derivative market in india

7/31/2019 Derivative Market in India

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DERIVATIVE MARKET IN INDIA

1. INTRODUCTION TO DERIVATIVE

The origin of derivatives can be traced back to the need of farmers to protect

themselves against fluctuations in the price of their crop. From the time it was sown to

the time it was ready for harvest, farmers would face price uncertainty. Through the use

of simple derivative products, it was possible for the farmer to partially or fully transfer

price risks by locking-in asset prices. These were simple contracts developed to meet

the needs of farmers and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he would

receive for his harvest in September. In years of scarcity, he would probably obtain

attractive prices. However, during times of oversupply, he would have to dispose off his

harvest at a very low price. Clearly this meant that the farmer and his family were

exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too would

face a price risk that of having to pay exorbitant prices during dearth, although

favourable prices could be obtained during periods of oversupply. Under such

circumstances, it clearly made sense for the farmer and the merchant to come together

and enter into contract whereby the price of the grain to be delivered in September

could be decided earlier. What they would then negotiate happened to be futures-type

contract, which would enable both parties to eliminate the price risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers

and merchants together. A group of traders got together and created the to-arrive

contract that permitted farmers to lock into price upfront and deliver the grain later.

These to-arrive contracts proved useful as a device for hedging and speculation on


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price charges. These were eventually standardized, and in 1925 the first futures

clearing house came into existence.

Today derivatives contracts exist on variety of commodities such as corn,

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also exist

on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

2. DERIVATIVE DEFINED

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset can be

equity, forex, commodity or any other asset. In our earlier discussion, we saw that

wheat farmers may wish to sell their harvest at a future date to eliminate the risk of

change in price by that date. Such a transaction is an example of a derivative. The price

of this derivative is driven by the spot price of wheat which is the underlying in this

case.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures

contracts in commodities all over India. As per this the Forward Markets Commission

(FMC) continues to have jurisdiction over commodity futures contracts. However when

derivatives trading in securities was introduced in 2001, the term security in theSecurities Contracts (Regulation) Act, 1956 (SCRA), was amended to include derivative

contracts in securities. Consequently, regulation of derivatives came under the purview

of Securities Exchange Board of India (SEBI). We thus have separate regulatory

authorities for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of derivatives is

governed by the regulatory framework under the SCRA. The Securities Contracts

(Regulation) Act, 1956 defines derivative to include-

A security derived from a debt instrument, share, loan whether secured or unsecured,

risk instrument or contract differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of underlying

securities.


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HISTORY OF DERIVATIVES

The history of derivatives is quite colourful and surprisingly a lot longer than most

people think. Forward delivery contracts, stating what is to be delivered for a fixed priceat a specified place on a specified date, existed in ancient Greece and Rome. Roman

emperors entered forward contracts to provide the masses with their supply of Egyptian

grain. These contracts were also undertaken between farmers and merchants to

eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts

have existed for centuries for hedging price risk.

The first organized commodity exchange came into existence in the

early 1700s in Japan. The first formal commodities exchange, the Chicago Board of

Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and

to provide centralised location to negotiate forward contracts. From forward trading in

commodities emerged the commodity futures. The first type of futures contract was

called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT

listed the first exchange traded derivatives contract, known as the futures contracts.

Futures trading grew out of the need for hedging the price risk involved in many

commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT,

was formed in 1919, though it did exist before in 1874 under the names of Chicago

Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The first

financial futures to emerge were the currency in 1972 in the US. The first foreign

currency futures were traded on May 16, 1972, on International Monetary Market (IMM),

a division of CME. The currency futures traded on the IMM are the British Pound, the

Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian

Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures.

Interest rate futures contracts were traded for the first time on the CBOT on October 20,1975. Stock index futures and options emerged in 1982. The first stock index futures

contracts were traded on Kansas City Board of Trade on February 24, 1982.The first of

the several networks, which offered a trading link between two exchanges, was formed

between the Singapore International Monetary Exchange (SIMEX) and the CME on

September 7, 1984.


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Options are as old as futures. Their history also dates back to ancient Greece and

Rome. Options are very popular with speculators in the tulip craze of seventeenth

century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing

to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip

bulb options. There was so much speculation that people even mortgaged their homes

and businesses. These speculators were wiped out when the tulip craze collapsed in

1637 as there was no mechanism to guarantee the performance of the option terms.

The first call and put options were invented by an American financier,

Russell Sage, in 1872. These options were traded over the counter. Agricultural

commodities options were traded in the nineteenth century in England and the US.

Options on shares were available in the US on the over the counter (OTC) market only

until 1973 without much knowledge of valuation. A group of firms known as Put and Call

brokers and Dealers Association was set up in early 1900s to provide a mechanism for

bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange (CBOE) was

set up at CBOT for the purpose of trading stock options. It was in 1973 again that black,

Merton, and Scholes invented the famous Black-Scholes Option Formula. This model

helped in assessing the fair price of an option which led to an increased interest in

trading of options. With the options markets becoming increasingly popular, the

American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began

trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and nineties.

The collapse of the Bretton Woods regime of fixed parties and the introduction of

floating rates for currencies in the international financial markets paved the way for

development of a number of financial derivatives which served as effective risk

management tools to cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the world on which

futures contracts are traded. The CBOT now offers 48 futures and option contracts (with


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the annual volume at more than 211 million in 2001).The CBOE is the largest exchange

for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500

stock indices. The Philadelphia Stock Exchange is the premier exchange for trading

foreign options.

The most traded stock indices include S&P 500, the Dow Jones Industrial

Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade

almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.


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Derivatives

Future Option Forward Swaps

3. TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Bombay Stock National Commodity &Exchange Exchange Derivative Exchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

4. TYPES OF DERIVATIVES


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Figure.2 Types of Derivatives

(i) FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a

specified price. One of the parties to the contract assumes a long position and

agrees to buy the underlying asset on a certain specified future date for a certain

specified price. The other party assumes a short position and agrees to sell the

asset on the same date for the same price. Other contract details like delivery

date, price and quantity are negotiated bilaterally by the parties to the contract.

The forward contracts are no rma l l y traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to the same

counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing

transaction costs and increasing transactions volume. This process of

standardization reaches its limit in the organized futures market. Forward contracts

are often confused with futures contracts. The confusion is primarily because both

serve essentially the same economic funct ions of allocating risk in the presence

of future price uncertainty. However futures are a significant improvement over

the forward contracts as they eliminate counterparty risk and offer more

liquidity.


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(ii) FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange,

to buy or sell a certain underlying instrument at a certain date in the future, at a pre-set

price. The future date is called the delivery date or final settlement date. The pre-set

price is called the futures price. The price of the underlying asset on the delivery date is

called the settlement price. The settlement price, normally, converges towards the

futures price on the delivery date.

A futures contract gives the holder the right and the obligation to buy or sell, which

differs from an options contract, which gives the buyer the right, but not the obligation,

and the option writer (seller) the obligation, but not the right. To exit the commitment,the holder of a futures position has to sell his long position or buy back his short

position, effectively closing out the futures position and its contract obligations. Futures

contracts are exchange traded derivatives. The exchange acts as counterparty on all

contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:

Futures contracts ensure their liquidity by being highly standardized, usually by

specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a short

term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the

notional amount of bonds, a fixed number of barrels of oil, units of foreign

currency, the notional amount of the deposit over which the short term interest

rate is traded, etc.

The currency in which the futures contract is quoted.


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The gradeof the deliverable. In case of bonds, this specifies which bonds can be

delivered. In case of physical commodities, this specifies not only the quality of

the underlying goods but also the manner and location of delivery. The delivery

month.

The last trading date.

Other details such as the tick, the minimum permissible price fluctuation.

2. Margin:

Although the value of a contract at time of trading should be zero, its price constantly

fluctuates. This renders the owner liable to adverse changes in value, and creates a

credit risk to the exchange, who always acts as counterparty. To minimize this risk, the

exchange demands that contract owners post a form of collateral, commonly known asMargin requirements are waived or reduced in some cases for hedgers who have

physical ownership of the covered commodity or spread traders who have offsetting

contracts balancing the position.

Initial Margin: is paid by both buyer and seller. It represents the loss on that contract,

as determined by historical price changes, which is not likely to be exceeded on a usual

day's trading. It may be 5% or 10% of total contract price.

Mark to market Margin: Because a series of adverse price changes may exhaust the

initial margin, a further margin, usually called variation or maintenance margin, is

required by the exchange. This is calculated by the futures contract, i.e. agreeing on a

price at the end of each day, called the "settlement" or mark-to-market price of the

contract.

To understand the original practice, consider that a futures trader, when taking a

position, deposits money with the exchange, called a "margin". This is intended to

protect the exchange against loss. At the end of every trading day, the contract is

marked to its present market value. If the trader is on the winning side of a deal, his

contract has increased in value that day, and the exchange pays this profit into his

account. On the other hand, if he is on the losing side, the exchange will debit his

account. If he cannot pay, then the margin is used as the collateral from which the loss

is paid.


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3. Settlement

Settlement is the act of consummating the contract, and can be done in one of two

ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the contract is

delivered by the seller of the contract to the exchange, and by the exchange to the

buyers of the contract. In practice, it occurs only on a minority of contracts. Most are

cancelled out by purchasing a covering position - that is, buying a contract to cancel

out an earlier sale (covering a short), or selling a contract to liquidate an earlier

purchase (covering a long).

Cash settlement - a cash payment is made based on the underlying reference

rate, such as a short term interest rate index such as Euribor, or the closing value of

a stock market index. A futures contract might also opt to settle against an index

based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many equity

index and interest rate futures contracts, this happens on the Last Thursday of certain

trading month. On this day the t+2 futures contract becomes the t forward contract.


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FUTURES TERMINOLOGY

Spot price:

The price at which an asset trades in the spot market

.

Futures Price:

The price at which the futures contract trades in the futures market.

Contract cycle:

The period over which a contract trades. The index futures contracts on the NSE have

one-month and three-month expiry cycles whichexpire on the last Thursday of the

month. Thus a January expiration contract expires on the last Thursday of January and

a February expiration contract ceases trading on the last Thursday of February. On the

Friday following the last Thursday, a new contract having a three-month expiry is

introduced for trading.

Expiry date:

It is the date specified in the futures contract. This is the last day on which the contract

will be traded, at the end of which it will cease to exist.

Contract size:

The amount of asset that has to be delivered under one contract. For instance, the

contract size on NSEs futures markets is 200 Nifties.

Basis:

In the context of financial futures, basis can be defined as the futures price minus the

spot price. These will be a different basis for each delivery month for each contract. In a

normal market, basis will be positive. This reflects that futures prices normally exceed

spot prices.


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Cost of carry:

The relationship between futures prices and spot prices can be summarized in terms of

what is known as the cost of carry. This measures the storage cost plus the interest

that is paid to finance the asset less the income earned on the asset

Initial margin:

The amount that must be deposited in the margin account at the time a futures contract

is first entered into is known as initial margin.

Marking-to-market:

In the futures market, at the end of each trading day, the margin account is adjusted to

reflect the investors gain or loss depending upon the futures closing price. This is

called marking-to-market.

Maintenance margin:

This is some what lower than the initial margin. This is set to ensure that the balance in

the margin account never becomes negative. If the balance in the margin account falls

below the maintenance margin, the investor receives a margin call and is expected to

top up the margin account to the initial margin level before trading commences on the

next day.


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PRICING OF FUTURE CONTRACT

In a futures contract, for no arbitrage to be possible, the price paid on delivery (the

forward price) must be the same as the cost (including interest) of buying and storing

the asset. In other words, the rational forward price represents the expected future

value of the underlying discounted at the risk free rate. Thus, for a simple, non-dividend

paying asset, the value of the future/forward, , will be found by discounting the

present value at time to maturity by the rate of risk-free return .

This relationship may be modified for storage costs, dividends, dividend yields, and

convenience yields. Any deviation from this equality allows for arbitrage as follows.

In the case where the forward price is higher:1. The arbitrageur sells the futures contract and buys the underlying today (on the

spot market) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and receives the

agreed forward price.

3. He then repays the lender the borrowed amount plus interest.

4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today (on thespot market); he invests the proceeds.

2. On the delivery date, he cashes in the matured investment, which has

appreciated at the risk free rate.

3. He then receives the underlying and pays the agreed forward price using the

matured investment. [If he was short the underlying, he returns it now.]

4. The difference between the two amounts is the arbitrage profit.


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OPTIONS -

A derivative transaction that gives the option holder the right but not the obligation to

buy or sell the underlying asset at a price, called the strike price, during a period or on a

specific date in exchange for payment of a premium is known as option. Underlyingasset refers to any asset that is traded. The price at which the underlying is traded is

called the strike price.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying

asset-stock or any financial asset, at a specified price on or before a specified date is

known as a Call option. The owner makes a profit provided he sells at a higher current

price and buys at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying asset-

stock or any financial asset, at a specified price on or before a specified date is known

as a Put option. The owner makes a profit provided he buys at a lower current price

and sells at a higher future price. Hence, no option will be exercised if the future price

does not increase.

Put and calls are almost always written on equities, although occasionally preference

shares, bonds and warrants become the subject of options.


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On the basis of exercise of option:

On the basis of the exercise of the Option, the options are classified into two

Categories.

American Option:

American options are options that can be exercised at any time up to the expiration

date. Most exchangetraded options are American.

European Option:

European options are options that can be exercised only on the expiration date itself.

European options are easier to analyze than American options, and properties of an

American option are frequently deduced from those of its European counterpart.


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SWAPS -

Swaps are transactions which obligates the two parties to the contract to exchange a

series of cash flows at specified intervals known as payment or settlement dates. They

can be regarded as portfolios of forward's contracts. A contract whereby two parties

agree to exchange (swap) payments, based on some notional principle amount is called

as a SWAP. In case of swap, only the payment flows are exchanged and not the

principle amount. The two commonly used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his series

of fixed rate interest payments to a party in exchange for his variable rate interest

payments. The fixed rate payer takes a short position in the forward contract whereas

the floating rate payer takes a long position in the forward contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the interest

on loan in one currency are swapped for the principle and the interest payments on loan

in another currency. The parties to the swap contract of currency generally hail from two

different countries. This arrangement allows the counter parties to borrow easily and

cheaply in their home currencies. Under a currency swap, cash flows to be exchanged

are determined at the spot rate at a time when swap is done. Such cash flows are

supposed to remain unaffected by subsequent changes in the exchange rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to access one

market and then exchange the liability for another type of liability. It also allows the

investors to exchange one type of asset for another type of asset with a preferred

income stream.


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5. OTHER KINDS OF DERIVATIVES

The other kind of derivatives, which are not, much popular are as follows:

BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options are

most popular form of baskets.

LEAPS -

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years. These

long-term option contracts are popularly known as Leaps or Long term Equity

Anticipation Securities.

WARRANTS -

Options generally have lives of up to one year, the majority of options traded on options

exchanges having a maximum maturity of nine months. Longer-dated options are called

warrants and are generally traded over-the-counter.

SWAPTIONS -

Swaptions are options to buy or sell a swap that will become operative at the expiry of

the options. Thus a swaption is an option on a forward swap. Rather than have calls

and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver

swaption is an option to receive fixed and pay floating. A payer swaption is an option to

pay fixed and receive floating.


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PARTICIPANTS IN THE DERRIVATIVES MARKETS

The following three broad categories of participants:

HEDGERS:

Hedgers face risk associated with the price of an asset. They use futures or options

markets to reduce or eliminate this risk.

SPECULATORS:

Speculators wish to bet on future movements in the price of an asset. Futures and

options contracts can give them an extra leverage; that is, they can increase both the

potential gains and potential losses in a speculative venture.

ARBITRAGEURS:

Arbitrageurs are in business to take advantage of a discrepancy between prices in two

different markets. If, for example they see the futures prices 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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DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational

Mechanism

Traded directly between

two parties (not traded on

the exchanges).

Traded on the exchanges.

Contract

Specifications

Differ from trade to trade. Contracts are standardized

contracts.

Counter-party

risk

Exists. Exists. However, assumed by the

clearing corp., which becomes the

counter party to all the trades or

unconditionally guarantees their

settlement.

Liquidation

Profile

Low, as contracts are

tailor made contracts

catering to the needs of

the needs of the parties.

High, as contracts are standardized

exchange traded contracts.

Price discovery Not efficient, as markets

are scattered.

Efficient, as markets are centralized

and all buyers and sellers come to a

common platform to discover the

price.

Examples Currency market in India. Commodities, futures, Index Futures

and Individual stock Futures in India.


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REGULATORY FRAMEWORK :

The trading of derivatives is governed by the provisions contained in the SC(R) A,

the SEBI Act, the rules and regulations framed there under and the rules and bye-laws

of stock exchanges.

In this chapter we look at the broad regulatory framework for derivatives trading and

the requirement to become a member and an authorized dealer of the F&O segment

and the position limits as they apply to various participants.

Regulation for derivatives trading:

SEBI set up a 24-members committeeunder the Chairmanship ofDr.L.C.GUPTA

to develop the appropriate regulatory framework for derivatives trading in India. On

May 11, 1998 SEBI accepted the recommendations of the committee and approved the

phased introduction of derivatives trading in India beginning with stock index futures.

The provision in the SC(R) A and the regulatory framework developed there under

govern trading in securities. The amendment of the SC(R) A to include derivatives

within the ambit of securities in the SC(R) A made trading in derivatives possible within

the framework of that Act.

Any Exchange fulfilling the eligibility criteria as prescribed in the L.C.Gupta

committee report can apply to SEBI for grant of recognition under Section 4

of the SC(R) A, 1956 to start trading derivatives. The derivatives

exchange/segment should have a separate governing council and

representation of trading/clearing members shall be limited to maximum of

40% of the total members of the governing council. The exchange would

have to regulate the sales practices of its members and would have to

obtain prior approval of SEBI before start of trading in any derivative

contract.


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The Exchange should have minimum 50 members.

The members of an existing segment of the exchange would not

automatically become the members of derivative segment. The members of

the derivative segment would need to fulfill the eligibility conditions as laid

down by the L.C.Gupta committee.

The clearing and settlement of derivatives trades would be through a SEBI

approved clearing corporation/house. Clearing corporations/houses

complying with the eligibility as laid down by the committee have to apply to

SEBI for grant of approval.

Derivatives brokers/dealers and clearing members are required to seek

registration from SEBI. This is in addition to their registration as brokers of

existing stock exchanges. The minimum net worth for clearing members of

the derivatives clearing corporation/house shall be Rs.300 Lakh. The net

worth of the member shall be computed as follows :

Capital + Free reserves

Less non-allowable assets viz.,

Fixed assets

Pledged securities

Members card Non-allowable securities ( unlisted securities)

Bad deliveries

Doubtful debts and advances

Prepaid expenses

Intangible assets

30 % marketable securities

The minimum contact value shall not be less than Rs.2 Lakh. Exchanges

have to submit details of the futures contract they propose to introduce.

The initial margin requirement, exposure limits linked to capital adequacy

and margin demands related to the risk of loss on the position will be

prescribed by SEBI / Exchanged from time to time.


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The L.C.Gupta committee report requires strict enforcement of Know your

customer rule and requires that every client shall be registered with the

derivatives broker. The members of the derivatives segment are also

required to make their clients aware of the risks involved in derivatives

trading by issuing to the clients the Risk Disclosure and obtain a copy of

the same duly signed by the clients.

The trading members are required to have qualified approved user and

sales person who have passed a certification programmed approved by

SEBI.

ELIGIBILITY OF ANY STOCK TO ENTER IN DERIVATIVES MARKET

Non Promoter holding ( free float capitalization ) not less than Rs. 750Crores from last 6 months

Daily Average Trading value not less than 5 Crores in last 6 Months

At least 90% of Trading days in last 6 months

Non Promoter Holding at least30%

BETA not more than 4 ( previous last 6 months )


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DESCRIPTION OF THE METHOD :-

The following are the steps involved in the study.

Selection of the scrip:-

The scrip selection is done on a random and the scrip selected is

OIL & NATURAL GAS CORPORATION LTD. The lot is 225. Profitability position of

the futures buyers and seller and also the option holder and option writers is studied.

Data Collection:-

The data of the ONGC Ltdhas been collected from thethe Economic

Times and theinternet. The data consist of the March Contract and period of Data

collection is from 23rd FEBRUARY 2007 - 29thMARCH 2007.

Analysis:-

The analysis consist of the tabulation of the data assessing the profitability Positions of

the futures buyers and sellers and also option holder and the option Writer, representing

the data with graphs and making the interpretation using Data.


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INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where prices

fluctuate every day. The introduction of risk management instruments in India gained

momentum in the last few years due to liberalisation process and Reserve Bank ofIndias (RBI) efforts in creating currency forward market. Derivatives are an integral part

of liberalisation process to manage risk. NSE gauging the market requirements initiated

the process of setting up derivative markets in India. In July 1999, derivatives trading

commenced in India

Table 2. Chronology of instruments

1991 Liberalisation process initiated

14 December 1995 NSE asked SEBI for permission to trade index futures.18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy

framework for index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an

Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index

futures trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September

2000

Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives


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(1) Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have become

the most important markets in the world. Today, derivatives have become part and

parcel of the day-to-day life for ordinary people in major part of the world.

Until the advent of NSE, the Indian capital market had no access to the latest trading

methods and was using traditional out-dated methods of trading. There was a huge gap

between the investors aspirations of the markets and the available means of trading.

The opening of Indian economy has precipitated the process of integration of Indias

financial markets with the international financial markets. Introduction of risk

management instruments in India has gained momentum in last few years thanks to

Reserve Bank of Indias efforts in allowing forward contracts, cross currency options etc.

which have developed into a very large market.

(2) Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have become

the most important markets in the world. Financial derivatives came into the spotlight

along with the rise in uncertainty of post-1970, when US announced an end to the

Bretton Woods System of fixed exchange rates leading to introduction of currency

derivatives followed by other innovations including stock index futures. Today,

derivatives have become part and parcel of the day-to-day life for ordinary people in

major parts of the world. While this is true for many countries, there are still

apprehensions about the introduction of derivatives. There are many myths about

derivatives but the realities that are different especially for Exchange traded derivatives,

which are well regulated with all the safety mechanisms in place.

What are these myths behind derivatives?

Derivatives increase speculation and do not serve any economic purpose

Indian Market is not ready for derivative trading Disasters prove that derivatives are very risky and highly leveraged instruments.

Derivatives are complex and exotic instruments that Indian investors will find

difficulty in understanding

Is the existing capital market safer than Derivatives?


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(i) Derivatives increase speculation and do not serve any

economicpurpose:

Numerous studies of derivatives activity have led to a broad consensus, both in the

private and public sectors that derivatives provide numerous and substantial benefits tothe users. Derivatives are a low-cost, effective method for users to hedge and manage

their exposures to interest rates, commodity prices or exchange rates. The need for

derivatives as hedging tool was felt first in the commodities market. Agricultural futures

and options helped farmers and processors hedge against commodity price risk. After

the fallout of Bretton wood agreement, the financial markets in the world started

undergoing radical changes. This period is marked by remarkable innovations in the

financial markets such as introduction of floating rates for the currencies, increased

trading in variety of derivatives instruments, on-line trading in the capital markets, etc.

As the complexity of instruments increased many folds, the accompanying risk factors

grew in gigantic proportions. This situation led to development derivatives as effective

risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional investors to

effectively manage their portfolios of assets and liabilities through instruments like stock

index futures and options. An equity fund, for example, can reduce its exposure to the

stock market quickly and at a relatively low cost without selling off part of its equity

assets by using stock index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks

and raising capital, derivatives improve the allocation of credit and the sharing of risk in

the global economy, lowering the cost of capital formation and stimulating economic

growth. Now that world markets for trade and finance have become more integrated,

derivatives have strengthened these important linkages between global markets,

increasing market liquidity and efficiency and facilitating the flow of trade and finance


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(ii) Indian Market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian capital

market is not ready for derivatives trading. Here, we look into the pre-requisites, which

are needed for the introduction of derivatives, and how Indian market fares:

TABLE 3.

PRE-REQUISITES INDIAN SCENARIO

Large marketCapitalisation

India is one of the largest market-capitalisedcountries in Asia with a market capitalisation ofmore than Rs.765000 crores.

High Liquidity in theunderlying

The daily average traded volume in Indian capitalmarket today is around 7500 crores. Which meanson an average every month 14% of the countrys

Market capitalisation gets traded. These are clearindicators of high liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing tradeshas become fully functional from July 1996 in theform of National Securities Clearing Corporation(NSCCL). NSCCL is responsible for guaranteeingall open positions on the National Stock Exchange(NSE) for which it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL)

which started functioning in the year 1997 hasrevolutionalised the security settlement in ourcountry.

A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital marketenjoys a strong, independent, and innovative legalguardian who is helping the market to evolve to ahealthier place for trade practices.

(3) Comparison of New System with Existing SystemMany people and brokers in India think that the new system of Futures & Options and

banning of Badla is disadvantageous and introduced early, but I feel that this new

system is very useful especially to retail investors. It increases the no of options

investors for investment. In fact it should have been introduced much before and NSE

had approved it but was not active because of politicization in SEBI.


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The figure 3.3a 3.3d shows how advantages of new system (implemented from June

20001) v/s the old system i.e. before June 2001

New System Vs Existing System for Market Players

Figure 3.3a

Speculators

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Deliver based 1) Both profit & 1)Buy &Sell stocks 1)MaximumTrading, margin loss to extent of on delivery basis loss possibletrading & carry price change. 2) Buy Call &Put to premiumforward transactions. by paying paid2) Buy Index Futures premiumhold till expiry.

Advantages

Greater Leverage as to pay only the premium.

Greater variety of strike price options at a given time.


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Figure 3.3b

Arbitrageurs

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Buying Stocks in 1) Make money 1) B Group more 1) Risk freeone and selling in whichever way promising as still game.another exchange. the Market moves. in weekly settlementforward transactions. 2) Cash &Carry2) If Future Contract arbitrage continuesmore or less than Fair price

Fair Price = Cash Price + Cost of Carry.

Figure 3.3c

Hedgers

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional

offload holding available risk latter by paying premium. cost is onlyduring adverse reward dependant 2)For Long, buy ATM Put premium.

market conditions on market prices Option. If market goes up,

as circuit filters long position benefit else

limit to curtail losses. exercise the option.

3)Sell deep OTM call optionwith underlying shares, earn

premium + profit with increase prcie

Advantages Availability of Leverage


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Figure 3.3d

Small Investors

Existing SYSTEM New

Approach Peril &Prize Approach Peril &Prize1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downside

stocks else sell it. implies unlimited based on market outlook remainsprofit/loss. 2) Hedge position if protected &

holding underlying upside

stock unlimited.

Advantages Losses Protected.


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4. Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few

years, which has accompanied the modernization of commercial and investment

banking and globalisation of financial activities. The recent developments in information

technology have contributed to a great extent to these developments. While both

exchange-traded and OTC derivative contracts offer many benefits, the former have

rigid structures compared to the latter. It has been widely discussed that the highly

leveraged institutions and their OTC derivative positions were the main cause of

turbulence in financial markets in 1998. These episodes of turbulence revealed the risks

posed to market stability originating in features of OTC derivative instruments and

markets.

The OTC derivatives markets have the following features compared to exchange-traded

derivatives:

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions,

2. There are no formal centralized limits on individual positions, leverage, or

margining,

3. There are no formal rules for risk and burden-sharing,4. There are no formal rules or mechanisms for ensuring market stability and

integrity, and for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the

exchanges self-regulatory organization, although they are affected indirectly by

national legal systems, banking supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial market

stability.

The following features of OTC derivatives markets can give rise to instability in

institutions, markets, and the international financial system: (i) the dynamic nature of

gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative


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activities on available aggregate credit; (iv) the high concentration of OTC derivative

activities in major institutions; and (v) the central role of OTC derivatives markets in the

global financial system. Instability arises when shocks, such as counter-party credit

events and sharp movements in asset prices that underlie derivative contracts, occur

which significantly alter the perceptions of current and potential future credit exposures.

When asset prices change rapidly, the size and configuration of counter-party

exposures can become unsustainably large and provoke a rapid unwinding of positions.

There has been some progress in addressing these risks and perceptions. However,

the progress has been limited in implementing reforms in risk management, including

counter-party, liquidity and operational risks, and OTC derivatives markets continue to

pose a threat to international financial stability. The problem is more acute as heavy

reliance on OTC derivatives creates the possibility of systemic financial events, which

fall outside the more formal clearing house structures. Moreover, those who provide

OTC derivative products, hedge their risks through the use of exchange traded

derivatives. In view of the inherent risks associated with OTC derivatives, and their

dependence on exchange traded derivatives, Indian law considers them illegal.


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5. FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the financial

theories.

A.} PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects having value

maybe commodities, local currency or foreign currencies. The concept of price is clear

to almost everybody when we discuss commodities. There is a price to be paid for the

purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of

another persons money is called interest rate. And the price one pays in ones own

currency for a unit of another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have

demand and producers or suppliers have supply, and the collective interaction of

demand and supply in the market determines the price. These factors are constantly

interacting in the market causing changes in the price over a short period of time. Such

changes in the price are known as price volatility. This has three factors: the speed of

price changes, the frequency of price changes and the magnitude of price changes.

The changes in demand and supply influencing factors culminate in market adjustments

through price changes. These price changes expose individuals, producing firms and

governments to significant risks. The break down of the BRETTON WOODS agreement

brought and end to the stabilising role of fixed exchange rates and the gold convertibility

of the dollars. The globalisation of the markets and rapid industrialisation of many

underdeveloped countries brought a new scale and dimension to the markets. Nations

that were poor suddenly became a major source of supply of goods. The Mexican crisis

in the south east-Asian currency crisis of 1990s has also brought the price volatility

factor on the surface. The advent of telecommunication and data processing bought


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information very quickly to the markets. Information which would have taken months to

impact the market earlier can now be obtained in matter of moments.

Even equity holders are exposed to price risk of corporate share fluctuates rapidly.

These price volatility risks pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against adverse

price changes in commodity, foreign exchange, equity shares and bonds.

B.} GLOBALISATION OF MARKETS

Earlier, managers had to deal with domestic economic concerns; what happened in

other part of the world was mostly irrelevant. Now globalisation has increased the size

of markets and as greatly enhanced competition .it has benefited consumers who

cannot obtain better quality goods at a lower cost. It has also exposed the modern

business to significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the

competitiveness of our products vis--vis depreciated currencies. Export of certain

goods from India declined because of this crisis. Steel industry in 1998 suffered its

worst set back due to cheap import of steel from south East Asian countries. Suddenly

blue chip companies had turned in to red. The fear of china devaluing its currency

created instability in Indian exports. Thus, it is evident that globalisation of industrial and

financial activities necessitates use of derivatives to guard against future losses. This

factor alone has contributed to the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES

A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed processors,

network systems and enhanced method of data entry. Closely related to advances in

computer technology are advances in telecommunications. Improvement in

communications allow for instantaneous worldwide conferencing, Data transmission by

satellite. At the same time there were significant advances in software programmes

without which computer and telecommunication advances would be meaningless.


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These facilitated the more rapid movement of information and consequently its

instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole

resources are rapidly relocated to more productive use and better rationed overtime the

greater price volatility exposes producers and consumers to greater price risk. The

effect of this risk can easily destroy a business which is otherwise well managed.

Derivatives can help a firm manage the price risk inherent in a market economy. To the

extent the technological developments increase volatility, derivatives and risk

management products become that much more important.

D.} ADVANCES IN FINANCIAL THEORIES

Advances in financial theories gave birth to derivatives. Initially forward contracts in its

traditional form, was the only hedging tool available. Option pricing models developed

by Black and Scholes in 1973 were used to determine prices of call and put options. In

late 1970s, work of Lewis Edeington extended the early work of Johnson and started

the hedging of financial price risks with financial futures. The work of economic theorists

gave rise to new products for risk management which led to the growth of derivatives in

financial markets.

The above factors in combination of lot many factors led to growth of derivatives

instruments


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ANALYSIS

The Objective of this analysis is to evaluate the profit/loss position futures and

options. This analysis is based on sample data taken of NTPC Scrip. This

analysis considered the JANUARYcontract ofNTPC. The lot Size of NTPC is

1625, the time period in which this analysis done is from 01-1-2009 to 18-2-2009.

Date Open High Low Close Qty

1-Jan-09 179.4 181.4 178.1 180.9 43441780

2-Jan-09 181.2 184.2 178.55 182.85 43378320

5-Jan-09 182.5 182.5 177.5 179.4 50263850

6-Jan-09 178.9 179 172.7 174.75 64962540

7-Jan-09 175.05 175.05 165.55 168.85 49464510

9-Jan-09 168.9 174.8 165.8 173.9 54847000

12-Jan-09 177.5 177.5 165 166.55 60508820

13-Jan-09 166.1 167 162 163.15 1.26E+08

14-Jan-09 164.15 166.3 161.85 164.7 4.37E+0815-Jan-09 162.25 164.45 160 160.8 2.05E+08

16-Jan-09 162 175.8 162 174.45 3.12E+08

19-Jan-09 174.25 175.5 172.4 174.1 1.46E+08

20-Jan-09 172.05 182.15 169.3 180.4 5.67E+08

21-Jan-09 178 181.1 173.4 174.95 1.07E+09

22-Jan-09 174.95 176.5 171.65 173.05 7.17E+08

23-Jan-09 172.1 173.45 167.45 170.55 1.13E+09

27-Jan-09 173.85 186.3 171.6 185.25 2.33E+09

28-Jan-09 185.9 188.8 183 187.35 2.06E+09

29-Jan-09 189.8 189.8 181.1 184.55 2.83E+09

30-Jan-09 183 188.9 182.2 188.05 2.58E+09

2-Feb-09 187 187 177.5 178.05 2.38E+093-Feb-09 179.8 181.4 174.3 175.95 3.67E+09

4-Feb-09 178.1 179.8 173.55 175.4 2.35E+09

5-Feb-09 176.25 176.7 173.25 175.8 1.52E+09

6-Feb-09 176.5 181.25 176.5 179.45 2.21E+09

9-Feb-09 180.1 182.9 177 182.4 2.29E+09

10-Feb-09 181.5 183.35 178.1 180.2 2.61E+09

11-Feb-09 178.5 182.5 177.4 180.5 1.87E+09

12-Feb-09 179.15 181.75 179.15 180 1.54E+09

13-Feb-09 181.45 184.6 180.9 182.75 2.12E+09

16-Feb-09 182.9 182.9 176.75 177.6 2.31E+09

17-Feb-09 177.25 177.25 172.75 173.4 2.01E+0918-Feb-09 171.6 176.55 171.55 175.75 15089750


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GRAPH ON PRICE MOVEMENTS OF NTPC FUTURES

FUTURE MARKET

BUYER SELLER

15/1/2009(buying) 162.25 162.25

17/2/2009 (Closing period) 177.25 177.25

Profit 15.00 Loss 15.00

Profit 15 x 1625= 24375, Loss 15 x 1625 = 24375

Because buyer future price will increase so, profit also increases, seller future price

also increase so, and he can get loss. Incase seller future will decrease, he can get

profit.

The closing price of NTPC at the end of the contract period is 177.25 and this is

considered as settlement price.

The following table explains the market price and premiums of calls.

The first column explains TRADING DATE.

Second column explains the SPOT MARKET PRICE in cash segmenton that date.

The fifth column explains the FUTURE MARKET PRICE in cashsegment on that date.

Open

140

150

160

170

180

190

200

1/1/20

09

1/8/20

09

1/15/200

9

1/22

/200

9

1/29

/200

9

2/5/20

09

2/12/200

9

Date

Future

prices

Open


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CALL PRICES

PRICES PRIMIUM

DATE SPOTPRICE FUTUREPRICE 140 150 160 170 175

20-Jan-09 176.1 185.95 45 21.45 11 13.75

21-Jan-09 182.7 179.95 * * * 15.55 *

22-Jan-09 182 178.55 * * * 12 *

23-Jan-09 178 179.85 * * 17.95 12 *

24-Jan-09 * * * * *

25-Jan-09 * * * * *

26-Jan-09 * * * * *

27-Jan-09 180.55 190.1 * 35 24 13.25 *

28-Jan-09 190.1 191.25 * * 28 22.8 *

29-Jan-09 189.9 190.25 * * * 20 *

30-Jan-09 187.4 189.65 49 34.75 28.9 18.25 *31-Jan-09 * * * * *

1-Feb-09 * * * * *

2-Feb-09 188.5 181.2 43 29 19.05 *

3-Feb-09 182 176.9 * * 22 16 *

4-Feb-09 177 176.85 * * 22.5 14 *

5-Feb-09 177 176.85 * * 18.85 11 7.2

6-Feb-09 180 180.35 * * * 12 9.6

7-Feb-09 * * * * *

8-Feb-09 * * * * *

9-Feb-09 182 182.95 * * 23 12.5 *

10-Feb-09 183.9 180.3 * * * 15.5 *

11-Feb-09 178.1 180.45 * * * 15 7.05

12-Feb-09 179 179.85 * * * 12.65 *

13-Feb-09 180.7 182.95 * * * 14.5 *

14-Feb-09 * * * * *

15-Feb-09 * * * * *

16-Feb-09 184.5 182.95 * * * 9.7 7.35

17-Feb-09 177.05 180.3 26 * 9 5

18-Feb-09 172 180.45 0 27 6.5 2.85


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OBSERVATIONS AND FINDINGS

CALL OPTION

BUYERS PAY OFF:

As brought 1 lot of NTPC that is 1625, those who buy for 170, paid 9.7premiums per share.

Settlement price is 184.50

Spot price 184.50

Strike price 170.00

Amount 14.50

Premium paid (-) 09.70

Net Profit 04.80 x 1625= 7800

Buyer Profit = Rs. 7800(Net Amount)

Because it is positive it is in the money contract, hence buyer will get more profit,

incase spot price increase buyer profit also increase.

SELLERS PAY OFF:

It is in the money for the buyer, so it is in out of the money for seller;

hence his loss is also increasing.

Strike price 170.00

Spot price 184.50

Amount -14.50

Premium Received 09.70

Loss - 04.80 x 1625 = -7800

Seller Loss = Rs. -7800(Loss)

Because it is negative it is out of the money, hence seller will get more loss,

incase spot price decrease in below strike price, seller get profit in premium level.


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PUT PRICES

PRICES PRIMIUM

DATE

SPOT

PRICE

FUTURE

PRICE 140 150 160 17020-Jan-09 176.1 185.95 1.45 3.45 * 10

21-Jan-09 182.7 179.95 1.9 3.45 4.8 7.5

22-Jan-09 182 178.55 1.05 3.85 5 9.55

23-Jan-09 178 179.85 1.55 4 6.9 9.5

24-Jan-09 * * *

25-Jan-09 * * *

26-Jan-09 * * *

27-Jan-09 180.55 190.1 1.6 3.15 4.35 7.5

28-Jan-09 190.1 191.25 1.5 2 3.15 4.25

29-Jan-09 189.9 190.25 1.2 2 2.8 4.3

30-Jan-09 187.4 189.65 1.05 1.35 3.1 4.7

31-Jan-09 * * *

1-Feb-09 * * *

2-Feb-09 188.5 181.2 0.95 1.8 2.55 3.55

3-Feb-09 182 176.9 1 1.6 2.5 4.8

4-Feb-09 177 176.85 1.05 1.35 3.45 4.95

5-Feb-09 177 176.85 1.05 1.9 3.3 5.4

6-Feb-09 180 180.35 0.7 1.2 2.1 3.6

7-Feb-09 * * *

8-Feb-09 * * *

9-Feb-09 182 182.95 0.45 0.8 1.6 3.8510-Feb-09 183.9 180.3 0.3 0.55 1.2 2.95

11-Feb-09 178.1 180.45 0.4 0.75 1.5 2.75

12-Feb-09 179 179.85 0.3 0.5 1.35 2.5

13-Feb-09 180.7 182.95 0.2 0.45 0.8 2

14-Feb-09 * * *

15-Feb-09 * * *

16-Feb-09 184.5 182.95 0.25 0.25 0.6 1.5

17-Feb-09 177.05 180.3 0.15 0.3 0.7 2.55

18-Feb-09 172 180.45 0.2 0.6 1.45 3.25

Table 4.7


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OBSERVATION AND FINDINGS

PUT OPTION

BUYERS PAY OFF:

Those who have purchase put option at a strike price of 170, the premiumpayable is 10

On the expiry date the spot market price enclosed at 172

Strike Price 170.00

Spot Price 172.00

Net pay off - 02.00 x 1625 = 3250

=====Already Premium paid 10

So, it can get loss is 3250

Because it is negative, out of the Moneycontract, Hence buyer gets more loss,

incase Spot price decrease in below strike price, buyer get profit in premium level.

SELLERS PAY OFF:

As Seller is entitled only for premium so, if he is in profit and also seller hasto borne total profit.

Spot price 172.00

Strike price 170.00

Net pay off 02.00 x 1625 = 3250

======

Already Premium received 10

So, it can get profit is 3250

Because it is positive, in the MoneyContract, Hence Seller gets more profit,incase Spot price decrease in below strike price Seller can get loss in premium

level.


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DATA OF NTPC - THE FUTURES AND OPTIONS OF THE JAN-FEB

MONTHS

DATE

SPOT

PRICE

FUTURE

PRICE20-Jan-09 176.1 185.95

21-Jan-09 182.7 179.95

22-Jan-09 182 178.55

23-Jan-09 178 179.85

24-Jan-09

25-Jan-09

26-Jan-09

27-Jan-09 180.55 190.1

28-Jan-09 190.1 191.25

29-Jan-09 189.9 190.25

30-Jan-09 187.4 189.65

31-Jan-09

1-Feb-09

2-Feb-09 188.5 181.2

3-Feb-09 182 176.9

4-Feb-09 177 176.85

5-Feb-09 177 176.85

6-Feb-09 180 180.35

7-Feb-09

8-Feb-09

9-Feb-09 182 182.9510-Feb-09 183.9 180.3

11-Feb-09 178.1 180.45

12-Feb-09 179 179.85

13-Feb-09 180.7 182.95

14-Feb-09

15-Feb-09

16-Feb-09 184.5 182.95

17-Feb-09 177.05 180.3

18-Feb-09 172 180.45


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OBSERVATIONS AND FINDINGS

The future price of ONGC is moving along with the market price.

If the buy price of the future is less than the settlement price, than the buyer

of a future gets profit.

If the selling price of the future is less than the settlement price, than the

seller incur losses.

GRAPH SHOWING PRICE MOVEMENTS OF SPOT

AND FUTURE

160165170175180185190195

1/20

/2009

1/22

/2009

1/24

/2009

1/26

/2009

1/28

/2009

1/30

/2009

2/1/20

09

2/3/20

09

2/5/20

09

2/7/20

09

2/9/20

09

2/11/2009

2/13/2009

2/15/2009

2/17/2009

CONTRACT DATES

prices

Series 1 Series 2


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DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of

the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on

options in securities. The market for derivatives, however, did not take off, as there was

no regulatory framework to govern trading of derivatives. SEBI set up a 24member

committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop

appropriate regulatory framework for derivatives trading in India. The committee

submitted its report on March 17, 1998 prescribing necessary preconditions for

introduction of derivatives trading in India. The committee recommended that

derivatives should be declared as securities so that regulatory framework applicable to

trading of securities could also govern trading of securities. SEBI also set up a group in

June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk

containment in derivatives market in India. The report, which was submitted in October

1998, worked out the operational details of margining system, methodology for charging

initial margins, broker net worth, deposit requirement and realtime monitoring

requirements. The Securities Contract Regulation Act (SCRA) was amended in

December 1999 to include derivatives within the ambit of securities and the regulatory

framework were developed for governing derivatives trading. The act also made it clearthat derivatives shall be legal and valid only if such contracts are traded on a recognized

stock exchange, thus precluding OTC derivatives. The government also rescinded in

March 2000, the three decade old notification, which prohibited forward trading in

securities. Derivatives trading commenced 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, NSE and BSE, and their clearing house/corporation to commence

trading and settlement in approved derivatives contracts. To begin with, SEBI approved

trading in index futures contracts based on S&P CNX Nifty and BSE30 (Sense) index.

This was followed by approval for trading in options based on these two indexes and

options on individual securities.


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Farther month futures contracts are still not actively traded. Trading in equity

options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as a less

risky alternative (read substitute) to generate profits from the stock price movements.

The fact that the option premiums tail intra-day stock prices is evidence to this. If calls

and puts are not looked as just substitutes for spot trading, the intra-day stock price

variations should not have a one-to-one impact on the option premiums.

The spot foreign exchange market remains the most important segment but

the derivative segment has also grown. In the derivative market foreign exchange

swaps account for the largest share of the total turnover of derivatives in India

followed by forwards and options. Significant milestones in the development of

derivatives market have been (i) permission to banks to undertake cross currency

derivative transactions subject to certain conditions (1996) (ii) allowing corporates to

undertake long term foreign currency swaps that contributed to the development

of the term currency swap market (1997) (iii) allowing dollar rupee options (2003)

and (iv) introduction of currency futures (2008). I would like to emphasise that

currency swaps allowed companies with ECBs to swap their foreign currencyliabil ities into rupees. However, since banks could not carry open positions the risk

was allowed to be transferred to any other resident corporate. Normally such risks

should be taken by corporates who have natural hedge or have potential foreign

exchange earnings. But often corporate assume these risks due to interest rate

differentials and views on currencies.

This period has also witnessed several relaxations in regulations relating to forex

markets and also greater liberalisation in capital account regulations leading to

greater integration with the global economy.

Cash settled exchange traded currency futures have made foreign currency a

separate asset class that can be traded without any underlying need or exposure


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BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT

Futures and options contract can be used for altering the risk of investing in spot

market. For instance, consider an investor who owns an asset. He will always be

worried that the price may fall before he can sell the asset. He can protect himself by

selling a futures contract, or by buying a Put option. If the spot price falls, the short

hedgers will gain in the futures market, as you will see later. This will help offset their

losses in the spot market. Similarly, if the spot price falls below the exercise price, the

put option can always be exercised.

2.] PRICE DISCOVERY

Price discovery refers to the markets ability to determine true equilibrium prices. Futures

prices are believed to contain information about future spot prices and help in

disseminating such information. As we have seen, futures markets provide a low cost

trading mechanism. Thus information pertaining to supply and demand easily percolates

into such markets. Accurate prices are essential for ensuring the correct allocation of

resources in a free market economy. Options markets provide information about the

volatility or risk of the underlying asset.

3.] OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction costs.

Secondly, they offer greater liquidity. Large spot transactions can often lead to

significant price changes. However, futures markets tend to be more liquid than spot

markets, because herein you can take large positions by depositing relatively small

margins. Consequently, a large position in derivatives markets is relatively easier to

take and has less of a price impact as opposed to a transaction of the same magnitude

in the spot market. Finally, it is easier to take a short position in derivatives markets than

it is to sell short in spot markets.


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4.] MARKET EFFICIENCY

The availability of derivatives makes markets more efficient; spot, futures and options

markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is

possible to exploit arbitrage opportunities quickly and to keep prices in alignment.

Hence these markets help to ensure that prices reflect true values.

5.] EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in spot

transactions. Also, the amount of capital required to take a comparable position is less

in this case. This is important because facilitation of speculation is critical for ensuring

free and fair markets. Speculators always take calculated risks. A speculator will accept

a level of risk only if he is convinced that the associated expected return is

commensurate with the risk that he is taking.

The derivative market performs a number of economic functions.

The prices of derivatives converge with the prices of the underlying at the

expiration of derivative contract. Thus derivatives help in discovery of future as

well as current prices.

An important incidental benefit that flows from derivatives trading is that it acts asa catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.

Transfer of risk enables market participants to expand their volume of activity.


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15. National Exchanges

In enhancing the institutional capabilities for futures trading the idea of setting up

of National Commodity Exchange(s) has been pursued since 1999. Three such

Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE),

Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai, and

Multi Commodity Exchange (MCX), Mumbai have become operational. National

Status implies that these exchanges would be automatically permitted to conduct

futures trading in all commodities subject to clearance of byelaws and contract

specifications by the FMC. While the NMCE, Ahmedabad commenced futures trading

in November 2002, MCX and NCDEX, Mumbai commenced operations in October/

December 2003 respectively.

MCX

MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

mutulised multi commodity exchange has permanent recognition from Government of

India for facilitating online trading, clearing and settlement operations for commodity

futures markets across the country. Key shareholders of MCX are Financial

Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of Indore, State

Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co. Ltd., Union Bank

of India, Bank of India, Bank of Baroda, Canera Bank, Corporation

Bank

Headquartered in Mumbai, MCX is led by an expert management team with deep

domain knowledge of the commodity futures markets. Today MCX is offering

spectacular growth opportunities and advantages to a large cross section of the

participants including Producers / Processors, Traders, Corporate, Regional Trading

Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others

MCX being nation-wide commodity exchange, offering multiple commodities for trading

with wide reach and penetration and robust infrastructure.


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MCX, having a permanent recognition from the Government of India, is an

independent and demutualised multi commodity Exchange. MCX, a state-of-the-art

nationwide, digital Exchange, facilitates online trading, clearing and settlement

operations for a commodities futures trading.

NMCE

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by

Central Warehousing Corporation (CWC), National Agricultural Cooperative Marketing

Federation of India (NAFED), Gujarat Agro-Industries Corporation Limited (GAICL),

Gujarat State Agricultural Marketing Board (GSAMB), National Institute of Agricultural

Marketing (NIAM), and Neptune Overseas Limited (NOL). While various integral

aspects of commodity economy, viz., warehousing, cooperatives, private and public

sector marketing of agricultural commodities, research and training were adequately

addressed in structuring the Exchange, finance was still a vital missing link. Punjab

National Bank (PNB) took equity of the Exchange to establish that linkage. Even today,

NMCE is the only Exchange in India to have such investment and technical support

from the commodity relevant institutions.

NMCE facilitates electronic derivatives trading through robust and tested trading

platform, Derivative Trading Settlement System (DTSS), provided by CMC. It has robust

delivery mechanism making it the most suitable for the participants in the physical

commodity markets. It has also established fair and transparent rule-based procedures

and demonstrated total commitment towards eliminating any conflicts of interest. It is

the only Commodity Exchange in the world to have received ISO 9001:2000 certification

from British Standard Institutions (BSI). NMCE was the first commodity exchange to

provide trading facility through internet, through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The contracts are

marked to market on daily basis. The system of upfront margining based on Value at

Risk is followed to ensure financial security of the market. In the event of high volatility

in the prices, special intra-day clearing and settlement is held. NMCE was the first to

initiate process of dematerialization and electronic transfer of warehoused commodity


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stocks. The unique strength of NMCE is its settlements via a Delivery Backed System,

an imperative in the commodity trading business. These deliveries are executed through

a sound and reliable Warehouse Receipt System, leading to guaranteed clearing and

settlement.

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a technology driven

commodity exchange. It is a public limited company registered under the Companies

Act, 1956 with the Registrar of Companies, Maharashtra in Mumbai on April 23,2003. It

has an independent Board of Directors and professionals not having any vested interest

in commodity markets. It has been launched to provide a world-class commodity

exchange platform for market participants to trade in a wide spectrum of commodityderivatives driven by best global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures trading in

commodities. Besides, NCDEX is subjected to various laws of the land like the

Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and

various other legislations, which impinge on its working. It is located in Mumbai and

offers facilities to its members in more than 390 centres throughout India. The reach will

gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew, Castor

Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil, Expeller

Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags, Mild Steel

Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw Jute, RBD

Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver, Soy Bean,

Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow Red Maize &

Yellow Soybean Meal.


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16. The Present Status:

Presently futures trading is permitted in all the commodities. Trading is taking

place in about 78 commodities through 25 Exchanges/Associations as given in the table

below:-

TABLE 4 Registered commodity exchanges in India

No. Exchange COMMODITY

1. India Pepper & Spice Trade

Association, Kochi (IPSTA)

Pepper (both domestic and

international contracts)

2. Vijai Beopar Chambers Ltd.,

Muzaffarnagar

Gur, Mustard seed

3. Rajdhani Oils & Oilseeds Exchange

Ltd., Delhi

Gur, Mustard seed its oil &

oilcake

4. Bhatinda Om & Oil Exchange Ltd.,

Bhatinda

Gur

5. The Chamber of Commerce, Hapur Gur, Potatoes and Mustard

seed

6. The Meerut Agro Commodities

Exchange Ltd., Meerut

Gur

7. The Bombay Commodity Exchange

Ltd., Mumbai

Oilseed Complex, Castor oil

international contracts

8. Rajkot Seeds, Oil & Bullion Merchants

Association, Rajkot

Castor seed, Groundnut, its

oil & cake, cottonseed, its oil

& cake, cotton (kapas) and

RBD palmolein.

9. The Ahmedabad Commodity

Exchange, Ahmedabad

Castorseed, cottonseed, its

oil and oilcake

10. The East India Jute & Hessian

Exchange Ltd., Calcutta

Hessian & Sacking

11. The East India Cotton Association Ltd., Cotton


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Mumbai

12. The Spices & Oilseeds Exchange Ltd.,

Sangli.

Turmeric

13. National Board of Trade, Indore Soya seed, Soyaoil and Soya

meals,

Rapeseed/Mustardseed its oil

and oilcake and RBD

Palmolien

14. The First Commodities Exchange of

India Ltd., Kochi

Copra/coconut, its oil &

oilcake

15. Central India Commercial Exchange

Ltd., Gwalior

Gur and Mustard seed

16. E-sugar India Ltd., Mumbai Sugar

17. National Multi-Commodity Exchange of

India Ltd., Ahmedabad

Several Commodities

18. Coffee Futures Exchange India Ltd.,

Bangalore

Coffee

19. Surendranagar Cotton Oil & Oilseeds,

Surendranagar

Cotton, Cottonseed, Kapas

20. E-Commodities Ltd., New Delhi Sugar (trading yet tocommence)

21. National Commodity & Derivatives,

Exchange Ltd., Mumbai

Several Commodities

22. Multi Commodity Exchange Ltd.,

Mumbai

Several Commodities

23. Bikaner commodity Exchange Ltd.,

Bikaner

Mustard seeds its oil &

oilcake, Gram. Guar seed.

Guar Gum24. Haryana Commodities Ltd., Hissar Mustard seed complex

25. Bullion Association Ltd., Jaipur Mustard seed Complex


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18. Business Growth in Derivatives segment (NSE)

TABLE 11A Index futures

FIGURE 11A Number of contracts per year

INTERPRETATION: From the data and the bar diagram above, there is high businessgrowth in the derivative segment in India. In the year 2002-03, the number of contractsin Index Future were 1025588 where as a significant increase of 4116679 is observed inthe year 2008-09.

0

20000000

40000000

60000000

80000000

100000000

120000000

140000000

160000000

year

2008-09

2007-08

2006-07

2005-06

2004-05

2003-04

2002-03

Year No. of contracts

2008-09 4116649

2007-08 156598579

2006-07 81487424

2005-06 58537886

2004-05 21635449

2003-04 17191668

2002-03 2126763

2001-02 1025588


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Table 11B No of turnovers

Year Turnover (Rs. Cr.)

2008-09 925679.96

2007-08 3820667.27

2006-07 2539574

2005-06 1513755

2004-05 772147

2003-04 554446

2002-03 43952

2001-02 21483

FIGURE 11B Turnover in Rs. Crores

INTERPRETATION:

From the data and above bar chart, there is high turn over in the derivative segment in

India. In the year 2001-02 the turnover of index future was 21483 where as a huge

increase of 92567996 in the year 2008-09 are observed.

0

500000

1000000

1500000

2000000

25000003000000

3500000

4000000

year

2008-09

2007-082006-07

2005-06

2004-05

2003-04

2002-03

2001-02


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TABLE 12A STOCK FUTURES

Year No. of contracts

2008-09 51449737

2007-08 203587952

2006-07 104955401

2005-06 80905493

2004-05 47043066

2003-04 32368842

2002-03 10676843

2001-02 1957856

2000-01 -

FIGURE 12A Number of contracts per year in stock future

INTERPRETATION:From the data and bar diagram above there were no stock futures available but in the

year 2001-02, it predominently increased to 1957856. Then there was a huge increase

of 20, 35, and 87,952 in the year 2007-08 but there was a steady decline to 51449737

in the year 2008-09.

0

50000000

100000000

150000000

200000000

250000000

year

2008-09

2007-08

2006-07

2005-06

2004-05

2003-04

2002-03

2001-02


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FINDINGS & CONCLUSION

From the above analysis it can be concluded that:

1. Derivative market is growing very fast in the Indian Economy. The turnover of

Derivative Market is increasing year by year in the Indias largest stock exchange

NSE. In the case of index future there is a phenomenal increase in the number of

contracts. But whereas the turnover is declined considerably. In the case of stock

future there was a slow increase observed in the number of contracts whereas a

decline was also observed in its turnover. In the case of index option there was a

huge increase observed both in the number of contracts and turnover.

2. After analyzing data it is clear that the main factors that are driving the growth of

Derivative Market are Market improvement in communication facilities as well as

long term saving & investment is also possible through entering into Derivative

Contract. So these factors encourage the Derivative Market in India.

3. It encourages entrepreneurship in India. It encourages the investor to take more

risk & earn more return. So in this way it helps the Indian Economy by developing

entrepreneurship. Derivative Market is more regulated & standardized so in this

way it provides a more controlled environment. In nutshell, we can say that the

rule of High risk & High return apply in Derivatives. If we are able to take more

risk then we can earn more profit under Derivatives.

Commodity derivatives have a crucial role to play in the price risk management process

for the commodities in which it deals. And it can be extremely beneficial in agriculture-

dominated economy, like India, as the commodity market also involves agricultural

produce. Derivatives like forwards, futures, options, swaps etc are extensively used in

the country. However, the commodity derivatives have been utilized in a very limited

scale. Only forwards and futures trading are permitted in certain commodity items.

RELIANCE is the most active future contracts on individual securities

traded with 90090 contracts and RNRL is the next most active futures contracts with

63522 contracts being traded.


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BIBLIOGRAPHY

Books referred:

Options Futures, and other Derivatives by John C Hull Derivatives FAQ by Ajay Shah

NSEs Certification in Financial Markets: - Derivatives Core module

Financial Markets & Services by Gordon & Natarajan

Reports:

Report of the RBI-SEBI standard technical committee on exchange traded

Currency Futures

Regulatory Framework for Financial Derivatives in India by Dr.L.C.GUPTA

Websites visited:

www.nse-india.com

www.bseindia.com

www.sebi.gov.in

www.ncdex.com

www.google.com

www.derivativesindia.com
http://www.nse-india.co

derivative market in india

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