indian derivative market - final

8/3/2019 Indian Derivative Market - Final

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(FOLLOWING SHOULD BE MENTIONED ON BLACK COVER PAGE)

A PROJECT REPORT ON

TITLE OF THE PROJECT

SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR

MASTERs DEGREE IN HUMAN RESOURCES DEVELOPMENT

MANAGEMENT

FOR MASTERs DEGREE IN MARKETING MANAGEMENT

FOR MASTERs DEGREE IN FINANCIAL MANAGEMENT

TOUNIVERSITY OF MUMBAI

BY

FULL NAME OF THE STUDENT

ROLL NO.

2009-2012

UNDER THE GUIDANCE OF DR. / PROF.

LALA LAJPATRAI INSTITUTE OF MANAGEMENT

MAHALAXMI, MUMBAI 400 034

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A PROJECT REPORT ON

Indian Derivative Market

SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR

FOR MASTERs DEGREE IN FINANCIAL MANAGEMENT

TO

UNIVERSITY OF MUMBAI

BY

Sangeeta Sanil45.

2009-2012

UNDER THE GUIDANCE OF PROF.

Avani Pramod

LALA LAJPATRAI INSTITUTE OF MANAGEMENT

MAHALAXMI, MUMBAI 400 034

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DECLARATION

I hereby declare that this dissertation submitted in partial fulfilment of the requirementfor the award of MASTERs DEGREE IN FINANCIALMANAGEMENT(MMM/MFM/MHRDM) of the University of Mumbai is my originalwork and has not been submitted for award of any other degree or diploma fellowship orother similar title or prizes.

I further certify that I have no objection and grant the rights to LLIM to publish anychapter or project if they deem fit in journals or magazines and newspaper etc. withoutmy permission.

Sangeeta Sanil Kuppa

CLASS: MFM III SEM I

BATCH: 2009-2012

ROLL NO.:45

DATE:

PLACE: MUMBAI

SIGNATURE

(Sangeeta Sanil)

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PROJECT GUIDE CERTIFICATE FORM

I Mr. /Ms. (Full Name of the Student), the undersigned Roll No. _________ studying inthe Third Year of MHRDM /MMM / MFM is doing my project work under the guidanceof Dr./ Prof. ___________________________ wish to state that I have met my internalguide on the following dates mentioned below for Project Guidance:-

SR. NO. DATE SIGNATURE OF THE

INTERNAL GUIDE

______________________ __________________________ Signature of the Candidate Signature of Internal Guide

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Certificate

This is to certify that the dissertation submitted in partial fulfillment of the requirementfor the award ofMHRDM /MMM / MFM of the University of Mumbai is a result ofthe bonafide work carried out by Ms. / Mr._________________________ under mysupervision and guidance. No part of this report has been submitted for award of anyother degree, diploma fellowship or other similar titles or prizes. The work has also notbeen published in any scientific journals/ magazines.

DATE: 08th October 2011 NAME:

PLACE: MUMBAI ROLL NO.:

------------------------------ ---------------------------Dr. V. B. Angadi Dr. /Prof __________

(Director, LLIM) (Project Guide)

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ACKNOWLEDGEMENT

This project has been a great learning experience for me. I take this opportunity to thank Dr. /

Prof. Avani Pramod, my internal projectguide whose valuable guidance& suggestions made this

project possible. I am extremely thankful to him/her for his/her support. He/She has encouragedme and channelized my enthusiasm effectively.

I express my heart-felt gratitude towards my parents, siblings and all those friends who havewillingly and with utmost commitment helped me during the course ofmyproject work.

I also express my profound gratitude to Dr. Angadi, Director of Lala Lajpatrai Institute ofManagement for giving me the opportunity to work on theproject and broaden my knowledge andexperience. My sincere thanks to Prof. Arati Kale for her valuable guidance and advice incompleting this project.

I would like to thank all the professors and the staff of Lala Lajpatrai Institute especially theLibrary staff who w ere very helpful in providingbooks and articles I needed formyproject.

Last but not the least, I am thankful to all those who indirectly extended their co-operation and

invaluable support tome.

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EXECUTIVE SUMMARY

Firstly I am briefing the current Indian market and comparing it with it past. I am also

giving brief data about foreign market. Then at the last I am giving my suggestions and

recommendations.

With over 25 million shareholders, India has the third largest investor base in the world

after USA and Japan. Over 7500 companies are listed on the Indian stock exchanges

(more than the number of companies listed in developed markets of Japan, UK, Germany,

France, Australia, Switzerland, Canada and Hong Kong.). The Indian capital market is

significant in terms of the degree of development, volume of trading, transparency and its

tremendous growth potential.

Indias market capitalization was the highest among the emerging markets. Total market

capitalization of The Bombay Stock Exchange (BSE), which, as on July 31, 1997, was

US$ 175 billion has grown by 37.5% percent every twelve months and was over US$ 834

billion as of January, 2007. Bombay Stock Exchanges (BSE), one of the oldest in the

world, accounts for the largest number of listed companies transacting their shares on a

nationwide online trading system. The two major exchanges namely the National Stock

Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5 in the world,

calculated by the number of daily transactions done on the exchanges.

The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 An

increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years only. Turnover

in the Spot and Derivatives segment both in NSE & BSE was higher by 45% into 2006 as

compared to 2005. With daily average volume of US $ 9.4 billion, the Sensex has posted

excellent returns in the recent years.

Derivatives trading in the stock market have been a subject of enthusiasm of research in

the field of finance the most desired instruments that allow market participants to manage

risk in the modern securities trading are known as derivatives. The derivatives are defined

as the future contracts whose value depends upon the underlying assets. If derivatives are

introduced in the stock market, the underlying asset may be anything as component of

stock market like, stock prices or market indices, interest rates, etc. The main logic

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behind derivatives trading is that derivatives reduce the risk by providing an additional

channel to invest with lower trading cost and it facilitates the investors to extend their

settlement through the future contracts. It provides extra liquidity in the stock market.

Derivatives are assets, which derive their values from an underlying asset. These

underlying assets are of various categories like

Commodities including grains, coffee beans, etc.

Precious metals like gold and silver.

Foreign exchange rate.

Bonds of different types, including medium to long-term negotiable debt securities

issued by governments, companies, etc.

Short-term debt securities such as T-bills.

Over-The-Counter (OTC) money market products such as loans or deposits.

Equities

For example, a dollar forward is a derivative contract, which gives the buyer a right & an

obligation to buy dollars at some future date. The prices of the derivatives are driven by

the spot prices of these underlying assets.

However, the most important use of derivatives is in transferring market risk, called

Hedging, which is a protection against losses resulting from unforeseen price or volatility

changes. Thus, derivatives are a very important tool of risk management.

There are various derivative products traded. They are;

1. Forwards

2. Futures

3. Options

4. Swaps

A Forward Contractis a transaction in which the buyer and the seller agree upon a

delivery of a specific quality and quantity of asset usually a commodity at a specified

future date. The price may be agreed on in advance or in future.

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A Future contract is a firm contractual agreement between a buyer and seller for a

specified as on a fixed date in future. The contract price will vary according to the

market place but it is fixed when the trade is made. The contract also has a standard

specification so both parties know exactly what is being done.

An Options contractconfers the right but not the obligation to buy (call option) or sell

(put option) a specified underlying instrument or asset at a specified price the Strike or

Exercised price up until or an specified future date the Expiry date. The Price is called

Premium and is paid by buyer of the option to the seller or writer of the option.

A call option gives the holder the right to buy an underlying asset by a certain date for acertain price. The seller is under an obligation to fulfill the contract and is paid a price of

this, which is called "the call option premium or call option price".

A put option, on the other hand gives the holder the right to sell an underlying asset by a

certain date for a certain price. The buyer is under an obligation to fulfill the contract and

is paid a price for this, which is called "the put option premium or put option price".

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

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I had conducted this research to find out whether investing in the derivative market

is beneficial or not? You will be glad to know that derivative market in India is the

most booming now days.

So the person who is ready to take risk and want to gain more should invest in the

derivative market.

On the other hand RBI has to play an important role in derivative market. Also

SEBI must encourage investment in derivative market so that the investors get the

benefit out of it. Sorry to say that today even educated persons are not willing to

invest in derivative market because they have the fear of high risk.

So, SEBI should take necessary steps for improvement in Derivative Market so that

more investors can invest in Derivative market.

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INTRODUCTION

A Derivative is a financial instrument whose value depends on other, more basic,

underlying variables. The variables underlying could be prices of traded securities

and stock, prices of gold or copper.

Derivatives have become increasingly important in the field of finance, Options and

Futures are traded actively on many exchanges, Forward contracts, Swap and

different types of options are regularly traded outside exchanges by financial

intuitions, banks and their corporate clients in what are termed as over-the-counter

markets in other words, there is no single market place or organized exchanges.

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NEED OF THE STUDY

The study has been done to know the different types of derivatives and also to know

the derivative market in India. This study also covers the recent developments in the

derivative market taking into account the trading in past years.

Through this study I came to know the trading done in derivatives and their use in the

stock markets.

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LITERATURE REVIEW

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 asset

prices, 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

for financial 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 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 vis-

vis derivative products based on individual securities is another reason for their growing

use.

As in the present scenario, Derivative Trading is fast gaining momentum, I have

chosen this topic

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OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives

To know the role of derivatives trading in India.

To analyse the performance of Derivatives Trading since 2001with special

reference to Futures & Options

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SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. For better

understanding various strategies with different situations and actions have been given.

It includes the data collected in the recent years and also the market in the derivatives

in the recent years. This study extends to the trading of derivatives done in the

National Stock Markets.

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LIMITAITONS OF STUDY

1. LIMITED TIME:The time available to conduct the study was only 2 months. It being a wide topic had

a limited time.

2. LIMITED RESOURCES:

Limited resources are available to collect the information about the commodity

trading.

3. VOLATALITY:

Share market is so much volatile and it is difficult to forecast anything about it

whether you trade through online or offline

4. ASPECTS COVERAGE:

Some of the aspects may not be covered in my study.

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HISTORY OF THE STOCK BROKING INDUSTRY

Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200

years ago.

In 1887, they formally established in Bombay, the "Native Share and Stock Brokers'

Association" (which is alternatively known as "The Stock Exchange"). In 1895, the Stock

Exchange acquired a premise in the same street and it was inaugurated in 1899. Thus, the

Stock Exchange at Bombay was consolidated.

Thus in the same way, gradually with the passage of time number of exchanges were

increased and at currently it reached to the figure of 24 stock exchanges.

This was followed by the formation of associations /exchanges in Ahmadabad (1894),

Calcutta (1908), and Madras (1937).

In order to check such aberrations and promote a more orderly development of the stock

market, the central government introduced a legislation called the Securities Contracts

(Regulation) Act, 1956. Under this legislation, it is mandatory on the part of stock

exchanges to seek government recognition. As of January 2002 there were 23 stock

exchanges recognized by the central Government. They are located at Ahmadabad,

Bangalore, Baroda, Bhubaneswar, Calcutta, Chennai,(the Madras stock Exchanges ),

Cochin, Coimbatore, Delhi, Guwahati, Hyderabad, Indore, Jaipur, Kanpur, Ludhiana,

Mangalore, Mumbai(the National Stock Exchange or NSE), Mumbai (The Stock

Exchange), popularly called the Bombay Stock Exchange, Mumbai (OTCExchange of

India), Mumbai (The Inter-connected Stock Exchange of India), Patna, Pune, and Rajkot.

Of course, the principle bourses are the National Stock

Exchange and The Bombay Stock Exchange, accounting for the bulk of the business done

on the Indian stock market.

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BSE (BOMBAY STOCK EXCHANGE)

The Stock Exchange, Mumbai, popularly known as "BSE" was established in

1875 as "The Native Share and Stock Brokers Association". It is the oldest one in

Asia, even older than the Tokyo Stock Exchange, which was established in 1878. It is the

first Stock Exchange in the Country to have obtained permanent recognition in 1956 from

the Govt. of India under the Securities Contracts (Regulation) Act, 1956.

A Governing Board having 20 directors is the apex body, which decides the

policies and regulates the affairs of the Exchange. The Governing Board consists of 9

elected directors, who are from the broking comm.

Unity (one third of them retire ever year by rotation), three SEBI nominees, six public

representatives and an Executive Director & Chief Executive Officer and a Chief

Operating Officer.

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NSE (NATIONAL STOCK EXCHANGE)

NSE was incorporated in 1992 and was given recognition as a stock exchange in

April 1993. It started operations in June 1994, with trading on the Wholesale Debt

Market Segment. Subsequently it launched the Capital Market Segment in November

1994 as a trading platform for equities and the Futures and Options Segment in June 2000

for various derivative instruments.

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MCX (MULTI COMMODITY EXCHANGE)

MULTI COMMODITY EXCHANGE of India limited is a new order exchange

with a mandate for setting up a nationwide, online multi-commodity market place,

offering unlimited growth opportunities to commodities market participants. As a true

neutral market, MCX has taken several initiatives for users in a new generation

commodities futures market in the process, become the countrys premier exchange.

MCX, an independent and a de-mutualised exchange since inception, is all set up to

introduce a state of the art, online digital exchange for commodities futures trading in the

country and has accordingly initiated several steps to translate this vision into reality.

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NCDEX (NATIONAL COMMODITIES AND DERIVATIVES EXCHANGE)

NCDEX started working on 15th December, 2003. This exchange provides

facilities to their trading and clearing member at different 130 centres for contract. In

commodity market the main participants are speculators, hedgers and arbitrageurs.

Facilities Provided By NCDEX

NCDEX has developed facility for checking of commodity and also provides a

ware house facility

By collaborating with industrial partners, industrial companies, news agencies,

banks and developers of kiosk network NCDEX is able to provide current rates

and contracts rate.

To prepare guidelines related to special products of securitization NCDEX works

with bank.

To avail farmers from risk of fluctuation in prices NCDEX provides special

services for agricultural.

NCDEX is working with tax officer to make clear different types of sales and

service taxes.

NCDEX is providing attractive products like weather derivatives

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STOCK MARKET BASIC

What are corporations?

Companies are started by individuals or may be a small circle of people. They pool

their money or obtain loans, raising funds to launch the business.

A choice is made to organize the business as a sole proprietorship where one

Person or a married couple owns everything, or as a partnership with others who may

wish to invest money. Later they may choose to "incorporate". As a

Corporation, the owners are not personally responsible or liable for any debts of the

company if the company doesn't succeed. Corporations issue official-looking sheets of

paper that represent ownership of the company. These are called stock certificates, and

each certificate represents a set number of shares. The total number of shares will vary

from one company to another, as each makes its own choice about how many pieces of

ownership to divide the corporation into. One corporation may have only 2,500 shares,

while another, such as IBM or the Ford Motor Company, may issue over a billion

Shares. Companies sell stock (pieces of ownership) to raise money and provide funding

for the expansion and growth of the business. The business founders give up part of their

ownership in exchange for this needed cash. The expectation is that even though the

owners have surrendered a portion of the company to the

Public, their remaining share of stock will become increasingly valuable as the business

grows. Corporations are not allowed to sell shares of stock on the open

Stock market without the approval of the Securities and Exchange Commission (SEC).

This transition from a privately held corporation to a publicly traded one is

Called going public, and this first sale of stock to the public is called an initial public

offering, or IPO.

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Why do people invest in the stock market?

When you buy stock in a corporation, you own part of that company. This gives you a vote

at annual shareholder meetings, and a right to a share of future profits.

When a company pays out profits to the shareholder, the money received is called a

"Dividend".

The corporation's board of directors choose when to declare a dividend and how much to pay.

Most older and larger companies pay a regular dividend, most newer and smaller companies

do not.

The average investor buys stock hoping that the stock's price will rise, so the shares can be

sold at a profit. This will happen if more investors want to buy stock in a company than

wish to sell. The potential of a small dividend check is of little concern.

What is usually responsible for increased interest in a company's stock is the prospect of the

company's sales and profits going up.

A company who is a leader in a hot industry will usually see its share price rise

dramatically.

Investors take the risk of the price falling because they hope to make more money in the

market than they can with safe investments such as bank CD's or government bonds.

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What is a stock market index?

In the stock market world, you need a way to compare the movement of the market, up and

down, from day to day, and from year to year. An index is just a benchmark or yardstickexpressed as a number that makes it possible to do this comparison. For e.g. S&P CNX

Nifty is the index of NSE and SENSEX is the index of BSE.

The price per share, like the market cap, has nothing to do with how big a company is.

The Securities Market consists of two segments, viz. Primary market and Secondary

market. Primary market is the place where issuers create and issue equity, debt or hybrid

instruments for subscription by the public; the Secondary market enables the holders of

securities to trade them.

Secondary market essentially comprises of stock exchanges, which provide platform for

purchase and sale of securities by investors. In India, apart from the Regional Stock

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Exchanges established in different centres, there are exchanges like the National

Stock Exchange (NSE) and the Over the Counter Exchange of India (OTCEI), who

provide nationwide trading facilities with terminals all over the country. The trading

platform of stock exchanges is accessible only through brokers and trading of securities

is confined only to stock exchanges.

Corporate Securities :

The no of stock exchanges increased from 11 in 1990 to 23 now. All the exchanges

are fully computerized and offer 100% on-line trading. 9644 companies were available

for trading on stock exchanges at the end of March 2002. The trading platform of the

stock exchanges was accessible to 9687 members from over 400 cities on the same date.

Derivatives Market :

Derivatives trading commenced in India in June 2000. The total exchange traded

derivatives witnessed a volume of Rs. 442,343 crore during 2002-03 as against Rs. 4018

crore during the preceding year. While NSE accounted for about 99.5% of total turnover,

BSE accounted for about 0.5% in 2002-03. The market witnessed higher volumes from

June 2001 with introduction of index options, and still higher volumes with introduction of

stock options in July 2001. There was a spurt in volumes in November 2001 when stock

futures were introduced. It is believed that India is the largest market in the world for

stock futures

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Supply and Demand

A stock's price movement up and down until the end of the trading day is strictly a result

of supply and demand. The SUPPLY is the number of shares offered for sale at anyone

one moment. The DEMAND is the number of shares investors wish to buy at exactlythat same time. What a share of a company is worth on anyone day or at any one minute,

is determined by all investors voting with their money. If investors want a stock and are

willing to pay more, the price will go up. If investors are selling a stock and there aren't

enough buyers, the price will go down Period.

S econdary Market Intermediaries

Stock brokers, sub-brokers, portfolio managers, custodians, share transfer agents

constitute the important intermediaries in the Secondary Market.

No stockbrokers or sub-brokers shall buy, sell or deal in securities unless he holds a

certificate of registration granted by SEBI under the Regulations made by SEBI ion

relation to them.

The Central Government has notified SEBI (Stock Brokers & Sub-Brokers) Rules, 1992 in

exercise of the powers conferred by section 29 of SEBI Act, 1992. These rules came into

effect on 20th August, 1992.

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INTRODUCTION TO DERIVATIVE MARKET:

According to dictionary, derivative means something which is derived from

another source. Therefore, derivative is not primary, and hence not independent. In

financial terms, derivative is a product whose value is derived from the value of one or

more basic variables. These basic variable are called bases, which may be value of

underlying asset, a reference rate etc. the underlying asset can be equity, foreign

exchange, commodity or any asset.

For example: - the value of any asset, say share of any company, at a future date

depends upon the shares current price. Here, the share is underlying asset, the current

price of the share is the bases and the future value of the share is the derivative.

Similarly, the future rate of the foreign exchange depends upon its spot rate of exchange.

In this case, the future exchange rate is the derivative and the spot exchange rate is the

base.

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Derivatives are contract for future delivery of assets at price agreed at the time of

the contract. The quantity and quality of the asset is specified in the contract. The buyer

of the asset will make the cash payment at the time of delivery.

Meaning:

Derivatives are the financial contracts whose value/price is dependent on the

behavior of the price of one or more basic underlying assets (often simply known as the

underlying). These contracts are legally binding agreements, made on the trading screen

of stock exchanges, to buy or sell an asset in future. The asset can be a share, index,

interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee

etc.

In the Indian Context the Security Contracts (Regulation) Act, 1956 (SC(R) A)

defines derivative to include

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

unsecured, risk instrument or contract for differences or other form of security.

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

underlying securities.

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In financial terms derivatives is a broad term for any instrumental whose value is derived

from the value of one more underlying assets such as commodities, forex, precious

metal, bonds, loans, stocks, stock indices, etc.

Derivatives were developed primarily to manage offset, or hedge against risk but

some were developed primarily to provide potential for high returns. In the context of

equity markets, derivatives permit corporations and institutional

Investors to effectively manage their portfolios of assets and liabilities through

instrument like stock index futures.

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Contracts agreement

Cash Derivatives

Forward Others likeSwaps, FRAs etc

Merchandising,

customized

Futures

(Standardized

)

Options

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11. 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 price at 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 tradingin 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.

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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.

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

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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

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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EMERGENCE OF THE DERIVATIVE TRADING IN INDIA

Approval For Derivatives Trading

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 ofderivatives. SEBI set up a 24 member 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

pre-conditions 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.Verma, to recommend measures for risk containment in

derivative market in India.

The repot, 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 real - time monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the

ambit of securities and the regulatory framework were developed for governing

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derivatives trading. The act also made it clear that derivatives shall be legal and valid

only if such contracts are traded on

PARTICIPANTS OF THE DERIVATIVE MARKET :-

Market participants in the future and option markets are many and they perform

multiple roles, depending upon their respective positions. A trader acts as a hedger when

he transacts in the market for price risk management. He is a speculator if he takes an

open position in the price futures market or if he sells naked option contracts. He acts as

an arbitrageur when he enters in to simultaneous purchase and sale of a commodity,

stock or other asset to take advantage of mispricing. He earns risk less profit in this

activity. Such opportunities do not exist for long in an efficient market. Brokers provide

services to others, while market makers create liquidity in the market.

Hedgers

Hedgers are the traders who wish to eliminate the risk (of price change) to which

they are already exposed. They may take a long position on, or short sell, a commodity

and would, therefore, stand to lose should the prices move in the adverse direction.

Speculators

If hedgers are the people who wish to avoid the price risk, speculators are those

who are willing to take such risk. These people take position in the market and assume

risk to profit from fluctuations in prices. In fact, speculators consume information, make

forecasts about the prices and put their money in these forecasts. In this process, they

feed information into prices and thus contribute to market efficiency. By taking position,

they are betting that a price would go up or they are betting that it would go down.

The speculators in the derivative markets may be either day trader or position

traders. The day traders speculate on the price movements during one trading day, open

and close position many times a day and do not carry any position at the end of the day.

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They monitor the prices continuously and generally attempt to make profit from

just a few ticks per trade. On the other hand, the position traders also attempt to gain

from price fluctuations but they keep their positions for longer durations may is for a few

days, weeks or even months.

Arbitrageurs

Arbitrageurs thrive on market imperfections. An arbitrageur profits by trading a

given commodity, or other item, that sells for different prices in different markets. The

Institute of Chartered Accountant of India, the word ARBITRAGE has been defines as

follows:-

Simultaneous purchase of securities in one market where the price there of is

low and sale thereof in another market, where the price thereof is comparatively higher.

These are done when the same securities are being quoted at different prices in the two

markets, with a view to make profit and

carried on with conceived intention to derive advantage from difference in prices

of securities prevailing in the two different markets

Thus, arbitrage involves making risk-less profits by simultaneously entering into

transactions in two or more markets.

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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 n o r m a 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, whic h 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 bec au se bo th serve e ssent ially th e same

economic fu nctions 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

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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.

Thegrade of 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 constantlyfluctuates. 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 as

Margin 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

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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.

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.

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:

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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 the

spot 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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TABLE 1-

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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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. Underlying

asset 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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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 agreeto 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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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 2000. SEBI permitted the derivative segment of

two stock exchanges, NSE and BSE, and their clearing house/corporation to

commence trading and settlement in approved derivatives contract.

To begin with, SEBI approved trading in index future contracts based on

S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for

trading in options based on these two indices and options on individual securities.

The trading in index options commenced in June 2001.

Futures contracts on individual stocks were launched in November 2001.

Trading and settlement in derivatives contracts is done in accordance with the rules,

byelaws, and regulations of the respective exchanges and their clearing

house/corporation duly approved by SEBI and notified in the official gazette.

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Risk Associated With Derivatives:

While derivatives can be used to help manage risks involved in investments, they

also have risks of their own. However, the risks involved in

derivatives trading are neither new nor unique they are the same kind of risks

associated with traditional bond or equity instruments.

Market Risk

Derivatives exhibit price sensitivity to change in market condition, such as

fluctuation in interest rates or currency exchange rates. The market risk of leveraged

derivatives may be considerable, depending on the degree of leverage and the nature of

the security.

Liquidity Risk

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Most derivatives are customized instrument and could exhibit substantial

liquidity risk implying they may not be sold at a reasonable price within a reasonable

period. Liquidity may decrease or evaporate entirely during unfavorable markets.

Credit Risk

Derivatives not traded on exchange are traded in the over-the-counter (OTC)

market. OTC instrument are subject to the risk of counter party defaults.

Hedging Risk

Several types of derivatives, including futures, options and forward are used as

hedges to reduce specific risks. If the anticipated risks do not develop, the hedge may

limit the funds total return.

FUNCTION OF DERIVATIVES MARKET:-

The derivative market performs a number of economic functions:-

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. The prices of derivative converge with the prices of the underlying

at the expiration of the derivative contract. Thus, derivatives help in discovery of

future as well as current prices.

The derivatives market helps to transfer risks from those who have them but may

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

Derivatives, due to their inherent nature, are linked to the underlying cash

market. With the introduction of the derivatives, the underlying market witnesses

higher trading volumes because of the participation by more players who would

not otherwise participate for lack of arrangement to transfer risk.

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Speculative trades shift to a more controlled environment of derivatives market.

In the absence of an organized derivative market, speculators trade in the

underlying cash market.

An important incidental benefit that flows from derivatives trading is that it acts

as a catalyst for new entrepreneurial activity.

The derivatives have a history of attracting many bright, creative, well-educated

people with an entrepreneurial attitude. They often energize others to create new

businesses, new products and new employment opportunities, the benefit of

which are immense.

Derivatives markets help increase savings and investment in the end. Transfer of

risk enables market participants to expand their volumes of activity.

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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 of Indias

(RBI) efforts in creating currency forward market. Derivatives are an integral part ofliberalisation 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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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.

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.

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Derivatives are complex and exotic instruments that Indian investors will find

difficulty in understanding

Is the existing capital market safer than Derivatives?

(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 to

the 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,

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

(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 market Capitalisation India is one of the largest market-capitalised countries inAsia with a market capitalisation of more than

Rs.765000 crores.

High Liquidity in theunderlying

The daily average traded volume in Indian capitalmarket today is around 7500 crores. Which means on anaverage every month 14% of the countrys Marketcapitalisation gets traded. These are clear indicators ofhigh liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing trades hasbecome fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL).

NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) forwhich it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL) whichstarted functioning in the year 1997 has revolutionalisedthe security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital market enjoys astrong, independent, and innovative legal guardian who

is helping the market to evolve to a healthier place fortrade practices.

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Comparison of New System with Existing System

Many 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.

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 &Prize

1) 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


1) 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


1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additionaloffload 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 elselimit to curtail losses. exercise the option.

3)Sell deep OTM call optionwith underlying shares, earnpremium + profit with increase prcie

Advantages

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Availability of Leverage

Figure 3.3d

Small Investors

Existing SYSTEM New


1) If Bullish buy 1) Plain Buy/Sell 1) Buy Call/Put options 1) Downsidestocks else sell it. implies unlimited based on market outlook remains

profit/loss. 2) Hedge position if protected &holding underlying upsidestock unlimited.

Advantages

Losses Protected.

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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.

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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

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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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 ofanother 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 information

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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.

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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. 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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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 clear that 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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The trading in BSE Sensex options commenced on June 4, 2001 and the trading in

options on individual securities commenced in July 2001. Futures contracts on individual

stocks were launched in November 2001. The derivatives trading on NSE commenced

with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options

commenced on June 4, 2001 and trading in options on individual securities commenced

on July 2, 2001. Single stock futures were launched on November 9, 2001. The index

futures and options contract on NSE are based on S&P CNX Trading and settlement in

derivative contracts is done in accordance with the rules, byelaws, and regulations of the

respective exchanges and their clearing house/corporation duly approved by SEBI and

notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade

in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the NSE

report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the F&O

segment. It constituted 70 per cent of the total turnover during June 2002. A primary

reason attributed to this phenomenon is that traders are comfortable with single-stock

futures than equity options, as the former closely resembles the erstwhile badla system.

On relative terms, volumes in the index options segment continue to remain poor.

This may be due to the low volatility of the spot index. Typically, options are considered

more valuable when the volatility of the underlying (in this case, the index) is high. A

related issue is that brokers do not earn high commissions by recommending index

options to their clients, because low volatility leads to higher waiting time for round-trips.

Put volumes in the index options and equity options segment have increased since

January 2002. The call-put volumes in index options have decreased from 2.86 in January

2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are

increasingly becoming pessimistic on the market.

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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

shoul

indian derivative market - final

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