order to convey the ‘state of the art’. We seek to convey some insights into what is going on with the equity derivaWe are grateful to Indian Quotation Systems for making available unique intra-day data for NSE, to Infotech Financials (http://www.infofin.com) for the use of a modiﬁed version of their ‘Chanakya’ program and Tirthankar C. Patnaik for data assistance. The views expressed in this paper are those of the authors and not their employers. 1
Equity Derivatives in India
tives market, and summarise broad empirical regularities about pricing and liquidity. Our treatment is organised around the following issues. We start with a treatment of some general issues about measurement in Section 1. The state of the art in terms of pricing, and the characteristics of futures and options prices are presented in Section 2. We examine the growth in liquidity in Section 3, and turn to problems of turnover in Section 4. Questions about market participants are examined in Section 5. We conclude in Section 7.
Problems of measurement
Many of the interesting quantities of interest in the derivatives markets unfold in realtime and require unprecedented care in terms of creating and handling data. This necessitates special care in processing data when doing measurement. Implied rates of return At any point in time, there can be an arbitrage transaction for a given underlying, such as buying on the spot and selling at the future date. To correctly measure the returns in arbitrage, we need to accurately utilise the offer price on the spot market and the bid price on the futures market. In the case of the spot market, we need to be sure that the offer price pertains to a transaction which is as big as one market lot on the futures market.2 Since bid and offer prices ﬂuctuate from moment to moment, it is important to utilise a ‘snapshot’ of both markets, at a certain point in time, in measuring the rates of return. Hence, sound measurement of the rates of return in arbitrage always pertain to a point in time, and seeks to accurately portray the returns that an arbitrageur would have obtained if the transaction had been initiated at that timepoint. If information from different timepoints for the spot and derivatives market is utilised, i.e. if the data is ‘nonsynchronous’, then misleading rates of return are obtained.3 2 The market lot on the spot market is 1 share and the ‘typical’ market lot on the derivatives market is Rs.200,000. Hence, the computation of the effective transaction price on the spot market requires computation of ‘impact cost’ for a transaction of Rs.200,000, using the limit order book of the spot market. 3 This also requires that the trading computers at the exchanges should all be highly synchronised. If the NSE trading computer for the spot market has a different clock than
Derivatives Markets in India: 2003
If the ofﬁcial closing prices on the spot and derivatives markets are utilised, then they yield extremely misleading information when it comes to computation of...