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INTRODUCTION:

The only stock exchange operating in the 19th century were those

of Bombay set up in 1875 and Ahmadabad set up in 1894. These were

organized as voluntary non-profit-making association of brokers to

regulate and protect their interests. Before the control on securities

trading became a central subject under the constitution in 1950, it was a

state subject and the Bombay securities contracts (control) Act of 1925

used to regulate trading in securities. Under this Act, The Bombay stock

exchange was recognized in 1927 and Ahmadabad in 1937.

During the war boom, a number of stock exchanges were

organized even in Bombay, Ahmadabad and other centers, but they were

not recognized. Soon after it became a central subject, central legislation

was proposed and a committee headed by A.D.Gorwala went into the

bill for securities regulation. On the basis of the committee's

recommendations and public discussion, the securities contracts

(regulation) Act became law in 1956.

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SEBI Advisory Committee Derivatives

Report on

Development and Regulation of

Derivative Markets in India

1 BackgroundThe SEBI Board in its meeting on June 24, 2002 considered someimportant issuesRelating to the derivative markets including: Physical settlement of stock options and stock futures contracts. Review of the eligibility criteria of stocks on which derivative products

arepermitted. Use of sub-brokers in the derivative markets. Norms for use of derivatives by mutual fundsThe recommendations of the Advisory Committee on Derivatives onsome of these issueswere also placed before the SEBI Board. The Board desired that theseissues be reconsidered by the Advisory Committee on Derivatives(ACD) and requested a detailed report on the aforesaid issues for the

consideration of the Board. n the meantime, several other importantissues like the issue of minimum contract size,the segregation of the cash and derivative segments of the exchange andthe surveillanceissues in the derivatives market were also placed before the ACD for itsconsideration.The Advisory Committee therefore decided to take this opportunity topresent a comprehensive report on the development and regulation ofderivative markets including a review of the recommendations of the L.

C. Gupta Committee (LCGC). Four years have elapsed since the LCGCReport of March 1998. During this period therehave been several significant changes in the structure of the IndianCapital Markets which include, dematerialization of shares, rollingsettlement on a T+3 basis, client level and Value at Risk (VaR) basedmargining in both the derivative and cash markets and Proposed

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demutualization of Exchanges. Equity derivative markets have now beenin Existence for two years and the markets have grown in size anddiversity of products.This therefore appears to be an appropriate time for a comprehensive

review of the Development and regulation of derivative markets.

2 Regulatory ObjectivesThe LCGC outlined the goals of regulation admirably well in Paragraph3.1 of its report. We endorse these regulatory principles completely andbase our recommendations also on these same principles. We therefore

reproduce this paragraph of the LCGC Report:.2 The Committeebelieves that regulation should be designed to achieve specific, well-defined goals. It is inclined towards positive regulation designed toencourage healthy activity and behaviour. It has been guided by thefollowing objectives:(a) Investor Protection: Attention needs to be given to the following fouraspects:

(i) Fairness and Transparency:(ii) Safeguard for clients moneys:(iii) Competent and honest service:(iv) Market integrity:

(b) Quality of markets: The concept of Quality of Markets goes wellbeyond market integrity and aims at enhancing important marketqualities, such as cost-efficiency, price-continuity, and price-discovery.

This is a much broader objective than market integrity.(c) Innovation: While curbing any undesirable tendencies, the regulatoryframework should not stifle innovation which is the source of alleconomic progress, more so because financial derivatives represent anew rapidly

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Developing area, aided by advancements in information technology..

3 Derivative Products

3.1 Interest and Currency Futures

3.2 Single Stock Derivatives3.2.1 Introduction of single stock Derivativ

3.2.2 Position limits3.2.3 Margins

3.3 Eligibility Required3.4 Contracts on New Indices3.5 Minimum Contract Size3.6 Adjustment for Corporate Actions

4 Risk Containment4.1 VaR Framework4.2 Cross Margining: Basic Principles

4.3 Cross Margining between single stock derivative and the underlying4.4 Cross margining between index futures and a basket of constituentstocks

4.4.1 Eligibility Condition for Cross Margining with Basket

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4.4.2 Margin offset between index futures and replicaportfolio

4.4.3 Margin on total deviation portfolio.

4.5 Cross margining between index options and options on constituentstocks4.6 Cross margining between two indices4.7 Cross margining between two stocks

5 Market Structure and Governance5.1 Separation of cash and derivatives markets5.2 Sub brokers5.3 Inspection

5.4 Surveillance.5.5 Physical Settlement.6 Use of Derivatives by Mutual Funds6.1 New Schemes: Utilising mainstream governance and disclosuremechanisms

,6.2 Existing Schemes: Rules governing hedging and portfoliorebalancing.6.3 Ongoing disclosure requirements

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7 SEBI Related Issues7.1 Derivatives Cell and Advisory Committee

7.2 SEBI and RBI

Appendix A: Methodology for Corporate AdjustmentsMethodology laid down in SEBI Circular of June 2001

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OBJECTIVES OF STUDY:

1. To study various trends in derivative market.

2. Comparison of the profits/losses in cash market and derivative

market.

3. To find out profit/losses position of the option writer and option

holder.

4. To study in detail the role of the future and options.

5. To study the role of derivatives in Indian financial market.

6. To study various trends in derivative market.

7. Comparison of the profits/losses in cash market and derivative

market.

8. To find out profit/losses position of the option writer and option

holder.

9. To study in detail the role of the future and options.

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10. To study the role of derivatives in Indian financial market.

NEED OF THE STUDY

Different investment avenues are available investors. Stock

market also offers good investment opportunities to the investor

alike all investments, they also carry certain risks. The investor

should compare the risk and expected yields after adjustment off

tax on various instruments while talking investment decision the

investor may seek advice from exparty and consultancy include

stock brokers and analysts while making investment decisions.

The objective here is to make the investor aware of the

functioning of the derivatives.

Derivatives act as a risk hedging tool for the investors. The

objective if to help the investor in selecting

the appropriate derivates instrument to the attain maximum risk

and to construct the portfolio in such a manner to meet the

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investor should decide how best to reach the goals from the

securities available.

To identity investor objective constraints and performance,

which help formulate the investment policy?

The develop and improvement strategies in the with investment

policy formulated. They will help the selection of asset classes

and securities in each class depending up on their risk return

attributes.

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SCOPE OF THE STUDY

The study is limited to Derivatives with special reference to

futures and options in the Indian context; the study is not based on the

international perspective of derivative markets.

The study is limited to the analysis made for types of instruments

of derivates each strategy is analyzed according to its risk and return

characteristics and derivatives performance against the profit and

policies of the company.

The present study on futures and options is very much

appreciable on the grounds that it gives deep insights about the F&O

market. It would be essential for the perfect way of trading in F&O. An

investor can choose the fight underlying or portfolio for investment

3which is risk free. The study would explain the various ways to

minimize the losses and maximize the profits. The study would help the

investors how their profit/loss is reckoned. The study would assist in

understanding the F&O segments. The study assists in knowing the

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different factors that cause for the fluctuations in the F&O market. The

study provides information related to the byelaws of F&O trading. The

studies elucidate the role of F&O in India Financial Markets.

Derivative Markets today

The prohibition on options in SCRA was removed in 1995.

Foreign currency options in currency pairs other than Rupee were

the first options permitted by RBI.

The Reserve Bank of India has permitted options, interest rate

swaps, currency swaps and other risk reductions OTC derivative

products.

Besides the Forward market in currencies has been a vibrant

market in India for several decades.

In addition the Forward Markets Commission has allowed the

setting up of commodities futures exchanges. Today we have 18

commodities exchanges most of which trade futures.

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e.g. The Indian Pepper and Spice Traders Association (IPSTA) and

the Coffee Owners Futures Exchange of India (COFEI).

In 2000 an amendment to the SCRA expanded the definition of

securities to included Derivatives thereby enabling stock

exchanges to trade derivative products.

The year 2000 will herald the introduction of exchange traded

equity derivatives in India for the first time.

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METHODOLOGY

To achieve the object of studying the stock market data ha beencollected.

Research methodology carried for this study can be two types

Primary

Secondary

PRIMARY

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The data, which is being collected for the time and it is theoriginal data is this

project the primary data has been taken from IIFL staff and guide

of the project.

SECONDARY

The secondary information is mostly from websites, books,journals, etc.

INDUSTRY PROFILE

STOCK MARKET :

Indian stock market has shown dramatic changes last 4 to 5

years. As of 2004 march-end, Indian stock exchanges had over 9400

companies listed. Of course, the number of companies whose shares are

actively traded is smaller, around 800 at the NSE and 2600 at the BSE.

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Each company may have multiple securities listed on an exchange.

Thus, BSE has over 7200 listed securities, of which over 2600 are

traded. The market capitalization of all listed stocks now exceeds Rs. 13

Lakh crore. Total turnover-or the value of all sales and purchases on

the BSE and the NSE now exceeds Rs. 50 lakh crore.

As large number of indices are also available to fund

managers. The two leading market indices are NSE 50-shares (S&P

CNX Nifty) index and BSE 30-share (SENSEX) index. There are index

funds that invest in the securities that form part of one or the other index.

Besides, in the derivatives market, the fund managers can buy or sell

futures contracts or options contracts on these indices. Both BSE and

NSE also have other sect oral indices that track the stocks of companies

in specific industry groups-FMCG, IT, Finance, Petrochemical and

Pharmaceutical while the SENSEX and Nifty indices track large

capitalization stocks, BSE and NSE also have Mid cap indices tracking

mid-size company shares. The number of industries or sectors

represented in various indices or in the listed category exceeds50. BSE

has 140 scrips in its specified group A list, which are basically large-

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capitalization stocks. B 1 Group includes over 1100 stocks, many of

which are mid-cap companies. The rest of the B2 Group includes over

4500 shares, largely low-capitalization.

National Stock Exchange (NSE):

The NSE was incorporated in NOVEMBER 1994 with an

equity capital of Rs.25 Crores. The International Securities Consultancy(ISC) of Hong Kong has helped in setting up NSE. The promotions for

NSE were financial institutions, insurance companies, banks and SEBI

capital market ltd,Infrastructure leasing and financial services ltd.,stock

holding corporation ltd.

NSE is a national market for shares, PSU bonds, debentures

and government securities since infrastructure and trading facilities are

provided. The genesis of the NSE lies in the recommendations of the

Pherwani Committee (1991).

NSE-Nifty:

The NSE on April22, 1996 launched a new equity index. The

NSE-50 the new index which replaces the existing NSE-100, is expected

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to serve as an appropriate index for the new segment of futures and

options.

Niftymeans National Index for Fifty Stocks.

The NSE-50 comprises 50 companies that represent 20 broad

industry groups with an aggregate market capitalization of around Rs.

1,70,000 crores. All the companies included in the Index have a market

capitalization in excess of Rs. 500 crores. Each and should have traded

for 85% of trading days at an impact cost of less than 1.5%.

NSE-Midcap Index:

The NSE midcap index or the Junior Nifty comprises 50 stocks

that represents 21 board Industry groups and will provide proper

representation of the midcap. All stocks in the index should have market

capitalization of greater than Rs.200 crores and should have traded 85%

of the trading days an impact cost of less 2.5%.

The base period for the index is Nov 4, 1996 which signifies

2 years for completion of operations of the capital market segment of the

operations. The base value of the index has been set at 1000. Average

daily turnover of the present scenario 258212(laces) and number ofaverage daily trades 2160(laces).

Bombay Stock Exchange (BSE):

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This stock exchange, Mumbai, popularly known as BSE was

established In 1875 as The native share and stock brokers association,

as a voluntary non-profit making association .It has evolved over the

years into its present status as the premier stock exchange in the country.

It may be noted that the stock exchange is the oldest one in Asia, even

older than the Tokyo Stock Exchange, this was founded in 1878.

The Bombay Stock Exchange Limited is the oldest stock

exchange in Asia and has the greatest number of listed companies in the

world, with 4700 listed as of August 2007.It is located at Dalal Street,

Mumbai, India. On 31 December 2007, the equity market capitalization

of the companies listed on the BSE was US$ 1.79 trillion, making it the

largest stock exchange in South Asia and the 12th largest in the world.

A governing board comprising of 9 elected directors, 2 SEBInominees, 7 public representatives and an executive director is the apex

body, which decides the policies and regulates the affairs of the

exchange.

BSE Indices:

In order to enable the market participants, analysts etc., to track

the various ups and downs in Indian stock market, the exchange had

introduced in 1986 an equity stock index called BSE-SENSEX that

subsequently became the barometer of the moments of the share prices

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in the Indian stock market. It is a market capitalization weighted

index of 30 component stocks representing a sample of large, well

established and leading companies. The base year of sensex is 1978-79.

The Sensex is widely reported in both domestic and

international markets through print as well as electronic media. Sensex is

calculated using a market capitalization weighted method. As per this

methodology, the level of index reflects the total market value of all 30-

component stocks from different industries related to particular base

period. The total value of a company is determined by multiplying theprice of its stock by the number of shares outstanding.

Statisticians call an index of a set of combined variables (such

as price number of shares) Composite index. An Indexed number is used

to represent the results of this calculation in order to make the value

easier to work with and track over a time. IT is much easier to graph a

chart base on indexed values then one based on actual values world over

majority of the well known indices are constructed using Market

capitalization weighted method. The divisor is only link to original base

period value of the sensex.

New base year average = old base year average*(new market

value/old market value)

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OTC Equity Derivatives

Traditionally equity derivatives have a long history in India in the

OTC market.

Options of various kinds (called Teji and Mandi and Fatak) in un-

organized markets were traded as early as 1900 in Mumbai

The SCRA however banned all kind of options in 1956.

BSE's and NSEs plans Both the exchanges have set-up an in-house segment instead of

setting up a separate exchange for derivatives.

BSEs Derivatives Segment, will start with Sensex futures as its

first product.

NSEs Futures & Options Segment will be launched with Nifty

futures as the first product.

Product Specifications BSE-30 Sensex Futures

Contract Size - Rs.50 times the Index

Tick Size - 0.1 points or Rs.5

Expiry day - last Thursday of the month Settlement basis - cash settled

Contract cycle - 3 months

Active contracts - 3 nearest months

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Product Specifications S&P CNX Nifty Futures

Contract Size - Rs.200 times the Index

Tick Size - 0.05 points or Rs.10

Expiry day - last Thursday of the month

Settlement basis - cash settled

Contract cycle - 3 months

Active contracts - 3 nearest months

Membership Membership for the new segment in both the exchanges is not

automatic and has to be separately applied for.

Membership is currently open on both the exchanges.

All members will also have to be separately registered with SEBI

before they can be accepted.

Membership Criteria

NSE

Clearing Member (CM)

Networth - 300 lakh

Interest-Free Security Deposits - Rs. 25 lakh

Collateral Security Deposit - Rs. 25 lakhIn addition for every TM he wishes to clear for the CM has to deposit

Rs. 10 lakh.

Trading Member (TM)

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Networth - Rs. 100 lakh

Interest-Free Security Deposit - Rs. 8 lakh

Annual Subscription Fees - Rs. 1 lakh

BSE

Clearing Member (CM)

Networth - 300 lacs

Interest-Free Security Deposits - Rs. 25 lakh

Collateral Security Deposit - Rs. 25 lakh

Non-refundable Deposit - Rs. 5 lakh Annual Subscription Fees - Rs. 50 thousand

In addition for every TM he wishes to clear for the CM has to deposit

Rs. 10 lakh with the following break-up.

Cash - Rs. 2.5 lakh

Cash Equivalents - Rs. 25 lakh

Collateral Security Deposit - Rs. 5 lakh

Trading Member (TM)

Networth - Rs. 50 lakh

Non-refundable Deposit - Rs. 3 lakh

Annual Subscription Fees - Rs. 25 thousand

The Non-refundable fees paid by the members is exclusive and will be atotal of Rs.8 lakhs if the member has both Clearing and Trading rights.

Trading Systems

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NSEs Trading system for its futures and options segment is

called NEAT F&O. It is based on the NEAT system for the cash

segment.

BSEs trading system for its derivatives segment is called DTSS. It

is built on a platform different from the BOLT system though most

of the features are common.

Certification Programmes

The NSE certification programme is called NCFM (NSEs

Certification in Financial Markets). NSE has outsourced trainingfor this to various institutes around the country.

The BSE certification programme is called BCDE (BSEs

Certification for the Derivatives Exchnage). BSE conducts its own

training run by its training institute.

Both these programmes are approved by SEBI.

Rules and Laws

Both the BSE and the NSE have been give in-principle approval on

their rule and laws by SEBI.

According to the SEBI chairman, the Gazette notification of the

Bye-Laws after the final approval is expected to be completed by

May 2000. Trading is expected to start by mid-June 2000.

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REVIEW LITERATURE

A Derivative is a financial instrument that derives its value

from an underlying asset. Derivative is an financial contract whose

price/value is dependent upon price of one or more basic underlying

asset, these contracts are legally binding agreements made on trading

screens of stock exchanges to buy or sell an asset in the future. The mostcommonly used derivatives contracts are forwards, futures and options,

which we shall discuss in detail later.

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The emergence of the market for derivative products, most

notably forwards, futures and options, can be traced back to the

willingness of risk-averse economic agents to guard themselves against

uncertainties arising out of fluctuations in asset prices. By their very

nature, the financial markets are marked by a very high degree of

volatility. Through the use of derivative products, it is possible to

partially or fully transfer price risks by locking-in asset prices. As

instruments of risk management, these generally do not influence the

fluctuations in the underlying asset prices. However, by locking-in assetprices, derivative products minimize the impact of fluctuations in asset

prices on the profitability and cash flow situation of risk-averse

investors.

Derivative products initially emerged, as hedging devices

against fluctuations in commodity prices and commodity-linked

derivatives remained the sole form of such products for almost three

hundred years. The financial derivatives came into spotlight in post-

1970 period due to growing instability in the financial markets.

However, since their emergence, these products have become very

popular and by 1990s, they accounted for about two-thirds of total

transactions in derivative products. In recent years, the market forfinancial derivatives has grown tremendously both in terms of variety of

instruments available, their complexity and also turnover. In the class of

equity derivatives, futures and options on stock indices have gained

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more popularity than on individual stocks, especially among institutional

investors, who are major users of index-linked derivatives. Even small

investors find these useful due to high correlation of the popular indices

with various portfolios and ease of use. The lower costs associated with

index derivatives vie derivative products based on individual securities

is another reason for their growing use.

The main objective of the study is to analyze the derivatives

market in India and to analyze the operations of futures and options.

Analysis is to evaluate the profit/loss position futures and options.Derivates market is an innovation to cash market. Approximately its

daily turnover reaches to the equal stage of cash market

In cash market the profit/loss of the investor depend the market

price of the underlying asset. Derivatives are mostly used for hedging

purpose. In bullish market the call option writer incurs more losses so

the investor is suggested to go for a call option to hold, where as the put

option holder suffers in a bullish market, so he is suggested to write a

put option. In bearish market the call option holder will incur more

losses so the investor is suggested to go for a call option to write, where

as the put option writer will get more losses, so he is suggested to hold aput option.

Initially derivatives was launched in America called Chicago.

Then in 1999, RBI introduced derivatives in the local currency Interest

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Rate markets, which have not really developed, but with the gradual

acceptance of the ALM guidelines by banks, there should be an

instrumental product in hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the

derivatives market was index futures

The following factors have been driving the growth of financial

derivatives:

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with theinternational markets,

3. Marked improvement in communication facilities and sharp

decline in their costs,

4. Development of more sophisticated risk management tools,

providing economic

agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine

the risks and

returns over a large number of financial assets, leading to higher

returns, reduced

risk as well as trans-actions costs as compared to individualfinancial assets.

Derivatives defined

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Derivative is a product whose value is derived from the value of

one or more basic variables, called bases (underlying asset, index, or

reference rate), in a contractual manner. The underlying asset can be

equity, forex, commodity or any other asset. For example, wheat farmers

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

change in prices 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 the Indian context the Securities Contracts (Regulation) Act, 1956

(SC(R) A) defines

equity derivative to include

1. A security derived from a debt instrument, share, loan

whether secured or

unsecured, risk instrument or contract for differences or any other form

of security.

2. A contract, which derives its value from the prices, or index

of prices, of

underlying securities.

Derivatives is derived from the following products:

A. Shares

B. Debuntures

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C. Mutual funds

D. Gold

E. Steel

F. Interest rate

G. Currencies.

DEFINATIONS

According to JOHN C. HUL A derivatives can be defined as a

financial instrument whose value depends on (or derives from) thevalues of other, more basic underlying variables.

According to ROBERT L. MCDONALD A derivative is simply

a financial instrument (or even more simply an agreement between two

people) which has a value determined by the price of something else.

FUNCTIONS OF DERIVATIVES MARKET:

The following are the various functions that are performed by

the derivatives markets. They are:

Prices in an organized derivatives market reflect the perception of

market participants about the future and lead the prices of underlying

to the perceived future level.

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Derivatives market helps to transfer risks from those who have them

but may not like them to those who have an appetite for them.

Derivative trading acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long

run.

TYPES OF DERIVATIVES:

The most commonly used derivatives contracts are

forwards, futures and options which we shall discuss in detail later.

Here we take a brief look at various derivatives contracts that have

come to be used.

Forwards:

A forward contract is a customized contract between two

entities, where settlement takes place on a specific date in the future

at todays pre-agreed price

Futures :

A futures contract is an agreement between two parties to buy

or sell an asset at a certain time in the future at a certain price. Futures

contracts are special types of forward contracts in the sense that the

former are standardized exchange-traded contracts

Options :

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Options are of two types - calls and puts. Calls give the buyer

the right but not the obligation to buy a given quantity of the underlying

asset, at a given price on or before a given future date. Puts give the

buyer the right, but not the obligation to sell a given quantity of the

underlying asset at a given price on or before a given date.

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 aregenerally traded over-the-counter.

Leaps :

The acronym LEAPS means Long-Term Equity Anticipation

Securities. These are options having a maturity of up to three years.

Baskets :

Basket options are options on portfolios of underlying assets.

The underlying asset is usually a moving average of a basket of assets.

Equity index options are a form of basket options.

Swaps :

Swaps are private agreements between two parties to exchange

cash flows in the future according to a prearranged formula. They can be

regarded as portfolios of forward contracts. The two commonly used

swaps are

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Interest rate swaps:

These entail swapping only the interest related cash flows

between the

Parties in the same currency.

Currency swaps:

These entail swapping both principal and interest between

the parties, with the cash flows in one direction being in a different

currency than those in the opposite Direction.

Swaptions:

Swaptions are options to buy or sell a swap that will become

operative at the expiry of the options. Thus a Swaptions is an option on a

forward swap.

PARTICIPANTS IN THE DERIVATIVES MARKET:

The following three broad categories of participants in the

derivatives market.

HEDGERS:

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

futures or options markets to reduce or eliminate this risk.

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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 thefutures price of an asset getting out of line with the cash price, they will

take offsetting positions in the two markets to lock in a profit.

ANY EXCHANGE FULFILLING THE DERIVATIVE SEGMENT

AT NATIONAL STOCK EXCHANGE:

The derivatives segment on the exchange commenced with S&P

CNX Nifty Index futures on June 12, 2000. The F&O segment of NSE

provides trading facilities for the following derivative segment:

1. Index Based Futures2. Index Based Options

3. Individual Stock Options

4. Individual Stock Futures

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REGULATORY FRAMEWORK:

The trading of derivatives is governed by the provisions

contained in the SC (R) A, the SEBI Act and the regulations framed

there under the rules and byelaws of stock exchanges.

Regulation for Derivative Trading:

SEBI set up a 24 member committed under Chairmanship of

Dr.L.C.Gupta develop the appropriate regulatory framework for

derivative trading in India. The committee submitted its report in March

1998. On May 11, 1998 SEBI accepted the recommendations of the

committee and approved the phased introduction of Derivatives tradingin India beginning with Stock Index Futures. SEBI also approved he

Suggestive bye-laws recommended by the committee for regulation

and control of trading and settlement of Derivatives contracts.

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The provisions in the SC (R) A govern the trading in the

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 the Act.

1. Eligibility criteria as prescribed in the L.C. Gupta committee report

may apply to SEBI for grant of recognition under Section 4 of the

SC ( R ) A, 1956 to start Derivatives Trading. The derivatives

exchange/segment should have a separate governing council andrepresentation of trading / clearing members shall be limited to

maximum of 40% of the total members of the governing council.

The exchange shall regulate the sales practices of its members and

will obtain approval of SEBI before start of Trading in any

derivative contract.

2. The exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not

automatically become the members of the derivative segment. The

members of the derivative segment need to fulfill the eligibilityconditions as lay down by the L.C.Gupta Committee.

4. The clearing and settlement of derivates trades shall be through a

SEBI

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approved Clearing Corporation / Clearing house. Clearing

Corporation /

Clearing House complying with the eligibility conditions as lay

down

By the committee have to apply to SEBI for grant of approval.

5. Derivatives broker/dealers and Clearing members are required to

seek registration from SEBI.

6. The Minimum contract value shall not be less than Rs.2 Lakh.

Exchanges should also submit details of the futures contract they

purpose to introduce.

7. The trading members are required to have qualified approved user

and sales person who have passed a certification programmed

approved by SE

INTRODUCTION TO FUTURE MARKET:

Futures markets were designed to solve the problems that exit

in forward markets. A futures contract is an agreement between two

parties to buy or sell an asset at a certain time in the future at a certain

price. There is a multilateral contract between the buyer and seller for a

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underlying asset which may be financial instrument or physical

commodities. But unlike forward contracts the future contracts are

standardized and exchange traded.

PURPOSE:

The primary purpose of futures market is to provide an efficient

and effective mechanism for management of inherent risks, without

counter-party risk. The future contracts are affected mainly by the prices

of the underlying asset. As it is a future contract the buyer and seller hasto pay the margin to trade in the futures market.

It is essential that both the parties compulsorily discharge their

respective obligations on the settlement day only, even though the

payoffs are on a daily marking to market basis to avoid

default risk. Hence, the gains or losses are netted off on a daily basis and

each morning starts

with a fresh opening value. Here both the parties face an equal amount

of risk and are also

required to pay upfront margins to the exchange irrespective of whether

they are buyers or

sellers. Index based financial futures are settled in cash unlike futures onindividual stocks which

are very rare and yet to be launched even in the US. Most of the

financial futures worldwide are

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index based and hence the buyer never comes to know who the seller is,

both due to the presence

of the clearing corporation of the stock exchange in between and also

due to secrecy reasons

EXAMPLE:

The current market price of INFOSYS COMPANY is

Rs.1650.There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is

bullish and kishore is

bearish in the market. The initial margin is 10%. paid by the both

parties. Here the Hitesh has

purchased the one month contract of INFOSYS futures with the price of

Rs.1650.The lot size of

Infosys is 300 shares.

Suppose the stock rises to 2200.

Unlimited profit for the buyer(Hitesh) = Rs.1,65,000 [(2200-1650*3oo)]

and notional profit forthe buyer is 500.

Unlimited loss for the buyer because the buyer is bearish in the market

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Suppose the stock falls to Rs.1400

Unlimited profit for the seller = Rs.75,000.[(1650-1400*300)] and

notional profit for the seller is

250.

Unlimited loss for the seller because the seller is bullish in the market.

Finally, Futures contracts try to "bet" what the value of an

index or commodity will be at some date in the future. Futures are often

used by mutual funds and large institutions to hedge their positions when

the markets are rocky. Also, Futures contracts offer a high degree ofleverage, or the ability to control a sizable amount of an asset for a cash

outlay, which is distantly small in proportion to the total value of

contract.

DEFINITION

A Futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. To facilitate

liquidity in the futures contract, the exchange specifies certain standard

features of the contract. The standardized items on a futures contract

are: Quantity of the underlying

Quality of the underlying

The date and the month of delivery

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The units of price quotations and minimum price change

Locations of settlement

Types of futures:

On the basis of the underlying asset they derive, the futures are

divided into two types:

Stock futures:

The stock futures are the futures that have the underlying asset as

the individual securities. The settlement of the stock futures is of cash

settlement and the settlement price of the future is the closing price of

the underlying security.

Index futures:

Index futures are the futures, which have the underlying asset as an

Index. The Index futures are also cash settled. The settlement price of

the Index futures shall be the closing value of the underlying index on

the expiry date of the contract.

STOCK INDEX FUTURES

Stock Index futures are the most popular financial

futures, which have been used to hedge or manage the systematic risk by

the investors of Stock Market. They are called hedgers who own

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portfolio of securities and are exposed to the systematic risk. Stock

Index is the apt hedging asset since the rise or fall due to systematic risk

is accurately shown in the Stock Index. Stock index futures contract is

an agreement to buy or sell a specified amount of an underlying stock

index traded on a regulated futures exchange for a specified price for

settlement at a specified time future.

Stock index futures will require lower capital adequacy

and margin requirements as compared to margins on carry forward of

individual scrips. The brokerage costs on index futures will be muchlower.

Savings in cost is possible through reduced bid-ask

spreads where stocks are traded in packaged forms. The impact cost will

be much lower in case of stock index futures as opposed to dealing in

individual scrips. The market is conditioned to think in terms of the

index and therefore would prefer to trade in stock index futures. Further,

the chances of manipulation are much lesser.

The Stock index futures are expected to be extremely

liquid given the speculative nature of our markets and the overwhelming

retail participation expected to be fairly high. In the near future, stock

index futures will definitely see incredible volumes in India. It will be ablockbuster product and is pitched to become the most liquid contract in

the world in terms of number of contracts traded if not in terms of

notional value. The advantage to the equity or cash market is in the fact

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that they would become less volatile as most of the speculative activity

would shift to stock index futures. The stock index futures market

should ideally have more depth, volumes and act as a stabilizing factor

for the cash market. However, it is too early to base any conclusions on

the volume or to form any firm trend.

The difference between stock index futures and most

other financial futures contracts is that settlement is made at the value of

the index at maturity of the contract.

Futures terminology :-

a) Spot price : The price at which an asset trades in the spot

market

b) Futures price : The price at which the futures contract tradesin the futures market.

c) Contract cycle : The period over which a contract trades.

The index futures contracts on the NSE have one-month,

two-month and three-months expiry cycles which expire on

the last Thursday of the month. Thus a January expiration

contract expires on the last Thursday of January and a

February expiration contract trading on the last Thursday of

February. On the Friday following the last Thursday, a new

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contract having a three-month expiry is introduced for

trading.

d) 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.

e) Contract size : The amount of asset that has to be delivered

under one contract. For instance, the contract size on NSEs

futures market is 200 Nifties.

f) Basis :In the context of financial futures, basis can be definedas the futures price minus the spot price. There 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.

g) 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.

h) Margin: Margin is money deposited by the buyer and the

seller to ensure the integrity of the contract. Normally themargin requirement has been designed on the concept of

VAR at 99% levels. Based on the value at risk of the

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stock/index margins are calculated. In general margin ranges

between 10-50% of the contract value.

i) 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. Both buyer and seller are

required to make security deposits that are intended to

guarantee that they will infact be able to fulfill their

obligation. These deposits are Initial margins and they are

often referred as performance margins. The amount ofmargin is roughly 5% to 15% of total purchase price of

futures contract

j) 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.

k) Maintenance margin : This is somewhat 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 themargin account to the initial margin level before trading

commences on the next day.

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PARTIES IN THE FUTURES CONTRACT:

There are two parties in a future contract, the Buyer and the Seller.

The buyer of the futures contract is one who is LONG on the futures

contract and the seller of the futures contract is one who is SHORT on

the futures contract.

The pay off for the buyer and the seller of the futures contract are as

follows.

Pay off for futures:

A Pay off is the likely profit/loss that would accrue to a market

participant with change in the price of the underlying asset. Futures

contracts have linear payoffs. In simple words, it means that the losses

as well as profits, for the buyer and the seller of futures contracts, are

unlimited.

PAYOFF FOR A BUYER OF FUTURES:

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The pay offs for a person who buys a futures contract is similar

to the pay off for a person who holds an asset. He has potentially

unlimited upside as well as downside.

Take the case of a speculator who buys a two-month Nifty index

futures contract when the Nifty stands at 1220. The underlying asset

in this case is the Nifty portfolio. When the index moves up, the long

futures position starts making profits and when the index moves down

it starts making losses

CASE 1:

The buyer bought the future contract at (F); if the futures price

goes to E1 then the buyer gets the profit of (FP).

CASE 2:

The buyer gets loss when the future price goes less than (F), if the

futures price goes to E2 then the buyer gets the loss of (FL).

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LOSS

PROFIT

F

L

P

E1

E2


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PAYOFF FOR A SELLER OF FUTURES:

The pay offs for a person who sells a futures contract is

similar to the pay off for a person who shorts an asset. He has

potentially unlimited upside as well as downside.

Take the case of a speculator who sells a two-month Nifty index

futures contract when the Nifty stands at 1220. The underlying assetin this case is the Nifty portfolio. When the index moves down, the

short futures position starts making profits and when the index moves

up it starts making losses.

F FUTURES PRICE

47

F

LOSS

PROFIT

E1

P

E2

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E1, E2 SETTLEMENT PRICE.

CASE 1:

The Seller sold the future contract at (f); if the futures price goes to

E1 then the Seller gets the profit of (FP).

CASE 2:

The Seller gets loss when the future price goes greater than (F), ifthe futures price goes to E2 then the Seller gets the loss of (FL).

Pricing the Futures:

The fair value of the futures contract is derived from a model

known as the Cost of Carry model. This model gives the fair value of

the futures contract.

Cost of Carry Model:

F=S (1+r-q) t

Where

F Futures Price S Spot price of the Underlying r Cost of Financing q Expected Dividend Yield T Holding

Period.

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INTRODUCTION TO OPTIONS:

It is a interesting tool for small retail investors. An option is a contract,

which gives the buyer (holder) the right, but not the obligation, to buy or

sell specified quantity of the underlying

assets, at a specific (strike) price on or before a specified time(expiration date). The underlying

may be physical commodities like wheat/ rice/ cotton/ gold/ oil or

financial instruments like

equity stocks/ stock index/ bonds etc.

Option Terminology:-

a) Index options: These options have the index as the underlying.

Some options are

i. European while others are American. Like index futures

contracts, index options

ii. contracts are also cash settled.b) Stock options: Stock options are options on individual stocks.

Options currently

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i. trade on over 500 stocks in the United States. A

contract gives the holder the right

to to buy or sell shares at the specified

price.

c) Buyer of an option: The buyer of an option is the one who by

paying the option

i. premium buys the right but not the obligation to

exercise his option on the

ii. seller/writer.d) Writer of an option: The writer of a call/put option is the one who

receives the

i. option premium and is thereby obliged to sell/buy the

asset if the buyer exercises on

ii. him. There are two basic types of options, call options

and put options.

e) Call option: A call option gives the holder the right but not the

obligation to buy an asset by a certain date for a certain price.

f) Put option: A put option gives the holder the right but not the

obligation to sell an asset by a certain date for a certain price.

g) Option price: Option price is the price which the option buyerpays to the option

seller.

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h) Expiration date: The date specified in the options contract is

known as the

expiration date, the exercise date, the strike date or the

maturity.

i) Strike price: The price specified in the options contract is known

as the strike price

or the exercise price.

j) American options: American options are options that can be

exercised at any timeUp to the expiration date. Most exchange-traded

options are American.

k) European options: 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.

l) In-the-money option: An in-the-money (ITM) option is an

option that would lead to a positive cash flow to the holder if it

were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike

price (i.e. spot price > strike price). If the index is much higher than the

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strike price, the call is said to be deep ITM. In the case of a put, the put

is ITM if the index is below the strike price.

m) At-the-money option: An at-the-money (ATM) option is an

option that would lead

to zero cashflow if it were exercised immediately. An option on the

index is at-themoney

when the current index equals the strike price (i.e. spot price = strike

price)._

n) Out-of-the-money option: An out-of-the-money (OTM)

option is an option that

would lead to a negative cash flow it were exercised immediately. A call

option on

the index is out-of- the-money when the current index stands at a level

which is less

than the strike price (i.e. spot price < strike price). If the index is much

lower than the

strike price, the call is said to be deep OTM. In the case of a put, the put

is OTM ifthe index is above the strike price.

o) Intrinsic value of an option: The option premium can be

broken down into two

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components - intrinsic value and time value. The intrinsic value of a call

is the

amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic

value is zero.

Putting it another way, the intrinsic value of a call is N.P which means

the intrinsic

value of a call is Max [0, (St K)] which means the intrinsic value of a

call is the (St

K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. thegreater of 0 or

(K - St ). K is the strike price and St is the spot price.

p) Time value of an option: The time value of an option is

the difference between its premium and its intrinsic value. A call that is

OTM or ATM has only time value. Usually, the maximum time value

exists when the option is ATM. The longer the time to expiration, the

greater is a calls time value, all else equal. At expiration, a call

should have no time value.

TYPES OF OPTION:

CALL OPTION

A call option gives the holder (buyer/ one who is long call),

the right to buy specified quantity of the underlying asset at the strike

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price on or before expiration date. The seller (one who is short call)

however, has the obligation to sell the underlying asset if the buyer of

the call option decides to exercise his option to buy. To acquire this right

the buyer pays a premium to the writer (seller) of the contract.

Illustration

Suppose in this option there are two parties one is Mahesh

(call buyer) who is bullish in the market and other is Rakesh (call seller)

who is bearish in the market.The current market price of RELIANCE COMPANY is Rs.600

and premium is Rs.25

1)Call buyer

Here the Mahesh has purchase the call option with a strike price

of Rs.600.The option will be excerised once the price went above 600.

The premium paid by the buyer is Rs.25.The buyer will earn profit once

the share price crossed to Rs.625(strike price + premium). Suppose the

stock has crossed Rs.660 the option will be exercised the buyer will

purchase the RELIANCE scrip from the seller at Rs.600 and sell in the

market at Rs.660.

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Unlimited profit for the buyer = Rs.35{(spot price strike price)

premium}

Limited loss for the buyer up to the premium paid.

2)Call seller:

In another scenario, if at the tie of expiry stock price falls below

Rs. 600 say suppose the stock price fall to Rs.550 the buyer will choose

not to exercise the option.

Profit for the Seller limited to the premium received = Rs.25Loss unlimited for the seller if price touches above 600 say 630

then the loss of Rs.30

Finally the stock price goes to Rs.610 the buyer will not exercise the

option because he has the

lost the premium of Rs.25.So he will buy the share from the seller at

Rs.610.

Thus from the above example it shows that option contracts are

formed so to avoid the unlimited losses and have limited losses to the

certain extent

Thus call option indicates two positions as follows:

LONG POSITION

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If the investor expects price to rise i.e. bullish in the market he

takes a long position by buying call option.

SHORT POSITION

If the investor expects price to fall i.e. bearish in the market he

takes a short position by selling call option.

PUT OPTION

A Put option gives the holder (buyer/ one who is long Put),

the right to sell specified quantity of the underlying asset at the strike

price on or before a expiry date. The seller of the put option (one who is

short Put) however, has the obligation to buy the underlying asset at the

strike price if the buyer decides to exercise his option to sell.

Illustration

Suppose in this option there are two parties one is Dinesh (put

buyer) who is bearish in the

market and other is Amit(put seller) who is bullish in the market.

The current market price of TISCO COMPANY is Rs.800 and premium

is Rs.2 0

1) Put buyer(dinesh)

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Here the Dinesh has purchase the put option with a strike price

of Rs.800.The option will be excerised once the price went below 800.

The premium paid by the buyer is Rs.20.The buyers breakeven point is

Rs.780(Strike price Premium paid). The buyer will earn profit once the

share price crossed below to Rs.780. Suppose the stock has crossed

Rs.700 the option will be

exercised the buyer will purchase the RELIANCE scrip from the market

at Rs.700and sell to the

seller at Rs.800Unlimited profit for the buyer = Rs.80 {(Strike price spot price)

premium}

Loss limited for the buyer up to the premium paid = 20

2) put seller(Amit):

In another scenario, if at the time of expiry, market price of

TISCO is Rs. 900. the buyer of the Put option will choose not to exercise

his option to sell as he can sell in the market at a higher rate.

Unlimited loses for the seller if stock price below 780 say 750 then

unlimited losses for

the seller because the seller is bullish in the market = 780 - 750 = 30Limited profit for the seller up to the premium received = 20

Thus Put option also indicates two positions as follows:

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LONG POSITION

If the investor expects price to fall i.e. bearish in the market he

takes a long position by buying Put option.

SHORT POSITION

If the investor expects price to rise i.e. bullish in the market he

takes a short position by selling Put option

FACTORS AFFECTING OPTION PREMIUM:

Price of the underlying asset: (s)

Changes in the underlying asset price can increase or decrease

the premium of an option. These price changes have opposite effects on

calls and puts. For instance, as the price of the underlying asset rises, the

premium of a call will increase and the premium of a put will decrease.

A decrease in the price of the underlying assets value will generally

have the opposite effect

Strike price: (k)

The strike price determines whether or not an option has any

intrinsic value. An options premium generally increases as the option

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gets further in the money, and decreases as the option becomes more

deeply out of the money.

Time until expiration: (t)

An expiration approaches, the level of an options time value,

for puts and calls, decreases.

Volatility:

Volatility is simply a measure of risk (uncertainty), or

variability of an options underlying. Higher volatility estimates reflect

greater expected fluctuations (in either direction) in underlying price

levels. This expectation generally results in higher option premiums for

puts and calls alike, and is most noticeable with at- the- money options.

Interest rate: (R1)

This effect reflects the COST OF CARRY the interest that

might be paid for margin, in case of an option seller or received from

alternative investments in the case of an option buyer for the premium

paid. Higher the interest rate, higher is the premium of the option as the

cost of carry increases.

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FUTURES V/S OPTIONS:

Right or obligation :

Futures are agreements/contracts to buy or sell specified quantity of

the underlying assets at a

price agreed upon by the buyer & seller, on or before a specified time.

Both the buyer and seller

are obligated to buy/sell the underlying asset. In case of options the

buyer enjoys the right & not the obligation, to buy or sell the underlying

asset.

Risk:

Futures Contracts have symmetric risk profile for both the buyer as

well as the seller.While options have asymmetric risk profile. In case of Options, for a

buyer (or holder of the

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option), the downside is limited to the premium (option price) he has

paid while the profits may

be unlimited. For a seller or writer of an option, however, the downside

is unlimited while profits

are limited to the premium he has received from the buyer.

Prices:

The Futures contracts prices are affected mainly by the prices of the

underlying asset.While the prices of options are however, affected by prices of the

underlying asset, time

remaining for expiry of the contract & volatility of the underlying asset.

Cost:

It costs nothing to enter into a futures contract whereas there is a

cost of entering into an options contract, termed as Premium.

Strike price:In the Futures contract the strike price moves while in the option

contract the strike price

remains constant .

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Liquidity:

As Futures contract are more popular as compared to options. Also

the premium charged is high in the options. So there is a limited

Liquidity in the options as compared to Futures. There is no dedicated

trading and investors in the options contract.

Price behavior:

The trading in future contract is one-dimensional as the price offuture depends upon the price of the underlying only. While trading in

option is two-dimensional as the price of the option

depends upon the price and volatility of the underlying.

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BIBLIOGRAPHY

1. Economic Times

2. www.nseindia.com

1. www.google.com

1. www.bseindia.com

1. Business Standard
http://www.nseindia.com/http://www.nseindia.com/http://www.google.com/http://www.google.com/http://www.bseindia.com/http://www.bseindia.com/http://www.nseindia.com/http://www.google.com/http://www.bseindia.com/

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