INTRODUCTION TO STOCK MARKET AND STOCK EXCHANGE

A STOCK MARKET OR EQUITY MARKET is a public (a loose network of economic transactions, not a physical facility or discrete) entity for the trading of company stock (shares) and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. Stock markets refer to a market place where investors can buy and sell stocks. The price at which each buying and selling transaction takes is determined by the market forces . Let us take an example for a better understanding of how market forces determine stock prices. ABC Co. Ltd. enjoys high investor confidence and there is an anticipation of an upward movement in its stock price. More and more people would want to buy this stock (i.e. high demand) and very few people will want to sell this stock at current market price (i.e. less supply). Therefore, buyers will have to bid a higher price for this stock to match the ask price from the seller which will increase the stock price of ABC Co. Ltd. On the contrary, if there are more sellers than buyers (i.e. high supply and low demand) for the stock of ABC Co. Ltd. Inthe market, its price will fall down. In earlier times, buyers and sellers used to assemble at stock exchanges to make a transaction but now with the dawn of IT, most of the operations are done electronically and the stock markets have become almost paperless. Now investors dont have to gather at the Exchanges, and can trade freely from their home or office over the phone .

TYPES OF STOCK MARKET

There are two types of stock market 1. Primary market - The primary market is the place where the shares are issued for the first time. So when a company is getting listed for the first time at the stock exchange and issuing shares this process is undertaken at the primary market. That means the process of the Initial Public Offering or IPO and the debentures are controlled at the primary stock market. 2. Secondary market - The secondary market is the stock market where existing stocks are brought and sold by the retail investors through the brokers. It is the secondary market that controls the price of the stocks. Generally when we speak about investing or trading at the stock market we mean trading at the secondary stock market. It is the secondary market where we can invest and trade in the stocks to get the profit from our stock market investment.

A STOCK EXCHANGE is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and dividends. Securities traded on a stock exchange include shares issued by companies, unit trusts, derivatives, pooled investment products and bonds. To be able to trade a security on a certain stock exchange, it must be listed there. Usually, there is a central location at least for record keeping, but trade is increasingly less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of increased speed and reduced cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets is driven by various factors that, as in all free markets, affect the price of stocks . There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or overthe-counter. This is the usual way that derivatives and bonds are traded. Increasingly, stock exchanges are part of a global market for securities.

STOCK EXCHANGE IN INDIA

BOMBAY STOCK EXCHANGE 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 an evolved over the years into its present status as the premiere stock exchange in the country. It may be noted that the stock exchanges the oldest one in Asia, even older than the Tokyo Stock exchange which was founded in 1878. The exchange, while providing an efficient and transparent market for trading in securities, upholds the interests of the investors and ensures redressed of their grievances, whether against the companies or its own member brokers. It also strives to educate and enlighten the investors by making available necessary informative inputs and conducting investor education programmes. A governing board comprising of 8 elected directors, 3 SEBI nominees, 4 public representatives and an executive director is the apex body, which decides the policies and regulates the affairs of the exchange. The Executive director as the chief executive officer is responsible for the day today administration of the exchange. NATIONAL STOCK EXCHANGE The NSE was incorporated in Nov 1992 with an equity capital of Rs. 25 crs. The International securities consultancy (ISC) of Hong Kong has helped in setting up NSE. ISC has prepared the detailed business plans and installation of hardware and software systems. The promotions for NSE were financial institutions, insurances companies, banks and SEBI capital market ltd, Infrastructure leasing and financial services ltd and stock holding corporation ltd. It has been set up to strengthen the move towards professionalization of the capital market as well as provide nation wide securities trading facilities to investors. NSE is not an exchange in the traditional sense where brokers own and manage the exchange. A two tier administrative set up involving a company board and a governing aboard of the exchange is envisaged. NSE is a national market for shares PSU bonds, debentures and government securities since infrastructure and trading facilities are provided.

HISTORY
OF LSE

LUDHIANA STOCK EXCHANGE The Ludhiana Stock Exchange Limited was established in 1981, by Sh. S.P. Oswal of Vardhman Group and Sh. B.M. Lal Munjal of Hero Group, leading industrial luminaries, to fulfill a vital need of having a Stock Exchange in the region of Punjab, Himachal Pradesh, Jammu & Kashmir and Union Territory of Chandigarh. Since its inception, the Stock Exchange has grown phenomenally. The Stock Exchange has played an important role in channelizing savings into capital for the various industrial and commercial units of the State of Punjab and other parts of the country. The Exchange has facilitated the mobilization of funds by entrepreneurs from the public and thereby contributed in the overall, economic, industrial and social development of the States under its jurisdiction. Ludhiana Stock Exchange is one of the leading Regional Stock Exchange and has been in the forefront of other Stock Exchange in every spheres, whether it is formation of subsidiary for providing the platform of trading to investors, for brokers etc. in the era of Screen based trading introduced by National Stock Exchange and Bombay Stock Exchange, entering into the field of Commodities trading or imparting education to the Public at large by way of starting Certification Programmes in Capital Market. The vision and mission of Stock Exchange is: "Reaching small investors by providing services relating to Capital Market including Trading, Depository Operations etc and creating Mass Awareness by way of education and trading in the field of capital market. To create educated investors and fulfilling the gap of skilled work force in the domain in Capital Market." Further, the Exchange has 295 members out of which 162 are registered with National Stock Exchange as Sub-brokers and 121 with Bombay Stock Exchange as sub-brokers through our subsidiary.

GOVERNANCE AND MANAGEMENT LSE has a strong governance and administration, which encompasses a right balance of Industry Experts with highest level educational background, practicing professionals and independent experts in various fields of Financial Sector. The administration is presently headed by Sr. General Manager CUM Company Secretary and team of persons having indepth knowledge of Secretarial, Legal and Education & Training. The Governing Board of our Exchange comprises of eleven members, out of which two are Public Interest Directors, who are eminent persons in the fields of Finance and Accounts, Education, Law, Capital Markets and other related fields, Six are Shareholder Directors, and Three are Broker Member Director and the Exchange has four Statutory Committees namely Disciplinary Committee, Arbitration Committee, Defaults Committee and Investor Services Committee. In addition, it has advisory and standing committees to assist the administration. LSE has a Code of Conduct in place that governs the elected Board Members and the Senior Management Team. The same is monitored through periodic disclosure procedures. The Exchange has an Ethics Committee, which looks into any issue of conflict of interest and has in place general code of conduct for the Senior Officials. The composition of the Governing Board is as under:Sr. No. 1 2 3 4 5 6 7 8 9 10 11 7

12 STRENTHS OF LUDHIANA STOCK EXCHANGE LSE brand is popular among masses. The brand image of LSE can be capitalized. Requisite infrastructure for the Capital Market activities which includes a multi-storied, centrally air conditioned building situated in the financial hub of the city i.e. Feroze Gandhi Market. Well experienced staff handling operations of Stock Exchange. Competent Board and professional management. Much needed networking of sub brokers in the entire region, who are having rich experience in Stock Market operations for the last 25 years. More than 40,000 clients spread across Punjab, Himachal Pradesh, Jammu & Kashmir and adjoining areas of Haryana and Rajasthan. The turnover of our subsidiary is the highest amongst all subsidiaries of Regional Stock Exchanges in India. LISTING OF COMPANIES AT LUDHIANA STOCK EXCHANGE At present, Ludhiana Stock Exchange has 330 listed companies, out of which 214 are regional and 116 are Non-regional. The total listed capital of aforesaid companies is Rs. 3168.91 Crores app. The market capitalization of the said companies is more than Rs. 3372.34 crores. The Stock Exchange is covering the vast investor base through the listing of above said companies, which are situated in the region comprising of Punjab, Himachal Pradesh, Jammu & Kashmir, and Chandigarh. Despite the fact, the implementation of SEBI (Delisting of Securities) guidelines, 2003 has resulted into the Delisting of good companies listed at Exchange, however still there are leading Companies listed with our Exchange, notable among them are United Breweries Limited, Vardhman Acrylics Limited, SMC global securities limited, Himachal Futuristic Communications Limited etc. Ludhiana Stock Exchange has facilitated the capital generation for Name of Director Prof. Padam Parkash Kansal Sh. Joginder Kumar Sh. Rajinder Mohan Singla Sh. Satish Nagpal Sh. Vikas Batra Sh. Varun Chhabra 8

Dr. Raj Singh Sh. Ashwani Kumar Sh. V.P. Gaur Sh. Jaspal Singh Sh. Sunil Gupta Sh. Sanjay Anand Category Chairman (Shareholder Director) Vice Chairman (Shareholder Director) Shareholder Director Shareholder Director Shareholder Director Shareholder Director Registrar of Companies (Public Interest Director) Public Interest Director Public Interest Director Trading member Director Trading Member Director Trading member Director agro based industries as Punjab is a agricultural led economy. It will continue to do so, once it gets approval for a tie up with bigger Exchanges for commencing trading operations. INVESTORS RELATED SERVICES The Exchange has been providing a variety of services for the benefit of investing public. The services include Investor Service Centers, Investor Protection fund and Investor Educational Seminars. (i).Investor Service Centers The Exchange has set-up Investor Service Centers at various DP branches of its subsidiary for providing information relating to Capital Market to the general public. The Centers subscribe to leading economic, financial dailies and periodicals. They also store the Annual Reports of the companies listed at the Stock Exchange. The Investor Service Centers are also equipped with a Terminal for providing live rates of trading at NSE and BSE. A large number of the investors 9

visit the centers to utilize the services being provided by the Exchange. (ii).Investor Awareness Seminars The Exchange has been organizing Investor Awareness Seminars for the benefit of Investors of the region comprising State of Punjab, Himachal Pradesh, Jammu & Kashmir, Chandigarh and adjoining areas of Haryana and Rajasthan. This massive exercise of organizing Investor Awareness Seminars has been launched as a part of Securities Market Awareness Campaign launched by SEBI in January, 2003. The Exchange apprises the investors about Dos and Donts to be observed while dealing in Securities Market. Till date, Exchange has organized more than 200 workshops in the region mentioned above. (iii).Website of the Exchange: www.lse.co.in The Exchange has its own website with the domain name www.lse.co.in. The website provides valuable information about the latest market commentary, research reports about companies, daily status of International markets, a separate module for Internet trading, information about listed companies and brokers and sub-brokers of the Exchange and its subsidiary. The website also contains many useful links on portfolio management, investor education, frequently asked questions about various topics relating to Primary and Secondary Market, information about Mutual Funds, Financials of the Company including Quarterly Results, Share Prices, Profit and Loss Accounts, Balance Sheet and Many More. The website also contains daily Technical Charts of various scrips being traded in BSE and NSE.

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HISTORY OF DERIVATIVES

The history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardized

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around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today. Derivatives have had a long presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Since then contracts on various other commodities have been introduced as well. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges. The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 227 securities stipulated by SEBI. With the opening of the economy to multinationals and the adoption of the liberalized economic policies, the economy is driven more towards the free market economy. The complex nature of financial structuring itself involves the utilization of multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk, economic risk and political risk. With the integration of the financial markets and free mobility of capital, risks also multiplied. For instance, when countries adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates. Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk of default or counter party risk. Apart from it, every assetwhether commodity or metal or share or currencyis subject to depreciation in its value . It may be due to certain inherent factors and external factors like the market condition, Governments policy, economic and political condition prevailing in the country and so on. In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets In this context, derivatives occupy an important place as risk reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In fact, the financial service companies can play a very dynamic role in dealing with such risks. They can ensure

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that the above risks are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to the financial service companies. This really protects the clients from unforeseen risks and helps them to get there due operating profits or to keep the project well within the budget costs. To hedge the various risks that one faces in the financial market today, derivatives are absolutely essential.

INTRODUCTION TO DERIVATVES

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Derivatives are defined as financial instruments whose value derived from the prices of one or more other assets such as equity securities, fixed-income securities, foreign currencies, or commodities. Derivatives are also a kind of contract between two counterparties to exchange payments linked to the prices of underlying assets. Derivative can also be defined as a financial instrument that does not constitute ownership, but a promise to convey ownership. Examples are options and futures. The simplest example is a call option on a stock. In the case of a call option, the risk is that the person who writes the call (sells it and assumes the risk) may not be in business to live up to their promise when the time comes. In standardized options sold through the Options Clearing House, there are supposed to be sufficient safeguards for the small investor against this. Derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that

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have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance.

Example Suppose you have a home of Rs. 50, 00,000. You insure this house for premium of Rs 15000 (It is a very risky house!) Now you think about policy (ignoring the house) as an investment. Suppose the house is fine after 1 year. You have lost the premium of Rs 15000. Suppose your house is fully damaged and broken in one year . You receive Rs 50,00,0000 on just paying premium of Rs 15,000.If you have bought insurance of any sort you have bought an option. Option is one type of a derivative. Derivatives are usually broadly categorized by: the relationship between the underlying asset and the derivative (e.g., forward, option,); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile.

ROLE OF DERIVATIVES:

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Derivative markets help investors in many different ways: 1. RISK MANAGEMENT Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised. Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk, can transfer some of that risk to a person who wants to take more risk. Consider a riskaverse individual. He can obviously reduce risk by hedging. When he does so, the opposite position in the market may be taken by a speculator who wishes to take more risk. Since people can alter their risk exposure using futures and options, derivatives markets help in 16

the raising of capital. As an investor, you can always invest in an asset and then change its risk to a level that is more acceptable to you by using derivatives. 2. PRICE DISCOVERY Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset.

3. OPERATIONAL ADVANTAGES As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.

4. MARKET EFFICIENCY The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.

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SCOPE OF DERIVATIVES IN INDIA

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In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But, it has not yet received the necessary permission from the securities and Exchange Board of India. In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committees report was already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible. These are always between two parties and one among them is always a financial intermediary. However, there should be proper legislations for the effective implementation of derivative contracts. The utility of derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of

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financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions. Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since derivates are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market. Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index-based derivative products rather than security based derivative products. There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day. Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users

ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

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In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions. 1. 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 derivatives 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. 2. 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. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trade volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.

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5. 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. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Based on the survey results, the authors identified some important policy issues such as the need to bring in more institutional participation to make the derivative market in India more efficient and to bring it in line with the best practices. Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.

DERIVATIVES INSTRUMENTS

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A) Forward Contract
There are no sure things in global markets. Deals that looked good six months ago can quickly turn sour if unforeseen economic and political developments trigger fluctuations in exchange rates or commodity prices Over the years traders have developed tools to cope with these uncertainties. One of this tool is the forward agreements A contract that commits one party to buy and other to sell a given quantity of an asset for fixed price on specified future date. In Forward Contracts one of the parties assumes a long position and agrees to buy the underlying asset at a certain future date for a certain price. The specified price is called the delivery price. The contract terms like delivery price, quantity are mutually agreed upon by the parties to contract. No margins are generally payable by any of the parties to the other.

Features of Forward Contract

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1. It is negotiated contract between two parties i.e. Forward contract being a bilateral contracts, hence exposed to counterparty risk. 2. Each Contract is custom designed and hence unique in terms of contract size, expiration date, asset quality, asset type etc. 3. Contract has to be settled in delivery or cash on expiration date 4. In case one of two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command at the price he wants.

Example
A Ltd requires $500000 on May 2006 for repayment of loan installment and interest .As on December 2005 it appears to the company that the dollar may become dearer as compared to the exchange rate, prevailing on that date say. Accordingly A Ltd may enter into forward contract with banker for $500000.The Forward rate may be higher or lower than spot rate prevailing on the date of the forward contract. Let us assume forward rate as on December 2005 was 1$=Rs 44 as against spot rate of Rs 43.50. As on future i.e. May 2006 the banker will pay A Ltd $500000 at Rs 44 irrespective of the spot rate as on that date.

B) FUTURES
A Future contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. Future contracts are special type of forward contracts in the sense that the former are standardized exchange-traded contracts. A future contract is one in which one party agrees to buy from/ sell to the other party a specified asset at price agreed at the time of contract and payable on future date. The agreed price is known as strike price. The underlying asset can be commodity, currency debt, or equity. The Futures are usually performed by payment of difference between strike price and market price on fixed future date and not by the physical delivery and payment in full on that date.

Features of Future Contract

The common features of futures are: 1) Futures are exchange-traded derivatives. 2) Futures are highly standardized. 24

3) The underlying asset The particular asset as well as the quantity are specified in the futures contract. 4) The currency - The currency in which the contract is to be executed is also specified. 5) Settlement - The delivery month and the last trading date are also mentioned in the contract. 6) Futures are used for hedging, particularly in a bear market. Those who have an interest in the underlying asset can protect themselves from the risk of price changes via futures contracts. 7) Futures have lower transaction costs than other debt instruments.

MARGINS
Participants in a futures contract are required to post performance bond margins in order to open and maintain a futures position. Futures margin requirements are set by the exchanges and are typically only 2 to 10 percent of the full value of the futures contract. Margins are financial guarantees required of both buyers and sellers of futures contracts to ensure that they fulfill their futures contract obligations. Initial Margin Before a futures position can be opened, there must be enough available balance in the futures trader's margin account to meet the initial margin requirement. Upon opening the futures position, an amount equal to the initial margin requirement will be deducted from the trader's margin account and transferred to the exchange's clearing firm. This money is held by the exchange clearinghouse as long as the futures position remains open. Maintenance Margin The maintenance margin is the minimum amount a futures trader is required to maintain in his margin account in order to hold a futures position. The maintenance margin level is usually slightly below the initial margin. If the balance in the futures trader's margin 25

account falls below the maintenance margin level, he or she will receive a margin call to top up his margin account so as to meet the initial margin requirement. Variation margin If a margin call is made additional money is deposited by the investor/trader, to bring the account to level of initial margin. This amount is called variation margin. Example Let's assume we have a speculator who has Rs10000 in his trading account. He decides to buy September RIL at Rs 40 per share. Each RIL futures contract represents 1000 shares and requires an initial margin of Rs 9000 and has a maintenance margin level set at 6500. Since his account is 10000, which is more than the initial margin requirement, he can therefore open up one September RIL futures position. One day later, the price of September RIL drops to Rs38 per share. Our speculator has suffered an open position loss of Rs2000 (Rs2 x 1000 barrels) and thus his account balance drops to Rs8000. Although his balance is now lower than the initial margin requirement, he did not get the margin call as it is still above the maintenance level of Rs6500.

MARKING TO MARKET
Once a future contract is bought/sold and a contract is issued, its value with respect to market price of futures fluctuates on a daily basis. his render the owner liable to adverse changes in value, and create a credit risk to exchange. To minimize this risk, the exchange demands that contract owner pay what is known as margin. At the end of every trading day , the contract is marked to its closing market price of the future contract. If the closing price of future contract is not given , one can use the closing price of the underlying for this purpose. If the trader is on winning side of a deal, his contract is increases in value that day, and exchange become liable to a trader and his margin account is credited with differential amount. On the other hand, if he is on losing side, he may face a margin call from the exchange/broker , depending on the fall in margin account balance and in this case he is liable to exchange for difference. In this way each account is credited or debited accordingly to the settlement price on a daily basis. This is known as marking to market.

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Settlement Mechanism
Daily Mark-to-Market Settlement
The positions in the futures contracts for each member is marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous day's settlement price, as the case may be, and the current day's settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who have made a profit. This is known as daily markto-market settlement. CMs are responsible to collect and settle the daily mark to market profits / losses incurred by the TMs and their clients clearing and settling through them. The pay-in and pay-out of the mark-to-market settlement is on T+1 days (T = Trade day). The mark to market losses or profits are directly debited or credited to the CMs clearing bank account.

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Final Settlement On the expiry of the futures contracts, NSCCL marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. The final settlement of the futures contracts is similar to the daily settlement process except for the method of computation of final settlement price. The final settlement profit / loss is computed as the difference between trade price or the previous day's settlement price, as the case may be, and the final settlement price of the relevant futures contract. Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+1 day (T= expiry day). Open positions in futures contracts cease to exist after their expiration day of futures contracts on index and individual securities

PAY OFF OF FUTURES

A Pay off is the likely profit/loss that would accrue to a market participant with changes 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. Pay off for Buyer of futures: (Long futures) 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 Pay off for seller of futures: (short futures)

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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 asset in 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. Example 1 When you are dealing in March 2006 Futures Infosys the minimum market lot i.e. minimum quantity that you can buy and sell is 1000 shares of Infosys The contract would expire on 28th March 2006 The price is quoted per share the tick size is 50 paisa per share 1500*.05=Rs 75 per contract/per market lot. The contract would be settle in cash and closing price in cash market on the expiry date would be the settlement price. Example 2 On 1st September Mr. A enters into Futures contract to purchase 100 equity shares of X Ltd at an agreed price of Rs 100 in December. If on maturity date the price of equity stock rises to Rs120 Mr. A will receive Rs 20 per share and if the price of share falls to Rs 90 Mr. A will pay Rs 10 per share. As compared to forward contract the futures are settled only by the difference between the strike price and market price as on maturity date.

DISTICTION BETWEEN FORWARD AND FUTURE : The basic nature of a forward and future, in a strict legal sense, is the same, with the difference that futures are market-driven organized transactions. As they are exchangetraded, the counterparty in a futures transaction is the exchange. On the other hand, a forward is mostly an over-the-counter transaction and the counterparty is the contracting party. To maintain the stability of organized markets, market-based futures transactions are subject to margin requirements, not applicable to OTC forwards. Futures markets are normally marked to market on a settlement day, which could even be daily, whereas forward contracts are settled only at the end of the contract. So the element of credit risk is far higher in case of forward contract.

29

C) OPTIONS
Option As the name implies, trading in options involves choice Someone who invest in option is purchasing right but not the obligation, to buy or sell a specified underlying item at an agreed upon price, known as exercise price or strike price. In other words Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of certain underlying assets at a specified price on or before a specified date. On the other hand, the seller is under obligation to perform the contract (buy or sell). The underlying asset can be a share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, Soya bean, cotton, coffee etc. An option contract is a unilateral agreement in which one party, the option writer, is obligated to perform under the contract if the option holder exercises his or her option. (The option holder pays a fee or "premium" to the writer for this option.) The option holder, however, is not under any obligation and will require performance only when the exercise price is favorable relative to current market prices. If, on the one hand, prices move unfavorably to the option holder, the holder loses only the premium. If, on the other hand, prices move favorably for the option holder, the holder has theoretically unlimited gain at

30

the expense of the option writer . In an option contract the exercise price (strike price), delivery date (maturity date or expiry), and quantity and quality of the commodity are fixed.

THERE ARE TWO BASIC TYPES OF OPTIONS 1. CALL OPTION 2. PUT OPTION

1. CALL OPTION
The option that gives the buyer the right to buy is called a call option. A call option grants the holders of the contract the right, but not the obligation, to purchase a good from the writer of the option in consideration for the payment of cash (the option premium). Example: Suppose you have bought a call option of 2,000 shares of Hindustan Lever Ltd (HLL) at a strike price of Rs250 per share. This option gives you the right to buy 2,000 shares of HLL at Rs250 per share on or before March 28, 2006. The seller of this call option who has given you the right to buy from him is under the obligation to sell 2,000 shares of HLL at Rs250 per share on or before specified date say March 28, 2004 whenever asked.

31

2. PUT OPTION
The option that gives the buyer the right to sell is called a put option. A put option grants the holder the right, but not the obligation, to sell the underlying good to the option writer. Suppose you bought a put option of 2,000 shares of HLL at a strike price of Rs250 per share. This option gives its buyer the right to sell 2,000 shares of HLL at Rs250 per share on or before specified date say March 28, 2006. The seller of this put option who has given you the right to sell to him is under obligation to buy 2,000 shares of HLL at Rs250 per share on or before March 28, 2006 whenever asked.

OPTIONS CLASSIFICATIONS
Options are often classified as In the money - These result in a positive cash flow towards the investor. At the money - These result in a zero-cash flow to the investor. Out of money - These result in a negative cash flow for the investor. The following summarizes the relationship between an options strike price X and the market price S of underlying asset. Market scenario S>X S<X S=X Call Option In the money Out of the money At the money Put Option Out of the money In the money At the money

32

Consider ACC call options with a strike price of 910 and RIL put options with a strike price of 1000. let us study how the options will be In the money (ITM), At the money (ATM) and Out of the money in following scenario.

ACC Call X=910 Status

S=810

Stock Price

RIL Put X=1000 Status

S=900

Stock Price

S=910

S=1010

S=1000

S=1100

S<X OTM Will not be exercised 0

S=X ATM Will not be exercised 0

S>X ITM exercised

S>X ITM exercised

S=X ATM Will not be exercised 0

S<X OTM Will not be exercised 0

Exercis e Status Payoff

Exercis e Status Payoff

S-X

X-S

For both Call & Put : Only ITM options gives positive payoff; Only ITM Options are exercised

SETTLEMENT PROCEDURE
Settlement of options contracts on index and individual securities

Daily Premium Settlement

Premium settlement is cash settled and settlement style is premium style. The premium payable position and premium receivable positions are netted across all option contracts for each CM at the client level to determine the net premium payable or receivable amount, at the end of each day. The CMs who have a premium payable position are required to pay the premium amount to NSCCL which is in turn passed on to the members who have a premium receivable position. This is known as daily premium settlement. CMs are responsible to collect and settle for the premium amounts from the TMs and their clients clearing and settling through them. The pay-in and pay-out of the premium settlement is on T+1 day (T = Trade day). The premium payable amount and premium receivable amount are directly debited or credited to the CMs clearing bank account.

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Final Exercise Settlement

Final Exercise settlement is effected for option positions at in-the-money strike prices existing at the close of trading hours, on the expiration day of an option contract. Long positions at in-the money strike prices are automatically assigned to short positions in option contracts with the same series, on a random basis. For index options contracts and options contracts on individual securities, exercise style is European style. Final Exercise is Automatic on expiry of the option contracts. Option contracts, which have been exercised, shall be assigned and allocated to Clearing Members at the client level. Exercise settlement is cash settled by debiting/ crediting of the clearing accounts of the relevant Clearing Members with the respective Clearing Bank. Final settlement loss/ profit amount for option contracts on Index is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Final settlement loss/ profit amount for option contracts on Individual Securities is debited/ credited to the relevant CMs clearing bank account on T+1 day (T = expiry day). Open positions, in option contracts, cease to exist after their expiration day. The pay-in / pay-out of funds for a CM on a day is the net amount across settlements and all TMs/ clients, in F&O Segment.

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PAY OFF IN OPTIONS

CALL OPTIONS (PAY OFF)

A brought 1 Lot of HUL that is 1000, with the strike price for 250 paid 2.9 Premium Per Share. Settlement Price is 263.5 Buyers Pay OFF: Spot price Strike price Amount Premium Paid (-) 263.5 250.00 13.5 2.9

35

Net Profit

10.6*1000=10600

Buyer Profit = Rs 10600(Net Amount) Because it is positive it is IN THE MONEY contract, SELLERS PAY OFF: It is in the money for the buyer, so it is out of the money for seller , hence his loss is also increases. Strike price Spot price Amount Premium Received Loss 263.5 250.00 -13.5 2.9 -10.6*1000=-10600

Seller loss = Rs -10600(Loss) Because it is negative it is out of the money, hence seller will get more loss,

Illustration 2: An investor buys one European Call option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the contract matures on 30 September . The payoffs for the investor on the basis of fluctuating spot prices at any time are shown by the payoff table (Table 1). It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.
S Xt c Payoff Net Profit

57 58 59 60

60 60 60 60

2 2 2 2

0 0 0 0

-2 -2 -2 -2 36

61 62 63 64 65 66

60 60 60 60 60 60

2 2 2 2 2 2

1 2 3 4 5 6

-1 0 1 2 3 4

A European call option gives the following payoff to the investor: max (S - Xt, 0). The seller gets a payoff of: -max (S - Xt,0) or min (Xt - S, 0). Notes: S - Stock Price Xt - Exercise Price at time 't' C - European Call Option Premium Payoff - Max (S - Xt, O )

GRAPH

Exercising the Call Option and what are its implications for the Buyer and the Seller? The Call option gives the buyer a right to buy the requisite shares on a specific date at a specific price. This puts the seller under the obligation to sell the shares on that specific date and specific price. The Call Buyer exercises his option only when he/ she feels it is 37

profitable. This Process is called "Exercising the Option". This leads us to the fact that if the spot price is lower than the strike price then it might be profitable for the investor to buy the share in the open market and forgo the premium paid. The implications for a buyer are that it is his/her decision whether to exercise the option or not. In case the investor expects prices to rise far above the strike price in the future then he/she would surely be interested in buying call options. On the other hand, if the seller feels that his shares are not giving the desired returns and they are not going to perform any better in the future, a premium can be charged and returns from selling the call option can be used to make up for the desired returns. At the end of the options contract there is an exchange of the underlying asset. In the real world, most of the deals are closed with another counter or reverse deal. There is no requirement to exchange the underlying assets then as the investor gets out of the contract just before its expiry.

PUT OPTION (PAY OFF)

B purchased a 1 lot of HUL that is 1000, with strike price for Rs 250, the premium payable is 20.25 spot market price enclosed at 268.4 BUYERS PAY OFF: Strike Price 250 Spot price 268.4

Net Pay Off -18.4*1000=-18400 Already Premium paid is 20.25 per share So, he get loss up to Rs 18400 Because it is negative, out of the money contract, hence buyer gets more loss. SELLERS PAY OFF:

38

As seller is entitled only for premium so, if he is in profit and also seller has to get total profit . Spot Price Strike Price Net Pay off 268.5 250.0 18.4*1000=18400

Already Premium Received 20.25 So, he can get profit up to Rs 18400 Because it is positive, in the money Contract, hence seller gets more profit. Illustration 2: An investor buys one European Put Option on one share of Reliance Petroleum at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The payoff table shows the fluctuations of net profit with a change in the spot price.
S Xt Payoff from Put Buying/Long (Rs.) p Payoff Net Profit

55 56 57 58 59 60 61 62 63 64

60 60 60 60 60 60 60 60 60 60

2 2 2 2 2 2 2 2 2 2

5 4 3 2 1 0 0 0 0 0

3 2 1 0 -1 -2 -2 -2 -2 -2

The payoff for the put buyer is :max (Xt - S, 0) The payoff for a put writer is : -max(Xt - S, 0) or min(S - Xt, 0)
GRAPH

39

SUMMARY OF OPTIONS

Call option buyer Pays premium Right to exercise and buy the share Profits from rising prices

Call option writer (seller) Receives premium Obligation to sell shares if exercised Profits from falling prices or remaining neutral Limited losses, potentially unlimited gain Potentially unlimited losses, limited gain Put option buyer Put option writer (seller) Pays premium Receives premium Right to exercise and sell shares Obligation to buy shares if exercised Profits from falling prices Profits from rising prices or remaining neutral

Limited losses, potentially unlimited gain

Potentially unlimited losses, limited gain

40

DIFFERENCE BETWEEN FUTURES & OPTION:

FUTURES 1) Both the parties are obligated to perform. 2) With futures premium is paid by either party.

OPTIONS 1) Only the seller (writer) is obligated to perform. 2) With options, the buyer pays the seller a premium.

3) The parties to futures contracts must perform at 3) The buyer of an options contract can exercise any the settlement date only. They are not obligated to time prior to expiration date. perform before that date. 4) The holder of the contract is exposed to the entire 4) The buyer limits the downside risk to the option

41

spectrum of downside risk and had the for all upside return.

potential premium but retain the upside potential.

5 5) In futures margins to be paid. They are ) In options premiums to be paid. But they are very less approximate 15-20% on the current stock price. as compared to the margins.

Contract Specifications
Parameter Underlying Security Descriptor: Instrument Underlying Symbol Index Futures 5 indices Index Options 5 indices Futures on Options on Individual Securities Individual Securities 230 securities 230 securities OPTSTK FUTIDX OPTIDX FUTSTK

Symbol of Underlying Symbol of Underlying Symbol of Underlying Symbol of Underlying Index Index Security Security

42

Expiry Date Option Type Strike Price Trading Cycle

DD-MMM-YYYY -

DD-MMM-YYYY CE / PE Strike Price

DD-MMM-YYYY -

DD-MMM-YYYY CE / PE Strike Price

3 month trading cycle - the near month (one), the next month (two) and the far month (three)

Expiry Day

Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry day is the previous trading day. Depending on underlying price Underlying specific Rs.0.05 Depending on underlying price Underlying specific Rs.0.05 A contract specific price range based on its delta value is computed and updated on a daily basis

Strike Price Intervals

Permitted Lot Size Underlying specific Price Steps Rs.0.05

Underlying specific Rs.0.05

Price Bands

A contract specific price range based on Operating range of Operating range of its delta value is 10% of the base price 20% of the base price computed and updated on a daily basis

Business Growth in FO Segment

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Index Futures Year No. of contracts 201112 201011 200910 200809 200708 200607 200506 200405 200304 200203 200102 200001 Turnover ( cr.)

Stock Futures

Index Options Notional Turnover ( cr.) 8193453.97 18365365.76 8027964.20 3731501.84 1362110.88 791906 338469 121943 52816 9246 3765 -

Stock Options Notional Turnover ( cr.) 323075.82 1030344.21 506065.18 229226.81 359136.55 193795 180253 168836 217207 100131 25163 -

Total Average Daily Turnover ( cr.)

No. of contracts

Turnover ( cr.)

No. of contracts

No. of contracts

No. of contracts

Turnover ( cr.)

48883256 165023653 178306889 210428103 156598579 81487424 58537886 21635449 17191668 2126763 1025588 90580

1274890.73 4356754.53 3934388.67 3570111.40 3820667.27 2539574 1513755 772147 554446 43952 21483 2365

56657526 186041459 145591240 221577980 203587952 104955401 80905493 47043066 32368842 10676843 1957856 -

1496766.68 5495756.70 5195246.64 3479642.12 7548563.23 3830967 2791697 1484056 1305939 286533 51515 -

293007790 650638557 341379523 212088444 55366038 25157438 12935116 3293558 1732414 442241 175900 -

11701581 32508393 14016270 13295970 9460631 5283310 5240776 5045112 5583071 3523062 1037529 -

410250153 1034212062 679293922 657390497 425013200 216883573 157619271 77017185 56886776 16768909 4196873 90580

11288187.08 29248221.09 17663664.57 11010482.20 13090477.75 7356242 4824174 2546982 2130610 439862 101926 2365

121378.36 115150.48 72392.07 45310.63 52153.30 29543 19220 10107 8388 1752 410 11

44

PARTICIPANTS IN THE DERIVATIVES MARKET:

45

The participants in the derivatives market are as follows: TRADING PARTICIPANTS: 1. HEDGERS The process of managing the risk or risk management is called as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximizing of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk. 2. SPECULATORS Speculators do not have any position on which they enter into futures and options Market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency. They consider various factors like demand and supply, market positions, open interests, economic fundamentals, international events, etc. to make predictions. They take risk in turn from high returns. Speculators are essential in all markets commodities, equity, interest rates and currency. They help in providing the market the much desired volume and liquidity. 3. ARBITRAGEURS Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary. Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly well-informed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed. INTERMEDIARY PARTICIPANTS: 4. BROKERS For any purchase and sale, brokers perform an important function of bringing buyers and sellers together. As a member in any futures exchanges, may be any commodity or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange. This transaction can be in the pit of the trading hall or on online computer terminal. All persons hedging their transaction exposures or speculating on price movement

46

, need not be and for that matter cannot be members of futures or options exchange. A nonmember has to deal in futures exchange through member only. This provides a member the role of a broker. His existence as a broker takes the benefits of the futures and options exchange to the entire economy all transactions are done in the name of the member who is also responsible for final settlement and delivery. This activity of a member is price risk free because he is not taking any position in his account, but his other risk is clients default risk. He cannot default in his obligation to the clearing house, even if client defaults. So, this risk premium is also inbuilt in brokerage recharges. More and more involvement of non- members in hedging and speculation in futures and options market will increase brokerage business for member and more volume in turn reduces the brokerage. Thus more and more participation of traders other than members gives liquidity and depth to the futures and options market. Members can attract involvement of other by providing efficient services at a reasonable cost. In the absence of well functioning broking houses, the futures exchange can only function as a club. INSTITUTIONAL FRAMEWORK: 5. EXCHANGE Exchange provides buyers and sellers of futures and option contract necessary infrastructure to trade. In outcry system, exchange has trading pit where members and their representatives assemble during a fixed trading period and execute transactions. In online trading system, exchange provide access to members and make available real time information online and also allow them to execute their orders. For derivative market to be successful exchange plays a very important role, there may be separate exchange for financial instruments and commodities or common exchange for both commodities and financial assets. 6. CLEARING HOUSE A clearing house performs clearing of transactions executed in futures and option exchanges. Clearing house may be a separate company or it can be a division of exchange. It guarantees the performance of the contracts and for this purpose clearing house becomes counter party to each contract. Transactions are between members and clearing house. Clearing house ensures solvency of the members by putting various limits on him. Further, clearing house devises a good managing system to ensure performance of contract even in volatile market. This provides confidence of people in futures and option exchange. Therefore, it is an important institution for futures and option market. 7. BANK FOR FUND MOVEMENTS Futures and options contracts are daily settled for which large fund movement from members to clearing house and back is necessary. This can be smoothly handled if a bank works in association with a clearing house. Bank can make daily accounting entries in the accounts of members and facilitate daily settlement a routine affair. This also reduces a possibility of any fraud or misappropriation of fund by any market intermediary.

47

8. REGULATORY FRAMEWORK A regulator creates confidence in the market besides providing Level playing field to all concerned, for foreign exchange and money market, RBI is the regulatory authority so it can take initiative in starting futures and options trade in currency and interest rates. For capital market, SEBI is playing a lead role, along with physical market in stocks, it will also regulate the stock index futures to be started very soon in India. The approach and outlook of regulator directly affects the strength and volume in the market. For commodities, Forward Market Commission is working for settling up national National Commodity Exchange.

48

REGULATORY FRAMEWORK OF DERIVATIVES MARKET IN INDIA

With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading 49

environment, safety & integrity and provide facilities for redressal of investor grievances. Some of the important eligibility conditions areo o

o o o

o o

Derivative trading to take place through an on-line screen based Trading System. The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation. The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country. The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country. The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading. The Derivative Segment of the Exchange would have a separate Investor Protection Fund. The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades. The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both. The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days. The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments. In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions. The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients margin money in trust for the client purposes only and should not allow its diversion for any other purpose. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment.

50

Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE. Membership categories in the derivatives market The various types of membership in the derivatives market are as follows:
o o

Trading Member (TM) A TM is a member of the derivatives exchange and can trade on his own behalf and on behalf of his clients. Clearing Member (CM) These members are permitted to settle their own trades as well as the trades of the other non-clearing members known as Trading Members who have agreed to settle the trades through them. Self-clearing Member (SCM) A SCM are those clearing members who can clear and settle their own trades only.

Requirements to be a member of the derivatives exchange/ clearing corporation

o

Balance Sheet Net worth Requirements: SEBI has prescribed a net worth requirement of Rs. 3 crores for clearing members. The clearing members are required to furnish an auditor's certificate for the net worth every 6 months to the exchange. The net worth requirement is Rs. 1 crore for a self-clearing member. SEBI has not specified any net worth requirement for a trading member. Liquid Net worth Requirements: Every clearing member (both clearing members and self-clearing members) has to maintain at least Rs. 50 lakhs as Liquid Net worth with the exchange / clearing corporation. Certification requirements: The Members are required to pass the certification programme approved by SEBI. Further, every trading member is required to appoint at least two approved users who have passed the certification programme . Only the approved users are permitted to operate the derivatives trading terminal.

Requirements for a Member with regard to the conduct of his business

The derivatives member is required to adhere to the code of conduct specified under the SEBI Broker Sub-Broker regulations. The following conditions stipulations have been laid by SEBI on the regulation of sales practices:
o

Sales Personnel: The derivatives exchange recognizes the persons recommended by the Trading Member and only such persons are authorized to act as sales personnel of the TM. These persons who represent the TM are known as Authorized Persons. Know-your-client: The member is required to get the Know-your-client form filled by every one of client.

51

Risk disclosure document: The derivatives member must educate his client on the risks of derivatives by providing a copy of the Risk disclosure document to the client. Member-client agreement: The Member is also required to enter into the Member-client agreement with all his clients.

Lot size of a contract Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

52

CONCLUSION

53

Derivative securities markets play an important role by allowing investors who do not want the risks associated with holding an asset to transfer it to those who do. However, because they are markets for risk as opposed to physical assets, derivatives markets can be very dangerous places for unsophisticated investors. People who reduce their risk by entering a derivative market are called hedgers, and those who increase their risk are called speculators. The derivative securities markets play a vital role in the modern financial systems, and without them many common business transactions would be rendered much riskier or practically impossible.

54

BIBLOGRAPHY

55

1. www.mbaknol.com/business-finance 2. www.nseindia.com 3. www.sebi.gov.in/ 4. www.sebi.gov.in/acts/SecuritiesContractAct.html 5. www.bseindia.com/ 6. www.derivativesindia.com 6. John C. Hull (2011), Options, Futures and Other Derivatives, Pearson Education, 8th Edition 7. Chiara Oldani, 2005. Chiara Oldani, 2005. "An Overview of the Literature about Derivatives," 8. Mehraj Mattoo (1997), Structured Derivatives: New Tools for Investment Management

56

ANNEXURE

57

Glossary
Bears Those who believe stock prices will decline. A bear market is one in which prices trend downward. Bid The bid is the highest price a buyer will pay for a security; the offer is the lowest price at which a security is offered by sellers. Bulls Those who believe the market will rise. A bull market is rising. Exercise Price The exercise price is the price at which a call's (put's) buyer can buy (or sell) the underlying instrument Spot price The price in the cash market for delivery using the standard market convention Strike Price The price at which the holder of a derivative contract exercises his right if it is economic to do so at the appropriate point in time as delineated in the financial product's contract. Primary Markets The primary exchange on which a listed stock trades . Derivative Security A financial security whose value is determined in part from the value and characteristics of another security, the underlying security . Exercise

58

To implement the right under which the holder of an option is entitled to buy (in the case of a call) or sell (in the case of a put) the underlying security. Exercise Settlement Amount The difference between the exercise price of the option and the exercise settlement value of the index on the day an exercise notice is tendered, multiplied by the index multiplier. Expiration Cycle An expiration cycle relates to the dates on which options on a particular underlying security expire. A given option, other than LEAPS, will be assigned to one of three cycles, the January cycle, the February cycle or the March cycle. At any point in time, an option will have contracts with four expiration dates outstanding, the two near-term months and two further-term months. Expiration Date The day in which an option contract becomes void . All holders of options must indicate their desire to exercise, if they wish to do so, by this date. Expiration Time The time of day by which all exercise notices must be received on the expiration date. Hedge A conservative strategy used to limit investment loss by effecting a transaction which offsets an existing position. Holder The purchaser of an option . Clearing Member Clearing Member means a Member of the Clearing Corporation. Contract Month Contract month means the month in which a contract is required to be finally settled. 59

Derivatives Contract A contract that derives its value from the prices of underlying securities . Expiration Day The day on which the final settlement obligation are determined in a Derivatives Contract . Futures Contract Means a firm contractual agreement to buy or sell the underlying security in the future. Last Trading Day Means the day up to and on which a Derivatives Contract is available for trading. Long Position Long Position in a Derivatives contract means outstanding purchase obligations in respect of a permitted derivatives contract at any point of time. Open Position Open position means the sum of long and short positions of the Member and his constituent in any or all of the Derivatives Contracts outstanding with the Clearing Corporation. Open Interest Open Interest means the total number of Derivatives Contracts of an underlying security that have not yet been offset and closed by an opposite Derivatives transaction nor fulfilled by delivery of the cash or underlying security or option exercise. For calculation of Open Interest only one side (either the long or the short) of the Derivatives Contract is counted. Options Contract Options Contract is a type of Derivatives Contract, which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell 60

the underlying security at a predetermined price within or at end of a specified period. The option contract that gives a right to buy is called a Call Option and the option contract that gives a right to sell is called a Put Option. Option Holder Option Holder means a Trading Member who is the buyer of the Options Contracts. Option Writer Option Writer means a Trading Member who is the seller of the Options Contracts. Outstanding Obligation Means the obligation which has neither been closed out nor been settled. Market Lot Means the number of units that can be bought or sold in a specified derivatives contract and it is also termed as Contract Multiplier. Settlement Date Means the date on which the settlements of outstanding obligations in a permitted Derivatives contract are required to be settled. Short Position Short position in a derivatives contract means outstanding sell obligations in respect of a permitted derivatives contract at any point of time. Trading cycle Trading cycle means the period during which the derivatives contract will be available for trading. Trading Member Trading Member is a member of Derivative Exchange. Underlying Securities 61

Means a security with reference to which a derivatives contract is permitted to be traded on the Futures & Options segment of the Exchange from time to time Contract Size It is the value of the contract at a specific level of Index. It is Index level * Multiplier. Multiplier It is a pre-determined value, used to arrive at the contract size. It is the price per index point. Contract Month It is the month in which the contract will expire. Volume Number of contracts traded during a specific period of time - During a day, during a week or during a month.

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