What is a "spot transaction"?

In a spot market, transactions are settled �on the spot�. Once a trade is agreed upon, the settlement � i.e. the actual exchange of money for goods � takes place with the minimum possible delay. When a person selects a shirt in a shop and agrees on a price, the settlement (exchange of funds for goods) takes place immediately. That is a spot market

There are two real�world implementations of a spot market: rolling settlemen and real-time gross settlement (RTGS). With rolling settlement, trades are netted through one day, and settled x working days later; this is called T + x rolling settlement. For example, with T+5 rolling settlement, trades are netted through Monday, and the net open position as of Monday evening is settled on the coming Monday. Similarly, trades are netted through Tuesday, and settled on the coming Tuesday. With RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a close approximation, and RTGS is a true spot market. The equity market in India today, for the major part, is not a spot market. For example, the bulk of trading on NSE takes place with netting from Wednesday to Tuesday, and then settlement takes place five days later. This is not a spot market. The �international standard� in equity markets is T+3 rolling settlement.

One key motivation for derivatives is to enable the transfer of risk between individuals and firms in the economy. This can be viewed as being like insurance, with the difference that anyone in the economy (and not just insurance companies) would be able to sell insurance. A risk averse person buys insurance; a risk�seeking person sells insurance. On an options market, an investor who tries to protect himself against a drop in then index buys put options on the index, and a risk-taker sells him these options. One special motivation which drives some (but not all) trades is mutual insurance between two persons, both exposed to the same risk, in an opposite way. In the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This is a situation where both parties in the transaction seek to avoid risk. In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, this is a considerable gain. The largest derivatives markets in the world are on government bonds (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk).

The empirical evidence broadly suggests that market efficiency and liquidity on the spot market improve once derivatives trading comes about. Speculators generally prefer implementing their positions using derivatives rather than using a sequence of trades on the underlying spot market. Hence, access to derivatives increases the rate of return on information gathering, research and forecasting activities, and thus serves to spur investments into information gathering and forecasting. This helps improve market efficiency. From a market microstructure perspective, derivatives markets may reduce the extent to which informed speculators are found on the spot market, thus reducing the adverse selection on the spot market. Derivatives also help reduce the risks faced by liquidity providers on the spot market, by giving them avenues for hedging. These effects help improve liquidity on the spot market. A liquid derivatives market tends to become the focus of speculation and price discovery. When news breaks, the derivative market reacts first. The information propagates down to the cash market a short while later, through the activities of arbitrageurs.

Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because (a) the costs of taking or making delivery of wheat is avoided, and (b) funds are not blocked for the purpose of speculation.

Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a good�faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is �leverage of 20 times�. This example involves a forward market. More generally, all derivatives involve leverage. Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling leverage is equivalent to understanding and controlling derivatives.

A forward contract is a bilateral relationship between two people. Each requires good behaviour on the part of the other for the contract to perform as promised. Suppose L agrees to buy gold from S at a future date T at a (forward) price of Rs.5,000/tola. If, on date T, the gold spot price is at Rs.4,000/tola, then L loses Rs.1,000/tola and S gains Rs.1,000/tola by living up to the terms of the contract. When L buys at Rs.5,000/tola by the terms of the contract, he is paying Rs.1,000 more than what could be obtained on the spot market at the same time. Hence, L is tempted to declare bankruptcy and avoid performing as per the contract. Conversely, if on date T the gold spot price is at Rs.6,000/tola, then L gains and S loses by living up to the terms of the contract. S stands to sell gold at Rs.5,000/tola by the terms of the contract, which is Rs.1,000/tola worse than what could be obtained by selling into the spot market at date T. In this case, S is tempted to declare bankruptcy and avoid performing as per the contract. In either case, this leads to counterparty risk. When one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counterparty risk

A market has price�time priority if it gives a guarantee that every order will be matched against the best available price in the country, and that if two orders are equal in price, the one which came first will be matched first. Forward markets, which involve dealers talking to each other on phone, do not have price�time priority. Floor�based trading with open�outcry does not have price�time priority. Electronic exchanges with order matching, or markets with a monopoly market maker, have price�time priority. On markets without price�time priority, users suffer greater search costs, and there is a greater risk of fraud.

Futures markets feature a series of innovations in how trading is organised: _ Futures contracts trade at an exchange with price�time priority. All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. This harnesses the gains that are commonly obtained in going from a non�transparent club market (based on telephones) to an anonymous, electronic exchange which is open to participation. The anonymity of the exchange environment largely eliminates cartel formation. _ Futures contracts are standardised � all buyers or sellers are constrained to only choose from a small list of tradeable contracts defined by the exchange. This avoids the illiquidity that goes along with the unlimited customisation of forward contracts.

A new credit enhancement institution, the clearing corporation, eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This is called novation. This insulates each from the credit risk of the other. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk. Novation at the clearing corporation makes it possible to have safe trading between strangers. This is what enables large�scale participation into the futures market � in contrast with small clubs which trade by telephone � and makes futures markets liquid.

The forward or futures contracts discussed so far involved physical settlement. On 31 Dec 2001, the seller was supposed to come up with 100 tolas of gold and the buyer was supposed to pay for it. In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an inter�bank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use �cash settlement�. Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement. Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Dec 2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation organises a payment of Rs.3,000 from S and a payment of Rs.3,000 to L. This is called cash settlement. into many products where physical settlement was unviable

India�s �cash market� for equity is ostensibly a cash market, but it functions like a futures markets in every respect. NSE�s � EQ� market is a weekly futures market with tuesday expiration. The trading modalities on NSE from wednesday to tuesday, in trading ITC, are exactly those that would be seen if a futures market was running on ITC with tuesday expiration. On NSE, when a person buys on thursday, he is not obligated to do delivery and payment right away, and this buy position can be reversed on friday thus leaving no net obligations. Equity trading on NSE involves leverage of seven times. Like all futures markets, trading at the NSE is centralised and there is no counterparty risk owing to novation at the clearing corporation ( NSCC).

The only difference between ITC trading on NSE, and ITC trading on a true futures market, is that futures contracts with several different expiration dates would all trade at the same time on a true futures market; this is absent on India�s �cash market�.

Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from a futures: which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating �guaranteed return products�.

The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer �nonlinear payoffs� whereas futures only have �linear payoffs�. By combining futures and options, a wide variety of innovative and useful payoff structures can be created.

Security options are of limited interest because the pool of people who would be interested (say) in options on ACC is limited. In contrast, every single person with any involvement in the equity market is affected by index fluctuations. Hence risk- management using index derivatives is of far more importance than risk management using individual security options. This goes back to a basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the composition of the portfolio. All portfolios of around ten stocks or more have a pattern of risk where 70% or more of their risk is index related. Hence investors are more interested in using index�based derivative products. Index derivatives also present fewer regulatory headaches when compared to leveraged trading on individual stocks. Internationally, this has led to regulatory encouragement for index futures and discouragement against futures on individual stocks.

On futures markets, open positions as of the expiration date are normally supposed to turn into delivery by the seller and payment by the buyer. It is not feasible to deliver the market index. Hence open positions are squared off in cash on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date, the last mark to market margin is calculated with respect to the spot Nifty instead of the futures price.

Several issues play a role in terms of the choice of index.

Diversification: A stock market index should be well�diversified, thus ensuring that hedgers or speculators are not vulnerable to individual company� or industry�risk. This diversification is reflected in the Sharpe�s Ratio of the index

Liquidity of the index: The index should be easy to trade on the cash market. This is partly related to the choice of stocks in the index. High liquidity of index components implies that the information in the index is less noisy.

Liquidity of the market: Index traders have a strong incentive to trade on the market which supplies the prices used in index calculations. This market should feature high liquidity and be well designed in the sense of supplying operational conveniences suited to the needs of index traders.

Operational issues: The index should be regularly maintained, with a steady evolution of securities in the index to keep pace with changes in the economy. The calculations involved in the index should be accurate and reliable. When a stock trades at multiple venues, index computation should be done using prices from the most liquid market.

Nifty has a higher Sharpe�s ratio. Nifty is a more liquid index. Nifty is calculated using prices from the most liquid market (NSE). NSE has designed features of the trading system to suit the needs of index traders. Nifty is better maintained. Nifty is used by three index funds while the BSE Sensex is used by one.

The general principle is: you need hedging using index futures when your exposure to movements of Nifty is not what you would like it to be. If your index exposure is lower than what you like, you should buy index futures. If your index exposure is higher than what you like, you should sell index futures

A few situations are:

• You are a speculator about an individual stock or an industry.

• You have an equity portfolio and become uncomfortable about equity market risk for the near future.

• You expect to obtain funds at a known future date, but you would like to lock in on equity investments right now at present prices.

• You have underwritten an IPO and are vulnerable to losses if the market crashes and the IPO devolves on you.

• You are uncomfortable with the vulnerabilities of your business, where cashflows swing dramatically with movements of Nifty.